Chapter 7: Costs, Revenue and Profits

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

The two concepts, marginal costs an average total costs are related to each other because when one changes, the other will change too. To find marginal costs all you need to do is divide the average total costs by the amount of quantity. This shows that the two are related to each other because to find one, you must look at the other.

Define the law of diminishing returns and assess the likelihood that it will be experienced by a firm producing a product in a consumer good market.

The law of diminishing returns shows us the effects of changing one variable that will effect production of a product (typically this variable is labour) while other factors of production like land and capital remain the same. Typically marginal productivity will decrease, but this does not mean that a firm will receive negative returns UNLESS the amount of workers exceeds the amount of space available. The likeliness that a firm producing a product in a consumer good market will experience the effects of the law of diminishing returns is high because products like food, clothing and automobiles must all go through a process dictated by labour to reach the final product. Therefore, a workplace might become overcrowded if a firm was trying to reach its potential in the short run, thus demonstrating the law of diminishing return. This might happen on a smaller scale, a firm might not go as far as overcrowding their workplace but workers might not be as effective as they could be. If we use a fast-food joint like McDonalds as an example, if they firm was trying to maximize profits in the short run they would begin to employ more workers, but because they still have the same amount of ovens and fryers then return will begin to diminish after certain point.

Chapter Five: Government Intervention

Explain the concepts of maximum and minimum price controls.

Often, because the market can be such a competitive place, there are times when not everyone can afford some of a necessity. In these kinds of situations a government might choose to intervene by implementing a maximum price on specific products. When a government does this, it is called enforcing a price ceiling. If this were to happen it would have been because the government saw a potential rise in price, which would have made the product unaffordable to poorer residents. Although, intervening in this manner has its faults – it can cause shortage, rationing, decreased market size, elimination of allocative efficiency and informal (black) markets.

Governments also have to intervene in situations where the price is too low. This is called minimum price control. When a government does this, it will enforce a price floor, which means it will artificially the prices of some goods and resources. These instances normally happen when a good is a necessity or is supporting employment. But just like maximum price control, it has several faults – it can cause surplus, reduced market size, cost inefficiency, allocative inefficiency, and informal markets.

Evaluate the idea that government intervention in the form of price ceilings and price floors is well intentioned, but often leads to undesirable side effects.

Whenever a government intervenes to enforce a price ceiling or a price floor, it is almost always for the good of the people so that necessities are affordable. However, often these interventions will lead to undesirable side effects. A common circumstance where the government might choose to intervene is with rent prices. New York city is one of the most expensive places to live in the world, which is why it might not be affordable to those that aren’t earning a big figure for their salary. For this reason, the government might decide to enforce a price ceiling so that the maximum price of an apartment to rent is affordable to those involved in professions like teaching. But when this happens, there might be a shortage, the low price for apartments will increase the amount of demand but also there will be a decrease in supply because they will not be making as much profit. This will also cause rationing, while will result in a decreased market size. Also an informal market might begin to form so that producers are making as much money as they can do. Also owners of apartments will lose all incentives to maintain their building because they are not making as much profit.

Select a product and create a market supply and demand diagram.

• Show the equilibrium price and quantity, and set a binding price ceiling
• Calculate the change in consumer expenditure/producer revenue
• Identify and calculate the government subsidy expenditure needed to eliminate the shortage

Select a product and create a market supply and demand diagram. (Mr. Nguyen, I’m not sure about the consumer expenditure and the subsidy needed to eliminate surplus in this question)

• Show the equilibrium price and quantity, and set a binding price floor
• Calculate the change in consumer expenditure/producer revenue
• Identify and calculate the government subsidy expenditure needed to eliminate the surplus

What is the effect of price controls on allocative efficiency?

Allocative efficiency refers a time in a market when the marginal benefit equals the marginal costs (MB = MC). However, when a government tries to control price (often by enforcing price ceilings and price floors), it can be fatal to allocative efficiency. This is because a price control like a price ceiling means that the marginal benefit will not be equal to the marginal cost. By exerting a price ceiling there will be a shortage in supply, because society is not producing enough of the good with the price ceiling in place. Or if a government exerted a price floor the high price will inspire producers to produce at a quantity where the marginal cost is a lot higher than the marginal benefit. Supply will not equal demand.

Evaluate the effectiveness of rent control.

One type of a price ceiling is rent control. Rent control is implemented when housing is too expensive for low-income citizens. Although rent control is enforced with good intentions, it is not very effective. Producers or renters will become frustrated and try to find loopholes. One of these loopholes is to bid the effective price higher by paying direct payments to owners. Another negative impact rent control has is it lowers the amount of supply of housing, renters will take their houses or apartments off of the market and try and rent it out somewhere where they will receive a higher payment (often on black markets, which is illegal). The producers that do decide to stay on the market lose incentive to maintain their buildings, which can lead to unsafe and poor-quality housing.