Business objectives

Question 1

Explain the two ways in which profit maximisation can be looked at.

Answer 1

1) The point where total revenue and total cost are at the greatest difference apart; or price minus cost per unit multiplied by quantity is greatest.
2) The point where the revenue gained from selling one more unit, marginal revenue (MR) is exactly equal to the cost of producing one more unit (MC); MR = MC.

Question 2

What is revenue maximisation?

Answer 2

Revenue maximisation cuts its price to the point where the extra revenue received from selling another unit of the product is balanced by the reduced price on every item that it is already selling, i.e. MR = 0.

Question 3

In what circumstances would revenue maximisation be a reasonable aim? (3)

Answer 3

1) If a firm will have to dispose of all its stock, then effectively, the costs are not relevant. For example a flower seller.
2) Managers may be paid based on sales figures and will therefore aim to maximise revenue.
3) Firms which are about to be taken over may be valued on the basis of its revenue, therefore it would be logical for this firm to revenue maximise.

Question 4

What is sales maximisation?

Where does sales maximisation occur?

Answer 4

Sales maximisation is where a firm aims to sell as much as possible, subject to the constraint that it at least makes normal profit. This may be a short-run policy to eliminate competition with the intention of returning to profit maximisation in the long-run.
Sales maximisation occurs where AC=AR.

Question 5

Give two reasons why a firm may wish to sales maximise.

Answer 5

1) To avoid the attention of competition authorities who may investigate firms if they continuously make large amounts of profit.
2) Cutting prices and selling more prevents new firms from entering the market.

Question 6

What is satisficing?

Answer 6

Satisficing is the process of making enough profit to satisfy shareholders, after which managers can aim for other objectives.

Question 7

Give three reasons why a business may satisfice.

Answer 7

1) Firms may wish to keep their profits down so that they do not get taken over by other firms. For managers, the satisfaction of being in control of their own business is worth more than money.
2) Managers may gain greater satisfaction from pursuing other aims, than making more profit.
3) The manager of the business may wish to keep the business small in order to minimise risk.

Question 8

At what point will a profit maximising firm produce?

At what point will a revenue maximising firm produce?

At what point will a sales maximising firm produce.

Answer 8

The profit maximising firm will produce at the point where marginal cost is equal to marginal revenue, MC=MR.

The revenue maximising firm will produce at the point where marginal revenue is equal to zero, MR=0.

The sales maximising firm will produce at the point where AC=AR.

Question 9

What is total revenue?

How is it calculated?

Answer 9

Total revenue (TR) is the total amount of money received from the sale of any given level of output. It is calculated as the total quantity sold (Q) multiplied by the average price received (P). TR=QP.

Question 10

What is average revenue?

How is it calculated?

Answer 10

Average revenue is the amount of money received per unit sold.
It is calculated by the following formula:
(PxQ)/Q.

Question 11

What is marginal revenue?

How is it calculated?

Answer 11

Marginal revenue is the amount of money received per extra unit sold. Gradient of total revenue.
It is calculated by the following formula:
Change in PXQ/ Change in Q.

Question 12

What is a fixed cost?

Give examples.

Answer 12

A fixed cost also known as an indirect or overhead cost is a cost which does not vary directly with output. As levels of production change, the value of a fixed cost will not change.
Fixed costs include: capital goods, rent and rates, office staff and advertising and promotion.

Question 13

What is a variable cost?

Answer 13

A variable (direct or prime) cost is a cost, the value of which does change with changes in the level of production. As production increases, so does variable cost. The cost of raw materials is variable.

Question 14

What is a semi-variable cost?

Answer 14

Many costs are semi-variable costs. Labour is an example of a semi-variable cost, although a firm may employ permanent staff, they may ask these members of staff to do overtime. Equally some firms will be happy to hire and fire staff as levels of production change. In the short-run at least one factor of production is fixed in quantity. Therefore, in the short run, some costs are fixed costs whilst others will be variable. In the long run all factors of production can vary, so in the long run, all costs will be variable.

Question 15

Define total cost.
What are the two components of total cost?
What is the formula for total cost?

Answer 15

The total cost of production (TC) is the cost of producing a given level of output. Increased production will almost certainly lead to a rise in total costs. The total cost of production is made up of two components:
1) Total variable cost (TVC) which varies with output.
2) Total fixed cost (TFC) which remains constant whatever the level of output.
Total cost (TC) = Total variable cost (TVC) + Total fixed cost (TFC).

Question 16

Define average cost.
What are the two components of average cost?
What is the formula for average cost?

Answer 16

The average cost of production is the total cost divided by the level of output.
Average cost (AC) = Total cost (TC)/Quantity or level of output (Q)
OR
Average cost (AC) = Average variable cost (AVC) + Average fixed cost (AFC).
Average cost is made up of two components:
1) Average variable cost (AVC) is total variable cost divided by the level of output.
2) Average fixed cost (AFC) is total fixed cost divided by the level of output.

Question 17

Define marginal cost.

