Econ Midterm 2

Front 1

Explicit costs:

Back 1

Input costs that require an outlay of money by the firm

Front 2

Implicit costs:

Back 2

Input costs that do not require an outlay of money by the firm.

Front 3

An economist measures a firm’s economic profit as

Back 3

the firm’s total revenue minus all the opportunity costs (explicit and implicit) of producing the goods and services sold.

Front 4

An accountant measures the firm’s accounting profit

Back 4

as the firm’s total revenue minus only the firm’s explicit costs

Front 5

Accountants consider what costs?

Back 5

Accountants only consider explicit cost

Front 6

economists consider what costs?

Back 6

economist consider both explicit AND implicit cost

Front 7

Variable cost:

Back 7

Costs that do vary with the quantity of output produced.

Front 8

Fixed cost:

Back 8

Costs that do not vary with the quantity of output produced.

Front 9

A firm’s total cost is

Back 9

the sum of fixed and variable costs

TC = TFC + TVC

Front 10

Average total cost (ATC):

Back 10

Total cost divided by the quantity of output.

ATC = TC/Q

Front 11

Marginal cost (MC):

Back 11

The increase in total cost that arises from an extra unit of production.

MC = Change in TC / change in quantity

Front 12

Total Cost

Back 12

TC=TFC+TVC e.g., producing coffee include rent (TFC) and also raw material, salary etc. (TVC)

Front 13

Average fixed cost

Back 13

AFC=TFC/Q

 Average fixed cost is fixed cost distributed into each unit, shared by each unit

Front 14

Average variable cost

Back 14

AVC=TVC/Q

Average variable cost is variable cost per unit

Front 15

Average total cost

Back 15

ATC= TC/Q=AVC+AFC

Total cost is equal to total cost per unit, which can also be broken down into the fixed cost per unit plus the variable cost per unit

Front 16

Marginal cost

Back 16

MC = change in TC / change in Q

Cost change per incremental unit

Front 17

Cost curves and their shapes:

Rising Marginal Cost

Back 17

marginal cost rises with the quantity of output produced.

This reflects the property of diminishing marginal product.

Front 18

Cost curves and their shapes:

U-Shaped Average Total Cost

Back 18

 To understand why this is so, remember that average total cost is thesum of average fixed cost and average variable cost.

 Average fixed cost always declines as output rises because the fixedcost is spread over a larger number of units.

 Average variable cost typically rises as output increases because ofdiminishing marginal product.

Front 19

The Relationship between Marginal Cost and AverageTotal Cost

Back 19

 Whenever marginal cost is less than average total cost, average total cost is falling.

 Whenever marginal cost is greater than average total cost, average total cost is rising.

Front 20

Typical Cost curves

Back 20

the threeproperties that are most important to remember:

1. Marginal cost eventually rises with the quantityof output.

2. The average-total-cost curve is U-shaped.

3. The marginal-cost curve crosses theaverage-total-cost curve at the minimumof average total cost.

Front 21

THE RELATIONSHIP BETWEEN SHORT-RUNAND LONG-RUN AVERAGE TOTAL COST

Back 21

For many firms, the division of total costs betweenfixed and variable costs depends on the time horizon.

Because many decisions are fixed in the short run butvariable in the long run

Front 22

profit maximization: total revenue

Back 22

total revenue = price x quantity

Front 23

Total revenue (TR):

Back 23

The amount a firm receives for the sale of its output.

Front 24

Total cost: (TC)

Back 24

The market value of the inputs a firm uses in production.

Front 25

Profit

Back 25

Total revenue minus total cost.

PROFIT= TR-TC

Front 26

Average Revenue

Back 26

Average revenue tells us how much revenue a firm receives for the typical unit sold.

Average revenue (AR): Total revenue divided by the quantity sold.

AR = (P x Q) / Q = P

Front 27

Marginal revenue (MR):

Back 27

The change in total revenue from an additional unit sold.

MR = (change in TR) / (change in quantity)

Front 28

Company’s profit maximizing rule

Back 28

is producing where MR=RC

Front 29

if MR > MC

Back 29

then increase in production

Front 30

if MR < MC

Back 30

then decrease in production

Front 31

MR = MC

Back 31

firm is maximizing profits

Front 32

Short run vs. long run

Back 32

Short Run

Only some inputs (e.g. raw material) can be adjusted

Not enough time to adjust all inputs (such as capital)

Long Run

long enough time to adjust all inputs (capital as well as labor and raw material )

Front 33

Shutdown

Back 33

A shutdown refers to a short-run decision not toproduce anything during a specific period of timebecause of current market conditions

Front 34

Exit

Back 34

An exit refers to a long-run decision to leave themarket

Front 35

The short-run and long-run decisions differ because

Back 35

most firms cannot avoid their fixed costs in the short run but can do so in the long run.

