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Microeconomics
3.1 Marginal analysis and behaviour of firms
3.1 - MICROECONOMICS 1 - Marginal analysis and behaviour of firms
Utility
As people consume goods or services, they gain satisfaction. Utility is a measure of that
satisfaction.
Marginal utility - Changes or additions to total utility, resulting from the consumption of an
additional good or service.
Total utility - The aggregate satisfaction gained from consuming successive quantities of
a good or service.
The Law of Marginal Utility - Marginal utility typically decreases as consumption
increases. For example, a can of coke. If you are very thirsty, you will appreciate the
first drink a lot. As you drink more and more cans of coke, the added satisfaction you
get is less as you get less and less thirstier. It gets to the point where there is no
marginal utility; therefore total utility is at its maximum.
Quantity
0
1
2
3
4
5
6
Utility Schedule for cola
Marginal Utility
10
9
7
2
0
-2
Total Utility
0
10
19
26
28
28
26
Optimum Purchase rule
The optimum purchase rule - Satisfaction is maximised. Marginal Utility will be zero.
Price will equal Marginal Utility.
As Total Utility is increasing,
Marginal Utility is positive.
As Total Utility is decreasing,
Marginal Utility is negative.
When Total Utility is at its
maximum, Marginal Utility is zero,
demonstrating the optimum
purchase rule.
By convention, plot Marginal Utility
midway between the numbers.
For example, if units consumed
are 4, plot it at 3.5.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
The individual demand curve is derived from their Marginal Utility curve.
1. Consumers gain less extra satisfaction from each extra unit of consumption.
They are willing to pay less for the next unit of consumption until P=MU. They
will only buy a small quantity when price is high and vice versa.
2. When the price of a good increases, it increases relative to substitutes (whose
prices stay constant), therefore fewer consumers will demand the good as they
are buying substitutes instead. This is known as the substitution effect.
3. When price goes up, people can afford to buy less of the good (income effect).
Equimarginal rule:
Is all income spent?
Yes
MUa = MUb
Pa
Pb
Do nothing
because the
consumer is in
equilibrium
MUa > MUb
Pa
Pb
Spend more on good a, because MU
per dollar is higher, so the MU per
dollar will drop.
Spend less on good b, because MU
per dollar is lower, so the MU per
dollar will rise.
No
Spend more on
both goods as
you must spend
all your income
Some Examples:
1. Income is $200
Good A: 15 units are bought at $6 each. Marginal Utility is 30.
Good B: 10 units are bought at $11 each. Marginal Utility is 55.
Has all $200 been spent? 15 x $6 + 10 x $11 = $200. Yes.
Is the consumer in equilibrium? 30/6 = 55/11 → 5 = 5. Yes.
Therefore they should do nothing.
2. Income is $220
Good A: 15 units are bought at $6 each. Marginal Utility is 30.
Good B: 10 units are bought at $11 each. Marginal Utility is 55.
Has all $220 been spent? 15 x $6 + 10 x $11 = $200. No.
Therefore they should spend more on both goods.
3. Income is $50.
Good A: 20 units are bought at $1 each. Marginal Utility is 8.
Good B: 15 units are bought at $2 each. Marginal Utility is 12.
Has all $50 been spent? 20 x $1 + 15 x $2 = $50. Yes.
Is the consumer in equilibrium? 8/1 ≠ 12/2 → 8 ≠ 6. No.
Therefore more should be spent on Good A and less should be spent on Good B.
If asked for the order of which a consumer will buy something, look at the marginal utility
per dollar. The highest marginal utility per dollar will be purchased first, then the next
highest and so on until they have spent all their money.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Market Structures
Feature
Perfect
Monopolisti
c
Imperfect
Oligopoly
Duopoly
Monopoly
Imperfect
Imperfect
Imperfect
Two firms
only
One firm
only
Differentiate
d
Very Strong
One product
only
Very Very
Very Strong
Very Strong
Price Maker
Strong
Type of
competitio
n
Number of
sellers
Perfect
Lots
Many small
firms
Type of
product
Barriers to
entry
Control
over price
Control
over
quantity
sold
How do
firms
compete?
