Costs, revenues and profits

Question 1

How do you define short run and long run?

Answer 1

• Short run – the time period when at least one input factor of production is fixed. For instance, in the short run, a cafe may be able to hire more workers, but it cannot increase its building size
• Long Run – the time period in which all inputs are variable

Question 2

Define total product, average and marginal product

Answer 2

Total Product – the total quantity of good produced; the total output

Average Product – the output produced per unit of input
AP = TP/no. of variable inputs

Marginal Product – the extra output produced per additional unit of variable input
MP = change in total product / change in variable input

Question 3

describe what happens when you add more units of varibale input

Answer 3

Stage 1
- At first, adding more units of labour increases output because workers can specialise and be more efficient as a team
- Marginal product is increasing, meaning that the addition to total product of each additional worker gets bigger and bigger
- Total product is increasing

Stage 2
- After a certain point, output begins to increase by less and less
- Marginal product is decreasing, which means that each additional worker is now contributing less and less to the total product
- Total product still increases, but by less

Stage 3
- Eventually output starts to decrease, e.g., due to overcrowding
- Marginal product will be negative, as each extra worker is taking away from the total product
- Total product decreases

Question 4

describe the relationship between marginal product and average product

Answer 4

• When the marginal product is above the average product, the average product is increasing
• When the marginal product is equal to AP, the average product is at its peak
• When MP is below AP, the average product decreases

Question 5

Describe the law of diminishing marginal returns

Answer 5

• At first, as more units of variable input are added, marginal product increases
• There comes a point where adding more variable inputs causes marginal product to begin to decrease, because the gains from specialisation have already been had. For instance, workers begin to overcrowd each other, making them less effective at their jobs
• When marginal product becomes negative, average product decreases.

Question 6

whats the difference between fixed and variable costs

Answer 6

Fixed costs – costs which don’t change as output changes. E.g., rent, machinery
Variable costs – change as output increases or decrease. The more the variable inputs a firm uses, the greater the variable costs. E.g., wages, ingredients

Question 7

what are the formulas for average variable, fixed and total costs

Answer 7

Average variable costs = total variable costs / Q
Average fixed costs = total fixed costs / Q
Average total costs = total cost / Q

Question 8

define the marginal cost

Answer 8

Marginal cost = the extra cost of producing one more unit of output
MC = ∆TC / ∆Q

Question 9

why is AFC downward sloping

Answer 9

AFC slopes downwards as output increases, because the same cost is being divided by a bigger and bigger output

Question 10

Why do AVC, ATC and MC all follow similar curves

Answer 10

AVC, ATC, MC, all follow the same general trend of sloping downwards before rising again. This is due to the concept of diminishing marginal returns

Question 11

Why does the MC curve intersect the ATC and AVC curve at their minimum points?

Answer 11

• When your marginal cost is below your average cost, the average cost will fall
• When your marginal cost is above the average cost, your average cost will rise
• Therefore, the marginal cost must intersect the average cost where the AC curve is neither rising nor falling. Therefore, it must intersect where the gradient of the AC curve is zero, which is at its minimum point.

Question 12

Define total revenue, and its formula

Answer 12

• The price of the good multiplied by the quantity sold
• P X Q

Question 13

Define Marginal revenue, and give its formula

Answer 13

• the extra revenue received from selling an additional unit of output
• ∆TR / ∆Q

Question 14

Define average revenue, and give its formula

Answer 14

• the revenue received per unit sold
• i.e., the price
• =P

Question 15

why is average revenue a downward sloping curve in a monopoly

Answer 15

• In a monopoly, the firm is the market, therefore the market demand curve is the firm’s demand curve
• The demand curve is also the average revenue curve because it tells us the price a monopoly firm would receive for every quantity it wishes to sell.

Question 16

why is average revenue completely elastic in perfect competition

Answer 16

• The firm takes the price from the market, as it can have no influence on the price.
• They are such a small part of the market that they can sell an unlimited amount at the market price without influencing the market price.
• They therefore have a perfectly elastic demand curve.

Question 17

Why is the level of profit maximisation at MC=MR?

Answer 17

If the firm increases output beyond Q, any additional output is contributing more towards total cost than it is towards total revenue, meaning that profits will be lower, as (MC>MR)

If the firm opts for a lower output below Q, additional units of output could be produced which add more to total revenue than they do to total cost, meaning that current profits are also lower than maximum profit. I.e., continuing to add units of output will continue to increase the distance between TR and TC, so long as MR is above MC.

