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Economics > Firms and Decisions > Flashcards

Firms and Decisions Flashcards

1
Q

What is the theory of the firm?

A

Firms aim to maximise profit.

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2
Q

What is a firm’s total profit?

A

The difference between total revenue and total cost.

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3
Q

What are the three types of economic profit?

A

Supernormal profit: TR>TC
Normal profit: TR=TC
Subnormal profit: TC>TR

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4
Q

What is marginal revenue?

A

The additional revenue that a firm makes from selling one more unit of output produced, ΔTR/ΔQ.

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5
Q

What is marginal cost?

A

The additional cost that a firm incurs from increasing output produced by one unit.

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6
Q

When should firms stop producing?

A

When MR=MC

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7
Q

What are the limitations of the traditional theory of profit maximisation?

A

There is lack of sufficient information about demand and cost conditions that exist, hence marginal revenue and marginal cost is hard to estimate accurately and these concepts might not be able to be used when making decisions.
The cost of obtaining sufficient information is too high.
The time period to maximise profits is hard to decide as demand and cost conditions keep changing due to factors outside the firm’s control as well as the actions of a firm.

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8
Q

What are the three alternative objectives of firms?

A
  1. Revenue maximisation
  2. Profit satisficing
  3. Market share dominance
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9
Q

What is the principal agent problem?

A

Principals employ agents. Agents control day-to-day operations while shareholders have ownership. This results in the principal agent problem, where the objective of principals, which is profit maximisation, may be different from that of agents, which might be power, bonuses, prestige etc. In their self interests, managers would maximise managerial utility.

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10
Q

Why might firms want to maximise revenue?

A

This is due to the theory of sales revenue. Income of sales managers and commission-based employees are dependent on firms’ total revenue, thus firms with dominant sales department might choose to maximise revenue rather than profits.

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11
Q

When is total revenue maximised?

A

At the output where no additional revenue can be reaped from producing and selling an extra unit of output, ie MR=0.

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12
Q

Why might firms focus on profit satisficing?

A

Instead of choosing the best possible choice from all available alternatives, satisficers choose the best among a limited set of choices, This decreases needless expenditure of time, energy and resources.
Due to the divorce of ownership from control and the principal agent problem, decision makers/agents could decide against making profit-maximising decisions where they don’t stand to benefit, and instead decide to achieve a given level of profits deemed acceptable by owners though it might not be the maximum. they thus have the discretion to pursue their own interests, and managerial utility is maximised.
Some firms might consider the impact of their goods or production on society or the environment and use less harmful inputs or production methods, even if this might increased total cost and decrease total profits.
Social enterprises might have primarily social objectives.

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13
Q

Why might firms focus on market share dominance?

A

Larger firms attract better talent as employees prefer working in bigger companies due to greater prestige and higher salaries.
Gains and losses in market share may also correlate with stock performance. This is done by trying to reduce prices, shift the demand curve rightwards, and making demand less price elastic.

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14
Q

What is market share dominance?

A

The proportion of the firm’s total sales revenue vis-a-vis the market.

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15
Q

What are the two specific strategies firms might engage in to increase market share dominance?

A
  1. Entry deterrence

2. Predatory pricing

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16
Q

How can entry deterrence increase market share dominance?

A

Successful entry by new firms into a market lowers market share and possibly profits for incumbent firms. To avoid losing market share, firms might:
Non-price strategy: increase brand proliferation to differentiate their products, new entrants would have to match the amount spent on advertising and promotion and rethink entering the market.
Price strategy: lower the price of the good, making it unprofitable for new entrants to enter the market.

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17
Q

How can predatory pricing increase market share dominance?

A

By pricing goods below the profit maximising price, it can deter new entrants. It has sufficient past profits to cope with the losses incurred while rival firms might not, and thus exit the market.

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18
Q

What is a market?

A

The coming together of producers and consumers to transact with each other.

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19
Q

What is a firm?

A

An organisation formed by entrepreneurs to bring together FoPs to produce goods and services for sale.

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20
Q

What is an industry?

A

A group of firms that produce a single good or service, or a group of related goods and services.

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21
Q

What is production?

A

The process by which FoPs are used to create goods and services.

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22
Q

What is a production function?

A

The mathematical relationship between output and FoPs used in producing them for a given level of technology within a specific period of time.

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23
Q

What is the short run?

A

The time period where at least one FoP is fixed. Output only increases by using more variable factors.

