Section 3 - Business Economics Flashcards
1
Q
What is the definition of production?
A
>Production means manufacturing something in order to sell it.
>Production involves converting inputs (e.g. raw materials, labour) into outputs (things to sell).
2
Q
Input
A
>The inputs can be any of the four factors of production - land, labour, capital and enterprise.
>Inputs can be tangible or intangible.
3
Q
Tangible
A
>Things you can touch, like raw materials or machines.
4
Q
Intangible
A
>‘Abstract’ things that can’t be touched - like ideas, talent or knowledge.
5
Q
Output
A
>The outputs produced should have an exchangeable value - they need to be something that can be sold.
6
Q
What is the definition of productivity?
A
Productivity is a way of measuring how efficiently a company or an economy is producing its output.
It’s defined as the output per unit input employed. So if one company could take the same amount of inputs as the other company, but produce more stuff, their productivity would be greater.
You can work out overall level of productivity (involving all four possible inputs) or productivityof any one of the four individual factors of production.
Improving productivity of any one of these separate factors should increase overall production.
7
Q
Labour productivity - definition
A
>Output per worker or per hour worked.
8
Q
Labour productivity - how to calculate
A
- Take the amount of output produced in a particular time.
- Divide this by the total number of workers (or per worker-hour).
9
Q
What does labour productivity allow?
A
>Labour productivity allows workers to be compared against other workers.
>E.g. labour productivity is calculated for whole economies, so that the productivity of different labour forces can be compared.
10
Q
How can labour productivity be improved?
A
- Better training.
- More experience.
- Improved technology.
Specialisation can also improve labour productivity - if each worker performs tasks that they are good at doing, have practised a lot and have been trained to do, then they’ll produce more than if they did lots of different tasks.
11
Q
Specialisation
A
>Division of labour is a type of specialisation where production is split into different tasks and specific people are allocated to each task.
>Adam Smith explained the increase in productivity that could be achieved through the division of labour. He said that one untrained worker wouldn’t even make 20 pins a day, but 10 workers, specialising in different tasks could make 48,000.
>There are advantages and disadvantages of specialisation, but overall an economy can produce more stuff if people and firms specialise.
>It’s not just individuals and firms that can specialise - whole regions and even countries can specialise to an extent. E.g, there are loads of technology companies based in Silicon Valley in California.
12
Q
Advantages of specialisation
A
- People can specialise in the thing they’re best as or by doing it, they learn to become better at it.
- This can lead to better quality and a higher quantity of products for the same amount of effort overall i.e. - increased labour productivity.
- Specialisation is one way in which firms can achieve economies of scale e.g. a production line (where each person may perform just one or two tasks) is a form of specialisation.
- Specialisation leads to more efficient production - this helps to tackle the problem of scarcity, because if resources are used more efficiently, more output can be produced per unit of input.
- Training costs are reduced if workers are only trained to perform certain limited tasks.
13
Q
Disadvantages of specialisation
A
- Workers can end up doing repetitive tasks, which can lead to boredom.
- Countries can become less self-sufficient - this can be a problem if trade is disrupted for whatever reason (e.g. a war or dispute). E.g. if a country specialises in manufacturing, and imports (rather than producing) all its fuel, then that country could be in trouble if it falls out with its fuel supplier.
- It can lead to a lack of flexibility - e.g. if the companies eventually move elsewhere, the workforce left behind can struggle to adapt.
14
Q
Link between trade and specialisation
A
>Specialisation means that trade becomes absolutely vital - economies (and individuals and firms) have to be able to obtain the things they’re no longer making for themselves. This means it’s necessary to have a way of exchanging goods and services between countries.
15
Q
Trade
A
>Swapping goods with other countries is one way a country can get what it needs.
>This way of trading goods is called a barter system - it’s very inefficient because it takes a lot of time and effort to find traders to barter with (requires a double coincidence of wants)
>The most efficient way of exchanging goods and services between countries is using money (with the use of exchange rates where necessary).
16
Q
Money - definition
A
>Money is a medium of exchange - it’s something both buyers and sellers value and that means that countries can buy goods, even if sellers don’t want the things that the buying country produces.
17
Q
Money’s other functions
A
Money has 3 other functions too:
- A measure of value - e.g. the value given to a good can be measured in US dollars.
- A store of value - e.g. an individual who receives a wage may wait before buying something if they know that the money they have will be of similar value in the future.
- A standard (or method) of deferred payment - money can be paid at a later date for something that’s consumed know, e.g. people often borrow money to buy a car or pay university fees.
18
Q
Firms - definition
A
>A firm is any sort of business organisation, like a family-run factory, a dental practice or a supermarket chain.
19
Q
Industry - definition
A
>An industry is all the firms providing similar goods or services.
20
Q
What do markets contain?
A
>A market contains all the firms supplying a particular good or service and the firms or people buying it.
21
Q
Firms
A
>Firms generate revenue (money coming in) by selling their output (goods or services).
>Producing this output uses factors of production, and this has a cost.
