Economics 1: Micro and Macro Theory and Application 2016/2017

1. Explain the impact the law of diminishing marginal returns as on

both marginal cost and average total cost.

Firstly, this impact is possible only in the short run when one of the factor is fixed. When a
variable cost increase consequently the production does, too. However, there is a turning point
where the productivity start to decrease. Eventually, the marginal cost decreases.

The following example with a graphic shows a situation to understand better the concept.

There is a restaurant which has ten tables for customers and five waiters. At this moment, there
are one waiter for two tables. The manager decides to hire another one to serve customer faster. In
this case the productivity increase and the manager thinks that it is a good idea to hire more people.
At the end, there are ten tables and twelve waitress. The manager finds out that there is something
wrong because the productivity is less than he thought. That is because of the law of diminishing,
there is a point where hiring a waiter will have an additional cost which will not generate any extra
output. In other words, five people working there are more than enough to serve the restaurant
because there are not more tables. In this case two table per waiter.

To sum up, when the Marginal Cost (MG) is equal to Average Total Cost it is not useful to hire
more staff.

The following graphic shows this concept but with different figures. Marginal Cost and Total cost
are equal in 2,so this is the turning point.

Dimishing Marginal Returns

150

100
PRODUCT

50

0
0 1 2 3 4 5 6 7 8 9 10
-50
LABOUR

Total Product Marginal Product

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Economics 1: Micro and Macro Theory and Application 2016/2017

2. With the aid of a diagram explain the long run average cost
curve and the influences upon it.

To understand the diagram, I will define what long run average costs is. It shows the cost per
unit of output viable when all factors of production are variable.

In the question one I explained that five waiters were enough to serve ten tables. However,
in LRAC all factors are variable so the restaurant can be bigger so that there is more space to have
more tables. Consequently, there will be more staff. The MC of hiring new staff will be quite low, in
other words, a proportional increase in inputs under the control of the firm causes a decrease in
average cost. This is known as Economies of Scale. The company will continue hiring staff until they
reach the new Optimum Output. From this moment onwards, a firm will tend to experience
Diseconomies of Scale, that means an increase in staff will cause an increase in average cost.

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Economics 1: Micro and Macro Theory and Application 2016/2017

3. Explain the concept of profit maximisation where marginal cost

equals marginal revenue.

A firm can maximise profit if

Maginal Revenue=Marginal Cost Marginal cost and Marginal
0.6 revenue are equals. If the company
represented in the diagrams
0.4
COST

produces less than 2.5 outputs MR

0.2 is greater than MC, the firm will
0 gain more revenue than cost.
0.5

1.5

2.5

3.5
3.75

4.5
0.25

0.75

1.25

1.75

2.25

2.75

3.25

4.25
0

4
However, after 2.5 units MC is
OUTPUT
greater than MR so the firm will
see a fall in its profits. For this
Marginal Revenue Marginal Cost reason, the maximisation point is
when MR=MC.

7 PROFIT MAXIMISATION Nevertheless, in the real market it

6 difficult to know what is the
5 marginal cost and marginal revenue
4 of last good sold. Furthermore, it
COSTS

3 also depends on how other

Total Cost
2 companies react. To solve it, firm
Total Revenue
1 can make a best estimation through
0 Profit
trial and error.
1
0

3.5

4
0.5

1.5

2.25
2.5

4.5
0.25

0.75

1.25

1.75

2.75

3.25

3.75

4.25

-1
-2
OUTPUT

Data in sources

4. Making references to the UK energy market for electricity and

gas: Describe the characteristics of an oligopoly.

The characteristics are:

1.) Only six companies supply energy in UK. These firm are SSE, Scottish Power, Centrica,
RWE npower, E.ON and EDF Energy. They control 96% of the electricity market.
2.) The product is the same. There is no difference among the product which is sold for the
Energy firms in UK. However, they use non-price competition methods in order to
difference the products, such as marketing, special offers, or superior customer service.
3.) Interdependence of firms, the six companies of energy are affected by how other firms
set price and output.
4.) Barriers to entry, for instance sufficient liquidity. Small companies have more problems
to get enough liquidity to enter in this sector.

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Economics 1: Micro and Macro Theory and Application 2016/2017

5.) In an oligopoly industry, firms often enter into agreements amongst themselves. These
agreements restrict competition so they can maximise their own benefits. That is illegal
but collusion can be hard to detect.

a) With reference to the theory of oligopoly explain the price

and output behaviour of the large UK energy firms

Economist use a kinked demand curve to explain why price in an oligopoly markets
is more stable than in other markets. Moreover, this curve illustrates
the interdependence that exists among the firms in an oligopoly.

www.slideshare.net/BibaswanMohanty1/micro-economics-55063632

Being K the equilibrium point, if the companies raise the price and other do not,
their competitors will not follow. Furthermore, they will lose share of the market so that
profits too. By contrast, if the oligopoly market reduces its price below K, its competitors
will follow and reduce their prices as well. Consequently, the companies will have less
profits.

