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Economic Rent
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a payment for the use of any resource over and above its opportunity cost; it can be viewed as a payment to resource owners in excess of what would be necessary to call forth that amount of the resource
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Firm
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an organization that brings together different factors of production, such as labor, land, capital, and entrepreneurial skill to produce a product or service that it hopes can be sold for a profit
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Proprietorship
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a firm owned by a single individual; this comprises 71% of businesses in the US
the sole owner is responsible for all the debts and obligations of the business; average annual sales revenue is $57,000
Advantages: easy to start, easy decision-making, income (profits) are taxed once as personal income
Disadvantages: unlimited liability, difficult to raise financial capital, usually ends with the death of the owner
the sole owner is responsible for all the debts and obligations of the business; average annual sales revenue is $57,000
Advantages: easy to start, easy decision-making, income (profits) are taxed once as personal income
Disadvantages: unlimited liability, difficult to raise financial capital, usually ends with the death of the owner
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Partnership
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a firmed owned by two or more co-owners, partners are jointly responsible for running the business (ex. lawyers and physicians), and each partner is legally responsible for all the debts and obligations of the firm; comprises 9.7% of businesses in the US
Advantages: easy to start, income (or profit) is taxed once as personal income, and permits specialization
Disadvantages: disagreement among partners may slow down decision-making, death of a partner usually means dissolution, and unlimited liability
Advantages: easy to start, income (or profit) is taxed once as personal income, and permits specialization
Disadvantages: disagreement among partners may slow down decision-making, death of a partner usually means dissolution, and unlimited liability
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Corporation
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a legal entity that conducts business in its own name (separate from owners), owners are called shareholders (entitled to a share of the profit, also known as dividends), and limited liability (owners liable up to their investments); comprises 19.0% of businesses in the US
Advantages: limited liability, easier to raise financial capital, they outlive their owners
Disadvantages: double taxation, separation of owners and management
Advantages: limited liability, easier to raise financial capital, they outlive their owners
Disadvantages: double taxation, separation of owners and management
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Accounting Profit
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Accounting Profit = Total Revenue - Explicit Costs
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Explicit Costs
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costs that business managers must take into account because they must be paid (out-of-pocket money such as wages, cost of materials, utilities, etc.)
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Economic Profit
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Economic Profit = Total Revenue - Explicit Costs - Implicit Costs
EC + IC = Opportunity Cost of all Inputs
EC + IC = Opportunity Cost of all Inputs
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Implicit Costs
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expenses that managers do not have pay out-of-pocket and hence do not explicitly calculate
typically applicable to forgone costs
typically applicable to forgone costs
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Profit Maximization
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the overriding goal of all firms, to make the difference between total costs and total revenues as large as possible
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Stocks
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a corporate financing method, a legal claim to a share of the company's profit
if you own shares in a company, you are entitled to a share of the company's profits (a percentage or proportion of the total shares you own)
Common Stockholders - you get to vote
Preferred Stockholders - you can't vote BUT you get paid first
Dividends - what gets paid out to the shareholders
if you own shares in a company, you are entitled to a share of the company's profits (a percentage or proportion of the total shares you own)
Common Stockholders - you get to vote
Preferred Stockholders - you can't vote BUT you get paid first
Dividends - what gets paid out to the shareholders
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Bonds
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a bond is a note of indebtedness issued by a firm in return for funds lent to the firm
bondholders are entitled to coupon interest and a lump-sum amount at the maturity date of the bond
bondholders are legally entitled to payment regardless of the company's performance
bondholders are typically paid before any dividends are paid out to shareholders
bondholders are entitled to coupon interest and a lump-sum amount at the maturity date of the bond
bondholders are legally entitled to payment regardless of the company's performance
bondholders are typically paid before any dividends are paid out to shareholders
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Reinvestment
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reinvestment involves a firm using some of its profits for business expansion (such as buying capital investment) instead of paying out dividends
referred to as retained profits (or retained earnings)
referred to as retained profits (or retained earnings)
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Short-Run
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a time period short enough that some inputs, such as plant size, cannot be changed (varied)
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Fixed Input
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a factor of production that cannot be varied practically in the short-run; we assume capital (such as plant size) to be fixed in the short-run
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Variable Input
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a factor of production whose quantity can be changed readily by the firm during the relevant time period; labor is typically assumed to variable input
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Long-Run
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a time period that all factors of production are varied
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Total Physical Product (TP)
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total output produced by all the inputs (and technology) employed in production
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Average Product (AP)
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output per worker
OR
Total Product (TP) / Input of Labor (# of workers)
OR
Total Product (TP) / Input of Labor (# of workers)
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Marginal Product (MP)
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a change in total product resulting from a unit increase in labor input (note: the labor input could be measure per hour of work, per worker-week, etc.)
