Question

Q1. [5 marks] Explain the relationship between the different cost elements, the scale of production, and marginal productivity.

Q2. [20 marks]

Consider the following statement from ‘The Conversation’1 regarding trade:

“The Federal Government’s new Buy Australian campaign comes amid growing concern that further layoffs will follow the loss of 1000 BlueScope jobs…”

a. [10 marks] Use your knowledge from this course to explain why buying foreign goods would lead to workers losing their jobs.

b. [10 marks] Would you encourage the government to continue funding the ‘Buy Australia campaign’? Explain your reasoning.

Answer 1

ANS. 1.

Total Cost

In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.

Calculating total cost: This graphs shows the relationship between fixed cost and variable cost. The sum of the two equal the total cost.

Variable Costs

Variable cost (VC) changes according to the quantity of a good or service being produced. It includes inputs like labor and raw materials. Variable costs are also the sum of marginal costs over all of the units produced (referred to as normal costs). For example, in the case of a clothing manufacturer, the variable costs would be the cost of the direct material (cloth) and the direct labor. The amount of materials and labor that is needed for each shirt increases in direct proportion to the number of shirts produced. The cost “varies” according to production.

Fixed Costs

Fixed costs (FC) are incurred independent of the quality of goods or services produced. They include inputs (capital) that cannot be adjusted in the short term, such as buildings and machinery. Fixed costs (also referred to as overhead costs) tend to be time related costs, including salaries or monthly rental fees. An example of a fixed cost would be the cost of renting a warehouse for a specific lease period. However, fixed costs are not permanent. They are only fixed in relation to the quantity of production for a certain time period. In the long run, the cost of all inputs is variable.

Economic Cost

The economic cost of a decision that a firm makes depends on the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost is the sum of all the variable and fixed costs (also called accounting cost) plus opportunity costs.

Average and Marginal Cost

Marginal cost is the change in total cost when another unit is produced; average cost is the total cost divided by the number of goods produced.

Marginal Cost

In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is $30. The total cost for making two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.

Average Cost

The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.

Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:

Cost curve: This graph is a cost curve that shows the average total cost, marginal cost, and marginal revenue. The curves show how each cost changes with an increase in product price and quantity produced.

• When the average cost declines, the marginal cost is less than the average cost.
• When the average cost increases, the marginal cost is greater than the average cost.
• When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.

Short Run and Long Run Costs

Long run costs have no fixed factors of production, while short run costs have fixed factors and variables that impact production.

In economics, “short run” and “long run” are not broadly defined as a rest of time. Rather, they are unique to each firm.

Long Run Costs

Long run costs are accumulated when firms change production levels over time in response to expected economic profits or losses. In the long run there are no fixed factors of production. The land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of producing a good or service. The long run is a planning and implementation stage for producers. They analyze the current and projected state of the market in order to make production decisions. Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired quantity of the goods at the lowest possible cost. Examples of long run decisions that impact a firm’s costs include changing the quantity of production, decreasing or expanding a company, and entering or leaving a market.

Short Run Costs

Short run costs are accumulated in real time throughout the production process. Fixed costs have no impact of short run costs, only variable costs and revenues affect the short run production. Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials. The short run costs increase or decrease based on variable cost as well as the rate of production. If a firm manages its short run costs well over time, it will be more likely to succeed in reaching the desired long run costs and goals.

Differences

The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run. In the long run the general price level, contractual wages, and expectations adjust fully to the state of the economy. In the short run these variables do not always adjust due to the condensed time period. In order to be successful a firm must set realistic long run cost expectations. How the short run costs are handled determines whether the firm will meet its future production and financial goals.

Cost curve: This graph shows the relationship between long run and short run costs.

Economies and Diseconomies of Scale

Increasing, constant, and diminishing returns to scale describe how quickly output rises as inputs increase.

In economics, returns to scale describes what happens when the scale of production increases over the long run when all input levels are variable (chosen by the firm). Returns to scale explains how the rate of increase in production is related to the increase in inputs in the long run. There are three stages in the returns to scale: increasing returns to scale (IRS), constant returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between industries, but typically a firm will have increasing returns to scale at low levels of production, decreasing returns to scale at high levels of production, and constant returns to scale at some point in the middle.

