The core of Capitalism: The Profit-Maximising Firm Flashcards Preview

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Flashcards in The core of Capitalism: The Profit-Maximising Firm Deck (66)
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1
Q

Why must you understand how firms behave in competitive industries?

A
  1. Most firms in the real world face a lot of competition because they are memebers of industries in which firms can enter and exit relatively freely. Therefore, firms have to worry about competitors already in the industry and those that may potentially come into the industry.
  2. All firms - even those that don’t face much competition - behave in remarkably similar ways.
2
Q

How do all firms go about maximising profits?

A

By producing exactly the level of output at which the cost of producing one more unit just equals the increase in revenue that the firm gets from seeling that unit.

3
Q

Why do economists assume that the overriding goal of firms is to make as much profit as possible?

A
  1. Every firm has profit maximisation near the top of its to-do list
  2. Every firm wants to maximise profits after taking steps to achieve whatever other goals it may have.
4
Q

Give examples of firms maximising profits after taking steps to achieve other goals.

A
  1. When Ben and Gerry’s started, it donated a large % of its profits to charity. Given such a policy, the best way to help worhty causes was for Ben and Gerry’s to make as much big profit as possible.
  2. The Body shop and Innocent smoothie follow a social purpose and do so as profit-making companies.
5
Q

Why is an industry in perfect competition easiest to understand?

A

This situation is the easiest case to understand, because in an industry in which many competitors are producing identical products, non of the firms have any control over the price they charge.

6
Q

What are the 3 things which perfect competition assumes about firms in an industry?

A
  1. Each firm is one of many
  2. Each firm represents a very small part of the industry
  3. Each firm sells identical or nearly identical products
7
Q

Give an example of perfect competition using the market analogy.

A
  • People used to do their shopping in markets, and a market comes close to fullfilling the 3 criteria previosuly mentioned.
  • Individual stallholder are gathered together so that each only has a small share of the industry.
  • This situation means that individual stallholders are, price takers, that is, no single stallholder can affect the price that consumers are willing to pay for their produce.
  • A nice shiny apple is therefore likely to cost the same no matter which vendor you buy it from.
8
Q

Using an example, what is a commodity?

A

A commodity is something that has a defined quality i.e. silver.

Ex. something is either gold or it is not gold - there’s no such thing as being more goldy than something else.

9
Q

Why do individual miners have no control over the price of gold?

A
  • Firstly, they are producing a nearly identical product.
  • Because the gold from one place is identical to the gold from elsewhere, the only way an Angolan producer can entice you to buy from him rather than a Russian is to offer you a lower price.
  • because all the gold is identical, all the producers have to compete on is price and price alone.
10
Q

What is the market supply curve for gold unaffected by?

A

So many producers of gold exist and so many produce such a very small part of the total supply of gold that the market supply curve for gold is basically unaffected by the presence or absence of any given individual supply curve or any particualr gold producer.

11
Q

Give an ex. of a player who’s too small to change the market price.

A

If a trillion troy ounces of gold or sold every year, the market price is unaffected by whether a small producer with only 1,000 ounces to sell bothers showing up to the market or not. He’s just too small a player to cause the market price to change.

12
Q

What happens if every player is too small to cause the makret to change price?

A

If every player is too small to cause the makret to change price, each one has to take as a given whatever price is generated by market demand interacting with market supply.

13
Q

How are perfectly competitive firms price takers but quantity makers?

A

Because firms have no control over their prices under perfect competition, the only thing that price-taking firms can control is how much to produce.

14
Q

What quantity do firms choose to make?

A

Firms choose to make whatever quantity maximises their profits.

This fact is mathematically convenient because it turns out that the quantity of output that a firm chooses to produce controls each of the two things that determines profit: total revenue and total costs.

15
Q

Define a firm’s profit.

A

Profit = TR - TC

Tr for a competitive firm is simply the q of its output sold times the market price, p, that it can get for each unit;

TR = p x q

16
Q

Give an example of how costs pile up for firms, as each successive unit costs more than the previous unit.

A

Suppose an apple vendor can sell as many apples as he wants at £1 each. The fist apple costs 10p to produce, the 2nd costs 20p, the 3rd costs 30p, and so on.

In such a case he’s only willing to produce no more than 10 apples. Why? Because for each of the first 9 apples, he makes a profit, but for apple 10 (which costs £1 to produce), he only breaks even.

If he produces any more apples, he sustains a loss. (Apple number 11, for example, costs £1.10 to produce, but he only gets a quid for selling it).

17
Q

What do economists mean by profit and loss?

