Theory of the Firm
Interactive Web Exercise
In the following web activity, you can examine how a firm decides the most appropriate plant size resulting in the lowest average cost of production. Review the following reading on a firm's LRAC curve and then try the interactive graph activity.
Profit Maximization for the Perfectly Competitive Firm
As a price-taker and quantity adjuster the perfect competitor has two decisions to make: how much to produce or whether to produce at all? Using the profit maximizing principle of setting price where MR = MC, the firm, in the short-run, is able to maximize profits or minimize losses depending on the relationship between price (average revenue) and average total cost (ATC). If the price falls below average variable cost (AVC) then the firm should shut down and only pay its fixed costs.
Interactive Web Exercise
In the following web activity, you can examine how the perfectly competitive firm will adjust its output based on different prices. Note how the revenue, profit and average cost change to reflect this adjustment based on the MC=MR profit maximizing output rule.
Begin the Interactive Graph Activity
Long-Run Equilibrium in Perfect Competition: Industry and Firm
Firms and industries can be in short-run equilibrium - equating marginal cost and marginal revenue - without being in long-run equilibrium. Adjustments to achieve long-run equilibrium are likely to involve changes in both the number of firms in the industry and the average size of firms. Changes in the number of firms will depend on whether any existing firms are making economic (super-normal) profits or realizing losses in the short run. Firms will continue to enter or leave the industry until the total revenue of each firm is sufficient to cover its total costs, including a normal profit, but no firm is realizing an economic profit. This will occur when each firm is at the output level where its average cost is at a minimum.
Long-Run Equilibrium in a perfectly competitive industry requires that:
1) The market price is equal to the firm's minimum average total cost
2) Firms adjust their size so that they are producing the quantity at which long-run average cost is at a minimum
Price = Marginal Cost = Short-Run Average Total Cost = Long-Run Average Cost
Interactive Web Exercise
In the following web activity, you can examine how the perfectly competitive industry adjusts to an increase in demand and its effect on short-run economic profits and ultimately long-run equilibrium.
Begin the Interactive Graph Activity
Oligopoly Games
Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decision-making process. A popular approach to understanding how oligopolists operate is based on the 'Prisoner's Dilemma' game. Observe the following video reviewing the prisoner's dilemma.
Monopoly
Monopoly involves the provision of a good/service by a single producer with no close substitutes. Monopoly may arise due to natural barriers to entry, control over a key resource or some form of legal protection designed to encourage the provision of a good. Patents are the exclusive right granted by a government to an inventor to manufacture, use, or sell an invention for a certain number of years. Recently, a pharmaceuticals entrepreneur raised concerns when, following the purchase of a drug manufacturer, the price of a needed drug rose over 55 times in one night! Read the New York Times article and watch the video addressing this case below:
Natural Monopoly
A natural monopoly occurs when the most efficient number of firms in the industry is one and will typically have very high fixed costs. This means having more than one firm produce the good would be inefficient.
"An example of a natural monopoly is tap water. It makes sense to have just one company providing a network of water pipes and sewers because there are very high capital costs involved in setting up a national network of pipes and sewage systems. To have two different companies offering water wouldn’t make sense as the average cost would be very high compared to just one firm and one network. There would also be the inconvenience of having two firms dig up the road to lay a duplicate set of water pipes."
(https://www.economicshelp.org/blog/glossary/natural-monopoly/)
Observe this video to review your understanding of natural monopoly.
Long-Run Average Costs
In the long-run, a firm can vary all factors of production (fixed and variable inputs), particularly plant and equipment. In the long-run a firm can change:
- plant size
- amount or type of machinery utilized
- amount & proportions of such factors as labour, raw materials etc...
The number of firms in the industry producing a specific good may also change as some firms enter or exit the industry depending on the presence or absence of economic (super-normal) profits in the short run. Since all factors are variable in the long-run, the distinction between fixed and variable costs is not relevant in the long-run: reference to total costs is only necessary. Options for the firm are studied in terms of average total costs and alternative plant sizes.
The curve showing all the lowest possible average total cost for any given output level is the long-run average total cost curve (LRATC). Graphically, the LRATC curve represents the envelope of all SRATC curves when the lowest ATC for each level of output is joined. Note, only at the minimum point of the LRATC does the LRATC curve coincide with the minimum point of any short-run ATC curve.
Source: Stager, D., Economic Analysis and Canadian Policy, 7th ed., Toronto: Butterworths, 1992.
Research and Study Links
Use the links below to access readings and video tutorials relating to microeconomics topics discussed in class.
The Law of Diminishing Returns
Read about this key micro concept influencing productivity and the efficiency of the firm.
A great video tutorial on diminishing marginal returns may also be found here.
Profit Maximization and Alternative Goals
Use this video to review alternative views of profit maximization such as revenue maximization and satisificing.
