Chapter Notes: Production and Costs in the Short Run & Long Run

Hello everyone! Welcome to one of the most important topics in microeconomics. Ever wondered how a company like a bubble tea shop or a big tech firm decides how much to produce? It all comes down to understanding their production and costs.

In this chapter, we'll peel back the curtain on how businesses operate. We'll look at how they make decisions in the "short run" when they're a bit stuck with their current setup, and in the "long run" when they can plan for big changes. Understanding this will help you see the business world in a whole new way! Let's get started.


1. The Two Time Periods in Economics: Short Run vs. Long Run

In economics, "time" isn't just about days or years. It's about flexibility! It's about what a firm can and cannot change about its production process. To understand this, we first need to know about the inputs, or factors of production.

There are two types of factors:

Fixed Factors: These are inputs that a firm CANNOT easily change in a short period, no matter how much it produces.
Example: The size of a restaurant's kitchen, a factory building, or a large, expensive pizza oven. You can't just double your kitchen size overnight!

Variable Factors: These are inputs that a firm CAN easily change in a short period.
Example: The number of workers, raw materials like flour and sugar, or electricity used. A restaurant can easily hire one more waiter or buy more ingredients if it gets busy.

Now, let's define our time periods based on these factors:

Short Run: This is a period of time when at least one factor of production is fixed. The firm can only increase its output by using more of its variable factors.
Analogy: Imagine you run a small bakery. In the short run, your oven (fixed factor) is the size it is. To bake more cakes, you can hire more bakers and buy more flour (variable factors), but you're still limited by that one oven.

Long Run: This is a period of time when all factors of production are variable. The firm has enough time to change everything, including its fixed factors. It can change its entire scale of operation.
Analogy: In the long run, you can plan to expand your bakery. You can rent a bigger space, buy more ovens, and completely change the size of your business. Nothing is fixed!

Key Takeaway

The difference between the short run and the long run is about flexibility, not the clock.
Short Run = At least one factor is FIXED.
Long Run = ALL factors are VARIABLE.


2. Production in the Short Run: The Law of Diminishing Marginal Returns

So, a firm is in the short run. It has a fixed factory and wants to produce more. It starts hiring more workers (a variable factor). What happens to its total output? This is explained by a very famous economic law.

First, let's learn three key terms:

  • Total Product (TP): The total quantity of output produced with a given amount of factors.

  • Average Product (AP): The output per unit of the variable factor. Think of it as the average productivity of each worker.
    $$AP = \frac{\text{Total Product (TP)}}{\text{Quantity of Variable Factor (L)}}$$

  • Marginal Product (MP): The extra output produced by adding one more unit of the variable factor. Think of it as the contribution of the newest worker hired.
    $$MP = \frac{\text{Change in Total Product (ΔTP)}}{\text{Change in Quantity of Variable Factor (ΔL)}}$$

Now for the big idea:

The Law of Diminishing Marginal Returns states that as a firm adds more units of a variable factor (like labour) to a fixed factor (like capital/land), the marginal product (MP) of the variable factor will eventually decrease.

Analogy: Let's go back to the bakery with one oven (fixed factor).
- The 1st baker can produce 10 cakes (MP = 10).
- You hire a 2nd baker. They can work together, one mixing and one using the oven. They produce 25 cakes in total. The 2nd baker's MP is 15 (25 - 10). Great! This is 'increasing returns'.
- You hire a 3rd baker. The kitchen is getting a bit crowded. They produce 35 cakes in total. The 3rd baker's MP is 10 (35 - 25). The MP has started to fall. This is 'diminishing returns'.
- You hire a 4th baker. They are now bumping into each other and getting in the way. They produce 38 cakes in total. The 4th baker's MP is only 3 (38 - 35). The MP is still falling.

Notice that total product is still going up, but the *extra* product from each new worker is getting smaller. That's the law of diminishing returns!

Working with Schedules (Tables)

In your exam, you'll need to calculate TP, AP, and MP from a table. Don't worry, it's just simple maths! Let's see how they relate.