A

To an economist, the terms profit and loss refer to whether the gains from running a business are bigger or smaller than the costs involved.

18
Q

What does an economist mean by “running a profit/running a loss”?

A

If the gains exceed the costs, you’re said to be running a profit, whereas if the costs exceed the gains, you’re said to be running a loss.

If the two are just equal, you’re said to be breaking even.

19
Q

How do accountants and economists disagree on what to count as costs?

A

Consider a business that sells lomonade.

Accountants - consider costs to be only actual monies spent in running the business. If TR = 10 grand, and it spends 9 grand to make those revenues, the account concludes that the firm’s profit is 1 grand- this is the firm’s accounting profit.

Economists - prefer a more subtle concept known as economic profit which takes into account not just the money costs directly incurred by running a business but also the oppurtunity costs incurred.

20
Q

What are the oppurtunity costs regarding the lemonade business?

A

Remember: oppurtunity costs are what you have to give up in order to do something.

Suppose that this person left a job as a florist to open the lemonade business, and in the same amount of time that it took the lemonade business to turn 1 grand of profit, she would have made 10 grand in wages at her old job as a florist.

21
Q

What is the most important application of the economic profit concept?

A

The most important application of this concept is to determine how much output a firm needs to produce.

If producing the 12th unit of a product produces an economic profit, obviouslt the firm wants to produce it.

But if increasing production to a 13th unit results in an economic loss, obviously the firm doesn’t want to produce it.

22
Q

What do you get at by taking into account economic profits and losses?

A

By taking into account economic profits and losses, you get directly at what motivates firms to produce not only the types of goods they choose to produce, but also the quantities of those goods.

23
Q

What are fixed costs?

A

Costs that have to be paid even if the firm isn’t producing anything.

Ex. after a rent contract is signed for the firm’s hq, that rent must be paid whether the firm produces anything or not.

Or

if the firms has taken out a loan, it’s legally required to make its debt payments whether its produced 0 units or a billion.

24
Q

What are Variable costs?

A

Costs that vary with the amount of output produced.

Ex. if you are in the lemonade making business and you choose to produce nothing, you obviously don’t ahve to buy any lemons. But the more lemonade you do produce, the more you spend on lemons… and what about labour costs?

25
Q

What is the sum for total costs?

A

TC = FC + VC

26
Q

In the LemonAid example, what is the second workers marginal output?

A

From one worker to 2, output increases from 50 to 140 bottles. In other words, the marginal output of the 2nd worker is 90 bottles (whereas the 1st worker’s marginal output is only 50 bottles)

27
Q

What is meant by increasing returns?

A

If you have to pay each worker the same wage of £80 per day, you’re going to like the fact that whereas the 1st worker produces 50 bottles for his £80 pay, the 2nd produces 90 bottles for her £80 pay.

This is known as increasing returns because the amount of return you get for a given amount of input (on more worker) increases as you add successive units.

Spolier alert: it doesn’t last long as diminishing returns set in.

28
Q

Give an example of an Average Variable Cost calculation.

A

AVC = variable costs divided by the quantity (VC/q)

EX. One worker produces 50 bottles of output at a VC of £80 then the AVC is 80/50 = £1.60 per bottle

EX 2. Two workers produce 140 bottles of output at a VC of £160 then the AVC of the two workers is 160/140 = £1.14 per bottle.

The decrease in AVC is due to increasing returns.

29
Q

What happens to AVC when diminishing returns sets in?

A

AVC start to rise because although each additional worker costs an extra £80, each additional worker after the 2nd worker brings a smaller increase in output than his predecessor.

In other words, each successive £80 wage payment brings with it fewer and fewer additional bottles produced, so the AVC per bottle must rise.

30
Q

What does the firms AVC curve look like?

A
31
Q

Give an example of Average Fixed costs calculation.

A

AFC = fixed costs divided by the quantity (FC/q).

Ex. the fixed costs of LemonAid are always the £100 the firm paid for the juicer machine, no matter what the putput level is. As a result, the more lemonade it produces, the lower its AFC.

1 worker produces 50 bottles AFC = £2.00 per bottle

8 workers producing 470 bottles AFC = £0.21 per bottle

32
Q

Why do AFC always decline?

A

Because the same fixed cost gets divided up over a greater and greater no. of units of output as output increases.

33
Q

How do you calculate ATC?

A

ATC = AFC + AVC

34
Q

Explain why the ATC must always be greater than the AVC?

