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Chapter 22 Answers
Chapter 22 Answers
Individual activities
1
Output TC TFC TVC AC AFC AVC
0 160 60 110 — — —
1 110 60 150 110 60 50 1
The profit maximising output is 40 units, since this is where profit is highest.
2
Four-part question
a A variable cost is a cost that changes when output changes. As output increases the cost of raw
materials, for example, would increase.
b A firm’s profit would increase if its revenue rose while its costs remained unchanged. For
example, an increase in income would be likely to increase demand for luxury handbags. This
would be likely to increase the revenue and profit received by the handbag producers.
A firm’s profit would also increase if its revenue remained unchanged while its costs fall. Its costs may
decline as a result, for instance, of a rise in labour productivity or a fall in the price of raw materials.
c A rise in output would have no effect on total fixed cost. This is because fixed costs are those
costs that are not directly related to output. They do not change as output changes in the short
run. For example, if a handbag producer makes more handbags, the cost of insuring its factory is
unlikely to alter. Figure 1 shows that total fixed cost remains unchanged as output increases.
Costs
0 Output
Figure 1
In contrast, average fixed cost falls with output. This is because the unchanged total fixed cost
is spread over more units. The more output that is produced, the lower the average fixed cost of
production. Figure 2 shows how average fixed cost falls continuously with output.
Costs
AFC
0 Output
Figure 2
d It is usually assumed that firms in the private sector try to maximise profit. Profit is the reward to
entrepreneurs and provides the incentive to take the risk of making a loss. Profit also provides
the funds for further investment.
Firms in the public sector may follow a different objective. A state-owned enterprise (SOE) may
have a number of objectives. These are likely to be linked to social welfare. For example, a SOE
may try to reduce the external costs arising from pollution by investing in cleaner technology. It
may also seek to improve worker welfare by providing good working conditions.
Private sector firms may also try to improve working conditions. Firms have a number of
stakeholders, including shareholders, workers and consumers. A firm may try to satisfy the
interests of all these groups. At any one time, it may be focusing on one particular group but it
has to remember that it always has to keep its shareholders happy.
At certain times, a firm may not be able to think about making a profit. The economy may be 3
in recession with demand for most products falling. In this situation, a firm may put its efforts
into survival. It may, for instance, have to search for a favourable loan to cover any losses and for
lower-priced raw materials.
A firm may also, at least for a period of time, favour growth over profit maximisation. It may seek
to become larger to increase its market power and to raise the salary and status of its managers.
In the long run, all the objectives that private sector firms might pursue are likely to lead to profit
maximisation. Becoming larger may involve a firm eliminating competitors and gaining more
monopoly power. This may enable its ability to raise its price without losing many sales and
so may raise its revenue. Growing in size may also enable the firm to take greater advantage of
economies of scale and so lower its costs of production. Keeping all the stakeholders happy
may also increase profit. For instance, better working conditions and higher pay for workers
may increase labour productivity, which could lower costs of production and increase demand
because of higher quality. Achieving higher environmental standards may also increase demand
and firms that are seeking to survive are likely to want to maximise profit in the long run.