FinQuiz - Smart Summary - Study Session 4 - Reading 15

2015, Study Session # 4, Reading # 15
DEMAND AND SUPPLY ANALYSIS: THE FIRM

2. OBJECTIVES OF THE FIRM
Profit = Total revenue Total cost
Total Revenue: Amount received by a firm from

sale of its output.
Total Cost: Market value of the inputs that are

used by a firm in its production.
Level of output
Firms
efficiency
Resource price
Profit depends on:

Characteristics of the product market &
Characteristic of resource market
Output profit TR > TC

Output profit TR < TC
2.1 Types of Profit Measures
Accounting Profit (Net Income):

AP = TR Explicit cost (Accounting Cost).
AP < 0 Accounting loss.
Economic Profit:
EP = TR Explicit cost Implicit cost.
(or) EP = Accounting Profit Implicit cost
(or) EP = TR Total economic Cost (EP is also called
Abnormal or Supernormal profit).
Explicit Cost:
It refers to payments made to
non-owner parties for the
services or resources provided
by them.
Implicit Cost:
It doesnt require cash outlay.
Normal profit: its the difference b/w accounting profit & economic profit.
Normal Profit = Accounting Profit Economic Profit.
Positive Economic Profit:
Firm is able to generate
greater than opportunity cost
of resources.
Negative Economic Profit:

Firm is not able to generate
enough profits to cover
opportunity costs of the
resources.
Economic loss: Economic profit is less than zero.

Economic rent: Extra amount of earnings that a factor earns over
and above its opportunity cost necessary to keep a resource in
its current use.
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2.2 Comparison of Profit Measures
Relationship
between
Accounting
Profit and
Normal Profit
Accounting
profit > Normal
profit
Accounting
profit = Normal
profit
Accounting <
Normal profit
Economic Profit
Firms Market
value of Equity
Economic profit
> 0 and firm is
able to protect
economic profit
over the long
run
Economic profit
=0
Positive effect
Economic profit
< 0 implies
economic loss
Negative
effect
No effect
3. ANALYSIS OF REVENUE, COSTS, AND PROFITS
Revenue
Total Revenue = Price Quantity

=
/

Marginal Revenue = TR / Q
Cost
Total Cost = Sum of all costs incurred by a firm.

TC = TVC + TFC
Avg. Total Cost = TC/Q

ATC curve is U shaped.
Efficient Scale: quantity
at which ATC is
minimized.
Marginal Cost (MC):

increase in total cost
from producing one
more unit =
Fixed Cost: Any cost that

doesnt depend on firms level
of output.
Quasi-fixed Cost: Fixed cost
that changes when production
moves beyond certain range.

It exhibits J-shaped
pattern.
MC < MR, Q
profit
Avg. Fixed Cost (AFC):

=

Q AFC
Variable Cost: Cost that varies

with the quantity produced TVC =
VC/unit Q
At Q =0, TVC = 0.
Avg. Variable Cost (AVC)

=

Initially Q AVC
later Q AVC
Relationship between MC, ATC & AVC.

MC < ATC ATC is declining.
MC > ATC ATC is increasing.
Same relationship holds for MC & AVC.
Rising MC curve intersects ATC & AVC curve at their
minimum points.
3.1 Profit Maximization
Functions of Profit
Motivate firms
Promote efficient
allocation of
resources
Promote economic
welfare & standard
of living.
Promote innovation &

development
Simulate business
investment & increase
economic growth.
To create wealth for

investors
Approaches for Determining Profit Maximizing Level of Output
Total Revenue Total cost Approach:

Based on the fact that TR TC =
Profit
Q TC & TR EP
EP reach maximum & than falls
down.
Profit in maximized at output level
where (TR TC) = max.
Marginal revenue-Marginal cost

Approach:
Based on comparison between MR
& MC.
Q MC
MR > MC Q profit.
Profits is maximized at point where
MR = MC
Per unit revenue - Per unit cost

