4. The Theory of The Firm

Question 1

Why do firms exist?

Answer 1

• economies of scale
• more efficient risk sharing
• reduction in transaction costs

Question 2

Technology

Answer 2

The conversion of inputs into outputs

Question 3

Isoquant

Answer 3

A way of showing how much of a good different combinations of capital and labour produce

Question 4

Homogeneity

Answer 4

A production function is homogenous if an increase in all inputs leads to an increase in the output

Question 5

Relating to homogeneity when does a production function show increasing returns to scale

Answer 5

When the degree of homogeneity is r>1

Question 6

Relating to homogeneity when does a production function show constant returns to scale

Answer 6

When the degree of homogeneity is r=1

Question 7

Relating to homogeneity when does a production function show decreasing returns to scale

Answer 7

When the degree of homogeneity is r<1

Question 8

Marginal product

Answer 8

The amount output changes when we increase one input marginally

Question 9

Marginal rate of technical substitution

Answer 9

The rate at which one factor must decrease so that the same level of productivity can be maintained when another factor is increased

Question 10

What is the MRTS equal to?

Answer 10

MPL/ MPK

Question 11

Isocost

Answer 11

Levels of K and L that incur a constant cost

Question 12

Isoquant

Answer 12

Defines combinations that produce constant output

Question 13

How can we work out the total cost?

Answer 13

Using the production function and W/r=MRTS we can derive expressions for K and L in terms of Y. Derive the optimal inputs given output and plug this into the cost function

Question 14

Solution methods for profit max

Answer 14

• Lagrange
• substitution method
• cost minimisation

Question 15

When does an interior solution for profit max occur?

Answer 15

It exists if in the domain of K and L the price ratio W/r= MRTS

Question 16

Perfectly competitive market

Answer 16

One in which the invisible hand operates unimpeded

Question 17

Properties of competitive market

Answer 17

• homogeneous good
• buyers and sellers are price takers
• no barriers to entry
• complete information
• firms are profit maximisers

Question 18

What does the demand curve for a perfectly competitive firm look like and why?

Answer 18

Horizontal because firms are price takers

Question 19

Where does a profit maximising firm produce in a perfectly competitive market?

Answer 19

Price=MC=MR=AR

Question 20

When is marginal benefit equal to marginal cost

Answer 20

In perfect competition because P=MB and P=MC

Question 21

Why do perfectly competitive firms make zero profits in the long run

Answer 21

• there are profits in market in long run
• other firms see this and enter because there are no barriers to entry
• market supply increases so price falls until p=AR=AC

Question 22

What are the types of efficiency?

Answer 22

• allocative efficiency
• productive efficiency
• consumer surplus
• producer surplus

Question 23

Allocative efficiency

Answer 23

Also known as Pareto efficiency- it is impossible to make someone better off without making someone else worse off

Question 24

Productive efficiency

Answer 24

When output is produced at lowest cost per unit, occurs if q is at minimum of the average cost curve

Question 25

Consumer surplus

Answer 25

The difference between amount consumers are willing to pay and what they actually paid

Question 26

Producer surplus

Answer 26

Difference between amount producer receives and the amount they are willing to accept

Question 27

What is the short run?

Answer 27

The period where at least one factor of input is fixed

Question 28

Long run

Answer 28

When all inputs can be varied

Question 29

Monopolistic competition

Answer 29

One seller and many buyers

Question 30

Properties of monopoly

Answer 30

Firms are price makers | Would expect a downward sloping demand curve

Question 31

1st degree price discrimination

Answer 31

The monopolist knows exactly his much the consumer is willing to pay and charges this amount

Question 32

2nd degree price discrimination

Answer 32

Selling of excess capacity, consumers self select into different groups

Question 33

3rd degree price discrimination

Answer 33

Firms offer different linear prices to different exogenous groups of consumers

Question 34

Benefits of price discrimination for consumers

Answer 34

* could experience net welfare gain as a result of cross subsidisation * some consumers who previously couldn’t afford the good now can * could lead to new products since firms can invest their increased profits

Question 35

Which type of price discrimination is Pareto efficient?

Answer 35

1st degree, total surplus is maximised which means it is Pareto efficient

Question 36

Why must price discrimination schemes be incentive compatible?

Answer 36

The consumers must prefer to get the offered product to everything else or they won’t buy it

Question 37

Oligopolistic competition

Answer 37

A finite number of firms with same market power

Question 38

What does the nature of oligopolistic competition depend on?

Answer 38

* whether the firms set p or q * whether they move simultaneously or sequentially * whether the game is one shot or repeated

Question 39

If oligopolistic competition is simultaneous and price is set what theory do we use?

Answer 39

Bertrand

Question 40

If oligopolistic competition is sequential and price is set what theory do we use?

Answer 40

Bertrand

Question 41

If oligopolistic competition is simultaneous and quantity is set what theory do we use?

Answer 41

Cournet

Question 42

If oligopolistic competition is sequential and quantity is set what theory do we use?

Answer 42

Stackelberg

Question 43

What happens in a duopoly with infinite price options which the firm can choose?

Answer 43

There is a unique NE at P1=P2=c

Question 44

What happens in a duopoly with monopoly or marginal cost price options which the firm can choose?

Answer 44

There are two NE’s at (Pm,Pm) and (Pc,Pc)

Question 45

What happens to the NE in a duopoly as N increases?

Answer 45

As the number of price strategies increases, the only possible NE is (Pc,Pc)

Question 46

How does adding a third player as consumer with search costs impact the Bertrand competition?

Answer 46

There is one pure strategy NE at (Pm,Pm, doesn’t check prices). This holds even if we increase the number of price strategies to infinity

Question 47

How do we solve for cournot competition when we have a duopoly?

Answer 47

Each agent maximises profit conditional on other agents strategy. This gives us a BR1(q2) and BR2(q1). The NE is the intersection of the best response functions

Question 48

How do we solve stackelberg problems?

Answer 48

We solve by backwards induction to find BR2(q1). We solve for q1 and then plug solution into BR2(q1) to find q2

Question 49

What is dynamic competition?

Answer 49

Where profits are discounted over time

Question 50

When does a grim trigger strategy have a sustained equilibrium in dynamic competition?

Answer 50

Only in infinite time and if the discount factor is >1/2

Question 51

In a boom and bust cycle for dynamic competition when is there more incentive to deviate?

Answer 51

In booms, therefore firms need to value the future more (have a greater discount factor)