Chapter 4

Question 1

Define fixed factors and variable factors.

Answer 1

Fixed factors: an input that cannot be increased within a given time period (e.g., buildings).
Variable factors: an input that can be increased in supply within a given time period (e.g., labour).

Question 2

Define the short run and the long run.

Answer 2

The short run: a time period during which at least one factor of production is fixed. Output can be increased only by using more variable factors.
The long run: a time period long enough for all new inputs to be varied. Given long enough, a firm can build a second factory, install new machines, etc. The actual length of time will vary from firm to firm.

Question 3

Explain the law of diminishing returns in relation to production in the short term.

Answer 3

Production in the short run is subject to the law of diminishing returns. When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.

Question 4

Explain the relationship between cost and output.

Answer 4

The more a firm produces, the more factors it must use and the greater its costs will be. This relationship is based on two elements:
1. the productivity of the factors: the greater their productivity, the smaller will be the number of them that is needed to produce a given level of output, and hence the lower the cost of that output.
2. the price of the factors: the higher their price, the higher will be the costs of production.

Question 5

Define fixed costs and variable costs.

Answer 5

Fixed costs: do not vary with output (i.e., stay the same regardless of if a firm produces a lot or a little).
Variable factors: vary with output. E.g., The more that is produced, the more raw materials are used and therefore the higher their total cost. Total cost = total fixed cost + total variable cost.

Question 6

Define average costs.

Answer 6

Average total cost is cost per unit of production = total cost/unit
Average cost can be broken down further = total fixed cost/unit + average variable cost/unit.
Marginal cost is the extra cost of producing one more unit: that is, the rise in total cost per one unit rise in output. Triangle sign means “a rise in”. ∆total cost/∆unit

Question 7

Explain marginal cost curve.

Answer 7

Relates to the law of diminishing returns. Initially, extra units of output cost less than previous units. MC falls. Beyond a certain level of output, diminishing returns set in.
Thereafter, MC rises. Additional units of output cost more and more to produce because they require ever increasing amounts of the variable factor.

Question 8

Explain average fixed cost curve.

Answer 8

This falls continuously as output rises, since total fixed costs are being spread over a greater and greater output.

Question 9

Explain average (total) cost curve.

Answer 9

The shape of the AC curve depends on the shape of the MC curve. As long as new units of output cost less than the average, their production must pull the average cost down. That is, if MC is less than AC, AC must be falling. Likewise, if new units cost more than the average, their production must drive the average up.
That is, if MC is greater than AC, AC must be rising. Therefore, the MC curve crosses the AC curve at its minimum point.

Question 10

Explain average variable cost curve.

Answer 10

Since AVC = AC - AFC, the AVC curve is simply the vertical difference between the AC and the AFC curves. Note that, as AFC gets less, the gap between AVC and AC narrows. Since all marginal costs are variable (by definition, there are no marginal fixed costs), the same relationship holds between MC and AVC as it did between MC and AC. That is, if MC is less than AVC, AVC must be falling, and if MC is greater than AVC, AVC must be rising. Therefore, as with the AC curve, the MC curve crosses the AVC curve at its minimum point.

Question 11

List three universal rules about averages and marginals.

Answer 11

1. If the marginal equals the average, the average will not change.
2. If the marginal is above the average, the average will rise.
3. If the marginal is below the average, the average will fall.

Question 12

Define and explain three economies of scale.

Answer 12

Economics of scale = when increasing the scale of production leads to a lower cost per unit of output.
1. Constant returns to scale. This is where a given percentage increase in inputs will lead to the same percentage increase in output.
2. Increasing returns to scale. This is where a given percentage increase in inputs will lead to a larger percentage increase in output.
3. Decreasing returns to scale. This is where a given percentage increase in inputs will lead to a smaller percentage increase in output.
The words ‘to scale’ mean that all inputs increase by the same proportion. Decreasing returns to scale are therefore quite different from diminishing marginal returns (where only the variable factor increases).

Question 13

List 6 reasons why firms are likely to experience economies of scale (plant economics of scale).

