Questions for Review with Answers
Chapter 11. Supply Theory II. Firm Behaviour
I. Preliminary Remarks
Chapter 11 – Question 1
Name some further analogies between the theories of supply and demand.
* Consumer methods of utility maximisation and firm methods of profit maximisation are completely analogous.
The equimarginal principle is applied to bundles bought by consumers and factor mixes employed by suppliers.
Indifference analysis, which describes consumer choices between bundles of commodities, is analogous to isoquant analysis, which describes firm choices between factor combinations.
Chapter 11 – Question 2
What is the great advantage of supply theory over demand theory?
* Unlike marginal utility, which is the centrepiece of demand theory, marginal revenue, marginal product and marginal product revenue can all be quantified.
II. Firm Motives
Chapter 11 – Question 3
How are profits maximised?
* By choosing the right level of output.
Please note that profit maximisation is not achieved by cost minimisation as one would assume. The two methods are completely separate.
Chapter 11 – Question 4
How are costs minimised?
* By choosing the right factor mix.
III. Revenues, Profits and Costs
Chapter 11 – Question 5
Please distinguish implicit and explicit costs.
* Explicit costs are payments such as wages that leave a firm. Implicit costs are foregone revenues. They consist of what an entrepreneur sacrifices to operate his firm: a salary earned through employment in another firm, interest on the money he invests in his firm, rent for his plant which he foregoes. Both costs, explicit and implicit, are opportunity costs.
Chapter 11 – Question 6
Distinguish accounting profits and economic profits.
* Accounting profits are revenues minus explicit costs.
Economic profits are revenues minus explicit and implicit costs.
Chapter 11 – Question 7
Why do economists classify accounting profits as costs?
* Because for an economist revenues must cover all opportunity costs. It could also be said that this view of economists is a way to explain profits away. It must be noted that the salary that an entrepreneur could earn elsewhere and the interest he could receive elsewhere would also be liable to taxation.
IV. How Firms Maximise Profits
Chapter 11 – Question 8
What is the rule that a profit maximiser must keep in mind?
* MC = MR. Profits are maximised by expanding output until the cost incurred by producing the last unit equals the revenue received for the last unit.
Chapter 11 – Question 9
Profits per unit are maximised at efficient scale. Can you explain that?
* Efficient scale is the size of output at which average total costs are minimised. Profit per unit is: Price minus ATC.
Chapter 11 – Question 10
Overall profits are maximised above efficient scale. Please explain that, too.
* Overall profits are price minus average total costs times units. Without the units produced above efficient scale, a firm would not receive the difference between price and ATC for these units.
V. How Firms Minimise Costs
Chapter 11 – Question 11
Write down the least-cost rule.
* MP of capital/price of capital = MP of labour/ price of labour. The least-cost rule states that firms minimise costs by choosing a factor mix where the ratio of marginal product to price is equal for each factor.
VI. Advanced Topic: Isoquant Analysis
Chapter 11 – Question 12
Isoquant analysis is the equivalent of indifference analysis. About what are firms indifferent?
* About the mix of factors they employ; they are supposed to have no preference for labour or capital.
Chapter 11 – Question 13
Define the following terms
A. isoquant curve
B. isocost curve
C. isoquant map
D. the MRS
* A. An isoquant curve shows technologically feasible combinations of factors for the same output. (Remember that isos means equal.)
* B. An isocost line shows financially affordable combinations of factors that cost the same.
* C. An isoquant map consists of several isoquant curve, each of which shows technologically feasible combinations for a different output level.
* D. The MRS is the rate at which one factor is substituted for another while output is held constant.
Chapter 11 – Question 14
How do you calculate the MRS?
* Change in factor on y-axis/change in factor on x-axis.
VII. Why Firms Always End up with Zero Profits
Chapter 11 – Question 15
What does equilibrium of an industry mean?
* It means no firm leaves the industry, no firm enters it.
Chapter 11 – Question 16
Why are there still economic profits before equilibrium has been reached?
* Economic profits are price minus ATC x units.
Chapter 11 – Question 17
Why do they disappear in equilibrium?
* New firms have competed the discrepancy between price and ATC away. In this stage all firms operate at efficient scale and sell at the lowest average total costs possible. In equilibrium P = MC = ATC.
Chapter 11 – Question 18
There are still accounting profits in equilibrium. What do they consist of?
* Accounting profits are revenues minus payments that leave a firm. Accounting profits are the residual, that is, the "salary" of the firm's owner and a return on his investment.
Chapter 11 – Question 19
Why is the market supply curve a horizontal line in equilibrium?
* The horizontal line illustrates constant costs. All firms produce at the same cost, namely minimum ATC, sell for the same price and satisfy all demand at this price.
VIII. An Excursus on the History of Profit Theory
Chapter 11 – Question 20
How do neo-classical economists manage to explain profits away?
* They say there are only accounting profits, and these are not profits, they are opportunity costs. Accounting profits are returns to capital and the salary of the firm's owner. Economists deduct from accounting profits implicit costs, i.e. what the owner's work and investment could earn elsewhere.
IX. An Excursus on the History of the Firm
Chapter 11 – Question 21
How did Ronald Coase explain the existence of firms?
* Ronald Coase stated that firms are founded because they help to save costs for communication and transactions.
Chapter 11 – Question 22
What is the relationship between a principal and an agent?
* A principal wants an agent to do something on his behalf.
Chapter 11 – Question 23
What is the difference between horizontal and vertical integration?
* Vertical integration means that a company itself produces everything that is needed to make its final product. In the make-or-buy decision faced by any firm, the answer of vertically integrated firms is make. In contrast, horizontal integration means that a company buys competitors that produce the same product.
Chapter 11 – Question 24
And what is disintegration?
* Disintegration means outsourcing. Firms become smaller because they farm out production and services to other firms.
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