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1 1.5 Theory of the firm and its market structures - Production and costs Syllabus item: 42 Weight: 3 Definition: Total product (TP): The total output that a firm produces, using its fixed and variable factors in a given time period Average product (AP): The output that is produced, on average, by each unit of the variable factor. (Total output number of units of the variable factor employed) Marginal product (MP): The extra output that is produced by using an extra unit of the variable factor Distinguish between the short run and long run in the context of production. Define total product, average product and marginal product, and construct diagrams to show their relationship. Explain the law of diminishing returns. Calculate total, average and marginal product from a set of data and/or diagrams. Short run: the period of time in which at least 1 f.o.p is fixed so that production can be altered by changing variable inputs. Long run: the period of time in which all f.o.p is variable, but the state of technology is fixed. Can expand scale or size of firm. All the planning takes place. Production in the short run: The law of diminishing returns Variable factors of production: Inputs which can be adjusted to alter production in the short run àlabor or materials Fixed factors of production: Inputs which cannot be adjusted to alter production in the short run à Capital or land

2 Capital Labour (L) Total product (TP) Average product (AP) Marginal product (MP) Table: Total, average, and marginal product per week - The total product keeps rising even though the marginal, and the average product is falling. - It is only when the marginal product is negative, with the addition of the ninth worker that total product starts to fall. - Marginal product curve cuts the average product curve at its highest point, where it is momentarily flat.

3 The law of diminishing returns: Definition: As more and more of a variable factor (e.g. Labour) are added to a fixed factor, output will rise initially but will eventually fall. 1) Short-run concept 2) Influences shape of SRAC curve 3) At least one of the f.o.p is fixed 4) Leads to inefficiency and waste of scarce resources 5) Where MP ( TP) starts to fall or, where MC ( TC/ TP) starts to rise (If AVC is rising, it implies diminishing marginal returns but for an accurate analysis it is necessary to do a marginal analysis, looking at changes in MC or even better at MP) 6) Output (TP) initially rises at an increasing rate (up to A), but marginal output then starts to diminish. This means that total output still increases, but at a decreasing rate (the slope of the curve tails off) AFC (SR) DMR (SR) Economies of scale (LR) Diseconomies of scale (LR)

4 Syllabus item: 43 Weight: 3 Definition: Economic cost: the opportunity cost of the firm s production (including entrepreneur ship) Explain the meaning of economic costs as the opportunity cost of all resources employed by the firm (including 1. Explicit costs à Any costs to a firm that involve the direct payment of money i.e. Wage expense, rent or lease costs 2. Implicit costs entrepreneurship). Distinguish between explicit costs and implicit costs as the two components of economic costs. à Represented by lost opportunity in the use of a company's own resources, excluding cash i.e. the loss of interest income on funds, or depreciation of machinery used for a capital project. Costs of production: economic costs

5 Syllabus item: 44 Weight: 3 Definition: Total costs: the complete costs of producing output a) Total fixed cost (TFC): Total cost of the fixed assets that a firm uses in a given time period. They do not change as production is increased or decreased. They exist even if output is zero. b) Total variable cost (TVC): Total cost of the variable assets that a firm uses in a given time period. They vary with output. c) Total cost (TC): TFC +TVC Explain the distinction between the short run and the long run, with reference to fixed factors and variable factors. Distinguish between total costs, marginal costs and average costs. Draw diagrams illustrating the relationship between marginal costs and average costs, and explain the connection with production in the short run. Short-run: at least 1 f.o.p is fixed. In other words, the firm cannot change at least 1 factor Costs of production in the short run (e.g. factory building) Long-run: all factors variable and therefore the firm can plan the ideal scale of the operation. Short-run AFC, AVC, ATC, and MC curves The MC curve cuts the AVC and ATC curves at their lowest points. AFC falls as output increases, and, since it is the difference between ATC and AVC, the vertical gap between ATC and AVC gets smaller as output grows Definition: Average costs: Costs per unit of output. Total costs level of output a) Average fixed cost (AFC): Total fixed costs level of output b) Average variable cost (AVC): Total variable costs level of output c) Average (total) cost (ATC): Total costs level of output Marginal costs: The increase in total cost of producing an extra unit of output. Change in TC Change in level of output

