Chapter 9: Business and the Costs of Production

Question 2

what is economic cost?

Answer 2

the payment that must be made to obtain and retain the services of a resource. It is the income the firm must provide to resource suppliers to attract resources away from alternative uses. (pg. 173)

Question 3

economic costs are a combination of what costs?

Answer 3

Explicit and Implicit Costs

Question 4

what are explicit costs?

Answer 4

the total input costs that require an outlay of money by the firm. (pg. 174)

Question 5

what are examples of explicit costs?

Answer 5

lease, payroll, equipment/utilities.

Question 6

are explicit costs an opportunity cost?

Answer 6

yes, because every purchase of outside resources necessarily involves forgoing the best alternatives that could have been purchased with the money.

Question 7

what are implicit costs?

Answer 7

Implicit costs are the monetary payments the self‑employed resources could have earned in their best alternative employment. They are opportunity costs of using self-owned resources. (pg. 174)

Question 8

what are examples of implicit costs?

Answer 8

the total of forgone interests, rents, wages, and entrepreneurial income (from last job)

Question 9

what is Accounting Profit?

Answer 9

Net income after subtracting Revenue (sales) and Total Explicit Costs. (pg. 175)

Question 10

what is normal profit?

Answer 10

it is the “normal” amount of accounting profit that you likely would have earned in other ventures. (pg 176)

Question 11

what is economic profit?

Answer 11

accounts for all of your economic costs—both explicit costs and implicit costs: Economic Profit = Revenue − Explicit Costs − Implicit Costs (including normal profit that could’ve been earned from previous job). (pg. 176)

Question 12

What is the Short Run?

Answer 12

the short run is a period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the plant’s current capacity is used. The firm’s plant capacity is fixed in the short run. However, the firm can vary its output by applying larger or smaller amounts of labor, materials, and other resources. That is, it can use its existing plant capacity more or less intensively in the short run. (pg 176)

Question 13

In a Short Run what is the plant Capacity (the size of factory building, the amount of machinery and equipment and other capital resources)?

Answer 13

Fixed Plant with some variable inputs

Question 14

What is a Long Run?

Answer 14

the long run is a period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity. From the industry’s view-point, the long run also includes enough time for existing firms to leave the industry or for new firms to enter the industry. (pg 176)

Question 15

what is the Plant Capacity in a Long Run:

Answer 15

Variable Plant

Question 16

difference between Short Run and Long Run:

Answer 16

-Short run would consist of hiring more people or adding more shift

-Long Run would consist of adding a new production facility or installing more equipment.

If Boeing hires 100 extra workers for one of its commercial airline plants or adds an entire shift of workers, we are speaking of the short run. If it adds a new production facility and installs more equipment, we are referring to the long run. The first situation is a short-run adjustment; the second is a long-run adjustment. (pg 176)

Question 17

Why does the actual time associated with the short and long run will differ among light industries and heavy industries.

Answer 17

Light industry and retailing (small t-shirt manufacturer) can adjust quickly compared to heavy industry (an oil company) which may take years to change capacity.​

Question 18

what is Total Product (TP):

Answer 18

It is the total quantity output produced. (pg 176)

Question 19

What is Marginal Product (MP)?

Answer 19

It is the the additional output produced when 1 additional unit of a resource is employed (labor changes by 1 unit, a new hire). the quantity of all other resources employed remaining constant). MP also measures the rate of change of TP (Pg 176)

Question 20

What is the formula for Marginal Product (MP):

Answer 20

change in Total Product ÷ Change in Labor Input​

Question 21

What is Average Product (AP)?

Answer 21

It is the output that is produced per unit of labor.​

Question 22

what is the formula for Average Product (AP)?

Answer 22

Total Product (TP) ÷ Units of Labor

Question 23

What is the Law of Diminishing Returns?

Answer 23

As a variable resource (labor) is added to fixed amounts of other resources (land or capital), the total product that results will eventually increase by diminishing amounts, reach a maximum, and then decline. (pg 177)

Question 24

What does the Law of Diminishing Returns assume?

Answer 24

-Resources are of equal quality.​

-Technology is fixed.​

-Variable resources are added to fixed resources.​

-At some point, marginal product will fall.​

Question 25

Flip over for an example of the Law of Diminishing Returns.

Answer 25

As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will decrease. Essentially, the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource, when there isn’t any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of labor, the machinery is still underused—there is machinery that is often idle as that one unit of labor has to perform all of the tasks. As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used more and more to its capacity. However, at some point there will be so much labor that the fixed resources are overutilized and the individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns—where the TP is still increasing when hiring one more unit of labor, but it doesn’t increase as much as it did with the previous unit of labor.

Question 26

Look at this Example of Diminishing Marginal Returns

Answer 26

(Labor) (TP) (MP)
{0} {0} {0}
{1} {10} {10}
{2} {25} {15}
{3} {45} {20}
{4} {60} {15}
{5} {70} {10}
{6} {75} {5}
{7} {75} {0}
{8} {70} {-5}

Between {0} - {3) Workers, there is an increasing marginal return.

Between {3} - {7) Workers, there is a diminishing marginal return.

Between {7} - {8) Workers, there is a negative marginal return.

TP continues to increase but by smaller and smaller amounts. This is called diminishing marginal returns. TP is still positive and rising, but it is now rising at a slower rate.

Question 27

What are the classifications of Short-Run Production Costs?

Answer 27

-Total Fixed Costs (TFC): Costs that do not vary with output (interdependent)
- Total Variable Costs (TVC): costs that DO vary with output.

-Total Cost (TC): TFC + TVC

Question 28

Given a table with information how do we know if it relates to Short run or Long Run

Answer 28

If there are fixed costs and variable then it is a short run.
If it’s just variable costs then it is long run

Question 29

What is Total Cost and the formula for it?