Long Run ATC Curves: This graph shows that as the output (production) increases, long run average total cost curve decreases in economies of scale, constant in constant returns to scale, and increases in diseconomies of scale.

Increasing Returns to Scale

The first stage, increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced causes a decrease in the average cost of each unit. In other words, a firm is experiencing IRS when the cost of producing an additional unit of output decreases as the volume of its production increases. IRS may take place, for example, if the cost of production of a manufactured good would decrease with the increase in quantity produced due to the production materials being obtained at a cheaper price.

Constant Return to Scale

The second stage, constant returns to scale (CRS) refers to a production process where an increase in the number of units produced causes no change in the average cost of each unit. If output changes proportionally with all the inputs, then there are constant returns to scale.

Diminishing Return to Scale

The final stage, diminishing returns to scale (DRS) refers to production for which the average costs of output increase as the level of production increases. The DRS is the opposite of the IRS. DRS might occur if, for example, a furniture company was forced to import wood from further and further away as its operations increased.

Economic Costs

The economic cost is based on the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen.

Economic Cost

Throughout the production of a good or service, a firm must make decisions based on economic cost. The economic cost of a decision is based on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost includes opportunity cost when analyzing economic decisions.

An example of economic cost would be the cost of attending college. The accounting cost includes all charges such as tuition, books, food, housing, and other expenditures. The opportunity cost includes the salary or wage the individual could be earning if he was employed during his college years instead of being in school. So, the economic cost of college is the accounting cost plus the opportunity cost.

Components of Economic Costs

Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity. Before making economic decisions, there are a series of components of economic costs that a firm will take into consideration. These components include:

• Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
• Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and buildings. Variable input is traditionally assumed to be labor.
• Total variable cost (TVC): same as variable costs.
• Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
• Total fixed cost (TFC): same as fixed cost.
• Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
• Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function continuously declines as production increases.
• Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is normally U-shaped. It lies below the average cost curve, starting to the right of the y axis.
• Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
• Cost curves: a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.

"Scale of production is set by the size of plant, the number of plants installed and the technique of production adopted by the producer".

Classifications/Types:

The scale of production is classified as under:

(i) Small Scale Production.

(ii) Large Scale Production.

(iii) Optimum Scale of Production.

(i) Small Scale Production: If a firm produces goods with small sized plants, the scale of production is said to be small scale production. Small scale of production is associated with low capital output and capital labor ratios. In small scale of production, the economies of scale do not occur to the firm.

(ii) Large Scale of Production: If a firm uses more capital and larger quantities of other factors, it is said to be operating on large scale production. Large scale production enjoys both internal and external economies of scale.

(iii) Optimum Scale of Production. The optimum scale of production refers to that size of production which is accompanied by maximum net economics of scale, it is a scale at which the cost of production per unit is the lowest.

Economies of Scale refer to the cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the inverse relationship between per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output. This is brought about by operational efficiencies and synergies as a result of an increase in the scale of production.

Economies of scale can be implemented by a firm at any stage of the production process. In this case, production refers to the economic concept of production and involves all activities related to the commodity, not involving the final buyer. Thus, a business can decide to implement economies of scale in its marketing division by hiring a large number of marketing professionals. A business can also adopt the same in its input sourcing division by moving from human labor to machine labor.

Effects of Economies of Scale on Production Costs

1. It reduces the per-unit fixed cost. As a result of increased production, the fixed cost gets spread over more output than before.
2. It reduces per-unit variable costs. This occurs as the expanded scale of production increases the efficiency of the production process.

Diseconomies of Scale

The graph above plots the long-run average costs faced by a firm against its level of output. When the firm expands its output from Q to Q2, its average cost falls from C to C1. Thus, the firm can be said to experience economies of scale up to output level Q2. (In economics, a key result that emerges from the analysis of the production process is that a profit-maximizing firm always produces that level of output which results in the least average cost per unit of output).