6 Short-run AFC, AVC< ATC< and MC curves Notes: a) Average fixed cost (AFC) curve: AFC decreases throughout the output (Q) range. AFC moves closer and closer to the horizontal axis à Why? AFC=TC/Q AFC as Q b) Average variable cost (AVC) curve The average variable cost is U-shaped. AVC first decreases, reaches a minimum, and the increases.! Why? Law of diminishing returns and the law of increasing costs c) Average total cost (ATC) curve ATC has similar shape of AVC. I It falls faster than AVC in the beginning and rises slower after reaching its minimum point.! Why? ATC = AFC + AVC. When the increase in AVC outweighs the decrease in AFC, the ATC will begin to increase forming the familiar U - shaped curve. d) Marginal cost (MC) curve: a. This curve also decreases at first, reaches a minimum, then increases. b. When MC < AVC, AVC are decreasing When MC > AVC, AVC are increasing. c. The only way for AVC to decrease (fall) is for the extra cost of the next unit produced (MC) to be less than the AVC of all the preceding units. d. MC intersects AVC and ATC at their minimum.

7 Syllabus item: 45 Weight: 3 Distinguish between increasing returns to scale, decreasing returns to scale and Definition: Returns to scale: à Long run concept that examines the change in total output as a result of increasing the total inputs constant returns to scale. (Dis) Economies of scale Long-run concept Measure the change in average unit cost Causes the LRAC to rise or fall Returns to scale Long-run concept Measures the change in total output Growth of firm can result in increasing, constant or decreasing returns to scale Production in the long run: returns to scale Efficient (=economies of scale) Inefficient (=diseconomies of scale)

8 Syllabus item: 46 Weight: 3 Main idea 1 Long run average cost curve (LRAC): 1. Since we know all costs are variable in the long run, we just call it the LRAC. 2. It is constructed from a series of SRAC curves + points which are tangent to the minimums of the SRAC curves associated with a series of different output levels (Q) Outline the relationship between short-run average costs and long-run average costs. Explain, using a diagram, the reason for the shape of the long-run average total cost curve. 3. U-shaped because of the existence of economies and diseconomies of scale Short run average cost curve (SRAC): 1. U-shaped because of the hypothesis of diminishing returns. Costs of production in the long run Main idea 2 In theory, LRAC curve is an envelope curve, as it envelops an infinite number of short-run average cost curves. SRAC curves represent all of the possible combinations of fixed and variable factors that could be used to produce different levels of output for this firm Ø The LRAC curve and SRAC curves At output level q3, LRAC is at its lowest point. This would be the economically efficient output level to achieve.

9 Definition: Economies of scale: Any decreases in long-run average costs that come about when a firm alters all of its f.o.p in order to increase its scale (size) of output à Leads to firms experiencing increasing returns to scale. Diseconomies of scale: Any increases in long-run average costs that come about when a firm alters all of its f.o.p in order to increase its scale (size) of output à Leads to firms experiencing decreasing returns to scale. Describe factors giving rise to economies of scale, including specialization, efficiency, marketing and indivisibilities. Describe factors giving rise to diseconomies of scale, including problems of coordination and communication Costs of production in the long run Main idea 1 Factors giving rise to economies of scale: a) Specialization b) Division of labour Main idea 2 Factors giving rise to diseconomies of scale: a) Control and communication problems b) Alienation and loss of identity c) Bulk buying d) Financial economies e) Transport economies f) Large machines g) Promotional economies

10 1.5 Theory of the firm and its market structures - Revenues Syllabus item: 47 Weight: 3 Definition: Revenue: Income that a firm receives from selling its products, goods, and services, over a certain time period 1. Total revenue (TR): All the revenue earned by the business. TR = p x q 2. Average revenue (AR): AR = TR q 3. Marginal revenue (MR): Change in TR Change in q Distinguish between total revenue, average revenue and marginal revenue. Draw diagrams illustrating the relationship between total revenue, average revenue and marginal revenue. Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams. 1. Perfect competition (When elasticity of demand is infinity) Theory Perfectly elastic demand curve Does not have to lower price as output increases and it wishes to sell more of its product AR =Price = MR Total revenue, average revenue and marginal revenue Cannot rise because consumer have perfect knowledge +products are homogenous

