<2.11.1 PRODUCTION, REVENUE, COSTS & PROFIT THEORY>

--THINK AHEAD--

"If someone asked you today what your capacity for learning is, you'd think about your current knowledge—that's your short-run production limit. All you can do is study harder. But if they asked what it could be in a year, that's the long run—where you can take whole new subjects, change your major, and completely rebuild your intellectual 'factory'."

--SHORT-RUN THEORY--

-DEFINITION: THE SHORT RUN-

As we already learned production of any type requires FOUR FACTORS OF PRODUCTION: LAND, LABOUR, CAPITAL, and ENTERPRISE.
The 'SHORT-RUN' is a TIME PERIOD during which at least ONE OF THESE FACTORS OF PRODUCTION (INPUT) IS FIXED IN QUANTITY/QUALITY, while the other factors remain VARIABLE, and can easily be changed in quantity/quality at very short notice.
In order to illustrate this and the related concepts that follow, we will use the example of a BUBBLE TEA SHOP.
So we can say that in the short-run as this shop produces more tea, and its need for more factors grows, it can easily hire more workers and increase the number of cups and raw materials it has to accommodate greater output, but it cannot quickly change the size of its workspace and therefore, as at least one factor is fixed the shop is said to be operating in the short run.
Furthermore, if we assume that businesses always intend to grow, we can rename the short run as the 'PLANNING PERIOD' that occurs before you can change all factors (E.g Move to a bigger shop in 5 yrs?), however once that planning period is reached we once again have fixed factors thus we are back in the short-run.

--REVENUE THEORY--

-DEFINITIONS/FORMULAS-

--REVENUES are PAYMENTS firms receive when they sell their goods and services

TOTAL REVENUE (TR) = P × Q

MARGINAL REVENUE (MR) = ΔTR / ΔQ

AVERAGE REVENUE (AR) = TR / Q

AVERAGE REVENUE is always = PRICE

-CURVES WITH NO MARKET POWER-

D = AR = MR

A firm WITH NO MARKET POWER has to accept the market price and has NO DESIRE TO SELL MORE BY LOWERING ITS PRICE, nor THE ABILITY TO SELL LESS BY RAISING ITS PRICE, hence if it ALWAYS RECEIVES THE SAME PRICE each time then the following must be true:

--P * Q = TR therefore TR/Q = P = AR--

We know now that MR = ΔTR --

--So, If P is always the same,...

....revenue for every sale = ΔTR = P = AR--

-- ∴ MR = ΔTR --

-- ∴ MR = AR = P --

-EXCEL TASK-

PLOT THE TR, MR & AR CURVES

(1) Open up a blank Excel sheet and copy the table below into it.
(2) DO NOT include the second column.
(3) Now select the entire table and go to the 'INSERT' tab.
(4) Choose the 'Scatter with smooth lines' chart.
(5) Explain the shape & slope of the TR curve.
(6) Explain the relationship between MR, AR, and price (P).

-CURVES WITH MARKET POWER-

D = AR ≠ MR

A firm WITH MARKET POWER doesn't have to accept the market price and has THE ABILITY TO SELL MORE BY LOWERING ITS PRICE, or THE ABILITY TO SELL LESS BY RAISING ITS PRICE.
In order to sell an additional unit, the price (‘AR’) must fall, however, the change in TR (‘MR’) does not change only by this new price, as all other units sold are now at this new lower price so there is a loss of revenue for each of these units, therefore, the MR = AR minus this loss. Hence MR will always be less than AR
Eventually

-EXCEL TASK-

PLOT THE TR, MR & AR CURVES

(1) Open up a blank Excel sheet and copy the table below into it.

(2) DO NOT include the second column.

(3) Now select the entire table and go to the 'INSERT' tab.

(4) Choose the 'Scatter with smooth lines' chart.

(5) Explain the shape & slope of the TR curve.

(6) Explain the relationship between MR, AR, and price (P).

--PRODUCT THEORY--

"So far we have covered revenue theory; now let's look at product theory, which we will see later has a direct impact on cost theory and the associated curves."

