Business and Their Costs

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Chapter Six
Businesses and Their Costs

Study Questions:

1. Explain the difference between a plant, a firm, and an industry.

Plant – establishments such as a factory, farm, mine or store.

Firm – an organization that employs resources to produce goods/services for profit.

Industry – group of firms that produce the same or similar products.

2. State the advantages and disadvantages of the corporate form of business.

Advantages – most effective form of business organization for raising money to finance the expansion of its facilities and capabilities. Corporations finance the expansion of its facilities and capabilities. Corporations provide limited liabilities to owners.

Disadvantages – the owners of a corporation lose direct control and do not manage the corporation

3. Describe the principal-agent problem.

Principles (stockholders) hire executives (agents) to run the business. These interests in the corporation do not always coincide. And conflicts of interest may develop

4. (a) Distinguish between explicit and implicit costs, and (b) between accounting, normal, and economic profits.

a) A firm’s explicit cost are the monetary payments (or cash expenditures) it makes to those who supply labor services, materials, fuel, transportation services, and the likes. Such money payments are for the use of resources owned by others. A firm’s implicit costs are the opportunity costs of using its self-owned, self-employed resources. To the firm, implicit costs are money payments that self-employed resource could have earned in their best alternative use.

b) Economic profit is total revenue less economic costs. Normal profit is the cost of doing business, or the revenue remaining after all costs have been paid. To accountants, profit is the firm’s total revenue less its implicit costs.

c) Explicit costs are considered by the accountants, implicit costs are not considered by the accountant.

5. Explain why normal profit is an economic cost, but economic profit is not.

Because normal profit is the cost of doing business and economic profit is total revenue minus economic cost. Revenue remaining after all costs have been paid is normal profit.

6. Work study-question five at the end of the chapter to demonstrate your ability to calculate accounting and economic profit.

See attached.

7. Differentiate between the short run and the long run.

Long run (building more-variable) is a time period that allows producers to change the quantity of resources used whereas short run (remains fixed) can only change some of the resources being used.

8. Define, graph, and explain the relationship between total, marginal, and average product.

See attached.

9. (a) State the law of diminishing returns. (b) Is the law of diminishing returns a long-run or short-run concept?

Law of diminishing returns – the principle that as successive units of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decline.

10. (a) Graph the relationship between marginal and average product. (b) Explain.

Marginal product measures the change in total product associated with each succeeding unit of labor. Whereas Marginal Product exceeds average product, and product average rises. It goes up for a short period, reaches a max then decreases. Marginal product MP intersects AP where AP is at a maximum

11. (a) Define and distinguish between fixed, variable and total costs. (b) Provide an example of each.

• Fixed costs are costs that do not vary with changes in output. Fixed costs are associated with the very existence of the firms’ plant and therefore must be paid even if its output is at zero. Examples include rental payments, interest on a firm’s debt, a portion of depreciation on equipment and other capital.

• Variable costs, unlike fixed...
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