Key diagrams for A2 Economics unit 3 – business economics & theory of the firm Advice on drawing diagrams in the exam 

The right size for a diagram is about ½ of a side of A4 – don’t make them too small – if needed, move onto a new side of paper rather than trying to squeeze a diagram in at the bottom of a page

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Avoid wrapping text around the diagram – keep the text separate and leave a line between the text and your page

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Remember to label each curve clearly so that it is clear which curves are shifting

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Remember to label carefully and accurately both the x and the y axis

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Draw diagrams to the right technical level, don’t resort to simple supply and demand analysis when more complex cost and revenue curves are required (remember that this is A2!)

Diagrams included in this revision document 1. The law of diminishing returns 2. Fixed and variable costs in the short run 3. Cost curves when there are no variable costs, fixed costs only 4. Marginal profit 5. Changes in variable costs and the effect on the profit maximising price, output and profit 6. An increase in AR and MR 7. The long run minimum efficient scale 8. Economies and diseconomies of scale in long run production and the effect on profits 9. External economies of scale 10. Long run average and marginal cost for a natural monopoly 11. A natural monopoly and economic efficiency 12. Understanding average, marginal and total revenue 13. Different objectives of businesses – effect on price, output and profit (including satisficing) 14. The shut down price for a business in the short run 15. Short and long run in perfect competition and comparison with pure monopoly 16. Entry barriers for a monopolist and economies of scale with a monopoly 17. Price discrimination (i) peak and off-peak pricing (ii) 3rd degree discrimination 18. Oligopoly – the kinked demand curve model 19. Game theory – price collusion and the economics of a cartel 20. Elasticity of demand and pricing power for a business in imperfect competition

The short run is a period of time where at least one factor of production is assumed to be in fixed supply i.e. it cannot be changed. In the short run, the law of diminishing returns states that as we add more units of a variable input (i.e. labour or raw materials) to fixed amounts of land and capital, the change in total output will at first rise and then fall.

Total Output (Q)

(Q) Slope of the curve gives the marginal product of labour Diminishing returns are apparent here – total output is rising but at a decreasing rate I.e. the marginal product of labour is decreasing

Units of Labour Employed (L) In many industries as a business expands in the long run, it is more likely to experience increasing returns leading to lower unit costs of production.

Fixed and Variable Costs in the Short Run

Fixed costs (FC) are independent of output and must be paid out even if production stops. Capital intensive industries with a high ratio of fixed to variable costs offer scope for economies of scale. AFC = Fixed Costs (FC) / Output (Q). Costs

£2000

Total Fixed Cost

£1000

Average Fixed Cost 1

Output (Q)

20

Marginal Cost (MC)

Costs

Average Total Cost (AC)

Average Variable Cost (AVC)

Average Fixed Cost Output (Q)

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These are the “traditional” short run cost curves Marginal cost cuts both AVC and ATC at the minimum point of each Your diagrams need to be accurate so it is worth practising them as often as possible to improve your accuracy

Cost Curves for a Business with No Variable Costs Costs

Average Fixed Cost = Average Total Cost Output (Q)

The Concept Marginal Profit Revenue And Cost

Marginal profit: the increase in profit when one more unit is sold or the difference between MR and MC

Marginal Cost

Profits are increasing when MR > MC

Profits are decreasing when MR < MC

Q1

Marginal Revenue

Output (Q)

Changes in Variable Costs and the effect on the profit maximising price; output and profit Important: A rise in fixed costs has no effect on marginal cost – it simply causes an upward shift in the average cost curve. But a rise in variable cost causes a shift in both MC and AC Costs MC1 AC2

AC1

Output (Q)

Higher variable costs – the effect on equilibrium prices and profits (ceteris paribus) MC2

Profit after cost rise Costs

MC1 AC2 P2 P1 AC1

AC2

AC1

MR

Q2 Q1

AR Output (Q)

An Increase in Demand (AR and MR) – effect on price, output and profit

A rise in demand (causing an outward shift in AR and MR) causes an expansion of supply, a higher profit maximising price and an increase in supernormal profits

Profit Max at Price P2 Costs Profit Max at Price P1

AC

P2 P1

MC

AC1 AC2 AR2 AR1 (Demand)

MR2 Q1

Q2

MR1

Output (Q)

Long run Minimum Efficient Scale of Production (MES)

Cost per unit in the long run

In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is called returns to scale. Economies of scale are the cost advantages exploited by expanding the scale of production in the long run. The effect is to reduce long run average costs over a range of output.

