= the additional output of additional workers.
Fixed costs: costs that do not vary with output ( rent, insurance, basic wages- managers wages are fixed)
Variable costs: Those costs that vary directly with output ( e.g. labour, overtime, energy, resources, depreciation)
Total Costs: total fixed costs + total variable costs
TC= TFC + TVC
TC= A(verage)TC x OUTPUT
Total fixed costs= TFC= TC-TVC ( total variable costs)
Total variable costs= TVC= TC- TFC
Average total costs= ATC= total cost / output
= average fixed costs + average variable costs
Marginal costs= the cost incurred by a firm when it produces ONE extra unit of output. It can be considered the most important cost to a firm.
= the change in total costs caused by change in total output of one unit.
= change in total costs / change in number of units produced
Total revenue ( TR)= price per unit X number of units sold
Average revenue ( AR) = total revenue/ number of units sold
Profit (or loss)= total revenue- total costs
What determines the demand for factors of production and effects of substituting one factor with another
Large scale productions and diminishing returns
If a firm wants to increase production it can do three main things:
- can reorganize labour to increase efficiency short run
- can employ more labour
- increase capital or increase or change all factors of production- this occurs in the long run.
- in the very long run ( 10+) years, production can increase as tech changes.
As production increases in the long run after a change in all factor inputs, we have 3 possible outcomes:
- production increases by less than doubling inputs- called a diminishing return to scale.
- Production doubles- constant return to scale
- Production more than double- increasing return to scale.
These 3 changes to production, constant, diminishing and increasing returns to scale are all called ECONOMIES OF SCALE, and describe production changes after changes in all factor inputs in the long run.
What is an economy of scale?
An economy of scale is where company makes cost savings by increasing production.
Internal economies- firm controls
External economies- outside firms control
Types of economies of scale ( INTERNAL economies of scale)
- FINANCIAL ECONOMIES
A large firm has several financial advantages because it is large, well known and becomes a more credit-worthy borrower than a smaller firm. This means that
a) a large firm can borrow money from a number of different sources, to buy new machines. Large firms may also be able to raise money from the genral public by selling them shares through the Stock Exchange.
b) large firms have more assets than a small firm, like machinery, deeds to factories and offices, that they can offer to lenders in case of the nlikely even that they cannot repay the loan. Because this even is so unlikely, financial institutions are very willing to lend money to these firms.
c) because large firms represent such low risk borrowers, financial institutions may not charge them so much for giving them a loan.
- MARKETING ECONOMIES
The way large firms buy materials, transport and sell their products can also bring them advantages.
- a large firm is able to buy in large quantities of the materials they need and may also be able to store them. Because of this, suppliers will often sell things in bulk at discount pirces. They may also offer to deliver the goods to the firm at special low rates to secure their regular custom.
- The large firm is able to afford to employ specialist buyers who have the knowledge and the skills necessary to buy the best quality materials at the best possible prices.
- In large shops specialist sales staff can help customers to buy the things they want, while large manufacturing firms can employ specially trained staff to visit shops and warehouses to sell the products they make.
- Although large firms spend huge amounts of money on advertising their products to create a demand for them, their advertising costs are spread over a large output.
- TECHNICAL ECONOMIES
The larger firm can afford to use different methods of production.
- Large firms can afford to employ specialist workers and machines. They can divide up the production process into specialized tasks so that production becomes faster as each worker becomes an expert in their particular job ( division of labour). In small firms there are simply not enough workers or specialized machinery to make this profitable.
- Large firms can also afford to research and develop new faster methods of production and new products. The cost may be high but it is spread over a large output.
- The larger the firm, the more transport it needs to carry materials and products to and fro. As a firm grows in size, it can afford to use large types of transport like juggernauts, or in the case of oil companies, supertankers.
- RISK-BEARING ECONOMIES
Running a firm is a risky business and clearly the bigger the firm the more things can go wrong. Therefore larger firms try to overcome the risk in a number of ways:
- a small firm is likely to need only small amounts of raw materials or components to produce goods or services and so it would probably only obtain these from one supplier. A large firm will, however, need to buy materials in bulk and if they cannot obtain these for some reason, for example, a strike at their suppliers or some transport problems, then their whole operation will grind to a halt. Large firms will try to resolve the risk of this happening by using many different suppliers, buying some of the materials they need from each/
- a small firm is only likely to produce the one particular good or service and they could find themselves in trouble if consumers suddenly decided not to buy that product. If a large firm did the same, a fall in consumers’ demand for their product would have devastating effects. In order to reduce the risk of a fall in consumer demand damaging the firm, large enterprises orften produce a whole variety of hoods and services, so that if demand for one falls they still have other they can make and sell. This is known as diversification which means producing a diversity or whole variety of products.
External Economies ( of scale)
External economies of scale are factors that affect company costs but are outside the control of the company. Usually these factors are controlled by the government. Examples are:
- Tax. Reduction in tax causes costs to fall
- Interest rates. Reduction in interest causes costs to fall.
- Exchange rates. Reduction in exchange rates causes costs to fall.
- Education and training. Improvement in labour reduce costs.
- Infrastructure. An improvement in roads etc. reduce costs.
- pollution laws can increase or reduce costs.
Diseconomies of scale
Diseconomies take place when increases in production increase costs; this can result from lower efficiency in the company- called internal diseconomies of scale. Other factors outside the firm also increase costs- called external diseconomies ( see above).
