Firms and Decision definitions

things to remember for microeconomics

average revenue (AR)

is the same as the price of the product

Total revenue (TR)

a firms total earnings per period of time from the sale of a particular amount of output

TR formula

Price(P)x Output (Q)

AR curve

functions as the demand curve for the product of the firm

Marginal revenue (MR)

the change in TR as result of the sale of an additional unit of output

MR formula

change in TR/change in output

MR_n=

TR_n - TR_n-1

fixed factors

factors of production that are fixed in quantity in the short run

variable factors

factors of production that are not fixed in quantity, in the short and/or long term.

factor of production that will never be a variable factor even in the long run

technology

Total cost(TC)

the total cost of producing any given levelof output

TC=

TFC+TVC

Total fixed cost

the total amount paid for fixed factors of production, which does not vary with the level of output.
also known as overheads, irrelevant, indirect, supplementary, unavoidable, sunk or contractual cost.
remains constant as output increases and are incurred even if production is zero

Total variable cost

the total amount paid for variable factors of production, varying directly with the level of output.
incurred only if there is production.
also called direct, avoidable, prime, running or non-contractual cost

Marginal cost (MC)

the change in total cost resulting from an increasing output by one unit.
since only variable costs changes with output, it is affected by variable cost only.

MC=

change in TC/change in quantity
or
change in TVC/change in quantity

MC_n=

TC_n-TC_n-1
or

TVC_n-TVC_n-1

shape of MC curve + explanation

U-shaped to represent the fall in ____ as output increases, until LMDR sets in, resulting in ____ increasing with output. does not touch the axes

Average fixed cost (AFC)

amount of fixed cost per unit of ouptut

AFC=

total fixed cost/quantity

behaviour of AFC curve+explanation

falls continuously with increases in output because TFC which is constant, is being spread over a larger output. hence, the curve is a downward sloping, rectangular hyperbola that does not touch the axes

Average variable cost (AVC)

total variable cost per unit of ouput

AVC=

Total variable cost/quantity

shape + explanation of AVC

the average falls when the marginal is less than the average, hence the _____ first falls when MC is lower than it. as LMDR sets in, MC will start rising, when it rises above the ____, ____ starts rising. hence the MC curve cuts the ____ curve at the minimum point of the ____ curve. thus, the _____ curve is U shaped

universal rules about averages and marginals

if marginal=average, average remains the same
if marginal>average, average rises
if marginal<average, average falls

Average Total Cost (AC)

the unit cost of production

AC curve behaviour +explanation

determined by AFC and AVC.
At the beginning, when AFC and AVC are falling, ____falls as well. However, the subsequent rise in AVC due to LMDR eventually overrides the falling AFC and pulls up the ____. The rise in AVC does not immediately offset the fall in AFC, which is why ____ continuous to fall. Only when the rise of the AVC is greater than the fall in AFC, does the ___ rise. This results in ___ and the AVC having different minimum points, where the output at minimum AVC is less than the output at minimum AC. Hence the ____ is U-shaped, and lies above the AVC curve by the amount of the AFC. This explains why the distance between AC and AVC curves becomes smaller and smaller as output increases

Short run average costs curves represent

one scale of production

LRAC formed by

portion of various SRAC curves, where the ____ is U-shaped and tangent to each SRAC curve. This is why, diagrammatically, the SRAC curve cannot fall below the ____ curve

internal economies of scale

in the long run, when the scale

short run

the period of time during which at least one factor of production is fixed in quantity

long run

a time period long enough for all factors of production to be variable

Minimum efficient scale

The size beyond which no significant additional economies of scale can be achieve. It is where the LRAC curve reaches its lowest or minimum point

Internal economies of scale

are lower average costs due to cost savings that firms enjoy when they expand their scale of production and hence output

internal diseconomies of scale

higher average costs that firms may experience when they grow beyond a certain or scale production

external economies of scale

the cost savings by a firm that arises from a growth of the industry, ceteris paribus

external diseconomies of scale

the higher average cost imposed on a firm arising from the growth of the industry ceteris paribus

price-setter

a firm that has a relatively large share of the market and can make pricing decisions. The firm enjoys market power but the extent depends.

three market structures that have price-setter firms

monopoly, monopolistic competition and oligopoly

sales revenue maximisation goal

when firms aim to maximise the firm’s short-run total revenue rather than maximising profits

Profit satisficing goal

decision makers in a firm aim for a target level of profit rather than the absolute maximum level

market share dominance goal

firms aiming for growth maximisation in the size of the firm, rather than profit maximisation

perfect competition

a market structure where there is a large number of small firms selling a homogenous/identical product with perfect knowledge/information, and there is freedom of entry and exit for firms