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Law of Diminishing Marginal Product
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the observation that successive increases in a variable factor of production, such as labor, added to fixed factors of production will reach a point beyond which the extra or marginal product that can be attributed to each additional unit of variable factor of production will decline
in other words, marginal product eventually decreases once there are too many additional workers
in other words, marginal product eventually decreases once there are too many additional workers
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Short-Run Costs to the Firm
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Total Fixed Costs (TFC): costs that do not vary with output; ex. cost of heavy equipment, rent, insurance premiums
Total Variable Costs (TVC): costs that vary with the rate of production; ex. cost of labor, cost of materials
Total Cost (TC): the sum of a firm's total variable and total fixed costs (TC = TFC +TVC)
Total Variable Costs (TVC): costs that vary with the rate of production; ex. cost of labor, cost of materials
Total Cost (TC): the sum of a firm's total variable and total fixed costs (TC = TFC +TVC)
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Short-Run Average Cost Curves
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Average Fixed Costs (AFC) = TFC / Q (output)
Average Variable Costs (AVC) = TVC / Q (output
Average Total Costs (ATC) = TC / Q (output) = AFC + AVC
Average Variable Costs (AVC) = TVC / Q (output
Average Total Costs (ATC) = TC / Q (output) = AFC + AVC
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Marginal Cost (MC)
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refers to the change in total costs due to a change in production of one unit; when the marginal product (MP) rises, the marginal cost (MC) falls, when MP falls, MC will rise
Marginal Cost (MC) = Change in TC / Change in Q
Marginal Cost (MC) = Change in TC / Change in Q
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Average Variable Costs and Marginal Costs
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when marginal cost is less than average variable costs, the AVC curve is falling; when marginal cost is greater than average variable costs, AVC is rising; marginal cost will equal average variable costs at its minimum point
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Average Total Costs and Marginal Costs
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when marginal cost is less than average total costs, the ATC curve is falling; when marginal cost is greater than average total cost, the ATC is rising; marginal cost will equal average total cost at its minimum point
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Minimum Cost Points
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the marginal cost curve intersects the minimum point of the average total cost curve and the minimum point of the average variable cost curve
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Long-Run Cost Curves
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in the long run, all factors of production are variable; long-run curves are sometimes called planning curves or the planning horizon
fixed costs are avoidable in the long-run
Long-Run Average Cost (LAC) Curve: a focus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices
fixed costs are avoidable in the long-run
Long-Run Average Cost (LAC) Curve: a focus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices
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Why the Long-Run Average Cost Curve is U-Shaped
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Economies of Scale (increasing returns to scale): an increase in the scale of production (plant size) leads to a fall in unit costs (avg. cost), LAC slopes downwards, if the firm doubles its inputs, outputs more than double
Constant Returns to Scale: an increase in the scale of production does not change per unit costs, the LAC is at the minimum point, if the firm doubles its inputs, output would double as well
Diseconomies of Scale (decreasing returns to scale): an increase in scale of production leads to an increase in unit costs, LAC slopes upwards, if a firm doubles its input, output would less than double
Constant Returns to Scale: an increase in the scale of production does not change per unit costs, the LAC is at the minimum point, if the firm doubles its inputs, output would double as well
Diseconomies of Scale (decreasing returns to scale): an increase in scale of production leads to an increase in unit costs, LAC slopes upwards, if a firm doubles its input, output would less than double
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Perfect Competition
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a market structure in which the decisions of buyers and sellers as individuals have no effect on the market price, each firm is so small that it cannot significantly affect the price of the product in question and is a price-taker
a) there are a large number of buyers and sellers (each firm is a price-taker)
b) identical or standardized product, the product sold by the firms in the industry is homogeneous (from the viewpoint of the consumer/buyer)
c) perfect information, both buyers and sells have equal access to all relevant information
d) freedom of entry and exit, any firm can enter or leave the industry without serious impediements
a) there are a large number of buyers and sellers (each firm is a price-taker)
b) identical or standardized product, the product sold by the firms in the industry is homogeneous (from the viewpoint of the consumer/buyer)
c) perfect information, both buyers and sells have equal access to all relevant information
