Transcript Section 1.5 Theory of the firm and market structures (HL
SECTION 1.5 THEORY OF THE FIRM AND MARKET STRUCTURES (HL ONLY)
REVENUE, PROFIT, THE GOALS OF THE FIRM, AND PERFECT COMPETITION
1.
Distinguish between total revenue, average revenue and marginal revenue.
Total revenue (TR)
Total revenue is the total receipts of a firm from the sale of any given quantity of output.
It can be calculated as the selling price of the firm's product times the quantity sold, i.e.
total revenue = price × quantity Average revenue (AR)
Average revenue is the total revenue divided by total quantity sold.
AR=TR/Q Marginal Revenue (MR)
Marginal revenue (MR) is the amount of extra revenue which is generated by selling one more unit of a product in a given time period.
MR=Change in TR/Change in quantity
2 . Draw
diagrams
illustrating the relationship between total revenue, average revenue and marginal revenue.
When the AR curve is a 'normal' downward sloping demand curve
2
. Draw
diagrams
illustrating the relationship between total revenue, average revenue and marginal revenue.
When the AR curve is a flat demand curve
3.
Calculate
total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
HOW TO:
Total revenue (TR) = price X quantity
Average revenue (AR)
is simply the price of the good. The demand curve can be labelled
“D=AR=P”
to help you remember this.
AR = TR/Q Marginal revenue (MR)
last unit sold. = the change in total revenue divided by the change in quantity. This is the change in total revenue resulting from the
For a PC firm, MR
firm is a
price taker
is constant and equal to the market price (since the and can sell additional units for the same price.) But for an imperfectly competitive firm, beyond the first unit of output, since the firm must lower its price to sell additional units of output.
MR
fall twice as steeply as the an imperfect competitor diagram.
MR
is lower than price
D=AR=P
curve in
3.
Calculate
total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
a flat demand curve downward sloping demand curve
4. Describe
economic profit (abnormal profit)
as the case where total revenue exceeds economic cost.
Super-normal (economic) profit
If a firm makes more than normal profit it is called super-normal profit.
Supernormal profit
is also called
economic profit
, and
abnormal profit
, and is earned when total revenue is greater than the total costs. Total costs include a reward to all the factors, including normal profit. This means that, when total revenue equals total cost, the entrepreneur is earning normal profit, which is the minimum reward that keeps the entrepreneur providing their skill, and taking risks.
The level of
super-normal profits
available to a firm is largely determined by the level of competition in a market – the more competition the less chance there is to earn super-normal profits.
Super-normal profits = Price > ATC
4. Describe
economic profit (abnormal profit)
as the case where total revenue exceeds economic cost.
Super-normal profit can be derived in three general cases:
By firms in level.
perfectly competitive markets in the short run,
before new entrants have eroded their profits down to a normal
By firms in less than competitive markets,
like firms operating under
monopolistic competition
and
competitive oligopolies
These will eventually be eroded away, providing further incentive to innovate and become more cost efficient.
,
by innovating or reducing costs, and earning head start profits.
By firms in highly uncompetitive markets,
like
collusive oligopolies
and
monopolies, who can erect barriers to entry
protect themselves from competition in the long run and earn persistent above normal profits.
5. Explain the concept of
normal profit (zero economic profit)
as the amount of revenue needed to cover the costs of employing self-owned resources (implicit costs, including entrepreneurship) or the amount of revenue needed to just keep the firm in business.
In markets which are perfectly competitive, the profit available to a single firm in the long run is called
normal profit.
This exists when total revenue, TR, equals total cost, TC.
Normal profit
is defined as the minimum reward that is just sufficient to keep the entrepreneur supplying their enterprise. In other words, the reward is just covering opportunity cost - that is, just better than the next best alternative. To the economist,
normal profit
is a cost and is included in total costs of production.
Total revenue just covers both explicit and implicit cost.
Normal Profit: Price = ATC
6. Explain that
economic profit
(abnormal profit) is profit over and above
normal profit
(zero economic profit), and that the firm earns
normal profit
when
economic profit
(abnormal profit) is zero.
Normal profits
reflect the
opportunity cost
of using funds to finance a business. Because we treat normal profit as an
ATC opportunity cost
then it is making normal profits.).
of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its
Normal profit
occurs at the level of output where total revenue = total cost (TR = TC). At this point, average revenue = average cost as well. In other words, the firm is at break-even point. Where total revenue just equals its explicit and implicit cost. Sub-normal profit , (Economic Loss) is profit less than normal (P < average total cost)
Abnormal profit -
is any profit achieved in excess of normal profit - also known as
supernormal profit
. When firms are making
abnormal profits
, there is an incentive for other producers to enter a market to try to acquire some of this profit.
