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goal of a firm
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to maximize profit
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profit
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= TR - TC
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costs
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explicit and implicit
TC = explicit + implicit
TC = explicit + implicit
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explicit costs
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monetary payments for market supplied inputs
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implicit costs
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- incurred but not paid
- opportunity cost
- opportunity cost
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opportunity cost of using the firm's resources
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the return the firm's resources could have earned elsewhere
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opportunity cost of equity capital
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the return the equity capital could have earned elsewhere
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opportunity cost of the owner's time
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income forgone
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economic profit
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= TR - TC
= TR - (explicit + implicit)
= TR - (explicit + implicit)
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accounting profit
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= TR - explicit costs
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economic profit < accounting profit
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...
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if economic profit > 0
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firm's resources earn higher return than they could have elsewhere
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if economic profit < 0
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firm's resources could have earned a higher return elsewhere
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π (Q)
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= profit function
= TR(Q) - TC(Q)
= TR(Q) - TC(Q)
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Q
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firm's output
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profit function
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economic profit
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to maximize π(Q)
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dπ/dQ = 0
dTR/dQ = dTC/dQ
dTR/dQ = dTC/dQ
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MR
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= dTR/dQ
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SMC
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= dTC/dQ
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profit maximizing condition
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MR = SMC
dTR/dQ = dTC/dQ
dTR/dQ = dTC/dQ
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profit margin
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= (P - ATC) * Q
profit per unit
profit per unit
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firms must decide
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- what to produce?
- how much to produce?
- how to produce?
- how to price and promote product?
- how much to produce?
- how to produce?
- how to price and promote product?
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market structure
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economic characteristics of the environment in which the firm operates
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perfect competition
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- many firms
- homogenous product
- low barriers to entry/exit
- perfect information
- homogenous product
- low barriers to entry/exit
- perfect information
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price taker
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- the individual firm cannot influence the market price
- take Pe as given or pre-determined
- demand curve is horizontal (perfectly elastic)
- take Pe as given or pre-determined
- demand curve is horizontal (perfectly elastic)
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MR
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= change in TR / change in Q
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TR
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= P * Q
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Dfirm
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= MR
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π maximizing
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MR = SMC
P = SMC
P = SMC
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if Q < Q*
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- P > SMC
- firm has an incentive to increase Q
- firm has an incentive to increase Q
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if Q > Q*
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- P < SMC
- firm has an incentive to decrease Q
- firm has an incentive to decrease Q
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if Q = Q*
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- P = SMC
- firm has no incentive to change Q
- π max
- firm has no incentive to change Q
- π max
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π = (P - ATC) * Q
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P = Pe
(P - ATC) = profit margin
Q -> MR = SMC
(P - ATC) = profit margin
Q -> MR = SMC
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normal profit
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= implicit costs
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if P > ATC
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- π > 0
- new firms enter the market
- accounting profit > normal profit
- new firms enter the market
- accounting profit > normal profit
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if P = ATC
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- π = 0 , no economic profit
- no new firms enter
- accounting profit = economic profit
- no new firms enter
- accounting profit = economic profit
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if P < ATC
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- π < 0 , economic loss
- (P - ATC) < 0
- accounting profit < normal profit
- (P - ATC) < 0
- accounting profit < normal profit
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if new firms enter the market
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- P decreases
- (P - ATC) decreases
- π decreases
- (P - ATC) decreases
- π decreases
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new firms enter until
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- P = ATC
- (P - ATC) = 0
- π = 0
- (P - ATC) = 0
- π = 0
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in long-run
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π = 0 for perfectly competitive firms
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under perfect competition
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- economic profit is not possible in the long-run (π = 0)
- firm still earns an accounting profit equal to its normal profit (implicit costs)
- firm still earns an accounting profit equal to its normal profit (implicit costs)
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negative attributes of perfect competition
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- no product variety
- firms have no incentive to invest in research and development (someone has to fund it)
- firms have no incentive to invest in research and development (someone has to fund it)
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if P < ATC, (P - ATC) < 0, π < 0
answer
- economic loss
- 2 choices:
1. continue to produce (Q > 0)
2. shut down (Q = 0)
- 2 choices:
1. continue to produce (Q > 0)
2. shut down (Q = 0)
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if Q = 0
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- the firm shuts down, the fixed cost must still be paid in short run