What is the formula for marginal cost?

Answer 17

Marginal cost is the cost of producing an extra unit of output. Marginal cost is calculated by dividing the change in total cost by the change in total output.
MC = Change in TC/Change in Q

Question 18

Name four types of economies of scale.

Answer 18

1) Technical economies
2) Managerial economies
3) Purchasing and marketing economies
4) Financial economies

Question 19

Explain managerial economies of scale.

Answer 19

Specialisation is an important source of greater efficiency. In a small firm, the owner may have to play many roles within the firm. Employing specialist staff is likely to lead to greater efficiency and therefore lower costs. The reason why small firms often don’t employ specialist staff is because they represent and indivisibility.

Question 20

Explain purchasing and marketing economies of scale.

Answer 20

The larger the firm, the more likely it is to be able to buy raw materials in bulk. Bulk buying often allows large firms to secure lower prices for their factors of production. Large firms are also able to enjoy lower average costs from their marketing operations. For example, a 30 second advert costs the same for a large firm selling 5million units of their product as it does for a small firm who sells 500 units of their product.

Question 21

Explain financial economies of scale.

Answer 21

Small firms find it difficult and expensive to raise finance for new investment. When loans are given, small firms are charged at relatively high rates of interest because banks know that small firms are far more at risk from bankruptcy than large firms. Large firms have a much greater choice of finance and it is likely to be much cheaper than for small firms.

Question 22

Name five types of diseconomies of scale.

Answer 22

1) Managerial
2) Geographical
3) X-inefficiency
4) Poor communication
5) Lack of engagement

Question 23

Explain managerial diseconomies of scale.

Answer 23

Diseconomies of scale arise mainly due to managerial problems. As a firm grows, it becomes increasingly difficult for management to keep control of the activities of the business. Controlling an organisation with hundreds of thousands of employees is very challenging, and there may come a point where management, no matter how well organised is unable to prevent average costs from rising.

Question 24

Explain geographical diseconomies of scale.

Answer 24

Geography may also be a cause of diseconomies of scale, if a firm is forced to transport its goods over long distances because the firm is very large, average costs may start to rise.

Question 25

Explain x-inefficiency as a cause of diseconomies of scale.

Answer 25

X-inefficiency, lack of competition for a large firm may lead to a rise in costs.

Question 26

Explain communication diseconomies of scale.

Answer 26

Poor communication can also lead to inefficiency in a large firm, which in turn would lead to rising costs.

Question 27

Explain lack of engagement as a cause of diseconomies of scale.

Answer 27

In a large firm the worker and manager may become very distant, which may lead to a lack of loyalty amongst the workers towards management. This may lead to a rise in absenteeism and a fall in productivity.

Question 28

What is the minimum efficient scale?

Answer 28

Productive efficiency is said to exist when production takes place at the lowest possible average cost. If the long run average cost curve is U-shaped, then this will occur at the bottom of the curve when constant returns to scale are said to exist. The output range over which average costs are at a minimum is said to be the optimum level of production. The output level at which lowest cost production starts is called the minimum efficient scale (MES) of production.

Question 29

What are external economies and diseconomies of scale?

Answer 29

Sometimes an industry as a whole may grow, as a result individual firms may benefit. Some firms benefit from good infrastructure in their location such as a strong road network or fast broadband speeds. In these situations, the firms themselves take no action but are the beneficiaries of external factors which may enable them to cut costs and produce more efficiently. It is also possible that as an industry grows, firms may experience external diseconomies of scale. For example, in terms of marketing, so many companies produce adverts and run marketing campaigns that it becomes very difficult for a single company to get themselves noticed.

Question 30

At what point does profit maximisation occur?

Answer 30

Profit maximisation occurs when the firm is unable to increase profits, whether by increasing or decreasing price or output. Marginal profit is the extra profit gained from producing one extra unit. As long as a firm can make additional profit by producing an extra unit of output, it will carry on expanding production. However, it will cease extra production when the extra unit yields a loss, the point at which marginal profit moves from positive to negative. Economic theory predicts that profits will be maximised at the output level where marginal cost equals marginal revenue.

Question 31

What is normal profit?

At what point does normal profit occur?

Answer 31

Normal profit is the minimum amount of profit required to keep the factors of production in their current use.

It occurs at the point where average cost (AC) is equal to average revenue (AR) or the point where total cost (TC) is equal to is equal to total revenue (TR).

Question 32

What is supernormal profit?

How is super normal profit shown on a diagram?

Answer 32

Supernormal profit is any profit generated above normal profit.
Supernormal profit is the difference between TC and TR or the difference between AC and AR.

Question 33

When do losses occur?

Answer 33

Losses occur when a firm’s total costs exceed total revenues, TC>TR, or the average cost is greater than the average revenue.

Question 34

At what point do firms shut down because they are making a loss?

Answer 34

If a firm is covering its average variable costs then it will stay in business, the point where P=AVC. At any point below that, the firm will shut down. Firms will only shut down when total revenue fails cover total variable costs.