Question

Use your knowledge of the interaction between production and cost to advise a person wishing to start a firm regarding optimal levels of operation and advise him/her on what to check if the firm sees signs of trouble as it continues to grow. The answer should NOT be less than eight pages of A4 paper and not more than 15 pages of A4 paper. You are also required to use relevant diagrams and equations to support your answers.

Answer 1

In economics and in particular neoclassical economics, the marginal product or marginal physical productivity of an input (factor of production) is the change in output resulting from employing one more unit of a particular input

Marginal Cost: the cost added by producing one additional unit of a product or service.

Marginal Cost is the increase in cost caused by producing one more unit of the good. The Marginal Cost curve is U shaped because initially when a firm increases its output, total costs, as well as variable costs, start to increase at a diminishing rate. Then as output rises, the marginal cost increases

In the short run, the only way to vary output is by varying the amount of the variable input. Consequently, total cost is fixed cost (FC) plus variable cost (VC), or TC = FC + VC

In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, with cost per unit of output decreasing with increasing scale

Average total cost (ATC) equals total fixed and variable costs divided by total units produced. Average total cost curve is typically U-shaped i.e. it decreases, bottoms out and then rises. In the short-run, labor is variable cost and capital is fixed but in the long-run, all costs are variables.

The average total cost is the sum of the average variable cost and the average fixed costs. That is,. ATC = AFC + AVC.

When the marginal cost curve intersects the average cost curve, it goes from being below the average to above the average. To the left of the intersection, mc is below ac, so ac is declining.So right at the point of intersection, ac goes from declining to rising, and so therefore must be at its lowest point.

Overall, from all the above graphs, one thing is clear that, with increase in output Total cost will increase, but ATC reduces first and then increases, this reduction in ATC is economies of scale. So, this advise is important for the person who is starting the firm, that he should minimise ATC.

Also, ATC is minimum when MC cuts AC.

MC is marginal cost, increase MC can cut ATC at its minimum point.

Signs of trouble for a firm can be when the total revenue < total costs

i.e. Economic loss

In short run, firm should operate if total revenue > total variable costs

But in long run shut down.

If firm is unable to recover total variable costs, then the firm should shut down in short run as well.

Kindly add more text to this answer to fill 8 pages A4 size.

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Thank you.