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24
Q

What is the long run?

A

A time period long enough for all inputs to be varied.

25
Q

What is total economic cost?

A

The total opportunity cost of using scarce resources to produce one particular commodity in terms of the next best alternative forgone, consisting of of explicit and implicit costs.

26
Q

What is LDMR?

A

As more units of a variable factor are applied to a fixed quantity of a fixed factor, there comes a point beyond which the additional output from additional units of the variable factor employed will eventually diminish.

27
Q

What are the 3 stages of short run production?

A

Stage 1: Total output rises, increasing marginal output (additional output each new unit of variable factor adds), because labour-capital combination is more efficient when fixed variable is used more effectively by variable factor and division of labour and specialisation of tasks lead to greater efficiency.
Stage 2: Total output rises, decreasing marginal output, because labour-capital combination is inefficient, overcrowding arises and fixed variable is being overused, LDMR sets in.
Stage 3: Total output falls, marginal product of labour is negative.

28
Q

Definitions of costs:

A

TC: sum of costs of all factors of production a firm uses in production (TC=TFC+TVC)
TFC: cost that does not vary with output level, incurred in the utilisation of fixed FoPs.
TVC: cost that varies with output level, incurred in the utilisation of variable FoPs.
AC: cost per unit of output (AC=TC/Q=AFC+AVC)
AFC: total fixed cost per unit output (AFC=TFC/Q)
AVC: total variable cost per unit output (AVC=TVC/Q)
MC: change in total costs from increasing output by one additional unit (MC=ΔTC/ΔQ)

29
Q

Short run cost curve:

A

AFC is continuously downward sloping
MC initially falls then rises, U-shaped
AVC initially falls then rises, U-shaped. Only starts to rise after MC has risen above the AVC
AC decreases as decreasing effects of AFC outweighs increasing effects of AVC. It eventually increases as increasing effects of AVC outweighs decreasing effects of AFC.
MC curve intersects AVC and AC curves at the minimum points

30
Q

Decision making of firms in the short run:

A

Reduce cost of production to maximise profits by reducing fixed costs. MC is unchanged, AC falls.
Source for cheaper variable inputs so that variable cost of production falls.

31
Q

What is the long run?

A

The time period where all factors of production can be varied.

32
Q

Why is the LRAC curve U-shaped?

A

As output rises, average cost falls as firm benefit from internal economies of scale. When LRAC is at its minimum, the firm reaches its minimum efficient scale. However, average cost starts to increase due to internal diseconomies of scale.

33
Q

What is internal economies of scale?

A

Cost savings that occur as a result of the firm’s expansion and have been created by the firm’s own policies and actions. It arises from spreading out fixed costs, productivity improvements and greater buying power over inputs.

34
Q

What are the 6 internal economies of scale?

A
  1. Technological economies of scale
  2. Financial economies of scale
  3. Marketing economies of scale
  4. Managerial economies of scale
  5. Risk-bearing economies of scale
  6. Network economies of scale
35
Q

Explain technological economies of scale.

A
  1. Factor indivisibility : some inputs are of a minimum size and cannot be divided into smaller units. Purchasing these may cause a firm to operate below maximum capacity if its output is small.
  2. Law of increased dimensions: capital equipment used to contain materials cost less per unit output the larger its size due to cubic law.
  3. Specialisation of labour: for firms with high output workers can be assigned to do more specific and repetitive jobs. less training is needed, workers are more efficient in specific areas. Gain in productivity lowers unit cost of production.
36
Q

Explain financial economies of scale.

A

Large firms are given lower interest rates and larger loans due to better credit ratings and greater collateral, while banks think loaning to smaller firms is riskier and thus give higher interest rates. Large firms are public limited companies can raise capital through issuance of bonds and can thus take better advantage of financial economies of scale.

37
Q

Explain marketing economies of scale.

A

Large firms have bargaining advantage due to preferential treatment from suppliers as they buy raw materials in bulk, allowing firms to dictate price, quality and delivery requirements more effectively. Economies of selling result from bulk advertising and large scale promotion.

38
Q

What is network economies?

A

As network expands, high fixed cost of establishing the network decreases as long run cost per user decreases and marginal cost of adding one user to the network is close to zero. Additionally, customer acquisition cost decreases as the network effect helps to draw customers and service providers to use a certain platform, reducing the need for advertising.

39
Q

What is risk-bearing economies of scale?

A

The ability of firms to spread the risk and uncertainty over a large level of output and thus reduce unit costs, for example R&D costs.

40
Q

What is managerial economies of scale?

A

Employing specialists to supervise production systems, increasing productivity and reducing unit costs.

41
Q

What are internal diseconomies of scale?

A

Increases in cost due to expansion of the firm, which is the result of the firm’s own policies and actions. It arises from fall in productivity from greater complexity and low morale, and employment of more resources to manage such problems.

42
Q

What are the 2 internal diseconomies of scale?

A
  1. High cost of monitoring and management

2. Low morale of employees

43
Q

Explain high cost of monitoring and management.

A

Monitoring productivity and quality in big corporation is imperfect and expensive as larger firms have less effective flow of information and poor communication. Time lags also create problems in terms of speed of response.

44
Q

Explain low morale of employees.

A

When firms are too large, relationships are less personal, workers may feel a sense of alienation and loss of morale, reducing productivity and efficiency, wasting factor inputs, increasing cost.

45
Q

What are external economies of scale?

A

Cost savings that occur to all firms due to expansion of an industry or concentration of firms in a certain location, illustrated by a downward shift of the LRAC curve.

46
Q

What are the 2 external economies of scale?

A
  1. Economies of information

2. Economies of concentration

47
Q

Explain economies of information.

A

Firms in an industry may share common R&D knowledge, improving productivity and reducing average costs.

48
Q

Explain economies of concentration.

A
  1. Availability of skilled labour: special educational institutions can be set up to train people in skills that are in high demand. Well known regions also attract talent for firms.
  2. Well-developed infrastructure: Governments may be encouraged to invest in infrastructure in areas where many firms are concentrated, improving productivity, increasing output per unit input and reducing average costs.
49
Q

What are external diseconomies of scale?

A

Increases in costs that occur to all firms due to expansion of the industry or concentration of firms in a certain location. illustrated by an upward shift of the LRAC curve.

50
Q

What are the 2 external diseconomies of scale?

A

1, Increased strain on infrastructure

2. Shortage of industry-specific resources

51
Q

Explain increased strain on infrastructure.

A

With localisation, infrastructure will be taxed to its limits, reducing productivity and hence output and increasing cost.

52
Q

Explain shortage of industry-specific resources.

A

As industries grow, there may be a growing shortage of specific raw materials. Competition will push up prices and increase costs.

53
Q

What does minimum efficient scale show?

A

Optimum size of firms and the number of firms in the industry. If MES is small, low output level is optimal. If MES is large, high output level is optimal.

54
Q

Decision making in the long run:

A

Affected by cost. If average revenue is unable to cover LRAC and at least earn normal profits, firm will shut down and leave the market.

55
Q

What are the factors affecting the size of firms?

A
  1. Cost factors
  2. Revenue factors
  3. Business risk and uncertainty
  4. Alternative objectives of firms
56
Q

How do cost factors affect the size of firms?

A

Firms tend to be small if diseconomies occur at low levels of output.
Small firms tend to emerge when the entire production process is broken up into separate processes as diseconomies emerge quickly in each of these processes. This lowers unit cost incurred.
Small and large firms can coexist where economies of scale are exhausted quickly followed by constant unit costs.
Independent businesses can band together to gain advantage in bulk buying, advertising and promotions.

57
Q

How do revenue factors affect the size of firms?

A

Nature of product: personalised goods require direct attention, thus is impossible to have mass production. Demand is limited, firms remains small.
Market segmentation and specialisation: large firms cater to mass produced items while small firms cater to customised items. Market for specialised products tends to be small. Demand in niche markets is more price inelastic, firms can set a high price to cover its high cost of production
Geographical factors: if product has great bulk in relation to value, transport costs will be relatively high, market is likely to be local.
Profit-cycles: at early stages of product cycle, demand tends to be low, firm tend to be small and takes time to grow.

58
Q

How does business risk and uncertainty affect size of firms?

A

Firms may have to borrow from banks if they cannot raise enough capital. Risk of investment is greater. If firms are unwilling to bear the significant risks, they remain small. Firms may also fear future fall in price due to sudden expansion and thus choose to remain small.

59
Q

How do alternative objectives affect size of firms?

A

Firms may remain small if owners prefer to keep them small due to reasons not related to profit and just aim to profit satisfice.

Economics (6 decks)

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