Given this information, can you fill in the blanks?
(Fixed Factor = 1 Factory)

Labour (L) | Total Product (TP) | Average Product (AP) | Marginal Product (MP)
0 | 0 | - | -
1 | 8 | ? | ?
2 | 20 | ? | ?
3 | 33 | ? | ?
4 | 40 | ? | ?
5 | 45 | ? | ?

Step-by-step Solution:

  1. Calculate MP: It's the change in TP.
    MP for 1st worker = 8 - 0 = 8
    MP for 2nd worker = 20 - 8 = 12
    MP for 3rd worker = 33 - 20 = 13 (Here, MP is still rising)
    MP for 4th worker = 40 - 33 = 7 (Ah! Diminishing returns have set in!)
    MP for 5th worker = 45 - 40 = 5

  2. Calculate AP: It's TP divided by L.
    AP at L=1 is 8 / 1 = 8
    AP at L=2 is 20 / 2 = 10
    AP at L=3 is 33 / 3 = 11
    AP at L=4 is 40 / 4 = 10
    AP at L=5 is 45 / 5 = 9

Completed Table:

Labour (L) | Total Product (TP) | Average Product (AP) | Marginal Product (MP)
0 | 0 | - | -
1 | 8 | 8 | 8
2 | 20 | 10 | 12
3 | 33 | 11 | 13
4 | 40 | 10 | 7
5 | 45 | 9 | 5

Common Mistake Alert!

Diminishing returns is NOT the same as negative returns. Diminishing returns means the extra output (MP) is getting smaller but is still positive (so TP is still rising). Negative returns would mean MP is negative, causing TP to actually fall!

Key Takeaway

The Law of Diminishing Marginal Returns is a short-run concept. It happens when you add more of a variable factor to a fixed factor. Eventually, the marginal product will fall.


3. Costs in the Short Run

Producing things isn't free! A firm has to pay for its fixed and variable factors. This leads to different types of costs.

Let's define our cost terms:

  • Fixed Cost (FC): Costs of the fixed factors. These costs do not change with the level of output. The firm must pay them even if it produces zero.
    Example: Rent for the factory, insurance.

  • Variable Cost (VC): Costs of the variable factors. These costs increase as output increases.
    Example: Raw materials, wages of production workers.

  • Total Cost (TC): The total cost of production. It's simply the sum of fixed and variable costs.
    $$TC = FC + VC$$

We also look at costs "per unit" of output:

  • Average Fixed Cost (AFC): The fixed cost per unit.
    $$AFC = \frac{\text{Fixed Cost (FC)}}{\text{Quantity (Q)}}$$

  • Average Variable Cost (AVC): The variable cost per unit.
    $$AVC = \frac{\text{Variable Cost (VC)}}{\text{Quantity (Q)}}$$

  • Average Cost (AC) (also called Average Total Cost, ATC): The total cost per unit.
    $$AC = \frac{\text{Total Cost (TC)}}{\text{Quantity (Q)}}$$ or $$AC = AFC + AVC$$

And the most important one for making decisions:

  • Marginal Cost (MC): The extra cost of producing one more unit of output.
    $$MC = \frac{\text{Change in Total Cost (ΔTC)}}{\text{Change in Quantity (ΔQ)}}$$
    Since fixed costs don't change, the change in TC is always equal to the change in VC. So, MC is also $$\frac{\Delta VC}{\Delta Q}$$.

Working with Cost Schedules (Tables)

Just like with production, you need to be able to calculate these costs. Let's try an example.
A firm has a Fixed Cost (FC) of $50.

Quantity (Q) | FC | VC | TC | AFC | AVC | AC | MC
0 | 50 | 0 | ? | - | - | - | -
1 | 50 | 20 | ? | ? | ? | ? | ?
2 | 50 | 35 | ? | ? | ? | ? | ?
3 | 50 | 45 | ? | ? | ? | ? | ?
4 | 50 | 65 | ? | ? | ? | ? | ?

