Microeconomics Exam 3: Market Structures, Costs, and Firm Strategies

Economic Profits

Total revenue minus total costs including implicit opportunity costs. Economic Profit = TR - (Explicit + Implicit).

Normal Profit

Normal Profit = 0 economic profit. Firm is doing 'just okay' (stays in market).

Explicit

A cost that requires a money outlay (wages, rent, materials paid in cash).

Implicit costs

A cost that does not require an outlay of money (opportunity cost of owner's time, forgone interest on own capital, etc).

Short Run

The period before exit and entry can occur (at least one input is fixed).

Long Run

The time after all exit and entry has occurred (all inputs are variable).

Marginal Product

Additional output produced by adding one more unit of an input (ex, one more worker).

Division of Labor & Specialization

Breaking production into small tasks and assigning workers to specialize; gains come from differences in skill, less time switching tasks, learning-by-doing, and innovation.

Law of Diminishing Returns

If capital and technology are fixed (short run), adding more workers eventually causes smaller and smaller increases in output.

Marginal Cost

A change in total cost from producing an additional unit.

Average Cost of Production

Simply the cost per barrel. The average cost of producing Q barrels of oil is the total cost of producing Q barrels divided by Q.

Fixed Cost

Costs, such as rent, that do not vary with output.

Variable Costs

Costs that do vary with output.

Economies of Scale

The advantages of large-scale production that reduce average cost as quantity increases.

Diseconomies of scale

Average cost rises as output increases (coordination problems, bureaucracy, etc).

Minimum efficient scale

The lowest output level at which long-run average cost is minimized (bottom of the LRAC curve).

Market Structures

Organizational features of a market: number of firms, product type (identical or differentiated), barriers to entry, and interdependence.

Perfect Competition

Many firms making identical products.

Marginal revenue

The change in total revenue from selling an additional barrel of oil.

Profit Maximizing Rule

Produce the quantity where Marginal Revenue = Marginal Cost (MR = MC).

Sunk Costs and Uncertainty

Sunk cost is a cost that once incurred cannot be recovered (affects entry/exit decisions because of uncertainty).

Break Even Point

Output level where price = ATC (economic profit = 0).

Shut Down Point

Output level where price = minimum AVC. If P < minimum AVC, the firm shuts down in the short run.

Increasing Cost Industry

Industry costs rise as total industry output increases -> Long-run supply curve slopes upward.

Constant Cost Industry

An industry in which costs of production do not change with greater industry output; shown with a flat supply curve.

Decreasing Cost Industry

An industry in which the costs of production decrease with an increase in industry output; shown with a downward-sloped supply curve.

Industry Clusters

Geographic concentrations of related firms, suppliers, and institutions that lower costs through knowledge spillovers and specialized labor.

Long Run Industry Supply Curve

Shows how price changes as the industry expands in the long run (flat = constant cost, upward = increasing cost, downward = decreasing cost).

Creative Destruction

New innovative firms displace old firms, driving economic progress (Schumpeter's idea).

Elimination Principle

The principle that in a competitive market, above-normal profits are eliminated by entry and below-normal profits are eliminated by exit.

Monopoly

A market structure in which there is one firm.

Market Power

The power to raise prices above marginal cost without fear that other firms will enter the market.

Barriers to entry

Things that make it difficult for other firms to jump in the market and compete (legal, natural, strategic).

(Price) Markup

The amount by which price exceeds the marginal cost (P - MC); larger when demand is less elastic.

Deadweight Loss

The reduction in total surplus caused by a market distortion or inefficiency.

Rent Seeking

Using resources to obtain or maintain monopoly power (lobbying, lawsuits, political favors) instead of producing better products.

Natural Monopoly

A situation when a single firm can supply the entire market at a lower cost than two or more firms.

Patents

Temporary legal monopoly (usually 20 years) granted to inventors to encourage innovation.

Price discrimination

Selling the same good to different customers at different prices.

Arbitrage

The practice of taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market.

Perfect price discrimination

The situation that exists when each customer is charged his or her maximum willingness to pay.

Oligopoly

A market structure in which there are a few interdependent firms.

Strategic Decision Making

Decision making in situations that are interactive (game theory).

Game Theory

The study of strategic decision making in interactive situations (used in oligopoly, war, business, etc).

Dominant Strategy

A strategy that is best for a player no matter what the other player does.

Nash Equilibrium

A situation in which no player has an incentive to change strategy unilaterally.

Collusion

Attempts to reduce competition and increase profits by acting as one firm.

