Dr Butler test on costs, revenue and profit (4.1-end of 4.7)

Question 1

what is the difference between short run and long run costs

Answer 1

• short run costs are made up of fixed costs and the costs incurred when hiring the services of the variable factors of production
• long run costs are always variable costs, as fixed costs don’t exist in the long run when a firm can move from one size to another

Question 2

equation for total cost

Answer 2

TC = TFC + TVC

Question 3

equation for average total cost

Answer 3

ATC = AFC + AVC

Question 4

define fixed cost

Answer 4

a cost of production which in the short run does not change with output

Question 5

define variable cost

Answer 5

a cost of prodction which changes with the amount that is produced, even in the short run

Question 6

define total cost

Answer 6

all costs incurred when producing a particular size of output

Question 7

explain the difference between fixed and variable costs

Answer 7

• fixed costs are the costs a firm incurs when hiring or paying for the fixef FsOP
• in the short run, capital is assumed to be a fixed FOP, so costs do not change (costs include maintaining the firm’s building)
• however, variable costs change as the level of output changes
• the costs of hiring labour and buying raw materials are usually regarded as variable costs of production (in the long run all costs are variable as all the FsOP can be changed)

Question 8

explain the difference between total cost, average variable cost and marginal cost

Answer 8

• when a firm increases its output, the total cost of production increases
• at any level of output, the average cost can be calculated by dividing total cost by the size of the output produced
• marginal cost is the addition to total cost of producing one additional unit of output

Question 9

describe the shape of the short run average fixed cost curve (AFC)

Answer 9

• AFC curves always slope downwards to the right, with costs approaching zero but never touching x-axis
• this is because the higher level of output, the more spread the costs are over a larger amount of output

Question 10

describe the shape of the short run average total cost curve (ATC)

Answer 10

• average total cost curve is obtained by adding together the output of the AFC and AVC curves
• this curve is a U shape, which gets very close to the AVC curve but never touches, as the very small amount of AFC is being added on, and is never zero

Question 11

what are sunk costs + example

Answer 11

costs incurred which cannot be recovered if the business closes. e.g. advertising

Question 12

what are some points to remember when all cost curves are put on the same graph

Answer 12

• the marginal cost curve cuts through from below both the AVC and ATC curves at the turning point of both

Question 13

what are economies of scale

Answer 13

• falling long-run average costs of production that result from an increase in the size of scale of the firm

Question 14

what are diseconomies of scale

Answer 14

• rising long run average costs of production

Question 15

describe the graph of economies of scale and why

Answer 15

• the U-shape of the short run ATC curve is explained by the assumption that labour becomes more productive as it is added to fixed capital, before eventually becoming less productive because of the law of diminishing returns
• several short-run average total costs curves are on the LRAC curve, each one represents a particular firm size
• in the long run, a firm can move from one short run cost curve to another, with each curve associated with a different scale of capacity that is fixed in the short run
• the LRAC curve forms a tangent to the SRATC curves, each of which touches the LRAC curve

Question 16

what is the difference between internal and external economies of scale

Answer 16

• external economies of scale occur when average costs of production fall because of the growth of the industry or market that the firm is part of. external diseconomies occur when average costs of production increase because of the growth of the whole industry
• internal economies and diseconomies are the same but occur because the firm itself increases its size and scale

Question 17

what are the different types of internal economies of scale

Answer 17

• technical
• managerial
• marketing
• financial
• risk-bearing
• economies of scope

Question 18

what generates technical internal economies of scale

Answer 18

• generated through changes to the productive process as the scale of production and level of output increase

Question 19

what are the causes of technical economies of scale

Answer 19

indivisibilities - many types of machinery are indivisible as there is a certain minimum size below which they cannot efficiently operate

spreading of R&D costs - with larger plants, R&D costs can be spread over a much longer production run, reducing unit costs in the long run

volume economies - costs increase less rapidly than capacity with many types of capital equipment (doubling dimensions will increase cost by 4 times but volume increases by 8 times)

economies of massed resources - operation of a number of identical machines in a large plant means that proportionally fewer spare marts need to be kept than when fewer machines are involved

economies of vertically linked processes - much manufacturing activity involves a large number of vertically related processes such as purchase of raw materials and energy to completion and sale of the finished product. The linking of processes in a single plant can lead to saving time, transport costs and energy

Question 20

describe managerial economies of scale

Answer 20

the larger the scale of a firm, the greater its ability to benefit from specialisation and division of labour within management and labour force

Question 21

describe marketing economies of scale and the types

Answer 21

two types:
- bulk buying and bulk marketing economies
- large firms may be able to use their market power both to buy supplies at lower prices and to market their products on better terms negoiated with retailers

Question 22

describe financial economies of scale

Answer 22

similar to bulk buying except they relate to bulk-borrowing of funds required to finance the business’s expansion
- large firms can often borrow from banks and other financial institutions at a lower rate of interest and on better terms than those available to small firms