Demand
curve
New
Zealand
Example
Homogenou
s (identical)
None
Differentiated
Weak
A few large
firms
dominate
Differentiate
d
Strong
None
Weak
Price Maker
None
Weak
Limited
Strong Price
Maker
Limited
Unable
Price and
non-price
competition
Elastic
Non Price
competition
Non Price
competition
No
competition
Kinked
Inelastic
Retail shops
Oil
companies
Banks
Vodafone
and
Telecom
Perfectly
inelastic
NZ Post,
Personalise
d Plates
Perfectly
Elastic
Dairy
farmers
Vegetable
growers
Monopsony is a single buyer.
Barriers to entry include high capital costs for formation and many regulations.
Perfect competitors are so insignificant
that they have to accept the price that
is prevailing on the market. If they set
the price too low, they will lose out on
profits. If they set the price too high, no
one will buy from them and they will
have to close down.
A monopolist cannot control price and quantity at
the same time. It can control only one at a time.
The market will control the other. For example, if
they raise price, the market will determine the
quantity sold.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Strategies that firms use
The common goal of all firms is profit maximisation. They may include sales
maximisation (making as many sales as possible) so that they establish themselves in
the market, gain market share or gain market power. Satisficing is a goal where firms
set up a sales or profit target than can be achieved with ease.
Price competition
 Discounts
 Buy one get one free
 Having sales (e.g. end of season, clearance, stocktaking or closing down sale)
 Interest free terms
 Trade ins
 Undercutting a competitors price
 A price war (other firms use the same tactics by lowering their price. In the end,
the firm’s market share will remain largely unchanged)
Non Price Competition
 Packaging
 Giveaways (different product)
 Competition
 Sponsorship
 Location
 Modifications
 24 hour service
 advertising
Advantage to producers:
Reduces the likelihood of price wars while their sales and
market share still increase.
Disadvantage to producers: Costs increase to provide these extras.
Advantage to consumers:
Better quality of goods and services and greater choice.
Disadvantage to consumers: Price increases (because of increased costs) and they may
buy the product for the wrong reasons.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Revenue Curves - Perfect competition
Output
1
2
3
4
5
Price ($)
10
10
10
10
10
Total Revenue
10
20
30
40
50
Average Revenue
10
10
10
10
10
Marginal Revenue
10
10
10
10
10
Total Revenue: Price times Quantity (P x Q)
Average Revenue: Total Revenue divided by Quantity (P ÷ Q)
Marginal Revenue: Change in Total Revenue.
Marginal Revenue is the additions to Total Revenue made as each extra unit of output is
sold.
Price is the same as Average Revenue (mathematically this is correct).
Since the price is constant and the firms have to accept the price on the market, Average
Revenue will equal Marginal Revenue.
Price will equal the demand curve because the market determines the price.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Revenue Curves - Imperfect competition
Output
1
2
3
4
5
Price ($)
10
8
6
4
2
Total Revenue
10
16
18
16
10
Average Revenue
10
8
6
4
2
Marginal Revenue
10
6
2
-2
-6
When Output increases, Price decreases and vice versa.
When Total Revenue is at its maximum, Marginal Revenue is zero.
It is illogical to sell past the point where Marginal Revenue equals zero as Total Revenue
decreases as more quantities are sold.
Marginal Revenue is always less than Total Revenue.
If Marginal Revenue and Average Revenue are different, it is imperfect competition (if
they are the same, it is perfect competition).
Marginal Revenue intersects the x axis halfway of the intersection of Average Revenue
and the x axis.
A firm’s demand curve is the Average Revenue curve.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Accounting Costs
The actual (or explicit) costs involved in production, for example, mortgage, rent, power,
wages and raw materials.
Economic Costs
The accounting costs plus opportunity costs. For example, the lost salary if a teacher
sets up a lawn mowing business or lost interest that could have been earned if the
owner invested the funds in the bank instead of a business.
