Unit 7 - The Firm and its Customers Flashcards
how does the firm choose prices for its products?
- depends on the demand it faces and its production costs
- Firms can influence both consumer demand and costs through innovation or advertising as well
Demand curve
how quantity demanded varies with changes in price
formula for total costs
Total costs = unit cost x quantity
formula for total revenue
Total revenue = price x quantity
formula for profit
Profit = total revenue - total costs
Profit = (price - cost) x quantity
Isoprofit curve
- joins the points that give the same level of total profit
- The firm is indifferent between combinations of price and quantity that give the same profit
- The isoprofit curves nearer to the origin correspond to lower levels of profit
what determines profit maximisation
To achieve a high profit, you would like both price and quantity to be as high as possible, but you are constrained by the demand curve.
The demand curve determines what is feasible.
profit function
it shows the profit achieved for every quantity, set at the highest price the demand function allows you to set
explanation of the graph that determines profits
- The slope of the isoprofit curve - the MRS - the trade-off you are willing to make between P and Q
- You would be willing to substitute a high price for a lower quantity if you obtained the same profit
- The slope of the demand curve - the MRT - the rate at which the demand curve allows you to transform Q into P
- The two trade-offs balance at the profit-maximizing choice of P and Q
why do large firms produce output at a lower cost per unit
- Technological advantages
- Cost advantages
Economies of scale or increasing returns
- the technological advantages of large-scale production - when a firm grows beyond a size when it’s more profitable to produce larger quantities
–> Results from specialization
–> Marketing economies of scale - buying in bulk
–> Financial economies of scale - it’s easier to get financial loans when a firm growns beyond a certain size
Constant return to scale
output increases proportionally to the increase in input
Diseconomies of scale or decreasing returns to scale
- if inputs are increased by a given proportion, output increases less than proportionally
- Communication issues within a big firm
- Increasing production requires more than a proportional increase in supervision and management
fixed cost
costs independent of the level of the firm’s output
network economies of scale
People are more likely to buy products when they know other people are also using them
opportunity cost of capital
- the return on investment they would receive if they invested their money in something else
- Part of the cost of producing cars is the amount that has to be paid out to shareholders to cover the opportunity cost of capital
- for them to continue to invest to produce cars
Average cost curve
Average cost = total cost/quantity
Marginal Cost
- the additional cost of producing one more unit of output - it is the slope of the cost function
- MC = change in cost/change in quantity
- To draw the MC curve - calculate the MC at every point on the cost function
- When AC = MC - AC is flat - the slope of AC is 0
differentiated product
“Differentiated product” refers to products that can remain competitive despite being put against competing products that are very similar. “
We expect a firm selling a differentiated product to face a downward-sloping demand curve.
how to calculate the profit in isoprofit curves
Profit = total revenue - total costs = P(Q) - C(Q)
Normal profits
Cost function includes the opportunity cost of capital, which is referred to as normal profits
Economic profits
is the additional profit above the minimum return required by shareholders
Profit
- Profit is the number of units of output multiplied by the profit per unit, which is the difference between the price and the average cost
- Profit = total revenue - total costs = P(Q) - C(Q)
Profit per Unit
- Profit = Q(P - AC)
- Profit per unit - the difference between the price and the average cost - P - AC
demand curve
- The product demand curve is a relationship that tells you the number of items they will buy at each possible price
- Each consumer has a willingness to pay, which depends on how much customer values it; a consumer will buy a car if the price is less than or equal to his or her WTP
- If P is lower there are a larger number of consumers willing to buy, so the demand is higher
- We expect demand curves to slope downward (not necessarily straight though)
- The demand curve determines the feasible set of combinations of P and Q, so in order to find the profit-maximising point we will draw the isoprofit curves, and look for the point of tangency
slope of the isoprofit curve
will depend on the shape of the ac curve
the zero economic profit curve
P=AC at all points of the curve
If the price received by the firm causes it to produce at a quantity where price equals average cost, which occurs at the minimum point of the AC curve, then the firm earns zero profits.
isoprofit curves - when do they slope downward/upward
Isoprofit curves slope downward at points where P > MC
Isoprofit curves slope upward where P < MC
profit margin
- The difference between the price and the marginal cost is called the profit margin, at any point on the isoprofit curve the slope is given by:
- Profit margin = P - MC
- Slope of isoprofit curve = - profit margin / quantity
- The profit margin is positive so the slope is negative, vice versa
when does a firm maximise profits
The firm maximises profit at the tangency point where the slope of the demand curve is equal to the slope of the isoprofit curve, so that the two trade-offs are in balance
At the profit maximisation point, MRT = MRS
constrained optimization
A decision-maker chooses the values of one or more variables - to achieve an objective subject to a constraint that determines the feasible set
Marginal revenue
MR = change in revenue/change in quantity
- When P is high and Q is low, MR is high: the gain from selling one more car is much greater than the total loss on the small number of other cars.