LRAC

Falling LRAC – Economies of Scale (Increasing Returns to Scale)

Rising LRAC – Diseconomies of Scale (Decreasing Returns to Scale)

MES

Costs per unit in the long run (ATC)

 

Output (Q)

Minimum efficient scale (MES) is the scale of production where internal economies of scale have been fully exploited. MES corresponds to the lowest point on LRAC and is an output range over which a business achieves productive efficiency. The MES will differ from industry to industry as we can see from the diagram below. LRAC1 - Low MES – characteristic of a competitive market LRAC1

LRAC3

LRAC2

MES1

MES2

LRAC3 - High MES – characteristic of a natural monopoly

Output (Q)

MES3

Economies and dis-economies of scale in long run production and the effect on profits

Deriving the long run average cost curve – the envelope of a series of short run average cost curves Costs

SRAC1

SRAC3 SRAC2 AC1

LRAC AC2 AC3

Q1

Costs

Q2

Q3

MC1

Output (Q)

Profit at Price P1 Profit at Price P2 SRAC1

P1

Lower costs allows a profit maximising firm to charge a lower price (P2) but make higher total profits because of the fall in AC per unit

P2

SRAC3 MC2

AR (Demand) MR Q1

Q2

Output (Q)

External Economies of Scale (EEoS) 

External economies of scale occur outside of a firm but within an industry.

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Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from

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Agglomeration economies may also result from the clustering of businesses in a distinct geographical location e.g. software in Silicon Valley or investment banks in the City of London

Cost (Per unit of output)

Economies of Scale A B LRAC1 External Economies of Scale

C

LRAC2

Output

Natural Monopoly and the Long Run Average Cost Curve

Natural Monopoly and Economic Efficiency

Profit at price P1

Revenue Cost and Profit

Loss at price P2

P1

AC1 LRAC AC2 LRMC P2 Demand (AR)

MR Q1

Q2

Output (Q)

A natural monopoly – splitting infrastructure from the final delivery of services A natural monopoly occurs in an industry where LRAC falls over a wide range of output levels such that there may be room only for one supplier to fully exploit all of the internal economies of scale, reach the minimum efficient scale and therefore achieve productive efficiency. The major utilities such as gas, electricity and water are often put forward as examples of industries with strong "natural tendencies" towards being a natural monopoly in part because of the huge fixed costs of building and maintaining nationwide networks / infrastructures of cables and pipes. In fact we can make an important distinction between the supply and distribution of services such as gas and electricity and internet services. Often a monopolistic firm is in charge of maintaining a network but a regulator will seek to inject competition into the market by allowing new firms to come in a use the existing network and compete for customer contracts in the delivery of services. Good examples include the liberalisation of postal services and also the decision by OFCOM to force British Telecom to open up its networks to household and business customers so that rival firms can compete for the market demand in telecommunication services.

Understanding average, marginal and total revenue Total revenue is maximized when MR = 0

Revenue

Total Revenue (TR)

Ped >1 for a price fall along this length of AR

Price elasticity of demand = 1 at this output

Average Revenue (Demand) AR

Marginal Revenue (MR)

Output (Q)

Average and marginal revenue

Total revenue is maximised at price P1 where marginal revenue is zero

P2

A rise in price to P2 causes a reduction in total revenue P1

AR (Demand)

Total revenue at price P2

Q2

Output (Q)

Q1

MR

Different objectives of businesses – effect on price, output and profit Costs Profit Max at Price P1 Revenue Max at Price P2 SRAC MC

P1 P2

AC1 AC2 P3 AR (Demand)

Q1

Q2

MR

Q3

Output (Q)

It is widely accepted that modern businesses depart frequently from pure profit maximisation pricing strategies as part of competition within markets. The objectives and strategies of firms will vary with market conditions and with the aims of the different stakeholders that are part of the decision-making process in modern corporations. The profit maximising output is at Q1 (where marginal revenue = marginal cost) Total revenue is maximised at output Q2 where marginal revenue is zero. This gives a lower level of total profits, although supernormal profits are still being earned. If shareholders insist on the business achieving a normal rate of profit as a minimum then the managers of a business have the discretion to vary price anywhere above P3 At any output beyond Q3 (where average revenue and average cost intersect) losses are made (i.e. sub-normal profits). Be aware of the reasons for firms moving away from profit maximisation and also the effects of different price strategies on consumer and producer welfare and economic efficiency.

Satisficing Satisficing behaviour is when businesses move away from pure profit maximisation and choose instead to aim for minimum acceptable levels of achievement in terms of revenue and profit. Satisficing is when someone only considers a limited number of alternatives

The shut down price for a business in the short run ATC

MC = supply Costs, Revenues

AVC

P2

P2

Break-Even Price

P1 The Shut Down Price

Q1

Output (Q)

The shut down price for a business in the short run The theory of the firm assumes that a business needs to make at least normal profit in the long run to justify remaining in an industry but this is not a strict requirement in the short term. In the short run the firm will continue to produce as long as total revenue covers total variable costs or put another way, so long as price per unit > or equal to average variable cost (AR = AVC). The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs are sunk costs (i.e. they cannot be covered if the firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered. In the short run, the supply curve for a competitive firm is the marginal cost curve above average variable cost.

