Chapter 11

Question 1

What is a firm (business)?

Answer 1

An organisation that produces output (a good or service)

Question 2

What does short run mean?

Answer 2

The period in which at least one factor of production is fixed in supply

Question 3

What does long run mean?

Answer 3

The period over which the firm is able to vary the inputs of all its factors of production

Question 4

How can production vary in the short and long run?

Answer 4

In the short run firms faces limited flexibility. Varying the quantity of labour input may be relatively straightforward a firm can increase the use of overtime, or hire more workers, fairly quickly.

However, varying the amount of capital that the firm has at its disposal may take longer. For example, it takes time to commission a new piece of machinery or to build a new factory.

Hence labour is often regarded as a variable factor and capital as a fixed factor. The short run is defined as the period over which the firm is free to vary the input of variable factors but not of fixed factors. In the long run, the firm is able to vary inputs of both variable and fixed factors.

Question 5

What is the law of diminishing returns?

Answer 5

A law stating that if a firm increases its inputs of one factor of production while holding inputs of the other factor(s) fixed, eventually the firm will get diminishing marginal returns from the variable factor.

Question 6

What is AN EXAMPLE of the law of diminishing returns?

Answer 6

It can readily be seen why this should be the case. Suppose a firm has 10 computer programmers working in an office, using 10 computers. The 11th worker may add some extra output, as the workers may be able to ‘hot-desk’ and take their coffee breaks at different times. The 12th worker may also add some extra output, perhaps by keeping the printers stocked with paper.

However, if the firm keeps adding programmers without increasing the number of computers, each extra worker will be adding less additional output to the office. Indeed, the 20th worker may add nothing at all, being unable to get access to a computer.

In other words, as the input of a variable factor is increased, the additional output produced by each additional unit of input falls.

Question 7

What is the Marginal Physical Product of Labour (MPP)?

Answer 7

The additional quantity of output produced by an additional unit of labour input.

Question 8

What is the total cost?

Answer 8

The sum of all costs that are incurred in producing a given level of output (including opportunity cost)

Question 9

What is the average cost?

Answer 9

Total cost divided by the quantity produced, sometimes known as unit cost

Question 10

What is the marginal cost?

Answer 10

The cost of producing an additional unit of output

Question 11

What are fixed costs?

Answer 11

Costs that do not vary with the level of output

Question 12

What are variable costs?

Answer 12

Costs that do vary with the level of output

Question 13

What is the formula for total costs?

Answer 13

total costs = total fixed costs + total variable costs

Question 14

What are sunk costs?

Answer 14

Costs incurred by a firm that cannot be recovered if the firm ceases trading

Question 15

What is an example of total costs?

Answer 15

A fast-food outlet may be able to expand production in the short run by hiring more staff and buying more ingredients (variable costs), but it would need to make do with its existing premises and kitchen equipment in the short run (fixed costs).

Total costs increase as the firm increases the volume of production because more of the variable input is needed to increase output. The way in which the costs will vary depends on the nature of the production process, and on whether the prices of labour or other factor inputs alter as output increases.

Question 16

What does a short run cost curve show?

Answer 16

The short-run cost curves show the relationship between the volume of production and costs under the assumption that the quantity of capital and other inputs are fixed, so that in order to change output the firm has to vary the amount of labour. The position of the cost curves therefore
depends on the quantity of capital. In other words, there is a short-run average total cost curve for each given level of other inputs.

Question 17

How does costs in the long run work for a firm?

Answer 17

In the long run, a firm is able to vary capital and labour (and other factor inputs). It is therefore likely to choose the level of capital that is appropriate for the level of output it expects to produce.

A diagram shows a selection of short-run average total cost curves corresponding to different expected output levels, and therefore different levels of capital. With the set of SATC curves in the diagram, the long-run average cost curve can be seen to take on a U-shape.

Question 18

How does short and long run AVERAGE costs work?

Answer 18

For a firm, the choice of capital is important. Suppose the firm wants to produce the quantity of output q1. It would choose to install the amount of capital corresponding to the short-run total cost curve SATC1, and could then produce q1, at an average cost of C1 in the short run.

However, if the firm finds that demand is more buoyant than expected, and so wants to increase output to q2, in the short run it has no option but to increase labour input and expand output along SATC1, taking cost per unit to C2.

In the longer term, the firm will be able to adjust its capital stock and move on to SATC2, reducing average cost to C3. So, as soon as the firm moves away from the output level for which capital stock is designed, it incurs higher average cost in the short run than is possible in the long run. In this way a long-run average cost curve can be derived to illustrate how the firm chooses to vary its capital stock for any given level of output. The long-run average cost curve (LAC) just touches each of the short-run average cost curves, and is known as the ‘envelope’ of the SATC curves.

