6: The theory of the firm I: production, costs, revenues and profit.

Question 1

Differentiate between the short run and the long run in the context of production:

Answer 1

The short run is a time period during which at least one input is fixed and cannot be changed by the firm. For example, if a firm wants to increase output, even if it can hire more labour and increase equipment, if it cannot quickly change the size of its buildings or factories, it is in the short run. The long run is a time period when all inputs can be changed, they are all variable.

Question 2

What is the total product (TP)?

Answer 2

The total quantity of output produced by a firm.

Question 3

What is the marginal product (MP)? How is it calculated?

Answer 3

The extra or additional output resulting from one additional unit of the variable input, or labour.
MP = ∆TP / ∆units of labour

Question 4

What is the average product (AP)? How is it calculated?

Answer 4

The total quantity of output per unit of variable input, or labour. This tells us how much each unit of labour (each worker) produces on average. AP = TP/units of labour.

Question 5

Describe the total product curve, marginal product curve and average product curve:

Answer 5

Units of variable input (labour) on the x axis.
Units of output on the y axis.

The TP curve is increasing as there is an incresaing marginal output, until it curves the other way and marginal output is decreasing (kind of like an s). Eventually it curves over, and there is a negative marginal output.

The MP curve increases until the MP starts to be negative and then it just keeps being negative. It hits 0 when the TP curve starts to go down. When the TP curve goes downward, MP is negative so MP curve crosses the x axis.

AP curve is simply increasing and then decreasing in the middle.

Question 6

What is the relationship between the average and marginal product curves? What does this mean?

Answer 6

When the marginal product curve lies above the average product curve (MP>AP), average product is increasing. When the marginal product curve lies above the AP curve (AP>MP) the average product curve is decreasing. This means the marginal product curve always intersects the average product curve when it is at its maximum.

Question 7

What is the law of diminishing returns?

Answer 7

The law of diminishing returns/marginal product states that as more and more units of a variable input (such as labour) are added to one or more fixed inputs, the marginal product of the variable input at first increases, but there comes a point where it begins to decrease.

Question 8

What are costs of production?

Answer 8

Cost of productions are money payments to buy resources, which include land, labour, capital and entrepreneurship.

Question 9

What are explicit costs?

Answer 9

Payments made by a firm to outsiders to acquire resources for use in production.

Question 10

What are implicit costs?

Answer 10

The sacrificed income arising from the use of self owned resources by a firm.

Question 11

What are economic costs?

Answer 11

The sum of explicit and implicit costs, or total opportunity costs incurred by a firm for its use of resources, whether purchased or self owned.

Question 12

What are fixed costs? Examples?

What are variable costs? Example?

Answer 12

Fixed costs are costs that do not change as output changes. For example, rental payment. Even if there is zero output, these payments still have to be made in the short run.

Variable costs are costs that vary as output increases or decreases. An example is the wage cost of labour

Question 13

Why are there no fixed costs in the long run?

Answer 13

Because in the long run there are no fixed inputs.

Question 14

What is total cost?

Answer 14

The sum of fixed costs and variable costs.

Question 15

How do you calculate average fixed cost (AFC)?

Answer 15

TFC/Q (Units of output)

Question 16

How do you calculate average variable cost (AVC)?

Answer 16

TVC/Q (Units of output)

Question 17

How do you calculate average total cost (ATC)?

Answer 17

TC/Q (Units of output)

TC = TFC + TVC

Question 18

How do you calculate ATC?

Answer 18

ATC = AFC + AVC

Question 19

What is marginal cost?

How is it calculated?

Answer 19

It is the extra or additional cost of producing one more unit of output. MC = TC / ∆Q = ∆TVC / Q because fixed cost is fixed and does not change.

Question 20

Draw a diagram illustrating the total cost curves in the short run:

Answer 20

The TFC curve is a horizontal line as it is a fixed amount that does not change as output changes.
The TVC increases as output increases but at a varying rate due to the law of diminishing returns.
The TC curve is the vertical sum of TFC and TVC, so the vertical difference between TC and TVC is TFC. TC and TVC are parallel.

