Week 7 Prices and Markets Flashcards
The firm
The firm is a planning unit which produces goods (outputs) using factors of production (inputs)
for financial return.
Firms have the responsibility to manage a large proportion of society’s productive resources.
Economists want to know whether this stewardship is efficient.
To find out, economists build models of the firm based on assumptions. These
models are then analysed for equilibrium and efficiency.
the SCP paradigm
The Structure-Conduct-Performance (SCP) paradigm provides a structured framework to study the firm.
Developed by Joe Bain (1959), used as a starting point for analysing markets and industries.
The performance of a market is determined by the conduct of the firms within the market which in turn is determined by the structure of the market.
SCP causal relationship
Structure to conduct to performance
Structure
The competitive environment in the market.
Conduct
How firms behave in a given market structure (pricing strategies, advertising, research and development).
Performance
Market efficiency (social welfare, consumer surplus, profits).
Industry analysis: market structure
Market structure describes the competitive environment in which firms operate.
It is determined by four characteristics which determine how firms behave (conduct) and how efficient the market is (performance).
These yield four types of market structure:
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Number of firms
Firm size
Entry barriers
Product differentiation
For each, we want to study:
Structure: the relevant costs, revenues and associated curves for a firm in the particular market structure;
Conduct: Use these to determine how the firm decides how much Q to produce and how much P to charge, both in the short and long run; and
Performance: whether these decisions lead to efficiency.
Profit
total revenue minus cost
Profit = TR - TC
Profit maximisation - Introduction
Neoclassical economics assumes that the main objective of the firm is to maximise its profits.
To identify how to produce to maximise profits, the firm needs to know how its revenues and costs change as it produces more.
TR and TC
Total revenue (TR) = total output produced (and sold) (Q) x price per unit (P)
Total cost (TC) = total output produced (Q) x cost per unit (C)
Total revenue
(TR) = P x Q
[ TR = P x Q ]
Average revenue
(AR) = total revenue divided by the quantity sold.
[ AR = TR / Q ]
As TR = P x Q, therefore, for all types of firm, AR equals the price of the good. [ AR = TR / Q = P ]
Marginal revenue
(MR) = the change in TR from an additional unit sold.
[ MR = ∆ TR / ∆ Q ]
Revenue measures
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Revenue when demand is elastic
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When a demand curve is elastic (PED > 1), an increase in price lowers TR because the rise in price is proportionately smaller than the fall in quantity demanded.
Revenue when demand is inelastic
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When a demand curve is inelastic (PED < 1), an increase in price raises TR because the rise in price is proportionately larger than the fall in quantity demanded.
The general rule for profit maximisation
Profit is maximised when MC = MR
Marginal revenue
the extra revenue earned in selling one additional unit of output
Marginal cost
the extra cost incurred in producing one additional unit of output
MR and MC
If MR > MC, the firm should increase its output;
If MC > MR, the firm should decrease its output;
At MC = MR, profit is maximised.
Firms will produce output up to quantity where MC = MR.
Profit and marginal profit
Profit = TR - TC Marginal profit (MP) = MR - MC Profit is maximal if MP = 0 MR – MC = 0, therefore MC = MR
Profit maximisation photo
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Profit maximisation photo
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Production and costs - Introduction
opportunity and explicit costs
When economists calculate a firm’s total cost of production, they include all the opportunity costs of producing the output.
The amount spent on purchasing raw materials and paying workers’ wages are opportunity costs because this money cannot be used to buy something else. When a cost involves money flowing out of the firm it is called an explicit cost.
Production and costs - Introduction
implicit costs
In contrast, the opportunity costs of resources owned and used by the firm, but not explicitly paid for by the firm (no outflow), are implicit costs. For e.g. the opportunity cost of an entrepreneur’s labour. An important implicit cost is the opportunity cost of the financial capital invested in the business.
Economic and accounting profit
Economists include implicit costs in total costs, but accountants do not. Therefore accounting profit is larger than economic profit.
Production function
The relationship between quantity of inputs used to make a good and the quantity of output of the good.
Production function (actual function)
Q = f (K, L), where Q = total output; K = capital (input); L = labour (input).
In order to increase Q, the firm has to increase K or L or both, thereby increasing total costs.
Problem with increasing Q
certain inputs (i.e. K) take time to increase
Fixed and variable inputs
Fixed inputs are those that cannot be increased in the short term (e.g. capital (k), factory, plant, heavy machinery); variable inputs are those that can (e.g. labour (L)).
Short run
The period of time during which at least one factor of production/input is fixed.
A firm typically cannot build a larger factory overnight. In the short run, a firm must take the size of its factory as given.
Long run
The period of time needed for all factors of production/input to become variable.
How long is the long run? For someone operating a coffee cart, perhaps a couple of months. In the case of an airport, could be a decade or more
The production function: diminishing marginal product
Marginal product
The marginal product of an input is the increase in the quantity of output obtained from an additional unit of that input.