>The profit a firm makes is its total revenue minus its total costs.
>In the long run firms need to make profit to survive.
22
Q
What is the difference between accounting and economics when considering total cost?
A
Total Costs are split into explicit and implicit costs (note that accountants do not consider implicit costs, unlike economists)
Company A, B and C are all making laptops and could make tablets (next best alternatives). Their accounting profit would be £100,000 in each case, but an economist would include OC of production.
With OC, no difference for A (£0 is a normal profit) so do whatever; a gain of 10,000 to B (supernormal profit) so continue laptops and loss of £10,000 to C (subnormal profit) so switch to tablets.
The definitions of supernormal and normal profit mean that profit on a diagram drawn by an economist will show supernormal profit only, normal is part of ATC and rises when ATC=AR.
23
Q
Economists and the cost of production
A
>When economists talk about the cost of production they are referring to the economic cost of producing the output.
>The economic cost includes the money cost of factors of production that have to be paid for, but also the opportunity cost of the factors that aren’t paid for (e.g. a home office that a business is run from).
>The opportunity cost of a factor of production is the money that you could have got by putting it to its next best use.
>E.g. if you run your own business the money you could earn doing other work is the opportunity cost of your labour.
>So, in economics, cost isn’t just a calculation of money spent - it takes into account all of the effort and resources that have gone into production.
24
Q
The opportunity cost of a factor of production
A
>The opportunity cost of a factor of production is the money that you could have got by putting it to its next best use.
>E.g. if you run your own business the money you could earn doing other work is the opportunity cost of your labour.
25
Short run
\>The short run is the period of time when at least one of a firm's factors of production is fixed.
\>The short run isn't a specific length of time - it varies from firm to firm.
\>E.g. the short run of a cycle courier service could be a week because it can hire new staff with their own bikes quickly, but a steel manufacturer might have a short run of several years because it takes lots of time and money to build a new steel-manufacturing plant.
\>Costs can be fixed or variable.
26
Long run
\>The long run is a period of time when all factors of production can be varied.
\>In the long run all costs are variable.
27
What can costs be in short run?
\>Fixed or variable.
28
Fixed costs
\>Fixed costs don't vary with output in the short run - they have to be paid whether or not anything is produced.
\>E.g. the rent on a shop is a fixed cost - it's the same no matter what the sales are.
Total Fixed Cost is unaffected by the law of diminishing returns as it is constant. TFC = TC-TVC or AFCxQ
29
Variable costs
\>Variable costs do vary with output - they increase as output increases,
\>The cost of the plastic bags that a shop gives to customers is a variable cost - the higher sales are, the higher the overall cost of the bags.
TVC = TC-TFC
30
Total cost
\>The total cost (TC) for a particular output level is the total fixed costs (TFC) plus the variable costs (TVC) for that output level:
TC = TFC + TVC.
31
Average cost
\>Average cost (AC) a.k.a. average total cost (ATC) is the cost per unit produced.
\>AC is calculated by dividing total costs by the quantity produced (Q): AC = TC/Q.
\>Average fixed cost (AFC) = TFC/Q.
\>Average variable cost (AVC) = TVC/Q.
32
Marginal cost - definition
\>Marginal cost (MC) is the extra cost incurred as a result of producing the final unit of output.
33
Marginal cost
\>Marginal cost is only affected by variable costs - fixed costs have to be paid even if nothing is produced.
\>You can calculate it by finding the difference between total cost at the current output level (TCn) and total cost at one unit less (TCn-1):
\>MC = TCn - TCn-1.
34
More general formula for MC
MC = Change in TC / Change in quantity.
35
Trend of MC
\>Marginal cost decreases initially as output increase, then begins to increase in the short run because of the law of diminishing returns.
\>So the MC curve is always u-shaped.
\>Changes in MC affect average cost.
36
How does MC affect AC?
1. When the MC is lower than the AC, the AC will be falling. This is because each extra unit produced will decrease the average cost (adding something smaller than the average will decrease the average).
2. When the MC is higher than the AC, the AC will be rising because each extra unit produced will increase the average cost.
3. So the MC curve meets the AC curve at the lowest AC, i.e. AC will be lowest when MC = AC - this is the point of productive efficiency.
MC\>AC, AC falls because each extra unit produced decreases the average cost (adding something smaller than the average lowers it).
MC\>AC, AC rises because each extra unit produced will increase the AC
37
Other than the average cost curve, which other curve does the marginal cost curve cross?
\>The MC curve also meets the AVC curve at the minimum AVC.
\>Marginal cost is made up of variable costs, so it increases and decreases AVC in the same way it does AC.
\>This means AVC and AC curves also always form a u-shape in the short run - they both decrease until they reach a a minimum, then begin to increase.
38
AFC Curve
\>AFC falls as output rises because the total fixed cost is spread across the greater output.
39
What are increases in output limited by in the short run?
\>Diminishing returns.
40
What does the law of diminishing returns explain?