-PRODUCT FORMULA-

-- TOTAL PRODUCT (TP) = TOTAL Q. OF OUTPUT --

-- AVERAGE PRODUCT (ATC) = TP / ΔVAR. FACTOR --

-- MARGINAL PRODUCT (MP) = ΔTP / ΔVAR. FACTOR --

-DIMINISHING MARGINAL RETURNS-

Continuing the bubble-tea example, IN THE SHORT RUN AS THE FLOOR-SPACE IS FIXED, any increases in output can only be achieved through the CONTINUAL ADDITION OF WORKERS (THE VARIABLE FACTORS) TO THE LIMITED FLOOR-SPACE (FIXED FACTOR)
As you would expect, INITIALLY MORE WORKERS (VARIABLE FACTORS) CREATE OPPORTUNITIES FOR DIVISION OF LABOUR & SPECIALISATION, which INCREASES PRODUCTIVITY ("Two is better than one, three is better than two, and so on,.....") and therefore BOTH AP and MP RISE as each additional worker is added however, eventually there will come a combination of worker-to-floor-space at which the additional output added by the next worker will start to fall ('diminish)' CAUSING BOTH AP and MP TO FALL ('DIMINISHING RETURNS').

This type of scenario illustrates the following law.

THE LAW OF DIMINISHING MARGINAL RETURNS, states that in the SHORT-RUN, as more and more of a VARIABLE INPUT is added to FIXED INPUTS, the MARGINAL PRODUCT of the variable input, INITIALLY INCREASES, but will EVENTUALLY DIMINISH (FALL). LINK

In the following FORMULA ONE PIT-STOP EXAMPLE, this can occur due to limited space in the pit area and tire-changing and refueling equipment causing the members of the pit crew to get in each other's way or have to share equipment. Eventually, the number of successful pit stops per time period starts to diminish.
What would need to change to improve the quantity of pit stops?

-TASK-

--HOW DOES DIMINISHING RETURNS RELATE TO THIS PICTURE--

-EXCEL TASK-

(1) Open up a blank Excel sheet and copy the table below into it.
(2) Now select the entire table and go to the 'INSERT' tab.
(3) Choose the 'Scatter with smooth lines' chart.
(4) Which range of variable factors shows specialisation?
(5) At what quantity of labour shows diminishing returns?
(6) Explain the relationship between TP and MP?
(7) Explain the relationship between AP and MP?

--THINK AHEAD--

"When Elon Musk was weighing up whether to switch jobs from Tesla CEO to fish shop owner, what costs did he consider?", "Was it solely the costs of setting up and running the shop?" "Do you think there is a cost to using his labour in the shop rather than elsewhere?" "Would his decision change if the fish shop made profit?"

↓

"In the above example, you rightly recognised that a 'rational' Elon Musk would never decide to work in a fish and chip shop, not because his fish business wouldn't cover the running costs, but rather it wouldn't come close to covering the running costs + the opportunity cost of not using his labour resource in its highest-paid alternative use, namely, him earning billions (trillions??) as CEO of Tesla and more...."

--COST THEORY--

ECONOMIC COSTS

"In economics, therefore, when a rational decision involving costs is made, the 'economic cost' of the decision includes not only the explicit costs of production like raw materials, rent etc.. but also implicit opportunity costs of using resources that you already own (e.g. your own labour).

EXPLICIT COST

EXPLICIT COSTS refer to those costs that a firm incurs by EMPLOYING FACTORS OF PRODUCTION THAT YOU DON'T ALREADY OWN, for example PAYING RENT ON FACTORY SPACE THAT ISNT YOURS or PAYING YOUR STAFF WAGES...

