ECON 102 - Exam 2

Chapter 7: Behavior of Profit Maximizing Firms

…

Profit(π) = ?

Total Revenue (TR) - Total Cost (TC)

Total Revenue =?

Price (P) x Quantity (Q)

Costs have 2 components…

1. Explicit costs (visible costs)

2. Implicit costs (invisible costs)

Examples of explicit costs:

Accounting costs

• cost of supplies

• employee wages

• advertising

• electricity bills

Examples of implicit costs:

Opportunity costs

• the capital (machinery) invested in the business has an opportunity cost (OC)

• OC of time

• labor of an owner who isn’t getting paid a salary

There is a difference between Accounting π and Economic π…

• Accounting π = Total Revenue (TR) - Explicit Costs

• Economic π = Total Revenue (TR) - Total Costs (TC)

  • Economic π includes opportunity cost!

What are the 2 kinds of costs? (NOT the components)

1. Fixed costs

2. Variable costs

Fixed costs

paid once in order to start production

Variable costs

vary with output (aka how much you are producing)

Production is eventually subject to ____________________.

diminishing marginal product

Diminishing marginal product

as you increase the # of units of output, it becomes more costly to do so (in a single kind of output)

• as you increase the amount of one input to producing a good, ceteris paribas, smaller additional units of output are produced

Total Cost (TC) =

Total Fixed Cost (TFC) + Total Variable Cost (TVC)

Average ______ Cost (for any of them that say “Average”) =

(whatever cost) / Quantity (Q)

Marginal Cost =

(Change in TC) / (Change in Q)

Total Costs Graph —> DRAW IT

SEE IMAGE

Average and Marginal Costs Graph —> DRAW IT

SEE IMAGE

The minimums for Average Total Cost (ATC) and Average Variable Cost (AVC) MUST…

be touching the Marginal Cost line

Marginal Cost (MC) < Average Total Cost (ATC) means…

average cost falls

Marginal Cost (MC) > Average Total Cost (ATC) means…

average cost rises

Production Function:?

Q = F(K, L)

• Q = Quantity

• F = Function

• K = Capital

• L = Labor

Total cost equation in terms of the production function?

TC = (Cost of L) + (Cost of K)

Some output is more labor intensive, some more capital intensive, but the same _________ can be produced with different combinations of _____ and _______

• output

• capital (K)

• labor (L)

The total cost will be the lowest possible cost to produce a good…

• L tends to be _________ costs

• K tends to be __________ costs

• variable costs

• fixed costs

Chapter 9: Long-Run Costs

…

Long-run

defined by a timeframe where fixed costs (which are big machines or factories that take a long time to build or get rid of) become variable costs

Long-run Average Total Cost (LRATC) shows…

scale and cost of providing additional output in long-run

• this is where economies and diseconomies of scale are!

Economies of Scale

when a firm decreases average cost by scaling up all production (L, K) equally (increasing returns to scale)

• EX: Technology, bulk buying, learning by doing, etc.

Constant/Efficient Scale

when a firm maintains average cost by scaling up all production (L, K) equally.

• Efficient because it is the minimum ATC

Diseconomies of Scale

when a firm increases average cost by scaling up all production equally (L, K) (decreasing returns to scale)

• EX: Transportation issues, management issues, etc.

Long-Run Average Total Cost (LRATC) is the lowest point of other __________________.

short-run ATC curves (SRATC) —> You are stuck at those fixed costs in short-run)

• In LR a firm can go to any SRATC

Chapters 8, 9, & 12: The Firm in a Perfectly Competitive Market

…

Perfectly competitive market characteristics:

1. similar (if not identical) goods

2. many buyers and sellers

3. free entry/exit of goods

4. firms are price-takers

EX: Produce

price-takers

firms have no control over the price they charge due to all other seller’s goods being identical

Perfect competition is more of a ____________. In reality, very few markets are exactly perfect competition.

benchmark

a firm profit maximizes by expanding until…

Marginal Revenue (MR) = Marginal Cost (MC)

Graph of Perfectly Competitive Market:

SEE IMAGE

• D=MR is horizontal because firms are price-takers

What are the 2 profit equations?

1. TR - TC

2. (P - ATC) x Q

Short-run firm behavior:

• P>ATC =?

• AVC<P<ATC =?

• P<ATC =?

• + profit —> operate

• - profit —> BUT should still operate to minimize loss

• - profit —> shut down

sunk costs

costs that have been paid as a result of past decisions

in the short-run, ____________ are sunk costs.

fixed costs

Sunk Cost Fallacy

when an economic agent makes a different decision without a sunk cost than with a sunk cost.

In the short-run for firms, ____________ should be the ONLY costs that impact decision making

variable costs

In the long-run, everything is a ______________, so _________ act as a signal for firms to enter and exit.

• variable cost

• profits

In the long run:

• When profits are + —>?

• When profits are - —>?

• Store openings —> More competition —> Price decreases —> profit decreases

• Firms exit —> Less competition —> Price increases —> Profit increases

In the long-run, where is equilibrium price on a graph?

• At equilibrium price, what does profit =?

