Econ Exam 3

What is a firm’s objective

Maximize Profit, where Profit= Total Revenue - Total Cost

In Economics, total cost is broken down into:

Explicit and Implicit costs

Explicit costs

costs that require the firm to pay out money

money the business actually pays out

• rent

• utility bills

• cost of raw materials, inventory, or equipment

• wages and salaries paid to workers

Implicit Costs

costs that do not require money

the value of an opportunity the business gives up

• The salary you could have earned at another job

• Rent you could have earned by renting out a building you own

• Interest you could have earned by keeping your money in a savings account instead of investing it in your business

Accounting Profit

accounting profit= total revenue - explicit costs

economic profit

Total Revenue - (explicit costs + implicit costs)

fixed costs

costs that do not vary with output

variable costs

costs that do vary with output

production function

the relationship between the quantity of an input and the quantity of output.

Shows how inputs (like workers) turn into output (like cupcakes).

marginal product of labor

The increase in output from an additional worker

The extra output produced by hiring one additional worker.

diminishing marginal product

the marginal product of an input (in this case labor) declines as the quantity of the input increases.

As more workers are added, each additional worker eventually contributes less extra output, assuming other inputs stay fixed.

total cost curve

the relationship between output and total cost

tells us all total costs

average fixed cost

fixed cost / quantity

average variable cost

variable cost / quantity

average total cost

total cost / quantity = average fixed cost + average variable cost

it is “U-shaped” – it declines at low levels of output and then starts to rise.

marginal cost

the increase in total cost that arises from an extra unit of production

Typically rises as output increases because of diminishing marginal product (eventually MC must rise)

marginal cost equation

change in total cost / change in quantity

key concepts about cost curves

• The marginal cost curve eventually rises with the quantity of output once diminishing marginal product sets in.

• The average variable cost and average total cost curves are U-shaped

• Whenever marginal cost is less than average total cost, average total cost is falling.

• Whenever marginal cost is more than average total cost, average total cost is rising

• The marginal cost curve crosses the average total cost curve at its minimum

cost curves in the long and short run

many costs are fixed in the short run, but variable in the long run

for example, the cost of a new factory: in the short run, some costs are fixed because a business cannot easily change certain resources, such as its factory size. In the long run, the business has enough time to change all inputs, so even factory costs become variable.

the long run average total cost curve must be ______ than the short run average total cost curve

FLATTER, firms have greater flexibility over the long run

economics of scale

occur when long run average total cost falls as the quantity of output increases

diseconomics of scale

occur when long run average total cost rises as the quantity of output increases

constant returns to scale

anytime long run average total cost stays the same as the quantity of output increases

assumptions and basic setup of competitive markets

• Many buyers and sellers

• The goods in the market are largely the same (little or no product differentiation among sellers)

• Firms are free to enter and exit the market

• Actions by individual buyers or sellers will NOT impact price → Sellers are Price Takers in competitive markets

revenue of a competitive firm

total revenue= P x Q

average revenue= TR / Q

marginal revenue

the change in total revenue from an additional unit sold

For a firm in perfect competition: Marginal revenue = average revenue = price

Profit maximization and the supply curve of a competitive firm

• if marginal revenue exceeds marginal cost, increasing quantity produced raises profits

• if marginal cost exceeds marginal revenue, increasing quantity produced lowers profits

  • profit maximization occurs where marginal cost = marginal revenue

  • for a competitive firm, this also occurs where price = marginal cost (because price is marginal revenue for these firms)

the marginal cost curve determines the quantity of the good a firm is willing to sell at various prices, therefore

the marginal cost curve is the supply curve for an individual firm

in the short run, a firm will ____ if price is less than average variable cost

it will shut down

since fixed costs are sunk in the short-run, these costs are irrelevant for short-run supply decisions

in the short run, a competitive firm’s supply curve is its marginal cost curve at or above AVC.

(fixed costs are sunk = Some costs are already committed and can't easily be avoided. They're treated as fixed costs)

in the long run, a firm will _____ if price is less than average total cost

it will exit the industry

Since fixed costs are NOT sunk in the long-run, these costs are relevant for long-run supply decisions.

(fixed costs are not sunk = businesses can change or avoid costs like factory rent or equipment expenses in the long run so they must consider those costs when deciding whether to stay in business).

measuring profits and losses in our graph of a competitive firm

profit= Total Revenue - Total Cost

expressed another way: Profit = (Price-ATC) x Q see pop quiz

monopoly

a firm that is the sole seller of a product in a market

a monopoly is a price MAKER (a firm that must lower price to sell more units), it has market power to influence price when it changes production

a monopolist faces the downward sloping demand curve

profit maximization for a monopoly occurs:

where marginal cost equals marginal revenue (just like in competition)

competitive firm vs monopolist

For a competitive firm: Price = MR = MC (Sells at the market price)

