Economics Stage 3

Question 1

What is a Firm in Economics and what is their purpose?

Answer 1

• Firms are social institutions which combine Factors of Production (FOPs) in order to produce goods or services for sale in markets.
• Firms have a primary objective to maximise profits.
• If a firm does not profit maximise they risk the cessation of trading.

Question 2

What is the term used to describe using a FOP?

Answer 2

Opportunity Cost (OC).

Question 3

How do OC’s relate to a Firm?

Answer 3

OCs to a firm come in two types:

▪ Explicit OCs– costs paid in money by the firm for FOPs such as wages, materials, and rent.

▪ Implicit OCs– the value of forgone alternatives such as renting equipment out for other purposes and normal profit (i.e. cost of entrepreneurial ability).

Question 4

How is Economic Profit calculated?

Answer 4

Economic Profit = Total Revenue - Opportunity Cost
Explicit Costs + Implicit Costs Sales * Price

• Economists and accountants differ in their
  definition of profit.
• Accounting Profit only considers explicit costs.

Question 5

What must a Firm consider in order to maximise profit?

Answer 5

▪ What to Produce– the types of goods and services to produce with the FOPs and in what quantities.

▪ How to Produce– the manufacturing process to follow.

▪ Management– the organisation and renumeration of labour.

▪ Marketing– the advertisement and price strategy for the goods and services produced.

▪ Suppliers– what FOPs to buy-in and what to produce in-house.

Question 6

What are the three forms of Constraints that affect FOP’s?

Answer 6

Technology Constraints.

Information Constraints.

Market Constraints.

Question 7

What is the meaning of Economical and Technological efficiency?

Answer 7

▪ Technological Efficiency– producing output with the fewest inputs.

▪ Economic Efficiency– producing output at the lowest cost.

Question 8

What is a Command System?

Answer 8

• A hierarchy is implemented in the firm where managers direct the activity of subordinates.
• Orders are passed from mangers to subordinates.
• Information is passed from subordinates to managers.

Question 9

What is an Incentive System?

Answer 9

• The renumeration of staff is directly affected by performance.
• Performance on key metrics is measured and staff are rewarded for their contributions (e.g. sales bonus).

Question 10

What is the Principal Agent Problem?

Answer 10

The Principal-Agent-Problem denotes to difficulties that principals (e.g. owners) have with ensuring agents (e.g. workers) perform in the best interests
of the firm.

Question 11

What three options solve the Principal Agent Problem?

Answer 11

▪ Part Ownership– agents are provided with a stake in the firm (e.g. shares) and benefit from the profits made by the firm.

▪ Incentive Pay– the wage an agent receives is linked to their job performance.

▪ Employment Contracts– agents are awarded permanent contracts which provide career progression.

Question 12

What determines the type of Market?

Answer 12

• Five different types of market structure are generally defined, each with different levels of market power for the firm.
• These market structures are defined by:

▪ The number of firms which are present.

▪ The number of consumers that are present.

▪ The degree of information held by the firms and consumers.

▪ The ease of entry and exit.

▪ The type of good produced.

Question 13

Name as many market types as possible.

Answer 13

Perfect Competition, Monopolistic Competition, Monopoly and Oligopoly.

Question 14

What is Perfect Competition?

Answer 14

• This market has many firms and consumers.
• The firms produce homogenous goods (i.e.
  highly similar).
• Barriers to entry and exit are low.
• Firms and consumers have complete
  knowledge of the prices charged.

Question 15

What is Monopolistic Competition?

Answer 15

• Similar to perfect competition.
• Firms differentiate their products from their
  competitors (e.g. heterogeneity though
  branding).
• This provides firms with a monopoly other their
  product variant.

Question 16

What is an Oligopoly?

Answer 16

• This market has few firms and many
  consumers.
• The firms may produce homogenous or
  heterogenous goods.
• Barriers to entry and exit are high.

Question 17

What is a Monopoly?

Answer 17

• A sole firm supplies the majority of the market.
• No close substitutes for the product supplied
  are available.
• Barriers to entry and exit are high.

Question 18

What is the concentration ratio?

Answer 18

• One measure which helps to distinguish market structure is the concentration ratio.
• This ratio measures the percentage of the market controlled by the largest 5 firms.
• Market control can be considered in different ways, such as number of employees, number of sales or total revenue.
• This ratio does have a number of limitations.

