20 Chapter Costs and the Supply of Goods
1. Why are business firms used by societies everywhere to organize production? - Business firms are designed to organize raw materials, labor, and machines with the goal of producing goods and/or services. Firms (1) purchase productivity resources from households and other firms, (2) transform them into a different commodity, and (3) sell the transformed product or service to consumers. Every society relies on business firms to organize resources and transform them into products. 2. How are firms organized in market economies? - Firms in market economies are organized in one of three ways: 1. Proprietorship 2. Partnership 3. Corporation 3. What are the pros and cons of the different firm organizational structures? 4. What factors motivate corporate management to minimize costs? - There are three major factors that motivate corporate management to minimize cost 1. Competition among firms for investment funds and consumers. 2. Compensation and management incentives. 3. The threat of corporate takeover. 5. What are explicit and implicit costs, and how do they impact the firm? - Explicit costs are payments by a firm to purchase the services of productive resources. - Implicit costs are the opportunity costs associated with a firm's resources that it owns. These costs do not involve a direct money payment. Examples include wage income and wage forgone by the owner of a firm who also provides labor services and equity capital to the firm. 6. How does economic profit differ from accounting profit? Why is this difference important? - Economic profit is its total revenue minus the costs, including both the explicit and implicit cost components. - Accounting profit is the sales revenue minus the expenses of a firm over the designated time period, usually one year. Accounting profits typically make allowances for changes in the firm's inventories and depreciation of its assets. No allowance is made, however, for the opportunity cost of the equity capital of the firms owners, or other implicit costs. - These differences are important because accounting profits approximate the returns to the firm's equity capital 7. How will increases in output influence product cost in the short run?
Why is this the case? - Increases in output will influence product cost in the short run by over utilization, this will mean congestion or time spent by workers waiting for machines and similar costly delays. When diminishing marginal returns are present, successively larger amounts of variable input will be required to increase output by one more unit. As this happens marginal cost will rise. - This is the case because requiring output beyond the least-cost, or designed, output of a plant will lead to high marginal cost and therefore to high average total cost. 8. How will production cost generally vary in the long run? Why is this the case? - Production cost generally varies in the long run because if economies of scale are present, long run average total cost will decline. When constant returns to scale are experienced, LRATC will be constant. When diseconomies are present, LRATC will rice. - This is the case because the firm can choose its plant size. 9. What are the major factors that cause product cost curves to shift? - The major factors that cause product cost curves to shift are: - Resource prices - Taxes - Regulations - Technology 10. What are sunk costs and how do they matter? - Sunk costs are costs that have already been incurred as a result of past decisions. They are sometimes referred to as historical costs. These matter because they give managers hindsight when it comes to making current decisions, but the specific costs themselves are no longer directly relevant for current and future decisions. 11. What are the primary links between production costs and output decisions? - The primary links between production costs and output decisions are that costs explains a firms' supply decisions.
Key Terms Residual Claimants- Individuals who personally receive the excess, if any, or revenues over costs. Residual claimants gain if the firm's costs are reduced or revenues increase. Team Production- A production process in which employees work together under the supervision of the owner or the owner's representative. Shirking- Working at less than expected rate of productivity, which reduces output. Shirking is more likely when workers are not monitored, so that the cost of lower output falls on others. Principal-Agent Problem- The incentive problem that occurs when the purchaser of services (the principal) lacks full information about the circumstances faced by the
seller (the agent) and cannot tell how well the agent performs the purchased services. The agent to some extent work toward objectives other than those sought by the principal paying for the service. Proprietorship- A business firm owned by an individual who possesses the ownership right to the firm's profits and is personally liable for the firm's debts. Partnership- A business firm owned by two or more individuals who possess ownership rights to the firm's profits and are personally liable for the debts of the firm. Corporations- A business firm owned my shareholders who possess ownership rights to the firm's profits, but whose liability is limited to the amount of their investment in the firm. Explicit Costs- Payments by a firm to purchase the services of productive resources. Implicit Costs- The opportunity costs associated with a firm's resources that it owns. These costs do not involve a direct money payment. Examples include wage income and wage forgone by the owner of a firm who also provides labor services and equity capital to the firm. Total Cost- The costs, both explicit and implicit, of all the resources used by the firm. Total cost includes a normal rate of return for the firm's equity capital. Opportunity Cost of Equity Capital- The rate of return that must be earned by investors to induce them to supply financial capital to the firm. Economic Profit- The difference between the firm's total revenues and its total costs, including both the explicit and implicit cost components. Normal Profit Rate- Zero economic profit, providing just the competitive rate of return on the capital (and labor) of owners. An above-normal profit will draw more entry into the market, whereas a below-normal profit will lead to an exit of investors and capital. Accounting Profits- The sales revenue minus the expenses of a firm over a designated period, usually one year. Accounting profits typically make allowances for changes in the firm's inventories and depreciation of its assets. No allowance is made, however, for the opportunity cost of the equity capital of the firms owners, or other implicit costs. Short Run (in production)- A time period so short that a firm in unable to vary some of its factors of production. The firm's plant size typically cannot be altered in the short run. Long Run (in production)- A time period long enough to allow the firm to vary all of its factors of production. Total Fixed Cost- The sum of the costs that do not vary with output. They will be incurred as long as a firm continues in business and the assets have alternative uses. Average Fixed Cost- Total fixed cost divided by the number of units produced. It always declines as output increases. Total Variable Cost- The sum of those costs that rise as output increases. Examples of variable costs are wages paid to workers and payments for raw materials. Average Variable Cost- The total variable cost divided by the number of units produced. Average Total Cost- Total cost divided by the number of units produced. It is sometimes called per-unit cost.
