Microeconomics Semester 1 - Week 7-11

Question 1

What is a firm?

Answer 1

A firm is a business organisation which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit.

Question 2

What is the division of labour and how is it coordinated?

Answer 2

The division of labour is the specialisation of producers to carry out different tasks in the production process, and it is coordinated by firms and markets.

Different groups within firms will produce goods which they specialise in, or may be bought together in collaboration between firms in the market. These goods will then be bought and sold on the market.

Question 3

How is the labour coordination in firms different to that in markets?

Answer 3

-Firms represent a concentration of economic power: This is placed in the hands of the owners and managers, who will regularly issue directives with the expectation that their employees will carry them out. An ‘order’ in the firm is a command.
-Markets are characterised by a decentralisation of power: Purchases and sales result from the ‘buyers’ and ‘sellers’ autonomous decision. An ‘order’ in a market is a request for a purchase that can be rejected if the seller pleases,

Question 4

How are firms structured?

Answer 4

Most firms will have a structure in which there are owners (the board of directors) who will pass orders to a manager, and then the manager who will organise and monitor the workers, assigning them tasks to be carried out.

Question 5

What is a contract?

Answer 5

A contract is a legal document or understanding that specifies a set of actions that parties to the contract must undertake.
One example of this is a wage labour contract, in which producers are paid for the amount of time they work for their employers.

Question 6

How do firms and markets differ in the contracts which they form?

Answer 6

In a market, a contract will permanently transfer ownership of a good from the seller to buyer, but contracts for labour in a firm will temporarily transfer authority over a persons activities from the employee to the manager or owner.

Question 7

What issues are caused by the separation of ownership and control in a firm?

Answer 7

There will often be a conflict of interest between managers and owner of a firm, as the managers may not use funds fully as intended, since the manager will want to maximise their own utility, rather than the owners, and this can cause the principle-agent problem.
-One way this can be resolved is by giving the manager an incentive which lines up with the desires of the owners. In this case, a bonus based of profit of the firm could be awarded to the manager. Another way is that owners can monitor managers, and shareholders can monitor owners, both having the right to file for a dismissal of those in the position if the standards are not upheld correctly.

Question 8

What is a firm-specific asset?

Answer 8

This is something that a person owns or can do that has more value in the individual’s current firm than the next best alternative one.
When this firm-employee relationship ends, both lose out as the workers skill now becomes less relevant, and the firm loses an employee who could use their asset to produce greater output than a new employee will.

Question 9

What is an residual claimant?

Answer 9

This is the person who will relieve all income left over from a firm after the payment of all contractual costs. Usually, this will not be a manager or employee, but rather the firms owner/shareholders.

Question 10

What is an incomplete contract?

Answer 10

This is a contract which does not specificy, in an enforceable way, every aspect of the exchange that effects the interests of parties to the exchange.
Firms will never be able to see the exact output a worker produces, and therefore if working in a team, it would be easy for an individual to give minimal effort for his wage labour contract, and free ride to still be credited for the work of the team. As well as this, some tasks depend on future unknown events, so a full contract cannot be provided.

Question 11

What is piece-rate work?

Answer 11

This is a type of employment in which the worker is paid a fixed amount for each unit of the product made. One example of this would be a car-wash, where a wage would be higher for the more cars washed, since they will be paid more that day.

However, in modern economies, only about 5% of manufacturing companies pay on this scheme, let alone firms not in the manufacturing industry, and it is very difficult to measure the output of a knowledge and service based economy, as well as the fact employees rarely work alone.

Question 12

What is economic rent?

Answer 12

The economic rent a worker is when the net value of her job exceeds the net value of the next best alternative (which in this case is being employed).

Question 13

How do economic rents benefit managers and employees?

Answer 13

-The employee is more likely to stay with the firm (reducing recruitment and training costs)
-They can threaten to fire a worker (this will usually cause a worker to put more effort into their job, as this will reduce their risk of dismissal).

Question 14

What are some costs of jobs which need to be included when calculating economic rent?

Answer 14

1) The disutility of work: Employees have to spend time doing things they would rather not do
2) The monetary cost of travelling to work each day.

Question 15

What are the benefits included when calculating economic rent of a job?

Answer 15

-Wage income, however this may be offset in some cases by an unemployment benefit
-Firm-specific assets: workplace friends or proximity of work to place of residence
-Medical insurance which may be provided
-The social status of being employed, there can be a mental/social stigma associated with being unemployed.

Question 16

What is utility?

Answer 16

Utility is the numerical indicator of the value that one places on an outcome, such that higher valued outcomes will be chosen over lower valued ones when both are feasible.

