Costs, revenues and profits

Question 1

The short run production function

Answer 1

This is a model that represents how the volume of output changes as factor inputs are increased.
A number of assumptions are made…

1. The firm uses only two factors of production, labour (L) and capital (K).
2. K is fixed in the short run, but variable in the long-run.
3. L is variable in both the short and long run.

Question 2

Average output

Answer 2

This is total output per variable input.

Total output/inputs = Average output

Question 3

Marginal output

Answer 3

The additional output that an additional input adds to total output.

Change in total output/change in inputs = marginal output

Question 4

Short-run production function

Answer 4

This summarises the most technically efficient combinations of inputs to produce output. There are three phases of the DIAGRAM.

1. Increasing marginal returns, as the firm employs more workers they can become more specialised, boosting marginal productivity.
2. Diminishing marginal returns, as the firm employs more workers they begin to get into each others way, benefits of specialisation are maximised. Marginal productivity falls.
3. Negative marginal returns, workers now prevent each other from working efectively and they get into each others way to the extent in which productivity of existing workers fall, this means there is negaitve marginal productivity.

Question 5

Productivity definition

Answer 5

Measures output per unit of input

Question 6

Relationship between the marginal product curve and the average product curve

Answer 6

• Both curves rise and then begin to fall, the average output begins to fall when it is intersected by the marginal output curve. Diminishing marginal returns/productivity takes place when the marginal product/output curve begins to fall.

The average product curve lages the marginal product curve.

Question 7

Law of diminishing returns

Answer 7

At a certain point, employing an additional factor of production causes a relatively smaller increase in output.

Question 8

Total short run FIXED costs

Answer 8

These are costs that do not vary with input, they are independant of output and are strictly a short run Phenomen.

E.G Rent

Question 9

Total short run variable costs

Answer 9

Costs which vary with output, if output is 0 than the variable costs will also be 0. This include wages.

Question 10

Total short run costs

Answer 10

TFC + TVC = TC

Question 11

Explain the shape of the Average Fixed Cost curve

Answer 11

TFC/Q = AFC

• Continuosly sloping downwards for all levels of output.
• Decreasing at a slowing rate
• As output rises the TFC remains constant so the AFC approaches 0 as Q rises, but never meets it.

Question 12

Explain the shave of the AVC curve

Answer 12

• AVC falls and then rises as output increases, U shaped.
• This is because the Marginal Cost curve fall and then rises. As MC falls it is below the AVC and do it drags down the AVC, but as MC rises it eventually rises above the AVC, causing the AVC to subsequently rise.
• MC falls initially as output rises because of increasing marginal productivity of the factor inputs, driven by specialisation.
• MC turns and begins to rise due to diminshing marginal productivity of inputs (MP falls).

Question 13

Explain the shape of the ATC curve

Answer 13

ATC = AFC + AVC

• Initially AFC and AVC fall as output rises, as ATC is the sum of AVC and ATC, it too will fall.
• AVC rises at a certain point, but AFC continues to fall, the decrease in AFC is larger than the increase in AVC, so the ATC continues to fall.
• Because AVC rises at an increasing rate and AFC falls at a decreasing rate the ATC will eventually begin to rise (AVC becomes the more dominant factor determing the ATC shape)

Question 14

Long run cost curve

Answer 14

In the long run all factor inputs can be varied, in the short run factor inputs are fixed.
This means that in the long-run the firm can produce on any of its short run cost curves, inputs are not fixed, the firm can vary inputs and therefore operate on a different short run cost curve.

The long run cost curve is therefore serived from a combination of short run cost curves.

Question 15

Internal economies of scale

Answer 15

As a firm increases its sale of production in the long run by varying its capital stock, the firm is able to move onto previouslt inaccessible short run average cost curves. As capital stock is increasing the SRATCs are falling. This is economies of scale.

Any factor which drives down long-run average costs as output increases.

Question 16

Examples of economies of scale

Answer 16

• Purchasing
• Managerial
• Technical
• Financial
• Risk bearing

Question 17

Examples of economies of scale - Purchasing

Answer 17

As a firm scales up production it will purchase more inputs in order to facilitate this increased production. The firm might be able to access discounts on its inputs by buying them in bulk. This means its total costs rise by less than its output rises by. Dragging down LRATC.

Question 18

Examples of economies of scale - Managerial

Answer 18

Larger firms have the revenue to justify hiring more managers than smaller firms, this allows for them to take on more specialised roles, this therefore should boost productivity of the teams they manage, as they can have a more narrow focus and develop a more detailed knowledge on the field. Total output rises by more than the increased cost from hiring more managers, reducing long run average costs.

Question 19

Examples of economies of scale - Technical

Answer 19

Larger firms are able to spend more on capital and technology allwoing them to access better quality machinery and tech than smaller firms who cannot justify the expense. This boosts productivity, raising total output by more than the decreased cost of this new technology, decreasing LRATC.

Question 20

Examples of economies of scale - Financial

Answer 20

Large buisnesses which produce more output are likely to have greater stock of assets to borrow against, this means firms producing at a large scale might be able to access credit at a lower interest rate than smaller firms. Therefore firms producing at a larger scale with have lower borrowing costs.

Question 21

Examples of economies of scale - Risk bearing

Answer 21

Larger firms are able to take greater business risks than smaller firms, due to more reliable revenue firms and more assets. Firms can take more risks in developing cost saving techniques, such as new production methods than smaller firms. This drives down long run average costs for firms producing on a larger scale

Question 22

Examples of diseconomies of scale

Answer 22

• Workers in large organisations might feel insignifcant and less motivated so productivity falls and costs rise.
• Management issues arise when a firm becomes too large, teams may grow in size and become difficult to manager, coordination issues between different layers of manegement.
• If firms grow too large they may attract the attention of government regulators, introducing regulatory framework will increase their costs.

