Costs, Revenue, Profit and Market Structures

Question 1

Define normal profit

Answer 1

Normal profit is the amount of profit that the firm could have made if the resources used in production were used to make the next best available option.

Question 2

Define opportunity cost

Answer 2

Opportunity cost is the next best available option forgone when an economic decision is made.

Question 3

Define supernormal profit with words and in a formula

Answer 3

Supernormal profit is the profit over and above normal profit.
Supernormal profit= Total revenue – Total costs

Question 4

What is the profit maximising condition

Answer 4

Marginal costs = Marginal revenue

Question 5

What is meant by an economic loss

Answer 5

A loss is where total costs are higher than total revenue.

Question 6

What is the short-run shut down position

Answer 6

The short run shutdown position is where a firm is not able to cover their total variable costs with their revenue, or in other words, where the price or average revenue does not cover their average variable costs.

Question 7

What is the long-run shut down position

Answer 7

In the long-run, a firm will shut down if they are not able to cover all of their costs.

Question 8

Explain the role of profit in an economy

Answer 8

Profit acts as an incentive for risk taking amongst firms, and as a signal for firms to enter or leave a market

Question 9

Name 4 characteristics of a perfectly competitive market

Answer 9

i. Homogenous goods
ii. Perfect knowledge amongst consumers and producers
iii. Low/no barriers to entry or exit
iv. Large number of buyers and sellers

Question 10

Give two examples of markets that are competitive

Answer 10

i. Foreign currency

ii. Commodities

Question 11

What other assumptions do we make about firms in competitive markets

Answer 11

Assume that there are no economies of scale and no externalities

Question 12

Give two reasons why perfect competition is thought to be the most desirable market structure?

Answer 12

In perfect competition the consumer is sovereign, so they have perfect choice and low prices. Firms in perfect competition are efficient as they are competing against many other firms all selling identical products.

Question 13

Explain two reasons why the assumptions behind the model of perfect competition are unrealistic

Answer 13

This is because there is no such thing as perfect knowledge, economies of scale might exist to some extent, and externalities will also exist to some extent. There will therefore be some barriers to entry albeit that they may be small.

Question 14

In what circumstances might perfect competition NOT be desirable?

Answer 14

In markets where Research and Development are important e.g. in technology or pharmaceutical industries, the fact that only normal profits are made will be an issue as there will be no funds available for investment. This makes dynamic efficiency impossible. In addition, in markets where economies of scale are so great that no one firm can fully exploit them it will be more efficient for there to be only one firm rather than many small firms (e.g. in the case of natural monopoly)

Question 15

Define monopolistic competition

Answer 15

Monopolistic competition is a market close to perfect competition, but where products are slightly differentiated.

Question 16

Name 4 assumptions associated with this market structure

Answer 16

i. Differentiated products
ii. Large number of buyers and sellers
iii. Near perfect information amongst buyers and sellers
iv. Low barriers to entry

Question 17

Can firms in a monopolistic market structure make supernormal profits in a) the long run, and b) the short run?

Answer 17

Firms can make supernormal profits in the short run, but not in the long run in monopolistic competition as firms will enter the market, (due to low entry barriers) and compete away all the profits.

Question 18

Are firms in Monopolistic Competition productively and allocatively efficient in the short and long run?

Answer 18

Firms in monopolistic competition are neither productively nor allocatively efficient in the short or run.

Question 19

Define short run

Answer 19

The short run is the time period when at least one factor of production is fixed.

Question 20

Define long run

Answer 20

The long run is the time period when all factors of production become variable.

Question 21

Define total product

Answer 21

Total product is the total output of a firm at a particular level of resource employment.

Question 22

Define average product

Answer 22

Average Product is the output per unit of variable input.

Question 23

How do you calculate average product

Answer 23

If labour is the variable factor, then average product is TP/L where TP is total product, and L is the amount of labour employed.

Question 24

Define marginal product

Answer 24

Marginal Product is the additional output from one extra unit of input.

Question 25

How do you calculate marginal product

Answer 25

Change in TP/change in variable input.

Question 26

What is the law of diminishing returns

Answer 26

The law of diminishing returns states that as you add more of a variable factor of production to a fixed factor of production, at first the marginal product increases but eventually starts to fall. Diminishing marginal returns is said to take place when marginal product starts to fall.

Question 27

Explain the shape of the curves with reference to the law of diminishing returns

Answer 27

Marginal product rises at first, but then starts to fall as consecutive units of a variable factor add less and less to total product. As the marginal product starts to fall this then brings down the average product. Diminishing Marginal Returns takes place when Marginal Product falls, and Diminishing Average Returns takes place when Average Product falls.

Question 28

Define constant returns to scale

Answer 28

Constant returns to scale are a long run phenomenon whereby as the amount of resources employed doubles, output doubles.

Question 29

Define increasing returns to scale

Answer 29

Increasing returns to scale are a long run phenomenon whereby as the amount of resources employed doubles, output more than doubles.

Question 30

Define decreasing returns to scale

Answer 30

Decreasing returns to scale are a long run phenomenon whereby as the amount of resources employed doubles, output less than doubles.

Question 31

How do productivity and factor prices affect firms’ costs of production and the choice of factor inputs?

