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P. 1
Chap 07

Chap 07

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Published by Syed Hamdan

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Published by: Syed Hamdan on Dec 11, 2010
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CHAPTER 7ANALYSIS OF COST
I. CHAPTER OVERVIEW
This chapter continues the discussion of firm production and short-run supply decisions by exploring the natureof costs. A firm’s production costs are determined by its level of output and are represented along a total costschedule. Given the law of diminishing returns, these costs also depend critically upon the particular combination of inputs used in the production process. As you can imagine there are many ways to build any product, and it is the firm’s job to choose the most efficient method from among the options available. Themajor objective here is for you to obtain a solid understanding of an economist’s perspective of cost accountingso that subsequent descriptions of market structure will make sense.The chapter is divided into three sections. First, the short-run cost function is described and then integratedinto the short-run production theory developed in Chapter 6. Second, the nature of business accounting isoutlined. Third, the notion of opportunity cost is explained to differentiate the accountant’s definition of costsfrom that used by economists.
II. LEARNING OBJECTIVES
After you have read Chapter 7 in your text and completed the exercises in this Study Guide chapter, you should be able to:1.Define and describe
total cost
,
fixed cost
,
variable
 
cost
,
marginal
 
cost
, and
average
 
cost
,understanding what these measures of cost are designed to reflect and how they are related to one another.2.Derive the associated average and marginal cost statistics from total, fixed, and variable cost.3.Explain the link between productivity and cost.4.Demonstrate precisely why marginal cost always intersects average cost at the minimum of any U-shaped average cost curve.5.Demonstrate why production costs are minimized when inputs are hired in combinations such that theratios of their marginal products to their prices are all equal.6.Explain carefully the information that a balance sheet is intended to convey. List the major categoriesappearing on the two sides of a balance sheet and indicate the meaning (or definition) of each of thosecategories.7.List the major items appearing on an income statement. Indicate the information that an incomestatement is intended to convey.8.Explain the role of depreciation in the correct and accurate construction of an income statement.9.Define the term
opportunity
 
cost
and apply it to management decisions made by firms andindividuals.
III. REVIEW OF KEY CONCEPTS
Match the following terms from column A with their definitions in column B.
AB
 __ Total cost1.The ratio of the marginal product of an input to its price is equal for all inputs.function __ Average cost2.The extra cost required to produce 1 extra unit of output. __ Marginal cost3.A variable that represents change per unit of time. __ Least-cost rule4.Total cost divided by the number of units produced. __ Income5.Shows the minimum attainable costs of production, given a particular level ostatementtechnology and set of input prices. __ Balance sheet6.Represents the level of a variable. __ Assets7.A statement showing revenues, costs, and profits incurred over a given time period. __ Liabilities8.A statement of a firm’s financial position as of a given date, showing assetsequal to the sum of liabilities and net worth. __ Net worth9.The value of the next best use for an economic good. __ Opportunity10.A physical property or intangible right that has economic value.cost
 
116
 __ Stock11.Debts or financial obligations owed to other firms or persons. __ Flow12.Total assets minus total liabilities.
IV. SUMMARY AND CHAPTER OUTLINE
This section summarizes the key concepts from the chapter.
A. Economic Analysis of Costs
1.Total costs include all costs incurred when a firm produces and sells a product; this chapter concentrates onshort-run cost functions so there are two possible categories of costs. Variable costs are those costs whose totalamount varies with the quantity of inputs used and output produced. Fixed costs are those costs that must be paid by the firm even if its output is zero. Note that in the long run, all costs are variable, since all inputs arevariable.2.Marginal costs measure the increase in total cost resulting from a l-unit increase in output. Like marginal product (from Chapter 6), marginal costs focus on the effect of incremental changes.3.Average costs measure the per unit costs of production at any given level of output. You can find averagevariable cost, average fixed cost, or average total cost; all these concepts share the common characteristic of  being per unit measures.4.The law of diminishing returns, which you learned in Chapter 6, also speaks to the nature of a firm’s costs.As the firm increases production, additional variable inputs are added to a fixed capital base; as marginal product begins to fall, marginal costs will begin to rise. Cost curves are U-shaped when short-run returnsincrease in the early range of production but eventually start to rise as output increases and more of the variableinputs are employed.5.Profit-maximizing firms will attempt to choose the combination of inputs that allows them to produce withminimum costs. This combination will be such that the marginal productivity of the last dollar spent on eachinput is equal for all inputs used in the production process.
B. Economic Costs and Business Accounting
1.The balance sheet is a stock concept, or a snapshot of a firm’s financial health—it reflects the economiccondition of an economic enterprise at some prescribed point in time. The balance sheet begins by listing thefirm’s assets; that is, everything it owns, including cash, buildings, equipment, inventory, and so on.2.The income statement is a flow concept, or a motion picture—it reflects growth or problems over a given period of time. Its primary function is to record how much profit (or loss) the company earned from its salesduring some particular period.3.Depreciation is a way of measuring the annual cost of a capital input that the company owns. Although thefirm does not have to write a check to itself when its own capital equipment is used, it must recognize thatequipment wears out as it is used in the production process. Capital equipment will eventually have to bereplaced, and prudent managers do indeed make allowances for this in their budgets.4.The firm’s “worth” is not likely to be the same figure as the total monetary value of its assets. Any debtsowed to others—the firm’s liabilities—must be deducted to get an accurate portrait of financial health. Theresulting figure is net worth, the difference between the total value of assets and the total value of liabilities.
C. Opportunity Costs
1.Opportunity costs measure the value of a resource at its next-best alternative use. As long as a resource isat least as useful as it would be in its next-best alternative use, economists can be sure that no reallocationwould improve the overall efficiency of the firm (or even the economy).2.If markets are functioning properly the price of the last unit of output sold is just equal to its opportunitycost. This means that the amount that a buyer is willing and able to pay is exactly equal to the value of the itemat its next-best alternative use; there is no more productive use for the resources used to make that marginal unitof output.
V. HELPFUL HINTS
1.Marginal product and marginal costs both measure the effect of incremental changes. However, they differ in an important way. Marginal product measures the addition to total product, or output, when an additionalunit of an input is hired. By contrast, marginal cost measures the addition to total cost when an additional unitof output is produced. Remember, “margin” means change.2.Note that marginal cost, even though it is a per unit cost measure, is not the same thing at all as averagecost. To illustrate the difference, consider some baseball or softball statistics. A batter has a batting average
 
117
that indicates the number of hits he or she has gotten out of his or her total number of trips to the plate. Anyaverage is calculated by dividing some total by the appropriate number of something else. (For example, a batting average is found by dividing total at-bats by the number of hits. A class average on a test is calculated by dividing the total of all the test scores by the number of students who took the test.) The marginal productivity of that batter would indicate how successful that batter was at the very last trip he or she made tothe plate. Remember, “margin” means change.3.The law of diminishing returns tells us that as we add additional units of a variable input to a fixed capital base, eventually marginal product will fall. This generates a downward-sloping marginal product curve andalso generates an upward-sloping marginal cost curve. Think of it this way: As a firm attempts to increase production in the short run, it becomes increasingly more difficult to extend production; hence, it becomesincreasingly more expensive to extend production.4.Throughout this discussion, we are assuming that the firm is attempting to minimize production costs. Thisis consistent with profit maximization but does not necessarily imply that the firm is maximizing profits. Thereare things to be considered on the revenue side of the ledger before we can make any claims about profits;notice that a firm could be producing with minimum costs, but if it gives its product away for free, it will notearn any profits!
VI. MULTIPLE CHOICE QUESTIONS
These questions are organized by topic from the chapter outline. Choose the best answer from the optionsavailable.
A. Economic Analysis of Costs
1.If AVC rises with output, each increment in cost would have to be ___ the previous average to push theaverage higher.a.greater than b.equal toc.less thand.twice as large ase.one-half as large as2.Fixed costs facing any firm in the short run include:a.any cost whose total is established at the time the input is purchased. b.the minimum cost of producing any given quantity of output under the most favorable operatingconditions.c.any cost whose per unit charge has been settled for some future period, such as a long-term wagecontract with a labor union.d.total expenses which must be covered even if nothing is produced.e.none of these things.3.Marginal costs facing any firm considering a change in output represent:a.extraordinary overtime charges that must sometimes be paid to increase output. b.the cost incurred even if the firm produces zero output.c.the difference between the total cost actually incurred to produce any given output and the smallest possible total cost of producing that output.d.the increase in total cost that accrues from a 1-unit increase in quantity produced.e.the increase in total cost that accrues from any increase in quantity produced, whether 1 unit or more.4.Suppose that the property taxes paid by a firm on its plant are increased; i.e., suppose that its fixed costsincrease. As a result, the marginal cost curve for this firm would move:a.to the right. b.to the left.c.upward.d.downward.e.not at all.5.Total cost in a certain plant, at an output level of 1000 units daily, is $4900. If production is reduced by 1unit, total cost would be $4890. Within this output range:a.average cost is greater than marginal cost. b.average cost and marginal cost are approximately equal.c.marginal cost is greater than average cost.d.we cannot compare average and marginal cost, since we cannot derive marginal cost from the giveninformation.

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