Answer 29

Total cost is the sum of total fixed and total variable costs at each level of output.​

TC= TFC + TVC

Question 30

What are Total Variable Costs

Answer 30

costs that DO vary with output.

Question 31

What are examples of Fixed Costs?

Answer 31

-rental payments
-insurance premiums
- interest payments

Question 32

What are examples of Variable Costs?

Answer 32

payments for materials, fuel, power, transportation services, labor.

Question 33

what are Average Fixed Costs? What is the formula?

Answer 33

Average fixed costs reflect the fixed costs per unit produced.

Formula is AFC = TFC/Q

Question 34

What are Average Variable Costs (AVC)? What is the formula?

Answer 34

the average variable costs reflect the variable costs per unit produced.

formula is AVC= TVC/Q

Question 35

What is Average Total Cost (ATC) formula?

Answer 35

AVC= TC/Q

Question 36

what is Marginal Cost (MC) and what is the formula for it?

Answer 36

Marginal Cost (MC) is the extra, or additional, cost of producing one more unit of output.

MC tells a firm how much it will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of change in the total costs.​

formula: MC= change in TC/ change in Q

Question 37

Flip over for The Average Cost Curve analysis:

Answer 37

AFC falls as a given amount of fixed costs is apportioned over a larger and larger output. AVC initially falls because of increasing marginal returns but then rises because of diminishing marginal returns. Average total cost (ATC) is the vertical sum of average variable cost (AVC) and average fixed cost (AFC). The only difference between the ATC and AVC is the AFC (remember ATC = AFC + AVC or AFC = ATC - AVC), so the vertical distance between the ATC and AVC is the AFC. You want to get used to measuring AFC in this way because at some point the AFC will no longer be included in the graphs. (pg 181)

Question 38

Flip over for Marginal Cost Curve analysis:

Answer 38

Shifts in the curves will occur if either resource prices or technology change. For example, if fixed costs increase, both AFC and ATC shift up. If labor costs (or some other variable input costs) rise, then the AVC, ATC, and MC would shift up. This graph shows the relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves. The marginal-cost (MC) curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their minimum points. When MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average variable cost, AVC falls; when MC is above average variable cost, AVC rises. Marginal decisions are very important in determining profit levels. In order to make marginal decisions, marginal revenue and marginal cost are compared. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise.​

Question 39

Marginal Cost and Marginal Product Cost Curve Analysis:

Answer 39

The marginal-cost (MC) curve and the average-variable-cost (AVC) curve are mirror images of the marginal-product (MP) and average-product (AP) curves. Assuming that labor is the only variable input and that its price (the wage rate) is constant, then when MP is rising, MC is falling, and when MP is falling, MC is rising. Under the same assumptions, when AP is rising, AVC is falling, and when AP is falling, AVC is rising.​

Question 40

The relationship of the Marginal-Cost curve to the Average Total Cost and Average Variable Cost curves.

Answer 40

The marginal-cost (MC) curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their respective minimum points. When MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average variable cost, AVC falls; when MC is above average variable cost, AVC rises

Question 41

What happens in a Long Run?

Answer 41

• The firm can change all input amounts, including plant size.​

All costs are variable in the long run.​

Long-run ATC: Now consider costs in terms of average total costs.

Question 42

Describe the Long Run Cost Curve

Answer 42

The long-run ATC curve just “envelopes” the short-run ATCs. If the number of possible plant sizes is very large, the long-run average-total-cost curve approximates a smooth curve. Economies of scale, followed by diseconomies of scale, cause the curve to be U-shaped.​

Question 43

Flip over for Long Run Firm Sizes and Cost analysis.

Answer 43

Any number of short-run optimum size cost curves can be constructed. The long-run average-total-cost curve is made up of segments of the short-run cost curves (ATC-1, ATC-2, etc.) of the various-size plants from which the firm might choose. The long-run cost curve is also called the planning curve. Each point on the bumpy planning curve shows the lowest unit cost attainable for any output when the firm has had time to make all desired changes in its plant size.​ (pg 186)

​

Question 44

What are Economies of Scale?

Answer 44

• Labor specialization​
• Managerial specialization​
• Efficient capital​

Other factors​ Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.​

Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output.
Economies of scale, or economies of mass production, explain the down sloping part of the long-run ATC curve. As plant size increases, a number of factors will for a time lead to lower average costs of production.

Question 45

what are the factors assoicatied with Economies of Scale?

Answer 45

• Labor specialization​
• Managerial specialization​
• Efficient capital​

Other factors​ Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.​

Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output.

Question 46

What are Diseconomies of scale:​

Answer 46

Diseconomies of Scale in time the expansion of a firm may lead to diseconomies and therefore higher average total costs. The main factor causing diseconomies of scale is the difficulty of efficiently controlling and coordinating a firm’s operations as it becomes a large-scale producer.

Question 47

what are the factors associated with Diseconomies of Scale?

Answer 47

-Control and coordination problems​

-Communication problems​

-Worker alienation​

-Shirking​

Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long-run ATC curve. As the firm expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will cause a less than proportionate increase in output.​

Reasons that diseconomies of scale occur include the difficulty in controlling and coordinating large scale operations; large bureaucracies lead to communication problems; workers may feel alienated and therefore may not work efficiently; and shirking, or work avoidance, may be easier in a larger firm.​

Question 48

what is Minimum efficient scale (MES)​?

Answer 48

Lowest level of output at which long-run average costs are minimized.​

Can determine the structure of the industry.

Where MES occurs on an industry’s long-run ATC determines if there will be many or few producers and whether they will be large, small, or different sizes.

Question 49

What happens to Long Run Costs under Natural monopoly:

Answer 49

Long-run costs are minimized when only one firm produces the product.