A
  • The ATC curve is above the AVC curve
  • the vertical distance between them at any particular level of output is equal to the AFC at that output level.
  • as you move from lower output levels to higher output levels, the ATC and AVC curves converge because AFC becomes smaller and smaller.
35
Q

Explain why ATC reaches its minimum value at a higher level of output than AVC?

A

Look at the table below

  • AVC reach their minimum value of £1.09, when 3 workers are hired and 220 bottles are produced
  • ATC, however, reach thier min of £1.43 when 5 workers are hired and 350 bottles are produced
  • This happens because AFC are always falling
  • This constant decline helps to offset temporarily the incrases in AVC that happens when diminishing returns set in
36
Q

Define marginal cost.

A

Marginal cost is how much total costs increase when you produce one more unit of output. The marginal cost of one more unit of output depends on how much output has already been produced.

37
Q

Why might someone use marginal costs?

A

The manager of a firm wants to know what quantity, of output she needs to produce in order to maximise profits. To solve this problem, she needs one more cost concept: marginal cost.

38
Q

Give an example of a marginal costs calculation.

A
  • Total costs increase from £100 in the 1st row to £180 in the 2nd as output increases from 0 to 50 bottles when the firm hires one worker
  • in other words, costs go up £80 while output goes up 50 bottles
  • so each of these extra, marginal 50 bottles on average increases costs by 80/50 = £1.60
  • MC = (Change in TC)/(Change in q)
39
Q

In the LemonAid example, why do marginal costs first fall and then rise?

A
  • Yet another reflection of the fact that LemonAid’s production process exhibits incrasing returns followed by diminishing returns
  • Beacuse the 2nd worker produces much more than the first worker but costs the same, the marginal cost falls when the second worker is added
  • For successive workers, costs keep increasing but marginal output keeps declining, which means marginal costs much rise.
40
Q

Where does the MC intersect the ATC and AVC curves?

A

The MC curve crosses both the AVC and ATC curves at their minimum - at the bottom of their curves.

41
Q

Why does the MC curve go throguh the minimum points on both the AVC and ATC curves?

A

This happens because the MC at each unit determines whether the AVC and ATC curves are increasing or decreasing.

42
Q

Instead of costs, use height to explain why the MC curve goes through the ATC and AVC curves at their minimum.

A

Imagine a room with 10 people in it. Say the average height is 156cm. Now think what happens to the average height when another person walks in:

  • if he is taller than the previous average, the average rises
  • if he is smaller than the average, the average falls
  • if he is exactly 156cm, the average stays the same.
43
Q

Expand the height analogy.

A
  • The same sort of reasoning applies to marginal costs and average costs. After q units of output, you can figure out the ATC and AVC, just like you can compute the average height after the first ten people enter the room.
  • After that, ATC and AVC rise or fall depending on the MC of the next unit of output
  • just as the average height of people in the room increases, decreases or stays the same, depending on the next person entering the room.
44
Q

What ahppens if MC is less/greater or exactly the same as the previous average cost?

A
  • if the MC is less than the previous average cost, the averages fall
  • if it is larger than the previous average, the averages rise
  • if its the exact same as the previous average, the averages stay the same
45
Q

Explain what is occuring to the left and to the right of the point where the MC curve crosses the ATC and AVC curves.

A
  • To the left the averages must be falling because the MC is less than the averages
  • To the right, the averages must be rising because the MC is larger than the averages
  • Where the curves cross, the averages are neither rising nor falling because the MC of that unit of output = the current average (in other words, someone who is 156cm has walked in)
46
Q

What is special about the fact that the MC curve crosses through the ATC and AVC at their minimum?

A

Economists love to bang on about this fact but really it just reflects the effect that increasing and decreasing returns have on cost curves.

47
Q

If a firm wants to produce a positive amount of output, what is the formula used to determine the optimal quantity of output, q, that it needs to produce?

A

The firm wants to produce at the level of output where MR= MC

48
Q

What are the benefits of producing at the point where MR = MC?

A
  1. It minimises the firm’s losses if it has to take a loss due to a low selling price for its output.
  2. It maximises the firm’s profit if it can make a profit, because the selling price is high enough.
49
Q

What is the key concept behing MR = MC?

A

The idea behind MR = MC is very simple and comes down to a cost benefit analysis. If producing and selling a bottle brings in more revenue than it costs to produce the bottle, produce it. If not, don’t produce it.

50
Q

If LemonAid can sell a bottle of lemonade that it produces for £2 each, what is the MR for each bottle?

A

Economists like to say the MR of each bottle is £2, beacuse each and every bottle when sold brings in an extra £2.

Therefore P = MR

51
Q

How do firms decide how much Lemonade to produce?

