Test 2

Economics – LCI: Self assessment

1. Distinguish between short run and long run in Economics (5)

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2. Distinguish between normal and economic profit (5)

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3. Explain the Short Run production Function using the graph below:(10)

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4. Explain the law of diminishing marginal returns (6)

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20 Using the graph below indicate the points where the firm:

a) Should produce for maximum profit at P5

b) At what price the firm makes “normal profit”

c) At what price level the firm should shut down.

d) Does the firm make normal profit at point h

e) Does the firm make normal profit at point g

f) does the firm make a loss, normal profit or economic profit at point f

Give a short explanation for each answer.

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Economics – LCI: Self assessment

1. Distinguish between short run and long run in Economics (5)

The long term is characterised by the fact that within it both the size (1) of the firm as well as the number of firms (1) can change. The size of the firm affects the cost curves of the firm (1); the second characteristic is of particular importance in the derivation of the long term equilibrium (1) and long term supply curve (1).

2. Distinguish between normal and economic profit (5)

Normal profit exists in the state of equilibrium and includes the functions that the entrepreneur fulfils such as coordinating the activities of the firm – he is compensated like any other factor of production is compensated. Economic profit it earned because of the disequilibrium caused by the entrepreneurial actions taken by the entrepreneur to be in and create markets that do not exist and where other firms have not yet established themselves. This is not possible in the theoretical model of perfect market conditions – where time lags are excluded. So, one may say that in relatively perfect market conditions an entrepreneur may make economic profits in the short term, but other producers will enter the market and that will cause the supply curve of the market for that good or service to shit to the right and cause the market clearing price to fall - thus reducing economic profit. This process will continue until only normal profits are made.

The free entry of firms ensures that for example under monopolistic competition excess profits will disappear.

3. Explain the Short Run production Function using the graph below:(10)

The short run production function, can be divided 3 stages.

In Stage 1 (from the origin to point Q1) the variable input is being used with increasing output per unit, the latter reaching a maximum at quantity L1 (since the average physical product is at its maximum at that point). (later one will see that because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage).

In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. ( The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1).

In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

4. Explain the law of diminishing marginal returns (6)

The law of diminishing marginal returns means that the productivity of a variable input declines as more is used in short-run production, holding one or more inputs fixed. This law has a direct bearing on market supply, the supply price, and the law of supply. If the productivity of a variable input declines, then more is needed to produce a given quantity of output, which means the cost of production increases, and a higher supply price is needed. The direct relation between price and quantity produced is the essence of the law of supply.

5 Using the chart below indicate the points where the firm:

Should produce for maximum profit at P5

At what price the firm makes “normal profit”

At what price level the firm should shut down.

Does the firm make normal profit at point h

Does the firm make normal profit at point g

Give a short explanation for each answer.