Theory of the Firm: Revenues/Profit and Goals of Firms
Syllabus Requirements:
Total Revenue, average revenue and marginal revenue:
- Distinguish between total revenue, average revenue and marginal revenue.
- Draw diagrams illustrating the relationship between total revenue, average revenue and marginal revenue.
- Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
Profit
Economic profit (sometimes know as abnormal profit) and normal profit (zero economic profit occurring at the break-even point)
- Describe economic profit (abnormal profit) as the case where total revenue exceeds economic cost.
- Explain the concept of normal profit (zero economic profit) as the amount of revenue needed to cover the costs of employing self-owned resources (implicit costs, including entrepreneurship) or the amount of revenue needed to just keep the firm in business.
- Explain that economic profit (abnormal profit) is profit over and above normal profit (zero economic profit), and that the firm earns normal profit when economic profit (abnormal profit) is zero.
- Explain why a firm will continue to operate even when it earns zero economic profit (abnormal profit).
- Explain the meaning of loss as negative economic profit arising when total revenue is less than total cost.
- Calculate different profit levels from a set of data and/or diagrams.
Goals of Firms:
Profit Maximization:
- Explain the goal of profit maximization where the difference between total revenue and total cost is maximized or where marginal revenue equals marginal cost.
Alternative goals of firms:
- Explain alternative goals of firms, including revenue maximization, growth maximization, satisficing and corporate social responsibility.
Perfect Competition
- Describe, using examples, the assumed characteristics of perfect competition: a large number of firms; a homogenous product; freedom of entry and exit; perfect information; perfect resource mobility.
Revenue Curves
- Explain, using a diagram, the shape of the perfectly competitive firm's average revenue and marginal revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price taker.
- Explain, using a diagram, that the perfectly competitive firm's average revenue and marginal revenue curves are derived from market equilibrium for the industry.
Profit maximization in the short run
- Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short run based on the marginal cost and marginal revenue profit maximization rule.
Profit maximization in the long run
- Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit (zero economic profit).
- Explain, using a diagram, how a perfectly competitive market will move from short run equilibrium to long run equilibrium.
Shut-down price and break even price
- Distinguish between the short run shit-down price and the break-even price.
- Explain, using a diagram, when a loss-making firm would shut down in the short run.
- Explain, using a diagram, when a loss making firm would shit down and exit the market in the long run.
- Calculate the short run shit down price and the break even price from a set of data.
Efficiency
- Explain the meaning of the term allocative efficiency.
- Explain that the condition for allocative efficiency is P=MC (or with externalities, MSB=MSC).
- Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the short run and the long run.
- Explain the meaning of the term productive/technical efficiency.
- Explain that the condition for productive efficiency is that the production takes place at minimum average total cost.
- Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run.
Monopoly
Assumptions of the Model
- Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in the market; no close substitutes; significant barriers to entry.
Barriers to Entry
- Explain, using examples, barriers to entry, including economies of scale, branding and legal barriers.
Revenue Curves
- Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward sloping.
- Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly.
- Explain why a monopolist will never choose to operate in the inelastic portion of its average revenue curve.
Profit maximization
- Explain, using a diagram, the short-run and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firm's economic profit (abnormal profit) or losses.
- Examine the role of barriers to entry in permitting the firm to earn economic profit (abnormal profit)
Revenue Maximization
- Explain, using a diagram, the output and pricing decision of a revenue maximizing monopoly firm,
- Compare and contrast, using a diagram, the equilibrium positions of a profit maximizing monopoly firm and a revenue maximizing monopoly firm.
- Calculate from a set of data and/or diagrams the revenue maximizing level of output.
Natural monopoly
- With reference to economies of scale, and using examples, explain the meaning of the term “natural monopoly”.
- Draw a diagram illustrating a natural monopoly.
Monopoly and efficiency
- Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency.
- Evaluate reasons why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale.
Policies to regulate monopoly power
- Evaluate the role of legislation and regulation in reducing monopoly power.
- The advantages and disadvantages of monopoly compared with perfect competition
Monopolistic competition
Assumptions of the model
- Describe, using examples, the assumed characteristics of a monopolistic competition: a large number of firms; differentiated products; absence of barriers to entry and exit.
Revenue curves
- Explain that product differentiation leads to a small degree of monopoly power and therefore to a negatively sloping demand curve for the product.
Profit maximization in the short run
- Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit maximizing (loss minimizing) firm in monopolistic competition, identifying the firm’s economic profit (or loss).