IMPLICIT COST

IMPLICIT COSTS refer to those costs that a firm incurs by EMPLOYING FACTORS OF PRODUCTION THAT IT ALREADY OWNS, for example USING FACTORY SPACE THAT IT ALREADY OWNS or THE USE OF THEIR OWN LABOUR.
These costs are ALL OPPORTUNITY COSTS, as the USE OF THEIR OWN FACTORY SPACE means THEY FORGO RENTAL INCOME while USING THEIR OWN LABOUR means they FORGO SALARY INCOME

--TASK--

"Suppose Mr. B's current SALARY is £60,000 a year, and he wishes to quit to open his own tutoring business. He intends to set up his OFFICE in a SPARE ROOM of his house that he currently RENTS out for £4,000 a year. Further, he estimates that he will spend £20,000 per year on RAW MATERIALS and a further £18,000 a year on ADMIN STAFF. If he expects to earn an INCOME of $100,000, do you think he should open the business? Why? Why not? What are the explicit costs of the tutoring business? What are the implicit costs of the tutoring business?"

--THINK AHEAD--

"Spot the difference (It's really slight) and explain why the 'total cost' per cup has increased from $2 to $2.50..."

↓

"...That's right, the productivity (average product) of labour has fallen from 30 cups p/h to 15 cups p/h, and with a fixed hourly wage of $15 p/h the average labour cost per cup has risen from $1 to $2."

--SHORT-RUN COSTS--

"If each subsequent worker is paid the same hourly wage, yet their contribution to total output starts to fall, what do you think happens to the average labour cost of each unit produced?"

↓

"We just learned that in the SR as output increases, the average and marginal product start to rise, then 'diminish' when more and more variable factors are added to a fixed factor. Now, on a per-unit basis what

-FIXED vs VARIABLE COSTS-

FIXED COSTS arise from the "USE OF FIXED INPUTS".
- - Fixed costs are "COSTS THAT DO NOT CHANGE WHEN OUTPUT CHANGES". Examples of fixed costs include RENT, PROPERTY TAXES, INSURANCE premiums, and INTEREST on loans.
  - Note that fixed costs only arise in the short run, as in the long run there are no fixed inputs and therefore all costs are variable.
VARIABLE COSTS arise from the "USE OF VARIABLE INPUTS".
- - These are "COSTS THAT VARY (CHANGES) AS OUTPUT CHANGES", Examples include WAGES for LABOUR, ELECTRICITY & WATER BILLS, RAW MATERIALS etc...

-COSTS & FORMULAS-

-- TOTAL COST (TC) = TFC + TVC --

-- AVERAGE TOTAL COST (ATC) = TC / Q --

-- AVERAGE FIXED COST (AFC) = TFC / Q --

-- AVERAGE VARIABLE COST (AVC) = TVC / Q --

-- MARGINAL COST (MC) = ΔTC / ΔQ --

-EXCEL TASK-

PART 1:-

- (1) Open up a blank Excel sheet and copy the table below into it.
- (2) Select the TP, TFC, TVC & TC and go to the 'INSERT' tab.
- (3) Choose the 'Scatter with smooth lines' chart.
- (4) What relationships do you observe?

PART 2:-

(1) Open up a new Excel sheet and copy the table below into it.
(2) Select TP, AFC, AVC, ATC, & MC and go to the 'INSERT' tab.
(3) Choose the 'Scatter with smooth lines' chart.
(4) What relationships do you observe?

--'U-SHAPED' SR COST CURVES--

--WHY ARE SR COST CURVES 'U-SHAPED'?--

The answer is LINKED DIRECTLY TO the shape of the AVERAGE & MARGINAL PRODUCT CURVES, which if you remember are 'Hump-shaped', why is it that these curves rise and fall, whilst cost curves fall and rise?
Well, if you think about it the falling product curves reflect increasing productivity per variable factor (think one extra worker) added, which should mean the cost of that factor (the worker's wage) is spread out over a greater number of units produced, implying average and marginal costs are falling and vice versa.
For example, if a firm added an extra worker at a cost of $10 per hour and they produced 20 units extra, we can say that the marginal (labour) cost per unit is $10/20 = $0.5, now if we added another worker at the same cost of $10 per hour, and they produced 40 extra units, we can say that the marginal (labour) cost per unit is now $10/40 = $0.25, so we can see as the marginal product rises from 20 to 40 units, the marginal cost falls from $0.5 to $0.25. Now if diminishing return sets in and a further additional worker only adds 30 more units, marginal costs will now start to rise to $10/30 = $0.33, hence we start to see a 'U-shaped' MC curve....

