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Business Firm
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An economic institution that transforms inputs (resources) into goods and services (outputs); Inside the firm operates like a command economy.
- Circular flow: buy resources, Sell products.
- Circular flow: buy resources, Sell products.
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Objective of a Firm
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Maximization of PROFITS (greed).
profits = total revenue - total costs
profits = total revenue - total costs
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Economic vs. Accounting Profit
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Due to differences in how costs are treated.
Economic: Opportunity Cost (explicit costs + implicit costs); take more off.
Accounting: does not include the Implicit Costs.
* Revenue and Explicit Costs have same impact.
Economic: Opportunity Cost (explicit costs + implicit costs); take more off.
Accounting: does not include the Implicit Costs.
* Revenue and Explicit Costs have same impact.
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Explicit Costs
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Input (resource) costs that require an outlay of money and are measured in terms of opportunity cost.
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Implicit Costs
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Inputs (resource) costs that do not require an outlay of money are measured in terms of opportunity cost; hidden, typically for self owned resources.
- Labor: best alternative employment
- Financial Costs: Interest Payments
- Labor: best alternative employment
- Financial Costs: Interest Payments
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Production Function
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- The term economists use to describe the technology of production.
- Portrays the relationship between the quantity of inputs (resources) and the quantity output of a good or service.
- There is a production function for every good that shows the maximum output you can get from any quantities of inputs.
- Apply to firms.
E.g., MSU has a production function for producing alfalfa.
GM has a production function for producing Chevy's.
- Portrays the relationship between the quantity of inputs (resources) and the quantity output of a good or service.
- There is a production function for every good that shows the maximum output you can get from any quantities of inputs.
- Apply to firms.
E.g., MSU has a production function for producing alfalfa.
GM has a production function for producing Chevy's.
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Profit Maximization
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Economic Profit
1. ) What price to change?
2. ) What output to produce?
a. ) Must examine how costs and revenue vary by amount of output.
b. ) Start with costs technology (production) and inputs.
1. ) What price to change?
2. ) What output to produce?
a. ) Must examine how costs and revenue vary by amount of output.
b. ) Start with costs technology (production) and inputs.
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Inputs
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Anything used in the production process.
- Two general types:
Fixed and Variable.
- Two general types:
Fixed and Variable.
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Fixed Inputs
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Cannot be changed during the production period (time).
E.g. machinery, building, land
E.g. machinery, building, land
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Variable Inputs
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Can be changed during the production period (time).
E.g. labor, raw material
E.g. labor, raw material
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Time Periods of Analysis
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1. Market
2. Short Run
3. Long Run
2. Short Run
3. Long Run
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Market Period
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All inputs are fixed; very short period of time.
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Short Run Period
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At least one input is fixed.
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Long Run Period
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All inputs are variables; planning period of time.
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Perfect Competition
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Structured market; many firms in an industry producing identical products.
Example: Apple Farm (firm) - typical orchard has 80 acres producing 35,000 bushels per year, inputs: trees as a fixed input, labor as a variable input
Example: Apple Farm (firm) - typical orchard has 80 acres producing 35,000 bushels per year, inputs: trees as a fixed input, labor as a variable input
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Single Variable Total Product Curve
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Shows output as a function of a single variable input, LABOR, holding all other things constant.
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Marginal Product of Labor
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Increase in output that arises from an additional unit of labor.
= Change in OUTPUT/
Change in LABOR
= Change in OUTPUT/
Change in LABOR
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Law of Diminishing Marginal Productivity
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As the amount of an input increases, all other inputs being held constant, the marginal product of the input will eventually decline.
SHORT RUN PHENOMENON
Total product curve eventually gets flatter as the amount of the variable input increases.
SHORT RUN PHENOMENON
Total product curve eventually gets flatter as the amount of the variable input increases.
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Costs of Production
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If you know the technology of production (the production function or total production curve), and if you know the prices of the inputs to production, then you can find the firm's costs at any level of output.
Costs are determined by the technology of production and input prices.
