TYPES OF COST,

REVENUE AND
PROFIT, SHORT-
RUN AND
LONG-RUN
PRODUCTION

Chapter 34
 Syllabus learning objectives
Short-run production function:

• fixed and variable factors of production

• definition and calculation of total product, average product and marginal product

• law of diminishing returns (law of variable proportions)

Short-run cost function:

• definition and calculation of fixed costs (FC) and variable costs (VC)

• definition and calculation of total, average and marginal costs (TC, AC, MC), including average total cost
(ATC), total and average fixed costs (TFC, AFC) and total and average variable costs (TVC, AVC)

• explanation of shape of short-run average cost and marginal cost curves

 Independent study

- Study the reading on your own including the activities

SHORT-RUN
PRODUCTION
FUNCTION
Capital vs labour

- Which method of production (curve A-B-C) would take place in high-

income and lower/middle-income countries respectively?

• Isoquant – a curve showing the different combinations of inputs

(labour and capital) to produce the same (set) level of output (thus it
is not a cost curve, but the output)

- "Iso" means "equal" or "same."

- "Quant" is short for "quantity."

- What might be the reason for such combination of inputs for C (i.e. so
much labour needed)?
SHORT-RUN
PRODUCTION
FUNCTION
 The relationship between total, marginal and average values.

 Labour is usually/most often a variable
FOP (in the short run) and all other
usually are fixed.
 Short-term: at least one FOP is fixed
 Total product = total output  MP – the change in output after additional unit
of input (e.g. labor)
 AP =TP/units of labour = productivity (i.e.
output per worker)
 Diminishing marginal returns

 Production function – maximum production level out of the given factor

inputs (FOPs)

 In short-run, adding additional unit of labour increase output, but with

diminishing marginal product (curve is flattening), which can eventually
become negative.

ACTIVITY 34.1 (not the most accurate diagram drawn) 1. Draw MP and AP curves

2. Both curves slope downwards. MP is below AP and decreases at a greater rate than AP.

3.

o Knowledge of where MP starts to decline helps a firm in determining the optimal level
of output, ensuring they are neither overproducing nor underproducing.

o The average product (AP) of labor provides a measure of overall workforce

productivity: TP/L or Output / number of workers

o Capital-Labor Decisions: If the marginal product of labor starts decreasing, it might be

a sign for the firm to consider investing in machinery or technology rather than hiring
more workers.
 Law of diminishing marginal returns
1) One student come up to board and write your name within that rectangle as many times as possible within 20
seconds. You should not write outside of the rectangle.
2) A second one joins. Write their together your own names within that rectangle as many times as possible within
20 seconds.
3) Third; fourth; fifth; sixth.
 Reflection
- What have you noticed?

- The number of names in the rectangle should increase but at a

decreasing rate. This is the definition of the Law of Diminishing
Marginal Returns: where the output from an additional unit of
input leads to a fall in the marginal product.
 Labour Total product Marginal product
(total number names) (Additional number of names per additional
unit of labour)
1
2
3
4
5
6

Task: plot this data (x-axis should be labour, y-axis should be total product and marginal product).
- Could you come up with their own experiment to demonstrate
the Law of Diminishing Marginal Returns?

Video lesson on the diminishing marginal rerturns

SHORT-RUN COST
FUNCTION
Implicit costs of production is the opportunity cost (the profit the firm could made producing the next
best alternative)

Explicit costs:
 Having and using a car
Task: allocate the costs into variable and fixed

- insurance, road tax, fuel, buying the car, maintenance costs (wear and tear of tyres), cleaning the car.

Task 2: Draw a diagram (vertical axis – costs;

horizontal – output (km driven)) with two
curves – total fixed costs and total variable
costs

In the short run, fixed costs are fixed because they've already been committed to
and can't be easily changed without incurring additional costs or losses. However,
in the long run, all these costs become variable. You can choose not to renew your
insurance, sell the car, or decide not to replace it once its lifecycle is over.
Fixed costs are expenses that do not change in response to the quantity
of goods or services produced within a given period. They remain
constant regardless of the level of production or sales (i.e. independent
of production process or output). Fixed costs are incurred even if
production or sales volume is zero. E.g.:
 Rent (property, machinery, or equipment). This cost remains the
same regardless of how much or little you produce or sell.
Variable costs are expenses that change in proportion to the
production volume or activity level of a business (i.e. directly
involved in the production process). E.g.:
 Wage / Labor costs are variable IF they change depending on the
level of production. If you hire workers based on hours worked OR
the number of units produced, then your labor cost will vary with
your level of output.

