Chapter 11: Costs, economies of scale, revenue and profit

Question 1

Define firm

Answer 1

An organization that produces output (a good or service)

Question 2

Describe firms

Answer 2

They range from sole traders to large companies and vary in size from local concerns to large multinational corporations operating in global markets

Question 3

Define short run

Answer 3

The period in which at least one factor of production is fixed in supply

Question 4

Define long run

Answer 4

The period over which the firm is able to vary the inputs of all its factors of production

Question 5

Define law of diminishing returns

Answer 5

A law stating that if a firm increases its inputs of one factor of production while holding inputs of the other factors fixed, eventually the firm will get diminishing marginal returns from the variable factor

Question 6

Define marginal physical product of labor

Answer 6

The additional quantity of output produced by an additional unit of labor input

Question 7

Define total cost

Answer 7

The sum of all costs that are incurred in producing a given level of output (including opportunity cost)

Question 8

Define average cost

Answer 8

Total cost divided by the quantity produced sometimes known as unit cost

Question 9

Define marginal cost

Answer 9

The cost of producing an additional unit of output

Question 10

Define fixed costs

Answer 10

Costs that do not vary with the level of output

Question 11

Define variable costs

Answer 11

Costs that do vary with the level of output

Question 12

Define sunk costs

Answer 12

Costs incurred by a firm that cannot be recovered if the firm ceases trading

Question 13

Define economies of scale

Answer 13

Occur for a firm when an increase in the scale of production leads to production at a lower long-run average cost

Question 14

Define internal economies of scale

Answer 14

Economies of scale that arise form the expansion of a firm

Question 15

Define external economies of scale

Answer 15

Economies of scale that arise from the expansion of the industry in which a firm is operating

Question 16

Define diseconomies of scale

Answer 16

Occur for a firm when an increase in the scale of production leads to higher long-run average costs

Question 17

Define the minimum efficient scale

Answer 17

The level of output at which long-run average cost stops falling as output increases

Question 18

Define total revenue

Answer 18

The revenue received by a firm from its sales of a good or service - it is the quantity sold, multiplied by the price

Question 19

Define average revenue

Answer 19

The average revenue received by the firm per unit of output - it is total revenue divided by the quantity sold

Question 20

Define marginal revenue

Answer 20

The additional revenue received by the firm if it sells an additional unit of output

Question 21

Define normal profit

Answer 21

The return needed for a firm to stay in a market in the long run

Question 22

Define supernormal profit

Answer 22

Profit above normal profits - also known as abnormal or economic profit

Question 23

Define accounting profit

Answer 23

Profit made by a business based on explicit costs incurred but excluding opportunity cost

Question 24

Define shut-down price

Answer 24

The price below which a firm will choose to exit the market because it is not able to cover its fixed costs

Question 25

Apply the concept of the margin to societal decisions (4)

Answer 25

1. A firm will only take on an extra worker if the benefit of employing them is greater than or equal to the wage paid
2. When externalities are present - say a factory produces goods, but in so doing creates atmospheric pollution
3. It should produce where MSB = MSC
4. Beyond this point the MSC > MSB so the production of extra units would make society worse off

Question 26

Name 5 assumptions of marginal utility theory

Answer 26

1. Consumers are rational
2. Utility can be described in cardinal terms
3. Constant prices and incomes
4. Goods can be split up into small units
5. Marginal utility and diminishing marginal returns

Question 27

Name 6 limitations of marginal utility theory

Answer 27

1. Difficulty evaluating utility
2. Consumers don’t have time to work out marginal utility/price
3. Consumers are not always rational
4. Numerous goods
5. Many goods are related
6. Often goods can’t be split into small portions

Question 28

Why is the average revenue curve also the demand curve?

Answer 28

Because it shows the relationship between average price and quantity sold

Question 29

Explain the relationship between revenue and price elasticity (5)

Answer 29

1. When the price received by a firm is constant, the AR and MR curves are identical and horizontal. This means that PED = infinity (perfectly elastic)
2. Usually as price falls, sales increase and AR is downwards sloping
3. Top half of AR curve is price elastic and bottom half is price inelastic
4. Total revenue increases as quantity demanded increases over the top half of AR curve. Total revenue will fall as quantity demanded increases over the bottom half of the AR curve
5. The slope of the MR curve is twice as steep as the AR curve

Question 30

Draw a diagram illustrating costs in the long run

Answer 30

Check diagram sheet

Question 31

Analyze the costs in the long run diagram (4)

Answer 31

1. If a firm wants to increase its output from q1 to q2 with a fixed factor of production, it would remain on SRAC with an average cost of B
2. In the long run it can increase its fixed factor of production to produce more
3. This will move the firm onto a new SRAC curve, SRAC2 where the average cost of q2 is C
4. LRAC is an envelope of all the associated SRAC curves as the LRAC is either equal or less than the relevant SRAC

Question 32

When are internal economies of scale experienced?

Answer 32

When the firm expands to move onto a new lower SRAC curve

Question 33

When are constant returns to scale experienced?

Answer 33

When the firm expands it moves onto a SRAC at the same level

Question 34

When are internal diseconomies of scale experienced?

Answer 34

When the firm expands it moves onto a higher SRAC curve

Question 35

Name 6 types of internal economies of scale

Answer 35

1. Purchasing
2. Managerial
3. Marketing
4. Financial
5. Technical
6. Risk-bearing

Question 36

Name 4 types of technical economies of scale

Answer 36

1. Specialisation
2. Indivisibilities
3. Overhead
4. Volume (increased dimensions)

Question 37

Name 3 reasons why diseconomies of scale may occur

Answer 37

1. Poor communication and coordination
2. Low morale - employees may feel alienated as the company grows so they may be less productive
3. A lack of control

Question 38

Draw a diagram illustrating external economies of scale

Answer 38

Diagram sheet

Question 39

Draw a diagram illustrating the minimum efficient scale

Answer 39

Diagram sheet