Abnormal profit
persists in the long run in imperfectly competitive markets such as
oligopoly
can successfully block the entry of new firms. and
monopoly
where firms
7. Explain why a firm will continue to operate even when it earns
zero economic profit
(normal profit).
Normal profit
In markets which are perfectly competitive, the profit available to a single firm in the long run is called
normal profit
. This exists when total revenue, TR, equals total cost, TC.
Normal profit
is defined as the minimum reward that is just sufficient to keep the entrepreneur supplying their enterprise. In other words, the reward is just covering opportunity cost - that is, just better than the next best alternative.
Accounting profit
occurs when revenues are greater than costs, and not equal, as in the case of
normal profit
.
To the economist,
normal profit
is a cost and is included in total costs of production.
( P = ATC)
8. Explain the meaning of loss as
negative economic profit
arising when total revenue is less than total cost.
When the
implicit cost
exceeds the
accounting profit
, firms have what's known as a "
negative economic profit
." This means that a firm can have a
positive accounting profit
and a
negative economic profit
simultaneously.
Economic profit
, however, provides a means for coordinating economic activity.
Positive economic profits
attract more investors, while
negative economic profit
drive away investors, who then search for more productive firms and sectors in which to invest their money.
A
negative economic profit
implies that you could be doing better by pursuing an alternative opportunity.
9. Calculate different profit levels from a set of data and/or diagrams.
HOW TO:
Economic profit
is usually found by the following equation.
Profit = (P-ATC)Q
. Find the per-unit profit
(P-ATC)
and multiply it by the quantity of output
(Q).
If you are given total revenue
(TR)
and total cost
(TC)
data, then
economic profit = TR-TC.
If
ATC>P
or if
TC>TR
, then the firm’s profit is negative, and it is earning losses.
10. Explain the goal of
profit maximization
where the difference between total revenue and total cost is maximized or where
marginal revenue equals marginal cost.
Marginal profit
is the additional profit from selling one extra unit. A profit per unit will be achieved when marginal revenue (
MR
) is greater than marginal cost (
MC
).
At
profit maximization
, marginal profit is zero because
MC = MR
.
MC and the Firm’s Supply Decision
Rule:
MR
=
MC
at the profit-maximizing
Q
.
Costs At Q
a
,
MC < MR
.
So, increase Q to raise profit. At Q
b
,
MC > MR
.
So, reduce Q to raise profit. At Q
1
,
MC = MR
.
Changing Q would lower profit.
P
1
Q
a
Q
1
Q
b
MC MR
Q
MC and the Firm’s Supply Decision
If price rises to P
2
, then the profit maximizing quantity rises to Q
2
. The MC curve determines the firm’s Q at any price. Hence, Costs
P
2
P
1
the
MC
curve is the firm’s supply curve.
Q
1
Q
2
MC MR
2
MR
Q
As Moses Said
Profit maximization
occurs at the quantity where marginal revenue equals marginal cost.
The Golden Rule!!!
When MR > MC , thou shalt increase Q When MR < MC , thou shalt decrease Q thus MR = MC , Profit is maximized.
10. Explain the goal of
profit maximization
where the difference between total revenue and total cost is maximized or where
marginal revenue equals marginal cost.
One way that a firm might work out the level of output where profits are maximized is to find the level of output
where the difference between total revenue and total cost is largest.
As one would expect, given the fixed costs, a firm actually makes a loss at low levels of output. It only starts to make a profit after the level of output rises above
Q 1
(which is a break-even level of output). The distance between the total revenue curve and the total cost curve is greatest at Q
max
, so this is the
profit maximizing
level of output. output at Q
2
Profits fall after this point, reaching another break-even level of , after which point the firm is again making a loss, given the acceleration of marginal costs due to diminishing marginal returns.
10. Explain the goal of
profit maximization
where the difference between total revenue and total cost is maximized or where
marginal revenue equals marginal cost.
The marginal cost curve (MC) and the marginal revenue curve (MR).
Profit maximization
occurs at the level of output where MC = MR. So why are profits maximized when this occurs?