d) freedom of entry and exit, any firm can enter or leave the industry without serious impediements
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Market Structure
answer
a firm produces and sells its product
markets are categorized by 1) the number of firms in the industry, 2) ease of entry and exit in the industry, 3) degree or product differentiation
markets are categorized by 1) the number of firms in the industry, 2) ease of entry and exit in the industry, 3) degree or product differentiation
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The Demand Curve of the Perfect Competitor
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the demand schedule for a perfectly competitive firm is thus perfectly elastic (horizontal) at the market-determined price
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Marginal Analysis
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used to determine the profit-maximizing rate of production is preferred to comparing total cost and revenue; profit maximization occurs at the rate of output at which marginal revenue equals marginal cost (and the marginal cost is rising)
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Short-Run Profits
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in the short-run, a perfectly competitive firm can make positive economic profits, incur economic losses, or break-even (make zero economic profits)
TR - TC
(P x ATC) x Q
TR - TC
(P x ATC) x Q
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The Short-Run Break-Even Price and the Short-Run Shutdown Price
answer
in the short-run, the firm WILL NOT shut down as long as the loss from staying in business is less than the loss from shutting down
the firm must compare the cost of producing (while incurring losses) with the cost of closing down
Ex. Should a firm shut down if its weekly revenue is $1,000, its variable cost (VC) is $500, and its fixed cost (FC) is $600? (Hint: Use TR - TC)
Staying in Business: $1,000 - $1,100 = -$100
Shutdown: $0 - $600 = -$600
Verdict: STAY
the firm must compare the cost of producing (while incurring losses) with the cost of closing down
Ex. Should a firm shut down if its weekly revenue is $1,000, its variable cost (VC) is $500, and its fixed cost (FC) is $600? (Hint: Use TR - TC)
Staying in Business: $1,000 - $1,100 = -$100
Shutdown: $0 - $600 = -$600
Verdict: STAY
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Long-Run Equilibrium
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in the long-run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal
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Competitive Pricing
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a system of pricing in which the price charged for the last unit produced is qual to the opportunity cost to society of producing one more unit of the good as measured by marginal cost
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Market Failure
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a situation in which an unrestrained market operation leads to either too few or too many resources going a specific economic activity
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Monopoly
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the only supplier of a good for which there is no substitute, a monopoly can set its price (not a price-taker), maximizes profits by setting marginal revenue equal to marginal cost
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Monopoly Barriers to Entry
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monopoly power is only sustainable in the long-run if there are barriers to entry in the industry, barriers to entry could be legally imposed or some aspects of the industry's technical or cost structure may prevent entry
a) Ownership of Resources without Close Substitutes: exclusive ownership of the entire supply of the industry and essential input
b) Economies of Scale: exist when per unit costs drop as the scale of production (the size of the firm) increases, a natural monopoly is the first firm to take advantage of the persistent drop in per unit cost; examples include electrical utility companies
c) Legal or Governmental Restrictions: licenses, franchises, and certificates of convenience (authorities can prevent entry into an industry by not issuing the required permit or license, ex. cable television / radio broadcasting, natural gas transmission), patents (issued by the government to protect an invention from being copied or stolen, the patent holder has a monopoly over her invention, ex. brand name pharmaceutical products), tariffs (taxes imposed on specific imported goods, tariffs may give monopoly power to the domestic producer), and regulations (costly regulations can prevent entry into an industry and effectively give monopoly power to an existing large firm
a) Ownership of Resources without Close Substitutes: exclusive ownership of the entire supply of the industry and essential input
b) Economies of Scale: exist when per unit costs drop as the scale of production (the size of the firm) increases, a natural monopoly is the first firm to take advantage of the persistent drop in per unit cost; examples include electrical utility companies
c) Legal or Governmental Restrictions: licenses, franchises, and certificates of convenience (authorities can prevent entry into an industry by not issuing the required permit or license, ex. cable television / radio broadcasting, natural gas transmission), patents (issued by the government to protect an invention from being copied or stolen, the patent holder has a monopoly over her invention, ex. brand name pharmaceutical products), tariffs (taxes imposed on specific imported goods, tariffs may give monopoly power to the domestic producer), and regulations (costly regulations can prevent entry into an industry and effectively give monopoly power to an existing large firm
