1.5 Theory of the firm

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Terms in this set (...)

Short run
One input is fixed and cannot be changed by the firm
Long run
All inputs can be changed
Total product
Total quantity of output produced by a firm
Marginal product
Additional output resulting from one additional unit of the variable input
Average product
Total quantity of output per unit of variable input
Law of diminishing returns
Increased variable factors of production added to the production process, when at least one factor of production is fixed, will at some point result in falling marginal output.
Economic costs as the opportunity cost of all resources employed by the firm
The use of any resource by firm involves a sacrifice of the best alternative use of that resource.
Explicit costs
Payments made by a firm to outsiders to acquire resources for use in production.
Implicit costs
The sacrificed income arising from the use of self-owned resources by a firm is an implicit cost.
Economic costs
Sum of explicit and implicit costs or total opportunity costs incurred by a firm for its use of resources
Total costs
Total costs are the costs to produce all of a specified level of output.
Average costs
Costs per unit of output
Marginal cost
Additional cost of producing one more unit of output
Explain the relationship between the product curves.
- When the average cost is declining as average product increases, MC < AC.
- MC = AC, when AC is neither rising nor falling.
- When AC is increasing as AP is declining, MC > AC.
Economies of scale
Reductions in cost per unit gained from increasing the scale of production
Result of economies of scale
Lower average costs of production in the long run
Factors responsible for economies of scale
Internal growth, factor indivisibility, marketing economies, external growth.
Factors responsible for diseconomies of scale
Interdependency, coordination and communication, industrial relations.
Constant returns to scale
An increase in inputs leads to a proportionally equal increase in output.
Increasing returns to scale
An increase in inputs leads to a proportionally larger increase in output.
Decreasing returns to scale
An increase in inputs leads to a proportionally smaller increase in output.
Relationship between short-run average costs and long-run average costs.
LRAC curve is either equal to or below the relevant SRAC curve.
The reason for the shape of the long-run average total cost curve.
The U-shape of the LRATC curve can be found in economies and diseconomies of scale.
Total revenue
Price of the good multiplied by the number of units sold
Average revenue
Revenue per unit
Marginal revenue
Revenue of selling one extra unit of output
Economic profit
Economic profit occurs when total revenue is higher than economic costs (Economic profit = Total revenue - Economic costs)
Normal profit
Amount of revenue that covers all implicit costs
Positive economic profit
Total revenue (TR) > total cost (TC)
Zero economic profit
Total revenue (TR) = Total cost (TC)
Negative economic profit
Total revenue (TR) < Total cost (TC)
Explain why a firm will continue to operate even when it earns zero economic profit.
The firm is earning just the necessary revenues to cover payment for entrepreneurship and all other implicit costs of self-owned resources, after revenues have also covered explicit costs. Therefore, when a firm is earning normal profit, it has covered all its opportunity costs, and will continue to operate.
Goal of profit maximisation
Profit = Total revenue (TR) - total cost (TC)
Determining the level of output that the firm should produce to make profit as large as possible.
The firm's profit-maximisation rule is to choose to produce the same level of output where MC = MR.
Alternative goals of firms
Revenue maximisation, growth maximisation, satisficing goals, corporate social responsibility
Characteristics of perfect competition
Large number of firms, all firms produce identical or homogeneous products, free entry and exit, perfect information, perfect resource mobility.
Explain the shape of the perfectly competitive firm's average revenue and marginal revenue curves.
The demand curve for a good facing the perfectly competitive firm is perfectly elastic at the price determined in the market for that good. This means the firm is a price taker, as it accepts the price determined in the market. P=MR=AR are constant at the level of the horizontal demand curve.
Explain 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 maximisation rule.
- As price is greater than the short run average cost, the firm makes abnormal profits.
- As price is less than the average cost, the firm makes a loss in the short run.
- As price is equal to the average cost, the firm makes a zero economic profit.
Explain why, in the long run, a perfectly competitive firm will make normal profit.
In the long run, perfectly competitive firms can only earn normal profits. Any losses in the industry lead to some firms exiting, so total supply falls, leading to a higher market price unit the industry returns to normal profit. Any abnormal profits in the industry will attract more firms to enter due to the absence of barriers to entry. This raises market supply and reduces the price until equilibrium is restored. In the long run: MR=MC=AR=AC.
Short run shut-down price
P = minimum AVC
Break-even price
P = minimum ATC
Explain when a loss-making firm would shut down in the short run.
It stops producing and shuts down when price falls below minimum AVC.
Explain when a loss-making firm would shut down in the long run.
In the long-run, the break-even price and the shut-down price are the same. The reason is that in the long run, any loss-making firm facing a price lower than minimum ATC will shut down.
Allocative efficiency
Occurs at the level of output where MSB = MSC.
Explain why a perfectly competitive market leads to allocative efficiency in both the short run and the long run.
MR=AR and P =MC
Productive/technical efficency
Occurs when firms produce at their lowest cost per unit
Explain why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run.
Firms are productively efficient when MC = AC. In the LR, ACmin coincides with the profit maximising level of output and production becomes efficient.
Characteristics of a monopoly
Single seller or dominant firm in the market, no close substitutes, significant barriers to entry.
Barriers to entry
Economies of scale, branding, legal barriers, control of essential resources and anti-competitive behaviour.
Explain the relationship between demand, average revenue and marginal revenue in a monopoly.
If demand is linear, then MR is also linear. MR has the same vertical intercept and double the slope as AR. D = AR.
Explain the short- and long-run equilibrium output and pricing decision of a profit maximising monopolist, identifying the firm's economic profit or losses.
- Determine the profit-maximising level output using the MC = MR rule.
- For that level of output, it determines profit per unit or loss per unit by using profit/Q=P - ATC. If P>ATC, the monopolist is making profit; if P = ATC it is earning normal profit; if P<ATC it is making a loss.
- The firm multiplies profit/Q by Q to determine total profit, or loss/Q by Q to determine total loss.