Let's think of a level of output below Q
max
. At
Q 3
, marginal revenue is greater then marginal cost. This means that the extra revenue gained through the sale of that unit is greater than the cost of making it. The firm is making a profit on that unit. But this does not mean that the firm is maximizing total profit. What happens if the firm makes one more unit, taking it to the level of output Q
4
? Marginal revenue is still greater than marginal cost, so the firm again makes profit on that unit. This will be true for every unit that they produce up to Q
max
, so they should make all of these units.
10. Explain the goal of
profit maximization
where the difference between total revenue and total cost is maximized or where
marginal revenue equals marginal cost.
At Q
5
, marginal revenue is less than marginal cost. The firm is making a loss on that unit. This is true of all units made after Q
max
. This does not necessarily mean that the firm is making a loss overall (what about all the profit made up to Q small.
max
maximized at Q ?), but it does mean that overall profit will be
max
. Even if the firm makes just one extra unit, where marginal cost is only a little bit bigger than marginal revenue, the overall profit will fall, however
10. Explain the goal of
profit maximization
where the difference between total revenue and total cost is maximized or where
marginal revenue equals marginal cost.
Q 1
and Q
2
are the break-even levels of output. Notice that these are the levels of output where profit = 0 in the top diagram and
TR = TC
in the middle diagram. Q above Q
max max
is the profit maximizing level of output. Notice that this is the level of output where the profit curve is at its highest in the top diagram, the gap between TR and TC is greatest in the middle diagram and
MC = MR
in the bottom diagram. It is important to understand that, while profits are no longer maximized if production rises , total profit is still positive, even though it is falling. Just because MC is greater than MR for each unit produced after Q on each unit, it does not mean that the firm is making a loss overall. This only happens when the firm's output rises above Q
2
.
max
, so losses are made
11.
Explain alternative goals of firms,
including
revenue maximization
, growth maximization, satisficing and corporate social responsibility.
Maximizing total revenue
means gaining the maximum possible revenue from selling a product. Economic theory suggest that a price can be identified which achieves this goal.
Revenue maximization (sales revenue): where MR =
zero
Firms often seek to increase their market share – even if it means less profit. This could occur for various reasons: Increased market share long run.
increases monopoly power
and may enable the firm to put up prices and make more profit in the Managers prefer to work for bigger companies as it leads to
greater prestige and higher salaries
.
Increasing market share may
force rivals out of business
. E.g. supermarkets have lead to the demise of many local shops.
11.
Explain alternative goals of firms,
including revenue maximization ,
growth maximization
, satisficing and corporate social responsibility.
Growth Maximization
This is similar to
sales maximization
and may involve mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order to increase in size and gain more market share.
Market share
Some firms may wish to increase their share of a market. This motive is significant for firms operating in markets with a few large competitors, called oligopolies, and where winning market share from rivals is less risky and costly than trying to win brand new customers.
11.
Explain alternative goals of firms,
including revenue maximization , growth maximization ,
satisficing
and corporate social responsibility.
Satisficing
and competing objectives, without attempting to ‘maximize’ any single one. means attempting to take into account a number of different
For example
, managers may first try to ensure that shareholder's get a reasonable rate of return first, and then seek to reward themselves.
Satisficing can also be referred to as 'profit satisficing'.
Profit Satisficing
In many firms there is separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company.
This is a problem because although the owners may want to maximize profits, the managers have much less incentive to max profits because they do not get the same rewards, (share dividends) Therefore managers may create a minimum level of profit to keep the shareholders happy, but then maximize other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them) This is the problem of separation between owners and managers.
11.
Explain alternative goals of firms,
including revenue maximization , growth maximization , satisficing and
corporate social responsibility.
Social/ Environmental concerns
A firms may incur extra expense to choose products which don’t harm the environment or products not tested on animals.
Alternatively, firms may be concerned about local community / charitable concerns.
Many companies who have adopted such strategies have been quite successful. This has encouraged more firms to consider these over objectives, but a cynic may argue they see it as another opportunity to increase profits rather than a genuine sacrificing of profits in order to promote other objectives.
11.
Explain alternative goals of firms,
including revenue maximization , growth maximization , satisficing and
corporate social responsibility.
12. Describe, using examples,
the assumed characteristics of perfect competition:
a large number of firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource mobility.
Perfectly competitive markets exhibit the following characteristics:
There is perfect knowledge
, with no information failure or time lags. Knowledge is freely available to all participants, which means that risk taking is minimal and the role of the entrepreneur is limited.
