Costs

Question 1

Short run

Answer 1

The short run is when at least one factor of production is fixed.

Question 2

Long run

Answer 2

The long run is when all factors are variable.

Question 3

Fixed costs

Answer 3

Costs which do not vary with output e.g. rent and salaries

Question 4

Variable costs

Answer 4

Costs which vary with output e.g. raw materials and wages

Question 5

Total cost (TC)

Answer 5

Total cost = Total Variable Cost + Total Fixed Cost

TC = TVC + TFC

Question 6

And finally, it’s important to remember that TFC and AFC are relevant in:

Answer 6

Factors are only fixed in the short run so Total Fixed Cost and Average Fixed Cost are only relevant in the short run.

Question 7

Marginal cost

Answer 7

Marginal cost is the additional cost from selling one extra unit.

Question 8

The law of diminishing marginal returns states that:

Answer 8

In the short run, as more factors are employed, the marginal returns from these factors will eventually decrease!

Question 9

But as we continue adding factors, at some point productivity will decrease because of:

Answer 9

Diminishing marginal returns.

Question 10

So in the short run, as quantity rises, and more factors are employed, if productivity increases and then decreases, marginal cost will:

Answer 10

Decrease and then increase

Question 11

Why does MC decrease and then increase?

Answer 11

Marginal cost initially decreases because as output increases and more workers are hired, they can specialise, increasing productivity and decrease marginal cost.

But marginal cost will then increase because diminishing marginal returns will decrease productivity, increasing marginal cost.

Question 12

Marginal cost (MC)

Answer 12

Marginal cost is the cost of selling an additional unit.

MC = ∆TC/∆Q

Question 13

Diminishing marginal returns (or the law of diminishing marginal returns)

Answer 13

In the short run, as more factors are employed, the marginal returns from these factors will eventually decrease!

Question 14

Explaining why the marginal cost (MC) curve goes down and then up

Answer 14

MC decreases because initially workers will specialise, increase productivity and decreasing marginal cost.

MC will then increase because diminishing marginal returns will set in, which will decrease productivity and increase marginal cost.

Question 15

If MC is below AVC, AVC will:

Answer 15

decrease

Question 16

Average Variable Cost formula

Answer 16

AVC = TVC/Q

Question 17

MC & AVC relationship

Answer 17

When MC is below AVC, AVC will decrease

When MC is above AVC, AVC will increase

When MC = AVC, AVC is at its lowest

Question 18

But these cost curves only apply in:

Answer 18

This will only apply in the short run because we have fixed costs (AFC) on our diagram - and fixed costs are only present in the short run. In the long run, all factors become variable.

Question 19

So only as firms scale up and expand can they exploit technical economies of scale - when big firms invest in specialist capital to:

Answer 19

Specialist capital, like robot lettuce farmers, will increase productivity and decrease LRAC.

Question 20

So we’ve now seen how as companies get bigger, they can exploit internal economies to:

Answer 20

Internal economies of scale only apply to long run average costs, because it’s only in the long run when firms can expand enough to take advantage of economies of scale. In the long run, internal economies of scale help a firm reduce their long run average costs.

Question 21

Internal economies of scale

Answer 21

Internal economies of scale are when long run average costs fall as a firm’s quantity increases.

Question 22

Types of internal economies of scale

Answer 22

(RMFPTM)
Richard’s Mum Flies Past The Moon

Risk-bearing economies

Managerial economies

Financial economies

Purchasing economies

Technical economies

Marketing economies

Question 23

Risk-bearing economies

Answer 23

Bigger firms can use their big profits to diversify into new areas, reducing the cost of failure in one sector.

E.g. Virgin have diversified into 400 different areas.

Question 24

Managerial economies

Answer 24

Bigger firms can afford to hire highly skilled specialist managers, increasing a firm’s productivity and decreasing their LR average costs!

E.g. Amazon hire specialist accounting, software and marketing managers.

Question 25

Financial economies

Answer 25

Bigger firms are less risky, so they can secure cheaper loans, reducing their long run average costs.

E.g. Alibaba.com borrowed £3bn at a tiny 2% interest rate.

Question 26

Purchasing economies

Answer 26

Bigger firms can bulk-buy and negotiate lower prices, reducing their long run average costs!

E.g. McDonald’s purchase thousands of tonnes of chicken breast at a very low average cost.

Question 27

Technical economies

Answer 27

Bigger firms can invest in specialist capital, to increase a firm’s productivity and decrease their long run average costs.

E.g. Amazon’s warehouse robots and Kameoka’s robot lettuce farmers have massively increased productivity.

Question 28

Marketing economies

Answer 28

Bigger firms can spread their marketing costs across many units, decreasing their long run average costs.

E.g. Guinness, Beats or Nike, who spend millions on marketing in total but just pennies on average, because their costs are so spread out.

Question 29

And as employee motivation falls:

Answer 29

productivity falls, and long run average costs rise

Question 30

when LRAC starts to rise like this, firms are experiencing

Answer 30

Internal diseconomies of scale.

Question 31

Internal diseconomies of scale

Answer 31

Internal diseconomies of scale lead to a rise in long run average cost, as a firm expands.

Question 32

Types of internal diseconomies of scale (ABC)

Answer 32

Alienation

Bureaucracy

Communication

Question 33

Alienation

Answer 33

Workers feel alienated in very large firms, like they’re just another cog in the machine. This leads to demotivation, decreasing productivity, increase LRAC.

E.g. large call centres in India.

Question 34

Bureaucracy

Answer 34

Bureaucracy is all the paperwork, managers, filing and secretaries that a firm has to pay for when it expands, increasing LRAC.

Question 35

Communication

Answer 35

In big firms, employees may argue with each other and communication will be slow because big firms have so many layers. These factors will reduce productivity, increasing LRAC.

Question 36

internal economies of scale

Answer 36

Internal economies of scale are when long run average cost falls, as a firm expands.

Question 37

External economies of scale

Answer 37

External economies of scale will reduce long run average cost, as the industry expands.

Question 38

3. External economies of scale: lower recruitment costs

Answer 38

When an industry expands, lots of specialist workers will be move to that area to find work. This makes it easier to recruit workers, reducing a firm’s recruitment costs, decreasing their LRAC.

E.g. In Silicon valley, there are 60,000+ coders which reduces tech firms’ recruitment costs.

Question 39

External economies of scale: knowledge transfers

Answer 39

When an industry expands, knowledge will be transferred between firms. This helps firms learn more effective new production techniques, decreasing their LRAC.

E.g. In LA’s film industry, the green screen technique was spread by knowledge transfer. Using green screens has reduced film producers’ long run average costs.