Micro Test 3

profit formula

total revenue - total cost

total revenue

amount a firm receives from the sale of its output

total cost

market value of the inputs a firm uses in production

explicit costs

require an outlay of money; “on the books” —> ex. paying wages to workers

implicit costs

do not require a cash outlay; “not on the books” —> ex. opportunity cost of the owner’s time

accounting profit

total revenue - total explicit costs

economic profit

total revenue - total cost (including explicit and implicit)

production function

shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good (can be organized as table, equation, or graph)

marginal product

any input is the increase in output arising from an additional unit of that input, holding all other inputs constant

marginal product of labor (MPL)

output per worker decreases —> slope of production function x MPL diminishes

the reason MPL diminishes

MPL diminishes as labor rises whether the fixed input is land or capital

diminishing marginal product

the marginal product of an input declines as the quantity of the input increases (other things equal)

fixed costs (FC)

do not vary with quantity of output produced —> ex. cost of equipment, loan payments, rent

variable costs (VC)

vary with the quantity produced —> ex. cost of materials, wages

total cost formula

FC + VC

average fixed cost (AFC)

FC/Q (fixed cost / quantity)

as AFC falls, Q rises

what is the relationship between AFC and Q?

average variable cost (AVC)

VC/Q (variable cost / quantity)

as Q rises, AVC may fall initially; AVC will eventually rise as output rises

what is the relationship between AVC and Q?

average total cost (ATC)

TC/Q (total cost / quantity) -also- = AFC + AVC

marginal cost (MC)

change in total cost / change in quantity

rising as Q rises, “fish hook” (falls before rising), and remains constant (something produced on the assembly line)

what are the three forms MC can take?

initially, falling AFC pulls ATC down —> eventually rising AVC pulls ATC up

why is ATC usually Q shaped?

efficient scale

the quantity that minimizes ATC

• when MC < ATC, ATC is falling

• when MC > ATC, ATC is rising

• MC curve crosses the ATC curve at the ATC curve’s minimum

what is the relationship between ATC and MC?

cost in the short run

some inputs are fixed (ex. factories, land); the cost of these inputs are FC 

cost in the long run

all inputs are variable (ex. firms can build more factories, or sell existing ones)

ATC in the long run

ATC at any Q is cost per unit, using the most efficient mix of inputs for that Q (ex. factory size with the lowest ATC)

small, medium, and large

what are the three factory sizes firms can choose from?

yes, no

can firms change to different factory sizes in the long run? can they change in the short run?

economies of scale

ATC falls as Q increases

constant returns to scale

ATC stays the same as Q increases

diseconomies of scale

ATC rises as Q increases

when increasing production allows greater specialization

when do economies of scale occur?

when there are coordination problems in large organizations

when do diseconomies of scale occur?

4 characteristics of perfect competition

1. many buyers and many sellers

2. goods offered for sale are largely the same

3. firms can freely enter or exit the market

4. each buyer and seller is a “price taker” —> takes price as given, no control over price; market determines the price

revenue of a competitive firm

• TR (total revenue) = P x Q

• AR (average revenue) = TR/Q = P

• MR (marginal revenue) = change in TR / change in Q

true

a perfectly competitive firm can keep increasing its output without affecting the market price. true or false?

perfectly competitive

MR = P can only be true for firms in what type of markets?

profit maximization

• if MR > MC, then increase Q to raise profit

• if MR < MC, then reduce Q to raise profit

peaked; can’t get bigger

what does it mean when change in profit reaches zero?

perfect competition

marginal revenue is perfectly elastic in what type of competition?

rule for MR in perfect competition

MR = MC at the profit-maximizing Q

stay open

a short run decision to remain open and continue to produce when P is less than ATC but greater than AVC —> still produce where MC = MR even when making a loss

shutdown

a short run decision not to produce anything because of market conditions

exit

a long run decision to leave the market

cost of shutting down

revenue loss = TR

benefit of shutting down

cost savings = VC (firm must still pay FC)

firm decides to shut down

if P < AVC

competitive firm’s short run supply curve

• SR supply curve is portion of its MC curve above AVC

• if P > AVC, then firm produces Q where P=MC

• if P < AVC, then firm shuts down (produces Q=0)

sunk costs

a cost that has already been committed and cannot be recovered

they will be paid regardless of the choice

why are sunk costs irrelevant to decisions?

