3.3.2 - COSTS

Question 1

What are fixed costs?

Answer 1

The costs that do not vary with output.
EG: salaries, property, insurance

Question 2

What are variable costs ?

Answer 2

The costs that do vary with output.

EG: wages, raw materials, electricity

Question 3

What is the short run?

Answer 3

This is when there is at least 1 fixed factor of production.

Question 4

What is the long run?

Answer 4

Where all the FoP are variable, making it easier for a firm to increase output.

Question 5

What is the law of diminishing marginal returns?

Answer 5

In the short run only, when a variable factor of production is added to a stock of fixed factors of production, the result is a relatively small increase in output.

Total/marginal product will initially rise, and then it would get smaller and then fall.

Question 6

MP and the MP curve

Answer 6

Marginal product is the change in output that results from employing an additional FoP.

The curve is the inverse of the MC curve. It has an upside down nike tick shape. Initially marginal product will be rising as employing an extra FoP will increase productivity, however when the curve stops rising and starts sloping downwards, diminishing returns sets in and and productivity starts falling

Question 7

MC and the MC curve

Answer 7

MC is the extra cost after producing an additional unit of a good.

The MC curve is a nike tick curve due to diminishing marginal productivity. (inverse of MP curve)
The marginal cost decreases initially, as extra FoP are added and when marginal product is rising. Then the lowest point of MC is reached and MC starts increasing, and this is when diminishing marginal returns sets in, causing cost to increase. When MC is rising, marginal productivity is falling.

Question 8

Relationship between MC and MP

Answer 8

There is an inverse relationship. When MP is increasing, MC is falling, and when MP is falling, MC is increasing.

Question 9

Why does diminishing marginal returns occur? (Using the labour FoP)

Answer 9

In stage 1 of the graphs, there is specialisation between workers as they teach each other, and there is underutilisation of machinery which employees can utilise to be more productive and efficient.

Then, when DMR sets in, in stage 2 of the graphs, productivity and efficiency falls, as marginal product falls, causing costs to increase.

Question 10

AFC and the curve

Answer 10

AFC is FC/Q

AFC starts high because the fixed cost (which are constant) are being divided by a small quantity, however then, as output increases, AFC falls because the same fixed costs are now being divided by a larger quantity.

Question 11

AC/ATC and the curve

Answer 11

AC is TC/Q
ATC=TC/Q OR AFC+AVC

The curve is the smile face u-shaped curve. This is due to the law of diminishing marginal productivity. The costs are initially falling as FoP are being added and being use efficiently however when production continues to expand, FoP are overused and efficiency falls.

When AC is falling, this is due to economies of scale, and when it starts to rise, this is due to diseconomies of scale.

Question 12

Relationship between MC and AC.

Answer 12

MC meets AC at the lowest part of the AC curve.

When MC<AC, AC is falling, because to produce an additional unit, it costs less than the average.
When MC>AC, AC is rising,
When they are equal, we are at the minimum point of AC when diminishing returns starts to set in.

Question 13

AVC and the graph

Answer 13

AVC = VC/Q

AVC is always under the AC/ATC curve. It is also a U-shaped smiley curve and it is seen to gradually get closer to AC as AFC gradually falls.

It is u-shaped due to the law of diminishing marginal productivity.

Question 14

TFC and the curve

Answer 14

Costs are fixed, so they don’t change and this is represented by a straight horizontal line.

Question 15

TVC and the graph

Answer 15

TVC = TC/Q

TVC starts from the origin because when quantity produced is 0, there are no variable costs.

Initially, as more variable FoP are employed, productivity increases without an increase in costs and this is shown by the horizontal part of the graph. This continues until diminishing marginal returns sets in, and then TVC increases as productivity falls.

Question 16

TC and the graph

Answer 16

TC = TFC + TVC

The curve starts from the top of the TFC curve as TC is the sum.

The difference in both of these curves is constant and this constant is equal to TFC. TC and TVC are drawn parallel to each other.

Question 17

What is long-run in economics?

Answer 17

This is when all the FoP are variable. This is called scale, and when businesses increase their FoP to expand, they are said to be scaling up.

Question 18

What are returns to scale ?

Answer 18

This refers to the changes that take place to the firms costs and production as we vary the FoP in the long run.

Question 19

What are constant RTS?

Answer 19

This is when the change in output responds proportionately to the change in input.
% change in output = % change in input
Shown by the flat part of the LRAC curve

Question 20

What are increasing RTS?

Answer 20

This is when output responds by a greater proportion to input, and this can cause AC to fall.
% change in input < % change in output
This is shown by the downwards sloping part of the LRAC curve.

Question 21

What are decreasing RTS?

Answer 21

This is when output increases by a smaller proportion than input, and can result in higher AC.
% change in output < % change in input
Shown by the upwards sloping part of the LRAC curve.

Question 22

Difference between SRAC and LRAC curves

Answer 22

The SRAC curve is U-shaped due to the law of diminishing marginal returns, however the LRAC curve is U-shaped due to the firm first experiencing economies of scae, causing the AC to decrease, but then the firm experiences diseconomies of scale, causing AC to increase.

Question 23

Minimum point of the LRAC curve

Answer 23

This is when AC are at their lowest, and firms tend to operate at this point due to competition, because if firms operate at any other point, their AC will be higher so consumers will face higher costs and therefore buy from competitor firms.

Question 24

What is the MES?

Answer 24

This is as soon as the curve stops decreasing and it is the minimum level of output required for firms to fully exploit economies of scale. In order to compete, firms should AT LEAST be producing at the MES.

Question 25

Why does MC intersect Ac at its lowest point?

Answer 25

When Mc is less than AC, this means the cost of producing an extra unit will bring the extra cost down, and after they meet, the additional cost will raise the average.