Marginal Cost- The change in total cost required to produce an additional unit of output. Law of Diminishing Returns- The postulate that, as more and more units of a variable resource are combined with a fixed amount of other resources, using additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached it will take successively larger amounts of the variable factor to expand output by one unit. Total Product- The total output of a good that is associated with each alterative utilization rate of a variable input. Marginal Product- The increase in the total product resulting from a unit increase in the employment of a variable input. Mathematically, it is the ratio of the change in total product to the change in the quantity of the variable input. Average Product- The total product (output) divided by the number of units of the variable input required to produce the output level. Economies of Scale- Reductions in the firm's per-unit costs associated with the use of large plants to produce a large volume of output. Constant Returns to Scale- Unit costs that are constant as the scale of the firm is altered. Neither economies nor diseconomies of scale are present. Sunk Costs- Costs that have already been incurred as a result of past decisions. They are sometimes referred to as historical costs.
Chapter 21
Price Takers and the Competitive Process
1. How do firms that are price takers differ form those that are price searchers? - Price takers are sellers who must take the market price in order to sell their product. Because each price taker's output is small relative to the total market, price takers can sell all their output at the market price, but they are unable to sell any of their output at a price higher than the market price. - Price searchers are firms that face a downward-sloping demand curve for their product. The amount the firm is able to sell is inversely related to the price it charges. 2. What are the primary characteristics of price-taker markets? - The primary characteristics of price taker markets are: - All firms in the market are producing an identical product (for example, beef, or cattle of a given grade). - A large number of firms exist in the market. - Each firm supplies only a very small portion of the total amount supplied to the market. - No barriers limit the entry or exit of firms in the market. 3. What determines the level of output of a price taker firm? How does a price taker firm decide the level of output? - Price taker firms determine their level of output by whatever will maximize their profit. - Price taker firms decide their level of output by comparing benefits whit costs. 4. How do price taker firms respond to changes in price in the short run? - Price taker firms respond to changes in price in the short run by expanding output until marginal price is equal to the market price. Firms also do not have enough time to alter the size of their plants. Price taker firms that experience losses but that anticipates being able to cover its costs in the long run will operate in the short term if it can cover its average variable costs. Conversely, the firm will shut down if it cannot cover average variable costs. - If there is an increase in price the firm will expand output along its marginal cost curve. - If there were a decrease in the market price the firm would shut down immediately because it is unable to cover even its variable costs. 5. How do price taker firms respond to changes in price in the long run? - Price taker firms respond to changes in price in the long by also expanding output until marginal price is equal to the market price. In the long run, however, firms will have the opportunity to expand the sizes of their pant. Firms will be able to enter and exit the industry in the long run. As long-run adjustments are made, output in the whole industry may either expand or contract. A firm that does not anticipate being able to cover its average total cost even in the long run will minimize losses by immediately going out of business.