11 2. Imperfect competition (Monopoly, monopolistic competition, oligopoly etc.) (When the demand curve is downward sloping, i.e. when elasticity of demand falls as output increases) Price (\$) Quantity Total revenue Average Marginal PED demanded (TR) (\$) revenue (AR) revenue (QD) (\$) (MR)(\$) AR = Price. Price has to be lowered to sell more products à D = AR curve MR falls as output increases twice as steeply as the AR curve and also goes below the x axis TR rises at first but will eventually start to fall as output increases. This is because negative MR + means that TR will fall ( Helpful for firms to know the impact that a change in the price of their product will have upon the total revenue that they receive)

12 Notes: The basic rules are: 1. When PED elastic à lower price to increase revenue 2. When PED inelastic à raise price to increase revenue 3. When PED unity à leave the price unchanged since revenue is already maximized

13 1.5 Theory of the firm and its market structures - Profit Syllabus item: 48 Weight: 3 Definition: Total profit: à In economics, it is Total revenue economic cost (the sum of explicit costs +implicit costs) à i.e. Abnormal, normal and loss Describe economic profit (abnormal profit) as the case where total revenue exceeds economic cost. Describe normal profit (zero economic profit) as the case where total revenue is equal to total economic costs or the situation in which the amount of revenue Economic cost: à Explicit costs + implicit costs earned is just sufficient to keep the firm in its current line of business. Explain that economic profit (abnormal profit) is profit over and above normal profit (zero economic profit), and that the firm earns normal profit when economic profit (abnormal profit) is zero. Economic profit and normal profit Main idea 1 Ø Profit = TR- TC à Profit = TR EC (EC includes explicit and implicit costs) If TR = TC à Normal profit (or zero economic profit) If TR > TC à Abnormal profit (or economic profit) If TR < TC à Loss (or negative economic profit)

14 Main idea 1 Ø Why a firm continues to operate even when earning zero economic profit Explain why a firm will continue to operate even when it earns zero economic profit (abnormal profit). Zero economic profit means that TR = EC. When we say a firm is earning zero economic profit, the firm is earning just the necessary revenues to cover payment for entrepreneurship (a cost) and all other implicit costs and explicit costs. Thus, it means that the firm has covered all Explain the meaning of loss as negative economic profit arising when total revenue is less than total cost. Calculate different profit levels from a set of data and/or diagrams. its opportunity costs, and will continue to operate. Economic profit and normal profit

15 1.5 Theory of the firm and its market structures - Goals of firms Syllabus item: 49 Weight: 2 Main idea 1 There are two approaches to analyzing profit maximization: one involves the 1) use of the total revenue and total cost concepts, and the other involves the 2) use of marginal revenues and costs. (Though 2 nd approach is more relevant to analyzing Explain the goal of profit maximization where the difference between total revenue and total cost is maximized or where marginal revenue equals marginal cost. market structures) Main idea 2 Maximum profit MC = MR (always. No matter the market structure) Profit maximization

16 Syllabus item: 50 Weight: 4 Main idea 1 Revenue maximization: à Entrepreneurs may attempt to maximize their sales revenue by producing where the marginal revenue is zero. They will actually produce above the profit Describe alternative goals of firms, including revenue maximization, growth maximization, satisficing and corporate social responsibility. maximizing level of output. Growth maximization: à Companies may set their target to achieve growth in the short run, rather than profits, in order to gain a large market share and then dominate the market in the long run. Alternative goals for firms Main idea 2 Satisficing: à It is where an economic agent aims to perform satisfactorily rather than to a maximum level, in order to be able to pursue other goals. Corporate social responsibility (CSR): à This is where a business includes the public interest in its decision making. à i.e. Encouragng developing in the workforce and the local community through educational projects and fair trade projects à Advantages such as attracting and keeping a better workforce, building up reputation and developing brand loyalty for being an ethcal business à Disadvantages that companies may be adopting a CSR approach to gain a good reputation in order to take people s attention away from their main product

17 Syllabus item: 51 Weight: 4 Definition: Perfect competition: à A model used as the starting point to explain how firms operate. à Some industries in the world that get quite close to being perfectly competitive markets ex) wheat industry in European Union (Only differences are that there are costs in order to entry or exit the industry and also it is unlikely that producers and consumers will Describe, using examples, the assumed characteristics of perfect competition: a large number of firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource mobility. have perfect knowledge ) Assumptions of the model (Perfect competition) Main idea 1 The assumptions of perfect competition: Made up of large number of firms Individual firms are price takers (cannot affect the price of the industry; must sell at whatever the price is) Sell homogenous products (identical; no brand names) Freedom of entry and exiting the industry (=No barriers to entry or barrier to exit) Perfect knowledge Perfect information Perfect resource mobility