Approach:
Profit is maximized when per-unit
revenue = per-unit cost.
Per-unit revenue > per-unit cost
profit
Per-unit revenue < per-unit cost
profit.
3.1.1 Total, Average and Marginal Revenue
In perfect competition (an individual firms is a small seller in

the industry).
Firm faces an infinitely elastic demand curve.
Price is determined by the market supply and demand
which implies that shift in supply curve of a single firm
doesnt affect market price.
Total quantity supplied & demanded is mainly
determined by price.
TR increases by a constant amount.
MR = AR = Price = Demand.
MR, AR & Price only changes when there is a shift in
demand and / or supply factors creating price changes.
3.1.2 Factor of Production
Land: Site location of the

business.
Labor: Physical & Mental

human effort used in
production.
Capital: Building, Machinery

& Equipment used in
production.
Production function: It represents the relationship between

the quantity of input used to produce a good & the quantity
of output of that good.
Material: Any good that firm

buys as input to produce
goods/services
3.1.6 Short-Run versus Long-Run Profit Maximization
Short Run
In Short-run, two
conditions exist:
Fixed scale of
production.
Firms can neither enter
nor exit from industry.
Profit is maximized at the
output level where MR =
MC.
MR > MC Q
Profit.
MR = MC profit is max.
MR < MC Q
profit.
MC curve of a perfectly
competitive profitmaximizing firm represents
the firms short-run supply
curve.
Breakeven price: Price at

which economic profit is
zero i.e. P = ATC is known
breakeven price.
Its the output level at
which
P = AR = MR = ATC or TR =
TC
Loss: If P< ATC firm incurs losses.
TR > TVC but TR < TVC + TFC.

SR: firms will continue operating.
LR: if situation persists, firms will exit.
Revenue < Variable cost i.e. P < AVC, firms incur operating losses & Total
losses > Fixed cost, hence, to minimize losses firms will:
SR: Shut-Down
LR: Exit.
Long Run
All inputs are variable.

Firms are able to or production scale.
New firms can enter or exit the industry.
Entry & Exit from the Industry
Effects of Entry:
when P > ATC Firms earn Economic Profit
incentive for new firms to enter Supply
P profit.
Effects of Exit:
When P < ATC firms incur economic losses
incentive for existing firm to exit Supply
P losses.
Long Run v/s Short Run
Long-run industry supply curve exhibits the relationship between

quantities supplied & output prices for an industry when firms can
enter or exit the industry.
In the long-run (under perfect competition), profit is max. Firm will
operate at the minimum efficient scale point on its LRATC.
In the short-run, supply curve of a competitive firm is that part of MC
curve that remains above the AVC curve.
Effects of Change in Demand
Demand P firms earn economic profit

new firm enter no. of firms in LR firms
earn normal profit.
Demand P firm incur economic losses

firms exit no. of firms market supply
P.
Effects of Change in Technology
Use of new technology Cost of production

market supply (keeping demand constant)
Price.
Due to lower cost of production, firms earn economic
profit.
Opposite is true for firms with old technology.
Long-run average cost (LRAC)
FIRMS DECISIONS IN THE SHORT AND LONG RUN

Short Run
Condition
Total
Revenue
(TR) Total
Cost (TC)
Short Run
Decision
P = MC and
firm will
continue
operating
Losses
Operating
profit (TR >
Variable
Cost) but TR
< TFC + TVC
Losses
Operating
Loss (TR <
Variable
Cost)
P = MC and
losses
fixed costs
firm will
continue
operating
Shut down
and losses
fixed costs
firm will
Shut down.
Profits
Long Run
Decision
Existing firms
stay in the
market.
Expand:
New firms
will enter
the industry
Contract:
Existing firms
exist the
Industry.
Contract:
Existing firms
exist the
Industry.
Economies of scale or increasing return to scale:

Occurs when;
% in output > % in inputs e.g. 20% increase in factor inputs 35% rise in output.
Diseconomies of scale or Decreasing return to scale

Occurs when;
% in output < % in inputs.
e.g. 50% rise in inputs leads to 25% rise in output.
Constant return to scale:

