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Flashcards in Week 7 Prices and Markets Deck (66)
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The firm

The firm is a planning unit which produces goods (outputs) using factors of production (inputs)
for financial return.

Firms have the responsibility to manage a large proportion of society’s productive resources.
Economists want to know whether this stewardship is efficient.

To find out, economists build models of the firm based on assumptions. These
models are then analysed for equilibrium and efficiency.


the SCP paradigm

The Structure-Conduct-Performance (SCP) paradigm provides a structured framework to study the firm.

Developed by Joe Bain (1959), used as a starting point for analysing markets and industries.

The performance of a market is determined by the conduct of the firms within the market which in turn is determined by the structure of the market.


SCP causal relationship

Structure to conduct to performance



The competitive environment in the market.



How firms behave in a given market structure (pricing strategies, advertising, research and development).



Market efficiency (social welfare, consumer surplus, profits).


Industry analysis: market structure

Market structure describes the competitive environment in which firms operate.

It is determined by four characteristics which determine how firms behave (conduct) and how efficient the market is (performance).
These yield four types of market structure:

Photo in favourites 12/9/18


Number of firms

Firm size

Entry barriers

Product differentiation

For each, we want to study:

Structure: the relevant costs, revenues and associated curves for a firm in the particular market structure;

Conduct: Use these to determine how the firm decides how much Q to produce and how much P to charge, both in the short and long run; and

Performance: whether these decisions lead to efficiency.



total revenue minus cost

Profit = TR - TC


Profit maximisation - Introduction

Neoclassical economics assumes that the main objective of the firm is to maximise its profits.
To identify how to produce to maximise profits, the firm needs to know how its revenues and costs change as it produces more.


TR and TC

Total revenue (TR) = total output produced (and sold) (Q) x price per unit (P)

Total cost (TC) = total output produced (Q) x cost per unit (C)


Total revenue

(TR) = P x Q
[ TR = P x Q ]


Average revenue

(AR) = total revenue divided by the quantity sold.
[ AR = TR / Q ]

As TR = P x Q, therefore, for all types of firm, AR equals the price of the good.
[ AR = TR / Q = P ]


Marginal revenue

(MR) = the change in TR from an additional unit sold.
[ MR = ∆ TR / ∆ Q ]


Revenue measures

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Revenue when demand is elastic

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When a demand curve is elastic (PED > 1), an increase in price lowers TR because the rise in price is proportionately smaller than the fall in quantity demanded.


Revenue when demand is inelastic

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When a demand curve is inelastic (PED < 1), an increase in price raises TR because the rise in price is proportionately larger than the fall in quantity demanded.


The general rule for profit maximisation

Profit is maximised when MC = MR


Marginal revenue

the extra revenue earned in selling one additional unit of output


Marginal cost

the extra cost incurred in producing one additional unit of output


MR and MC

If MR > MC, the firm should increase its output;
If MC > MR, the firm should decrease its output;
At MC = MR, profit is maximised.
Firms will produce output up to quantity where MC = MR.


Profit and marginal profit

Profit = TR - TC
Marginal profit (MP) = MR - MC
Profit is maximal if MP = 0
MR – MC = 0, therefore MC = MR


Profit maximisation photo

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Profit maximisation photo

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Production and costs - Introduction

opportunity and explicit costs

When economists calculate a firm’s total cost of production, they include all the opportunity costs of producing the output.

The amount spent on purchasing raw materials and paying workers’ wages are opportunity costs because this money cannot be used to buy something else. When a cost involves money flowing out of the firm it is called an explicit cost.


Production and costs - Introduction

implicit costs

In contrast, the opportunity costs of resources owned and used by the firm, but not explicitly paid for by the firm (no outflow), are implicit costs. For e.g. the opportunity cost of an entrepreneur’s labour. An important implicit cost is the opportunity cost of the financial capital invested in the business.


Economic and accounting profit

Economists include implicit costs in total costs, but accountants do not. Therefore accounting profit is larger than economic profit.


Production function

The relationship between quantity of inputs used to make a good and the quantity of output of the good.


Production function (actual function)

Q = f (K, L), where Q = total output; K = capital (input); L = labour (input).

In order to increase Q, the firm has to increase K or L or both, thereby increasing total costs.


Problem with increasing Q

certain inputs (i.e. K) take time to increase