1) What is the principle-agent problem and how can it be avoided? 2

1. Principle agent problem means when the agent agrees to take decisions for the principle (other person). The agent has more information than the principle due to which asymmetric information occurs and market fails. It leads to the problem of moral hazard and conflicts. It can be resolved by eliminating the intermediates and the direct participation of the principle in the market decision making process.

2. Explicit cost occurs when the firm makes payment for using the factors of production such as labor and raw materials. On the other hand, implicit cost occurs when the firm uses resources belonging to the owner. For instance, capital or inventory.

3. The law of diminishing return refers to the process where more and more fixed inputs when combined with the variable inputs, will initially lead to a decrease in the total product at an increasing rate, then at decreasing rate and ultimately fall.

4. The short run production cost is U shaped because of the law of diminishing return. In the short run some factors are fixed and some are variable. When more and more variables are employed with the fixed factors, initially it will lead to a rise in the marginal product and marginal cost falls due to increasing returns. Then the marginal product will start falling due to which the marginal cost will rise due to decreasing returns. This will give the U shape to the short run production cost curve.

5. Economies of scale are the cost advantage to the firms due to their large scale of operation in the long run. On the other hand, dis economies of scale refer to when a firm grows so large that the cost per unit increases with the increase in the output. The U shape of the long run average cost curve is due to the returns to scale. Initially when the firm increases its inputs in the long run, it will lead to a fall in the average cost due to economies of scale. After sometime, when the firm will keep on increase its inputs, it will lead to an increase in its average cost due to dis economies of scale.