Costs are determined by the technology of production and input prices.
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Total Cost
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= total variable costs + total fixed costs
(or TC = VC + FC)
(or TC = VC + FC)
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Total Variable Cost
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Costs that change as output changes.
Depends on:
1. Amount of Inout Used (Labor Quantity)
2. Price of Inout (Wage Rate).
Depends on:
1. Amount of Inout Used (Labor Quantity)
2. Price of Inout (Wage Rate).
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Total Fixed Cost
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Costs that do not change with output.
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Ways to Depict Firm's Costs
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1 ) Total cost curves
2 ) Unit (avg. and marginal) cost curves
2 ) Unit (avg. and marginal) cost curves
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Unit (Average and Marginal) Costs
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Businesses also focus on the costs per unit of output.
Average the Total, Fixed, and Variable Costs.
= (TC + FC + VC) / Quantity
Average the Total, Fixed, and Variable Costs.
= (TC + FC + VC) / Quantity
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Finding Average Total Cost (Alternatively)
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ATC = AFC + AVC
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Marginal Cost
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The increase in total cost due to increasing output by one unit of production.
= Change in TVC / Unit change in output
Slope of the total cost curve; shape of a "cobra".
= Change in TVC / Unit change in output
Slope of the total cost curve; shape of a "cobra".
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Fixed Costs vs. Marginal Costs
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- No relations
- Marginal cost is also found by Change in TVC / Change in Q
- Marginal cost is also found by Change in TVC / Change in Q
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Efficient Scale of Firm
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Bottom of AC curve.
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If Marginal Cost is GREATER than Avg. Total/Variable Cost
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Then Avg. Total/Variable Cost RISES.
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If Marginal Cost is LESS than Avg. Total/Variable Cost
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Then Avg. Total/Variable Cost DECLINES.
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If Marginal Cost is EQUAL to Avg. Total/Variable Cost
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Then Avg. Total/Variable Cost is at MINIMUM.
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Average Fixed Costs
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ALWAYS DECLINES. (overall total head increases which leads to decline)
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Short Run Costs
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At least one input fixed. Marginal costs looks like a cobra striking marginal costs
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When the average is RISING
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The marginal quantity must be GREATER than the average quantity.
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Relationship Between Marginal and Average Costs
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ATC = AFC + AVC
Avg. Total Cost = Avg. Fixed Cost + Avg. Variable Cost
Avg. Total Cost = Avg. Fixed Cost + Avg. Variable Cost
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When the average is neither RISING NOR FALLING (at a maximum or minimum)
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Average and marginal quantity are equal.
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When the average is FALLING
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The marginal quantity must be LESS than the average quantity.
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Economies of Scale
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Average costs decline as output increases.
Cause: Specialization and Division of Labor (only applies to large, small cannot achieve the same as big) - ADAM SMITH
Graph: Starting point of Long Run Costs.
Cause: Specialization and Division of Labor (only applies to large, small cannot achieve the same as big) - ADAM SMITH
Graph: Starting point of Long Run Costs.
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Diseconomies of Scale
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Average costs increase as output increases.
Cause: Problems of Management and Control.
Graph: Ending point of Long Run Costs.
Cause: Problems of Management and Control.
Graph: Ending point of Long Run Costs.
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Constant Returns to Scale
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Average costs constant as output increases.
Graph: The center/straight line of Long Run Costs.
Graph: The center/straight line of Long Run Costs.
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Long Run Costs
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All inputs are variable. Cross over points
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Total Revenue Equation
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Price charged x Quantity sold
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How is Price Established?
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Depends on Market (Industry) Structure.
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Market (Industry) Structures Example
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Individual Firms: Apple Co.
Industry: all the apple firms
Industry: all the apple firms
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Four Types of Industry Structures
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1 ) Perfect Competition
2 ) Monopolistic Competition
3 ) Oligopoly
4 ) Monopoly
2 ) Monopolistic Competition
3 ) Oligopoly
4 ) Monopoly
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1 ) Perfect Competition
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Many firms in the industry.
