Question 1

Using appropriate diagrams, Explain the concept of:

a. Variable cost

= Variable cost incurred by variable input. Therefore, variable cost is the cost of variable input.
Labor and raw materials are two examples of variable input.

b. Fixed cost

= Fixed cost incurred by fixed input. Therefore, fixed cost is the cost of fixed input. Land, factory,
equipment and production line are examples of fixed input.

c. Marginal Cost

Marginal Cost (MC) can be defined as the change in total cost when one additional unit of
output is produced. According to diagram, its initially fall as output increases, reach a
minimum point and then MC start rises due to an increase in the total variable cost. The U-
shaped curve of MC is due to the law of diminishing marginal returns.
d. Average variable cost

Average Variable Cost (AVC) is the total variable costs of producing any given output divided
by number of units produced. According to diagram, the AVC decreases in the first stage of
production, reaches minimum and then increases. It is a U-shaped curve because of the law of
diminishing marginal returns.

Question 2

Differentiate between short run and long run production periods. Using examples, explain types of short
run production cost.

Production Period
Short run Long run
 A period in which there is a combination of  A time period that is long enough for all
at least one fixed input with one or more factors of production to be varied, and all
than one variable input. are variable inputs.
 To increase output, a manufacturer can  To increase output, a manufacturer expand
increase his variable inputs such as labour the capacity by increasing the fixed variables
and raw materials but not his fixed inputs. such as purchases more machinery and or
 Fixed input: Land & Capital build more factories.
 Variable input: Labour & raw materials  Variable input: Land, Capital, Labour & Raw
materials.
Question 3

With the aid of diagrams, explain the stages of production.

Stage 1
 Begin from the origin until the AP curve reaches its maximum point.
 TP increases at an increasing rate.
 MP reaches its maximum and declines.
 AP increases and intersects MP when AP is at its maximum.
 Ends when AP = MP
 Producer will continue to increase production as he can still increase TP.
Stage 2
 Starts after AP = MP
 TP increases, but at a decreasing rate, until it reaches its maximum.
 MP declines until MP=0
 AP starts to declines, but is still positive.
 Ends when TP is at its maximum and at the same time MP=0.
 A rational producer will choose to stop production at this stage as he is able to maximize the
output.
 Most efficient stage.
Stage 3
 Starts when MP is negative
 TP is declining
 AP is declining
 Overcrowding. Addition of one unit of labour to fixed input, total product will decrease.
Question 4

List and explain four causes of economies of scale and diseconomies of scale.

Economies of scale

1. Economies of concentration. It refers to the concentration of forms or a particular

industry in one area. With concentration, firms will be able to save on transportation
cost and advertising costs to advertising their location and products. This Will result in
increasing returns to scale and decreasing cost to industry.
2. Supply of skilled workers. The pool of labour will search for jobs in the location. The
industry will be able to obtain skilled workers without advertising in the newspapers.
3. Existence of specialist companies. With the expansion and establishment of a firm
involved in mass production, specialist companies will exist to supply the needs of the
firm.
4. Economies of information. To expose consumer to new products or to boost sales, firms
in the industry will work together with one another to organize trade fairs, meetings,
conferences, seminars and publication of journals. Hence, producers will be exposed to
new ideas and new information.

Diseconomies of Scale

1. Low morale. With the specialization of labour, work becomes routine and monotonous,
causing workers to lose interest in work and productivity to decrease.
2. Management difficulties. Managerial problems in controlling and co-coordinating a
firm’s operating efficiently when there is mass production.
3. Technologies problems. The machinery may break down due to extensive use and may
require high maintenance cost.
4. Social problems. The firms will incur additional costs to resolve the social problems such
as taxes, fines and regulations in compliance with government requirements.
 Question 5

i. =

Machin Labo Total Product Average Product Marginal Product

e r
2 0 0 - 0
2 1 TP= AP x Q= 3x1 = 3 3 MP= (3-0) / (1-0) = 3
2 2 TP= AP x Q= 4x2 = 8 4 MP= (8-3) / (2-1) = 5
2 3 TP= AP x Q= 4x3 = 12 4 MP= (12-8) / (3-2) = 4
2 4 TP= AP x Q= 3.5x 4 = 14 3.5 MP= (14-12) / (4-3) = 2
2 5 TP= AP x Q= 2.8x5 = 14 2.8 MP= (14-14) / (5-4) = 0
2 6 TP= AP x Q= 2x6 = 12 2 MP= (12-14) / (6-5) = - 2

ii. =

Stages of Production in the Short run

16

14

12

10

0
0 1 2 3 4 5 6
-2

-4

TP AP MP
Question 6

= a.

Quantity TFC TVC TC AFC AVC ATC MC

(Q) (TFC+TVC) (TFC/Q) (TVC/Q) (TC/Q) (TCnew-
TCold) /
(Qnew-
Qold)
0 20 0 20 0 0 0 0
1 20 15 35 20 15 35 15
2 20 25 45 10 12.5 22.5 10
3 20 30 50 6.67 10 16.67 5
4 20 35 55 5 8.75 13.75 5
5 20 45 65 4 9 13 10
6 20 65 85 3.33 10.83 14.17 20
7 20 90 110 2.86 12.86 12.86 25

b. Relationship between ATC & MC:

1. When ATC is falling, MC is falling and then rising, but is below ATC.
2. When ATC is rising, MC is above ATC.
3. When MC cuts ATC from below, it is at ATC minimum point: MC = ATC, ATC is at its minimum

c.

Short Run Costs

120

100

80

60

40

20

0
0 1 2 3 4 5 6 7 8

TFC TVC TC AFC AVC ATC MC

Question 7

Accounting profit the net income for a company, which is revenue minus expenses. Accounting profit
includes explicit costs, such as raw materials and wages.

Economic profit is similar to accounting profit, but it includes opportunity costs. Economic profit
includes explicit and implicit costs, which are implied or imputed costs.