Firms and Decisions Part 1 Flashcards
Types of profit
Define MR MC
- Supernormal profit: positive economic profit (TR>TC)
- Normal profit: 0 economic profit (TR=TC)
- Subnormal profit: negative economic profit (TR<TC)
Marginal revenue is additional revenue a firm makes from selling one more unit of output produced. Marginal cost is additional cost that firm incurs from increasing output produced by one unit.
Alternative objectives of firms
- Revenue maximisation
- Profit satisficing
- Market share dominance
Revenue maximisation
Cause
Impact
Who?
Total revenue is maximised at the output where no additional revenue can be reaped from producing and selling an extra unit of output.
Entrepreneurs/ employers (principals) have to employ agents to carry out specialised task
Principal agent problem where objective of shareholders (profit maximisation) may be different from that of directors and managers (agents).
- Shareholders want strong returns for dividend payments and rising share price
- Managers want power, bonus, prestige and status and hence would maximise ‘managerial utility’ in their self-interest -> because income/ bonus of sales managers are dependent on firm’s total revenue (higher revenue, higher commission)
Firms with a dominant sales department would choose this.
Profit satisficing
Cause
Given level of profits that is deemed acceptable by owners even though it falls below the profit-maximising level is achieved
Divorce of ownership from control, managers in firm aim for target level of profit rather than maximum level as they (decision makers) may not stand to benefit and maximise managerial utility (save time, energy and resources), altruistic intentions with social aims
Market share dominance
Cause
Impact on firms’ behaviour
Proportion of firm’s total sales (revenue) compared to the market
Greater prestige/ higher salaries for employees, while better stock performance from gains in market share for managers/ executives
Firms will reduce prices or engage in strategies to shift their demand curve outwards and making demand relatively less price elastic, enabling the firm to raise prices and increase total revenue and profit
Strategies firms may go for to increase their market share
- Entry deterrence
- Successful entry of new entrants will lower firm’s market share and profits
- Can deter entry of new firms by focusing their price and non-price decisions on it, through spending more on development of brand/ good so new entrant has to match the significant amount spent on it
- Price good low enough that makes it unprofitable for new firms to enter the market - Predatory pricing
- Prices goods at unreasonably low price with intention of driving out competitors
- May even incur losses from it but able to do so due to sufficient past profits to cope with losses incurreed
- Rival firms may not cope with losses incurred due to low prices and exit the market
- Allowing remaining firms to increase market share and power
Definitions: Market, firm, industry, production, variable factors, fixed factors, short run and long run
Market= Exists whenever producers and consumers come together to transact with each other
Firm= Organisation or enterprise formed by entrepreneurs who bring together factors of production to produce goods or services for sale
Industry= Group of firms that produce a single good or service, or a group of related goods or services
Production= Process by which factors of production are used to create goods and services
Variable factors= Factors that can be increased wen firm increases output in short run
Fixed factors=
LDMR
As more units of a variable factor are applied to a given quantity of a fixed factor, additional output from additional units of the variable factor employed will eventually diminish
3 stages of production in short run and reasons
- INITIALLY:
Total output RISES (total product rises)
Increasing marginal output (marginal product of labour rises= extra output produced by employing one more unit of variable factor)
= Total output rises at an INCREASING rate
- More efficient labour-capital combination, fixed capital used more effectively by adding more workers
- Division of labour and specialisation of tasks lead to greater efficiency - IN THE MIDDLE:
Total output RISES
Decreasing marginal output (marginal product of labour falls)
= Total output rises at a DECREASING rate
- Inefficient labour-capital combination
- Overcrowding arises and fixed factor is being over-utilised
- LDMU sets in, marginal product of labour falls
- Each additional unit of labour eventually adds less to total output than previous unit of labour (marginal output falling) - FINALLY:
Total output FALLS
NEGATIVE marginal product of labour
- Additional output attributable to the next unit of variable factor is negative
Short run costs DEFINITIONS
- Fixed cost
- Variable cost
- Total cost
- Total fixed cost
- Total variable cost
- Average total cost
- Average fixed cost
- Average variable cost
- Marginal cost
Fixed cost -> cost that does not vary with output level, must be paid even when production does not take place
Variable cost -> cost that varies with output level, not incurred when production does not take place
Total cost -> Sum of costs of all factors of production a firm uses in production
Total fixed cost -> cost incurred in utilisation of fixed factors of production
Total variable cost -> cost incurred in utilisation of variable factors of production
Average total cost -> cost per unit of output
Average fixed cost -> total fixed cost per unit of output
Average variable cost -> total variable cost per unit of output
Marginal cost -> change in total costs from increasing output by one additional unit
Short run cost curves (AFC, MC, AC, AVC)
AFC is continuously downward sloping as output rises, TFC is spread over larger quantities of output and it is constant regardless of level of output.
MC is U-shaped as MC initially decreases as production experiences increasing marginal returns due to more efficient labour-capital combination or better utilisation of fixed factors, resulting in initial fall in MC. However, MC subsequently increases as production experiences decreasing marginal returns due to diminishing returns setting in (LDMU) due to fixed factor being over utilised.
AVC is U-shaped as rise in MC will cause AVC to eventually rise.
AC is also U-shaped and is the vertical summation of AFC and AVC curves. As AFC and AVC are initially decreasing as quantity increases, AC also decreases. AVC subsequently increases while AFC continues to decrease. AC continues to fall as decreasing effects of AFC outweighs increasing effects of AVC. However, AC eventually increases as increasing effects of AVC outweighs decreasing effects of AFC. As AFC continues to fall with increases in Q, vertical distance between ATC and AVC decreases.
Relationship between MC and AVC/ ATC Curves
When MC < AC, AC is falling as additional units of output cost less than average
When MC >AC, AC must be rising as new units of output cost more than average
MC curve must intersect AVC and AC curves at the minimum points of them.
Types of returns to scale
- Constant returns to scale -> output increases proportionately to increase in inputs
- Decreasing returns to scale -> output increases less than proportionately to the increase in inputs as internal diseconomies of scale are present
- Increasing returns to scale -> output increases more than proportionately to the increase in inputs as average costs falls as output increases, showing that the firm is able to reap internal economies of scale
Shape of LRAC curve and reason
Definition of LRAC
U-shaped
INITIALLY
As output rises, average costs fall initially as firm benefits from internal economies of scale, leading to increasing return to scale
IN THE MIDDLE
Long run average cost is at its minimum, firm reached minimum efficient scale, where LRAC stops falling as no significant or additional internal economies of scale can be achieved
AT THE END
Average costs increases, reflecting internal diseconomies of scale, leading to decreasing return to scale
All points on LRAC represent least-cost factor combinations for the given level of output, points above the LRAC curve are attainable but unwise, while points below the LRAC curve are unattainable given present factors of production and level of technology
Internal economies of scale
Type of internal economies of scale
Cost savings that result from firm’s expansion and created by firm’s own policies and actions, arise from spreading out of fixed costs, productivity improvements and greater buying power over inputs when a firm expands its production
Technical economies of scale
Financial economies of scale
Marketing economies of scale
Technical Economies of Scale
- Factor indivisibility
- Inputs are of a minimum size and cannot be divided into smaller units
- Purchasing such factors of production may be unfeasible if firm’s output is small, hence it is operating below factor’s maximum capacity - Law of increased dimensions
- Lower unit cost of production due to cubic low, where doubling height, width and breadth of a tanker leads to a more than proportionate increase in capacity
- Capital equipment used to contain materials costs less per unit of output the larger the size - Specialisation and division of labour
- Workers can be assigned to do specific and more repetitive jobs
- Less training needed, increased efficiency in workers, less time lost in workers switching from one operation to the other
- Higher output per worker hence less unit cost of production for firm
Financial economies of scale
Larger firms given lower interest rates and larger loans due to better credit ratings and greater collaterals while small firms face higher rates of interest on loans as it is riskier to lend to smaller companies.
Larger firms can also be public limited companies, firms can raise capital through issuance of bonds to public, taking advantage of financial economies of scale better.
Marketing economies of scale
Large firms have bargaining advantage and accorded a preferential treatment by suppliers as they buy raw materials and components in bulk, allowing them to dictate requirements with regard to price, quality and delivery more effectively.
Internal diseconomies of scale and types of diseconomies of scale
Increases in cost that occur to a firm as a result of the firm’s expansion, resulting from the firm’s own policies and actions. Arises from fall in productivity due to greater complexity and lower labour motivation, as well as the employment of more resources to manage such problems when a firm expands its production.
- High cost of monitoring and management
- Low morale
High cost of monitoring and management
Monitoring productivity and quality of output in big complex firms is imperfect and expensive, linking to the concept of principal-agent problem.
Low morale of employees
Workers in large firms develop a sense of alienation and loss of morale, do not consider themselves to be an integral part of the business, hence productivity may fall leading to a wastage of factor inputs and higher costs.
External economies of scale
Savings in costs that occur to all firms due to expansion of the industry or concentration of firms in a certain location, represented diagramatically by a downward shift of the LRAC curve as average costs fall for each level of output
- Economies of information
- Economies of concentration/ agglomeration economies
Economies of information
Increased information flows about R&D processes allowed for firms to share information on cost-saving technologies, improving productivity of individual firms and reduce average costs
Many scientific and trade journals provides information to all the firms relating to new markets, sources of raw materials and latest techniques of production
Economies of concentration/ agglomeration economies
- Availability of skilled labour
- Special educational institutions can be set up to train people in such skills, firms can join together to develop training facilities for workers, helping firms to reduce costs of training for workers
- Well known geographical regions also attract talent for firms reducing labour search costs - Well-developed infrastructure
- Many firms are concentrated in one area, so governments are encouraged to invest infrastructure to support and cater to the industry
- Can help improve productivity increasing output per unit input and reduce average costs for individual firms
External diseconomies of scale and types of external diseconomies of scale
Increases in costs that occur to all firms as a result of expansion of industry or concentration of firms in a certain location, diagrammatically it is represented by an upward shift of LRAC curve as average costs rises for each level of output
Increased strain on infrastructure
Shortage of industry-specific resources
Increased strain on infrastructure
If concentration of firms happens in a geographical region, infrastructure will be taxed to its limits (eg: traffic congestion)
Shortage of industry-specific resources
As industry grows larger, there may be a growing shortage of specific raw materials or skilled labour.
Competition for such resources will push up prices and increase firms costs.
Minimum efficient scale
Scale of production where internal economies of scale have been fully exploited, lowest point on the long run average cost curve.
If MES is a small percentage of market demand, a low output level of a firm is optimal as large firms have significant diseconomies of scale and MES is achieved at low levels of output.
If MES is a large percentage of market demand, a high output level of a firm is optimal as large firms have significant economies of scale and MES is achieved at high levels of output.
Supply side/ cost factors that allow small firms to remain small
Firms reach Minimum Efficient Scale at very low levels of output relative to market output
Saucer shaped LRACs
Banding and joint ventures
Firms reach MES at very low levels of output relative to market output
- Diseconomies occur at low levels of output
Such industries usually provide services that require personal attention (tailoring)
- Average cost rises sharply as output increases
- If specific detail has to be mass produced, diseconomies of scale will set in, any advantages to large scale production are more than offset by disadvantages
Vertical disintegration
- Entire production process is broken up into series of separate processes
- Diseconomies of scale emerge in each of processes
- Small firms each performing a small part of whole task incurs a lower unit cost
- Small firms can complement larger firms in same industry if they specialise in single process or make components for larger organisations
Saucer-shaped LRACs
Small and large firms co-exist due to cost reasons
- Economies of scale are quickly exhausted, followed by constant unit/ average costs over a wide range of output
- Small and large firms can be equally cost efficient and coexist in same industry
Banding and joint ventures
Independent businesses engage in joint ventures or band together
- Gain advantages of bulk buying, advertising and promotion while retaining independence and ownership of business
- Can set up jointly owned enterprises to source for raw materials, obtaining many economies of scale enjoyed by larger firms
Demand side/ revenue factors that allow small firms to remain small
Nature of product, market segmentation and specialisation, geographical factors and profit cycles
Nature of product
Personalised goods and services required direct individual attention
- Good or service is very specific hence demand for firm’s services is limited
- Consumers have preference for variety and choice rather than standardisation and mass production
Market segmentation and specialisation
Industry caters to diversified range of products and customers, can instead by segmented into smaller markets
- Large firms can focus on mass produced items while small firms concentrate on customised items
- Small firms can cater to niche markets which is smaller due to high and restrictive prices
- However, demand is more price inelastic
- Although firm may not be exploiting fully available internal economies of scale, can set a relatively higher price to cover higher unit costs of production
Geographical factors
Transport costs will be high relative to total production costs if product has great bulk in relation to value
- Market more likely to be local than national, hence smaller and more localised
Smaller firms can distinguish themselves by being placed in convenient areas within an inaccessible location that contains a smaller market, better catering to them
Profit cycles
New products appear continually while others disappear. At the early stage of a product cycle, total demand for product is low, but it will slowly grow, outpace rival firms, merge and force others out of business
Business risk and uncertainty
Unwillingness to take greater risk
- Expansion require funds and involves larger capital outlay
- Firms have to borrow from banks if they cannot raise the money
- Risk of investment is greater as losses can be potentially greater if business does not work out
- Firms may be risk-averse and remain small as they are unwilling to bear significant risk involved
- Firms may fear a future fall in product price
- Sudden expansion of output may lead to large enough increase in market supply
- Huge surplus causes price of product to decrease
- Lower prices and hence profits may prevent firms from expanding
Profit satisficing
Entrepreneur could be contented with reasonable income from domestic/ localised market and unwilling to take on increased risks, stress or perceived challenges from growth
