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2.3 Wiki Theory of the Firm
Cost Theory
Fixed costs - costs that do not vary wit the quantity of output produced.
They are incurred even if the firm produces nothing at all. Fixed costs are
variable in the long run.
Ex: rent, salary of employee
Variable Cost- costs that do vary wit the quantity of output produced. For
example if Susan wants to make more lemonade, she will need more
lemons, cups, straws, etc.
Ex: amount of workers needed for the job, supplies necessary for
production
Total Cost- A firm’s total cost is the sum of fixed costs plus variable
costs.
Ex) Rent+ Lemons+Cups+Salary of Workers = Total Cost
Average Total Cost- total cost divided by the quantity of output; Average
total cost tells us the cost of a typical unit of output if total cost is
divided evenly over all the units produced.
AVT= TC/ Q
Marginal Cost- the increase of total cost that arises form an extra unit of
production; Marginal cost tell us the increase in total cost that arises
from producing an additional unit of output
MC = Δ TC/ Δ Q
Accounting cost + Opportunity Cost = Economic Cost
Economists include all opportunity costs when analyzing a firm, whereas
accountants measure only explicit costs. Therefore economic profit is
smaller than accounting profit.
Short Run

Because fixed costs are variable in the long run, the average-totalcost curve in the short run differs from the average-total-cost
curve in the long run.
Law of Diminishing Returns- The law of diminishing returns states that
the benefit from an extra unit of an output declines as the quantity of the
input increases.
Ex) If McDonalds starts out with only 3 workers who can each
produce 2 burgers per minute, adding 2 more workers at first will
increase the efficiency of the workers because one will be helping with
the burgers and other will be on the cashier. After having let’s say 10
workers though, they all start to bump into each other and instead of
being more productive, they are actually slowing each other down. Thus,
after a certain point, the benefit of the extra unit of input declines as the
quantity of the input increases.
Total Product- the amount of good produced in a period
Average Product- production per worker
Marginal Product- the increase in output that arises from an additional
unit of input
Short Run/ Long Run Cost Curves:
Because many decisions are fixed in the short run but variable in the
long run, a firm’s long-run cost curves differ from its short run cost
curves. As the firm moves to the long run, it is adjusting the size of its
factory to the quantity of production. The long run average-total-cost
curve is a much flatter U-shape than the short average total cost curve.
These properties arise because firms have greater flexibility in the long
run. In the long run, the firm gets to choose which short run curve it
wants to use but in the short run it ha to use whatever shirt run curve it
has chosen in past.
Economies of Scale: The property whereby long run average total cost
curve falls as the quantity of output increases.
Diseconomies of Scale: The property whereby long run average total cost
rises as the quantity of output increases.
Revenues:
Total revenue: the amount a firm receives for the sale of its output
Marginal revenue: Marginal revenue is the additional revenue of selling
an additional unit of output. MR = ∆TR ∕ ∆Q.
Average revenue: Average revenue is a firm’s revenue per unit of output,
MR = TR ∕ Q
Profit:
Zero economic profit (normal profit) - Zero economic profit occurs when
a firm’s revenues precisely cover opportunity costs, and is a characteristic
of the long run equilibrium in a perfect competition.
Abnormal Profit (supernormal) – this is a profit that exceeds the normal
profit. Normal profit equals the opportunity cost of labor and capital,
while supernormal profit exceeds the normal return from these input
factors in production. Abnormal profit is usually generated by an
oligopoly or a monopoly

In order to maximize total revenue, the firm must maximize its
sales and minimize its costs
Perfect Competition

Assumptions of the model: Many buyers and many sellers; they
have a negligible impact on the market price. They have limited
control over the price because the products sold by the sellers are
very similar. They have similar prices because if one seller chooses
to raise its price, buyers will simply go elsewhere to get the same
product for less. Buyers and sellers are price takers. There is
freedom of entry and exit, but in the long run. An example a
perfectly competitive market is the wheat industry; there are many
sellers and many consumers.

Price
MC
ATC

p=mc
p= mr
(Demand curve)
Quantity produced =
Quantity
Efficient scale
Demand curve: It is horizontal in perfect competition. This is
because since the firms are price takers they cannot sell their
product for less nor for more but they can sell as much quantity as
they want.

