HL - Theory of the Firm

Question 1

What’s the difference between the short run and the long run? Give an example

Answer 1

In the short run fixed factors of production exist (but you can still have variable factors as well).

In the long run all factors of production are variable
E.g a lease that may last for 12 months.

Question 2

Definition of total product (TP)

Answer 2

Total output

Question 3

Definition of average product (AP)

Answer 3

It means the total product/ variable factor (e.g workers).

Question 4

What does marginal product mean?

Answer 4

The extra output produced by employing one extra variable factor of production. E.g employing one more worker

Question 5

What’s the formula for calculating MP?

Answer 5

Change in output/ change in variable factor

Question 6

What happens to MP when TP is at its maximum?

Answer 6

MP must be equal to zero

Question 7

Why do negative marginal returns eventually set in?

Answer 7

Because there’s always a fixed factor e.g if you have a field to grow grain and you keep employing people, at one point there will be too many people and they will start to tread on the grain, which is inefficient.

Question 8

Why does MP cut AP at its highest point?

Answer 8

If you’re creating a new average by adding numbers that is higher than the existing average, then it must be rising. If you are creating a new average by adding values lower than the existing average then the new average must be falling.

Question 9

What is the law of diminishing returns?

Answer 9

As more units of variable factor get added to a fixed factor, although increasing returns may initially apply (due to divisor of labour), diminishing returns will eventually set in. This can only happen in the short run because it’s only in the short run that we have fixed factors.

Question 10

What are the benefits and negative aspects of the division of labour, and what is it?

Answer 10

It’s the separation of talks involved in that labour.
Benefits:
More efficient sit to time saving and specialisation. Create more output
Negatives:
Boring for the working

Question 11

What happens to the rate of increase according to the law of diminishing returns?

Answer 11

At first the rebate of increase slows down (decreases) but then it becomes disadvantageous and total output decreases.

Question 12

What are economic costs?

Answer 12

It’s the opportunity cost of all resources employed by the firm. It’s the sum of explicit and implicit costs. Including profit for the entrepreneur.

Question 13

What are the explicit and implicit costs in economic costs?

Answer 13

Explicit - payments the firms makes to buy resources from external suppliers
Implicit - the sacrificed income the firm loses when it uses its own resources. E.g The firm using its own money rather than borrowing, it could have been earning interest in the bank.

Question 14

What happens to fixed costs and variable costs as output changes?

Answer 14

Nothing happens to the fixed costs

Variable costs change

Question 15

What’s the relationship between Total costs and variable costs in the long run?

Answer 15

TC = VC

Question 16

What’s the equation for TC?

Answer 16

TC = TVC + TFC

Question 17

What’s the equation for Average Fixed Costs and Average Variable Costs?

Answer 17

AFC = TFC / Q 
AVC = TVC / Q

Question 18

What’s the equation for Average Total Costs?

Answer 18

ATC = TC / Q

Question 19

What’s the equation for Marginal costs?

Answer 19

It’s the extra cost of producing one more unit of output.

Change in TC / change in output

Question 20

What does the Average Total Cost curve show in the long term?

Answer 20

Shows the lowest possible total costs. It’s made up of the points of tangency of an infinite number of SRATC curves, which show all the different possible scales of operation.

Question 21

What are increasing, constant and decreasing returns to scale?

Answer 21

Increasing returns - increase in inputs leads to a bigger than proportionate amount of output.
Constant returns - increase in inputs is exactly matched by increase in output
Decreasing returns - increase in input leads to a proportionately smaller increase in output.

Question 22

When do economies of scale occur?

Answer 22

When average costs of production are falling as output increases. (increasing returns)

Question 23

What are the reasons for economies of scale? (1)

Answer 23

Specialisation - the division of labour
Efficiency - larger firms can use capital equipment that can have lower costs per unit. E.g doubling the dimensions of a container makes the capacity increase more than proportional. So transportation per unit and storage per unit are cheaper for larger firms.

Question 24

What are the reasons for economies of scale? (2)

Answer 24

Marketing - cost per unit of marketing is cheaper for larger firms
Indivisibilities - equipment might not be used to maximum efficiency in a small firm. E.g a photocopier

Question 25

What are diseconomies of scale?

Answer 25

Occurs when average costs rise as output increases (decreasing returns).

Question 26

Why do diseconomies of scale occur?

Answer 26

Co-ordination: May be hard to organise large groups of workers
Communication: May be more difficult to make sure everyone knows what they are doing in a bigger organisation
Motivation: workers may feel like their contribution isn’t noticed in a large group.

Question 27

Why AVC decrease and then increase?

Answer 27

Increasing returns means output is cheaper to produce. When there are diminishing returns every extra unit of output is more expensive.

Question 28

What are revenues?

Answer 28

The payments firms receive from the sale of their goods and services.

Question 29

What are the equations for Total revenue, Average Revenue and Marginal Revenue?

Answer 29

TR = P x Q 
AR = TR / Q     (AR = P) 
MR = change in TR/ change in Q

Question 30

What is economic profit and Normal profit?

Answer 30

Economic (abnormal) profit: total revenue exceeds economic cost
Normal profit (zero economic profit): total revenue is equal to economic costs. Amount of revenue is just enough to keep the firm in its current line of business, as its still getting enough return for all the factors of production.

Question 31

What is negative economic profit?

Answer 31

When total revenue is less than total costs.

Question 32

What does it mean when your revenue exceeds your cots by the greatest amount?

Answer 32

Your profit must be maximised

Question 33

What happens after peak profit?

Answer 33

Your profit is decreasing because it’s costing you more for each unit, then the revenue you are getting for each unit.

Question 34

When does profit maximisation occur?

Answer 34

Total revenue exceeds total costs by the greatest amount, or where marginal revenue equals marginal costs.

Question 35

How is revenue maximisation an alternative goal of the firm?

Answer 35

The divorce between ownership and control (manager isn’t necessarily the owner) resulting in the managers being tasked with maximising revenue. Rewards to staff are often set to incentivise increasing revenue.

Question 36

How is growth maximisation a alternative goal for the firm?

Answer 36

May help the firm benefit from economies of scale and it may get more market power. Firm may diversify to reduce risk.

Question 37

How is satisficing a alternative goal?

Answer 37

Reaching a compromise between different stakeholders that have different objectives. It’s about achieving the satisfactory level rather than maximising. If it doesn’t do this, it may be detrimental to its future.

Question 38

How is corporate social responsibility a alternative goal for the firm?

Answer 38

Being concerned with minimising negative externalities and considering what’s best for society. E.g environmental and ethical issues, as consumers may stop buying if they do not approve of the way it operates.