Profit maximization in the long run
- Explain, using diagrams, why in the long run a firm in monopolistic competition will make normal profit.
Non-price competition
- Distinguish between price competition and non-price competition.
- Describe examples of non- price competition, including advertising, packaging, product development and quality of service.
Monopolistic competition and efficiency
- Explain, using a diagram, why neither allocative efficiency nor productive efficiency are achieved by monopolistically competitive firms.
Monopolistic competition compared with perfect competition and monopoly
- Compare and contrast, using diagrams, monopolistic competition with perfect competition, and monopolistic competition with monopoly, with reference to factors including short run, long run, market power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and exit, size of firms and product differentiation.
Oligopoly
Assumptions of the model
- Describe, using examples, the assumed characteristics of an oligopoly: the dominance of the industry by a small number of firms; the importance of interdependence; differentiated or homogeneous products; high barriers to entry.
- Discuss the role of interdependence in the dilemma faced by oligopolistic firms—whether to compete or to collude.
- Explain how a concentration ratio may be used to identify an oligopoly.
Game theory
- Explain how game theory (the simple prisoner’s dilemma) can illustrate strategic interdependence and the options available to oligopolies.
Open/formal collusion
- Explain the term “collusion”, give examples, and state that it is usually (in most countries) illegal.
- Explain the term “cartel”
- Explain that the primary goal of a cartel is to limit competition between member firms and to maximize joint profits as if the firms were collectively a monopoly.
- Explain the incentive of cartel members to cheat.
- Examine the conditions that make cartel structures difficult to maintain.
Tacit/informal collusion
- Explain the term “tacit collusion”, including reference to price leadership by a dominant firm.
Non-collusive oligopoly
- Explain that the behaviour of firms in a non-collusive oligopoly is strategic in order to take account of possible actions by rivals.
- Explain, using a diagram, the existence of price rigidities, with reference to the kinked demand curve.
- Explain why non-price competition is common in oligopolistic markets, with reference to the risk of price wars.
- Describe, using examples, types of non-price competition.
Price discrimination
- Describe price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost.
- Explain that price discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticities of demand for the product; the firm must be able to separate groups to ensure that no resale of the product occurs.
- Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand.
Day 1: Total Revenue, average revenue and marginal revenue:
- Distinguish between total revenue, average revenue and marginal revenue.
- Draw diagrams illustrating the relationship between total revenue, average revenue and marginal revenue.
- Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
Profit
Economic profit (sometimes know as abnormal profit) and normal profit (zero economic profit occurring at the break-even point)
- Describe economic profit (abnormal profit) as the case where total revenue exceeds economic cost.
- Explain the concept of normal profit (zero economic profit) as the amount of revenue needed to cover the costs of employing self-owned resources (implicit costs, including entrepreneurship) or the amount of revenue needed to just keep the firm in business.
- Explain that economic profit (abnormal profit) is profit over and above normal profit (zero economic profit), and that the firm earns normal profit when economic profit (abnormal profit) is zero.
- Explain why a firm will continue to operate even when it earns zero economic profit (abnormal profit).
- Explain the meaning of loss as negative economic profit arising when total revenue is less than total cost.
- Calculate different profit levels from a set of data and/or diagrams.
ACDC Econ Review of Economic Profit:
Goals of Firms:
Profit Maximization:
- Explain the goal of profit maximization where the difference between total revenue and total cost is maximized or where marginal revenue equals marginal cost.
Alternative goals of firms:
- Explain alternative goals of firms, including revenue maximization, growth maximization, satisficing and corporate social responsibility.
Perfect Competition
- Describe, using examples, the assumed characteristics of perfect competition: a large number of firms; a homogenous product; freedom of entry and exit; perfect information; perfect resource mobility.
Revenue Curves
- Explain, using a diagram, the shape of the perfectly competitive firm's average revenue and marginal revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price taker.
- Explain, using a diagram, that the perfectly competitive firm's average revenue and marginal revenue curves are derived from market equilibrium for the industry.
Profit maximization in the short run
- Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short run based on the marginal cost and marginal revenue profit maximization rule.
Profit maximization in the long run
- Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit (zero economic profit).
- Explain, using a diagram, how a perfectly competitive market will move from short run equilibrium to long run equilibrium.
Shut-down price and break even price
- Distinguish between the short run shit-down price and the break-even price.
- Explain, using a diagram, when a loss-making firm would shut down in the short run.