\>The law of diminishing returns explains what happens when a variable factor of production increases while other factors stay fixed. Because at least one factor stays fixed, the law of diminishing returns only applies in the short run.
\>When you increase one factor of production by one unit, but keep the others fixed, the extra output you get is called the marginal product.
\>E.g. if you add one more unit of labour, the extra output is the marginal product of labour.
41
Marginal product - definition
\>Marginal product (MP) is the additional output produced by adding one more unit of a factor input.
\>I.e. by adding one more unit of any of the factors of production being used.
\>Another term for marginal product is marginal returns.
42
Increasing output - MP and law of diminishing returns explaination
1. Initially, as you add more of a factor of production the marginal product will increase - each unit of input added will add more output than before.
2. This might happen because more specialisation is possible with more of a particular factor. As more people are employed, for example, they can specialise in carrying out particular tasks.
3. Eventually, if you keep adding units of one factor of production, the other fixed factors will begin to limit the additional output you get, and the marginal product will begin to fall. E.g. if a clothes manufacturer only has 5 sewing machines, employing a 6th machinist will probably add less output than employing the 5th did, and employing a 7th will add even less.
\>This is the point of diminishing returns - the point where marginal product begins to decrease as input increases.
43
Law of diminishing returns - key
\>If one variable factor of production is increased while other factors stay fixed, eventually the marginal returns from the variable factor will begin to decrease.
44
Law of diminishing returns says..
Plus other names
\>The law of diminishing returns says that there is always a point where marginal product begins to decrease.
\>Law of diminishing marginal returns.
\>Law of variable proportions.
45
What does marginal returns do to marginal cost?
\>Increases it.
46
Marginal returns or marginal product - relation to marginal cost
\>MP is related to the marginal cost.
\>As marginal returns rise, marginal cost falls.
\>As marginal returns fall, marginal cost rises.
\>The MC curve is a mirror image of the MP curve.
\>MC will rise as marginal returns fall because, ceteris paribus, if you're getting less additional output from each unit of input then the per unit of that output will be greater.
47
What does diminishing marginal returns eventually cause?
\>Productivity to fall
48
Diminishing returns and productivity
\> The Law of diminishing returns says that as the level of a variable factor input is increased, MP will eventually begin to diminish.
\>As the level of that factor input continues to be increased, the average product will eventually start to fall too. The MP curve always meets the AP curve when AP curve is at its max.
\>The average product is also known as productivity.
\>E.g. if the variable factor is labour, the labour productivity would be the average output per worker. So if a firm employs more and more people, it will eventually find that the productivity of those employees falls.
\>If you keep adding more of the variable factor, you can even reach a stage where adding further input results in a fall in the total product. (MP becomes negative).
49
Average product
\>AP is the output produced per unit of factor input.
50
Total product
\>TP is the total output produced using a particular combination of factor inputs.
51
How can productivity be improved?
\>There are various ways to increase labour productivity - e.g. through better training or better management.
\>Improved technology can also help improve productivity - faster computers could allow employees to achieve more during their working day, for example.
\>Increasing productivity will allow a firm to reduce its costs of production.
\>Improved technology might also allow a firm to track its costs and productivity more accurately, meaning it can see when it's encountering the point of diminishing returns.
52
Economies of Scale - definition
\>An economy is experiencing economies of scale when the average cost of production is falling as output rises.
53
Intro -economies of scale
\>The average cost to a firm of making something is usually quite high if they don't make very many of them.
\>But in the long run, the more of those things the firm makes, the more the average cost of making each one falls.
\>Economies of scale - the cost advantages of production on a large scale.
54
2 categories economies of scale can be divided into two categories?
1. Internal.
2. External
55
Internal economies of scale
\>Internal economies of scale involve changes within a firm:
1. Technical Economies of Scale.
2. Purchasing Economies of Scale.
3. Managerial Economies of Scale.
4. Financial Economies of Scale.
5. Risk-bearing Economies of Scale.
6. Marketing Economies of Scale.
56
Internal: Technical Economies of Scale
\>Production line methods can be used by large firms to make a lot of things at a very low average price.
\>Large firms can purchase specialised equipment to help reduce AC.
\>Workers can specialise (become more efficient at their task) - might not be possible for small firm.
\>Another potential economy of scale arises from the law of increased dimensions.
57
Law of increased dimensions
\>The price you pay for a new warehouse might be closely related to the total area of the walls and roof, say.
\>If you make the dimensions of the walls and roof twice as big, the total area of the walls and roof will be 4 times greater so will cost about 4 times as much to build.
\>But the volume of the warehouse will be 8 times greater, meaning that you're getting more storage space for each pound you spend.
\>Same is true for things like oil tankers - e.g. bigger tankers reduce the cost of transporting each unit of oil.
58
Internal: Purchasing Economies of Scale.
\>Larger firms making lots of good will need larger quantities of raw materials, and so can often negotiate with suppliers.
\>As large firms will be most important customers of suppliers, they'll be able to drive a hard bargain.
59
Internal: Managerial Economies of Scale.