Front 36

What determines a firm’s shutdown decision?

Back 36

If the firm shuts down, it loses all revenue from the saleof its product

At the same time, it saves the variable costs of makingits product (but must still pay the fixed costs).

Thus, the firm shuts down if the revenue that it wouldearn from producing is less than its variable costs ofproduction

Front 37

Sunk cost:

Back 37

A cost that has already been committed and cannot be recovered. Because nothing can be done about sunk costs, they can be ignored when making decisions about various aspects of life, including business strategy

Front 38

when is a short-run decision to shut down made?

Back 38

shut down if TR < VC

shut down if TR/Q < VC/Q

shut down if P < AVC

Front 39

when does a firm exit a market in the long-run?

Back 39

If the firm exits, it again will lose allrevenue from the sale of its product, butnow it saves on both fixed and variablecosts of production.

The firm exits the market if the revenue itwould get from producing is less than itstotal costs.

Exit if TR < TC

exit if P < ATC

exit if TR/Q < TC/Q

Front 40

Market structure – identifies how a market is made up interms of:

Back 40

The number of firms in the industry

The nature of the product produced

The degree of monopoly power each firm has

The degree to which the firm can influence price

Profit levels

Firms’ behaviour – pricing strategies, non-price competition, output levels

The extent of barriers to entry

The impact on efficiency

Front 41

PERFECT COMPETITIVE MARKET CHARACTERISTICS

Back 41

One extreme of the market structure spectrum

 Characteristics:

 Large number of firms

 Products are homogenous (identical) – consumer has noreason to express a preference for any firm

 Freedom of entry and exit into and out of the industry

 Firms are price takers – have no control over the pricethey charge for their product

 Each producer supplies a very small proportion of totalindustry output

 Consumers and producers have perfect knowledgeabout the market

Front 42

PROFIT IN THE PERFECT COMPETITIVE MARKET

THE LONG RUN: MARKET SUPPLYWITH ENTRY AND EXIT

Back 42

If firms already in the market are profitable, thennew firms will have an incentive to enter the market.

This entry will expand the number of firms, increasethe quantity of the good supplied, and drive downprices and profits. (Vice versa.)

At the end of this process of entry and exit, firmsthat remain in the market must be making zeroeconomic profit.

Front 43

The long-run equilibrium of a competitive marketwith free entry and exit must have

Back 43

firms operating at their efficient scale

Front 44

Why Do Competitive Firms Stay in Business If TheyMake Zero Profit?

Back 44

In the zero-profit equilibrium, economic profit is zero, but accounting profit is positive.

Front 45

monopoly

Back 45

Pure monopoly – where only one producer exists in theindustry

 In reality, rarely exists – always some form of substitute available!

 Monopoly exists, therefore, where one firm dominates themarket

 In practice: Firms may be investigated for examples ofmonopoly power when market share exceeds 25%

Front 46

Monopoly power

Back 46

refers to cases where firms influence the market in some way through their behaviour – determined by the degree of concentration in the industry

Front 47

Summary of characteristics of firms exercisingmonopoly power:

Back 47

Price – could be deemed too high, may be set to destroy competition, price discrimination possible. Monopolist has the power of deciding price.

Substitutes- A monopoly sells a good that has no close substitutes.

Barriers to entry- A constraint that protects a firm from potential competitors. In Monopoly market, there are usually high barriers to entry.

Front 48

The fundamental cause of a monopoly is barriers toentry, which have three main sources:

Back 48

1. Monopoly resources: A key resource is owned by a single firm.

2. Government-created monopolies: The government gives a single firm the exclusive right to produce some good or service.

3. Natural monopolies: A single firm can produce output at a lower cost than can a large number of producers.

Front 49

Monopoly resource

Back 49

The simplest way for a monopoly to arise is for asingle firm to own a key resource.

Although exclusive ownership of a key resource is apotential cause of monopoly, in practice,monopolies rarely arise for this reason.

Front 50

government created monopolies

Back 50

In many cases, monopolies arise because thegovernment has given one person or firm theexclusive right to sell some good or service.

