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Economic Environment of Business

factor of production that displays first increasing and then decreasing marginal productivity. Increasing marginal productivity is associated with the negatively sloped portion of the marginal cost curve, while decreasing marginal productivity is associated with the positively sloped portion. The average fixed cost (AFC) curve is the cost of the fixed factor of production divided by the quantity of units of the output, while the average variable cost (AVC) curve cost traces out the per unit cost of variable factor of production.

The U-shaped average total cost (ATC) curve is derived by adding the average fixed and variable costs. Declining average total costs are explained as the result of spreading the fixed costs over greater quantities and, at low quantities, the result of the increasing marginal productivity, in addition. Increasing average costs occur when the effect of declining marginal productivity overwhelms the effect of spreading the fixed costs. In the short run, the law of diminishing returns states that as we add more units of a variable input (i. e. labour or raw materials) to fixed amounts of land and capital, the change in total output will at first rise and then fall.

Diminishing returns to labour occurs when marginal product of labour

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starts to fall. This means that total output will still be rising – but increasing at a decreasing rate as more workers are employed. Figure 1. Short-run unit cost curves: marginal cost (MC), average total cost (ATC), average variable cost (AVC) and average fixed cost (AFC). Long-run Cost Curves

In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market. The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable). The LRAC curve or envelope curve is drawn on the assumption of infinite plant sizes. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves, each based on a particular fixed level of capital usage.

The points of tangency occur at the point where the minimum efficient scale (MES) is achieved. MES is the minimum level of output required to fully exploit economies of scale in the long run. Figure 2. The long-run average cost (LRAC) curve is an envelope curve of the short-run average cost (SRAC) curves. Increasing, constant and decreasing returns to scale are exhibited at points a, b and c, respectively Different firms have different short term cost curves as the potential for a firm to exploit economies of scale is different.

Similarly, the long run average total cost curve does not always have to have the shape illustrated in the diagram above. Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation which allows smaller suppliers to sell their output at a premium price to the market average, taking advantage of the willingness and ability of consumers to pay higher prices to cover the increased cost per unit.

There may be room for one firm to exploit the increasing returns to scale available in the industry greater than some other firm in the industry. For example for a natural monopoly the long-run average cost curve falls continuously over a very large range of output. There is likely to be great potential to exploit technical economies of scale. As a result the MES will be a high proportion of total market demand. b) Transaction Costs Transaction costs as discussed in economic theory refer to the cost of anything that might be defined as a transaction.

Whenever goods exchange hands, there are transaction costs. Broadly defined, transaction costs include that which would have been saved had the goods not exchanged hands. Depending on the situation, transaction costs may be independent of the quantity or value of goods transferred. In other cases there may be pronounced economies of scale, where larger transactions incur relatively smaller transaction costs on a cost per unit basis. The two most important factors to consider in a make-or-buy decision are cost and the availability of production capacity.

If the purchase price is higher than what it would cost the manufacturer to make it. Cost considerations should include all relevant costs and be long-term in nature. Also if the manufacturer has excess capacity that could be used for that product, or the manufacturer’s suppliers are unreliable, then the manufacturer may choose to make the product. A company choosing to make or buy also requires making a thorough analysis of various other conditions alternative sources, design flexibility, and access to technological innovations. c)

Economies and Diseconomies of Scale In the long run all factors of production are variable; the whole scale of production can change. In this note we look at economies and diseconomies of large scale of production. Economies of Scale When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs.

The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods. For example as the firm grows, division of labour and specialization could be possible to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs.

The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production levels increased. There are two types of economies of scale: -External economies – the cost per unit depends on the size of the industry, not the firm. -Internal economies – the cost per unit depends on size of the individual firm. Diseconomies of Scale Some firms become too large and reach a point where the average cost per unit begins to increase, which is called diseconomies of scale.

Diseconomies of scale leads to rising long run average costs which are due to firms expanding beyond their optimum scale. Diseconomies are difficult to identify precisely. They are often caused by the complex nature of managing large scale firms with the growth of a business such as managing large organisation with many workers spread over a large area can be very difficult due to following factors – costs of administration and coordination, problems in monitoring the effectiveness of workers, growth of corporate bureaucracy, increase in transportation costs to distant markets.

Diseconomies can lead to misallocation of scarce resources if firms do not achieve long run productive efficiency. How a profit maximising manager might deal with them The U-Shape of Average cost curve further helps to deal efficiently with economies and diseconomies of scale. The curve shows relationship between cost and quantity produced in short run (when labour is variable) and in the long run (when other factors of production are variable). When cost curve goes downward, it shows economies of scale i. e. Gains and efficiencies associated with efficient employment of factors of production.