Monopolistic competition

a market structure where there are many small firms selling a differentiated product with freedom of entry and exit firms

oligopoly

market structure dominated by a few large firms where the product could be homogenous or differentiated and high barriers to entry exist against potential new firms

monopoly

a market structure where there is only firm in the industry, selling a unique product with strong barriers to entry of new firms

barriers to entry

includes any factor which prevent or deter the entry of new firms into an industry despite the incentive to so (i.e. incumbent firms are earning supernormal profits)

concentration ratio

the percentage of total industry size accounted for by the few largest firms in the industry. It can be specified for any of the largest firms in an industry, such as 3-firm, 5-firm etc.

LRAC curve shows

the lowest possible average cost of producing any given output

shape of LRAC explained by

internal economies and diseconomies of scale

technical economies: specialisation

larger plant —→ more workers —→ divide production process into many smaller & simpler tasks —→ workers can specialise according to skills —→ they can complete their task in the last possible time —→ overall productivity increases —→ cost per unit of output falls —→ lower AC

technical economies: increased dimensions (a greater inefficiency of large machines)

large machine used instead of employing labour or small machines —→ the initial cost is not twice as much nor is the running cost doubled —→ increase in output with lower initial investment and operating costs —→ AC falls

financial economies

easier and cheaper for large firms to raise funds —→ expansion can be financed out of retained profits + reputation for reliability among bankers (lower rates of interest for loans) —→ cost savings, ceteris paribus lower AC

Managerial economies

large firms=more complicated business operations —→ can justify the hiring of specialised managers in the different parts of its business (RnD, marketing, supply chain). Delegation of responsibility enables top management to focus on strategic planning instead of managing large swaths of the business personally. This results in higher output with same cost, contributing to a lower AC.

Marketing economies

since ______ cost does not need increase proportionately with output increase —→ increase in cost is less than the increase in output —→ larger firm enjoys a lower cost per unit —→ lower AC

Managerial diseconomies

Organisation etc. are more complex in a large operation —→ slower decision making + slow to respond to changing market conditions —→ potential lower productivity —→ higher CoP —→ higher AC

staff problems

low morale more likely in large organisations —→ individuals with less authority may not identify with firm —→ do not feel understood by management —→ less loyal + higher staff turnover —→ lower labor productivity—→ higher CoP —→ higher AC

Marketing diseconomies

large firms are further from customer base —→ more market research needed —→ communication costs higher —→ additional marketing expenditure —→ increase in cost > increase in output —→ higher AC

types of internal diseconomies of scale

managerial, staff problems, marketing

types of internal economies of scale

technical economies (specialisation and greater efficiency of large machines), financial economies, managerial economies, marketing economies

natural monopoly

MES only achieved at a very high output, efficient production will be achieved only with a small number of industrial giants, small firms with a limited amount of consumer demand cannot realise the MES and will not be viable —→ single large firm dominates the market as it is able to enjoy the lowert average cost possible by producing all the market output

external economies of scale curve shift

downward

external diseconomies of scale curve shift

upward

types of external economies of scale

concentration(location), information

economies of concentration

occurs when there is an increase in the number of firms from the same industry in an area —→ specialised firms established to provide components for all productions + pool of skilled labour developed when talent is attracted to area/training institutes focus programmes to better cater to industry + better infrastructure(warehousing, transport etc.) developed concurrently —→ AC falls

example of economies of concentration

Jurong island in SG —→ petrochemical industry concentrated —→ accompanying storage and transport facilities sprout out—→ reduction of AC of all petrochemical companies

economies of information

industry expands —→ sharing of knowledge and information among firms by government or firms —→ raise productivity and lower firms’ AC

examples of economies of information

setting up of specialist research and development facilities —→ publication of specialist journals

A*STAR(SG lead government research agency) launching Model Factory Initiative in 2015 to facilitate digital industry, partnering with over 20 industries and public sector research institutes to provide support and facilities for companies to either test out their ideas without disruption to their own operations, or co-develop comprehensive and suitable intelligence systems that speed up decision making processes in production. —→more than 50 companies taking part in MFI

causes of external diseconomies of scale

strain on physical infrastructure, shortage of industry specific resources, raw materials, or labour with appropriate skills —→ bidding up of wages to attract more labour + increasing demand for raw materials leads to bidding up of prices + land for expansion becoming increasingly scarce (more expensive to purchase and rent) + transport cost increasing due to congestion (productivity) —→rising factor prices —→ AC of firm increases, upward shift of LRAC

