H2 ECONOMICS

REVISION SERIES
TERM 3 WEEK 5 LECTURE 1 BAND B2
2013 A LEVELS QUESTION 3
 QUESTION
“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 cost in the decision of a firm to
close when faced by a fall in the demand for its products. [10]
(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]
 FOCUS OF THE LECTURE

• How to rephrase questions when it is too complicated and long?

[SKILLS]

• Content knowledge from Market Structure [KNOWLEDGE]

 PRACTISE 1:

Explain the relevance of different types of cost in the decision of a firm to close
when faced by a fall in the demand for its products.

Key terms: EXPLAIN, RELEVANCE OF DIFFERENT TYPES OF COST,

DECISION TO CLOSE, DEMAND FOR PRODUCTS FALL

What does this

mean in your
own words?
 WHAT GOES ON IN THE HEAD…

THOUGHT 1: WHEN FIRMS FACE A FALL IN DEMAND OF THEIR

PRODUCTS, THEY SHOULD BE MAKING A SUBNORMAL PROFIT
[ASSUMPTION]
THOUGHT 2: SINCE MAKING SUBNORMAL PROFIT (TR < TC), SHOULD
THEY CLOSE?
THOUGHT 3: WHAT ARE THE COSTS THAT ARE RELEVANT TO THIS
DECISION? SHUT DOWN CONDITION?
THOUGHT 4: BUT THIS IS ONLY FOR SHORT RUN? WHAT ABOUT
LONG RUN?
 BASED ON THAT…

REPHRASE:

EXPLAIN WHICH TYPE OF COST ARE RELEVANT IN FIRMS

MAKING DECISION TO SHUT DOWN IN THE SHORT RUN &
LONG RUN IF MAKING SUBNORMAL PROFIT
[Explain the relevance of different types of cost in the decision of a
firm to close when faced by a fall in the demand for its products.]
SUGGESTED SOLUTION FOR PART (A) [SUMMARY]

TYPE OF PROFITS

NORMAL /
SUBNORMAL
SUPERNORMAL
 FOR THE NON-VISUAL LEARNERS…

[ASSUMPTION] Fall in demand will result in the firm making losses which in
this case is that TR < TC.

The conditions for whether a firm should shut down would be dependent on the

TIME PERIOD
 LECTURE BOOKLET
SHORT RUN TIME PERIOD Pg15-25

1) Making subnormal profits does not immediately mean shut down.

2) Total cost in the short run consists of Total Fixed Cost (TFC) and Total Variable
Cost (TVC)

3) If TR can cover TVC (AR > AVC), the excess revenue over the variable cost can
be used to write off the fixed cost hence makes it worthwhile to stay in production.
RELEVANT COST TYPES: TOTAL VARIABLE COST
 LECTURE BOOKLET
LONG RUN TIME PERIOD Pg15-26

• Total cost in the long run is purely variable cost (LRTC = LRTVC)

• Hence in this case, if the subnormal profit is made in the Long Run time period,
the firm should immediately shut down.

• RELEVANT COST TYPE: TOTAL COST

 PART 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.

Rephrase: Discuss whether low market power firms (example MC firms) are more
prone to shut down as compared to high market power firms (example Oligopoly
or Monopoly) in times of recession.
 SUGGESTED SOLUTION
Introduction
Provide examples of firms in a competitive environment (MC firms) – travel agencies; confectionary shops
●

Provide examples of firms in less competitive environment (Oligopoly) – Mobile service providers; cable TV
●

service provider

Characteristics MC firms – small firms with low start up costs and low capital funding
●

●
Oligopolistic firms – large firms with high start up costs and large financial backing

Thesis Due to the different characteristics of the two market structure

●

firms, it is more likely for the MC firms to close down

Anti-thesis The firms in the more competitive environment may not be more prone to closing (AT1)
●

In fact, the firms in the less competitive environment may be more prone to closing down (AT2)
●
 THESIS (MC FIRMS MORE PRONE TO CLOSING DOWN)
• Recession  falling revenue  cash flow problems and forced to close down
(Small firms with less capital funding)
• Firms in MC market structure long run normal profits  more vulnerable to
making losses during recession
• Big firms have large financial backing  more funds to tide over difficult period
 can do R & D and innovation
• Big firms can merge to take advantage of EOS / diversify risk
 ANTI-THESIS 1 (MC FIRMS ARE LESS PRONE TO CLOSING
DOWN)
• Small firms easier to adapt to changing market conditions (in fact could switch
to producing inferior goods in the face of falling income)
• MC firms are small firms that face low start up costs. With low fixed cost and
also variable cost, it can be seen from Part a that it would take very low TR to be
lower than TVC (Shut down condition in SR).
• Due to competitive nature, the firm has a higher chance of achieving productive
efficiency hence the cost should already be the lowest possible. Harder to reach
shut down condition.
 ANTI-THESIS 2: OLIGOPOLISTIC MORE PRONE
TO SHUTTING DOWN
• With the firms earning past supernormal profits, no incentive to opt for lowest
cost of production
X inefficiency  overspending on equipment, underspending on maintenance
of equipment, unwillingness to invest in better machinery or streamline processes
Results in TC being unexpectedly high and a falling TR could result in these
firms close down
[Dependent on the extent of Supernormal profits that the firm had previously
earned (the extent of the fall in AR/MR)  Diagrams to show both scenarios]
PRE RECESSION SCENARIO
AC

MC

PRIOR TO RECESSION
THE FIRM IS MAKING
SUPERNORMAL PROFIT OF
THE SHADED AREA.
DECISION ON WHETHER TO
SHUT DOWN IS NOT NEEDED

MR AR
POST RECESSION SCENARIO
AC

MC
RECESSION SETS IN. THERE IS
A FALL IN THE DEMAND FOR
THE PRODUCTS.
THE FIRM IS MAKING
SUBNORMAL PROFIT OF THE
SHADED AREA.
DECISION ON WHETHER TO
SHUT DOWN IS NOW NEEDED

MR AR
 POST RECESSION SCENARIO 1: SHUT DOWN
AC
AVC
MC
With the subnormal profit
experienced, the AVC would now
be important in determining
whether to shut down.
P2
P1 In this case,
AR (P1) < AVC (P2)
so must shut down!

MR AR
 POST RECESSION SCENARIO 2: C
AC
AVC
MC
With the subnormal profit
experienced, the AVC would now
be important in determining
whether to shut down.
P1 In this case,
P2 AR (P1) > AVC (P2)
so continue production!

MR AR
 EVALUATION
• Whether a firm is more susceptible to closing down during a recession though
largely depends on the market structure it belongs to but it also is dependent
on:-
1) The nature of the product sold (necessity, luxury, inferior goods)
2) The past operational decisions and also the investment in R & D (time period
is long and hence cannot be regarded as a measure against recession)
3) The extent of the fall in the AR/MR