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Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 1 CHAPTER 8 Theory of Firm Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 2 CONCEPT OF REVENUE TOTAL REVENUE (TR) The total amount received from the sale of a firm’s goods and services. Total Revenue (TR) = Price (P) x Quantity (Q) AVERAGE REVENUE (AR) Average revenue is the total revenue per unit output sold. Average revenue (AR) is also equal to the price (P) of the good. Average Revenue (AR) AR = P x Q = Total Revenue (TR) Quantity (Q) = PRICE Q Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 3 CONCEPT OF REVENUE MARGINAL REVENUE (MR) The change in total revenue resulting from one unit increase in quantity sold. Marginal Revenue (MR) = Change in Total Revenue Change in Quantity MR = TR/ Q (1) Quantity (2) Price (3) Total Revenue (1)X(2) (4) Average Revenue (3) / (1) (4) Marginal Revenue (3) / (1) 10 50 500 50 50 20 45 900 45 40 30 40 1200 40 30 40 35 1400 35 20 50 30 1500 30 10 60 25 1500 25 0 70 20 1400 20 -10 Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 4 CONCEPT OF REVENUE Case I: Imperfect Market Quantity Price Total Revenue (TR) Marginal Revenue (MR) 10 10 100 10 10 20 9 180 9 8 30 8 240 8 6 40 7 280 7 4 50 6 300 6 2 15 AR, MR Average Revenue (AR) Price 10 Price AR 5 MR 0 10 20 30 40 Microeconomics © Oxford University Press Malaysia, 2008 50 Quantity AR equals to price but MR is less than the price when the price changes. The graph shows that AR and MR are downward sloping and MR curve lies below the AR curve. All Rights Reserved 8– 5 CONCEPT OF REVENUE (CON’T) Case II: Perfect Market Quantity Price Total Revenue (TR) Marginal Revenue (MR) 10 10 100 10 10 20 10 200 10 10 30 10 300 10 10 40 10 400 10 10 50 10 500 10 10 15 AR, MR Average Revenue (AR) Price 10 AR 5 MR 0 10 20 30 40 Microeconomics © Oxford University Press Malaysia, 2008 50 Quantity AR, MR and price are same when the price is constant. The graph shows the horizontal line at a price of RM10 which indicates that MR = AR = Price. All Rights Reserved 8– 6 CONCEPT OF REVENUE BY EQUATION Given demand curve as: P = a – bQ TR = P x Q = (a – bQ) x Q = aQ – bQ2 (b is the slope) Derivation of MR from demand curve MR = dTR/dQ MR = a – 2bQ (MR is ½ of the slope of DD) Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 7 DIFFERENCES BETWEEN ECONOMIC PROFIT AND ACCOUNTING PROFIT Economic Profit Economic profit is defined as the total revenue minus the implicit and explicit cost. Accounting Profit Accounting profit is defined as the firm’s total revenue minus the explicit cost. Considers explicit and implicit cost. EC = TR – [Explicit Cost + Implicit Cost] Microeconomics © Oxford University Press Malaysia, 2008 MICROECONOMICS Considers only explicit cost AC = TR – Explicit Cost All Rights Reserved 8– 88 DEFINITION OF A FIRM A firm is an institution that buys or hires factors of production and organizes them to produce and sell goods and services. A firm is an independent unit producing goods and services for sale. Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 9 OBJECTIVES OF A FIRM The main goal or objective of a firm is to maximize profit and to minimize the cost. Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 10 TOTAL REVENUE USING THE TOTAL COST APPROACH Case I: Perfect Market (1) Quantity (Q) (2) Price (P) 0 300 0 100 -100 1 300 300 500 -200 2 300 600 600 0 3 300 900 4 300 1200 5 300 1500 300 1800 6 (3) Total Revenue (TR) (4) Total Cost (TC) 800 9500 1150 1400 (5) Profit (TR - TC) 100 250 350 400 7 300 2100 8 300 2400 2100 300 9 300 2700 2700 0 10 300 3000 3100 -100 Microeconomics © Oxford University Press Malaysia, 2008 Using Table: Profit maximization is determined by scanning through the profit at each level, and the level which gives the highest profit is the profit maximizing output. 