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Perfect Competition v. Monopoly
answer
MR for Perfect Competition: MR = Price
MR for Monopolist: MR is less than Price; MR = (P12-P1)Q +P2
MR for Monopolist: MR is less than Price; MR = (P12-P1)Q +P2
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Price Discrimination
answer
selling a given product at more than one price, with the price difference being unrelated to differences in marginal cost
Necessary Conditions: a0 the firm must face a downward-sloping demand curve (this implies price-setting ability, unlike perfect competition), the firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand, and the firm must be able to prevent the resale of the product or service
Necessary Conditions: a0 the firm must face a downward-sloping demand curve (this implies price-setting ability, unlike perfect competition), the firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand, and the firm must be able to prevent the resale of the product or service
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The Social Cost of Monopolies
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the monopolist will charge a higher price and produce a lower output than will a perfectly competitive industry, assuming the same cost structure
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Monopolistic Competition
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a market structure where a large number of firms produce similar (CLOSE SUBSTITUTES) but not identical products (DIFFERENTIATED PRODUCTS); examples include plumbers in a small town
firms make quantity and pricing decisions independent of their rivals (firms ignore the decisions of rivals), no substantial barriers to entry (freedom of entry and exit), the firm is a price-setter (downward sloping demand curve)
in monopolistic competition, there is a large number of firms but not as many as in perfect competition
Independence: each one acts independently of the others; no firm attempts to take into account all of its rival firms
Product Differentiation: the distinguishing of products by brand name, color, minor attributes, and the like
Easy of Entry: monopolistically competitive markets do not have barriers to entry, so firms enter the market until no new firm can enter profitably
Price and Marginal Cost: monopolistically competitive firms face downward-sloping residual demand curves, so they charge prices above marginal cost
firms make quantity and pricing decisions independent of their rivals (firms ignore the decisions of rivals), no substantial barriers to entry (freedom of entry and exit), the firm is a price-setter (downward sloping demand curve)
in monopolistic competition, there is a large number of firms but not as many as in perfect competition
Independence: each one acts independently of the others; no firm attempts to take into account all of its rival firms
Product Differentiation: the distinguishing of products by brand name, color, minor attributes, and the like
Easy of Entry: monopolistically competitive markets do not have barriers to entry, so firms enter the market until no new firm can enter profitably
Price and Marginal Cost: monopolistically competitive firms face downward-sloping residual demand curves, so they charge prices above marginal cost
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The Long-Run Equilibrium of Monopolistic Competition
answer
in the long-run, price is equal to average cost, this another way of saying that firms will earn zero economic profits
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Oligopoly
answer
a market structure with a small number of firms in a market with substantial barriers to entry, an oligopoly market structure can exist for either a homogeneous or a differentiated product
Characteristics of Oligopolies:
a) small number of firms
b) interdependence: in decision-making, each firm takes into account the price and quantity decision of tis rivals, firms must try to predict the actions of rivals
Characteristics of Oligopolies:
a) small number of firms
b) interdependence: in decision-making, each firm takes into account the price and quantity decision of tis rivals, firms must try to predict the actions of rivals
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Why Oligopoly Occurs
answer
Economies of Scale: large-scale production (larger firms) is associated with lower per unit costs, this is especially true where the market size is not sufficient to efficiently support more than a few
Barriers to Entry: these could be legal barrier or ownership of key resources
Oligopoly to Merge: the joining of two or more firms; vertical merger is a firm joining with another firm that supplies its input (ex. GM buys Bridgestone (a tire company)); horizontal merger is a firm joining with another firm that produces and sells a similar product (ex. GM buys Hyundai); only horizontal mergers can form an oligopoly
Barriers to Entry: these could be legal barrier or ownership of key resources
Oligopoly to Merge: the joining of two or more firms; vertical merger is a firm joining with another firm that supplies its input (ex. GM buys Bridgestone (a tire company)); horizontal merger is a firm joining with another firm that produces and sells a similar product (ex. GM buys Hyundai); only horizontal mergers can form an oligopoly
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Concentration Ratio
answer
the percentage of all sales contributed by the leading four or leading eight firms in an industry: sometimes called the industry concentration ratio
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Herfindahl-Hirshman Index
answer
the sum of the squared percentage sales shares of all firms in an industry
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