Cost & Production (Theory) PDF

ECONOMICS COST & PRODUCTION (THEORY) ?/- KASUN LIYANAGE MBA (Merit) (Sri J), B.Sc MKT (Sp) (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (...

ECONOMICS COST & PRODUCTION (THEORY) ?/- KASUN LIYANAGE MBA (Merit) (Sri J), B.Sc MKT (Sp) (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 2 Mock Question 1. What is a production firm? Any firm associated with the manufacturing of goods can be considered as a production firm. Life cycle of a production firm can be sub divided in to main two periods. a. Short Run b. Long Run A/L 2011/2019 2. Distinguish between the short run and the long run in production. Short run Short run refers to a period of time during which at least one factor of production is considered fixed, while other factors can be varied. In other words, it's a timeframe in which certain aspects of the firm's operations are constrained and cannot be easily changed, while others can be adjusted. Time period too short for capital (plant size) to be changed, non-capital resources (labor & material) can be changed. There are 2 assumptions in short run. a. At least one factor of production is fixed b. Production technology remain unchanged Long run The long run refers to a period of time during which all factors of production can be adjusted and varied. Unlike the short run, where at least one factor is fixed, the long run allows a firm to make changes to all aspects of its operations, including both fixed and variable factors. In the long run, a firm can make decisions related to its production capacity, facilities, technology, and other fixed factors. This means that it can expand or contract its physical facilities, invest in new machinery, hire or lay off employees, change its production techniques, and even enter or exit new markets. (Essentially, all inputs are considered variable in the long run.) A/L 2020 3. What is a production function? Distinguish between short run and long run production functions. Production Function A production function is a concept in economics that represents the relationship between inputs (factors of production) and the resulting output (goods or services) produced by a firm or an economic entity. It's a mathematical or graphical representation that shows how various combinations of inputs are used to produce a certain level of output. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 3 Short run Production Function The short run production function represents the relationship between the quantity of output produced and the variable inputs, while at least one input is held fixed or constant. In the short run production function, it is assumed that output quantity is changed by changing the labour resources (variable input) while holding capital resources constant (fixed input). Thus, short production function is shown as; Q = ƒ (K, L) Long run Production Function The long run production function represents the relationship between the quantity of output produced and all inputs, where all factors of production are fully variable and adjustable. In the long run production function, it is assumed that all input are changed and output quantity is changed with the change of all inputs. Thus, long run production function is shown as; Q = ƒ (K, L) Mock Question 4. Explain the ‘Laws of marginal returns’. (02 marks) Marginal returns or marginal production refers to the additional output generated as more units of a variable resource are added to the fixed resource in a production process. In the short run there are two types of marginal production can be seen. a. Increasing Marginal Returns b. Diminishing Marginal Returns Mock Question 5. Explain the ‘Laws of Increasing marginal returns. Increasing marginal returns, also known as increasing marginal productivity or increasing marginal output, is a concept in economics that describes a situation where adding one more unit of a variable input to the production process while holding some inputs cosntant, leads to a greater increase in output compared to the previous units of input. In other words, the marginal product of the variable input is rising. Mock Question 6. Explain the reasons behinds’ Laws of Increasing marginal returns. (Mock Question) In this phase, as more units of the variable input are added, the efficiency of combining inputs leads to a proportionately greater increase in output. Increasing marginal returns often occur due to increased specialization of labor and the efficient use of complementary inputs. As the workforce or variable input grows, tasks can be divided more effectively, and each unit of input can be used to its fullest potential. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 4 A/L 2011 7. Explain the ‘Laws of Diminishing returns. (02 marks) The Law of Diminishing Returns, also known as the Law of Diminishing Marginal Returns, is an economic principle that describes how the addition of a variable input, while keeping other inputs fixed, will eventually lead to a decrease in the marginal output or returns. In simpler terms, it means that as a firm increases the amount of one input while keeping other inputs constant, there comes a point where the additional output gained from each additional unit of that input starts to diminish. Mock Question 8. Explain the reasons behinds’ Laws of diminishing marginal returns. Since in the short run, at least one factor of production is held constant or fixed, leads to a situation where the increase in variable input (such as labor) causing inefficiencies after a certain point. For instance, in agricultural production, adding more labor to a fixed piece of land can lead to overcrowding, making it difficult for each worker to contribute effectively to cultivation. Further each additional unit of the variable input may not be equally productive due to factors such as space limitations, or limited