Question 19

What are the limitations of the concentration ratio?

Answer 19

▪ Geographical Scope– the reach of the market e.g. regional, national, or international.

▪ Contestability– some markets may have few firms but new firms can enter easily if opportunities are present.

▪ Multiple Markets– some firms operate in different markets with different levels of integration.

Question 20

What are Timescales?

Answer 20

• To determine how to produce a given output, a firm must be aware of the cost implications of alternative approaches.
• These cost implications are generally considered over two timeframes:

▪ Short-Run: the quantities of some FOPs available to firms are fixed (e.g. capital such as machinery, land such as factory space) while others are variable (e.g.
labour). These fixed FOPs are often referred to as a firm’s plant.

▪ Long-Run: the quantities of all FOPs are variable.

Question 21

What is Short-Run Product?

Answer 21

• To increase output in the short-run, a firm must increase its use of one the variable FOPs (e.g. labour).
• To understand how this increase in FOP use impacts output, three ways of measuring output are useful.

Question 22

What are the 3 ways of measuring output?

Answer 22

▪ Total Product (TP)– measures the output of goods produced by a firm for a given input of FOP.

▪ Marginal Product (MP)– measures the change in the output of goods produced by a firm given a one unit change of FOP input.

▪ Average Product (AP)– measures the mean output produced per unit of FOP input at a given output level (i.e. total output divided by total FOP input).

Question 23

What are Price Takers in a Perfect Competition (PC) market?

Answer 23

Firms in a PC market accept the market price for a good– they are said to be price takers.

Question 24

How do Price Takers affect a PC?

Answer 24

Small Scale Production:

• PC firms only produce a small fraction of the overall output of a market.
• PC firms can sell all of the output they want at the market price.
• If a PC firm was to double its output, it would have a minuscule effect on the overall QS in the market.

Homogenous Products:

• PC firms sell an identical product to a market (i.e. there is no diversification).
• Buyers are fully aware of the market price.
• If a PC firm was to increase its price, consumers would simply purchase their product
  from another firm.

Question 25

How does a PC market value revenue?

Answer 25

* A PC firm has a goal to maximise the economic profit which it makes. * Economic profit is experienced when a firm’s TR > TC. * Normal profit is included in the firm’s TC as an OC. * The TR received by a PC firm is the quantity of a good it sells multiplied by the market price of the good: TR = Market Price * Quantity Sold AR = TR/Quantity Sold MR = ∆TR/ ∆Quantity Sold

Question 26

How will a PC firm strategise in its market?

Answer 26

* A firm in a PC market will not alter the price at which it sells its goods. * The firm can only change the quantity of goods it sells in the PC market. * How does a firm decide what quantity of goods to sell? * A firm will sell the quantity of goods at which it maximises profits. * Decisions can be taken across two timeframes.

Question 27

What two timeframes affect a PC firm?

Answer 27

Short-Run: * Whether to operate or hibernate. * What quantity to sell in the market. Long-Run: * Whether to operate or exit the market. * Whether to increase or decrease the plant size.

Question 28

What is PC profit maximisation?

Answer 28

* One method to identify the profit maximisation point for a firm operating in a PC market is to examine the TR and TC curve. * Profit maximisation occurs when a firms TR exceeds its TC by the largest amount. * A second method to identify the profit maximisation point for a firm operating in a PC market is to examine the MR and MC cost. * Profit maximisation occurs when a firms MR = MC.

Question 29

What is Short-Run Operation in a PC Market?

Answer 29

* The price a firm operating in a PC market receives may vary in the short-run due to such issues as seasonality or supply shocks. * In the short-run, a firm operating in a PC market can: 1. Make an economic profit– TR exceeds TC. 2. Break-even– TR = TC and normal profit is made. 3. Make an economic loss– TC exceeds TR.

Question 30

Why is Short Term loss in a PC Market?

Answer 30

* A firm in a PC market may continue to operate even if it is making an economic loss in the short term

Question 31

What is Long Run Operation in a PC Market?

Answer 31

* In the long-run, a PC market can adjust to situations in the following ways: 1. Firms can exit or enter the market. 2. Firms can change their plant size. Example– Firms Making Economic Profit: * A PC market has a price which exceeds the ATC of most firms operating in it. * Firms in the PC market are making an economic profit. * As there are no barriers to entry, new firms enter the market in the search for profit. * The market’s supply curve shifts to the right.

