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AS Market Failure

Production and Costs

In this note we consider some of the background to the theory of supply in markets by considering the concepts of production and productivity and how they relate to the costs that all businesses must face.

Production

Production refers to the output of goods and services produced by businesses within a market. This production creates the supply that allows our needs and wants to be satisfied. To simplify the idea of the production function, economists create a number of time periods for analysis.

1. Short run production

The short run is a period of time when there is at least one fixed factor input. This is usually the capital input such as plant and machinery and the stock of buildings and technology. In the short run, the output of a business expands when more variable factors of production (e.g. labour, raw materials and components) are employed.

1. Long run production

In the long run, all of the factors of production can change giving a business the opportunity to increase the scale of its operations. For example a business may grow by adding extra labour and capital to the production process and introducing new technology into their operations.

The length of time between the short and the long run will vary from industry to industry. For example, how long would it take a newly created business delivering sandwiches around a local town to move from the short to the long run? Let us assume that the business starts off with leased premises to make the sandwiches; two leased vehicles for deliveries and five full-time and part-time staff. In the short run, they can increase production by using more raw materials and by bringing in extra staff as required. But if demand grows, it wont take the business long to perhaps lease another larger building, buy in some more capital equipment and also lease some extra delivery vans – by the time it has done this, it has already moved into the long run.

The point is that for some businesses the long run can be a matter of weeks! Whereas for industries that requires very expensive capital equipment which may take several months or perhaps years to become available, then the long run can be a sizeable period of time.

The meaning of productivity

When economists and government ministers talk about productivity they are referring to how productive labour is. But productivity is also about other inputs. So, for example, a company could increase productivity by investing in new machinery which embodies the latest technological progress, and which reduces the number of workers required to produce the same amount of output. The government’s objective is to improve labour and capital productivity in the British economy in order to improve the supply-side potential of the country.

Productivity of the variable factor labour and the law of diminishing returns

In the example of productivity given below, the labour input is assumed to be the only variable factor by a firm. Other factor inputs such as capital are assumed to be fixed in supply. The “returns” to adding more labour to the production process are measured in two ways:

Marginal product (MP)             =          Change in total output from adding one extra unit of labour

Average product (AP) =          Total Output divided by the total units of labour employed

In the example below, a business hires extra units of labour to produce a higher quantity of wheat. The table below tracks the output that results from each level of employment.

Diminishing returns is said to occur when the marginal product of labour starts to fall. In the example above, extra labour is added to a fixed supply of land when a farming business is harvesting wheat. The marginal product of extra workers is maximized when the 4th worker is employed. Thereafter the output from new workers is falling although total output continues to rise until the seventh worker is employed.

Notice that once marginal product falls below average product we have reached the point where average product is maximized – i.e. we have reached the point of productive efficiency.

Explaining the law of diminishing returns

The law of diminishing returns occurs because factors of production such as labour and capital inputs are not perfect substitutes for each other. This means that resources used in producing one type of product are not necessarily as efficient (or productive) when switched to the production of another good or service. For example, workers employed in producing glass for use in the construction industry may not be as efficient if they have to be re-employed in producing cement or kitchen units. Likewise many items of capital equipment are specific to one type of production. They would be much less efficient in generating output if they were to be switched to other uses. We say that factors of production such as labour and capital can be “occupationally immobile”; they can be switched from one use to another, but with a consequent loss of productivity.

There is normally an inverse relationship between the productivity of the factors of production and the unit costs of production for a business. When productivity is low, the unit costs of supplying a good or service will be higher. It follows that if a business can achieve higher levels of efficiency among its workforce, there may well be a benefit from lower costs and higher profits.

Costs of production

Costs are defined as those expenses faced by a business when producing a good or service for a market. Every business faces costs and these must be recouped from selling goods and services at different prices if a business is to make a profit from its activities. In the short run a firm will have fixed and variable costs of production. Total cost is made up of fixed costs and variable costs

Fixed Costs

These costs relate do not vary directly with the level of output. Examples of fixed costs include:

1. Rent paid on buildings and business rates charged by local authorities.
2. The depreciation in the value of capital equipment due to age.
3. Insurance charges.
4. The costs of staff salaries e.g. for people employed on permanent contracts.
5. Interest charges on borrowed money.
6. The costs of purchasing new capital equipment.
7. Marketing and advertising costs.

Variable Costs

Variable costs vary directly with output. I.e. as production rises, a firm will face higher total variable costs because it needs to purchase extra resources to achieve an expansion of supply. Examples of variable costs for a business include the costs of raw materials, labour costs and other consumables and components used directly in the production process.

We can illustrate the concept of fixed cost curves using the table below. The greater the total volume of units produced, the lower will be the fixed cost per unit as the fixed costs are spread over a higher number of units. This is one reason why mass-production can bring down significantly the unit costs for consumers – because the fixed costs are being reduced continuously as output expands.

In our example below, a business is assumed to have fixed costs of £30,000 per month regardless of the level of output produced. The table shows total fixed costs and average fixed costs (calculated by dividing total fixed costs by output).

When we add variable costs into the equation we can see the total costs of a business.

The table below gives an example of the short run costs of a firm

Average Total Cost (ATC) is the cost per unit of output produced. ATC = TC divided by output

Marginal cost (MC) is defined as the change in total costs resulting from the production of one extra unit of output. In other words, it is the cost of expanding production by a very small amount.

Long run costs of production

The long run is a period of time in which all factor inputs can be changed. The firm can therefore alter the scale of production. If as a result of such an expansion, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if average total cost rises as the firm expands, diseconomies of scale are happening.

The table below shows a simple example of the long run average cost of a business in the long run when average costs are falling, then economies of scale are being exploited by the business.