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1.- THE IMPACT OF THE LAW OF DIMINISHING MARGINAL RETURNS ON MARGINAL COST
AND AVERAGE TOTAL COST

The Law of diminishing marginal returns only occur in the short run ¿Why? Because in the long run
all the factors of production are variables and the law of diminishing marginal states its conclusion
presupposing that at least one of those factors is fixed. When one of the variable factors is increased,
the productivity increases too, but only until certain point, where the productivity starts decreasing.

Let’s use the college as an example. Let’s suppose that we have 4 classrooms and enough students to
fill them (and even people in waiting list). We hire the first teacher for one classroom and every
student pay the fee for the course, so the fixed costs begin to be distributed among the several
students.

We hire our second, third and fourth teacher, fulfilling every classroom with students who pay the
fees, which means that our productivity continues raising and our Marginal and Average Total Costs
decreasing. One teacher per group is more than enough and the college cannot provide us more
classrooms. In this case, the facilities are our fixed factor and the teachers are our variable factor
(labour), so from now on every teacher we hire is going to be an additional cost which will not generate
any other extra output (there is no more facilities therefore there is no place for more students, the
ones who pay the fees).

In conclusion: Once we have reached this situation with the fourth teacher, where MC = ATC
(Optimum Output) it is not worthy to contract more staff. After this point, the Marginal Cost increases
dramatically and so does the Average Total Cost due to Diseconomies of Scale.

In the long run, the college could think in acquire new facilities to set new classrooms and, therefore
contract more teachers and accept more students.

Let’s have a look to a different example, this time with more concrete figures:

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2.- THE LONG RUN AVERAGE COST CURVE AND THE INFLUENCES UPON IT

As we can say in the diagram above, LRAC curve is made by all the SRAC curves, so the sum of all the
short run periods is equals to the long run period.

While in the short run at least one of the factors has to be fixed, in the long run all the factors are
variables.

The LRAC is the cost per unit of output when all the factors of production are variables. When the firm
expands its capacity of production in the long run it allows to produce more output. The more output
the firm produces, the more the ATC is reduced.

Let’s continue using the college case of the previous question as an example. As we said before, the
Optimum Output point is reached with 4 teachers teaching in 4 classrooms (we considered that there
were a long waiting list of students, so there will not be any problem in fulfilling the classrooms). In
the short run we were limited for the capacity of the facilities but in the long run, being variable all
the factors, the college can consider to expand the number of classrooms.

So, hiring a fifth teacher in this case, the college could fulfil another classroom composed by
approximately 20 students who pay the course fees each one, reducing the ATC even more as there
are more output (students) to distribute the costs among them thanks to the effect of what we call
Economies of scale (The MC of hiring a new teacher would be also quite low, as the teacher is only
one person receiving a wage and there are going to be at least 20 students who pay course fees). The
college will continue enabling new classrooms and hiring new teachers until they reach the new
Optimum Output, moment in which the ATC will begin to increase due to the opposite effect:
Diseconomies of scale.

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3.- THE CONCEPT OF PROFIT MAXIMISATION WHERE MARGINAL COST EQUALS MARGINAL
REVENUE

Coming back to our College example: they will continue accepting students as long as the profit ia
increased. However, if a class is full and there are only 3 students in waiting list, the college should not
just hire a new classroom and teacher for those 3 prospect students as the cost would be far higher
than the revenue got with the course fees of the students. That means, the MC would overpass the
MR, making the operation unprofitable. In conclusion, the profit maximisation is found in the point
where MR=MC.

Let’s see a different example with numbers:

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In this case, the Marginal Revenue and the Marginal Cost are equals when the company reaches the
output of 2.5 units.

According to the law of diminishing of marginal returns, at certain point producing more output
requires more and more input, being this the reason why eventually the MC curve intersects the MR,
as it is shown in the diagram on the left.

Looking at the right-hand diagram we can clearly see that, at the same point where MC intersects MR
in the left-hand graph, the distance between the Total Revenue and the Total Cost curves is the
farthest, so the profit is maximized, as we can also see if we have a look to the Profit curve.

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4.- THE UK ENERGY MARKET FOR ELECTRICITY AND GAS

a) Making references to the UK energy market for electricity and gas, describe the
characteristics of an oligopoly

There are several reasons which make the UK energy market an oligopoly:

1.- A few large firms dominate the Market.

The UK energy market is controlled by 6 large companies known as “The big 6”: SSE, Scottish Power,
Centrica, RWE npower, E.ON and EDF Energy, which control more than the 96& of the market.

2.- Product differentiation.