\>Large firms will be able to employ specialist managers to take care of different areas of the business. These specialist managers gain expertise and experience in a specific area of the business, which usually leads to better decision-making abilities in that area.
\>And the number of managers a firm needs doesn't usually depend directly upon the production scale - i.e. twice as many managers won't be needed to produce twice as many goods. This reduces the management cost per unit.
60
Internal: Financial Economies of Scale.
\>Larger firms can often borrow money at a lower rate of interest - lending to them is seen as less risky by banks.
61
Internal: Risk-bearing Economies of Scale.
\>Larger firms can diversify into different product areas and different markets (countries). This diversification leads to more predictable overall demand and safety if one good or country falls.
\>It also means large firms can take more risks as if a product is unsuccessful, a large firm's other activities allow it to absorb the cost of failure more easily.
62
Internal: Marketing Economies of Scale.
\>Advertising is usually a fixed cost - this is spread over more units, so the cost per unit is lower.
\>The cost per product of advertising several products may also be lower than the cost of advertising just one, i.e. several products advertised on a single flyer.
\>Larger firms may also benefit from brand awareness - products will be trusted more by consumers so might mean firm doesn't need to advertise as much to get sales.
63
External economies of scale
\>External economies of scale involve changes outside a firm.
\>Local colleges may start to offer qualifications needed by big local employers, reducing the firms' training costs.
\>Large companies locating in an area may lead to improvements in road networks or local public transport.
\>If lots of firms doing similar or related things they may be able to share resources and suppliers may also decide to locate in same area, reducing transport costs.
64
What can extremely successful companies gain?
\>Monopoly power in a market.
65
Economies of sales - main advantage
\>As a firm's AC for making a product falls, it can sell that product at a lower price, undercutting its competition.
\>This can lead to a firm gaining a bigger and bigger market share, as it continually offers products at a lower price than its' competition.
\>In this way, a firm can eventually force its competitors out of business and become the only supplier of the product - i.e. it will have a monopoly.
66
Diseconomies of scale
\>The disadvantages of being big.
\>Getting bigger isn't always good - as a firm increases in size, it can encounter diseconomies of scale.
\>Diseconomies of scale cause AC to rise as output rises.
\>They can be internal or external.
67
Internal diseconomies of scale
1. Wastage and loss can increases, as materials might seem in plentiful supply. Things may get lost of mislaid easier.
2. Communication may become more difficult as a firm grows, affecting staff morale.
3. Managers may be less able to control what goes on.
4. Becomes more difficult to coordinate activities between different departments/divisions.
5. A 'them and us' attitude can develop between workers in different parts of a large firm - workers might put their department's interests before the company's, leading to less cooperation and lower efficiency.
68
External diseconomies of scale.
1. As a whole industry becomes bigger, the price of raw materials may increase (since demand will be greater).
2. Buying larger amounts of materials may not make them less expensive per unit. If local supplies aren't sufficient, more expensive goods from further afield may have to be bought.
69
How can economies of scales be made even larger?
\>There are huge economies of scale in industries with high fixed costs and low variable costs.
\>In some cases, the structure of whole industries can change to take advantage of this.
70
What do you need to use to show economies and diseconomies of scale?
\>Long run average cost curves.
71
SRAC (short run average cost) curve and LRAC (long run average cost) curve.
\>In the short run a firm has at least one fixed factor of production, meaning it operates on a particular SRAC curve.
\>As a firm increases output in the short run by increasing variable factors of production, it moves along its SRAC curve.
\>In the long run a firm can change all factors of production. When it does this it moves onto a new SRAC curve.
\>The minimum possible average cost at each level of output is shown by a long run average cost curve (LRAC curve).
\>SRAC curves can touch the LRAC curves but can't go below it.
\>For a firm to operate on its LRAC curve at a particular level of output, it has to be using the most appropriate mix of all FoPs.
\>This means that it may not be able to reduce costs to this minimum level in the short run (since some factors are fixed).
\>But in the long run a firm can vary all factors of production and bring costs down to the level of the LRAC curve.
72
The shape of the LRAC curve
\>The shape of the LRAC curve is determined by internal economies and diseconomies of scale.
\>AC falls as output increases when a firm is experiencing internal economies of scale.
\>AC rises as output increases when a firm is experiencing internal diseconomies of scale.
\>Firms may face specific economies and diseconomies of scale at the same output level - whether the firm is experiencing economies or diseconomies overall will depend on which is having the greater effect.
73
External changes and the LRAC curves
\>External economies of scale will the the LRAC curve to shift downwards by reducing average costs at all output levels.
\>External diseconomies of scale will force the LRAC curve to shift upwards.
\>A change in taxation might cause the LRAC curve to shift up or down.
\>New technology could cause the LRAC curve to shift down if it means firms can use factors of production more efficiently as all levels, e.g. faster computers for workers.
74
L-Shaped LRAC Curve
\>Some economists argue that the LRAC curve is L-shaped.
\>They claim average costs fall sharply as output increases, and then either continue to fall slowly or level off.
