Micro - Theory of the Firm Flashcards
What does the short run refer to in economics?
Short run – where one factor of production (e.g. capital) is fixed while other factors of production may be variable.
- If a firm wants to increase output in the short run it can only do so by increasing the units of variable factors (i.e. working hours) and not fixed variables (i.e. capital - the number of machines).
- Diminishing marginal returns and marginal costs may start to increase quickly —> more and more workers –> inefficient.
Note - The short run will vary between industries.
What does the long run refer to in economics?
Long run – where all factors of production of a firm are variable. Planning takes place in the long run.
A firm can decide to increase any factor of production i.e. the number of factories etc.
When do planning and production take place in terms of the short/long term?
All production takes place in the short term
All planning takes place in the long term
What is total product (TP)?
Total product is the total output that a firm produces, using its fixed and variable factors in a given time period.
What is average product (AP)?
Average product (AP) is the output that is produced, on average, by each unit of the variable factor.
AP = TP/V
TP - Total output
V - Number of units of the variable factor employed
What is Marginal product (MP)
Marginal product is the extra output that is produced by using an extra unit of the variable factor.
MP = ΔTP/ ΔV
ΔTP - Change in total output
ΔV - Change in the number of units of variable factor employed.
Useful when examining the extra units of output produced by adding one more unit of the variable factor (i.e. Labour)
Definition of diminishing marginal returns?
Diminishing marginal returns
As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.
I.E. —> When trying to paint a room, adding more painters will increase the rate of painting but up to a certain point. Eventually, there are too many painters (variable factors) and they get in each other’s way.
Definition of diminishing average returns?
Diminishing Average Returns
As extra units of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.
I.E. —> When trying to paint a room, adding more painters will increase the rate of painting but up to a certain point. Eventually, there are too many painters (variable factors) and they get in each other’s way.
What is economic cost?
The economic cost of producing a good is the opportunity cost of the firm’s production.
Opportunity cost –> next best alternative given up
In this case, it is the opportunity cost of the factors of production that have been used to produce the good/service.
What are the factors that influence the economic cost of production?
- Factors that are purchased from others and not already owned by the firm. (Explicit cost)
Opportunity cost –> price that is paid for factor and the alternative that could have been bought.
I.e. Hiring a worker for $1000 –> cost = $1000 and other things that the money could have been spent on.
- Factors that are already owned by the firm (Implicit cost)
Even though a firm owns these factors, they still have to take into account the opportunity cost of using it.
What are explicit costs?
Explicit costs are any costs to a firm that involve the direct payment of money.
What is implicit cost?
Implicit cost –> the earnings that a firm could have had if it had employed it factors in another way or if it had hired out or sold them to another firm.
Examples
- The owner of a firm may be able to earn $100, 000 per year in her next best alternative job –> Lawyer
- Rent of a building –> $15 000 –> opportunity cost of using the building is the rent that is foregone and things that could be purchase with that money.
How can total cost be measured?
Total cost is the complete costs of producing output.
Three measures are used.
What is the definition of the total fixed cost?
Total fixed cost (TFC) is the total cost of the fixed assets that a firm uses in a given time period.
TFC is considered constant as the fixed assets/variables are fixed by definition.
TFC = Number of fixed assets x Cost of each asset
I.e. Machines –> they will be there regardless.
What is the definition of the total variable cost?
TVC is the total cost of the variable assets that a firm uses in a given period of time.
TVC increases as a firm uses more units of the variable factor.
TVC = Number of variable factors x cost of each
I.e. Employment of workers.
What is the definition of total cost?
TC is the sum of the total fixed cost and the total variable cost.
TC = TFC + TVC
What is the definition of the average fixed cost?
Average fixed cost is the fixed cost per unit of output.
AFC = TFC/q
TFC - total fixed cost
q - Units of output.
Note - As TFC is consider constant –> AFC will always fall as the units of output increase.
What is the definition for the average variable cost?
AVC –> the variable cost per unit of output.
Equation –> AVC = TVC/q
TVC –> Total variable cost
q –> level of output
Normal trend in AVC –> intially decreases as there are more units for the variable factors (i.e. labour) but eventually due to the law of diminishing average returns –> it increases.
What is the definition for Average total cost?
ATC –> the total cost per unit of output.
ATC = AFC + AVC
ATC = TC/q
TC –> total cost
q —> Units of output
Same trend as AVC –> intial fall but eventually due to the law of diminishing average returns AVC increases.
What is the definition of marginal cost?
MC is the increase in total cost of producing an extra unit of output.
Equation –> MC = ΔTC/ΔQ
ΔTC –> change in total cost
ΔQ –> change in output
MC tends to fall as output increase and then eventually rises due to the law of diminishing marginal returns.
What is the relationship between the Marginal cost curve and the AVC/ATC cost curve?
