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Chapter 9

Economics 1021A/B Chapter Notes - Chapter 9: Oligopoly

Course Code
ECON 1021A/B
Terry Biggs

of 4
Economics 1021A Chapter 10 2013-11-03
A firm is an institution that hires factors of production and organizes them to produce and sell goods and
A firm’s goal is to maximize profit.
Profit equals total revenue minus total cost.
If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm that seeks to
maximize profit.
Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show its
investors how their funds are being used.
Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these
decisions is to maximize economic profit.
Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity
cost of production.
A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm
uses in production.
A firm’s opportunity cost of production is the sum of the cost of using resources:
Bought in the market
The amount spent by a firm on resources bought in the market is an opportunity cost of production because
the firm could have bought different resources to produce some other good or service.
Owned by the firm
If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost, because it
could have sold the capital and rented capital from another firm.
The firm implicitly rents the capital from itself.
The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital.
The implicit rental rate of capital is made up of
Economic depreciation
Economic depreciation is the change in the market value of capital over a given period.
Interest forgone
Interest forgone is the return on the funds used to acquire the capital.
Supplied by the firm's owner
The owner might supply both entrepreneurship and labour.
The profit that an entrepreneur can expect to receive on average is called normal profit.
Normal profit is the cost of entrepreneurship and is an opportunity cost of production.
In addition to supplying entrepreneurship, the owner might supply labour but not take a wage.
The opportunity cost of the owner’s labour is the wage income forgone by not taking the best alternative
Economic profit equals a firm’s total revenue minus its total opportunity cost of production.
To maximize profit, a firm must make five basic decisions:
What to produce and in what quantities
How to produce
How to organize and compensate its managers and workers
How to market and price its products
What to produce itself and what to buy from other firms
The firm’s profit is limited by three features of the environment:
Technology constraints
Technology is any method of producing a good or service.
Using the available technology, the firm can produce more only if it hires more resources, which will
increase its costs and limit the profit of additional output.
Information constraints
A firm never possesses complete information about either the present or the future.
It is constrained by limited information about the quality and effort of its workforce, current and future buying
plans of its customers, and the plans of its competitors.
The cost of coping with limited information limits profit.
Market constraints
What a firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by
the prices and marketing efforts of other firms.
The resources that a firm can buy and the prices it must pay for them are limited by the willingness of
people to work for and invest in the firm.
The expenditures that a firm incurs to overcome these market constraints limit the profit that the firm can
Technological efficiency occurs when a firm uses the least amount inputs to produce a given
quantity of output
Different combinations of inputs might be used to produce a given good, but only one of them is
technologically efficient.
If it is impossible to produce a given good by decreasing any one input, holding all other inputs constant,
then production is technologically efficient.
A technologically efficient process may not be economically efficient.
Economic efficiency occurs when the firm produces a given quantity of output at the least cost
The economically efficient method depends on the relative costs of capital and labour.
The difference between technological and economic efficiency is that technological efficiency concerns the
quantity of inputs used in production for a given quantity of output, whereas economic efficiency concerns
the cost of the inputs used.
A firm that is not economically efficient does not maximize profit.
An economically efficient production process also is technologically efficient.
Changes in the input prices influence the value of the inputs, but not the technological process for using
them in production.
Economists identify four market types:
Perfect competition
Many firms and many buyers
All firms sell an identical product
No restrictions on entry of new firms to the industry
Both firms and buyers are all well informed about the prices and products of all firms in the industry.
Examples include world markets in rice, wheat, corn and other grain crops.
Monopolistic competition
Many firms
Each firm produces similar but slightly different products—called product differentiation
Each firm possesses an element of market power
No restrictions on entry of new firms to the industry
Examples include the markets for athletic shoes, pizza and cell phones.
A small number of firms compete.
The firms might produce almost identical products or differentiated products.
Barriers to entry limit entry into the market.
Examples include the markets for motor vehicles, breakfast cereals, cigarettes and gasoline.