FC is a sunk cost

the firm must be pay its fixed costs regardless whether it produces or shuts down

firm’s long run decision to exit the market

• cost of exiting the market: revenue loss = TR

• benefit of exiting the market: cost savings = TC (zero FC in the long run)

• frim exits if TR < TC

• exit if P < ATC

new firm’s decision to enter the market

• firm can enter a perfectly competitive market only in the long run

• will enter if TR > TC

• will enter if P > ATC

firm’s LR supply curve

the portion of its MC curve above the LRATC

how to solve PC graph (profit or loss)

1. determine how much firm will produce —> where MC=MR

2. Determine if firm is making profit or loss —> if ATC is below price - profit, if ATC is above price - loss

3. calculate total profit or loss (P-ATC) x Q

when existing firms earn profit

new firms enter the market and prive falls

when existing firms incur losses

some firms exit and price rises

characteristics of zero profit condition

• long run equilibrium → process of entry/exit complete → remaining firms earn zero economic profit

• zero profit occurs when P = ATC

• P = MC = ATC

• P = minimum ATC in the long run

firms earn enough revenue to cover implicit costs + accounting profit is positive

why do firms stay in business if profit = 0?

it maximizes total surplus (only in perfect competition because you get lowest price)

why is the competitive equilibrium efficient?

monopoly

firm that is the sole seller of a product without close substitues

market power

ability to influence the market price of the product it sells; competitive firms have no market power

3 sources of barrier to entry

1. a single firm owns a key resource (ex. DeBeers owns majority of diamond mines)

2. government gives a single firm the exclusive right to produce the good (ex. patent, copyright laws)

3. natural monopoly → single firm can produce entire market Q at a lower cost than could several firms

downward

what direction does a monopoly demand curve slope?

relationship between MR and P in a monopoly

a monopoly’s marginal revenue decreases the more they produce and sell, MR < P

always below the demand curve

where is marginal revenue on the graph for monopolies?

increasing Q effect on monopolist’s MR

1. output effect - higher output raises revenue

2. price effect - lower price reduces revenue

producing Q where MR=MC

how do monopolist’s maximize profit?

how to solve a monopoly graph

1. Determine profit maximizing output → where MC = MR

2. Determine monopoly’s price → find P from demand curve at this Q

3. Determine if it’s a profit or loss → (P-ATC) x Q; if ATC is below price - profit, if ATC is above price - loss

no; they are “price-makers” not “price-takers”

does monopoly have a supply curve?

public policy toward monopoly

1. increasing competition with antitrust laws → ban anticompetitive practices

2. regulation → gov agencies set monopoly’s price

3. public ownership

4. doing nothing

price discrimination

selling the same good at different prices to different buyers → firms can increase profit by charging higher price to buyers with higher WTP

monopolistic competition

many firms sell similar but not identical products

characteristics of monopolistic competition

• many sellers

• product differentiation

• free entry + exit

• examples

  • apartments

  • books

  • bottled water/soft drink

  • fast food

short run monopolistic competition

frim behavior is similar to monopoly

long run monopolistic competition

entry and exit drive profit to zero

reasons why monopolistic competition is less efficient than perfect competition

1. excess capacity

2. markup over marginal cost

3. 
   

concentration ratio

the percentage of the market’s total output supplied by its four largest firms

oligopoly

a market structure in which only a few sellers offer similar or identical products

game theory

the study of how people behave in strategic situations

collusion

an agreement among firms in a market about quantities to produce or prices to charge

cartels

group of firms acting in unison (ex. T-Mobile and Verizon determine outcome with collusion)

dominant strategy

strategy that is best for a player in a game regardless of the strategies chosen by other players

prisoner’s dilemma

a “game” between two captured criminals that illustrates why co-operation is difficult even when it is mutually beneficial

nash equilibrium

a situation in which economic participants interacting with one another each choose their best strategy given the strategies that all others have chosen