Cost & Revenue Theory 2
The Law of Diminishing Returns 3
Economies of Scale 4
Opportunity Cost & Production Possibility Frontiers 5
Cost & Revenue Theory
There are five main types of production costs which are defined and explained below:
1. Fixed costs (FC) are costs such as rent and interest which do not vary with output. These costs still have to be paid by the firm in the short run whether or not they are producing output.
2. Variable costs (VC) are costs such as wages and raw materials which do vary with output. The more output a firm produces in the short run the higher will be its variable costs of production.
3. Total costs (TC) refer to the sum of fixed and variable costs of production for a firm i.e. TC = FC + VC
4. Average cost (AC) refers to the average cost of producing a unit of output by a firm. Average costs are determined by dividing the total cost (TC) of production by the number of units of output (O) produced by a firm i.e. TC/O = AC
5. Marginal cost refers to the change in total cost as one more unit of output is produced by a firm i.e. ∆TC/∆O = MC
• Total revenue (TR) refers to the total sales receipts a firm receives from selling a given level of output and is equal to the price multiplied by the quantity of output sold i.e.
TR = Price x Output
• Average revenue (AR) refers to the average price a firm receives for selling its output. It is calculated by dividing total revenue (TR) by the number of units of output (O) sold i.e.
TR AR= O
• Marginal revenue refers to the change in total revenue as one more unit of output is sold by a firm i.e.
∆TR MR = ∆O
The Law of Diminishing Returns
Fixed Factors of Production: Do not vary with output e.g. land and capital.
Variable Factors of Production: Vary with output in the short run e.g. labour and raw materials.
The law of diminishing returns or variable proportions suggests that as increasing quantities of a variable factor are added to a fixed factor of production in the short run, total output will eventually decline, leading to diminishing returns to the variable factor. Various assumptions are made regarding the use of the following economic model to explain the law of diminishing returns:
• There are only two factors of production: land and labour.
• One factor such as land is a fixed factor, and the other factor, such as labour, is a variable factor.
• A farmer is assumed to use various quantities of the variable factor of labour in combination with the fixed factor of land to produce wheat.
• The level of technology and all other factors of production are held constant.
Total Physical Product (TPP): The total output of goods using the sum of fixed and variable factors of production.
Average Physical Product (APP): Measure of the productivity of the variable factor of production labour.
Marginal physical product (MPP): The change in total physical product that occurs with the addition of one more unit of the variable factor of labour. MPP = △TPP
TPP increases at an increasing rate with each successive unit of labour employed between 1 and 5. This indicates increasing returns to the variable factor of labour. After the employment of the sixth unit of labour, TPP still increases but at a decreasing rate. This indicates diminishing returns to the variable factor of labour. TPP declining indicates negative returns to the variable factor of labour.
APP increases between the employment of the first and sixth units of labour. This indicates the rising productivity of labour as the total physical product of wheat increases with each successive unit of labour employed.
MPP indicates the rate of change in TPP. The MPP of the seventh, eighth and ninth units of labour are less than the APP of each of these workers, indicating the declining productivity of labour.
The principle of diminishing returns is important in guiding firms to use the most efficient combination of resources to produce…