Chapter 7 - Costs

Question 1

1. What is the difference between a firm’s accounting and economic costs? How do these costs relate to a firm’s accounting and economic profits?

Answer 1

1. Accounting costs include the direct costs of operating a business, while a firm’s economic costs are its accounting costs plus its opportunity costs. A firm can calculate its profits in one of two ways: as accounting profits equal to its total revenue minus its accounting costs, or as economic profits equal to its total revenue minus its economic costs.

Question 2

2. Define opportunity cost. How does a firm’s opportunity cost relate to its economic cost?

Answer 2

2. Opportunity cost is the value of what a producer gives up by using an input, i.e. the value of the input’s next-best use. A firm’s opportunity costs are what differentiate the calculation of its accounting costs from that of its economic costs. Specifically, opportunity costs are included in economic cost but not in accounting cost.

Question 3

3. What is the sunk cost fallacy?

Answer 3

3. A firm that lets its sunk costs affect its operating decisions has committed the sunk cost fallacy. In the forward-looking perspective, firms-and people-shouldn’t allow costs that have already been paid and cannot be recovered to affect their decisions in the present.

Question 4

4. Provide some examples of unavoidable fixed costs. How are these related to sunk costs? Describe why a firm should not consider sunk costs when making decisions.

Answer 4

4. Fixed costs include expenditures on overhead such as the cost of the building or plant and utility bills. Once paid, these types of expenditures become sunk costs, but a firm can avoid them by closing up shop and shutting down. Once they are sunk costs, however, the firm shouldn’t take them into consideration when making production decisions. That would be committing the sunk cost fallacy, as we saw in Question 3 above.

Question 5

6. Why is a fixed cost curve horizontal? Why does a variable cost curve have a positive slope?

Answer 5

6. A firm’s fixed costs are constant no matter what its output level is, resulting in a horizontal fixed cost curve. The variable cost curve is positively sloped-as production increases, the associated variable costs increase.

Question 6

7. Name the three measures that examine a firm’s per unit cost at a given level of output.

Answer 6

7. Average fixed, average variable, and average total cost curves calculate a firm’s fixed, variable, and total costs as costs per unit.

Question 7

8. Why does a firm’s fixed cost not affect its marginal cost of producing an additional unit of a product?

Answer 7

8. Since a firm’s fixed cost does not vary with the level of output, fixed cost does not affect its marginal cost of producing an additional unit of output. That marginal cost is dependent only on the firm’s variable cost

Question 8

9. Why is a firm’s short-run total cost greater than its long-run total cost? Explain why this is also true for a firm’s short-run and long-run average costs.

Answer 8

9. In the short run, a firm has fixed costs on capital, while in the long run, the firm can vary both its capital and labor inputs. As a result, short-run total cost may be greater than long-run total cost. Since average cost is calculated as the total cost per unit of output, the same relationship holds true for a firm’s short-run and long-run average costs.

The long-run average cost envelops all short-run average cost curves. The two curves touch where the chosen level of capital (capital is fixed in the short run) is actually optimal. but they need not coincide at minimum of short-run average cost…

Question 9

10. Describe the conditions under which a firm has economies of scale, diseconomies of scale, and constant economies of scale.

Answer 9

10. Economies of scale look at the way a firm’s costs increase with output.

A firm with economies of scale has costs that increase at a slower rate than the increase in output (average cost falls).

With diseconomies of scale, the firm’s costs increase at a faster rate than the increase in output (average cost increases).

Constant economies of scale indicate that the firm’s costs increase at the same rate as the increase in output (constant average cost).

Question 10

11. When does a producer face economies of scope? When does a producer face diseconomies of scope?

Answer 10

11. Economies of scope look at how a firm’s costs change when it produces more than one product. Economies of scope exist when a firm can produce more than one product simultaneously at a lower cost than producing the products separately. Diseconomies of scope indicate that a firm produces more than one product simultaneously at a higher cost than producing the products separately.

Question 11

What is sunk costs?