There are
no barriers to entry into or exit
out of the market.
Firms produce
homogeneous, identical, units
of output that are not branded.
Each unit of input, such as units of labor, are also homogeneous.
No single firm can influence the market price, or market conditions. The single firm is said to be a
price taker
, taking its price from the whole industry.
There are a very
large numbers of firms
in the market. There is no need for government regulation, except to make markets more competitive.
There are assumed to be
no externalities
, that is no external costs or benefits.
Firms can only make
normal profits in the long run
, but they can make abnormal profits in the short run.
13. Explain, using a diagram
, the shape of the perfectly competitive firm’s average revenue and marginal revenue curves,
indicating that the assumptions of perfect competition imply that each firm is a price taker.
Every firm is a
price taker
setting their price at the market price of
P.
Each firms' demand curve is perfectly elastic. This means that they can sell as much as they want at the given market price. If one of the firms were to raise its price above
P
, their sales would plummet to zero because the buyers would go to one of the other numerous firms selling the identical good at
P
. Each firm can sell as much as they want at price
P
.
Finally, notice that the firms' demand curve has also been labelled
AR = MR
. The
demand curve
is the
average revenue curve, and average revenue = marginal revenue when AR is constant.
As the all the firms produce
homogenous products
and moreover, consumers have
perfect knowledge
of producers who can supply goods at lower prices.
14. Explain, using a diagram, that the
perfectly competitive firm’s
average revenue and marginal revenue curves are derived from market equilibrium for the
industry
.
In
perfect competition,
the
industry
and supply curve i.e. demand curve slopes downwards and supply curve is upward sloping. will face normal demand The reason being suppliers are willing to supply more at higher prices and consumers are willing to buy more at lower prices. Thus the price in the
industry
is the equilibrium point.
In
perfect competition,
a firm is
price taker
, thus it has to adopt the prevalent price in the
industry
.
The single firm takes its price from the
industry
, and is, consequently, referred to as a
price taker.
The
industry
is composed of all firms in the
industry
and the market price is where market demand is equal to market supply. Each single firm must charge this price and cannot diverge from it.
15. Explain, using diagrams, 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 maximization rule.
Profit maximization level of output for a firm is where MC=MR
15. Explain, using diagrams, 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 maximization rule.
In the short run, a firm in perfect competition can make
abnormal profits
. It may be due to some cost advantages due to technological changes or some production innovation. This means the firm will be covering more than the economic cost (total cost + opportunity cost) The diagram illustrates that firm is producing at Q which is the
(MC=MR).
profit maximization level of output
At this output the firms Average Total Cost
(AC)
is at
C
and its Average Revenue is at
P,
thus leading to
abnormal profit
for the firm
(Shaded blue region) P-C.
15. Explain, using diagrams, 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 maximization rule.
There may be cases, when a firm may not be able to cover its Total cost due to some inefficiency in their production process. As the diagram show the firm is producing at
Profit Maximization level of output (MC=MR),
its
AC
is
C
which is more than its
AR
(at P), thus leading to a
loss
C-P (Shaded in blue).
16. Explain, using a diagram, why,
in the long run, a perfectly competitive firm will make normal profit
(zero economic profit).
16. Explain, using a diagram, why,
in the long run, a perfectly competitive firm will make normal profit
(zero economic profit).
With
perfect competition
there are
no barriers to entry or exit
. This means that new firms will be attracted, in quite large numbers, into the market if there are
economic profits
in the
short run
. This will increase
market supply
, shifting the supply curve to the right. This will keep happening until the given price is such that all firms in the market earn only
normal profit
. All of the
super normal profit
will have been competed away.
Some firms will leave the industry if they are at a
loss
, causing the
market supply curve
to shift to the left. This will keep happening until the given price is such that all firms in the market earn only
normal profit
. Once the supply curve has shifted in, then every firm in the industry will be earning
normal profit
and there will be
no
incentive for any firm to enter or leave the industry. This is, therefore, the
long run equilibrium
.
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
Moving from short run abnormal profit to long run normal profit
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
In the diagram, the industry price is
P
and the firm takes its price from the industry price. The firm is making
abnormal profits
by producing at
q
(Profit Maximization level) and is having an
abnormal profit P-C.
On the industry graph,
more firms are attracted,
which results in a increase in supply (shift of supply curve from
S
to
S1
). This leads to a lower in the industry price to
P1
. The firm has to take this price P1 and its demand curve shifts downwards i.e.
