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 Home > CFA Exam Level 1 (06/2015) Study Notes > Study Session 4. Economics: Microeconomics Analysis > Reading 15. Demand and Supply Analysis: The Firm > LOS c. describe a firm's factors of production;
LOS c. describe a firm's factors of production;
Cost measures.
Factors of Production

A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. Such factors include land, labor, capital, and materials.

The total product curve shows how total product changes with the quantity of variable input employed.

As more and more units of a variable resource are combined with a fixed amount of other resources, employment of additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit.

The law of diminishing returns basically explains the old adage: too many cooks spoil the broth, or the adage - too much of a good thing is bad.

Total, Average, Marginal, Fixed, and Variable Costs

To produce more output in the short-run, the firm must employ more variable inputs, which means that it must increase its costs. In the short-run, a firm's total costs (TC) can be broken down into two categories: fixed costs and variable costs (TC = TFC + TVC). Which costs are fixed and which costs are variable depends on the time horizon being dealt with. For a short time horizon, most costs are fixed. For a long time horizon, all costs are variable.

• Total Fixed Cost. The sum of the costs that do not vary with output. They will be incurred as long as a firm continues in business and the assets have alternative uses. Examples of fixed costs include rent, property taxes and insurance premiums.

• Average Fixed Cost. Total fixed cost divided by the number of units produced. It always declines as output increases.

• Total Variable Cost. The sum of those costs that rise as output increases. Total variable costs are zero if output is zero. Examples are wages paid to workers and payments for raw materials.

• Average Variable Cost. The total variable cost divided by the number of units produced.

• Average Total Cost. Total cost divided by the number of units produced. It is sometimes called per unit cost.

ATC is high at low levels of output, decreases as output increases (since fixed costs are spread across more units), and then increases as the firms maximum capacity is approached (since marginal costs increase).

• Marginal Cost. The change in total cost required to produce an additional unit of output.

The law of diminishing returns implies that the marginal costs of producing each additional unit would increase by increasing amounts. Initially, as output expands, the cost of producing each additional unit of output falls, but then begins to rise as the firm approaches its maximum capacity (e.g. too many workers, congested production lines).

Over the output range with increasing marginal returns, marginal cost falls as output increases. Once a firm confronts diminishing returns, larger and larger additions of the variable factor are required to expand output by one unit. This will cause marginal cost (MC) to rise. As MC continues to increase, eventually it will exceed average total cost. Until that point, MC is below ATC (per unit cost), bringing ATC down. When MC is greater than ATC, the additional units cost more than the average, and ATC must increase. A U-shaped short-run average total cost curve results.

The vertical distance between the AVC and ATC curves measures AFC. The vertical distance between the AVC and ATC curves gets smaller as output increases because AFC decrease as output expands.