Answer 11

Sunk costs - a cost that, once paid, the firm cannot recover. A fixed costs that you cannot avoid. If it is avoidable, it is not a sunk cost.

Question 12

What is specific capital?

Answer 12

Whether capital can be used by another firm is an important determinant of sunk costs

Capital that is not very useful outside of its original application is called specific capital

Question 13

What is a cost curve?

Answer 13

Cost curve - the mathematical relationship between a firm’s production costs and its output

There are different types of cost curves depending on what kind of costs we relate to the firm’s output

All cost curves are measured over a particular time period

The total cost curve shows how a firm’s total production cost changes with its level of output

Question 14

What is marginal cost and how do we calculate it?

Answer 14

The cost of producing an additional unit of output.

MC = change in total cost/ 1 unit change in output

Question 15

After a certain output level, marginal cost begins to rise, and at even higher output levels, it rises steeply. Why?

Answer 15

Marginal cost may initially fall at low quantities because complications may arise in producing the first few units that can be remedied fairly quickly, or because having more scale allows workers to specialize in those tasks that they are best at. As output continues to increase, however, these marginal cost reductions stop, and marginal cost begins to increase with the quantity produced

There are many reasons why it becomes more and more expensive to make another unit as output rises: Capacity constraints may occur, inputs may become more expensive as the firm uses more of them, it may be harder for the company to coordinate its operations, and so on.

Question 16

What happens if the marginal cost of output is less than the average cost?

Answer 16

If the marginal cost of output is less than the average cost at a particular quantity, producing an additional unit will reduce the average cost because the extra unit’s cost is less than the average cost of making all the units before it.

This means that if the marginal cost curve is below an average cost curve at some quantity, average cost must be falling-that is, the average cost curve is downward-sloping. This is true whether we’re talking about average total cost or average variable cost, because the marginal cost of producing another unit of output creates the same increment to both total and variable cost. This is also true even if, as is often the case, marginal costs are rising while they are below average costs. Producing another unit of output at a cost below the firm’s current average will still bring down the average even if that marginal cost is rising with output. Just remember that the marginal cost curve is the cost at a specific output level-how much it costs to produce that specific unit-while average costs are averaging over all the previous units’ costs, too.

Question 17

What happens when the marginal cost of the additional unit is above average cost?

Answer 17

When the marginal cost of the additional unit is above average cost, then producing it increases the average cost.

Therefore, if the marginal cost curve is above an average cost curve at a quantity level, average cost is rising, and the average cost curve slopes up at that quantity. Again, this is true for both average total cost and average variable cost. This property explains why average variable cost curves and average total cost curves often have a U-shape. If marginal cost continues to increase as quantity increases, it eventually rises above average cost and begins pulling up the average variable and average total cost curves. The only point at which there is no change in average cost from producing one more unit occurs at the minimum point of the average variable and average total cost curves, where marginal and average cost are equal.

Question 18

What does flexibility of inputs depend on?

Answer 18

Time horizon: Over short time horizons, many inputs are fixed costs. As the time horizon expands, wait staff can be hired or fired, new capital can be purchased, and space can be expanded.

The presence of active capital rental and resale markets allow some capital expenditures to become variable (e.g., renting an extra webserver).

Flexibility of labor contracts: it may be difficult to fire workers, and firms may become reluctant to hire unless absolutely necessary.

Question 19

What is the average cost?

Answer 19

Cost per unit of output C(Q)/Q

Question 20

Where does the marginal cost curve cross the average cost curve?

Answer 20

The marginal cost curve crosses the average cost curve at the minimum of the average cost curve

Question 21

Where are short-run and long-run marginal costs equal?

Answer 21

Short-run and long-run marginal costs are equal where the level of outputs for the fixed amount of capital is efficient. The long-run marginal cost curve connects the short-run marginal cist levels for efficient outputs.

Question 22

How can we determine if a business should stay open?

Answer 22

If there is ECONOMIC profit they should

Question 23

What is the difference between short-run and long-run cost curves?