6. How does time influence the elasticity of supply? - It takes time for firms to adjust to a change in the price of a product. Since it is less costly to expand output slowly in response to a demand increase, the expansion of output by firms will increase with time, as long as the price exceeds cost. The elasticity of the market supply curve will be greater when firms have more time to adjust their output. - If the price rises in the short run, firms can only expand output only by utilizing their existing plants more intensely. - If the price rises in the long run they have time to build new plants. This allows firms to expand output by larger amounts in response to an increase in price. Therefore, the market supply curve will be more elastic in the long run than the short run. What 7. must firms do in order to make profits? - In order for firms to make a profit they must first produce goods that can be sold for more than the cost of the resources required to produce them. Profits are only awarded to firms who increase the value of the goods they produce. 8.How do profits and losses influence the supply and market price of a product? - Profits and losses influence the supply and market price of a product when firms anticipate correctly the products and services for which future demand will be mostly urgent (relative to the production costs), and produce and market them efficiently will make economic profits. Those that are inefficient and allocate resources incorrectly to areas of weak demand (relative to costs) will be penalized with losses. 9. How does competition lead to the provision of product that consumers want at lowest possible prices? - Competition motivates producers to operate efficiently and heed the views of consumers. Competition and the market process harness self-interest and direct producers toward wealth-creating activities. Key Terms Price Takers- Sellers who must take the market price in order to sell their product. Because each price taker's output is small relative to the total market, price takers can sell all their output at the market price, but they are unable to sell any of their output at a price higher than the market price. Price Searchers- Firms that face a downward-sloping demand curve for their product. The amount the firm is able to sell is inversely related to the price it charges. Competition as a Dynamic Process- Rivalry or competitiveness between or among parties (for example, producer or input suppliers) to deliver a better deal to buyers in terms of quality, price, and product information. Barriers to Entry- Obstacles that limit the freedom of potential rivals to enter and compete in an industry or market. Marginal Revenue- The incremental change in total revenue derived from the sale of one additional unit of a product. Shutdown- A temporary halt in the operation of a firm. Because the firm anticipates operating in the future, it does not sell its assets and go out of business. The firm's variable cost is eliminated by the shutdown, but its fixed cost continues.
Going Out of Business- The sale of a firm's assets, and its permanent exit from the market. By going out of business, a firm is able to avoid its fixed cost, which would continue during a shutdown. Constant Cost Industry- An industry for which factor prices and costs of production remain constant as market output is expanded. The long run market supply curve is therefore horizontal in these industries. Increasing-Cost Industry- An industry for which costs of production rise as output is expanded. In these industries, even in the long-run, higher market prices will be needed to induce firms to expand total output in such industries. As a result, the long-run market supply curve in these industries will slope upward to the right. Decreasing-Cost Industry- An industry for which costs of production decline as the industry expands. The market supply is therefore inversely related to price. Such industries are atypical.
Chapter 22 Price-Searcher Markets with Low Entry Barriers 1. What are the primary characteristics of competitive price-searcher markets? - The primary characteristics of competitive price-searcher markets are: 1. Low entry barriers 2. Firms that face a downward-sloping demand curve 2. How do competitive price-searcher firms determine price and output? - Firms in price-searcher markets with low barriers to entry face a downward-sloping demand curve. They are free to set the prices for the products that they sell but face strong competitive pressure from existing and potential rivals. Because good substitutes are readily available from other suppliers, the demand curve faced by the firms in competitive price-searcher markets will be highly elastic. Although the price searcher can set the price of its products, the quantity sold at alternative prices will be determined by market forces. Any firm can increase profits by expanding output as long as marginal revenue exceeds marginal cost. Therefore, a price searcher will lower price and expand output until marginal revenue is equal to marginal cost. Thus, firms in competitive pricesearcher markets can make either economic profits or losses in the short run. But, after long-run adjustments occur, only a normal profit (that is, zero economic profit) will be possible because of the competitive conditions. 3. What is the connection between innovative actions by some firms and business failure by others? Are business failures bad for the economy? - The connection between innovative actions by some firms and business failure by others is product differentiation. Price searchers use product quality, style, convenience of location, advertising, and price as competitive weapons. Because each firm competes with rivals offering similar products, each confronts a highly elastic demand curve for its products. - Business failures are not bad for the economy because they weed out inefficient, highcost producers. It is important to recognize that business failures do not destroy either the assets owned by the firm or the talents of its workers. Instead, they release these resources for more productive use by other firms. 4. Can competitive results exist even when there are few firms in a market? - Competitive results can exist even when there are few firms in a market. This is because competition can come from potential as well as actual rivals. If entry and exit can be arranged at low cost, and if there are no legal barriers to entry, the theory of contestable markets indicates that competitive results will be approximated, even if there are only a few firms actually in the market. 5. Why is the role of the entrepreneur left out of these market models? - Entrepreneurs are left out of these market models because no one knows when the next innovative or precisely which productions techniques will minimize per-unit costs.
