Micro economics chapter 8 (Firms in output markets)

Explain sole proprietorship

Assets of the firm are not strictly separated from the owners assets. In the case of bankruptcy, creditors can seize not only the firms assets but also the owners personal assets.

Explain a private limited company

The firms ownership rests with one or a limited number of individuals. The assets of the private limited company are distinct from the personal assets of the partners. Shareholders are only reliable for their own contribution to the capital.

Explain a public limited company

Shares are no longer private, but freely transferable to others.

Explain the three types of members in a firm

1. Employees: have defined tasks and usually receive a fixed wage.

2. Managers: responsible for critical business decisions, overseeing the implementation by employees, and often receive a compensation linked to performance.

3. Owners or shareholders: who own the capital, fund new investments, and receive an uncertain return (eg. Through dividends) in ećxchange for their investment

What are nonprofit organisations?

Do no have profit as their primary goal. They aim to enhance consumer utility and may be more willing to incur additional costs to improve quality even if the impact on turnover is small. Ex. Hospitals and universities

Why is production not organised exclusively through market transactions between individuals?

Because of transaction costs:

• All the costs on top of the price of what is traded

• Bargaining costs

• Search costs

What are bargaining costs?

The cost of agreeing on all possible issues related to the transaction

What are search costs?

The cost of finding a partner and check its reliability

What is economic profit?

Total economic revenue - total economic cost

What is profit

Total revenue - total cost

What are economic costs?

(Or opportunity costs)

The value of all factors of production in their best alternative use.

What are implicit costs?

Opportunity costs of resources already owned by the firm. Ex. The owner of a shop could have rented the shop space for 10 000 per year

What is the short run?

The time period during which we assume that some factors of production are fixed and cannot be changed by the firm.

Ex. Capital goods such as buildings and machines are fixed in the short run.

When demand increases in the short run, the producer can only increase the use of the variable production factor of labor.

What is the long run?

It’s a longer time frame where firms are no longer hampered by adjustment costs and fixed factors of production.

All inputs are variable.

As soon as the firm is no longer bound by ongoing commitments, we speak of long run.

There is the possibility of free entry and exit of firms.

Why is the firms demand curve usually smaller and flatter than the market demand?

Because there are more substitution possibilities

Explain perfect competition

Each firm is a price taker and faces perfectly elastic demand for its product

How do you count average revenues?

Total revenues divided by amount of output

How do you count marginal revenues?

Change in total revenues due to a very small change in the quantity of output,

What is the total cost function?

Describes the minimum cost of inputs needed to produce a given level of output

What’s the average cost (AC)?

Cost per unit of output

What’s the marginal cost? (MC)

The change in total costs for a small change in output. It’s the derivative of the total cost function

If the average cost is falling is marginal cost (MC) or average cost (AC) larger?

MC<AC

If the average cost is rising is marginal cost (MC) or average cost (AC) larger?

MC>AC

Where does the MC curve cross the AC curve?

At its minimum

As long as MR(q) (<, >,=) MC(q), the firm can increase its profit by producing more

MR(q)>MC(q)

As long as MR(q) (<, >,=) MC(q), the firm can increase its profit by producing less

MR(q)<MC(q)

The profit maximising firm chooses and output level q* where MR(q*) (<>=) MC(q*)

=

Does the equality of marginal revenues and marginal costs guarantee that producing is better than shutting down (not producing)?

No, profit can be negative.

What is the shutdown rule?

The profit maximizing firm will shut down if the highest possible profit in the case of production is smaller than the profit in the case of shutting down.

If a sandwich shop was in perfect competition what would happen at a slight increase in price?

All customers would go to another shop

What should a firm do when choosing its output in perfect competition?

Make sure given market price equals marginal cost

What is the market demand?

The horizontal sum of individual demanded quantities.

What’s the market supply?

The sum of the quantities offered by all producers. In the long run there is also entry and exit of firms

What happens when firms are making losses?

• exit industry

• Market supply curve shifts to left

• The Equilibrium price rises until it reaches the minimum of the average cost and firms are making zero profits

What three conditions describe the long-term competitive equilibrium?

1. The price must equal marginal costs (profit maxxxing by the individual firm)

2. The price must clear the market (market supply=market demand)

3. The price equals the minimum of the average cost, no economic profit is made (free entry and exit)

Why might managers and shareholders disagree?

Shareholders want to maximise profit, while managers might value time off, benefits etc

What is a principal agent problem?

Agents have different objectives. Ex. Managers and shareholders have different goals

How can shareholders make sure also managers want to maximise profit?

Tie managers pay to achieved goals through a variable bonus.

Managers can receive compensation through stock options