Production and supply

Question 1

What is the key assumption about firms made in a standard market context?

Answer 1

They are profit maximisers.

Question 2

What is the key difference between standard accounting profit and economic profit?

Answer 2

Economic profit accounts for the opportunity cost - the cost of not pursuing the next best alternative to the firm.

Question 3

Suppose you have £1 million.

You can pursue one of two ventures; spend your £1 million on option A, which makes £600k per-year but costs are £500k. Or option B, which costs £500k to start but makes £280k per-year with costs of £200k. The interest rate is 5%.

According to economic profit, which option is most lucrative over time (think on a per-year basis).

Answer 3

Option B.

While option A makes £100k accounting profit per-year, it costs the full £1 million to set up leaving no money in the bank to earn interest. While option B only earns £80k accounting profit per-year, you’d still have £500k in the bank to earn 5% interest - £25k. This totals to £105k per-year income.

In each case, the “next best alternative” is the other alternative. In option B’s case, the economic profit is £5k as the difference between B and A’s accounting profits is £105k - £100k = £5k. Opposite from A’s point of view, where the economic profit is -£5k.

Question 4

What are two scenarios which the idea of “profit maximising firms” breaks down (think from the point of firm’s owner).

Answer 4

Firm’s owner is the manager: Consider the backward-bending labour supply curve. A scenario where profit maximisation would involve the owner to exert so much effort it isn’t deemed “worth it” (marginal cost of labour exceeds marginal benefit).

Ethical/humanitarian concerns: It’s common that profit maximisation incurs costs to the environment or other ethical costs. Owners that place more importance on these concerns than profit are unlikely to profit maximise.

Question 5

What condition needs to be fulfilled for a firm to maximise profits? Why is this? Show with a basic example.

Answer 5

Marginal cost equals marginal benefit of production.

This is because if MC > MB, then profit will be cut into. Vice versa for MC < MB, there is profit to be made so production increases.

Suppose you produce 10 units of X earning revenue of £50 and incurring costs of £30. When producing 11 units, if revenue earned is £51 and costs incurred are £35, then MC (£5) > MB (£1) and the firm would not produce this volume of goods.

Question 6

Broadly describe the difference between the short and long term.

Answer 6

Short term: Choices are constrained in the short term as there are fixed effects present (number of units in stock, current orders, etc.).

Long term: Most things can be changed in the long-term and it’s assumed any necessary changes to production can be made.

Question 7

What assumptions are made about capital (inanimate assets used in production) and labour? Are they fixed or variable?

Are these assumptions applicable to the more modern, service-based economy?

Answer 7

We assume capital is fixed and labour is variable. So in the short term a labour response is often stronger than capital.

Currently, one may pose that buying or dumping a few computers (capital) is easier than hiring and firing a specialist employee (labour).

Question 8

Suppose you’re the owner of a profit maximising firm in the short term. What is one thing (arguably) you could do to increase your output? Explain why other options wouldn’t work.

Answer 8

As labour is variable in the short term, the main thing to do would be to hire new staff.

Capital is fixed in the short term so cannot be brought in on short notice. Also, the productivity of individual workers cannot improve as under profit-maximising scenarios it is assumed all workers are as productive as possible.

Question 9

When increasing a firm’s output in the short term via labour, what is the key thing to consider from the owner’s point of view and how much labour is hired?

Answer 9

The marginal product of labour (MPL) - the additional output generated per-worker hired. The optimal point is when the MPL equals zero.

A well-behaved MPL curve is concave in shape.

Question 10

Cost definition lightning round, define: total costs, fixed costs, variable costs, average costs, marginal costs.

Answer 10

Total costs: Total payments incurred by a firm to inputs it uses for production.

Fixed costs: The “overheads” of production in the short run which don’t change and must be paid out no matter how much the firm produces.

Variable costs: Costs accrue to variable inputs such as wages paid to labour.

Average costs: Costs expressed per-unit of output produced.

Marginal cost: Cost incurred of producing one more unit of output.

Question 11

What is the relationship between marginal product of labour and marginal costs of a firm?

Answer 11

They mirror each other. The MPL curve is a concave shape that peaks then dips, while the MC curve is convex.

As the number of workers hired increases, the MPL first rises then dips. This increases outputs and MC decreases until it reaches it’s trough then rises as output increases.

Question 12

What assumption present in “perfect market” conditions is somewhat applicable to small firms in a large market?

Answer 12

That they are “price takers” - they take the price of output as given and work on the basis that they can sell as much or as little of the output at that price.

Imagine you have a single farmer producing potatoes to sell. Their production of one more field of potatoes is unlikely to impact the global price of potatoes. This is the kind of market we consider.

Question 13

What does a firm’s short-run supply curve describe?

Answer 13

The relationship between the price of the good and the amount of it that firm will sell, all else held constant.

Question 14

When a firm is a price-taker, how is their supply curve derived? How much do they supply?

Answer 14

The firm’s supply curve is determined by their marginal cost curve when they are a price-taker. The decision on whether or not to sell one more unit of a good is determined by whether selling that unit in isolation is profitable. There is no worry about the impact on overall price levels.

If marginal revenue exceeds marginal cost when considering the next unit, the firm produces the good for sale.