- TC = TFC
- TC = TFC
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if TR < TVC
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- the firm shuts down
- P < AVC
- P < AVC
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if TR >= TVC
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- the firm continues to produce even if π = 0
- P >= AVC
- P >= AVC
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Psd
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shut down price
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Qsd
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shut down output
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if P >= Psd
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Q > 0
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if P < Psd
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Q = 0
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SMC curve
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- firm's supply curve
- since SMC is upward sloping, the firm experiences diminishing marginal returns
- since SMC is upward sloping, the firm experiences diminishing marginal returns
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short - run
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Q = f(L)
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average revenue product (ARP)
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- revenue per worker
= TR / L
= P * AP
= TR / L
= P * AP
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marginal revenue product (MRP)
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- additional revenue from hiring one more worker
= change TR / change L
= P * MP
= change TR / change L
= P * MP
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AP max
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when MP = AP
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π maximizing output choice
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MR = SMC
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π maximizing output choice for a price taker
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P = SMC
P = W / MP
P = W / MP
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MRP = W
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π maximizing input choice
MRP = MB of hiring another worker
W = MC of hiring another worker
MRP = MB of hiring another worker
W = MC of hiring another worker
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if MRP > W
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firm will hire more L
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if MRP < W
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firm will hire fewer L
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if MRP = W
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- firm has no incentive to change L
- optimal choice
- optimal choice
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in short-run, the firm will shut down if
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ARP < W
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if W > Wsd
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firm shuts down
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if W <= Wsd
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firm will employ L along MRP
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MRP curve
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firm's demand curve for labor
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industry supply
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1. increasing cost industry - input prices rise as industry output increases
2. constant cost industry - input prices remain constant as industry output increases
2. constant cost industry - input prices remain constant as industry output increases
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market power
answer
- when a firm can raise the price of its product without losing all sales
- P < MC
- P < MC
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lerner index
answer
= (P - MC) / P
- higher lerner index -> greater market power
- for a price taker, lerner index = 0
- higher lerner index -> greater market power
- for a price taker, lerner index = 0
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for a firm, with market power
answer
Dfirm is downward sloping
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MR is twice as steep as
answer
Dfirm
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firms with market power
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- monopoly
- monopolistic competition
- oligopoly
- monopolistic competition
- oligopoly
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monopoly
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- one single firm
- firm = market (D and Q)
- no close substitutes
- significant barriers to entry/exit
- firm = market (D and Q)
- no close substitutes
- significant barriers to entry/exit
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sources of monopoly
answer
- ownership of a key resource or input
- consumer brand loyalty
- network externalities
- government created barriers (patents, copyrights, licenses)
- economies of scale
- consumer brand loyalty
- network externalities
- government created barriers (patents, copyrights, licenses)
- economies of scale
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on graph
answer
- Q* is where MR = SMC
- P is from Dfirm at Q
- P > SMC, market power
- (Q, P), set by firm
- P is from Dfirm at Q
- P > SMC, market power
- (Q, P), set by firm
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at Q*
answer
- P > ATC, (P - ATC) > 0, π > 0
- firm earns economic profit
- economic profit is possible in the long run (due to barriers to entry)
- firm earns economic profit
- economic profit is possible in the long run (due to barriers to entry)
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uses of economic profit
answer
- enrich the owners
- invest in barriers to entry (R & D for new patents and copyrights
- invest in barriers to entry (R & D for new patents and copyrights
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government regulation of monopolies
answer
- policy targeting the price that is charged (set P below P*)
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regulated price
answer
= Pr
- set by government
- set by government
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marginal cost pricing
answer
- Pr = SMC
- Pr < P*
- Qr > Q*
- Pr < P*
- Qr > Q*
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At Qr
answer
- Pr > ATC
- the monopolist still earns and economic profit
- the monopolist still earns and economic profit
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At Q*, P < ATC, (P - ATC) < 0, π < 0
answer
- in the long run, the monopolist will have an incentive to exit market (industry dies)
- to maintain industry, the government must subsidies the firm (compensate for economic loss)
- to maintain industry, the government must subsidies the firm (compensate for economic loss)
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At Q*, P = ATC, (P - ATC) = 0, π = 0
answer
firm still earns an accounting profit equal to its normal profit
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monopolistic competition
answer
- many firms
- low barriers to entry/exit
- differentiated products (design, quality, materials, features, brand)
- low barriers to entry/exit
- differentiated products (design, quality, materials, features, brand)
question
Dfirm, Qfirm
answer
do not = Dmarket, Qmarket
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if monopolistically competitive firm earns a profit,
answer
- new firms will enter the market (due to low barriers)
- as new firms enter, Dfirm will shift left
- will continue to enter until π = 0
- economic profit is not possible in the long-run (first-mover advantage)
- to prolong short-run, firm has incentive to spend money (advertising, promoting, and introduction of new product varieties)
- as new firms enter, Dfirm will shift left
- will continue to enter until π = 0
- economic profit is not possible in the long-run (first-mover advantage)
- to prolong short-run, firm has incentive to spend money (advertising, promoting, and introduction of new product varieties)
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