3.3

Question 1

What is average revenue?

Answer 1

AR=Price per unit= total revenue/ output

Question 2

What is marginal revenue?

Answer 2

MR= the change in revenue from selling one extra unit of output.

Question 3

What is total revenue?

Answer 3

Price per unit x quantity or AR x Q

Question 4

What are price takers?

Answer 4

-They operate in highly (perfectly) competitive markets
- They have no pricing power and have to accept the prevailing market price and do as well as they can; this means they will have a perfectly elastic demand curve. AR= MR because every unit will be sold at exactly the same price.
- Price takers have a low percentage market share
- Their TR curve will be an upwards sloping line

Question 5

What are price makers?

Answer 5

• They have the ability/ power to set their own prices for the goods and services they sell
• this happens in all imperfectly competitive markets
• the demand curve is downward sloping
• MR will lie below AR

Question 6

What is the relationship between PED and TR?

Answer 6

-PED along a straight line demand curve will vary
- At high prices, a fall in price will have an elastic response i.e cutting prices will cause TR to increase
-Demand is price inelastic (PED<1) towards the bottom of the demand curve- i.e. a fall in prices cause TR to drop

Question 7

What are the costs of production in the SR vs the LR?

Answer 7

SR: At least one of the factor inputs is fixed (usually capital but can also be land). In the SR, businesses are constrained with fixed and variable costs
LR: All factors of production are variable, and the scale of production can also change allowing the firm to benefit from economies of scale.

Question 8

What are fixed costs?

Answer 8

They don’t vary at all as the level of output changes in the SR.
- It has to be paid, whatever the level of sales achieved. Fixed costs are incurred even if output is zero in the SR.
- The higher the level of fixed costs in a business, the higher must be the output in order to break even.

Question 9

Give some examples of fixed costs.

Answer 9

-Consulting fees
- Rental costs
- business insurance

Question 10

What are variable costs?

Answer 10

• Costs that relate directly to the production or sale of a product
• An increase in SR output will cause TVC to rise.
• AVC= TVC/Q
• Variable cost is determined by the marginal cost of extra units as more labour is hired.

Question 11

Give some examples of variable costs

Answer 11

• Commission bonuses
• Wage costs
• Component parts
• basic raw materials

Question 12

What is diminishing marginal productivity?

Answer 12

Its a SR concept that is used to explain the shape of cost curves in the SR. As amount of workers increase, productivity starts to increase as division of labour can be used, however past a certain point, due to fixed capital, capital becomes increasingly scarce. This causes workers to get in each others’ way, causing productivity to fall.

Question 13

What factors cause shifts in supply costs?

Answer 13

1. Change in the unit cost of production- lower unit cost= more can be supplied at each price, higher unit cost= inwards shift of supply.
2. fall in exchange rate= higher prices of imported components and raw materials
3. Advances in production technology= outwards shift
4. Entry of new producers into market= outward shift
5. favourable weather conditions= increased supply
6. Taxes= inwards shift of supply
7. Subsidies= outwards shift of supply

Question 14

How can gov. policy influence costs of businesses?

Answer 14

1. change in VAT and other indirect taxes on producers
2. Environmental taxes and introducing a minimum price for each tonne of carbon emitted within the EU carbon trading scheme
3. Changes in labour market interventions e.g. national minimum wage
4. gov. subsidies targeting producers such as an employment subsidy or guaranteed minimum payment.

Question 15

Why is expensive capital inputs a cause of technical economies of scale?

Answer 15

Large scale businesses can afford to invest in specialist capital machinery e.g. supermarkets may invest in data base technology that improves control of stock and reduces transportation and distribution costs.
A smaller independent store may not be able to justify this initial cost.

Question 16

Why does specialisation of the workforce create technical economies of scale?

Answer 16

Larger firms can split the production processes into separate tasks to boost productivity. e.g. the use of division of labour in the mass production of motor vehicles.

Question 17

Why does the law of increased dimensions cause technical economies of scale?

Answer 17

It is linked to the cubic law where doubling the height and width of a tanker or building leads to more proportionate increase in cubic capacity.
- It opens up the possibility of scale economies in distribution and freight industries and also in travel and leisure sectors with the emergence of super-cruisers.

Question 18

Why does learning by doing cause technical economies of scale?

Answer 18

The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale.

Question 19

What is monopsony power?

Answer 19

• In larger firms, fixed costs such as advertising campaigns have a smaller effect on the cost per unit.
• A large firm can purchase factor inputs in bulk at lower prices if it has monopsony power; purchasing economies.
• e.g. amazon has huge buying power in the publishing industry.

Question 20

What are managerial economies of scale?

Answer 20

• This is division of labour where firms employ specialists to supervise production systems.
• Better management and increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.

Question 21

What are financial economies of scale?

Answer 21

The financial markets usually rate larger firms more credit worthy and have access to credit with favourable rates of borrowing- they may borrow much more overall than a small firm and pay lower rates of interest.
- Smaller firms often pay higher interest rates on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the scale of equities to the capital market.

Question 22

What are network economies of scale?

Answer 22

Some networks and services have huge potential for economies of scale. That is, as they’re more widely used, and become more valuable to the business that provides them.
- In most cases, the marginal cost of adding one more user or customer to a network is close to 0, but the resulting financial benefits may be huge because each new user to the network can trade with the existing members or parts of the network.
- given the high fixed costs of establishing a network, the more users, the lower the fixed costs per unit. As a network expands, there are gains in extra revenue and the LR cost per user diminishes. Internal economies of scale and it is a key factor behind the profitability of a network business e.g. Netflix

Question 23

What are external economies of scale?

