GENERAL ECONOMICS CHAPTERS 5 AND 6

5. THEORY OF COST

5. 1 MEANING OF COST

Cost is expenditures incurred on resources used in producing goods and services

5.2. TYPES OF COSTS

1) FIXED COST (TFC): Cost that does not vary with the level of output in the SR e.g rental cost,
interest rates, cost of full time contracted staff, insurance cost, depreciation etc .

Formula; TFC =TC-TVC or AFC x Q

AFC = TFC or ATC –AVC.

Q
2) TOTAL VARIABLE COSTS (TVC); It is cost that varies as the level of output varies eg wages,
cost of fuel
Calc as TVC=TC-TFC or AVC x Q
AVC = TVC or ATC-AFC
Q
3) TOTAL COST (TC); is total expenses to produce each level of out put

TC=TFC +TVC or ATC x Q

ATC=TC/Q or AVC +AFC

4) MARGINAL COST (MC); it is the addition to TC resulting from increasing output by one unit.

Calc as; MC =∆TC

∆Q
5) Explicit Cost: It is direct cost incurred in the production process

6) Implicit cost: It is the opportunity cost of employing a particular factor of production

TC
ILLUSTRATION C
TOTAL COST CURVES TVC

TFC

Q
UNIT COST CURVES

COST

MC ATC
AVC

AFC

O Q

The MC curve cuts the AC and AVC curves at their minimum points when rising.

5.3 LAWS OF COSTS (SEE LAWS OF RETURNS)

 With increasing returns MC goes down

 With constant returns MC goes sideward
 With diminishing returns MC goes up

Therefore it is as a result of the laws of variable proportions that the short run MC and AC curves are U-
shaped.

5.4 LONG RUN AVERAGE COST (LAC) CURVE

The long run is a period of time in which it is possible to change the quantity of all factors of production
employed. The LAC curve is an envelope of the various short run AC ( SAC) curve

ILLUSTRATION SAC SAC 5

Cost 1 SAC2 SAC SAC 4
3 LAC

ECONOMIES OF
SCALE DISECONOMIES OF
SCALE

Q
O Q
Output level Q = technical optimum because AC is at minimum

The shape of the LAC curve above is U-shaped explained by changes in scales of production or returns to
scale. When there is increasing returns to scale, there is overall decrease in unit cost (AC) as output
increases also when there are diseconomies of scale unit cost increases as output increases.

5.5 REVENUE OR TOTAL REVENUE (TR)

Revenue is the income a firm can earn from selling its products ‘

TR = P x Q or AR x Q

AVERAGE REVENUE (AR) is how much income a firm gets from selling a unit of output

AR = TR = P
Q
MARGINAL REVENUE (MR) is the incremental earning from an additional unit sold.

MR = ∆TR
∆Q
ILLUSTRATION

R
R B) MR/AR. in an
A) MR/AR in a perfect imperfect market
mkt

P MR
=AR

AR

O Q
Q
MR
 R
R A) TR in perfect Mkt B) TR in imperfect Mkt

TR

TR

Q
O
Q
5.6. PROFIT MAXIMIZATION

Profit maximization is the short run and long run process by which a firm determines the price and output
level that returns the greatest profits. There are several approaches to this problem. The TR/TC and
MR/MC approaches

Profits are maximized by the TR and TC approach where the positive difference between TR and TC is
highest.

Also, profits are maximized by the MR/MC approach where MR = MC. Hence, the basic assumption is
that firms are profits maximizers.

Profit is defined as.

Profit = Rev – costs

∏( q) =R(q) - C(q)

∏ (q ) = P( q).q- C(q)

dΠ = dR - dC =O
dQ dQ dQ

dR = dC implies MR = MC
dQ dQ
 TC
ILLUSTRATION
TR/TC approach in perfect market C /R TR

Q
O PROFIT

The maximal profit is measured at CB

MR/MC approach in a perfect market ‘

CIR MC
Maximal profit is at output q
MR where MR =MC

Q
q
 6. THEORY OF THE FIRM
6.1. INTRODUCTION

Firms’ behaviour depends on the market structure that they operate within. Here, we shall discuss the two
extremes. Perfect and imperfect competition

6.2. PERFECT COMPETITION

The firm operating in conditions of perfect competition will face a number of features or characteristics
which include

 Larger number of buyers and sellers

 Homogenous products
 Free entry and exit
 Perfect knowledge of market conditions ( eg prices)
 Firms are price takers that is they accept the market price given

6.2.1 ILLUSTRATION OF PERFECT COMPETITION PROFIT MAXIMIZING OUTPUT AND

PRICE P R
S
MC

P D= MR = AR

D Q
O Q
O Q
Industry Representative Firm

Because the firm in perfect competition is too small to influence the market price its MR is the market
price .Therefore, it will maximize profits where MR= MC=P. In fact the supply curve for the firm is the
MC curve. Also, it is the industry that determines or makes the price and given to the firms that are price
takers