5. Explain why firms cannot make supernormal/abnormal profits in

the long-run in a perfectly competitive market.

Before to start it is worthwhile remembering what is supernormal/abnormal and normal profit.

- Supernormal/abnormal: It is an extra profit above normal profit.

- Normal: It occurs when total revenue less total cost is equal to zero. A minimum level of
profit to remain the company in the market.

Firms can make supernormal profit in the short term in perfect competition. Perfect
competition means perfect information and freedom of entry and exit of the market.

Then, if a firm make abnormal profit, other companies will be aware of it and they will enter
in the market. Consequently, the price will fall until the normal profit. For this reason, only normal
profit will be made in the long run.

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Economics 1: Micro and Macro Theory and Application 2016/2017

http://www.economicsonline.co.uk/Business_economics/Perfect_competition.html

6. Sales revenue maximization.

Sales revenue maximization is an alternative theory to profit maximisation. This theory was
developed by Willam Baumol (1959). He focused on managers who controlled businesses. He
explained that some expenses as annual salaries might be related to total sales revenue than
profits. Employees can be given higher earnings or/and better working conditions if the sales are
high. In addition, larges sales, give prestige to managers while huge profits go to shareholders.
Furthermore, a company with big sales can adopt competitive tactics. These tactics are likely to
use price discrimination.

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Economics 1: Micro and Macro Theory and Application 2016/2017

7. Sources

Question 1

• http://www.economicshelp.org/microessays/costs/diminishing-returns/
• http://www.amosweb.com/cgi-
bin/awb_nav.pl?s=wpd&c=dsp&k=law+of+diminishing+marginal+returns

Question 2

• https://www.tutor2u.net/economics/reference/long-run-average-cost-lrac

Question 3

Table to make the diagram

Fixed Variable Total Total Marginal Marginal
Output Profit
Cost Cost Cost Revenue Revenue Cost
0.00 1 0.00 1.00 0.0000 -1.00 0.0000 0
0.25 1 0.02 1.02 0.3125 -0.71 0.3125 0.02
0.50 1 0.06 1.06 0.6250 -0.44 0.3125 0.04
0.75 1 0.14 1.14 0.9375 -0.20 0.3125 0.08
1.00 1 0.25 1.25 1.2500 0.00 0.3125 0.11
1.25 1 0.39 1.39 1.5625 0.17 0.3125 0.14
1.50 1 0.56 1.56 1.8750 0.32 0.3125 0.17
1.75 1 0.77 1.77 2.1875 0.42 0.3125 0.21
2.00 1 1.00 2.00 2.5000 0.50 0.3125 0.23
2.25 1 1.27 2.27 2.8125 0.54 0.3125 0.27
2.50 1 1.56 2.56 3.1250 0.57 0.3125 0.29
2.75 1 1.89 2.89 3.4375 0.55 0.3125 0.33
3.00 1 2.25 3.25 3.7500 0.50 0.3125 0.36
3.25 1 2.64 3.64 4.0625 0.42 0.3125 0.39
3.50 1 3.06 4.06 4.3750 0.32 0.3125 0.42
3.75 1 3.52 4.52 4.6875 0.17 0.3125 0.46
4.00 1 4.00 5.00 5.0000 0.00 0.3125 0.48
4.25 1 4.52 5.52 5.3125 -0.21 0.3125 0.52
4.50 1 5.06 6.06 5.6250 -0.44 0.3125 0.54

• https://www.slideshare.net/mfladlien/why-marginal-revenue-equals-marginal-cost-
determines-profit
• http://www.economicshelp.org/blog/3201/economics/profit-maximisation/

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Economics 1: Micro and Macro Theory and Application 2016/2017

Question 4

• http://www.economicshelp.org/microessays/markets/oligopoly/
• https://www.tutor2u.net/economics/reference/oligopoly-the-uk-market-for-electricity-and-
gas-supplies
• https://www.sheffield.ac.uk/polopoly_fs/1.407253!/file/energysupplymarketsmallfirms.pdf
• https://www.slideshare.net/BibaswanMohanty1/micro-economics-55063632
• https://www.cliffsnotes.com/study-guides/economics/monopolistic-competition-and-
oligopoly/kinked-demand-theory-of-oligopoly

Question 5

• http://www.investopedia.com/terms/n/normal_profit.asp
• http://www.economicsonline.co.uk/Business_economics/Perfect_competition.html
•

Question 6

• http://www.economicsdiscussion.net/theories/baumols-managerial-theory-of-sales-
revenue-maximization/5680
• https://www.tutor2u.net/economics/blog/a2-micro-moving-away-from-profit-max

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