Question

a.Carefully explain what is meant by explicit; implicit; and sunk costs. How are they used to calculate accounting profit and economic profit? [5 marks]

b. Explain the relationship between total product, marginal product, and average product. [3 marks]

c. Explain the difference between the short run and the long run. [4 marks]

d. Why is the level of output at which marginal revenue equals marginal cost the profit maximizing output? [5 marks

Answer 1

a)

Explicit costs:

Explicit costs are those that require monetary payments like rent, salary, repairs etc.

Implicit costs:

Implicit costs do not require actual monetary payments. Implicit costs are opportunity costs. Opportunity cost is the value of the next best alternative. Examples of implicit costs are salary foregone, rent foregone for owned premises if used for business activities, interet foregone on personal savings if used for business purposes.

Sunk costs are already incurred based on a past decision and they cannot be recovered. Sunk costs are not relevant for future decision making as they are already incurred.

Examples of sunk costs are investment in machinery, building. These costs are already incurred.

Accounting profit is total revenue minus explicit costs.

Economic profit is total revenue minus (explicit costs + implicit costs).

2.

Marginal product (MP) and Average product (AP).

The marginal product of an input is the extra output produced by 1 additional unit of that input while other inputs are held constant. Average product is the total product divided by total units of input.

Relationship between MP and AP

If marginal product is less than average product, then average product falls. If marginal product is greater than average product, then average product rises. If marginal product is equal to average product, then average product is constant.

Relationship between total product (TP) and marginal product (MP).

Total product is the total output produced by using the given inputs. The relationship between TP and MP is governed by law of variable proportions which implies that if one input is made variable and other inputs are fixed. If MP increases, then TP increases at an increasing rate. If MP falls but is positive, then TP increases at a decreasing rate. If MP is zero, TP has reached its maximum. If MP falls and is negative, then TP falls.