Unit 7: Firm and its Customers Flashcards
what strategies allow firms to grow?
pile it high and sell it cheap - tesco
charge a price premium - apple
why are large firms different from small firms
because of economies of scale
firm’s cost depends on its scale of production and technology
large firms can be more profitable due to technological and/or cost advantages
this leads to economies of scale
Explaining economies of scale
if inputs increase by a given proportion & production increases more/as/less proportionally
Then the technology exhibits increasing/constant/decreasing returns to scale in production
Economies of scale include
Cost advantages - large firms can purchase inputs on more favourable terms as they have more bargaining power with suppliers
Demand advantages - network effects (value of output rises with no. of users)
But large firms can experience diseconomies of scale e.g additional layers of bureaucracy due to too many employees
Technological advantages - e.g specialisation, larger machines
Diseconomies of scale include
Increased bureaucracy
inability to adapt to change
Average cost
Average cost per unit produced
slope of production function drawn from origin to the point
Marginal cost
the effect on total cost of producing one additional unit of output
calculated as the slope of the cost function at a given point
Relationship between MC & AC
If AC greater than MC - AC is decreasing
if AC less than MC - AC is increasing
The MC curve always intersects AC curve at the AC curves lowest point
Demand curve
Price against quantity
quantity that consumers will buy at each price
Isoprofit curves
Economic profit = total revenue - total costs (costs include opportunity cost of capital)
isoprofit curves show price-quantity combinations that give the same profit
Profit = Q(P - AC)
Profit maximisation
Demand curve = firm’s feasible frontier (MRT=slope)
Isoprofit curves = firm’s indifference curves (MRS=slope)
profits maximised where MRT=MRS
profits maximised where marginal revenue = marginal cost
Marginal revenue
change in revenue from selling an additional unit
Price elasticity of demand
elasticity = -%change in quantity/% change in price
to say in order to sell one more unit, firm has to change price by $x
price elasticity of demand = degree of responsiveness (of consumers) to a price change
= -%change in demand/%change in price
MR is always positive when demand is elastic
A firms markup (profit margin in proportion to price) is inversely proportional to price elasticity of demand
Price elasticity and policy
Specific taxes depends on the elasticity of demand for a certain good
governments raise more tax revenue by levying taxes on price-inelastic goods
Market power & elasticity
firm’s profit margin depends on the elasticity of demand, which is determined by competition:
- demand is relatively inelastic if there are few close substitutes
- firms with market power have enough bargaining power to set prices without losing customers to competitors
competition policy (limits on market power) can be beneficial to consumers when firms collude to keep prices high
Monopolies
firms selling specialised products face little competition and hence have inelastic demand
they can set prices above marginal cost without losing customers, thus earning monopoly rents
this is a form of market failure because there is deadweight loss
Natural monopolies
arise when one firm can produce at lower average costs than two or more firms e.g utilities
instead of encouraging competition, policymakers may put price controls or make these firms publicly owned e.g the underground
Firms gaining market power
- Innovation and product differentiation
tech innovation allows firms to differentiate products from competitors
firms inventing new products may prevent competition altogether through patents or copyright laws
- Advertising
attracts consumers away from competing products and creates brand loyalty
can be more effective than discounts in increasing demand for product
Consumer surplus
total difference between willingness-to-pay and purchase price
calculated as area of price, quantity graph under demand curve as a triangle above willingness-to-pay line
Producer surplus
the total difference between the revenue and marginal cost (profit = producer surplus - fixed cost)
area of rectangle under demand curve and line between willingness-to-pay line - marginal cost (area under marginal cost line)
total surplus
consumer surplus + producer surplus
Deadweight loss
loss of total surplus relative to a Pareto efficient allocation (unexploited gains from trade)
total surplus os highest when demand = marginal cost
firm doesn’t produce at social optimum thus
Little triangle in the graph
