Week 3 - Modelling the firm & perfect competition Flashcards
Two types of costs
- Total costs
- Margnal costs
Define total cost
Is the lowest way to make a given profit
Define marginal cost
Shows how much extra it costs to produce an additional unit of output
Two types of revenue
- Total revenue = price x quantity sold
- Marginal revenue - additional revenue of selling one extra unit
When does profit maximisation occur?
Marginal cost = marginal revenue
Interpret revenue and cost curves
- When MR > MC, we produce more output
- When MR < MC, we produce less output
- When MR = MC profit is maximised
3 general factors of production
- Land
- Capital - physical capital (machinery), human capital
- Labour
What makes up costs of production?
Inputs - any good/service used in the production process
Difference between fixed and variable costs
Fixed costs cannot be varied but variable costs can be varied
How are costs associated through short run and long run? (2)
- In the long run all costs are variable e.g labour costs
- Land and capital are usually fixed costs
Short run assumption about factors of production
In SR we assume factors of production are fixed and there is at least one variable factor
How can a firm increase/decrease output in the short run? And the impact (3)
- Changing the quality of the variable factor
- However, if you increase the number of workers, firms often encounter diminishing marginal product
- If you keep adding a variable factor to a fixed factor the productivity of the additional units of the variable factors begins to fall
Define marginal product
The increase/decrease in total product from adopting on extra unit of input holding all other inputs constant
Marginal product curve
As MP increases it reaches a maximum at L* and then starts to decrease
Marginal cost curve (2)
- This curve mirror the marginal product (MP) curve
- MC decreases at first, but then it reaches a maximum at Q* then it increases
Optimal output in the SR (3)
- Firms maximise profit in the SR where MC = MR
- If Q
- If Q>Q*, then the firm should produce less
Perfect competition Market assumptions (5)
- The firm is the profit taker (MR is determined by the market)
- MR is constant
- P = MR = MC
- Firm produces at Q and maximises profit
- ATC = AVC + AFC
Interpret Short run graph in perfect competition
- Here the firm should continue to produce
- If P > AVC, the firm is covering AVC and some of AFC
Interpret a Shut-down rule diagram in perfect competition (2)
- AVC can’t be covered so firm must shut down
- If P < AVC, the firm is not covering AVC or any AFC
Costs & supply in LR in perfect competition (4)
- Profit maximised in LR is when MC = MR
- If P < LRAC the firm should shut-down
- As the firm increases output, LRAC falls
- Point B is the minimum efficient scale which is output where all scale economies are achieved
Why does LRAC fall as firm increases output? (3)
- Fixed costs are spread over a large number of produced units
- Specialisation - become better a producing goods more effectively
- A larger scale takes advantage of better physical capital
Interpret a LR and SR AC curve (3)
- Each factory has a capacity and is designed for a given level of output (Q)
- In the LR new factories or production lines can be added hencce numerous SRAS
- Each SRAS corresponds to a different optimal level of output
Supply decisions in Short run summary:
- Profit maximising point
- shut down point
- Profit maximising output is where: MR= SRMC
- Shuf down temporarily when: P < SRAVC
Supply decisions in Long run summary:
- Profit maximising point
- shut down point
- Profit maximising when: MR = LRMC
- Shut down permanently when: P < LRAC
Define industry
The set of all firms making the same product
Define market structure
A description of the behaviour of buyers and sellers in the market
Different market structures
Perfect completion assumptions (6)
- Each firm produces a homogenous product (exactly the same)
- There are an infinite no.of potential buyers and sellers in the industry
- There is perfect information available to all buyers and sellers
- There are no entry or exit barriers to prospective firms or current firms in the industry
- Each firm sets out to profit maximise (MC=MR)
- Firm is a price taker - the actions of buyers and sellers has no impact on the market price
Interpret perfect completion demand curves (5)
- The interaction of market demand and supply sets the market price (P1)
- The firm then ‘takes’ the price, creating the elastic firm demand curve (AR1)
- The firm produces Q1 units, at point A, where MC = MR
- Here, P > AVC and more importantly, P > ATC
- The blue shaded area represents abnormal profit
Formula for average revenue
AR = TR/Q
How much output should a firm produce in a perfectly competitive market? (3)
- Firm maximises profit at MC = MR
- In a competitive market (only) when demand is perfectly elastic P = MR (price taker)
- If you sell a unit for £10 every time p, your MR = £10
How do you get industry supply curve in a perfect competitive market?
Simply horizontally sum the indivual supply curves
Entry and exit in a perfect competition market (3)
- The market price become depressed (P1 to P2)
- Firms are forced to reduce prices (price takers), AR = MR shifts (AR1 to AR2)
- At point B, abnormal profit no longer exists and firms make normal profit
Define abnormal profit
TR - TC
Define normal profit
Ecom version of break even: TR =TC
What happens in imperfect competition? (4)
- The market does not satisfy the conditions for perfect competition
- Indivudal firms or consumers have some influence on the market price
- Subsequently firms face a downward sloping demand curve
- Firms therefore have market power and are seen as price-setters (price-makers)
Types of monopolies (2)
- Pure monopoly - the sole supplier of the industry’s output
- Natural monopoly - arises where the largest supplier in an industry, often the first supplier in amendment, has an overwhelming cost advantage over other actual and potential customers
3 Key characteristics of monopolies
- High capital costs
- High entry barriers
- Significant scale economies
Monopoly assumptions (5)
- One seller of the good/service
- No substitute goods available
- High barriers to entry
- Profit max: MC = MR
- Faces a downward sloping demand curve, market demand curve = firm demand curve
Monopoly demand curve (AR & MR) (3)
- As there is only one firm in the market this is also the market demand curve
- MR does not equal AR so firm must reduce price to sell more units
- Eventually MR tends to 0 and then becomes negative
How much should monopolies produce? (5)
- Proit max: MC = MR
- Monopolist produces at Q and changes P
- As P is above ATC, the monopolist makes abnormal profit
- Monopoly: P > MC
- Perfect competition: P = MC
How to measure monopoly power?
P - MC
Interpret a Perfect competition vs monopoly curve
- D is the market demand curve
- Under PC, D(AR) = MR
- LRS is the MC curve (supply curve)
- Monopoly - produce less (Qm) and change more (Pm)
- Perfect competition - produce more (Qc) and charge less (Pc)
Arguments for monopoly (3)
- Making abnormal profits may allow better R&D
- Patents are another form of giving a monopoly - can encourage investment
- Economies of scale - lower costs passed on to consumers
