(2013) A Level H2 Econs Paper 2 Essay Q3

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3. ‘Recessions put weak firms out of business whilst strong firms use a recession to become more efficient.’

(a) Explain the relevance of different types of costs in the decision of a firm to close when faced by a fall in the demand for its products. [10]

Introduction

• Fixed costs are costs that do not change with the level of output, e.g. machinery & equipment, rent

• Variable costs are costs that change with the level of output, e.g. wages for hourly-rated workers, cost of raw materials

• Average fixed costs are total fixed costs divided by output

• Average variable costs are total variable costs divided by output

Conditions for shut-down

• The condition for which a firm should shut down in the long run is when AR < AC.

• The condition for which a firm should shut down in the short run is when AR < AVC.

Impacts of a fall in demand for a firm’s products

1. When there’s a fall in demand for a firm’s products, as seen in Figure 1 below, DD0=AR0 and MR0 will both shift leftwards.

2. This can cause AR to be now less than AVC

3. If AR cannot cover AVC, then the firm should shut down

Fixed costs versus variable costs

1. In deciding whether to shut down, firms should consider only variable costs and not fixed costs

2. Fixed (or sunk) costs are incurred regardless of level of output and thus are no longer key / material consideration to whether a firm should continue operations.

3. To continue operations, a firm should make enough revenue to cover its variable costs.

4. If AR > AVC, then a firm should continue its operations since it can cover its variable costs and would also be able to cover part of its fixed costs (which is a bonus)

5. If AR < AVC, then a firm should shut down its operations. Variable costs are incurred only when a firm produces output. If a firm cannot even cover its variable costs, then it should shut down to avoid making more losses.

(b) Discuss the extent to which firms faced by high levels of competition are more vulnerable to closure in a recession than firms in less competitive industries. [15]

Introduction

As mentioned in a), in a recession, demand for a firm’s good could potentially fall given a fall in incomes. This will shift both the AR & MR curves to the left.

Retained supernormal profits for firms in less competitive industries

1. In less competitive industries, such as that of an oligopoly or a monopoly, there are high barriers to entry

2. The high barriers to entry gives rise to supernormal profits in the long run

3. This is so as the high barriers to entry prevent new entrants from coming in to the market and erode away the profits of the incumbent firms

4. Thus, in less competitive industries, there can be a build-up of retained supernormal profits.

5. In a recession, firms in less competitive industries can rely on the retained supernormal profits to survive and continue paying for operational costs and avoid the situation of having to shut-down

6. Firms faced with high levels of competition like that of a monopolistic competitive market structure will make only normal profits in the long run.

7. This thus means that they do not have such retained supernormal profits to fall back on to fund losses during a recession.

Low fixed costs for firms faced with high levels of competition

1. In less competitive industries, there tend to be more fixed costs (associated with the higher barriers to entry) such as cost of research and development, rental of large premises and venues, hiring of management staff & the purchase of expensive equipment, building of extensive infrastructure

2. While in more competitive industries, fixed costs tend to be lower

3. In a recession, the fall in demand will cause price and average revenue to fall.

4. Given the lower fixed costs, the demand (and therefore price) will have to drop much lower before firms will reach their shut-down price

Firms producing inferior goods

1. Inferior goods are goods with a negative YED value, where demand increases when income decreases and vice versa

2. In a recession, income falls, and firms producing inferior goods will experience an increase in demand

3. Firms selling inferior good are likely faced with high levels of competition as there are typically low barriers to entry (e.g. sale of close-to-expiry food)

4. These firms are thus not likely to shut down as revenue will increase instead.

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