Business Microeconomics Notions

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Table of Contents

The law of diminishing returns
Demand
Competition
Supernormal profits
Reference List

The law of diminishing returns

According to the law of diminishing returns, if all resources and inputs are held constant, the additional returns from an additional variable will be higher up to a certain point after which the returns will begin to decrease. This is due to the increased demand for the resources thus reducing the efficiency of the workers and the organization as a whole. For example, if a manufacturing company continues taking in new employees without increasing company resources, eventually the workers will have to compete for space, tools, materials, and other amenities. This will reduce the productivity of the company and the total quantity produced by the company will reduce up to zero as more employees are employed (Blinder & Baumol, 2008).

Diminishing economies of scale.

Fig 2: Diminishing economies of scale.Economies of scale refer to the increased output by a firm as it increases in size. Diminishing economies of scale refer to a condition whereby a certain increase in the size of a company produces output that is less than the increase in size. The primary cause of diminishing economies of scale is the fact that it is difficult to manage and coordinate operations when a firm becomes very large. (Gorman, 2003)

Diminishing marginal returns are relevant when at least one production input is fixed in the short run. On the other hand, decreasing economies of scale are relevant when all inputs are variable in the long run. This is because diminishing returns assume that the supply of a resource is fixed yet all resources are variable in the long run (McConnel, Brue & Campbell, 2004).

The diminishing economies of scale deals with the relationship between total output produced and the increase in company size. In contrast, diminishing marginal returns deals with a decrease in output if a variable resource is increased beyond a certain optimum point. (Gorman, 2003)

Demand

a) The demand curve is affected differently by price and non-price influences. Non-price influences include changes in prices of related products, changes in consumer incomes, changes in tastes and fashion, etc. When there is a change in the non-price determinants of demand, there is a shift in the entire demand curve. For instance, if there is an increase in the income level of a population, the demand curve would shift to the right as in figure 1 below. On the other hand, if there is a change in the price of a commodity, there is movement along the demand curve. A price increase will cause an upward movement in the demand curve therefore decreasing demand. (Hooks, 2003; Hartley & Tisdell, 2008)

Movement along the demand curve.

Fig 4: Movement along the demand curve.The non-price influences that affect the supply curve include the cost of production, technology, the profitability of alternative products, expectations of changes, etc. Non-price influencers cause the whole supply curve to shift. A change in the price causes a movement along the supply curve which results in a change in the quantity that is being supplied. Therefore if there is a price increase, there will be an increase in the quantity supplied. (Hooks, 2003)

Supply curve shift.

Fig 5: Supply curve shift.

The short-run and long-run marginal cost curves coincide at the point when the fixed factor output is at an optimum level. The long-run supply curve is more responsive to price because, in the long-term, a firm can get zero profits by stopping operations. In the long run, the price should be like the average cost. Hence, the important section of the long-run supply curve is the upward sloping part. This part is the marginal cost curve that lies above the long-run average cost curve. The break-even point is the least point on the average cost curve. The long-run supply curve is the section of the marginal cost curve which is above the break-even point. Therefore, the marginal cost curve maps out the supply curve (Lovell, 2004).

Fig 7: The marginal cost maps out the supply curve.

If a government wishes to increase sales tax revenue, the elasticity of the goods must be taken into consideration. Goods having high elasticity will give less revenue because a tax increase will raise their price which thus reducing the demand for the product. The less the demand for the product by the public the less the revenue that can be gotten from the product. On the other hand, goods which have a lower price elasticity of demand will have a very little decrease in demand if the taxes are imposed on them. The increase in price due to tax marginally affects the demand for these products. Therefore the government should choose the product with the lower price elasticity of demand as these will ensure that more revenue is received. The tax incidence in this situation lies with the customer. Since the customer will still demand the same quantity with price changes, the producer can pass almost all the value of the additional tax to the customer. (Ohri & Jain, 2007)

Fig 8: The effect of tax on commodities with elastic and inelastic demand.

Competition

The bread industry in Australia is an example of perfect competition. Bread is consumed in most households in Australia therefore many buyers are not significant enough to influenced price by their purchasing decision. There are many companies supplying bread but none of these is large enough to influence supply in the market. Although there are many types of bread such as white bread brown bread etc, all companies produce a relatively similar product. The companies are price takers and thus take whatever price is in the market. The average revenue and the marginal revenue of a company are equal. (Hartley & Tisdell, 2008)

The profit-maximizing price for the individual firm is determined by finding the price and output that is produced for a profit-maximizing firm is at the level where the marginal revenue and the marginal costs are equal. Also, the marginal cost curve should be rising at the point of intersection with the marginal revenue curve. The price and output for the industry are determined by demand and supply. (Hartley & Tisdell, 2008)

Fig: The profit maximization for the industry and firm.

Supernormal profits

Q* is the profit-maximizing output. This is where the marginal revenue and the marginal cost are equal.

14 – 10 = 4

Supernormal profits made at Q* is $4 per unit of output.

In the long run, the price will move from P1 to P2. This is how supernormal profits are eroded in the industry in the long run. P2 is the normal profit. It is important to have information about the long-run average cost because the long-run equilibrium is reached when the average revenue is equal to the marginal revenue which is equal to the average cost. Long-run equilibrium takes place when a firm has a perfectly elastic demand curve which is tangent to the base of the average total cost. (Ohri & Jain, 2007)

Reference List

Blinder, A. & Baumol, W. (2008). Microeconomics: Principles and Policy. USA: Cengage Learning.

Campbell, R. R., McConnell, C. R., & Stanley, L. B. (2004). Microeconomics: principles, problems, and policies. New York: McGraw-Hill Professional.

Gorman, T. (2003). The Complete Idiot’s Guide to Economics. New York: Alpha Books.

Hartley, K. & Tisdell, C. (2008). Microeconomic policy: a new perspective. Massachusetts: Edward Elgar Publishing

Hooks, J. A. (2003). Economics: fundamentals for financial services providers. London: Kogan Page Publishers.

Lovell, M. C. (2004). Economics with calculus. London: World Scientific.

Ohri, V. & Jain, T. (2007). Economics. New Delhi: VK publications.

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