Quiz 8: Cost Analysis and Estimation

Business

The below answers explains the reason for true or false: (A)The marginal cost cuts average cost at its minimum. The answer is true. The below figure explains the relation between average and marginal cost: img img MC Cost AC Quantity (B)The breakeven point is when img . If total fixed cost and price are held constant, an increase in average variable cost would decrease the breakeven point. The answer is true. (C) Point cost elasticity is change in cost due to change in output. img img 1, change in cost is greater than change in output: decreasing returns to scale img 1, change in cost is less than change output: increasing returns to scale img =1, change in cost is equal to change in output: constant returns to scale When there is decreasing returns to scale, the average cost starts rising which is also called as diseconomies of scale. The answer is true. (D) The average cost increases with increasing output. Therefore larger plants can be operated rather than smaller plants which have already reached its peak efficiency. The answer is true. (E)The degree of operating level is defined as follows: img If total fixed cost is equal to zero, then increase or decrease in average variable cost does not change the degree of operating level. The answer is false.

Current cost refers to estimation of cost using current market trends and conditions. On the other hand, historical cost refers to the cost estimation method that is based on past few years' analysis. Tax and stockholder reporting depends on historic cost as using the same method to calculate cost is easy and less cumbersome. However, if there is huge difference between the actual and historic cost due to, then using historic cost method is inappropriate and current cost should be followed. Each cost method has its own advantage and disadvantage. One should weigh the market conditions and changes before adopting any cost method.

Long run average cost is the envelope of short run average cost curves. The following explains the effect on long run average cost curve. (A) A rise in wage rate: A rise in the wage rate will increase the cost for firms of hiring labors. Therefore, the long run average cost curve will shift upward. img The long run cost curve shifts from LRAC to LRAC* showing increase in cost and hence an upward shift. (B) A decline in output: This will increase the cost and reduce the quantity. There would be a leftward movement along the same LRAC. img The quantity decreases and the cost increase from Q to Q* and C to C* respectively. (C) An energy saving technical change : This will decrease the cost for firms. Therefore, the long run average cost curve will shift downward. img The long run cost curve shifts from LRAC to LRAC* showing decrease in cost and hence a downward shift. (D) A fall in interest rate : A fall in interest rate would make capital available cheaper rates. This will reduce the cost of the firm and hence a downward shift in long run average cost curve. img (E) An increase in learning or experience : This will help reduce the firm's operational cost and hence a downward shift in the long run average cost curve as shown in the below diagram. The LRAC shifts from LRAC to LRAC*. img