D
At this point the existing firms will not leave the industry as they can cover their economic cost and new firms will stop entering the industry as there is no more
abnormal profits 1 =AR 1 =MR 1
. The industry has reached long term equilibrium.
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
In the short run a firms in a perfectly competitive market might make
losses
. In this case the firms will start
shut down
industry will go down pushing the prices up and the firms will start
normal profits in the long run.
as there is no sunk cost . The supply in the
making
Looking at the firm diagram, we see the firm producing at profit maximizing level
q
is making a loss ( losses.
C-P
)as its
AC
is above the
AR
. However, as more and more firms start leaving the industry the industry supply curve shifts to the left to will lead to the upward movement of firm’s demand curve from
D
to
D1 S1
. This raises the price in the industry. Due to the fact that the firm is a ‘price taker’ it resulting in reduction of losses. The process will continue firms in the industry are making
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
The industry has reached its long term equilibrium where no more firms will enter or exit the industry and all the firms will be making normal profits.
18. Distinguish between the
short run shut-down price
and the
break-even price
.
Breakeven point
is the point where price is equal to average total cost or
P=ATC
At this price the firm is covering all of its economic costs (recall this is accounting cost plus opportunity cost) In economics when a firm is at a
breakeven point
it is said to be earning a
normal profit.
Breakeven price is when P = ATC
18. Distinguish between the
short run shut-down price
and the
break-even price Shutdown point:
Recall that
Total Cost =FC + VC
If a firm can’t even receive a price to cover the
shutdown
.
Variable Cost
of producing a good then it should In this case though it will still have to
pay its
fixed costs
At any price point between
shutdown
(above AVC) and
breakeven
will receive a contribution to cover
Fixed Cost
operate.
(ATC) at least the firm so it will continue to
SHUTDOWN is where P < AVC
Shutdown vs. Exit
Shutdown:
A short-run decision not to produce anything because of market conditions.
Exit:
A long-run decision to leave the market. A firm that shuts down temporarily must still pay its fixed costs. A firm that exits the market does not have to pay any costs at all, fixed or variable.
A Firm’s Short-run Decision to Shut Down
If firm shuts down temporarily, revenue falls by TR costs fall by VC So, the firm should shut down if TR < VC.
Divide both sides by Q: TR/Q < VC/Q So we can write the firm’s decision as:
Shut down if P < AVC
A Competitive Firm’s SR Supply Curve
The firm’s SR supply curve is the portion of its MC curve above AVC.
, then firm produces
Q
where
P
=
MC
.
Costs If
P
<
AVC
, then firm shuts down (produces
Q
= 0).
MC ATC AVC
Q
Short Run Rules
If Price > ATC, Stay Open with an Economic Profit . (P> ATC)
If Price = ATC, Stay Open with a Normal Profit . (P=ATC)
If AVC < price < ATC, Stay Open with a loss .
If Price
19. Explain, using a diagram, when
a loss-making firm would shut down in the short run.
If price is less than
average variable cost
to pay , a firm does not receive enough revenue
variable cost
let alone any part of
fixed cost
. As such, the economic loss of operating is better off
GREATER
than total fixed cost. A firm is
shutting down
production in the short run, producing zero output, and awaiting a higher price.
20. Explain, using a diagram, when a loss-making firm would shut down and exit the market in the long run.
Firms can take a reasonable sized loss in the short run, but this is not sustainable as we move into the long run. Again, there are
normal profit. no barriers to exit,
so some firms will leave the industry, causing the market supply curve to shift to the left. This will keep happening until the given price is such that all firms in the market earn only Once the market supply curve has shifted all the way to new market equilibrium, then every firm in the industry will be earning
normal profit
and there will be no incentive for any firm to enter or leave the industry. This is, therefore, the long run equilibrium.
20. Explain, using a diagram, when a loss-making firm would shut down and exit the market in the long run.
The Irrelevance of Sunk Costs
Sunk cost:
a cost that has already been committed and cannot be recovered Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down.
So, FC should not matter in the decision to shut down.
A Firm’s Long-Run Decision to Exit
If firm exits the market, revenue falls by TR costs fall by TC So, the firm should exit if TR < TC.