Types of Economies of Scale

1. Internal Economies of Scale

This refers to economies that are unique to a firm. For instance, a firm may hold a patent over a mass production machine, which allows it to lower its average cost of production more than other firms in the industry.

2. External Economies of Scale

These refer to economies of scale enjoyed by an entire industry. For instance, suppose the government wants to increase steel production. In order to do so, the government announces that all steel producers who employ more than 10,000 workers will be given a 20% tax break. Thus, firms employing less than 10,000 workers can potentially lower their average cost of production by employing more workers. This is an example of an external economy of scale – one that affects an entire industry or sector of the economy.

Sources of Economies of Scale

1. Purchasing

Firms might be able to lower average costs by buying the inputs required for the production process in bulk or from special wholesalers.

2. Managerial

Firms might be able to lower average costs by improving the management structure within the firm. The firm might hire better skilled or more experienced managers.

3. Technological

A technological advancement might drastically change the production process. For instance, fracking completely changed the oil industry a few years ago. However, only large oil firms that could afford to invest in expensive fracking equipment could take advantage of the new technology.

Diseconomies of Scale

Consider the graph shown above. Any increase in output beyond Q2 leads to a rise in average costs. This is an example of diseconomies of scale – a rise in average costs due to an increase in the scale of production.

As firms get larger, they grow in complexity. Such firms need to balance the economies of scale against the diseconomies of scale. For instance, a firm might be able to implement certain economies of scale in its marketing division if it increased output. However, increasing output might result in diseconomies of scale in the firm’s management division.

Frederick Herzberg, a distinguished professor of management, suggested a reason why companies should not blindly target economies of scale:

“Numbers numb our feelings for what is being counted and lead to adoration of the economies of scale. Passion is in feeling the quality of experience, not in trying to measure it.”

In economics and in particular neoclassical economics, the marginal product or marginal physical productivity of an input (factor of production) is the change in output resulting from employing one more unit of a particular input (for instance, the change in output when a firm's labor is increased from five to six units), assuming that the quantities of other inputs are kept constant.

The marginal product of a given input can be expressed as:

where is the change in the firm's use of the input (conventionally a one-unit change) and is the change in quantity of output produced (resulting from the change in the input). Note that the quantity of the "product" is typically defined ignoring external costs and benefits.

If the output and the input are infinitely divisible, so the marginal "units" are infinitesimal, the marginal product is the mathematical derivative of the production function with respect to that input. Suppose a firm's output Y is given by the production function:

where K and L are inputs to production (say, capital and labor). Then the marginal product of capital (MPK) and marginal product of labor (MPL) are given by:

In the "law" of diminishing marginal returns, the marginal product initially increases when more of an input (say labor) is employed, keeping the other input (say capital) constant. Here, labor is the variable input and capital is the fixed input (in a hypothetical two-inputs model). As more and more of variable input (labor) is employed, marginal product starts to fall. Finally, after a certain point, the marginal product becomes negative, implying that the additional unit of labor has decreased the output, rather than increasing it. The reason behind this is the diminishing marginal productivity of labor.

The marginal product of labor is the slope of the total product curve, which is the production function plotted against labor usage for a fixed level of usage of the capital input.

In the neoclassical theory of competitive markets, the marginal product of labor equals the real wage. In aggregate models of perfect competition, in which a single good is produced and that good is used both in consumption and as a capital good, the marginal product of capital equals its rate of return. As was shown in the Cambridge capital controversy, this proposition about the marginal product of capital cannot generally be sustained in multi-commodity models in which capital and consumption goods are distinguished.

Relationship of marginal product (MPP) with the total product (TPP)

The relationship can be explained in three phases- (1) Initially, as the quantity of variable input is increased, TPP rises at an increasing rate. In this phase, MPP also rises. (2) As more and more quantities of the variable inputs are employed, TPP increases at a diminishing rate. In this phase, MPP starts to fall. (3) When the TPP reaches its maximum, MPP is zero. Beyond this point, TPP starts to fall and MPP becomes negative.