Answer 13

Plant economies of scale are due to the large size of an individual factory, workplace or machine.
1. Specialisation and division of labour. In large-scale plants workers can do more simple, repetitive jobs. With this specialisation and division of labour less training is needed; workers can become highly efficient in their particular job, especially with long production runs; less time is lost by workers switching from one operation to another; and supervision is easier.
2. Indivisibilities. Some inputs are of a minimum size: they are indivisible. E.g., machinery. Take the case of a combine harvester. A small-scale farmer could not make full use of one. They only become economical to use on farms above a certain size. The problem of indivisibilities is made worse when different machines, each of which is part of the production process, are of a different size.
3. The ‘container principle’. Any capital equipment that contains things (e.g. blast furnaces, oil tankers, pipes, vats) tends to cost less per unit of output the larger its size. The reason has to do with the relationship between a container’s volume and its surface area. Its output depends largely on its volume. Large containers have a bigger volume relative to surface area than small containers.
4. Greater efficiency of large machines. Large machines may be more efficient in the sense that more output can be gained for a given amount of inputs.
5. By-products. With production on a large scale, there may be sufficient waste products to enable a by-product to be made.
6. Multi-stage production. A large factory may be able to take a product through several stages in its manufacture. This saves time and cost incurred moving the semi-finished product from one firm or factory to another.

Question 14

List 3 economies of scale associated with a firm being large (e.g., having many factories, offices or shops).

Answer 14

1. Organisational economies. In a large firm, individual plants can specialise in particular functions. There can also be centralised administration of the firm.
2. Spreading overheads. Some expenditures are only economic when the firm is large, such as research and development. This is another example of indivisibilities, only this time at the level of the firm rather than the plant. The greater the firm’s output, the more these overhead costs are spread.
3. Financial economies. Large firms may be able to obtain finance at lower interest rates than small firms. They may be able to obtain certain inputs more cheaply by buying in bulk.

Question 15

Define economies of scope.

Answer 15

Often a firm is large because it produces a range of products. This can result in each individual product being produced more cheaply than if it was produced in a single-product firm. The reasons for these economies of scope are that the various overhead costs and financial and organisational economies can be shared among the products.

Question 16

Define diseconomies of scale and list 4 reasons why these occur.

Answer 16

When firms get beyond a certain size, costs per unit of output may start to increase.
1. Management problems of coordination may increase as the firm becomes larger.
2. Workers may feel ‘alienated’ if their jobs are boring and repetitive, and if they feel an insignificantly small part of a large organisation. Poor motivation may lead to shoddy work.
3. Industrial relations may deteriorate as a result of these factors and also as a result of the more complex inter-relationships between different categories of worker.
4. Production-line processes and the complex interdependencies of mass production can lead to great disruption if there are hold-ups in any one part of the firm.

Question 17

Define external economies of scale.

Answer 17

Where a firm’s costs per unit of output decrease as the size of the whole industry grows.
As an industry grows, this can lead to external economies of scale for its member firms. This is where a firm, whatever its own individual size, benefits from the whole industry being large.
The member firms of a particular industry might, however, experience external diseconomies of scale. For example, as an industry grows larger, this may create a growing shortage of specific raw materials or skilled labour. This will push up their prices and hence the firms’ costs.

Question 18

Explain long-run average cost.

Answer 18

Since there are no fixed factors in the long run, there are no long-run fixed costs. All costs, then, in the long run are variable costs.
Long-run average cost curves: These can take various shapes, but a typical one is saucer shape. It is often assumed that, as a firm expands, it will initially experience economies of scale and thus face a downward-sloping LRAC curve. After a point, however, all such economies will have been achieved and the curve will flatten out. Then, possibly after a period of constant LRAC, the firm will become so large that it will start to experience diseconomies of scale and thus a rising LRAC. At this stage, production and financial economies begin to be offset by the managerial problems of running a giant organisation. The effect of this is to give a saucer-shaped curve.

Question 19

What are 3 assumptions behind the long-run average cost curve?

