Theme 3.3

Question 1

What is total revenue?

Answer 1

The total amount of money coming into the business through the sale of goods and services. quantity x price

Question 2

What is average revenue?

Answer 2

Demand is equal to AR: ​total revenue/output

Question 3

What is marginal revenue (MR)?

Answer 3

The extra revenue that the firm earns from selling one more unit of production: total revenue from ‘N’ goods- total revenue from (N-1) goods OR
​change in total revenue/change in output

Question 4

What happens when a firm has perfect elasticity of demand?

Answer 4

Some firms experience a ​perfectly elastic demand curve​; these are firms in perfect competition, a concept looked at in the next unit. These firms have no price setting power. In this case, the price received by the firm for the good is constant and so MR=AR=D. Their demand curve is horizontal. The TR curve is upward sloping because prices are constant and so the more goods that are sold, the higher the revenue made.

Question 5

What does the demand curve look like for the majority of goods?

Answer 5

However, for most goods, the price decreases as output increases and there is a ​downward sloping demand curve ​and therefore a downward sloping AR curve. The demand curve for the firm is the same as the firm’s AR revenue curve, as it indicates the price that consumers are willing to pay for each quantity sold. Firms with a downward sloping demand curve are firms that are in imperfect competition and so they have some ​price setting power​.

Question 6

What is the elasticity of demand linked to for goods with a downwards sloping demand curve?

Answer 6

Marginal revenue. In Theme 1, we ignored that the price elasticity of demand changes along the demand curve

Question 7

How can the concept of price elasticity and revenue learnt in theme 1 be developed and linked to marginal revenue?

Answer 7

● If ​marginal revenue is positive​, when the firm sells the product at a lower price (or when they increase output), total revenue still grows and so the demand curve is elastic​. Up until output Q, the demand curve is elastic.
● If ​MR is negative​, TR decreases as price decreases (or output increases) and so the demand curve is​ inelastic​. After output Q, the demand curve is inelastic.
● When ​MR=0​, ​TR is maximised and the demand curve is ​unitary elastic​; this is at point Q.
This explains why the ​TR curve is a U-shape​: at first, total revenue rises with output (when MR is positive) but it then begins to decline (when MR is negative).

Question 8

What is the economic cost of production for a firm?

Answer 8

the ​opportunity cost of production​; the value
that could have been generated had the resources been employed in their next best use.

In the short run, at least one factor of production is fixed and cannot be changed and so therefore some costs are fixed whilst in the long run, all costs are variable e.g. more property can be used so rent becomes higher.

Question 9

What is total cost?

Answer 9

The cost of producing a given level of output: fixed + variable costs

Question 10

What is total fixed cost?

Answer 10

Costs that do not change with output and remain constant
e.g. rent, machinery

Question 11

What is total variable cost?

Answer 11

Costs that change directly with output e.g. materials

Question 12

What is average (total) cost (ATC)?

Answer 12

​total costs/output

Question 13

What is average fixed cost? (AFC)

Answer 13

Total fixed cost/output

Question 14

What is average variable cost?

Answer 14

Total variable cost/output

Question 15

What is marginal cost?

Answer 15

The extra cost of producing one extra unit of a good:
total cost of producing N goods - total cost of producing (N-1) goods OR
change in total cost/change in output

Question 16

What is the difference between short and long run?

Answer 16

The short run is the length of time when ​at least one factor of production is fixed and cannot be changed; this varies massively with different types of production. The long run is when ​all factors of production become variable.

Question 17

What is the law of diminishing marginal activity?

Answer 17

If a factor of production is fixed, this will ​affect the business if it decides to expand. More workers can be added relatively easily and this will see an increase in production as machinery is used more efficiently. However, it will take a long time for the factory to expand and adding more labour will mean that they will have less and less impact on the amount produced as they get in the way and have no machines to use.

Diminishing marginal productivity means that if a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.

Question 18

What will happen to marginal output as more inputs are added in the short run?

Answer 18

Marginal output will decrease as more inputs are added in the short run. This will mean that the ​marginal cost of production will rise.