Short and long run in perfect competition

No barriers to entry and super normal profits encourage the entry of new firms shifting market supply & price downward until price falls back to P2. Normal profits are restored. Individual Firm’s Costs and Revenues

Market Demand and Supply Price (P)

Price (P) MC (Supply) Market Supply (MS) AR1 = MR1

P1 P1

AC

MS2 P2

P2

P2

AR2 = MR2 Long run equilibrium output

2 Market Demand

Q1

Q2

Output (Q)

Output (Q)

Q3

Competitive Market

Pure Monopoly

Price (P)

Price (P)

Market Supply

Market Supply

P mon P comp

Monopoly Demand

Market Demand MR Q1

Q2

Q1

Output (Q)

Entry barriers for a monopolist and monopoly with economies of scale

Revenue Cost and Profit

A P1 AC = MC (Potential Entrant into the market)

D

B

C Pc

LRAC = LRMC (Existing Monopolist) Monopoly Demand (AR)

MR Qc

Q1 Competitive Market

Output (Q) Pure Monopoly

Price (P)

Price (P)

Competitive Supply (MC)

Market Supply

P comp Monopoly Supply with Large Scale Economies

P mon

Monopoly Demand

Market Demand MR Q1

Q1 Q2

Output (Q)

Price discrimination (i) peak and off-peak pricing (ii) 3rd degree discrimination Price (P) and Costs

Supply (Marginal Cost)

Price Peak

Price Off-Peak

Peak Demand

MR Peak

Off-Peak Demand MR Off-Peak

Output Off-Peak

Output

Output Peak

Market A

Market B

Price Price

Profit from selling to market A – with a relatively elastic demand – and charging a lower price

Demand in segment B of the market is relatively inelastic. A higher unit price is charged

Pb

Pa

MC=AC

MC=AC

ARa

MRa MRb Qa

Quantity

Qb

ARb Quantity

Monopolistic Competition – Short Run Supernormal Profits Price and Cost

MC P1 AC

AC1

AR

MR

Q1

Quantity of Output

Long run price and output equilibrium with monopolistic competition In the long run, normal profits are made; average and marginal revenue is affected by the entry of new products into the market

Oligopoly – the Kinked Demand Curve Model

Costs Revenues

Raising price above P1 Demand is relatively elastic Firm loses market share and some total revenue

Assume we start out at P1 and Q1: Will a firm benefit from raising price above P1? Will it benefit from cutting price below P1?

MC1 P1

Reducing price below P1 Demand is relatively inelastic Little gain in market share – other firms have followed suit Total revenue may still fall

AR Q1

Output (Q)

MR

An oligopoly is a market dominated by a few producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure. The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms in the market to a change in its price or another variable. The common assumption is that firms in an oligopoly are looking to protect and maintain market share and that rival firms are unlikely to match another’s price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm. The kinked demand curve model therefore makes a prediction that a business might reach a stable profit-maximizing equilibrium at price P1 and output Q1 and have little incentive to alter prices. Even a shift in the marginal cost curve (MC1) in the diagram above might not be enough to change the profit maximizing equilibrium. The kinked demand curve model predicts periods of relative price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits.

Game theory – price collusion and the economics of a cartel

Individual Firm

Industry

MC

AC

P(cartel)

P(cartel)

MC (industry) AC

Demand

MR Quota

Firms Output

Industry Output

Collusion is a desire to achieve joint-profit maximization within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly. To fix prices, the producers in the market must be able to exert control over market supply. In the diagram below a producer cartel is assumed to fix the cartel price at output Qm and price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation. Although the cartel as a whole is maximizing profits, the individual firm’s output quota is unlikely to be at their profit maximizing point. For any one firm, within the cartel, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits. Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same. If all firms break the terms of their cartel agreement, the result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement might break down. Collusive behaviour is often predicted by game theory Game theory is concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions. Collusive behaviour reduces some of the uncertainty that is characteristic of oligopolistic markets.

Elasticity of demand and pricing power for a business in imperfect competition

Price and Costs

Low Price Elasticity of Demand

MC

Price and Costs

Low Price Elasticity of Demand

MC

SRAC

SRAC

P1

P1 AC1

AC1

AR (Contestable market) MR MR

AR (Monopoly)

Q1

Q2

Output (Q)

The importance of price elasticity of demand in theory of the firm Price elasticity of demand is a concept that was introduced at AS level. Horizontal synopticity requires you to apply the concept in theory of the firm diagrams. A good example of when this can be done is on questions on contestable markets Highly contestable markets Baumol defined contestable markets as existing where “an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers, and entry decisions can be reversed without cost.” For a contestable market to exist there must be low barriers to entry and exit so that there is always the potential for new suppliers to come into a market to provide fresh competition to existing suppliers. For a perfectly contestable market, entry into and exit out of the market must be costless. When a market is contestable there are likely to be a large number of competing suppliers; the cross-price elasticity of demand will be high because of strong substitution effects when relative prices in a market change. Hence we can draw the average revenue curve to be price elastic. This reduces the potential for a business to charge a price that is well above the marginal cost of production. Profit margins are lower, output is higher and consumer welfare is great than it would be with a monopolist exploiting an inelastic demand curve (see left hand diagram).

Contestable Markets