THE THEORY OF THE FIRMDANIEL CHENWITH SOME MINOR HELP FROM HIS

COLLEAGUES AT HARVARD :

MICROECONOMICS

• is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources(WIKIPEDIA.ORG)

• This unit examines the behavior of the individual firm and household in detail. You will learn the reasoning and incentives behind firms and their decisions. Ultimately, I am giving you the key, the key to understanding how the world responds to different situations. So, love it, learn it, memorize it. Twenty years from now, you will live it.

The Costs of Production

• So what is the main goal behind a firm’s decision: to reduce its costs and thereby increase its profit.

• Therefore, to best understand microeconomics we must consider the costs and revenues each firm faces:

• Total Cost– the market value of the inputs a firm uses in production

• Explicit Costs: input costs that require an outlay of money by the firm

• Implicit Costs: input costs that do not require an outlay of money by the firm

COSTS OF PRODUCTION• Accounting profit: total revenue minus total cost, including both explicit costs• Economic profit: total revenue minus total cost, including both explicit and

implicit costs• Marginal Product: The increase in output that arises from an additional unit

of output• Diminishing Marginal Product: The property whereby the marginal product of

an input declines as the quantity of the input increases• Fixed Costs: costs that do not vary with the quantity of output produced• Variable Costs: costs that vary with the quantity of output produced• Average Total Cost: total cost divided by the quantity of output• Average fixed cost: fixed cost divided by quantity of output• Marginal Cost: the increase in total cost hat arises from an extra of

production

Cost Curves and Their Shapes

• ATC is U- shaped (This is because ATC = FC + VC and FC declines as output increases and VC increases as output increases)

• Rising MC (diminishing marginal product)

The Relationship Between MC and ATC

• Whenever marginal cost is less than average total cost, average total cost is falling. When marginal cost is greater than average total cost, average total cost is rising.

• Marginal Cost crosses Average Total Cost at it’s minimum point.

PERFECTLY COMPETITIVE MARKET

• So what makes a market perfectly competitive?

• Consider the following:1. Low entry and exit barriers2. Identical products3. No single buyer or seller has a large impact

upon the market price: EVERYBODY IS A PRICE TAKER

A PERFECTLY COMPETITIVE FIRM

• So, now that we understand the basics and conditions behind a perfectly competitive market, we should be able to analyze the decisions and reasoning behind the individual firm:

Profit Maximization

• Firms produce at the output where the MC and MR curves cross.

• This is because…• If MR is greater than MC, the firm will earn a

profit by increasing output• If MC is greater than MR, the firm will earn a

profit by decreasing output

I’m Shutting YOU DOWN• So what influences a firm’s short run decision to shut

down?• A firm shuts down if the revenue that it would get from

producing is less than its variable costs of production• In other words, when TR<VC• Or by dividing both sides by Q when• P<AVC• In the short run fixed costs are a sunk cost: a cost that has

already been committed and cannot be recovered.

When does a firm EXIT?

• So when does a firm make the long run decision to exit the market?

• A firm exits the market if the revenue it would get from producing is less than its total costs.

• This can be expressed as…• TR< TC or when dividing both sides by Q• As P<ATC• In the long run decision to exit the market, FC is no

longer viewed as a sunk cost

Measuring Profit

• Profit= TR-TC• We can rewrite this definition as..• (TR/Q-TC/Q) X Q All I did was factor Q out• Therefore Profit= (P-ATC) Q• So in a graph, to determine the profit a firm is

making, simply go down from Price to the ATC and multiply this value by the Profit maximizing Q of output

MONOPOLIES

• monopoly :Market in which there is a sole supplier of a product with no close substitutes

• An important characteristic of a monopolized market is barriers to entry new firms cannot profitably enter the market

• Some things that can cause Barriers to entry are– Legal restrictions– Economies of scale– Control of an essential resource

Revenue for the Monopolist• Because a monopoly is the single firm in the market, the demand

curve for a monopolist is also the market demand• The demand curve for the monopolist’s output therefore slopes

downward• MR is below demand in a Monopoly due to the output and price

effects.• After MR crosses the x axis, Demand becomes inelastic

0

Marginal revenue

Elastic

Inelastic

Unit elastic

D = Average revenue

Firm’s Costs and Profit Maximization

• Because the monopolist controls the market price, we can say that the monopolist is a price maker

• For the same reasons as that of a competitive firm, monopolies produce where MR=MC. They then move up to the demand curve to find the corresponding price to charge.

