Firms are defined as economic organizations that purchase inputs and sell outputs.

We will
assume that a firm's objective is to maximize profits. Let's take a look at some equations
relating to costs.

Profit = Total Revenue (TR) - Total Costs (TC)

Total Revenue = Price x Quantity Sold
Total Costs = Sum of all opportunity costs related to the production process
Opportunity Costs = Explicit Costs + Implicit Costs

Explicit costs of production include:

• wages and salaries to employees

• costs of raw materials
• taxes

Implicit costs of production include:

• value of time of owner/entrepreneur

• opportunity cost of financial capital invested in the firm i.e. interest rate foregone

"Economic profit" is the difference between total revenue and total cost, where total cost
includes both explicit and implicit costs. In contrast, "accounting profit" is the difference
between total revenue and explicit cost. For example: A dancer gives dancing lessons for $20
per hour. Instead, he could be performing on stage for $30 per hour. What is the economic
profit of performing on stage?

Total costs = $0 (explicit cost) + $20 (implicit cost)

Economic Profit = $30 (TR) - $20 (TC)

Recall that supply is primarily determined by the productivity of inputs, and the cost of the
inputs. The production functions show the relationship between quantity of inputs and the
quantity of output.

The short run refers to a period in which at least one input (usually capital) is fixed. The short
run production function shows a relationship between total output and inputs, when one input
is varied and one is fixed. This is also referred to as the total product (TP). Average product
(AP) is the average production per unit of variable input, and is equal to TP/L, where L is
labour (the variable input). Marginal product (MP), shows the change in total output when
input changes by one unit. Therefore, MP is the slope of the total product curve, and thus
shows the productivity of labor.

Total Product Function

A very key assumption, is that of the diminishing marginal product (or diminishing marginal
returns). If we add more and more of the variable input(s) and there is at least one fixed
input, then eventually the MP of the variable input will decline. The TP curve will flatten out as
the quantity of the variable input increases. Therefore, MP may rise initially, but it must fall
(TP is increasing but at a decreasing rate).

Product and Cost curves

To go from production to cost, we assume that the costs of inputs are fixed (i.e. a firm can
hire all the labour it wants at the going wage). Cost are divided into two broad categories:
 • Fixed costs - costs that do not vary with output, such as cost of plant or some fixed
inputs
• Variable costs - costs that vary with output, such as cost of labour or other variable
inputs.

Total costs (TC) is the sum of Total Fixed Costs (TFC) and Total variable Costs (TVC).
Graphically, TFC is represented by a horizontal line since costs are fixed. The total cost
eventually gets steeper as more is product is produced. Average cost (AC) is how much a
typical unit costs and is equal to TC divided by number of units produced. Mathematically we
have,

AC = (TFC + TVC)/Q = AFC + AVC

AFC: average fixed costs
AVC: average variable costs

Note that AFC will constantly fall as output increases. AVC will fall and then increase due to
diminishing returns. Marginal Cost (MC) is the change in total cost divided by change in
output, and addresses the question: how much will it cost to produce one additional unit of
output?

Production Possibilities Frontier

11

11
Email
26
Share

An example of a model is the Production Possibility Frontier (PPF). PPF is a graph/table that
shows the maximum possible combinations of outputs that can be produced from given inputs.
Simplifying assumptions:

• Assume the economy produces just 2 goods

• Assume that technology and the quantity of factors (inputs such as labour, capital, &
raw materials) are fixed

Example: A farmer has a 10 acre field and can grow either wheat or barley on it. The only
input is land. He has the following possible combinations:

4 3 2 1
Wheat 0
0 0 0 0
1 1
Barley 0 5 20
0 5
Draw the PPF with Wheat on vertical axis. Note that this is a straight line. Any point on the
Production Possibility Frontier is said to be "efficient". The economy is getting the most it can
given the fixed resources & technology, and there are many possible efficient combinations.

Inside the PPF is considered inefficient, since the business can produce more of one good
without producing less of the other. Inefficiencies arise from unemployed resources or
inefficient management. Points outside the PPF are currently unavailable. The PPF can be
increased by economic growth which shifts the curve outward. Growth can come from
more/better inputs like capital & labour, or from better technology/organization. PPF shows
the trade-off between quantities of the two goods (is always downward or negatively sloped).