Large firms have to be divided up into many specialist departments, for example, the planning department, personnel, accounts, production, design, sales etc. Each department will have a manager responsible for running it. For the firm to run successfully, all the departments must work together, but with so many departmental managers, decisions will take a long time and there may be disagreement.
Large firms use very specialized mass-production techniques. Labour is divided up into many specialized tasks but workers may then become very bored with their repetitive and often monotonous jobs. The work-force may then become less co-operative or less attentive to their work, so that the quality of the products they produce suffers. Strikes and disruptions may also occur if the workers feel they are poorly treated.
The Advantages of a Whole Industry Being Large
When a whole industry expands, either because the number of firms within it is growing or the existing firms are getting bigger, the firms in the industry may find they can enjoy certain benefits. External economies of scale use those advantages in the form of lower average costs which a firm gains from the growth of the industry. They are especially important when all the firms in an industry tend to locate together in one particular place. In this case external economies of scale are known as economies of concutation.
SKILLED LABOUR: When firms involved in the same type of activities locate near each other they all employ certain local people in the work skills they need. A large skilled labour force emerges which can benefit other firms who move into the area.
ANCILLARY FIRMS: In areas where similar firms locate, other firms may join them to cater for some of their needs.
CO-OPERATION: Where firms locate together to produce one particular good or service they tend to help each other though they are also competing with each other to sell their products.
However there may be disadvantages if there are too many firms in an area. This can lead to traffic congestion, pollution etc.
Why are there SMALL FIRMS?
( main reasons for the different sizes of firms)
Large firms can enjoy special advantages like bulk buying, receiving loans at low interest rates and employing specialist staff. With lower average costs than smaller firms, large businesses can lower their prices to attract consumers. With such fierce competition why is it that small firms can still survive and why does there appear to be a growth in their number?
- THE SIZE OF THE MARKET MAY BE SMALL
Small numbers of consumers are willing to buy a product. The size of the market will therefore decide the size of the firm. There may be reasons why the Markey for a particular good is small.
- the market is LOCAL- where only one small firm is able to supply a good or service to the people of a particular area. We call it a local monopoly.
- A WIDE VARIETY of goods and services are wanted-consumers may want a wide variety of choice of products in different colours, styles and designs. Large firms that mass produce goods cannot afford to keep changing the colours and designs, while smaller firms can often cater for a variety of tastes.
- Luxury items are HIGHLY PRICED- the market may be limited by price. That is high prices mean that only a handful of rich people can afford to buy a very expensive product, that is produced by small firms for a small number of people.
- People like PERSONAL SERVICE- industries which provide services rather than goods usually consist of a large number of small firms e.g. lawyers.
- A large firm requires COMPONENT PARTS- many small firms can survive by producing parts of large manufacturers. They are protected by a PATENT, which disallows by law any other firm from copying their idea.
2.SMALL FIRMS CAN CO-OPERATE
Co-operation between small firms can lead them to set up jointly-owned enterprises which allow them to enjoy many of the economies of scale that large firms have.
3.THE GOVERNMENT HELPS SMALL FIRMS
Successive UK govt. have provided help to small businesses because they are a key provider of employment and innovations. Govt. have a variety of measures to help owners of small and medium sized enterprises:
- Business Link: it provides affordable advice and training to all businesses.
- Loan guarantee scheme: it encourages banks and other financial institutions to lend money for periods between teo and ten years to small businesses.
- Enterprise allowance: financial help and training is available for unemployed people between 18 and 24 years of age who can’t start their own business.
- The small business service: provides advice
- Tax measures: corporation tax has been recently lowered for small businesses, so they can spend the credits on new research and development.
THE GROWTH OF FIRMS ( INTEGRATION)
Firms may wish to become large due to the advantages of economies of scale but also so that they can put up their prices and stop smaller firms from competing with them.
There are two methods by which a firm can grow. The first is by INTERNAL GROWTH where the firm increases its own size by producing more under its existing structure of management and control. The second and more common method today, is by AMALGAMATION ( OR INTEGRATION). This occurs where one or more firms join together to form a larger enterprise.
Firms can amalgamate or integrate in one of these two ways:
It occurs when one company buys all, or at least 50% of the shares in the ownership of another company. In this way, the firm being taken over by another company often loses its identity and becomes part of another company.
It occurs when two or more firms agree to join to form a new enterprise. This is usually done by shareholders of the two or more companies exchanging their shares for new shares of the new company.
There are THREE main forms of integration between firms;
- HORIZONTAL INTEGRATION
This occurs when firms engaged in the production of the same type of good or service combine. Most amalgamations are of this type e.g. British Petroleum with Amoco in the oil and gas industry
- VERTICAL INTEGRATION
This occurs when firms engaged in different stages of production combine. This would be the case if an oil refinery combined with a chain of petrol stations. This is called forward integration. Firms can also undertake a backward integration e.g. a bread manufacturer combining with a wheat producers’ association. In this way the firm can ensure a supply of materials.
- LATERAL INTEGRATION
This happens when firms in the same stage of production, for eg primary or secondary production, but producing different products combine. This is often a conglomerate merger to form conglomerates which are firms which produce a wide range of products e.g. unilever is a firm famous for its detergents but with interests in food, chemicals, paper, plastics, animal feeds etc.