Costs

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

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The test

1Which statement about fixed costs in the short run is correct?

A Total fixed cost rises in proportion to output
B Fixed costs are zero when output is zero
C Total fixed cost does not change with output, so average fixed cost falls as output rises
D Average fixed cost rises as output rises

2A firm's total cost is £5,000 when it makes 100 units and £5,300 when it makes 101 units. The marginal cost of the 101st unit is:

A £300
B £52.48
C £5,300
D £53

3Diminishing marginal returns set in when:

A average cost reaches its lowest point
B each extra unit of the variable factor adds less to output than the one before
C all factors of production can be varied
D total output starts to fall

4The marginal cost curve passes through the lowest point of the average variable cost curve because:

A fixed costs are constant in the short run
B marginal cost always rises
C average variable cost includes fixed costs
D when MC is below AVC it pulls the average down, and when MC is above AVC it pulls the average up

5Average fixed cost falls continuously as output rises because:

A fixed costs fall as the firm grows
B the same total fixed cost is spread over more units
C marginal cost is falling
D variable costs fall as output rises

6Which one of the following is a financial economy of scale?

A A large firm borrowing at a lower rate of interest because lenders see it as less risky
B A large firm getting a discount for buying raw materials in bulk
C A large firm using a bigger furnace that costs less per unit to run
D A large firm spreading the cost of a television advert over more sales

7Internal diseconomies of scale arise mainly because, as a firm grows:

A its total fixed cost rises
B its technology becomes out of date
C communication and coordination become harder and motivation falls
D the prices of its inputs rise for every firm in the industry

8An external economy of scale is:

A a rise in average cost as the industry grows
B a cost of production paid by people outside the firm
C a fall in average cost that comes from the firm's own growth
D a fall in average cost that comes from growth of the whole industry and is available to every firm in it

9A firm's long-run average cost is the same over a wide range of output. Over that range the firm experiences:

A economies of scale
B diminishing marginal returns
C diseconomies of scale
D constant returns to scale

10In the long run:

A all factors of production can be varied
B at least one factor of production is fixed
C diminishing marginal returns set in
D fixed costs are higher than in the short run

11Average total cost is equal to:

A total cost multiplied by output
B marginal cost plus average fixed cost
C average fixed cost plus average variable cost
D total variable cost divided by total fixed cost

12A firm doubles all of its inputs and its output more than doubles. This is an example of:

A constant returns to scale
B increasing returns to scale
C diseconomies of scale
D diminishing marginal returns

13Hollowbrook is a small gin distillery that makes its spirit in a single still on a rented site. The still, the lease and the licence are fixed costs; botanicals, bottles, energy and casual labour vary with output. Table 1 shows the distillery's costs at different levels of monthly output. Figures are illustrative.

Table 1: Hollowbrook's monthly costs
Output (thousand bottles)	0	1	2	3	4	5	6
Total fixed cost (£ thousand)	12	12	12	12	12	12	12
Total variable cost (£ thousand)	0	8	14	18	24	33	45

(a)Using Table 1, calculate the average total cost of a bottle when the distillery makes 4,000 bottles a month. [2]

(b)Using the data, explain at which level of output diminishing marginal returns set in at Hollowbrook. [4]

(c)With the aid of a diagram, explain the relationship between a firm's marginal cost, average variable cost and average total cost in the short run. [6]

(d)Hollowbrook is considering moving to a larger site with three stills. Explain two economies of scale it might gain, and one reason its average cost might not fall as far as it hopes. [6]

14Evaluate the view that large firms will always have lower average costs than small firms. [20]

Answers

Show the answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

	Answer	Why
1	C	Rent, insurance and loan repayments are paid whatever the firm produces. Spread over more units, the same total gives a smaller cost per unit.
2	A	Marginal cost is the change in total cost from one more unit: 5,300 − 5,000 = £300. £52.48 is the average cost of 101 units.
3	B	With a fixed factor such as a kitchen or a machine, extra workers eventually add less and less output as they share it. Marginal product falls, so marginal cost rises.
4	D	An extra unit that costs less than the current average lowers the average; one that costs more raises it. The average is at its lowest exactly where the marginal equals it.
5	B	AFC = TFC ÷ Q. With TFC fixed, a larger Q gives a smaller AFC, which is why the gap between ATC and AVC narrows as output rises.
6	A	Financial economies come from cheaper or easier access to funds. The others are marketing, purchasing and technical economies.
7	C	Beyond some size, layers of management slow decisions, messages get lost and workers feel less connected to the firm, so cost per unit starts to rise.
8	D	When an industry clusters, firms share trained workers, specialist suppliers and infrastructure. Each firm's LRAC curve shifts down even if the firm itself has not grown.
9	D	If doubling all inputs exactly doubles output, cost per unit does not change: constant returns. The flat section of the LRAC curve starts at the minimum efficient scale.
10	A	The long run is the period in which a firm can change everything, including the size of its premises and the number of machines. Diminishing returns belong to the short run, when something is fixed.
11	C	Total cost is fixed plus variable cost; divide each part by output and ATC = AFC + AVC.
12	B	Output rising by more than the inputs means cost per unit falls: increasing returns to scale, the source of economies of scale.