Cartel

A group of suppliers that tries to act as if they were a monopoly.

repeated games

Games played more than once, allows ***-for-tat strategies that can sustain cooperation.

cooperative equilibrium

Outcome in which players cooperate and achieve higher joint profits than the non-cooperative Nash equilibrium.

tactic collusion

When firms limit competition with one another but they do so without explicit agreement or communication.

Price fixing

Illegal agreement among competitors to set the same (usually high) price.

network good

A good that increases in value to a given person the more other people use the good.

contestable markets

Markets where entry and exit are easy; even a monopoly behaves competitively because of the threat of potential entry.

switching costs

Costs (time, money, learning) that make it hard for consumers to switch from one product to another.

Monopolistic Competition

Many firms making differentiated products.

Product Differentiation

Making products slightly different (taste, style, features, location, branding) so each firm faces a downward-sloping demand curve.

Excess Capacity

In long-run monopolistic competition, firms produce less than the output that minimizes ATC (they have unused capacity).

Efficiency /variety tradeoff

Monopolistic competition gives consumers more variety but at the cost of higher prices and inefficiency (excess capacity and markup).

Non-Price Competition

Competing through advertising, quality, features, location, etc., instead of lowering price.

Advertising

Spending to shift demand right or make demand less elastic (signals quality or differentiates product).

Signaling

An expensive action that is taken to reveal information (e.g., heavy advertising signals the firm believes the product will be successful).

Elasticity of demand

The more and the better the substitutes, the more elastic the demand.

Economic Profit

Total Revenue (TR) - Total Cost (TC) where TC includes both explicit + implicit costs.

Gains to division of labor and specialization

Create gains due to taking advantage of differences in labor traits and skill, decrease in time between tasks, learning by doing, and more innovation.

Average Product

Total Product / Input.

Average Total Cost

Total Cost / Q.

Average Variable Cost

Variable Cost / Q.

Average Fixed Cost

Fixed Cost / Q.

Total Revenue

Total Revenue = Price (P) x Quantity (Q).

Profit-Max rule

Produce the quantity where MR = MC.

Marginal Product of Labor (MPL)

The additional output generated by adding one more unit of labor.

Marginal Cost (MC)

The additional cost resulting from the production of one more unit.

Average Cost (AC)

Cost per unit produced.

Total Cost (TC)

Total economic cost of production, including opportunity cost of inputs.

Variable Cost

A cost that changes as the amount produced changes.

Sunk Cost

A fixed cost that has already been incurred and cannot be recovered.

Long-Run Average Cost (LRAC)

The average cost of production when all inputs are variable.

Marginal Revenue (MR)

The additional revenue received from selling one more unit.

Short-Run Equilibrium

The point where a firm's marginal cost equals marginal revenue in the short run.

Entry and Exit Decisions

Firms make entry or exit decisions based on potential profits and sunk costs.

Market Concentration

The degree to which a small number of firms dominate the market.

Congestion Issues

Problems that arise when too many workers are added to fixed capital.

Maintenance Issues

Problems related to the upkeep of fixed capital.

Average Variable Cost (AVC)

Variable cost per unit produced.

Market Demand

The total quantity of a good that all consumers are willing to purchase at different prices.

Price Elasticity of Demand

The responsiveness of quantity demanded to a change in price.

Short-Run Shutdown Decision

A decision made by firms to cease production temporarily when they cannot cover variable costs.

Long-Run Adjustments

Changes firms make to their scale of production in response to market conditions.

Perfectly Elastic Demand

Demand where consumers will buy any quantity at a given price.

Firm Behavior Under Perfect Competition

Firms operate where price equals marginal cost to maximize profits.

Irrecoverable Costs

Costs that cannot be recovered once incurred, influencing firm decisions.

Free Entry and Exit

The ability of firms to enter or leave a market without barriers.

Long-Run Profitability

In the long run, firms in perfect competition will only make a normal profit.

Long Run Equilibrium in Perfect Competition

The state where firms make normal profits, and no incentive exists for firms to enter or exit the market.

Economic View on Competition

Competition maximizes total surplus, drives innovation, and benefits society through lower prices and more output.

Characteristics of a Monopoly

Less competition, lower elasticity of demand, one seller, high barriers to entry, and significant market power.

Monopoly Pricing Strategy

Charge the highest price the buyer is willing to pay for the profit-maximizing quantity.

Monopoly Quantity Determination

The quantity that maximizes profits where Marginal Revenue equals Marginal Cost.

Social Costs of Monopolies

Higher prices, lower quantity, deadweight loss, reduced consumer surplus, and less pressure for efficiency.