Final Exam Review (Chapter 13 –21)
Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
Costs: Explicit vs. Implicit
Explicit costs require an outlay of money,
e.g., paying wages to workers.
Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
This is true whether the costs are implicit or explicit. Both matter for
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
Case 1: borrow $100,000
• explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings,
borrow the other $60,000
• explicit cost = $3000 (5%) interest on the loan
• implicit cost = $2000 (5%) foregone interest you could have
earned on your $40,000.
Economic Profit vs. Accounting Profit
= total revenue minus total explicit costs
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Costs in the Short Run & Long Run
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones). In the long run, ATC at any Q is cost per unit using the most efficient
mix of inputs for that Q (e.g., the factory size with the lowest ATC).
How ATC Changes as the Scale of Production Changes
Economies of scale occur when increasing production allows greater
workers more efficient when focusing on a narrow task.
• More common when Q is low.
Diseconomies of scale are due to coordination problems in large
E.g., management becomes stretched, can’t control costs.
• More common when Q is high.
Implicit costs do not involve a cash outlay,
yet are just as important as explicit costs
to firms’ decisions.
Accounting profit is revenue minus explicit costs. Economic profit is
revenue minus total (explicit + implicit) costs.
The production function shows the relationship between output and
The marginal product of labour is the increase in output from a one-
unit increase in labour, holding other inputs constant. The marginal
products of other inputs are defined similarly.
Marginal product usually diminishes as the input increases. Thus, as
output rises, the production function becomes flatter, and the total
cost curve becomes steeper.
Variable costs vary with output; fixed costs do not.
Marginal cost is the increase in total cost from an extra unit of
production. The MC curve is usually upward-sloping.
Average variable cost is variable cost divided by output.
Average fixed cost is fixed cost divided by output. AFC always falls as
Average total cost (sometimes called “cost per unit”) is total cost
divided by the quantity of output. The ATC curve is usually U-shaped.
The MC curve intersects the ATC curve
at minimum average total cost.
When MC < ATC, ATC falls as Q rises.
When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable.
Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC
rises as Q rises. Constant returns to scale: ATC remains constant as Q
Chapter 14 Characteristics of Perfect Competition
1. Many buyers and many sellers.
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
The Revenue of a Competitive Firm
Total revenue (TR)
Average revenue (AR)
Marginal revenue (MR):
The change in TR from
selling one more unit.
MR = P for a Competitive Firm
A competitive firm can keep increasing its output without affecting the
So, each one-unit increase in Q causes revenue to rise by P, i.e., MR =
What Q maximizes the firm’s profit?
To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.
Shutdown vs. Exit
A short-run decision not to produce anything because of market
A long-run decision to leave the market.
A key difference:
If shut down in SR, must still pay FC.
If exit in LR, zero costs.
A Firm’s Short-run Decision to Shut Down
Cost of shutting down: revenue loss = TR
Benefit of shutting down: cost savings = VC
(firm must still pay FC)
So, shut down if TR < VC
Divide both sides by Q: TR/Q < VC/Q
So, firm’s decision rule is: The Irrelevance of Sunk Costs
Sunk cost: a cost that has already been committed and cannot be
Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed costs whether it
produces or shuts down.
So, FC should not matter in the decision to shut down.
A Firm’s Long-Run Decision to Exit
Cost of exiting the market: revenue loss = TR
Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC
Divide both sides by Q to write the firm’s decision rule as:
Market Supply: Assumptions
1) All existing firms and potential entrants have identical costs.
2) Each firm’s costs do not change as other firms enter or exit the
3) The number of firms in the market is
fixed in the short run
(due to fixed costs)
variable in the long run
(due to free entry and exit)
Entry & Exit in the Long Run
In the LR, the number of firms can change due to entry & exit.
If existing firms earn positive economic profit,
• new firms enter, SR market supply shifts right.
• P falls, reducing profits and slowing entry.
If existing firms incur losses,
• some firms exit, SR market supply shifts left.
• P rises, reducing remaining firms’ losses.
The Zero-Profit Condition
The process of entry or exit is complete –
remaining firms earn zero economic profit.
Zero economic profit occurs when P = ATC.
Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum ATC.
Hence, in the long run, P = minimum ATC. Why Do Firms Stay in Business if Profit = 0?
Recall, economic profit is revenue minus all costs – including implicit
costs, like the opportunity cost of the owner’s time and money.
