lecture 14 and 15

Question 1

what are the firms goals?

Answer 1

• to maximize profit
  (or minimize costs)

Question 2

what do firms choose?

Answer 2

• quantity (how much to produce at a given market price)

Question 3

what are the contraints that firms face in their maximization problem?

Answer 3

• technology and input costs
• demand curve

Question 4

what is the cost of firms?

Answer 4

• firms combine inputs to produce final goods and services
• using a production function to represent how inputs are combined to generate a final good
• each input has a cost

Question 5

what are the inputs and the costs of a cost function?

Answer 5

• labour (L) → wage (w)
• capital (K) → rental cost (r)
  L and K depend on the quantity produced (Q)
  Cost= wL+ rK
  Q: C(Q)

Question 6

explain the cost minimization problem

Answer 6

• how to find the lowest cost of achieving a certain production function, that is, to minimize costs by choosing L and K for a given level of r and w

Question 7

what are the implications of the minimization problem?

Answer 7

• different input costs (w,r) will lead to different choices of (L,K)
• different levels of production (Q) will lead to different choices of (L,K)
• this implies that labor and capital can be written as functions of input costs and the quantity produced: L(w, r, Q), K(w,r, Q)

Question 8

what are the different types of costs?

Answer 8

• fixed costs (FC) → costs that do not change with Q
• Variable costs (VC) → costs that change with Q
  -Total cost of production (TC)= FC+VC

Question 9

what are the main differences betwwen economic costs and accounting costs?

Answer 9

economic costs include opportunity costs

Question 10

what is the average cost (AC)?

Answer 10

• average unitary cost of each unit produced
• AC (Q) = (TC (Q)) / Q
• usually U-shaped

Question 11

what is the marginal cost (MC)?

Answer 11

• additional cost of produing one more unit of output, that is the cost of increasing production by 1 unit
• 𝑀𝐶 = Δ𝑇 / Δ𝑄, or 𝑀𝐶 = 𝑑𝑇𝐶(𝑄) / 𝑑Q
• mostly upward sloping

Question 12

Compare MC and AC

Answer 12

• MC > AC: AC is increasing
• MC < AC: AC is decreasing
• MC = AC at the minimum of AC
• That is, MC and AC cross at the
  minimum of AC
• MC is crucial to determine the level of output that maximizes profit

Question 13

what are economies of scale or increasing returns?

Answer 13

• technological advantages of large- -scale production
• production increases proportionally more than inputs
• implication: with economies of scale, doubling the production less than doubles total cost
  → AC is decreasing in Q

Question 14

What are the other types of retuns of scale? Explain

Answer 14

• Constant return → production increase in the same proportion as inputs
  More generally: 𝑄 𝛼𝐿, 𝛼𝐾 = 𝛼𝑄(𝐿,𝐾)
• Decreasing return → production increases proportionally less than inputs
  More generally: 𝑄 𝛼𝐿, 𝛼𝐾 < 𝛼𝑄(𝐿,𝐾)

Question 15

What is the formula of profits?

Answer 15

Profits = Total Revenue – Total Cost = TR - TC
- Total cost (TC(Q)) includes opportunity costs
- Economic profits might differ from accounting profits

We can write profits as:
𝜋 = 𝑃𝑄 − 𝑇𝐶 = (𝑃 − 𝐴𝐶)𝑄
- (𝑃 − 𝐴𝐶) → unitary profit (profit per unit of output)
- Zero economic profits when P = AC

Question 16

What is a monopoly and his key feature?

Answer 16

• when there is only one supplier of the good (one firm)
• key feature of monopolies: the firm can choose both the quantity produced and the price

Question 17

Explain the trade-off between price and quantity

Answer 17

• the monopolist is contrained by the demand curve
• if it chooses a high price, it will only be able to sell a small quantity
• if it wants to sell a large quantity, it must choose a lower price

Question 18

There are 2 differents approach to maximizate profit. Explain the less usual one

Answer 18

• Contraint: the demand curve
  → the trade-off between P and Q that the firm ir constrained to make
  → slope of MRT
• Isoprofit curve
  → the trade-off the firm is willing to make between P an Q and still achieve the same level of profits
  → slope of MRS
• MRS=MRT (slope of demand curve is equal to the slope of the isoprofit curve

Question 19

There are 2 differents approach to maximizate profit. Explain the main approach

Answer 19

• present the same optimal choice without isoprofit curves
• the firm will choose the quantity produced (Q) to maximize profits

→ MR=MC
- marginal revenue (MR) → change in total revenue obtained by producing and selling on extra unit
→ the MR curve has the same intercept as the demand curve, and it is twice as steep
- marginal cost (MC) → the cost of producing one extra unit

Question 20

What is the intuition behind MR and MC?

Answer 20

• MR > MC → the increase in total revenue from selling 1 extra unit is smaller than the cost of producing (the firm could increase profits by increasing Q)
• MR < MC → the increase in total revenue from selling 1 extra unit is smaller than the cost of producing it (the firm can increase profits by decreasing Q)

Question 21

What are the implications of a monopoly?

Answer 21

A monoplost doesn’t:
- take the price as give
however, the monopolist is constrained by the demand curve
- have a supply curve
For a given demand curve, there is just one quantity the monopolist is willing to supply
- produce where MC=P

Question 22

Hoe does the elasticity of demand affect firm’s decisions?

Answer 22

• price elasticity of demand is related to the ffirm’s marginal revenue (MR)
  𝑀𝑅 = 𝑑𝑇𝑅 / 𝑑Q = P (1 +1/𝜀D)

Question 23

What is the relatioship between the firm’s profit margin and markup and the elasticity of demand? What does that imply?

Answer 23

• Profit margin: 𝑃 − 𝑀𝐶 = 𝑃 / |𝜀𝐷|
• Markup : (𝑃 − 𝑀𝐶) / 𝑃 = 1 / |𝜀𝐷|
  Implication:
• the less elastic the demand is, the more the firm will raise the price above the marginal cost
• this will lead to higher profit margin and markup

Question 24

what is a economic surplus?

Answer 24

a measure of thee amount by which buyers and seller benefit from participating in the market

Question 25

What is the total economic surplus the sum of?

Answer 25

• consumer surplus
  → difference between willingnes to pay (WTP) and price actually paid
  → alternative definition: marginal benefit→ the dollar value of consumer of another unit of a good (WTP)
  → area above price paid and below the demand curve, for a given price and quantity
• producer surplus
  → difference between price received and marginal cost
  → area above MC and below price, for a given (P,Q)
• government revenue (if relevant)

Question 26

What is tthe welfare analysis of a monopoly and perfect competition?

Answer 26

under a monopoly there is a deadweight loss (DWL)
- total surplus is not maximized
- the monopoly outcome is not pareto efficient (this is only achieved when toatal surplus is as large as possible)
under perfect competition, the total surplus is maximized
- WTP (or maginal benefit) is equal to MC
- pareto efficient

Question 27

What are the conditions for pareto efficiency?

Answer 27

the good is:
- produced up to the point where MB=MC
- allocated to consumers with the highest MB (or WTP)
- the good is produced by the producers with the lowest MC