Product type is the same.
Product type is the same.
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2 ) Monopolistic Competition
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Many firms in the industry.
Product type is different.
Product type is different.
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3 ) Oligopoly
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A few firms in the industry.
Product type is the same.
Product type is the same.
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4 ) Monopoly
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Only one firm in the industry.
Product type is the same.
Product type is the same.
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Firms in a Perfectly Competitive Market
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Firms are the PRICE TAKERS.
Price = Marginal Revenue (to maximize output)
Total Profit = Total Revenue (demand) - Total Costs (supply)
Price = Marginal Revenue (to maximize output)
Total Profit = Total Revenue (demand) - Total Costs (supply)
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Measuring Profit
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(Total Revenue - Total Cost = Profit)/Quantity
Profit - Average Cost = Profit/Quantity
Profit is area (shaded) part made from points P at maximized output, point crossed on AC curve and the y-axis.
Profit - Average Cost = Profit/Quantity
Profit is area (shaded) part made from points P at maximized output, point crossed on AC curve and the y-axis.
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Profit Area
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Is not equal to Profit divided by Quantity.
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How does the price (p) get determined?
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Must distinguish between demand (revenue) of firm and demand of industry.
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Industry vs. Firm
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In Perfect Competition, price is determined by the INDUSTRY.
apple industry - all firms producing apples
Two demand and supple graphs:
1 ) Industry - all apple firms
2 ) firm - apple company
apple industry - all firms producing apples
Two demand and supple graphs:
1 ) Industry - all apple firms
2 ) firm - apple company
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What does it mean when the demand curve (price line) is in perfect competition horizontal?
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Firm is a Price Taker - no control over price.
Raising the price will "do no good" because consumers will not buy the product if it's more expensive than the market price and he wont lower it to under.
Raising the price will "do no good" because consumers will not buy the product if it's more expensive than the market price and he wont lower it to under.
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Average Revenue (AR) in Perfect Competition
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= Total Revenue / Quantity
or
(Price x Quantity) / Quantity
= THE PRICE
The Firm's total revenue divided by output.
or
(Price x Quantity) / Quantity
= THE PRICE
The Firm's total revenue divided by output.
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Marginal Revenue (MR) in Perfect Competition
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= Change in TR / Change in Quantity
or
(Price x Change in Quantity) / Change in Quantity
= THE PRICE
The change in total revenue per unit change in output.
or
(Price x Change in Quantity) / Change in Quantity
= THE PRICE
The change in total revenue per unit change in output.
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The Firms Objective Goal
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Maximizing Profits
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Green Rule
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Alternative Profit Maximization: Marginal Analysis (M Revenue = M Cost)
Profit Maximization where:
marginal revenue = marginal cost
Profit Maximization where:
marginal revenue = marginal cost
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MR > MC
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Increase/expand output
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MR < MC
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Decrease/contract output
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MR = MC
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Profit Maximized, Minimize Loss
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How to Measure Profit?
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TR - TC = Profit
(TR/Q - TC/Q = Profit/Q)
P - AC = Profit/Quantity
(TR/Q - TC/Q = Profit/Q)
P - AC = Profit/Quantity
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Total Profit
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Profit/Quantity X Quantity sold = Profit
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P < AVC
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The firm should shut down in the long run. (Shut Down Rule)
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P > AVC
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The firm shouldn't shut down in the long run. (Shut Down Rule)
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Short Run
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Forget the fixed costs. Only concentrate on the costs you can control - variable costs.
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Negative Loss in Short-Run
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Price > Average Cost
Do not shut down, especially if Price > Average Variable Cost. (forget Fixed Costs)
Do not shut down, especially if Price > Average Variable Cost. (forget Fixed Costs)
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What is the Short-Run Supply Curve of a firm?
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Relationship between price and quantity.
Marginal Cost curve is greater than or equal to Average Variable Cost. EXCEPT below AVC
Marginal Cost curve is greater than or equal to Average Variable Cost. EXCEPT below AVC
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What is the Short-Run Supply Curve of an industry?