\>This is based on the idea that while some internal diseconomies of scale will occur with increasing output (e.g. managerial diseconomies of scale) they'll be offset by continued reductions in AC due to things like production and technical economies of scale - so the LRAC won't begin to curve upwards.
75
Diseconomies of scale - definition
\>A firm is experiencing diseconomies of scale when the average cost of production is rising as output rises.
76
Returns to Scale - definition
\>How much a firm's output changes as they increase input (i.e. increase all factors of production).
\>Returns to scale are increasing if output increases more than proportionally with input, constant if output increases proportionally with input, and decreasing if output increases less than proportionally with input.
77
Returns to Scale info
\>Returns to scale describe the effects of increasing the scale of production.
\>In the long run firms can increase all of their factor inputs.
\>Returns to scale describe the effect on output of increasing all factor inputs by the same proportion.
78
Returns to scale vs economies of scale
\>Not the same thing.
\>Returns to scale describe how much output changes as input is increased.
\>Economies of scale describe reductions in average costs as output is increased.
79
Link between returns to scale and economies of scale
\>Increasing returns to scale contribute to economies of scale.
\>Decreasing returns to scale contribute to diseconomies of scale.
80
Increasing returns to scale
\>When returns to scale are increasing, long run average cost will fall.
\>An increase in input leads to a more than proportional increase in output, so more output is being produced per unit input.
81
Constant returns to scale
\>When returns to scale are constant, long run average cost will stay the same - costs are increasing proportionally to output.
82
Decreasing returns to scale
\>When returns to scale are decreasing, long run average cost will rise.
\>Less output is produced per unit of input.
83
MES - definition
\>Minimum Efficient Scale of Production.
\>The lowest level of output at which a firm can achieve the lowest possible average cost of production.
84
When are LRACs minimised?
\>At the point of MES.
85
MES - info
\>The minimum efficient scale of production is the lowest level of output at which the minimum possible average cost can be achieved - it's the first point at which the LRAC curve reaches its minimum value.
\>This is likely to be the optimal level of production.
\>There might be a range of production levels where LRAC is minimised, or the MES might be the only LRAC minimising level.
86
How does the MES vary?
\>The MES varies between industries - industries with very high fixed costs (e.g. oil extraction) have a very large MES.
\>This affects the whole structure of an industry - industries with a large MES will favour large firms more.
87
Total revenue - definition
\>Total revenue (TR) is the total amount of money received, in a time period, from a firm's sales.
\>TR = Q x P, where Q is quantity sold and P is the price.
88
Average revenue - definition
\>Average revenue (AR) is the revenue per unit sold.
\>AR = TR/Q.
\>So AR is the price.
89
Marginal revenue - definition
\>Marginal revenue (MR) is the extra revenue received as a result of selling the final unit of output.
\>It is the difference between TR at the new sales level and TR at one unit less.
\>MR = TR(n) - TR(n-1).
90
What does a firm's demand curve determine?
\>A firm's demand curve determines how revenue relates to output.
\>Demand curves show what quantity of a product a firm will be able to sell at a particular price.
\>Price = average revenue, so the same curve shows the relationship between quantity sold and average revenue (so the demand curve could be labelled AR).
91
Price Takers
\>A firm that's a price taker has no power to control the price it sells at - price takers have to accept the price set by the market.
\>A price taker has a perfectly elastic demand curve (i.e. it's flat).
\>If the firm increases the price then quantity sold will drop to zero and there's no reason to decrease the price because the same quantity would sell at the original higher price.
92
Perfectly elastic demand curve
\>When demand is perfectly elastic the price is the same, no matter what the output level.
\>In this case marginal revenue = average revenue, because each extra unit sold brings in the same revenue as all the others.
\>When the AR is constant, the total revenue increases proportionally with sales.
93
Price makers
\>Price makers (e.g. monopolists) have some power to set the price they sell at.
\>A price maker's demand curve will slope downwards - to increase sales the firm must reduce the price.
94
Downward sloping demand curves
\>If a firm's demand curve is a straight line sloping downwards then PED will change depending on where the firm is operating on the curve.
\>With a downward sloping demand curve, total revenue is maximised when the firm is operating at the midpoint of the demand curve - when PED = -1.
95
Why is TR maximised when PED = - 1?
\>At the midpoint of a downward sloping demand curve, PED = -1.
\>To the left of the midpoint, demand is elastic, so decreasing a product's price towards the midpoint will cause a more than proportionate increase in sales and total revenue will increase.
\>To the right of the midpoint, demand is inelastic, so decreasing a product's price below the price at the midpoint will cause a less than proportionate increase in sales and total revenue will decrease.
\>TR is maximised when the firm is operating at the midpoint of the demand curve - when the PED = -1.
96
Relationship between MR, AR and TR
\>The demand curve is also the AR curve.
\>So the maximum total revenue occurs at the midpoint of the AR curve.
\>The MR curve is twice as steep as the AR curve.
\>When TR is at its maximum, MR=0.