--THINK AHEAD--

"In the previous bubble tea shop example, the situation was termed 'the short-run' due to the fact that the factor of floor space was fixed; however, if we were to look into the future ('the long-run'), we can envisage a time when ALL factors are variable, and the 'scale of production' has increased, right?" "But what happens when it becomes a reality?" "Is it still considered the long run?"

--LONG-RUN THEORY--

-DEFINITION: THE LONG RUN-

So with reference to our bubble tea shop example above, the LONG-RUN, refers to THE TIME-PERIOD when ALL FACTOR INPUTS CAN EVENTUALLY BE CHANGED (ALL FACTORS ARE VARIABLE)
Of course, as soon as the 'long run' is reached, a new short run begins, as once again the factor input of classroom size (including the new ones) has become fixed.

--THINK AHEAD--

"If I asked most business owners why they wanted to grow their business, what do you think would be the most popular answer?" [Insert here!!!] "How do you think they will achieve this? "By selling more at a higher price?" "By selling more at the same price?" or even "by selling more at lower prices?"

↓

"Clearly the answer is always 'to make as much profit as possible,' but in a world of multiple substitute goods, selling more is difficult; market power allows you to lower price and become more competitive, but surely that will lower profit margins, right?."

--WHY 'SCALE MATTERS'--

If in the long run firms can grow in scale, then we have to ask the question, WHY DO FIRMS WANT TO GROW IN THE LR?
Under the assumption that they are PROFIT MAXIMISERS, the answer is clearly TO MAKE MORE PROFITS which if correct, raises the question of how they will achieve this.
If PROFIT MARGIN per unit = Price per unit LESS Cost per unit, then there are clearly TWO MEANS of increasing PROFIT PER UNIT:
- - - - By RAISING THE PRICE PER UNIT? or
      - By LOWERING THE COST PER UNIT (AVERAGE COST)?
In most cases, it will be the latter, as competitive pressure means most firms have RELATIVELY ELASTIC DEMAND CURVES and so can't simply raise prices and make more revenue and profits.
What we will soon discover is that as a firm increases its scale (Output) it is able to LOWER its AVERAGE COSTS and enjoy a larger profit margin per unit. Though we will also discover this scenario will not last forever.

--RETURNS TO SCALE--

Let’s examine the long-run relationship between inputs and output. An important point to bear in mind is that in the long run, there are NO FIXED INPUTS.
All inputs are variable. We are interested in seeing WHAT HAPPENS TO OUTPUT WHEN THE FIRM CHANGES ITS INPUTS. There are three possibilities, explained BELOW.

-CONSTANT RETURNS TO SCALE-

CONSTANT RETURNS TO SCALE means that when a firm DOUBLES THE QUANTITY OF ALL OF ITS INPUTS, it results in its OUTPUT ALSO DOUBLING meaning PRODUCTIVITY REMAINS THE SAME.
For example, the 3rd column in the table below shows that when the land and labour INPUTS ARE DOUBLED, the OUTPUT ALSO DOUBLES from 100 to 200 units.

-INCREASING RETURNS TO SCALE-

INCREASING RETURNS TO SCALE means that when a firm DOUBLES THE QUANTITY OF ALL OF ITS INPUTS, it results in its OUTPUT MORE THAN DOUBLING meaning PRODUCTIVITY INCREASES.
For example, the 4th column in the table below shows that when the land and labour INPUTS ARE DOUBLED, the OUTPUT MORE THAN DOUBLES from 100 to 250 units.

-DECREASING RETURNS TO SCALE-

DECREASING RETURNS TO SCALE means that when a firm DOUBLES THE QUANTITY OF ALL OF ITS INPUTS, it results in its OUTPUT LESS THAN DOUBLING meaning PRODUCTIVITY DECREASES.
For example, the 5th column in the table below shows that when the land and labour INPUTS ARE DOUBLED, the OUTPUT LESS THAN DOUBLES from 100 to 150 units.