Question 19

What does the average fixed cost curve look like?

Answer 19

The ​average fixed cost curve (AFC) starts high because the whole fixed costs are being divided by a small output. As output is increased, AFC falls as the same amount is divided by a larger number.

Question 20

What does the average total cost curve look like?

Answer 20

The ​average total cost curve (AC/ATC) is U-Shaped due to the law of diminishing marginal productivity. Costs initially fall as machinery is used more efficiently but as production continues to expand, efficiency falls as machinery is overused.

Question 21

What does the average variable cost curve look like?

Answer 21

The ​average variable cost curve (AVC) is also U-Shaped, but it gets closer to ATC as output increases since AFC gets smaller.

Question 22

What does the marginal cost curve look like?

Answer 22

The ​marginal cost (MC) will also be U-Shaped due to the law of diminishing marginal productivity. It will initially fall as the machines are used more efficiently but will rise as production continues to rise.

Question 23

Where will the marginal cost curve cut the average cost curve?

Answer 23

The marginal cost line will always cut the AC line at the lowest point on the AC curve: if MC is below AC, then AC will continue to fall since producing one more costs less than the average so the average falls; but if MC is above AC, then AC will rise. Marginal costs can be rising whilst AC is still falling, as long as MC is still below AC.

Question 24

Why will each firm have a different total cost curve?

Answer 24

Each firm will have a different ​total cost curve. If average costs are constant, the line would be a straight diagonal line beginning at the origin. When output is 0, fixed costs are equal to total costs since there are no variable costs. Average costs can be worked out from the total cost curve.

Question 25

What is the difference between short run and long run cost curves?

Answer 25

Short run average cost (SRAC) curves are U-Shaped because of the law of diminishing returns whilst long run average cost (LRAC) curves are ​U-Shaped because of ​economies and diseconomies of scale.

Question 26

What is the relationship between the short and long run cost curves?

Answer 26

The LRAC is an ‘​envelope’ for all associated SRAC curves because the LRAC is either equal to or below the relevant SRAC as shown in the diagram. The firm may initially be set up to produce a certain amount a day and have enough machinery to do so effectively. They may become popular and need to produce more than that this amount and in the short run this will cause a rise in SRAC due to the law of diminishing returns as some factors of production are fixed. In the long run, all factors become variable and so the SRAC curve can be shifted. The new SRAC curve will be lower since the firm is able to enjoy economies of scale. This will continue to occur until the firm begins to experience constant returns to scale and eventually diseconomies of scale.

Question 27

What does the LRAC (Long run average cost) curve represent?

Answer 27

The long run average cost curve is a boundary representing the ​minimum level of average costs attainable at any given level of output. Points below the LRAC are unattainable and producing above the LRAC is inefficient.

Question 28

What do movements and shifts related to the long run average cost curve show?

Answer 28

Movement along the LRAC is due to a ​change in output ​which changes the average cost of production due to internal economies/diseconomies of scale. A shift can occur due to external economies/diseconomies, taxes or technology, which affects the cost of production for a given level of output.

Question 29

What are economies of scale?

Answer 29

Economies of scale are the ​advantages of large scale production ​that enable a large business to produce at a lower average cost than a smaller business. As a result, the firm is able to experience ​increasing returns to scale where an increase in inputs by a certain percentage will lead to a greater percentage increase in output.

Question 30

What are diseconomies of scale?

Answer 30

Diseconomies of scale are the ​disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise. The firm experiences ​decreasing returns to scale,​ where output increases by a small percentage than inputs.

Question 31

What are constant returns to scale?

Answer 31

Constant returns to scale is where firms increase inputs and receive an increase in output by the same percentage.

Question 32

What is the minimum efficient scale?

Answer 32

The ​minimum efficient scale is the minimum level of output needed for a business to fully exploit economies of scale. It is the point where the LRAC curve first levels off and when constant returns to scale is first met.

Question 33

What are internal economies of scale?