 Capital (its costs do not change based on the quantity of output in  Raw materials
the short run. Whether you produce one unit or a thousand units, the
 Packaging costs
initial investment in these capital assets remains the same).
 Shipping fees
 Salaries to labor as consistent payments to employees, unlike
hourly wages that change based on hours worked.  Credit card transaction fees

 Insurance  Utilities directly tied to production

 Depreciation (machinery, equipment)  Fuel used in delivery trucks

 Property taxes

 Fixed administration of utilities (independent from the amount

used)

 Licenses / permits
 Imagine you and your friends have decided to start a small online business selling custom-designed t-shirts to fellow students
in your school. You're operating it from your home, designing the t-shirts based on each order you get, and then delivering
them. Based on the context of your online t-shirt business, list down the potential fixed costs and variable costs you
might incur while operating your business.

Fixed Costs:

1. Subscription fee for the online platform where you sell your t-shirts (e.g., Shopify or Wix
monthly fee).

2. Monthly internet charges.

3. Cost of any design software you've purchased.

4. A basic amount you pay to a friend who helps manage the website, regardless of sales.

Variable Costs:

5. Cost of blank t-shirts which you buy to print on (this would vary depending on the number of
orders).

6. Printing costs for each design.

7. Packaging for each t-shirt (plastic/box, stickers, labels).

8. Delivery charges or fuel costs if you're delivering the t-shirts yourself.

9. Any promotional costs, like if you decide to run an online ad for a week.

10.Commissions or bonuses you give to friends who help get more orders.
 Total, average and marginal costs

- What patterns can you identify for each average

cost?

- How ATC is related with the MC?

Memorise 
Handouts: Formulae
 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed variable total cost cost
cost cost

0 500 0
200 500 1000
400 500 1800
600 500 2400
800 500 2800
1000 500 3000
1200 500 3400
1400 500 4000

Note: All costs are in $000s.

Calculate total costs and then sketch the three curves (FC, VC and TC).
 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed variable total cost cost
cost cost

0 500 500 0
200 1500 500 1000
400 2300 500 1800
600 2900 500 2400
800 3300 500 2800
1000 3500 500 3000
1200 3900 500 3400
1400 4500 500 4000
Note: All costs are in $000s.
TOTAL, FIXED AND VARIABLE COST CURVES

Price / Cost ($)

Figure 34.2 Output (cars per day)

 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed cost variable total cost cost
cost

0 500 500 0 n/a n/a n/a

200 1500 500 1000
400 2300 500 1800
600 2900 500 2400
800 3300 500 2800
1000 3500 500 3000
1200 3900 500 3400
1400 4500 500 4000
Note: All costs are in $000s.
Calculate average fixed costs, average variable costs and average total costs
from this data. Then sketch all three curves.
 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed cost variable total cost cost
cost

0 500 500 0 n/a n/a n/a

200 1500 500 1000 2.5 5 7.5
400 2300 500 1800 1.25 4.5 5.75
600 2900 500 2400 0.83 4 4.83
800 3300 500 2800 0.63 3.5 4.13
1000 3500 500 3000 0.5 3 3.5
1200 3900 500 3400 0.42 2.83 3.25
1400 4500 500 4000 0.36 2.86 3.21
Note: All costs are in $000s.
Calculate average fixed costs, average variable costs and average total costs
from this data. Then sketch all three curves.
AVERAGE FIXED COST, AVERAGE VARIABLE COST AND
AVERAGE TOTAL COST CURVES

Price / Cost ($)

Output (cars per day)

Figure 34.3
 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed cost variable total cost cost
cost