18 Syllabus item: 52 Weight: 3 Explain, using a diagram, the shape of the perfectly competitive firm s average revenue and marginal revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price taker. Explain, using a diagram, that the perfectly competitive firm s average revenue and marginal revenue curves are derived from market equilibrium for the industry. Revenue curves (Perfect competition) Main idea 1 The industry is in perfect competition will face normal demand and supply curves à Firm derives its price of P from equilibrium price in the industry (= price taker ) The firm can sell as much as it wants at P as it does not affect the industry supply curve an so it does not alter the industry price à The shape of the perfectly competitive firm s AR and MR curves are perfectly elastic because each firm is a price-taker

19 Syllabus item: 53 Weight: 3 Normal profits in short-run: Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short run based on the marginal cost and marginal revenue profit maximization rule. Abnormal profits in short-run: Profit maximization in the short run (Perfect comp.) Losses in short-run:

20 Main idea 1 In long-run, firms in perfect competition will make normal profits (zero economic profits) There is no abnormal profits. Explain, using a diagram, why, in the long run, a perfectly competitive firm Product efficiency (minimum AC) + Allocatively efficiency (MC = AR) will make normal profit (zero economic profit). Explain, using a diagram, how a perfectly competitive market will move from short-run equilibrium to long-run equilibrium. Firms are selling at price P, which they are taking from the industry. MC = MR so they are maximizing profits by producing q, and that output P = AC so they are making normal profits. Profit maximization in the long run (Perfect competition)

21 Main idea 2 Short-run abnormal profits to long-run normal profits As more and more firms enter the industry, attracted by the abnormal profits, the industry supply curve will start to shift to the right, driving down the price à abnormal profits that they had been making will start to be eroded As a result, we are left with the long run equilibrium position à We now find that the firms are making normal profits with P1 = C1. (exactly covering opportunity cost) à HOWEVER, there is no abnormal profit to attract more firms!! Ø Outcome: Bigger industries producing Q1 units, with smaller firms each producing q1 units. Short-run loss to long-run normal profits As more and more firms leave the industry, unable to achieve normal profit, the industry supply curve will start to shift to the left As a result, the demand curve is D1 = AR1 = MR1 à We now find that the firms are making normal profits with P1 = C1. (exactly covering opportunity cost) à HOWEVER, there is no abnormal profit to attract more firms!! Ø Outcome: A smaller industry producing only Q1 units, with bigger firms each producing q1 units.

22 Syllabus item: 55 Weight: 3 Definition: Shut-down price: à The level of price that enables a firm to cover its variable costs in the short-run, i.e. it is the price where P = AVC. If price does not cover AVC, then the firm will shut down in the short run. (P in figure 6.12) Distinguish between the short run shut-down price and the break-even price. Explain, using a diagram, when a loss-making firm would shut Break-even price: àthe level of price that enables a firm to cover all of its costs (FC + VC) in the long-run, i.e. it is the price where P = ATC. If price does not cover ATC, then the firm will shut down for good. (P1 in figure 6.12) Break-even price down in the short run. Explain, using a diagram, when a loss-making firm would shut down and exit the market in the long run. Calculate the short run shutdown price and the breakeven price from a set of data Shut-down price Shut-down price and break-even price

23 Syllabus item: 56 Weight: 3 Definition: Allocative efficiency: à It is where MC = AR. à The condition for allocative efficiency is P = MC (or, with externalities, MSB = MSC). Explain the meaning of the term allocative efficiency. Explain that the condition for allocative efficiency is P = MC (or, with externalities, MSB = MSC). Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the short run and the long run. Explain the meaning of the term productive/technical efficiency. Explain that the condition for productive efficiency is that production takes place at minimum average total cost. Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run. Definition: Productive/technical efficiency: Efficiency (Perfect competition) à Producing its product at the minimum ATC à q = productively efficient level of output (MC = AC)

24 Productive and allocative efficiency with short-run profits in perfect competition: Productive and allocative efficiency with short-run losses in perfect competition: Productive and allocative efficiency in the long run in perfect competition:

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