Dr Butler test on costs, revenue and profit (4.1-end of 4.7) Flashcards
what is the difference between short run and long run costs
- short run costs are made up of fixed costs and the costs incurred when hiring the services of the variable factors of production
- long run costs are always variable costs, as fixed costs don’t exist in the long run when a firm can move from one size to another
equation for total cost
TC = TFC + TVC
equation for average total cost
ATC = AFC + AVC
define fixed cost
a cost of production which in the short run does not change with output
define variable cost
a cost of prodction which changes with the amount that is produced, even in the short run
define total cost
all costs incurred when producing a particular size of output
explain the difference between fixed and variable costs
- fixed costs are the costs a firm incurs when hiring or paying for the fixef FsOP
- in the short run, capital is assumed to be a fixed FOP, so costs do not change (costs include maintaining the firm’s building)
- however, variable costs change as the level of output changes
- the costs of hiring labour and buying raw materials are usually regarded as variable costs of production (in the long run all costs are variable as all the FsOP can be changed)
explain the difference between total cost, average variable cost and marginal cost
- when a firm increases its output, the total cost of production increases
- at any level of output, the average cost can be calculated by dividing total cost by the size of the output produced
- marginal cost is the addition to total cost of producing one additional unit of output
describe the shape of the short run average fixed cost curve (AFC)
- AFC curves always slope downwards to the right, with costs approaching zero but never touching x-axis
- this is because the higher level of output, the more spread the costs are over a larger amount of output
describe the shape of the short run average total cost curve (ATC)
- average total cost curve is obtained by adding together the output of the AFC and AVC curves
- this curve is a U shape, which gets very close to the AVC curve but never touches, as the very small amount of AFC is being added on, and is never zero
what are sunk costs + example
costs incurred which cannot be recovered if the business closes. e.g. advertising
what are some points to remember when all cost curves are put on the same graph
- the marginal cost curve cuts through from below both the AVC and ATC curves at the turning point of both
what are economies of scale
- falling long-run average costs of production that result from an increase in the size of scale of the firm
what are diseconomies of scale
- rising long run average costs of production
describe the graph of economies of scale and why
- the U-shape of the short run ATC curve is explained by the assumption that labour becomes more productive as it is added to fixed capital, before eventually becoming less productive because of the law of diminishing returns
- several short-run average total costs curves are on the LRAC curve, each one represents a particular firm size
- in the long run, a firm can move from one short run cost curve to another, with each curve associated with a different scale of capacity that is fixed in the short run
- the LRAC curve forms a tangent to the SRATC curves, each of which touches the LRAC curve
what is the difference between internal and external economies of scale
- external economies of scale occur when average costs of production fall because of the growth of the industry or market that the firm is part of. external diseconomies occur when average costs of production increase because of the growth of the whole industry
- internal economies and diseconomies are the same but occur because the firm itself increases its size and scale
what are the different types of internal economies of scale
- technical
- managerial
- marketing
- financial
- risk-bearing
- economies of scope
what generates technical internal economies of scale
- generated through changes to the productive process as the scale of production and level of output increase
what are the causes of technical economies of scale
indivisibilities - many types of machinery are indivisible as there is a certain minimum size below which they cannot efficiently operate
spreading of R&D costs - with larger plants, R&D costs can be spread over a much longer production run, reducing unit costs in the long run
volume economies - costs increase less rapidly than capacity with many types of capital equipment (doubling dimensions will increase cost by 4 times but volume increases by 8 times)
economies of massed resources - operation of a number of identical machines in a large plant means that proportionally fewer spare marts need to be kept than when fewer machines are involved
economies of vertically linked processes - much manufacturing activity involves a large number of vertically related processes such as purchase of raw materials and energy to completion and sale of the finished product. The linking of processes in a single plant can lead to saving time, transport costs and energy
describe managerial economies of scale
the larger the scale of a firm, the greater its ability to benefit from specialisation and division of labour within management and labour force
describe marketing economies of scale and the types
two types:
- bulk buying and bulk marketing economies
- large firms may be able to use their market power both to buy supplies at lower prices and to market their products on better terms negoiated with retailers
describe financial economies of scale
similar to bulk buying except they relate to bulk-borrowing of funds required to finance the business’s expansion
