Business Economics and the Distribution of Income This Answers book provides answers for the questions asked in the workbook. They are intended as a guide to give teachers and students feedback. The candidate responses supplied here for the longer essay-style questions are intended to give some idea about how the exam questions might be answered. The examiner commentaries (underlined text) have been added to give you some sense of what is rewarded in the exam and which areas can be developed.
Again, these are not the only ways to answer such questions but they can be treated as one way of approaching questions of these types. Topic 1 The firm: objectives, costs and revenues 1 Both private and public companies are privately owned capitalist business enterprises. The difference stems from their ownership. Private companies are owned by private shareholders who can choose the buyer of their shares. Public company shares are listed on the stock market, which means that they have to comply with the rules of the stock market and any member of the public can buy shares in the company. An excess of sales receipts over the spending off business during a period of mime, which can be calculated using the formula: profit = revenue – costs. 3 At any level of output, revenue is calculated by multiplying output by the price at which each unit of output is sold. In perfect competition, because it is always possible to increase sales revenue by selling more units of output, the revenue- maximizing level of output does not exist. In other market structures, including monopoly and oligopoly, marginal revenue falls as more units of the good are sold.
Revenue mastication occurs at the level of output at which marginal revenue is zero (MR. = O). By contrast, in all market structures, including perfect competition, profit mastication occurs at the level of output at which marginal revenue equals marginal cost (MR. = MAC). 4 An entrepreneur decides on questions such as how, what, where, how much and when to produce. Entrepreneurs decide how to employ the factors of production, and Economics Aqua By animism often the founder of the firm, building the business by investing his/her own time and money.
The entrepreneur directly manages the business and takes the important decisions about its direction and strategy. The management could control information and take decisions without the shareholders being able to influence the decision or even being aware of an issue. 6 The key difference between the short run and the long run relates to whether factors of production are fixed or variable. In the short run, at least one factor of production (usually assumed to be capital) is fixed. Labor is assumed to be variable. In the long run, all factors of production are variable and none is fixed. This question is the obverse of question 6. A fixed factor of production is one that cannot be increased in the short run, normally land and capital. A variable factor of production, normally labor, can be increased in the short run. 8 The law of diminishing returns sets in when units off variable factor of production, such as labor, are added to fixed factors of production. Eventually the extra output (marginal returns) produced by the marginal worker falls to be less than the marginal product of the previous worker added to the labor force. (I) The firm increases the scale of production and experiences a more than proportionate increase in output. (it) The firm increases the scale of production and experiences a proportionate increase in output. Iii) The firm increases the scale of production and experiences a less than 10 [pick] 11 Average variable costs are total variable costs divided by the size of output. Average total costs are total costs divided by the size of output. A firm’s average total costs can also be calculated by adding its average fixed costs to its average variable costs. 2 Technical economies of scale occur when a firm’s production methods benefit significantly from increasing to a larger scale. The productivity increases experienced by a firm in traditional economic theory stem from the larger scale of production allowing for a greater division of labor and improved specialization. Hence the firm experiences a technical improvement in production and more than proportionate production in his car factories in the early years of the 20th century. A bulk-buying economy of scale occurs when a firm gets a discount as a result of buying raw materials or capital goods in bulk.
For example, a school may be able to buy 100 computers at IEEE each, whereas a single computer would be priced at IEEE. 13 (I) If a firm in a perfectly competitive market sets its price above Pl, the ruling market price, it will not sell any of its products. This is because its products are identical to those of its competitors, and buyers who possess perfect market information and will buy from the cheaper rival firms selling at the ruling market price. (it) If the firm sets its price below Pl it will sell all of its output, but it will not be maximizing profit.
There is no sense in doing this, given that an infinite number of customers are willing to buy the good at the higher price of Pl . 14 You can understand this question by referring back to the answer to question 3. As long as marginal revenue is positive (at all levels of output below IQ), the monopoly can increase sales revenue by producing and selling more. But when marginal revenue is negative (at all levels of output above IQ), the monopoly can increase sales revenue by producing and selling less. Exam-style answers (essay) 01 The laws of diminishing returns and returns to scale are both parts of production theory. The law of diminishing returns is also known as the law of diminishing marginal productivity. ) Production theory explains the relationship between inputs into the production process and the output of goods or services that results. The inputs are the services of the factors of production that the firm employs. The basic nature of production is shown in the diagram below. Production theory divides into short-run production theory and long-run production theory. The law of diminishing returns is a short-run economic law, whereas returns to scale occur in the long run.