For a monopolist: Price > MR = MC (Chooses quantity, then reads price from demand)

deadweight loss in monopolies

monopolies result in a deadweight loss (just like a tax)

calculating deadweight loss in monopolies = ½ x B (subtract the quantities differences) x H (subtract the price differences)

oligopoly

only a few sellers offer very similar or identical products

strategy and cooperation are very important in determining the oligopoly outcomes

game theory

a way of analyzing how people and firms behave in strategic ways

dominant strategy

the best strategy for a player in a game REGARDLESS of the strategies chosen by others

cooperative outcome

the best COMBINED outcome in a game between two players

where oligopoly markets fall between monopoly and competition depends on:

the number of firms

cooperation vs strategy (we use game theory to model this concept)

collusion

an agreement among firms to set prices and quantities

cartel

a group of firms acting as one

cartels attempt to:

• raise price above competition levels

• reduce output below competition levels

a perfect cartel

enables oligopolies to reach the monopoly outcome (the cooperative outcome in game theory)

individual firm incentives often hinder a group of firms from maintaining the monopoly outcome. these individual firm incentives are the main reason why many cartels fail. Game theory illustrates this perfectly

monopolistic competition

firms sell similar but differentiated products

• Industry firms sell differentiated products that consumers do not view as perfect substitutes (but they are substitutable on some margin).

• Each firm produces a good that is different from those of the other firms in terms of (i) quality, (ii) appearance, and (iii) reputation.

• Because of product differentiation, there is a key outcome of monopolistic competition: Investment in brand name capital and advertising.

investment in brand name capital

Creates a reputational capital asset (or bond) that the company posts to consumers

• If the firm reduces quality → savings in the short-run, but the damage to the reputational asset is greater than short-run savings.

• Provides firms an incentive to maintain high quality.

Provides an informational signal about quality when quality is hard to judge before purchase or when consumers lack perfect information.

• Why do old bank buildings in cities have massive columns, heavy stone, and marble floors → to project power, stability, and wealth

The Sherman Act of 1890

the major foundation of Antitrust law in the US

outlaws contracts “in the form of trust… or conspiracy, in restraint of trade” and prohibits “monopolization of…interstate commerce”

• created to prevent businesses from becoming too powerful by eliminating competition.

• Businesses cannot work together or use their power to unfairly control a market and hurt competition.

price fixing

an agreement among firms to set prices and/or quantity; attempting to form a cartel (a group of firms acting as one)

“evidence” can be:

• Explicit (phone calls or emails among competitors about prices)

• Implicit: “parallel conduct”

  • Can be difficult to distinguish from natural price competition

  • its when competing firms make similar pricing decisions without an obvious agreement

Example: 1984 NCAA case that went to the Supreme Court. As a result of the decision, what happened to the price and quantity of television media rights for college football games? (a very basic application of Econ 2110 concepts that we covered very early in this class!) → it ended the NCAA's restrictive control over college football television rights. Competition increased, supply increased, price decreased, and quantity of televised games increased.

antitrust practices

these practices are not always legal and can be difficult to prove as antitrust violations

price fixing, predatory pricing, resale price maintenance, tying, price discrimination

predatory pricing

a firm lowers its price to drive rivals out of business and scare off entry of firms

• firm incurs short-run losses to obtain long-run gains

• there must be barriers to entry into the market

• usually in the form of specialized assets required for production

• famous case: standard oil (owned by Rockefeller)

resale price maintenance

parent companies requiring retailers to sell products at a specified price

tying (tie in sales)

occurs when a customer can buy one product only if another if purchased

price discrimination

under perfect competition, a firm can’t sell the same good at different prices. but a firm with market power can often sell the same good at different prices. This is called price discrimination.

• It can sell all it wants at the market price.

• If it raises price above the market price, it sells nothing.

Consumers are charged different prices for the same good based on their willingness to pay (i.e., the value they place on the good).

• High willingness to pay customers are charged a higher price.

• Low willingness to pay customers are charged a lower price.

conditions for price discrimination

The firm must have some market power.

The firm must be able to infer consumers’ willingness to pay.

The firm must be able to prevent or limit resales by customers who pay the lower price to those who pay the higher price.

outcome of price discrimination

High willingness to pay customers are charged a higher price.

• These are the more inelastic demanders

Low willingness to pay customers are charged a lower price.

• These are the more elastic demanders

example of price discrimination

airline prices

coupons

rebates

movie tickets

broadway tickets (line waiting to identify low willingness to pay)

time of day (or day of week pricing)

over the long run, as producers have more flexibility and time to change their production processes, the supply curve teds to become

flatter

_____ costs require the firm to pay out money;_____ costs include the firm owner’s (or manager’s) highest valued foregone income

Explicit; implicit

a bakery hires additional workers to make loaves of bread while its ovens and kitchen space remain fixed. after the fifth worker is hired, total output continues to increase, but each additional worker adds fewer loaves of bread to total output than the previous worker. this situation is described as

diminishing marginal product

a bakery hires additional workers to make loaves of bread while its ovens and kitchen space remain fixed. after the fifth worker if hired, total output continues to increase, but each additional worker adds fewer loaves of bread to total output than the previous worker. what will most likely happen to the bakery’s marginal cost as a result of hiring the fifth worker?

marginal cost will increase because each additional worker contributes less additional output