Answer 19

1. Factor prices are given. If factor prices change, both short-run and long-run cost curves will shift. Thus, an increase in energy prices would shift the curves upward. However, factor prices might be different at different levels of output. For example, one of the economies of scale that many firms enjoy is the ability to obtain bulk discounts on raw materials and other supplies. In such cases the curve does not shift.
2. The state of technology and factor quality are given. These are assumed to change only in the very long run. If a firm gains economies of scale, it is because it has been able to exploit existing technologies and make better use of the existing availability factors of production.
3. Firms choose the least-cost combination of factors for each output. The assumption here is that firms operate efficiently: that they choose the cheapest possible way producing any level of output. If the firm did not operate efficiently, it would be producing at a point above the LRAC curve.

Question 20

Define an envelope curve.

Answer 20

From the succession of short-run average cost curves we can construct a long-run average cost curve. This is known as an envelope curve because it envelops the short-run curves.

Question 21

Define 4 different time periods for decision making.

Answer 21

1. Very short run (immediate run). All factors are fixed. Output is fixed. The supply curve is vertical. On a day-to-day basis a firm may not be able to vary output at all.
2. Short run. At least one factor is fixed in supply. More can be produced, but the firm will come up against the law of diminishing returns as it tries to do so.
3. Long run. All factors are variable. The firm may experience constant, increasing or decreasing returns to scale. But although all factors can be increased or decreased, they are of a fixed quality.
4. Very long run. All factors are variable, and their quality and hence productivity can change. Improvements in factor quality will reduce costs and thus shift the short-run and long-run cost curves downwards.
   Just how long the ‘very long run’ is will vary from firm to firm. It will depend on how long it takes to develop new techniques, new skills or new work practices. It is important to realise that decisions for all four time periods can be made at the same time. They can make both short-run and long-run decisions today.

Question 22

Which of the four time periods does economics focus on most?

Answer 22

Short run and long run. There is very little the firm can do in the very short run. And in the very long run, the firm will not be in the position to make precise calculations on how to increase productivity.

Question 23

Define total revenue.

Answer 23

Total revenue is the firm’s total earnings per period (P) of time from the sale of a particular amount of output (Q). TR = P x Q

Question 24

Define average revenue.

Answer 24

Average revenue is the amount that the firm earns per unit sold. TR (amount earned) / Q (x amount of units).

Question 25

Define marginal revenue.

Answer 25

Marginal revenue is the extra total revenue gained by selling one more unit (per time period). ∆TR/∆Q
This relationship will depend on the market conditions under which a firm operates. A firm that is too small to be able to affect market prices will have different looking revenue curves from a firm that is able to choose the price it charges.

Question 26

What happens to the revenue curve when price is not affected by the firm’s output?

Answer 26

1. Average revenue: If a firm is very small relative to the whole market, it is likely to be a price taker. But, being so small, it can sell as much as it is capable of producing at that price. It thus faces a horizontal demand ‘curve’ at this price (average revenue is constant). The firm’s average revenue curve must therefore lie along exactly the same line as its demand curve.
2. Marginal revenue: In the case of a horizontal demand curve, the marginal revenue curve will be the same as the average revenue curve, since selling one more unit at a constant price (AR) merely adds that amount to total revenue.
3. Total revenue: As price is constant, total revenue will increase at a constant rate as more is sold. The total revenue “curve” will be a straight line through the origin.

Question 27

What happens to the revenue curve when price varies with output?