The Marginal cost curve cuts the AVC and ATC curves at their lowest points.
What is the relationship between the Short Run Average cost curves and the Long Run Average cost curve?
In theory, the LRAC is a U shape as it is made up of an infinite number of short-run average cost curves (tangent to the LRAC curve)
This diagram shows us that if demand were to increase the firm could…
- Increase the variable factors
- But they also know that in the long term they could increase all factors (including fixed) of production which is cheaper.
Hence, they can plan ahead.
Definition of increasing returns on scale?
Increasing returns on scale —> This is when long-run unit costs are falling as output increases.
Basically –> a given percentage increase in all factors of production will lead to a greater percentage increase in output –> reducing long-run average cost.
This refers to the downward sloping section of the LRAC curve.
Definition for constant returns on scale?
Constant returns on scale —> This is when long-run unit costs are constant as output increases.
Basically –> a given percentage increase in all factors of production will lead to the same percentage increase in output –> no change in long-run average cost.
This refers to the section of the LRAC curve where the gradient in 0 (minimum).
Definition of decreasing returns on scale?
Decreasing returns on scale —> This is when long-run unit costs are rising as output increases.
Basically –> a given percentage increase in all factors of production will lead to a smaller percentage increase in output –> increasing long-run average cost.
This refers to the upward sloping section of the LRAC curve.
What two factors influence whether the long-run cost may increase or decrease as output increase?
- Economies of scale –> occur when increasing output leads to lower long-run average costs.
Leads to a firm experiencing increasing returns to scale.
- Diseconomies of scale –> occur when increasing output leads to a higher long-run average cost
Leads to a firm experiencing decreasing returns to scale
What are the different economies of scale that might benefit a firm?
- Specialisation –> large-scale operations workers can do specific tasks –> With little training –> very proficient in their task –> greater efficiency.
- Division of Labour –> Breaking down the production process into small activities –> workers can perform repeatedly and efficiently.
- Bulk Buying —> Firms increase in scale –> they often negotiate discounts with suppliers —> reduces the cost of inputs –> reduces the cost of production.
- Financial economies –> Large firms can raise financial capital more cheaply –> bank charge lower interest rates as large firms are less risky.
- Transport economies —> Bulk orders may be charged less for delivery + firm might invest in their own transport –> reduces cost
- Technical –> some production processes require high fixed costs –> Hence, using the factory to full capacity –> drive average costs down.
- Promotional economies –> Cost for promotion is not directly proportional to the cost of output –> more you produce –> cost of promotion per unit falls
What are the different diseconomies of scale that might negatively impact firms?
- Control and communication problems –> Firm grows larger –> manager will find it difficult to control and coordinate activities –> lead to inefficiency –> increase in cost per unit of output. Same applies to communication.
- Alienation and loss of identity –> Firm grows larger –> individuals feel ‘smaller’ –> they believe that their actions don’t matter as much + lose a sense of belonging/loyalty –> decrease in hard work/productivity –> increase costs.
What is the difference between internal and external economies?
When considering economies and diseconomies of scale it is important to consider internal and external economies.
Internal —> refers to the impact of economies/diseconomies towards individual firms.
External —> refers to the impact of the size of a whole industry increasing on individual firms.
Example of external economies and diseconomies of scale?
Economies of scale –> growth of industry in an area —> results in local Uni’s/colleges setting up courses relating to that specific industry —> Firms will have labour available –> reduces cost.
Diseconomies of scale –> Rapid growth —> more competition —> firms can’t acquire raw materials/capital/labour —> this forces up prices of the prices and thus unit cost.
Summary of Short and Long-run average cost curves?
- Short-run average cost curve is U shaped due to the law of diminishing returns.
- Long-run are U shaped, in theory, because of the existence of economies and diseconomies of scale.
- In reality –> there is no evidence to support U-Shaped Long run curve —> diseconomies don’t outweigh economies of scale.
Actual output Long run curve may be draw as follows:
What is the definition of revenue?
Revenue is the income that a firm receives from selling its products, goods and services over a certain period of time.
Definition of total revenue?
Total revenue is the total amount of money that a firm receives from selling a certain amount of good or service in a given time period.
TR = p x q
p –> price of good/service
q –> quantity of the good/service
Definition of average revenue?
AR is the revenue that a firm receives per unit of it sales.
Equation –> AR = (TR)/q = (p x q)/q = P
As we can see AR = Price as quantity (q) cancels out.
What is the definition of marginal revenue?
MR is the extra revenue that a firm gains when it sells one more unit of a product in a given time period.
Mr = ΔTR/Δq
How is revenue affected when the price does not change with the output (Perfectly elastic demand curve)?
Theory —> When the demand curve is completely elastic then we assume that the firm sells all its products at the same price.
Hence…
Price = Average revenue = Marginal revenue = Demand
All these variables are all the same.
Hence, revenue increase at a constant rate as output increases.
How is revenue affected with a normal downward sloping demand curve?
Important to remember –> In order to increase output (demand) –> price has to decrease. (Law of demand)
This is given that the firm controls price.
- Since AR = Price —> as output falls –> AR will fall —> Average revenue downward sloping.
- MR also decreases as output falls BUT at a quicker rate (twice as steep) –> It is below AR as in order to sell more one more unit –> price has to decrease.
- TR normally rises at first but eventually will start to fall as output increases –> extra revenue from dropping price/selling more is outweighed by the loss of revenue from the units that could be sold at a higher price.
What are the relationships between the price elasticity of demand and revenue?
- Demand is inelastic —> increase in price —> increase revenue.
- Demand is elastic —> increase in price –> decrease in revenue.
- If PED = 1 –> price shouldn’t be changed as revenue is already maximised (This is when MR = 0)
Hence, PED = 1 when MR = 0.
How does one calculate Total Profit?
Total profit = Total revenue - Economic cost (Explicit and implicit costs)
How does one define Abnormal profits, normal profits and a loss?
Abnormal profit –> This is when total revenue is greater than total cost.
Normal profit –> This is when total revenue is equal to total cost.
A loss –> This is when total revenue is less than total cost.
What is the shut-down price?
The shutdown price is the price at which a firm will decide to stop producing. This happens when the firm can no longer cover its variable costs of production (AVC>AR)
If the price does not cover the average variable cost, then the firm will shut-down in the short run.
There are two situation firms can find themselves in:
- A firm may close down temporarily –> they only have to pay the fixed cost but no variable cost.
- The firm can continue producing –> but only if they can cover the variable cost.
However… In both cases in the long run they have change their factors of production so that they can make a normal profit.
What is the break-even price?
Break-even price –> the price at which a firm is able to make normal profits in the long run.
Means that they cover all their costs including the opportunity cost.
This happens at the point –> Price (P) = Average total cost (ATC).
What is the profit-maximising level of output?
Economists assume that the main aim of a firm is to maximise profits.
Whenever MR>MC, then firms should increase output.
Hence…
If a firm wishes to maximise its profits, it should produce at the level of output where Marginal cost (MC) cuts Marginal revenue (from below).
MC = MR
When one has found the profit-maximising level of output, how can you find the price?
To find the price, we look at what consumers are willing to pay for at this quantity. This is shown by the demand curve. It is found by going up from q (profit-maximising level) up to the demand curve and then across to the y-axis.
The same idea applies when you find the cost with the AC curve.
Explain the diagram of perfect competition?
Normal profits
As the industry decides the price –> we need 2 diagrams.
- Industry diagram –> Normal supply and demand
- The firm diagram –> With the following curves:
- Perfectly elastic demand curve at the equilibrium price level of the industry diagram (Label - D = AR = MR)
- MC curve (J - shape) –> Profit maximised when MC = MR —> Firm produces at this level (q)
- AC cost curve (U-Shape) —> MC cuts AC at the lowest point –> local minimum.
Show how a firm in perfect competition can make an abnormal profit in the short run.
Short-run abnormal profits –> This means that the firm is more than covering their total cost including opportunity cost.
The firm is selling at the industry price, P, and profit maximising by producing the quantity ‘q’ which is where MC=MR.
Average cost is less than average revenue –> this creates abnormal profit –> shown by the shaded area.
Show how a firm in perfect competition can make a loss in the short term.
Short run loss –> This means that the firm is not covering their total cost.
On the diagram, the firm is selling at the industry price, P, and producing at the profit maximising level of q.
However, their Average cost is greater than their Average revenue so the firm is making a loss –> shown by shaded region.
Can firms in perfect competition make a loss/abnormal profits in the long run?
No!!! Only possible in the short run.
Firms can only make a normal profit in the long run because if there are any loses/abnormal profits –> the industry will adjust with firms entering and leaving the industry until a normal profit is reached.
Once the Long run equilibrium has been reached –> there is no incentive for firms to enter or leave –> equilibrium will persist until …
- Change in industry demand
- Change in the cost of production
What happens to a firm in perfect competition if it is making an abnormal profit (transition short run to long run)?
As there is perfect information and No barriers to entry –> firms outside the industry will realise that firms are making abnormal profits and thus enter the market.
Consequently, as more firms enter –> industry supply shifts outwards —> this decreases price —> firms are price-takers —> they must accept change.
This process continues until firms make a normal profit (Average revenue = Average cost) –> long-run equilibrium.
Note –> industry supply has increased Q –> Q1 .
What happens to a firm in perfect competition if it is making a loss (transition short run to long run)?
As firms are making a loss —> over time firms in the industry will leave –> eventually the decrease is in the number of firms will result in an inward shift of the supply curve.
The process will continue until normal profits are made —> Long-run equilibrium.
The outcome for the industry –> Lower levels of production.
Do firms in a perfectly competitive market produce at a productive and allocative efficient level in the short run?
They will not be producing at the productive level if they are making abnormal profits or loses.
- Abnormal profits diagram —> Firm producing at profit maximising the level of output (MC=MR) and allocatively efficient level (MC=AR) at the level ‘q’
But they are not producing at the productively efficient level of where MC=AC –> q1 .
- Loss diagram —> Firm producing at profit maximising the level of output (MC=MR) and allocatively efficient level (MC=AR) at the level ‘q’
But they are not producing at the productively efficient level of where MC=AC –> q1 .
Do firms in a perfectly competitive market produce at a productive and allocative efficient level in the long run?
In the long run, firms will always make normal profits —> in this scenario firms will produce at a productively and allocatively efficient level.
Explain the monopoly diagram.
As the monopolist is the industry –> the monopolist’s demand curve is the industry’s demand curve.
Demand curve (D=AR) –> downward sloping –> Monopolist can decide either price OR level of output –> not both
Marginal revenue (MR) curve below demand curve –> roughly half.
Marginal cost (MC) curve —> J-shape curve upwards
Profit Maximizing when MC = MR
Average cost curve (AC) –> U shape –> cut by MC curve at the local minimum.
Are monopolists able to make abnormal profits in the long run? If yes –> explain the diagram.
The monopolist can make abnormal profits in SR
If they have effective barriers to entry –> no new firms enter –> no competition that can take away profits —> This situation monopolist can make abnormal profits in the long run.
On diagram –> At profit maximising level ‘q’ –> the firm is making an abnormal profit (AR>AC) shown by the area shaded in red.
Explain what would happen if a monopoly were to make losses?
If AC>AR then the monopoly would be making a loss.
In the short run they could…
- Temporarily close down
- Continue producing for the time being
However, they would have to adjust their factors of production to ensure that normal profits are made in the long term.
If not? Then the firm will have to shut-down.
Diagram —> AC > AR –> Loss –> Area shaded in red.
Can monopolies choose for revenue maximization?
Yes, monopolies can choose to revenue maximize instead of profit maximising.
This would correspond to producing at the level where MR = 0.
They might do this if they want to push competitors out of the market.
Are monopolies productively and allocatively efficient?
Unlike perfect competition –> Monopolists produce at a level of output that is neither productively or allocatively efficient.
They do not produce at the…
Allocative efficient level of MC = AR
Productive efficient level of MC = AC
Difference between monopolistic competition and perfect competition?
The only difference is that in monopolistic competition –> products are differentiated.
They may be differentiated by…
- Colour, appearance, packaging, design, quality of service, skill levels and many other methods.
What are the possible short-run profit and loss situations in monopolistic competition?
Firms in a monopolistic competition can make profits and losses in the short run.
Same diagram as a monopoly.
In the long run, what happens in monopolistic competition?
Due to the freedom of entry and exit –> firms will always tend towards the long run equilibrium where firms are making a normal profit.
- Short run profit –> Firms are attracted to market and enter –> possible as there are no barriers to entry –> new firms take away demand from original firms –> demand curve shifts inwards (decrease).
- Short run loss –> firms will leave the market –> increases demand for other firms in the industry –> outward shift of demand curve.
Both cases –> industry will settle at long-run equilibrium (normal profits) —> no incentive for firms to enter or leave.
Explain the oligopoly diagram (kinked demand curve)
The kinked demand curve supports the idea of price rigidity.
The reason why the demand curve is kinked is because…
1. If a firm raised their price above the market price –> other firms won’t follow –> Higher price less attractive for consumers –> elastic demand curve –> change in demand proportionally larger than a change in price.
Most likely result in a decrease in trade, sales and profit.
2. If a firm lowered the price —> other firms will most likely follow….
Price war –> firms undercut each other –> decrease price but don’t gain any market share/increase in sales –> fall in revenue –> Represented by an inelastic curve as –> change is the price is proportionally greater than the change in quantity
What is the first level of price discrimination?
First-degree price discrimination, alternatively known as perfect price discrimination, occurs when a firm charges a different price for every unit consumed.
Basically, each consumer pays exactly what he/she is prepared to pay.
Imagine a market/bazar where traders are selling products at the highest possible price.
What is imperfect competition?
Monopolists –> push up prices in order to maximize profits –> fail to allocate at socially efficient level.
A monopolist produces at the level of MC = MR which is not the socially optimum level (Q)
Results in a loss of consumer and producer surplus –> community surplus is not maximised –> market failure.
Diagram for price discrimination?
