Microeconomics: short summary final exam year 1

ME short summary final exam
CH8:
 Model of perfect competition rests on three basic assumptions: (if they hold, market
demand and supply curves can be used to analyze the behavior of market prices)
1. price taking
2. product homogeneity
3. free entry and exit

 When is a market highly competitive?
- Each firm faces perfectly horizontal demand curve for homogeneous product in industry that
it can freely enter or exit
- Highly competitive in sense that firms face highly elastic demand curves an deasy entry and
exit
- There is no simple indicator to tell us when a market is highly competitive
 necessary to analyze both the firms themselves and their strategic interactions

 Do firms maximize profit?
- In smaller firms, profit dominates all decisions
- In larger firms, owners cannot monitor manager’s behavior, they have leeway in how they
run the firm and can deviate from profit-maximizing behavior
- Managers more concerned with revenue maximization/growth, and payment dividends, and
short run profit at expense of its longer-run profit
- Long-run profit better serves interest of stockholders
- Firms that survive in competitive industries make long-run profit maxim. One of their highest
priorities

 Alternative forms of organization
- Cooperative: association of businesses or people jointly owned and operated by members
for mutual benefit (provide at lowest cost, set prices so that cooperative avoids losing
money, but any profits are incidental and are returned to members)
- Condominium (condo): a housing unit that is individually owned byt provides access to
common facilities that are paid for and controlled jointly by an association of owners
- Compared to cooperative the condo has the important advantage of simplifying governance

 Marginal revenue, marginal cost, and profit maximization
- Profit = TR – TC
- To maximize profit, select output for which difference between revenue and cost is greatest
- Slope of revenue curve = marginal revenue (derivative)
- Marginal revenue: the change in revenue resulting from a one-unit increase in output
- Marginal cost: additional cost of producing one additional unit of output
- Total cost is positive when output is zero, because there is a fixed cost in the short run
- At point q* (profit-maximizing output level), MR and MC are equal
- At output levels above q*, cost rises more rapidly than revenue  profit declines from its
maximum when output increases above q*
- Profit maximized when MR and MC are equal holds for ALL FIRMS

 Demand and marginal revenue for a competitive firm
- How much output the firm decides to sell will have no effect on the market price of product
- Market price is determined by industry demand and supply curves  competitive firm =
price taker  because price taker, demand curve facing individual competitive firm is given
by a horizontal line (firms sales will have no effect on price)

, - Price is determined by interaction of all firms and consumers in the market, not by output
decision of a single firm
- The DEMAND curve is perfectly elastic (horizontal), the MARKET DEMAND curve is
downward sloping
- Demand curve in a competitive market is both is average revenue curve and its marginal
revenue curve (P=AR=MR)

 Profit maximization by a competitive firm
- Demand curve facing competitive firm is horizontal (P=MR)
- Rule profit maximization applied can be simplied, choose output where MR=P (price is fixes,
this rule is or setting output)

 Short-run profit maximization by a competitive firm (MR=MC)
- Fixed amount of capital and must choose the levels of its variable inputs (labor and
materials) to maximize profit
- Condition for profit maxim.: MR = MC at a point at whuch MC curve is rising
- Output rule: if a firm is producing any output, it should produce at the level MR=MC
- A firm need not always earn profit in the short run
- Short run: A competitive firm should shut down if P is below AVC
- Higher fixed cost of production raises ATC but does not change AVC and MC cuves
- Average loss: P<AC, average gain: P>AC
- Profit = (P-ATC) *Q

 When should the firm shut down?
- Answer depends on firm’s expectations about future business conditions
 believed conditions will improve/profitable?  operate at loss in short run
- Firm loses money when P<ATC at profit maximing output q*  shut down and leave
industry  continue to produce? Firm minimizes its losees at output q* but will still have
losses rather than profits because P<AC
(does not matter tha P is greater than AVC)
- Because of presence of fixed cost  ATC exceeds AVC, ATC also exceeds P, so that firm is
indeed losing money
- Fixed costs don’t change with level of output but can be eliminated if firm shuts down
- Shutting down not always sensible  firm might operate at a loss in the short run because it
expects to become profitable again in the future, when price of its product increases or cost
of production falls
- Operating at a loss: painful but will keep open the prospect of better times in future
- Benefit staying in business: firm retained flexibility to change the amount of capital that is
uses and thereby reduces its ATC

 The competitive firm’s short-run supply curve
- In the shortrun, the firm chooses its output so that MC = O, as long as the firm covers its
AVC. The short-run supply curve is given by the crosshatched portion of the marginal cost
curve, for which MC>AVC
- For P less than (or equal to) minimum AVC, the profit-maximizing output is equal to 0
- Short-run supply curves for competitive firms slope upward for the same reason that MC
increases – the presence of diminishing marginal returns to one or more factors of product.
 increase in MP will induce those firms already in market to increase Q they produce.
- Higher P makes additional profits profitable and increases firms’ total profit because applies
to all units
- When MC of production for a firm increases, the level of output that maximizes profit falls.