Chapter 6 Cost Solutions
Question - 1 : - Briefly explain the concept of the cost function.
Answer - 1 : -
Cost function shows functional relationship between output and cost of production. It gives the least cost combination of inputs corresponding to different levels of output. Cost function is given as:
C = f(X), ceteris paribus,
where, C = Cost and X = Output
Question - 2 : - What are total fixed cost, total variable cost and total cost of a firm? How are they related?
Or
Draw TVC, TC, and TFC curves in a single diagram.
Answer - 2 : -
(i) TC is divided into two parts TFC and TVC such that TC = TFC + TVC.
(ii) TFC is the overhead cost and it remains constant or fixed whatever be the level of output. TFC curve is a horizontal line parallel to the x-axis.
(iii) TVC is cost due to increased use of variable factors like raw material, labour, etc. TVC is inverse S-shaped starting from the origin due to law of variable proportion.
(iv) TC is aggregate of TFC and TVC. TC curve is inverse S-shaped starting from the level of fixed cost. The reason behind it shape is the law of variable proportion.
Question - 3 : - What are the average fixed cost, average variable cost and average cost of a firm? How are they related?
Answer - 3 : -
AFC: The per unit cost incurred on fixed factors of production is known as average fixed cost.
AFC=TFC/Q
AFC always decreases as the firm increases the level of production. AVC: It is variable cost per unit of output produced.
AC=TC/Q
t is obtained by dividing the total variable cost by the quantity of output.
AVC initially decreases. But after reaching the stage of minimum cost it starts increasing. AVC is U-Shaped. AC: It is cost per unit of output produced. It can be obtained by dividing the total cost by the quantity of output produced.
Relationship between AFC, AVC and AC. There is a unique relationship among AC, AFC and AVC. AC is the sum of AFC and AVC, i.e.,
AC = AFC + AVC.
Answer - 4 : - No, there are no fixed costs in the long run as all the factors become variable. Fixed cost exists only in short run.
Question - 5 : - What does the average fixed cost curve look like? Why does it look so?
Answer - 5 : -
The shape of AFC is downward sloping Rectangular hyperbola. AFC falls as output increases because TFC=TFC/Output and TFC remains Output constant. So, as output increases, TFC remains constant, but AFC falls.
Question - 6 : - What do the short run marginal cost, average variable cost and short run average cost curves look like?
Answer - 6 : - The Short run marginal cost, average variable cost and short run average cost curves are U-shaped because of Law of variable proportion.
Question - 7 : - Why does SMC curve cut AVC curve at the minimum point of AVC curve?
Answer - 7 : -
(i) It happens because when AVC falls, SMC is less than AVC.
(ii) When AVC starts rising, SMC is more than AVC.
(iii) So, it is only when AVC is constant and at its minimum point, that SMC is equal to AVC. Therefore, SMC curve cuts AVC curve at its minimum point.
Question - 8 : - At which point does the SMC curve cut the SAC curve? Give reason in support of your answer.
Answer - 8 : -
(i) It happens because when SAC falls, SMC is less than SAC.
(ii) When SAC starts rising, SMC is more than SAC.
(iii) So, it is only when SAC is constant and at its minimum point, that SMC is equal to SAC. Therefore, SMC curve cuts SAC curve at its minimum point.
Question - 9 : - Why is the short run marginal cost curve U- Shaped?
Answer - 9 : - Marginal cost is U-shaped because of Law of variable proportion:
(i) As we know the shape of MC depends on the shape of TVC or TC. Let us suppose TVC.
(ii) Initially, TVC increases at a diminishing rate (Total Product increases at Increasing rate), which makes the gap of TVC, i.e. MC to fall.
(iii) Thereafter, TVC increases at an increasing rate( Total Product increases at diminishing rate) which makes the marginal cost to rise.
(iv) So, from inverse S-shape TVC curve, we derive U-shape MC curve.
What do the long run marginal cost and the average cost curves look like?
Answer - 10 : -
The long run marginal cost (LMC) and long run average cost (LAC) are U shaped curves. The reason behind them being U-shaped is due to the law of returns to scale. It is argued that a firm generally experiences IRS during the initial period of production followed by CRS, and lastly by DRS. Consequently, both LAC and LMC are U-shaped curves. Due to IRS, as the output increases, LAC falls due to economies of scale. Then falling LAC experiences CRS at Q1 level of output which is also called the optimum capacity. Beyond Q1 level of output, the firm experiences diseconomies of scale and if the firm continues to produce beyond Q1 level, the cost of production will rise.