Profit maximizing level of output and price in the short-run and longrun: In the long and short run price equals marginal cost. In order for a
firm to receive the most profit it is important that either marginal cost or
marginal revenue is equal, which will give the firm normal profit. If
marginal cost is less than marginal revenue the firm will then be able to
increase production which means that profits will also increase. However,
if marginal cost is more than marginal revenue than the firm has to
decrease production in order to increase its profit. In the short run, in
order for a firm to receive profit marginal cost must always be above
average variable cost. In order to receive positive profit than marginal
revenue must be above average cost. The firm will stop producing and
exit in the long run when marginal cost is below average variable cost. In
the long run, average cost must equal marginal cost.

Shut-down price, break even-price: Shut down price is when a firm has
enough profit to only cover its total variable cost. Here the firm is not
really making any profit of its own since its all being wasted in the total
variables costs and this is why some firms choose to “shut down”. Breakeven price is when cost and revenue equal. There are not real gains but
there are any losses either, meaning that the firm can stay open.

Allocative Efficiency and Productive Efficiency: Allocative efficiency is
when resources are allocated in a way that benefits society the most. This
is achieved when price equals marginal cost. In productive efficiency each
firm must decrease the cost of producing their output. Basically, firms are
operating through the production possibilities frontier. Firms try to
achieve the production of one good with the lowest cost. Firms try to
produce on the lowest point on the average cost curve.

Efficiency in perfect competition: Perfect competition is very efficient
since it will be both allocative and productive efficient. But perfect
competition is impossible to achieve.
Monopoly

An example of a monopoly would be in a town where there is only one
well and it is impossible to get water from somewhere else. Therefore the
owner of the well would have a monopoly on water. He or she will have a
lot more market power since only they will have the product and no one
else, causing them to be price makers and not price takers, unlike in
perfect competition. In perfect competition there is only one firm and
there are no close substitutes.

Sources of monopoly power/ barriers to entry: A key resource is owned
by a single firm. The government gives a single firm the exclusive right to
produce some good or service. The costs of production make a single
producer more efficient than a large number of producers. Some of the
barriers of entry are patents, limit pricing, cost advantages, advertising
and marketing, international trade restrictions and sunk costs. A patent
gives a firm the right to produce a product for a number of years. Limit
pricing is when the monopolistic firm has a very low price, that way if any
other firms try to enter the market they will end up losing profit .Tariffs
and quotas are some trade restrictions that would be a barrier to entry
when it comes to domestic markets.

Natural Monopoly- A single firm can supply a good or service to an entire
market at a lower cost than could two or more firms. It arises when there
are economies of scale over the relevant range of output.

Price
MC
ATC
P
Marginal
Cost
MR
Demand
Quantity
Efficient
Produced
Scale
Quantity
Excess Capacity
The demand curve for a monopoly is downward sloping. This is because a
monopolist has market power, so they are able to push prices up and
limit output.

Profit maximizing level of output- It is the same as in perfect
competition, marginal cost must equal marginal revenue. This happens
because when the producer increases output it lowers the price, therefore
marginal revenue is always below price. If MR is greater than MC than the
producer will increase profit by increasing output. If MR is less than MC
than the producer has to decrease output. Once the firm is at a place
where MR equals MC, than it is maximizing profit.

In a monopoly, the producer can greatly influence the price of its output.
In perfect competition a firm has barely any influence on the price of its
output. A monopoly is the sole producer in its market; it can alter the
price of its good by adjusting the quantity it supplies to the market. In a
monopoly there are no risks of over production and there is also a
reduction of price. Resources are also used efficiently. The disadvantages
of a monopoly are that there is a restriction of choice and an increase in
price of product. Because of the lack of competition there is inefficiency.
In perfect competition the advantages are that there is allocative
efficiency and the competition in the market increases efficiency.
Consumers are also charged a lower price. There are more disadvantages
however than there are advantages. There is a lack of product variety
unequal distribution of goods and income, insufficient profits for
investment and there are certain externalities that arise like pollution.

Efficiency in monopoly- A monopoly is not as efficient as in perfect
competition. This is because a monopolist will sell less for more. There is
also deadweight loss because of the higher price and the less demand.
Monopolistic Competition
Assumptions of the model: There are many firms and each firm produces
a product which is somewhat different in character from other products
produced by other firms in the industry, this is one of the differences
from perfect competition. Products are also able to be substituted for if
one firm chooses to increase its price, just like perfect competition. Free
entry and exit of firms and there are economies of scale in production.

