# Revision Questions on Theory of Firm

## Question 1

A firm in perfect competition is producing at the profit maximizing output, but making a loss. Using diagrammatic analysis, explain how this is possible.

You are expected to:

Explain that profit maximizing output is where MC = MR and if , at this output, AC is greater than AR, the firm will make a loss in the short run.

Illustrate this point using the standard perfect competition diagram.

{xtypo_info}Label the diagram and explain it properly{/xytpo_info}

## Question 2

Explain the relationship in the short-run between the marginal costs of a firm and its average total costs.

You are expected to

Define

• short-run
• marginal cost (MC)
• average total cost (ATC)

• Explain the concept of diminishing returns
• Draw diagram showing marginal cost (MC) and average total cost (ATC). Label it properly and explain it
• Explain MC cuts ATC at lowest point
• Explain the impact of marginal cost (MC) changes on average total cost (ATC)
• Expalin that  MP cuts AP at highest point.

## Question 3

Using appropriate diagrams, discuss whether monopoly is more efficient or less efficient than perfect competition.

You are expected to

Explain perfect competition

Explain that a firm in perfect competition in long-run is allocatively and productively efficient

Explain monopoly

The firm in monopoly in long-run is neither allocatively nor productively efficient

However there is higher output and lower prices in monopoly than in perfect competition due to economies of scale

## Question 4

Using a diagram, explain how allocative and productive efficiency will be achieved in long run equilibrium in perfect competition.

You are expected to

Define allocative and productive efficiency.

Draw the standard perfect competition equilibrium diagram showing and explaining that in perfect competition output will occur on the lowest point of the ATC curve (productive efficiency), and that price will be equal to MC (allocative efficiency).

Label your diagram properly and explain it.

## Question 5

A monopolist decides to maximize profits rather than revenue. Using a diagram, explain how price and quantity will change.

You are expected to

Define monopoly

Explain that a monpolist strives to proudce at the revenue maximizing level of output (MR = 0) and the profit maximizing level of output (MC = MR)

Support your answer with an accurately labelled diagram showing the levels of price and output when profit is maximized and when revenue is maximized.

Explain the fact that when the change from revenue maximization to profit maximization is made, output will fall and price will rise.

## Question 6

Using appropriate diagrams, explain the difference between the law of diminishing returns and economies of scale.

You are expected to

Define short run and long run

Explain the concepts of

• law of diminishing returns
• economies of scale

Draw a properly labelled diagram of product curves and/or short run cost curve showing law of diminishing returns

Support your answer with a diagram illustrating economies of scale using long run cost curves

Explain the linkage between the two concepts

## Question 7

Using at least one diagram, explain the difference between profit maximization and sales revenue maximization as goals of the firm.

You are expect to

Explain the concept of profit maximization (MC=MR) with the help of properly labelled diagram

Explain that many firms may have profit maximization as a goal.

Explain the concpet of Sales revenue maximization (MR=0), or where TR is at its maximum

Explain that sales revenue maximization may be a goal of the firm.

## Question 8

A monopoly firm decides to maximize revenue rather than profit. Use a diagram to explain what will happen to price and quantity.

You are expected to

Define monopoly

Distinguish between revenue and profit

Draw a diagram should show profit maximizing level of output (MC = MR)

Draw a diagram should show revenue maximizing level of output (MR = 0)

These diagrams should include AR(D), MR and MC curve

Support your diagram with an explanation that when there is a move from profit maximization to revenue maximization, output will increase and the price of the good will fall.

## Question 9

Using diagrams, explain the difference between the short-run and long-run profit maximizing positions of a firm in monopolistic competition.

You are expected to

Explain the characteristics of monopolistic competition

Support with an example of monopolistic competition, e.g. food, clothing, restaurants

Draw a diagram illustrating a short-run profit maximizing position, e.g. abnormal profits or losses

Draw a diagram illustrating the long-run profit maximizing position, i.e. normal profits

Explain long-run profit maximizing position and how it differs from the short-run profit maximizing position.

## Question 10

Explain why prices tend to be relatively stable in a non-collusive oligopoly.

You are expected to:

Define an oligopoly and characteristics of an oligopoly market structure

Distinction between a collusive and non-collusive oligopoly

Explanation of prices may not change due to interdependence among firms.

Support your explanation with the help of an kinked demand curve

Explain the diagram

Explain that there might be non-price competition in this kind of market structure such as advertising.

However despite their relative stability, prices may change in a non-collusive oligopoly:

– price change operated by market leaders

– long-run changes leading to economies of scale and lower LRACs.

## Question 11

Explain why an airline would want to practice price discrimination. Under what conditions would the airline be able to do so?

You are expected to

Define price discrimination

Explain that an airline would want to practice price discrimination in order

• to earn higher revenues and earn greater economic (supernormal) profits through the capture of consumer surplus
• to drive higher cost competitors out of the market by lowering prices for some consumer groups, and therefore it can increase its monopoly power

You answer should also include an explanation about how an airline can practice price discrimination:

It may do so by spliting the market and discriminate between different buyers: they can charge the elderly lower prices on certain days, give discounts for students' weekend travel, offer lower fares to travellers who make advance bookings and charge higher fares to those making their travel plans closer to the day of travel