Theme 3.3: Costs and Revenue

Question 1

Total Fixed Costs (TFC)

Answer 1

Costs which do not vary with output

Question 2

Average Fixed Costs (AFC)

Answer 2

Average fixed cost per unit: falls as output increases (fixed costs are being spread out over more items of production)

Question 3

Variable Costs

Answer 3

Costs which vary with output

Question 4

Marginal Costs (MC)

Answer 4

The cost of producing one more item

Question 5

Total Variable Costs (TVC)

Answer 5

The cumulative total of all marginal costs

Question 6

Average Variable Costs (AVC)

Answer 6

Average variable cost per unit (total variable costs divided by output)

Question 7

Total Costs (TC)

Answer 7

Overall costs of producing at a particular level of output

Question 8

Average Costs (AC)

Answer 8

Average cost of production per unit (total cost divided by output)

Question 9

Give three examples of fixed costs

Answer 9

Rent / mortgage on business facilities
Insurance premiums for the business
Licensing and permits

Question 10

Give three examples of variable costs

Answer 10

Raw materials
Direct labour
Manufacturing costs (electricity for machinery to run)
Sales commission

Question 11

Total Revenue (TR)

Answer 11

The overall revenue gained from all sales (P x Q)

Question 12

Average Revenue (AR)

Answer 12

Revenue generated per unit sold (TR / Q = Price)

Question 13

Marginal Revenue (MR)

Answer 13

The revenue gained from selling one more item

Question 14

What is profit?

Answer 14

The difference between revenue and costs

Question 15

Define normal profit

Answer 15

The amount of profit required to keep factors of production in their current use
(no incentive to join or leave the industry), AR = AC

Question 16

Define supernormal profit

Answer 16

Any profit above normal profit
Has the effect of attracting new entrants into the market

Question 17

Define shut down point

Answer 17

The point at which the business flips from being viable to not being viable

Question 18

Shut down point LR

Answer 18

All factors are variable, so there are no longer any fixed costs: if AR < AC, they are better off leaving the industry

Question 19

Shut down point SR

Answer 19

Loss making firm might have a reason to stay in the industry
* If AR > AVC, the firm will continue to produce in the SR as it is making a contribution to its fixed costs
* If AR = AVC, the firm is on the shut down point. Losses = fixed costs
* AR < AVC, the firm will leave the industry in the SR as its losses from production are greater than the fixed costs

Question 20

Define Short Run

Answer 20

The period of time where at least one factor input is fixed

Question 21

Define Long Run

Answer 21

The period of time where all factor inputs are variable

Question 22

Describe diminishing marginal productivity

Answer 22

Short run: as you add increasing amounts of a variable input (often labour) to fixed inputs (capital and land), the marginal output will start to fall
Diminishing returns to labour occurs when marginal products of labour start to fall: total output will increase at a decreasing rate
When marginal product starts to fall, it becomes more expensive to produce an additional unit of output, so marginal cost and average cost eventually starts to rise

Question 23

Define the term ‘Dilution of capital’

Answer 23

Beyond a certain point, new workers won’t have as much capital equipment to work with, so it becomes diluted among the larger workforce

Question 24

Where can diminishing marginal productivity be seen on diagrams?

Answer 24

Marginal product: peak
Marginal cost: trough
Short run average cost: trough

Question 25

Define Economies of Scale

Answer 25

Economies of Scale are the cost advantages exploited by expanding the scale of production in the Long Run The effect is to reduce LR average costs over a range of output

Question 26

Define Internal Economies of Scale

Answer 26

Increase in the scale of a firm due to internal reasons e.g. the firm itself increases in size, regardless of the industry

Question 27

Define External Economies of Scale

Answer 27

Increases in the size of the industry or a wider change in the economy which allows firms in the industry to increase their own scale

Question 28

Explain technical EoS

Answer 28

Arise from the increased use of large scale mechanical processes and machinery Some production processes require high fixed costs (e.g. large factories). If a factory was only used on a small scale, it would be very inefficient. Using the factory to full capacity lowers average costs Large scale businesses can afford to invest in expensive and specialist capital machinery

Question 29

Explain commercial EoS

Answer 29

Large firms can negotiate favourable prices as a result of buying in bulk Large firms can gain lower transport costs because more products are moved with each shipment e.g. large supermarket chains can buy fresh fuit in much greater quantities than a smaller supplier More efficient inventory management can reduce average unit costs (Just in Time)

Question 30

Explain financial EoS

Answer 30

Bigger firms can usually borrow money and generate funds more cheaply than small firms Large firms have more valuable assets which can be used as security, so are seen as more credit worthy by lenders e.g. a business quoted on the stock market can issue shares which will raise funds more cheaply than borrowing

Question 31

Explain managerial EoS

Answer 31

A form of division of labour Large scale manufacturers employ specialists to supervise production systems, management marketing systems and overseeing human resources e.g. large manufacturing company being able to invest more in staff training, thereby increasing productivity and reducing costs

Question 32

Explain risk bearing EoS

Answer 32

Large firms can bear business risks more effectively than smaller firms Some investments are very expensive and risky, so only a large firm will be willing and able to undertake the necessary investment e.g. new drugs can have unknown and severe side effects, so only large pharmaceutical firms can invest in new medicines

Question 33

Describe the minimum efficient scale of production

Answer 33

The minimum amount of output required to be productively efficient (lowest AC) If the MES is very high, it acts as a barrier to entry If the MES falls over time, the industry should become more competitive

Question 34

Define diseconomies of scale

Answer 34

When a business grows so large that the costs per unit increase Output rising doesn't necessarily mean that unit costs will fall Diseconomies of scale generally occur as a result of the difficulties of managing a larger workforce

Question 35

Summarise the reasons for diseconomies of scale

Answer 35

**Poor communication**: more layers in the hierarchy means messages and instructions get distorted, less feedback and less effective communication **Lack of motivation**: Workers might feel isolated and less appreciated in larger businesses, so their loyalty and motivation may diminish. Hard for managers to build up a strong team environment... falling productivity levels and increase in average labour costs per unit **Loss of direction/coordination**: Harder to ensure all workers have the same end goals, more difficult for managers to supervise their subordinates, they may need to delegate more tasks, leaving them less in control