Micro 16 - Profits and losses

Question 1

Define profit

Answer 1

Profit is the difference between revenue and costs and is made when revenue is greater than costs

Question 2

State the formula for calculating profit

Answer 2

Profit = Revenue - Total costs

Question 3

What is profit maximisation as an objective for a firm?

Answer 3

Profit maximisation is an objective for some firms and involves making as high a level of profit as possible

Question 4

When is profit maximisation acheived?

Answer 4

MR=MC

Question 5

Explain the steps to draw a costs and revenue diagram for all types of profits/losses being made

Answer 5

1- Draw the axis and label them with costs and revenues on the y-axis and quantity of output on the x-axis
2- Draw the AR and MR curve remembering MR is twice as steep as AR
3- Draw the MC curve
4- Find the profit maximising output which is where MR=MC, label this Q1
5- Label the price level of this output level by going up to the AR curve from Q1
6- Draw the AC curve. Where you place this will determine how big a profit or loss your business makes. Wherever it goes it must cross MC at its lowest point
7- At Q1 find the average cost and draw a dotted line across and label this C1
8- At the profit maximising output, look at the vertical difference between P1 and C1. The difference between the two is the profit per unit.
9- To find the total profit, multiply the profit per unit by the number of units. This rectangle represents supernormal profit
10- This process is the same whether you want to show supernormal profit, normal profit or a loss, the only thing that changes is the position of the AC curve

Question 6

What is the difference between the general idea of costs and economic costs?

Answer 6

Accounting/general costs only include what economists call ‘explicit costs’. These are physical costs of production such as energy costs and wages whereas economic costs include opportunity costs

Question 7

What are economic costs in terms of a formula?

Answer 7

Economic cost = Money cost + opportunity cost

Question 8

Define Normal profit

Answer 8

Normal profit is the minimum reward (level of profit) that is just sufficient to keep a firm in a particular industry.

Question 9

On a diagram, where does normal profit occur?

Answer 9

On a diagram, normal profit occurs when total revenue is equal to total costs

Question 10

Draw a costs and revenues diagram to show a firm making normal profit

Answer 10

See page 7 in pack 16

Question 11

Define Supernormal profit

Answer 11

Supernormal profit is profit that is made in excess of normal profit

Question 12

Draw a costs and revenues diagram to show a firm making supernormal profits

Answer 12

See page 8 in pack 16

Question 13

Draw a costs and revenues diagram to show a firm making a loss

Answer 13

See page 8 in pack 16

Question 14

Which curves shift on a costs and revenues diagram if fixed costs change?

Answer 14

• If fixed costs change only AC shifts
• This means the quantity stays the same

Question 15

If fixed costs increase/decrease which way will the AC curve shift?

Answer 15

• If fixed costs increase AC will shift upwards
• If fixed costs decrease AC will shift downwards

Question 16

Which curves shift on a costs and revenues diagram if variable costs change?

Answer 16

• If variable costs change then both MC and AC shift
• This will mean a new quantity

Question 17

If variable costs increase/decrease which way will the AC and MC curves shift?

Answer 17

• If variable costs increase they both shift upwards
• If variable costs decrease they both shift downwards

Question 18

Which curves shift on a costs and revenues diagram if demand changes?

Answer 18

• If demand changes then MR and AR will shift
• This will mean a new quantity

Question 19

What is generally the easiest way to draw a costs and revenues diagram involving shifting curves?

Answer 19

Start with a normal profit diagram before shifting curves

Question 20

When shifting both the MR and AR curves what must you make sure?

Answer 20

When shifting the MR and AR curves you must make sure the shifted curves are parallel to their original curves

Question 21

Draw a costs and revenues diagram to show a firm revenue maximising

Answer 21

See page 10 in pack 16

Question 22

What type of profit must a firm make to justify staying in an industry in the long run?

Answer 22

A business needs to make at least normal profit in the long run to justify remaining in an industry, but in the short run a firm will continue to produce as long as total revenue exceeds total variable costs

Question 23

What is the short run shutdown point?

Answer 23

The short-run shutdown point is when price per unit is equal to average variable cost (AR=AVC)

Question 24

In the short run should a firm shutdown if AR>AVC?

Answer 24

In the short run, if AR>AVC then each additional unit sold will reduce the size of any losses and contribute to fixed costs. The firm will be better off continuing to operate as they will be reducing the size of their losses

Question 25

In the short run should a firm shutdown if AVC>AR?

Answer 25

A firm will shutdown when AVC>AR because every additional unit sold will add to losses

Question 26

Why should a firm continue to operate when its making a loss in the short run?