Decisions of a firm
Firms try to use resources efficiently. If some industries are declining, resources will be
switched. The supply curve is related to cost as an increase in costs causes a shift to
the left.
Cost Curves
Output
Fixed
Costs
Variable
Costs
Total
Costs
Average
Costs
Marginal
Costs
0
1
2
3
4
5
6
7
8
9
10
11
12
13
250
250
250
250
250
250
250
250
250
250
250
250
250
250
70
120
140
160
190
230
280
350
440
540
660
800
960
250
320
370
390
410
440
480
530
660
690
790
910
1050
1210
320
185
130
102.5
88
80
75.71
75
76.67
79
82.73
87.5
93.08
70
50
20
20
30
40
50
70
90
100
120
140
160
Average
Variable
Costs
70
60
46.67
40
38
38.33
40
43.75
48.89
54
60
66.67
73.85
Average
Fixed
Costs
250
125
83.33
62.15
50
41.67
35.71
31.25
27.78
25
22.73
20.83
19.23
Fixed Costs -
Do not change no matter how much is produced, e.g. rent.
Variable Costs -
The more you produce, the more these costs will be.
These are the costs that change when output changes.
Total Costs -
Fixed Costs plus Variable Costs.
Average Cost -
Total costs divided by output (similar to average revenue)
or Average Variable Costs plus Average Fixed Costs.
Marginal Cost -
The additional cost when each extra output is produced.
Average Variable Costs -
Variable costs divided by output.
Average Fixed Costs -
Fixed Costs divided by output.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Average Fixed Cost Curve
This is because the cost is fixed. Average
Fixed Cost gets less and less because it is
spread over a greater amount of outputs.
Average Fixed Cost Curve/Average Variable Cost Curve/Average Cost Curve
The Average Variable Cost curve
decreases first as firms make better use of
resources. Then as output rises,
resources are used inefficiently.
Technical optimum output occurs at the
minimum point of AC. Resources are
effectively combined.
As output increases, the AVC and AC
curves get closer together because AFC +
AVC = AC, and AFC is decreasing.
Adding in the Marginal Cost Curve
The Marginal Cost Curve initially decreases
because of efficient use of resources and
increasing returns. Eventually diminishing
returns will occur therefore the Marginal
Cost curve will increase.
The Marginal Cost Curve intersects the
AVC and AC curves at their minimum
points. This is because the Marginal Cost
Curve is less than AVC and AC when they
are decreasing and the Marginal Cost
Curve is more the AVC and AC when they
are increasing. This is because Marginal
Costs are the additions to costs as output
increases.
MC is the supply curve above AVC.
Variable Cost Curve/Total Cost Curve/Fixed Cost Curve
The vertical gap between the Total Cost Curve
and the Variable Cost Curve is Fixed Costs
because FC + VC = TC.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
The size of a firms operation
Short Run
REMEMBER: Short run is concerned about an input/factor, not inputs/factors.
Diminishing returns is the idea that as more and more of a factor is used, with at least
one fixed factor; there is some point at which the increase in output will be at a
decreasing rate.
Firms will experience diminishing returns in the short run because at least one factor is
fixed. If additions of other factors are added into the production process, the total output
will increase at a diminishing rate (marginal product must eventually fall). This is
because each factor has less of the fixed factor to work with, reducing its ability to
produce extra output.
Diminishing returns sets in when the firm’s marginal costs increase because as each
extra variable unit produces less when diminishing returns are occurring. Therefore the
production of extra units of output will require more and more of variable inputs to
produce them compared with earlier units.
For example, when given a table like this:
Output
10
100
250
Machines/Workers
1
2
3
Add another row with marginal output:
Marginal Output
10
90
150
Therefore after the 4th machine, diminishing returns sets in OR:
With the 5th machine, diminishing returns sets in.
450
4
550
5
200
100
Increasing returns to a factor reflect that a firm’s short run average costs are falling.