0 500 500 0 n/a n/a n/a

200 1500 500 1000 2.5 5 7.5
400 2300 500 1800 1.25 4.5 5.75
600 2900 500 2400 0.83 4 4.83
800 3300 500 2800 0.63 3.5 4.13
1000 3500 500 3000 0.5 3 3.5
1200 3900 500 3400 0.42 2.83 3.25
1400 4500 500 4000 0.36 2.86 3.21
Note: All costs are in $000s.
Calculate the marginal cost column and sketch the MC curve.
 SHORT-RUN COSTS
Cars per Total cost Fixed Variable Average Average Average Marginal
day cost cost fixed cost variable total cost cost
cost

0 500 500 0 n/a n/a n/a n/a

200 1500 500 1000 2.5 5 7.5 5
400 2300 500 1800 1.25 4.5 5.75 4
600 2900 500 2400 0.83 4 4.83 3
800 3300 500 2800 0.63 3.5 4.13 2
1000 3500 500 3000 0.5 3 3.5 1
1200 3900 500 3400 0.42 2.83 3.25 2
1400 4500 500 4000 0.36 2.86 3.21 3
Note: All costs are in $000s.
Calculate the marginal cost column and sketch the MC curve.
 MARGINAL COSTS

Price / Cost ($)

Figure 34.4 Output (cars per day)

Diagram analysis: ATC and MC

 ATC we already studied. It is as simple as TC/Q (or total cost divided by

output). Find the explanation in your notes of the ATC curve. Video lesson

 MC we already studied too. Another example of its slope:

MC slopes downwards due to unused capacity: At the start, the fixed resources (like
capital) might be underutilized. Imagine a big oven in a bakery that can bake 50 loaves of
bread at once, but initially, only 10 loaves are being baked at a time. Together with the
“learning effect” (becoming faster, skilled, efficient) and with specialisation as more
workers allow to do so (the first worker might be baking, the second might be preparing
the dough for the next batch, the third might be packing, and so on), the MC declines.

MC slopes upward as production continues to increase, the principle of diminishing

marginal returns starts to kick in. This means that after a certain point, adding more of the
variable input results in smaller and smaller increases in output. This happens due to the
fixed nature of other inputs which leads to inefficiencies, overcrowding, or other
logistical challenges. As a result, the MC curve will start to slope upwards.
 Diagram analysis: AVC and AFC (sum of both = ATC)

AVC slopes downward for the same reasons as MC (learning, specialisation, better
deals for a larger amounts of raw materials, labor can better use still unused fixed
capacity like machinery)

AVC slopes upward (law of diminishing marginal returns): At certain point, after
adding e.g. more workers, each new addition produces less extra output than before. This
happens because there's only so much of the fixed resources (like machinery) for each
new additional worker to use. Consequently, the marginal cost of production begins to
rise.

When MC is above AVC, it pulls the average up. Hence, the AVC starts to increase as
quantity further increases in this phase.

AFC always slopes downwards because the more you produce, the more you can spread
out these fixed costs over a larger number of units, leading to a lower average fixed cost
per unit. This is why the AFC curve always slopes downwards. I.e. AFC=FC/Q

Memory test: Where it the productively efficient (optimum) point of production?

Task: Explain why ATC has a “U” shape
- Use terms AFC, AVC, MC

The Average Total Cost (ATC) curve has a "U" shape because it
combines both Average Fixed Costs (AFC) and Average
Variable Costs (AVC). As production increases, AFC
continuously decreases because the fixed costs are spread over
more units. Initially, AVC may also decrease due to efficiencies
gained in production. However, after a certain point, AVC starts
to rise because of diminishing returns, meaning each
additional unit of input (like worker) results in less and less
output. The ATC curve starts to decline when both AFC and
AVC are decreasing, but it begins to rise again when the
increasing AVC outweighs the decreasing AFC. The point
where the Marginal Cost (MC) intersects the ATC is the
minimum of the ATC curve, highlighting the most cost-effective
level of production.
 ATC U-shape in organising a party
 Fixed Costs (AFC): This is like the cost of renting a venue. Whether you invite 10 people or 100
people, the venue cost is the same. But on a per-person basis, if more people come, the venue cost for
each person goes down (because you're dividing the total venue cost by a larger number of people).

