Section 3 - Business Economics

Question 1

What is the definition of production?

Answer 1

>Production means manufacturing something in order to sell it.
>Production involves converting inputs (e.g. raw materials, labour) into outputs (things to sell).

Question 2

Input

Answer 2

>The inputs can be any of the four factors of production - land, labour, capital and enterprise.
>Inputs can be tangible or intangible.

Question 3

Tangible

Answer 3

>Things you can touch, like raw materials or machines.

Question 4

Intangible

Answer 4

>‘Abstract’ things that can’t be touched - like ideas, talent or knowledge.

Question 5

Output

Answer 5

>The outputs produced should have an exchangeable value - they need to be something that can be sold.

Question 6

What is the definition of productivity?

Answer 6

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.

Question 7

Labour productivity - definition

Answer 7

>Output per worker or per hour worked.

Question 8

Labour productivity - how to calculate

Answer 8

1. Take the amount of output produced in a particular time.
2. Divide this by the total number of workers (or per worker-hour).

Question 9

What does labour productivity allow?

Answer 9

>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.

Question 10

How can labour productivity be improved?

Answer 10

1. Better training.
2. More experience.
3. 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.

Question 11

Specialisation

Answer 11

>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.

Question 12

Advantages of specialisation

Answer 12

1. People can specialise in the thing they’re best as or by doing it, they learn to become better at it.
2. This can lead to better quality and a higher quantity of products for the same amount of effort overall i.e. - increased labour productivity.
3. 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.
4. 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.
5. Training costs are reduced if workers are only trained to perform certain limited tasks.

Question 13

Disadvantages of specialisation

Answer 13

1. Workers can end up doing repetitive tasks, which can lead to boredom.
2. 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.
3. It can lead to a lack of flexibility - e.g. if the companies eventually move elsewhere, the workforce left behind can struggle to adapt.

Question 14

Link between trade and specialisation

Answer 14

>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.

Question 15

Trade

Answer 15

>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).

Question 16

Money - definition

Answer 16

>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.

Question 17

Money’s other functions

Answer 17

Money has 3 other functions too:

1. A measure of value - e.g. the value given to a good can be measured in US dollars.
2. 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.
3. 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.

Question 18

Firms - definition

Answer 18

>A firm is any sort of business organisation, like a family-run factory, a dental practice or a supermarket chain.

Question 19

Industry - definition

Answer 19

>An industry is all the firms providing similar goods or services.

Question 20

What do markets contain?

Answer 20

>A market contains all the firms supplying a particular good or service and the firms or people buying it.

Question 21

Firms

Answer 21

>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.

Question 22

What is the difference between accounting and economics when considering total cost?

Answer 22

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.

Question 23

Economists and the cost of production

Answer 23

>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.

Question 24

The opportunity cost of a factor of production

Answer 24

>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.

Question 25

Short run

Answer 25

>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.

Question 26

Long run

Answer 26

>The long run is a period of time when all factors of production can be varied.
>In the long run all costs are variable.

Question 27

What can costs be in short run?

Answer 27

>Fixed or variable.

Question 28

Fixed costs

Answer 28

>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

Question 29

Variable costs

Answer 29

>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

Question 30

Total cost

Answer 30

>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.

Question 31

Average cost

Answer 31

>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.

Question 32

Marginal cost - definition

Answer 32

>Marginal cost (MC) is the extra cost incurred as a result of producing the final unit of output.

Question 33

Marginal cost

Answer 33

>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.

Question 34

More general formula for MC

Answer 34

MC = Change in TC / Change in quantity.

Question 35

Trend of MC

Answer 35

>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.

Question 36

How does MC affect AC?

Answer 36

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

Question 37

Other than the average cost curve, which other curve does the marginal cost curve cross?

Answer 37

>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.

Question 38

AFC Curve

Answer 38

>AFC falls as output rises because the total fixed cost is spread across the greater output.

Question 39

What are increases in output limited by in the short run?

Answer 39

>Diminishing returns.

Question 40

What does the law of diminishing returns explain?

Answer 40

>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.

Question 41

Marginal product - definition

Answer 41

>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.

Question 42

Increasing output - MP and law of diminishing returns explaination

Answer 42

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.

