The core of Capitalism: The Profit-Maximising Firm Flashcards
Why must you understand how firms behave in competitive industries?
- Most firms in the real world face a lot of competition because they are memebers of industries in which firms can enter and exit relatively freely. Therefore, firms have to worry about competitors already in the industry and those that may potentially come into the industry.
- All firms - even those that don’t face much competition - behave in remarkably similar ways.
How do all firms go about maximising profits?
By producing exactly the level of output at which the cost of producing one more unit just equals the increase in revenue that the firm gets from seeling that unit.
Why do economists assume that the overriding goal of firms is to make as much profit as possible?
- Every firm has profit maximisation near the top of its to-do list
- Every firm wants to maximise profits after taking steps to achieve whatever other goals it may have.
Give examples of firms maximising profits after taking steps to achieve other goals.
- When Ben and Gerry’s started, it donated a large % of its profits to charity. Given such a policy, the best way to help worhty causes was for Ben and Gerry’s to make as much big profit as possible.
- The Body shop and Innocent smoothie follow a social purpose and do so as profit-making companies.
Why is an industry in perfect competition easiest to understand?
This situation is the easiest case to understand, because in an industry in which many competitors are producing identical products, non of the firms have any control over the price they charge.
What are the 3 things which perfect competition assumes about firms in an industry?
- Each firm is one of many
- Each firm represents a very small part of the industry
- Each firm sells identical or nearly identical products
Give an example of perfect competition using the market analogy.
- People used to do their shopping in markets, and a market comes close to fullfilling the 3 criteria previosuly mentioned.
- Individual stallholder are gathered together so that each only has a small share of the industry.
- This situation means that individual stallholders are, price takers, that is, no single stallholder can affect the price that consumers are willing to pay for their produce.
- A nice shiny apple is therefore likely to cost the same no matter which vendor you buy it from.
Using an example, what is a commodity?
A commodity is something that has a defined quality i.e. silver.
Ex. something is either gold or it is not gold - there’s no such thing as being more goldy than something else.
Why do individual miners have no control over the price of gold?
- Firstly, they are producing a nearly identical product.
- Because the gold from one place is identical to the gold from elsewhere, the only way an Angolan producer can entice you to buy from him rather than a Russian is to offer you a lower price.
- because all the gold is identical, all the producers have to compete on is price and price alone.
What is the market supply curve for gold unaffected by?
So many producers of gold exist and so many produce such a very small part of the total supply of gold that the market supply curve for gold is basically unaffected by the presence or absence of any given individual supply curve or any particualr gold producer.
Give an ex. of a player who’s too small to change the market price.
If a trillion troy ounces of gold or sold every year, the market price is unaffected by whether a small producer with only 1,000 ounces to sell bothers showing up to the market or not. He’s just too small a player to cause the market price to change.
What happens if every player is too small to cause the makret to change price?
If every player is too small to cause the makret to change price, each one has to take as a given whatever price is generated by market demand interacting with market supply.
How are perfectly competitive firms price takers but quantity makers?
Because firms have no control over their prices under perfect competition, the only thing that price-taking firms can control is how much to produce.
What quantity do firms choose to make?
Firms choose to make whatever quantity maximises their profits.
This fact is mathematically convenient because it turns out that the quantity of output that a firm chooses to produce controls each of the two things that determines profit: total revenue and total costs.
Define a firm’s profit.
Profit = TR - TC
Tr for a competitive firm is simply the q of its output sold times the market price, p, that it can get for each unit;
TR = p x q
Give an example of how costs pile up for firms, as each successive unit costs more than the previous unit.
Suppose an apple vendor can sell as many apples as he wants at £1 each. The fist apple costs 10p to produce, the 2nd costs 20p, the 3rd costs 30p, and so on.
In such a case he’s only willing to produce no more than 10 apples. Why? Because for each of the first 9 apples, he makes a profit, but for apple 10 (which costs £1 to produce), he only breaks even.
If he produces any more apples, he sustains a loss. (Apple number 11, for example, costs £1.10 to produce, but he only gets a quid for selling it).
What do economists mean by profit and loss?
To an economist, the terms profit and loss refer to whether the gains from running a business are bigger or smaller than the costs involved.
What does an economist mean by “running a profit/running a loss”?
If the gains exceed the costs, you’re said to be running a profit, whereas if the costs exceed the gains, you’re said to be running a loss.