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Industry supply curve is the sum of the Marginal Cost for each firm.
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Long-Run Difference from Short-Run
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Existing firms expand or contract by altering previously fixed capital.
New firms can enter or old firms can close permanently.
New firms can enter or old firms can close permanently.
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Profits
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Lures new firms to enter an industry.
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Long-Run Equilibrium
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Economic profits for the typical firm is ZERO. As more and more firms enter, the supply curve shifts right and price decreases until it reaches the bottom of the Average Cost Curve.
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Competitive Market Equilibrium in Long-Run
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Price must settle at bottom of firms Average Cost Curve.
Profits (economic) of typical firms must be ZERO.
Numbers of firms will adjust to provide the market quantity demanded at that place.
Market price is still determined by short-run supply and demand.
Profits (economic) of typical firms must be ZERO.
Numbers of firms will adjust to provide the market quantity demanded at that place.
Market price is still determined by short-run supply and demand.
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In the New Equilibrium
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Firm's quantity is unchanged
Industry quantity is increased
Firm's profits are unchanged
Industry quantity is increased
Firm's profits are unchanged
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Why do firms stay in business (even with zero profits)?
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Economic profits are different between REVENUE and Opportunity COST, the existence of profit means a firm is earning more on its invested resources than it could get in its next best alternative.
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Long-Run Perfect Competition Performance
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Economic Profit = ZERO
Costs at minimum (efficient scale of the firm - bottom of the Average Cost curve)
Price = Marginal Cost (maximization of economic welfare)
Costs at minimum (efficient scale of the firm - bottom of the Average Cost curve)
Price = Marginal Cost (maximization of economic welfare)
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Maximization of Economic Welfare
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When the welfare of the entire economy is maximized.
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Marginal Cost Curve Above AVC
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The supply curve of a firm in perfect competition
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New Firms will Enter
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If there are economic profits in a perfectly competitive industry.
The industry supply curve will shift to the right and the price will fall.
The industry supply curve will shift to the right and the price will fall.
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Profit Maximizing/Loss Minimizing Rules (MEMORIZE)
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1. MC = MR for output level of firm.
2. Price compared with Average (Total) Cost for profit or loss Per Unit.
3. Price compared with Average Variable Cost for shut down.
2. Price compared with Average (Total) Cost for profit or loss Per Unit.
3. Price compared with Average Variable Cost for shut down.
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Long Run Perfect Competition Economic Performance
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1. Economic Profit = 0
2. Costs at minimum
(Efficient scale of the firm)
3. Price = Marginal Cost
(Economic welfare of society maximized)
2. Costs at minimum
(Efficient scale of the firm)
3. Price = Marginal Cost
(Economic welfare of society maximized)
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Monopoly
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One firm in the Industry.
Firm = Industry (Demand curve is downward sloping, sell more if you lower the price)
A Price Maker
MR is no longer equal to PRICE. but still equal to average revenue.
Firm = Industry (Demand curve is downward sloping, sell more if you lower the price)
A Price Maker
MR is no longer equal to PRICE. but still equal to average revenue.
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Paper Collars
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The only monopoly in the U.S.
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Why do Monopolies arise?
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1) Control of Resources
2) Government Created
3) Natural Monopoly
2) Government Created
3) Natural Monopoly
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1. Control of Resources
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Firm has a Monopoly on the resources needed to produce the product.
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2. Government Created
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Patents (20 year license) and franchises (ex. Cata bus in EL)
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Key Difference of a Monopoly From Perfect Competition
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Demand
- In perfect competition
- Firms price elasticity is infinite
- Horizontal.
- In perfect competition
- Firms price elasticity is infinite
- Horizontal.
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Revenue Curves for a Monopolist
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The market demand curve for a good is the firms average revenue curve.
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Price Maker
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Choose output where MC = MR then choose price by going to the demand curve.
