DP 1 Study Guide for Economics chapter 5 and 6

Students please use your textbook to study for the test on Friday December
4, 2015
CHAPTER 5
1. What is the difference between a specific tax and a percentage (ad
volarem) tax?
Specific Tax - Is where a fixed amount of tax is imposed upon a product. is where
a fixed amount of tax is imposed upon a product.
Shifts supply curve vertically upward by the amount of the tax
Ad valorem tax: is where the tax is a percentage of the selling price.
Gap between S & S+tax gets bigge
Gap between S & S+tax gets bigger
When either specific taxes or valorem taxes are imposed, the market will shrink
in size (decrease in quantity), thus possibly lower the level of employment in the
market, since firms might employ fewer people. (Curve shifts up because it
increases costs of production.)
A flat rate tax is a tax which is the same rate regardless of price or income
Greater burden on those with lower income
An ad valorem tax is a tax which is a percentage of the price of a good
The United States has an ad valorem tax of ten percent
2. Why is the burden of tax different than who actually pays the tax?

Firms try to pass these increased costs on to consumers

An indirect tax raises the price of a good: its elasticity determines if the burden of
the tax is on the producer or on the consumer
In the case of a good with inelastic demand the tax burden can be easily passed
on to the consumer (PED is less than PES)
Who actually pays the tax very much depends on the elasticities of the two
curves

If the product is demand inelastic or supply elastic, the consumer

would need to bear the majority of the burden of tax
If demand is more inelastic than supply the consumer will pay a
greater proportion or incidence of tax
It is easier for consumers to shift the tax back to the producer if there
are easily available substitutes
If the product is demand elastic or supply inelastic, the producer

would need to bear the majority of the burden of tax

If supply is more inelastic than demand, the supplier will pay a greater
proportion or incidence of tax
A tax on pure profits should not have any influence on price or output,
thus the producer bears the full burden
If the govt imposed a 15% tax, then profits would fall, but this would
be true no matter what level of output would be produced
If the definition of profits includes payments to factors such as
shareholders, the incidence of a profits tax could be shared by
shareholders (lower profits on capital), wage earners (lower wages)
or by consumers (higher prices)

3.
How is the burden of tax different
depending on the elasticity of demand or
supply? Page 65

If the product is demand inelastic or supply elastic, the consumer

would need to bear the majority of the burden of tax
If demand is more inelastic than supply the consumer will pay a
greater proportion or incidence of tax
It is easier for consumers to shift the tax back to the producer if there
are easily available substitutes
If the product is demand elastic or supply inelastic, the producer
would need to bear the majority of the burden of tax
If supply is more inelastic than demand, the supplier will pay a greater
proportion or incidence of tax
A tax on pure profits should not have any influence on price or output,
thus the producer bears the full burden
If the govt imposed a 15% tax, then profits would fall, but this would
be true no matter what level of output would be produced
If the definition of profits includes payments to factors such as
shareholders, the incidence of a profits tax could be shared by

shareholders (lower profits on capital), wage earners (lower wages)

or by consumers (higher prices)
4. What is the impact of subsidy on the demand and supply of a product?
Page 68
A subsidy is a form of financial assistance paid by the government to a business
or economic sector.
Subsidy reduces the cost of production. Thus the supply curve for the

product shifts vertically downwards by the amount of subsidy provided.

5. Why does the government use price controls? How are market forces of
demand and supply NOT ALWAYS the best solution to the problem of
scarcity? Give examples.

Set to protect consumers

Usually in markets of necessity or merit goods (good that would be
underprovided if the market were allowed to operate freely)
I.e. Maximum food price controls during food shortage?ensure low-cost food for
the poor.
I.e. Maximum rent controls?ensure affordable accommodation for those on low
incomes.

6. Explain with examples and the help of diagrams the challenge of

imposing
a. Price Ceiling

Price floor

CHAPTER 6
1. Identify the following:
a. Total Costs Sum Of total fixed cost and total variable cost
b. Average Costs - total costs per unit of output: AC = TC/Q
c. Marginal Costs - the cost of producing one more unit of
output
d. Fixed Costs -: costs that do not vary with the amount of
output produced
e. Variable Costs - costs that do vary with the amount of output
produced
f. Accountants Profit
g. Economic Profit
h. Opportunity costs
i. Total Revenue - firms total earnings from a specified level of
sales within a specified period
Marginal revenue:
period of time)
MR = in TR
in Q

the total extra revenue by selling one more unit (per

Average Revenue is the amount that the firm earns per unit sold
AR = TR
Q
2. Recognize and practice drawing the shape of different cost and
revenue curves.

