# Production and Costs Production Costs and

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```					          Production, Costs and Revenue
AS Economics
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Short and long run production
• Production refers to the output of goods and services
produced within a market
• Short run production
– The short run is a period of time when there is at least
one fixed factor of production. This is usually the
capital input such as plant and machinery and the
stock of building and technology
– In the short run, output expands when more variable
factors (labour, raw materials and components) are
employed
• Long run production
– In the long run, all factors of production can change as
a business can increase the scale of its operations
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In the short run

• In the short run
we assume that
operating with a
fixed amount of
capital and a
given state of
technology
• How does
production
increase in the
short run?

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In the long run
• In the long run, all of
the factors of
production are
variable
• The whole scale of
production can
change
long run can take         The warehouse at
economies of scale        Northamptonshire

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The Production Function
• Output (Q) = f (K, L, La, T)
• Where
– Q = output per period
– K = capital input
– La = labour input
– L= natural resource input (land)
– T= the state of technology

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The law of diminishing returns
• 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
• Diminishing returns occur when the marginal product
of labour starts to fall
– The Law of Diminishing Returns occurs because
factors of production are not perfect substitutes for
each other
– Resources used in producing one type of product are
not necessarily as efficient when switched to the
production of another good or service

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Marginal and average product
Units of Labour   Total Physical Product   Marginal Product    Average Product
Employed          (tonnes of wheat)        (tonnes of wheat)   (tonnes of wheat)
0                 0

1                 3                        3                   3

2                 10                       7                   5
3                 24                       14                  8
4                 36                       12                  9
5                 40                       4                   8
6                 42                       2                   7
7                 42                       0                   6

When does diminishing returns start to occur here?
When is output per worker at a maximum?
What is the relationship between marginal product and
average product?
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Fixed and variable costs of production
• Costs are those expenses faced by a business when
producing a good or service for a market
• Total Cost
– Total Cost is made up of fixed costs and variable costs
• Fixed Costs
– These costs relate to the fixed factors of production
and do not vary directly with the level of output
• 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
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Fixed and variable costs - SpeedFerry

Identify some of the fixed and variable costs facing the
SpeedFerry business as it competes in the cross-
channel transport market
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Average fixed costs fall as output rises

Output   Total Fixed Costs   Average Fixed Cost
(000s)        (£000s)              (AFC)
0             30
1             30                 30
2             30                 15
3             30                 10
4             30                 7.5
5             30                  6
6             30                  5
7             30                 4.3

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Average Fixed Costs

Costs
Average fixed cost falls as output increases
– because fixed costs are being spread over
a higher level of production

£30k                                                       Total Fixed Costs

Average Fixed Cost

1                                                        Output (Q)

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Example of operating costs - Ryanair
2004 (million Euro)

Staff costs                      123.6

Depreciation of capital          98.1

Fuel and oil                     175.0

Maintenance / materials / repairs 43.4

Aircraft rentals                 11.5

Route charges                    110.3

Airport and handling charges     147.2

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• Low operating costs
• High load factor (% of flight seats booked is high)
• Aggressive route expansion (network economies)
• Growth of ancillary revenues (car hire, hotels, in-flight
entertainment)
• Low prices (exploiting the concept of price elasticity
of demand)

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Threats to Ryanair
• Volatility of fuel prices
• Fluctuations in the exchange rate
• External shocks such as terrorist attacks
• Pricing strategies of other airlines
• Introducing of a aviation fuel tax to control pollution
• Regulatory decisions of international bodies

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Revenue and Profit
Revision presentation on revenue and profit
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Total Sales Revenue

Supply
Price

Revenue at
price P1 and
output Q1

P1

D1       D2

Q1                     Quantity

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Total Sales Revenue – Shift in demand

Supply
Price

Revenue at
price P2 and
output Q2
P2
P1

D1       D2

Q1 Q2                     Quantity

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Costs and Revenues
Output    Total   Average Total   Marginal   Price per unit      Total   Profit (loss)
(units)   Cost            Cost       Cost        (demand)     Revenue
0    100
20     140               7          2                8        160              20
40     160               4          1              7.5        300             140
60     174              2.9        0.7               7        420             246
80     184              2.3        0.5             6.5        520             336
100     190              1.9        0.3               6        600             410
120     204              1.7        0.7             5.5        660             456
140     238              1.7        1.7               5        700             462
160     288              1.8        2.5             4.5        720             432
180     360               2         3.6               4        720             360
200     460              2.3         5              3.5        700             240
220     660               3         10                3        660               0

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Description: Production and Costs