The law of diminishing returns has the status of an economic ‘law, because in the short run at least one of the factors of production (usually assumed to be capital) is held fixed. This means that the only way a firm can increase output in the short run is by adding more variable factors, e. G. labor, to fixed capital. Eventually, as labor is already existing labor force and the additional output attributable to the marginal worker begins to fall. This is when the law of diminishing returns has set in. Returns to scale by contrast occur in the long run when all the factors of production increase.
The firm increases its scale or size of operation. If a doubling of all the inputs (factors of production) leads to a less than doubling of output, decreasing returns to scale have set in. (Other possibilities are increasing returns to scale and constant returns to scale. ) To understand the relationship between the law of diminishing returns and short- UN cost curves, consider the diagram on the next page. The upper panel of the diagram shows the marginal and average returns (or productivity) of labor. Diminishing marginal returns begin at point A.
Increasing marginal productivity of labor (or increasing marginal returns) is shown by the positive (or rising) slope of the marginal product curve, while diminishing marginal returns are represented, beyond point A, by the curve’s negative (or falling) slope. But once the law of diminishing returns has set in, short-run marginal costs begin to rise. This is shown by the upward-sloping section of the MAC curve in the lower panel of the diagram. And as soon as MAC rises through the average variable cost (PVC) curve (and later the average total cost (TACT) curve), the two average cost curves begin to rise.
This means that the PVC and the TACT curves are U-shaped. Just as short-run cost curves are derived from the short-run law of diminishing returns, so long-run cost curves result from the nature of returns to scale. When a firm changes the scale of all the factors of production in the economic long run, it is usual to assume that to start with it benefits from increasing returns to scale but that eventually decreasing returns to scale set in. Given this assumption, the firm’s long- UN average cost (LIAR) curve is U-shaped, as shown in the diagram below.
However, other assumptions about the impact of returns to scale on long-run production would lead to different possible shapes of the LIAR curve. The mark scheme for the first part of an essay question is ‘issue based’. The mark scheme sets out all the issues deemed to be relevant to the question and indicates the maximum marks that can be awarded for each issue. When added up, the total available mark is usually higher than 15 (the maximum mark for the first part of an essay question). When an answer scores more than 15 marks, the actual mark warded is constrained to the maximum of 15. This is the case with this answer.
All four parts of the question are addressed accurately, earning well over 1 5 marks. The 02 Large firms are sometimes and perhaps often better than small firms, but they are not always better. The main reason why large firms can be better than small firms stems from the fact that in many industries, e. G. Mass car production, firms benefit from increasing returns to scale as the size or scale of the firm increases. As the final diagram in the answer to question 01 indicates, increasing returns to scale translate onto economies of scale when measured in terms of long-run average costs of production.
Economies of scale are defined as falling long-run average costs of production, whereas discomposes of scale are rising long-run average costs of production. Increasing returns to scale mean that as plant size increases, a firm can combine its inputs in a technically more efficient way. As a result average costs of production fall. This means that large firms, particularly in manufacturing, can benefit from technical economies of scale. Many types of plant or machinery are indivisible, in the sense hat there is a certain minimum size below which they cannot operate efficiently.
A firm requiring only a small level of output must therefore choose between installing plant or machinery that it will be unable to use continuously, or using a different but less efficient method to produce the smaller level of output required. Large firms can also benefit from volume economies of scale. With many types of capital equipment (for example, metal smelters, transport containers, storage tanks and warehouses), costs increase less rapidly than capacity. When a storage tank or boiler is doubled in emission, its storage capacity actually increases eightfold.
Since heat loss depends on the area of the container’s walls (which will only have increased fourfold) and not upon volume, a large smelter or boiler is technically more efficient than a small one. Volume economies are thus important in industries such as transport, storage and warehousing, as well as in metal and chemical industries, where an increase in the scale of plant provides scope for the conservation of heat and energy. When there are substantial economies of scale available to a firm, its LIAR curve will look like the one in diagram (a) of the following:
When firms can benefit from substantial economies of scale (and economies of large- scale production), this will benefit firms. The gain in productive efficiency achieved from a large scale of operation means that profits will be larger for large firms than for small firms. However, the opposite will be true if discomposes of scale set in early on as a firm increases its size. Economies of small-scale production (as depicted in diagram (b)) show that small firms producing at IQ are more productively efficient than large firms.
This is likely to be the situation in personal service industries such as building customized furniture for clients. Order to exploit the monopoly power that large size often gives to firms. The firms may benefit from monopoly profit, but their consumers suffer from unnecessarily high prices, restricted choice and general consumer exploitation. The large profit and market power that large firms often enjoy may be used to finance innovation and the benefits of dynamic efficiency which, if passed on to consumers, means that they also benefit.
