Module 5 - Production And Costs

Question 1

Explicit costs

Answer 1

The payments to outside suppliers of inputs.

for factors not owned by the firm

Question 2

Implicit costs

Answer 2

Costs which do not involve a direct payment of money to a third party, but which nevertheless involve a sacrifice of some alternative.
(for factors already owned by the firm)

Question 3

Historic costs

Answer 3

The original amount the firm paid for factors it now owns.

Question 4

Replacement costs

Answer 4

What the firm would have to pay to replace factors it currently owns.

Question 5

Sunk cost

Answer 5

Costs that cannot be recouped (e.g. by transferring assets to other uses)

Question 6

Bygones principle

Answer 6

The ‘bygones’ principle states that sunk (fixed) costs should be ignored when deciding whether to produce or sell more or less of a product. Only variable costs should be taken into account.

Question 7

How to measure the opportunity cost for a firm

Answer 7

In order to measure a firm’s opportunity cost, we split the factor inputs, and the associated costs, into two categories: explicit costs and implicit costs. Historic costs are irrelevant to production decisions, whilst replacement costs are relevant only when a factor needs to be replaced.

Question 8

Fixed factor

Answer 8

An input that cannot be increased in supply within a given time period.

Question 9

Variable factor

Answer 9

An input that can be increased in supply within a given time period.

Question 10

Short run

Answer 10

The period of time over which at least one factor is fixed.

Question 11

Long run

Answer 11

The period of time long enough for all factors to be varied.

Question 12

Total physical product (TPP)

Answer 12

The total output of a product per period of time that is obtained from a given amount of inputs.

Question 13

Average physical product (APP)

Answer 13

Total output (TPP) per unit of the variable factor (Qv) in question: APP = TPP/Qv.

Question 14

Marginal physical product (MPP)

Answer 14

The extra output gained by the employment of one more unit of the variable factor: MPP = ΔTPP/ΔQv.

Question 15

Production function

Answer 15

The mathematical relationship between the output of a good and the inputs used to produce it. It shows how output will be affected by changes in the quantity of one or more of the inputs.

Question 16

Law of diminishing marginal returns

Answer 16

When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less additional output than the previous unit.

When one or more factors are held fixed, there will come a point beyond which the extra output from additional units of the variable factor will diminish.

Question 17

Total cost (TC)

Answer 17

The sum of the total fixed costs (TFC) and total variable costs (TVC) : TC = TFC + TVC.

Question 18

Total fixed cost (TFC)

Answer 18

Total costs that do not vary with the amount of output produced.

Question 19

Total variable cost (TVC)

Answer 19

Total costs that do vary with the amount of output produced.

Question 20

Average total cost (AC)

Answer 20

Total cost (fixed plus variable) per unit of output: AC = TC/Q = AFC + AVC.

Question 21

Average fixed cost (AFC)

Answer 21

Total fixed cost per unit of output: AFC = TFC / Q

Question 22

Average variable cost (AVC)

Answer 22

Total variable cost per unit of output: AVC = TVC / Q

Question 23

Marginal cost (MC)

Answer 23

The cost of producing one or more unit of output: MC = ΔTC / ΔQ.

Question 24

Economies of scale and diseconomies of scale

Answer 24

Economies of scale: when increasing the scale of production leads to a lower cost per unit of output.
Diseconomies of scale: where costs per unit of output increase as the scale of production increases.

Question 25

Specialisation / division of labour

Answer 25

Where production is broken down into a number of simpler, more specialised tasks, thus allowing workers to acquire a high degree of eficiency.

Question 26

Indivisibilities

Answer 26

The impossibility of dividing a factor of production into smaller units.

Question 27

Plant economies of scale

Answer 27

Economies of scale that arise because of the large size of the factory.

Question 28

Rationalisation

Answer 28

The reorganisation of production (often after a merger) so as to cut out waste and duplication and generally to reduce costs.

Question 29

Overhead costs

Answer 29

Costs arising from the general running of an organisation, and only indirectly related to the level of output.

Question 30

Economies of scope

Answer 30

When increasing the range of products produced by a firm reduces the cost of producing each one.

