Essay Questions Flashcards
Explain the distinction between the short-run and the long-run in microeconomics.
The short-run and long-run in economics do not refer to fixed time periods but instead refer to the time required to bring about changes in the inputs of various factors of production.
The short-run exists when at least one factor input cannot be varied.
The long-run refers to that period when all factors inputs are variable, i.e. the planning period.
Once a long-run decision has been made and factors committed, e.g. a plant/factory has been built the firm is back in the short-run.
What constitutes the long-run varies from industry to industry, e.g. extending a nuclear power plant is likely to take longer than extending a university dormitory.p
Explain in detail the behaviour of a firm’s costs in the short-run.
Suggested Answer
Fixed costs (FC) are costs of the factors which cannot be varied in the short-run and which are unrelated to output levels (Q), e.g. rent on premises, property taxes, interest charges. Even if the firm produces zero output, fixed costs are incurred.
Since they do not vary with output levels average fixed costs will decline as output increases, asymptotically approaching zero as output becomes infinite!
i.e. declines as Q increases
Total variable costs increase as output increases and decrease as output decreases but not normally in a linear fashion because of increasing/diminishing marginal returns to variable factor inputs.
Average variable cost is determined by the average productivity of variable factor inputs and their market prices and marginal cost is determined by the marginal productivity of variable factor inputs and their market prices.
When marginal costs (MC) is less than average variable cost (AVC), AVC must be declining, i.e. the cost of each additional unit produced is less than the average and must therefore reduce the average. When MC is greater than AVC, AVC must increase.
Therefore, MC must pass through the minimum point on the AVC curve.
The AVC curve will approach the ATC as AFC approaches zero.
Explain in detail why economic efficiency cannot prevail in the presence of monopoly; explain what a government might do to bring about economic efficiency and explain why society might wish to preserve monopolies.
The concept of economic efficiency is captured in the marginal equivalency conditions (MEC)
and is derived from the conditions of utility maximising by households.
and profit maximising conditions by competitive firms in equilibrium
A monopoly faces the industry demand curve because it is the sole supplier and will maximise profit by producing that output level at price marginal revenue (MR) equals marginal cost (MC). There will be a unique price (P) which clears the market. This price (P) must be greater than MC because of the downward slope of the demand curve.
Consumers will attempt to maximise utility in their purchase of goods and services no matter the type of firm producing those goods. Consumers will take the prices as given and equal for all goods.
However when we attempt to substitute MC for P in the MEC equation the monopolist’s MC will be less than P and as a consequence
because MCm
Case Study: Why Farmers Hedge
To spread his risk a farmer with three identical fields plants one with wheat, one with barley and one with oats. He has to wait until harvest time to see what world prices are; only then can he assess which if any of his crops is profitable.
For each field his fixed costs are those costs associated with preparing the land for planting and the seeds. All other costs are associated with spraying and harvesting the crops and drying the grain. Grain merchants, for a fixed percentage of the world prices, collect the grain from the farms.
In the short run after a field has been planted and the crops sprayed and are ready for harvesting the potential output of that field is given, i.e. so many bushels of wheat. Thus the supply is a given amount independent of the world price. The inelastic supply curve however will not begin at the horizontal axis. If the price offered does not yield sufficient revenue to cover the costs of harvesting the grain and drying it out, the farmer will not harvest the crop but will either burn it or plough it in. If total revenue from a crop exceeds all costs, the crop is profitable. If total revenue exceed the harvesting/drying costs but not all costs it still pays the farmer to harvest the crop since all variable costs are covered and something is left to set against fixed costs.
Many farmers hedge typically, i.e. have a variety of agricultural activities, so that losses in one area are, hopefully, more than offset by profits in other areas.
In the long run a farmer may vary the size of his farm but each year (season) the farmer has to make short run decisions, i.e. he can vary the amounts of factor inputs in each/every field. Are last years’ profitable crops a good indicator of what to specialise in this year? If all farmers think ‘yes’ the supply curve of the crops in question will shift to the right and unless matched by corresponding demand shifts, prices will fall. The farmer moans that every year he has a bumper crop, so do most other farmers and the price is low. Every year the price is high he seems to have planted only a little of that crop.
