BUSINESS ECONOMICS

1. The law of diminishing marginal returns states that

The law of diminishing marginal returns states that adding an additional factor of production
results in smaller increases in output.
Or
The law of diminishing marginal utility states that all else equal, as consumption increases, the
marginal utility derived from each additional unit declines.

2. (a) Complete the following table of costs for a firm. (Note: enter the figures in the MC
column between outputs of 0 and 1, 1 and 2, 2 and 3, etc.)

Output TC (£) AC (£) MC (£)

0 55 –
.
1 85 85 30
2 110 55 25
3 130 43.33 20
4 160 40 30
5 210 42 50
6 280 46.67 70
7 370 52.86 90
8 480 60
110
9 610 67.78
130
10 760 76
150

Formula
Average Cost = Total Cost / Output
Marginal Cost = ΔTotal Cost / ΔOutput
Total Cost = Output * Average Cost
AFC = TFC / Q
TC = TFC=TVC
TVC = TC – TFC

AVC = TVC / Q

(b) How much is total fixed cost at:

(i) an output of 0? 55 (ii) an output of 6? 55
Cost incurred at zero unit of output is called fixed cost. Total fixed cost remains constant with the
increase in output.

(c) How much is average fixed cost at:

(i) an output of 5? 55/5=11 (ii)an output of 10? 55/10=5.5

(d) How much is total variable cost at an output of 5? 210 – 55 = 155

(e) How much is average variable cost at an output of 10? 705/10 = 70.5

TVC = 760-55
= 705

3. (a) Referring to the data from question 2, draw the firm’s average and marginal cost curves on
the following diagram. (Remember to plot MC mid-way between the quantity figures.)

(b) Mark on the diagram the output at which diminishing returns set in.

2
 (c) Assume that the firm is a price taker and faces a market price of £60 per unit.
Draw the firm’s AR and MR curves on the above diagram.

(d) How much will it produce in order to maximise profit? 5 Units

(e) Shade in the amount of profit it makes.

(f) Calculate how much profit this is. Profit = 90

4. The following is a list of various types of economies of scale:

(i) The firm can benefit from the specialisation and division of labour.
(ii) It can overcome the problem of indivisibilities.
(iii) It can obtain inputs at a lower price.
(iv) Large containers/machines have a greater capacity relative to their surface area.
(v) The firm may be able to obtain finance at lower cost.
(vi) It becomes economical to sell by-products.

3
 (vii) Production can take place in integrated plants.
(viii) Risks can be spread with a larger number of products or plants.

Match each of the following examples for a particular firm to one of these types of economy of
scale.

(a) Delivery vans can carry full loads to single destinations. (ii)

(b) It can more easily make a public issue of shares. (v)

(c) It can diversify into other markets. (viii)

(d) Workers spend less time having to train for a wide variety of different tasks, and
less time moving from task to task. (i)

(e) It negotiates bulk discount with a supplier of raw materials. (iii)

(f) It uses large warehouses to store its raw materials and finished goods. (iv)

(g) A clothing manufacturer does a deal to supply a soft toy manufacturer with offcuts
for stuffing toys. (vi)

(h) Conveyor belts transfer the product through several stages of the manufacturing
process. (vii)

4
5. The following diagram shows the cost curves of a firm under perfect competition.

(a) How much will the firm produce in order to maximise profits at a price
of £8 per unit? 70 units

(b) What will be its average cost of production at this output? 6

(c) How much (supernormal) profit will it make? 2*70 = 140

(d) How much will the firm produce in order to maximise profits at a price
of £5 per unit? 50 units

(e) How much (supernormal) profit will it make? 0

(f) How much will the firm produce in order to maximise profits at a price
of £4 per unit? 40 units

(g) What will be its profit position now? Loss of 60

(h) Below what price would the firm shut down in the short run? Below 5

(i) Below what price would the firm shut down in the long run? Below 3.5

5
6. Profit equals revenue minus cost. We have looked at costs. We now turn to revenue.
Let us assume that firm S is a price taker.

(a) In other words it faces a (i) downward-sloping/horizontal (ii) demand curve/supply curve

Let us assume that it faces a market price of £2 per unit for its product.

Firm S, as a price taker, faces a horizontal (ii) demand curve. In perfect competition, each firm
takes the market price as given, and its individual output level does not affect the market price.

Now, given a market price of £2 per unit:

(b) What is its total revenue from selling:

(i) 5 units? 5 * 2 = 10 Units

(ii) 8 units? 8 * 2 = 16 units

(c) What shape is its total revenue curve?

The total revenue curve for a price-taking firm in perfect competition is a straight line that starts
from the origin (zero quantity, zero revenue) and has a slope equal to the market price.

(d) What will be its marginal revenue from selling:

(i) the fifth unit? 2 Pounds

(ii) the eighth unit? 2 Pounds

Marginal Revenue is equal to the market price in perfect competition because selling an additional

unit doesn't affect the price.

(e) What shape is its marginal revenue curve?

As the MR is always constant, The MR curve is a Horizontal-shaped Straight Line.