0

MR

Marginal cost

D = Average revenue

Average total cost

Profita

b

e

10 16 32

The profit for a monopolistic firm is also found in the same manner as that of a perfectly competitive firm

DEADWEIGHT LOSS YO!

• A monopolist produces less than the socially efficient level of output because, not everybody that values the good at its marginal cost is able to purchase the good.

Perfect Price Discrimination

• If a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit and the demand curve would become the marginal revenue curve

• A perfectly discriminating monopolist charges a different price for each unit of the good

Perfect Price Discrimination

18

c

0 Q Quantity per period

e

D = Marginal revenue

a

Long-runaverage cost= marginal cost

P r o f i t

A perfectly discriminating monopolist would maximize profits at point e where marginal revenue equals marginal cost price set at point e

Increasing Competition

• Governments institute antitrust laws when a monopoly grows to powerful, to encourage competition in the market

Monopolistic Competition

• Power to set prices somewhat like a monopoly• Face competition like that of a perfectly

competitive firm Large number of firms

-- Each firm has relatively small market share No barriers to entry or exit

Characteristics of Monopolistic Competition

• Product Differentiation – Each firm makes a product that is slightly different from the products of competing firms.

Firms compete in Quality, Price, and Marketing-- Quality: design, reliability, service provided to buyer and ease of access to product-- Price: determined by the downward sloping demand curve-- Marketing: firm must market and advertise to attract customers

Profit Maximization• Due to the product differentiation within a monopolistically

competitive firm, this type of firm operates very similarly to a monopoly in the short run.

• To maximize profit, a monopolistically competitive firm produces at the output where MC equals MR and goes up to the demand curve to determine Price.

• In the long run, due to no barriers to entry or exit, the firm earns zero economic profit.

• A monopolistically competitive firm produces an excess capacity ( doesn’t produce at min. ATC)

• A monopolistically competitive firm marks up its price over MC

COST TO WELFARE

• Because of the mark up in price over Marginal Cost in a monopolistically competitive firm, dead weight loss occurs.

• However, reducing this deadweight loss is difficult since the firm already produces a zero profit.

Advertising

• To encourage consumers to purchase their products, Monopolistic firms use advertisement.

• Firms that advertise tend to have higher quality goods and more loyal customers, than firms that don’t advertise.

• Some may argue that advertising manipulates people’s tastes.

Oligopoly– An Oligopoly is a market type in which:

• A small number of firms compete.• Natural or legal barriers prevent the entry of new firms.

• Small Number of Firms– In contrast to monopolistic competition and perfect

competition, an oligopoly consists of a small number of firms.

• Each firm has a large market share• The firms are interdependent• The firms have an incentive to collude

Collusions and Cartels

When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly.

– Cartel: a group of firms acting together to limit output, raise price, and increase economic profit.

– Cartels are illegal but still do operate in some markets.

– Despite the temptation to collude, cartels tend to collapse.

Game Theory

– Game theory examines the interdependence of firms in an oligopoly:

– When a small number of firms compete in a market, they are interdependent in the sense that the profit earned by each firm depends on the firms own actions and on the actions of the other firms.

– Before making a decision, each firm must consider how the other firms will react to its decision and influence its profit.

Game Theory• To better depict Game Theory I will use an example: The

Prisoner’s dilemma--A game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.– Art and Bob been caught stealing a car: sentence is 2

years in jail.– DA wants to convict them of a big bank robbery: sentence

is 10 years in jail.– DA has no evidence and to get the conviction, he makes

the prisoners play a game.•

PRISONERS DILEMMA– Rules– Players cannot communicate with one another.

• If both confess to the larger crime, each will receive a sentence of 3 years for both crimes.

• If one confesses and the accomplice does not, the one who confesses will receive a sentence of 1 year, while the accomplice receives a 10-year sentence.

• If neither confesses, both receive a 2-year sentence.

– Strategies– The strategies of a game are all the possible outcomes of each player.– The strategies in the prisoners’ dilemma are:

• Confess to the bank robbery• Deny the bank robbery

Dominant Strategies and Nash EQ

Both Bob and Art reason that no matter the decision of the other, he or she will be better of confessing. Therefore both pursue their dominant strategies: a strategy that is best for a player in a game regardless of the strategies chosen by other players. As a result, both Bob and Art confess. This outcome, where dominant strategies are pursued is Nash Equilibrium.

“DANIEL CHEN HAS DONE A PHENOMENAL JOB WITH HIS REPRESENTATION OF THE THEORY OF THE FIRM. HE DESERVES A NOBEL PRIZE FOR HIS ACCOMPLISHMENTS”-RUSS B.