13 (a) Using Table 1, calculate the average total cost of a bottle when the distillery makes 4,000 bottles a month. [2: AO2 2]

AO2 (1) Total cost at 4,000 = 12 + 24 = £36,000
AO2 (1) 36,000 ÷ 4,000 = £9 a bottle

13 (b) Using the data, explain at which level of output diminishing marginal returns set in at Hollowbrook. [4: AO1 1, AO2 3]

AO1 (1) Marginal cost is the extra cost of one more unit (here, one more thousand bottles); with the still fixed, diminishing marginal returns mean each extra batch of inputs adds less output, so marginal cost starts to rise
AO2 (2) Marginal costs from the table: £8,000, £6,000, £4,000, £6,000, £9,000, £12,000 for each extra thousand bottles; marginal cost falls up to the third thousand and rises from the fourth
AO2 (1) So diminishing marginal returns set in beyond 3,000 bottles a month, when the single still is being pushed harder and extra labour and energy add less output per pound spent

Maximum 4: definition or mechanism (1), marginal costs calculated (2), the turning point identified from them (1).

13 (c) With the aid of a diagram, explain the relationship between a firm's marginal cost, average variable cost and average total cost in the short run. [6: AO1 2, AO3 4]

AO1 (2) Diagram: output on the horizontal axis and cost per unit on the vertical; a tick-shaped MC curve; U-shaped AVC and ATC curves with ATC above AVC; MC cutting each average curve at its lowest point
AO3 (2) MC falls at first as the variable factor is used more efficiently, then rises because of diminishing marginal returns to the fixed factor; while MC is below an average it pulls that average down, and once above it pulls it up, so MC passes through the minimum of both AVC and ATC
AO3 (1) ATC = AVC + AFC, so the vertical gap between the two curves is average fixed cost
AO3 (1) AFC falls continuously as fixed cost is spread over more units, so the gap narrows as output rises and ATC reaches its minimum at a larger output than AVC does

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with MC through the minimum points; 5 to 6 for the full chain, including why MC cuts the averages where it does and why the gap between ATC and AVC narrows.

13 (d) Hollowbrook is considering moving to a larger site with three stills. Explain two economies of scale it might gain, and one reason its average cost might not fall as far as it hopes. [6: AO1 1, AO2 2, AO3 3]

AO1 (1) Economies of scale are falls in long-run average cost as a firm increases the scale of all its inputs; diseconomies are rises in average cost beyond some size
AO2+AO3 (2) Technical economies: larger or more stills raise output more than they raise running costs, and the fixed costs of the site, licence and management are spread over three times the output, so cost per bottle falls
AO2+AO3 (2) Purchasing economies: buying botanicals, bottles and energy in larger quantities earns discounts from suppliers; or marketing economies, as the cost of a brand campaign is spread over more bottles; or financial economies, as a bigger firm borrows more cheaply for the move
AO3 (1) Average cost may not fall as far as hoped: with three stills and more staff the owner can no longer oversee every batch, so coordination problems and quality lapses raise costs (diseconomies of scale); or the firm may not sell enough to run the new site at the output where its lower costs are reached, so it operates on the falling part of the new short-run curve with high average fixed costs

Levels: 1 to 2 for naming economies of scale; 3 to 4 for two economies explained in the context of the distillery; 5 to 6 for the full chain including a developed reason why average cost might not fall as far.

14 Evaluate the view that large firms will always have lower average costs than small firms. [20: AO1 6, AO3 6, AO4 8]

Knowledge and analysis (AO1 to AO3)

Define economies of scale: falls in long-run average cost as the scale of production rises, shown by the downward-sloping section of the LRAC curve up to the minimum efficient scale. Internal economies: technical (larger machines, specialisation, the container principle), purchasing (bulk discounts), marketing (advertising spread over more output), managerial (specialist managers), financial (cheaper borrowing), risk-bearing (diversification). External economies from the growth of an industry in one area.
Why large firms often do have lower costs: in industries with high fixed costs, such as car making, steel, aircraft, networks and software, the fixed cost per unit falls steeply with output, and the minimum efficient scale is a large share of the market. Examples: supermarkets' buying power, energy companies, streaming platforms spreading content costs over millions of subscribers.
Why they may not: diseconomies of scale beyond some size, as communication, coordination and motivation suffer; the LRAC curve is U-shaped or L-shaped, so beyond the minimum efficient scale there is no further gain. In industries where MES is small (hairdressing, restaurants, consultancy, craft production) a small firm can reach lowest cost and a large one gains nothing.
Small firms' advantages: flexibility, closer customer contact, lower overheads, the owner's direct control, niche products where buyers pay for difference rather than low cost; large firms can also suffer X-inefficiency where competition is weak.
Diagram to use: a U-shaped LRAC with the minimum efficient scale marked and a small firm and a large firm at different points; or an L-shaped LRAC where costs flatten beyond MES.

Evaluation (AO4)

It depends on the industry's minimum efficient scale relative to the market: where MES is large, size is decisive; where it is small, size brings no cost advantage at all.
It depends on how well the large firm is managed: economies of scale are potential savings, and poor coordination or complacency can turn them into diseconomies, which is why some large firms demerge.
It depends on the measure: lower average cost is not the same as lower price or higher profit; a large firm may keep the savings as profit, while a small firm may compete on something other than cost.
Technology can change the answer: online platforms let small firms rent warehousing, computing and marketing by the unit, which lowers the output needed to reach low average cost and weakens the large firm's advantage.
'Always' is too strong: the evidence is that large firms have lower average costs in capital-intensive industries and no advantage, or a disadvantage, in many service industries.

Judgement

A supported judgement might conclude that large firms have lower average costs where fixed costs are high and the minimum efficient scale is a large share of the market, but not always: beyond MES there are no further economies, diseconomies can set in, and in industries with a small MES a well-run small firm matches or beats a large one on cost. Whether size pays depends on the shape of the industry's LRAC curve and on how the firm is managed, not on size itself.

Marking

Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.