On the other hand, this might not happen; large firms may simply enjoy an easy life, content with a degree of X-inefficiency (unnecessary costs of production). In conclusion, the answer to the question depends on the assumptions made about whether economies of scale are possible, the motives of firms, and the extent to which they can exploit monopoly power to the detriment of consumers. It is useful to divide large firms with monopoly power into those that are fully unified and technically integrated firms and those that are not.
A fully unified or technically integrated firm is one that grows because it organizes production in a productively efficient way in order to reduce average costs and increase profits. If monopoly power results, it is almost by accident. Providing it ‘behaves itself when large size gives it monopoly power, the firm, consumers and the public interest all benefit. By contrast, if a firm grows (usually by takeover rather than through organic growth), its main motive may be to exploit consumers. Clearly such firms are not ‘best’.
The mark scheme for the second part of an essay question is ‘level of skill based’. Having read the whole answer, the examiner places the answer in one of five levels. These are: Level 1 ? very weak Level 2 ? weak with some understanding Level 3 ? reasonable including some correct analysis but very limited evaluation Ђ Level 4 ? good analysis but limited evaluation or reasonable analysis and reasonable evaluation Level 5 ? good analysis and good evaluation This answer has been awarded a mark at the top of level 4 in the AQUA mark scheme.
The levels descriptors in the mark scheme are used for the second parts of all essay questions (and also all part 03 and 06 context data response questions at AY). The level 4 descriptor is: III Knowledge and I AAA Application of theories, I AAA Analysis of economic IA Evaluation of economic I I Levels mark scheme understanding of theories, I concepts and terminology I problems and issues
I arguments and evidence, I I I concepts and terminology I I making informed Judgments I Level 4 I Good throughout the answer Good application to issues I Relevant and precise with a I Where appropriate, good use lacer and logical chain of liberation of alternative I I(mid-point 19) reasoning I weaknesses I points of view I There is good awareness of I I the interrelatedness of I loft data to support answer I I I Good analysis but limited I I alleviation I Some good application to I economic issues I issues I Reasonable, showing an I Largely relevant and well Good throughout much of the I
Where appropriate, some good I organized with reasonable I appreciation of alternative I I Reasonable analysis and I answer with few errors and I use of data to support I logic and coherence evaluation awareness of I I economic issues I answer I I reasonable I There is some The answer displays both good analysis and good evaluation, but does not quite reach level 5. Although analysis of economies and discomposes of scale is excellent, the analysis on monopoly is too thin, based on assertion rather than rigorous development and application of economic theory. Hence the answer is placed at the pop of level 4 rather than level 5.
Topic 2 Competitive markets It is impossible for human beings to possess perfect information about what is happening in a market. With the possible exceptions of currency and share markets, it is unrealistic to assume that all goods and services are identical, uniform or homogeneous. 2 Motorists can research similar car models in trade magazines and on the internet to get a picture of the price of cars depending on age, mileage, condition and availability. 3 Whenever marginal revenue exceeds marginal cost (MR. > MAC), selling an extra unit of output always increases total profit.
The extra unit adds more to revenue than it does to costs. But whenever marginal revenue is less than marginal cost (MR. < MC), selling an extra unit of output always reduces total profit. The extra unit adds more to costs than it does to revenue. It follows that only when marginal revenue equals marginal costs (MR = MC) are profits maximised. incentive to stay in the market. As a profit level, it is not high enough to attract new firms into the industry to compete with existing firms, or low enough to force firms out of the market.
Supernormal profit is excess profit over and above normal profit. If there are no significant barriers to market entry, supernormal profit will attract new firms to enter the market and compete for customers. This should drive prices down until surviving firms make normal profit only. 5 When the price off good is greater than the marginal cost of production, the result is allocation inefficiency because the price charged by firms will be greater than the cost of making the last unit. This indicates that the firm is over-charging consumers.
Hence not enough of the good is demanded and society scarce resources are not properly allocated between competing uses. Allocation inefficiency occurs when P > MAC or P < MC. For any given employment of resources and any initial distribution of income and wealth among the population, total consumer welfare can increase if resources are re-allocated from markets where P < MC into those where P > MAC, until allocation efficiency is achieved when P = MAC in all markets. 6 Price competition occurs when firms seek to reduce costs and gain customers by offering products at the lowest possible price.