Question 43

Law of diminishing returns - key

Answer 43

>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.

Question 44

Law of diminishing returns says..
Plus other names

Answer 44

>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.

Question 45

What does marginal returns do to marginal cost?

Answer 45

>Increases it.

Question 46

Marginal returns or marginal product - relation to marginal cost

Answer 46

>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.

Question 47

What does diminishing marginal returns eventually cause?

Answer 47

>Productivity to fall

Question 48

Diminishing returns and productivity

Answer 48

> 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).

Question 49

Average product

Answer 49

>AP is the output produced per unit of factor input.

Question 50

Total product

Answer 50

>TP is the total output produced using a particular combination of factor inputs.

Question 51

How can productivity be improved?

Answer 51

>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.

Question 52

Economies of Scale - definition

Answer 52

>An economy is experiencing economies of scale when the average cost of production is falling as output rises.

Question 53

Intro -economies of scale

Answer 53

>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.

Question 54

2 categories economies of scale can be divided into two categories?

Answer 54

1. Internal.
2. External

Question 55

Internal economies of scale

Answer 55

>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.

Question 56

Internal: Technical Economies of Scale

Answer 56

>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.

Question 57

Law of increased dimensions

Answer 57

>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.

Question 58

Internal: Purchasing Economies of Scale.

Answer 58

>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.

Question 59

Internal: Managerial Economies of Scale.

Answer 59

>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.

Question 60

Internal: Financial Economies of Scale.

Answer 60

>Larger firms can often borrow money at a lower rate of interest - lending to them is seen as less risky by banks.

Question 61

Internal: Risk-bearing Economies of Scale.

Answer 61

>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.

Question 62

Internal: Marketing Economies of Scale.

Answer 62

>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.

Question 63

External economies of scale

Answer 63

>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.

Question 64

What can extremely successful companies gain?

Answer 64

>Monopoly power in a market.

Question 65

Economies of sales - main advantage

Answer 65

>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.

Question 66

Diseconomies of scale

Answer 66

>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.

Question 67

Internal diseconomies of scale

Answer 67

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.

Question 68

External diseconomies of scale.

Answer 68

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.

Question 69

How can economies of scales be made even larger?

Answer 69

>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.

Question 70

What do you need to use to show economies and diseconomies of scale?

Answer 70

>Long run average cost curves.

Question 71

SRAC (short run average cost) curve and LRAC (long run average cost) curve.

Answer 71

>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.

Question 72

The shape of the LRAC curve

Answer 72

>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.

Question 73

External changes and the LRAC curves

Answer 73

>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.

Question 74

L-Shaped LRAC Curve

Answer 74

>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.

Question 75

Diseconomies of scale - definition

Answer 75

>A firm is experiencing diseconomies of scale when the average cost of production is rising as output rises.

Question 76

Returns to Scale - definition

Answer 76

>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.

Question 77

Returns to Scale info

Answer 77

>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.

Question 78

Returns to scale vs economies of scale

Answer 78

>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.

Question 79

Link between returns to scale and economies of scale

Answer 79

>Increasing returns to scale contribute to economies of scale.
>Decreasing returns to scale contribute to diseconomies of scale.

Question 80

Increasing returns to scale

Answer 80

>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.

Question 81

Constant returns to scale

Answer 81

>When returns to scale are constant, long run average cost will stay the same - costs are increasing proportionally to output.

Question 82

Decreasing returns to scale

Answer 82

>When returns to scale are decreasing, long run average cost will rise.
>Less output is produced per unit of input.

Question 83

MES - definition

Answer 83

>Minimum Efficient Scale of Production.
>The lowest level of output at which a firm can achieve the lowest possible average cost of production.

Question 84

When are LRACs minimised?

Answer 84

>At the point of MES.

Question 85

MES - info

Answer 85

>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.

Question 86

How does the MES vary?

Answer 86

>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.

Question 87

Total revenue - definition

Answer 87

>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.

Question 88

Average revenue - definition

Answer 88

>Average revenue (AR) is the revenue per unit sold.
>AR = TR/Q.
>So AR is the price.

Question 89

Marginal revenue - definition

Answer 89

>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).

Question 90

What does a firm’s demand curve determine?

Answer 90

>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).

Question 91

Price Takers

Answer 91

>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.

