L2: Theory of the Firm

Question 1

cost concepts

Answer 1

variable costs: vary with amount of output
- average cost (cost per unit produced)
- marginal cost (cost of the additional unit)

fixed costs: do not vary with output
- paid even if q=0

sunk costs: costs that once incurred are not recoverable, irrelevant for exist

some costs fixed in the short run but variable in the long run

Question 2

marginal and average costs

Answer 2

AC decreases whenever AC > MC and increases when AC < MC
- when MC is cheaper than producing all other units on average, this decreases AC
- as you add more units that are cheaper, it brings the average down

AC tracks MC and is minimised when crossing MC
- MC = AC where the additional unit doesn’t increase AC
- once you move right and MC increases, AC gets larger as ewll
- minimum efficient scale quantity

Question 3

are there cost advantages of being large?

Answer 3

economies of scale within firms
- S = AC/MC
- S < 1: diseconomies of scale where the more you grow the more costly it becomes to keep growing so MC and AC are increasing
- S > 1: economies of scale so you want to get bigger and decrease AC

economies of scope across products
- cost of producing both goods is lower than the cost of producing them separately
- easier for firms to sell both products

Question 4

diseconomies of scale

Answer 4

disadvantage of being large

small firms have an advantage over bigger firms - many firms end up producing at the efficient scale quantity

Question 5

marginal profits

Answer 5

MP = MR - MC

when MP > 0 , MR > MC so firm should expand output

when MP < 0, MR < MC so firm should contract output

profit maximised when MP = 0 so MR = MC

Question 6

perfect competition assumptions

Answer 6

homogenous goods

perfect information

economies of scale small relative to market size
- market accommodates large number of firms with free entry

no entry/exit barriers

Question 7

supply under perfect competition

Answer 7

firm supply
- MR = p because firms are price-takers

market supply
- adds up output supplied across firms at price p

Question 8

market power

Answer 8

firm has market power if it can increase price and profits

Question 9

what determines the extent of market power?

Answer 9

supply side: availability of other producers to sell the same product (i.e. patents)

demand side: extent to which other products are acceptable substitutes

Question 10

cross-price elasticity

Answer 10

how much does demand change when the price of substitutes change?

low price elasticity implies that firm 2 can increase price with limited effect on sales by firm 1 (limited substitution)
- market power because there are few substitutes

homogenous goods in perfect competition have infinite cross-price elasticities