The Costs of a Firm

Question 1

Firms generate Revenue and incur Costs

Answer 1

1. A firm is any sort of business organisation, like a family-run factory, a dental practice or supermarket chain
2. An industry is all the firms providing similar goods or services
3. A market contains all the firms supplying a particular good or service and the firms or people buying it
4. Firms generate revenue by selling their output
5. Producing this output uses factors of production , and this has a cost.
6. The profit a firm makes is its total revenue minus its total costs
7. In the long run firms need to make profit to survive

Question 2

Economists include Opportunity Cost in the Cost of Production

Answer 2

1. When economists talk about the cost of production they are referring to the economic cost of producing the output.
2. The economic cost includes the money cost of factors of production that have to be paid for, but it also includes the opportunity cost of the factors that aren’t paid for
3. The opportunity cost of a factor of production is the money that you could have got by putting it to its best use.
4. Cost isnt just a calculation of money spent - it takes into account all of the effort and resources that have gone into production.

Question 3

In the short run some costs are fixed

Answer 3

1. The short run is the period of time when at least one factor of production is fixed.
2. The short run isn’t a specific length of time - it varies from firm to firm. E.g. the short run of a cycle courier service could be a week because it can hire new staff with their own bikes quickly, but a steel manufacturer might have a short run of several years because it takes lots of time and money to build a new steel-manufacturing plant.
3. The long run is the period of time when all factors of production can be varied.
4. Costs can be fixed or variable in the short run

Question 4

Examples of fixed and variable costs

Answer 4

Fixed costs =

• Fixed costs don’t vary with output in the short run - they have to be paid whether or not anything is produced.
• E.g. the rent on a shop is a fixed cost - it’s the same no matter what the sales are

Variable costs =

• Variable costs do vary with output - they increase as output increases
• The cost of the plastic bags that a shop gives to customers is a variable cost - the higher sales are, the higher the overall cost of the bags

5. In the long run all costs are variable

Question 5

Total Cost and Average Cost include Fixed Costs and Variable Costs

Answer 5

Total Cost (TC) is all the costs involved in producing a particular level of output 
- The total cost for a particular output level is the total fixed costs (TFC) plus total variable costs for that output level:
TC = TFC + TVC
Average cost is the cost per unit produced
- Average cost is calculated by dividing total costs by the quantity produced: AC = TC/Q
- Average fixed cost = total fixed costs/ quantity produced: AFC = TFC/Q
- Average variable cost = AVC = TVC/Q

Question 6

Marginal Cost is the cost of Increasing Output by One Unit

Answer 6

Marginal Cost is the extra cost incurred as a result of producing the final unit of output
- Marginal cost is only affected by variable costs - fixed costs have to be paid even if nothing is produced. You can calculate it by finding the difference between total cost at the current output level (TCn) and total cost of one unit less (TCn-1): MC = TCn - TCn-1

• Theres a more general formula that gives the extra cost of ‘the last few units’
  MC = Change in TC/ Change in Quantity
  LOOK AT TABLE ON PAGE 41

Question 7

Lowest Average Cost occurs when Marginal Cost equals Average Cost

Answer 7

1. Marginal cost (MC) decreases initially as output increases, then begins to increase in the short run because of the law of diminishing returns.
2. So the MC curve is always u-shaped
3. Changes in marginal cost affect average cost:
   - When the marginal cost is lower than the average cost (AC), the average cost will be falling. This is because each extra unit produced will decrease the average cost
   - When the marginal cost is higher than the average cost, the average cost will be rising because each extra unit produced will increase the average cost.
   - So the marginal cost curve meets the average cost curve at the lowest average cost, i.e. average cost will be lowest when MC = AC - this is the point of productive efficiency
4. The MC curve also meets the AVC curve at the minimum AVC.
5. This means AVC and AC curves also always form a u-shape in the short run - they both decrease until they reach a minimum, then begin to increase
6. AFC falls as output rises because the total fixed cost is spread across the greater output
   * LOOK AT DIAGRAM ON PAGE 41*