If the two are just equal, you’re said to be breaking even.
How do accountants and economists disagree on what to count as costs?
Consider a business that sells lomonade.
Accountants - consider costs to be only actual monies spent in running the business. If TR = 10 grand, and it spends 9 grand to make those revenues, the account concludes that the firm’s profit is 1 grand- this is the firm’s accounting profit.
Economists - prefer a more subtle concept known as economic profit which takes into account not just the money costs directly incurred by running a business but also the oppurtunity costs incurred.
What are the oppurtunity costs regarding the lemonade business?
Remember: oppurtunity costs are what you have to give up in order to do something.
Suppose that this person left a job as a florist to open the lemonade business, and in the same amount of time that it took the lemonade business to turn 1 grand of profit, she would have made 10 grand in wages at her old job as a florist.
What is the most important application of the economic profit concept?
The most important application of this concept is to determine how much output a firm needs to produce.
If producing the 12th unit of a product produces an economic profit, obviouslt the firm wants to produce it.
But if increasing production to a 13th unit results in an economic loss, obviously the firm doesn’t want to produce it.
What do you get at by taking into account economic profits and losses?
By taking into account economic profits and losses, you get directly at what motivates firms to produce not only the types of goods they choose to produce, but also the quantities of those goods.
What are fixed costs?
Costs that have to be paid even if the firm isn’t producing anything.
Ex. after a rent contract is signed for the firm’s hq, that rent must be paid whether the firm produces anything or not.
Or
if the firms has taken out a loan, it’s legally required to make its debt payments whether its produced 0 units or a billion.
What are Variable costs?
Costs that vary with the amount of output produced.
Ex. if you are in the lemonade making business and you choose to produce nothing, you obviously don’t ahve to buy any lemons. But the more lemonade you do produce, the more you spend on lemons… and what about labour costs?
What is the sum for total costs?
TC = FC + VC
In the LemonAid example, what is the second workers marginal output?
From one worker to 2, output increases from 50 to 140 bottles. In other words, the marginal output of the 2nd worker is 90 bottles (whereas the 1st worker’s marginal output is only 50 bottles)
What does the firms AVC curve look like?
Explain why ATC reaches its minimum value at a higher level of output than AVC?
Look at the table below
- AVC reach their minimum value of £1.09, when 3 workers are hired and 220 bottles are produced
- ATC, however, reach thier min of £1.43 when 5 workers are hired and 350 bottles are produced
- This happens because AFC are always falling
- This constant decline helps to offset temporarily the incrases in AVC that happens when diminishing returns set in
Give an example of a marginal costs calculation.
- Total costs increase from £100 in the 1st row to £180 in the 2nd as output increases from 0 to 50 bottles when the firm hires one worker
- in other words, costs go up £80 while output goes up 50 bottles
- so each of these extra, marginal 50 bottles on average increases costs by 80/50 = £1.60
- MC = (Change in TC)/(Change in q)
What quantity of bottles should lemonAid choose to produce to maximise profits?
Quantity q* = 440 bottles
This corresponds to where th horizontal p = MR = £2 line crosses the MC curve. This quantiy
Using a graph of a profit-making firm, show TR.
TR = P x q*
rememeber q* = profit maximising output level
Using a graph of a profit making firm, show TC.
- B shows the ATC per unit when thee firm is producing output level q*.
- At q*, ATC = TC/q* so when you multiply both sides of this equation you find that ATC x q* = TC
- This equation tells you that TC is indeed equal to the product of ATC and q*
Using a graph of a profit making firm, show profit.
Profit = TR - TC
Profit is equal to the area of the shaded rectangle because profits are simply the difference between TR and TC.
If the TR rectangle is bigger than the TC rectangle the firm is making a profit.
Demonstrate a firm making a loss, using a graph.
Because the TR rectangle is much smaller than the TC rectangle, the firm is therefore running a loss equivalent to the size of the shaded area.
Give an example of the short-run shutdown condition.
Imagine FC = £1000 and that by producing Q* units the firm makes TR = £400 and incurs variable costs of £500.
Because TR only cover £400 of the £500 in variable costs, the firm loses £100 in variable costs by producing.
Add the £1000 in FC to that and the firm loses a total of £1100 by producing Q* units.
If however, the firm shuts down and produces zero units, it only loses £1000 in FC. Clearly in this situation the firm should shut down.