A

The firm’s mgmt must decide how much to produce based on whether any given bottle costs more or less than the £2 MR that the firm would get by selling it.

52
Q

Why do managers look at an individual bottles MC when deciding how much to produce?

A

Because if they’re deciding whether or not to produce that bottle, they need to isolate that bottle’s production cost from the costs of all previously produced bottles in order to compare it to the revenue that the bottle brings if produced and sold.

MC does just that by ignoring all previous bottles and focusing on what the next bottle is going to cost to make.

53
Q

What quantity of bottles should lemonAid choose to produce to maximise profits?

A

Quantity q* = 440 bottles

This corresponds to where th horizontal p = MR = £2 line crosses the MC curve. This quantiy

54
Q

Using an example, explain why MR = MC maximises profits.

A

Take bottle no. 140. It has a MC of only £0.89 but can be sold for £2. Clearly you need to make such a bottle because you make more selling it than it costs to produce it.

The same is true for each unit of output, q, for which q < 440.

55
Q

Why doesn’t producing at MR= MC GUARANTEE you a profit?

A

Because it doesn’t take into account the fixed costs you have to pay no matter what level of output you’re producing.

i.e. even though you only produce bottle for which MR is greater than MC, you may still not make enough of a gain from these bottles to pay off your fixed costs.

56
Q

Using a graph of a profit-making firm, show TR.

A

TR = P x q*

rememeber q* = profit maximising output level

57
Q

Using a graph of a profit making firm, show TC.

A
  • B shows the ATC per unit when thee firm is producing output level q*.
  • At q*, ATC = TC/q* so when you multiply both sides of this equation you find that ATC x q* = TC
  • This equation tells you that TC is indeed equal to the product of ATC and q*
58
Q

Using a graph of a profit making firm, show profit.

A

Profit = TR - TC

Profit is equal to the area of the shaded rectangle because profits are simply the difference between TR and TC.

If the TR rectangle is bigger than the TC rectangle the firm is making a profit.

59
Q

Demonstrate a firm making a loss, using a graph.

A

Because the TR rectangle is much smaller than the TC rectangle, the firm is therefore running a loss equivalent to the size of the shaded area.

60
Q

When is it best for the firm to pull the plug?

A

Even though the firm is running a loss they may continue to do business, sometimes because they believe that the price at which they can sell its products will rise or it expects it can somehow reduce its costs of production.

But sometimes it is better off for the firm to pull the plug. The determining factor is once again fixed costs.

61
Q

What is the short-run shutdown condition?

A

If a firms total revenues at Q* are less than variable costs, its better to shut down completely.

This happens anytime the horizontal p = MR line intersects the MC curve at a point lower than the AVC curve.

62
Q

Give an example of the short-run shutdown condition.

A

Imagine FC = £1000 and that by producing Q* units the firm makes TR = £400 and incurs variable costs of £500.

Because TR only cover £400 of the £500 in variable costs, the firm loses £100 in variable costs by producing.

Add the £1000 in FC to that and the firm loses a total of £1100 by producing Q* units.

If however, the firm shuts down and produces zero units, it only loses £1000 in FC. Clearly in this situation the firm should shut down.

63
Q

Give a real life example of why producing when you’re losing money on each item you produce is never a good idea.

A

Factory records famously discovered this on the release of New Order’s ‘Blue Monday’ single.

The packaging turned out to be so expensive that every single copy sold lost money.

Worse still, the record was so successful that the losses per sale totalled up to a staggering amount of money.

The packaging was changed later and factory went bust.

64
Q

What is the long-run shut down condition?

A

This occurs when a firms TR exceed its variable costs but are less than its TC.

This happens when the horizontal p = MR line crosses the MC curve at the point where the MC curve lies above the bottom of the AVC curve but below the bottom of the ATC curve.

65
Q

Why is producing rather than shutting down preferable during the long run shut down condition?

A

In such a situation, the firm is guaranteed to lose money.

But as the firm is stuck with its current FC commitments, producing rather than shutting down immediately is preferable.

If it produces, its TR exceeds its variable costs, meaning it can use the excess to pay off at least part of its FC’s.

If it shuts down immediately and produces nothing, it loses all its FC and thereby does worse.

As soon as its FC contracts expire, it shuts down permanently.

66
Q

Why are perfectly competitive firms in some sense totally at the mercy of the market price?

A

Because, if the price is high, it makes profits.

If the price is low, it sustains losses.

And even then, its decision to continue operating at a loss or shut down unitl it can get out of its FC’s commitments depends entirely on the price.

Perfectly competitive firms have no control.