Economics and Institutions Final Exam

question

Ways to contain or cut costs popular during the past decade

answer

1. Most common: reduce number of people on the payroll
2. Consolidation of shared services
3. Outsourcing components of the business
4. Mergers and consolidation (usually with a reduction in employees)

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Relevant Cost

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cost that is affected by a management decision

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Historical Cost

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Cost incurred at the time of procurement

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Opportunity Cost

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amount or subjective value that is forgone in choosing one activity over the next best alternative

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Incremental Cost

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varies with the range of options available in the decision

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Sunk Cost

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does not vary in accordance with decision alternatives
-expenditure that has been made and cannot be recovered (retrospective)
-Should NOT influence firms decisions
-accounting costs, not economic costs

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Cost function

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Production function expressed in monetary rather than physical units
-assume the firm is a 'price taker' in the input market

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Total Variable Cost (TVC)

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cost associated with the variable input, found by multiplying the number of unites by the unit price

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Marginal cost (MC)

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rate of change in total variable cost
-law of diminishing returns implies that MC will eventually increase

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Short-run cost function assumptions:

answer

-firm employs two inputs, labor and capital
-firm operates in a short-run production period where labor is variable, capital is fixed
-firm produces a single product
-firm employs a fixed level of technology
-firm operates at every level of output in the most efficient way (operates at the efficiency frontier)
-firm operates in perfectly competitive input markets and must pay for its inputs at a given market rate ('price taker')
-short-run production function is affected by the law of diminishing returns

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Standard variables in the short-run cost function

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-quantity(Q) is the amount of output that a firm can produce in the short run
-Total fixed cost (TFC) is the total cost of using the fixed input, capital (K)
-total variable cost (TVC) is the total cost of using the variable input, labor (L)
-total cost (TC) total cost of using all the firm's inputs (TC=TFC+TVC)
-Average fixed cost (AFC) is the average per-unit cost of using the fixed input K (AFC=TFC/Q)
-Average Variable Cost is the average per unit cost of using the variable input L (AVC=TVC/Q)
-Average Total Cost (AC) average per-unit cost of all the firm's inputs (AC=AFC+AVC=TC/Q)
-Marginal Cost (MC) change in a firm's total cost (or total variable cost) resulting from a unit change in output (MC=change in TC/ change in Q=change in TAVC/change in Q)

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Two critical Relationships:

answer

-Productivity and cost are inversely related
-Marginal cost pulls average either up or down depending on if it is above or below average
-reduction in the firm's fixed cost would cause the average cost line to shift downward
-reduction in the firm's variable cost would cause all 3 cost line (AC,AVC,MC) to shift downward

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Alternative specifications of the Total Cost Function (total cost and output)

answer

-linear relationship-as output increases, total cost increases at a constant rate
-quadratic relationship-as output increases, total cost increases at an increasing rate
-cubic relationship-as output increases, total cost first increases at a decreasing rate, then increases at an increasing rate

question

In the long run, all inputs to a firm's production function may be changed

answer

-no fixed inputs, no fixed costs
-firm's long run marginal cost pertains to returns to scale
-at first firms achieve increasing returns to scale, then as they mature they have constant returns, then they may experience decreasing returns to scale

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When a firm experiences increasing returns to scale:

answer

-a proportional increase in all inputs increases output by a greater proportion
-as output increases by some percentage, total cost of production increases by some lesser percentage

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Economies of Scale:

answer

situation where a firm's long run average cost (LRAC) declines as output increases

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Diseconomies of scale:

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situation where a firm's LRAC increases as output increases (in general, LRAC curve is u-shaped)

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Economies of scale

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exist when long run average costs decline as output rises
-costs rise more slowly than production

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Constant economies of scale

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costs rise at the same rate as output

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diseconomies of scale

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exist when long run average costs increase as output rises
-costs rise more quickly than production

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Not the same as returns to scale!

