4. The Theory of The Firm Flashcards
Why do firms exist?
- economies of scale
- more efficient risk sharing
- reduction in transaction costs
Technology
The conversion of inputs into outputs
Isoquant
A way of showing how much of a good different combinations of capital and labour produce
Homogeneity
A production function is homogenous if an increase in all inputs leads to an increase in the output
Relating to homogeneity when does a production function show increasing returns to scale
When the degree of homogeneity is r>1
Relating to homogeneity when does a production function show constant returns to scale
When the degree of homogeneity is r=1
Relating to homogeneity when does a production function show decreasing returns to scale
When the degree of homogeneity is r<1
Marginal product
The amount output changes when we increase one input marginally
Marginal rate of technical substitution
The rate at which one factor must decrease so that the same level of productivity can be maintained when another factor is increased
What is the MRTS equal to?
MPL/ MPK
Isocost
Levels of K and L that incur a constant cost
Isoquant
Defines combinations that produce constant output
How can we work out the total cost?
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
Solution methods for profit max
- Lagrange
- substitution method
- cost minimisation
When does an interior solution for profit max occur?
It exists if in the domain of K and L the price ratio W/r= MRTS
Perfectly competitive market
One in which the invisible hand operates unimpeded
Properties of competitive market
- homogeneous good
- buyers and sellers are price takers
- no barriers to entry
- complete information
- firms are profit maximisers
What does the demand curve for a perfectly competitive firm look like and why?
Horizontal because firms are price takers
Where does a profit maximising firm produce in a perfectly competitive market?
Price=MC=MR=AR
When is marginal benefit equal to marginal cost
In perfect competition because P=MB and P=MC
Why do perfectly competitive firms make zero profits in the long run
- 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
What are the types of efficiency?
- allocative efficiency
- productive efficiency
- consumer surplus
- producer surplus
Allocative efficiency
Also known as Pareto efficiency- it is impossible to make someone better off without making someone else worse off
Productive efficiency
When output is produced at lowest cost per unit, occurs if q is at minimum of the average cost curve
Consumer surplus
The difference between amount consumers are willing to pay and what they actually paid
Producer surplus
Difference between amount producer receives and the amount they are willing to accept
What is the short run?
The period where at least one factor of input is fixed
Long run
When all inputs can be varied
Monopolistic competition
One seller and many buyers
Properties of monopoly
Firms are price makers
Would expect a downward sloping demand curve
1st degree price discrimination
The monopolist knows exactly his much the consumer is willing to pay and charges this amount
2nd degree price discrimination
Selling of excess capacity, consumers self select into different groups
3rd degree price discrimination
Firms offer different linear prices to different exogenous groups of consumers
Benefits of price discrimination for consumers
- 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
Which type of price discrimination is Pareto efficient?
1st degree, total surplus is maximised which means it is Pareto efficient
Why must price discrimination schemes be incentive compatible?
The consumers must prefer to get the offered product to everything else or they won’t buy it
Oligopolistic competition
A finite number of firms with same market power
What does the nature of oligopolistic competition depend on?
- whether the firms set p or q
- whether they move simultaneously or sequentially
- whether the game is one shot or repeated
If oligopolistic competition is simultaneous and price is set what theory do we use?
Bertrand
If oligopolistic competition is sequential and price is set what theory do we use?
Bertrand
If oligopolistic competition is simultaneous and quantity is set what theory do we use?
Cournet
If oligopolistic competition is sequential and quantity is set what theory do we use?
Stackelberg
What happens in a duopoly with infinite price options which the firm can choose?
There is a unique NE at P1=P2=c
What happens in a duopoly with monopoly or marginal cost price options which the firm can choose?
There are two NE’s at (Pm,Pm) and (Pc,Pc)
What happens to the NE in a duopoly as N increases?
As the number of price strategies increases, the only possible NE is (Pc,Pc)
How does adding a third player as consumer with search costs impact the Bertrand competition?
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
How do we solve for cournot competition when we have a duopoly?
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
How do we solve stackelberg problems?
We solve by backwards induction to find BR2(q1). We solve for q1 and then plug solution into BR2(q1) to find q2
What is dynamic competition?
Where profits are discounted over time
When does a grim trigger strategy have a sustained equilibrium in dynamic competition?
Only in infinite time and if the discount factor is >1/2
In a boom and bust cycle for dynamic competition when is there more incentive to deviate?
In booms, therefore firms need to value the future more (have a greater discount factor)
