Theory of the firm Flashcards
What are the assumptions of perfect competition?
Firms produce the same (homogenous) product
Firms do not have the power to change prices – because of an infinite number of firms
There are no barriers to entering or leaving the industry
Average cost curves eventually end up sloping upwards – because of no persistent increasing returns to scale
Perfect information between buyers and sellers, between buyers themselves and between sellers themselves
Firms maximize profits
At what output level would a firm operating under perfect competition in the short run?
As long as price covers average variable cost, the firm will choose an output where marginal cost = marginal revenue
If MC < MR increase output to increase profits
If MC > MR reduce output to increase profits
Under perfect competition, MR for the individual firm is always equal to the price – because firms can sell as much as they want at the given market price
The firm’s supply curve is given by the part of the short-run marginal cost curve that lies above the average variable cost curve. This means that the firm may produce positive output even if it is making a loss. However, it cannot maintain losses in the long-run and will exit the market.
What is an isoquant?
Isoquant shows all possible combinations of imputed that can produce a given level of efficient output. Different points on the isoquant represent different production techniques. (Curved line)
What is an isocost line?
The isocost line shows different input combinations with the same total cost. To chose the right technique from the different production techniques represented by the isoquant, we need to use the isocost line to know how much a given technique costs.
When using isocost and isoquant lines, how would a firm produces at the lowest cost?
For cost minimisation the firm chooses a production technique where the isoquant is tangent to the lowest possible isocost line.
What effect would a change in the price of inputs have on the isocost line?
An increase in the relative price of capital would increase the slope of the isocost line (and vice versa) so it will make using less capital intensive techniques more attractive. The point of tangency now means the marginal rate of technical substitution.
How do costs differ in the short and long run for firms
In the long run firms can vary all inputs
In the short run firms may only be able to vary some inputs
What is the short run marginal cost curve?
This is the increase in the short run total cost if output increases by one unit
What is the long run marginal cost curve?
The increase in the long-run total cost if output increases permanently by one unit
What is the relationship between the marginal and average cost curves?
When the marginal cost is below average cost, average cost must be falling
When marginal cost is above average cost, average cost must be rising
The marginal cost curve always intersects the corresponds average cost curve at its minimum point. This holds for both the long and short run.
A firm will produce at an output at which…
Price is just enough to cover average costs and marginal cost = marginal costs for revenue