Inputs ↑5%
Inputs ↓10%
↑Returns to ↓Costs
↑Marginal
Efficient
Outputs ↑10% Outputs ↓5%
a factor
output
Decreasing returns to a factor reflect that a firm’s short run average costs are rising.
Inputs ↑10%
Inputs ↓5%
↓Returns to ↑Costs
↓Marginal
Inefficient
Outputs ↑5%
Outputs ↓10% a factor
output
Long Run
REMEMBER: Long run is concerned about inputs/factors, not an input/factor.
In the long run, factors are variable because the firm is more adaptable to change.
Economies of scale (increasing returns to factors) may be due to existing or new
machinery being more efficiently utilised. Fixed costs are spread over more units pulling
down long run average costs. Buying in bulk may result in discounts.
Inputs ↑5%
Inputs ↓10%
Economies ↓Costs
↑Marginal
Efficient
Outputs ↑10% Outputs ↓5%
of scale/
output
↑Returns to
factors
Diseconomies of scale (decreasing returns to factors) may be because of expansion in a
firm’s operation resulting in less efficient use of resources.
Inputs ↑10%
Inputs ↓5%
Diseconomies ↑Costs
↓Marginal
Inefficient
Outputs ↑5%
Outputs ↓10% of scale/
output
↓Returns to
factors
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Short Run and Long Run
SAC 1: Short run Average Cost curve for machine 1
SAC 2: Short run Average Cost curve for machine 2 etc etc.
LRAC: Long run Average Cost curve
A: ↓Costs, returns to a factor are increasing and the firm is efficient.
B: ↓Costs, returns to factors are increasing (economies of scale) and the firm is efficient.
C: ↑Costs, returns to a factor are decreasing and the firm is inefficient.
D: ↑Costs, returns to factors are decreasing (diseconomies of scale) and the firm is
inefficient.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Break-even
Break-even is when revenue covers all
economic costs; i.e. AR=AC
(AC=AFC+AVC).
The preferred point is to be operating at
Break-even or higher.
The Break-even point occurs at the minimum point of AC. This is because all costs are
covered, therefore there is no loss.
For example:
AFC
AVC
AR
Loss
50
40
90
0
Shutdown
Shutdown is when revenue just covers
variable costs.
The Shutdown point occurs at the minimum
point of AVC. Firms will not be willing to
supply anything below this point as they will
be making a greater loss compared to what
they will lose if they shut down. This is why
the supply curve is generated by the MC
curve above AVC. Quantity Supplied at a
price below the minimum point of AVC will
always be zero.
Firms will still operate between break-even and shut down point because they are still
covering a part of their fixed costs. Therefore they will lose less if they continue to
operate compared to the loss they will make if they shut down.
For example:
If a firm chooses to continue operating:
AFC
AVC
AR
Loss
50
40
50
40
If a firm chooses to shut down:
AFC
AVC
AR
Loss
50
0
0
50
Therefore if they continue to operate, they will lose only $40 instead of $50 if they shut
down.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Accounting Profit
In accounting, profit is Revenue (Income) minus actual costs (expenses). The costs are
the actual (explicit) costs involved. Therefore a profit in accounting is made when actual
income is greater than expenses.
For example:
A teacher quits their job and sets up a lawn mowing business. The teacher got paid
$50,000 salary. The income from the lawn mowing business is $120,000 and expenses
were $40,000. They also had $50,000 worth of savings in a bank account with a 7%
interest rate. The accounting profit will be:
Income
120,000
Less Expenses
40,000
Accounting Profit
$80,000
Economic Profit
In economics, profit is Revenue (Income) minus total costs. The costs are actual
(explicit) costs plus opportunity (implicit) costs. Economic profit is less than Accounting
profit. Economic costs are greater than Accounting costs.
For the example above:
Income
120,000
Less Expenses
40,000
Less lost salary
50,000
Loss lost interest
3,500 (7% of $50,000)
Economic Profit
$26,500
Maximising Profit
If the firm is able to make a profit, their goal is to
maximise that profit. To maximise their profit, they
would operate at point Q. Beyond Q’, the firm would be
making a loss.