 Variable Costs (AVC): This is like the cost of snacks and drinks for each person. At first, buying in bulk
or getting deals might make the cost per person go down. But, after a certain point, maybe you run out of
deals or storage space, and the cost per person starts going up again.

 Total Costs (ATC): This is the sum of both venue costs and snack costs for each person. At the start, as
you invite more people, the venue cost per person drops quickly, pulling the total cost per person down.
Then, as the snack costs start rising, it pushes the total cost per person up.

 Marginal Costs (MC): This is like asking, "How much would it cost to invite one more person?" Early
on, this might be low because you have plenty of space and snacks. But after a while, squeezing in just
one more person might require more significant expenses, like extra food or even a larger venue.

Conclusion: The U-shape of the ATC comes from these combined effects. Initially, the benefit of spreading
out the venue cost makes costs per person drop. But as you keep adding more people, the increasing snack
costs (and other challenges) eventually make the cost per person rise again.
 ACTIVITY 34.2

- In which ways the marketing could be a fixed cost and when a variable cost?

Fixed when it is related to marketing staff fixed monthly salaries, long-term

contracts with marketing company or if a company commits to spending a set
amount on advertisements every month regardless of sales or production volume,
then this expenditure is fixed.

Variable when
o marketing personnel or external partners are paid based on commission (for
example, a percentage of sales they generate), this cost is variable. The more
they sell, the higher the commission expense;
o pay-per-click Ad Campaigns;

o If a company produces brochures, posters, or other promotional materials

based on the quantity of products they produce or expect to sell, these costs
can vary with production or sales levels;
o Sales promotions as a percentage of sales
 Production vs cost function in the short run
Differences
Similarities I. Components
I. Time Period: Both the short run production and short run Production Function primarily involves total product (TP), marginal product
cost functions operate within the same time frame, i.e., when (MP), and average product (AP).
at least one factor of production is fixed.
Cost Function includes total cost (TC), total variable cost (TVC), total fixed cost
II. Law of Diminishing (marginal) Returns: This law (TFC), average total cost (ATC), average variable cost (AVC), and marginal cost
applies to both functions. As more of a variable input is (MC).
added (while keeping one input constant), there will
eventually be a point where adding more of the variable input II. Behavior
will (1) result in smaller increases in output/production and Production function: marginal product eventually declines as more of a variable
(2) cost per additional unit can rise. input is added

Cost function: the marginal cost may eventually rise as more units are produced.
 Differences in (short run) product and cost diagrams

Production function (first image) explains how output/production changes as the quantity of one or more inputs (most often labour)
change while other inputs are kept constant (e.g. capital and land).

Cost function explains how the total cost of production changes with the level of output.

*X axis (horizontal) is independent variable and Y axis (horizontal) is dependent (on the values of independent) variable
LONG-RUN PRODUCTION FUNCTION
 Long-run production function: the best combination of factors (of production) can
be only when ALL factors are variable (i.e. long-run) and thus firms aim to be in a position
where:

Easy example: Imagine you're assembling a dream team where you can choose different types of players. Each type has its own strengths, and each
player costs a different amount of in-game currency.

You want to make sure you get the best value for your money. So, you look at how good each player is (their strength or "marginal product")
compared to how much they cost.

Now, let's say Player A is super strong and costs a lot, Player B is medium strength and has a medium cost, and Player C is less strong but is really
cheap. To build the best team with a limited budget, you'd want to make sure that the strength you get from each player, relative to their cost, is about
the same. In other words, you want the "bang for your buck" to be equal for all players.

If Player A gave you way more strength for each in-game coin compared to Player B, you'd want to spend more on Player A types until they're equal.

Back to the economic theory: businesses are trying to do something similar. They're trying to get the most output (like goods produced) for the least
cost. So, they compare how much additional output they get from spending money on different resources (like workers or machines) and aim to
make sure the value they get for each dollar spent is the same across all resources.

