Sunday, February 21, 2010

Unit 3 - Economic costs and profit

Unit 3 was focused on economic costs and profit for individual firms in a competitive perfect market. It was broken down into the following three sections, production, economic cost and economic profit.

The first part of the production section briefly discussed how companies produce outputs from operations and inputs. It also discussed value chains which can help managers think about a firm’s value adding activities, resources and capabilities. In a value chain there are primary activities which directly relation to producing/selling a company’s product, while there are also secondary activities which assist a firm in accomplishing its primary activities. For example, a primary activity for McDonald’s is the service of the front staff when ordering a burger while a secondary activity is the human resource management managing the staff.

This section briefly described the operation and services choices for a company and their associated trade-offs. For example, professional services offers large amount of variety in the products and services they offer customers the more likely the volume they produce is small, compared to a line operations where they generally offer limited products and services to clients but can produce large volumes. The implicit opportunity costs is where firms are able to increase their variety and while increasing their volume as well.

Variable inputs are easy to change, while fixed inputs are hard and costly to change. However, time is often a determining factor in considering if an input is fixed or variable. I.e. A firm may find it impossible to increase inputs for a product over a period of a day however are easily able to do this over a period of a year. For example, relocating factory to increase output may not be able to be changed within a day due to lease agreements however over a year the lease agreement may expire and they are able to move to a bigger factory.

Total Product is the total quantity of products produced when combining the variable inputs with fixed inputs. Marginal product is the difference in total product per a unit change in variable inputs. Average product is different from the marginal product is it is the total product per each unit. When the marginal product is above the average product curve the average product is rising and when it falls below the average product curve the average product decreases. Meaning that the curves will intersect at the highest point on the average product curve.

Diminsihing marginal returns is when the marginal product decreases with each additional unit of variable input. This is generally happens when the efficiency of adding another unit has reached its maximum and an additional unit does not add as much value as the previous unit added. This is a result of input over-crowding as management of these inputs become harder due to room or support.

Law of diminishing returns is where the total product falls when additional units of variable inputs are increased.

Economic costs are talked about in section 2 of this unit. If the economic costs are employed properly a equilibrium point between the products and costs can be found. Fixed costs are the opportunity costs associated with input. I.e. if a factory is leasing a building, this is generally a fixed costs as it does not matter on the success of the factory on what it needs to pay. If it is producing a lot of products, turning over a large profit the rent would be the same as if the factory was producing no products and therefore no profits. Variable costs are opportunity costs associated with variable inputs, which vary with changes in output.

Total costs is the cost of both fixed and variable costs combined.

Average fixed cost (AFC) is the total fixed cost per each unit of output. Average variable cost (AVC) is the total variable cost per each unit of output. Average total cost is AFC combined with AVC.

Marginal cost is the extra cost to produce one additional unit of output. Note that the MC and ATC curves intersect at the lowest value of the ATC, as the ATC will increase if the MC curve is above it or decrease of the MC is below it.

The cost curves will shift for many reasons such as a change in fixed costs or variable costs. Technology change or new operations producers.

There were three main sections when viewing the costs over the long run. The first section was economies of scale, then constant returns to scale and finally diseconomies of scale. These are dependent of the coordination costs or over-crowding of inputs that are not within the firms control. Managers can integrate many techniques into their businesses to capture economies of scale such as labour and managerial specialisation, efficient capital and head office, producing by-products and outsourcing.

A firm has a cost advantage if the total opportunity cost of performing all activities within a firm is lower than the total opportunity cost of a competitor costs. This is normally achieved by controlling the cost drivers and/or reconfiguring the value chain to make it more efficient in producing, distributing or marketing a product.

Note in this unit we are under the assumption of a competitor perfect market making a company’s demand curve perfectly elastic i.e. flat. This means they do not have any influence on the market and have to follow market driven prices.

Total revenue (TR) is the total amount in dollars received by a firm from the sale of their product. Average revenue(AR) is the average price received for the product per an output. Marginal revenue (MR) is the change in the total product per a change in level of the output.

Economic profit (EP) is greatest when the difference between TR and TC is greatest. Marginal economic profit (MEP) is MR minus MC, which means when MC=MR the EP is maximised.

A firm should enter the market when TR is greater than TC, MR is greater than MC and the price is greater than the market price. A firm should exit in the long run when the above is the exact opposite.

However, a company should only temporarily shut down when total revenue is less than variable costs, marginal revenue is less than marginal variable costs and the price is less than the average variable cost. This is because if a firm can cover its variable costs it may of well keep on trading in the short turn as any profit made above the variable costs can be put towards paying for fixed costs.

Please note that this was discussing an ideal case, there are not many firms that do not have at least some market power and the

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