Economics Test
ECOMONIMICS TEST
7/12/2018
Question 1
Explain the impact the law of diminishing marginal returns has on both marginal cost and average total cost.
Diminishing returns only occurs in the short run due to the fixed factors of production.
When a variable factor of production increases, at some point, it becomes less and less productive, and eventually it’s marginal a then average product decreases
The law of diminishing marginal returns implies that margina costs rise leads to a simultaneous increase in the output level
Effect on the Marginal Cost:
The short-run marginal cost curve at first declines and then goes up and eventually intersects the average total cost and average variable cost curves at their minimum point (I.B, 2011)
Effect on the Average Total Cost:
The average variable cost (AVC) curve will go down (but will not be as steep as the marginal cost), and then go up. This will not go up as fast as the marginal cost curve.
The average fixed cost (AFC) curve will decline as additional units are produced and continue to decline.
The average total cost (ATC) curve initially declines as fixed costs are spread over a larger number of units but will go up as marginal costs
Question 2
With the aid of a diagram explain the long run average cost curve and the influences upon it.
The long-run average cost curve depicts the costs incurred by a firm in production when all inputs are variable. It combines the short run cost curves. The short-run cost curves represent a specific level of fixed costs
When firms apply economies of scale, the average costs decline as production expands
The size of the firms in the industry and economies of scale are major determinants of the size and shape of the Long-run average cost curve
The Long-run average cost curve is U-shaped. Commonly referred to as the envelope curve, its U-shaped nature of the curve is due to the returns to scale. (A, 2009)
Cost
Q1 Q2 Q3 Q4
Quantity
Question 3
Explain the concept of profit maximization where marginal cost equals marginal revenue.
Profit maximization concept is used by firms to determine the level of output as well as the prices to charge to realize maximum profits. (McEachern, 1988)
It can occur in the short run or the long run or even both according to the nature of the market in which a business is operating.
The marginal revenue marginal cost perspective is used by firms to determine the profit maximization output and price level
At the profit maximization level, the marginal costs must equal the marginal revenue.
The marginal cost is the additional cost of producing one extra unit of output while the marginal revenue is the extra revenue generated from the extra sale of a unit.
To get the marginal cost and the revenue function, differentiate the total cost and revenue function with respect to output
Question 4
Making references to the UK energy market for electricity and gas:
(a) Describe the characteristics of an oligopoly
A small number of large firms
An oligopoly market structure is has a small number of large firms that have a significant share of the market. The firms exercise a reasonable amount of market control
Significant barriers to entry in the market industry
Barriers to entry in this type of market structure are due to the high start-up costs, government restrictions, exclusive ownership of resources and patents and copyrights.
Sale of identical or differentiated products
An oligopoly that offers identical products is known as an identical product oligopoly while one that offers differentiated products is known as a differentiate product oligopoly. An identical product oligopoly focusses on the production of raw materials or the intermediate goods while a differential product oligopoly focusses on consumption goods. (Dwivedi, 2010)
Firms Interdependence
Interdependence exists between the firms. The firms are few and decisions of each about the price and output policies can adversely affect other firms.
Advertising
Advertising is key in an oligopoly market structure as firms strain to reach more customers. Substantial cash flow on advertising costs as a strategy for a continued increase in the customer base is critical.
Competition
Competition in this type of market structure is stiff.Firms are always devising strategies that come with leverage from the rivals
(b) Concerning the theory of oligopoly explain the price and output behavior of the large UK energy firms
The Big Six UK energy firms are the British Gas, EDF Energy, SSE, Scottish Power, Npower and E. ON
These firms represent an oligopoly form of market structure illustrated by the concentration ratio of each of the firms, the high startup costs that create a substantial barrier to entry and the high interdependence that exists among the firms.
The behavior of the firms is dependent on the nature of the objectives of each of the firms, the barriers to entry and the government regulation.
There has been a continuous media debate on increasing gas and electricity prices in the UK
The challenges with facing the industry are;
Weak Customer Response-There has been a significant decline in customer trust in suppliers
High barriers to entry that limit potential entrants who lack the high start-up costs
An increase in supplier profits
Question 5
Explain why firms cannot make supernormal/abnormal profits in the long-run in a perfectly competitive market. Your response should refer to the characteristics of a perfectly competitive market and contain one or more diagrams to support your explanation.
A perfectly competitive market is a type of a market structure characterized by;
Many buyers and sellers
Supply of homogenous products by all suppliers that are perfect substitutes
Free entry and exit into the market industry
Perfect Information by both the sellers and the buyers on the product price
Free Mobility of the industry resources
A firm in a Perfect Competitive Market can make economic profits in the short run and makes zero profits in the long-run (R.A, 2010)
In the long run, firms are attracted to the market industry. The result is a shift in the supply curve to the right causing profits to decline. As more and more firms enter the industry, the more the increase in the supply. The demand goes way below the quantity supplied causing firms to significantly reduce the product prices to make them appealing to the consumers. In the long run, the economic profits are reduced to zero.
Illustration: FIRM INDUSTRY
LMC LAC P S1
S2
D
Q Q2 Q1
OUTPUT
Question 6
Profit Maximization Theory
The Conventional Theory
According to the Convention Theory, profit maximization is the sole purpose of a firm.
The conventional theory of firm assumes profit maximization is the sole objective of business firms.
Firms choose to specialize on maximizing profits and assume other objectives such as maximizing sales revenue, ensuring sustained growth of the firm and its survival, maximizing the utility function of managers and avoiding risks. (Dwivedi and Dwivedi, 2009)
Assumptions of the Conventional theory;
Owner Management and right; This will enable the motivation from the property rights gain which then triggers the generation of maximum profits. (U, 2012)
Management and ownership -The management and separation must be under one person to ensure conflict of interests do not arise
Appraisal of financial and investment decisions that explicitly focus on the profit maximization goal
References:
MCEACHERN, W. A. (2009). Economics: a contemporary introduction. Mason, OH, South-Western Cengage Learning.
TRIVEDI, M. L. (2002). Managerial economics: theory and applications. New Delhi, McGraw-Hill.
MARSHALL, A. (2009). Principles of economics.
DWIVEDI, D. N., & DWIVEDI, D. N. (2009). Essentials of business economics. Noida, U.P, Vikas Pub. House Pvt. Ltd.
ARNOLD, R. A. (2010). Economics. Australia, South-Western Cengage Learning.
DWIVEDI, D. N. (2010). Principles of economics. New Delhi, Vikas Publishing House Pvt. Ltd.
MÄKI, U. (2012). Philosophy of economics. Amsterdam, Elsevier/North Holland.
TUCKER, I. B. (2011). Microeconomics for today. Mason, OH, Southwestern.
Bibliography:
McEachern, W. (1988). Economics. Cincinnati: South-Western Publishing.
A, M. (2009). Principles of Economics.
Dwivedi, D. and Dwivedi, D. (2009). Essentials of business economics. Noida, U.P: Vikas Pub. House Pvt. Ltd.
R.A, A. (2010). ECONOMICS.
Dwivedi, D. (2010). Principles of economics. New Delhi: Vikas Publishing House Pvt. Ltd.
U, M. (2012). Philosophy of Economics Amsterdam.
I.B, T. (2011). Microeconomics for Today.
Economicsonline.co.uk. (2018). Oligopoly. [online] Available at: http://www.economicsonline.co.uk/Business_economics/Oligopoly.html
Fontinelle, A. (2018). Perfect Competition. [online] Investopedia. Available at: https://www.investopedia.com/terms/p/perfectcompetition.asp