Chapter 5 - Costs of production

Question 1

What is the economic (opportunity) cost?

Answer 1

The amount of other products that must be foregone or sacrificed to obtain a unit of any product. There are both explicit and implicit opportunity costs.

Question 2

What are explicit costs?

Answer 2

Those monetary payments a firm makes to non-owners of the firm who are suppliers of labour, materials, fuel, transport etc

Question 3

What are implicit costs?

Answer 3

Are the monetary incomes a firm sacrifices when it employes a resource it owns to produce a product rather than supplying the resource in the market. Ie the income forgone by a self employed person to work for themselves.

Question 4

What is normal profit?

Answer 4

A cost and is the minimum payment required that is just sufficient to obtain and retain the entrepreneur’s talent and effort

Question 5

What is accounting profit?

Answer 5

It is the total revenue of a firm less all of its explicit costs. ie. Total revenue - explicit costs

Question 6

What is an economic (pure) profit?

Answer 6

It is the total revenue of a firm less all its economic costs (including the cost of entrepreneurial ability. i.e total revenue - opportunity costs of all inputs.

Question 7

Resources in a company are classified in what two ways?

Answer 7

Variable resources and fixed resources

Question 8

What are variable resources?

Answer 8

Factors of production whose quantity can be increased or decreased during a particular period

Question 9

What are fixed resources?

Answer 9

Factors of production whose quantity cannot be increased or decreased during a particular period.

Question 10

How do resources vary over the short run and long run?

Answer 10

Over the short run, only some resources are variable, but over the long-run they are all variable.

Question 11

What is the law of diminishing returns?

Answer 11

As successive units of a variable resource are added to a fixed resource, beyond some point the extra product attributable to each additional unit of the variable resource will decline. Eg. fertilising a field will initially yield more, but there will be a point where it does no extra benefit or could do harm.

Question 12

What is total product (TP)?

Answer 12

It is the total output of a particular good or service produced by a firm (or group of firms) as a result of combining resources.

Question 13

What is marginal product (MP)?

Answer 13

The additional output of a particular good or service resulting from the addition of an extra unit of a resource.

Question 14

What is average product (AP)?

Answer 14

The total output of a particular good or service per unit of a resource employed.

Question 15

Where does MP intersect AP?

Answer 15

Where AP is at it’s maximum.

Question 16

What are fixed costs?

Answer 16

Costs that do not vary with changes in output - they must always be paid.

Question 17

What are variable costs?

Answer 17

They are costs which vary with changes in output, for example materials and labour.

Question 18

How is total cost calculated?

Answer 18

The sum of fixed and variable costs.

Question 19

What is the average fixed cost (AFC)? and how is it drawn?

Answer 19

It is the total fixed cost (TFC) divided by the corresponding output (Q). It is drawn left to right dropping quickly then levelling out.

Question 20

What is the average variable cost (AVC)? and how is it drawn?

Answer 20

It is the total variable cost (TVC) divided by the corresponding output (Q). Is an envelope shape, dropping slightly and after crossing MC rising slightly

Question 21

What is the total variable cost (TVC)? and how is it drawn?

Answer 21

Both fixed and variable costs divided by the output. It starts high, drops quickly then rises after crossing the MC. Because it is total costs in includes AVC and AFC

Question 22

What is Marginal Cost (MC)? and how is it drawn?

Answer 22

It is the extra or additional cost of producing one more unit of output, ie the change in TC divided by the change in Q. It is drawn as a U with the minimum close to the origin of the axes.

Question 23

What does marginal cost when combined with marginal revenue tell a firm?

Answer 23

Whether it is profitable to expand or contract its level of production.

Question 24

When MC is greater than the ATC, what happens to ATC?

Answer 24

It increases.

Question 25

What does it mean when ATC is equal to MC?

Answer 25

ATC is at its minimum.

Question 26

What could cause fixed costs to change?

Answer 26

Technology

Question 27

What does the ATC long-run curve show?

Answer 27

The lowest per-unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in the plant size.

Question 28

So what is the long-run ATC curve shape dependent on?

Answer 28

• The level of economies of scale, and

* scale is variable based on different levels of plant utilisation.

