Mod 3 - Topic 1 - Costs of production

Question 1

Cost is an important component of business, what are three common ways to reduce cost? (3)

Answer 1

1) reduce staff
2) outsource components of the business
3) merge, consolidate and then reduce headcount

Question 2

What is relevant cost?

Answer 2

A cost that is affected by a management decision. Variable costs and incremental costs are considered to be relevant costs.

Question 3

What is historical cost?

Answer 3

A cost incurred at the time of procurement. A past activity.

Question 4

What is opportunity cost?

Answer 4

The amount or subjective value that is forgone in choosing one activity over the next best alternative

Question 5

What is incremental cost?

Answer 5

The total cost associated with a particular decision. If incremental cost is considered on a per-unit basis, it becomes marginal cost.

Question 6

What is a sunk cost?

Answer 6

A cost incurred int he past that is not affected by a current decision. If a resource has no opportunity cost (ie it has no value) it is said to be sunk

Question 7

In determining whether to enter a market, which costs should be used?

Answer 7

Replacement cost over historical cost.

Question 8

What is total variable cost (TVC)?

Answer 8

the cost associated with the variable input found by multiplying the number of units by the unit price

Question 9

What is marginal cost (MC)?

Answer 9

The rate of change in the total variable cost for each additional unit. MC = Change in TVC/ Change in Quantity or Change in TC / Change in Quantity

Question 10

How are TVC and TP related and why?

Answer 10

When TP increases, TVC decreases. They mirror each other. This is because of the law of diminishing returns, which implies that MC will eventually increase.

Question 11

What are the assumptions that an economist will make before analysing a short run cost function model? (7)

Answer 11

The firm:
* employs two inputs - labor & capital
* operates in a short run production period where labor is variable and capital is fixed
* production of only one product
* employs a fixed level of technology
* operates at every level of output in the most efficient way
* Operates in perfectly competitive input markets and must pay at market rates (price taker)
and, the short run production function is affected by the law of diminishing returns.

Question 12

In the short run cost function, TVC is what and TFC is what?

Answer 12

TVC - Total cost of the variable input (labor)

TFC - Total fixed cost (capital)

Question 13

What is TC? AVC? and AFC?

Answer 13

TC - total cost = TVC + TFC
AVC - average variable cost = TVC/Q
AFC - average fixed cost = AFC/Q

Question 14

Where does MC intercept AC and AVC on a graph?

Answer 14

At their lowest point.

Question 15

What does it mean where:

• MC is less than AVC?
• MC is greater than AVC?

Answer 15

• Less than means AVC is falling

* More than means AVC is rising

Question 16

How does a change to the firm’s fixed cost affect Average Cost?

Answer 16

It is a shift downward along the MC Curve, so that it intersects AC at a lower point.

Question 17

How does a change to the firm’s variable cost affect Average Cost?

Answer 17

It moves the curve lower, and will also move the AVC and MC curves.

Question 18

What is the Total Cost Function? and the three types?

Answer 18

Economic analysis considers three basic functional firms of total cost: cubic, quadratic and linear.

Question 19

What is the cubic relationship?

Answer 19

As output increases, total cost first increases at a decreasing rate, then increases at an increasing rate (due to law of diminishing returns). This is the most common in economic theory.

Question 20

What is the Quadratic relationship?

Answer 20

As output increases, total cost increases at an increasing rate.

Question 21

What is the Linear relationship?

Answer 21

As output increases, total cost increases at a constant rate.

Question 22

Why in the long run may all inputs to a firms production function be changed?

Answer 22

• because there are no fixed inputs over the long run, (ie no fixed costs because all can change)
  The firm’s long run marginal cost pertains to returns of scale: at first increasing returns to scale then as firms mature they achieve constant returns and then ultimately decreasing returns to scale.

Question 23

When a firm experiences increasing returns to scale what happens? (2)

Answer 23

• a proportional increase in all inputs increases output by a greater proportion
• as output increases by some percentage, total cost of production increases by some lesser percentage.

Question 24

What are economies of scale?

Answer 24

Situations where a firm’s long-run average cost (LRAC) declines as output increases.

Question 25

What are diseconomies of scale?

Answer 25

Situation where LRAC increases as output increases.

Question 26

What are the reasons for long run economies of scale? (5)

Answer 26

• specialisation of labor and capital
• prices of inputs may fall with volume discounts in firm’s purchasing
• use of capital equipment with better price-performance ratios
• larger firms may be able to raise funds in capital markets at a lower rate
• larger firms may be able to spread out promotional costs.

Question 27

What are the reasons for long run diseconomies of scale? (2)

Answer 27

• scale of production becomes so large that it affects the total market demand for inputs, so input prices rise.
• transportation costs tend to rise as production grows, due to handling expenses, insurance, security and inventory costs.

Question 28

In the long run the firm can choose any level of capacity. What happens once it commits to a level of capacity?

Answer 28

At least one of the inputs must be fixed. This then becomes the short run problem.

Question 29

What shape is the LRAC curve and why?

Answer 29

It is an envelope shape and is made up of many SRAC curves, each which outline the lowest per-unit costs the firm will incur over a range of output.

Question 30

Is the long run curve the only determinant to understanding what size plant to build?

Answer 30

No, must also consider the level of demand. The LRAC may indicate a plant that can cater for 50,000 units may be appropriate, however, if demand is only 20,000, costs would be overstated.

Question 31

What does the learning curve show?

Answer 31

It is a line that shows the relationship between labor cost and additional units of output. Its downward slope indicates that this additional cost per unit declines as the level of output increases, because workers improve with practice.

Question 32

How is the learning curve measured?

Answer 32

In terms of percentage decrease in additional labor cost as output doubles.

Question 33

What is the experience curve?

Answer 33

It is the relationship between the unit cost of labor and all inputs associated with the production process (ie. both direct labor (factory workers) and indirect labor (engineers).

Question 34

What are economies of scope?

Answer 34

Reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately. Eg a business produces two kinds of drink but uses one marketing, sales, distribution etc.

Question 35

What is supply chain management (SCM)?

Answer 35

Efforts by a firm to improve efficiencies through each link of a firms supply chain from supplier to customer.

Question 36

What are the types of costs that can be decreased in a supply chain? (3)

Answer 36

• transaction costs - incurred by using external resources
• coordination costs - arise due to uncertainty and complexity of tasks
• information costs - arise to properly coordinate activities between the firm and suppliers

Question 37

What are the ways to develop better supplier relationships? (2)

Answer 37

• strategic alliances - firm and outside supplier join together in some sharing of resources
• competitive tension - firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control.

Question 38

What are the ways that companies cut costs to remain competitive? (7)

Answer 38

• The strategic use of cost
• Reduction in cost of materials
• Using information technology to reduce costs
• Reduction of process costs
• Relocation to lower wage countries or regions
• Mergers, consolidation and subsequent downsizing
• Layoffs and plant closings