ANS. 2.

The Federal Government’s new Buy Australian campaign comes amid growing concern that further layoffs will follow the loss of 1000 BlueScope jobs and that the mining boom is crushing manufacturing.

But Ministers Kim Carr and Martin Ferguson are wasting their time calling for industry to buy Australian.

The idea that a government should lobby consumers to buy ethnocentrically is nothing new. The Buy Australian campaign has been pushed for nearly 20 years by various governments, although the idea first emerged in the 1920s. The Kiwis have been doing it since 1988 and the British have been doing it since 1931.

While such programs may have a slight impact on consumer preferences, the evidence is pretty clear that they do not make significant differences to market share of locally made products.

Even entrepreneur Mr. Smith accepts that the majority of what goes into an Australian supermarket trolley is not made by Australian companies.

Academic research suggests that consumers are more concerned about product quality and price than country of origin. So why do we expect them to buy Australian?

Aside from the fact such campaigns have little real effect, we need to keep in mind that when governments are keen to join the WTO and reduce trade barriers, such programs are nothing more that hypocritical public relations exercises for the electorate.

Governments are clearly wasting tax revenue on a marketing campaign that is unlikely to have any real effect: perhaps aside from patronising unions.

The recent demand by the Federal Government for Australian businesses to buy Australian is no different. These businesses are expected by their shareholders to buy materials at the best possible price in order to get the best return for their money.

As many of these shareholders are offshore, no CEO is going to be popular if he or she allows a purchasing department to use company revenue to subsidise Australian industry.

The government who is making this demand is the same government that complained when the United States implemented a “Buy American” campaign as part of its financial stimulus bill.

If we want to reduce trade barriers and become part of the global community, then we have to accept that jobs will be lost in industries that are not competitive.

Unfortunately, the difference between being competitive and not being competitive could be as simple as a swing in the value of the dollar, as we are experiencing now.

Australian companies who export are suffering enough; to ask them to lose more revenue to support other Australian businesses just won’t work.

The research demonstrates consumers are more concerned about product quality and price than country of origin.

When the evidence over years suggests consumers do not respond to buy locally campaigns, there is no reason to think that businesses would do any different.

In short, the Federal Government is wasting their time. Australian companies that export are already facing more difficult trading conditions because of the dollar; asking them for a handout to support other Australian companies is just not going to happen.

ANS.3.

Buying of Foreign goods lead workers to loose their jobs because the effect of rising imports on total employment is offset by rising export employment and the reallocation of workers to other industries. Due to the advancement of technology many foreign products are modified and upgraded to the next level which attract consumers towards them. Also, they become cheap due to less manpower. Tons of products can be produced in one through advanced technology which workers cannot. These machines are so typical that workers find it difficult to operate. Also, the effect of excessive imports is said to be the purchase of cheaper foreign goods by domestic consumers rather than purchasing the slightly more expensive domestic varieties. As demand for domestic firms’ products falls, these firms are forced to downsize, resulting in the layoff of domestic workers. imports exceed exports is because exports are too low; they are smaller than they should be. The most common reason given for low exports, especially in the developed countries, is the relatively high barriers to trade in developing countries. Although many countries participate in the World Trade Organization (WTO), the average applied tariffs still remain considerably higher in developing countries.The effect of insufficient exports is that products that could be produced and sold abroad are not produced and sold abroad because of the barriers to trade.

ANS. 4.

Yes.

In a victory for the union movement, the government has done a backflip on its opposition to the unions 'Buy Australia' campaign - geared to give preferential treatment to Australian companies and businesses. Industry and Innovation Minister Kim Carr has announced a funding package that he says should give local industry a better chance at winning local contracts. Government supports growers, processors and manufacturers in Australia by helping businesses to clearly identify to consumers that their products are Australian. At the same time it provides consumers with a highly recognised and trusted symbol for genuine products and produce. It does both of these things in conjunction with a campaign encouraging consumers to look for the logo when shopping.It will also help the businesses to grow and expand in the competitive world and attract more consumers so that their demand can be increased.