Topic 2

Question 1

How do companies differ from the other two forms of ownership?

Answer 1

They differ in terms of personal liability for the debts of the firm. Sole proprietors and partners are personally responsible for the debts of their firms (meaning all of an owner’s personal wealth is at risk if the business become bankrupt and unable to pay its bills). Whereas companies have limited liability.

Question 2

What is profit?

Answer 2

The difference between revenues (R = what a firm earns from selling the good) and costs (C = what a firm pays for labour, materials and other inputs): π = R – C

Question 3

What is revenue?

Answer 3

The price (P) times the firm’s quantity (q): R = P x q

Question 4

What does efficient production lead to?

Answer 4

Profit maximisation – as if a firm does not produce efficiently, then profit maximisation is possible.

Question 5

What is the production function?

Answer 5

The relationship between the quantities of inputs used and maximum quantity of output that can be produced, given current knowledge about technology and organisation. The various ways inputs can be transformed into output are summarised in the production function.

Question 6

What is the production function for a firm that uses only labour and capital?

Answer 6

Q = f (L, K)
Where q = units of output produced using L and K (e.g. chocolate bars)
L = units of labour services (e.g. days of work by relatively unskilled assembly-line workers)
K = units of capital (e.g. the number of conveyor belts)

Question 7

What does the production function show?

Answer 7

Only the maximum amount of output that can be produced from given levels of labour and capital, because the production function includes only efficient production processes (as a profit-maximising firm would not be interested in inefficient and input wasting production processes).

Question 8

How easily can firms adjust their inputs?

Answer 8

A firm can more easily adjust its inputs in the long run than in the short run. Typically, a firm can vary the amount of materials and of relatively unskilled labour it uses comparatively quickly. However, it needs more time to find and hire skilled workers, order new equipment, or build a new manufacturing plant. The more time a firm has to adjust its inputs, the more factors of production it can alter.

Question 9

What is a fixed input?

Answer 9

A factor of production that cannot be varied practically in the short run.

Question 10

What is a variable input?

Answer 10

A factor of production whose quantity can be changed readily by the firm during the relevant time period.

Question 11

In the short-run, what is a firm’s production function?

Answer 11

Q = f (L, K̅)

Where: q = output, L = workers, K̅ = the fixed number of units of capital.

Question 12

What is marginal product of labour (MPL)?

Answer 12

The change in total output (Δq) resulting from using an extra unit of labour (ΔL), holding other factors constant: MPL = Δq/ΔL. Before deciding whether to hire one more worker, a manager wants to determine how much this extra worker, ΔL = 1, will increase output (MPL).

Question 13

What is average product of labour (APL)?

Answer 13

The ratio of output (q) to the number of workers (L) used to produce that output: APL = q/L. Before hiring workers, a manager may also want to know whether output will rise in proportion to this extra labour. To answer this question, the firm determines how extra workers affect the APL.

Question 14

What is the total product of labour?

Answer 14

The amount of output (or total product) that can be produced by a given amount of labour.

Question 15

What is the effect of extra labour

Answer 15

In most production processes, the average product of labour first rise and then falls as labour increases. Output may also initially rise more than in proportion to labour because of greater specialisation of activities (as time is saved by not having workers move from task to task). However, output may not increase by as much per worker as they have to wait to use a particular piece of equipment or get in each other’s way.

Question 16

What does the law of diminishing marginal return determine?

Answer 16

The shapes of the total product and marginal product of labour curves as the firm uses more and more labour.

Question 17

What is the law of diminishing marginal returns (or diminishing marginal product)?

Answer 17

It holds that if a firm keeps increasing an input, holding all other inputs and technology constant, the corresponding increases in output will become smaller eventually. That is, if only one input is increased, the marginal product of that input will diminish eventually.

Question 18

What is the difference between diminishing returns and diminishing marginal returns?

Answer 18

DMR – MPL curve is falling, but it may be positive
DR – extra labour causes output to fall
Thus, saying that there are diminishing returns is much stronger than saying that there are diminishing marginal returns to labour.

Question 19

How is long-run production similar to consumer decisions?

Answer 19

? In long run production both factors are variable, meaning a firm can substitute one input for another while continuing to produce the same level of output (in much the same way that a consumer can maintain a given level of utility by substituting one good for another.

Question 20

What is an isoquant?

Answer 20

A curve that shows the efficient combinations of labour and capital that can produce a single level of output.