Minimising a loss
If a firm is unable to make a profit at all, the goal is to
minimise their loss. To minimise a loss, they will
operate at point Q. At any other point there will be a
greater loss.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Marginal Analysis
Determining output
For perfect and imperfect competition the Equilibrium output position is where MC = MR.
Note MC must cut MR from below (if MC and MR intersect twice).
This is because you are either maximising your profits or minimising your losses.
If you produce at a level less than this point, you are not maximising your profits as you
are losing out on potential profits. Therefore you should increase output.
If you produce at a level higher than this point, you are not minimising your losses as you
are losing money for each extra unit of output. Therefore you should decrease output.
Price is when Output intersects the Average Revenue Curve.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Supernormal Profit
Supernormal Profit is when a return is more than sufficient to keep an entrepreneur in
their present activity. At MR = MC, AR>AC. Supernormal Profit is shaded in blue below.
Subnormal Profit
Subnormal Profit is when a return is insufficient to keep an entrepreneur in their present
activity. At MR = MC, AR<AC. Subnormal Profit is shaded in blue below.
Normal Profit
Normal Profit is when a return is sufficient to keep an entrepreneur in their present
activity. All costs including opportunity costs of production are fully covered. AR = AC.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
The long run for a monopoly
A monopoly prefers to operate at their profit maximising position where MC = MR. This
position is called mark up pricing. A monopoly restricts quantity by deliberately charging
a higher price compared to what would happen in perfect competition.
This results in a deadweight loss.
Deadweight loss is a loss of welfare to
individuals or society which is not offset by a
welfare gain to some other individual or
group. It is not transferred anywhere else
but just disappears from the system.
Deadweight loss occurs when equilibrium
cannot be achieved because of the high
prices charged.
Deadweight loss is shaded in blue.
Because of the fact that monopolies have
high barriers to entry, the government can
regulate a monopoly by the administering
of price to control the ill effects of
monopoly organisation in the market.
They can regulate the price to P2/Q2. This
is where MC = AR (i.e. the demand curve
intersects with the supply curve). This is
called the Social Optimum, Marginal Cost
Pricing or Allocative Efficiency. This is
where consumers are very happy.
They can also further regulate prices to
P3/Q3. This is where AC = AR (i.e. normal
profits) and the firm is breaking even.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
The long run for a perfect competitor
In the short run a perfect competitor will earn supernormal, normal or subnormal profits.
In the long run a perfect competitor will earn normal profits (At MR = MC, AR = AC).
This is because if firms are operating at supernormal profit, since there are no barriers to
entry, more people will set up businesses in that industry to try and get the high profits.
Therefore the supply for the whole industry increases shifting the market supply curve to
the right. This decreases price for the whole industry. Since the market determines the
price for perfect competitors, price will decrease for individual firms to where AR = AC
which are normal profits.
On the flip side, if a firm is operating at a subnormal profit in the long run they will shut
down because of the losses they are making. Therefore market supply will decrease,
shifting the supply curve for the industry to the left, raising price to where MC = MR and
AC = AR, which are normal profits.
It will remain at normal profits, because if more firms enter, they will increase supply to
the industry, decreasing price and therefore they would earn subnormal profit. No firms
would exit either because they are happy as they are breaking even.
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Microeconomics
3.1 Marginal analysis and behaviour of firms
Demand shifting in the long run for perfect competition
If demand increases in the market, the demand curve shifts to the right. This increases
the price. Because resources are now more scarce, costs increase and the individual
firm’s supply curve (i.e. the MC curve above minimum AVC) shifts to the left. If they
keep operating at Q1, MC2 is greater than MR2. Therefore to reduce marginal costs
and to maximise profit, the firm must decrease production to Q2 where MC2 = MR2 to
maximise profit.
This can happen in reverse if demand in the market decreases.
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