Divide both sides by Q to rewrite the firm’s decision as:
Exit if P < ATC
A New Firm’s Decision to Enter Market
In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firm’s entry decision as:
Enter if P > ATC
If P = ATC, Firms will remain in business with a Normal Profit (P = ATC)
Long Run Rules
If Price > ATC, Firms Enter
If Price = ATC, There is no entry nor exit. All firms remain.
If Price < ATC, Firms Exit
The Competitive Firm’s Supply Curve
The firm’s LR supply curve is the portion of its MC curve above LRATC.
Costs
MC LRATC
Q
Entry & Exit in the Long Run
In the LR, the number of firms can change due to entry & exit. If existing firms earn positive economic profit, New firms enter.
SR market supply curve shifts right.
P falls, reducing firms’ profits.
Entry stops when firms’ economic profits have been driven to zero. (MC = ATC) All firms remaining are earning a normal Profit. (P=ATC)
Entry & Exit in the Long Run
In the LR, the number of firms can change due to entry & exit. If existing firms incur losses, • • • • • Some will exit the market. SR market supply curve shifts left.
P
rises, reducing remaining firms’ losses. Exit stops when firms’ economic losses have been driven to zero. (MC = ATC) All firms remaining are earning a normal Profit. (P=ATC)
The Zero-Profit Condition
Long-run equilibrium: The process of entry or exit is complete – remaining firms earn zero economic profit. Zero economic profit occurs when P = ATC. Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum ATC.
Hence, in the long run, P = minimum ATC.
P= ATC, Normal Profit
21. Calculate the short run shutdown price and the breakeven price from a set of data.
HOW TO:
A firm should shut down if the price in the market is lower than the firm’s minimum average variable cost . At this point, the firm’s total losses are greater than its total fixed costs, so it will LOSE LESS by shutting down!
A firm will break even when the price in the market equals the firm’s minimum ATC, or if the TR = TC (see above). Economic profits at that point is Zero.
22. Explain the meaning of the term allocative efficiency.
Allocative efficiency
is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. Condition required is that
price = marginal cost
. When this condition is satisfied, total economic welfare is maximized.
Pareto
defined
allocative efficiency
where no one could be made better off without making someone else at least as worth off.
as a situation There is no deadweight loss as a result.
23. Explain that the condition for
allocative efficiency
is P = MC (or, with externalities, MSB = MSC).
Allocative efficiency
This is the socially optimal level of output. At this point it is impossible to make one person better off without making someone else worse. There is
pareto optimality
. It occurs where
MC = AR
In other words, a firm in a perfectly competitive market produces at the profit maximizing level which is
MR=AR
. This is also the point where
MC=AR
. Thus we conclude that in perfect competition there is allocative efficiency in the long run.
24. Explain, using a diagram, why a perfectly competitive market leads to
allocative efficiency
in both the short run and the long run.
When a firm is making abnormal profit in the short-run:
The firm produces at
q
which is both profit maximizing level
[ MC=MR ]
and also the allocative efficient level
q2
[MC=AR].
24. Explain, using a diagram, why a perfectly competitive market leads to
allocative efficiency
in both the short run and the long run.
When a firm is making abnormal loss in the short run:
The firm produces at
q
which is both profit maximizing level efficient level
q2
[MC=MR]
and also the allocative
[MC=AR].
24. Explain, using a diagram, why a perfectly competitive market leads to
allocative efficiency
in both the short run and the long run.
In the long run:
A perfectly competitive market will have both productive efficiency and allocative efficiency in the long run.
25. Explain the meaning of the term productive/technical efficiency.
Productive efficiency
occurs when a firm is combining resources in such a way as to produce a given output at the lowest possible average total cost. Costs will be minimized at the lowest point on a firm's short run average total cost curve. This also means that
ATC = MC,
because MC always cuts ATC at the lowest point on the ATC curve.
Technical efficiency
relates to how much output can be obtained from a given input, such as a worker or a machine, or a specific combination of inputs. Maximum technical efficiency occurs when output is maximized from a given quantity of inputs.
The simplest way to differentiate productive and technical efficiency is to think of
productive efficiency
in terms of cost minimization by adjusting the mix of inputs, whereas
technical efficiency
is output maximization from a given mix of inputs.
26. Explain that the condition for
productive efficiency
is that production takes place at minimum average total cost.
Productive efficiency:
As we know
productive efficiency
level of production is where
MC=ATC
at diagram
MC=ATC
. That means it is known to be
productively efficient
producing at a point where , because MC always cuts ATC at its lowest point.
