(a) Distinguish between the following pairs of cost concepts. (i) Fixed cost and variable cost. (ii) Real cost and money cost (iii) Implicit cost and explic...

(a) Distinguishing the cost concepts.

• (i) Fixed cost vs variable cost. Fixed cost is a cost that does not change with the level of output in the short run; it is incurred even when output is zero (for example rent, insurance, salaries of permanent staff). Variable cost is a cost that changes directly with the level of output, rising as output rises and falling as it falls (for example raw materials, wages of casual labour, fuel).
• (ii) Real cost vs money cost. Real cost is the cost of producing a good measured in terms of the effort, sacrifice, and other goods forgone to produce it (an opportunity-cost idea). Money cost is the actual amount of money spent by the firm on the factors of production used to produce the good.
• (iii) Implicit cost vs explicit cost. Implicit cost is the value of the owner's own resources used in the business for which no actual money payment is made (for example the rent forgone on the owner's own building or the salary he could have earned elsewhere). Explicit cost is the actual money payment made to outsiders for factors and inputs (for example wages, purchases of raw materials, rent paid).

(b)(i) Recommendation when average cost is greater than price. When \( AC > P \), the firm is making a loss on each unit. In the short run the firm should continue to produce provided the price is still above average variable cost, so that it can cover its variable costs and part of its fixed costs; if the price is below average variable cost, it should shut down. In the long run, if the loss persists, it should close down and leave the industry.

(b)(ii) Reason. Fixed costs must be paid whether or not the firm produces. As long as price covers average variable cost and leaves something towards fixed cost, producing gives a smaller loss than closing (which would mean losing the whole of the fixed cost), so it pays to keep operating in the short run.