--LONG-RUN COSTS--

--IF INCREASING RETURNS TO SCALE--

If we assume that a firm is achieving INCREASING RETURNS TO SCALE, and assuming FACTOR COSTS ARE FIXED, then we can conclude that PRODUCTIVITY is INCREASING and therefore AVERAGE COSTS WILL FALL, this is called 'ECONOMIES of SCALE'.

--IF DECREASING RETURNS TO SCALE--

If we assume that a firm is achieving DECREASING RETURNS TO SCALE, and assuming FACTOR COSTS ARE FIXED, then we can conclude that PRODUCTIVITY is DECREASING and therefore AVERAGE COSTS WILL RISE, this is called 'DISECONOMIES of SCALE'.

--ECONOMIES OF SCALE--

-TECHNICAL ECONOMIES-

LARGER SCALE means it is now COST EFFECTIVE to utilise LARGER MACHINERY, which MAKES LABOUR MORE PRODUCTIVE, meaning AVERAGE LABOUR COSTS FALL.
For example, as a coffee shop expands in size it can upgrade its expresso machine which allows for faster preparation of coffee.

-MANAGERIAL ECONOMIES-

LARGER SCALE means more workers & managers will be employed allowing for GREATER SPECIALISATION which MAKES LABOUR MORE PRODUCTIVE, meaning AVERAGE LABOUR COSTS FALL.

-PURCHASING ECONOMIES-

LARGER SCALE means RAW MATERIAL ORDERS will also be LARGER meaning that SUPPLIERS WILL OFFER BULK DISCOUNTS, which will result in LOWER AVERAGE RAW MATERIAL COSTS.

-FINANCIAL ECONOMIES-

LARGER SCALE means the firm has MORE FIXED ASSETS that can act as COLLATERAL (SECURITY FOR LOANS), meaning banks view them as LESS RISKY, and therefore offer them LOWER INTEREST RATES, which in turn LOWERS AVERAGE DEBT-SERVICING COSTS.

--TASK--

Using the concepts of 'increasing returns to scale' and 'economies of scale' explain how OFS managed to lower its average costs after 'doubling' the size of its campus. (Use the 4x economies of scale mentioned above with examples)

--DISECONOMIES OF SCALE--

-COORDINATION DISECONOMIES-

The LARGER the SCALE of a business the WIDER the SPAN OF CONTROL & the LONGER the CHAIN OF COMMAND which inevitably leads to a higher amount of DELEGATION which can INCREASE THE POTENTIAL FOR MISMANAGEMENT
These issues could easily result in costly errors that would result in HIGHER AVERAGE COSTS.

-COMMUNICATION DISECONOMIES-

The LARGER the SCALE of a business the LARGER the NEED FOR COMMUNICATION required to coordinate its operations, hence the POTENTIAL for MISCOMMUNICATION ISSUES GROWS.
This can be especially problematic for MULTINATIONAL COMPANIES that have to deal with DIFFERENT TIMEZONES, CULTURES, and LANGUAGES.
These issues could easily result in costly errors that would result in HIGHER AVERAGE COSTS.

-MOTIVATION DISECONOMIES-

The LARGER the SCALE of a business the MORE ISOLATED and UNIMPORTANT the WORKERS MAY FEEL which can affect their productivity, which in turn RAISES AVERAGE COSTS.

--TASK--

Continuing our example, use the concepts of 'decreasing returns to scale' and 'diseconomies of scale' to explain how OFS suffered rising average costs after trebling the size of its campus. (Use the 3x diseconomies of scale mentioned above with examples)

-THE LRAC CURVE-

We can see below that as the scale (output) increases (in the long-run) the average costs initially start to fall, as the firm enjoys ECONOMIES OF SCALE (and higher profits), however eventually these average costs start to rise, when it experiences DISECONOMIES OF SCALE.
This pattern creates a 'U-Shaped' LONG RUN AVERAGE COST CURVE.

--TASK--

Continuing our school example, sketch and label the LRATC of the school, noting the shape of the curve, when scale doubled, and then trebled.

