3.1.2 Business objectives cost/revenues

Question 1

What is the law of diminishing returns?

Answer 1

If a firm increases just one of its inputs whilst holding the others fixed, it will eventually derive diminishing marginal returns in the long run, so inputs start to fall the more variable the factor increases, giving a concave downwards slope over time

Question 2

What is the marginal/average product curve?

Answer 2

Marginal product of labour is the total increase in output when labour is increased by a unit (or any factor of production).

It is concave as division of labour drives it upwards but as output rises diminishing marginal returns makes it start to decrease.

It begins at 0.5 because it is marginal.

The average product of labour is the total output/total labour, and also rises until it crosses the MPL curve as when it starts to decline so does the average product of labour.

Question 3

What is product?

Answer 3

Total product is total output

Marginal product is addition output produced when an extra factor is employed

Average product is total output/number of workers

Question 4

What are the costs of production in the short and long run?

Answer 4

Short run - at least one factor is fixed in the short run

Long run - all factors are variable and benefit from EofS

Question 5

What are fixed and variable costs?

Answer 5

Fixed costs do not vary at all as the level of output changes in the short run however may vary in the long run. Examples may include rent, marketing budgets, research projects, fixed salaries, insurance

Variable costs relate directly to production or sale of a product. An increase in output causes total variable costs to rise, and they go up with every extra unit of output made. Examples include wages, electricity, raw materials, packaging, energy and fuel costs

Question 6

What is the law of diminishing productivity?

Answer 6

Increasing one input whilst keeping other inputs at the same level may increase output in the short run, however further increases in just that input will have a limited effect. Eventually there may be a negative effect on output and so the marginal product of labour starts to decline below existing average product, so the marginal cost increases.

Question 7

How do you graph total fixed costs, variable costs and total costs?

Answer 7

• Total fixed costs are fixed, so a vertical line
• Total variable costs curve upwards
• Total costs are the total variable cost curve + the size of the total fixed cost curve.

Question 8

How do you graph costs?

Answer 8

AC=MC at lowest point of AC curve since as soon as marginal cost is higher than the average cost it drives it up

Average variable costs may also be diagrammed below the average cost, which is variable cost per unit output. The difference between AC and AVC indicates the AFC

Question 9

How do you calculate marginal costs?

Answer 9

Change in total cost over change in output

Question 10

What causes shifts in short run costs?

Answer 10

• Changes in cost of production
• Depreciation in exchange rates cause higher prices of imported components and raw materials
• Technological advancements
• Entry of new producers
• Better weather conditions - agricultural products
• Taxes, subsidies and government regulations.
• VAT, environmental taxes, NMW, subsidies

Question 11

What is the effect of a rise in fixed costs, and a rise in variable costs?

Answer 11

Fixed costs only increase the average cost as the total cost all increase simultaneously so don’t rise

Variable costs shift both AC and MC as marginal cost varies with rising variable costs.

Question 12

How do average costs work in the long run?

Answer 12

In the long run, all factors of production are variable and how the output responds is called returns to scale. In the long run the scale of production can change and they are graphed by the LRAC.

Economies of scale are indicated by the unit cost of advantages from expanding the scale of production in the long run. The lower costs represent improvement in productive efficiency and give a business a competitive advantage in the market and lower prices.

Question 13

What is the LRAC curve?

Answer 13

The LRAC represents the minimum attainable average cost of production.
When output increases and costs decrease, the firm experiences returns to scale of economies of scale, which cause AC to move.

Question 14

What is average, marginal and total revenue?

Answer 14

Average revenue is the price per unit, also known as the demand curve

Marginal revenue is the change in revenue from selling one extra unit of output

Total revenue is the price per unit x quantity

It is equivalent to demand and so when demand for a good changes so does the AR and MR curve for the firm.

Question 15

Where is revenue maimised?

Answer 15

Revenue maximisation is where marginal revenue is 0, as below this point total revenue is rising and after it is is falling, so this is the maximum point. This is why profit maximisation is when MR is = MC as it is where marginal revenue is equal to marginal cost so there is no excess revenue or cost.

Question 16

What are price makers/takers?

Answer 16

Price takers operate in perfectly competitive markets, and have no pricing power so accept the market price. They have a low market share and TR curve will simply be upwards sloping

Price makers have the ability to set their own prices for the goods and services they sell, usually monopolies.

Question 17

What is the effect of PED on revenues?

Answer 17

At high prices, a fall in price may have an elastic price response - cutting prices causing total revenue to rise.

Demand becomes more inelastic towards the bottom of the demand curve, so a fall in price could cause total revenue to drop.

Question 18

What are the 4 business objectives?

Answer 18

Profit maximisation at MR=MC

Revenue maximisation when MR=0

Sales maximisation when AR=AC

Satisficing behaviour - owners of the business set minimum acceptable levels of achievement of either revenue or operating profits

Question 19

What are some reasons for different objectives?

Answer 19

Managerial objectives often revenue or sales growth whilst reaching satisficing for shareholders

Small businesses target rapid growth over profit

State owned corporations ranging objectives

Information gaps - firms may lack information on cost and revenues in the market

Question 20

What is profit maximisation?

Answer 20

This occurs where MR=MC as there is no marginal cost or revenue made past the value or before the value.

