3.3.2 Costs

Question 1

Explain what economic costs are and how they relate with opportunity costs

Answer 1

• Economic costs are incurred by a business engaged in producing / supplying an output
• Some of these costs relate to the opportunity cost of production.
• For example, if an entrepreneur invests £200,000 of their own money into a business, that money could have yielded an alternative return (interest) by being saved in a bank.
• Thus, the next best alternative rate of return on this money is treated as part of the economic cost of
  production.

Question 2

What are short run costs of production?

Answer 2

At least one of the factor inputs is fixed (usually this is capital but can also be land). In the short
run, businesses are constrained with fixed & variable factors.

Question 3

What are long run costs of production?

Answer 3

All factors of production are variable, and the scale of production can also change allowing the
firm to benefit from economies of scale

Question 4

Explain what fixed costs are

Answer 4

• Fixed costs do not vary at all as the level of output changes in the short run
• Fixed cost has to be paid, whatever the level of sales achieved. Fixed costs are incurred even if output is zero
  in the short run
• The higher the level of fixed costs in a business, the higher must be the output in order to break-even

Question 5

What are examples of fixed costs?

Answer 5

Question 6

Explain variable costs

Answer 6

• Variable costs are costs that relate directly to the production or sale of a product.
• An increase in short run output (Q) will cause total variable cost to rise (TVC).
• Average variable cost (AVC) = total variable cost / output (i.e. TVC divided by Q).
• Variable cost is determined by the marginal cost of extra units as more labour is hired

Question 7

What are examples of variable costs?

Answer 7

Question 8

How do you work out Total Costs?

Answer 8

• Total Cost = Total Fixed Costs + Total Variable Costs

Question 9

What is marginal cost?

Answer 9

• Marginal Cost = the addition to total costs of producing one more unit

Question 10

What is average cost?

Answer 10

• Average Cost = Total Cost ÷ Output

Question 11

What is total product?

Answer 11

Total product = total output, or total units produced

Question 12

What is marginal product?

Answer 12

Marginal product = the additional output produced when an extra worker (or other factor of production) is
employed

Question 13

What is average product?

Answer 13

Average product = total output ÷ number of workers. This is also the same as productivity

Question 14

Explain the law of diminishing returns

Answer 14

In the short run, at least one factor of production is fixed. Let’s assume that this is capital. The only way to increase output is to employ more workers. Initially, adding an additional worker will cause productivity to rise, as the workers can use some division of labour and focus on tasks that they are relatively better at. However, as more workers are added to the fixed amount of capital, the capital becomes increasingly scarce – there may not be enough to go round,
causing workers to get delayed and in each other’s way. This causes productivity to fall. At the point where marginal product start to fall, we say that “diminishing returns has set in”.

Question 15

Explain what happens in this table.

Answer 15

• When diminishing returns set in then the marginal product of labour starts to fall
• When marginal product of labour declines below existing average product then the average product of labour will fall – e.g. in this case when the 5th worker is employed

Question 16

What happens when the marginal product of extra labour is falling?

Answer 16

When the marginal product of extra labour is falling – assuming that each worker is paid the same wage rate – then
the marginal cost of supplying extra output will increase. Diminishing returns help to explain the conventional shape
of the short-run marginal cost curve.

Question 16

Show the relationship between the marginal and the average cost curve with a short run cost curve

Answer 16

Question 17

Explain the fixed and variable costs on a short run cost curve

Answer 17

• Average variable cost (AVC) is variable cost per unit of output.
• The shape of AVC is determined by the shape of marginal cost – rising MC is due to diminishing returns
• Average fixed costs fall continuously as output increases because total fixed costs are being spread over a higher level of production
• AFC is the difference between AC and AVC

Question 18

What does the Total fixed costs and average fixed costs look on a short run cost curve?

Answer 18

Question 19

What are factors causing shifts in supply costs?

Answer 19

Changes in the unit costs of production:

• Lower unit costs mean that a business can supply more at each price – for example higher labour productivity
• Higher unit costs cause an inward shift of supply e.g. a rise in wage rates or an increase in energy
  prices / other raw material prices
• A fall (depreciation) in the exchange rate causes higher prices of imported components and raw materials
• Advances in production technologies – outward shift of supply

Taxes, subsidies and government regulations:
* Indirect taxes cause an inward shift of supply
* Subsidies cause an outward shift of supply
* Regulations increase costs – causing an inward shift of supply

Question 20

Show a change in fixed costs on a short run cost curve, but explain what happens with a change in variable costs

Answer 20

• An increase in fixed costs causes an upward shift in average total cost but does not cause the marginal cost
  curve to change!
• A change in fixed costs will only shift the AC curve and not the MC curve; a change in variable costs will shift
  both

Question 21

Show an increase in variable costs on a short run cost curve

Answer 21

Question 22

What are ways in which changes in government economic policy can influence the costs of businesses?

Answer 22

1. Changes in value added tax (VAT) and other indirect taxes on producers such as the Sugar Levy
2. Environmental taxes (including a possible carbon tax) and introducing a minimum price for each tonne of
   carbon emitted within the EU carbon trading scheme
3. Changes in labour market interventions such as the National Minimum Wage
4. Government subsidies targeting producers such as an employment subsidy or guaranteed minimum payment

Question 23

Analyse how a rise in the minimum wage might affect the profitability of a business, using chains of analysis

Answer 23