tools and equipment. Besides, as more units of the variable input are added, coordination and communication challenges might arise. This means that the additional output gained from each extra unit of input starts to decrease. Mock Question 9. Explain how the laws of ‘marginal returns’ affect a firm’s production curves Marginal Product Curve: The marginal product curve shows how the addition of one more unit of the variable input affects the marginal output (additional output gained from each additional unit of input). It's derived from the slope of the total product curve. a. Increasing Marginal Returns Phase: The marginal product curve is upward-sloping during the phase of increasing marginal returns. This indicates that adding one more unit of the variable input leads to a greater increase in output, reflecting the efficiencies of specialization and optimal input usage. b. Diminishing Marginal Returns Phase: The marginal product curve starts to slope downwards during the phase of diminishing marginal returns. This indicates that adding one more unit of the variable input contributes less to the increase in output. It reflects the reduced efficiency and potential overcrowding or resource limitations. Total Product Curve: The total product curve shows the relationship between the quantity of a variable input (such as labor) and the total output produced. As more units of the variable input are added, the total output initially increases, but eventually, the increase starts to slow down and fall, leading to diminishing marginal returns. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 5 a. Increasing Marginal Returns Phase: Initially, the total product curve slopes upwards steeply, indicating the phase of increasing marginal returns. This means that each additional unit of the variable input contributes significantly to increasing the total output. b. Diminishing Marginal Returns Phase: As more units of the variable input are added, the total product curve starts to flatten out and then fall, indicating diminishing marginal returns. Each additional unit of the variable input now contributes less to the increase in total output. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 6 Mock Question 10. Explain relationship between marginal product curve and average product curve Marginal Product Curve: The marginal product (MP) curve shows the change in output that results from adding one more unit of a variable input (e.g., labor) while keeping other inputs constant. It represents the rate of change in output with respect to changes in input quantity. Average Product Curve: The average product (AP) curve, also known as the average marginal product (AMP) curve, shows the average output produced per unit of the variable input. It is calculated by dividing the total output by the quantity of the variable input. a. Initial Relationship: When the marginal product is greater than the average product, the average product curve rises. This is because the additional output from each extra unit of input (marginal product) is contributing more than the average output per unit of input. b. At Maximum: The point where the marginal product equals the average product is the point of maximum average product. This is because the additional output gained from each additional unit of input is exactly in line with the average output per unit of input. c. Declining Relationship: When the marginal product is less than the average product, the average product curve falls. This indicates that the additional output from each extra unit of input is contributing less than the average output per unit of input, resulting in a decrease in the overall average efficiency. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 7 Mock Question 11. Explain how the laws of ‘marginal returns’ affect a firm’s production curves. Marginal Cost (MC) Curve: The MC curve shows the additional cost of producing one more unit of output. The relationship between the law of diminishing marginal returns and the MC curve is closely tied: a Increasing Marginal Returns Phase: When the firm is operating in the phase of increasing marginal returns, the MC curve tends to fall. This is because each additional unit of output requires less additional cost due to the greater efficiency of the production process. b. Diminishing Marginal Returns Phase: As the firm moves into the phase of diminishing marginal returns, the MC curve starts to rise. This is because, as output increases, the additional cost of producing each unit becomes higher due to the diminishing efficiency gains. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 8 Mock Question 12. Explain the relationship between marginal cost curve and marginal product curve The relationship between the MC curve and the MP curve can be explained as follows: a. Increasing Returns: At the outset, when the marginal product is increasing, the marginal cost tends to decrease. This is because the efficiency gains from increased output result in lower marginal costs for producing additional units. b. Diminishing Returns: As output increases beyond a point, diminishing marginal returns start to set in. This leads to decrease in marginal product and an increase in marginal costs, as each additional unit of output requires more resources and incurs higher costs. c. Minimum & Maximum points: When marginal product (MP) curve reaches its highest level, marginal cost (MC) curve reaches its lowest level. