Theme 3.3: Costs and Revenue Flashcards
Total Fixed Costs (TFC)
Costs which do not vary with output
Average Fixed Costs (AFC)
Average fixed cost per unit: falls as output increases (fixed costs are being spread out over more items of production)
Variable Costs
Costs which vary with output
Marginal Costs (MC)
The cost of producing one more item
Total Variable Costs (TVC)
The cumulative total of all marginal costs
Average Variable Costs (AVC)
Average variable cost per unit (total variable costs divided by output)
Total Costs (TC)
Overall costs of producing at a particular level of output
Average Costs (AC)
Average cost of production per unit (total cost divided by output)
Give three examples of fixed costs
Rent / mortgage on business facilities
Insurance premiums for the business
Licensing and permits
Give three examples of variable costs
Raw materials
Direct labour
Manufacturing costs (electricity for machinery to run)
Sales commission
Total Revenue (TR)
The overall revenue gained from all sales (P x Q)
Average Revenue (AR)
Revenue generated per unit sold (TR / Q = Price)
Marginal Revenue (MR)
The revenue gained from selling one more item
What is profit?
The difference between revenue and costs
Define normal profit
The amount of profit required to keep factors of production in their current use
(no incentive to join or leave the industry), AR = AC
Define supernormal profit
Any profit above normal profit
Has the effect of attracting new entrants into the market
Define shut down point
The point at which the business flips from being viable to not being viable
Shut down point LR
All factors are variable, so there are no longer any fixed costs: if AR < AC, they are better off leaving the industry
Shut down point SR
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
Define Short Run
The period of time where at least one factor input is fixed
Define Long Run
The period of time where all factor inputs are variable
Describe diminishing marginal productivity
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
Define the term ‘Dilution of capital’
Beyond a certain point, new workers won’t have as much capital equipment to work with, so it becomes diluted among the larger workforce
Where can diminishing marginal productivity be seen on diagrams?
Marginal product: peak
Marginal cost: trough
Short run average cost: trough
Define Economies of Scale
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
Define Internal Economies of Scale
Increase in the scale of a firm due to internal reasons
e.g. the firm itself increases in size, regardless of the industry
Define External Economies of Scale
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
Explain technical EoS
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
Explain commercial EoS
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)
Explain financial EoS
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
Explain managerial EoS
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
Explain risk bearing EoS
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
Describe the minimum efficient scale of production
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
Define diseconomies of scale
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
Summarise the reasons for diseconomies of scale
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
