Background to Supply

Question 1

What is short run production?

Answer 1

It entails that at least one factor input (or a factor of production e.g. capital) has to be fixed.

If a firm wishes to increase its production it will take a long time to acquire a greater quantity of certain types of resources (inputs), so if it wants to increase output quickly it will only be able to increase the quantity of certain inputs.

There is a distinction between fixed factors (machinery, buildings etc.) and variable factors (labour, raw materials etc.) in the short run

Question 2

What is the production function for the relationship between output and input?

Answer 2

TPP = f(K, L)
- but in the short run (capital) K is fixed

Question 3

What does the law of diminishing return state?

Answer 3

When increasing amounts of a variable factor (e.g. labour) are used with a given amount of a fixed factor (e.g. capital), there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.

Question 4

What happens to the total physical product (TPP) (or output) produced based on the law of diminishing return?

Answer 4

It will:
1. Initially increase at an increasing rate when a variable input is added (i.e. the marginal physical product (MPP) is increasing)
2. Then will increase at a decreasing rate when variable input is added (where the diminishing returns set in i.e. the MPP decreases)
3. Will eventually decline with the increase in the variable input (MPP will be negative)

Question 5

What is the Marginal physical product (MPP)?

Answer 5

The extra output produced as a result of adding one more unit of a variable input in production

If the variable input is labour (L) then MPP=
changeTPP/
changeL

Question 6

What is the average physical product (APP)?

Answer 6

The total physical product divided by the variable input

If the variable input is labour (L) then APP = TPP/L

Therefore the APP is maximum when it is equal to MPP

Question 7

What are the costs in the short run production made of?

Answer 7

The total cost (TC) of production is made up of total fixed costs (such as capital costs) which do not change with the change in output and total variable costs (such as labour costs) which change with the change in levels of output

Question 8

How are the costs of short run production shown mathematically?

Answer 8

TC = TFC + TVC

• In a graph showing costs (y-axis) and output (x-axis), the VC CURVE will start from the origin (zero), the FC CURVE will be horizontal, and the TC CURVE will start from the fixed cost.
• The TC and TVC curves move together, because the changes in the TC are due to changes in the TVC.

Question 9

What happens to the total costs when divided by the units produced (Q)?

Answer 9

You get the average total cost (ATC or AC), average fixed cost (AFC) and average variable cost (AVC)

Question 10

What is the marginal cost (MC)?

Answer 10

The cost associated with producing an additional unit, it is equal to the change in the total cost divided by the change in the output.

Question 11

How is the marginal cost shown mathematically?

Answer 11

MC = changeTC/ changeQ

• When the MC curve falls, the AC and AVC curves also fall, and when the MC curve rises, the AC and AVC curves also rise
• The MC curve cuts the AC and AVC curve at their minimum
• This is because where additional units cost less than the average, they will necessarily pull the average downward, and where additional unit costs more than the average they will necessarily push the average up

Question 12

What is an isoquant?

Answer 12

A line showing all the alternative combinations of two factors that can produce a given level of output

Question 13

What is the Marginal rate of factor substitution (MRS)?

Answer 13

The rate of substituting one factor input for another

• Diminishing MRS is the key to the shape of the curve
• It is related to diminishing returns
• Thus MRS = MPPl/ MPPk

Question 14

What is an isoquant map?

Answer 14

Where the same producer can have a second set of combination of labour and capital that provide the same level of output, with this level of output being higher than the first set & a third set with an even higher level of output than the previous one.
When these are drawn on the same graph = isoquant map

Question 15

What is an isocost?

Answer 15

A line showing all the combination of two factors that cost the same to employ, the line connects the intercept of the prices of the two factors of production

Question 16

What happens when you equate isoquants to isocosts?

Answer 16

We can obtain the least cost combination of the factor to produce a given level of output

Question 17

What are economies of scale?

Answer 17

When increasing the scale of production leads to a lower cost per unit of output

Question 18

How do economies of scale arise?

