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M03EFA: Economic Environment of Business



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    There are two types of cost curves, long term cost and short term cost curves. Many firms use these curves in evaluating and determining the optimal point of production. Some cost curves are different from each other while some are related. For example, the long run cost curves reflects the cost per unit of output when all factors of production come to play (Posner, 2010). This means that all productive inputs can be varied, in other words they portray variation. The behavioral assumption that relates to this curve is that the producer will take a combination of units or inputs that will produce a given output at the least possible cost.  The long run average cost curve can be defined as a curve that shows the average quantity of goods and services while the long run marginal cost curve shows the cost of one more unit that a producer uses for him to get the final output. Long run cost curve is an envelope of an endless number of short run average total cost curves of which each is based on a particular fixed level of capital usage (Posner, 2010). An original long run average cost curve is u-shaped where it reflects economies of scale. An average cost curve which is positively sloped reflects diseconomies of scale while a negatively sloped average cost curve reflects economies of scale.

    A short run marginal cost curve shows the relationship between the marginal cost that is obtained by the firm in the short run production of goods and services. This curve shows the relationship between marginal cost and the level of output while other variables like technology and recourses are held constant (Shone, 2002).When all factors of production are variable, the long run marginal cost curve is used to show the minimum cost that is incurred per unit change in output (Edward, 2003). Long run marginal cost curve is flatter that short run marginal cost curve because it has high input flexibility. The long run marginal cost curve meets with short run marginal cost at the minimum point. Long run average costs cost tends to fall when the long run marginal cost is below it. The long run marginal costs are equal to the short run marginal cost at the least long run average cost level of production.

    Part b

    Transaction costs refer to the costs that are provided for the goods in the market rather than the firm deciding its costs. It is very important for a producer to carry out a market research in order to discover the person that he is dealing with before engaging in contracts. He may also be required to carry out negotiations so that he will know and understand the terms of the contract and that they are followed. Most of the transaction costs carried are; search and information costs, bargaining and decision costs, and policing and enforcement costs (Edward, 2003). It is important to understand the working of the economic system so that a producer will establish a proper sound basis for good economic policies (Edward, 2003). For example Cowasaki company ltd may decide to apply transaction costs in determining the cost of their engines, this will require them to go to the field and determine the costs of their engines rather than establishing their own prices within the firm. It will be important for this company to understand the working of economic policies so that they may know how they can maximize their profit and minimize their costs. Since transaction costs require a firm to use market prices, the company will be in a better position to govern its relationships with other firms although the firm’s decision will be made on the basis which is different from maximizing profit subject to market prices.   These two firms may have a great organization in the way they produce their goods. For example Cowasaki Company limited may decide to hire workers on a day to day basis since it’s a small organization but may as well look for permanent employees since hiring employees on short term basis is believed to be expensive. On the other hand the PLC Company limited may prefer to employ its on labor permanent basis to run away from diseconomies of scale which may be brought about by its high production. Many firms prefers  employing their labor on permanent basis because some problems may arise when a firm decides to employ on a short term contracts since they will be  required to gather information and incur some extra  costs of negotiating contracts. Therefore, many firms will prefer using long term contracts to short term contracts because their payments are specified for the contractee in return for obeying within limits the direction of the contractor (Shone, 2002). At times these market transactions may bring inconveniencies although some organizations have to be made when these transactions are not governed by a proper price system (Shone, 2002).

    Part c

    Economies of scale refer to the increase in competence as the unit of goods produced increases. A company lowers its average cost per unit if the manager of a particular company decides to increase production because fixed costs are shared over an increased number of goods.

    If a producer can manage to produce more goods or services on a large scale, and the same time use the minimum production cost, he will manage to achieve an economy of scale in the firm. Therefore many producers achieve economies of scale by producing more units of goods or services at the same time using the minimum cost in producing that good or service (Posner, 2010). This will bring about the growth of the company at the same time its production will increase. The company will manage to decrease its costs. Economic theory suggests that economic growth will only be achieved if economies of scales are realized. Therefore Cowasaki which is a small scale producer of these motor cycles may not experience these economies of scale as compared to the specialist motorcycle engine manufacturer who produces her engines in large scale. Although Cowasaki produces in small scale the manager must try hard to minimize the cost of production so that the company will grow when it realizes its economies of scale. If this particular company reduces its production costs it will realize good profit and therefore expand. The later which is a large scale manufacturer of engines must play hard to minimize diseconomies of scale which might be brought about by its large production (Shone, 2002).

    There are various sources of economies of scale for example; Bulk buying.  If a firm decides to go to a cash and carry warehouse and buys a large quantities of goods the price per unit is going to be smaller. The owner of the goods may decide to strike a deal with the seller so that he will incur less storage prices in the warehouse. The more you buy goods in large scale the higher the buyer will have a bargaining power.

