Unit 7: Firm and its Customers

Question 1

what strategies allow firms to grow?

Answer 1

pile it high and sell it cheap - tesco

charge a price premium - apple

Question 2

why are large firms different from small firms

Answer 2

because of economies of scale

firm’s cost depends on its scale of production and technology

large firms can be more profitable due to technological and/or cost advantages

this leads to economies of scale

Question 3

Explaining economies of scale

Answer 3

if inputs increase by a given proportion & production increases more/as/less proportionally

Then the technology exhibits increasing/constant/decreasing returns to scale in production

Question 4

Economies of scale include

Answer 4

Cost advantages - large firms can purchase inputs on more favourable terms as they have more bargaining power with suppliers

Demand advantages - network effects (value of output rises with no. of users)

But large firms can experience diseconomies of scale e.g additional layers of bureaucracy due to too many employees

Technological advantages - e.g specialisation, larger machines

Question 5

Diseconomies of scale include

Answer 5

Increased bureaucracy

inability to adapt to change

Question 6

Average cost

Answer 6

Average cost per unit produced

slope of production function drawn from origin to the point

Question 7

Marginal cost

Answer 7

the effect on total cost of producing one additional unit of output

calculated as the slope of the cost function at a given point

Question 8

Relationship between MC & AC

Answer 8

If AC greater than MC - AC is decreasing

if AC less than MC - AC is increasing

The MC curve always intersects AC curve at the AC curves lowest point

Question 9

Demand curve

Answer 9

Price against quantity

quantity that consumers will buy at each price

Question 10

Isoprofit curves

Answer 10

Economic profit = total revenue - total costs (costs include opportunity cost of capital)

isoprofit curves show price-quantity combinations that give the same profit

Profit = Q(P - AC)

Question 11

Profit maximisation

Answer 11

Demand curve = firm’s feasible frontier (MRT=slope)

Isoprofit curves = firm’s indifference curves (MRS=slope)

profits maximised where MRT=MRS

profits maximised where marginal revenue = marginal cost

Question 12

Marginal revenue

Answer 12

change in revenue from selling an additional unit

Question 13

Price elasticity of demand

Answer 13

elasticity = -%change in quantity/% change in price

to say in order to sell one more unit, firm has to change price by $x

price elasticity of demand = degree of responsiveness (of consumers) to a price change

= -%change in demand/%change in price

MR is always positive when demand is elastic

A firms markup (profit margin in proportion to price) is inversely proportional to price elasticity of demand

Question 14

Price elasticity and policy

Answer 14

Specific taxes depends on the elasticity of demand for a certain good

governments raise more tax revenue by levying taxes on price-inelastic goods

Question 15

Market power & elasticity

Answer 15

firm’s profit margin depends on the elasticity of demand, which is determined by competition:

• demand is relatively inelastic if there are few close substitutes
• firms with market power have enough bargaining power to set prices without losing customers to competitors

competition policy (limits on market power) can be beneficial to consumers when firms collude to keep prices high

Question 16

Monopolies

Answer 16

firms selling specialised products face little competition and hence have inelastic demand

they can set prices above marginal cost without losing customers, thus earning monopoly rents

this is a form of market failure because there is deadweight loss

Question 17

Natural monopolies

Answer 17

arise when one firm can produce at lower average costs than two or more firms e.g utilities

instead of encouraging competition, policymakers may put price controls or make these firms publicly owned e.g the underground

Question 18

Firms gaining market power

Answer 18

1. Innovation and product differentiation

tech innovation allows firms to differentiate products from competitors

firms inventing new products may prevent competition altogether through patents or copyright laws

2. Advertising

attracts consumers away from competing products and creates brand loyalty

can be more effective than discounts in increasing demand for product

Question 19

Consumer surplus

Answer 19

total difference between willingness-to-pay and purchase price

calculated as area of price, quantity graph under demand curve as a triangle above willingness-to-pay line

Question 20

Producer surplus

Answer 20

the total difference between the revenue and marginal cost (profit = producer surplus - fixed cost)

area of rectangle under demand curve and line between willingness-to-pay line - marginal cost (area under marginal cost line)

Question 21

total surplus

Answer 21

consumer surplus + producer surplus

Question 22

Deadweight loss

Answer 22

loss of total surplus relative to a Pareto efficient allocation (unexploited gains from trade)

total surplus os highest when demand = marginal cost

firm doesn’t produce at social optimum thus

Little triangle in the graph