6. How do entrepreneurs influence/impact economic progress? - Entrepreneurs influence/impact economic progress by discovering and producing lowercost production methods and new products that are highly valued relative to cost promote economic progress. Entrepreneurs also have a strong incentive to discover the type of business structure, firm size, and scope of operation that can best keep per-unit cost of products or services low. 7.Why do some economists criticize competitive price-searcher markets, while others do not? - Competitive price-searcher markets provide more variety but may raise costs relative to price-taker markets because: 1. Price exceeds marginal cost at the profit maximizing output level 2. Long-run average cost is not minimized 3. Advertising is costly - When barriers to entry are low, however, price searchers have an incentive to: 1. Produce efficiently 2.Undertake production, if and only if, their actions will increase the value of resources used 3. Be innovative in offering new product options 8.What is price discrimination and is it a bad thing? - Price discrimination is when a practice whereby a seller charges different consumers different prices for the same product or service. When a price searcher can identify groups of customers that have different price elasticities of demand and prevent customers from retrading the product, price discrimination may emerge. Price discrimination is not a bad thing because sellers can often gain by charging higher prices to those with less elastic demand. Price discrimination can also increase the total gains from trade and thereby reduce allocative inefficiency. Sometimes it even allows production where none would have otherwise occurred.
Key Terms Competitive Price-Searcher Market- A market in which the firms have a downwardsloping demand curve, and entry into and exit from the market are relatively easy. Differentiated Products- Products distinguished from similar products by characteristics like quality, design, location and method of promotion. Monopolistic Competition- A term often used by economists to describe markets characterized by a large number of sellers that supply differentiated products to a market with low barriers to entry. Essentially, it is an alternative term for a competitive pricesearcher market. Contestable Market- A market in which the costs of entry and exit are low, so a firm risks little by entering. Efficient production and zero economic profits should prevail in a contestable market. Price Discrimination- A practice whereby a seller charges different consumers different prices for the same product or service.
Chapter 23 Price-Searcher Markets with High Entry Barriers 1. What are some of the barriers to entry that substantially protect some firms from potential competition? - Four barriers to entry: 1. Economies of scale (in uncontestable markets) 2. Government licensing 3. Patents 4. Control of an essential resource 2. What is a monopoly and does being one guarantee economic profit? - A monopoly is a market structure characterized by (1) a single seller of a well-defined product for which there are no good substitutes and (2) high barriers to entry of any other firms into the market for that product. Being one does guarantee economic profit. 3.What is an oligopoly and why is there not a general model of oligopoly? - An oligopoly is a market situation in which a small number of sellers constitutes the entire industry. It is competition among few. The distinguishing characteristics of an oligopolistic market are (1) small number of rival firms, (2) interdependence among the sellers because each is large relative to the size of the market, (3) substantial economies of scale, and (4) high entry barriers to the market. There is not a general model of an oligopoly because there are few sellers. 4.Why and when are oligopoly firms likely to collude? - Collusion occurs at the expense of buyers. If oligopoly firms collude perfectly they are able to profit as a group by restricting output and raising prices. - Some obstacles to collusion are: 1. As the number of firms in an oligopolistic market increases, the likelihood of effective collusion declines. 2. When it is difficult to detect and eliminate price cuts, collusion is less attractive. 3. Low entry barriers are an obstacle to collusion. 4. Unstable demand conditions are an obstacle to collusion. 5. Vigorous antitrust action increases the cost of collusion. 5.How are the results of industries with high entry barriers likely to differ from the results of industries with low entry barriers? - When entry barriers are high in industries: 1. When entry barriers are high are there are few, if any, alternative suppliers, the discipline of market forces is weekend. 2. Reduced competition results in allocative inefficiency. 3. Government grants of monopoly power will encourage rent seeking; resources will be wasted by firms attempting to secure and maintain grants of market protection.
6.What remedies might improve the performance of high barrier industries? - The remedies that might improve the performance of high barrier industries are; 1. Antitrust action designed to maintain or increase the number of firms in the industry 2. Relaxation of regulations that limit entry and trade 3. Price regulation 4. Provision of output by government firms - When feasible, option (2) is the most attractive alternative. Under most circumstances, all other options have shortcomings. Key Terms Licensing- A requirement that one obtain permission from government in order to perform certain business activities or work in various occupations. Monopoly- A market structure characterized by (1) a single seller of a well-defined product for which there are no good substitutes and (2) high barriers to entry of any other firms into the market for that product. Oligopoly- A market situation in which a small number of sellers constitutes the entire industry. It is competition among few. Collusion- Agreement among firms to avoid various competitive practices, particularly price reductions. It may involve either formal agreements or merely tactic recognition that competitive practices will be self defeating in the long run. Tactic collusions is difficult to detect. In the U.S., antitrust laws prohibit collusion and conspiracies to restrain trade. Cartel- An organization of sellers designed to coordinate supply decisions so that the joint profits of the members will be maximized. A cartel will seek to create a monopoly in the market.