Production and Cost
Domain 4 covers how inputs become output and what that output costs: factors of production and their rewards, the production function, the law of variable proportions, returns to scale, cost curves and revenue relationships.
Production
- Factors: land (rent), labour (wages), capital (interest), organisation (profit).
- Short run: at least one factor fixed. Long run: all factors variable.
- Law of variable proportions (short run): Stage I - TP rises at an increasing rate and MP rises; Stage II - TP rises at a diminishing rate, MP falls but stays positive, AP falls; Stage III - MP is negative and TP falls. A rational producer operates in Stage II.
- Returns to scale (long run): increasing, constant or decreasing when all inputs rise proportionately.
Cost and revenue
- TC = TFC + TVC; AC = TC/Q; MC = change in TC / change in Q.
- MC is independent of fixed cost. MC cuts AC at the minimum point of AC.
- Short-run AC is U-shaped because of the law of variable proportions; long-run LAC is an envelope of short-run curves.
- TR = P x Q; AR = TR/Q = price; MR = change in TR / change in Q. MR = AR(1 - 1/e).
Worked example
TFC = 100. TVC for 0, 1, 2, 3 units is 0, 50, 90, 120. Then TC = 100, 150, 190, 220. AC = 150, 95, 73.3 for the three positive outputs. MC = 50, 40, 30. MC (40, 30) lies below AC (95, 73.3), so AC keeps falling; AC will bottom out only where MC equals AC.
Traps
- Deducting fixed cost when computing MC; MC depends only on variable cost.
- Saying AC is minimum where MC is minimum; it is minimum where MC = AC.
- Confusing diminishing returns (one input rises) with decreasing returns to scale (all inputs rise).
- Writing AR as different from price under perfect competition; there AR = price.