A Firms Process of Production - Assignment Example

Finance and Accounting Question 1a. The table below summarizes various aspects associated with a firm’s process of production. There are nine columnsin the table, which plot values of the variables of a particular firm. The first column shows the output that can be defined as tangible goods or intangible services, which are produced as end result of a production process (Gillespie, 2001). The second column shows possible combination of units of price that can be charged by the firm. The third column shows total revenue and total cost for the firm. The other columns are explained as: Total Profit= Total Revenue-Total Cost Average Total Cost= Total Cost/ Output Average Revenue= Total Revenue/ Output Marginal Revenue= change in Total Revenue/ change in output= d(TR)/ d(Q) Marginal Cost= change in Total cost/ change in output= d (TC)/ d (Q) Table 1 Output Price Total Revenue Total costs Total profit Average Total Cost Average Revenue Marginal Revenue Marginal cost 0 1 0 500 -500 0 0     200 2 1000 1200 -200 6 5 5 3.5 400 3 2000 1700 300 4.25 5 5 2.5 600 4 3000 2700 300 4.5 5 5 5 800 5 4000 3900 100 4.88 5 5 6 1000 6 5000 4850 150 4.85 5 5 4.75 1200 7 6000 6100 -100 5.08 5 5 6.25 1400 8 7000 7200 -200 5.14 5 5 5.5 The graphical presentation of total revenue, total cost and total profit has been shown in the following figure. Figure 1: Graph showing TR, TC and Total Profit (Source: Author’s creation) The graph below shows the profit maximization condition for the firm. The y axis represents cost of per unit of production and the x axis plots amount of output that is produced by the firm. Figure 2: Conditions of profit maximization (Source: Authors Creation) On analyzing this graph, it can be clearly understood that the firm is working under conditions of perfect competition. This is because average revenue is equal to marginal revenue for every unit of production. This is because demand curve is a straight horizontal line indicating that the firm is a price taker in market with no power to influence market price. The demand curve is represented by a horizontal line, where MR=AR=P (Gillespie, 2011). As prominent from the table, AR=MR for each unit of production. As the condition of profit maximization requires P=MC for a perfectly competitive market, it can be said that this occurs when output produced is 600 units. The equilibrium price is five units. In the above graph, this point is shown where marginal cost line cuts the demand curve. The main characteristics of perfectly competitive market can be summarized below (Mahajan, 2008): The primary assumption is that there is infinite number of sellers in the market. This makes producers accept the price that is determined by forces of demand and supply for which they are categorized as price takers. This automatically implies that there is no control over price of products. Secondly, there is no distinction between products that are being sold in the market. The products are termed as homogenous and can be regarded as perfect substitutes of one another. Thirdly, this type of a market structure also implies that there are no barriers to entry. The conditions of exit do not involve any barrier either. Fourthly, a perfectly competitive market eliminates scope of advertising and any other promotional measures for selling products. As the products are homogenous in nature, additional promotion is not required. One of the most important features of perfect competition is that firms can earn abnormal profit only in short run. In long run, they are bound to earn normal profits. The amount of normal profit shows the extent of production that is necessary for the firm to remain competitive. Normal profit occurs under the condition, where total revenue of a firm is equal to its total cost of production (Armitage, 2005). Abnormal profits cannot be earned in perfect competition because any abnormal profit earned by a firm will force new firms to enter the market as there are no entry barriers. This will cause a rightward shift of the supply curve, thereby lowering prices charged by the firm. This condition will persist until the firm moves to a point, where it earns normal profit once again. As a result, firms earn only normal profit in a perfectly competitive market (Sherman, 1989). Question 1 b. Table 2 Quantity Price Total Revenue Marginal Revenue Marginal Cost Average Cost Elasticity 0 24 0 24 1 23 23 23 17 19.4 -47.00 2 22 44 21 13 16.2 -15.00 3 21 63 19 10 12.7 -8.60 4 20 80 17 8 9.3 -5.86 5 19 95 15 6 6 -4.33 6 18 108 13 12 8 -3.36 7 17 119 11 14 9.8 -2.69 8 16 128 9 16 10.2 -2.20 9 15 135 7 19 11.3 -1.82 10 14 140 5 21 11.9 -1.53 11 13 143 3 22 12.6 -1.29 12 12 144 1 24 13.4 -1.09 13 11 143 -1 25 13.9 -0.92 14 10 140 -3 27 14.5 -0.78 15 9 135 -5 29 14.9 -0.66 16 8 128 -7 30 15.4 -0.55 17 7 119 -9 31 15.8 -0.45 18 6 108 -11 33 16.5 -0.37 19 5 95 -13 35 17.3 -0.30 20 4 80 -15 36 17.9 -0.23 21 3 63 -17 38 18.4 -0.17 22 2 44 -19 39 19.3 -0.12 23 1 23 -21 40 20.4 -0.07 24 0 0 -23 40 21 -0.02 The elasticity column has been calculated by using mid-point formula. The formula is (Wilkinson, 2005): Elasticity= [(Q2-Q1)]/[(Q2+Q1)/2]/[P2-P1]/[P2+P1]/2 This formula is generally used to calculate price elasticity of demand between two points on the demand curve. The numerator represents percentage change of the quantity, whereas denominator is the representation of percentage change of price. Both are calculated by using mid-point method. The following graph shows demand curve, marginal revenue curve, marginal cost and average cost curve of the firm. Figure 3: Graph showing AR, MR, MC and AC (Source: Author’s creation) The standard economic theory states that profit maximization occurs at the point where MR=MC. This is the first order necessary condition for profit maximization. The second order condition demands that marginal revenue must be falling and marginal cost must be rising (A. J. Hoag and J. H. Hoag, 2006). Based on these conditions, it can be said that this occurs when marginal revenue curve cuts the marginal cost curve. The second order condition is also fulfilled at this point as marginal cost is rising and marginal revenue is falling. This signifies that at equilibrium, price that is being charged by the firm is close to 19 units and quantity of output that is being produced is around 7 units. ‘A’ marks the point of profit maximization for the firm. Figure 4: Graph showing profit maximizing condition (Source: Author’s creation) The above graph simplifies figure 3 and tries to locate the equilibrium output and price of the firm. The profit that is being earned at this point has been shown by using a shaded region in the graph. It can be observed from the graph that cost that is required by the firm to produce this quantity of output is close to 8 units and price that is charged by the firm is 18 units. Profit= Equilibrium output * (Price charged from customers-Cost incurred in production) = 6 * (18-8) =60 This result is also consistent with profits tabulated in Table 2. Figure 5: Graph showing TR, TC and Profit (Source: Author’s creation) The above graph shows total cost, total revenue and total profit of the company. Table 3 The total cost for the company has been calculated by using the following formula. Total Profit= Total Revenue-Total Cost Total Cost= Total Profit-Total Revenue The relationship between elasticity of demand and total revenue curve has been widely discussed in economic literature. It has been observed that if demand curve is linear, which is true in this case, then consumers tend to be more price sensitive when the initial price is higher. As one moves down the demand curve, the prices fall, thereby reducing price sensitiveness of consumers. This trend has also been observed in this particular case. The figures plotted in Table 3 clearly indicate that initially, when prices are higher, consumers react strongly with one unit reduction in price. However, values tend to fall consistently as the price continues to fall and consumers’ responsiveness to price change fades. The lower values of elasticity in Table 2 indicate that customers become less sensitive to price change. Hence, it can be concluded that demand curve is more elastic in its upper half, perfectly elastic at the mid-point and less elastic at the lower half. Question 2 The existing literature emphasize that different researchers have identified multiple sources of business cycle. Over years, a number of approaches have been developed in order to point out sources of business cycle fluctuations (Mankiw, 2011). One group of researchers has indicated country specific or industry specific shocks as the main reason that leads to fluctuations in the business cycle. The common element in these researches is that there has to be presence of an external shock, which may be country specific or industry specific. Another group of researchers have identified the role of international trade in business cycle fluctuations. A third approach that has developed over time applied dynamic general equilibrium models based on unconditional correlations for explaining the process of business cycle fluctuations. Some of the common sources that have been identified are adverse or favourable technological change, oil price shocks and permanent shifts in labour supply. Shocks of investment have also been recognised as one of the major reasons that cause business cycle fluctuations. The contemporary literature shows that recession in recent times occurred mainly during financial shocks. This is closely related to investment efficiency shocks