Production Possibilities Frontier and Opportunity Costs

PPF illustrates the opportunity cost of gaining more of one good. Opportunity cost is equal to
"loss" divided by "gain". Opportunity cost of good on vertical axis = 1/absolute slope of PPF.
Opportunity cost of good on horizontal axis = absolute slope of PPF. Therefore, when the PPF
is a straight line, opportunity cost is constant. What is the opportunity of Barley and Wheat in
the example above? One good can be traded off for the other at a constant rate, and inputs
are equally good at producing either good.

When the Production Possibilities Frontier is a curve (bowed out from the origin), the
opportunity cost increases as we want more of a good. Inputs become specialized, and it
becomes more efficient to produce one good than the other.

Trade and Production Possibilities

Trade is another way we can increase the combinations of outputs that we can
consume. Principle of Economics #5: Trade can make everyone better off. Assume that we
have 2 individuals with different PPFs. With no trade/exchange, each must consume what each
produces; however, with trade, each can specialize in the good they are better at and trade
for the other good. So in general, both can benefit from the exchange.

To understand why, let's define some terms. Absolute advantage occurs when one party is
more productive than the other, and can produce an amount with fewer inputs. Comparative
advantageoccurs when one party has a lower opportunity cost than the other in producing
some good. In other words, one is relatively more productive in producing one of the two
goods.

In terms of trade, comparative advantage is the important factor. Trade can benefit both
parties if they specialize in the good in which they have a comparative advantage. This is still
the case, even if one has an absolute advantage in producing both goods.

Example: A worker in the United States can produce either 15 computers or 5 tonnes of wheat
per month. Suppose a worker in China can produce either 4 computers or 4 tonnes of grain in
a month.

computers grain
United States
China

Which country has an absolute advantage for each product, and which country has a
competitive advantage for each product?
Quick Summary

1. Comparative Advantage determines specialization and trade.

2. Comparative advantage means that countries have different opportunity costs to
produce goods.
3. Countries will tend to specialize in goods in which they have the lower opportunity
costs.
4. Price at which trade occurs is between the original trade-offs in the two countries
5. Trade allows countries to consumer more than they would if they produced everything
themselves.

Supply and Demand

37

17

23
Email
78
Share

A market is defined as a group of buyers and sellers of a particular product or service.

Competitive markets are markets with many buyers and sellers, so that each has a very small
influence on the price. Supply and demand is the most useful model for a competitive market,
and shows how buyers (citizens) and sellers (businesses) interact in that market.

Quantity Demanded & Supplied

The demand for a product is the amount that buyers are willing and able to purchase. Quantity
demanded is the demand at a particular price, and is represented as the demand curve. The
supply of a product is the amount that producers are willing and able to bring to the market
for sale. Quantity supplied is the amount offered for sale at a particular price. The main
determinant of supply/demand is the price of the product.

Law of Demand

The Law of Demand states that other things held constant, as the price of a good increases,
the quantity demanded will fall. Other factors that can influence demand include:

1. Income - Generally, as income increases, we are able to buy more of most goods.
When demand for a good increases when incomes increase, we call that good a
"normal good". When demand for a good decreases when incomes increase, then that
good is called an inferior good.
2. Price of related products - Related goods come in two types, the first of which are
"substitutes".Substitutes are similar products that can be used as alternatives.
Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people
substitute away to the less expensive good. Other related products are classified as
"complements". Complements are products that are used in conjunction with each
other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar.
3. Tastes and preferences - Tastes are a major determinant of the demand for
products, but usually does not change much in the short run.
 4. Expectations - When you expect the price of a good to go up in the future, you tend
to increase your demand today. This is another example of the rule of substitution,
since you are substituting away from the expected relatively more expensive future
consumption.

Demand Curves and Schedules

Demand curves isolate the relationship between quantity demanded and the price of the
product, while holding all other influences constant (in latin: ceteris paribus). These curves
show how many of a product will be purchased at different prices. Note that demand is
represented by the entire curve, not just one point on the curve, and represents all the
possible price-quantity choices given the ceteris paribus assumptions. When the price of the
product changes, quantity demanded changes, but demand does not change. Price changes
involve a movement along the existing demand curve.

Market demand is the summation of all the individual demand curves of those in the market.
It is the horizontal sum of individual curves and add up all the quantities demanded at each
price. The main interest is in market demand curves, because they are averages of individual
behaviour tend to be well-behaved.

