Theory of the Firm: Cost of Production

Question 1

Economic Cost

Answer 1

The cost to a firm for utilizing economic resources in production

Question 2

Accounting Cost

Answer 2

The actual expense + depreciation charges for capital equipment

Question 3

Opportunity Cost

Answer 3

The cost associated with opportunities lost when a firm’s resources aren’t put to their best alternative use. (Useful when the alternatives don’t reflect monetary outlays)

Question 4

Implicit Cost

Answer 4

The cost that doesn’t require an outlay of money from the firm.

Question 5

Explicit Cost

Answer 5

The cost that requires an outlay of money from the firm

Question 6

Sunk Costs

Answer 6

Expenditures that have been made and can’t be recovered.
- Shouldn’t influence a firms decisions e.g. purchasing certain equipment that only have one use: the items therefore don’t have an opportunity cost.
- Can be a problem as when the expenditure is gone it can’t be recovered even after shutting down.

Question 7

Total Costs (TC)

Answer 7

Total economic cost of production: Fixed Costs and Variable Costs

Question 8

Fixed Costs (FC)

Answer 8

Costs that don’t vary with the level of output that can be eliminated only by ‘shutting down’.
- Over time a short time a firm’s costs are mostly fixed
- Affect a firms decisions for the future if they’re high and can’t be reduced = bad: earning 0 profit but getting rid of fixed costs is better

Question 9

Shutting down

Answer 9

Reducing the output of the factory to zero: eliminating the cost of raw materials and a lot of labour because of market conditions
Firm will shut down if:
- TR < VC
- TR/Q < VC/Q
- P < ATC

Question 10

Exit

Answer 10

A long-run decision to leave the market
A firm will exit if:
- TR < TC
- TR/Q < TC/Q
- P < ATC
A firm will enter a market if its the opposite of ^

Question 11

Variable Cost (VC)

Answer 11

Costs that vary as output varies
- Over a long time a firms costs are mostly variable

Question 12

Marginal Cost (MC)

Answer 12

The increase in cost resulting from production of 1 extra unit.
- As FC don’t affect level of output changes, MC is essentially the increase of VC when there’s another unit of output
- MC = change in VC/ change in Q

Question 13

Average Total Cost (ATC)

Answer 13

Firm’s total cost divided by the level of output
- ATC = TC/Q

Question 14

Average Fixed Costs (AFC)

Answer 14

Firm’s fixed costs divided by level of output
- AFC = FC/ Q

Question 15

Average Variable Costs (AVC)

Answer 15

The firms variable costs divided by the level of output
- AVC = VC/ Q

Question 16

what is the change in variable cost

Answer 16

cost per unit of extra labour x the amount of extra labour is the change in out put
- change in VC = w(extra labour) x L(change in extra labour)

Question 17

Diminishing Marginal Returns

Answer 17

Marginal Product of Labour (MPL) declines as quantity of labour employed increases.
- When there are diminishing marginal returns, marginal cost increases as output increases

Question 18

MP, AP, MC, AVC and their relationship

Answer 18

• When labour is the only variable factor: ∆VC= ∆wL, MC = ∆wL/∆Q
• When wage rates are fixed: w∆L/∆Q as ∆L/∆Q = 1/MP, MC=w/MP
• Calculating AVC: AVC=w/AP as L /Q = 1/AP

Question 19

Production Processes

Answer 19

There’s a constant marginal cost therefore, AVC and MC are identical
- MC lies below ATC in these processes graphically

Question 20

User Cost of Capital (r)

Answer 20

UCC = economic depreciation + (interest rates)(value of capital)
- Firms try keep costs low - factories in LICs

Question 21

Rental rate

Answer 21

the rate of renting per unit - in a competitive market, rental rate should = the user cost

Question 22

Isocost line

Answer 22

The graph that shows all possible combinations of labour and capital that cane be purchased for a total cost
- C = wL + rK (capital cost)
- Rewrite ^ with the formula of a straight line, where k is Y and L is X: K = C/ r – (w/r)L

Question 23

Expansion Path

Answer 23

A curve passing through the points of tangency between a firms isocost line and its isoquants

Question 24

Expansion Path –> Cost Curve

Answer 24

• Chose an output level represented by an isoquant and find its point of tangency with an isocost line.
• From that chosen isocost line, determines the minimum cost of producing the output level that has been selected.
• Graph this output-cost combination.

Question 25

Economies of Scale

Answer 25

Situation in which output can be doubled for less than a doubling of cost
- Measured in terms of a cost-output elasticity, Ec
- The percentage change in cost of production caused from a 1 per cent increase in output.
- Ec = (∆C/C)/(∆q/q) = MC/ AC

Question 26

Diseconomies of Scale

Answer 26

When a doubling output requires more than a doubling of costs

Question 27

Increasing Returns to Scale

Answer 27

Output more than doubles when quantities of an input are doubles