Question 92

Perfectly elastic demand curve

Answer 92

>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.

Question 93

Price makers

Answer 93

>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.

Question 94

Downward sloping demand curves

Answer 94

>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.

Question 95

Why is TR maximised when PED = - 1?

Answer 95

>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.

Question 96

Relationship between MR, AR and TR

Answer 96

>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.

Question 97

Profit - definition

Answer 97

>Profit is the difference between total revenue and total costs.
>There are 2 types: normal and supernormal (abnormal) profit.
>Profit = TR -TC.

Question 98

Normal Profit

Answer 98

>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

Question 99

Supernormal profit

Answer 99

>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.

Question 100

Economic assumptions about firms

Answer 100

>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.

Question 101

Firm objectives

Answer 101

>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

Question 102

Maximising revenue

Answer 102

>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.

Question 103

Maximising sales

Answer 103

>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.

Question 104

What is the difference between invention and innovation?

Answer 104

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.

Question 105

How does technological change affect methods of production?

Answer 105

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.

Question 106

How does technological change affect productivity?

Answer 106

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

Question 107

How does technological change affect efficiency?

Answer 107

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.

Question 108

How does technological change affect costs of production?

Answer 108

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.

Question 109

What is the difference between mechanisation and automation?

Answer 109

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.

Question 110

How can you assess the impact of technological change on market structures?

Answer 110

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).

Question 111

Show the impact of technological change on the LRAS diagram.

Answer 111

Question 112

What is disruptive innovation?

Answer 112

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.

Question 113

What is sustained innovation?

Answer 113

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.

Question 115

Example of the influence of technological change on the structure of markets: Kodak Case Study

Answer 115

1. K

Question 116

What is creative destruction?

Answer 116

Capitalism evolving and renewing itself over time through new technologies and innovations replacing older technologies and innovations.

• Term coined by Joseph Schumpeter 1942

Question 117

Show economies and diseconomies of scale on a diagram

Answer 117

Question 118

What is short run average cost and what does it show? Explain the SRAC curve

Answer 118

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.

Question 119

Explain the two curves

Answer 119

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

Question 120

What do the production curves of TP, AP and MP look like? How do they relate?

Answer 120

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

Question 121

What do the fixed and variable cost curves look like and how do they relate? (TFC and AFC)

Answer 121

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

Question 122

What does the average variable cost curve look like (AVC)?

Answer 122

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

Question 123

What do the average and marginal cost curves look like, how do they relate (MC&AC)?

Answer 123

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

Question 124

What does the total cost curve look like (TFC, TVC, TC)?

Answer 124

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

Question 125

What is long run average cost and what does it show? Long Run Cost Theory

Answer 125

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

Question 126

Explain constant returns to scale

Answer 126

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.

Question 127

Increasing returns to scale

Answer 127

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.

Question 128

Decreasing returns to scale

Answer 128

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.

Question 129

What is the significance of returns to scale in terms of long run costs?

Answer 129

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

Question 130

What are the features of the long run cost curve and explain.

Answer 130

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.

Question 131

What is the LRAC curve determined by?

Answer 131

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.

Question 132

What are examples of diseconomies of scale?

Answer 132

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

Question 133

How are economies and diseconomies of scale categorised?

Answer 133

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

Question 134

How would you depict an LRAC curve?

Answer 134

Question 135

Subnormal profit

Answer 135

AR

Question 136

How would you define revenue and what are the key equations?

Answer 136

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)

Question 137

What does a revenue curve dependent on perfect competition look like?

Answer 137

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

Question 138

What does a revenue curve dependent on imperfect competition look like?

Answer 138

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.

Question 139

Diagrams showing profit in perfect competition vs. Monopoly

Answer 139

Question 140

Profit with revenue maximisation

Answer 140

Question 141

Profit maximisation in a monopolistically competitive market.

Answer 141

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.

Question 142

Market Share maximisation

Answer 142

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)

Question 143

Explain this diagram

Answer 143

Question 144

What is the main (assumed) objective of a firm and why?

Answer 144

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

Question 145

What is the shut-down condition?

Answer 145

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.

Question 146

Show what a loss of profit (subnormal) looks like in perfect competition.

Answer 146

AC>AR, so there is a loss.