Microeconomic of the Firm - Essay Example

Microeconomic of the firm Price Taking (10 points) We assume that competitive firms are "price takers." Explain what this means. What is keeping competitive firms from setting prices? Is this a plausible assumption? For which industries is it a likely assumption? For which is it not plausible? In the competitive market the firms are many and the actions of one seller will not create any disturbance in the market. This is particularly in respect of the price since buyers will seek firms which sell at a cheaper price due to a wide market to choose from. In this respect, the firms only have the option of working with the prevailing price or lower. This constitutes what taking price is. There are various assumptions that compel the firms in this market to take prices. Sellers and buyers are many and any action towards increasing prices will only worsen sales through migration of buyers. Products are homogeneous and change of price will only divert buyers to get the same products from other firms selling at the prevailing or lower prices. These assumptions play a significant role in pushing firms to take the market prices or fail. Some of the industries with such assumptions include clothing and textile, Cosmetics, electrical and electronics industry among others. Some industries like medicine and drugs, energy among others cannot accommodate these assumptions hence exhibit other market structures. 2. Shut-down Point for a Firm (20 points) When will the competitive firm shut down in the short run? When will it incur a loss but continue to produce? Draw a graph showing each scenario and explain. It is important to note that shut down point is the level of output and price where the firm can just cover its total variable cost. Some of the key issues to consider in determining this point include; relative position of the average variable cost which is always at its minimum for this condition. Where the marginal cost curve crosses the average variable cost curve also sums up to shut down of the firm. At this point, the producer is indifferent between producing and temporarily shutting down. The firm incurs a loss from either action. In the event that market prices fall below the firm’s average variable cost, temporary shutdown is preferable in the short run. In case the firm continues to produce, losses from its operation merely add to losses that results from the firm’s fixed costs and shut down will lead to slump in losses. Figure 1 : Shut down when P < AVC ATC Price MC AVC P = MR Quantity A price taking firm that intends to remain operational will minimize losses or maximize profit if it will be able to produce the output level at the point where P = MC and variable costs are also covered. In this case, the portion of the firm’s short run marginal cost curve which lies above its average variable cost becomes the short-run curve of the firm. Figure 2: retrieved on May 13, 2013 from: http://www.analystnotes.com/notes/subject.php?id=119 Considering the grahp above, in case the price is below P1, the firm should shut down its operation. Long-Run Cost Curve, Economies of Scale, and Firm Size (15 points, 5 points each) A. Explain how economies of scale and the long-run cost curve influence firm size and firm concentration. The theoretical presentation starts with the short-run and shows the average cost curves (Total, fixed and variable) along with the marginal cost. The curves are presented in Figure 1 MC ATC cost in $ AVC AFC Quantity Figure 1. Short-run unit cost curves: marginal cost (MC), average total cost (ATC), average variable cost (AVC) and average fixed cost (AFC). The short-run cost curves are normally based on a production function with one variable factor of production that displays first increasing and then decreasing marginal productivity. Increasing marginal productivity is associated with the negatively sloped portion of the marginal cost curve, while decreasing marginal productivity is associated with the positively sloped portion. The average fixed cost (AFC) curve is the cost of the fixed factor of production divided by the quantity of units of the output, while the average variable cost (AVC) curve cost traces out the per unit cost of variable factor of production ATC in $ SRAC LRAC SRAC SRAC c a b Quantity The long-run average cost (LRAC) curve is shown to be an envelope of the short-run average cost (SRAC) curves, lying everywhere below or tangent to the short-run curves. The firm is constrained in the short-run in selecting the optimal mix of factors of production and so will never be able to find a cheaper mix than can be found in the long-run when there are no constraints. If there are a discrete number of plant sizes available, the LRAC will be the scalloped curve obtained by joining those parts of the SRAC curves that represent the lowest cost of production for a given quantity. B. Give an example of industries with the following: i. decreasing returns to scale Energy industry falls under this category. ii. constant returns to scale Healthcare industry iii. Increasing returns to scale Durable goods industries show some evidence of increasing returns: C. Give a real life example of economies of scope. The diversified car manufacturing by Toyota is a typical experience of economies of scope. 3. Profit Maximization (25 points) The table below summarizes information for a representative firm in a competitive industry that currently has 1,000 such businesses. Current market price is $6. Output (Q) Total Cost (TC) Total Revenue (TR) MC MR 0 5 0 0 0 1 6 6 1 6 2 8 12 2 6 3 11 18 3 6 4 17 24 6 6 5 25 30 8 6 A. Calculate marginal revenue and marginal cost for each output level. Graph them (See Figure 12.3 for guidance). (10 points) Price MC 6 MR = P 4 Output B. How much should the firm produce to maximize profit? (Hint: you need to set MR = MC) What is the total quantity supplied in the market? (5 points) Profit is maximized at the output level where marginal Revenue (MR) is equal to Marginal cost (MC) and this can be expressed in an equation as MR=MC. In respect of the data given in the table above, MC=MR = 6 at an output level of 4 units. This means that at an output level of 4 units, profit is at its maximum. C. Are firms in the industry earning positive or negative profits? (Hint: Profit = TR-TC at the profit maximizing quantity) (5 points) Total Profit = TR-TC TR = 24, TC = 17 Total Profit = 24- 17 Total Profit = $7 The firms are earning positive profit of $7 D. As this market makes the transition to its long-run equilibrium, will this industry experience entry or exit? Will the price rise or fall? (5 points) It is worth to note that the long-run response to short-run profits constitutes transition in output and profits increase motive. This profit will attract more producers in the market with an effect on the increased industry supply which lowers the price of the market. As this continues, there will be an observed movement of profits towards Zero economic profit. This experience will lead to no entry or exit of the industry by more firms. Fixed Costs and Entry (15 points: 10, 5) Suppose that an industry has high fixed costs to enter but, other than that, is competitive. A. What will be the effect of the high fixed costs to the number of firms in the industry? To the firm size? Is marginal cost higher or lower for a firm with high fixed costs? Is price higher or lower? Is quantity produced higher or lower? It is important to note that fixed costs cannot be altered in response to output in the short run and therefore tends to be very tricky to the firms. High fixed costs in the industry are likely to raise prices as a result of input factor cost. This means that the pricing will be based on marginal cost approach and the subsequent reduction in profit. Most firms may begin to quit due to possible losses. For a firm with high fixed cost, marginal cost tends to be high and the prices are equally high. This will make the quantity of output to fall. B. Give an example of a firm with a high fixed cost and a firm with a low fixed cost. Give an example of a firm with low variable costs and a firm with high variable costs. A firm with a relatively large amount of variable costs may exhibit more predictable per-unit profit margins than a company with a relatively large amount of fixed costs. This means that if a firm has a large amount of fixed costs, profit margins can really get squeezed when sales fall, which adds a level of risk to the stocks of these companies. Conversely, the same high-fixed-costs firm will experience magnification of profits because any revenue increases are applied across a constant cost level. Thus, as you can see in the example, fixed costs are a critical part of profit projections and the computation of break-even points for a business or project. Airlines, auto manufacturers, and drilling operations are among the firms that usually have high fixed costs. Businesses focusing on services like website design, insurance, or tax preparation generally depend on labor instead of physical assets and are thus don't have several fixed costs. References Besanko, D., Braeutigam, R. R., & Gibbs, M. (2011). Microeconomics. Hoboken, NJ, John Wiley. Read More