Patent and copyright laws are two importantexamples of how the government creates amonopoly to serve the public interest.

The benefit of the patent and copyright lawsis the increased incentive for creative activity.

The cost of the patent and copyright laws ismonopoly pricing.

Front 51

natural monopoly

Back 51

A natural monopoly arises because a single firmcan supply a good or service to an entire market ata smaller cost than could two or more firms.

A natural monopoly arises when there areeconomies of scale over the relevant range ofoutput.

Front 52

The key difference between a competitive firmand a monopoly is

Back 52

the monopoly’s ability to influence the price of its output.

Front 53

HOW MONOPOLIES MAKEPRODUCTION AND PRICING DECISIONS

Back 53

The monopolist’s goal is to maximize profit.

Remember the profit maximization rule for firms is to producewhere: MR=MC

Marginal revenue for monopolies is very different frommarginal revenue for competitive firms.

When a monopoly increases the amount it sells, it has twoeffects on total revenue:

1. The output effect: More output is sold, so Q is higher,which tends to increase total revenue.

2. The price effect: The price falls, so P is lower,which tends to decrease total revenue.

Front 54

A monopolist’smarginalrevenue

Back 54

is always less than the price of its good.

Front 55

profit maximization for a monopoly:

the intersection of the marginal revenue curve and the marginal cost curve determines the...

Back 55

profit maximizing quantity

and then the demand curve shows the price consistent with this quantity

Front 56

The monopolist’s profit-maximizing quantity of output isdetermined by

Back 56

the intersection of the marginalrevenue curve and the marginal-cost curve.

competitive firms: P = MR =MC

monopolist: P > MR =MC

Front 57

How does the monopoly find the profit-maximizingprice for its product?

Back 57

1. It chooses the quantity of output that equates MR and MC.

2. It uses the demand curve to find the highest price it can charge for that quantity.

Front 58

Question: Is monopoly a good way to organize a market?

Back 58

The Inefficiency of Monopoly

 The welfare effects of a monopoly are measured by comparing the level of output that the monopolist chooses with the level of output of a Perfect Competitive market as perfect competitive market is efficient

Front 59

THE MONOPOLY’S PROFIT: A SOCIAL COST?

Back 59

The problem in a monopolized market arises becausethe firm produces and sells a quantity of output belowthe level that maximizes total surplus.

The deadweight loss measures how much theeconomic pie shrinks as a result.

This inefficiency is connected to the monopoly’s highprice:

Consumers buy fewer units when the firm raisesits price above marginal cost.

Front 60

Trade-Offs from Patents

Back 60

It is sensible for a government to grant a patent for a product that would otherwise not be developed, but it is not sensible for other products.

Unfortunately, no one knows in advance whether a particular product would be developed without a patent, so the government can’t be selective in granting patents.

In some cases, patents lead to new products, while in other cases they merely prolong monopoly power.

Front 61

Monopolistic competition

Back 61

: A market structure in which many firms sell products that are similar but not identical.

Front 62

Monopolistic competition has the following attributes:

Back 62

1. Many sellers: There are many firms competing for the same group of customers.

2. Product differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downwardsloping demand curve.

3. Free entry and exit: Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero.

4. Imperfect information: Consumer and producer knowledge imperfect

Front 63

monopolistic competition examples?

Back 63

 Restaurants

 Private schools

 Insurance brokers

 Health clubs

 Hairdressers

 Funeral directors

 Estate agents

Front 64

LONG-RUN EQUILIBRIUM OF MONOPOLISTICCOMPETITION

Back 64

In the short run, firms can make profits or loss.

In the long run, as there is free entry and exit, the processof entry and exit continues until the firms in the market aremaking exactly zero economic profit.

Front 65

The monopolistically competitive firm follows what rule for profit maximization

Back 65

The monopolistically competitive firm follows amonopolist’s rule for profitmaximization:

It chooses the quantityat which marginalrevenue equalsmarginal cost andthen usesits demand curve tofind the priceconsistentwith that quantity.