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Mark-Up Pricing
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(COST)(MARK-UP) = PRICE
Cost = marginal cost
Mark up = Ed/(Ed - 1)
Ed =price elasticity
Cost = marginal cost
Mark up = Ed/(Ed - 1)
Ed =price elasticity
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Higher the Elasticity
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Lower the Mark-up
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Lower the Elasticity
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Higher the Mark-up
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Unit Profits
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Price - A(T)C = Profit per unit
Total Profit = (Profit/unit)( ...
Total Profit = (Profit/unit)( ...
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Monopoly - Long Run Equilibirum
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1 ) Economic profits possible
2 ) No production at lowest possible cost
3 ) Price > MC: price higher, output lower than in perfect competition
2 ) No production at lowest possible cost
3 ) Price > MC: price higher, output lower than in perfect competition
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Efficiency of Markets and Economic Welfare Analysis
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A study of how allocation of resources affects economic well being of society as a whole - As well as who are winners and who are losers.
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Total Surplus
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Consumer Surplus + Producer Surplus
= Total Surplus
OR (D - Price) + (Price - S)
(Demand - Supply = TS)
= Total Surplus
OR (D - Price) + (Price - S)
(Demand - Supply = TS)
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Producer Surplus - Supply
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The amount the seller receives for the good MINUS the cost.
Cost is the supply curve (MC) of the firms.
Direct relationship with price - Increases when the price increases.
Opposite of CONSUMERS.
Cost is the supply curve (MC) of the firms.
Direct relationship with price - Increases when the price increases.
Opposite of CONSUMERS.
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Consumer Surplus - Demand
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A consumer's willingness to pay MINUS the amount actually paid (price).
Inverse relationship with price - Increases when the price declines.
Inverse relationship with price - Increases when the price declines.
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Optimality of Competitive Markets
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The principle claim is that economic welfare (the sum of producer and consumer surplus) is maximized at the perfectly competitive price and quantity for a good.
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Willingness to Pay
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The maximum price that a buyer will pay for a good. Forms
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Market Efficiency Overall
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Where total surplus is maximized, have found most efficient market outcome
Maximum economic efficiency (Note that this says nothing about equity).
Maximum economic efficiency (Note that this says nothing about equity).
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Deadweight Loss
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Loss of total surplus.
Triangle of difference
Remember: Grateful Dead Phil Lesh
If output is too low
Triangle of difference
Remember: Grateful Dead Phil Lesh
If output is too low
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Perfect Competition Principle
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Perfect competition DOES generate maximum economic efficiency.
Equilibrium: where D = S
where: Price = MC
If less output than QE:
Consumer surplus LOWER
Producer surplus LOWER
-Difference is triangle called DEADWEIGHT LOSS
Equilibrium: where D = S
where: Price = MC
If less output than QE:
Consumer surplus LOWER
Producer surplus LOWER
-Difference is triangle called DEADWEIGHT LOSS
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MEMORIZE Compare Price and Output: Perfect Comp and Monopoly
answer
Overall EC. Efficiency
Perfect Comp.: P = MC
Monopoly: P > MC
(P is higher and Q is lower)
Cost
Perfect Comp.: Minimum AC
Monopoly: No minimum AC
EC Profit
Perfect Comp.: 0
Monopoly: above 0
Perfect Comp.: P = MC
Monopoly: P > MC
(P is higher and Q is lower)
Cost
Perfect Comp.: Minimum AC
Monopoly: No minimum AC
EC Profit
Perfect Comp.: 0
Monopoly: above 0
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Industry Equilibrium in Perfect Competition
answer
If the demand curve is a good measure of the value of a good and
if the supply curve is a good measure of the cost to society to produce a good,
then the best amount of the good to produce is where supply and demand are equal.
if the supply curve is a good measure of the cost to society to produce a good,
then the best amount of the good to produce is where supply and demand are equal.
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Demand Curve
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Willingness to pay
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Supply Curve
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The firm's cost
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Economic Welfare Analysis
answer
Refer to Graph.
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