Question 19

What are economies of scale?

Answer 19

It occurs for a firm when an increase in the scale of production leads to production at lower long-run average cost

Question 20

How does technical economies of scale work?

Answer 20

One source of economies of scale is in the technology of production. There are many activities in which the technology is such that large-scale production is more efficient.

One source of technical economies of scale arises from the physical properties of the universe. There is a physical relationship between the surface area of an object and the volume of material that it can enclose. In other words, the storage capacity of an object increases proportionately more than its surface area. A large ship can transport proportionally more than a small ship, and large barrels hold more liquid relative to the surface area of the barrel than small barrels. Hence there may be benefits in operating on a large scale.

Furthermore, some capital equipment is designed for large-scale production, and would only be viable for a firm operating at a high volume of production. Combine harvesters cannot be used in small fields, while a production line for car production would not be viable for small levels of output.

There are many economic activities in which there are high overhead expenditures. Such components of a firm’s costs do not vary directly with the scale of production. For example, having built a factory, the cost of that factory is the same regardless of the amount of output that is produced in it. Expenditure on research and development could be seen as such an overhead, which may be viable only when a firm reaches a certain size.

Question 21

How is marketing a source of economies of scale?

Answer 21

Firms need to reach their intended customers. This means that they need to devote resources to advertising in order to attract buyers. But this is not all—they also need to find out what characteristics those potential buyers are looking for in the product. This requires firms to devote part of their resources to a marketing budget.

There may be scale economies involved here, as the average spend on marketing for a large firm is likely to be less per unit sold than for a small firm. In other words, the average cost per unit of marketing may be lower for a larger firm.

A large firm such as Cadbury’s incurs high marketing expenditure, but because of its large volume of sales, its per unit spend is lower than some smaller-scale chocolatiers with lower sales volume. Although expenditure may increase as output increases, it will do so less than proportionately.

Question 22

How is management a source of economies of scale?

Answer 22

A source of economies of scale pertains to the management of firms. One of the key factors of production is managerial input. A certain number of managers are required to oversee the production process. As the firm expands, there is a range of volumes of output over which the management team does not need to grow as rapidly as the overall volume of the firm, as a large firm can be managed more efficiently.

All firms need to conduct certain functions such as accounting or human resource management. As a firm expands, it may be able to employ specialist staff to handle these functions, and may not need to expand those sections of the company proportionately with the growth of the business. Again, this may lead to economies of scale.

For a firm operating on a small scale, it may need to buy in the expertise that it needs, for example to audit its accounts or advise on employment law. However, if its market is limited in size, or confined to a local area, this may be unavoidable, and the firm may not be looking to expand.

Question 23

How is finance a source of economies of scale?

Answer 23

Large firms may have advantages in a number of other areas. For example, a large firm with a strong reputation may be able to raise finance for further expansion on more favourable terms than a small firm. In other words, a large firm may be able to persuade the bank to advance them loans at lower rates of interest than a small firm, where the risks may be seen to be greater. This, of course, reinforces the market position of the largest firms in a sector and makes it more difficult for relative newcomers to become established.

Question 24

How is purchasing a source of economies of scale?

Answer 24

Once a firm has grown to the point where it is operating on a relatively large scale, it will also be purchasing its inputs in relatively large volumes. In particular, this relates to raw materials, energy and transport services. When buying in bulk in this way, firms may be able to negotiate good deals with their suppliers, and so again reduce average cost as output increases.

It may even be the case that some of the firm’s suppliers will find it beneficial to locate in proximity to the firm’s factory, which would reduce costs even more.

Question 25

What are internal economies of scale?

Answer 25

Economies of scale that arise from the expansion of a firm

Question 26

What are external economies of scale?

Answer 26

Economies of scale that arise from the expansion of the industry in which a firm is operating.

Question 27

What are some examples of economies of scale?

Answer 27

Concentration: One example of an external economy of scale is where a firm is located close to other firms in the same industry or related activities. Such geographical concentration can mean that transport and communication links will be developed, so all firms will benefit. Technology and skills: Some of the most successful firms of recent years have been involved in activities that require high levels of technology and skills. Web design is one example of an economic activity that has expanded rapidly. As the sector expands, a pool of skilled labour is built up that all the firms can draw upon. The very success of the sector encourages people to acquire the skills needed to enter it, colleges may begin to find it viable to provide courses and so on. Each individual firm benefits in this way from the overall expansion of the sector. The greater availability of skilled workers reduces the amount that individual firms need to spend on training. Web design is by no means the only example of this. Formula 1 development teams, pharmaceutical companies and others similarly enjoy external economies of scale.

Question 28

How does economies of scope work?