Answer 18

• SPECIALISATION AND DIVISION OF LABOUR = less training needed and workers can become highly efficient
• INDIVISIBILITY = the impossibility of dividing a factor into smaller units
• PRODUCING BY-PRODUCTS
• GREATER EFFICIENCY OF LARGE MACHINES = more output can be gained for a given amount of inputs
• FINANCIAL ECONOMIES = obtain money at lower interest rates than smaller firms since they are seen as lower risk
• SPREADING OVERHEADS = some expenditure such as R&D are economical only when the firm is larger
• ORGANISATIONAL ECONOMIES = specialisation in specific functions
• ECONOMIES OF SCOPE = producing more than one product can lead to cheaper costs per unit

Question 19

What are diseconomies of scale?

Answer 19

When increasing production leads to higher cost per unit

Question 20

How can diseconomies of scale arise?

Answer 20

• Management inefficiencies
• Free riding
• Information transmission failures

THEY ARE RARE

Question 21

What are returns to scale?

Answer 21

The change in the amount of output due to increase in the scale of production

1. Constant returns to scale
   
   • where a given percentage increase in inputs will lead to the same percentage increase in output
2. Increase returns to scale
   
   • where a given percentage increase in inputs will lead to a larger percentage increase in output
3. Decrease returns to scale
   
   • where a given percentage increase in inputs will lead to a smaller percentage increase in output

Question 22

What is the Cobb- Douglass production function & how are the returns to scale interpreted?

Answer 22

TPP=AKαLβ (with only 2 factors)

1. Constant economies of scale = α + β = 1
2. Increasing economies of scale = α + β > 1
3. Decreasing economies of scale = α + β < 1

Question 23

What is total revenue (TR) and what is the formula?

Answer 23

Refers to the firms earnings from a specified level of sales within a specific period

TR = P x Q
P = price of goods sold
Q = quantity of goods sold

Question 24

What is the average revenue (AR) and what is the formula?

Answer 24

When the total revenue is divided by the quantity sold, we obtain the average revenue

AR = TR/Q

Question 25

What is the marginal revenue (MR) and what is the formula?

Answer 25

The extra revenue gained by selling one more unit per period of time (or the change in the total revenue divided by the change in the quantity sold)

MR = changeTR/ changeQ

Question 26

What is the revenue curve for a price taking firm?

Answer 26

The same as the horizontal demand curve.

The implication of the horizontal demand curve is that the PRICE REMAINS CONSTANT
- therefore AR which is (PQ/Q) = Price
- similarly the MR which is changeTR/change Q where P doesn’t change then MR = (PchangeQ)/ changeQ = Price
- therefore MR=D=AR=P

In addition the TOTAL REVENUE CURVE will be UPWARD SLOPING STRAIGHT LINE FROM THE ORIGIN

Question 27

What is the revenue curve for a non price taking firm?

Answer 27

As the firm has a large share in the market, the price varies with output

• Only the AR = Demand curve
• The MR curve is below the Demand curve

THEY ARE BOTH DOWNWARD SLOPING

The total revenue curve will be an arch shape starting from the origin with TR maximised when the MR is zero

Question 28

What is the profit maximisation rule?

Answer 28

Entails that profit is maximised where marginal revenue (MR = marginal cost (MC)

Profit (∏) is the difference between TR and TC

• Total utility is max when marginal utility (MU) is zero
• Total revenue is max when marginal revenue (MR) is zero
• Total cost is max when marginal cost (MC) is zero

In the same manner, total profit is max when marginal profit (M∏) is zero
As ∏ = TR-TC; then M∏ = MR - MC

Now at maximum∏, M∏ = 0

Thus MR - MC = 0 thus MR = MC

Question 29

What is a perfect competitive market?

Answer 29

Founded on the following assumptions:
- there are many buyers and sellers with perfect knowledge in the market
- sells are of homogenous product
- the demand curve in this market is perfectly elastic (horizontal)
- firms cannot raise their prices, as this would lead to a total loss in the demand for their product
- they do not lower prices as they will not be able to sell additional units and thus suffer losses
- forms are ‘price takers’, the price is set my the market

Question 30

Why is the supply curve the same as the marginal cost curve?

Answer 30

A supply curve tells us the quantity that will be produced at each price, and that is what the firm’s marginal cost curve tells us.

The firm’s supply curve in the short run is its marginal cost curve for prices above the average variable cost.

• at prices below average variable cost, the firm’s output drops to zero