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There are many buyers and sellers in the market. Buyers and sellers are said to be price takers. There is freedom of entry and exit from the industry. Buyers are sellers possess perfect knowledge of prices. All firms produce a homogenous product. There is no branding of products and products are identical.
In a perfectly competitive market all firms receive the same price for each good sold (P1). As the price is the same however many units are sold, this must also equal average revenue (P=AR). The AR curve is the demand curve because it shows the relationship between price and quantity sold. The demand curve is perfectly elastic. The marginal revenue, the additional revenue from each unit sold, is also P1. At any quantity sold, MR=AR=D. The total revenue curve is linear and upward sloping as sales increase.
P1
D=AR=MR
Output
Price
The AR curve is also the demand curve because it shows the relationship between price and quantity sold. Average revenue, or average price, is falling as sales get larger. The marginal revenue curve is also downward sloping. Mathematically, the slope of the MR curve is twice as steep as the AR curve (measuring the distance horizontally on the graph is, MR is always exactly half of AR).
TR Output
The total revenue curve for a firm will peak where MR=0. As sales increase, the extra revenue gained (the MR) is falling. Total revenue is therefore increasing, but at a decreasing rate. TR is maximised when MR=0. At this point no extra revenue is gained from the sale of an additional unit. Units sold beyond this point bring in negative MR which leads to falling TR. Thus, TR is maximised when MR=0 at output Q1.
TR Q1 Output
Refer to Anderton, Table 2 and Figures 3 and 4 on pp. 283-284. Complete Question 1, p.283.
When the average revenue curve (or demand curve) of a firm is downward sloping there is likely to be a change in elasticity of demand along the average revenue curve.
Price () E = infinity
E=1
E = zero 0 Quantity
E=1
If demand is price inelastic, the percentage fall in quantity demanded in less than the percentage rise in price and total revenue will increase. Conversely, if demand is price elastic, then a percentage rise in price will bring about an even larger percentage fall in quantity demanded. As a result there will be a fall in total revenue. In terms of MR, demand is price elastic so long as MR is positive i.e. TR is rising. When MR is negative, demand is price inelastic. Price elasticity is 1 or unitary when total revenue is maximised. This is when marginal revenue is zero.
D=AR
E = zero
TR Q1 Output
SR Cost of Production
The firms short run costs of production
What is a firm?
The firm is the economic organisation that transforms factor inputs into goods and services for the market. } It has particular objectives such as:
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profit maximisation the avoidance of risk-taking the achievement of long term economic growth
A firm may be a sole trader with a small factory or corner shop or a large multinational corporation with plants and businesses all over the world. } In economic theory, all firms are headed by an entrepreneur.
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Costs of production
In an accountants view, a firms costs are production expenses paid out at a particular time and price. } However, an economists view of costs is wider than this. } In addition to the money paid out to factors, an economists definition of costs also includes the opportunity costs of employing the different factors such as financial capital and labour.
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Normal profit
Profits are what is left when the expenses are deducted from the firms income or sales revenue. } The entrepreneur will expect a minimum level of profit, reflecting what his or her capital and labour would have earned elsewhere. } This is the concept of normal profit. } Economists regard this element of the entrepreneurs reward as a cost of production, because without it there would be nothing produced by the firm.
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Suppose he could have earned $50 working another job for the day (the next best alternative forgone). } The $50 is therefore his normal profit the profit that is just sufficient to ensure that he will continue to supply his existing product to the market. } Hence, the opportunity cost of his labour must be included as an economic cost of production.
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Abnormal profit
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If this is positive, then it is abnormal profit. } The possibility of making abnormal profit motivates the entrepreneur to take the business risks in supplying goods and services to the market.
Total cost
Total cost (TC) equals total fixed cost (TFC) plus total variable cost (TVC) } Increased production will almost certainly lead to an increase in total costs (they may need to by more raw materials, increase the number of workers, and increase factor inputs). } Note that total fixed costs remain constant and all levels of output in the short-run, even when output is zero.
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The average cost of production is the total cost divided by the level of output.
average fixed cost (AFC) = total fixed cost output total variable cost output total cost output
Marginal cost
Marginal cost is the addition to the total cost when making one extra unit of output. } Marginal cost is therefore a variable cost. } For most firms the decision to increase output will raise the total cost, that is, the marginal cost will be positive as extra inputs are used. } Firms will only be keen to do this when the expected sales revenue outweighs the extra cost.
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MC =
Anderton, Table 3 p.273. Anderton, Question 3, p.273.
TC Q
The shape of the average and marginal cost curves is determined by the law of diminishing returns. Diminishing marginal returns set in at an output level of 145 when the marginal cost curve is at its lowest point. Diminishing average returns set in at the lowest point of the average variable cost curve at an output of 210 units. Note that the MC and AC curves are mirror images of the MP and AP curves (but only if there are constant factor costs per unit).
Note that the MC curve cuts the AC curve at its lowest point.