If the production function is q= f(L, K), then the equation of the isoquant where output is held constant at Q bar is: q bar = f(L,K)

Question 21

What does an isoquant show?

Answer 21

The flexibility that a firm has in producing a given level of output.

Question 22

What are the properties of isoquants?

Answer 22

They have most of the same properties as ICs. The biggest difference between them is that an isoquant holds quantity constant, whereas an IC holds utility constant.
Properties:
- The further the isoquant is rom the origin, the greater the level of output
o The input the firm uses, the more output it gets
- Isoquants do no cross
o Such intersections are inconsistent with the requirement that the firm always produce efficiently.
- Isoquants slop downwards
o If it sloped upward the firm could produce the same level of output with relatively less inputs or relatively many inputs (inefficient)
 Same argument can be made for why isoquants must be thin.

Question 23

What does the shape of an isoquant show?

Answer 23

How readily a firm can substitute one input for another. 2 extreme cases:
- Inputs are perfect substitutes
o Each isoquant is a straight line
- Inputs cannot be substituted (aka fixed proportions production function)
o Each isoquant is a right angle (only efficient point is the corner of each isoquant)

Question 24

What does the slope of an isoquant show?

Answer 24

The ability of a firm to replace one input with another while holding output constant.

Question 25

What happens to the MRTS when isoquants are straight lines? This

Answer 25

This is a special case and results in the isoquant not exhibiting diminishing MRTS because neither input becomes more valuable in the production process. - The inputs remain perfect substitutes.

Question 26

What ratio does the MRTS equal?

Answer 26

The MRTS equals the ratio of marginal product of labour to the marginal product of capital. - MPL = Δq/ΔL - MPK = Δq/ΔK - MRTS = - MPL/MPK - MRTS = ΔK/ΔL

Question 27

What is constant returns to scale (CRS)?

Answer 27

Property of a production function whereby when all inputs are increased by a certain percentage, output increases by that same percentage. e.g. doubles input and also doubles output: f(2L, 2K) = 2f(L,K)

Question 28

What is increasing returns to scale (IRS)?

Answer 28

Property of a production function whereby output increases more than in proportion to an equal increase in all inputs. e. g. doubling inputs more than doubles output: f(2L, 2K) > 2f(L, K) e. g. firm could duplicate small factory and double its output, but firm might be able to double its output by building a single large plant (allows for greater specialisation of labour or capital)

Question 29

What is decreasing returns to scale (DRS)?

Answer 29

Property of a production function whereby output increases less than in proportion to an equal percentage increases in all inputs. e. g. doubling inputs causes outputs to rise less than in proportion: f(2L, 2K) < 2f(L, K) e. g. can occur due to difficulty or organising, coordinating and integrating activities as firm size increases OR there are large teams of workers which may not function as well as small teams (oranges passing activity in MAE101 lecture)

Question 30

What is economic (or opportunity cost)?

Answer 30

The value of the best alternative use of a resource. - Economics include all relevant costs o Explicit and Implicit costs

Question 31

What is a sunk cost?

Answer 31

An expenditure that cannot be recovered. This usually occurs when a firm bought a specialised piece of equipment with no alternative use, meaning they cannot resell the equipment. - The opportunity cost of the capital is zero.

Question 32

What are fixed costs (FC)?

Answer 32

Production expenses that do no vary with output.

Question 33

What are variable costs (VC)?

Answer 33

Production expenses that change with the quantity of output produced. VC = wL (or VC = rK in long run)

Question 34

What is total cost (TC)?

Answer 34

The sum of a firm’s VC and FC: TC = VC + FC.

Question 35

What are average fixed costs (AFC)?

Answer 35

The fixed costs divided by the units of output: AVFC = FC/q

Question 36

What are average variable costs (AVC)?

Answer 36

The variable cost divided by the units of output produce: AVC = VC/q

Question 37

What is average cost?

Answer 37

The total cost divided by the units of output: AC = C/q

Question 38

What is the shape of the variable cost curve?

Answer 38

If input prices are constant the production function determines the shape of the VCC. - Vertical axis: Quantity, Q units per day - Horizontal axis: L, Hours of labour per day AND VC = wL, Variable cost, $

Question 39

What is the shape of the marginal cost curve?

Answer 39

- In short run, K is fixed, so only way to produce more output is to use more labour - Extra labour costs firm w (wages) per unit - MC = w/MPL

Question 40

What are the shapes of the average cost curves?

