Economic Primer: Basic Principles Flashcards
Cost function
Profit = Revenue - Costs
Total cost function
relationship between a firm’s total costs and the amount of output it produces in a given time period, assuming that the firm produces in the most efficient manner possible given its current technological capabilities
average cost function, AC(Q)
how the firm’s average/per-unit-of-output costs vary within the amount of output it produces
economies of scale
average cost decreases as output increases
diseconomies of scale
average cost increases as output increases
constant returns to scale
average cost remains unchanged with respect to output
minimum efficient scale (MES)
the smallest level of output at which economies of scale are exhausted
marginal cost function, MC(Q)
the rate of change of total cost with respect to output or thought of as the incremental cost of producing exactly one more unit of output
marginal cost often depends on …
marginal cost often depends on the total volume of output
at low levels of output (Q’), increasing output by one unit does …
at low levels of output, increasing output by one unit does not change total costs much as reflected by the low MC
at higher levels of output (Q’’), a one-unit increase in output has …
at higher levels of output (Q’’), a one-unit increase in output has a greater impact on total costs, corresponding MC is higher
If AC is a decreasing function of output
MC < AC
If AC neither increases/ decreases in output, because it is either constant (independent of output) or at a minimum point
MC = AC
If AC is an increasing function of output
MC > AC
Short run is the period in which …
Short run is the period in which the firm cannot adjust the size of its production facilities
SAC
short-run average cost
short-run average cost function
annual variable inputs (labor, materials) as well as the FC (e.g., plant)
Sunk costs
unavoidable costs that must be incurred no matter what the decision is
avoidable costs
costs that can be avoided if certain choices are made
when weighing the costs of a decision, the decision maker should …
when weighing the costs of a decision, the decision maker should ignore sunk costs and consider only avoidable costs
whether a cost is sunk depends on …
whether a cost is sunk depends on the decision being made and the options at hand
Sunk costs = fixed costs?
Sunk costs ≠ fixed costs: all sunk costs are fixed but not all fixed costs are sunk
opportunity costs
the economic cost of deploying resources in a particular activity is the value of the best foregone alternative use of those resources
accounting profit
sales revenue - accounting cost
Accounting profit is the net income for a company, which is revenue - expenses
economic profit
sales revenue - economic cost = accounting profit - (economic cost - accounting cost)
Similar to accounting profit but includes opportunity costs
demand function
the relationship between the quantity of a product the firm is able to sell and all the variables that influence that quantity
law of demand
inverse relationship (of demand function); may not hold if high prices corner prestige or enhance the product’s image
price elasticity of demand
measures the sensitivity of quantity demanded to price
price elasticity < 1
demand is inelastic
price elasticity > 1
demand is elastic
factors that tend to make demand for a firm’s product more sensitive to price (more elastic)
- product has unique features that differentiate it from rival products
- buyers’ expenditures on the product are a large fraction of their total expenditures, where savings from finding a comparable item at a lower price is large
- the product is an input that buyers use to produce a final good whose demand itself is sensitive to price
factors that tend to make demand less sensitive to price (more inelastic)
- comparisons among substitute products are difficult (complex, no experience, costly, …)
- because of tax deduction/insurance, buyers pay only a fraction of the full price of the product (e.g., health insurance)
- high switching costs (e.g., arises when product requires specialized training)
- product is used in conjunction with another product that buyers have committed themselves to (printer & toners)
total revenue function, TR(Q)
indicates how the firm’s sales revenues vary as a function of how much product it sells
marginal revenue, MR(Q)
the rate of change in total revenue that results from the sales of ΔQ additional units of output
revenue destruction effect
to sell more, a firm must lower its price. thus, while it generates revenue on the extra units of output it sells at the lower price, it loses revenue on all the units it would have sold at the higher price
positive marginal revenue (depending on price elasticity of demand)
demand is elastic > 1 –> MR > 0 –> increase in output brought about by a reduction in price will total sales revenues
negative marginal revenue (depending on price elasticity of demand)
demand is inelastic < 1 –> MR < 0 –> increase brought about by a reduction in price will lower total sales revenue
MR < P
the marginal revenue curve must lie everywhere below the demand curve, except at a quantity of 0
theory of the firm
assumes that the firm’s ultimate objective is to make profit as large as possible
- how prices are established in markets provides tools to aid managers in pricing decisions
a firm would likely increase profit if …
- if MR > MC, the firm can increase profit by selling more (ΔQ > 0) by lowering prices
- If MR < MC, the firm can increase profit by selling less (ΔQ < 0) by raising prices
- If MR = MC, the firm cannot increase profits by increasing/decreasing Q. Output and price must be at their optimal levels
Express MR in terms of the price elasticity of demand
VC are directly proportional to output, so that MC = AVC
PCM
percentage contribution margin
percentage contribution margin
the percentage contribution margin on additional units sold is the ratio of profit per unit to revenue per unit
the lower a firm’s PCM (e.g., because MCs are high) …
… the greater its price elasticity of demand must be for a price-cutting strategy to raise profits
If MR - MC > 0 as n > 1/PCM …
if MR - MC > 0 as n > 1/PCM: A firm should lower its price whenever the price elasticity of demand is less than the reciprocal of the PCM on the additional units it would sell by lowering its price
if MR - MC < 0 as n < 1/PCM …
if MR - MC < 0 as n < 1/PCM: A firm should raise its price when the price elasticity of demand is less than the reciprocal of the PCM of the additional units it would not sell by raising its price
perfect competition
a stark competitive environment: an industry with many firms producing identical products and where firms can enter or exit the industry at will
industry-level price elasticity of demand
the industry-level price elasticity of demand facing a perfect competitor is infinite, even though the industry-level price elasticity is finite
marginal supply curve
how a firm’s optimal output changes as the market price changes, the supply curve for a perfect competitive firm is identical to its marginal cost function
industry supply curve (SS)
aggregate of the firm supply curves of all active producers in the industry
game theory
the analysis of optimal decision making when all decision makers are presumed to be rational, and each is attempting to anticipate the actions and reactions of its competitors
Nash equilibrium
each player is doing the best it can, given the strategies of other players
dominant strategy
when a player has a dominant strategy, it follows that the strategy must also be the player’s Nash equilibrium strategy. they are not inevitable.
prisoner’s dilemma
conflict between collective interest and self-interest
subgame perfect Nash equilibrium (SPNE)
each player chooses an optimal action at each stage in the game that it might conceivably reach and believes that all other players will behave in the same way
