Chapter 16-20 Firms and Decisions

Total fixed cost (TFC)

Payments to those inputs which are fixed in the short run

Do not vary directly with the level of output

Total variable cost (TVC) (definition)

Payments to those inputs which are variable in the short run

Vary directly with the level of output

Total cost (TC) (definition)

Sum of total fixed costs and variable costs incurred in producing any level of output

Marginal Cost (definition)

Measures the change in total cost when an additional output is produced

What does the LRAC curve show

The minimum cost of producing per unit of a given output level when all factor inputs can be varied and any desired scale of plant capacity can be built

Internal Economies of Scale [IEOS] (definition)

Reductions in the long-run average costs enjoyed by a firm as a result of expanding its output

What are the reasons for IEOS?

1. Technical economies of scale

   1. Specialisation of workforce

   2. Principles of increased dimensions

2. Administrative / managerial economies of scale

3. Commercial / marketing economies of scale

Non-economic terms to link the benefits of IEOS

Spreading out of fixed costs

Productivity improvements

Greater buying power over inputs when a firm expands its production

Internal Diseconomies of Scale (definition)

Cost advantages accruing to a firm as a result of the expansion of the firm

Internal Growth (meaning)

Organic growth - when a firm seeks to increase its output and sales by increasing its scale of operations

External Growth (meaning)

When a firm seeks to increase its output by merging with other firms, or by acquiring other firms

Integration (of external growth) (meaning)

When two or more firms merge together to form one new firm

Horizontal integration (of external growth) (meaning)

When two or more firms which process the same product or which are engaged in the same stage of production integrate / merge

Vertical integration (of external growth) (meaning)

Links processes in the order in which the product is manufactured

What are the types of vertical integration and elaborate a little

Backward integration - ensure adequate supply of raw materials

Forward integration - ensure access to the market

Conglomeration (of external growth) (definition)

A process of taking over firms that do not produce related output

External Economies of Scale (definition)

Cost savings that accrue to individual firms in an industry because of the expansion of the industry

External diseconomies of scale (definition)

Cost disadvantages accruing to the firm because of the expansion of the industry

Total Revenue (TR) (definition)

The total payment received by seller from the sale of the product

Average Revenue (AR) (definition)

Payment received from each unit of output sold

Marginal Revenue (MR) (definition)

Revenue received from an additional unit of output sold or the change in total revenue as a result of selling one more unit of a product

Normal profit (meaning)

The minimum amount of returns the firm expects to get in order to stay in production

Supernormal profit (meaning)

Profit level where a firm is earning higher than normal profit

Subnormal profit (meaning)

Profit level where a firm is earning lower than normal profit

Explain the Marginalist Approach to maximise profits

Profit maximisation is realised when TR - TC is at maximum. The marginalist principle explains that profit maximising occurs at the output level where MC = MR, such that MC is rising

Profit Satisficing (meaning)

An objective of achieving just enough profits to satisfy the owners, rather than achieving the highest possible profits

Dominant firm (meaning)

One which has a significant share of a given market

Characteristics of the Perfectly Competitive (PC) market

1. Large number of small firms

2. Homogenous / Identical products (perfect substitutes)

3. No Barriers to Entry and Exit in the LR

4. Perfect Knowledge of Existing Market Conditions Amongst Buyers and Sellers

When is the equilibrium of a firm achieved

When it has no desire or incentive to change its present position or output level

Productive efficiency (definition)

When a given level of output is produced at the lowest average cost

Allocative efficiency (definition for markets)

The output level where society’s welfare is maximsed

Dynamic efficiency (definition)

When a firm is able to improve its productivity and product quality over time

Barriers to entry (definition)

Obstacles that prevents new competitors from competing on an equal basis with established firms in an industry

The obstacles may be naturally existing or artificially created by firms or by the government

Sunk costs (definition)

Costs that cannot be recovered if firms decide to leave an industry

Artificial barriers (meaning)

Man-made barriers that prevent potential competitors from entering the industry

Predatory pricing (definition)

Anti-competitive measure employed by a dominant firm to protect its market share from new or existing competitors

Concentration ratio (definition)

Percentage of total sales or output accounted for by the largest three, five or eight firms in the industry

When does a contestable market occur (meaning)

When a firm can be challenged or contested by potential entrants looking to enter the industry

Product differentiation (definition)

The process of distinguishing a firm’s product or service from those of other firms

Growth (output expansion) (definition)

A business strategy that enables a firm to capture market share, which leads to increased market power, thus allowing it to charge higher prices and earn more revenue

Diversification (definition)

A business strategy where a firm develops new products and services or enters new markets

Economies of scope (definition)

Cost advantages accruing to the firm as a result of producing a variety of products

Process innovation (definition)

The development of new and better production techniques or methods of organisation that can result in reduced unit production

Price discrimination (definition)

The practice of selling the same goods and services at different prices to different groups of consumers for reasons unrelated to costs (3rd degree price discrimination)

Characteristics of the Monopoly market

1. One big firm

2. Very high barriers to entry and exit

Characteristics of the Monopolistic Competitive (MC) market

1. Large number of small firms

2. Differentiated (Non-homogenous) products

3. Low Barriers to Entry and Exit in the LR

Characteristics of the Oligopoly market

1. Few large firms

2. Identical products OR differentiated products / service

3. Substantial Barriers to Entry

4. Interdependence between firms

Collusion (definition)

The situation where firms in a market cooperate to jointly fix prices or output

Explicit Collusion (definition)

When a group of firms directly communicate with each other with the intention of controlling price and output in the market

Cartel (meaning)

A group of firms that agree to coordinate their production or pricing decisions so that they act as a single firm to earn monopoly profits

Tacit collusion (definition)

When competitors reach an unspoken agreement with each other with regards to coordinating price and output in the market

Price leadership (definition)

When one firm takes on the leadership role and establishes a price that the other firms eventually accept as the market price

Barometric price leadership (meaning)

When firms with the best reputation at foreseeing future trends be the price leader in tacit collusion

Dominant price leadership (meaning)

When the dominant / largest firm be the price leader in tacit collusion

Explain the MR curve for a non-collusive oligopolic firm

The MR curve has two distinct segments

1. Above the price of P0, the MR curve is elastic

2. Below P0, the MR curve is inelastic

There is a discontinuous portion

Price war (definition)

When firms in an industry undertake several rounds of price reduction against rival firms in order to gain market share