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returns to scale-describes how production changes when all inputs are changed by a common factor
-economies of scale does not impose this common factor rule in input proportions

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Reasons for long-run economies of scale:

answer

-specialization of labor and capital
-prices of inputs may fall with volume discounts in firm's purchasing
-use of capital equipment with better price-performance ratios
-larger firms may be able to raise funds in capital markets at a lower cost
-larger firms may be able to spread out promotional costs
-management efficiencies (line and staff)
*taking advantage of economies of scale is predicated on the demand for the product

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Reasons for diseconomies of scale:

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-input market imperfections (e.g., wage rates driven up)
--disproportionate increase in the number of staff and indirect labor
-scale of production is not optimal for the total market demand
--management coordination and control problems
-disproportionate rise in transportation costs
--due to rise in production, increase in handling expenses, insurance, security, and inventory costs

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In the long run:

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-the firm can choose any level of capacity
-once it commits to a level of capacity, at lease on of the inputs must be fixed. this then becomes a short-run problem
-the LRAC curve is an envelope of SRAC curves, and outlines the lowest per-unit costs the firm will incur over a range of output

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Economies of scale

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exists when the average cost is decreasing (dAC/dQ is negative)

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Economies of scope

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reduction of a firm's unit cost by producing two or more goods or services jointly rather than separately
-closely related to economies of scale

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Supply Chain Management (SCM)

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efforts by a firm to improve efficiencies through each link of a firm's supply chain from supplier to customer
-transaction costs are incurred by using resources outside the firm
-coordination costs arise because of uncertainty and complexity of tasks
-information costs arise to properly coordinate activities between the firm and its suppliers

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Ways to develop better supplier relationships

answer

-strategic alliance: firm and outside supplier join together in some sharing of resources
-competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control

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Ways companies cut costs

answer

-strategic use of cost
--price leadership (Walmart, southwest)
-reduction in cost of materials
--material substitution or modification
-using information technology to reduce costs
--automating routine tasks
-reduction of process costs
--use of software and electronic filing
-relocation to lower-wage countries or regions
-mergers, consolidation, and subsequent downsizing
-layoffs and plant closings
-reductions in fixed assets

1 of 29

question

Ways to contain or cut costs popular during the past decade

answer

question

Relevant Cost

answer

cost that is affected by a management decision

question

Historical Cost

answer

Cost incurred at the time of procurement

question

Opportunity Cost

answer

amount or subjective value that is forgone in choosing one activity over the next best alternative

question

Incremental Cost

answer

varies with the range of options available in the decision

question

Sunk Cost

answer

question

Cost function

answer

Production function expressed in monetary rather than physical units
-assume the firm is a 'price taker' in the input market

question

Total Variable Cost (TVC)

answer

cost associated with the variable input, found by multiplying the number of unites by the unit price

question

Marginal cost (MC)

answer

rate of change in total variable cost
-law of diminishing returns implies that MC will eventually increase

question

Short-run cost function assumptions:

answer

question

Standard variables in the short-run cost function

answer

question

Two critical Relationships:

answer

question

Alternative specifications of the Total Cost Function (total cost and output)

answer

question

In the long run, all inputs to a firm's production function may be changed

answer

question

When a firm experiences increasing returns to scale:

answer

-a proportional increase in all inputs increases output by a greater proportion
-as output increases by some percentage, total cost of production increases by some lesser percentage

question

Economies of Scale:

answer

situation where a firm's long run average cost (LRAC) declines as output increases

question

Diseconomies of scale:

answer

situation where a firm's LRAC increases as output increases (in general, LRAC curve is u-shaped)

question

Economies of scale

answer

exist when long run average costs decline as output rises
-costs rise more slowly than production

question

Constant economies of scale

answer

costs rise at the same rate as output

question

diseconomies of scale

answer

exist when long run average costs increase as output rises
-costs rise more quickly than production

question

Not the same as returns to scale!

answer

returns to scale-describes how production changes when all inputs are changed by a common factor
-economies of scale does not impose this common factor rule in input proportions

question

Reasons for long-run economies of scale:

answer

question

Reasons for diseconomies of scale:

answer

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In the long run:

answer

question

Economies of scale

answer

exists when the average cost is decreasing (dAC/dQ is negative)

question

Economies of scope

answer

reduction of a firm's unit cost by producing two or more goods or services jointly rather than separately
-closely related to economies of scale

question

Supply Chain Management (SCM)

answer

question

Ways to develop better supplier relationships

answer

question

Ways companies cut costs

answer

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Economics and Institutions Final Exam

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