Topic 3 Flashcards
(40 cards)
What is Market Structure?
The number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals.
What are the characteristics of a perfectly competitive market?
- Price takers – firms cannot raise prices above what consumers are willing to pay (otherwise consumers will simply purchase products from rivals)
- Output is homogenous – identical to rival firms
- Each firm produces a small share of the total market output
- Can easily enter and exit the market
Why does a firm have to be a price taker?
Because it faces a demand curve that is horizontal at the market price, meaning it can sell as much as it wants at the market price but has no incentive to lower the price. Similarly, it cannot increase the price by restricting its output because it faces an infinitely elastic demand (a small increase in price = demand falling to zero)
When is a firm’s demand curve horizontal?
- When products are perfect substitutes – no firm can sell its product for a higher price because no consumer is willing to pay a premium for that product (e.g. when consumers don’t care which farm grew the apples they are buying because they view apples as homogenous or undifferentiated products).
- New firms can quickly and easily enter – A firm cannot raise its prices without other firms undercutting its price.
- There are lots of firms in the market – the more firms in a market, the less the effect of a price change will have on the total market output and price
- Customers know the prices other firms charge – meaning firms will easily lose customers when they raise prices
- Lowe transaction costs – easy for customers to buy from a rival firm it their usually supplier raises its prices
When is a firm’s demand curve downward sloping?
- When products are heterogenous or differentiated. This means one firms can charge more than other firms without losing all of its customers (e.g. Hondas and Porsches are considered different even though they are both car brands).
- Consumer don’t know the price other firms charge
- There are not many firm in the market
- Higher transaction costs – e.g. finding a new competent computer technician is time consuming
What does a firm’s profit function look like?
π(q) = R(q) – C(q)
A firm’s profit varies with its output level.
What 2 questions must a firm answer to maximise its profit?
- What output level (q*) maximises its profit? (Output decision)
- Is it more profitable to produce a* or to shut down and product no output? (shutdown decision)
What does the slope of the profit curve illustrate?
The firm’s marginal profit (the change in the profit the firm gets from selling one more unit of output – Δπ/Δq).
What are the output rules?
A firm can use one of three equivalent rules to choose how much output to produce:
Output rule 1: the firm sets its output where its profit is maximised.
Output rule 2: a firm sets its output where its marginal profit is zero.
Output rule 3: a firm sets its output where is marginal revenue equals its marginal cost.
Explain output rule 1:
The firm sets its output where its profit is maximised (where q* and π* meet – at the highest point of the profit curve). If a firm knows its entire profit curve it can immediately set its output to maximise its profit. Even if the firm doesn’t know the exact shape of their profit curve they can find this be experimenting (increasing output until profit does not change.
Explain output rule 2:
a firm sets its output where its marginal profit is zero. In figure 8.2, marginal profit (the slope) is positive when output is less than q, zero when output is q and negative when output is greater than q*.
Explain output rule 3:
a firm sets its output where is marginal revenue equals its marginal cost (MR(q) = MC(q)). The Marginal profit depends on a firms MC (ΔC/Δq) and MR (ΔR/Δq). The change in the firm’s profit is: Marginal Profit (q) = MR(q) – MC(q). If MR(q) > MC(q) --- Marginal profit is positive (should increase output) If MR(q) < MC(q) --- reduced firm profit (should reduce output until MR(q) – MC(q) = 0, meaning MR(q) = MC(q))
What are the shutdown rules?
he firm chooses to produce if it can make a profit. If the firm is making a loss, then whether the firm should shut down depends on the situation. A firm should shut down if:
Shutdown rule 1: the firm shuts down only if it can reduce its loss by doing so.
Shutdown rule 2: the firm shuts down only if its revenue is less than its avoidable cost.
Explain shutdown rule 1:
the firm shuts down only if it can reduce its loss by doing so. In the short run, a firm has variable and sunk fixed costs. By shutting down it can eliminate the variable costs (such as labour and materials) but usually not the fixed costs (such as the amount paid for the factory and equipment). By shutting down, the firm stops receiving revenue and stops paying the avoidable costs, but still stuck with its fixed costs, thus shutdown rule 2 applies.
the firm shuts down only if its revenue is less than its avoidable cost.
the firm shuts down only if its revenue is less than its avoidable cost.
e.g. suppose the firms weekly revenue is R = $2000, VC = $1000 and FC = $3000 (for a machine it cannot resell or use for any other purpose). This firm is making a short-run loss: π = R – VC – F = 2000 – 1000 – 3000 = -$2000
If the firm shuts down, it loses its FC so it is better off operating. Its revenue more than covers is avoidable VC and offsets some of the FC.
If the revenue was only $500, then its loss would be $3500, which is greater than the loss from the FC alone. Because its R Is less than its avoidable VC, the firm reduces its loses by shutting down.
In the long-run all costs are avoidable because the firm can eliminate the all by shutting down. Thus, in the long-run it pays to shut down if the firm faces any loss at all.
When does any firm maximise its profit?
At the output where its marginal profit is zero or where its marginal cost equals its marginal revenue.
A competitive firms MC:
MC(q) = P
When can a firm gain by shutting down?
Only if its revenue is less than its short-run variable cost:
Pq < VC
Can be rewritten as: P < AVC(q).
Translates to: A competitive firm shuts down if the market price is less than the minimum of its short-run average variable cost curve.
What is the competitive firm’s short-run supply curve?
It is its marginal cost curve above its minimum average variable cost.
What does an increase in factor prices cause?
It causes the production costs of a firm to rise, in turn shifting the firm’s supply curve to the left, shifting the AVC curve up and causes the shutdown price (intersection of S curve and AVC curve) to increase. Furthermore the equilibrium price will move to the left (where S and P intersect).
How do you measure consumer welfare using a demand curve?
Marginal willingness to pay and consumer surplus.
What is consumer welfare from a good?
The benefit a consumer gets from consuming that good minus what the consumer paid to buy the good (aka consumer surplus – how much pleasure do you get from a good above and beyond its price?).
What is marginal willingness to pay?
This represents the maximum amount a consumer will spend for an extra unit and is reflected in the demand curve. The consumer’s marginal willingness to pay is the marginal value the consumer places on the last unit of output.
The monetary difference between what a consumer is willing to pay
The monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs. CS is a dollar-value measure of the extra pleasure the consumer receives from the transaction beyond its price (Marginal willingness to pay minus what is actually payed)). An individuals consumer surplus is the area under the demand curve and above the market price up to the quantity the consumer buys.