Answer 27

If a firm has a relatively large share of the market, it will face a downward-sloping demand curve. This means that, if it is to sell more, it must lower the price. But it could also choose to raise its price. If it does so, however, it will have to accept a fall in sales.
1. Average revenue. Remember that average revenue equals price. If, therefore, the price has to be reduced to sell more output, average revenue will fall as output increases. Note that, as in the case of a price-taking firm, the demand curve and the AR curve lie along exactly the same line. The reason for this is simple: AR = P, and thus the curve relating price to quantity (the demand curve) must be the same as that relating average revenue to quantity (the AR curve).
2. Marginal revenue. When a firm faces a downward-sloping demand curve, marginal revenue will be less than average revenue and may even be negative. But why? If a firm is to sell more per time period, it must lower its price (assuming it does not advertise). This means lowering the price not just for the extra units it hopes to sell but also for those units it would have sold had it not lowered the price. Thus, the marginal revenue is the price at which it sells the last unit minus the loss in revenue it has incurred by reducing the price on those units it could otherwise have sold at the higher price. If demand is price elastic, a decrease in price will lead to a proportionately larger increase in the quantity demanded and hence an increase in revenue. Marginal revenue will thus be positive. If, however, demand is inelastic, a decrease in price will lead to a proportionately smaller increase in sales. In this case, the price reduction will more than offset the increase in sales and as a result revenue will fall. Marginal revenue will be negative. If, then, marginal revenue is a positive figure (i.e. if sales per time period are four units or less in Figure 4.5) the demand curve will be elastic at that quantity, since a rise in quantity sold (as a result of a reduction in price) would lead to a rise in total revenue. If, on the other hand, marginal revenue is negative (i.e. at a level of sales of five or more units in Figure 4.5) the demand curve will be inelastic at that quantity, since a rise in quantity sold would lead to a fall in total revenue. Thus, the demand (AR) curve is elastic to the left of point r and inelastic to the right.
3. Total revenue. Total revenue equals price times quantity. The TR line is a curve that rises at first and then falls. But why? As long as marginal revenue is positive (and hence demand is price elastic), a rise in output will raise total revenue. However, once marginal revenue becomes negative (and hence demand is inelastic) total revenue will fall. The peak of the TR curve will be where MR = 0. At this point, the price elasticity of demand is equal to (-)1.

Question 28

What happens when there is a shift in revenue curves?

Answer 28

A change in price will cause a movement along a demand curve. It is similar with revenue curves, except that here the causal connection is in the other direction. Here we ask what happens to revenue when there is a change in the firm’s output? Again, the effect is shown by a movement along the curves.
A change in any other determinant of demand, such as tastes, income or the price other goods, will shift the demand curve. By affecting the price at which each level output can be sold, there will be a shift in all three revenue curves. An increase in revenue is shown by a vertical shift upward, a decrease by a shift downward.

Question 29

How do you use marginal curves to arrive at the profit-maximising output?

Answer 29

Profit-maximising rule: if profits are to be maximised, MR must equal MC. But why are profits maximised when MR = MC? The simplest way of answering this is to see what the position would be if MR did not equal MC. Referring to Figure 4.7, at a level of output below 3, MR exceeds MC. This means that by producing more units there will be a bigger addition to revenue (MR) than to cost (MC). Total profit will increase. As long as MR exceeds MC, profit can be increased by increasing production. At a level of output above 3, MC exceeds MR. All levels of output above 3 thus add more to cost than to revenue and hence reduce profit. As long as MC exceeds MR, profit can be increased by cutting back on production.
Profits are thus maximised where MC = MR: at an output of 3.

Question 30

How do you use average curves to measure the size of the profit?

Answer 30

Once the profit-maximising output has been discovered, we can use the average curves to measure the amount of profit at the maximum. First, average profit (AT) is found. This is simply AR - AC. Total profit is obtained by multiplying average profit by output.

Question 31

Long-run profit maximisation

Answer 31

Assuming that the AR and MR curves are the same in the long run as in the short run long-run profits will be maximised at the output where MR equals the long-run MC. The reasoning is the same as with the short-run case.

Question 32

Elaborate on the meaning of profit and “normal profit”.

Answer 32

One element of cost is the opportunity cost to the owners of the firm incurred by being in business. This is the minimum return that the owners must make on their capital to prevent them from eventually deciding to close down and perhaps move into some alternative business. This opportunity cost to the owners is sometimes known as normal profit and is included in the cost curves.

Question 33

What determines the normal rate of profit? What is supernormal profit?