                Diseconomies of scale may occur in a company especially those that produce goods in large scale. They may occur from an inefficient management or bad labor policies. Average costs of a company may increase if the company is required to transport its products in a wide area which may result to diseconomies of scale. Firms are required to know their net effect of their decisions that affects their efficiency but not just looking at one particular source. A company may decide to increase its economies of scale but may end up getting diseconomies of scale due to poor distribution networks which make transportation inefficient because there was inadequate investment in terms of transport. When companies or firms are intending to take a strategic step or decision it is important to balance the net effects of different sources of economies and diseconomies so that it will result to an average cost of all decisions that are made and hence will give a greater efficiency all round.


    Part a

    Keynes perspective on investment came when there was a great depression in Europe. He brought up concepts that can explain great depression that took place in 1936(Shone, 2002). He came up with a non- interventionalist policy which states that if consumption declines due to savings, this decline in savings will result to a fall in interest rates. In classical approach a reduction in savings will lead to increased investment spending while demand remains constant. Keynes explained why investments do not rise automatically due to a decline in interest rates. In the same case we can see that investments are very volatile and can be affected by various factors rather than national income for example, in UK where its vitality lasted for thirty years. Therefore, businesses will make investments depending on what they expect as profit. For example if consumption decreases and seems to happen in long term basis business analyzing trends will decrease their future sales (Posner,  2010).

    Firms are required to increase future production as far as investment is concerned. Keynes said that the solution to great depression was to stimulate the economy through combination of two approaches that is reduction in interest rates and increase government spending especially on infrastructure (Posner, 2010). Any investment made by government leads to an additional income thus leading to an extra spending in the economy. This will make the producers to produce extra units and at the same time there will be more investments.

    Part b

    The term animal spirit was made famous by Keynes during the 1936 depression when he put forth the general theory of employment, interest and money (Johnson, 2006). In so doing he came up with a good definition of animal spirit as the spontaneous urge to action rather than inaction but not an outcome of a weighted average quantitative benefits multiplied quantitative probabilities (Posner, 2010). A decline in animal spirit makes consumers to cut their spending and firms do not want to hire more people. This name acts as an ingredient in economics regarding things like prosperity in business and confidence.

    Part c

    There are various factors that determine investments. Economists say that a firm level of investment is determined by expected benefits as well as available capital in terms of availability and interest rates (Johnson, 2006). The benefits that a firm will get from a particular investment recounts to the impact that a particular investment will bring in terms of added value, cost decline, and increased competitiveness (Johnson, 2006). In this case profits will be expected to be higher and the benefits obtained from this investment will be compared from time to time. Firms are required to carry out some decision processes and therefore, the value over time of these benefits will be discounted through subjective interest rates so that the firm will manage to keep into account time, detachment and ambiguity.

    Part d

    National income which is also referred to as GDP can be decomposed into four components namely; aggregate expenditure on consumption, investment, government and net export (Edward, 2003). Keynes income expenditure model brings together the relationship between these expenditures and the current real income (Johnson, 2006). There are expenditures which are autonomous or meant to be totally independent from national income these are expenditures on investment, government and net exports. According to Keynes the current real income determines the aggregate consumption expenditure. He also provided us with a summarized equation of aggregate consumption expenditures.

    Total aggregate expenditure is equal to;

    AE=A +mpc (Y)


    Y*=m (A)


    m=           1


    From the equation above it is clear that the equilibrium level of GDP is equal to the autonomous expenditure A, multiplied by m which gives the Keynesian multiplier.

    Equilibrium national income can also be demonstrated graphically using the income expenditure approach. The figure below represents various aggregate expenditure curves and corresponds to three different levels of autonomous expenditure. The upward slope depicted by the aggregate expenditure curve is due to positive value of the marginal propensity to consume. An increase in national income leads to an increase inn aggregate demand (Edward, 2003).






                         Y1             Y2                                                   Y3

                                                                Real national income


    Edward J., 2003. The Elgar companion to post Keynesian economics. Northampton, MA: Edward Elgar Publishing, pp. 358.

    Johnson H., 2006. Macroeconomics & monetary theory. Piscataway: Transaction Publishers, pp. 550.

    Posner, R., 2010. The Crisis of Capitalist Democracy. Cambridge, MA: Harvard University Press pp. 402.

    Shone R., 2002. Economic dynamics: phase diagrams and their economic application. Massachusetts: Cambridge University Press, pp. 678.

    M03EFA: Economic Environment of Business. (2016, Jul 01). Retrieved from

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