The Cost Curves

Question 1

What are costs?

Answer 1

Costs are payments to factors of production

Question 2

What is Normal Profit?

Answer 2

Normal Profit is the opportunity cost of running a business or the minimum level of reward to ensure that existing entrepreneurs are prepared to remain in the present area of production.

So: Accounting Profit = Total Revenue - “accounting costs”
But: Economic Profit = Total Revenue - (“accounting costs” + normal profit)

Or normal profit is included in the cost curves

Question 3

What is Supernormal profit?

Answer 3

Supernormal/Abnormal profit is profit beyond normal profit. It encourages new firms to enter the industry

Question 4

What are fixed costs?

Answer 4

Fixed Costs (FC) - costs which do not vary directly with outputs, such as rent (FC still have to be paid out if output is zero & only exist in SR)

Question 5

What are variable costs?

Answer 5

Variable Costs - costs which vary directly with output, raw materials are the most obvious example (VC=0 if output is zero)

Question 6

What are total costs?

Answer 6

Total Costs (TC) = Total Fixed Costs + Total Variable Costs = (T)FC+(T)VC

Question 7

What are average costs?

Answer 7

TC/Q i.e. Costs per unit

Also Average Fixed Costs and Average Variable Costs exist

Question 8

What are marginal costs?

Answer 8

Marginal Cost:

• the additional cost of producing 1 more unit (or cost of producing the last unit)
• it can be calculated as “change in TC/change in Q”
• it is the gradient of the TC curve

Question 9

Explain The Law of Diminishing Marginal Producitivity

Answer 9

The Law of Diminishing Marginal Productivity (DMP)

Also known as diminishing marginal returns, this rule applies to all firms, no matter their size or market they operate in. DMP applies in SR only where at least 1 FoP is fixed in quantity.
It say that “if one input in the production of a product is increased while all other inputs are held fixed, a point will eventually be reacher at which additions of the input yield progressively smaller, or diminishing, increases in output”

Diagram:
Marginal Physical Product Curve (Output v Units of Labour)
Marginal output curve - rises then falls when DMP begins
Total output curve - rises then falls where Marginal output becomes negative

Question 10

What do total cost curves look like?

Answer 10

Diagram:
Total Cost Curves (Costs v Quantity)
FC is a straight line
TC and VC have the same shape (rises sharply, stabilises, rises again), the gap between the two curves is FC

Question 11

What do average/ marginal cost curves look like?

Answer 11

Diagram:
Average/Marginal Cost Curves (Costs v Quantity)
MC - nike tick, minimum point where DMP starts, cuts AC and AVC at their respective minimum points
AC and AVC - parabolas, starting at different points with the gap in between them (AFC) decreasing
AFC - starts high then falls

Question 12

What’s the exam style diagram for costs and what are the key points(5) about it?

Answer 12

Diagram:
Cost Curves (C v Q)
MC - nike tick
AC & AVC - can be drawn linearly, with the gap in between (AFC) decreasing, cross MC at their minimum points

Key Points:

1. Since the DMP always applies, the basic shape of these curves is the same for all firms
2. MC cuts AC at the minimum point
3. MC cuts AVC at the minimum point
4. The minimum point on MC is where DMP sets in
5. A change in FC does not affect MC

Question 13

What do long run average cost curves look like?

Answer 13

Diagram:
Long Run Average Costs (C v Q)
LRAC:
- downwards sloping - Economies of Scale
- Minimum Efficient Scale
- straight line - Constant Returns to Scale
- upwards sloping - Diseconomies of Scale

Question 14

What do short run average costs look like and what is the principle and key points(4) behind the diagram?

Answer 14

Diagram:
Short Run Average Costs & Long Run Average Costs
LRAC: parabola, mostly downwards sloping
SRAC: small parabola touching LRAC at one point

Principle:
In SR a firm willing to increase quantity can move along SRAC (e.g. pay workers over time). In LR the firm can increase its capital (i.e. buy bigger/better machinery). This moves along LRAC and means SRAC now shifts to SRAC2. This allows the firm to reduce costs.

Key Points:

1. In the LR all FoPs can vary
2. Any point below the LRAC is unobtainable
3. We can operate at any point above the LRAC
4. The lowest point on the LRAC is called the Minimum Efficient Scale (MES) of production

Question 15

What is the definition of economies of scale?

Answer 15

Economies Of Scale is a fall in long run average costs as output increases. Their size depends on the industry, i.e. massive in manufacturing, less significant in personal services.

Question 16

What are the sources of EoS?(5+1)

Answer 16

Sources of Economies of Scale:

1. Purchasing Economies: Buying stock/ raw materials in bulk can get discounts per unit.
2. Marketing Economies: For larger firms marketing costs are spread over more units & so are lower per unit.
3. Technical Economies: These are savings in the actual process itself- a larger machine may be faster/ cheaper per unit, but produce far more than a small firm requires. It includes reduced transportation costs- doubling the surface area of a container more than doubles its capacity.
4. Managerial Economies: Large firms can employ specialist managers who are more productive than the owner ‘doing it himself. Similarly as firms grow they don’t need to duplicate many managerial positions (only need 1 CEO!)
5. Financial Economies: Large firms are considered safer by lenders & so can raise money at a lower interest rate than small firms. They also have a greater choice of lenders.

All the above are “internal Eos”, but there can be “external Eos”, which occur when the whole industry grows/ a region specialises in 1 industry. These may be more trained labour or better transport links.

Question 17

What are diseconomies of scale?

Answer 17

These are usually related to management. As a firm grows th management becomes more difficult, meaning more people employed in “red tape”(filling out paperwork), slower communication, more mis-communication. These often occur if firms spread geographically.