Answer 26

• In the short run firms cannot change industry - they are stuck in their current industry
• A firm’s fixed costs must be paid regardless of the level of output
• Often these costs cannot be recovered if the firm shuts down (sunk costs), so the loss per unit would be greater if the firm were to shutdown provided variable costs are covered

Question 27

When will firms shutdown in the long run?

Answer 27

Firms will shutdown in the long run if ATC>AR because every additional unit sold will add to losses. They may then leave the industry and switch their factors of production for use in more profitable markets

Question 28

How would short run and long run shutdown points be displayed on diagrams?

Answer 28

See page 14 in pack 16

Question 29

Define the scale of production

Answer 29

The scale of production refers to the number of products made and is determined by the quality and quantity of factors of production used and production techniques implemented

Question 30

Define the long run average cost (LRAC)

Answer 30

• The long run average cost (LRAC) of a firm shows the lowest average cost at which a firm can produce any given level of output in the long run (when all FOP are variable)

Question 31

What does the LRAC and SRAC curves on a costs diagram represent?

Answer 31

The LRAC curve is the envelope of the short run average total cost (SRAC) curves. Each SRAC curve shows the average costs in the short run at a specific quantity of capital goods

Question 32

Draw a LRAC and SRAC diagram

Answer 32

See page 17 in pack 16

Question 33

What can an LRAC and SRAC diagram be used to show?

Answer 33

It can be used to show both economies and diseconomies of scale

Question 34

Define Economies of scale

Answer 34

Economies of scale refers to the benefits gained through producing on a larger scale. A fall in long run average costs as output increases

Question 35

Define Diseconomies of scale

Answer 35

Diseconomies of scale refers to an increase in long run average costs as output increases beyond the point of minimum efficient scale

Question 36

Define Internal economies of scale

Answer 36

Internal economies of scale arise because of the growth in the scale of production within a firm

Question 37

What are the different types of internal economies of scale?

Answer 37

• Technical economies of scale
• Purchasing economies of scale
• Managerial economies of scale
• Financial economies of scale
• Marketing economies of scale
• Risk-bearing economies of scale

Question 38

What are technical economies of scale?

Answer 38

Technical economies of scale are occur when a firm is growing and it invests in expensive and capital machinery which allows the firm to have increased productivity and lower average costs. These lower costs can improve productive efficiency

Question 39

What are purchasing economies of scale?

Answer 39

Purchasing economies of scale occurs when larger firms are able to buy raw materials and components of production in bulk. Bulk buying enables the firm to secure lower prices for their purchases by gaining discounts which lowers average variable costs

Question 40

What are managerial economies of scale?

Answer 40

Managerial economies of scale occur when a firm expands and is able to employ specialist workers and managers to split complex production processes into separate tasks to boost productivity, lowering average cost

Question 41

What are financial economies of scale?

Answer 41

Financial economies of scale occur when a firm grows it is better able to access loans as larger firms are usually rated by the financial markets to be more ‘credit worthy’. These loans are also likely to be granted at a lower interest rate than those to smaller firms as larger firms are considered a lower risk

Question 42

Why may banks see larger firms as lower risk than smaller firms?

Answer 42

• They have more assets to put up as collateral
• They are more credit worthy

Question 43

What is marketing economies of scale?

Answer 43

Marketing economies of scale is when as a firm expands its product range it can spread its advertising and marketing budget over a large output. The firm is able to promote and raise product/brand awareness of any additional or new products in one marketing or advertising campaign for little to no additional costs

Question 44

What are risk-bearing economies of scale?

Answer 44

Risk bearing economies of scale happen when as a firm expands it is better able to develop a range of products and a wider customers base to spread risk and minimise the impact of any downturn

Question 45

Define Diseconomies of scale

Answer 45

Diseconomies of scale refers to an increase in long run average costs as output increases beyond the point of minimum efficient scale

Question 46

What are some examples of diseconomies of scale?

Answer 46

• Control - Monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly
• Co-ordination - It can be difficult to co-ordinate complicated production processes across several plants in different locations and countries
• Co-operation- Workers in large firms may develop a sense of alienation and loss of morale. If they do not consider themselves to be an integral part of the business their productivity may fall leading to wastage of FOP and higher costs

Question 47

Define the minimum efficient scale (MES)

Answer 47

The minimum efficient scale (MES) is the lowest level of output where long run average cost is minimised

Question 48

Draw to diagrams showing both a high MES and a low MES

Answer 48

See page 28 in pack 16

Question 49

Define External economies of scale

Answer 49

External economies of scale happen outside the control of a company and will result in a reduction in costs and increases in productivity of an entire industry