- Explain, using a diagram, when a loss making firm would shit down and exit the market in the long run.
- Calculate the short run shit down price and the break even price from a set of data.
Efficiency
- Explain the meaning of the term allocative efficiency.
- Explain that the condition for allocative efficiency is P=MC (or with externalities, MSB=MSC).
- Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the short run and the long run.
- Explain the meaning of the term productive/technical efficiency.
- Explain that the condition for productive efficiency is that the production takes place at minimum average total cost.
- Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run.
Monopoly
Assumptions of the Model
- Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in the market; no close substitutes; significant barriers to entry.
Barriers to Entry
- Explain, using examples, barriers to entry, including economies of scale, branding and legal barriers.
Revenue Curves
- Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward sloping.
- Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly.
- Explain why a monopolist will never choose to operate in the inelastic portion of its average revenue curve.
Profit maximization
- Explain, using a diagram, the short-run and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firm's economic profit (abnormal profit) or losses.
- Examine the role of barriers to entry in permitting the firm to earn economic profit (abnormal profit)
Revenue Maximization
- Explain, using a diagram, the output and pricing decision of a revenue maximizing monopoly firm,
- Compare and contrast, using a diagram, the equilibrium positions of a profit maximizing monopoly firm and a revenue maximizing monopoly firm.
- Calculate from a set of data and/or diagrams the revenue maximizing level of output.
Natural monopoly
- With reference to economies of scale, and using examples, explain the meaning of the term “natural monopoly”.
- Draw a diagram illustrating a natural monopoly.
Monopoly and efficiency
- Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency.
- Evaluate reasons why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale.
Policies to regulate monopoly power
- Evaluate the role of legislation and regulation in reducing monopoly power.
- The advantages and disadvantages of monopoly compared with perfect competition
Monopolistic competition
Assumptions of the model
- Describe, using examples, the assumed characteristics of a monopolistic competition: a large number of firms; differentiated products; absence of barriers to entry and exit.
Revenue curves
- Explain that product differentiation leads to a small degree of monopoly power and therefore to a negatively sloping demand curve for the product.
Profit maximization in the short run
- Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit maximizing (loss minimizing) firm in monopolistic competition, identifying the firm’s economic profit (or loss).
Profit maximization in the long run
- Explain, using diagrams, why in the long run a firm in monopolistic competition will make normal profit.
Non-price competition
- Distinguish between price competition and non-price competition.
- Describe examples of non- price competition, including advertising, packaging, product development and quality of service.
Monopolistic competition and efficiency
- Explain, using a diagram, why neither allocative efficiency nor productive efficiency are achieved by monopolistically competitive firms.
Monopolistic competition compared with perfect competition and monopoly
- Compare and contrast, using diagrams, monopolistic competition with perfect competition, and monopolistic competition with monopoly, with reference to factors including short run, long run, market power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and exit, size of firms and product differentiation.
Oligopoly
Assumptions of the model
- Describe, using examples, the assumed characteristics of an oligopoly: the dominance of the industry by a small number of firms; the importance of interdependence; differentiated or homogeneous products; high barriers to entry.
- Discuss the role of interdependence in the dilemma faced by oligopolistic firms—whether to compete or to collude.
- Explain how a concentration ratio may be used to identify an oligopoly.
Game theory
- Explain how game theory (the simple prisoner’s dilemma) can illustrate strategic interdependence and the options available to oligopolies.
Open/formal collusion
- Explain the term “collusion”, give examples, and state that it is usually (in most countries) illegal.
- Explain the term “cartel”
- Explain that the primary goal of a cartel is to limit competition between member firms and to maximize joint profits as if the firms were collectively a monopoly.
- Explain the incentive of cartel members to cheat.
- Examine the conditions that make cartel structures difficult to maintain.
Tacit/informal collusion
- Explain the term “tacit collusion”, including reference to price leadership by a dominant firm.
Non-collusive oligopoly
- Explain that the behaviour of firms in a non-collusive oligopoly is strategic in order to take account of possible actions by rivals.
- Explain, using a diagram, the existence of price rigidities, with reference to the kinked demand curve.
- Explain why non-price competition is common in oligopolistic markets, with reference to the risk of price wars.
- Describe, using examples, types of non-price competition.
Price discrimination
- Describe price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost.
- Explain that price discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticities of demand for the product; the firm must be able to separate groups to ensure that no resale of the product occurs.
- Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand.