Firms and Decisions Part 1

Question 1

Types of profit

Define MR MC

Answer 1

1. Supernormal profit: positive economic profit (TR>TC)
2. Normal profit: 0 economic profit (TR=TC)
3. 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.

Question 2

Alternative objectives of firms

Answer 2

1. Revenue maximisation
2. Profit satisficing
3. Market share dominance

Question 3

Revenue maximisation

Cause

Impact

Who?

Answer 3

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.

Question 4

Profit satisficing

Cause

Answer 4

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

Question 5

Market share dominance

Cause

Impact on firms’ behaviour

Answer 5

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

Question 6

Strategies firms may go for to increase their market share

Answer 6

1. 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
2. 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

Question 7

Definitions: Market, firm, industry, production, variable factors, fixed factors, short run and long run

Answer 7

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=

Question 7

LDMR

Answer 7

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

Question 8

3 stages of production in short run and reasons

Answer 8

1. 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
2. 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)
3. FINALLY:
   Total output FALLS
   NEGATIVE marginal product of labour
   - Additional output attributable to the next unit of variable factor is negative

Question 9

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

Answer 9

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

Question 10

Short run cost curves (AFC, MC, AC, AVC)

Answer 10

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.

Question 11

Relationship between MC and AVC/ ATC Curves

Answer 11

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.

Question 12

Types of returns to scale

Answer 12

1. Constant returns to scale -> output increases proportionately to increase in inputs
2. Decreasing returns to scale -> output increases less than proportionately to the increase in inputs as internal diseconomies of scale are present
3. 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

Question 13

Shape of LRAC curve and reason

Definition of LRAC

Answer 13

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

Question 14

Internal economies of scale

Type of internal economies of scale

Answer 14

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

Question 15

Technical Economies of Scale

Answer 15

1. 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
2. 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
3. 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

Question 16

Financial economies of scale

Answer 16

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.

Question 17

Marketing economies of scale

Answer 17

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.

Question 18

Internal diseconomies of scale and types of diseconomies of scale

Answer 18

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.

1. High cost of monitoring and management
2. Low morale

Question 19

High cost of monitoring and management

Answer 19

Monitoring productivity and quality of output in big complex firms is imperfect and expensive, linking to the concept of principal-agent problem.

Question 20

Low morale of employees

Answer 20

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.

Question 21

External economies of scale

Answer 21

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

1. Economies of information
2. Economies of concentration/ agglomeration economies

Question 22

Economies of information

Answer 22

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

Question 23

Economies of concentration/ agglomeration economies

Answer 23

1. 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
2. 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

Question 24

External diseconomies of scale and types of external diseconomies of scale

Answer 24

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

Question 25

Increased strain on infrastructure

Answer 25

If concentration of firms happens in a geographical region, infrastructure will be taxed to its limits (eg: traffic congestion)

Question 26

Shortage of industry-specific resources

Answer 26

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.

Question 27

Minimum efficient scale

Answer 27

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.

Question 28

Supply side/ cost factors that allow small firms to remain small

Answer 28

Firms reach Minimum Efficient Scale at very low levels of output relative to market output

Saucer shaped LRACs

Banding and joint ventures

Question 29

Firms reach MES at very low levels of output relative to market output

Answer 29

• 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

Question 30

Saucer-shaped LRACs

Answer 30

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

Question 31

Banding and joint ventures

Answer 31

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

Question 32

Demand side/ revenue factors that allow small firms to remain small

Answer 32

Nature of product, market segmentation and specialisation, geographical factors and profit cycles

Question 33

Nature of product

Answer 33

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

Question 34

Market segmentation and specialisation

Answer 34

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

Question 35

Geographical factors

Answer 35

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

Question 36

Profit cycles

Answer 36

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

Question 37

Business risk and uncertainty

Answer 37

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

Question 38

Profit satisficing

Answer 38

Entrepreneur could be contented with reasonable income from domestic/ localised market and unwilling to take on increased risks, stress or perceived challenges from growth