Theory question 107
Theory of Costs and Revenue(a) Distinguish between the following pairs of cost concepts (i) Fixed cost and variable cost (ii) Real cost and money cost (iii) Implicit cost and explicit cost
(b) (i) What would you recommend to a firm whose average cost is greater than its price? (ii) Give a reason for your answer in 7(b)(i) above
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(a)(i) Fixed cost does not change with output (e.g. rent); variable cost changes with output (e.g. raw materials).
(ii) Real cost is the alternative forgone (opportunity cost); money cost is the amount of money spent on factors of production.
(iii) Implicit cost is the cost of the owner's own resources used in the business, for which no money is paid (e.g. own labour, own building); explicit cost is the actual money payment to outsiders for factors (e.g. wages, rent).
(b)(i) In the short run, continue producing as long as price covers average variable cost; if price is below average variable cost (or the loss persists in the long run), shut down/leave the industry.
(ii) In the short run fixed costs must be paid anyway, so producing while price ≥ AVC reduces the loss; if price < AVC, producing only adds to the loss.
The shut-down point is where price equals minimum average variable cost.