The production function: diminishing marginal product
Fixed inputs
Due to the existence of fixed inputs in the short run, there will come a point when each additional unit of variable input will produce less output than the previous unit.
Therefore, in the short run, a firm’s production function displays diminishing marginal product.
The production function: diminishing marginal product
Diminishing marginal product
The property whereby the marginal product of an input declines as the quantity of the input increases.
Note however that total quantity of output continues to increase as more variable inputs are added.
The production function: diminishing marginal product
Diminishing marginal product
The property whereby the marginal product of an input declines as the quantity of the input increases.
Note however that total quantity of output continues to increase as more variable inputs are added.
The production function: diminishing marginal product
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From the production function to the total cost curve
Suppose that the factory (fixed input) costs $30 per hour, and that each worker (variable input) is paid $10 per hour.
As additional workers are hired, the cost of labour increases. However, because the size of the factory is fixed in the short run, the cost of the factory does not change.
We can use the production function to determine how the firm’s total costs vary with the quantity produced (Q).
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7.4.1. The production function and the total cost curve
Diminishing marginal product causes the production function to increase at a decreasing rate
Diminishing marginal product causes the total cost to increase at an increasing rate
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Fixed costs
Costs that do not vary with the quantity of output produced
Variable costs
Costs that do vary with the quantity of output produced
Total costs
The market value of all the inputs that a firm uses in production
TC = FC + VC
Average fixed cost
Fixed costs divided by the quantity of output
AFC = FC / Q
Average variable cost
Variable costs divided by the quantity of output
AVC = VC / Q
Average total cost
Total cost divided by the quantity of output
ATC = TC / Q
Marginal cost
The increase in total cost that arises from an extra unit of production
MC = ΔTC / ΔQ
Cost measures: TC, FC, VC
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Cost measures: ATC, AFC, AVC
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ATC tidbits
The ATC is U-shaped, reflecting the shapes of both average fixed cost and average variable cost.
The bottom of the U-shape occurs at the quantity that minimises ATC. This quantity is called the efficient scale of the firm.
If the firm produces more or less than the efficient scale, ATC rises above its minimum.
AFC tidbits
The AFC slopes downwards because fixed costs is spread over more units as output increases.
AVC tidbits
Past some point the AVC curve slopes upward, as a consequence of diminishing marginal product.
ATC AFC AVC tidbits
At very low levels of output, ATC is high because AFC is high. As output increases, ATC falls as fixed cost is spread over more units of output.
Eventually the increase in AVC becomes the dominant force and ATC starts rising.
At the efficient scale, the decline in AFC is balanced against the increase in AVC.
Cost measures: ATC, AFC, AVC curves
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Cost measures: MC
Marginal cost tells us how much total cost will change as the firm alters its level of production.
Marginal cost (MC): the increase in total cost that arises from an extra unit of output produced. [ MC = ∆ TC / ∆ Q ]
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MC curve
In many firms, the MPL is initially increasing because a team of workers can divide tasks more productively than a single worker. Hence, the MC curve initially slopes downward (MC falling).
Past some point, the MC curve slopes upward as diminishing marginal product sets in (MC increasing).
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Relationship between MC and ATC
The MC curve crosses the ATC curve at its minimum.
At low levels of output, MC is below ATC. The cost of the marginal unit reduces ATC and therefore ATC slopes down.
At high levels of output, MC is above ATC. The cost of the marginal unit increases ATC and therefore ATC slopes up.
. Costs in the short and long run
The division of total costs between fixed and variable costs depends on the time horizon being considered.
. Costs in the short run
In the short run, some inputs, such as the size of a factory, are fixed. Increasing output requires increasing the use of variable inputs such as labour. Each short run ATC curve is drawn for a specific level of fixed inputs.
. Costs in the long run
In the long run, a firm can adjust all inputs to the production process. Increasing the size of a factory imposes a larger fixed cost on the firm but also tends to increase the marginal product of labour.
. Costs in the short and long run explained
The long run ATC curve lies below the short run ATC curves. This curve is a much flatter U-shape than the short run ATC curves. In essence:
In the long run, the firm gets to choose which short run ATC curve it wants to use (which factory size).
In the short run, it has to use whatever short run ATC curve it has, based on decisions it has made in the past.
. Costs in the short and long run illustration
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Costs in the short and long run: economies and diseconomies of scale
The shape of the long run ATC curve conveys important information about the technology for producing a good.
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Economies of sale
Happens when the long run ATC declines (cost falls) as output increases.
Economies of scale often arise because higher production levels allow specialisation among workers.
Constant returns to scale
Happens when the long run ATC does not vary (costs constant) with the level of output .
Diseconomies of sale
Happens when long run ATC rises (cost rises) as outputs increases.
Diseconomies of scale can arise because of coordination problems that are inherent in any large organisation.