In the zero-profit equilibrium,
• firms earn enough revenue to cover these costs
• accounting profit is positive
For a firm in a perfectly competitive market,
price = marginal revenue = average revenue.
If P > AVC, a firm maximizes profit by producing the quantity where
MR = MC. If P < AVC, a firm will shut down in the short run.
If P < ATC, a firm will exit in the long run.
In the short run, entry is not possible, and an increase in demand
increases firms’ profits.
With free entry and exit, profits = 0 in the long run, and P = minimum
A monopoly is a firm that is the sole seller of a product without close
In this chapter, we study monopoly and contrast it with perfect
The key difference:
A monopoly firm has market power, the ability to influence the
market price of the product it sells. A competitive firm has no market
Why Monopolies Arise
The main cause of monopolies is barriers to entry – other firms cannot
enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
2. The govt gives a single firm the exclusive right to produce the good.
E.g., patents, copyright laws
Monopoly vs. Competition: Demand Curves
In a competitive market, the market demand curve slopes downward.
But the demand curve for any individual firm’s product is horizontal at the
market price. The firm can increase Q without lowering P,
so MR = P for the competitive firm.
Understanding the Monopolist’s MR
Increasing Q has two effects on revenue:
Output effect: higher output raises revenue
Price effect: lower price reduces revenue
To sell a larger Q, the monopolist must reduce the price on all the units
Hence, MR < P
MR could even be negative if the price effect exceeds the output effect
(e.g., when Common Grounds increases Q from 5 to 6).
Like a competitive firm, a monopolist maximizes profit by producing
the quantity where MR = MC.
Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to pay for that quantity.
It finds this price from the D curve.
Discrimination: treating people differently based on some
characteristic, e.g. age or gender.
Price discrimination: selling the same good
at different prices to different buyers.
The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher price to buyers
with higher WTP.
Price Discrimination in the Real World
In the real world, perfect price discrimination is not possible:
• No firm knows every buyer’s WTP
• Buyers do not announce it to sellers
So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.
Examples of Price Discrimination
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Discounts for Saturday-night stayovers help distinguish business travelers,
who usually have higher WTP, from more price-sensitive leisure travelers. Public Policy Toward Monopolies
Increasing competition with antitrust laws
• Ban some anticompetitive practices,
allow govt to break up monopolies.
• Govt agencies set the monopolist’s price.
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist or set P = ATC
for zero economic profit.
A monopoly firm is the sole seller in its market. Monopolies arise due
to barriers to entry, including: government-granted monopolies, the
control of a key resource, or economies of scale over the entire range
A monopoly firm faces a downward-sloping demand curve for its
product. As a result, it must reduce price to sell a larger quantity,
which causes marginal revenue to fall below price.
Monopoly firms maximize profits by producing the quantity where
marginal revenue equals marginal cost. But since marginal revenue is
less than price, the monopoly price will be greater than marginal cost,
leading to a deadweight loss.
Monopoly firms (and others with market power)
try to raise their profits by charging higher prices
to consumers with higher willingness to pay.
This practice is called price discrimination.
Between Monopoly and Competition
Perfect competition: many firms, identical products
Monopoly: one firm
In between these extremes: imperfect competition
Oligopoly: only a few sellers offer similar or identical products.
Monopolistic competition: many firms sell similar but not
Characteristics & Examples of Monopolistic Competition
Free entry and exit
Monopolistic Competition and Monopoly
Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
• If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
• If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.
A Monopolistic Competitor in the Long Run
Entry and exit occurs until
P = ATC and profit = zero.
Notice that the firm charges a markup of price over marginal cost and does
not produce at minimum ATC.
Why Monopolistic Competition Is Less Efficient than Perfect Competition
1. Excess capacity
The monopolistic competitor operates on the downward-sloping
part of its ATC curve,
produces less than the cost-minimizing output.
Under perfect competition, firms produce the quantity that
2. Markup over marginal cost
Under monopolistic competition, P > MC.
Under perfect competition, P = MC.
Monopolistic Competition and Welfare
Monopolistically competitive markets do not
have all the desirable welfare properties of perfectly competitive
Because P > MC, the market quantity is below
the socially efficient quantity.
Yet, not easy for policymakers to fix this problem: Firms earn zero
profits, so cannot require them
to reduce prices.
Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts on advertising may signal the
quality of its product to consumers, regardless of the content of ads. Ads may convince buyers to try a product once,