If they find out they're getting more value from one resource compared to another, they'd adjust their spending until the values align. That way,
they're ensuring they're operating efficiently and getting the most for their money.
 Pizza shop

As a manager of a pizza shop, you can spend money on different things (factors) to make more pizzas:
more chefs (Factor A), better ovens (Factor B), and higher-quality ingredients (Factor C). Each of these
has a cost (price) and gives you some extra pizzas (marginal product). The theory (and the equation
above) is essentially saying: "Spend your money where you get the most extra pizzas per dollar spent."

Here's why: If you spend one more dollar on chefs and it gives you two extra pizzas, but that same dollar
could get you four extra pizzas if you spend it on better ovens, then you should spend it on the ovens!
Same goes for other factors (like ingredients). In formula language:

 Marginal Product (MP) of a factor = extra pizzas you get by spending one more dollar on that factor
(like chefs, ovens, or ingredients).

 Price of a factor = how much you spend for using a little bit more of that factor.

So, is like saying "extra pizzas per dollar, if spent on chefs", and similarly for factors B and C.

The goal is to balance things out, so the "extra pizzas per dollar" is equal whether you spend that dollar on chefs, ovens, or ingredients. If this isn't the case, you
should shift your spending to where you get more pizzas per dollar, until it's balanced out. That way, you get the most pizzas possible out of your total spending.

Task: Make analogical analysis using the same equation when you are a manager of a coffee shop.
 Returns to scale

*Isoquant shows output, while both axes show the FOPs Long-run production function
required to produce a certain amount of output.

 Increasing returns to scale from the first curve (closest to

the origin) to the next one, i.e. the output increases
proportionally more than the increase in factors needed.

 Decreasing returns to scale from the middle to the outermost

curve shows that factor inputs required increase at

Capital
proportionately faster rate than the increase in output.

 See textbook Figure 34.9a (p. 344)

Labour
 ACTIVITY 34.3

a. Diminishing marginal returns (for both, long and

short run) would simply be decreasing marginal
output (100->80->65 etc.)

b and c can be put together (returns to scale refer to the

long run production where all FOPs are variable
including capital).

Task:

1) Make up numbers for output (in the table) so these

illustrate both increasing and decreasing returns to
scale.

*Carefully mind the definitions of both returns to scale.

**Make units L4 K4 as constant returns to scale

2) Draw a diagram with isoquants representing the table.

 Isoquant and isocost

1. Isoquant (to repeat): Represents all combinations of inputs

(like labor and capital) that produce the same level of output.

2. Isocost Line (straight lines): Represents all combinations of

inputs that cost the same amount for the firm.

Importance:

When firm is looking for the most economically efficient (least-

cost) production to maximise profit, it will seek to produce
where isocosts (costs for FOPs-economic side) and isoquant
(output from FOPs-physical side) intersects. This ensures firms
are getting the most production for their money and adapting to
changing input prices over time.
 The relationship between diagram and equation:

- The equation above ensures that the firm moves along the
isocost line to find the optimal combination of inputs.

- The equation above​​is met at the tangency point between an

isoquant and an isocost line. This tangency point indicates
the cost-minimizing combination of inputs for producing a
given level of output. The firm adjusts its input combination
to ensure that the marginal benefit (in terms of additional
output) of spending an additional dollar on any input is the
same across all inputs.
 Real-life example for isoquants, isocosts and equation of
cost minimisation in the long run
1. Setup: On the diagram, we'll have two axes. The vertical axis will represent capital (K), such
as machinery and buildings, while the horizontal axis will represent labor (L), which includes
engineers, production workers, etc.

2. Isoquants (the diagram does not represent the spacing for returns to scale)

(a) Increasing Returns to Scale: The first isoquant, closest to the origin, will represent the
production of, say, 100 smartphones. If the company doubles its input (both labor and capital), and
the output more than doubles (say, produces 220 smartphones), then the second isoquant will be
less than twice as far from the origin (i.e., they are closer together), illustrating increasing
returns to scale.

(b) Constant Returns to Scale: After a point, the firm may experience constant returns. Say, by
now, the firm is producing 1000 smartphones. If they double their inputs and the output exactly
doubles (producing 2000 smartphones), the corresponding isoquant will be evenly spaced from
the previous, showing constant returns.