400 All Rights Reserved 8– 11 TOTAL REVENUE USING TOTAL COST APPROACH (CON’T) Case I: Perfect Market TR, TC TC Using Graph: TR TR curve is a straight line through the origin. The maximum profit is where the vertical difference is the highest. Highest vertical differences Quantity Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 12 TOTAL REVENUE USING TOTAL COST APPROACH (CON’T) Case II: Imperfect Market (1) Quantity (Q) (2) Price (P) (3) Total Revenue (TR) 0 340 0 200 -200 1 340 340 400 -60 2 330 660 560 100 3 320 960 4 310 1240 5 300 1500 290 1740 6 (4) Total Cost (TC) 700 800 900 1040 (5) Profit (TR - TC) 260 440 600 700 7 280 1960 8 270 2160 1200 760 9 260 2340 1800 540 10 240 2400 2400 0 Microeconomics © Oxford University Press Malaysia, 2008 Using Table : Profit maximization is determined by scanning through the profit at each level, and the level which gives the highest profit is the profit maximizing output. 760 All Rights Reserved 8– 13 TOTAL REVENUE USING TOTAL COST APPROACH (CON’T) Case II: Imperfect Market TR, TC Using Graph : TC TR curve is increasing and after the profit maximizing output, the curve starts to decline. TR Maximum profit is where the vertical difference between TR and TC is the highest. Highest vertical differences Quantity Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 14 MARGINAL REVENUE USING MARGINAL COST APPROACH Case I: Perfect Market Quantity (Q) Price (P) Marginal Revenue (MR) Marginal Cost (MC) 0 300 300 400 1 300 300 200 2 300 300 100 3 300 300 150 4 300 300 200 5 300 300 250 6 300 300 450 7 300 300 300 8 300 300 400 9 300 300 600 10 300 300 700 Microeconomics © Oxford University Press Malaysia, 2008 Using Table: Profit maximizing output level is obtained following the MR = MC rule. All Rights Reserved 8– 15 MARGINAL REVENUE USING MARGINAL COST APPROACH (CON’T) Case I: Perfect Market MR, MC MC Using Graph: MR curve is perfectly elastic or horizontal to the price. P* The profit maximization rule, MR = MC, where the MC curve intersect with the MR curve. MR Quantity Q* Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 16 MARGINAL REVENUE USING MARGINAL COST APPROACH (CON’T) Case II: Imperfect Market Quantity (Q) Price (P) Marginal Revenue (MR) Marginal Cost (MC) 0 340 1 340 340 200 2 330 320 160 3 320 300 150 4 310 280 200 5 300 260 250 6 290 240 450 7 280 220 300 8 270 200 400 9 260 180 600 10 240 60 700 Microeconomics © Oxford University Press Malaysia, 2008 Using Table: Profit maximizing output level is obtained following the MR = MC rule. All Rights Reserved 8– 17 MARGINAL REVENUE USING MARGINAL COST APPROACH (CON’T) Case II: Imperfect Market MR, MC MC Using Graph: MR curve under imperfect market is downward sloping as the output increases. The profit maximization rule, MR = MC, where the MC curve intersect with the MR curve. P* AR=P MR Quantity Q* Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 18 TYPES OF MARKET STRUCTURE MONOPOLISTIC COMPETITION MONOPOLY There are large numbers of sellers and large number of buyers. Sellers sell differentiated products due to branding and labelling, and there are no barriers to entry and exit. There is a single seller and a large number of buyers. Sellers sell products that has no close subsitute and has a high entry and exit barrier. PERFECT COMPETITION There are a large number of buyers and sellers, buying and selling identical product without any restrictions on entry and exit and having perfect knowledge of the market at a time. Microeconomics © Oxford University Press Malaysia, 2008 TYPES OF MARKET STRUCTURE OLIGOPOLY There are only a few firms in the industry, but large number of buyers. Products can be either identical or differentiated, and there are barriers to entry and exit. All Rights Reserved 8– 19 TYPES OF MARKET STRUCTURE (CON’T) Market Structure Characteristics Number of firms Perfect competition Very large number Monopolistic competition Oligopoly Monopoly Large number Few One Type of firms Homogenous Dfferentiated Homogenous or differentiated Unique: no close substitutes Conditions to Entry Very easy Easy Significant obstacles Entry not possible Control over Price taker Price taker Independent Price maker Promotion strategy No Yes Yes Noor little Demand curve Horizontal Downward slope Kinked Downward slope price Microeconomics © Oxford University Press Malaysia, 2008 All Rights Reserved 8– 20