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Costs of PRODUCTION (3)

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Miss Cummins

on 13 March 2017

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Transcript of Costs of PRODUCTION (3)

Revenue
Revenue is the money received from sales, and as sales increase,does total revenue

We calculate revenue by multiplying price by quantity


How are Profits calculated?
A firm will make a profit if its TR exceeds its TC
What are Social Costs?
Cost to society of an action or output


What if the AR (price) is fixed??
Costs of PRODUCTION (3)
Social costs/Revenue/
The price that society has to pay as a result of the production/consumption of a commodity
Cost or price that society has to pay for the existence of a particular product
Examples of social costs?
Traffic congestion
Air and water pollution
Global warming
Disfigurement of the landscape due to roads
What is a social benefit?
An advantage that accrues to society as a whole as a result of an individual firm consuming/producing a commodity that is not measured by the price of the system
Examples?
Cycling to work - social benefits
Lower congestion on the roads
Lower pollution levels
Better health - lower health care costs


If a consumer takes action on something, there may be external effects - both benefits and costs to society -
EXTERNALITIES
External Diseconomies of Consumption
External Economies of Production
External Economies of Consumption
External Diseconomies of Production
Action taken by consumer and cost imposed on 3rd party - loud drummer
Action taken by producer and cost is imposed on 3rd party - firm causing air/noise pollution
Action taken by consumer and benefits 3rd party (consumer not compensated) - volunteer at local youth club
Action taken by producers (not compensated) which benefit 3rd parties - company training staff who later leave to work elsewhere
The
private

cost of a good or service is the
cost of the firm
of making the good or providing the service
Marginal revenue
= change in total revenue when an extra unit of output is sold
Average revenue
= dividing total revenue by quantity. Also known as the price of the good, AR is the demand curve
Avg revenue is the same as price
MR and AR relate in the same way as MC and AC
Company facing a downwards sloping demand curve may need to reduce its cost to sell more - this means MR will be less than AR
When MR is less than AR, AR is falling
Avg revenue = marginal revenue
This is also the demand curve
We can use this to calculate profit-maximising position
This includes normal profit - return that rewards the risk taken by the entrepreneur/minimum earned to stay in business
If a company wants to maximise profit, it will produce an extra unit output if its total profit is increased by making this unit !
This occurs if the MR received from producing the good is greater than the marginal cost of producing it - MR > MC
If the firm produces its 6th item - MR is 15 and MC is 11 - it adds 4 to the total profit (31-27=4)
The company therefore should continue to produce this until MC = MR
7th unit produced = MC is 15 and MR is 15
In fact, the firm doesn't have to produce the 7th unit since it adds €15 to TR and TC
Produce where MC = MR
Any good produced after the 7th unit will lead to a fall in profits
If the company produces the 8th unit then MC = 18 and MR = 15 and profits fall


This is our first profit-maximisation condition:
A company should produce when MC=MR
Therefore the company should not produce this unit
No loss but profits are lower than at 7 because MC>MR
Whereas, producing 7 means that MC cuts MR where MC is increasing faster than MR

This is wear the profit is maximised.
Examining the table again, we notice that:

MC = MR at two points


If the company produces two units (MC=MR) it would make a loss of 4
At unit 2 and unit 7
MC cuts MR from below/MC is increasing at a faster rate than MR
Costs
Quantity
Q1
Q2
MR=AR
MC
In the long run, all costs must be covered - AFC, AVC and normal profit
Third profit-maximisation condition:
If a firm is to continue trading in the long run,AR must be at least equal to AC.
Otherwise a business cannot pay its bills
Summary

Short Run Long Run
MC = MR

MC cuts MR from below

AVC covered
MC = MR

MC cuts MR from below

AC below
Question

(a) Assuming a competitive market, under what conditions would a profit-maximising firm at (1) long run equilibrium and (2) short run equilibrium?



1. A profit-maximising firm would be at long run equilibrium when:
MC=MR / MC cuts MR from below or MC is rising faster than MR / Avg revenue should cover all costs otherwise the firm will close down
2. The firm will be in equilibrium in the short run when:
MC=MR / MC cuts MR from below / AR must cover variable costs and contribute to a reduction in fixed costs
(b) Max Flow Ltd incurred the following costs in producing their maximum output of two units per week:

Rent €2,500 (p.w). Lease - 2 years
Normal profit €400 (€200 per unit)
Labour €500 (hired on a weekly basis)
Raw materials €600 (€300 per unit)

What is the minimum price at which each unit can be sold if production is to continue;
(i) In the short run?
(ii) In the long run?

Explain your answer.

(i) Short Run

Labour
Raw Materials
Total
500
600
1,100
Cover only variable costs
Normal profit does not have to be in the short run because price need only cover variable costs.
As €1,100 is the amount of variable cost, then €550 is the minimum price a unit can be sold.
(ii) The long run - cover all costs or else it has to close
Rent
Labour
Raw materials
Normal profit
Total

2,500
500
600
400
4,000
€4,000 for 2 units --> €2,000 for one
Therefore, LR firm must sell at a min price of €2,000 or it will have to close
Normal profit has to be included, as without it the business would not produce
Labour
+ Raw Materials
Total cost
Cost per unit

Cost per unit

A firm must cover its VC in the short run
2,000
3,500
5,500
5,500
÷100
55
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