as this is often found to be the guideline that determines financial shocks. In recent times, importance of technology shocks as a source of recession has declined, which has been validated by a number of independent research works (McEachern, 2012). The works of Greenwood, Hercowitz, and Huffman (1988) had first identified the importance of marginal efficiency of investment as a primary cause of recession. The global economic meltdown of 2008 could be largely attributed to bursting of the credit bubbles in U.S. economy, which had soon resonated in other powerful economies of the western world. Additionally, the research conducted by Hirose and Kurozumi (2010) had also confirmed that business cycle of investment in Japan during the 80s and 90s was also accountable for shock in the investment efficiency (cited in Prasad, 1999). The global economic downturn of 2008 had adversely affected the economy of both U.S. and U.K. In U.K., it was particularly observed that recession had adversely affected the lives of people as well as business community as a whole. The most severe impact was felt through loss of jobs. Disparity in employment has also been observed at regional level in U.K. North East U.K. had recorded maximum unemployment rate of 8.4 per cent, while that of Scotland is 5.1%. There were huge cuts in consumption spending, which had affected life standards of the people. Capital spending had dropped by 10%, which in turn had reduced investment by 18%. The GDP of the country had contracted in 2008 and 2009 and negative growth was recorded. The real income of the economy had stagnated due to rise in the rate of inflation. The trade sector of the economy had also suffered when there was a fall in global demand for goods. As a result, exports from U.K. had fallen automatically. The economy of the U.S. was also adversely affected, considering it was epicentre of the problem. The crisis that had begun in 2008 in the housing sector was observed to promptly cripple the entire economy as negative impacts were felt in other sectors of the economy as well. Declining investments in the residential sector were noted from the beginning of 2005. Nonetheless, significant decline in double digits occurred during the first quarter of 2008. The immediate impact was felt in labour market. Unemployment rates had reached 9.4%, which is considered as the highest since 1983. Investment in the business sector had also begun to show decline, immediately after the bursting of housing bubble when it fell by 35.5%. The spending of people on personal consumption had also started to slump in 2009 and recorded a fall of -4.3%. In the fourth quarter of 2008, export of the American economy fell by 23.6%. Similarly, imports had also slumped for the U.S. economy. As a result of these adversities, economy had weakened considerably affecting lives of middle class Americans. The global financial crisis of 2008 had witnessed a number of unconventional monetary and fiscal policies that had been adopted by governments of the U.S.A. and the U.K. The Central Bank of the U.S.A. had immediately introduced a policy termed as quantitative easing in order to solve short-term crisis. The immediate response by the government was to lessen taxes imposed on people and increase level of public spending. The rationale for introducing quantitative easing was to stimulate economy on multiple levels. Generally, during recession, governments of all countries tend to adopt expansionary monetary policy in order to influence interest rate in the market. A slight change in interest rate in the market can affect other key rates of the economy, including that of bonds issued by the government, of mortgage loans and of auto loans. The idea was to increase aggregate demand in the economy to pull out of the recessionary trap. It was argued that a lower interest rate charged by the central bank would provide incentive to firms for hiring more workers. Similarly, a cut in the taxes by the government was introduced in order to enhance consumer spending. The Central Bank of the U.S.A. began to purchase bonds from the government like, treasury and mortgage backed securities, so that it can keep the interest rate lower in long run. This in turn raised money supply in the economy (Liber8, 2011). In case of U.K., policies followed were similar to that of the U.S.A. The Bank of England had also adopted an expansionary monetary policy. The chief element of the monetary policy was to purchase assets with funds provided from Central bank. The purchase of government securities to stimulate the economy was known as quantitative easing. From 2009 to 2010, over 200 billion dollars was invested in this process, which represented about 14% of total GDP. The rationale for practising quantitative easing was again similar to