Unit 2.

11(1) Market power

- Theory of production and
costs (HL)

What you should know by the end of this chapter:

• Difference between the short-run and long-run in cost theory
• Theory of product
• Law of diminishing returns
• Total cost, fixed cost and variable cost
• Average total cost, average fixed cost and average variable cost
• Long-run average total cost
• Increasing and decreasing returns to scale
• Economies and diseconomies of scale

The nature of costs

The costs of production faced by producers in the economy have a very important influence over the
supply decisions they make. Along with consumer demand, costs are crucial in determining price and
output in all markets. The theory of costs underpins the theory of supply covered in Unit 2.2. There
are two ways of looking at costs, implicit costs and explicit costs.

Implicit costs
An implicit cost is the opportunity cost that exists in every business decision-making situation. For
example, if Coca-Cola open a new factory in Vietnam, they might have to give up a plan to open a
new factory in the USA which was their highest value alternative. This is sometimes called an implicit
cost of production because it is not stated in money terms but arises whenever a business chooses
between alternatives.

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Explicit costs
Explicit costs are business costs that firms incur in their operations. These are known as explicit
costs because they are a stated money value arising from the use of resources by firms. In
Economics we can categorise explicit costs in terms of the factors of production:

• Land cost is rent

• Labour cost is wages

• Capital cost is interest

• Enterprise/entrepreneur cost is normal profits

Firms also incur costs such as energy, administration, marketing, etc, in their normal course of
trading.

Time period
The short-run (production stage)
The short-run is the time period where at least one factor of production is fixed (normally capital)
while other factors such as labour can be varied. Firms operate in the short run which is why it is
called the production stage. For example, a coffee shop will find it relatively easy to vary the number
of workers and raw materials (coffee, milk, water, etc) in the short run. The buildings used by the
coffee shop along with the coffee-making machines are more difficult to change in the short run and
are categorised as fixed factors.

The long-run (planning stage)

The long-run is the time period where all factors of production are variable. Normally we would
express this as a business being able to vary both labour and capital. Firms cannot operate in the
long run which is why it is called the planning stage. In the long-run, a coffee shop business could
increase the number of outlets it opens and employ more workers.

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Costs in the short run
The theory of product
The theory of product is the quantitative way the output of a firm can be expressed in the short run.

There are three ways of measuring a firm’s product:

• Total product (TP): is the total output a firm can produce from a
given quantity of labour and capital inputs

• Marginal product (MP): is the change in TP when one extra unit of

labour is added (ΔTP/Δ labour input).

• Average product (AP): is the output per unit of labour input (TP/
labour input)

The table below sets out the product data for a shoe manufacturing business like Timberland. The
data shows the number of pairs of shoes that can be produced in one hour by different numbers of
workers working on two machines. The total product (TP), marginal product (MP) and average
product (AP) of the firm that manufactures the shoes are set out in the table.

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The law of diminishing returns
The law of diminishing return states that when a variable factor such as labour, is added to a given
set of fixed factors, such as capital there is a point where the marginal product of the extra unit of
variable factor added falls (diminishes).

In this shoe manufacturing example, the

point of diminishing returns sets in when
the fourth worker is added, marginal
product and average products are both
lower than is the case with 3 workers.
This means that as output is increased
the most efficient combination of labour
and capital is passed when the fourth
worker is employed in production.
Diagram 2.56 sets out marginal and
average product when more unit of
labour is employed and how marginal
and average product are affected by the
law of diminishing returns.

Classifying costs
In the theory of cost,
it is possible to
classify the different
types of costs that
affect businesses.
The table sets out
how a firm’s explicit
costs are
categorised.

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The effect of the law of diminishing returns on short-run cost
The law of diminishing returns only
affects variable costs because these are
the only costs that change with
output. When a firm starts producing
the marginal product and average
product increase at first which means
that marginal cost and average variable
cost fall initially, but once the law of
diminishing returns sets in both marginal
product and average product fall which
makes average variable cost and
marginal costs rise. Diagram 2.57 shows
the link between the law of diminishing
returns and marginal cost and average
total cost.

In the shoe firm example set out in the table below, the variable cost is labour which can be hired at
$10 per hour and the fixed cost is the machine which can be hired for $20 per hour. The table sets
out the link between the shoe firm’s unit costs and diminishing returns.

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Short-run cost curve diagram
The short-run average total cost, average fixed
cost, average variable cost and marginal cost
curves are set out in diagram 2.58. The ATC,
AVC and MC curves are U-shaped because of
the law of diminishing returns.