 In the short run capital is fixed, firms do not have time to build new
plant and equipment or get rid of obsolete ones
Only labour can be varied in the short run
As more labour is added to a fixed plant, total product will increase
Average and marginal productivity will rise at first and then tend to
fall as workers have less and less capital equipment to work with
In the long run capital can be varied, new plant and equipment
can be built, old ones destroyed or sold off
It is a planning period to allow the building of new capital, it can
actually be shorter than the short run!
In the very long run, it is assumed that new techniques can be
invented and applied which will increase productivity

3. What is the law of Diminishing returns? How does it apply to

different industries?

As additional variable units are added to fixed units, after a

certain point- the marginal product of the variable unit
declines
As more and more of the variable factor is applied to a fixed
amount of the other factor, eventually each additional unit of the
variable factor will add less to productivity

4. What are the Economies and Diseconomies of Scale?

5. What is the shut down point for a firm? Draw and explain with the
help of an example.

Shut down Price

When Marginal Revenues (MR) falls below Average Total Cost (ATC or AC), then in the
short-run it is not profitable to stay in business
The shut down price for a business in the short run is assumed to be the price which
covers average variable cost. Therefore if price < AVC then the supplier is better off
closing down a plant. We can use the concept of the shut down price to derive the
competitive firms supply curve. The supply curve is the marginal cost curve above the
shut down point
Short run:
The short run is the conceptual time period in which at least one factor of production is
fixed in amount and others are variable in amount.
Shut down Price
Short run:
The short run is the period of time in which at least one factor of production is
fixed. Over this time period the firm can only expand production by using more of
the variable factor.
Profit maximizationProfit maximization is the process of identifying the most
efficient manner of obtaining the highest rate of return from its production model.

Abnormal Profit
a profit that exceeds the amount that a company must make to be able to
continue trading

Loss
Situation in which a producer does not earn the level of profit that would justify
remaining in business in the long run.
The Short run should shut down when:
a. total revenue is less than total cost
b. total revenue is less than total cost but greater than variable cost
c. total revenue is less than total cost but greater than fixed cost
d. total revenue is greater than fixed cost
e. total revenue is more than the variable cost
The shutdown occurs if marginal revenue is below average variable cost at the
profit-maximizing output. Producing anything would not generate returns
significant enough to offset any fixed cost and part of the variable cost.
First, the firm should operate where MR = MC. Second, the firm should shutdown
rather than operate if it can reduce losses by doing so.

6. What are different aims of a firm other than profit maximization?

To maximise sales volume means to sell as many products as possible,
without making a loss. This means the firm must produce an output where the
total revenue generated from sales just covers the total costs of production.
Sales revenue maximisation- Maximising total revenue means gaining the
maximum possible revenue from selling a product. Economic theory suggest
that a price can be identified which achieves this goal. Sales revenue, or
sales turnover, maximisation is associated with 'managerial' theories of
business motives, which stress the importance of management decision
making in large organisations.
Market share Some firms may wish to increase their share of a market. This
motive is significant for firms operating in markets with a few large
competitors, called oligopolies, and where winning market share from rivals
is less risky and costly than trying to win brand new customers.
Survival Some firms take a short-term view and simply want to survive.

Survival is significant for new firms and those in highly competitive markets.
It is also common when there is a downturn or recession in the macroeconomy, meaning that consumer spending falls across the whole economy.
Shareholder value To increase shareholder value means to increase the
asset value of the business. Shareholder value is defined as the remaining
value of the business once all debts have been paid.
Ethical goals Increasingly, firms are introducing ethical goals such as those
associated with the environment and carbon emissions and with fair trade.
Satisficing Satisficing is a term first used by Herbert Simon in 1957, and
means attempting to take into account a number of different and competing
objectives, without attempting to maximise any single one. For example,
managers may first try to ensure that shareholder's get a reasonable rate of
return first, and then seek to reward themselves. Satisficing can also be
referred to as 'profit satisficing'.

PLEASE CHECK THE GRAPHS AND MAKE SURE YOU KNOW HOW TO COMPUTE
DIFFERENT COSTS