Question 18

define MC and MR

Answer 18

Marginal Cost – the extra cost of producing one more unit of output
Marginal Revenue – the extra revenue of producing one more unit of output

Question 19

define economies of scale

Answer 19

As output increases, and the scale of production therefore also increases, there is a fall in the average costs that the firm faces

Question 20

What are the different types of economies of scale

Answer 20

• technical economies of scale
• managerial economies of scale
• purchasing economies of scale
• financial economies of scale
• risk-bearing economies of scale

Question 21

technical economies of scale, definition and examples

Answer 21

• when firms increase their scale of production, they can invest in capital equipment and technology, which may have high fixed costs, but are more efficient than previous machinery, as they incur a lower cost per unit of output in the long run due to their superior efficiency
• smaller firms aren’t capable of making the same investment in newer and specialist machinery due to the limiting factors of being a smaller firm - they may have less space, lower output and profits, therefore the cost of buying the machinery would outweigh the profits that could be made
• for instance, large supermarket chains such as Tesco’s can invest in specialised technology which improves stock control
• or, e.g., expensive specialised machinery which speeds up the process of building a car

Question 22

managerial economies of scale

Answer 22

• as a firm gets bigger and increases its scale of production, workers are able to divide what was a complex production process into more manageable tasks - workers can specialise in these different tasks, which enables the firm to produce more output at the same time
• whereas when the firm was smaller, workers had to work on all areas of the production process, which not only slowed the process down, but perhaps also prevented them from becoming particularly skilled in one area, now that the firm is bigger and has more workers, each worker can specialise, thus boosting productivity

Question 23

purchasing economies of scale

Answer 23

• as a firm gets bigger, they have the technology to predict future demand, and the spare capacity to store and use a greater quantity of resources
• therefore, they can bulk buy the resources that they need. Large quantities of the same resource generally means that there are lower unit costs of the raw material used in the production process, because the firm can get a lower unit cost from the supplier when buying more of the good.
• car company bulk buying raw materials such as steel and aluminium for its production process

Question 24

financial economies of scale

Answer 24

Larger companies are generally deemed more credit-worthy, and therefore have greater access to credit, and lower borrowing costs. In contrast, smaller firms will face higher interest rates on their loans, and won’t be able to take out as much money for a capital investment

Question 25

risk-bearing economies of scale

Answer 25

• bigger firms are more able to spread their risk, meaning they have improved chances of surviving an economic downturn

Question 26

what is the difference between internal and external economies of scale, and give examples

Answer 26

external economies of scale depends on external factors, while internal economies of scale depends on internal factors.
- for instance, external EOS, includes any external factor which lowers the firms long run average costs. A group of universities offering highly skilled workers could lower the long run cost for all firms in the area
- internal EOS on the other hand are controlled by the company

Question 27

what is the minimum efficient scale

Answer 27

• earliest output at which the firm achieves it minium LRAC - smallest level of output for which all economies of scale have been taken advantage of but diseconomies of scale haven’t yet set in

Question 28

what are increasing returns, constant returns, and decreasing returns to scale

Answer 28

Increasing returns to scale
- when input increasesby a certain amount, output increases by more

Constant RTS
- when input increases by a certain amount, output increases by that same amount

Decreasing RTS
- when input increases by a certain amount, output inceases by less than this amount

Question 29

what is an external EOS, and give examples

Answer 29

• when a firm achieves lower average costs due to external factors
• skilled labour pool
• govt subsidies
• tax reduction
• improved transportation network

Question 30

what is an internal EOS, and give examples

Answer 30

• when a firm achieves lower LR average costs brought about by internal factors

Internal factors
- controlled by the company
- any time the company cuts costs, invests in better capital machinery, hires specialised workers

Question 31

Define diseconomies of scale

Answer 31

• as the firms scale of production gets bigger, its average costs rise

Question 32

what are the different types of diseconomy of scale

Answer 32

• communication diseconomies of scale
• managerial diseconomies of scale
• coordination and monitoring difficulties

Question 33

communication diseconomies of scale

Answer 33

• more difficult to send messages across quickly, the bigger the firm

Question 34

managerial diseconomies of scale

Answer 34

• as the firm gets bigger, works become alienated from the key aims of the firm, resulting in a loss of motivation and efficiency

Question 35

coordination and monitoring difficulties

Answer 35

• difficult to monitor everyone’s work in a big firm
• loss of organisation is possible

Question 36

what is the difference between returns to scale and economies of scale

Answer 36

Returns to scale refers to changes in the levels of output as inputs change, and economies of scale refers to changes in the costs per units as the number of units are increased.