Answer 33

An internal economy of scale is an advantage that a firm is able to enjoy because of a growth in the firm, independent of anything happening to other firms or the industry in general.

Question 34

What are technical economies?

Answer 34

These arise as a result of what happens to the production process.

Question 35

How can specialisation internal cause economies of scale?

Answer 35

Large firms will be able to appoint specialist workers and buy specialist machines which will be able to do their jobs more quickly and better than machines/workers which are not specialised.

Question 36

How will a balanced team of machines cause internal economies of scale?

Answer 36

Large firms can afford to buy a number of every kind of machine for each stage of production. By combining these machines, they can ensure they run each machine at its optimal level. Smaller companies may only be able to afford one machine for each stage and if one stage of production runs faster than the other, machines will spend a long time turned off.

Question 37

How will increased dimensions cause internal economies of scale?

Answer 37

This relates to the fact that if you double the size of the walls you can increase the area by four times, or if you double the size of a container you increase the amount it can carry by more than double. This all occurs without doubling the cost.

Question 38

How can the indivisibility of capital cause internal economies of scale?

Answer 38

Some processes require huge items of machinery and investment that make it only possible for them to produce on a large scale.

Question 39

How can research and development cause internal economies of scale?

Answer 39

Often it is only large firms that can afford to carry out large scale research and development, which means they are able to gain a large advantage over their competitor.

Question 40

What are examples of technical economies?

Answer 40

-Specialisation
-Balanced team of machines
-Increased dimensions
-Indivisibility of capital
-Research and development

Question 41

What are financial economies? (Internal)

Answer 41

Large firms have greater security because they have more assets and are therefore less likely to be forced out of business overnight. As a result, it is easier for them to obtain finance and interest rates will be lower due to lower risk. This makes investment more accessible.

Question 42

What are risk bearing economies? (Internal)

Answer 42

Large companies are able to operate in a range of different markets, producing different products which means that if one area of business fails, their whole business will not collapse.

Question 43

What are managerial economies? (Internal)

Answer 43

Large companies can afford to appoint specialist managers in every field, who are specialised and so have greater knowledge and are able to do their job better. Staff represent an indivisibility and so small firms cannot employ specialist staff.

Question 44

What are some examples of marketing and purchasing economies?

Answer 44

-Buying in bulk
-Specialisation
-Distribution

Question 45

How can buying in bulk cause internal economies of scale?

Answer 45

Large firms are able to buy in large numbers so may be able to buy
their raw materials at a cheaper price than competitors.

Question 46

How can specialisation cause internal economies of scale?

Answer 46

Like other areas, businesses can afford to take on specialist buyers and sellers who could be more efficient due to the extra time and knowledge.

Question 47

How can distribution cause internal economies of scale?

Answer 47

​Large firms are able to enjoy preferential rates from transport companies because they offer the company a lot of businesses. They will be transporting in large batches which means that they will be able to transport in full, large transporters which are cheaper per item than half-full or smaller transporters. Large businesses can also establish regional distribution centres which enables them to reduce transport costs by using large transporters over long distances, storing goods in the distribution centre and using smaller transport to take stock to individual shops.

Question 48

What are external economies of scale?

Answer 48

An external economy of scale is an advantage which arises from the growth of the industry within which the firm operates, independent to the firm itself. These cause the LRAC curve to shift downwards.

Question 49

How can external economies of scale be caused through labour?

Answer 49

● Businesses established in an area with other successful firms from the same industry find that ​labour tends to come to that area if they want a job in that industry, for example ​Silicon Valley​. This reduces the cost and time take to recruit.
● Another advantage for large industries is that ​local education and training providers are more likely to develop courses to prepare people to take up jobs in these businesses.
● Firms will be able to hire staff who have been ​trained by other businesses​, which is cheaper and more efficient for the firm than training the workers themselves.

Question 50

How can support services cause external economies of scale?

Answer 50

Businesses who provide products or services for large businesses will naturally move to the area where those businesses are based, which reduces transport cost/time delays for the business.

Question 51

How can workers cause diseconomies of scale?