Short run and long run equilibrium- In short run equilibrium, firms face a
downward-sloping demand curve and the marginal revenue curve is
below the demand curve. Firms have to produce the quantity where
marginal cost equals marginal revenue and charge consumers the highest
price. In the long run the profits that are being made encourage other
firms to enter the market therefore shifting the demand curve to the left.
Equilibrium here occurs when firms no longer have an incentive to enter
the market.

Product differentiation: This represents the differences between products.
It tries its best to make its product more attractive than others by
showing some special qualities that is has. If this is successful it creates
high competition and some competitive advantages. An example of this
could be toothpaste. Some producers will produce it purely white while
others will choose to put color in it like red and blue.

Efficiency in monopolistic competition: In this type of competition there is
neither allocative nor productive efficiency. This is because firms produce
at a place where P is greater than MC which means that resources are
under allocated. Firms do not produce at the place where price equals the
least point on the average total cost curve; therefore there is no
productive efficiency.
Oligopoly

Assumptions of the model: There are few sellers and
interdependence exists. This means that each seller must be
careful with the actions they make because there is rival
competition. There is tension between cooperation and selfinterest. They are best off by acting like a monopolist; producing a
small quantity of output and charging a price above marginal cost.
The actions of any one seller in the market can have a large impact
on the profits of all the other sellers.

Collusive and non-collusive oligopoly: In collusive oligopoly producers
make a deal and agree on a price for the output and allocation of output.
An example of collusive oligopoly is OPEC. This makes them act
somewhat as a monopoly. Non-collusive oligopoly is the opposite of
this. They do not cooperate with each other which cause them to always
have to be aware of what each firm is doing.

Cartels: A cartel is a group of firms acting in unison. Once a cartel is
formed, the market is in effect is served by a monopoly. They agree on a
monopoly outcome because that outcome maximizes the total profit that
producers can get from the market.

Kinked demand curve is one model to describe interdependent behavior:
There is a downward sloping demand curve but the elasticity of the curve
depends on the changes in both price and output. Because firms are
trying to get the highest profit firms will not follow a price increase done
by other firms. This means that the curve will be somewhat elastic. Firms
will also try to match a price fall in order to not get a loss when it comes
to market share.

Importance of non-price competition: This is when firms do not
differentiate their product by price, but rather by the looks and qualities
of their product. They try their best to distinguish their product through
their attributes; this is somewhat like monopolistic competition. Non
price competition can be made possible especially through
advertisement. It is important because it provides variety and it gives
buyers a choice because they are not left with simply buying the same
product no matter who they are buying from. It gives product
differentiation.

Theory of contestable markets: This happens when there is
freedom of exit and entrance to a market. It says that long run
equilibrium (competitive) is possible and that because of the free
exit and entrance there will be low sunk costs. When considering
this theory it is important to understand sunk costs, levels of
advertising and brand loyalty, profit level, vertical integration and
access to technology and skilled labor.
Price Discrimination

Definition: The business practice of selling the same good at
different prices to different costumers. They give different prices
even if the cost of producing it is the same.

Reasons for price discrimination: Revenue will increase which will
let firms stay open in the market since they are no longer making a
loss. The increase in revenue can then allow there to be money for
research which will in the end benefit consumers. By price
discriminating there will be a consumer surplus because there are
certain consumers that are willing to pay more for the product than
others.
Link to Article:
http://sanjose.bizjournals.com/sacramento/stories/2009/01/19/story11.html
This article discusses the difficult situation which auto companies
have found themselves to be in as a result of the economic recession
going on right now. With this in mind, we can analyze their fixed and
variable costs in the short and long run. In the short run, the fixed costs
of the factory and the daily rent are already set therefore the lack of car
sales is not affecting those fixed costs. In the long run, the ca
manufacturers can take in consideration the decreased number of sales
and it can only run for example eight factories instead f ten in order to
minimize costs. Variable costs are the wages p[aid to the workers
therefore many companies are firing employees or cutting their hours
because if there are no customers buying the cars, there is no need for so
many employees. In the short run, the companies cannot really do much
to minimize costs but those fixed costs will turn into variable costs in the
long run and the car dealerships can plan how to maximize their future
profit based on the new attitudes of the many citizens who have been
affected by the recession and have decided that it is time to save more
money and only buy what one can afford.