AP Microeconomics Review Session #3 Key Terms & Concepts

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1 The Firm, Profit, and the Costs of Production 1. Explicit vs. implicit costs 2. Short-run vs. long-run decisions 3. Fixed inputs vs. variable inputs 4. Short-run production measures: be able to calculate/graph these (only MP will go negative) a. Total product (TP) b. Marginal product (MP) c. Average product (AP) 5. Law of diminishing marginal returns 6. Short-run costs: be able to calculate/graph these a. Total costs: total fixed cost (TFC), total variable cost (TVC), and total cost (TC) b. Marginal & average costs: marginal cost (MC), average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) 7. Long-run average cost curve (LRAC) a. Economies of scale b. Constant returns to scale c. Diseconomies of scale 8. Efficiency a. Allocative efficiency occurs when P = MC; productive efficiency occurs when P = the minimum point on the ATC curve

2 Perfect Competition & Monopoly 1. Characteristics of perfect competition a. Price-takers; no barriers to entry/exit; many small producers; identical product 2. Understand the difference b/t the market S & D curves vs. those of the individual firm a. Side-by-side graph b. A perfectly competitive firm has a perfectly elastic (horizontal) demand curve c. Marginal revenue, demand, average revenue, & price are equivalent for a perfectly competitive firm (MR=D=AR=P) 3. Profit maximization a. Total economic cost = implicit costs + explicit costs b. Economic profit ( ) = total revenue total economic cost c. Choose the output level where MR = MC, or the level where MR is closest to MC without MC exceeding MR 4. Short-run profit & loss a. (P ATC) = per-unit profit or loss; multiply this by Q (the number of units produced) to find total profit (or loss) b. Be able to identify the profit rectangle at a determined quantity, and make sure to label it as positive or negative; if the firm is breaking even, there is not profit rectangle. i. If P > ATC, then > 0 (positive) ii. If P < ATC, then < 0 (negative loss) iii. If P = ATC, then = 0 (breaking even, a.k.a. normal profit) c. The shutdown point i. If the firm is taking a loss, it will continue to produce goods, unless its total revenue no longer covers its total variable costs. ii. If P < AVC, the firm shuts down and Q = 0. Loss is equal to TFC. iii. The MC curve above the shutdown point is the supply curve. 5. Long-run adjustment a. Long-run equilibrium for perfectly competitive firms is the breakeven point: i. Price in the long run (PLR) = MR = MC = ATC

3 ii. Economic profit ( ) = 0. iii. Zero economic profit is normal profit!!! iv. P.C. firms are productively & allocatively efficient in the long run!!! (they are also allocatively efficient in the short-run) 6. Characteristics of a monopoly a. Price-makers; single producer; no close substitutes; market power b. Barriers to entry: legal barriers, economies of scale, control of key resources 7. The graph for a monopoly a. The demand curve is downward sloping, and it also represents average revenue (P) and price for a non-discriminating monopoly. b. The marginal revenue (MR) curve is downward sloping and below the demand curve. c. The monopolist wants to operate on the elastic portion of the demand curve (above the midpoint). 8. Profit maximization a. An unregulated monopoly will set output level (Q) where MR = MC. b. From that point, go up to the demand curve and over the vertical axis to determine the price the monopoly will charge. c. Monopolies are likely to make positive economic profits in the long-run, unlike perfectly competitive firms. d. Profit rectangle is identified by drawing the height between the demand curve and the ATC curve, at the quantity where MR = MC, then drawing the width from that quantity over to the vertical axis. 9. Deadweight loss (DWL) a. DWL exists with a monopoly because the firm is not allocatively (P = MC) or productively (P = ATCmin) efficient. b. This is the triangle between the profit rectangle, MC, and D 10. Price discrimination a. Some monopolies charge different groups of people different prices (charge each person the most they are willing to pay) b. This turns consumer surplus into extra profit for the monopolist i. Consumer surplus = 0 for a price-discriminating monopoly c. No separate MR curve because MR = D d. Profit area: locate ATC at the quantity where MR = MC, draw a horizontal line over to the vertical axis, and shade all the way up to the demand curve

4 Monopolistic Competition & Oligopoly 1. Characteristics of monopolistic competition a. Relatively large number of firms; differentiated products (with marketing/advertising campaigns to set them apart); ability to set price above the competitive level; and ease of entry & exit into the market b. Examples: market for shoes or the fast food industry 2. Short-run profit maximization a. Graph looks similar to that of a monopoly i. Downward sloping demand curve determines price and is also equal to AR ii. Downward sloping MR curve below the demand curve iii. MC, ATC, and AVC curves all go down and then back up b. The firm will maximize profit by setting Q where MR = MC i. Price is found by finding the demand curve vertically at this quantity and going over to the y-axis ii. Profit is found in the rectangle with a width of Q and a height of the distance between price and ATC iii. Can earn positive, negative, or zero profits in the short-run; short-run positive profits won t last long 3. Long-run adjustment a. Just like in perfect competition, firms are attracted to enter the market when existing firms are making positive profits i. This in turn causes overall supply to increase and price to decrease, causing profits to shrink for each firm. ii. Firms stop entering the industry when P = ATC (when profits are zero). 1. On the graph, the demand curve is tangent to ATC b. In the long-run, these firms earn = 0. c. These firms do NOT achieve allocative efficiency (since P > MC), and they do NOT achieve productive efficiency (since they don t operate where ATC is at a minimum). d. Deadweight loss (DWL) DOES exist, but not as much as with a monopoly.

5 4. Characteristics of oligopoly a. A few large producers; differentiated or standardized products; high barriers to entry; mutual interdependence (the action of one firm is likely to affect others); collusion sometimes occurs b. Examples: local gasoline market; the big 3 American automakers; Coke & Pepsi 5. Game theory (the prisoner s dilemma) a. Use of a matrix to make a business decision when a duopoly exists b. Be sure you know how to read this matrix (which numbers apply to which firm), and how to revise it given new information c. Dominant strategy: no matter what the other player decides, this strategy has a better outcome than the other for you i. There is not always a dominant strategy. ii. If only one player has a dominant strategy, the other will assume they will follow it, and strategize accordingly. iii. Nash Equilibrium occurs when both players have a dominant strategy, or when one has a dominant strategy and the other strategizes accordingly; in both cases, both players end up in the same cell. 6. Collusive pricing a. Most forms of collusive behavior between direct competitors is illegal b. Based on the idea that if both firms price high, they both win i. Often there is incentive to cheat on these agreements c. Cartels: groups of firms that create a formal agreement not to compete with each other i. They collectively operate as a monopolist to maximize joint profits ii. These are illegal, but also face other challenges: 1. Difficulty in arriving at a mutually acceptable agreement 2. Need for a punishment mechanism for members who cheat 3. If new firms enter, the cartel loses monopoly power & profit

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