When any influence other than the price of the product changes, such as income or tastes,
demand changes, and the entire demand curve will shift (either upward or downward). A shift
to the right (and up) is called an increase in demand, while a shift to the left (and down) is
called a decrease in demand. In example, there are two ways to discourage smoking: raise the
price through taxes or; make the taste less desirable.

Law of Supply

As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies
that price and quantity supplied are positively related. The major factor that influences supply
is the "cost of production", and includes:

1. Input prices - As the prices of inputs such as labour, raw materials, and capital
increase, production tends to be less profitable, and less will be produced. This leads
to a decrease in supply.
2. Technology - Technology relates to methods of transforming inputs into outputs.
Improvements in technology will reduce the costs of production and make sales more
profitable so it tends to increase the supply.
3. Expectations - If firms expect prices to rise in the future, may try to product less
now and more later.

Supply Curves and Schedules

The relationship between the price of a product and the quantity supplied, holding all other
things constant is generally sloping upwards. Supply is represented by the entire curve and
not just one point on the curve. When the price of the product changes, the quantity supplied
changes, but supply does not change. When cost of production changes, supply changes, and
the entire supply curve will shift.

Market Supply is the summation of all the individual supply curves, and is the horizontal sum
of individual supply curves. It is influenced by the factors that determine individual supply
curves, such as cost of production, plus the number of suppliers in the market. In general, the
more firms producing a product, the greater the market supply.
When quantity supplied at a given price decreases, the whole curve shifts to the left as there
is a decrease in supply. This is generally caused by an increase in the cost of production or
decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital,
ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw
materials are perishable or unattainable due to transportation problems.

Reaching Equilibrium

We can analyze how markets behave by matching (or combining) the supply and demand
curves. Equilibrium is defined as the intersection of supply and demand curves. The
equilibrium price is the price where the quantity demanded matches the quantity supplied. The
equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the
equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity
the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market
towards the equilibrium.

Excess Supply/Demand

Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at
the current price. A large surplus is known as a "glut". In cases of excess supply:

• price is too high to be at equilibrium

• suppliers find that inventories increase
• suppliers react by lowering prices
• this continues until price falls to equilibrium

Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages
at current prices. In cases of excess demand:

• buyers cannot buy all they want at the going price

• sellers find that their inventories are decreasing
• sellers can raise prices without losing sales
• prices increase until market reaches equilibrium

Law of Supply and Demand

In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply
and demand, since actions of buyers and sellers tend to match prices back toward their
equilibrium levels.

Perfect Competition

11

6
Email
23
Share

In competitive markets there are:

 1. Many buyers and sellers - individual firms have little effect on the price.
2. Goods offered are very similar - demand is very elastic for individual firms.
3. Firms can freely enter or exit the industry - no substantial barriers to entry.

Competitive firms have no market power. Recall that businesses are trying to maximize
profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Revenue in a Competitive Business

Businesses in competitive markets take the market price (P) as given (price takers). How
much does the business receive for a typical unit is known as the "average revenue" (AR) and
is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is constant.
How much additional revenue does the firm get if it sells one additional unit? To answer this
question, we take a look at "marginal revenue" (MR) which is equal to the change in TR
divided by the change in quantity. Note that this too is equal to price, so the marginal revenue
is constant as well, and is equal to average revenue.

Profit Maximization

To maximize profit, we need to know the revenue and costs of the business. Profit is
maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why,
recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is
the additional cost from 1 additional unit.

When MR > MC, revenue is increasing faster than costs and the firm should increase
production. When MR < MC, revenue from the additional unit is less than additional cost, and
the firm should decrease production. As such, A firm maximizes profits when MR = MC.

So what happens to output at various prices? Since MC is upward sloping, as price increases,
quantity produced will increase too. As price falls, quantity produced falls. In each case, the
marginal cost curve determines how much the firm is willing to produce at each price, so it
translates into the supply curve.

Shutting Down a Company (temporary)

A company is considered to have shut down, if it temporary ceases production but keeps fixed
capital. A company has exit the industry when it has made a permanent decision to leave the
industry. The decision to temporarily shut down a business depends on a few factors. Recall
that ATC = AVC + AFC. So average fixed cost is the vertical distance between average
variable cost and average total cost.