Output
LR Cost of Production
The firms long run costs of production
In the long run all factors of production are variable. This has an effect on costs as output changes:
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Economies of scale are said to exist average costs fall as output increases. Diseconomies of scale may set in some firms become too large and average costs begin to rise.
diseconomies of scale
LRAC
diseconomies of scale
Output
Mercadona
Mercadona is a low-priced supermarket in Spain. Listen and read the article from the Economist and identify the benefits to Mercadona of it large scale of production. } Are there any disadvantages to its large scale of production?
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Attainable
A LRAC B
Output
} }
The growth of a particular industry in an area might lead to the construction of a better local road network, which in turn reduces costs for individual firms. A firm might experience lower training costs because other firms are training workers which it can then poach. The local government might provide training facilities free of charge geared to the needs of a particular industry.
External economies of scale will shift the LRAC curve of an individual firm downwards.
traffic congestion which increases distribution costs; land shortages and therefore rising fixed costs; shortages of skilled labour and therefore rising variable costs.
The relationship between the SRAC curve and the LRAC curve
In the short run, at least one factor is fixed. Short run average costs fall and then begin to rise because of diminishing average returns. } In the long run, all factors are variable. Long run average costs change because of economies and diseconomies of scale. } In the long run, a company is able to choose a level of production that will maximise profits.
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B C
SRAC1
Output
Output
sole traders partnerships co-operatives private and public limited companies state-owned firms multinational firms
The firm
Firms can range from small simple organisations to large complex, multinational organisations. } The characteristics and behaviour of a firm depend on the type of economic activity and the nature of the competition. } The factor mix in forms varies enormously, with some firms being highly labour intensive in and others more capital intensive. } The decisions firms take depends on the cost and availability of factors of production in different economic systems.
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The industry
In a competitive market structure, the industry is simply the sum of all the firms making the same product. This is the total market supply. } In other markets, the industry is taken to be the total number of firms producing within the same product group, i.e. things which are close substitutes with each other. } In reality many multi-product firms operate in more than one industry at the same time. } The industry is therefore a collection of business organisations which supply similar products to the market. } A firms market share is the sales of the firm divided by the total sales of the entire industry.
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MC
Quantity 0 1 2 3 4 5 6
TC 20 30 35 45 60 90 130
MC 0 10 5 10 15 30 50
Price 20 20 20 20 20 20 20
$20
D=AR=MR
Output
What will be the profit maximising level of output for this firm? Calculate the firms level of profit at this level of output. Complete Question 2, Anderton, p.287.
Profit is maximised at the level of output where the difference between total revenue and total cost is at its greatest, at 0C. This is the point where marginal cost equals marginal revenue. The firm will make a loss if it produces between 0 and B. B is the break-even point. Between B and D the firm is in profit.
0 Price
Output MC MR
Profit is maximised at C where the difference between TR and TC is at a maximum. If the firms produces more than D it will start making a loss again. D is the maximum level of output that the firm can produce without making a loss. D is the sales maximisation point subject to the constraint that the firm should not make a loss.
Output
0 Price
Output MC MR
The firm will make a loss on that extra unit and total profit will fall. The firm will expand production if marginal revenue is above marginal cost. The firm will reduce output is marginal revenue is below marginal cost.
Output
0 Price
Output MC MR
Output
P1
MR
The MC curve will shift up from MC1 to MC2. The profit maximising level of output will fall from 0Q1 to 0Q2. Hence a rise in costs will lead to a fall in the profit maximising level of output.
Q2
Q1
Output
P2 P1
MR2 MR1
Q1 Q2
Output
MC>MR MR>MC P1
Profit max output MC=MR
MR 0 Q Q2 Output
Why some firms do not operate at the profit maximising level of output
In practice, it may be difficult to identify this output. } Short-term profit maximising may not be in the long term interest of the company since:
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firms with large market shares may wish to avoid the attention of the government watch dog bodies; large abnormal profits may attract new entrants into the industry; high profits may damage the relationship between the firm and its stakeholders, such as consumers and the company workforce; profit maximisation may not main objective of the business; high profits might trigger action by the firms rivals and it could become the target for a take-over bid.
Objectives of firms
Profit maximisation
Costs and revenue ($) MC AC
Profit maximisation will occur where MC=MR. Profit is the difference between AC and AR and represented by the shaded area. The profit maximising level of output is therefore Q1.
Profit max output MC=MR
P1
D=AR Output
Q1 MR
Profit maximisation
The standard assumption made by economists is that firms will seek to maximise their profits. } Neo classical economics assumes that it is short run profits that a firm maximises. } Neo-Keynsian economists believe that firms maximise their long run profit rather than their short run profit.
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P1 P2
D=AR 0 Q1 Q2
Sales revenue maximisation: MR=0
Output MR
There may still be abnormal profit at this level of output if total revenue is higher than total cost.
Sales maximisation
Costs and revenue ($)
Sales maximisation: AR=AC
MC
AC
Sales maximisation occurs where AR=AC (breakeven). An additional unit sold beyond this point would cost the firm more than the revenue it would receive. Hence, the firm would be making a loss which would eventually lead to bankruptcy. Therefore, output Q3 is the most the firm can sell without making a loss.
P1 P2 P3
D=AR 0
Q1 Q2 Q3
Output
MR
Sales maximisation
This objective maximises the volume of sales rather than the sales revenue. } In sales maximisation, the firm would increase output up to break-even output. } Again, a firm may be prepared to accept a lower price and produce above the profit-maximising level of output in order to increase its market share or to break into new markets (penetration pricing strategy).
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Loss-making behaviour
Loss-making behaviour is when firms operate beyond their break-even level of output. } The only situation in which loss-making behaviour is possible is where the firm could use the profit from other activities to cover the losses using the principle of crosssubsidisation. } For example, in the public sector, a state-owned firm there could be social objectives lying behind price and output decisions. } The company might be instructed to keep prices down. Any resulting losses would be paid for from government tax revenue.
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Loss-making behaviour
In the private sector, the firm would have to be part of a diversified grouping where cross-subsidisation is being practiced. } Deliberately cutting the price to reduce profit might be a strategy to deter new firms from entering the market. } It may also be used to force out existing competitors and may result in a price war within the industry. } This is called predator or destroyer pricing.
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Satisficing profits
This behaviour occurs when a firm aims to make a reasonable level of profits, sufficient to satisfy the shareholders but also to keep the other stake-holding groups happy, such as the workforce and, of course, consumers. } There are a number of stakeholders in the firm, each with their own objective that may change over time. } Firms may therefore choose to sacrifice some short-term profits to satisfy the expectations of stakeholders.
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Stakeholder objectives
Workers will expect to see improvements in working conditions which may raise costs. } Shareholders will expect the firm to make profits. As a result, dividend payments to shareholders may have to be increased. } Consumers will expect a minimum level of quality for the price they pay for the goods purchased. } The government demands that laws be obeyed and taxes paid. } Local environmentalists will expect the company to be socially responsibly and may be able to exert enough pressure to prevent gross over-pollution.
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Complete Question 1, Anderton, p.292.
Other objectives
Consumer co-operatives aim to help consumers. } Worker co-operatives are often motivated by a desire to maintain jobs or to produce a particular product, such as health foods.
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Conclusion
Whilst it is simplistic to argue that all firms aim to maximise profit, it is not unreasonable to make the assumption that, in general, firms are profit maximisers.
Local, flexible and personal service small firms such as solicitors, accountants, hairdressers, dentists, hardware stores and small shops are able to offer customers personal attention for which they will pay a higher price.
Internal growth
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Internal growth simply refers to firms increasing their output, e.g. through increased investment or increased labour force.
External growth
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} } }
A merger or amalgamation is the joining together of two or more firms under common ownership. The boards of directors of the two companies, with the agreement of the shareholders, agree to merge their two companies together. A takeover implies that one company wishes to buy another company. A hostile takeover is when the board of directors recommends to its shareholders to reject the terms of the bid. A takeover battle is then likely to ensue. A company must get promises to sell at the offer price of just over 50 per cent of the shares to win and take control. http://www.youtube.com/watch?v=1w2hWzDKoYc
Types of merger
A horizontal merger is between two firms in the same industry at the stage of production, e.g. the merger of two car manufacturers. } A vertical merger is a merger between two firms at different stages of production.
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Forward integration involves a supplier merging with one of its buyers, such as a car manufacturer buying a car dealership. Backward integration involves the purchaser buying one of its suppliers, such as a car manufacturer buying a tyre company.
A conglomerate merger is the merging of two firms with no common interest, e.g. a food company buying a clothing chain.
Horizontal integration
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When one firm merges with or takes over another one in the same industry at the same stage of production.
Primary
Confectionary Manufacturer B
Tertiary
Secondary
Tertiary
Secondary
Manufacturer
Tertiary
Retail Stores
Conglomerate integration
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When one firm merges with or takes over a firm in a completely different industry.
Clothing Manufacturer Soft drink Manufacturer
The business now has activities in more than one industry. This means that the business has diversified its activities, which reduces the risk of making a loss. For example:
Newspaper
Computer manufacturer
Horizontal Integration
Toyota
Lateral Integration
Ice Cream
Conglomerate Integration
The desire to achieve a reduction in ATC over time through the benefits of economies of scale To achieve a bigger market share, which would boost sales revenue and possibly profits To diversify the product range To capture the resources of another business
1. The desire to achieve a reduction in ATC over time through the benefits of economies of scale
A larger company is able to exploit economies of scale more fully. } For example, the merger of two medium sized car manufacturers is likely to result in potential economies in all fields, from production and marketing to finance. } Vertical and conglomerate integration is less likely to yield economies of scale because there are unlikely to be any technical economies. } However, there may be some marketing economies and financial economies.
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2. To achieve a bigger market share, which would boost sales revenue and possibly profits
A larger company may be more able to control its markets. } It may therefore reduce competition in the market place in order to be better able to exploit the market.
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http:// www.bbc.co.uk/ news/ business-15494135 http://www.thelocal.se/ 37380/20111116/#