The point at which the curve becomes flat (or straight after going downward) is the Minimum Efficient Scale. At this point average cost is minimum. After that, because of over employment of factors of production, average cost curve starts rising and results in diseconomies of scale. A profit maximising manager must not expand beyond this level. a) The Keynesian perspective on investment The “Keynesian” approach has a more “behavioural” take on the investment decision. Namely, the Keynesian approach argues that investment is simply what capitalists “do”. (Trygve Haavelmo,1960).

Every period, workers consume and capitalists “invest” as a matter of course. This leads Keynesians to underplay the capital stock decision. This does not mean that Keynesians ignore the fact that investment is defined as a change in capital stock. Rather, they believe that the main decision is the investment decision; the capital stock just “follows” from the investment patterns rather than being an important thing that needs to be “optimally” decided upon beforehand. Thus, when businesses make investment decisions, they do not have an “optimal capital stock” in the back of their mind.

They are more concerned as to what is the optimal amount of investment for some particular period. For Keynesians, then, optimal investment not about “optimal adjustment” but rather about “optimal behaviour”. The Keynesian theory of investment places emphasis on the importance of interest rates in investment decisions. But other factors also enter into the model – not least the expected profitability of an investment project. Changes in interest rates should have an effect on the level of planned investment undertaken by private sector businesses in the economy.

A fall in interest rates should decrease the cost of investment relative to the potential yield and as result planned capital investment projects on the margin may become worthwhile. A firm will only invest if the discounted yield exceeds the cost of the project. b) Keynes’s concept of ‘animal spirits’ “Animal spirits” is the term John Maynard Keynes used in his 1936 book The General Theory of Employment (Keynes, 1936), Interest and Money to describe emotion or affect which influences human behaviour and can be measured in terms of consumer confidence..

It is clear that Keynes believes economic fluctuations can be partly explained by spontaneous (or exogenous) shifts in moods (optimism or pessimism). The causal chain form the change in moods to economic fluctuations, is not through changes in the expected utility of different alternatives, but through the degree to which we want to act or be passive. c) Potential determinants or ‘drivers’ of aggregate investment in macroeconomies Interest rates play a key role in the determination of the desired stock of capital and thus of investment.

A negative relationship exists between interest and all forms of investment: higher interest rates tend to reduce the quantity of investment, while lower interest rates increase it. Although investment certainly responds to changes in interest rates, changes in other factors appear to play a more important role in driving investment choices. Expectations A change in the capital stock changes future production capacity. Therefore, plans to change the capital stock depend crucially on expectations.

A firm considers likely future sales; a student weighs prospects in different occupations and their required educational and training levels. As expectations change in a way that increases the expected return from investment, the investment demand curve shifts to the right. Similarly, expectations of reduced profitability shift the investment demand curve to the left. The Level of Economic Activity Firms need capital to produce goods and services. An increase in the level of production is likely to boost demand for capital and thus lead to greater investment.

Therefore, an increase in GDP is likely to shift the investment demand curve to the right. To the extent that an increase in GDP boosts investment, the multiplier effect of an initial change in one or more components of aggregate demand will be enhanced. We have already seen that the increase in production that occurs with an initial increase in aggregate demand will increase household incomes, which will increase consumption, thus producing a further increase in aggregate demand. If the increase also induces firms to increase their investment, this multiplier effect will be even stronger.

The Stock of Capital The quantity of capital already in use affects the level of investment in two ways. First, because most investment replaces capital that has depreciated, a greater capital stock is likely to lead to more investment; there will be more capital to replace. But second, a greater capital stock can tend to reduce investment. That is because investment occurs to adjust the stock of capital to its desired level. Given that desired level, the amount of investment needed to reach it will be lower when the current capital stock is higher. Capacity Utilization

If a large percentage of the current capital stock is being utilized, firms are more likely to increase investment than they would if a large percentage of the capital stock were sitting idle. During recessions, the capacity utilization rate tends to fall. The fact that firms have more idle capacity then depresses investment even further. During expansions, as the capacity utilization rate rises, firms wanting to produce more often must increase investment to do so. The Cost of Capital Goods The demand curve for investment shows the quantity of investment at each interest rate, all other things unchanged.

A change in a variable held constant in drawing this curve shifts the curve. One of those variables is the cost of capital goods themselves. If, for example, the construction cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall. The investment demand curve thus shifts to the left. Other Factor Costs Firms have a range of choices concerning how particular goods can be produced. A factory, for example, might use a sophisticated capital facility and relatively few workers, or it might use more workers and relatively less capital.

The choice to use capital will be affected by the cost of the capital goods and the interest rate, but it will also be affected by the cost of labour. As labour costs rise, the demand for capital is likely to increase. Technological Change The implementation of new technology often requires new capital. Changes in technology can thus increase the demand for capital. Advances in computer technology have encouraged massive investments in computers. The development of fiber-optic technology for transmitting signals has stimulated huge investments by telephone and cable television companies.

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