Answer 23

They involve changes outside of the business i.e. they result from the expansion of the entire industry of which the business is a member. They lower unit costs for many/ all firms inside the market. The entire LRAC curve will shift downwards.

Question 24

What are diseconomies of scale?

Answer 24

They are increases in the unit cost of supply in the LR due to decreasing returns to scale.
- A business has moved beyond their optimum size
- Businesses are suffering from productive inefficiency because of organisational slack
- Breakdowns in communication may lead to the departure of highly skilled workers from a business.
- Workers morale can suffer which then reduces productivity and increases unit costs. Higher unit costs will reduce total profits. Businesses may then have to raise prices to cover increased costs.
- Lost competitiveness could lead to declining market share and a fall in the share price if the business is listed on the stock market.

Question 25

What causes diseconomies of scale?

Answer 25

1. Control and communication problems i.e. problems in monitoring productivity and work quality, risking increasing wastages of resources which adds to cost but not to total output.
2. Co-operation problems- workers in large firms may develop a sense of alienation and loss of morale.
3. Negative effects of internal corporate politics, information over-load for employees, unrealistic expectations among managers and cultural clashes between senior people with inflated egos.

Question 26

What are the consequences of diseconomies of scale?

Answer 26

• Lead to a rise in a firm’s LR average costs of production
• Result from a business expanding beyond optimum size and losing productive efficiency
• Higher LR average costs will reduce the profitability of a business if their prices remain the same.

Question 27

What is the minimum efficient scale?

Answer 27

Its the scale of production where all of the internal economies of scale have been fully exploited.
MES corresponds to the lowest level of output at which the lowest point on a firm’s LR average cost curve is reached
It is lively to be low relative to the size of the market demand in a very competitive industry- this means there is room for many businesses to compete e.g. hotels
Its likely to be high in a natural monopoly- the industry will be highly concentrated
If the LRAC remains the same as output increases, then a firm is experiencing constant returns of scale.

Question 28

Give 3 causes of a business having high MESs

Answer 28

1. MES will tend to be high when the fixed costs of setting up production are large e.g. in pharmaceuticals where it can costs hundreds of millions to bring a new drug to market because of research and testing costs.
2. MES will be high when the marginal cost of supplying extra customers is relatively low relative to fixed costs. e.g. digital businesses grow rapidly because of the marginal costs of adding one extra user to the network is very low. They can benefit from network economies of scale.
3. With a natural monopoly, LR average costs may continue to fall across the entire range of output which means that the minimum efficient scale is a very high percentage of total market demand. Thus, there may be room for only one firm to fully exploit economies of scale.

Question 29

Give examples of markets with high minimum efficient scale.

Answer 29

• Water, gas and electricity supply
• Underground transport systems
• Social networks and search engines

Question 30

Give 3 examples of markets with low minimum efficient scale.

Answer 30

• Cafes and coffee shops in large cities
• Hotels
• Dry cleaners

Question 31

What is normal profits?

Answer 31

It is the minimum profit needed to keep factor inputs in their current use in the LR.
- It reflects the opportunity cost of using funds to finance a business.
- If price at least covers AC, then a business is making normal profits in a market.

Question 32

What are supernormal profits?

Answer 32

Profit achieved in excess of normal profit.
- Profit when AR>AC
- When a firm is making supernormal profits, there is an incentive for other producers to enter the market

Question 33

What are subnormal profits?

Answer 33

• This is profit less than normal i.e. price per unit< average cost
• AKA economic loss

Question 34

What is the importance of profits?

Answer 34

1. Finance for capital investment and research; retained profits are a key source of finance for businesses undertaking investment + funds for acquisitions
2. Market entry: rising supernormal profits send signals to other producers within a market
3. Demand for and flow of factor resources: Resources flow where the risk- adjusted rate of profit is highest
4. Signals about health of the economy: rising profits might reflect improvements in supply- side performance. They are also the result of higher levels of aggregate demand for example during an economic recovery.

Question 35

What are 5 strategies to increase profit?

Answer 35

1. reduce overhead costs so that average cost per unit falls.
2. Increase labour productivity/ outsource some production to lower cost suppliers.
3. Move up the value chain- develop new products with lower PED and higher YED.
4. Discount prices if the business estimates that demand is highly price elastic.
5. Find new customers in new markets e.g. from exporting to more countries.

Question 36

What is short-run shut-down price?

Answer 36

• In the SR, a firm will supply their products as long as price per unit is greater than or equal to AVC. i.e. where AR=AVC
• Providing that P>AVC, then firms will stay in the market in the SR because there is a contribution being made to covering the fixed costs.
• If prices is less than AVC, then a firm will likely shut down.

Question 37

What is the LR shut-down price?

Answer 37

• A business needs to make at least normal profit in the LR to justify remaining in an industry i.e. at a price and output where P=AC
• If AR(P) <AC in the LR then firms will shut down in theory.
• Firms can survive whilst making a loss because the managers are satisficing, or where a downturn is seen as temporary and demand is expected to pick up again.
• Losses might be cross-subsidised by profits in another sector/ market.

Question 38

Explain the chain of reasoning for when a firm may consider shutting down production.

Answer 38

• In the SR, a business will continue to supply products as long as their revenues at least cover variable costs. Revenue= AR x Q
• Variable costs are cost that vary directly with output e.g. raw materials and employees paid an hourly wage.
• Providing that AR> AVC, then a contribution is being made to cover some of the fixed costs.
• As a result, the firm would be better off continuing production if we assume that fixed costs are lost if a shut-down decision is made.
• But if there is a fall in demand and price drops below AVC, then a firm might decide to shut down production to minimise their losses.
• This is because not enough revenue is being generated and total losses suffered would be higher if production continued.