Question 21

Draw a diagram illustrating the relationship between marginal cost and average costs and explain the connection with production in the short run (p148):

Answer 21

The AFC curve indicates that AFC falls continuously as output increases, because it represents the amount of fixed costs (TFC) divided by an ever growing quantity of output.
ATC, AVC and MC all fall originally, reach a minimum and then rise.
The ATC curve is the vertical sum of AFC and AVC, so the vertical difference between the ATC and AVC curves is equal to AFC. ATC is above AVC. The distance between them starts off large and then gets smaller as AFC gets much smaller.
The MC intersects the AVC and ATC curves at their minimum points.
AFC starts very high and then decreases exponentially until it is very small, with an asymptote at 0.

Question 22

Why does MC intersect the AVC and ATC curves at their minimum points?

Answer 22

Because when the marginal cost is lower than the average cost, the average cost falls. When it is greater than the average cost, the average cost rises.

Question 23

What is the relationship between MP/AP curves and MC/AVC curves?

Answer 23

They are mirror imagines of each other. Where MP and AP increase, MC and AVC decrease and visa versa.

Question 24

Explain the relationship between MP/AP curves and MC/AVC curves:

Answer 24

When output is lower, an increase in labour increases the marginal product, and this decreases marginal cost as productivity increases. Decreasing product means that additional output of each unit of labour is falling so the additional cost of each unit of labour (marginal cost) must be increasing. Thus, it is due to the law of diminishing returns.

Question 25

What qre constant returns to scale?

Answer 25

Constant returns to scale means that output increases at the same proportion as all inputs, they change by the same percentage.

Question 26

What are increasing returns to scale?

Answer 26

Increasing returns to sale means that output increases more than in proportion to the increase of all inputs.

Question 27

What are decreasing returns to scale?

Answer 27

Decreasing returns to scale means that output increases less than in proportion to the increase in all inputs.

Question 28

Can decreasing returns happen in the short run?

Answer 28

No because the short run implies that at least one variable is fixed and decreasing returns to scale shows what happens to output when all inputs are variable.

Question 29

Why is it convenient to think of the long run as the firm’s planning horizon?

Answer 29

If a firm wants to expand production it must think of increasing its fixed inputs, otherwise it will face the problem of diminishing returns. It must minimise costs for the level of output it wishes.

Question 30

What is the long run average total cost curve?

Answer 30

A curve that shows the lowest possible average cost that can be attained by a firm for any level of output when all the firm’s inputs are variable. It is also known as a planning curve.

Question 31

How does the LRATC curve relate to the SRATC curve

Answer 31

It touches each of many short run average total cost curves.

Question 32

Explain using a diagram, the shape of the LRATC curve:

Answer 32

Show a diagram with costs on the y axis and output on the x axis. Show many smaller SRATC curves and label their minimum points. You can label these curves SRATC1, SRATC2 and so on. The minimum points when connected should be a U shape curve, label this the LRATC curve. The shape is a U due to economies of scale.

Question 33

What are economies of scale?

Answer 33

Economies of scale are decreases in the average costs of production over the long run as a firm increases all of its inputs.

Question 34

What are the reasons for increasing returns to scale?

Answer 34

Increasing returns to scale means when a firm increases all of its inputs, its output increases by a larger proportion. This can happen because of:

1. Specialisation of labour
2. Specialisation of management
3. Efficiency of capital equipment
4. Indivisibilities of capital equipment
5. Indivisibilities of efficient processes
6. Spreading of certain costs over a larger volume of output
7. Buying in bulk

Question 35

Explain how specialisation of labour can lead to increasing returns to scale:

Answer 35

As the scale of the production increases, more workers must be employed, allowing for greater worker specialisation. Each worker specialises in performing tasks that make use of skills, interests and talents, increasing efficiency and allowing output to be produced at a lower average costs.
E.g. mcdonalds used specialisation as they had employees who only flipped burgers. Such repetitive tasks increase productivity.

Question 36

Explain how specialisation of management can lead to increasing returns to scale:

Answer 36

Larger scales of production allow for more managers to be employed, who can specialise in a particular area, such as finance.

