CHAPTER 7 (test 1) Flashcards
Define accounting costs, economic costs, and opportunity cost
Accounting costs: include the direct costs of operating a business, including costs for raw materials, wages paid to workers, rent paid for office or retail space, etc.
Economic cost: the sum of a producer’s accounting and opportunity costs (true cost of owning a business)
Opportunity cost: the value of what a producer gives up by using an input
What is accounting profit and economic profit?
accounting profit = total revenue - accounting (explicit) cost
economic profit = total revenue - economic cost
why do opportunity costs matter to economists?
Because when firms make decisions on the use of inputs, they consider opportunity costs
And since economists try to describe behaviour, they need to understand opportunity costs to know how firms make decisions
What are some examples of sunk costs and specific capital?
sunk costs: licensing fees, long-term lease contracts, etc.
specific capital: uniforms, menus, signs, etc. (capital that cannot be used outside of its original application)
What are sunk costs? What does this not include?
Sunk costs are a form of fixed costs that cannot be recovered once spent > cannot be recouped and therefore should not be considered in further decision making
Not included: fixed costs that are partially avoidable - some money can be recovered (ex. buildings, operating permits, durable equipment)
How should firms decide whether to keep their firm/business open or closed?
They should stay open as long as operating revenues exceed operating costs
(revenue - operating costs)
operating revenue = money a firm earns from selling its output
operating cost = the cost a firm incurs in producing its output
ex. wages for workers > disappear if you shut business down
What is the sunk cost fallacy?
Refers to the mistake of letting sunk costs affect a firm’s operating decisions
ex. continuing down one path because of a prior investment
Define the 2 categories of operating costs
Fixed cost: the cost of the firm’s fixed inputs, independent of the quantity of the firm’s output (ex. office lease)
Variable cost: the cost of inputs that vary with the quantity of the firm’s output (ex. raw materials)
Explain how the time horizon is the chief factor in determining flexibility of different input levels. What are 2 other factors affecting flexibility?
Over short time horizons, many inputs are fixed costs
At the time horizon expands, costs become more flexible and easier to change
- the presence (or lack) of active capital rental and resale markets allow some capital expenditures to become variable
- labour contracts may lead to stickiness in labour inputs; it may be difficult to fire workers, and firms may become reluctant to hire unless absolutely necessary
What is a cost curve?
The mathematical relationship between a firm’s production costs and output
(can be represented by a table or graph)
(curves associated with fixed, variable, and total costs will have different shapes)
With a cost curve graph ___ is a function of ___
y (cost) is a function of x (quantity)
Explain the shape of the fixed, variable, and total cost curves
fixed: horizontal
variable: changes with output, so it is not constant and the slope is always positive
> starts growing slowly and eventually grows rapidly partly due to the law of diminishing marginal returns
total: it is the sum of VC and FC, so it will have the same shape as the FC curve, but will be shifted up by the amount of FC
What is average cost? What are the different costs’ average cost equations?
Average cost is cost divided by output
AFC = FC / Q
AVC = VC / Q
ATC = TC / Q = (FC+VC) / Q
= (FC/Q) + (VC/Q) = (AFC + AVC)
What is marginal cost? the equation?
It is the additional cost of producing an additional unit of output (another factor in firms’ production decisions)
MC = change in TC / change in Q
OR change in VC / change in Q
also is TC (Q1) - TC (Q0)
Since fixed costs don’t change when a firm expands output, marginal cost only depends on _____ cost
variable!
change in VC / change in Q is the same as change in TC / change in Q
What happens when marginal cost is less than the average total cost? what does this explain?
this means producing another unit will reduce the average total cost
and if marginal cost is above average total cost, then producing another unit will increase the average total cost
*explains why ATC and AVC have a U shape!
When are average total costs minimzed?
When ATC = MC
What is a firm’s short-run total cost curve?
It describes the total cost of producing various quantities of output when the amount of capital available for use if fixed
Why does the ATC curve initially decrease and then eventually increase?
decrease = bc of the fixed cost decreasing > getting spread out over the output > initially this has power over ATC
increase = eventually gets impacted by the rising variable cost (bc of worsening productivity) and rapidly rising marginal cost (bc of diminishing marginal returns)
Can we derive a short-run expansion path?
Yes, we have to make isocost lines reflecting the short-run (will be equal or further from the origin than the long run isocost lines because total cost is higher in the short run because of not being able to control fixed capital)
THEN, the short-run expansion path will be a HORIZONTAL line connecting the points where the short-run isocost line and isoquant lines intersect (won’t necessarily be tangent anymore because we’re not profit maximizing because of fixed capital)
What fact holds true for all short-run and long-run TC and ATC curves?
The short-run ATC curve will NEVER fall below the long-run ATC curve
(also means the long-run ATC curve will envelop all of the short-run ATC curves
What is the short-run marginal cost and the long-run marginal cost? What does this imply for the shape of the respective marginal cost curves?
short-run marginal cost = the cost of producing an additional unit of output when capital is fixed
long-run marginal cost = the cost of producing an additional unit of output when both capital and labour are variable
this implies that in general, the long-run marginal cost curve will be flatter than the short-run marginal cost curve
What are economies of scale?
constant economies of scale?
diseconomies of scale?
where does each one lie on the ATCLR curve?
economies of scale = costs rise more slowly than production (doubled output = costs less than doubled)
constant economies of scale = costs rise at the same rate as outpout (doubled output = costs doubled)
diseconomies of scale = costs rise more quickly than production (doubled output = costs more than doubled)
ATCLR curve:
initial downward slope = economies of scale
very middle where slope is constant (horizontal) = constant economies of scale
later increasing slope = diseconomies of scale
What factors might cause diseconomies of scale to set in?
Overcrowding, overutilization of capital, organizational complexity, etc.
How are economies of scale and returns to scale different?
Economies of scale are the cost-based flip side of returns to scale
- returns to scale describes how production changes when all inputs are changed by a common factor/equal ratio
- economies of scale does not impose this common factor/ratio rule in input proportions
Increasing returns to scale imply economies of scale, but not necessarily the reverse
It can have economies of scale but constant or even decreasing returns to scale
What are economies of scope? Why might a firm observe economies of scope?
It is when the simultaneous production of multiple products comes at a lower cost than if a firm made each product separately then added up the costs
*about firms diversifying
Why?
- flexible inputs or production processes
- expertise is translatable across several products/services (ex. life and auto insurance)
___________ cost is the only cost that matters for many of the key decisions a firm makes
marginal
In the short run with capital fixed, there is only one output level at which a firm would choose that same level of capital - what point is this?/
It is the output at which the short-run average total cost curve touches the long-run average total cost curve
