Test: Theory of Cost - UGC NET MCQ

- The Assertion (A) is true because ATC initially decreases as both AFC and AVC decline with increasing output.

- The Reason (R) is also true, as it accurately describes that while AVC does rise after a certain output level, the continuing decline of AFC results in a decrease in ATC until that specific point is reached.

- Since the Reason provides an explanation for why the Assertion is true, the correct answer is Option A.

Rent for factory space is considered a fixed cost because it remains constant regardless of the level of output produced by the firm. Unlike variable costs, which change with production levels (like raw materials and temporary worker wages), fixed costs must be incurred even when production is halted. Understanding fixed costs is essential for businesses to manage their budgets effectively, as these costs represent unavoidable expenditures that influence overall profitability.

Statement 1 is correct. Large-scale firms indeed benefit from economies of scale, allowing them to purchase inputs at reduced costs due to bulk buying discounts. This enables them to lower their overall production costs.

Statement 2 is incorrect. As firms grow, the complexity of operations often leads to delays in decision-making and potential inefficiencies, which can hinder resource allocation. This is a classic example of diseconomies of scale, where the management structure becomes overburdened, resulting in diminishing returns.

Thus, the correct option is A: 1 Only.

• Assertion (A) is correct: AVC indeed decreases when MC is below AVC because each additional unit produced adds less to total cost than the average variable cost per unit.
• Reason (R) is also correct: When MC is above AVC, it signifies that producing additional units increases the average variable cost, hence AVC must rise.
• Reason (R) correctly explains Assertion (A): The relationship indicates that AVC falls when MC is below it and rises when MC exceeds it, affirming the assertion.

The Average Total Cost (ATC) is calculated by adding Average Fixed Cost (AFC) and Average Variable Cost (AVC). This illustrates that as output increases, the fixed costs are spread over more units, which can lower overall costs, while AVC may vary based on production levels. Understanding this relationship is crucial for firms to make informed production decisions and pricing strategies.

Average fixed cost (AFC) decreases as output increases because it is calculated by dividing total fixed cost (TFC) by output. As output rises, the same total fixed cost is spread over a larger number of units, causing the AFC to fall. This relationship results in the AFC curve approaching zero as output becomes very large. A key insight here is that while AFC decreases, it never actually reaches zero; it merely gets infinitesimally close.

Both statements are correct. Statement 1 accurately describes the behavior of long-run marginal costs, which, like in the short run, first decrease due to increasing returns to scale and then increase due to diminishing returns as production scales up. Statement 2 is also correct, as the long-run average cost (LAC) curve typically exhibits a U-shape. This reflects the initial benefits of economies of scale (decreasing average costs) followed by diseconomies of scale (increasing average costs) as the firm expands its production. Thus, the correct answer is Option C: Both 1 and 2.

- The Assertion (A) is correct: Average fixed costs decline as output increases because fixed costs are spread over more units.

- The Reason (R) is also correct: Average variable costs decrease initially due to increased efficiency with output, then rise due to diminishing returns.

- However, Reason (R) does not explain Assertion (A). The decrease in average fixed costs is independent of the behavior of average variable costs. Thus, the correct answer is Option B.

• The Assertion (A) states that when Average Cost (AC) is declining, Marginal Cost (MC) is indeed less than AC, which is a true statement based on cost theory.
• The Reason (R) correctly explains this relationship by stating that MC must be below AC during the declining phase of AC, reinforcing the assertion.
• Since both the Assertion and Reason are true, and the Reason provides a correct explanation for the Assertion, the correct answer is Option A.

Short-run total costs consist of both fixed and variable costs. Fixed costs do not change with the level of output and must be paid regardless of production levels, while variable costs fluctuate with the amount produced. This distinction is crucial for businesses as it helps in understanding cost behavior and making informed production decisions. For instance, while rent must be paid even if no goods are produced, costs such as raw materials only accumulate when production occurs.