Chapter 4-1: Costs and Revenue Flashcards
Explicit Costs
Costs incurred when an actual monetary payment is made
Wages / cost of raw materials
Implicit Costs
Those that do not have a direct payment of money to a third party
Opportunity cost in terms of next best alternative foregone
E.g. rent that could have been received by leasing an owned building to another firm
Accounting cost
Explicit costs of production
Economic cost
What is usually used
Explicit + implicit cost of production
Short-run COP
Production period during which there is at least one fixed factor, Output can only be adjusted by changing quantities of variable factors
E.g. factory itself (fixed)
Total Fixed Cost (TFC)
Costs that do not vary with output such as lease payments
Exist even when output is zero
Total Variable Cost (TVC)
Costs that vary positively with output such as wages for hiring workers
Zero if output is zero
Total Cost (TC)
TFC + TVC
Marginal Cost (MC)
Additional cost arising from an additional output
Change in TC or TVC / Change in Q
Average Fixed Cost (AFC)
Fixed cost per unit of output
TFC / Q
Average Variable Cost (AVC)
Variable cost per unit of output
TVC / Q
Average Cost (AC)
Cost per unit of output
AFC + AVC
Total cost / Q
MC cuts AC at
Minimum point of AC
Long-run COP
Long-run is a production period which all factors of production are variable
E.g. previously fixed costs such as size of restaurant has to change to accommodate increasing number of customers
Understand long-run as a consideration of the time period for which firms plan ahead to build the most appropriate scale of plant to produce the future anticipated level of output; once plant is built, completed, and operational, firm is back in the short run
Important for long-run production cost analysis - Not just expansion - Increase in scale of production
Scale of Production
When all factors are increased in fixed proportions we say that there is an increase in the scale of production
A firm can grow in size or scale of production by…
Can enjoy…
Internal expansion OR Merger and acquisition
Revenue and cost advantages
Mergers and acquisitions
Consolidation of companies or assets
Merger: Combination of 2 companies to form a new company
Acquisition: Purchase of 1 company by another in which no new company is formed
Revenue advantages enjoyed by large firms
Ability to set higher prices and ability to practise non-price competition
Ability to set higher prices - Dependent on PED faced by firm - Big firms enjoy greater market share, so more price inelastic demand curve, giving them ability to set higher prices to raise TR
Non-price competition - Such as product development (R&D and innovation) and product promotion (advertising) to raise demand for their products hence increasing TR
Long Run Average Cost Curve (LRAC)
Shows all lowest possible unit cost for the production of each output level
As firms get bigger by increasing its SOP, high cost savings they enjoy from the iEoS result in fall in unit cost - falling portion of LRAC
Firm gets too huge and expands beyond Minimum Efficient Scale (MES) output - unit cost rise as firms suffer from internal disEoS, large rise in unit cost that offsets cost savings enjoyed from various iEOS - Rising portion of LRAC
Can be considered planning curve for the firm
MES
Occurs at output level where LRAC first stops falling
Corresponds to lowest point on LRAC
iEoS
Fall in unit COP when firm increases output by expanding SoP
- Technical or plant EoS
- Marketing EoS
- Administrative and Managerial Economies
- Financial Economies
- Risk bearing Economies
Technical or plant economies
Cost savings arising from large size of factory
- Specialisation and Division of Labour
- Indivisibilities - For machines that come in specific and large sizes - Can spread huge capital outlay of the machine over larger output levels
- R&D - Financial ability + Incentive - Support research leading to development of better products and cheaper techniques of production
Marketing Economies
Bulk Purchase
- Bargaining advantage and given preferential treatment by suppliers because they buy in bulk
- Bulk buying of raw materials allows large firm to obtain goods at lower costs and better terms, lowering unit cost
Large Scale Advertising
- Advertising expenditure may be substantial but advertising cost per unit may be lower than that of a smaller firm
Administrative and Managerial Economies
Generally, total admin costs will not rise in proportion to the size of an order
Cost of admin per unit of output spread over larger output, greatly reduced
Each managerial role can be allocated to a specialist in that field - Buy management services and retain best management with attractive pay - Higher productivity and lower turnover cost
Financial Economies
Large firm with higher sales volume and more assets to offer as collateral, deemed by lenders to be more credit-worthy
Banking & Financial institutions more willing to offer loans or extend credit to large firms and enjoy lower interest rates when they borrow large amounts, lowering unit costs
Can also raise funds by issuing shares to the public (cheaper alternative to borrowing from banks - no interest)
Risk bearing Economies
Large firms have the ability to spread the costs of uncertainty over a larger range of output
Bear business risks more effectively than smaller firms e.g. large pharmaceutical firm can more easily bear risk of losses that could be mitigated by revenue generating drugs
iDEoS
Rise in unit cost of production when firm increases output by expanding its scale of production
Management Difficulties
Problems in communication & communication between different departments and sub-departments - inefficiency and higher unit COP
Low morale - Large number of workers - Difficult to ensure everyone is happy and equally well treated - People at lower end of the hierarchy feeling dissatisfied or even hostile - High absenteeism and low productivity
eEoS
Fall in unit COP experienced by firm as a result of growth in the INDUSTRY
Economies of Concentration
Economies of Information
Economies of Disintegration
Economies of Concentration
- Many firms carrying out similar activities located close to each other
Trained workforce: Industry expand, demand for labour with necessary skills increases, Training schools may be set up, a pool of skilled workers is readily available, reducing unit cost originally incurred by firms to train their employees
Better infrastructure: Concentration of industry in the region - better transport, banking & telecommunication systems may be set up to serve the needs of the industry, thereby lowering operating costs
Economies of Information
Common information services provided by trade association or central research centres through journals and newsletters
Firms can obtain info cheaply
Economies of Disintegration
Heavily localised, becomes possible for firms to split up production process and specialise in a single process or the manufacture of a single component
Mass produced to supply whole industry - components can be produced and supplied at a much lower unit cost
eDEoS
Rise in unit COP experienced by firm as a result of growth in the INDUSTRY
Higher input prices
- Industry expands, demand for FOP rises resulting in higher input prices (e.g. rent, wages)
- Especially if SS of FOP are price-inelastic
Increased Strain on Infrastructure
- Concentration and expansion of production, infrastructure stretched to its limit giving rise to congestion, overcrowding, pollution and other problems
Total Revenue (TR)
Firm’s total earnings per period of time from the sale of its output
PxQ
Average Revenue (AR)
Amount the firm earns per unit sold
Price of firm’s product at each level of output - AR is also firm’s DD curve
TR/Q
Marginal Revenue (MR)
Additional revenue obtained when one more unit of output is sold (per unit time)
Change in TR / Change in Q