Question 17

How do we calculate employment rent?

Answer 17

First we need to find the net utility per hour: wage - disutility of effort per hour. Then, we multiply this by the expected lost hours of work to find the total employment rent.

However, this calculation can be made more difficult if there is a reservation wage, such as an unemployment benefit. These unemployment benefits (no matter if from friends/family or government schemes, will often be time limited).

Question 18

What is a reservation wage?

Answer 18

This is what an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.

Question 19

When will workers be willing to work harder (give more effort) at work.

Answer 19

This will occur when either the wage of their current job is higher, or their is a lack of other jobs on the market. Both these cases will cause the underlying reason for more effort at work, as the employment rent will be greater, and so there is a incentive to not lose your job.

Question 20

What is the order of play between an employee and their manager (who acts for the owner)?

Answer 20

1) The employer will choose a wage
2) The employee will then choose an effort level to work at, taking into account the costs of losing her job if she doesn’t provide enough effort.

Question 21

When will there be a Nash equilibrium in the game between an employer and employee?

Answer 21

This will occur when the employee chooses her work effort as a best response to the employers offer, and the employer chooses the wage which will maximise their profit given the employee responds as they have. The employee knows they will have to work at a specific effort to minimise their chance of being fired.
Their strategies here are in Nash equilibrium, as no one has an incentive to deviate.

Question 22

What is a workers best response function/curve?

Answer 22

This is the optimal amount of work that a worker chooses to perform for each wage that the employer may offer.

The best response curve will begin at the x-axis at the workers reservation offer (since zero effort would be given for a wage which has no employment rent), and the curve will be concave but increase as the wage rises since more effort will be given (her best response) for a greater employment rent.

Question 23

Why is the best response curve concave?

Answer 23

This is because as the wage increases, the effort level will begin to get closer to the maximum possible level (1). As the maximum possible level of effort gets closer, the disutility of labour effort will also become greater, so a greater employment rent will be required to get more work out of the employee.

Question 24

What does the slope of the worker’s best response curve represent?

Answer 24

This represents the MRT. There is a trade off between the firm offering a higher wage and the effort level given, as if the wage is decreased, so will the effort level.

Question 25

What will an employer look for when setting the wage for a worker?

Answer 25

Firms face a trade off in which they can only offer receive more effort from a worker, by offering that worker a higher wage, which will increase costs. Therefore, the employer will look for the wage which will supply them with the most effort/dollar, and this can be worked out using isocost lines.

Question 26

What is an isocost line?

Answer 26

‘Iso’ means ‘the same’ in Greek, so the isocost lines in the labour discipline model show all the different points which will supply the same effort/dollar. There will be an unlimited amount of isocost lines in the diagram, and the slope of this line in the diagram represents the MRS. A firm will always want to reach a steeper isocost line as this will lower costs, but this will not be feasible if it lies outside of the workers feasible set.

Question 27

Where on the labour discipline model will the wage be set?

Answer 27

It will be set where the MRS = MRT. At this point, a nash equilibrium is reached, neither player wants to deviate unilaterally. These are sometimes known as the efficiency wages: as the payment an employer makes that is higher than an employee’s reservation wage, so as to motivate the employee to provide more effort on the job that they would otherwise choose to make.

Question 28

What is the labour discipline model?

Answer 28

This is a model that explains how employers set wages so that employees receive an economic (employment) rent which provides workers an incentive to work hard in order to avoid job termination.

Question 29

What is involuntary unemployment?

Answer 29

This is the state of being out of work, but preferring to have a job at the wages and working conditions that otherwise identical employed workers have. This is crucial to have in an economy, as if there was no involuntary unemployment, a worker would be able to find work for a similar salary instantly if they were to be fired, and so there would be no employment rent as the workers best response would be an effort level of zero, and workers would have no incentive to give effort at work, so theoretically the economy would have no output.

Question 30

What does the position of the best response curve depend on?

Answer 30

The employee will have an incentive to work harder when the employment rent is higher, so it will depend on: -The utility of things which can be bought with the wage (inflation will reduce this if wages don’t increase proportionally) -The disutility of effort -The reservation wage -The probability of getting fired when working at each effort level -The unemployment rate (an increase will cause the reservation wage to fall, as benefits don’t last forever, and the time unemployed would also likely increase). -Government policies (e.g unemployment benefits or minimum wages)

Question 31

How does the labour discipline model give firms power?

Answer 31

-Because Maria fears losing her economic rent, then the employer will be able to exercise power over her, by getting her to act in ways she wouldn’t be able to do without the threat of job loss. -This will not only reduce costs for the firm because they will have less recruitment and training costs as Maria is less likely to leave the job, but also because the fear of being fired will cause effort level to remain high, increasing output.

