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Microeconomics II
Georgi Georgiev
November 2014
Production, Costs, Revenue
and Profit
Main topics
1.
2.
3.
4.
Production - TP, AP and MP
Costs
- FC and VC
- TC, AC and MC
Revenue - TR, AR and MR
Profit – economic and accounting profit
and Profit maximization
Production



The total amount of output produced by a firm
is a function of the levels of input/factors of
production/ usage by the firm
Usually the amount of output is a function of
two inputs/production factors/ – Capital and
Labour.
Total Product (TP) function - a short-run
relationship between the amount of Labour
and the level of output, ceteris paribus.
Total product (TP)
Law of diminishing returns
As the level of a variable input rises in a
production process in which other inputs are
fixed, output ultimately increases by
progressively smaller increments.
Average product (AP)

AP = TP / amount of input/
Quantity
of labour
0
5
10
15
20
25
30
35
40
45
TPP
0
50
120
180
220
250
270
275
275
270
APP
10
12
12
11
10
9
7.86
6.88
6
Marginal product (MP)


the additional output that results from the use
of an additional unit of a variable input,
holding other inputs constant
measured as the ratio of the change in output
(TP) to the change in the quantity of labor (or
other input) used
Computation of MP and AP
Quantity
of labour TP
0
5
10
15
20
25
30
35
40
45

0
50
120
180
220
250
270
275
275
270
AP
10
12
12
11
10
9
7.86
6.88
6
MP
10
14
12
8
6
4
1
0
-1
Note that the MP is positive when an increase in
labour results in an increase in output; a negative
MP occurs when output falls when additional labour
is used.
TP
Shape of MP curve


MP rises when TP
increases at an
increasing rate, and
declines when TP
increases at a
decreasing rate.
MP is negative if TP
declines when labor use
rises
Relationship of AP and MP



AP rises when MP > AP
AP falls when MP < AP
AP is maximized when
MP = AP
Cost - Total Costs

Types of costs according to the change in
quantity produced:


fixed costs – costs that do not vary with the level
of output. Fixed costs are the same at all levels of
output (even when output equals zero).
variable costs – costs that vary with the level of
output (= 0 when output is zero)
Example
Overall Total Costs - TC
Fixed costs
Variable costs
TC, TVC, and TFC
Average fixed cost

Average fixed cost (AFC) = TFC / Q
Average variable cost

Average variable cost (AVC) = TVC / Q
Average total cost


Average total cost (ATC) = TC / Q
ATC = AFC + AVC (since TFC + TVC = TC)
Marginal cost

Marginal cost (MC) = cost of an additional
unit of output
Average fixed cost
AVC, ATC, and MC

Note that the MC curve intersects the AVC and
ATC at their respective minimum points
Long-run costs

In the long run, a firm may change not only the level
of Labour employed but also its level of Capital, and
will select a size of firm that provides the lowest
level of ATC.
Economies and diseconomies of
scale – producing at lowest ATC

Economies of scale – factors that lower average
cost as the size of the firm rises in the long run


Diseconomies of scale – factors that raise average
cost as the size of the firm rises in the long run


Sources: specialization and division of labor, indivisibilities
of capital, etc.
Sources: increased cost of managing and coordination as
firm size rises
Constant returns to scale – average costs do not
change as firm size changes
Long-run average total cost
(LRATC)
Minimum efficient scale

Minimum efficient scale = lowest level of
output at which LRATC is minimized
Revenue

Total Revenue – the overall revenue received from
the sale of output
TR = Q x p

Average Revenue = the revenue received from the
sale of an unit of output
AR=TR/q
Marginal revenue


Marginal revenue = additional revenue
received from the sale of an additional unit of
output.
In mathematical terms:
MR & MC


the additional revenue resulting from the sale
of an additional unit of output is called
marginal revenue (MR)
the additional cost resulting from the sale of
an additional unit of output is called marginal
cost (MC)
MR > MC


If marginal revenue exceeds marginal cost,
the production of an additional unit of output
adds more to revenue than to costs.
In this case, a firm is expected to increase its
level of production to increase its profits.
MR < MC



If marginal cost exceeds marginal revenue, the
production of the last unit of output costs more
than the additional revenue generated by the
sale of this unit.
In this case, firms can increase their profits by
producing less.
A profit-maximizing firm will produce more output
when MR > MC and less output when MR < MC.
MR = MC


