Rebecca Palmer        Student Number 4444590

BUSINESS ECONOMICS

PRODUCTION COSTS

“Working as an independent consultant economist for the local Business Forum Group 2005 (BFG 2005), you have been asked by the Chairman, Stuart Michaels, to explain to him and his members how economies and diseconomies of scale affect costs and what their respective sources are.  He would also like you to explain how costs in the short run differ from those in the long run”

Rebecca Palmer

1st March 2005

Student Number 4444590

Business Economics 2004/05 Individual assignment

Production Costs

“Working as an independent consultant economist for the local Business Forum Group 2005 (BFG 2005), you have been asked by the Chairman, Stuart Michaels, to explain to him and his members how economies and diseconomies of scale affect costs and what their respective sources are.  He would also like you to explain how costs in the short run differ from those in the long run”

(You should use diagrams where appropriate and make reference to economic theory)

This essay explains how economies and diseconomies of scale affect costs to business and their respective sources.  It also explains how costs in the short run differ from those in the long run.  Diagrams will be used to demonstrate the underpinning theory and relate it to the business environment.

‘Economies of scale are the cost advantages that a business can exploit by expanding its scale of production in the long run’ (Tutor2u., 2005).  As a business grows, its total cost increases but the cost of each unit produced will fall due to production efficiency. This is what gives larger companies a competitive advantage over its smaller rivals.  This reduction in unit cost as output increases is known as economies of scale which enable a company to reduce prices to its customer and increase its profits.

The cost associated with the firms production relates to the input factors used to create the product. Some of these costs are fixed and some are variable, for example, the rent on land is fixed regardless of the productivity of the company, whereas, raw materials are variable costs as the volume used increases with the increase in production.  The total cost (TC) of production is the sum of the total variable cost (TVC) and the total fixed cost (TFC) of production. (Sloman, J., & Sutcliffe, M., 2004 page 173)

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Therefore TC = TVC + TFC    (Sloman, J., & Sutcliffe, M., page 173)

If we take the companies total cost and divide it by each unit of output we have the average cost (AC) of production.  This figure is essential when evaluating the sale price for the unit of output.  It is also necessary to know the marginal cost, which is the cost of producing one additional unit of output.  In order to produce one more unit of output the company will need extra units of variable input, i.e. labour.  This marginal cost information will inform managers ...

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