Production, productivity and the two time periods

Production is total output. Productivity is output per unit of input — usually output per worker per hour. Productivity is the single most important determinant of long-run living standards and of a firm's unit costs.

Economists split time by which factors can be varied:

• Short run — at least one factor is fixed (usually capital: the factory, the machines). Output can only be raised by adding more of the variable factor (labour).
• Long run — all factors are variable. The firm can build a bigger plant, so its whole scale of operation changes.

Do not confuse them: diminishing returns is a short-run idea (a fixed factor is being crowded). Returns to scale and economies of scale are long-run ideas (everything is variable). Mixing them up is one of the most common errors at A-level.

The law of diminishing returns

Picture one kitchen with one oven. The 2nd and 3rd chefs raise output a lot — specialisation, no more idle oven. The 8th chef is elbowing others aside. The 12th chef adds almost nothing. Marginal product has fallen.

The crucial consequence for costs: if each extra worker adds less output but costs the same wage, then the cost of each extra unit of output must be rising. So:

Eventually is doing real work in that definition. At low output there may first be increasing marginal returns (specialisation), which is why MC falls before it rises — giving MC its distinctive tick shape.

Fixed, variable, total, average and marginal cost

• Total fixed cost (TFC) — does not change with output (rent, insurance, a loan taken out last year). It exists even at zero output.
• Total variable cost (TVC) — rises with output (materials, hourly wages, power).
• TC = TFC + TVC.
• AFC = TFC ÷ Q — always falls as output rises (spreading the overhead). It never reaches zero.
• AVC = TVC ÷ Q and ATC = TC ÷ Q = AFC + AVC.
• MC = ΔTC ÷ ΔQ — the cost of producing one more unit. Because TFC does not change, MC is really ΔTVC ÷ ΔQ.

The MC–AC relationship (learn this): if MC is below AC, AC is being pulled down; if MC is above AC, AC is pulled up. So MC cuts AC at AC's minimum point — exactly like adding a below-average exam mark to your average.

Your turn — marginal cost

Your turn — average total cost

MC below AC — what happens?

Returns to scale, economies and diseconomies

In the long run all factors vary, so we ask what happens to output when every input is scaled up by the same proportion:

• Increasing returns to scale — inputs double, output more than doubles → LRAC falls → economies of scale.
• Constant returns to scale — output doubles too → LRAC flat.
• Decreasing returns to scale — output less than doubles → LRAC rises → diseconomies of scale.

Internal economies (from the firm growing) — remember RFTMPT: Risk-bearing · Financial (cheaper borrowing) · Technical (bigger, more efficient machines; the container ship) · Managerial (specialist directors) · Purchasing (bulk buying) · Technological.

External economies (from the industry growing) — a skilled local labour pool, shared infrastructure, university research nearby (think Silicon Valley or the City of London).

Diseconomies — communication failures, coordination problems, low motivation, principal–agent problems in huge firms.

Minimum efficient scale (MES) is the output at which LRAC first reaches its minimum. Where MES is large relative to market demand, only a few firms can survive — that is why steel and rail are concentrated, and it is a barrier to entry (4.1.5). A natural monopoly is the extreme case: MES exceeds total market demand.

Internal, external or diseconomy?

Tap a statement, then tap the category it belongs to.

Total, average and marginal revenue

• Total revenue: TR = P × Q
• Average revenue: AR = TR ÷ Q = P. So the AR curve is the demand curve.
• Marginal revenue: MR = ΔTR ÷ ΔQ — the revenue from selling one more unit.

Price taker (perfect competition): the firm can sell any quantity at the market price, so AR = MR = P and both are horizontal.

Price maker (monopoly, oligopoly, monopolistic competition): to sell one more unit the firm must cut the price on every unit. So MR < AR, and MR falls twice as fast. MR can even be negative — that happens exactly where demand becomes inelastic, which is why a profit-maximising monopolist never operates on the inelastic part of its demand curve.

Your turn — marginal revenue

Profit and the profit-maximising rule

• Normal profit — the minimum return needed to keep the entrepreneur in the industry. It is an opportunity cost, so economists count it as a cost. Normal profit is earned when TR = TC.
• Supernormal (abnormal) profit — anything above normal profit; TR > TC. It is the signal that attracts new entrants (unless barriers stop them).
• Subnormal profit / loss — TR < TC.

Why MC = MR? While MR > MC, the next unit adds more to revenue than to cost, so making it raises profit. While MC > MR, that unit is losing money. Profit therefore peaks exactly where they are equal — pure marginal analysis.

Shut-down rules: in the short run a firm keeps producing as long as P ≥ AVC (it is at least covering its variable costs and making a contribution to the fixed costs it must pay anyway). In the long run it must cover all costs: P ≥ ATC, or it exits.

Your turn — profit

The profit-maximising rule

Fixed cost or variable cost?

Tap a cost on the left, then tap whether it is fixed or variable in the short run.

Short run or long run?

What is normal profit?

The big ideas to know

You have covered the whole of AQA 4.1.4. Press Finish to see your score.