Question 23

External economies of scale

Answer 23

• As the industry grows, there might be more technological progress so all the firms can benefit and reduce costs.
• Skilled labour, as industries grow more people train for that sector, meaning productivity for firms rise.
• CLustering effect, as industry gorws, supply clusters will develop which may push costs down.
• Government support for growing sector.

Question 24

External diseconomies of scale

Answer 24

• As a industry grows this places additional competition on factor resources, raw materials, pushing up their prices and therefore costs for firms rise. EVAL depends on PES of factor market.
• Issues with clustering, local strain on ifastructure might emerge. Industry growth might put a strain on local rental markets.
• Large industries might require more regulation to protect the rest of the economy from spill over effects.

Question 25

Total revenue

Answer 25

Quantaty sold * Price per unit = Total revenue

Question 26

Average revenue

Answer 26

Quantity sold * Price / Quantity sold

TR/Quantity sold

In other words average revenue is the price of the good.

Question 27

Marginal revenue

Answer 27

Additional revenue generated when you add a additional revenue of Q.

Change in TR / Change in Q

Question 28

Relationship between the average revenue curve and the Marginal revenue curve

Answer 28

The MR curve is twice as steep as the AR curve, the MR curve is alwys below the AR curve.

Question 29

Relationship between the marginal revenue and the total revenue curve

Answer 29

The MR curve falls at a constant rate, this means that the TR curve is rising at a slower rate. At 0, the total revenue turns and begins to fall, as the marginal revenue curve goes negative.

Question 30

AR and the demand curve

Answer 30

The average revenue curve for a firm is the same as its demand curve (as the AR shows the relationship between how much quantity is demanded at different prices).
If AR is downward sloping, this implues that the firm has some control over the price.

Question 31

Accounting Profit

Answer 31

Total revenue - Total costs = Accounting profits

(AR - ATC)*Q = accounting profit per unit

Question 32

Economic profit

Answer 32

Accounting profit - Oppurtunity cost or the value forgone from the next best alternative.

Question 33

If Economic profit is less than 0 or negative, what does this mean?

Answer 33

Oppurtuntiy cost is greater than the accounting profit and the value of the next best alternative is greater than the profit gained from this particular firm.

SUBNORMAL PROFIT (Is it rational to shutdown?)

Question 34

If Economic profit is greater than zero what does this mean?

Answer 34

This means that the accounting profit is greater than the oppurtunity cost. Or the profit from this buisness is greater than the value one could have achieved doing the next best thing

SUPERNORMAL PROFIT, this is where profit is more than enough to make staying in the industry worthwhile.

Question 35

If Economic profit is equal to zero what does this mean?

Answer 35

Opportunity cost in this case is equal to the accounting profit.
NORMAL Profit, this is just enough profit to make staying in this industry worthwhile.

Question 36

Why is Profit maximised where marginal costs equal marginal revenue?

Answer 36

At MC=MR the marginal costs of producing a good equals the marginal revenue that that extra unit of the good generates. If you were to increase production beyond this point than the marginal cost of producing the extra good will be greater than the marginal revenue that it creates. This means that total profit will fall. Furthermore if the firm was operating at a ouput below MC=MR than it will be profitbale to produce a extra unit of output until MC=MR, this is because the marginal revenue generated from producing the extra unit of that good is greater than the marginal cost, therefore total profit will rise.

Question 37

Shutdown conditions - If the price (AR) is greater than the average total cost (ATC)

Answer 37

The firm would be making positive economic profit or supernormal profit, this means the firm should coninue to operate as it is rational for them to do so.

Question 38

Shutdown conditions - If Price (AR) is lower than average total costs (ATC) but price is greater than average variable costs (AVC)

Answer 38

• In this case the firm is making economic loss, or subnormal profit.
  However the firm is generating positive contribution. If the firm shuts down immediately it will not incur any variable costs, no generate any revenue. The loss it makes would therefore be its TFC.

If the firm continues to operate in the short run, it makes contribution which can be used to offset some of its TFC, resulting in less of a loss than shutting down immediately. EFBA.

The firm would shutdown in the long run

Question 39

Shutdown conditions - If price is lower than average variable cost (AVC)

Answer 39

• In this case the firm is making economic loss, or subnormal profit.
  The firm is also generating negative contribution, as the Average variable costs are greater than than the total revenue. If the firm shuts down immediately it will not generate revenue but also not incur any variable costs, this means the firm will only lose the amount of TFC.

If the firm was to continue to operate in the short run, it makes negative contribution, this means that the firm would continue to lose money as the average variable costs are greater than the revenue generated. This means that the cost of continuing to operate would rise.

The firm should shutdown immediately.

Question 40

Allocative efficiency

Answer 40

• AR = MC
• Welfare maximising
• This occurs when there is an optimal distribution of goods and services, taking into account consumer prefferences, the marginal utility consumers recieve frm the good is equal to the price they pay for it.
• If AR is greater than MC than these units have a greater benefit to consumers than the value of the resources used to produce them. So these units add to total welfare until you reach AR=MC, therefore before this point welfare is not maximised.

Question 41

Productive efficiency

Answer 41

This is concerned with producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost.
- Using the fewest resources per unit of output (minimising costs). Resources are not wasted with respect to the output generated. ATC = MC

Long run productively efficient takes place as the lowest point on the LRAC curve or the MES.