Answer 40

When labour is the only variable input: | AVC = VC/q = wL/q = w/APL

Question 41

What is the effect of a tax on costs?

Answer 41

This some or all of the marginal and average cost curves. e. g. a tax which varies with output - Therefore, doesn’t effect FC and AFC curves - Effects VC, AC, AVC and MC curves

Question 42

What happens to variable cost and cost curves when there are diminishing marginal returns to a variable input?

Answer 42

The variable cost and cost curves become relatively steep as output increases, so the AC, AVC and MC curves rise with output.

Question 43

What is the effect of the relationship between marginals and averages?

Answer 43

Both the average cost and average variable cost curve fall when MC is below them and rise when MC is above them. Hence why MC cuts both these average cost curves at their minimum points.

Question 44

What is an isocost line?

Answer 44

All the combinations of inputs that require the same total cost. - The cost of producing a given level of output depends on the price of labour and capital. o Firm hires L hours of labour services at a wage rate of w per hour o Firm rents K hours of machine services at a rental rate of r per hour

Question 45

What is the firm’s total cost IN THE LONG RUN?

Answer 45

The sum of its labour and capital costs: | C = wL + rK

Question 46

What is the equation of an isocost line?

Answer 46

Along an isocost line, cost is fixed at a particular level (C bar), so by setting cost at Cbar we can write the equation for the isocost line as: C bar = wL + rK This can be rewritten to show how much capital the firm can buy if it spends a total of C bar and purchases L units of labour: K = Cbar/r – (w/r)L

Question 47

What are the properties of isocost lines?

Answer 47

- Where the isocost lines hit the K and L axes depends on the firms cost (C bar) and on the input prices - Isocosts that are further from the origin have higher costs than those that are closer to the origin - The slope of the isocost line is the same (slope/MRTS = -w/r)

Question 48

What are the similarities and differences between the isocost line and the budget line?

Answer 48

- Both are straight lines whose slopes depend on relative prices - The consumer has a single budget line determined by their income - The firm faces many isocost lines, each of which corresponds to the different level of expenditure the firm might take.

Question 49

What are the 3 equivalent approaches to minimising cost?

Answer 49

- Lowest isocost rule – pick the bundle of inputs where the lower isocost line touches the isoquant - Tangency rule – pick the bundle of inputs where the isoquant is tangent to the isocost line - Last-dollar rule – pick the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other input

Question 50

What happens when the price of a factor of production changes?

Answer 50

It can change the mix/combination of inputs firms use e.g. wage falls from $24 to $8, but rental rate remains constant at $8 - The firm minimises its new cost by substituting away from the now relatively more expensive input (capital), towards the now relatively less expensive input (labour). - New isocost is now much flatter o Is also tangent in scenario in figure 7.6 - Cost of producing same amount of units falls, due to the fall in wages

Question 51

Why does the MC curve cross the average cost curve at the lowest point on the average cos curve?

Answer 51

Because the long-run average cost curve falls when the long-run marginal cost curve is below it and rises when the marginal cost curve is above it.

Question 52

Why does the SHORT-RUN average cost curve first fall and then rise?

Answer 52

- Key reason why short-run average cost is initially downward sloping is: average fixed cost curve is downward sloping o This means FC is spread over more units of output, meaning AFC per unit is lowered o There are not fixed costs in long-run, so there is a different explanation for its nature to fall then rise. - Key reason short-run AC slopes upwards at higher levels of output is diminishing marginal returns o However, n long-run factors can be varied, so diminishing marginal returns do not explain the upward slope of long-run average cost curves.

Question 53

When must long-run average cost be U-shaped?

Answer 53

If a production function has the returns to scale pattern of IRS (at low levels of output) to CRS (at intermediate levels of output) and DRS (at high levels of output) AND the prices of inputs are constant – LRAC must be U-shaped.

Question 54

When does a cost function exhibit economies of scale?

Answer 54

If the average cos of production falls as output expands. | - Doubling inputs causes output to increase more than in proportion to the increase.

Question 55

When does a cost function exhibit no economies of scale?

Answer 55

? This is where CRS is present, meaning the average costs remains constant. If an increase on output has no effect on average cost (the average cost curve is flat) then there are no economies of scale. - Doubling inputs causes output to double as well

Question 56

When does a cost function exhibit diseconomies of scale?

Answer 56

If the average cost of production rises when output increases. - Doubling the inputs causes only a small increase in output.