Micro part 5- Efficiency and Business Objectives

Question 1

What is economic efficiency

Answer 1

1. Where resources are allocated in so every consumer benefits and waste is minimised.
2. There is allocative and productive efficiency

Question 2

What is static efficiency

Answer 2

1. Static efficiency refers to efficiency at one point in time (allocative and productive, resources are allocated efficiently)

Question 3

What does dynamic refer to

Answer 3

1. dynamic refers to new technology and increased productivity and how this increases efficient allocation of resources over time.
2. dynamic is when the rate of innovation is at the optimum level causing LRAC to fall over time.
3. It’s affected by short run factors like i.r. and confidence

Question 4

What is productive efficiency

Answer 4

1. Productive efficiency – when resources are used to give the maximum output at the lowest average cost. 2. When firms produce at the lowest point on the LRAC
2. Can only exist when there’s technical efficiency
3. For an economy it’s when producing on the PPF curve as there is no possibility of gaining any extra output if all firms are producing at lowest cost

Question 5

How do monopolies relate to productive efficiency

Answer 5

1. will be productively inefficient
2. this is because monopolies restrict output to maximise profit so it operates at an output where AC is not lowest
3. this means consumers take on higher costs creating higher prices

Question 6

What is perfect competition in respect to productive efficiency

Answer 6

1. firms will be trying to maximise their profits out of necessity to stay in the market.
2. If they were not then a new entrant would enter the market, produce at the bottom of its AC curve, undercut the price of the original firm and that firm would be forced out of business
3. this means firms will need to produce at the bottom of their AC curve (productively efficient) when in equilibrium
4. this is because having to compete means there is strong incentive for firms to reduce waste and inefficiencies

Question 7

What are problems with perfect competition in respect to AC cost/productive efficiency

Answer 7

1. may not be in the s.r. since the firm profit maximises so may make ANP in the s.r.
2. this means that allocative efficiency. output is greater than the ANP output
3. so when making ANP in the s.r. then not productively efficient

Question 8

What is allocative efficiency

Answer 8

1. when the price consumers are willing to pay is equal to the cost to society of producing an additional unit. 2. Goods are produced in the best interests to society which maximises consumer welfare and utility. Where P = MC
2. When resources are distributed to the g/s that consumers want

Question 9

How do monopolies relate to allocative efficiency

Answer 9

1. will be allocatively inefficient since P > MC
2. because monopolies that profit maximise operate at an output where MC = MR
3. this means consumers place greater value on the last unit bought tan the cost of producing that unit so the good is under-produced
4. therefore consumer welfare will be reduced

Question 10

What is perfect competition in respect to allocative efficiency

Answer 10

1. perfect competition ensures the price mechanism works
2. all firms are price takers (price is set by consumer preferences signalling and meaning resources are rationed)
3. there is perfect information so firms can act on incentives to know whether to leave/enter a market

Question 11

What does perfect competition in terms of allocative efficiency mean for consumer and producer surplus

Answer 11

1. means that price is set to what consumers are willing to pay since the price mechanism ensures firms produce exactly what is demanded, meaning P=MC (allocative efficiency).
2. This occurs because consumers are paying the price equal to the cost to society of producing an additional unit of the good (resources are allocated efficiently)
3. consumer and producer surplus are maximised

Question 12

What are problems with perfect competition in respect to allocative efficiency

Answer 12

1. the MC to the firm may not take into account external costs/benefits that affect 3rd parties not involved in the economic transaction
2. means MC of the firm is = MPC but due to externalities the MSC is > than MSB
3. good is overproduced and overconsumed meaning industry may not be allocatively efficient

Question 13

What is x-inefficiency

Answer 13

1. X-inefficiency – occurs when a firm is not producing at the lowest possible cost for a given level of output. 2. Operating within its AC curve (not on boundary)

Question 14

Why does x-inefficiency occur

Answer 14

1. management is poor at controlling costs e.g. doesn’t get cheap prices for raw materials
2. stakeholders within the firm are able to extract benefits greater than what the firm needs to pay e.g. managers taking higher bonuses

Question 15

What is normal profit

Answer 15

1. occurs when TR = TC.
2. This means the extra revenue left after covering a firm’s money costs is equal to the opp. cost of the FoP that aren’t paid for.
3. If extra revenue is less then it means the firm would have been better off putting the FoP to a different use. 4. It is the minimum profit to keep resources in their current use in l.r.