- large firms can often borrow from banks and other financial institutions at a lower rate of interest and on better terms than those available to small firms
describe risk-bearing economies of scale
large firms are usually less exposed to risk than small firms because risks can be spread out
- large firms can spread risks by diversifying their output, markets, supply sources and finance
- these can make the firm less vulnerable to sudden changes in demand or conditions of supply that might severely harm a smaller business that is less diversified
describe economies of scope
factors that make it cheaper to produce a range of products together than to produce each one of them on its own
what are the different types of internal diseconomies of scale
- managerial
- communication failure
- motivational
describe managerial diseconomies of scale
as a firm grows in size, administration of the firm becomes more difficult
- delegation of these to people lower in the organisation may mean that they make bad decisions as they lack experience
- this increases avergae costs of production
describe communication failure as a diseconomy of scale
in a large organisation, there may be too many layers of management between the top managers and ordinary production workers and staff may feel remote and unappreciated
- this could decrease staff productivity and unit costs begin to rise
describe motivational diseconomies of scale
with large firms, it is often difficult to satisfy and motivate workers
- over specialisation may lead to a situation where workers perform repetitive tasks and have little incentive to use personal initiative in ways that help their employer
describe external economies and diseconomies of scale
external economies of scale occur when a firm’s average or unit costs of production fall, because of the growth of the industry or market that the firm is part of
- external economies of scale are produced by cluster effects, which occur when a lot of firms in the same industry are located close together, producing sources of supply and labour
external diseconomies of scale occur in a similar way, with the growth of the whole market raising average costs of all the firms in the industry
- these can also come from cluster effects, as they could get in each other’s way
- there may be competition for labour among the firms
- there may be an increase in traffic congestion which lengthens delivery times and raises delvery costs for both firms and for their customers
describe what happens and what does it mean when the LRAC curve starts to curve upwards
when the LRAC curve starts to curve upwards, it means there are diseconomies of scale
- a business has grown beyond its optimum size
- a business is suffering from productive inefficiency
- a business may have to raise prices to lower costs
- lower competitiveness could lead to a loss in market share
- the company share price could fall
what is the formula for average revenue
average revenue = total revenue/output
what is total revenue
total revenue is all the money a firm earns from selling the total output of a product
what is the marginal revenue
marginal revenue is the addition to total revenue resulting from the scale of one more unit of output
what is the formula for marginal revenue
change in total revenue / change in output
what is the relationship between average revenue and the firm’s demand curve
the demand curve facing the firm is the same as its average revenue
describe the relationship between average and marginal graph and returns
- average revenue is the reflection of the average cost curve
- when marginal returns are above average returns, average returns are rising
- when marginal returns are below average returns, average returns are falling
what is the relationship between marginal revenue and total revenue
marginal revenue measures the change in total revenue that results from an increase in the quantity of goods sold
- it indicates how much revenue increases for selling an additional unit of a good
- marginal revenue is also shown by the the slope of the total revenue curve
- increasing marginal revenue can be shown by the total revenue curve becoming steeper
- falling marginal revenue is shown by the total revenue curve becoming less steep as sales increase
what is profit
profit is the difference between the sales revenue the firm reveives when selling the goods or services it produces and the costs it incurs when producing these gods or services
formula for profit
total profit = total revenue - total costs
what is profit maximisation and when does it occur
occurs when the firm is producing the level of output at which profit is greatest
what is the goal of a business according to classical economists
profit maximisation
explain the roles of profit in a free market
- acts as an incentive for firms to grow, for other firms to enter the market and for workers
- profit is a source of finance, as higher dividend payments encourage more shareholders to invest
- profit is a reward for innovation and entrepeneurship, encouraging risk taking
- if firms are making profit, it is a signal the economy is growing
what are the two types of profit
normal and supernormal
describe normal profit
normal profit is the minimum profit a firm must make to stay in business
- where firm breaks even (TR=TC)
- normal profit is insufficient to attract new firms into the market
- in the long run, if a firm cannot make normal profit, it will shut down
describe supernormal profit
it is the extra profit, above normal profit
- acts as a signal for resources to shift into this sector and for other firms to enter the market
when is there abnormal profits (<>)
when TR > TC
when is there a loss (<>)
when TC > TR
