Fundermentals of Business Economics Tute

8/4/2019 Fundermentals of Business Economics Tute

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THE FIRM'S OUTPUT DECISION

The assumption ofprofit maximisation provides a basis for beginning to look at the output decisions ofindividual firms. A firm will maximise its profits where its marginal costs equal marginal revenue (MC =MR).

Total revenue, average revenue and marginal revenue

There are three aspects of revenue to consider.

I. Total revenue (TR) is the total income obtained from selling a given quantity of output. We canthink of this as quantity sold multiplied by the price per unit.

II. Average revenue (AR) is the total revenue divided by the number of units sold. We can think of thisas the price per unit sold.

III. Marginal revenue (MR) is the addition to total revenue earned from the sale of one extra unit ofoutput. We can think of this as the incremental revenue earned from selling the last unit of output.

The average revenue curve

When a firm can sell all its extra output at the same price, the AR 'curve' will be a straight horizontal line ona graph. The marginal revenue per unit from selling extra units at a fixed price must be the same as theaverage revenue

If the price per unit must be cut in order to sell more units, then the marginal revenue per unit obtainedfrom selling extra units will be less than the previous price per unit. In other words, when the AR is fallingas more units are sold, the MR must be less than the AR.

Marginal cost equals marginal revenue

As a firm produces and sells more units, its total costs will increase and its total revenues will also increase(unless demand is price inelastic and MR has become negative).

(a)Provided that the extra cost of making an extra unit is less than the extra revenue obtained fromselling it, the firm will increase its profits by making and selling that extra unit.

(b)If the extra cost of making an extra unit of output exceeds the extra revenue obtainable from sellingit, the firm's profits would be reduced by making and selling that extra unit.

(c) If the extra cost of making an extra unit of output is exactly equal to the extra revenue obtainablefrom selling it, bearing in mind that economic cost includes an amount for normal profit, it will be

worth the firm's while to make and sell the extra unit. And since the extra cost of yet another unitwould be higher due to the law of diminishing returns, whereas extra revenue per unit from selling


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extra units is never higher: this extra unit would generate a loss. Therefore, the profit-maximizingoutput is reached where MC = MR.

Given the objective of profit maximisation there are three possibilities:

(a) IfMC is less than MR, profits will be increased by making and selling more.(b)IfMC is greater than MR, profits will fall if more units are made and sold, and a profit-maximising

firm would not make the extra output. In other words, if MC > MR a firm will look to reduceoutput.

(c) IfMC = MR, the profit-maximizing output has been reached, and so this is the output quantitythat a profit-maximizing firm will decide to supply.

QuestionEg; The following data refer to the revenue and costs of a firm.

Output Total revenue Total costs

$ $

0

1101 50 1402 100 1623 150 1754 200 1805 250 1856 300 1947 350 2298 400 2699 450 32510 500 425

Required(a) Calculate the marginal revenue for the firm.(b) Calculate the firm's fixed costs and the marginal cost at each level of output.(c) What level of output will the firm aim to produce and what amount of profit will it make at this level?


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EQUILIBRIUM UNDER MARKET STRUCTURES

Mainly four type of market structures

1. Perfect competition market2. Monopoly market3. Monopolistic competition market4. Oligopoly market

Perfect competition

Perfect competition: a theoretical market structure in which no supplier has an advantage over another.

Characteristics of perfect competition

I. There are a large number of buyers and sellers in the market.II. Firms are 'price takers', unable to influence the market price individually. Buyers and sellers can

trade as much as they want at the prevailing market price, as determined by the interaction of supplyand demand.

III. Producers and consumers have the same, perfect, information about the product and the market.IV. The product is homogeneous: one unit of the product is the same as any other unit.V. There is free entry of firms into and free exit of firms out of the market: there are no barriers to

entry.VI. There are also no restrictions on the mobility of factors of production.