\>At the point where additional sales reduce total revenue, MR becomes negative.
97
Profit - definition
\>Profit is the difference between total revenue and total costs.
\>There are 2 types: normal and supernormal (abnormal) profit.
\>Profit = TR -TC.
98
Normal Profit
\>A firm is making normal profit when its TR = TC.
\>So normal profit is an 'economic profit' of 0.
\>This means normal profit occurs when the extra revenue left, on top of what's needed to cover the firm's money costs, is equal to the opportunity costs of the factors of production that aren't paid for.
\>If the extra revenue is less than those opportunity costs, then the firm would have been better off putting the FoPs to a different use,
\>Normal profit is the minimum level of profit needed to keep resources in their current use in the long run.
No change to profit, minimum level of profit needed to keep factors of production in their current use, assumed to be an element of the ATC curve
99
Supernormal profit
\>Supernormal profit occurs when TR \> TC.
\>A firm is making supernormal profit when its total revenue is greater than its total costs.
\>This means the revenue generated from using the factors of production in this way is greater than could have been generated by using them in any other way.
\>If firms in an industry are making supernormal profit, this will create an incentive for other firms to try to enter that industry.
100
Economic assumptions about firms
\>Economists generally assume that firms are aiming to maximise their profits.
\>To do this, they need to find the optimum output level at which to operate.
101
Firm objectives
\>Traditional theory of a firm is based on the assumption they are aiming to maximise profit.
\>In reality, there are other objectives, e.g. revenue or sales maximisation
102
Maximising revenue
\>Revenue is maximised when MR = 0.
\>If a firm is aiming to maximise revenue they will keep increasing output past the point where profit is maximised, as long as adding more output leads to greater revenue.
103
Maximising sales
\>A firm aiming to maximise sales will produce at an output level where AR = AC.
\>This is the highest level of output the firm can sustain in the long run.
\>If sales increased further, the firm would be making a loss.
104
What is the difference between invention and innovation?
Invention: creation of a new idea without the idea necessarily becoming a commercial reality
Innovation: transforming an invention into commercial reality. Can be small scale (improving production techniques for example), or it can be greater (creating new products for sale). Therefore, it can be quite destructive. New services and products can destroy pre-existing markets and furthermore - jobs.
E.g. Internet access means less demand for library books, social media means less demand for letter services. The car market has destroyed public transport markets around the world. Also, how music streaming services have destroyed the demand for physical copies of albums and therefore reducing overall profits that an artist gains.
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How does technological change affect methods of production?
Technological change can advance methods of production, leading to firms achieving technical economies of scale. However, downsides to this might be that technology improves capital - which therefore replaces human capital and people lose jobs.
It is argued that technological change has increased job opportunities but in future, this might be the opposite case.
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How does technological change affect productivity?
Technological change increases labour productivity, this is the case following the introduction of mechanised and automated production methods - sometimes hasn't worked. e.g. NHS computer systems
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How does technological change affect efficiency?
Productive efficiency can increase as COPS are lower and the MES point happens at a greater level of output.
Allocative efficiency depends on whether or not the lower costs of productive efficiency is put on the consumer prices.
Dynamic efficiency will happen as technological improvements lead to innovation, new services etc.
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How does technological change affect costs of production?
Technology will reduce the cost of production. Long run average costs will decrease, and with better technology, specialist capital can be brought in to achieve technical economies of scale or further specialisation of labour. Therefore productivity increases.
The MES can happen at a greater level of output with greater productivity. Signifies more EoS to be exploited.
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What is the difference between mechanisation and automation?
Mechanisation: the process of moving labour intensive to a more capital intensive method of production, employing more machines and fewer workers.
Automation: automatic control where machines operate other machines.
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How can you assess the impact of technological change on market structures?
1. Barriers to entry - lower in industries like retail with the development of ecommerce (don't need online shop) costs of building infrastructure has come down. Can meet regulations and legislations that government might set, and with less need for labour you can meet employment law. Advertising might be easier to pay for with greater role of internet might increase brand loyalty.
In some industries, barriers might have increased i.e. if firms can access greater patents etc, this might restrict competition in some industries.
2. No. Firms depend on barriers to entry. Lower = more firms, higher = less firms (more monopoly with more copright e.g. pharmaceutical)
3. Product homogeneity - more variety with technological change
4. Knowledge - technological change improves information for consumers and producers. But also knowledge might be more imperfect depending on patents and copyrights (if a firm has more monopoly power in this sense).
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Show the impact of technological change on the LRAS diagram.
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What is disruptive innovation?
A disruptive innovation helps to create a new market but eventually disrupts an existing one over time (displacing earlier technology). It creates new goods or services for a different set of consumers in a new market which competes with the established market. This lowers the prices in the existing market.
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What is sustained innovation?
This does not create new markets but develops existing ones, enabling firms to offer better value and often compete against each other, sustaining improvements.
According to L. Bower and M Christensen, one of the most consistent patterns in business is the failure of leading companies to stay at the top when technologies in markets change. E.g. Xerox losing photocopier market to Canon 1990.
