MICROECONOMICS
TOPIC 3
Economics 2013-14
SUPPLY
NATURE OF PRODUCTION
SPECIALISATION



Modern production is based on the principle of
specialisation.
Specialisation is using a resource in the productive
capacity for which it is best suited.
Helps to use scarce resources efficiently.
BENEFITS OF SPECIALISATION

Increases the amount produced

Reduces the cost per unit produced

Efficient use of scarce resources.
APPLYING SPECIALISATION

Can be seen a number of different levels:
 National
– countries specialising eg coffee
 Regional – different areas of one country eg farming
 Industry eg whisky
 Firm eg whisky distilling, bottling
 Worker – called DIVISION OF LABOUR
DIVISION OF LABOUR

ADVANTAGES FOR THE WORKER
 Increased
productivity leading to increased income
 More
skills acquired
 Gain
more job satisfaction

DISADVANTAGES FOR THE WORKER
 Increased
risk of unemployment – too specialised and
can’t do anything else
 Interdependence
 Monotony
of workers
of tasks – gets boring!!!
PRODUCTION DECISIONS




Producers want to maximise their profits.
One way to do this is to use the most efficient method
of production in order to keep cost per unit low.
In the short run, the capacity of the firm is fixed and
so the firm will only be able to produce a maximum
number of products
In the long run, the capacity of the firm can be
increased or decreased, which can change the level of
production.
PRODUCTION IN THE SHORT RUN:
LAW OF DIMINISHING RETURNS



Factors of production – land, labour, capital and
enterprise.
Returns are what a producer gets back in output
when they employ more of a variable factor of
production.
Example – returns to labour means the output
gained when more labour is employed.


In the short run when deciding what output will be
the most efficient to produce the firm must take into
consideration the LAW OF DIMINISHING RETURNS
This states that as a producer uses more of a factor
of production the returns to begin with will increase
but diminishing returns will eventually happen.
TYPES OF OUTPUT



Total Output – the total amount produced
Marginal Output – the extra output produced when
an extra factor of production is employed
Average Output – the average amount produced.
Normally TOTAL OUTPUT divided by NUMBER OF
WORKERS
EXAMPLE

LOOK AT PAGE 27 IN THE CORE NOTES
Workers
Total output
(meals per hour)
Marginal output*
(meals per hour)
Average output**
(meals per hour)
0
0
0
0
1
20
20
20
2
54
34
27
3
100
46
33.3
4
151
51
37.75
5
197
46
39.4
6
230
33
38.3
7
251
21
35.9
8
234
–17
29.25


Increasing Marginal Returns – occurs when marginal
output is growing.
Diminishing Marginal Returns – occurs when
marginal output is decreasing.
PRODUCTION IN THE LONG RUN


in the long run all factors of production are
variable.
The firm can change its capacity which is also called
changing the scale of its operations.
RETURNS TO SCALE



Increasing Returns to Scale – output grows faster
than the size of the firm. Also called ECONOMIES
OF SCALE
Constant Returns to Scale – output rises at the same
rate as the size of the firm.
Decreasing Returns to Scale – output rises slower
than the size of the firm – also called
DISECONOMIES OF SCALE
Economies of Scale



The advantages of large scale production that
result in lower unit (average) costs (cost per unit)
AC = TC / Q
Economies of Scale – spreads total costs over a
greater range of output
ECONOMIES OF SCALE




Often referred to as the ADVANTAGES OF BEING A
BIG COMPANY
Two types:
Internal – improvements in output (productivity) as the
firm grows in size
External – improvements in output which a firm gains
from growth of its industry.
INTERNAL ECONOMIES OF SCALE




Technical
Financial
Purchasing
Managerial




Marketing
Research and
development (R&D)
Risk bearing
Welfare
INTERNAL ECONOMIES OF SCALE
1.
Technical




Increased division of labour and specialisation
Increased dimensions
Indivisibility
Principle of multiples
2.
Financial

Easier to attract investors due to low risk

Borrow money at lower rates of interest
3.
Purchasing

Gain large discounts for buying in bulk

Dictate to suppliers price, quality and delivery date
they want
4.
Managerial

Can afford to employ specialist staff e.g. an
accountant
5.
Marketing

Costs can be spread over a larger volume of sales

Transport costs per unit are lowered as ships, lorries
etc are full.
6.
Research and Development

Can afford to research

Can gain a competitive advantage through innovation

Maintain market share through product development
7.
Risk Bearing

Diversify products to reduce risk from demand
fluctuations

Diversify markets

Have different sources of supplies to reduce risk of
fluctuating prices and availability.
8.
Welfare

Can afford to offer benefits to employees that will
increase motivation and efficiency.