One of the main features of the oligopoly is the sale of a similar product using a strong brand identity
to compete in the same market. In this case, as the product offered is the same for all the companies,
they use non-price competition strategies as marketing or special offers for new/loyal customers to
compete.

3.- When the companies agree amongst themselves to restrict competition and maximise their own
profits, this situation is known as collusion. The government recognises the collusion and mystification
of pricing information that has been operating within the UK energy market.

4.- THE UK ENERGY MARKET FOR ELECTRICITY AND GAS

a) With reference to the theory of oligopoly explain the price and output
behaviour of the large UK energy firms

In an oligopolistic situation, normal demand curve can’t be used to analyse the changes in the market
share of a company when it makes changes in the price due to the uncertainty which governs in this
kind of environments.

For that reason, there is a different diagram to explain this situation: The Kinked Demand curve.

Being E the equilibrium point, if a company raised the price

and others leave it constant it is likely to expect a substitution
effect which will make demand elastic. The company which
raised the price will lose market share and therefore revenue.

On the other hand, if a company lower the price under E, the

competitors will follow its movement. If every company in the
market do that, the only benefited will be customers as they
get a lower price, but the companies will earn less revenue
producing the same output.

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5.- EXPLAIN WHY FIRMS CANNOT MAKE SUPERNORMAL /ABNORMAL PROFITS IN THE
LONG -RUN IN A PERFECTLY COMPETITIVE MARKET

First, let’s define what is normal profit and supernormal/abnormal profit:

- Normal profit: Minimum level of profit required to keep the company in the market. Normal
profit is reached when Average Revenue (AR) = Average Total Cost (ATC).
- Supernormal/Abnormal profit: Extra profit that overpass the normal profit. It happens
when AR > ATC. This situation acts as an incentive for other companies to enter the market.

Then, the companies in a perfect competition market situation can make supernormal profits in the
short run. The first diagram (left below) shows the equilibrium point of the market. The one on the
right shows how as long as the ATC curve is kept under the AR curve, the companies will make
supernormal profits.

As we saw before, this supernormal profit attracts other companies to the market which can freely
enter as there are perfect information and no entry barriers. However, this will have consequences
for sure:

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The Supply curve moves to the right when new companies enter the market. The prices go down to
adjust the changes suffered until supernormal profit is exhausted and only normal profit is made.
Finally, the non-profitable companies leave the market and the Supply curve comes back to the left,
raising the price and allowing the firms which left in the market get normal profits.

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6.- SATISFICING BEHAVIOUR – H. SIMON (1959)

This theory states that the only target of a company is not only make profits but it looks for other kind
of achievements such as Increasing sales, increasing market share or increasing the size of the firm.

The person on charge in each one of the company departments will chase a particular goal related
with that area. However, if what the firm wants is to reach a determined status of development, all
the managers must agree and lead the individual targets of their departments towards a common
objective.

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SOURCES

QUESTION 1

http://www.economicshelp.org/microessays/costs/diminishing-returns/

http://www.economicsonline.co.uk/Business_economics/Costs.html

QUESTION 2

http://www.tutor2u.net/economics/reference/long-run-average-cost-lrac

QUESTION 3

https://www.quora.com/Microeconomics-Why-profit-is-maximum-when-Marginal-Cost-equals-
Marginal-Revenue

http://www.investopedia.com/ask/answers/041315/how-marginal-revenue-related-marginal-cost-
production.asp

https://www.slideshare.net/mfladlien/why-marginal-revenue-equals-marginal-cost-determines-
profit

QUESTION 4

https://www.crowdcrusader.com/campaigns/stop-the-oligopolistic-exploitation-of-uk-consumers-
by-the-big-6-energy-com

http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=oligopoly,+characteristics

http://www.independent.co.uk/voices/finally-the-big-six-energy-oligopoly-shows-signs-of-breaking-
a6824066.html

https://www.tutor2u.net/economics/reference/oligopoly-the-uk-market-for-electricity-and-gas-
supplies.

http://www.academia.edu/9962504/What_are_the_barriers_for_new_entrants_to_the_UK_Energy
_Market

https://www.tutor2u.net/economics/reference/oligopoly-kinked-demand-curve

QUESTION 5

http://www.economicsonline.co.uk/Business_economics/Perfect_competition.html

http://www.economicshelp.org/blog/3181/economics/supernormal-profits/

QUESTION 6

http://www.yourarticlelibrary.com/economics/simons-satisficing-theory-with-criticisms-
behavioural-theories/28984/

Note: The chart figures have been taken from one of the webpages that I have used as a source but
the charts and the graphs themselves have been produced by myself.

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