Marginal costs and supply

The supply curve in a market is determined by the marginal cost curves of all the firms in the market.
This is called horizontal summing, which means the market supply curve is derived by adding
together all the marginal cost curves of the firms in the market. This means the upward slowing
nature of the market supply curve is determined by the law of diminishing returns.

Evaluation of short-run cost theory

• The law of diminishing returns exists, but its importance to many firms is arguable. In large
manufacturing organisations where labour is such a small proportion of the total cost,
diminishing returns does not have an important effect on unit costs.

• Product theory assumes that all labour is equally productive, but this is not the case in
reality. A firm might see marginal product fall when a less motivated, unproductive worker
is added to production but rise when a more motivated worker is employed.

• Costs such as maintenance are semi-variable and vary with output unpredictably. If a firm
increases output machines will break down more often and incur maintenance costs, but it is
difficult to predict how often this will happen.

• Economic theory looks at labour as a variable cost, but in some situations, labour is a fixed
cost. Once workers are hired and under contract, they have to be paid whatever the level of
output.

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Long-run costs
The long-run is the period where all factors of production are variable. This means it is possible to
vary capital as well as labour. Our shoe manufacturing firm can expand by increasing its factory
space as well as its workforce.

The long-run average total cost curve (LRATC)

Firms do not actually produce in the long run, but they can plan to produce at different scales of
output. In diagram 2.58 a shoe manufacturing firm produces on SRATC1 and minimises unit costs
cost at £25 for producing 20 pairs of shoes per hour. It can increase output to 30 pairs, but ATC rises
to £40 per pair. Alternatively, the firm could purchase new machinery, move to SRATC2 and
increase output to 50 pairs of shoes and see ATC fall to £15. This process continues each time the
shoe manufacturer increases the scale of production and moves to a new SRATC curve. If a curve is
drawn tangential to the SRATC curves (envelopes them) this gives us the LRATC curve.

Returns to scale
Increasing returns to scale

Increasing returns to scale is where increasing the level of production (employing more labour and
capital) in the long run leads to a fall in LRATC. This means an increase in labour and capital input
leads to a greater proportionate increase in output and LRATC falls. Increasing returns to scale occur
because of economies of scale.

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Constant returns to scale

Constant returns to scale occur when an increase in labour and capital input leads to the same
proportionate increase in output and the LRATC curve stays constant as output increases.

Decreasing returns to scale

Decreasing returns to scale occurs on the upward sloping portion of the LRATC curve. This means
that an increase in labour and capital input leads to a smaller proportionate increase in output and
LRATC rises. Over this range of output, the firm is experiencing diseconomies of scale.

Economies of scale
Economies are the cost advantages firms benefit from as they increase the scale of production.

Types of economy of scale

• Commercial economies (or marketing economies) arise from the ability of large firms to buy
and sell in bulk. Walmart, for example, has huge buying power and can negotiate very low
purchase prices from its suppliers. They are also able to sell in bulk which reduces their unit
cost of selling.

• Technical economies occur because large firms can use large-scale machinery that reduces
unit costs. Walmart moves their goods in large HGV lorries which are lower cost per unit
shipped than moving goods in small vans.

• Financial economies benefit large firms when they raise funds. Banks are willing to offer
firms like Walmart low rates of interest because they represent a lower risk than smaller
retailers, and Walmart borrows larger amounts of money which reduce the cost per $
borrowed.

• Labour or managerial economies (specialisation economies) arise because workers in large

firms can specialise in particular tasks. Workers at Walmart will be put into departments like
fruit and vegetables or the bakery, and this allows them to be more efficient than workers in
small firms who have to divide their time between functions.

Diseconomies of scale
Diseconomies of scale are the cost disadvantages that result from the increase in the size of a firm
and its scale of production.

Types of diseconomy of scale

• Communication diseconomies occur when firms become too big and it becomes more
difficult for managers to communicate with workers as the number of employees,
departments and offices increases. Walmart has outlets and offices all over the world which
makes communication challenging for managers.

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 • Motivation diseconomies arise as large firms find it more difficult to manage workers in
organisations that they find more difficult to identify with. A person who works for a small
independent retailer may feel more motivated than someone who works for Walmart.

• Administrative diseconomies are more likely in large organisations where the level of
bureaucracy increases which hinders the decision-making process. Imagine the
administrative difficulties that Walmart might experience when it tries to change the goods
it stocks.

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