By offering the good at a low price they hope to create an incentive for the consumer to buy the product. Quality competition is when a firm seeks to sell a product to consumers on the rounds that it is superior quality when compared to rival products. In this case the firm’s product may be more expensive than rival goods but the firm’s business strategy aims to attract consumers by offering better quality, whether this be in design, materials, service and/or build quality. The internet breaks down geographical frontiers, which enables buyers and sellers to engage in national and international markets. This has made some markets bigger and helped fulfill the assumption that there are a large number of buyers and sellers. Internet search engines and comparisons have allowed both business and nonusers to move closer to the perfect information assumption. Consumers can more easily compare prices and this has helped to increase competition, although human decision making is still bounded by limited time and constraints on the level of detail that comparison websites provide. Racket structure. These are: (I) a very large number of buyers and sellers; (it) each with perfect market information; (iii) each able to buy or sell as much as it wishes at the ruling market price determined in the market as a whole; (iv) individual buyers and sellers unable to influence the ruling market price through their own actions; (v) uniform or identical product; and (vi) an absence of barriers to entry into and exit from the market in the long run, I. E. Complete freedom of entry and exit.
A barrier to entry prevents new firms from entering a market. Taken together, these conditions tell us that a perfectly competitive firm, whose AR and MR. curves are depicted in panel (a) of the diagram below, faces a perfectly elastic demand curve for its product. The demand curve facing the firm is located at the ruling market price, Pl , which itself is determined through the interaction of market demand and market supply in the market as a whole, which is illustrated in anal (b) of the diagram.
The assumption that a perfectly competitive firm can sell whatever quantity it wishes at the ruling market price Pl, but that it cannot influence the ruling market price by its own action, means that the firm is a passive price-taker. Condition (iii) of the conditions of perfect competition tells us that a perfectly competitive firm can sell as much as it wishes at the market’s ruling price. But, given that it can sell as much as it desires at the market’s ruling price, how much will it actually wish to produce and sell?
Providing we assume that each firm’s business objective is solely to maximize refit, the answer is shown in panel (a) of the next diagram: Panel (a) in the diagram above adds the perfectly competitive firm’s average total cost (TACT) curve and its marginal cost (MAC) curve to the revenue curves shown in the earlier diagram. Point A in panel (a) (at which MR. = MAC) locates the profit-maximizing level of output IQ . At this level of output, total sales revenue is shown by the area OSI API . Total cost is shown by the area OSI BCC .
Supernormal profits (measured by subtracting the total cost rectangle from the total revenue rectangle) are shown by the shaded area CLC API . Referring back again to the list of the conditions of perfect competition, we can see that although firms cannot enter or leave the market in the short run, they can do so in the long run (condition (v’)). Suppose that in the short run, firms make supernormal profit. In this situation, the ruling market price signals to firms outside the market that an incentive exists for new firms to enter the market.
The next diagram shows what might then happen: Initially, too many new firms enter the market, causing the supply curve to shift to the right to SO in panel (b) of the diagram. This causes the price line to fall to UP, which lies below each firm’s TACT curve. When this happens, firms make a loss (or subnormal profit). But Just as supernormal profit creates the incentive for new firms to enter the market, subnormal profit provides the incentive for marginal firms to leave the market.
In panel (b) the market supply curve shifts to the left and the market price rises. Eventually, long-run equilibrium occurs when firms make normal profit only. For the market as a whole, this is shown at output and price UP. This answer is similar to the answer written for the Topic 1 exam-style essay question n that it includes more than enough coverage of issues to earn all the available 15 marks. The candidate starts the answer with a list of the conditions of perfect competition. Weak answers frequently go no further than this.
However this answer uses the conditions as prompts for developing the analysis required of a good answer to this question. Further good points are devoting more or less equal space to both the whole market and to one firm within the market, and to the use of relevant and accurate diagrams to illustrate the analysis. The maximum 15 marks are awarded. 02 In economics the word ‘efficiency has several meanings. For example: Technical efficiency. A production process is technically efficient if it maximizes the output produced from the available inputs or factors of production.
Productive efficiency or cost efficiency. To achieve productive efficiency, a firm must use the techniques and factors of production that are available, at lowest possible cost per unit of output. In the short run, the lowest point on the relevant short-run average total cost curve locates the most productively efficient level of output for the particular scale of operation. X-efficiency. This occurs when a firm has eliminated all unnecessary costs of reduction, which means that it must be producing on and not above its average cost curve.
Allocation efficiency. This occurs when it is impossible to improve overall economic welfare by reallocating resources between industries or markets (assuming an initial fairness’ in the distribution of income and wealth among the population). For resource allocation in the whole economy to be lucratively efficient, price must equal marginal cost (P = MAC) in each and every market in the economy. Dynamic efficiency. All the forms of efficiency mentioned above are examples of static
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