Pensions
Medical services
Fringe benefits
Recreational facilities
Economies of Scale
Capital
Land
Labour
Output
Scale A
5
3
4
100
Scale B
10
6
8
300
TC
AC
Assume each unit of capital = £5, Land = £8 and
Labour = £2
Calculate TC and then AC for the two different
‘scales’ (‘sizes’) of production facility
What happens and why?
Economies of Scale
Capital
Land
Labour
Output
TC
AC
Scale A
5
3
4
100
57
0.57
Scale B
10
6
8
300
114
0.38
Doubling the scale of production (a rise of 100%) has led to an
increase in output of 200% - therefore cost of production
PER UNIT has fallen
Don’t get confused between Total Cost and Average Cost,
Overall ‘costs’ will rise but unit costs can fall.
Why?
EXTERNAL ECONOMIES OF SCALE


Normally happens when firms in an industry are
focused in a particular area.
They can gain the following advantages:
 Lower
training costs
 Ancillary services provided by specialist suppliers
 Co-operation of firms
DISECONOMIES OF SCALE


These are the disadvantages of being a big
company.
INTERNAL DISECONOMIES
 Management
 Waste
problems – difficult to control
is difficult to control or detect.

EXTERNAL DISECONOMIES
 Shortages
 Shortage
of skilled labour and high wages
of raw materials
 Congestion
and high transport costs
COSTS OF PRODUCTION

These are the money values of resources used in
producing a good or service.
 Wages
to labour
 Rent for land
 Interest on capital

The owner of the firm provides enterprise. If
revenue earned is equal to cost of production this is
called NORMAL PROFIT, if revenue is greater than
costs, it is called SUPERNORMAL PROFITS
TYPES OF COSTS

Fixed Costs
 Costs
 If
which do not change with output.
nothing is made fixed costs still need to be paid
 Examples
include rent and insurance.

Variable Costs
 These
 If
are costs which do change with output.
output is zero then VC is zero
 Examples
include raw materials and wages

Total Costs
 This

is fixed costs plus variable costs
Average (Total) Cost
 Total
 Can
Costs divided by Output
also be called UNIT COST

Average Fixed Cost
 Fixed

cost divided by Output
Average Variable Cost
 Variable
cost divided by Output

Marginal Cost
 The
extra cost of producing one additional unit of
output.
The MC of the 50th unit is the Total Cost of the 50th
unit minus the Total Cost of the 49th Unit.
 E.g.
 MC
= TC n – TCn-1
SHORT RUN AND LONG RUN

In the short run the firm will have fixed capacity.

Some costs will be fixed and some variable

In the long run all costs are variable.
SHORT RUN COSTS

LOOK AT TABLE ON PAGE 35 OF CORE NOTES

DRAW THE GRAPHS
COST CURVES
Cost
TC
VC
FC
Output
Cost
AC
AVC
AFC
Output
Cost
MC
AC
AVC
Output
OBSERVATIONS

When output increases in the short run:
 Fixed
costs do not change
 Variable
 Total
costs increase, not always at a constant rate
costs increase at the same rate as variable costs
 Average
fixed costs fall, This is because fixed cost do
not change but is being spread over a larger volume
 Average
variable costs fall until a certain point but then
increase. Falls due to improved efficiency and
increasing returns. Rises due to inefficiency and
diminishing returns.
 Average
costs fall while average variable costs and
average fixed costs are falling. When the increase in
AVC exceeds the falls in AFC then AC will rise.
Combining the Factors of
Production

In the short run a firm cannot change its
fixed factors of production (eg land) but it
can change its variable factors (eg labour)
Law of Diminishing Returns

As successive units of one factor are added
to fixed amounts of other factors the
increments in total output at first rise and
then decline.
 Marginal
costs fall and then rise as output increases
 Marginal
cost is less than AVC and AC when AVC and
AC are falling
 Marginal
cost is greater than AVC and AC when AVC
and AC are rising
 MC
will cut both the AVC and AC at their lowest point.
OPTIMUM OUTPUT


This is the output where the firm would be
technically efficient.
At this point AC is at its lowest.
DIMINISHING RETURNS AND COSTS IN
THE SHORT RUN


When a firm has increasing marginal returns it will
have falling marginal costs
Diminishing marginal returns means rising marginal
costs

Increasing average returns means falling average cost

Diminishing average returns means rising average cost
OUTPUT DECISION IN THE SHORT RUN


Firms want to maximise profits.
Any decision on how much to produce is based on
the relationship between their sales revenue and
their costs.
REVENUE

Total Revenue – total amount earned from selling
output;


quantity sold X price per unit
Average Revenue – total revenue divided output. If
only one product is sold then AR will be the same as
price.

