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AQA Economics Unit 3

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  The Firm: Objectives, Costs and Revenues The Objectives of Firms: -   Main aim is to maximise profits:   o   MR=MC o   If MR>MC   produce   increase profit o   If MR<MC    don’t produce   decrease profit -   Other objectives: o   Maximise sales revenue:      Firms often seek to increase their market share - even if it means less profit. This could occur for various reasons:    Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run    Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries    Increasing market share may force rivals out of business. E.g. supermarkets have led to the demise of many local shops. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business o   Maximise growth of a business o   Maximise revenue:    May allow them to attain economies of scale or some form of monopoly power o   Maximise managerial objectives  (significant when there is divorce of ownership from control) -   Satisficing: o   Describes the situation where a firm is run in such a way as to satisfy a key stakeholder o   One form of satisficing if where those in control of the company seek to make sufficient profit to keep shareholders happy, by pursue their own objectives subject to this constraint o   This is called divorce of ownership from control    Q1 = Profit maximisation (MR=MC)    Q2 = Revenue Maximisation (MR=0)    Q3 = Marginal cost pricing (P=MC) - allocative efficiency    Q4 = Sales maximisation - maximum sales whilst still making normal profit (AR=ATC)  Divorce of Ownership from Control: -   Refers to the situation where the owners of the firm are not involved and therefore cannot control its conduct -   Could be run in a way that doesn’t maximise profits as th ose controlling it may have different objectives from those who own it -   There are 4 types of companies: o   Sole traders:  own the company and run it on a day-to-day basis o   Partnership:  own the company and run it on a day-to-day basis o   Private limited company:  owned by shareholders o   Public limited company:  owned by shareholders. Shares can be traded on the stock market, thus the composition of ownership can change constantly -   Effects: o   May affect the conduct (if it pursues profit maximisation or other objectives) and performance (economic efficiency and equity) o   Affecting a firm’s conduct depends on:      How accountable the directors and management of the firm are to shareholders (shareholders can remove directors)    Whether incentives are in place to encourage directors and staff to profit maximise (by encouraging employees to be shareholders)    How large the firm is (the larger the form the most difficult it may be to exercise control) -   Reasons for separation: o     Company may become too big to be run by owners o   Shareholders may not be interested in running the company, their motives simply lie in profit making o   Debt borrowing    Bonds    Pay back debt, interest, no partner, fixed not determined by contract, little uncertainty, low risk o   Equity    No deadline, dividends, has a say in the business, more return, higher risk o   Trade off facing public companies    Between having more resources but less control    Extending share capital when competition goes public, control is lost o   External finance (borrow from bank)    Has to be paid back with interest after a certain amount of time    Bank has no say    Dividend o   Internal finance:    Doesn’t have a payback time      Partner has a say    Expects return  –  share benefits  The Law of Diminishing Returns and Returns to Scale: Short-run Production and the Law of Diminishing Returns: -   A short-term law which states that as a variable factors of production is added to fixed factors, eventually the marginal returns of the variable product will begin to fall -   Short run: o   The time period in which at least one  factor of production is fixed -   If a small firm hires employees, the workers benefit from specialisation o   The marginal product of labour will increase o   Marginal product is the increase in output that results from adding an extra worker to the labour force o   However, the more workers there are, the sooner the benefits of specialisation will end o   The law of diminishing returns sets in when the marginal product of labour starts to fall (when one more worker adds less to the total output than the previous worker who  joined) -                 Marginal product vs average product:   Production Theory Short-run production theory Long-run production theory The Law of Diminishing Returns Returns to Scale   Output B C -Up to point C, MP>AP -At point C, MP=AP which is maximum average product of C -If MP>AP, AP is rising -If MP decreases, AP also decreases -B = diminishing marginal returns sets in -C  –  diminishing average returns sets in  Long-run Production and Returns to Scale: -   Long run: o   The time period in which no  factors of production is fixed -   Three possibilities: o   Increasing returns to scale    An increase in the scale of all factors of production causes a more than proportionate increase in output o   Constant returns to scale    An increase in the scale of all factors of production causes an exactly proportionate increase in output o   Decreasing returns to scale    An increase in the scale of all factors of production causes a less than proportionate increase in output Fixed and Variable Costs, Marginal, Average and Total Costs, Short-run and Long-run Costs: Fixed costs: -   Costs that do not vary with output. They must be pain the short run even if no output is produced o   Rent Variable costs: -   Costs that vary in proportion to output o   Electricity o   Gas -   When labour is the only variable factor of production, variable costs are simply wage costs. With increasing marginal labour productivity, the total variable cost of production rise at a slower rate than output. -   This causes the MC of production an extra unit of output to fall. However the law of diminishing marginal productivity sets in, marginal cost rises with output. Variable costs rise faster than output, so marginal costs also rise. Marginal costs: -   The additional cost of making one extra unit of output  Average costs: -               Total costs: -   Total cost of production = total fixed costs + total variable costs Short run costs: -   In the short run, when the inputs divide into fixed and variable factors of production, the costs of production can likewise be divided into fixed and variable costs -   Total cost = total fixed cost + total variable cost -   Average total cost = average fixed cost + average variable cost
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