Front 66

Two characteristics describe the long-run equilibrium in amonopolistically competitive market:

Back 66

1. As in a monopoly market, price exceeds MC. 2. As in a competitive market, price equals ATC

Front 67

oligopoly

Back 67

Oligopoly: A market structure in which only a few sellersoffer similar or identical products. Oligopoly in reality

May be a large number of firms in the industry but theindustry is dominated by a small number of very largeproducers

Front 68

oligopoly - concentration ratio

Back 68

Concentration Ratio – the proportion of total marketsales (share) held by the top 3,4,5, etc firms:

A 4 firm concentration ratio of 75% means the top 4firms account for 75% of all the sales in the industry

Front 69

Features of an oligopolistic market structure:

Back 69

Potential for collusion

Behaviour of firms affected by what they believe their rivals might do – interdependence of firms

Goods could be homogenous or highly differentiated

Relatively high barriers to entry

Front 70

The essence of an oligopolistic market is

Back 70

that there are only a few dominant sellers.

As a result, the actions of any one seller in the market can have a large impact on the profits of all the other sellers.

tension between cooperation and self-interest

Front 71

duopoly

Back 71

Duopoly is the simplest type of oligopoly, an oligopoly with onlytwo members.

Front 72

What outcome should we expect from our duopolists?

Back 72

1. Collusion: An agreement among firms in a market about quantities to produce or prices to charge.

Cartel: A group of firms acting in unison.

2. Self-interest: Together produce more than monopoly quantity

• Nash equilibrium: A situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen.

Front 73

When firms in an oligopoly individually choose productionto maximize profit, they produce a quantity of output …

Back 73

greater than the level produced by monopoly … less than the level produced by competition

The oligopoly price is … less than the monopoly price … greater than the competitive price

Front 74

Willingness to pay:

Back 74

The maximum amount that a buyer will pay for a good.

Willingness to pay=value to the consumer

Front 75

Consumer surplus

Back 75

The amount a consumer is willing to pay for a product minus the price the consumer actually pays.

 Price=actual payment (less than value to the consumer)

 Consumer surplus=value to the consumer –price

Front 76

Whatwould be the total consumer surplus in the market?

Back 76

The sum of individuals’ consumer surplus from all consumers

Front 77

Using the demand curve to measure consume surplus

Back 77

The area below the demand curve measures totalwillingness to pay in a market. (W)

The area below the market price measures the totalpayment from the consumers in the market (Payment)

Thus, the total area below the demand curve and abovethe price is the sum of the consumer surplus of all buyersin the market for a good or service. (CS=W-Payment)

Front 78

what does consumer surplus measure?

Back 78

Consumer surplus measures the benefit thatbuyers receive from a good as the buyersthemselves perceive it.

Thus, consumer surplus is a good measure ofeconomic well-being (if policymakers want torespect the preferences of buyers).

Front 79

2. How Suppliers Can Charge a Price Closer to Willingness toPay: to Increase Profit, Reduce Consumer Surplus?

Back 79

If everybody in the market pays the same price, consumers with higher willingness to pay get higher consumer surplus than others.

Firms with market power have incentives to use pricing strategy capture (obtain) consumer surplus in order to increase its profits

Firms can use price discrimination to capture more consumer surplus and increase profit

E.g., the “pink tax”, higher prices, on products specific for women compared to uni-sex products or men’s products.

For example, if the company can segmentthe consumers into three groups based ontheir willingness to pay and charge threedifferent prices.

Front 80

the minimum price a firm is willing to accept

Back 80

is the marginal price

 A supply curve is a marginal cost curve

Front 81

Producer surplus:

Back 81

The amount a seller is paid for a good minus the seller’s marginal cost.

Front 82

Total producer surplus

Back 82

is the sum of the producer surplus of each seller.

Front 83

how to measure producer surplus

Back 83

Graphically, the area above the supply curve and belowthe price measures the producer surplus in a market.

The logic is straightforward: The height of the supply curvemeasures sellers’ costs, and the difference between theprice and the cost of production is each seller’s producersurplus.

Thus, the total area is the sum of the producer surplus of allsellers.

Front 84

But how much does sellers’ well-being rise inresponse to a higher price?

Back 84

The concept of producer surplus offers a precise answer to this question.

Front 85

Is the allocation of resources determined by freemarkets in any way desirable?

Back 85

It is desirable if the total of consumer surplus and producer surplus is maximized

Front 86

total surplus

Back 86

= Value to buyers – Cost to sellers

Front 87

efficiency

Back 87

Efficiency: The property of a resource allocation ofmaximizing the total surplus received by all members ofsociety

Front 88

three insights about free market outcomes.

Back 88

Free markets allocate the supply of goods to thebuyers who value them most highly, as measured bytheir willingness to pay.

2. Free markets allocate the demand for goods to thesellers who can produce them at the lowest cost.

3. Free markets produce the quantity of goods thatmaximizes the sum of consumer and producersurplus