Question

In general a firm's __________ (LO2) a) total cost rises as output rises up to a certain point and then begins to decline b) marginal cost rises as output rises up to a certain point and then begins to decline c) average total cost declines as output rises up to a certain point and then begins to rise

Short answer

In general, a firm's \(\textbf{average total cost}\) declines as output rises up to a certain point and then begins to rise. This is because as a firm increases production, it becomes more efficient, spreading its fixed costs over a larger number of units. The average total cost decreases until the firm reaches its minimum efficient scale. Beyond this point, increasing output starts to increase the average total cost again, as diseconomies of scale start to occur.

Step-by-step solution

Understanding the Options

Before we dive into each option, let's make sure that we understand what each term means. - Total Cost (TC): All the costs a company incurs in producing a certain level of output. - Marginal Cost (MC): The additional cost incurred when producing one extra unit of output. - Average Total Cost (ATC): The total cost divided by the quantity of output produced. Now let's analyze each option:

Option A: Total Cost

Option A states that a firm's total cost rises as output rises up to a certain point and then begins to decline. In general, this statement is not accurate. Total cost typically increases as output rises, due to increasing raw materials and labor costs, as well as other factors. However, it's not common for the total cost to decrease after reaching a certain level of output.

Option B: Marginal Cost

Option B states that a firm's marginal cost rises as output rises up to a certain point and then begins to decline. This option correctly describes the behavior of marginal cost in many cases. Indeed, the marginal cost often decreases as output increases initially, but after a certain level of output, producing additional units begins to result in higher and higher costs, causing the marginal cost to rise.

Option C: Average Total Cost

Option C states that a firm's average total cost declines as output rises up to a certain point and then begins to rise. This option accurately describes the behavior of average total cost. As a firm increases production, it becomes more efficient, spreading its fixed costs over a larger number of units. The average total cost decreases until the firm reaches its minimum efficient scale. Beyond this point, increasing output starts to increase the average total cost again, as diseconomies of scale start to occur.

Conclusion

Based on our analysis, option C is the most correct answer. A firm's average total cost declines as output rises up to a certain point and then begins to rise.

Key concepts

Marginal Cost

Marginal cost (MC) is a fundamental concept in economics that represents the additional cost of producing one more unit of a good or service. It is a critical factor that firms consider when deciding how much to produce. As production increases, marginal cost can behave differently depending on the level of output. Initially, MC tends to decrease because of economies of scale and increased efficiency in production processes. However, as production continues to rise beyond a certain point, MC increases due to factors such as limited capacity, overtime labor costs, or exhaustion of resources, which are all part of the 'Law of Diminishing Returns'. This implies that there is an optimal level of production where MC is at its lowest before it starts to rise again.

For instance, imagine a factory that produces widgets. Up to a point, producing more widgets could become cheaper per unit because the cost of running the machinery is spread out across more widgets. But, after the optimal level of output is surpassed, maybe the machinery needs to run for extended hours, workers have to be paid overtime, or the wear and tear on equipment increases maintenance costs, all of these factors drive the MC up.

Total Cost

Total cost (TC) is the sum of all costs a company incurs in producing a certain level of output. It's a combination of fixed costs, which do not change with the amount produced, such as rent and salaries, and variable costs, which do increase with production quantity, like raw materials and utility expenses. Unlike marginal cost, total cost doesn't decrease as production increases; rather, it continually rises, though the rate at which it rises might change. If you're picturing a graph, total cost would start from the fixed cost level and slope upwards as production increases, mapping out the total expense incurred by the firm for different levels of output.

Total Cost Breakdown

Let’s break down TC further:

• Fixed Costs (FC): These are costs that remain constant regardless of output, like rent and salaried employees.
• Variable Costs (VC): These are costs that vary with output levels, like raw materials and hourly wages.

So, TC is calculated by adding fixed costs and variable costs together (TC = FC + VC). As more units are produced, FC gets spread over more units, reducing the average fixed cost per unit. VC increases with each additional unit produced. Hence, TC always increases as output goes up.

Minimum Efficient Scale

The minimum efficient scale (MES) is the smallest level of production a firm can achieve while still taking full advantage of economies of scale. Economies of scale occur when increasing production leads to lower average costs due to more efficient use of resources. Reaching MES is like hitting the sweet spot where a company operates most cost-effectively. Beyond the MES, additional increases in production may not reduce average costs any further and can potentially lead to higher average costs instead.

Think of MES as the optimal size for a company. For a small local bakery, the MES might be reached once it has enough orders to fully utilize its ovens and bakers. If the bakery keeps taking more orders without increasing its capacity, it might face inefficiencies, such as overworked staff or delays, which can increase costs and potentially harm the business.

Diseconomies of Scale

Diseconomies of scale are the opposite of economies of scale. While economies of scale mean that costs per unit decrease as output increases, diseconomies of scale lead to an increase in the average cost per unit with increased production. This typically happens when a firm has grown too big or complex, leading to issues like bureaucracy, communication problems, or logistical inefficiencies.

Common Causes of Diseconomies of Scale

There are several factors that can lead to diseconomies of scale:

• Management Challenges: As firms expand, the complexity of managing operations can lead to inefficiencies.
• Worker Morale: In a very large firm, employees might feel disconnected from the company’s goals, reducing productivity.
• Coordination Costs: Large firms often struggle with coordination between various departments, which can delay decision-making and implementation.

It's important for companies to recognize their optimum scale of operation to avoid falling into the trap of diseconomies of scale, as this can erode their competitive advantage and profitability.