Question 37

Explain how efficiency of capital equipment can lead to increasing returns to scale:

Answer 37

Large machines are more efficient than smaller ones, such as a large power generators, they waste less energy.

Question 38

Explain how indivisibility of capital equipment can lead to increasing returns to scale:

Answer 38

Mass production assembly lines for example require large volumes of output to be efficient. Smaller firms cannot make use of this.

Question 39

Explain how spreading of certain costs can lead to increasing returns to scale:

Answer 39

Fixed costs cost less when spread over larger volumes of output.

Question 40

What are diseconomies of scale?

Answer 40

Increases in the average cost of production as a firm increases its output by increasing all of its inputs. This means a firm is experiencing decreasing returns to scale.

Question 41

Reasons for decreasing returns to scale:

Answer 41

1. Co-ordination and monitoring difficulties.
2. Communication difficulties
3. Poor worker motivation

Question 42

What are constant returns to scale?

How does it look graphically?

Answer 42

Constant long run average costs over a certain range of output. As output increases, average costs do not change. The firm experiences neither economies or diseconomies of scale. It appears graphically as a horizontal segment of a graph.

Question 43

How is total revenue (TR) calculated?

Answer 43

Multiplying the price at which a good is sold (P) by the number of units of the good sold (Q).
TR = P * Q

Question 44

What is a firm’s marginal revenue (MR)?

Answer 44

Marginal revenue is the additional revenue that arises from the sale of an additional unit of output:
MR = ∆TR/∆Q

Question 45

What is a firm’s average revenue? What is this equal to?

Answer 45

Average revenue is the revenue per unit of output sold.

AR = TR/Q. This is always equal to P since TR = P*Q, P = TR/Q = AR.

Question 46

What does the total revenue curve look like when a firm has no control over the price of the good?

Answer 46

TR on y axis, Q on x axis.
The AR curve is horizontal as it equals price and P is constant since the firm has no control over the good.
The TR curve is linear since TR = P*Q and P is constant, as Q increases, TR increases linearly.

Question 47

What does the total revenue curve look like when a firm has some control over the price of the good?

Answer 47

TR increases until MR is negative, where it decreases. Price/AR goes down as when Q increases, price decreases. TR is a curve.

Question 48

What is economic profit?

Other names?

Answer 48

Economic profit is total revenue - total costs.

Also referred to as supernormal profit, or abnormal profit.

Question 49

What is normal profit?

Answer 49

The minimum amount of revenue required by a firm for business to keep running. Economic profit is at zero. It also includes the cost of entrepreneurship.

Question 50

Why would a firm continue to operate if economic profit is zero?

Answer 50

When a firm is earning normal profit it has covered all its opportunity costs as it has covered the cost of entrepreneurship and all other implicit costs, so it will continue to operate. It does not make sense to shut down as the firm will make no more money shut down than running and it has already paid for fixed costs.

Question 51

What are the types of economic profit?

Answer 51

Economic profit can be positive, zero, or negative.
Positive economic profit means that total revenue is greater than the economic cost, this is supernormal/abnormal profit.
Zero economic profit means that total revenue = economic cost, so the firm earns normal profit.
Negative economic profit means that total revenue is less than economic costs, meaning the firm makes a loss.

Question 52

What does standard economic theory dictate is a firm’s goal?

Answer 52

To maximise profit. If they cannot make a profit however, the goal is to minimise the loss until they may be forced to shut down.

Question 53

What is profit maximisation?

Answer 53

Determining the level of output that the firm should produce to make profit as large as possible.

Question 54

What are the two approaches to profit maximisation?

