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Cost Concepts • Fixed Costs – costs that are independent of level of output (eg. rent on land, advertising fee, interest on loan, salaries) • Variable Costs – costs that are directly linked to the quantity of output (eg. raw materials, electricity, shipping, wages) • Average Costs – cost per unit of production • Marginal Costs – cost of one additional unit of output Three Types of Costs Cost Total Cost Variable Cost Fixed Cost Output Production Costs Output Fixed Cost 0 40 5 Variable Cost Total Cost ---20 10 15 20 Average Marginal Cost Cost 7 90 50 Cost Curves Price £ MC AC MC crosses AC at min. AC Quantity For the average to be falling, the next unit (marginal) must be less than the average – so MC must be less than AC while AC is falling, and greater than AC when AC is rising. Long Run vs. Short Run AC • Short Run: time period in which at least one factor of production is fixed • Long Run: all factors of production can be varied Cost £ SRAC1 Economies of Scale: - decreases in LRAC from increased scale of production LRAC SRAC2 SRAC3 Quantity Revenue Curves D = AR because it represents all the prices at which consumers are willing to buy different quantities (at 40 units, the price will be £10, so this is also the average revenue if 40 units are sold) Price £ AR = D Quantity MR MR drops 2x as fast as AR, because as output is increased and price is dropped, all the people who were previously paying a higher price now pay the lower price, so the “extra revenue from one extra unit” is less than the actual revenue received for that unit. Profit Maximisation A firm will “maximise” profit where: MC = MR ***MEMORISE THIS*** • Because… if adding one extra unit of production adds more to revenue than to cost, it will increase total profit and should be produced • If adding one extra unit of production adds less to revenue than it does to cost, it will reduce profit and should not be produced • Firms will produce up until the point where MC=MR MC = MR Price £ MC Quantity MR Productivity Concepts - Returns Output expands when more units of variable factors (labour, raw materials) are added to fixed factors (land and equipment) Returns – a measure of how an increase in inputs affects the total output - a comparison of percentages Input 10% Input 20% Output 20% Output 10% Increasing Returns Decreasing or Diminishing Returns Efficiency Concepts to Assess Performance of Firms • Productive Efficiency: firm operates at the lowest possible average cost (bottom of AC curve) • Allocative Efficiency: firm sets price equal to marginal cost (scarce resources are allocated where they are most valued by consumers) • X Inefficiency: bureaucracy & complacency of firm with too much market power → higher costs Concentration Ratios • Used to measure “market concentration” – what percentage of the market is dominated by “x” number of firms? • Eg. “5-firm concentration ratio by sales” measure the total market share of the largest five firms in the industry using their sales numbers