Monday 18 January 2010

Economics -- Production in short run and long run

Production runs Variable factors are inputs that the quantities vary when output changes. Fixed factors are inputs that the quantities don’t vary when output changes. The change of output can be classifies into temporary or persistent. In temporary increase in demand, only factors like raw materials, electricity is used more. They’re variable factors that quantities changes with output. However some factors like factory premises are fixed factors and won’t change. In a persistent increase in demand, the factory may employ more. Then all production factors have become variable factors. Short run and long run is classified to the existence of fixed factors. Short run(SR) refers to the period that contain fixed factor where long run(LR) means no fixed factors over the period. Input and output relationship in SR 1) Total product (TP) refers to the total amount of output over a time. (unit: unit/time) 2) Average product (AP) refers to the average output produced per unit of variable factor employed in the period. i.e., AP = TP / units of variable factor. 3) Marginal product (MP) is the change of total amount of output that results from adding an additional unit of variable factor in the period. MP of the nth unit of a variable factor = TP of n units – TP of (n-1) units The law of diminishing marginal returns states that when a variable factor is added continuously to a given quantity of fixed factors, the marginal return (product) will eventually decrease, ceteris paribus. MP increases since specialization formed among the variable factors, but it decreases because fixed factors per that variable factor decreases so that they do not have enough fixed factors to use. Variable cost refers to the cost of employing variable factors which changes with output. Fixed cost refers to the cost of employing fixed factors which do not change with output. Measurement of costs 1) Total cost (TC) = Total variable cost (TVC) + Total fixed cost (TFC). 2) Average cost (AC) = TC / Units of output. (unit: cost per unit) 3) Marginal cost (MC) refers to the change in total cost that results from producing an additional unit of output. i.e. MC of the nth unit of output = TC of n units – TC of (n-1) units Note that when an extra cost only comes from variable factors, therefore: MC of the nth unit of output = TVC of n units – TVC of (n-1) units Now assume that the wage of labour is unique while labour is the only variable factor. Considering MP = ΔQ/Δv.f = ΔQ/ΔL. and MC = ΔTC/ΔQ, where Q is the quantity of output and Δ refers to the change. Denote L as labour. MC = ΔTC/ΔQ = ΔTVC/ΔQ = (wage*ΔL)/ ΔQ=(wage) ΔL//ΔQ = wage*MC-1 Therefore the marginal product is inversely proportional to the marginal product. When the marginal product is high, additional units of factor can help a lot and the marginal cost is lower. In a long run, scale of production is enlarged by employing all factors in the same proportion. The result is classified into economies/diseconomies of scale. The curve of long run average cost (LRAC) is U-shaped when LRAC is at minimum; we call that scale as the optimal scale. Economies of scale refer to the advantages associated with large scale production which lowers the LRAC. Diseconomies of scale refer to the disadvantages associated with large scale production which raises the LRAC. Possible sources of internal economies of scale: 1) Technical economies – they can buy larger machines and spread the cost into larger output, while machines can be fully utilized. 2) Managerial economics – specialization among managers and attracts more professionals to work for the firms increases the productivity. 3) Financial economies – raising funds at a lower cost and borrowing at a lower interest rate. 4) Purchasing economies – larger discount when buying inputs in bulk. 5) Marketing economies – spread the ad costs over a larger output. 6) Risk diversification economies – diversify products = diversify risks 7) Research and development (R&D) economies – can afford research and development. Possible sources of external economies of scale: 1) More workers are attracted to the industry, employed and trained. Then costs of recruiting and training workers are reduced. 2) Cost of back-up, a transport and communication service is shared among the firms. 3) More firms ads their products implies more people will know that industry and this will lower the marketing costs. Possible source of internal diseconomies of scale: 1) Managerial diseconomies – complex organizational structure delay decisions, block communication and weaken coordination. 2) Financial diseconomies -- risk of lending big sum of a firm is high → interest rate ↑ 3) Purchasing diseconomies – higher demand of resources implies higher average costs. 4) Marketing diseconomies – local market may be saturated and exploring oversea markets raises the average cost. Possible source of external diseconomies of scale: 1) Excessive expansion cause a drastic increase in demand for factor inputs, then the input prices like wages will be greatly increases. 2) Increasing concentration of business activities in a certain area causes traffic congestion and raises the transportation cost.

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