 Practice Question 1You've purchased a car for \$10,000 and now are deciding whether to have a moon roof installed for \$400 and a security system installed for \$200. The marginal cost of adding both the moon roof and security system is:Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 2When you produce wheat, it is relatively inexpensive to produce it initially, but then per unit costs tend to increase as more is produced. This would be an example of A. increasing marginal opportunity costs. B. decreasing marginal opportunity costs. C. constant marginal opportunity costs.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 3When output is 500, a firm's fixed costs are \$10,000 and its variable costs are \$15,000. The firm's total costs are therefore: A \$10,000. B. \$15,000. C. \$25,000.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 4If average fixed cost is \$2 and average variable cost is \$3, then total cost is \$5. True or false?Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 5If Gail's grade is currently a C and the grade she receives on her next exam is a B, then her: A. overall grade will fall or at least remain the same. B. overall grade will increase. C. marginal grade is less than her average grade.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 6What is total cost equal to when output is zero in the short run?Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 7In the short run, the cost that is independent of the amount of output produced is called: A. Implicit cost. B. Fixed cost. C. Variable cost.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 8A firm's variable costs A. directly reflect the price of the company's outputs. B. are dependent upon the level of fixed costs in the long-run. C. are always equal to the company's total average costs in the long-run. D. are determined by quantity of output produced by a firm. E. decrease as output increases.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 9A firm's average fixed costs A. are determined by dividing the total fixed cost by the amount produced. B. are always larger than variable costs in the short- and long-run. C. are the same no matter what quantity the firm produces. D. are equal to zero only when the level of production is also zero. E. always increase as output increases.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 10To graphically demonstrate the principle of increasing marginal opportunity cost the production possibility curve must be A. straight. B. bowed out. C. bowed in.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 11Refer to the graph below. At point A: A. marginal product is minimum. B. marginal product is maximum. C. marginal product is zero.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 12When production increases, the average variable cost and average total cost curves: A. spread further apart. B. become horizontal. C. cross. D. move closer together.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 13A firm is producing 100 units of output at a total cost of \$400. The firm's average variable cost is \$3 per unit. What is the firm's total fixed cost? A. \$1. B. \$100. C. \$300.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 14Refer to the graph below. Why does the distance between curves II and III get smaller? A. marginal cost is increasing. B. average variable cost is increasing. C. average fixed cost is declining.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 15Cost curves illustrate the relationship between output and: A. costs as input prices vary B. resource prices, other things constant C. costs, other factors affecting costs held constantCheck AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 16The short-run average total cost curve is generally assumed to be: A. U-shaped. B. upward sloping. C. downward sloping.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 17If a technological advance brings more capital and less labor into use, fixed costs ______ (increase/decrease) and variable costs ______ (increase/decrease). Average total cost ______ (increase/decrease) at low output levels and ______ (increase/decrease) at high output levels.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 18Which statement(s) is/are true? An increase in productivity: I. shifts the marginal product and cost curves upward. II. shifts the marginal product and cost curves downward. III. shifts the average product and cost curves upward. IV. shifts the average product and cost curves downward.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 19Which statement(s) is/are true? I. Even if nothing is produced, fixed costs are still constant in the short run. II. AFC increases as output increases. III. When output is zero, total cost (TC) is equal to TFC, since TVC = 0.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 20Which statement(s) is/are true? I. Where AVC is falling, MC is below AVC. II. Where AVC is rising, MC is above AVC. III. At the minimum AVC, MC equals AVC.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 21Which of the following will shift cost curves downward? I. technological improvements II. deregulation III. lower resource pricesCheck AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 22Suppose that an additional unit of output would require 5 additional hours of labor and 7 additional units of materials. If the wage is \$15 per hour and the price of materials is \$2 per unit, what is the marginal cost of production?Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 23Consider the following statement: I. Marginal cost is the additional cost incurred in undertaking an activity. II. The opportunity cost of undertaking an activity is the benefit forgone by undertaking the next best alternative. Which one(s) is(are) true?A. I and II.B. I only.C. II only.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 24Which of the following statement best explains why the average total cost of a firm is U-shaped?A. Marginal cost is high for low output levels and average fixed cost is high for high output levels. B. Average fixed cost is high for low output levels and marginal cost is high for high output levels. C. Marginal cost is low for low output levels and average fixed cost is low for high output levels.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 25Which of the following factors is not an explanation of the positive relationship between market price and quantity supplied? I. The law of diminishing returns makes it more costly for firms to expand output quickly. II. As all firms in an industry hire more factors of production, the prices paid for them often increase. III. For most firms, unit costs decrease as output increases in the long run. IV. As price increases, some less efficient firms will enter the market.A. III and IV.B. I and II.C. III only.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 26At higher levels of output, total cost tends to:A. increase at a decreasing rate. B. increase at an increasing rate. C. decrease at an increasing rate.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 27If marginal cost is greater than average total cost, then:A. average total cost is falling.B. average total cost will not change.C. average total cost is rising.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 28If the average cost of producing 9 sweaters is \$6.50 and the marginal cost of producing the 10th sweater is \$6.75, then the average cost of producing 10 sweaters will:A. increase.B. decrease.C. increase by 25 cents.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 29At levels of output where the firm's short-run average cost curve is increasing,A. the marginal cost curve is above the short-run average cost curve.B. the marginal cost curve is below the short-run average cost curve.C. the marginal cost curve may be above or below the short-run average cost curve.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 30An upward-sloping short-run marginal cost curve shows that:A. with a fixed amount of capital, as more and more labor is added, output increases at a decreasing rate, and thus each unit is more expensive than the previous unit.B. with a fixed amount of labor, as more and more capital is added, output increases at a decreasing rate, and thus each unit is more expensive than the previous unit.C. with a fixed amount of capital, as more and more labor is added, output decreases, and thus marginal cost increases.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 31If marginal cost is increasing but is less than average total cost, what do we know about average total cost?A. Average total cost is increasing.B. Average total cost is decreasing. C. Any of these could be true. Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 32Which of the following statements is true?A. If marginal cost is decreasing, average total cost must be decreasing.B. If average total cost is decreasing, marginal cost must be decreasing.C. If marginal cost is greater than average variable cost, average variable cost must be increasing.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 33The firm's short-run supply curve is:A. the marginal cost curve.B. the marginal cost curve above average variable cost.C. the marginal cost curve above average total cost. Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 34If a firm's average per-unit costs fall as it produces a larger output, then A. marginal cost must be less than average total cost.B. marginal cost must also decline as output expands.C. average variable cost must also decline as output expands.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 35When the average product is greater than the marginal product, then the average product isA. rising.B. not changing.C. falling.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 36Average fixed costA. remains unchanged with increasing output.B. continually declines with increasing output.C. initially declines and then rises with increasing output.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 37Diminishing returns cause which of the following costs to eventually increase?A. total cost.B. average variable cost.C. average fixed cost.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 38A firm's short-run cost curves will shift upward if there is aA. technological improvement or an increase in the price of a productive resource.B. technological improvement or a decrease in the price of a productive resource.C. downward shift in total product or an increase in the price of a productive resource.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 39In the short run, an increase in output at low levels of production will most likely cause:A. an increase in the marginal cost due to the rising total fixed cost.B. an increase in the marginal cost due to the law of diminishing returns.C. a decrease in the marginal cost due to economies from greater specialization.Check AnalystNotes for the correct answer and a detailed explanation.
 Practice Question 40In regard to the relation between output and costs in the short-run, a decline in the marginal cost most likely occurs at what level of production?A. Low outputB. High outputC. Profit-maximizing outputCheck AnalystNotes for the correct answer and a detailed explanation.
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