HCI_H2_ECONS_Q3

Q3 In recent years, natural calamities such as floods and earthquakes have caused the cost of raw materials to rise. (a) Distinguish between variable costs and fixed costs and explain whether a rise in these costs will affect a firm’s pricing decision differently. [10] INTRODUCTION Fixed and variable costs are two different types of costs in the short-run production period of a firm. The impact of a rise in these costs on a firm’s pricing decision can be analysed using the cost-revenue framework. BODY Distinguish between fixed & variable costs Distinguish well with definitions and examples: Remember to use words like, ‘on the other hand’ to distinguish the two concepts clearly. Variable Cost Fixed Cost Variable cost refers to cost that varies with output. while fixed cost is cost that does not change with level of output Variable cost is only incurred when production starts. On the other hand, fixed cost is already incurred when production is zero. Note: The 2nd point is often left out. Examples: Cost of energy, raw materials & daily rated workers will change with output. Examples: The initial capital outlay even before production of a single unit. It is a lump sum that needs to be spent on tools and equipment, to buy land, building & infrastructure by business unit before production process can take place. Exemplification details: When a car manufacturer increases the production of cars, they need to buy more raw material like steel and paint, pay more wages for overtime and there will be a rise in utility bills as machines are used more intensely. Thus variable costs increase with more output. And when there is no production, these costs will not be incurred. Exemplification details: When the same car manufacturer increases the production of cars, there will not be changes in the size of the factory or equipment that already exist or purchased when the manufacturing plant was first set up; the costs are already incurred even when production is zero and will not change with more output. Explain how a firm makes its pricing decision Assuming that the firm aims to maximise profits, it will produce an output where its marginal costs (MC) equals its marginal revenue (MR) and set its price on the corresponding point on its average revenue (AR). Price will change when MR or/and MC change. So wh ether a change in VC or FC will change a firm’s pricing decision will depend whether it changes MC. Explain how an  in VC & FC can affect a firm’s pricing decision differently.  An increase in variable costs (VC) will lead to an increase in MC as it is the additional cost arising from an additional output. (MC = TC/Q or MC = TVC / Q).  For example, rising oil prices can lead to an increase in the costs of jet fuel fo r an airline. Jet fuel is a variable cost as it varies with the number of flights conducted by the airline. If there are no flights, jet fuel cost wil