In the case of Perfect Competition, a firm produces
productive efficient
if it is level of output q as shown in the
27. Explain, using a diagram, why a perfectly competitive firm will be
productively efficient
in the long run, though not necessarily in the short run.
Productive efficiency
refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (ATC). For example we might consider whether a business is producing close to the low point of its long run average total cost curve. When this happens the firm is exploiting most of the available economies of scale.
Productive efficiency
exists when producers minimize the wastage of resources in their production processes.
27. Explain, using a diagram, why a perfectly competitive firm will be
productively efficient
in the long run, though not necessarily in the short run.
Time Period Short-Run Long-Run Allocative Efficiency P=MC Yes Yes Productive Efficiency MC = ATC Maybe Yes
The LR Market Supply Curve (Constant Cost Industry)
In the long run, the typical firm earns zero profit.
P
One firm
MC LRATC
P
= min.
ATC
Q
(firm)
P
The LR market supply curve is horizontal at
P
= minimum
ATC
.
Market long-run supply
Q
(market)
Why the LR Supply Curve Might Slope Upward
The LR market supply curve is horizontal if
1)
all firms have identical costs, and
2)
costs do not change as other firms enter or exit the market. If either of these assumptions is not true, then LR supply curve slopes upward.
1) Firms Have Different Costs
As P rises, firms with lower costs enter the market before those with higher costs. Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied.
Hence, LR market supply curve slopes upward.
At any P, For the marginal firm, P = minimum ATC and profit = 0.
For lower-cost firms, profit > 0.
2) Costs Rise as Firms Enter the Market
In some industries, the supply of a key input is limited (e.g., there’s a fixed amount of land suitable for farming).
The entry of new firms increases demand for this input, causing its price to rise. This increases all firms’ costs. Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping.
Constant Cost VS Increasing Cost
Constant Cost Industry
As firms enter and exit the firms cost remain unchanged
Increasing Cost Industry
As firms enter and exit the firms cost do change Firms enter: Input cost unchanged Firms enter: Input cost increase Firms exit: Input cost unchanged Firms exit: Input cost decrease
Inputs or Factor Costs
Up to now we have assumed that input prices remain constant. Costs rise and fall strictly because of changes in productivity not because of changes in factor costs themselves (wages per hour stay constant for labor).
A rise in the price of any of the inputs will lead to the whole set of curves shifting upward.
If it is a rise in the shift up. cost of Capital , then AFC & ATC will
If it is a rise in wages , then AVC, ATC and MC up.
will shift
Inputs or Factor Costs
A fall in the price of inputs leads to a fall in the curves.
If there is an increase in the
amount of Capital
, then
productivity will rise
and the
AVC, ATC
and
MC
curves will all shift down. New Technology More training
Inputs or Factor Costs
Determinates of Supply that shift the cost curves:
Input prices (wages)
Productivity (Technology)
Tax & subsidies
lump-sum
A
lump-sum tax
matter the change in circumstance of the taxed entity. is a tax that is a fixed amount, no It is a
regressive tax
, such that the lower the income is, the higher the percentage of income applicable to the tax. An example is a poll tax to vote, which is unchanged no matter what the income of the voter.
A
lump-sum subsidy
entity. is a subsidy that is a fixed amount, no matter the change in circumstance of the
Lump Sum Tax / Subsidy
Increase Lump sum tax ~ AFC, ATC shift up Decrease in Lump sum tax ~ AFC, ATC shift down Increase Lump sum subsidy ~ AFC, ATC shift down Decrease in Lump sum subsidy ~ AFC, ATC shift up Lump sum tax / subsidy
do NOT change AVC, MC Thus, output does not change since MC = MR is not effected.
Lump Sum Tax / Subsidy
Per Unit Tax / Subsidy
Increase Per Unit tax ~ AVC, ATC, MC shift up Decrease in Per Unit tax ~ AVC, ATC, MC shift down Increase Per Unit subsidy ~ AVC, ATC, MC shift down Decrease in Per Unit subsidy ~ AVC, ATC, MC shift up
Thus, since MC changes output changes!
Per Unit Tax / Subsidy
Lump Sum VS Per Unit
Lump Sum Tax / Subsidy
Treat as a Fixed Cost Cost curves that move: AFC & ATC Price and Output are NOT effected
Per Unit Tax / Subsidy
Treat as a Variable Cost Cost curves that move: AVC, ATC & MC Price and Output are effected