Answer 28

There are various ways in which firms expand their scale of operations. Some do so within a relatively focused market, but others are multi-product firms that produce a range of different products, sometimes in quite different markets. For example, look at Nestlé. You may immediately think of instant coffee, and indeed Nestlé produces 200 different brands of instant coffee worldwide. However, Nestlé also produces baby milk powder, mineral water, ice cream and pet food, and has diversified into hotels and restaurants. Such conglomerate companies can benefit from economies of scope, whereby there may be benefits of size across a range of different products. These economies may arise because there are activities that can be shared across the product range. For example, a company may not need a finance or accounting section for each different product, nor human resource or marketing departments. Therefore, there is scope for economies to be made as the firm expands.

Question 29

What are diseconomies of scale?

Answer 29

It occurs for a firm when an increase in the scale of production leads to higher long-run average costs

Question 30

How does diseconomies of scale affect communication?

Answer 30

One issue that arises as a firm expands is that it becomes more difficult to communicate across the organisation. This is especially the case if the firm has to operate across a range of different locations. This makes the organisation more difficult to manage, if the central managers cannot readily communicate their needs and intentions to the workforce.

Question 31

How does diseconomies of scale affect coordination?

Answer 31

Similarly, coordinating activity across a large firm becomes more costly and less efficient. For example, suppose that a manufacturing firm has separate factories producing components of a good, which then needs to be assembled somewhere else. Coordinating in order to establish an efficient supply chain becomes more and more difficult as the firm expands. Indeed, it is possible that some multinational corporations have divided their production activities across a number of countries in order to take advantage of local conditions or resources in different locations. This adds to the problems of coordinating the production process.

Question 32

How does diseconomies of scale affect motivation?

Answer 32

When a firm becomes large, it comes to rely on managers to oversee everyday production activities and take day-to-day decisions. The firm's owners may find it difficult to motivate these managers to run the firm in the way that they want.

Question 33

What is minimum efficient scale?

Answer 33

The level of output at which long-run average cost stops falling as output increases.

Question 34

What are economies of scale also known as?

Answer 34

Returns to scale (diseconomies of scale = decreasing economies of scale)

Question 35

What is the evaluation of economies and diseconomies of scale?

Answer 35

From a firm's perspective, the existence of economies of scale is of great importance. If the firm can produce at lower average cost by expanding its operations, there may be potential for increasing its profits – although this also depends upon the state of demand. A firm facing economies of scale therefore has an incentive to expand. Notice that such economies are more likely to be available in some activities than others, partly depending on the technology of production. Furthermore, a firm that overreaches itself and expands beyond the minimum efficient scale may find that diseconomies begin to set in. Economies of scale are likely to be especially important for a firm that faces large fixed relative to variable costs. As the firm expands, such fixed costs are spread across more units of output, so giving rise to falling average costs. However, such fixed costs may not be present in all activities, as explained earlier. The fixed costs entailed in constructing a new rail network are enormous compared to the variable costs of carrying a few extra passengers when the network is complete. Setting up a market stall to sell craft-based products carries no such upfront expenditure. Marketing and management economies of scale may be accessible across a wide range of sectors, as firms are able to rationalise their management functions, but there may be limits to how large a firm grows before hitting inefficiencies and diseconomies. The extent of economies of scale in an industry and the level of output at which diseconomies set in is also significant because it affects the operation of markets. In particular, the existence of economies of scale affects the ability of a firm to compete with other firms — and ultimately the extent of economies (or diseconomies of scale) has a major impact on the structure of the market and the number of firms that will be viable. When diseconomies of scale set in at a low level of output relative to the size of market demand, there is likely to be scope for firms to enter the market quite readily (ceteris paribus). However, if there are substantial economies of scale, it becomes more likely that the market will be dominated by a relatively small number of firms.

Question 36

What is total revenue?

Answer 36

The revenue received by a firm from its sales of a good or service - it is quantity sold, multiplied by price.

Question 37

What is average revenue?

Answer 37

The average revenue received by the firm per unit of output — it is total revenue divided by the quantity sold

Question 38

What is marginal revenue?

Answer 38

The additional revenue received by the firm if it sells an additional unit of output

Question 39

What is the formula for total, average and marginal revenue?

Answer 39

Total revenue = price x quantity sold Average revenue = total revenue / quantity sold Marginal revenue = Change in revenue / change in quantity sold

Question 40

What is normal profit?

Answer 40

The return needed for a firm to stay in a market in the long run

Question 41

What is supernormal profit?

Answer 41

Profit above normal profits

Question 42

What is accounting profit?

Answer 42

Profit made by a business based on explicit costs incurred but excluding opportunity cost

Question 43

What is shut down price?

Answer 43

The price below which a firm will choose to exit the market because it is not able to cover its fixed costs