Question

With the aid of a diagram, explain why according to economic theory, in the short run rational firms should only be operating at Stage two of production.

b. Why is it not rational for firms to operate at Stage one or Stage three of production?

c. The impact of COVID-19 has the CEO of a small manufacturing firm worried because of the reduced demand for its product has resulted in reduced production. She has asked you to explain how this will affect the firms fixed, variable, average and marginal costs ( 5 marks) .

Answer 1

Solution:

a) Under short run equilibrium, rational firms operate under second stage only.

According to law of variable proprtion or returns to factor there are 3 stages of production:

(i)Increasing returns to factor

(ii) Decreasing returns to factor

(iii) Negative returns to factor

Firms will operate in decreasing returns to factor. During this stage TPP becomes maximum and though MPP is falling but it remains positive.(Diagram is given after part b).

(b)The rational firms will not operate in first stage because firm can't achieve its maximum Total physical production (TPP) during this stage.

Firms will not operate under third stage also because Total production will fall and Marginal production becomes negative.

c)Due to COVID-19,the demand and production of good will fall.The effect on following:

(i)Fixed cost will not change because it does not depends on output level.Fixed cost will not become zero even at zero output level. e.g rent of factory

(ii)Variable cost will increase at decreasing rate.During initial stages when output is less,variable cost increases at decreasing rate. e.g wages of casual labour

(iii) Average cost is the ratio of total cost and output.The average cost will fall.

(iv) Marginal cost will increase because TVC increases at decreasing rate.Marginal cost is the cost incurred on producing additional unit of good.It is affected only by TVC.