- As we move down the demand curve P falls (so the gain on the last car gets smaller), and Q rises (so the total loss on the other cars is bigger), so MR falls and eventually becomes negative.
Using marginal revenue to find the point of profit maximization
Marginal profit = MR - MC
MR>MC - marginal profit is positive, so profit increases with Q
MR<MC - marginal profit is negative, profit decreases with Q
Profit max point - where MC = MR
Indicated by the max point of the profit curve
consumer surplus
The consumer surplus is a measure of the benefits of participation in the market for consumers.
producer surplus
The producer surplus is closely related to the firm’s profit, but it is not quite the same thing.
Producer surplus = Revenue - MC
Producer surplus is the difference between the firm’s revenue and the marginal costs of every unit, but it doesn’t allow for the fixed costs
gains from trade
Gains from exchange (or trade) is the total surplus for the parties involved in an economic interaction (sum of economic rent)
Total surplus
The total surplus arising from trade in this market, for the firm and consumers together, is the sum of consumer and producer surplus.
Total surplus = producer surplus + consumer surplus
determining profit with surplus and fixed cost
The profit is the producer surplus minus fixed costs.
Profit = producer surplus - fixed costs
deadweight loss
- the loss of potential surplus
- Under perfect price discrimination - the deadweight loss would disappear - the firm would capture the entire surplus - no consumer surplus
- This scenario is pareto efficient
pareto efficiency
A pareto-efficient allocation - where D curve intersects the MC curve - there are no more consumers willing to pay more than the P at the pareto-efficient allocation
Higher consumer surplus - consumers are better off
Total surplus is higher
The elasticity of demand
Profit maximization depends on the elasticity of demand
law of demand
quantity demanded falls when price increases
PED
- measure of the responsiveness of consumers to a price change
PED = - % change in q demanded/% change in price
PED = infinity - demand curve is flat - perfectly elastic
PED = 0 - demand curve is vertical - perfectly inelastic
PED = 1 - x=y - unitary elastic
PED>1 - elastic demand
PED<1 - inelastic demand
- Profit margin is related to the elasticity of demand
Elastic demand
PED>1
- Elastic —> for an elastic demand a percentage change in price would cause a higher percentage change in quantity demanded
- curve is flatter
Inealstic demand
PED<1 - inelastic demand
- Inelastic —> for an inelastic demand a percentage change in price would cause a lower percentage change in quantity demanded —> meaning you can play with the prices because people will still purchase
- The lower the elasticity of demand - the more the firm will raise P above MC to achieve a high profit margin
- curve is steeper
zero-economic-profit curve
the combinations of price and quantity for which economic profit is equal to zero— because the price is just equal to the average cost at each quantity.
markup
profit margin as a proportion of the price
Inelastic demand - high-profit markup
Using demand elasticities in government policy
The effect of a tax on a good will depend on the elasticity of demand for the good
If demand is highly elastic - the tax will cause a large reduction in sales - reducing potential tax revenue
A government wishing to raise tax revenue, has to tax products with inelastic demand
monopoly
- one seller on the market
- the firm can set a price greater than the MC
market failure
- when markets allocate resources in a Pareto-inefficient wat
-Deadweight loss - consequence of market failure - the unexploited gains from trade
Monopoly rents
economic profits over and above its production costs
firm with few subsidies
low elasticity of demand - the firm has market power
subsidies
a sum of money granted by the state or a public body to help an industry or business keep the price of a commodity or service low.
How is the firm is able to influence the demand curve to increase profits
By changing the selection of products - product differentiation; technological innovation
Through advertising - create brand loyalty
Natural monopoly
AC is lower when operating on a large-scale - when a single firm can supply the whole market at lower AC than multiple firms, then the industry is a natural monopoly
reciprocity
the practice of exchanging things with others for mutual benefit, especially privileges granted by one country or organization to another.
Economies of scale
a proportionate saving in costs gained by an increased level of production
–> for a bakery a the costs per croissaint are lower the more croissant the bakery bakes
–> relevant for specialisation
Economies of scope
a proportionate saving in costs gained by producing two or more distinct goods when the cost of doing so i less than that of producing separately
–> for a bakery the costs per croissant are lower the more cheese sticks the bakery sells
Comparative advantage
- who can produce the greatest advantage giving up the other good
–> who can produce more of a good; who is better at it
substitution effect
substitute free time for work because you earn more → incentive to work more because the opportunity cost of free time is higher
income effect
budget constraint shifts outwards effect of additional income with no change in the opportunity cost