Step-by-step Solution:

  1. Calculate TC: TC = FC + VC
    At Q=0, TC = 50 + 0 = 50
    At Q=1, TC = 50 + 20 = 70
    At Q=2, TC = 50 + 35 = 85
    At Q=3, TC = 50 + 45 = 95
    At Q=4, TC = 50 + 65 = 115

  2. Calculate MC: MC = ΔTC / ΔQ. Since Q increases by 1 each time, MC is just the change in TC.
    MC for 1st unit = 70 - 50 = 20
    MC for 2nd unit = 85 - 70 = 15
    MC for 3rd unit = 95 - 85 = 10
    MC for 4th unit = 115 - 95 = 20

  3. Calculate AFC, AVC, AC: Divide FC, VC, and TC by Quantity (Q).
    At Q=2: AFC=50/2=25; AVC=35/2=17.5; AC=85/2=42.5
    (You can check: AFC + AVC = 25 + 17.5 = 42.5 = AC. It works!)
    Now you can calculate the rest!

Completed Table:

Quantity (Q) | FC | VC | TC | AFC | AVC | AC | MC
0 | 50 | 0 | 50 | - | - | - | -
1 | 50 | 20 | 70 | 50 | 20 | 70 | 20
2 | 50 | 35 | 85 | 25 | 17.5 | 42.5 | 15
3 | 50 | 45 | 95 | 16.7 | 15 | 31.7 | 10
4 | 50 | 65 | 115| 12.5 | 16.25| 28.75 | 20

Key Takeaway

In the short run, costs are divided into fixed and variable.
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC).
Marginal Cost (MC) is the cost of producing one more unit and is key to a firm's output decisions.


4. Production in the Long Run: Economies and Diseconomies of Scale

Welcome to the long run! Here, the firm can change everything. It can build a bigger factory, buy more machines... it can change its scale. So, what happens to average cost when a firm gets much, much bigger?

Economies of Scale: This occurs when a firm's long-run average cost decreases as it increases its scale of production. In simple terms, "bigger is cheaper" (per unit).

Diseconomies of Scale: This occurs when a firm's long-run average cost increases as it increases its scale of production. This happens when a firm gets "too big for its own good".

The reasons for these can be internal (related to the firm itself) or external (related to the whole industry).

Internal Economies and Diseconomies of Scale

These are unique to the individual firm as it grows.

Reasons for Internal Economies of Scale (Why bigger is cheaper):

  • Technical Economies: A large firm can afford large, specialised machinery (like a car assembly robot) that is more efficient than what a small firm can use.
  • Financial Economies: Banks see large, established firms as less risky, so they offer them loans at lower interest rates.
  • Managerial Economies: A large firm can hire specialist managers (e.g., a Chief Financial Officer, a marketing expert), leading to better decisions and efficiency.
  • Marketing Economies: A large firm can buy its raw materials in bulk at a discount. Its advertising cost per unit sold is also lower.

Reasons for Internal Diseconomies of Scale (Why getting too big causes problems):

  • Control and Coordination Problems: A massive firm with thousands of employees is hard to manage. It's difficult to make sure everyone is doing their job properly.
  • Communication Problems: In a huge organisation, messages can get distorted or delayed as they pass through many layers of management.
  • Low Morale: Workers may feel alienated and unimportant in a giant corporation, which can lead to lower productivity.
External Economies and Diseconomies of Scale

These affect all firms in an industry when the entire industry grows in a specific location.

Reasons for External Economies of Scale (Benefits of an industry growing):

  • Pool of Skilled Labour: When many tech companies locate in one area (like Silicon Valley), it creates a large pool of skilled software engineers, making it easier for any firm in that area to hire talent.
  • Ancillary and Supporting Firms: Specialist firms that supply components, provide repairs, or offer transport services may set up nearby, reducing costs for all firms in the industry.

Reasons for External Diseconomies of Scale (Problems of an industry getting too crowded):

  • Increased Competition for Resources: As the industry grows, all firms compete for the same raw materials and skilled workers, bidding up prices and wages for everyone.
  • Congestion: If too many factories are in one area, local roads can become jammed, increasing transport costs and delivery times for all firms.
Quick Review: Internal vs. External

The easiest way to remember the difference:
Internal = Happens because of changes within ONE firm. It's about that firm's size.
External = Happens because of changes in the WHOLE industry. It affects all firms in the area.

Key Takeaway

In the long run, firms can change their scale.
Economies of scale lead to falling average costs as a firm grows.
Diseconomies of scale lead to rising average costs if a firm grows too large.
These can be caused by internal (firm-specific) or external (industry-wide) factors.