Question 32

What are the differences between differentiated and homogenous products?

Answer 32

If a product is homogenous, it will be the same no matter what firm you get it from. However, if the good is differentiated, there will be slight differences depending on which firm you buy the good from. For example, a smartphone will have different features depending on which firm you get it form (e.g some may have Face ID, but others won’t).

Question 33

What is the demand curve?

Answer 33

This is the curve that gives the quantity consumers will buy at each possible price. The demand function is a function where quantity is given in terms of price, but for the demand curve we the inverse demand function, which is the function with quantity in terms of price. Don’t get these two confused.

Question 34

How are demand curves often estimated?

Answer 34

Often, this will be done using surveys, however people may lie in order to get themselves a better shelf price, so to ask the survey effectively you must vary the price in the question, and ask the question to many different people at different prices to get a good response.

Question 35

What is the average cost?

Answer 35

This is the average cost per unit produced. It is the slope of the ray from the origin to the cost function.

Question 36

What is the marginal cost?

Answer 36

This is the change in costs for one additional unit produced. It is the slope of the cost function at a given point.

Question 37

What is the fixed cost?

Answer 37

This is the difference in costs when producing one extra unit of output. This will be where the cost function intercepts the y-axis.

Question 38

Why are firm’s total cost curves usually upwards sloping?

Answer 38

Usually, this is because of scarcity. As you hire more workers, there will be less skilled workers available, so the wage offered will have to rise to attract these workers. Similarly, as demand for resources rises (assuming supply remains constant), prices will also rise, so we assume cost functions will be convex as marginal cost always increases.

Question 39

What are isoprofit curves?

Answer 39

These curves are on a quantity-price diagram, and will show all the points at which the profits will remain equal. The curves will look different depending on if the average constant is variable or increasing (see week 8 slides).

Question 40

How do firms decide their optimal price setting point?

Answer 40

The demand curve here will represent the feasible frontier (and hence its slope will be the MRT), and the slope of the isoprofit curve will be the MRS. The firm will obviously want to reach the maximum possible isoprofit curve, so will choose the point at which MRS = MRT as any isoprofit line further that this will represent an infeasible level of profit. In real life, this equilibrium will likely be reached through a gradual process of trial and error.

Question 41

What two reasons allow for firms to lower costs due to economies of scale?

Answer 41

-Technological advantages: Large scale production will often use fewer inputs per unit of output, -Cost advantages: In larger firms, fixed costs such as advertising or acquiring the necessary patents or other intellectual property rights have a smaller effect of the cost per unit. Lower costs may also be achieved due to bargaining power or bulk buying. Similarly, specialisation of job roles means training costs for firms will be reduces, as they can hire specialised workers.

Question 42

What are economies of scale?

Answer 42

These occur when doubling all the inputs to a production process more than doubles the output. The shape of a firms long-run average cost curve depends both on returns to scale in production and the effect of scale on the price it pays for its inputs.

Question 43

What are diseconomies of scale?

Answer 43

These occur when doubling all of the inputs to a production process less than doubles the output. This may be due to the lack of organisation if a firm operated in multiple countries, the extra jobs needed for management/supervisor positions as well as recruitment costs.

Question 44

What are constant returns to scale?

Answer 44

These will occur when doubling all of the inputs to a production process doubles the output. The shape of a firms long-run average cost curve depends both on returns to scale in production and the effect of scales on the prices it pays for inputs.

Question 45

How may a firm gain cost advantages?

Answer 45

If output is greater, then a fixed cost is able to be split among a greater output so average costs fall naturally, such as a patent required for a product. They also gain from bargaining power and bulk buying.

Question 46

How can a firm gain from demand advantages?

Answer 46

People are more likely to buy a product if it already has a lot of workers. These demand side benefits of scale are known as network economies of scale (e.g more people use Facebook or others do as well).

Question 47

What are network economies of scale?

Answer 47

These exist when an increase in the number of users of an output of a firm implies an increase in the value of the output of each of them, because they’re connected to each other.

Question 48

What is the opportunity cost of capital?

Answer 48

This is the amount of income an investor could have received by investing the unit of capital elsewhere.

Question 49

When will a firms average costs be minimised?

Answer 49

This will occur when the marginal cost is equal to the average cost. If MC was less than AC, an additional unit would cause costs fall and if MC was larger than AC, an additional unit would cause costs to rise, so costs are lowers where the two curves meet.

Question 50

What are economies of scope?

Answer 50

These are cost savings that occur when two or more products that are produced jointly by a single firm, rather than being produced by separate firms.

