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James Pesando

ECO 100 Term Test 2 Study Notes 13. The Costs of Production Goal of firms is to maximize profit (= total revenue – total cost) When analyzing a firm’s behaviour, important to include all the opportunity costs of production. Some (e.g. wages) are explicit; others (e.g. wages firm owner gives up by working in firm rather than another job) are implicit Firm’s costs reflect its production process. Production function typically becomes flatter as the quantity of an input increases (diminishing marginal product), ∴firm’s total-cost curve becomes steeper as quantity produced rises Firm’s total cost can be divided between fixed & variable costs. From a firm’s total cost, 2 related measures of cost are derived: ATC is TC÷Q and MC=TC risif output increases by 1 unit Often useful to graph ATC & MC. Typically, MC rises with Q(output) & ATC first falls as output increases & then rises as output increases further. MC curve always crosses ATC curve at min of ATC Firm’s costs often depend on time horizon – many costs fixed in short run but variable in long run (∴ATC may rise more in short than long run when Q) Accounting profit – TR – TC[explicit] Constant returns to scale – property whereby long-run ATC stays same as Q(output) changes Diseconomies of scale – property whereby long-run ATC rises as Q(output) increases Economic profit – TR – TC (including both implicit & explicit costs) Economies of scale – the property whereby long-run ATC falls as Q(output) increases Efficient scale – the quantity of output that minimizes average total cost Explicit costs – input costs that require an outlay of money by the firm Implicit costs – input costs that do not require an outlay of money by the firm ° Whenever MC < ATC, ATC is falling. Whenever MC > ATC, ATC is rising. ° MC curve crosses the ATC curve at its minimum. 14. Firms in Competitive Markets Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. Price of good = both firms average revenue & marginal revenue. To maximize profit, firm chooses Q of output such that MR = MC. Because MR for a competitive firm = Pm , firm chooses Q so that P = MC. ∴firm’s MC curve is its supply curve In short run when firm cannot recover its FC, firm will choose to shut down temporarily if P of good < AVC. In long run when firm can recover both FC & VC, will choose to exit if P < ATC In market with free entry & exit, profits are driven to 0 in long run. In LReq, all firms produce @efficient scale, P = min of ATC, & # of firms adjusts to satisfy Q demanded @ this P Changes in demand have different effects over different time horizons. In short run, increase in D raises P & leads to profits, & decrease in D lowers P & leads to losses. But if firms can freely enter & exit market, in long run # of firms adjusts to drive the market back to 0-profit eq. ° Competitive market: 1. Many buyers & sellers in the market 2. Goods offered by various sellers are largely the same 3. Perfect knowledge of prices & technology 4. Firms can freely enter or exit the market in the LR ° For all firms, average revenue = P of good ° For competitive firms, MR = P of good ° At the profit-maximizing level of output, MR & MC are exactly = ° Because firm’s MC curve determines the Q of good firm is willing to supply @any price, it is the competitive firm’s supply curve ° The firm shuts down if the revenue that it would get from producing < variable costs of production ° Shut down if: TR < VC P < AVC ° The firm exits the market if the revenue it would get from producing < total costs ° Exit if: TR < TC P < ATC ° Enter if: P > ATC ° Profit = (P – ATC) X Q ° @ end of process of entry/exit, firms that remain in market must be making zero economic profit ° Process of entry & exit ends only when P & ATC are driven to equality ° LReq of a competitive market with free entry & exit must have firms operating @ efficient scale ° Because firms can enter & exit more easily in the LR than in SR, LR supply curve is typically more elastic than the SR supply curve 15. Monopoly ° A monopoly is a firm that is sole seller in its market. Arises when a single firm owns a key resource, when gov’t gives a firm exclusive right to produce a good or when single firm can supply the entire market @ smaller cost than many firms could ° Because monopoly is sole producer in its market, faces a downward-sloping demand curve. When monopoly increases production by 1 unit, causes price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, monopoly’s MR is always below price of its good. ° Like a competitive firm, monopoly firm maximizes profit by producing Q @ which MR = MC. Monopoly then chooses P @ which that Q is demanded. Unlike a competitive firm, monopoly firm’s P > MR, so P > MC ° Monopolist’s profit-maximizing level of output is below level that maximizes the sum of consumer & producer surplus. That is, when monopoly charges a P > MC, some consumers who value the good more than its cost of production don’t buy it. As a result, monopoly causes deadweight losses ° Policymakers can respond to inefficiency of monopoly by: 1) Use antitrust laws to try to make industry more competitive 2) Regulate prices that monopoly charges 3) Turn monopolist into a gov’t-run enterprise 4) If market failure is deemed small compared to inevitable imperfections of policies, do nothing ° Monopolists often can raise profits by charging diff. P for same good based on buyer’s willingness to pay. Practice of price discrimination can raise economic welfare by getting good to some consumers who otherwise would not buy. [In extreme case of perfect P discrimination, deadweight losses of monopoly are eliminated.] More generally, imperfect P discrim. can either raise or lower welfare compared to the outcome with a single monopoly price Price discrimination – the business practice of selling the same good @different P to different customers ° Fundamental cause of monopoly is barriers to entry; sources: 1. A key resource is owned by a single firm 2. The gov’t gives a single firm the exclusive right to produce some good or service 3. Costs of production make a single producer more efficient than a large # of producers [natural monopoly] ° A monopolist’s marginal revenue is always less than the price of its good ° When a monopoly increases the Q it sells, has 2 effects on TR (P X Q): 1. The output effect: more output is sold, so Q is higher 2. The price effect: price falls, so P is lower ° The monopolist’s profit-maximizing quantity of output is determined by the intersection of the MR curve & the MC curve ° In competitive markets, P = MC. In monopolized markets, P > MC ~ For a competitive firm: P = MR = MC ~ For a monopoly firm: P > MR = MC ° The socially efficient Q is found where the demand curve & MC curve intersect ° Monopolist produces less than socially efficient Q of output 16. Oligopoly Oligopolists maximize their total profits by forming a cartel & acting like a monopolist. Yet if make decisions about production levels individually, result is a greater Q & lower P than under monopoly outcome. The larger the # of firms in olig
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