Question 29

What does a short-run ATC curve show and how do multiple curves create the long-run ATC curve?

Answer 29

they show the short run curve applicable to the each plant capacity size. Together the minimums make up the long run curve, also called an ‘envelope curve’

Question 30

Why does the law of diminishing returns not apply to a long-run curve?

Answer 30

Because over the long run resources can be varied, and the law requires at least one resource is fixed in supply.

Question 31

What is the long-run ATC curve defined by?

Answer 31

By economies or diseconomies of scale.

Question 32

What economies of scale cause the down sloping part of the long-run ATC?

Answer 32

• labour specialisation
• managerial specialisation
• efficient capital - affording/using best technology
• sale/use of by-products - eg beer co sells yeast for vegemite.

Question 33

What are diseconomies of scale caused by?

Answer 33

Impared efficiency due to managerial coordination problems and bureaucratic red tape.

Question 34

What is the MES?

Answer 34

The minimum efficiency scale - it is the smallest level of output at which a firm can minimise long-run average costs.

Question 35

What does a long MES mean?

Answer 35

Companies of different sized can realise the MES and be viable

Question 36

What does a short MES at the far right of a graph suggest?

Answer 36

That there are large economies of scale to be had by increasing output, which means small firms may not be viable.

Question 37

What does a steep economies of scale and steep diseconomies of scale (v shape) graph suggest.

Answer 37

Economies of scale can be made quite quickly, but so can diseconomies of scale, suits retail, farming and manufacturing.

Question 38

What is a natural monopoly?

Answer 38

Where due to the nature of technology required in the production process and the size of the market, MES extends beyond the market’s size, so MES cannot be achieved due to the size and stock of capitial required for operation.

Question 39

Clearly state the nature of economic costs; that is what do economic costs represent?

Answer 39

Economic costs are opportunity costs, and represent those payments a firm must make, or the incomes it must provide to resource suppliers in order to attract their resources away from their alternative production opportunities.

Question 40

Distinguish between explicit and implicit costs, giving examples of each

Answer 40

Explicit costs are costs that flow to resource suppliers who are separate from a given enterprise, ie employing a second accountant, and implict costs are those that represent remuneration of self-owned and self-employed resources, including a normal profit to the entrepreneur. Ie, use of your house as office and payment of yourself.

Question 41

What is the importance of the difference between explicit and implicit costs to the calculation of economic and accounting profits?

Answer 41

Economic cost is calculated as total revenue less economic costs, where as accounting costs are total costs less explicit costs.

Question 42

Why does the economist classify normal profits as a cost?

Answer 42

It is a cost because it represents the minimum payment that must be received to secure the services of the entrpreneur.

Question 43

Are economic profits a cost of production?

Answer 43

No, they are simply the total revenue of the firm less all economic costs.

Question 44

Why can the distinction between fixed and variable costs be made in the short run, but not in the long run?

Answer 44

In the long run all resource inputs used by the firm are variable. In the short run some resources are variable and others, such as plant are fixed.

Question 45

What is the law of diminishing returns and by what other terms is it known?

Answer 45

Shows the impact on output in the short run as variable resoures are added to the production process and fixed resources are used more intensively. It is also known as the law of diminishing marginal productivity.

Question 46

What are the implications for short-run costs of the law of diminishing returns?

Answer 46

That the costs will become smaller until some point when they will start to rise. It is only applicable to the short run because there are no fixed resources in the long run.

Question 47

At what different levels do we consider costs in economics?

Answer 47

Fixed cost, variable cost and total cost. Also average cost and marginal cost.

Question 48

What are economies and diseconomies of scale?

Answer 48

Economies of scale are labour specialisation, managerial specialisation, efficient capital and by-products. Diseconomies of scale are managerial ‘red tape’ that are caused by constant returns to scale.

Question 49

What is the concept of minimum efficient scale and why is it of relevance in a discussion of long-run average costs?

Answer 49

It is the smallest level of out put at which a firm can minimise long-run average costs.

Question 50

What meaning may the detailed shape fo the long-run ATC curve have for the structure of an industry?

Answer 50

It can influence how successful a certain sized company will be within a particular industry.