Question 51

What is willingness to pay?

Answer 51

This is how much someone values a good, which is measured by the maximum amount he or she would pay to acquire a unit of the good.

Question 52

What is economic profit and normal profit?

Answer 52

-Economic profit is a firms revenue minus total costs (including the opportunity cost of capital). -Normal profits occur when there is zero economic profit so the rate of profit is equal to the opportunity cost of capital. Therefore, profit = Q(P - AC) or Q(P - C(Q)/Q) For the isoprofit curve which is equal to the average cost curve, there will zero economic profit.

Question 53

What is the slope of the isoprofit curve?

Answer 53

The shape of the isoprofit curve depends on the shape of the average cost curve, and the slope of the isoprofit curve will be equal to -(P-MC)/Q. When P>MC, the curve will slope downwards, and when P

Question 54

What is a constrained choice problem?

Answer 54

This is a problem where a economic agent has to work out how to do the best for themselves, given they’re preferences and constraints, and when the things that they value are scarce.

Question 55

What is the marginal revenue?

Answer 55

The marginal revenue is the increase in revenue which is obtained by increasing the quantity from Q to Q +1. If the marginal revenue gain from an extra unit is greater than the combined loss of revenue due to charging a lower new price for all previous units, then marginal revenue will be positive. However, if the loss is greater than the gain, marginal revenue will be negative.

Question 56

How can maximum profits be calculated by working out marginal revenues and costs?

Answer 56

The maximum profit will occur where the marginal revenue = marginal cost.

Question 57

What is the equation for marginal profits?

Answer 57

Marginal revenue - marginal cost

Question 58

What are the gains from exchange?

Answer 58

The gains from exchange are the benefits that each party gains from a transaction compared to how they would’ve fared without the exchange.

Question 59

What is the total surplus?

Answer 59

The total surplus is the total gains from trade received by both the consumers and producers combined, producer surplus + consumer surplus.

Question 60

What is consumer surplus?

Answer 60

This is the consumers willingness to pay for a good minus the price at which the consumer bought the good, summed across all units sold.

Question 61

What is the producer surplus?

Answer 61

The producer surplus is the price at which a firm sells a good minus the minimum price at which it would have been willing to sell the good, summed across all units sold.

Question 62

What is a dead-weight loss?

Answer 62

This is the loss of potential total surplus relative to a Pareto efficient allocation.

Question 63

When would a gains of trade Pareto improvement be possible?

Answer 63

This would be possible if the total potential gains of trade has not be fulfilled, as moving closer to this Pareto efficient allocation would increase both consumer and producer surplus, no one will become worse off.

Question 64

Why do firms not operate where there would be no DWL in trade?

Answer 64

This is because when firms set prices, they have to set one price for all consumers. As firms are selfish and only care about their own profits, not consumer welfare, they will simply set their price at the point where producer surplus is maximised, where MRS = MRT. As a result, there will be an area of DWL.

Question 65

What is another way to calculate firms profits?

Answer 65

This is the producer surplus minus the fixed costs.

Question 66

What is the price elasticity of demand, and it’s equation?

Answer 66

The PED is the percentage change in demand which would occur in response to a 1% increase in price. We will always express this as a positive number. If PED>1 it’s elastic, if <1 it’s inelastic. % change in demand/% change in price.

Question 67

How does the PED relate to the slope of the demand curve?

Answer 67

If the demand curve is quite flat, then the PED will be far more elastic than a steep demand curve, as a flat curve suggests a small change in price would correlate to a big change in quantity demanded. Another equation for PED = -(P/Q)(1/slope of the demand curve).

Question 68

How does the marginal revenue relate to the PED?

Answer 68

If the marginal revenue is positive, then the PED will be <1 (elastic), as firms will only need to drop the price slightly for an extra unit to be sold. But if the MR is negative, PED will be inelastic as to sell an extra unit, the extent of the drop in price will be far more significant.

Question 69

How does the PED change along the firms demand curve?

Answer 69

Initially, when demand is low the PED will be elastic, but as price falls and the quantity demanded increases, PED will become inelastic.

Question 70

What is the profit margin?

Answer 70

The profit margin is the difference between the price and the marginal cost. For price elastic goods, the profit margin will be relatively small as small changes in price make a big difference to sales, but for a inelastic good, the profit margin would be much higher.

Question 71

What is the price markup?

Answer 71

The price markup is the price minus the marginal cost divided by the price. It is inversely proportional to the elasticity of demand for the good. Essentially, it is the profit margin as a proportion of the price.

Question 72

What is the slope of the isoprofit curve?

Answer 72

-(P-MC)/Q