The change in revenue from producing an extra unit of output = change in cost from producing an extra unit

Question 21

What are the benefits and drawbacks of profit maximisation and why may people not do so?

Answer 21

Benefits:

• Higher dividends for shareholders
• Employees gain if pay linked to profit
• Higher profits lead to investment - benefit other businesses
• Businesses may use R&D - dynamic efficiency in the market
• Provides safety net for businesses in recession

Drawbacks:

• Higher prices for consumers
• Higher profits incentivise new entrants
• Companies lose sight on ethics
• Profits may be increased by reducing quality

Question 22

What is loss minimisation?

Answer 22

Losses are minimised at profit maximisation point

Question 23

What is revenue maximisation?

Answer 23

When MR=0 the firm is maximising revenues. It is noted that rewards for managers is better for sales revenues than profits. It may also deter entry of new firms and rivals as they gain more market share.

Helps dominate market and get greater market share, stock up on resources and usually if firms are not running for profits.

Question 24

What is sales maximisation?

Answer 24

The point where AC=AR is the maximum possible quantity without making a loss. At this output, normal profits are made so it is technically sustainable.

Question 25

What is satisficing?

Answer 25

• Satisficers choose the best possible option out of a limited set of alternatives, generally to keep a range of stakeholders happy and ensure the business is also profitable to do so.
• Satisficers may be the managers who are more concerned with increasing sales revenue and market share instead of profits.

Satisficing output occurs between profit maximisation and sales max as it sacrifices one or the other to satisfice

Question 26

What are the different types of profit?

Answer 26

Normal profit is the minimum profit needed to keep factor inputs in their current use in the long run, AC=AR

Supernormal profit is when profit is in excess of normal profit, so revenue is more than costs. This incentivises other producers to enter the market.

Subnormal profit - profit less than normal, also known as economic loss.

Question 27

Why is profit important?

Answer 27

• Finance for capital investment and research
• Important for market entry as encourages new entrants
• Demand for flow and factor resources
• Signals about health of the economy

Question 28

How may firms increase profit?

Answer 28

• Reduce fixed costs so average cost falls
• Increase labour productivity
• move up value chain - new products with lower PED
• Discount prices
• Find new customers in the market

Question 29

What causes short run shutdown

Answer 29

In the short run a firm will supply products as long as price per unit is greater than or equal to average variable costs

When price is greater than variable costs there is contribution to be made covering the fixed costs of production so can minimise losses to operate.

However, when it is less the firm will likely shut down to minimise its losses as it will not only not be covering fixed costs but also variable costs

Question 30

What is long run shutdown?

Answer 30

Businesses need normal profit in the long run to remain in an industry. If it is below normal in the long run, firms will shut down in the long run. Firms can survive while making a loss if managers are satisficing, or where a downturn is seen as temporary and demand is expected to pick up again.

The owner may be aware that resources should be reallocated elsewhere and exit the market in search of better profits.

Question 31

What are EofS and what is the minimum efficient scale?

Answer 31

Economies of scale are the average costs falling as outputs rise. Firms experience productive efficiency when output is at the point where ATC is lowest

They occur as outputs increase, fixed costs are spread across more units and so fixed costs per unit goes down. Variable costs may not increase in proportion to output and may go down as outputs rise.

MES is the level of output on the LRAS at which average costs are the lowest, and EofS have been full exploited

Question 32

What is the anagram for EofS?

Answer 32

Really - Risk
Fun - Financial
Mums - Marketing
Try - Technical
Making - managerial 
Pies - purchasing

Question 33

What are the 6 EofS?

Answer 33

Risk bearing - investments are expensive and risky, so larger firms are able and willing to undertake investment

Financial - large firms easy to obtain finance cheaper and easier due to credit

Marketing - Advertising, brand image all fixed costs so when spread over many sales the cost per unit is lower for a larger firm than a small firm.

Technical - Resulting from increased productivity, arising from process of production when the sale of a firm’s operation increases - there are 4 types:

• Specialisation - bigger firm, more specialised capital
• Indivisibilities - more efficient capital often requires investment
• Linkages of processes - fully utilise capacity of capital at each stage
• Increased dimensions - doubling height, width, depth of warehouses increase volume and reduce costs of storage and transport

Managerial - Division of labour, firm can employ specialist managers and departments - have better links and deal with key functional areas

Purchasing - Able to bulk buy for cheaper than small firms

Question 34

What are external economies of scale

Answer 34

Involve changes outside the business, usually from the expansion of an entire industry. They lower unit costs for all firms in the market, shifting the entire LRAC downwards.

This may include skilled labour, training, infrastructure, R&D, ancillary and commercial services, cooperation - it is the reason businesses agglomerate

Question 35

What are diseconomies of scale?

Answer 35

-Increases in the unit average cost of supply in the long run due to decreasing returns to scale, so they have moved beyond optimum size and MES and are experiencing inefficiency due to organisational slack.

Question 36

What are some diseconomies of scale?

Answer 36

• Bureaucracy - high paperwork and management
• Labour relations - workers lack motivation or means to work as firm big to advance in, working environment poor
• Control - hard to ensure all workers on same goal and hard to supervise
• Coordination - communication between departments gets harder along the chain of command with wider spans of control

Question 37

What are economies of scope?

Answer 37

Unit cost to produce a product will decline with more variety - the more different but similar goods produced the lower total cost to produce each one.