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.