Question 32

What is Long Run Plant Expansion in a PC Market?

Answer 32

* If a firm operating in a PC market is making an economic loss they may be able to expand their plant size to lower their ATC and MC. This assumes that the firm is not operating at the most efficient point on their LRAC curve. If making an economic loss, they must: * They decide to increase their plant size by purchasing new machinery (i.e. increase capital). * Both the MC and ATC curves shift rightward and the firm now profit maximises at point C.

Question 33

What causes a permanent change in demand within a PC Market?

Answer 33

The demand for goods traded in PC markets may be permanently changed due to: ▪ Changes in tastes and preferences amongst consumers. ▪ Changes in population and income levels. ▪ Changes in the price of related goods.

Question 34

How does permanent change affect a PC `market?

Answer 34

* These changes would have the effect of shifting the demand curve in the PC market. * Shifts in the demand curve would disturb a PC market which is currently in long-term equilibrium.

Question 35

What is a Monopoly Market?

Answer 35

* A monopoly is a firm that faces no competition within its market and has the ability to apply market power. * Two conditions often lead to the occurrence of monopoly. ▪ No Close Substitutes– no other good provides a similar function to that produced by the monopoly. ▪ High Barriers to Entry– entering the market in which the monopoly operates is difficult. o Legal Barriers– can take the form of exclusive rights or licenses to operate (e.g. DNOs are granted regional monopolies) or the use of patents to protect intellectual property and promote innovation (e.g. the development of new medicines). o Natural Barriers– economies of scale within the market are large allowing a sole producer to offer a price which new firms cannot compete with.

Question 36

What is the Monopoly Strategy?

Answer 36

* As the monopoly is the sole provider in the market, they face the market demand curve. * A monopoly has the ability to set either: ▪ The price it sells its good. ▪ The quantity of goods it sells.

Question 37

What is the Monopoly Market strategy?

Answer 37

* A monopoly faces similar cost functions to those present in a PC market. * The profit maximisation point is where MR = MC = Point A. * The economic profit derived from a monopoly is affected by their ATC.

Question 38

How does a Monopoly operate in a PC Market?

Answer 38

* If the market was operating in PC, a firm’s MR would be derived from the market demand curve. * Consumer surplus is the difference between what a consumer would be willing to pay compared to what they did pay. When a monopoly enters the market the consumer surplus therefore decreases. This causes the excess surplus to be redistributed to the Monopoly. Thus proving Monopoly Market structures are inefficient.

Question 39

How does a Monopoly Market structure affect Price Discrimination?

Answer 39

* So far, we have assumed that the monopoly applies a single price in the market. * The market power of monopolies allows them to practice price discrimination.

Question 40

What is Price Discrimination?

Answer 40

* Price discrimination is where a firm offers a different price to different types of consumer (i.e. some face lower and others face higher prices than the market price). * The application of price discrimination requires a few conditions. ▪ The firm can distinguish different types of consumer. ▪ The firm has knowledge of how much each type of consumer is willing to pay (WTP) for the good. ▪ The good sold by the firm cannot be easily re-sold. * Firms which practice price discrimination have the ability to further extend their profits.

Question 41

How does market research of consumers affect Price Discrimination?

Answer 41

* A monopoly conducts some market research and identifies three consumer groups with different WTP. ▪ The first group are employed consumers that have a WTP of 8. ▪ The second group are retired consumers that have a WTP of 6.5. ▪ The third group are student consumers that have a WTP of 5. * By charging different prices to these consumer groups the monopoly has been able to further capture the consumer surplus.

Question 42

What benefits are there for the Monopoly Market Structure?

Answer 42

* Given the comparison between a PC market and a monopoly, it can be easy to assume that monopolies are bad and PC is good. Economies of scale and scope: * However, there are two particular benefits that a monopoly market structure can offer economies of Scale and Scope. ▪ An economy of scale occurs when the ATC falls as output expands while an economy of scope occurs when the ATC falls as output diversifies. ▪ Monopolies are better positioned to achieved economies of scale and scope due to their high levels of output. Research and Development: ▪ The economic profit earned by a monopoly can be investing into R&D activities. ▪ The granting of patents encourages these R&D activities. ▪ If many firms in a PC market are conducting R&D, then it could lead to replication of effort.