Firm Behavior

 

Perfect Competition

1. The following conditions are true for a perfectly competitive market:

   1. A product sold by multiple firms is essentially the same.

   2. There is a large number of firms and consumers so none can individually influence the market.

   3. There are few or no barriers to entry into the market.

   4. Each firm is a price taker, meaning that the price they charge is determined by the market.

   5. Consumers and firms have perfect information, meaning that they are aware of all other products and firms in the market.

 

Profit-Maximization Framework

• Firms produce goods and services with the assumed goal of maximizing profits.

• Each firm has a supply function (supply curve) illustrating how much will be produced by the firm at various price levels in order to maximize profits.

• Profits: Total revenue minus total costs.

  1. Economic profits: Total costs include opportunity costs.

  2. Accounting profits: Total costs exclude opportunity costs.

Revenue

1. Total revenue (TR): (Price per unit) times (quantity sold).

2. Average revenue (AR): Total revenue divided by the number of goods sold.

3. Marginal revenue (MR): Revenue received for the last good sold.

4. Because markets are competitive, average and marginal revenues for each firm should be equal to the market price of the good.

Costs

1. Total costs: variable costs plus fixed costs.

   1. Total variable costs (TVC): Costs that are dependent upon the quantity produced (such as labor).

   2. Total fixed costs (TFC): Costs that are independent of the quantity produced (such as land).

2. Average total, variable, and fixed costs (ATC, AVC, and AFC): total, variable, or fixed costs divided by the number of goods produced.

3. Marginal cost (MC): The cost to make one additional unit.

4. Sunk costs: Costs that cannot be recovered.

Production Function

1. The production function is shown as a curve and illustrates how much can be produced for different amounts of inputs.

2. Two inputs are used in the production of goods, capital (K) and labor (L): Q=f(K, L).

3. Average product (AP): Total product / quantity produced.

4. Marginal product (MP): The change in output due to a unit increase in input.

5. To maximize profits, the quantity produced by a firm should be such that MC is equal to MR. In a competitive market, this means that MR and MC will equal price.

 

Short Run

1. Short run: the time frame in which fixed costs are not changeable.

2. In the short run, K is usually fixed, so the production function will reflect how the quantity produced changes as the labor input changes.

3. Returns to labor:

   1. Increasing returns to labor: MP increases and MC decreases as more labor is added.

   2. Decreasing returns to labor: MP decreases and MC increases as more labor is added.

4. Relationships between the short-run cost curves:

   1. When ATC and AVC are falling (rising), MC is lower (higher). This means that the MC curve will intersect the ATC and AVC curves at their lowest points.

   2. As the quantity produced increases, fixed costs become a smaller percentage of total costs. This means that the distance between the ATC and AVC curves will get smaller as more is produced.

   3. Because firms produce at a quantity where marginal cost equals market price, it is possible to represent a firm’s profit at any given price on the cost curves.

5. If price were set to where the MC curve and ATC curve intersect, the firm would break even.

6. If price were set below the ATC curve, the firm would have a loss.

7. If price is set at or below the minimum point of the AVC curve, the firm should shut down.

 

Long Run

1. Long run: the amount of time where fixed costs are able to change.

2. All inputs are variable in the long run, so there are many possible combinations of K and L. Plotting these combinations on a graph results in an isoquant. There are different levels of isoquants for different levels of production.

   1. Marginal rate of technical substitution (MRTS): Along the isoquant, it is possible to exchange one input for another and remain at the same output level. The exchange rate is the MRTS, which is equal to change in K divided by change in L.

3. The firm’s cost of production is based upon the prices of its inputs. The firm always tries to minimize total costs for a given level of production. All possible combinations of K and L for each cost level are illustrated in isocost lines.

4. Cost is minimized at the point where the isoquant is tangent to the isocost line.

Average Cost and Returns to Scale

1. Economies of scale (increasing returns to scale): Long-run ATC decreases as output increases.

2. Diseconomies of scale (decreasing returns to scale): Long-run ATC increases as output increases.

3. Constant returns to scale: Long-run ATC stays the same as output increases.

4. Most firms begin their growth with economies of scale, then have a period of constant returns to scale, then reach a point where they have diseconomies of scale.

5. Minimum efficient scale: Point of lowest production where ATC is at a minimum.

6. In the long run, a firm is able to expand, which will shift its ATC out. Each production option has its own ATC. Combined, the minimum points of the various ATCs will create the long-run ATC.

Long-Run Market Equilibrium

1. For individual firms, demand is set at a constant price because they cannot affect it. So, though the market demand curve may be downward sloping, the demand curve from the firm’s perspective is flat.

2. When the market is in equilibrium, the market price is equal to the profit-maximizing price of the individual firm. Profits are zero so no firms are leaving or entering the market.

   1. If the market demand increases (decreases), the price will rise (fall) in the short term.

   2. The higher (lower) price will increase (decrease) profits for the firm.

   3. Increased (decreased) profits will lead more firms to enter (leave) the market, increasing (decreasing) the market supply.

   4. This will push the price back down (up) to where profits for the firm are zero and the market is in equilibrium.