If MR = MC, however, the firm has no
incentive to produce either more or less
output.
The firm's profits are maximized at the level
of output at which MR = MC.
Profit maximization
Profit = (profit per unit) x No of units
= (P – ATC) x Q
Or
Profit = (TR – TC)
Profit maximization


Economic profit = total revenue - all
economic costs
Economic costs include all opportunity costs
(explicit and implicit).
Economic vs. accounting
profit

economic profit = total revenue - all economic
costs

accounting profit = total revenue - all
accounting costs

accounting costs include only current or
historical explicit costs, not implicit costs
Economic vs. accounting
profit

the difference between economic cost and
accounting cost is the opportunity cost of
resources supplied by the firm's owner.

the opportunity cost of these owner-supplied
resources is called normal profit.

normal profit is a cost of production.
Economic vs. accounting
profit


If the owners of a firm gain economic profits,
they are receiving a rate of return on the use
of their resources that exceeds that which
can be received in their next-best use.
In this situation, we'd expect to see other
firms entering the industry (unless barriers to
entry exist).
Economic vs. accounting
profit


If a firm is receiving economic losses
(negative economic profits), the owners are
receiving less income than could be received
if their resources were employed in an
alternative use.
In the long run, we'd expect to see firms
leave the industry when this occurs.
Economic profits = 0

If economic profits equal zero, then:



owners receive a payment equal to their
opportunity costs (what could be received in their
next-best alternative),
no incentive for firms to either enter or leave this
industry,
accounting profit = normal profit.
Economic profit

Economic profit = total revenue - economic costs

when output rises, both total revenue and total costs
increase (with a few exceptions that will be
discussed in later chapters)

profits increase when output increases if total
revenue rises by more than total costs.

profits decrease when output rises if total costs rise
by more than total revenue
Demand and MR for a firm facing a
downward sloping demand curve
Profit maximization
Main Types of Market
Structures
Main topics
1.
Perfect competition
2.
Monopoly
3.
Monopolistic competition
4.
Oligopoly
Perfect competition – main
characteristics
a very large number of buyers and sellers,
 easy entry,
 a standardized product, and
 each buyer and seller has no control over the
market price (this means that each firm is a
price taker that faces a horizontal demand
curve for its product).

Demand curve facing a single firm


no individual firm can affect the market price
demand curve facing each firm is perfectly elastic
Profit maximization

produce where MR = MC
P = MR
Profit-maximizing level of output
Economic Profits > 0
Economic profit
Loss minimization and the
shut-down rule




Suppose that P < ATC. Since the firm is
experiencing a loss, should it shut down?
Loss if shut down = fixed costs
Shut down in the short run only if the loss that
occurs where MR = MC exceeds the loss that would
occur if the firm shuts down (= fixed cost)
Stay in business if TR > VC. This implies that P >
AVC. Shut down if P < AVC.
Economic loss (AVC<P< ATC)
Loss if shut down
Break-even price



If price = minimum
point on ATC curve,
economic profit = 0.
Owners receive normal
profit.
No incentive for firms to
either enter or leave the
market.
Long run

Firms enter if economic profits > 0




market supply increases
price declines
profit declines until economic profit equals zero (and entry
stops)
Firms exit if economic losses occur



market supply decreases
price rises
losses decline until economic profit equals zero
Monopoly – main
characteristics


a single seller producing a product with no close
substitutes,
effective barriers to entry into the market,
and

the firm is a price maker, also called a price
searcher because it faces a downward sloping
demand curve for its product (in fact, note that this
demand curve is the market demand curve).
Barriers to entry



economies of scale/economic barriers/
actions by firms
actions by government/legislative barriers/
Natural monopoly



a monopoly that arises because of the
existence of economies of scale over the
entire relevant range of output.
a larger firm will always be able to produce
output at a lower cost than could a smaller
firm.
only a single firm can survive in a long-run
equilibrium.
Economies of scale – natural
monopolies

Natural
monopolies
are often
regulated
monopolies
Actions by firms to create and
protect monopoly power



patents and copyrights,
high advertising expenditures result in high
sunk costs (costs that are not recoverable on
exit), and
illegal actions designed to restrict competition
Monopolies created by
government action



patents and copyrights,
government created franchises, and
licensing.
Local monopoly

Local monopoly – a monopoly that exists in a
local geographical area (e.g., local
newspapers)
Price elasticity and MR




As noted earlier, since the demand curve
facing a monopoly firms is downward sloping,
MR < P
MR > 0 when demand is elastic
MR = 0 when demand is unit elastic
MR < 0 when demand is inelastic
Average revenue


As in all other market structures, AR=P (note
that AR = TR/Q = (PxQ) / Q = P)
The price given by the demand curve is the
average revenue that the firm receives at
each level of output.
Monopolist receiving positive
profits
Monopoly price setting



There is a unique profit-maximizing price and output
level for a monopoly firm.
It is optimal to produce at the level of output at
which MR = MC and to charge the price given by the
demand curve at this output level.
Charging a higher (or lower) price results in lower
profits.
Monopolistic competition –
main characteristics




a large number of firms,
the product is differentiated (i.e., each firm
produces a similar, but not identical product),
entry is relatively easy, and
the firm is a price maker that faces a
downward sloping demand curve.
Relationship to other market
models

Monopolistic competition is similar to perfect
competition in that:



There are many buyers and sellers
There are no barriers to entry or exit
Monopolistic competition is similar to monopoly in
that:


Each firm is the sole producer of a particular product
(although there are close substitutes)
The firm faces a downward sloping demand curve for its
product
Demand curve facing a
monopolistically competitive firm
The firm’s demand curve and
entry and exit

As firms enter a
monopolistically
competitive
market, the
demand facing a
typical firm
declines and
becomes more
elastic.
Short-run equilibrium in a
monopolistically competitive industry

Economic profits
lead to entry and
a reduction in the
demand facing a
typical firm.
Long-run equilibrium in a
monopolistically competitive industry


Entry continues
until economic
profit equals
zero for a
typical firm.
This
equilibrium is
often referred
to as a
“tangency
equilibrium.”
Monopolistic competition vs.
perfect competition


A monopolistically
competitive firm,
in the long run,
has “excess
capacity” – (i.e.,
it produces a
level of output
that is below the
least-cost level).
This is a cost of
product variety.
Monopolistic competition and
efficiency



As the number of firms rises, a monopolistically
competitive firm’s demand curve becomes more
elastic.
As the number of firms in a market expands, the
market approaches a perfectly competitive market.
Thus, economic inefficiency may be smaller when
there is a large number of firms in a monopolistically
competitive market.
Product differentiation and
advertising


Monopolistically competitive firms may
receive short-run economic profit from
successful product differentiation and
advertising.
These profits are, however, expected to
disappear in the long run as other firms copy
successful innovations.
Location decisions

Monopolistically competitive firms often
locate near each other to appeal to the
“median” customer in a geographical region.
(e.g., fast food restaurants and car
dealerships)
Oligopoly – main
characteristics




a small number of firms produce most output,
the product may be either standardized or
differentiated,
there are significant barriers to entry, and
recognized interdependence exists (i.e., each
firm realizes that its profitability depends on the
actions and reactions of rival firms).
Real-world markets

Most output is produced and sold in oligopoly
and monopolistically competitive industries.
Strategic behaviour

Strategic behaviour occurs when the best
outcome for one party depends upon the
actions and reactions of other parties.
Game theory – prisoners’
dilemma

Examines the payoffs associated with
alternative choices of each participant in the
“game.”
Game theory examples


Prisoners’ dilemma
Duopoly pricing game
Dominant strategy



A dominant strategy is one that provides the highest
payoff for an individual for each and every possible
action by rivals.
Confession is the dominant strategy in the prisoners’
dilemma game. A low price is the dominant strategy
in the duopoly pricing game
It is more difficult to predict the outcome when no
dominant strategy exists or when the game is
repeated with the same players.
Cartels




Cartels are legal in some countries
A cartel arrangement can maximize industry
profits
Each firm can increase its profits by violating
the agreement
Cartel agreements have generally been
unstable.
Imperfect information


Brand name identification – serves as a
signal of product quality. Customers are
willing to pay a higher price for products
produced by firms that they recognize.
Product guarantees also serve as a signal of
product quality