--PROFIT THEORY--

--"WHAT IS PROFIT?"--

PROFIT = TOTAL REVENUE (TR) - TOTAL COST (TC)
- - - - TOTAL COST (TC) = COSTS OF PRODUCTION
        COSTS OF PRODUCTION = ECONOMIC COSTS
        ECONOMIC COSTS = (EXPLICIT + IMPLICIT COSTS)

AV. PROFIT = AV, REVENUE (AR) - ATC COST (ATC)

--NORMAL PROFIT--

↓

"Yes, that's right! In economics if TOTAL REVENUE = TOTAL COST, the firm earns 'NORMAL PROFIT."

↓

It may seem confusing at first, but from the point of view of an economist, a firm STILL makes a PROFIT when TOTAL REVENUE (TR) = TOTAL COST (TC), (THE BREAKEVEN LEVEL OF OUTPUT), and this profit is referred to as NORMAL PROFIT.
Why? Because, as mentioned above, TOTAL COSTS not only includes EXPLICIT COSTS (wages, rent, etc), but also IMPLICIT COSTS (The loss of income from not using the factors of production you own in their next best alternative use).
Hence we can say that:
"Normal profit is equal to the minimum amount of revenue needed to make continuing the business worthwhile."

--ABNORMAL PROFIT--

--'If TR>TC, the firm earns ABNORMAL PROFIT'--

ABNORMAL PROFIT (AKA SUPERNORMAL PROFIT) refers to the amount of profit in EXCESS OF NORMAL PROFIT.

--ECONOMIC LOSSES--

--'If TR<TC, the firm makes ECONOMIC LOSSES'--

ECONOMIC LOSSES refers to the amount of losses made when TOTAL COSTS EXCEED TOTAL REVENUE.

--EXAMPLE--

In accounting terms he earns $200k less $50k = $150k
ABNORMAL PROFIT: Imagine Mr. B was a professional footballer earning $200k per year; his alternative job would be working as a teacher earning $20k per year. In addition, his living expenses work out at $50k per year, so we can say that he is earning abnormal profits of $130k ($200k - 450k - $20k), so he would certainly continue to be a footballer.
NORMAL PROFIT: Now if the next best alternative job as an econ teacher earned EXACTLY $150k per year, then this coupled with his expenses of $50k per year would mean that his football earnings ARE EQUAL TO his total costs. In other words, his income of $200k is just enough to keep him as a footballer rather than change jobs to his next best alternative.
ECONOMIC LOSSES: Now for Mr. B to earn economic losses, the alternative job would need to earn GREATER THAN 150k per year, say 180k, as this coupled to his expenses of $50k per year would mean that his football earnings ARE BELOW his total costs of $230k ($180k + $50k), so we can say that he is making economic losses.

--TASK--

"Using the definitions above, explain why this statement can be both correct and incorrect at the same time."

↓

"If your revenue is greater than explicit costs, you can make an 'accounting profit'; however, with implicit costs included, the total could be more than revenue, meaning you are actually making an 'economic loss'."

--PROFIT MAXIMISING OUTPUT--

-TOTALS-

TOTAL PROFIT = TR - TC

Therefore PROFIT WILL BE MAXIMISED at the level of output at which the DIVERGENCE BETWEEN THE TR AND TC IS THE LARGEST

-MARGINALS-

MARGINAL PROFIT = MR - MC

Therefore, as long as MR > MC the unit is profitable. As we know as output increases (in the SR) MC will eventually start RISING and assuming that the MR starts out higher than the MC there will eventually be a unit produced at which the revenue received for that unit (MR) is equal to the cost of making it (MC).

Therefore, the output level at which MR = MC is referred to as:

'THE PROFIT MAXIMISING LEVEL OF OUTPUT'

-MC CURVE = SUPPLY CURVE-

To understand why the MC CURVE = SUPPLY CURVE imagine yourself as a profit-maximizing producer and answer these questions...
If the MC of the 10th unit produced is $5, how many units would you be willing to supply at $5?
If the MC of the 11th unit produced is $6, how many units would you be willing to supply at $6?
If the MC of the 12th unit produced is $7, how many units would you be willing to supply at $7?
You should have answered 10, 11, and 12.

Now if you were to plot the MC curve and then the supply curve of this producer what do you notice about the curves?

--ASSESSMENT--

P3 PRACTICE

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