Marginal Revenue is the extra revenue from selling
an extra unit of output.
 MC

= TR n – TRn-1
When a firm sells all its output at the same price,
price and MR will be the same.
PROFIT MAXIMISING

1.
2.
This can be determined in two ways.
Maximum profit is where the difference between
total revenue and total cost is greatest.
Where MC = MR
SHUT DOWN POSITION IN THE SHORT
RUN




As long as a firm’s TR covers VC then the firm will stay
open.
Any money left over from paying VC can be used to
pay towards TC and reduce the loss the firm will
make.
Shut down would be where TR is less than VC or when
price is less than AVC
In the long run the firm must make at least normal
profit.
COSTS IN THE LONG RUN


In the long run all costs and factors of production
are variable.
Average cost in the long run fall because of
economies of scale and rise due to diseconomies of
scale.


The AC curve in the long run is U-shaped and has a
series of interlinking Short Run AC curves.
The point where LRAC is at its lowest is the optimum
size of the firm.
REMEMBER!!!





Short Run Average Costs fall due to increasing average
returns to the variable factor
They rise due to diminishing average returns to the variable
factor
Short Run Marginal Costs fall due to increasing marginal
returns to the variable factor
They rise due to diminishing marginal returns to the variable
factor
In the long run Average Costs falls due to economies of scale
and rises due to diseconomies of scale.
SUPPLY
UNIT 1
TOPIC 3
DEFINITION



Supply is the quantity of a good or service that
firms are able and willing to supply at a certain
price.
Individual supply is the supply of one firm
Market supply is the supply of all firms in the
market.
EFFECT OF PRICE ON SUPPLY



As the price of a product increases the supply of that
product will rise.
Represented by a MOVEMENT along the supply
curve.
This is due to:Existing producers will to supply more to earn more profit
 New firms entering the market to earn higher profits

SUPPLY CURVE
Price
Supply Curve
for Product A
S
P1
P
S
Q
Q1
Qty
CONDITIONS OF SUPPLY

A condition of supply will cause the supply curve to
either:
 shift
to the left (a decrease in supply)
 or

shift to the right (an increase in supply)

Prices of other commodities

Competitive Supply – where a supplier will switch resources
from the production of one product to another as a result of
an increase in price.

Example – price of beef increases so there would be a shift
to the right of the beef supply curve.

Joint Supply – a rise in the price could lead to an increase
in supply of another commodity

Example – increase in price of petrol leads to the increase in
supply of other oil products e.g. bitumen.

Costs of Production
A
fall in the cost of any resource will lead to an increase
in supply
 This
would be a shift to the right of the supply curve
A
rise in the cost of a resource would lead to an
decrease in supply
 This
would be a shift to the left of the supply curve

Change in availability of resources
 If
more resources are available then supply curve would
shift to the right.
 Example
– new oil field discovered in the North Sea
 If
less resources are available then supply curve would
shift to the left.
 Example
– bad harvest resulting in less wheat
SHIFT IN SUPPLY
Price
SHIFT TO THE
RIGHT OF SUPPLY
S
S1
S
S1
Qty
ELASTICITY OF SUPPLY
UNIT 1
TOPIC 3
DEFINTION


Price elasticity of supply measures the
responsiveness of supply to a change in price.
How do suppliers react when there is a change in
the price of their product?

Formula
% change in supply
% change in price

Answers

Greater than 1 – supply is price elastic and very responsive
to a change in price

Less than 1 – supply is price inelastic and not responsive to a
change in price

Equals 0 – supply did not or could not change in response to
price – PERFECTLY INELASTIC
FACTOR AFFECTING ELASTICITY OF
SUPPLY



The only factor that affects supply is TIME
In the short run a firm that is at full capacity cannot
change its supply in response to a change in price.
Supply would be perfectly inelastic and the supply
curve would be a vertical straight line.
PERFECTLY INELASTIC SUPPLY CURVE
Price
S
Qty


If the firm has spare capacity and stocks then it will
be able to increase supply
The more spare capacity or more stock the firm has
then the more elastic supply will be.
A LITTLE SPARE CAPACITY SOME
SPARE STOCKS
Price
PLENTY SPARE CAPACITY, PLENTY
STOCKS
Price
Qty
Qty


In the long run, supply will be elastic.
Firms will have time to increase their capacity and
new firms can enter the market.