(c) Decreasing Returns to Scale: If the company, which is now massive, decides to again double
their inputs, but this time, it only increases production to 3800 smartphones (not 4000), then the
new isoquant will be farther apart from the previous one, illustrating decreasing returns to scale.

*This one reflects the diagram

above (L-labor; K-capital)
 Real-life example for isoquants, isocosts and equation of
cost minimisation in the long run
3. Isocost Lines: On the same graph, the isocost lines represent combinations of labor and capital that the Mind, that spacing here
does not correspond to the
company can afford given a specific budget. In the long run, we often assume that prices of factors of
case study
production like labor and capital are relatively stable. This means that the slope of these isocost lines
remains constant. This constant slope is determined by the relative prices of labor and capital, reflecting the
trade-off between the two based on their prices.

4. Real-life Context in the Long Run Production Function (say, smartphone company is called
"TechBite”). In the long run, companies like TechBite make decisions about the optimal mix of labor and
capital they should employ to maximize efficiency and minimize costs. They are not limited by current
production capacities and can change all factors of production.

Increasing Returns to Scale: In its initial stages, as TechBite grows in the long run, it realizes benefits
from bulk ordering, more specialized machinery, and better division of labor among employees. This
reflects a situation where doubling inputs leads to more than a doubling in output, demonstrating increasing
returns to scale in the long run production function.

Constant Returns to Scale: As TechBite matures and becomes an industry giant, it achieves a production
rhythm. In the context of the long run, it means that if TechBite were to double all its inputs, its output
would also double, showcasing constant returns to scale.

Decreasing Returns to Scale: Eventually, in the long run perspective, TechBite might reach a point where
further doubling of inputs (like labor and capital) results in less than a double increase in output. For *This one reflects the diagram
instance, complexities in management, communication hurdles, and challenges in efficiently utilizing above (L-labor; K-capital)
additional machines become evident. This phase is indicative of decreasing returns to scale in its long run
production function.
 Real-life example for isoquants, isocosts and equation of
cost minimisation in the long run
5. Marginal Products and Factor Prices:
Mind, that spacing here
does not correspond to the
case study

6. Connection to Our Isoquant-Isocost Diagram:

7. Application to TechBite:

For TechBite, this equilibrium condition ensures that they are getting the most bang for their buck. For
instance, if the extra smartphones produced by hiring one more engineer (after accounting for their salary) is
more than the extra smartphones produced by investing in one more unit of machinery (after accounting for its
cost), TechBite would hire more engineers until this balance is achieved. Conversely, if machines provide a
better return on investment, TechBite would invest more in machinery .

This continuous evaluation helps TechBite to ensure that they are allocating resources in the most cost-efficient *This one reflects the diagram
above (L-labor; K-capital)
manner, thereby maximizing profits. On our diagram, this optimal point is where the isocost line is tangent to
an isoquant.
 Select three and
Returns to scale: limitations write them in
your notes
Textbook:
• Firms often do not have know-how (staff) or data to determine isoquants (different combinations of FOPs to produce the same amount of output.

• Theory states that in the long-run all FOPs can be changed, but in reality – not necessarily (e.g. a hotel cannot change its façade due to heritage regulations;
cannot expand floors up (regulations) or to other buildings because of the nature of the oldtown (not available property).

• Even if labour becomes more expensive than capital, employers may keep them due to social obligations

Extra:
o In the real world, production often involves more than just two inputs. Representing this on a two-dimensional graph with just labor and capital, as is often done
with isoquants, oversimplifies the complex processes involved in production.

o Isocost lines assume input prices are constant (due to simplification of analysis, ceteris paribus assumption; in the long-run prices are relatively stable, etc. ).
However, in reality, input prices (like wages or rental rates) can fluctuate, affecting production decisions.

o Continuous Substitutability: Isoquants assume continuous substitutability between inputs, i.e., one can always replace capital with labor or vice versa while
maintaining output. In reality, there might be points beyond which one cannot substitute without severely impacting production.

o Input Quality Variations: The quality of inputs like labor isn't always consistent. One worker may be more skilled or efficient than another. Isoquants assume
homogeneity in inputs, which doesn't always hold true.
LONG-RUN
COST
FUNCTION
 SRAC and LRAC

 Misconception: “economies of scale occur when output increases”.