Answer 31

As productivity rises (output per unit of input), then a firms’ average costs of production falls as each factor input is contributing more to total output. Investing in capital can increase the productivity of labour, depending on the ratio of capital to labour employed. Factor prices such as wages, or capital prices affect the cost of production – the higher the factor prices, the higher will be the costs of production. If one factor price rises in relation to another it might change the choice of factor inputs away from this factor e.g. if wages rise, then firms may prefer to employ more capital and less labour.

Question 32

Define fixed costs

Answer 32

Fixed costs are costs that do not change with output such as rent, interest payments and marketing.

Question 33

Define variable costs

Answer 33

Variable costs are costs that do change with output such as raw materials and wages.

Question 34

Write a formula showing how you calculate total costs

Answer 34

Total costs = Total Fixed Costs + Total Variable Costs.

Question 35

How would you calculate average total costs?

Answer 35

ATC = TC/Q.

Question 36

How would you calculate marginal costs?

Answer 36

MC = change in total costs/change in output.

Question 37

How does the law of Diminishing Returns affect the shape of the Marginal and Average costs curves?

Answer 37

When diminishing returns sets in, (when MP starts to fall), Marginal Cost starts to rise, and when AP starts to fall, ATC starts to rise. These curves are a mirror image of one another.

Question 38

Define economies of scale

Answer 38

Economies of scale are when the Long Run Average Total Cost falls as output increases.

Question 39

What is meant by internal economies of scale?

Answer 39

Internal economies of scale are when long run average total costs fall as the output of the firm increases.

Question 40

What is meant by external economies of scale?

Answer 40

External economies of scale are when long run average total costs fall as output of the industry increases.

Question 41

What is meant by the minimum efficient scale?

Answer 41

Minimum efficient scale is the lowest output at which long run average total costs are minimised.

Question 42

What are the implications of the minimum efficient scale for the size of a business?

Answer 42

If the minimum efficient scale is achieved at a very high level of output this suggests that this industry might favour large firms. If the minimum efficient scale is achieved at low levels of output, then there is less scope for economies of scale, so this industry favours smaller firms.

Question 43

What are the implications of the Minimum Efficient Scale for the size of barriers to entry?

Answer 43

If the minimum efficient scale is achieved at a high level of output, then there is scope for large economies of scale, therefore barriers to entry will be high as new firms would have to enter the market at a high level of output in order to compete on price with the incumbent firms.

Question 44

Name and briefly describe 6 different types of internal economies of scale

Answer 44

Purchasing/commercial/bulk buying economies of scale – lower cost per unit to purchase raw materials when buying in bulk.
Technical economies of scale – the fixed cost of machinery can be spread over a larger output when producing on a larger scale.
Managerial economies of scale – when specialist managers can be more efficient than workers with more general skills. Specialist managers can only be possible when producing large volumes.
Marketing economies of scale – when the fixed costs of marketing can be spread over a larger output, and where bulk buying can take place on marketing space such as billboards.
Financial economies of scale – when larger firms are lower risk to lend to, and hence attract a lower interest rate on loans.
Risk bearing economies of scale – when the cost of one part of the business failing can be spread across a larger output.

Question 45

What economies of scale might exist in the car industry?

Answer 45

Industries such as manufacturing use machinery to a large extent, hence technical economies of scale will be important. Similarly, they also use raw materials, so bulk buying will be important. They also use labour, so managerial economies might also be important.

Question 46

Briefly describe 3 diseconomies of scale

Answer 46

• Communications issues arise as a firm gets too large meaning that messages can get distorted as they pass through multiple layers of management and even different languages.
• Co-ordination issues arise as a firm gets too large meaning that the logistics of getting the right components in the right places at the right time start to become complicated and more difficult especially if a firm is a multinational.
• Motivation issues arise as a firm gets too large meaning that individuals feel that they are only a small part of a large organisation so that they do not really understand what they contribute and therefore do not see the benefit of working especially hard.

Question 47

Briefly describe 3 external economies of scale

Answer 47

• Economies of infrastructure mean that the larger the industry the more cost effective it is to build infrastructure such as airports or railways and the lower the average cost of production for the firms in this industry.
• Research and education infrastructure means that the larger the industry the more courses that will be set up to train workers for that industry, and the more productive new workers will be. The more productive staff are, the lower the average costs of production will be.
• The larger the industry, the more available staff with expertise will be. Staff with greater expertise are more productive, which lowers the average costs of production.

Question 48

Define total revenue

Answer 48

Total revenue is the total receipts from selling goods and services.

Question 49

Define average revenue

Answer 49

The revenue per unit of output.

Question 50

How do you calculate average revenue?

Answer 50

TR/Q.

Question 51

Define marginal revenue

Answer 51

The extra revenue from selling an extra unit of output.

Question 52

How do you calculate marginal revenue

Answer 52

The change in total revenue/the change in output.

Question 53

Explain why the average revenue and marginal revenue curves are this shape under perfect competition

Answer 53

AR and MR are horizontal as firms in perfect competition are price takers which means that the price is set by the market, and one individual firm is too small to affect the price. This means that firms do not need to reduce price in order to sell more and so average and marginal revenue are constant as each extra unit is sold at the same price.

Question 54

How does revenue affect decision-making by firms?

Answer 54

Revenue is part of profit, so as firms are profit maximisers revenue will affect profit.

Question 55

Explain the shape of the AR and MR curves under imperfect competition

Answer 55

This is because firms are price makers, so to sell more of their product they have to reduce the price.