Answer 54

One involves the total revenue and total cost concepts and the other involves the use of marginal revenues and costs.
The firm’s first profit maximisation rule is to produce the level of output where TR-TC is as large as possible. If TR

Question 55

With a firm that has no control over the price of the good (perfect competition), how can you use the total cost curve to predict the optimum quantity to produce at? (p162)

Answer 55

TC on y, Q on x.
The TR curve is linear. The TC curve is S shaped. If these two cross over, then where there is the most distance between the intersection of the curve (where it is fattest) This means TR>TC, this quantity will yield the biggest profit.
If The two graphs just touch each other, the point at which this happens is normal profit, and every other point shows a loss as TC>TR. Q* therefore will yield normal profit.
If the two graphs do not touch at all and TC is above TR then the firm is operating at a loss, find the point at which the curves are closest to minimise loss, this is Q*.

Question 56

With a firm that has some control over the price of the good, how can you use the total cost curve to predict the optimum quantity to produce at? (p162)

Answer 56

TC on y, Q on x.
The TR curve is a curve. The TC curve is an s shape.
If they intersect and TR is above TC at points, the largest vertical distance between the two curves is Qπmax (quantity that yields maximum profit). If the two curves do not intersect, TC will be above TR, meaning the firm is operating at a loss. Thus, it is best to find the vertical distance is smallest and this is Q1min.

Question 57

With a firm that has no control over the price of the good (perfect competition), how can you use the marginal cost curve to predict the optimum quantity to produce at? (p163)

Answer 57

Since the firm is operating at perfect competition the marginal revenue curve is a horizontal line. The marginal cost curve is still U shaped due to the law of diminishing returns. Where they intersect is Qπmax.

Question 58

With a firm that has some control over the price of the good, how can you use the marginal cost curve to predict the optimum quantity to produce at? (p163)

Answer 58

MC, MR on y, Q on x.
The MR is a linear line down (ask Dad WHY).
The MC is U shaped. Where they intercept is Qπmax.

Question 59

Why is profit maximised when MR = MC.

Answer 59

If MR > MC then it is in a firms interest to increase quantity as their revenue will increase by more than the quantity. This is the case until MR = MC, after which point increasing quantity produced will decrease output.

Question 60

What are alternative goals of firms:

What would shift the goal of the firm from profit maximisation to any of these?

Answer 60

1. Revenue maximisation
2. Growth maximisation
3. Managerial utility maximisation
4. Satisficing
5. Ethical and environmental concerns

Firms may have alternative goals if there is a separation of firm management from firm ownership.

Question 61

What is revenue maximisation?

Why would a firm be preoccupied with revenue maximisation?

Answer 61

Revenue maximisation is increasing sales and maximising revenues. This may be more useful than profit maximisation because:

1. Sales can be identified and measured more easily over the short run than profits. Increased sales targets can be used to motivate employees.
2. Rewards for managers and employees are often linked to increased sales rather then increased profit.
3. It is assumed that revenue from more sales will increase more rapidly than costs, if so increased sales will increase profits.
4. Increased sales gives rise to a feeling of success.

Question 62

Why would a firm be preoccupied with growth maximisation?

Answer 62

1. A growing firm can achieve economies of scale which will lower average costs.
2. A growing firm diversifies production of different products and markets and reduces its dependence on a single product in the market.
3. A larger firm has greater market power and ability to influence prices.
4. A larger firms is less likely to be bought by another firm.
5. Where profit maximisation is favoured by owners and revenue maximisation is favoured by managers, growth maximisation is favoured by both.

Question 63

Why would a firm be preoccupied with managerial utility maximisation?

Answer 63

When firm management is separated from firm ownership, managers develop their own objectives that maximise their utility such as increased salaries, larger fringe benefits such as company cars, and investment into their preferred projects. They may cut profits to do so.

Question 64

What is satisficing?

Answer 64

H Simon argues that the large modern enterprise cannot be looked upon as a single entity with a single maximising objective, instead they should try to receive satisfactory rather than optimal or best results.

Question 65

Why would a firm be preoccupied with environmental and ethical concerns rather than profit?

Answer 65

The self-interested firm often leads to negative externalities of production. Nowadays, it may be in a firms interest to focus on ethical and environmental concerns as disregarding them can lead to lower worker productivity and less quantity sold due to the negative media surrounding the company. For example the sales of Primark, a UK retailer, fell substantially after footage of their sweatshops were released. Considering ethical concerns may help to increase their profit.