Now if a business shuts down, its total revenue becomes zero, and its total cost equals the
fixed cost. So the company should continue producing its product, as long as it covers its
variable costs. This way, total revenue is greater than total variable cost, because losses are
then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and
so the company's short-run supply curve = MC curve above AVC. The firm therefore produces
where profit equals marginal cost.

Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore
cannot be recovered by shutting down in the short run. The decision to continue producing
depends on revenues and variable costs. If average revenue is greater than average variable
cost, then the business should continue to produce. It is rational to continue producing, so
long as AVC < P < ATC.

When to Leave An Industry (permanent)

A business should leave the industry when revenue is less than cost of operating in the long
run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive
markets, a company will make zero economic profits in the long run. If companies are making
more than zero economic profits, it will encourage other firms to enter the industry to share in
these profits. In other words, enter if total revenue is greater than total cost (P > AC). If
companies are making zero economic profits, there is no entry and no exit, which is a long run
condition.

Monopoly Companies

7
Email
14
Share

A monopoly is a single producer of a product which does not have close substitute. A
monopoly is characterized bybarriers to entry. Sources of a monopoly include:

• Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond

monopoly).
• Exclusive Right Given by Government - patents, copyrights, franchises
(pharmaceutical companies, research, authors).
• Falling Average Total Cost - making one company more efficient than others (also
known as a natural monopoly), arising from economies of scale over the relevant
range of output.
• Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions

A monopoly is a large enough business to influence its own price, such that it is the price
setter rather than taker, unlike a perfectly competitive market where each firm faces a
perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the
market demand is the company’s demand. Monopolists are still constrained by the negative
relationship between price and quantity demanded. With fraud becoming more widespread, it's
important to do a criminal background check prior to engaging in business activities.

Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its
price. There are two effects on total revenue (profit x quantity):

1. Output effect - gains more revenue because it sells more.

2. Price effect - gains less revenue because it gets less from each unit sold because of
the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue,
even though the company sells more. What determines value of MR? It depends on whether
the fall in price is larger than the increase in quantity. In other words, it depends on the
elasticity of demand. Note that MR = P [1-1/abs. E].
When E > 1, MR > 0 because output effect > price effect
When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect

Therefore, the monopolist will never produce in the inelastic portion of the demand curve since
MR < 0. A straight-line demand has elasticity that varies from zero to infinity. Assuming a
linear demand curve P = a-bQ, the MR curve for a straight line will:

• be a straight line with the same intercept and;

• have twice the slope of the demand curve (i.e. it is zero at the halfway point of the
demand curve).

Profit Maximization

Recall that the objective of a business is to maximize profits. As such, a company should
produce where profit is at a maximum. In marginal terms,

1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly
should increase quantity.
2. If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly
should decrease quantity.
3. Only when MR = MC (and MC cuts MR from below) is profit maximized.

A monopolist will generally produce less than a socially efficient level of output, and charge too
high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit
is still part of surplus but has been transferred from consumers to producers. Social cost arises
from inefficiently low output which leads to the dead weight loss. However, if the monopolist
uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then
this can be a welfare cost to society.

Price Discrimination

Price discrimination is selling the same good to different customers/markets at different prices.
Examples include movie tickets, airline tickets, and discount coupons. In order to practice
price discrimination, there must be easy to separate customer into groups. These groups are
determined based on their elasticities to demand. The company must also be able to prevent
resales between groups, as well as arbitrage, which is buying where a good is cheap and
selling where it is expensive.

Price Discrimination can increase the profit of monopolies, since they can charge a higher price
to those with less elastic demand, and a lower price to those with more elastic demand. In this
manner, a business does not have to lower prices to all buyers in order to sell more goods.

Between the definitions of perfect competition and pure monopoly lie oligopolies and
monopolistic competition. An oligopoly is where there are a few sellers with similar or identical
products, such as hockey skates (Bauer, CCM). Monopolistic competition has many companies
with similar but not identical products. Each firm has monopoly power over what it produces,
but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of
oligopolies include crude oil businesses and auto manufacturers.

The main key to behaviour in an oligopoly, is that companies must take into account what
other companies will do. In perfect competition, firms are price-takers and can ignore other
firms. In a monopoly, there is only one firm, and it does not take into account what
competitors will do. Oligopolists are torn between:
 1. cooperating to increase profits by obtaining the monopoly outcome, or;
2. competing to try to gain an advantage over competitors.

Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to
cooperate and agree to restrict output to the monopoly quantity, where price is greater than
margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi
Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less
than a competitive industry. Duopolies come from collusion where firms agree to share output
and set prices such as in a cartel.

A cartel is a group of companies acting in unison, such as OPEC. If the competing companies
cannot agree, then they may end up with the competitive position with profits equal to zero.
Cartels are known to restrict output quantities in order to raise prices, and consequently
profits.

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce
it. As the number of companies increases, the more the industry resembles a competitive
outcome, since each company has a smaller effect on the outcome. The mentality where each
company tends to think only of its own profits and strategic behaviour is reduced. Each
company will increase production as long as price is greater than marginal cost. As the
number of companies increases, we tend to move towards a perfectly competitive outcome.

Game Theory and Prisoners' Dilemma

Game theory is the study of how people behave in strategic situations (i.e. when they must
consider the effect of other people’s responses to their own actions). In an oligopoly, each
company knows that its profits depend on actions of other firms. This gives rise to the
"prisoners’ dilemma".

The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate,
even when it is in the best interest of both parties. Both players select their own dominant
strategies for shortsighted personal gain. Eventually, they reach an equilibrium in which they
are both worse off than they would have been, if they could both agree to select an alternative
(non-dominant) strategy.

Monopolistic Competition

5
Email
19
Share

Monopolistic competition has characteristics of both competition and monopoly. Similar to

competition, it has many firms, and free exit and entry. Similar to monopoly, the products are
differentiated and each company faces a downward sloping demand curve. Since the company
has a differentiated product, it is like a monopolist and faces a negatively-sloped demand
curve. In the short-run,

• marginal revenue is always less than demand

• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity

The short-run equilibrium in monopolitic competition is the same as for a monopolist, and
businesses may make positive, zero, or negative profits in the short run.

Long Run Equilibrium

In the long run, entry and exit are both possible. If profit is greater than zero, businesses will
enter, and each company's market share will fall because of more variety. As a result, each
company’s demand curve will decrease, along with price and quantity. If profit is less than
zero, businesses will exit, and each company’s market share will increase. This will cause the
remaining companies' demand curves to increase, along with the price and quantity.

If profit is equal to zero, there will be no entry into or exit from the industry. In the long run,
all the companies' economic profits must be zero.

Monopolistic Competition and Welfare

Let's compare a company in monopolistic competition with a company in perfect competition,

where both are in a long-run equilibrium. In both cases, profit equals zero. The two main
differences between the two are:

1. Excess Capacity
o companies in perfect competition produce where ATC is at a minimum
(efficient scale)
o companies in monopolistic competition produce where quantity of output is
smaller, and on a downward sloping part of ATC (excess capacity)
o could increase capacity and lower average costs
2. Make-up Over Marginal Cost
o for a competitive firm, price = marginal cost
o for a monopolistic competition firm, price > marginal cost
o there is a mark-up above MC even though the firm makes zero profits

Efficient Outcomes and Externalities

When price is greater than marginal cost, the value that consumers place on the last unit is
greater than the cost, so the good is under-produced. This leads to a deadweight loss like a
monopolist. The number of businesses in the industry may be inefficient, and each time a new
business enters, it creates externalities such as,

• Product Variety Externality - consumers get a wider choice of products, and an

increase in consumer surplus which is a positive externality
• Business-Stealing Externality - this is a negative externality whereby other businesses
lose customers

Since companies do not take these into account, there are no guarantees that there is an
optimum number of them in the industry. This means that there may be too few or too many
products available on the market.
Product Differentiation through Advertising

Companies that wish to differentiate products often use advertising. Advertising is common
with differentiated consumer products, and much less common with homogeneous goods.
Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a
wide range of costs and benefits.

One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers
without conveying any useful information. Advertising may also try to create differentiation
within products that are actually very similar. Also, advertising tries to make demand curves
less elastic, and impedes competition. This then leads to a high markup over marginal cost.

Some benefits to advertising, is that it does convey some useful information such as prices,
new products, locations, etc. Advertising may also foster competition by giving more
information on pricing and availability. Advertising may also be a “signal of quality”, because
willingness to spend money to advertise products may be a sign that the company has
confidence in its quality. This makes it rational for consumers to try such products even if
content of ads is minimal.