Answer 23

Short-run cost curves relate a firm’s production cost to its quantity of output when its level of capital is fixed. Long-run cost curves assume that a firm’s capital inputs can change just as its labour inputs may.

Question 24

Where do the marginal cost curves run through the average cost curve?

Answer 24

Marginal cost curves run through minimum of average cost curve

Question 25

Why is short-run total and average total costs higher than their long-run values?

Answer 25

In the short run, the firm’s capital inputs are held constant along its expansion path, and all changes in output come from changing labour inputs. This means that, for all quantities except that quantity at which the fixed capital level is cost-minimizing, short-run total and average total costs must be higher than their long-run values.

Question 26

What is the relationship between the short-run and long-run average total cost curves?

Answer 26

Every fixed capital level has its own short-run cost curves. The long-run average total cost curve is an “envelope” of all the short-run average total cost curves.

Question 27

Where does the long-run marginal cost equal the short-run marginal cost? How does the long-run marginal cost curve look compared to the short-run marginal cost curves?

Answer 27

Long-run marginal cost equals the short-run marginal costs at the quantities at which the fixed capital level is cost-minimizing. [Section 7.5] Long-run marginal cost curve is flatter than short-run marginal cost curves.

Question 28

Define economies of scale, diseconomies of scale and constant economies of scale

Answer 28

Economies of scale - total cost rises at a slower rate than output rises
Diseconomies of scale - total cost rises at a faster rate than output rises
Constant economies of scale - total cost rises at the same rate as output rises

Question 29

How does the long-run average total cost curve look when there is economies of scale, diseconomies of scale and constant economies of scale?

Answer 29

The long-run average total cost curve is downward-sloping when there are economies of scale, because total cost rises at a slower rate than quantity

Similarly, diseconomies of scale imply and upward-sloping long-run average total cost curve

Constant economies of scale make the long-run average total cost curve flat

Question 30

What does the typical U-shaped long-run average total cost curve imply about economies of scale?

Answer 30

At low output levels (the left, downward-sloping part of the ATC curve), total cost rises more slowly than output does. As a result, average total cost falls, and the firm has economies of scale.
At the very bottom of the average total cost curve where it is flat, average cost does not change, total cost rises proportionally with output, and marginal cost equals ATC. Here, therefore, average total cost increases at the same rate that output increases, and there are constant economies of scale.
At higher output levels (the right upward-sloping part of the ATC curve where ATC is rising), marginal cost is above average total cost, causing total cost to rise more quickly than output does. As a result, there are diseconomies of scale.

Question 31

Why does increasing returns to scale imply economies of scale, but not necessarily the reverse?

Answer 31

Because a firm can only reduce its cost more if it is able to change its input ratios when output changes, it can have economies of scale if it has constant or even decreasing returns to scale. That is, even though the firm might have a production function in which doubling inputs would exactly double output, it might be able to double output without doubling its total cost by changing the proportion in which it uses inputs. Therefore, increasing returns to scale imply economies of scale, but not necessarily the reverse.

Question 32

What is economies of scope?

Answer 32

Economies of scope - the simultaneous production of multiple products at a lower cost than if a firm made each product separately C(Q_1,Q_2 )

Question 33

What does it imply if the scope is larger, than smaller than or equal to zero?

Answer 33

If SCOPE > 0, the total cost of producing goods 1 and 2 jointly is less than making the goods separately, so there are economies of scope
The greater the scope, the larger are the firm’s cost savings from making multiple products
If SCOPE = 0, the costs are equivalent, and economies of scope are zero
If SCOPE < 0 it is cheaper to produce good 1 and 2 separately. There are diseconomies of scope

Question 34

What is diseconomies of scope?

Answer 34

Diseconomies of scope - the simultaneous production of multiple products at a higher cost than if a firm made each product separately

Question 35

What are the sources of scope economies?

Answer 35

There are many possible sources of scope economies. They depend on the flexibility of inputs and the inherent nature of the products. A common source of economies of scope is when different parts of a common input can be applied to the production of the firm’s different products.