VII. There are no transport costs or information gathering costs.VIII. Producers and consumers act rationally. This means that producers will always try to maximise

profits.IX. Normal profits are earned in the long run

Equilibrium in the short run

Above Figure also shows the average total cost curve (ATC) and the marginal cost curve (MC), with theMC cutting the ATC at the lowest point of the ATC. Given these cost curves and the demand curve D1, the

firm will produce the output Q1, where the MC curves cuts the MR horizontal curve at the point C. This isthe profit maximising level ofoutput (MC = MR)


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Note, however, that the profit maximising level of output is not the same as the level oftechnical efficiency.This would occur at output E, where average cost (ATC) is at its minimum. By definition, technicalefficiency is achieved when a firm is producing the level of output at which its average costs are minimised.At Q1, on Figure , average revenue is greater than average cost, so the firm is making supernormal profitsindicated by the rectangle ABCD. These supernormal profits will attract new firms into the industry and theprice will be bid down. This new position is illustrated in following Figure, where the new price is P2. Here,instead of making a profit, the firm makes a loss shown by the rectangle WXYZ. Once again the firmproduces where MC = MR giving an output of Q2. A firm could choose to do this for a short period so longas revenues covered its variable costs; in this case MC=MR is the loss minimizing position rather than theprofit maximising position.

Equilibrium in the long run

This long-term position is illustrated in above Figure . Note the following points about Figure.

(a) The market price, P, is the price which all individual firms in the market must take.(b) If the firm must accept a given MR (as it must in conditions of perfect competition) and it sets

MR = MC,then the MC curve is in effect the individual firm's supply curve. The market supply curve in Figure is

derived by aggregating the individual supply curves of every firm in the industry.

(c) Consumer surplus is represented by the area to the left of the demand curve above P.(d) The firm is operating at its most cost-effective point (the lowest point on the AC curve).


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In the long run, all firms in the industry will have MR = MC = AC = AR = price, as at output Qf in Figure . Because this position earns the entrepreneur the desired return on their capital (normal profit), ensuresallocative efficiency, and means that firms operate their most cost-effective point, long-run equilibriumunder perfectcompetition is held to be a desirable model for an economy.

The monopoly marketIn a monopoly, there is only one firm, the sole producer of a good which has no closely competingsubstitutes.

A firm's monopolistic position may result from some natural factor which makes it too costly for anotherfirm to enter the industry. For example, in the domestic water supply industry it will normally be too costlyfor a second firm to lay a second water supply system to compete for part of the business of an existing solesupplier: the sole supplier enjoys a natural monopoly.

A monopolist can either be a price maker (and thus a quantity taker) or set quantity (and take the equilibriumprice which results). However, it cannot fix both price and quantity because it cannot control market

demand. If price must be reduced to increase unit sales, average revenue is falling and marginal revenue willalways be lower than average revenue. If the monopolist increases output by one unit, the price per unitreceived will fall, so the extra revenue generated by the sale of the extra unit of the good is less than theprice of that unit. The monopolist therefore faces a downward sloping AR curve with an MR curve belowthe AR curve. For any given price, AR is double the MR on straight-line average revenue curves.

Profit-maximising equilibrium of a monopoly

The condition for profit maximisation is, as we have seen, that marginal revenue should equal marginal cost(MC = MR). This is true for any firm. As long as marginal revenue exceeds marginal cost, an increase inoutput will add more to revenues than to costs, and therefore increase profits. A monopolist will have theusual U-shaped cost curves.


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Price discrimination

Price discriminationoccurs when a firm sells the same product at different prices in different markets.

Four basic conditions are necessary for price discrimination to be effective andprofitable.

(a)The seller must be able to control the supply of the product and keep out any competitors whocould undercut the premium price. To this extent, the market must be imperfect.

(b)There must be at least two distinct markets with no cross-over between them. For example, a railfare will either be for a peak time or off-peak. If a customer buys an off-peak fare he or she cannotuse it during a peak period.

(c)The seller must be able to prevent the resale of the good by one buyer to another. The marketsmust, therefore, be clearly separated so that those paying lower prices cannot resell to those payinghigher prices

(d)There must be significant differences in the willingness to pay among the different classes of buyers.In effect this means that the elasticity of demand must be different in at least two of the separatemarkets so that total profits may be increased by charging different prices.

Monopolistic competition

Monopolistic competition is a market structure in which firms' products are comparable rather thanhomogeneous. Product differentiation gives the products some market power by acting as a barrier to entry.Monopolistic competition is a market structure which combines features of perfect competition andmonopoly.


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Fundermentals of Business Economics Tute