Chapter 6 Contemporary market capitalism: Output and price determination Profits $ Revenue Costs

Lecture Plan Price and output determination: perfect competition Revenue (total, average, marginal) Costs (fixed, variable, marginal) Profit maximisation methods Total revenue—total costs Marginal revenue—marginal cost Price and output determination in other market structures Monopoly Oligopoly Monopolistic competition 2

Price and Output Determination: Perfect Competition Market Individual $P $P S D D P1 D D Q Q Note: Demand can also be viewed as revenue for the firm

Revenue Total revenue: TR = P × Q where TR = total revenue P = price Q = quantity Average revenue: AR = TR ÷ Q where AR = average revenue TR = total revenue Marginal revenue = the addition to total revenue from selling one extra unit

Demand and Revenue Schedule for a Perfectly Competitive Firm Quantity demanded Price AR = TR ÷ Q TR = P × Q MR 12 -- 1 2 24 3 36 4 48 5 60 6 72

Demand and Revenue Curves for a Perfectly Competitive Firm 70 TR 60 50 40 30 20 P = AR = MR = D 10 Q 1 2 3 4 5 6

Cost Analysis Short run Long run Period of time where a firm is only able to increase output by using more of its existing factors of production, that is, a firm is restricted by a given amount of capital and labour Long run Period of time in which all factor inputs can be varied

Total cost (TC) = fixed costs (FC) + variable costs (VC) Fixed costs: Costs which, in the short run, do not vary with the level of output, e.g. initial plant and capital equipment, rates and government charges which will occur even before production begins Variable costs: Costs which increase as the level of output is increased, e.g. costs for raw materials and labour Total cost (TC) = fixed costs (FC) + variable costs (VC)

Average and Marginal Costs Average total cost: the total cost of producing divided by the number of units produced i.e. ATC = TC No. of units produced Marginal costs: additions to total costs through producing one additional unit

Short Run Cost Schedule for a Perfectly Competitive Firm Output units FC VC TC ATC MC 7 – 1 6 13 2 11 18 9 5 3 25 8.3 4 29 36 48 55 19 68 75 12.5 90 As output increases, VCs also increase however not by constant amounts, that is, initially VC increases by smaller amounts, then by increasing amounts

The Law of Diminishing Returns (Decreasing Returns) After a certain point, adding more variable factors of production causes a less than proportionate increase in the amount of extra output produced (this assumes that other factors are fixed/constant) Note: Diminishing returns only occur in the short run when firms are unable to increase all factors in their correct proportions

Cost Curves for a Perfectly Competitive Firm 80 40 $ 20 10 Q 6 3 1 2 4 5 TC VC FC MC

Profit Maximisation Short run profit maximisation for a perfectly competitive firm A firm must determine the level of output which will make the greatest profit Two methods: Total cost–total revenue method Marginal cost–marginal revenue method

Total Cost–Total Revenue Method Q FC VC TC TR Profit/Loss (TR – TC) 0 7 0 7 0 –7 1 7 6 13 12 –1 2 7 11 18 24 6 3 7 18 25 36 11 4 7 29 36 48 12 5 7 48 55 60 5 6 7 68 75 72 –3 The greatest profit is $12 and occurs when there is an output level of 4 units

Graphically P Q $ TR TC A B 4 Optimal production level at 4 units

Marginal Cost–Marginal Revenue Method Where MR > MC (i.e. the revenue from producing another unit is more than the cost of making it) Firms can increase profits by producing more Where MC > MR (i.e. the cost of making the last unit exceeds the revenue gained by selling it) Firms can increase profits by reducing output Where MC = MR, profit is maximised

Example Profit maximising level at 4 units, MR is greater than Q MC MR Difference 1 6 12 6 2 5 12 7 3 7 12 5 4 11 12 1 5 19 12 –7 6 20 12 –8 Profit maximising level at 4 units, MR is greater than MC but they are almost equal

Graphically P MC MR Q Level of profit maximisation is where Level of profit maximisation is where MC = MR i.e. where the curves intersect

Price and Output Determination: Monopoly Public utilities (Australia Post, old Telecom) Barriers to entry Control over essential raw materials Patents/copyrights Tariffs, quotas, subsidies Size of the market Economies of scale

Demand Curve for the Monopolist (Same as That for the Total Market) Q Q

Price and Output Determination: Monopoly Marginal revenue is less than the selling price The price that the monopolist charges for the product is indicated by the demand curve Monopolists are price makers and they can charge prices above the level of a perfectly competitive firm

Price and Output Determination: Monopolistic Competition Monopolistic competition places constraints on the ability of a firm to charge prices in excess of competitors However, firms in this market structure engage in considerable non-price competition (e.g. product differentiation) in order to be able to charge a higher price than competitors

Price and Output Determination: Oligopoly The ‘kinked’ demand curve P ($) D1(A,B,C) DA P3 D Firm’s demand if competitors don’t follow price change P2 P1 demand if competitors follow price change D1 for industry DA Q Q2 Q1A Q1(A,B,C)