Answer 51

● In a large business, people can think their efforts go unnoticed and have less chance of promotion so lose motivation and work less hard. They can also lose their sense of belonging and have less personal commitment and identification with the business

Question 52

How can geography cause diseconomies of scale?

Answer 52

● A firm may have to transport finished products huge distances and firms may find it harder to control parts of the business which is miles away.

Question 53

How can change cause diseconomies of scale?

Answer 53

It takes much longer and is much more difficult for a large firm to respond to change.

Question 54

How can prices of materials cause diseconomies of scale?

Answer 54

As business grows so does their demand for raw materials and equipment. Although this can increase their bargaining power as they buy in bulk, an increase in demand can cause prices to rise and therefore increase production costs. This could also occur if the whole industry increases and so firms bid up prices.

Question 55

How can management cause diseconomies of scale?

Answer 55

Coordination and control: As a business grows, it will become progressively more difficult to coordinate and keep control of all the different parts of the business. Coordination of a multinational company producing different parts of a car around the world is much more difficult than coordinating and controlling the work of a local garage. This could lead to poorer quality to work and business decisions which don’t work well together.
● Communication: ​Within a large business, communication can be slow and also can lose accuracy because of the distance and the number of people it has to be passed through.

Question 56

What is a natural monopoly?

Answer 56

This is a monopoly which forms because the the level of output necessary to reach the minimum economy of scale is so high that it only makes sense to have one high cost network. This can be seen on rail networks, where there will be one monopoly company for a region as the average fixed cost for a new company to create a new rail-way line to attempt to compete with the monopoly company is simply too high.

Question 57

What is profit?

Answer 57

Profit is the difference between revenue and costs.

Question 58

When is profit maximised?

Answer 58

● Profit is maximised when ​TR and TC are furthest apart​, with TR above TC.
● It also occurs when ​MC=MR​: this will always be true because if producing one more adds more to revenues than it does to cost (i.e. MR is higher than MC), producing that must have increased profit and vice versa. Sometimes, MR and MC may cross at two points and thus the profit maximising point is where marginal cost rises as it crosses the MR line.

Question 59

What is normal profit?

Answer 59

Normal profit is the ​return that is sufficient to keep the factors of production committed to the business​. In economics, costs include the level of profit needed to keep the producer in the market and to cover the opportunity cost. Therefore, if the firm covers its costs it earns normal profit. This is at the point where AC=AR or TC=TR.

Question 60

What is supernormal profit?

Answer 60

If the ​profit is greater than normal profit​, it is earning supernormal, abnormal or monopoly. This occurs where AR>AC or TR>TC.

Question 61

When will a firm make a loss?

Answer 61

A loss is where the firm ​fails to cover its costs,​ AR<AC or TR<TC.

Question 62

What can it be easier to consider normal profit as?

Answer 62

The economic cost. This includes costs of factors of production as well as opportunity costs. For a company to have normal profit, their total revenue must equal the economic costs. If their revenue exceeds the economic profit, they will make supernormal profit.

Question 63

Should a business shut down if making a loss in the short-run?

Answer 63

When a business is making a loss, it may not necessarily be the best decision to shut down straight away: this ​depends on the average variable cost​.
● If ​AVC<AR then ​firms should continue production​. Each good they make will generate more revenue than it cost for them to make it, and so this will help them to reduce the size of the loss by covering some of the fixed cost. In this case, they should only shut down when their fixed costs increase e.g. when machinery needs to be replaced, when their lease is up etc

Question 64

When should a business shut down in the short run?

Answer 64

However, if ​AVC>AR then producing more goods will increase the loss. As a result, they ​should leave the industry immediately​.

Question 65

What is necessary for firms in the long run to stay in business?

Answer 65

In the long run, the firm needs to make at least normal profit for them at stay in the industry. However, in the short run they should produce as long as their revenue covers their variable costs. Hence, the short run shut-down point is where ​AVC=AR​.
● Firms tend to produce on the shut run point even though it does not affect their losses as they do not want to let go of their workers or let down customers.