Transcript 5_Theory_of_the_Firm..

Introduction to Economics
Egor Sidorov
1. Revenue and profit
2. Perfect competition
3. Imperfect competition
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Rational producer
─ Producer aims at achieving an efficient level of
production with given inputs (and sales) in order to
maximize his profit.
─ Further examples of firms’ objectives:
─ Market share
─ Survive in the long run
─ Good reputation for management
─ Stakeholder interests
─ However, profit is an important factor of firm’s
competitiveness
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Revenue
─ Total revenue (TR) – income that a company
receives from the sale of goods and services.
TR = P*Q
─ Average revenue (AR) – income per unit of product.
─ Marginal revenue (MR) – is the extra income
generated by selling one more unit of production.
AR = TR / Q
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MR =
TR /
Q
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Profit
─ Profit is the difference between revenue and the
costs of bringing products to market:
Z = TR - TC
─ Accounting profit = TR – explicit costs
─ Economic profit = accounting profit – implicit costs
─ If the economic profit is equal to zero, the firm is still
getting the so-called “normal profit” which is the minimum
required by entrepreneur to stay in business and not to
think of changing the job.
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1. Revenue and profit
2. Perfect competition
3. Imperfect competition
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Ideal market model:
5 traits of perfect competition (1)
─ Numerous small producers and
consumers: none of them is capable of
influencing the price.
─ If any of them increases the price, consumers
will easily switch to the substitute.
─ Homogenic product: product parameters
are alike.
=
The agriculture market is very
close to perfect competition.
However, it is not totally the
same…
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Ideal market model:
5 traits of perfect competition (2)
─ No entrance or exit barriers: neither producers
nor consumers have problems with entering
or leaving the market. If the firm stops
generating profit, the entrepreneur would
easily leave.
─ Independent market agents: neither firms nor
customers can agree on common behavior
strategy and therefore influence the price.
─ Perfect information: firms and consumers
have a perfect overview of prices and other
market conditions and therefore act rationally.
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Ideal market model:
perfect competition
─ In perfect competition conditions the invisible hand
of market does work; source allocation is efficient
and the economy is on its production possibility
frontier.
─ Price is independent from the firm’s actions: the
firm is capable of selling all its stock without
influencing the price; demand is perfectly elastic.
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Perfect competition:
Price takers
─ Market supply and demand determine the price;
single firms are too small to influence prices.
─ The demand curve of the firm is perfectly elastic.
P
D
S
P
The firms
are price
takers
D
P = AR = MR
In perfect competition the
price, average revenue and
marginal revenue are
constant.
Q
Industry
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Q
Single firm
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Perfect competition:
profit maximizing
─ Since the price is exogenous,
producers should determine the
optimal production volume based
on interaction between costs and
price.
P, AC, MC
MC
TR = P*Q
TC = AC*Q
Z = TR - TC
Rule: In perfect
competition the firm
would maximize its profit
by producing such
quantity when MC are
equal to price.
AC
P
Max Z: MC = MR=P
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3
4
5
6
Q
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Perfect competition:
Relative and absolute loss
P, C
P, C
MC
Relative
loss
AC
Absolute
loss
MC
AC
P
1
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3
4
5
6
P
Q
1
2
3
4
5
6
Q
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Perfect competition:
when should the firm stop its
activities in the short run?P, C
A: At P1 the firm maximizes its profit
(A ;B): Profit declines
B: At P2 the profit is zero (break-even
point – point where costs are equal to
revenue)
(B ;C): Loss goes up. The firm, however,
continues production, since this is how it
minimizes its loss by covering the whole
sum of VC and a part of FC. If it stopped its
activities, the loss would equal to FC.
C: If the price is P3 the firm stops its
activities, since this is how it minimizes
the loss, i.e. looses only FC. If it
continued production it would lose as FC
as well as part of uncovered VC.
MC
AC
A
P1
B
P2
P3
AVC
C
1
2
3
4
5
6
Q
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Supply curve of the firm
─ Marginal cost curve (MC)
is therefore a supply
curve of the firm (D) (in
the part form point C and
higher).
P, C
MC=S
A
P1
B
P2
P3
C
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3
4
5
6
Q
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Long run view:
P, C
─ High prices mean high profits and
attract additional firms. The
increased competition motivates
price reductions and pushes profits
to zero level.
─ In the long run the firm would stop
its activity at the average costs’
level (in contrast to VC as it was in
the short run). If the price goes
below P2 level, part of firms would
leave the market which would lead
to price growth and back to
equilibrium level E.
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MC=S
AC
E
P2
P1
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2
3
4
5
6
Q
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Supply of the firm vs. market
supply
─ Market supply is the sum of individual supply curves
P (thous. CZK)
30
S1
25
S
S2
20
15
P
Škoda
BMW
Market
10
1
2
1+2=3
20
2
4
2+4=6
10
5
Q
1
2
3
4
5
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1. Revenue and profit
2. Perfect competition
3. Imperfect competition
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Imperfect competition:
─ Imperfect competition exists there, where sellers
have certain control over the price of their output
(market power).
─ This, however, doesn’t necessarily mean that the control
is absolute: its extent depends on the type of imperfect
competition.
─ Main types of imperfect competition:
─ monopoly,
─ oligopoly, and
─ monopolistic competition.
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Monopoly:
opposing perfect competition
─ It is an extreme case: one seller with the
total control over industry branch.
