Unit 7 Flashcards
What are the formulas for calculating total profit, total costs and total revenue?
Profit = total revenue - total costs
Total costs = unit cost x quantity
Total revenue = price x quantity
What are isoprofit curves and what do they show?
Isoprofit curves show all the combinations of price and quantity that result in the same level of profit.
All points on the same isoprofit curve yield equal profit and the firm is indifferent between these points.
Moving towards the right, profit increases, so firms would rather be on rightward isoprofit curves where the combinations of price and quantity are higher.
Why is it not possible for firms to charge a high price and quantity?
Firms are constrained by their demand curve which shows the quantity of product consumers would demand at any given price. The curve is downward sloping because as price increases, the quantity demanded falls.
The demand curve acts almost as a feasible set. Combinations of price and quantity above the demand curve are not possible to achieve.
How do firms choose the profit maximising price and quantity using their demand curve and isoprofit curves?
They choose the highest possible isoprofit curve inside the feasible set - where the demand curve is tangent to an isoprofit curve.
Why may larger firms be more profitable than smaller firms?
Larger firms can produce output at a lower cost per unit due to:
- Economies of scale: large scale production uses fewer inputs per unit of output. Increasing returns to scale occur when increasing all inputs by a given proportion increases output by a larger proportion.
- Cost advantages: fixed costs like advertising, acquiring patents and installing infrastructure have a smaller effect on cost per unit when output is high. Larger firms may be able to purchase inputs at a lower cost as they have more bargaining power.
- Demand advantages: consumers are more likely to by a product from a firm that already has a large customer base.
How do economies and diseconomies of scale come about?
- economies of scale can arise due to specialisation which allows employees to do the task they do best and reduces training time by limiting the skill set each worker needs. This improves productivity and lowers costs.
- diseconomies of scale can arise from a larger firm needing more layers of management and supervision. As the firm grows, the organisational costs will grow as a proportion of the firm’s overall costs.
How do fixed costs contribute to lower cost per unit from larger firms?
Fixed costs are ones that do not vary with production level. In the case of large infrastructure networks, there is a large upfront cost ie for water supply or electricity grids, but daily running costs are low compared to the upfront cost and so once in place, the more water or electricity that is supplied, the lower the unit cost of output.
Therefore even if a firm has decreasing returns to scale, cost per unit may fall as output rises.
What is a firm’s general cost function and how can it be drawn?
C(Q)=F+cQ
- F represents fixed costs - ones that must be paid regardless of output level
- c represents the cost per unit of output
- Q represents the quantity of output
With total cost on the y axis and quantity of output on the x axis, the cost function for a firm can be drawn which will look like an upward sloping straight line.
What is a firm’s average cost and how can this be drawn, and what is marginal cost?
Average cost can be calculated as total cost/quantity (AC=C(Q)/Q). This can be computed at each quantity of output and so an average cost curve can be drawn which is a downward sloping line.
Marginal cost is the change in cost when output increases by one unit - it is the gradient of the cost function. For a linear cost function, marginal cost is constant as it has a constant slope. Marginal cost = change in cost/change in quantity
How are average cost and marginal cost related for a linear cost function?
Because AC(Q)= C(Q)/Q = F+cQ/Q = c+F/Q, therefore the average cost is the marginal cost plus a share of the fixed costs.
In the linear cost function example, the marginal cost curve is a flat horizontal line as the cost function has a constant slope.
Average cost is always greater than marginal cost, but as output increases, the fixed costs are spread amongst more units and so average cost decreases, tending towards the marginal cost curve.
How are average cost and marginal cost related for a non-linear cost function?
When a cost function is non-linear, marginal cost is no longer constant. MC = C’(Q). If the cost curve is upward sloping then C’(Q) and C’’(Q) or dMC/dQ >0.
When plotted together, MC intersects AC(Q) at its minimum point. For any cost function, MC-AC always has the same sign as the slope of the AC curve:
d/dQ(C(Q)/Q) = QC’(Q)-C(Q)/Q^2 = MC - QxAC/Q^2 = MC-AC/Q
Since Q>0, it follows that the slope of AC at each value of Q has the same sign as MC-QC
What is the demand curve and what does it show?