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 9 Mock Question 13. Explain relationship between average product curve and average variable cost curve Average Product Curve (AP Curve): The average product curve shows the average output produced per unit of the variable input. It provides insights into the efficiency of the production process and indicates how well resources are utilized to produce output. Average Variable Cost Curve (AVC Curve): The average variable cost curve illustrates the average variable cost of producing each unit of output. The relationship between the AP curve and the AVC curve can be understood as follows: a. Initial Relationship: At the outset, when the average product is increasing (reflecting increasing marginal returns), the AVC curve tends to decline. This is because the firm is using its resources more efficiently, resulting in lower variable costs per unit of output. b. Diminishing Returns: Beyond the point, as the average product starts to decline (reflecting diminishing marginal returns), the AVC curve begins to rise. This indicates that the firm's cost efficiency is decreasing, and average variable costs per unit of output are increasing. c. Minimum & Maximum points: When average product (AP) curve reaches its highest level, average variable cost (AVC) curve reaches its lowest level. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 10 Mock Question 14. Explain relationship between marginal cost curve and average variable cost curve a. MC Below AVC: When the marginal cost is below the average variable cost, the average variable cost tends to decrease. This is because the additional cost of producing one more unit (MC) is less than the average variable cost per unit (AVC), which pulls the AVC downwards. b. MC Above AVC: When the marginal cost is above the average variable total cost, the average variable cost tends to increase. This occurs because the additional cost of producing one more unit (MC) is greater than the average variable cost per unit (AVC), causing the ATC to rise. c. MC Equal to AVC (Intersect): The point where the MC curve intersects the AVC curve is the minimum point of AVC curve. At this point, the marginal cost is equal to the average variable cost. (MC = AVC). Mock Question 15. Explain relationship between total fixed cost curve and average fixed cost curve Total Fixed Cost Curve (TFC Curve): The total fixed cost curve represents the total amount of fixed costs incurred by a firm at different levels of output. Fixed costs remain constant regardless of changes in production levels and include expenses like rent, insurance, and administrative salaries. Average Fixed Cost Curve (AFC Curve): The average fixed cost curve shows the average fixed cost per unit of output. It's calculated by dividing the total fixed costs by the quantity of output. As output increases, the AFC per unit of output decreases because the fixed costs are spread over a larger quantity of goods Key Points a. The TFC curve is a horizontal line because fixed costs remain constant regardless of output levels. As output increases, total fixed costs stay the same. b. The AFC curve slopes downward as output increases. This is because, as output increases, the total fixed costs are divided by a larger quantity of output, resulting in a lower average fixed cost per unit. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 11 c. The AFC curve approaches but never touches the horizontal axis. This is because the denominator in the average fixed cost calculation (output quantity) can never be zero. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 12 A/L 2017 16. What happens to the difference between average total cost and average variable cost as a firm’s output expands in the short run? Explain. In the short run, as a firm's output expands, the difference between average total cost (ATC) and average variable cost (AVC) tends to decrease. In otherwords, average variable cost curve (AVC) and average total cost curve (ATC) get closer to each other as a firm expands its output in the short run. This phenomenon is due to the behavior of the average fixed cost (AFC). As the firm's output expands, total fixed costs remain constant. However, fixed costs are spread over a larger quantity of output as production increases, the fixed cost per unit (AFC) decreases. This means that the difference between ATC and AVC due to fixed costs tends to decrease. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 13 A/L 2016 17. Explain the relationship between marginal cost and average total cost. Marginal Cost (MC): Marginal cost is the additional cost incurred by producing one more unit of output. It represents the change in total cost when output changes by one unit. The MC curve typically has an upward-sloping shape, indicating that as output increases, the cost of producing each additional unit tends to rise. Average Total Cost (ATC): Average total cost is the total cost per unit of output. It's calculated by dividing the total cost by the quantity of output. The ATC curve typically forms a U-shaped pattern, reflecting the relationship between fixed costs, variable costs, and the level of output. The relationship between MC and ATC can be summarized as follows: a MC Below ATC: When the marginal cost is below the average total cost, the average total cost tends to decrease. This is because the additional cost of producing one more unit (MC) is less than the average cost per unit (ATC), which pulls the ATC downwards. b. MC Above ATC: When the marginal cost is above the average total cost, the average total cost tends to increase. This occurs because the additional cost of producing one more unit (MC) is greater than the average cost per unit (ATC), causing the ATC to rise. c. MC Equal to AVC (Intersect): The point where the MC curve intersects the ATC curve is the minimum point of ATC curve. At this point, the marginal cost is equal to the average total cost. (MC = ATC). MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 14 Mock Question 18. Using a diagram explain the relationship between marginal cost, average total cost and average variable cost curve. Intersection Points: The MC curve intersects both the ATC and AVC curves at their respective minimum points. This is because the MC curve always passes through the lowest point of the ATC and AVC curves. Marginal Cost and Cost Averages: When the MC curve is below the ATC curve, the ATC is decreasing. When the MC curve is above the ATC curve, the ATC is increasing. The same applies to the relationship between the MC curve and the AVC curve. Optimal Output: The minimum point of the ATC curve represents the output level at which the firm is producing most efficiently in terms of cost per unit. This is where the MC equals the ATC. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 15 Mock Question 19. Using a diagram explain the relationship between total fixed cost, total variable cost and total cost curve. Total Fixed Cost (TFC) Curve: The total fixed cost curve is a horizontal line because fixed costs remain constant regardless of the level of output. It does not change with changes in production. Total Variable Cost (TVC) Curve: The total variable cost curve slopes upwards as output increases. At lower levels of output, the TVC curve tends to have a relatively gentle slope. (rises at a decreasing rate). Thereafter as output expands, the TVC curve becomes steeper. (rises at an increasing rate). Total Cost (TC) Curve: The total cost curve is the sum of the TFC and TVC curves. It starts at the same point as the TFC curve because fixed costs are incurred even at zero production. As output increases, the TC curve takes the same shape of TVC curve. (At lower levels of output, the TC curve tends to have a relatively gentle slope and thereafter as output expands, the TC curve becomes steeper) MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 16 A/L 2017 20. How would each of the following affect average total cost and average variable cost? a) A reduction in the price of electricity ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ b) A reduction in the wage rate ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ c) An increase in the salary of the Chief Executive Officer (CEO) ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ d) An increase in the cost of the rent of the firm’s buildings ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 17 A/L 2010 21. Explain the law of returns to scale. The law of returns to scale, also known as the principle of returns to scale, describes the relationship between changes in inputs and changes in output in the long run when all inputs are increased proportionately. It provides insights into how a change in the scale of production affects the level of output. There are three possible scenarios associated with returns to scale: increasing returns to scale, constant returns to scale, and diminishing returns to scale. a. Increasing Returns to scale b. Cosntant returns to scale c. Decreasing returns to scale Mock Question 22. Explain the law of increasing returns to scale. In the long run, when all inputs are increased, if the output increases by more than proportionate times to the increase of all inputs, the firm is said to experience increasing returns to scale. This can be attributed to factors like specialization, optimal utilization of resources, and better utilization of capital. Mock Question 23. Explain the law of cosntant returns to scale. When a proportionate increase in inputs results in an equal proportionate increase in output, the firm is said to have constant returns to scale. Mock Question 24. Explain the law of decreasing returns to scale. In the long run, when all inputs are increased, if the output increases by less than proportionate times to the increase of all inputs, the firm is said to experience decreasing returns to scale. Factors like inefficiencies due to large scale, transportation cost increases, and coordination challenges may contribute to this phenomenon. Mock Question 25. Explain the shape of long run average total cost curve Long run ATC curve takes bottom flat “U” shape. Initially, as the firm increases its scale of production, it experiences economies of scale. The LRATC curve slopes downward. Thereafter, the LRATC curve remains relatively flat and constant as output increases, the firm is experiencing constant returns to scale. However, beyond a certain point, the firm might encounter diseconomies of scale. The LRATC curve starts to rise as output increases further. This is due to factors like increased complexity, coordination challenges, and higher transportation costs which can lead to higher costs per unit of output. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 18 Important : Long run average cost curve represents the lowest cost per unit at which any output could be produced. A/L 2009 26 Define the term ‘economies of scale. a. Economies of scale refer to the cost advantages that a firm gain as it increases its level of production and expands its scale of operations in the long run that leads to a fall in long run average total cost (LATC). b. In other words, economies of scale occur when the long run average cost decreases as the quantity of output produced increases. Mock Question 27. What are the types of ‘economies of scale? (Mock Question) a. Technical Economies: These arise from the efficient utilization of production techniques and technologies. As output increases, a firm can invest in more advanced machinery, automation, and specialized tools, leading to higher efficiency and lower costs per unit of output. b. Managerial Economies: Larger firms often have access to specialized management teams and resources that can streamline operations, improve decision-making, and reduce waste. These managerial efficiencies contribute to lower costs. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 19 c. Financial Economies: Larger firms tend to have better access to capital markets and can negotiate favorable terms for loans and financing. This can lead to lower interest rates and financing costs. d. Marketing Economies: Larger firms can benefit from reduced per-unit marketing and advertising costs due to their broader customer base and greater visibility in the market. e. Purchasing Economies: Bulk purchasing of raw materials and inputs can lead to discounts and lower procurement costs. Larger firms have the capacity to negotiate better deals with suppliers. f. Diversification Economies: Firms that produce a wide range of products may achieve cost savings through shared resources, such as distribution networks and administrative functions. A/L 2009 - A/L 2011 28. How do the economies of scale arise? a. Indivisibility nature of inputs (Inputs are indivisible with output) Some of the input (such as machines) cannot be adjusted based on the level of output. For example, production capacities of the machines are fixed and it cannot be adjusted based on level of output. Thus, economies of scale take place when machines have large capacities are used in to production. However, if such machine is used in to small production there will be huge resources wastage since large part of machine capacity remain utilized. b. Ability to create specialization through division of labour Division of labour makes production efficient by increasing labour productivity. This helps to use more capital goods at each production process and reduce time consumed for production significantly. However, this benefit of division of labour can mostly be obtained by the large businesses only. For small businesses division of labour is not appropriate and probably through division of labour there can have resource wastage in small businesses. c. Ability to use machinery Due to division of labour large businesses will be able to introduce specific machinery (capital equipment) to each stage of production in order to improve productivity in production. However, this advantage will mostly be with the large businesses but not with the small businesses. d. Existence of one-time costs Expenditure such as research and development cost, advertising and promotional cost are one-time costs. These costs become productive if these costs help to increase sales and production of the business. Thereby, mostly large organizations will be able to spend large sums on their research and development cost, advertising and promotion etc. to improve their sales significantly and reduce unit cost greatly. Thereby, through these kinds of costs most of the time benefit is delivered to large organizations only. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 20 A/L 2003 /2010/2016 29. What is the difference, if any, between ‘diminishing returns’ and ‘decreasing returns to scale’? Diminishing Returns: Diminishing returns states that as a firm increases the quantity of a variable input while keeping other inputs constant, the marginal product of that input will eventually decrease. In other words, additional units of the input will lead to smaller and smaller increases in output. Diminishing returns occur due to factors like limited capacity of fixed inputs creates reduced efficiency in variable input. Diminishing returns influence a firm's production decisions in the short run and are represented by the downward-sloping portion of the marginal product curve and upward-sloping portion of the marginal cost curve Decreasing returns to scale: Decreasing returns to scale, on the other hand, refer to the long-run concept of how changes in the scale of production affect the long run average cost of production. It states that if a firm increase all of its inputs proportionally (enabling a change in production scale), the output will increase by a smaller proportion, resulting in higher long run average costs per unit of output (LATC rises). Decreasing returns to scale are associated with inefficiencies that arise when a firm becomes too large and complex to manage effectively. Coordination challenges, communication problems, and diseconomies of scale can contribute to higher costs as the firm expands. Decreasing returns to scale influence a firm's decisions about production scale in the long run and are reflected in the upward-sloping portion of the long-run average total cost curve A/L 2028 30. State whether the following statements are true or false and give reasons for your answer. a) Total product starts falling when diminishing returns set in. ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ b) Property taxes, building insurance payments and amortization payments are fixed costs. ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 21 c) Diminishing returns and decreasing returns to scale are different ways of saying the same thing. ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ d) If marginal cost is above the average variable cost, marginal cost must be falling. ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ ____________________________________________________________________________________________________________ 31. ‘Average variable cost curve and marginal cost curves are the mirror images of average product curve and marginal product curve’. Prove this stamen with appropriate diagram. (04 Marks) When productivity raises average product rises whereas average variable cost falls. (1/2 Marks) Thereby when production firm reaches its highest AP, firm reaches lowest AVC point. (1/2 Marks) When marginal product rises marginal cost falls whereas when marginal product falls marginal cost rises due to the law of marginal returns. (1/2 Marks) Whenever, MP > AP, average product rises and MP < AP, average product falls whereas MC < AVC, average variable cost falls and MC > AVC, average variable cost rises. (1/2 Marks) (02 Marks for appropriate diagram) MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 22 32. What is ‘minimum efficiency scale’ of production. Explain. The "minimum efficient scale" (MES) of production refers to the level of output at which a firm achieves the lowest possible average cost per unit of production in the long run. In other words, the minimum efficient scale (MES) of production is the lowest level of output at which a long run firm can produce at the lowest possible long run average cost per unit. At this point the benefits of producing more units (lower long run average costs) are maximized (economies of scale) while avoiding the drawbacks of excessive size (higher average costs due to diseconomies). 