6.2.2 SHORT RUN EQUILIBRIUM AND SUPERNORMAL PROFITS

A firm in perfect competition in the short run may make supernormal profit as AR> AC at output where
MR= MC
ILLUSTRATION
SAC
S MC
CIR

P A MR=AR=DD

C B

Q
O q

The firm above is making supernormal profit of CPAB at the profit maximizing output q where MR=MC

6.2.3 SHORT RUN EQUILIBRIUM AND LOSSES AND SUBNORMAL PROFIT

A firm in perfect competition in the short run may make losses as AC > AR at output where MR =MC
MC
ILLUSTRATION CIR

C A AC
P B MR = AR =D

O q Q

The firm above is making losses of CPAB because AC >AR at the profit maximizing output level q
6.2.4 LONG RUN EQUILIBRIUM

In the long run the short run supernormal profits will be eroded because of the following

 Higher price will attract new firms into the market

 The increased supply will lower the price
 This is level at the bottom at the AC curve PRICE
S /COST
ILLUSTRATION
MC
P S1

AC

P1
MR1=AR1=D1
MR=AR=D

D
Q Q
q

a) Industry B) Firm
O
In the long run the firm makes only normal profits due to freedom of entry as supply increases from S-S1.
The firm therefore produces at technical and allocative efficiency in the LR

Allocative or Pareto efficiency is when P/AR =MC

Technical efficiency is when AC =MC or AC is at minimum

6.2.5 SHUT DOWN CONDITION

In the short run a firm shuts down if it’s AR/P <AVC and will only continue production if variable costs
can be covered that is P ≥, AVC OR TR ≥ TVC because some fixed cost is still incurred even at zero
output.

In the long run a firm will continue production if P/AR ≥ ATC OR TR≥, TC
ILLUSTRATION

CIR MC
AC

AVC
B
P MR1=AR1
1
A MR=AR
P

Below the price p the firm shuts down in the SR. Any price p and above the firm continues production in
SR because AVC are cost. Portion ABMC is the short run supply curve. While portion BMC is the long
run supply curve

6.3 IMPERFECT COMPETITION

From studying perfect competition, we now turn to the more common imperfect competition. The sources
of imperfection are caused by barriers to entry formed when only a small number of firms actually supply
the market or other barriers may come from government regulations e g patent

6.3.1 MONOPOLY

6.3.1.1. DEFINITION

It is a market structure where there is just one firm supplying to the whole market.

Examples, national football leagues, eneo Cameroon tc

There is absence of competition, whatever price output choice they make as an individual firm is what it
is for the whole market.

6.3.1.2 FEATURES OF MONOPOLY

x Sole seller of a good

x Profit maximizing firm
x Price maker
x Earn supernormal profit
x Barriers to entry.
63.1LONG RUN EQUILIBRIUM OF A MONOPOLIST

Unlike perfect competition, there is no difference between the long run and short run equilibrium of the
monopolist. The firm faces a downward sloping demand curve because the AR decreases as output
increases.

The monopolist cannot simultaneously set price and quantity i.e if he cuts quantity price rises and if he
raises quantity price will fall.
C /R MC
ILLUSTRATION
A
P1
C

C1

AR
O q1 Q
MR
The firm may make supernormal profit by charging a price above AC. This has the effect of exploiting
the consumer. Total supernormal profits are q1 (p1-c1)

The firm can continue making supernormal profit in the long run due to the existence of barriers to entry.

6.3.1.4 THE MONOPOLIST CAN DETER ENTRY FROM COMPETITORS

The monopolist holding significant market power, they can prevent other firms from entering the market
due to the following reasons

x Economies of scale
x Legal barriers such as patents, copy rights licenses
x Vertical integration
x Control of key resources
x Reputation of incumbent

6.3.1.5. ADVANTAGES OF MONOPOLY

x Benefit from economies of scale

x Supernormal profits lead to R & D or greater investment
x Dormant domestically allows for international competitiveness
x Absence of cut-throat competition
 6.3.1.6 DISADVANTAGES OF MONOPOLY

 Limited output
 High prices
 Less consumer sovereignty
 Allocative inefficiency etc

6.3.1.7 PRICE DISCRIMINATION

DEFINITION

It is the action of selling the same product to different groups of buyers at different prices for reasons not
related to differences in costs. The aim is to maximize profit. For example; a first class seat on a plane
will have higher associated price than the economy seat, dumping. It can be first degree (perfect), second
degree(multipart) and third degree price(segmented market) price discrimination

6.3.1.8 CONDITIONS REQUIRED FOR PRICE DISCRIMINATION

 The firm must have the monopoly power or ability to set prices
 Elasticity of demand must be different in order to extract consumer surplus
 Market must be separated to avoid see page (buying from cheaper market and reselling in a dearer
market) either by distance age, sex, race etc

ILLUSTRATION
P /C
P /C
PB MC

MC
PA

AR
AR
Q O
O QA QB
MR MR

MKT A MKT B

What is important to note here is that a monopolist charges a lower price (PA) in elastic market A and
higher price (PB) in inelastic demand market B to increase profits. Without price discrimination just one
price would be charged and profits would be lower
6.3.2 MONOPOLISTIC COMPETITION

6.3.2.1 DEFINITIONS

A market structure where many sellers produce similar, but not, identical goods each producer can set
price and quantity without affecting the market as a whole for example, soap industry in Cameroon, hotels

6.3.2.2 FEATURES OF MONOPOLIST COMPETITION

 Many buyers and sellers

 Products are not identical but similar or substitutes
 Barriers to entry and exit exist but low
 Firms may engage in some form of marketing or advertising
 Brand loyalty may make demand less sensitive to price ( less elastic)
 Firms are price makers etc.

