Lesson 3 - Theory Of The Firm: Costs

Question 1

What are fixed costs and how do they work in the short run?

Answer 1

• costs that don’t change with the level of output
• do not change in the short run

Question 2

What are variable costs and how do they workin the short run?

Answer 2

• costs that are directly related to changes in output
• change in the short run

Question 3

How do you calculate total costs?

Answer 3

TC = FC + VC

Question 4

How do you calculate average costs?

Answer 4

Total costs / output

Question 5

What are marginal costs?

Answer 5

The cost of producing one more unit

Question 6

Explain the law of diminishing marginal returns

Answer 6

• fixed factor
• increasing a variable factor increases productivity and lowers average costs for the firm
• as the variable factor continues increasing, the fixed factor results in overcrowding
• this means when more of the variable factor is added, the marginal returns will fall
• this is when diminishing marginal returns kick in
• diminishing marginal returns then causes average returns to fall, increasing average costs

Question 7

Explain the relationship between marginal and average costs

Answer 7

• if marginal costs are higher than the average, then the average will rise
• if marginal costs are lower than the average, then the average will fall

Question 8

Describe costs in firms in the long run

Answer 8

• no fixed factor, so no laws and the LRAC curve can be any shape

Question 9

What is the MES?

Answer 9

• minimum efficiency scale of production
• The lowest level of output required to exploit full economies of scale

Question 10

What are economies of scale?

Answer 10

A reduction in LRAC as output increases

Question 11

What are returns to scale?

Answer 11

The relationship between inputs and outputs (output concept)

Question 12

What are diseconomies of scale?

Answer 12

An increase in LRAC as output increases

Question 13

What are the internal economies of scale?

Answer 13

All increase costs in a way, but their output is much greater
Risk bearing - firms can spread their risk over a larger range of output as they grow
Financial - firms can negotiate lower rates of interest as they grow, because their size and growth show low risk
Managerial - firms can employ specialist managers and boost productivity
Technical - bringing in specialist machinery to boost productivity
Marketing/Purchasing - firms buy raw materials in bulk, which can reduce costs, and advertising costs are spread

Question 14

What are the external economies of scale?

Answer 14

Benefits of economies of scale that don’t come from within the business
- better transport infrastructure
- R&D (research and development firms move closer)
- component suppliers move closer (decreases transporting costs)

Question 15

What are the main diseconomies of scale?

Answer 15

3 C’s and an M
Control - harder to manage the workforce and keep track of the business (can lower productivity)
Communication - harder to spread messages through the business
Coordination - firms are slow to respond due to how many layers the business has
Motivation - more workers make individuals feel less valued, which lowers their motivation to work