SEE IMAGE

• profit = 0 at LR equilibrium price

perfectly competitive markets in the long-run are economically _____________

efficient

• price such that ATC is minimized

Chapter 13: Understanding Monopoly

…

A monopoly has 3 characteristics:

1. Many buyers but exactly 1 seller

2. A unique product with no good substitutes

3. Has to produce in a market with high barriers to entry

EX: electricity, patents, DeBeer (diamonds)

Causes of monopoly:

• Natural monopoly

• Control of resources that could lead to monopolies

• Government can create monopolies

Natural monopoly

exists when a single large firm has lower costs than any potential competitor

• a firm exists in a market that makes it difficult for other firms to enter

• Caused by high fixed costs, low marginal costs

• Impacted by economies of scale: One firm controlling all power lines is less costly

EX: water, power lines

Pure monopoly demand line:

D does NOT = MR

• a firm is a price-setter

Perfect competition demand line:

D = MR

• a firm is a price-taker

MR is always ____________ D for a monopolist

below

• Because of price and output effect

• MR = Price effect + Output effect

price effect

loss in total revenue from decrease in price

output effect

increase in total revenue from an increase in Q

Defects of monopoly:

1. reducing competition limits options available to consumers

2. consumers are less able to direct producers to serve their interests

3. prices are higher and output is lower

4. rent-seeking

rent-seeking

the act of wasting resources in an effort to obtain market power or manipulate public policy

EX: political campaigns, firms lobbying politicians

How to deal with monopolies?

• Restructuring (AT&T was dissolved), Preventing mergers

• Reducing trade barriers

• Price controls —> dangerous for Natural monopolies because it can destroy the incentive to exist

• Do nothing!

antitrust policy

regulations that are aimed at preventing firms from gaining too much market power

• prevents monopolies

price discrimination

selling a given product at more than one price to different consumers where differences are unrelated to differences in cost

In order to price discriminate…

1. buyers have different willingness to pay

2. firm has to be able to prevent resale

3 degrees of price discrimination:

1st Degree/Perfect: firms can charge all consumers different prices (if done optimally, can charge their willingness to pay) —> NO consumer surplus

• EX: college tuition

2nd Degree: firms charge different prices for different quantities

• EX: bulk buying, coupons

3rd Degree: firms charge different prices to different groups of consumers

• EX: student discount, senior discount, military discount, etc.

Chapter 15: Monopolistic Competition

…

monopolistic competition

perfect competition with differentiated products

characteristics of monopolistic competition:

• many firms

• free entry/exit

• differentiated products

most industries are either ________________ or ______________

monopolistic competition or oligopoly

• monopoly and perfect competition are benchmarks

product differentiation is done through slight changes in _____________ and ____________

quality and advertising

monopolistic competition graph:

SEE IMAGE

• relatively elastic —> because there are a lot of substitutes

short-run profit maximization for a firm in monopolistic competition is…

the same picture as monopoly —> only difference is D is more elastic

in the long-run, firms in monopolistic competition still use _________ as a signal to enter and exit.

profit

In the long-run, what happens if firms in monopolistic competition:

• + profit —>

• - profit —>

• firms enter —> individual firm demand decreases —> profit decreases

• firms exit —> individual firm demand increases —> profit increases

A firm in long-run monopolistic competition graph:

• has the tangent!

• in the long-run, profit=0, however, ATC is NOT minimized, so the result id NOT efficient

characteristics of an oligopoly:

• a few sellers

• different products

• barriers to entry into the market

EX: airlines, soda (Coke/Pepsi), computers

oligopoly is a ______________________

strategic situation

game theory

an economic study about how agents interact in strategic situations

EX: oligopoly, chess, war, strategic communication

a game in game theory consists of the following:

• players

• strategies

• payoffs

requirements for players:

needs to be multiple players

strategies

• payoffs depend on ALL players’ strategies

• In this class: assume that actions and strategies are the same (generally not true)

payoffs

outcome

• typically represented by utility

utility

number that measures how happy someone is

extensive (tree) form game

a game form that reflects a sequential game

sequential game

players move one after another

a game tree consists of:

• a root (a player node)

• decisions (actions represented by branches)

• player nodes (where players make decisions)

• terminal nodes (payoffs)

NOTE: the top of 1st payoff is always the 1st player sequentially

in sequential games, we will use ________________ to predict play

backward induction

backward induction

Starting at the last nodes in the tree, denote what decision that person would make if they were at that node. Repeat this process going backward through the tree until the root is reached.

matrix/strategic form

a game form where players simultaneously choose their stratigies

matrix/strategic form consists of…

• players

• strategies

• payoffs —> 1st payoff belongs to the row player, 2nd payoff belongs to the column player

What are the 2 ways of predicting play in matrix/strategic form?

1. Dominant strategy

2. Nash equilibrium

dominant strategy

a strategy that yields the highest payoff for a player regardless of what the other person does

• does NOT guarantee the best overall outcome

Nash equilibrium

a strategy for each player such that, given what others are doing, another player cannot deviate and do better

• where both players pick the best response to what the other is doing

  • a Nash equilibrium is a stable point in a game

If a strategy is dominant, it must be used in any _____________________. However, a game having a Nash equilibrium does nor mean it has a ______________________.

• Nash equilibrium

• dominant strategy

committing to fighting is a behavior that firms (like Walmart) do to keep competition out. It’s called …

predatory pricing

oligopoly competition is a __________________

prisoner’s dilemma