6.3.2.3 SHORT RUN EQUILIBRIUM IN MONOPOLIST COMPETITION

In the short run a firm in monopolist competition makes abnormal or supernormal profit at output level
MR=MC.

ILLUSTRATION

C /R MC

AC

P A

C B
AR

O q Q

MR

As usual profit maximizing output occurs when MR=MC at q. in this instance the firm earns supernormal
profits represented by the area CPAB
6.2.2.3 LONG RUN EQUILIBRIUM IN MONOPOLISTIC COMPETITION

With near perfect information, the short run supernormal profits attract new firms into the market. As
more and more firms enter into the market, the AR or demand curve shift to left due to other substitute
goods . Consequently, the amount of profit earned will reduce to normal profit.

ILLUSTRATION
MC
CI AC
R
A
P

AR =DD

O q Q

MR

As the graph shows, the AR curve shifts back to the point whereby there is no supernormal profit can be
earned by any firm consequently only normal profits are earned in the long run

ADVANTAGES OF MONOPOLISTIC COMPETITION

 No significant barriers to entry meaning the market is relatively contestable (freedom of entry and
exist)
 Differentiation of products increase consumers choices
 Less inefficiency than monopolies

DISADVANTAGES OF MONOPOLISTIC COMPETITION

 Price is higher than MC relative to perfect competition

 Product differentiation through adverts can waste resources.
6.3.4 OLIGOPOLY

Definition

An industry dominated by a few giant firms or suppliers for example brewery industry in Cameroon, the
mobile phone service provider industry.

An industry in which there are only two dominant firms is a duopoly.

An oligopoly can be collusive act as a cartel (member firms work together in making pricing and output
decisions) or non-collusive. It can also be perfect, where few firms sell identical products at a unique
price) or imperfect.

6.3.4.2 FEATURES OF OLIGOPOLY

 Few giant sellers in the market

 Interdependence of firms –it is unique feature i.e a firm is not certain how its rivals will respond
to an action initiated by it
 Maximum advertisement
 Inside competition and outside agreement
 No unique pattern of pricing policy because of interdependence and rivalry
 Barriers to entry because economies of scale

6.3.4.3. NON COLLUSIVE OLIGOPOLY –KINKED DEMAND CURVE

In oligopoly a firm cannot pursue independent strategies. Theory of oligopoly suggests that, once a price
has been determined it will not change except to react to rivals

Therefore in oligopoly the firms face a kinked demand curve as the reaction of competitors to a price
change depends on whether price is increased or decreased. If a firm maker’s price increases, rivals will
not follow suit,

Also, if a firm drops the price, rivals will respond by lowering theirs. In either case the initiator loses out
total revenue. P

ILLUSTRATION-KINKED DEMAND CURVE

D Elastic DD

Inelastic DD

D
Q
Q
Initially the firm supplies q at a price of p if price increase above price, demand is elastic because rivals
will not follows price increases.

If price falls below p, demand is inelastic because rivals will follow price cuts

In order to reduce uncertainty among rival firms, price are stable or rigid at p and they may opt for non-
price competition such as advertisement, sales promotion etc.

ILLUSTRATION OF KINKED DEMAND CURVE SHOWING MR. CURVES

P
D1

P
MR 1

MR 1
MR
0 D
Q
O Q Q
The kinked demand curve leads to discontinuity in the MR. curve

ILLUSTRATION OF KINKED DEMAND CURVE SHOWING MAR AND MC CURVES

P /C
D1
MC
P
MR 1
MR 1

MR
D

q Q
MR
Providing the MC of the firm it remains the region between the MRs as the firm will not benefit from
changing price

6.3.4.5 ADVANTAGES OF OLIGOPOLY

 May make large profits since there are few players in the market
 Barriers to entry allow an oligopoly to earn long run abnormal profits
 Prices are relative stable because of kinked demand curve.
 Customers benefits from variety because of advertisement

6.3.4.6 ADVANTAGES OF OLIGOPOLY

- May develop into a monopoly charging high prices

- Oligopolies may suffer from price wars

- Innovation of small players in the industry is stifled or absorbed by large players

DEFINITIONS

1. Pareto efficiency or allocative efficiency -when in allocating resources one person cannot be
made batten off without at the same time making someone else worse off
2. Technical efficiency: where the production of a good is at the lowest AC possible
3. X-inefficiency. The difference between the efficient behavior of firms and the observed
behaviour of firm. It occurs owing to lack of competitive pressure.