33. Explicit costs and Implicit costs A/L 2015 1. Distinguish between explicit (direct) costs and implicit (indirect) costs giving examples of each. (4 marks) A/L 2011 2. Explain the difference between explicit and implicit costs giving examples. (04 marks) Explicit Cost (direct costs) is the cost which is actually incurred by the firm, during production for the factors of production. In otherwords these are costs which are the actual monetary expenses that a firm or individual incurs when producing goods or services. Example:- Salaries and wages, Rent, Utilities, Raw materials, Inventory, Transportation costs MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 23 Implicit costs (indirect costs) are not actual cash expenditures but represent the opportunity cost of using resources provided by the owner for the production. In otherwords, Implict costs are the resource costs of the production factors to which firm does not have to pay, but have to consider as costs since they have an opportunity cost. Examples:- Normal profits, the salary that a business owner could have earned if they had worked elsewhere, Foregone interest income of the invested capital. 34. Accounting profit Vs. economic profit A/L 2012 1. How do the concepts of accounting profit and economic profit differ? (04 marks) A/L 2004 2. Explain how economic profit differs from accounting profit. (4 marks) Accounting profit is the profit calculated by subtracting all explicit costs from total revenue. Accounting Profit = Total Revenue - Explicit Costs Economic profit is the profit calculated by subtracting both explicit costs and implicit costs from total revenue. In otherwords, profit calculated by subtracting total economic cost (explicit cost +implicit cost) from total revenue. Economic Profit = Total Revenue – (Explicit Costs + implicit cost) Economic Profit = Total Revenue – Economic Cost key difference between accounting profit and economic profit is the inclusion of implicit costs in the latter. Accounting profit focuses solely on explicit costs, while economic profit provides a more holistic view of profitability by considering both explicit and implicit costs. Economic profit is often a more accurate representation, as it reflects the full cost of using the firm's resources, including the opportunity costs associated with those resources. A/L 2015 3. Why do economists regard normal profit as a cost? (4 marks) Normal profit (zero economic profit), is the minimum level of profit necessary to keep a firm in its current operation without changing its resources from current industry to another industry, In other words, normal profit represents the return that an entrepreneur or business owner could earn by using their resources and time elsewhere and thereby expect as the minimum return to cover his opportunity cost. MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 24 Thereby normal profit has to be considered as a factor cost related to obtaining the entrepreneurship for the production (business operation). Thus, normal profit is a factor cost which is an implicit cost to which firm does not have to make an expenditure but has to consider as a factor cost. A/L 2005 4. Distinguish between the concepts in each of the following pairs. (3 marks) Normal profit and supernormal profit. A/L 2010 5. What is the difference between ‘producer surplus’ and ‘economic profit’? (02 marks) (A/L 2010) Normal profit Normal profit (zero economic profit), is the minimum level of profit necessary to keep a firm in its current operation without changing its resources from current industry to another industry. Zero Economic Profit = Total Revenue – Economic Costs (including explicit and implicit costs) Normal profit is considered necessary for the long-term sustainability of a business. It ensures that a business owner or entrepreneur receives compensation for their time, capital, and effort, but it doesn't provide additional returns beyond what could be earned in alternative opportunities Supernormal profit Supernormal profit, on the other hand, is the profit that exceeds normal profit. It represents a situation in which a firm earns an exceeding revenue to cover all its explicit and implicit costs (including the opportunity cost of entrepreneurship.) Positive Economic Profit = Total Revenue - Total Costs (including explicit and implicit costs) Supernormal profit is a sign of exceptional financial performance. It indicates that a business is not only covering all its economic costs but also earning a return that is higher than what could be achieved in alternative opportunities. This can attract competition and lead to adjustments in the market. Other concepts A/L 2008 6. Distinguish between a factor market and a product market. (03 marks) A/L 2018 7. Distinguish between economic rent and transfer earning. (4 marks) A/L 2016 8. Explain the concepts, producer surplus, economic profit and economic rent. (04 marks) MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 25 NOTES MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  COST & PRODUCTION (THEORY) E C O N O M I C S 26 NOTES MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM COST & PRODUCTION (THEORY) E C O N O M I C S 27 MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM  MBA (Merit) (Sri J), B.Sc MKT (Sp) KASUN LIYANAGE (Hons-1st class) (SriJ), DipM (UK), MCIM, MSLIM