It occurs when;
% in output = % in input.
e.g. 20% rise in inputs leads to 20% rise in output.
3.2 Productivity
It refers to average output produced per

unit of input.
Profit is maximized when productivity is
maximized.
Effects of increase in Productivity:

Production cost.
Profitability.
Investment value.
Synergies are created.
Strengthen firms competitive position in
the long-run.
Effects of decrease in productivity:

Production cost.
Profit ability.
Firms or industry become less competitive over time.
3.2.1 Productivity Measures
Total product: Total quantity of a good

produced in a given period from using all
inputs.
Greater the TP of a firm, greater the market
share.
Average product:
AP = Total product / Total quantity of input
used to produce product.
Greater the AP of a firm, more efficient it is.
Marginal Product (MP): Additional output that can be produced by employing one
more unit of a specific input.

=
=

Flaw: Difficult to measure individual workers productivity when work is performed
collectively. In this care, Average product is a preferred measure.
Relationships
MP & AP
When MP > AP; AP curve is increasing.
When MP < AP, AP curve is decreasing.
When MP = AP, AP curve is at maximum.
MP & MC
When, MP MC.
When MP MC.
When MP is at maximum MC is at its
minimum.
MC & AVC
MC < AVC; AVC is decreasing.
MC > AVC; AVC is increasing.
3.2.2 Marginal Returns & Productivity
Increasing marginal return occur when.

with L units.
>
Diminishing marginal product or law of

diminishing marginal productivity:
All else constant, Marginal product of an
input declines when additional units of a
variable input are added to fixed inputs.
Profit maximization guideline:

profit is maximum where

=

Least-cost optimization rule:

If
If
>
>

employ more labor.

employ more physical capital.
In short, firms prefer to use input with higher ratio to the

input with lower ratio, when it increases production.
Level of output at which profit is maximized:

Profit is maximized when:
=

(or)
MRP = MP of an input unit Price of the product.

When;
MRP > cost of an input, firm earns profit.
MRP < cost of an input, firm incurs loss.
Surplus value or contribution = MRP cost of an input.

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2015, Study Session # 4, Reading # 15

DEMAND AND SUPPLY ANALYSIS: THE FIRM

Profit = Total revenue Total cost

Total Revenue: Amount received by a firm from

Total Cost: Market value of the inputs that are

Profit depends on:

Output profit TR > TC

2.1 Types of Profit Measures

Accounting Profit (Net Income):

Negative Economic Profit:

Economic loss: Economic profit is less than zero.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 4, Reading # 15

3. ANALYSIS OF REVENUE, COSTS, AND PROFITS

Total Revenue = Price Quantity

Total Cost = Sum of all costs incurred by a firm.

Avg. Total Cost = TC/Q

Marginal Cost (MC):

Fixed Cost: Any cost that

Avg. Fixed Cost (AFC):

Variable Cost: Cost that varies

Avg. Variable Cost (AVC)

Relationship between MC, ATC & AVC.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 4, Reading # 15

3.1 Profit Maximization

Promote innovation &

To create wealth for

Approaches for Determining Profit Maximizing Level of Output

Total Revenue Total cost Approach:

Marginal revenue-Marginal cost

Per unit revenue - Per unit cost

3.1.1 Total, Average and Marginal Revenue

In perfect competition (an individual firms is a small seller in

3.1.2 Factor of Production

Land: Site location of the

Labor: Physical & Mental

Capital: Building, Machinery

Production function: It represents the relationship between

Copyright FinQuiz.com. All rights reserved.

Material: Any good that firm

2015, Study Session # 4, Reading # 15

3.1.6 Short-Run versus Long-Run Profit Maximization

Breakeven price: Price at

Loss: If P< ATC firm incurs losses.

TR > TVC but TR < TVC + TFC.

All inputs are variable.

Entry & Exit from the Industry

Long Run v/s Short Run

Long-run industry supply curve exhibits the relationship between

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 4, Reading # 15

Effects of Change in Demand

Demand P firms earn economic profit

Demand P firm incur economic losses

Effects of Change in Technology

Use of new technology Cost of production

Long-run average cost (LRAC)

FIRMS DECISIONS IN THE SHORT AND LONG RUN