For a firm producing a differentiated product, the demand curve is a downward sloping line showing the relationship between price and quantity.
Each consumer has a willingness to pay (WTP) for a product depending on how much they value it. A consumer will buy a product if the price is less than or equal to WTP.
Thus, the demand curve essentially orders consumers in ascending WTP, showing the quantity of consumers willing to buy the product at each price.
As price increases, less consumers have a WTP equal to or less than the price and so the quantity demanded falls.
What is price elasticity of demand?
PED measures the responsiveness of consumers to a price change. It is the percentage change in quantity demanded in response to a particular percentage change in price.
PED = %changeQ/%changeD
PED<1 - inelastic demand - the change in demand is less than proportional to the change in price (steep demand curve)
PED>1 - elastic demand - the change in demand is more than proportional to the change in price (shallow demand curve)
How is PED related to total and marginal revenue?
When PED for a good is elastic, a rise in price will mean the decrease in demand is proportionally greater than the rise in price, and so total revenue decreases.
When PED for a good is inelastic, a rise in price will be proportionally greater than the fall in demand and so total revenue increases.
Marginal revenue is positive when demand is elastic as a firm can increase revenue by increasing output and lowering price.
Marginal revenue is negative when demand is inelastic as a firm can increase revenue by decreasing output and raising price.
What are normal profits?
The opportunity cost of capital. Firm’s owners would not invest in the firm if they could make better use of their money elsewhere. Thus, the profit they could earn elsewhere is the opportunity cost of capital.
Given that firms must pay out dividends to shareholders, the opportunity cost of capital is included in the cost function.
A firm making normal profit is making 0 economic/supernormal profit.
What is economic/supernormal profit?
Additional profit made above the minimum return required by shareholders (in excess to normal profit).
Economic profit is the quantity of output multiplied by the profit per unit (price-average cost)
Profit = Q(P-AC) = Q(P-C(Q)/Q) = Q(P-(F+cQ)/Q) = Q(P-c)-F
Where does a firm maximise profit?
At the point of tangency where the slope of its demand curve is equal to the slope of an isoprofit curve.
This is also where MRS=MRT
- the isoprofit curve is essentially an indifference curve and its slope represents the marginal rate of substitution (the trade off the firm is willing to make between price and quantity)
- the demand curve is a feasible frontier and its slope represents the marginal rate of transformation (the trade off the firm is constrained to make between price and quantity)
At the profit maximising point, Price is equal to the inverse of the elasticity of the demand curve
How can the profit maximising choice be found using marginal revenue and marginal cost?
Marginal profit = marginal revenue - marginal cost
The profit maximising point is where MR=MC, so that marginal profit = 0. This is because when MR>MC, the firm could raise profit by producing more output and when MC>MR, the firm could raise profit by reducing output.
By computing the MR at all quantities, we can join together the points to form the MR curve which is a straight line with a steeper slope but below the demand curve.
The profit maximising point is found where MC=MR on the diagram, which is the same point as using isoprofit curves.
What is market power and what determines the level of market power firms have?
Market power is the ability of a firm to act as a price setter by being able to sell its product at a range of feasible prices.
The level of competition in the market determines market power. A market in which there are many close substitutes for a good will mean a firm has less market power and choosing a high price will cause demand to fall as some consumers will switch to other firms, the firm faces a more elastic demand cure.
What is a monopoly?
A monopoly is a market in which there is a sole dominant seller of a product with no close substitutes.
In actuality, pure monopolies are rare but markets in which a single firm has a significant market share are considered monopolies.
What is a natural monopoly?
A market in which the average cost curve is significantly downward sloping, even in the long run, so that a single firm can supply the whole market at a lower average cost than two firms can, leading to a single firm supplying the market.
This occurs most prevalently in utilities such as water and electricity where once networks and infrastructure are in place, the daily cost of maintenance is low relative to the initial upfront cost, so as output increases, costs are spread over more units of output and so average costs fall in the long run.