Question 15

As a price-taking firm’s supply curve is convex in nature with a trough, there exists a price range that intersects the curve at two points related the X-axis.

What level of output does the firm produce at in this case?

Answer 15

The level of output, Q, that corresponds with an upward-sloping supply curve.

If the point where the supply curve slopes down was chosen, it implies they could produce more and earn more profit as MC is decreasing.

Question 16

What decision may a price-taking firm face if prices for goods are forced very low?

Answer 16

Prices may be so low that profit maximising behaviour is not enough to cover short-term overheads. Therefore, shutting down may be a viable option to the firm.

Question 17

Define the price elasticity of supply. What do varying levels of PES look like? What do they mean in the context of a given price rise?

Answer 17

PES = % change in supply / % change in price.

Supply curves, the summation of all individual firm-level supply curves, slope upwards. This is because if a firm can earn more per-unit of a good, they will provide more of it in line with increasing marginal revenues.

A inelastic (elastic) PES is when PES is greater (less) than 1. Inelastic (elastic) supply curves are steep (shallow), and a 1% rise in price leads to less (more) than a 1% change in supply.

Question 18

What do capacity constraints mean for short-run supply when the price level rises? Give an example of an industry where this does/doesn’t apply.

Answer 18

Capacity constraints limit supply flexibility in the short run. This means marginal costs ramp up quickly thus a steep supply curve.

Industries like mining or nuclear power suffer from this. But for software development, the marginal cost of producing more code is essentially the cost of labour.

Question 19

Changes in factors other than price cause shifts in a firm’s ability to supply goods/services. What are the two core “shifts” that are seen in markets and what are their names?

Answer 19

An upward or leftward shift in the supply curve is called a contraction or reduction in supply, while a downward or rightward shift in this curve is called an expansion or increase in supply.

Question 20

As the aggregate supply of a market is the sum of individual firm supply curves - the firm’s marginal cost curves - anything that affects the firm’s marginal cost of production often causes a shift in the supply curve.

Provide examples that would cause a restriction and expansion of the supply curve.

Answer 20

Restriction: If wages rise, the cost of hiring additional workers necessary to raise output rises, forcing marginal costs upwards. This contracts the supply curve.

Expansion: Suppose some form of economic innovation occurs and the production of goods is now more efficient. This can be seen as a boost to labour productivity that means it takes fewer workers to produce one more unit of goods - marginal productivity of labour has shifted up thus marginal costs have shifted down. This causes supply to expand.

Question 21

Suppose a government imposes a tax on good A (flat rate or proportional). What does this do to the market price and the price producers receive to the good? How does this impact supply?

Answer 21

The tax drives a wedge between what consumers pay for the good - the market price - and the sum producers receive for it (market price less tax).

This wedge causes a shift in supply equal to the tax; that is, a flat rate tax shifts the supply curve up by £X and a proportional tax pivots the supply curve up %Y.

Consumption subsidies work in the opposite manner, with the government lowering the price consumers pay - the market price - by a flat or proportional rate causing supply to expand.

Question 22

France has strong labour protection, with 35-hour weeks and strict conditions on firing employees. However, compared to countries with looser labour protection practices, the Parisian metro has a higher degree of automation than alternative cities.

In terms of isoquant and isocost curves mapped over a capital-labour plane, why might this be the case?

Answer 22

One explanation is that onerous labour regulation makes train drivers more expensive relative to capital in France then elsewhere.

This pivots the isocost curve between capital (X-axis) and labour (Y-axis) to be shallower (intercept on capital axis moves outwards). Hence, the cost-minimising way of producing metro journeys in Paris is more geared towards capital, hence, automation.

Question 23

Similar to a consumer’s preferences over two goods, one can map a producers preferences over capital and labour in producing said goods.

Name and describe the slope of the two curves present in the long-run production trade-off.

Answer 23

The convex curve (or contour) that maps the combination of inputs to produce a given maximum output is known as an isoquant and is described as the “marginal rate of technical substitution”. This is akin to an individual’s indifference curve.

The straight line that describes the market rate of exchange between capital and labour is the isocost curve. This is akin to the budget line of an individual’s preferences.

Question 24

In the short run, with fixed capital, a firm can only produce more by employing more labour. This quickly leads to increasing marginal costs as labour decreases in marginal productivity (crowded offices, less work going round, etc.)

However, in the long run, capital is variable. How can this impact long-run growth and what is the term for this?

Answer 24

In the long run, both capital and labour can be increased. One could double output by doubling both capital and labour, therefore maintaining average costs.

There is the option that, as firms increase in size, they are able to afford more innovative production methods and decrease cost per-unit produced. This increases the marginal productivity of labour and thus decreases marginal cost of supply, thus costs fall (to a point) as size increases. This is economies of scale.

Question 25

Economies of scale describes how costs can fall for a firm that grow in size. Diseconomies of scale is the opposite, where firms past a point in size can see rising per-unit costs.

What could cause this?

Answer 25

Management becomes less focused, where different sections of the company become disjointed rather than acting as a profit-maximising unit.

Large labour forces can unionise, forcing up wage costs to the firm directly impacting the marginal cost of production.