Businesses struggle to change because loyal customers are likely to reject new goods.
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Example of the influence of technological change on the structure of markets: Kodak Case Study
1. K
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What is creative destruction?
Capitalism evolving and renewing itself over time through new technologies and innovations replacing older technologies and innovations.
- Term coined by Joseph Schumpeter 1942
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Show economies and diseconomies of scale on a diagram
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What is short run average cost and what does it show? Explain the SRAC curve
Each SRAC curve shapes is U-shaped. Assuming capital is fixed, diminishing marginal returns set in. When they become zero, the SRAC is at its lowest point. After that the marginal return is negative.
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Explain the two curves
Curve 1: Low level output, firm chooses to invest in no capital as the reduced VC will not compensate for cost of investment.
Curve 2: Increased output means firm will look to invest in new capital
Company promised a discount by a supplier ⇒ lowered fixed costs
Increase size of orders ⇒ need to make more supply
Leads to increasing returns to scale (economies of scale)
The SRAC curve will eventually slope upwards because at least one factor of production is fixed. They will, therefore, experience diminishing returns. Each extra waiter in a restaurant becomes less useful if the number of seats is fixed at 50 seats.
The law of diminishing returns determines the shape of the marginal returns curve in short-run production theory and marginal cost curve for long-run production theory
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What do the production curves of TP, AP and MP look like? How do they relate?
Total Product (TP), starts to diminish when Marginal Product is at 0.
Marginal Product is the change in TP/change in Q, which will start to diminish when the fixed factors become constraints with every extra unit added.
Average Product is the Total Product/Quantity
Average Product will increase when the MP is higher than it. → MP\>AP = AP increases, MP
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What do the fixed and variable cost curves look like and how do they relate? (TFC and AFC)
Total Fixed Cost is unaffected by the law of diminishing returns as it is constant. TFC = TC-TVC or AFCxQ
The Average Fixed Cost curve is constantly falling as output expands (costs are then spread out). AFC = AV-AVC or TFC/Q
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What does the average variable cost curve look like (AVC)?
AVC is affected by the law of diminishing returns and as the unit of the variable cost increases, the product will rise up to a point but then start to fall - increasing costs once more. AC-AFC or TVC/Q
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What do the average and marginal cost curves look like, how do they relate (MC&AC)?
Marginal Cost → change in total cost/change in quantity (or MP is the mirror reflection)
Average Cost → Total Cost/Quantity and mirrors AP or AFC+AVC
Reason for diminishing (increasing costs after a point) is over-specialisation and under-utilisation of factors = higher labour productivity
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What does the total cost curve look like (TFC, TVC, TC)?
TFC is constant over a range of output
TVC and TC affected by law of diminishing returns
Output will rise quicker when TVC line is more horizontal gradient = increasing returns to decreasing returns
TC = TFC+TVC
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What is long run average cost and what does it show? Long Run Cost Theory
The LRAC shows how average costs change with output when all FOPS are variable.
It is a combination of all short run average cost curves, given different levels of investment in capital, who are joined up by their minimum points.
The difference is that in the long run, a firm can choose their level of investment and can choose what SRAC to produce on.
Long-run concept of returns to scale is a major determinant of the shape of long-run cost curves
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Explain constant returns to scale
Constant returns to scale
For every extra unit input, a proportionate amount is returned in output. So increasing input by 10% means that you will receive 10% extra back.
Therefore, AVERAGE COST does not change when output increases.
Line of constant returns to scale is y=mx+c with no curve in the line ;)
Real life e.g. Whatsapp: 'Zero marginal cost' = meaning it costs them almost nothing to provide their service and has exploited all available economies of scale = constant LRAC.
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Increasing returns to scale
For every additional unit input, a larger amount is returned in output.
For example, a 10% increase in variable factors of production may result in 20% returns.
Shows exponential growth and reduces AC
Real life e.g. Amazon reduces AC as it grows through innovation and improvement in its warehouses and delivery. But vulnerable to diseconomies of scale.
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Decreasing returns to scale
For every additional unit input, less than the amount is returned.
For example, 10% extra added will perhaps only lead to a 5% return to scale.
Shows exponential decay.
Real life e.g. Tesla's financial performance under scrutiny perhaps due to large number of projects they're investing in → managerial diseconomies of scale.
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What is the significance of returns to scale in terms of long run costs?
When all factors are variable, the firm can 'scale up' any factor of production.
Returns to scale are what happens to the change in output as the factors are increased
The long run consists of the addition of multiple short runs and its shape is due to returns to scale
Increasing returns occurs when the %change in output \> %change in input
Constant returns occurs when %change in output = %change in input
Decreasing returns occurs when %change in output \< %change in input
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What are the features of the long run cost curve and explain.
Key Features:
Part 1 slopes downwards → increasing returns benefits the business → lowest point is MES and all due to economies of scale
MES - defined as minimum efficient scale is the lowest level of output required to exploit full EoS
Part 2 is unchanged → constant returns to scale business sees no change
Part 3 slopes upwards → decreasing returns to scale → diseconomies of scale
Capital + Labour are the changing variables (i.e. 170 to 300 means 100% change, then change in output...)
