Chapter 4-1: Costs and Revenue

Question 1

Explicit Costs

Answer 1

Costs incurred when an actual monetary payment is made

Wages / cost of raw materials

Question 2

Implicit Costs

Answer 2

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

Question 3

Accounting cost

Answer 3

Explicit costs of production

Question 4

Economic cost

Answer 4

What is usually used

Explicit + implicit cost of production

Question 5

Short-run COP

Answer 5

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)

Question 6

Total Fixed Cost (TFC)

Answer 6

Costs that do not vary with output such as lease payments

Exist even when output is zero

Question 7

Total Variable Cost (TVC)

Answer 7

Costs that vary positively with output such as wages for hiring workers
Zero if output is zero

Question 8

Total Cost (TC)

Answer 8

TFC + TVC

Question 9

Marginal Cost (MC)

Answer 9

Additional cost arising from an additional output

Change in TC or TVC / Change in Q

Question 10

Average Fixed Cost (AFC)

Answer 10

Fixed cost per unit of output

TFC / Q

Question 11

Average Variable Cost (AVC)

Answer 11

Variable cost per unit of output

TVC / Q

Question 12

Average Cost (AC)

Answer 12

Cost per unit of output
AFC + AVC
Total cost / Q

Question 13

MC cuts AC at

Answer 13

Minimum point of AC

Question 14

Long-run COP

Answer 14

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

Question 15

Scale of Production

Answer 15

When all factors are increased in fixed proportions we say that there is an increase in the scale of production

Question 16

A firm can grow in size or scale of production by…

Can enjoy…

Answer 16

Internal expansion OR Merger and acquisition

Revenue and cost advantages

Question 17

Mergers and acquisitions

Answer 17

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

Question 18

Revenue advantages enjoyed by large firms

Answer 18

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

Question 19

Long Run Average Cost Curve (LRAC)

Answer 19

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

Question 20

MES

Answer 20

Occurs at output level where LRAC first stops falling

Corresponds to lowest point on LRAC

Question 21

iEoS

Answer 21

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

Question 22

Technical or plant economies

Answer 22

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

Question 23

Marketing Economies

Answer 23

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

Question 24

Administrative and Managerial Economies

Answer 24

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

Question 25

Financial Economies

Answer 25

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)

Question 26

Risk bearing Economies

Answer 26

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

Question 27

iDEoS

Answer 27

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

Question 28

eEoS

Answer 28

Fall in unit COP experienced by firm as a result of growth in the INDUSTRY

Economies of Concentration
Economies of Information
Economies of Disintegration

Question 29

Economies of Concentration

Answer 29

• 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

Question 30

Economies of Information

Answer 30

Common information services provided by trade association or central research centres through journals and newsletters
Firms can obtain info cheaply

Question 31

Economies of Disintegration

Answer 31

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

Question 32

eDEoS

Answer 32

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

Question 33

Total Revenue (TR)

Answer 33

Firm’s total earnings per period of time from the sale of its output
PxQ

Question 34

Average Revenue (AR)

Answer 34

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

Question 35

Marginal Revenue (MR)

Answer 35

Additional revenue obtained when one more unit of output is sold (per unit time)
Change in TR / Change in Q