How it is: Economies of scale occur when a firm increases its scale
(which can only happen in the long-run). Firms can increase their output
in the short-run and, as a result, they will move along the SRAC curve.
However, SRAC is U-shaped and, because of the constraints of the short-
run, average costs will rise again.

 Minimum Efficient Scale (MES) should be marked at the first point

where LRAC is at a minimum. If, for example, LRAC is flat at the
bottom (due to constant returns), MES should be drawn at the start of
that flat part.

 SRAC = is the same ATC curve we studied in the short run. However,
the “ATC” term can be used for both short and long run.
 Real-life example for SRAC: through the stages of expansion

Context: Imagine you're opening a bakery in your hometown.

Short Run Average Cost Curves (SRACs):

1. First Stage: When you first open your bakery, you start small – a tiny shop
with one oven and a few employees. As you bake and sell more bread
loaves, your average cost per loaf goes down. Why? Because the costs of
the oven and shop rent get spread over more and more loaves. But there's a
limit – after a point, that one oven and your few workers can't handle more
orders efficiently. This is your first short-run average cost curve.
2. Second Stage: Seeing the demand, you expand. Now, you have two ovens
and more workers. With this setup, you can produce more bread at an even
lower average cost than before. But just like last time, there's a point where
even this setup becomes less efficient. This gives you your second short-run
average cost curve.
3. Several Stages: As your bakery grows in popularity, you keep expanding –
more ovens, maybe a bigger shop or multiple outlets. Each time you expand
or change your setup, you have a new short-run situation and a new short-
run average cost curve.
 Real-life example for LRAC
 The long run in economics doesn't refer to a specific time frame but rather to the
flexibility to change any of your inputs (like ovens, space, or workers). The
LRAC curve is an envelope of your SRAC curves – it takes the lowest cost at
each level of output from your different short-run scenarios.

 On this curve, there's a point where the cost is at its minimum for the most
efficient production scale. This point is called the Minimum Efficient Scale
(MES). It's like finding the perfect balance for your bakery – not too small that
you're overwhelmed with orders but not so big that you're wasting space and
resources.

Example: Think of a well-known bakery chain. At first, they might have started
small, but as they grew, they realized that having a central baking location and then
distributing to various outlets was more cost-effective than baking at every single
outlet. This central baking setup is their MES – the most efficient way for them to
operate without incurring extra costs.
o Where is the MES?

o Why the flat LRAC part is called constant returns to scale?

o Explain the quote from the textbook: “in industries where MES
is low there will be a large number of firms. Where the MES is
high, competition will tend to be between a few large players”

o What would explain the U-shape of ATC in the short run (aka
SRAC)?

- The decrease in AFC as well as initial decline of AVC and MC

(learning effect, specialisiation, better use of fixed capital - >
increasing marginal returns) but then slopes upward due to
decreasing marginal returns that is due to resource constraints in
the short run, learning effect diminish, specialisation reaches limit
etc.)

*LRAC is aka ‘envelope curve’ – enveloping SRAC curves.

TASK:

1) READ ECONOMICS IN CONTEXT AND SUB-CHAPTER 34.6

(“ECONOMIES OF SCALE AND DECREASING AC”)

2) CREATE 3 STAGES OF EXPANSION FOR EITHER THE

SHIPPING COMPANY OR YOUR OWN EXAMPLE. THE LAST
STAGE SHOULD END AT MINIMUM EFFICIENCY SCALE (MES)

*USE DIAGRAM AS WELL AS TERMS LIKE ECONOMIES OF

SCALE, SHORT AND LONG RUN, ETC. LEAVE SPACE FOR
LATER TO CONTINUE OVER DISECONOMIES OF SCALE.

**YOU MAY USE CHAT-GPT FOR SELF-CHECK

INTERNAL AND
EXTERNAL
ECONOMIES AND
DISECONOMIES
OF SCALE
Connecting returns to scale with long run average costs (LRAC)