─ Pure monopolies are rare today, before all, due to
antimonopoly laws. Reasons for their existence:
─ Legal barriers (patents, licences - Microsoft),
protectionist policy, high entrance barriers (ČEZ),
geographic location.
─ Natural monopoly
─ Is the case when the only one big firm with the
lowest AC is capable of satisfying market demand
instead of many smaller firms. Exists in branches
with wide returns to scale possibilities.
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Environment stimulating natural
monopoly and oligopoly
occurrence
D=MR
D
MC
D=MR
MC
AC
AC
AC
MC
Market demand
1
2
3
4 … 1000
Perfect competition
Market demand
100
200 300
Oligopoly
Market demand
100
200
300
Natural monopoly
The branch would rather consist of smaller number of firms if significant
returns to scale exist and costs are diminishing. Under these
circumstances large firms can produce and sell cheaper than their smaller
competitors.
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Oligopoly
─ Several (2, 5 or even 15) firms on the
market given each can influence the
market price.
─ Some economists assume that oligopoly is the situation
when 4 biggest firms have over 40 percent market share.
─ Returns to scale are lower than monopoly has.
─ Firms compete with each other:
─ Price wars: if one reduces the price,
others have to react.
─ Threat of cartel agreements.
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Monopolistic competetion
─ A lot of firms satisfying demand together .
─ Each of them has a small market share.
─ Product is differentiated, each producer tends to
create and hold its own segment.
─ Importance of non-price competition: ads,
marketing, customer services, etc.
…
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Imperfect competition:
Common traits (1)
─ Differentiated product:
─ One product differs from competitive ones.
─ Significant market shares of firms:
─ The firm can influence price and quantity supplied.
─ Entrance and exit barriers:
─
─
─
─
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Legal restrictions
Customer loyalty
Ads – not all products can be sold
Existing returns to scale and diminishing costs
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Imperfect competition:
Common traits(2)
─ Unfair competition: firms can agree on the
common strategy – cartel agreements
─ Insufficient information
─ Neither firms, nor consumers have the complete
overview of prices and market conditions;
uncertainty exists.
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Imperfect competition:
profit maximizing
─ Producers can influence price: e.g. by limiting
production they increase the price. The price
change therefore influences the revenues
depending on elasticity.
TR = P*Q
─ The firm is maximizing its profit by producing the
amount of goods that corresponds to equality of
marginal revenue and marginal costs.
Max Z: MC = MR
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!!! MC = MR < P
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Revenues in imperfect
competition
P (CZK)
6
D
E>1
4
E=1
2
E<1
Demand
Q
2
TR (CZK)
9
6
3
4
E=1
E>1
6
Q
TR
AR
6
0
0
-
5
1
5
5
4
2
8
4
3
3
9
3
2
4
8
2
1
5
5
0
6
0
AR, MR
6
E<1
TR curve is
non-linear
P
MR
5
3
1
-1
-3
1
-
-5
MR curve is different
from AR.
4
TR
2
E>1
AR=D
Total revenue
MR
Q
Q
2
4
6
2
E<1
6
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Optimal production volume of a
monopolist
─ Firms in imperfect competition get monopolist
profits; it may last much longer than in perfect
competition conditions due to entrance barriers.
P, C
D=AR
MR
AC
Profit
???
E
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3
TC = AC*Q
Z = TR - TC
Max Z: MC = MR
MC
P
1
TR = P*Q
4
5
6
Q
Rule: In order to maximize
profits the monopolist sets
production on the level where
MC=MR. This output level is
lower compared to what could
have been under perfect
competition conditions.
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Production volume optimization
differences between perfect and
imperfect competition
P, C
P, C
MC
D=AR
MR
MC
AC
P
=
AC
Profit
=
P
D=AR =MR=P
E
E
1
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3
4
5
6
Q
1
2
3
4
5
6
Q
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Market power
─ is the ability of a firm to alter the market price of a
good or service. A firm with market power can raise
prices without losing all customers switching to
competitors. Measuring market power:
─ Concentration ratio – percentage of sales,
by 2, 4, 8 biggest firms.
─ Herfindahl index – sum of squares of firms’ market shares
in percents (TRi). A better reflection of real concentration.
─ HI = 10 000 monopoly,
─ HI = 0 perfect competition.
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HI = Σ(TRi/TR)
Car sales in CZ 2008
143 600 pcs 100 %
of which Škoda
44 500 pcs
31 %
2
HI = 312=961
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Perfect and imperfect
competition differences
─ Perfect competition is an ideal model. Imperfect
competition is the economic reality.
─ Given the technology level, the output of imperfect
competition is lower compared to perfect
competition case.
─ Under imperfect competition conditions firms enjoy
returns to scale and are highly motivated to
generate innovations, not underestimating the role
of individuals and small firms of course.
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Conclusion
Type
No of
firms
Product
Market power
Entrance
barriers
Perfect
competition
many
homogenous
none
low
Monopolistic
competition
many
differentiated
limited
low
few
differentiated
medium
high
high
very high
Oligopoly
Monopoly
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one
Homogenous
without close
substitutes
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Thank you for attention!
Refernces:
SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha:
Svoboda, 2005.
KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management.
Ústí n. L.: UJEP, 2003.
MCDOUGAL LITTELL. Economics: Concept and Choices. Canada:
McDougal Littell, 2008.
www.intel.com