Question 16

What is abnormal profit

Answer 16

1. occurs when TR > TC.
2. This means the revenue generated from using the FoP in this way is greater than could have been generated in any other way.
3. Creates an incentive for firms to join the market

Question 17

What is divorce of ownership from control problem

Answer 17

1. An example of the principal agent problem due to asymmetric information.
2. The agent makes decisions for the principal, but the agent acts in their own interest
3. In smaller firms the owners likely work for the company but in larger firms the owners are more likely to be shareholders and cannot exercise control over managers – creating a divorce from ownership

Question 18

Why are the shareholders and managers are unlikely to have the same objectives

Answer 18

1. shareholders likely want to maximise s.r. profits as this increases the value of the shares
2. a manager may have pay/bonuses linked to total sales or revenue so they may want to maximise this

Question 19

What can the divorce of ownership from control problem lead to

Answer 19

1. This could lead to them satisficing (profits to the minimum acceptable level) as they still need some profits to stay in business and then work on other objectives
2. This can give rise to x-inefficiencies where the firms costs per unit at a given output are above the LRAC curve

Question 20

How can owners tackle the divorce of ownership from control problem

Answer 20

1. Owners can tackle this problem by making managers more accountable meaning they have to justify their actions and explain their future intentions.
2. However this can be limited due to asymmetric information

Question 21

What is Profit maximisation

Answer 21

1. occurs when MC = MR or the difference between TR and TC is greatest.
2. If MC > MR then decrease output since it’s costing firms more to produce the last unit of output than it receives in revenue.
3. If MC < MR then increase output because the revenue gained by increasing output is greater than the cost of producing it.

Question 22

What do neo-classical economists assume

Answer 22

1. Neo-classical economists assume that firms aim to maximise s.r. profits
2. implies firms are willing to supply in the s.r. even if they make a loss in the s.r. as long as price is higher than AVC

Question 23

What do Neo-Keynesian economists assume

Answer 23

1. Neo-Keynesian economists assume that firms aim to maximise l.r. profits
2. this is due to cost plus pricing techniques where the price is calculated by calculating ATC of operating at full capacity.
3. These means price and therefore profit is set based upon l.r. costs

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Question 24

What does s.r. profit maximisation imply

Answer 24

1. s.r. profit maximisation implies firms adjust price/output depending on changes in the market, but frequent price adjustments may damage their position in the market

Question 25

What effects could different price adjustments have

Answer 25

1. price reductions could lead to a price war
2. price increases may be seen as profiteering causing consumers to switch other brands as they feel they can receive better quality
3. price changes incur costs because firms have to frequently change prices
4. therefore firms will want to maintain stable prices based on l.r. costs

Question 26

Why might it be prefered to keep prices above market

Answer 26

1. may prefer to keep prices above market if believe price changes may have a permanent effect on prices and therefore l.r. profits

Question 27

What profit do firms need to keep operating in the l.r and what happens if it can’t

Answer 27

1. . Firms need to make normal profit to keep operating in the l.r.
2. If it can’t then will close because its revenue is not covering all the costs.

Question 28

What will allow firms to continue running in the short run and what will cause them to close immediately

Answer 28

1. . In the s.r. a loss-making firm has fixed costs to pay no matter the revenue so may continue to operate in the s.r.
2. if TR > TVC or AR > AVC then continue to operate in the s.r. since the extra revenue can contribute towards paying fixed costs
3. if TR < TVC then will close immediately

Question 29

What is the relevance of profit maximisation for businesses

Answer 29

1. important in perfectly competitive because if don’t profit maximise then forced out of business
2. important in oligopolistic/monopoly as it’s a source of funds for innovation

Question 30

What are the benefits of profit maximisation

Answer 30

1. more profit can be used to create dynamic efficiency through investment in R&D
2. profits can be used to pay higher wages to workers (not be equally shared if there is monopsony power)
3. greater profits can allow firms to negotiate low i.r. loan deals since they are perceived to be of lower risk due to their profitability. This can create internal economies of scale. This can reduce costs
4. reduce chance of aggressive takeover from another firm

Question 31

What is the extent to which profit maximise will depend on market structure

Answer 31

1. If concentration ratio is high then profit maximise to survive
2. whether they want to long run or short run profit maximise
3. monopolies may not as if there is a high contestability then don’t want to incentivise other firms to join the industry so instead may choose to sales revenue maximise to increase output