The first alternative shows that there is no point where a business will see constant returns before reaching decreasing returns (unrealistic)
For the LRAC of a natural monopoly, they have high fixed costs so will be able to utilise economies of scale for a greater period of time and won't reach decreasing returns until output is ridiculously high.
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What is the LRAC curve determined by?
The first part of the LRAC curve is determined by economies of scale (when the costs are reduced as output increases). Economies of scale can be defined by two categories: internal and external EoS.
A business that gets too big might suffer diseconomies of scale.
Increase in LRAC as output increases.
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What are examples of diseconomies of scale?
Remember: 3C's and an M
Control - large business can't control the workforce (managerial diseconomies of scale)
Communication - harder to spread messages from CEO's to bottom or the other way round (waste of time)
Coordination - can't coordinate different departments of a business, HR with marketing or IT with purchasing department → productivity suffers
Motivation - as a business gets larger, a worker will feel less valued
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How are economies and diseconomies of scale categorised?
Internal: Quantity rises faster than Total Product in each case
Risk Bearing - Larger firms can afford to take risks without the opportunity cost being detrimental to their survival in the market, meaning they may be able to progress further
As a business gets larger, they can spread their opportunity cost over a larger range of output
Financial - larger businesses can negotiate lower interest rates when they get a loan from a bank, a bank will assume they are lower risk - so they have rising costs which can be spread over a larger range of output
Managerial - as a firm gets larger, they can employ specialist managers who will boost the productivity of workers in addition to adding their skills (despite their cost of their salaries because Q\>TP)
Technical - specialist machinery will increase costs but make productivity even more efficient, or adding more workers who specialise after
Marketing - can bulk buy their advertising methods with larger sized firms, can spread their advertising costs over a larger range or products
Purchasing - bulk buying might mean you get a discount on each item or how a larger business might have more negotiating power to get these discounts
External: businesses within an industry can benefit from something affecting their market indirectly
Better transport infrastructure - larger business will see better transport around it, reduces transport of goods costs, easier to access raw materials and better mobility for workers
Component supplies move closer - cuts down costs of raw materials being transported to you, smaller suppliers will move closer to larger, profitable firms
R&D firms move closer - R&D might also do the same ^, can benefit from this personally as well
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How would you depict an LRAC curve?
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Subnormal profit
AR
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How would you define revenue and what are the key equations?
Revenue - money made from sales by business
TR = PxQ
AR = TR/Q or P
MR = change in TR/ change in Q
Revenue curves depend on the level of competition (perfect or imperfect i.e. monopoly)
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What does a revenue curve dependent on perfect competition look like?
Perfect Competition - many buyers and sellers (infinite); homogenous goods and services; firms are price takers with no price setting ability; no barriers to entry and exit; perfect information of market
AR and MR are the same, constant over a range of quantity
AR=MR = Demand
TR is linear, always increasing by 1
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What does a revenue curve dependent on imperfect competition look like?
Imperfect Competition - reverse of perfect competition. Few buyers and sellers, differentiated goods, price setters, imperfect information and high barriers to entry and exit
If they are price setters then P will not be constant - but will be affected by the law of demand.
At high prices, quantity will be low and at low prices, quantity will be high.
AR is just a demand curve.
MR starts at the same point as AR but is faster and can go negative - it is twice as steep as AR.
y=mx+c → AR=P=a-bQ
a-bQ is demand so AR = D
TR rises at a slower rate each time as MR falls, it hits a peak and then decreases.
TR hits peak when MR is 0 before falling.
TR is maximised when MR = 0.
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Diagrams showing profit in perfect competition vs. Monopoly
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Profit with revenue maximisation
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Profit maximisation in a monopolistically competitive market.
MC=MR (profit maximisation rule), the reward for enterprise. It is the return on investment in capital.
Assumption that all business aim to maximise profit is increasingly criticised.
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Market Share maximisation
Look for sales-maximising point, where AR=AC. This determined the quantity supplied.
AR=AC is the normal profit (minimum amount of profit needed to remain in the market)
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Explain this diagram
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What is the main (assumed) objective of a firm and why?
Profit maximisation is the assumed main objective of a firm because profits can be:
1. reinvested into the business to innovate/improve
2. pay dividends to shareholders
3. lower costs and prices for consumers and increase demand
4. reward staff for entrepreneurialism
LIMITATIONS:
1. MC=MR is profit maximisation
2. MR\>MC, there will be a loss
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What is the shut-down condition?
In the short run as long as AR covers AVC, the firm will remain in the industry. This is because the firm can cover its costs and 'survive' in the market in the short run at least. (AVC changes with output e.g. Wages, raw materials)
In the long run, the firm must cover its (ATC) to remain in the industry.
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Show what a loss of profit (subnormal) looks like in perfect competition.
AC\>AR, so there is a loss.