Economic cost =

Explicit cost +Implicit Cost

Explicit cost

payments by a firm on purchased or hired factors (factors not owned by the firm).

examples of explicit cost

payment of wages to labour, rent on land and building, payments of interest on borrowed capital, payment of utilities, expenditure on raw materials

Implicit cost

does not involve a direct payment of money, involves a sacrifice of some alternative.

examples of implicit cost

value of inputs owned and used by firms in its own production processes such as the interest on the funds supplied by the owners

Economic profit =

Total revenue - Implicit Cost - explicit cost

Profit maximisation condition

MR=MC, where the MC curve cuts the MR curve from below.

explanation of profit maximisation condition

if MR is greater than MC, it must benefit the firm to increase its output, as each extra unit will add to its total profit. If MC>MR, the extra cost is greater than the extra revenue and the additional units will not be produced as they would reduce the total profits

3 levels of economic profit

normal, subnormal and supernormal

Normal profit=

TR-TC=0, AC curve is tangential to D=AR curve at the profit maximising (MC=MR) output

Normal profits

the minimum level of profit required to keep the entrepreneur in an industry yet being insufficient to attract new firms into the industry

supernormal profits=

TR-TC>0, when total revenue exceeds total cost, resulting in positive economic profit. AR>AC at Q*(where MC=MR), size of profit is indicated by a rectangle encompassing AR at Q* to AC at Q* to P*.

Supernormal profits

attracts new firms to the industry in the long run—→ industry grows. Motivating force for a firm to undertake the risk of organising the production of some good or service.

subnormal profits=

TR-TC<0, when total revenue falls short of total cost, with negative economic profit. AR<AC at profit maximising (MC=MR) output(Q*). size of subnormal profit is indicated by the area of a rectangle encompassing AC at Q*, AR at Q* and P*

shut down condition

short run

at profit maximising output Q*, AR<AVC or equivalently, TR<TVC —→ (ability to offset AFC/TFC)

long run
at profit maximising output, AR<AC, or TR<TC aka firms not minimally making normal profits

loss minimisation

engaging in production where MC=MR in the short run while making subnormal profits

difficulties in maximising profits

1. imperfect information: production processes too complex for MC to be accurately estimated + implicit cost of entrepreneur’s time difficult to estimate and factor into unit CoP

2. impossibility of accurate estimation of demand for output and revenue: incomes, preferences, actions and reactions of competitors and consumers change too quickly to make a precise estimation of demand and MR

3. conflict of interest between decision makers and decision implementers: principal-agent problem (separation of ownership and control) + difference in self interest of workers and managers—→ gives rise to X inefficiency and makes it difficult to maximise profits

sales revenue maximisation goal occurs when

1. managers and sales personnel are paid based on sales revenue —→ incentive to sell as much as possible, subject to profit satisficing

2. owners of firms judging performance based on revenue and not profit —→ enticing managers to chase sales figures and revenue rather than profit to appeal to owners

profit satisficing goal occurs when

employees aim for a reasonable level of profit good enough to appease the owners —→ satisficing outcome rather than maximising outcome

can be sales revenue maximisation or any other condition that is not MC=MR

market share dominance goal

Firms aiming for growth maximisation due to higher profits in the long run + increased price setting ability

output maximisation

a way for firms to grow to achieve market dominance goal: firms aim to produce as much as possible while subjecting itself to the constraint that profits are not negative —→ production at AR=AC —→ firms make normal profits

mergers and acquisitions

a way for firms to grow to achieve market dominance goal

growth through diversification

a way for firms to grow to achieve market dominance goal: firms expanding range of products beyond its current industry, usually when current industry is stagnant, saturated or in decline —→ diversify into new markets to continue generating profits or to spread risks to be less affected by negative events that may reduce profits from a particular market

example of diversified firms

Samsung (South Korea): produces phones, telecommunications equipment, semiconductors, cosmetics and weapon technologies

Contestable market

threat of potential entry exists due to the ease of entering and exiting the industry

Limit pricing

when a firm charges a price below the profit maximising level in order to deter new entrants

Predatory pricing

when a firm charges a price below the short run profit maximising level in order to drive out current competitors

Price war

When rival firms engage in multiple rounds of price cuts to gain market share from each other

Price discrimination

firms charging different prices for an identical product to different buyers for reasons not associated with differences in cost

third degree price discrimination

where different groups of buyers are charged different prices for the exact same good aka specific to demographic rather than other factors.

sunk cost fallacy

when a person’s decision is affected by fixed rather than marginal costs