Question 23

describe risk-bearing economies of scale

Answer 23

large firms are usually less exposed to risk than small firms because risks can be spread out
- large firms can spread risks by diversifying their output, markets, supply sources and finance
- these can make the firm less vulnerable to sudden changes in demand or conditions of supply that might severely harm a smaller business that is less diversified

Question 24

describe economies of scope

Answer 24

factors that make it cheaper to produce a range of products together than to produce each one of them on its own

Question 25

what are the different types of internal diseconomies of scale

Answer 25

- managerial - communication failure - motivational

Question 26

describe managerial diseconomies of scale

Answer 26

as a firm grows in size, administration of the firm becomes more difficult - delegation of these to people lower in the organisation may mean that they make bad decisions as they lack experience - this increases avergae costs of production

Question 27

describe communication failure as a diseconomy of scale

Answer 27

in a large organisation, there may be too many layers of management between the top managers and ordinary production workers and staff may feel remote and unappreciated - this could decrease staff productivity and unit costs begin to rise

Question 28

describe motivational diseconomies of scale

Answer 28

with large firms, it is often difficult to satisfy and motivate workers - over specialisation may lead to a situation where workers perform repetitive tasks and have little incentive to use personal initiative in ways that help their employer

Question 29

describe external economies and diseconomies of scale

Answer 29

external economies of scale occur when a firm's average or unit costs of production fall, because of the growth of the industry or market that the firm is part of - external economies of scale are produced by cluster effects, which occur when a lot of firms in the same industry are located close together, producing sources of supply and labour external diseconomies of scale occur in a similar way, with the growth of the whole market raising average costs of all the firms in the industry - these can also come from cluster effects, as they could get in each other's way - there may be competition for labour among the firms - there may be an increase in traffic congestion which lengthens delivery times and raises delvery costs for both firms and for their customers

Question 30

describe what happens and what does it mean when the LRAC curve starts to curve upwards

Answer 30

when the LRAC curve starts to curve upwards, it means there are diseconomies of scale - a business has grown beyond its optimum size - a business is suffering from productive inefficiency - a business may have to raise prices to lower costs - lower competitiveness could lead to a loss in market share - the company share price could fall

Question 31

what is the formula for average revenue

Answer 31

average revenue = total revenue/output

Question 32

what is total revenue

Answer 32

total revenue is all the money a firm earns from selling the total output of a product

Question 33

what is the marginal revenue

Answer 33

marginal revenue is the addition to total revenue resulting from the scale of one more unit of output

Question 34

what is the formula for marginal revenue

Answer 34

change in total revenue / change in output

Question 35

what is the relationship between average revenue and the firm's demand curve

Answer 35

the demand curve facing the firm is the same as its average revenue

Question 36

describe the relationship between average and marginal graph and returns

Answer 36

- average revenue is the reflection of the average cost curve - when marginal returns are above average returns, average returns are rising - when marginal returns are below average returns, average returns are falling

Question 37

what is the relationship between marginal revenue and total revenue

Answer 37

marginal revenue measures the change in total revenue that results from an increase in the quantity of goods sold - it indicates how much revenue increases for selling an additional unit of a good - marginal revenue is also shown by the the slope of the total revenue curve - increasing marginal revenue can be shown by the total revenue curve becoming steeper - falling marginal revenue is shown by the total revenue curve becoming less steep as sales increase

Question 38

what is profit

Answer 38

profit is the difference between the sales revenue the firm reveives when selling the goods or services it produces and the costs it incurs when producing these gods or services

Question 39

formula for profit

Answer 39

total profit = total revenue - total costs

Question 40

what is profit maximisation and when does it occur

Answer 40

occurs when the firm is producing the level of output at which profit is greatest

Question 41

what is the goal of a business according to classical economists

Answer 41

profit maximisation

Question 42

explain the roles of profit in a free market

Answer 42

- acts as an incentive for firms to grow, for other firms to enter the market and for workers - profit is a source of finance, as higher dividend payments encourage more shareholders to invest - profit is a reward for innovation and entrepeneurship, encouraging risk taking - if firms are making profit, it is a signal the economy is growing

Question 43

what are the two types of profit

Answer 43

normal and supernormal

Question 44

describe normal profit

Answer 44

normal profit is the minimum profit a firm must make to stay in business - where firm breaks even (TR=TC) - normal profit is insufficient to attract new firms into the market - in the long run, if a firm cannot make normal profit, it will shut down

Question 45

describe supernormal profit

Answer 45

it is the extra profit, above normal profit - acts as a signal for resources to shift into this sector and for other firms to enter the market

Question 46

when is there abnormal profits (<>)

Answer 46

when TR > TC

Question 47

when is there a loss (<>)

Answer 47

when TC > TR