Answer 33

It has two components. First, someone setting up in business invests capital in it. There is thus an opportunity cost. This is the interest that could have been earned by lending the capital in some riskless form (e.g., by putting it in a savings account in a bank). Nobody would set up a business unless they expected to earn at least this rate of profit. Running a business is far from riskless, however, and hence a second element is a return to compensate for risk. Thus:
Normal profit (%) = rate of interest on a riskless loan + a risk premium.
The risk premium varies according to the line of business. Thus, supernormal profit is the excess of total profit above normal profit.

Question 34

Define loss-minimising.

Answer 34

Sometimes there is no output at which the firm can make a profit. Such a situation is illustrated in Figure 4.9: the AC curve is above the AR curve at all levels of output. In this case, the output where MR = MC will be the loss minimising output. The amount of loss at the point where MR = MC is shown by the shaded area.

Question 35

How to determine whether to produce at all in the short run and the long run?

Answer 35

The short run: Fixed costs have to be paid even if the firm is producing nothing at all. Provided, therefore, that the firm is more than covering its variable costs, it can go some way to paying off these fixed costs and will therefore continue to produce. It will shut down if it cannot cover its variable costs: that is, if the AVC curve is above, or the AR curve is below. This situation is known as the short-run shut-down point.
The long run: All costs are variable in the long run. If, therefore, the firm cannot cover its long-run average costs (which include normal profit), it will close down. The long-run shut-down point will be where the AR curve is tangential to (i.e. just touches) the LRAC curve.

Question 36

List 4 points that explain “irrational” producer choices.

Answer 36

1. Rules of thumb. Firms operate in very complex environments, with uncertainty about the present and the future. In order to make even an informed guess of marginal revenue, they must have some idea of how responsive demand will be to a change in price. But how are they to estimate this price elasticity? Market research can be unrealiable, and firms operate in changing environments where cost and revenue curves shift. If a firm chooses a price and output that maximises profits this year, it may as a result jeopardise profits in the future. Therefore, managers may resort to using rules of thumb or other shortcuts when making decisions. One approach is average cost or mark-up pricing. Here producers work out the price by simply adding a certain percentage (mark-up) for profit on top of average costs (average fixed costs plus average variable costs).
2. Alternative aims. in public limited companies the shareholders are the owners and presumably will want the firm to maximise profits so as to increase their dividends and the value of their shares. Shareholders elect directors. Directors in turn employ liability is limited to the professional managers who are often given considerable discretion in making decisions. What are the objectives of managers? Will they want to maximise profits, or will they have some other aim? Managers will still have to ensure that sufficient profits are made to keep shareholders happy, but that may be very different from maximising profits. Alternative theories of the firm to those of profit maximisation, therefore, tend to assume that large firms are profit satisficers. That is, managers strive hard for a minimum target level of profit, but are less interested in profits above this level. Perhaps the most well-known alternative theory of the firm is that of sales revenue maximisation. It may be that the success of managers, and in particular sales managers, is judged according to the level of the firm’s sales. Managers’ salaries, power and prestige may depend directly on sales revenue. The firm’s sales representatives may be paid commission on their sales. In the case of a sales revenue maximiser, rather than obeying the ‘MR = MC rule’ of profit maximisation, the firm will continue to expand output until producing more units ceases to increase revenue. In other words, it will produce output until the marginal revenue from the last unit is zero, i.e. MR = 0. An important consequence of this is that a sales revenue. maximiser will produce a greater level of output than a profit maximiser. This is because it will continue to increase output so long as this increases total revenue even when additional units increase costs by more than they increase revenue.
3. Asymmetric information and the principal-agent problem. Firms employ people with specialist knowledge and skills to carry out specific tasks. They can be seen as ‘agents’ of their employer. This can give rise to what in economics is known as the principal-agent problem whereby it becomes difficult for employers to ensure that the ‘agents’ are acting in their best interests.
4. Attitudes to risk. Trying to maximise any objective can be risky. Concern with survival, therefore, may make firms cautious. Some firms are likely to be adventurous and prepared to take risks. Adventurous firms are most likely to be those dominated by a powerful and ambitious individual–an individual who is risk-loving and therefore prepared to take gambles.