Question 31

External economies and diseconomies of scale

Answer 31

External economies of scale: where a firm’s costs per unit of output decrease as the size of the whole industry grows.
External diseconomies of scale: where a firm’s costs per unit of output increase as the size of the whole industry increases.

Question 32

Industry’s infrastructure

Answer 32

The network of supply agents, communications, skills, training facilities, distribution channels, specialised financial services, etc. that support a particular industry.

Question 33

Technical or productive efficiency

Answer 33

The least-cost combination of factors for a given output.

Question 34

3 decisions that firms will need to make in the long run

Answer 34

1. Scale of production
2. Location of production
3. Production techniques to use

Question 35

Differences between increasing, constant and decreasing returns of scale

Answer 35

• Increasing returns to scale arise when changing all inputs by the same percentage leads to a greater percentage change in output.
• Constant returns to scale arise when changing all inputs by the same percentage leads to the same percentage change in output.
• Decreasing returns to scale arise when changing all inputs by the same percentage leads to a smaller percentage change in output.

Question 36

6 factors that lead to plant economies of scale

Answer 36

1. Specialisation and division of labour
2. Indivisibilities
3. The ‘container principle’
4. Greater efficiency of large machines
5. By-products
6. Multistage production

Question 37

4 other possible economies of scale other than plant

Answer 37

1. Organisational
2. Spreading overheads
3. Financial economies
4. Economies of scope

Question 38

4 factors that may lead to diseconomies of scale

Answer 38

1. Managerial problems of co-ordination and communication
2. Alienation and poor motivation of the workforce
3. Poor industrial relations
4. Problems in one area holding up all production

Question 39

2 factors that will influence the choice of location

Answer 39

1. The availability, suitability and cost of factor inputs.

2. Transport costs - reflecting distance to both the market and raw materials.

Question 40

Industrial clusters

Answer 40

Groups of interconnected companies that are located in the same geographical region.

Question 41

Benefits of industrial clusters

Answer 41

1. Improve productivity - close proximity increases flexibility
2. Encourage innovation - interaction stimulates new ideas and aids dissemination
3. Encourage the formation of new businesses to meet the needs of the cluster - dedicated venture capital and labour skills help to reduce costs and lower the risks of new business start-ups.

Question 42

Condition for the cost-minimising combination of factors

Answer 42

Two-factor case:
MPPk / Pk = MPPl / Pl
This ensures that the extra output produced by the last pound spent on each factor is equal and that it is impossible to reorganise the factors to reduce costs.

Question 43

Distinguish between the very short run, the short run, the long run and the very long run

Answer 43

Very short run: is the period in which all factor inputs and hence output is fixed, giving a vertical supply curve.
Short run: at least one factor is fixed and production is eventually subject to diminishing returns to the variable factor.
Long run: all factors are variable, but of fixed quality. Production may face increasing, decreasing or constant returns to scale.
Very long run: all factors are variable and their quality and hence productivity may change.

Question 44

Long run average cost (LRAC) curve

Answer 44

A curve that shows how average cost varies with output on the assumption that all factors are variable. (It is assumed that the least-cost method of production will be chosen for each output.)

Question 45

Minimum efficient scale (MES)

Answer 45

The output level beyond which no further economies of scale can be achieved.

Question 46

Describe how long run average costs typically vary with output

Answer 46

Long-run average costs typically:
1. decrease up to a certain level of output due to economies of scale
2. increase beyond a certain level of output due to diseconomies of scale
In between, there may be a range of output levels, over which they are fairly constant.

Question 47

3 assumptions underlying the long-run average costs curves

Answer 47

1. Factor prices are given, although they may vary with output, eg. if the firm can obtain discounts for bulk purchases.
2. The stage of technology and factor quality are given
3. Firms choose the least-cost combination of factors for each output

Question 48

Relationship between short-run and long-run average costs (diagram)

Answer 48

The LRAC curve is typically an envelope curve lying below the corresponding short-run average cost curves, which are tangential to it. This is because in the long run, the quantities of all input factors can be varied and hence optimised, whereas in the short run, some are fixed and so cannot be re-optimised.

Question 49

Relationship between costs and factor inputs

Answer 49

The relationship depends on:

1. factor productivity - higher productivity implies lower production costs.
2. factor prices - higher prices imply higher production costs.