that of the U.S.A. The Central Bank wanted to stimulate nominal spending of the economy. The government had also immediately retaliated by introducing fiscal stimulus package in order to reduce impact of recession. Fiscal stimulus package of 20 billion pounds were incorporated right after the recession had hit the economy in 2008. Cuts in taxes were also made to boost the economy as VAT was lowered from 17.5% to 15%. Other measures included rise in income tax personal allowance and boost in the capital spending. All these policies were adopted in order to help the economy cope with the pressure of recession in short run. Few actions were also taken to help small businesses for improving their cash flows. The businesses were encouraged to delay their repayments of tax for an extended time, which in turn improved their cash flows. There was also reduction of corporation tax for small companies. The outcome of such expansionary fiscal policy was a rise in the government debt (Joyce, Tong and Woods, 2012). The forecasts about the U.K. economy indicate that economic growth will gain pace towards the end of 2015. However, it is expected that unemployment problem of the economy will persist longer. Even harsh critics of the U.K. economy had predicted that the economy will attain around 4% growth towards end of 2016. Though the current figure implies that growth of the economy in 2014 is about 1.5%, yet forecasters are confident that this situation will better from the end of 2015. Nevertheless, these results are always controversial as different publications and forecasters have separate methods of forecasting and their assumptions are dissimilar. For this particular reason, value of the growth and unemployment projections alters continuously. Most of these predictions have one common factor in them. All of them have shown that the economy will continue to recover in coming years. Only intensity of the recovery is different according to forecasters (BBC News, 2014). In context of U.S. economy, it has been predicted that economic growth will accelerate by the end of 2014. The growth of the economy had been considerably slower in 2013. Even so, it is believed that growth would gain pace by 2014. Regarding employment, it has been confirmed that rate of unemployment will remain considerably higher in 2014-2015. The rate of unemployment has been expected to be around 7.5% towards the end of 2014 (CO Bank, 2013). The value of dollar is expected to decline in forthcoming years, which can pose difficulty for economy of the U.S.A. in long run. The government has shown confidence that despite the long-term problem of high unemployment rate, growth rate of employment will be moderate in short-run, which can bring some respite to the economy. This is because continued decline in dollars will make investors diversify their portfolio with currencies of other countries that are relatively stronger. Despite this prediction, most economists believe that the decline will be necessary to boost exports of the American economy. This will in turn fuel growth for the economy (LAEDC, 2014). Reference List Armitage, S., 2005. The cost of capital: Intermediate theory. Cambridge: Cambridge University Press. BBC News, 2014. Budget 2014: Growth forecasts raised for 2014 and 2015. [online] Available at: < http://www.bbc.com/news/business-26648201> [Accessed 3 June 2014]. CO Bank, 2013. Growth prospects for the U.S. economy. [pdf] CO Bank. Available at: [Accessed 3 June 2014]. Gillespie, A., 2001. Advanced economics through diagrams. London: Oxford University Press. Gillespie, A., 2011. Foundations of economics. London: Oxford University Press. Hoag, A. J. and Hoag, J. H., 2006. Introductory economics. London: World Scientific. Joyce, M., Tong, M. and Woods, R., 2012. The United Kingdom’s quantitative easing policy: design, operation and impact. [pdf] Bank of England. Available at: [Accessed 3 June 2014]. LAEDC, 2014. 2014-2015 economic forecast & industry outlook. [pdf] LAEDC. Available at: < http://cdn.laedc.org/wp-content/uploads/2014/02/LAEDC-2014-15-February-Forecast-Report.pdf> [Accessed 3 June 2014]. Liber8, 2011. Fiscal and monetary policy in times of crisis. [pdf] Economic Information Newsletter. Available at: [Accessed 3 June 2014]. Mahajan, M., 2008. Managerial economics. New Delhi: Nirali Prakashan. Mankiw, N., 2011. Principles of economics. Connecticut: Cengage Learning. McEachern, W. A., 2012. Economics: A contemporary introduction. Connecticut: Cengage Learning. Prasad, E., 1999. International trade and the business cycle. Washington: International Monetary Fund. Sherman, R., 1989. The regulation of monopoly. Cambridge: Cambridge University Press. Wilkinson, N., 2005. Managerial economics: a problem-solving approach. Cambridge: Cambridge University Press. Read More