THE FIRM'S OUTPUT DECISION

The assumption of profit maximisation provides a basis for beginning to look at the output decisions of individual firms. A firm will maximise its profits where its marginal costs equal marginal revenue (MC = MR).

Total revenue, average revenue and marginal revenue

There are three aspects of revenue to consider. I. Total revenue (TR) is the total income obtained from selling a given quantity of output. We can think of this as quantity sold multiplied by the price per unit. Average revenue (AR) is the total revenue divided by the number of units sold. We can think of this as the price per unit sold. Marginal revenue (MR) is the addition to total revenue earned from the sale of one extra unit of output. We can think of this as the incremental revenue earned from selling the last unit of output.

II.

III.

The average revenue curve

When a firm can sell all its extra output at the same price, the AR 'curve' will be a straight horizontal line on a graph. The marginal revenue per unit from selling extra units at a fixed price must be the same as the average revenue If the price per unit must be cut in order to sell more units, then the marginal revenue per unit obtained from selling extra units will be less than the previous price per unit. In other words, when the AR is falling as more units are sold, the MR must be less than the AR.

Marginal cost equals marginal revenue As a firm produces and sells more units, its total costs will increase and its total revenues will also increase (unless demand is price inelastic and MR has become negative). (a) Provided that the extra cost of making an extra unit is less than the extra revenue obtained from selling it, the firm will increase its profits by making and selling that extra unit. (b) If the extra cost of making an extra unit of output exceeds the extra revenue obtainable from selling it, the firm's profits would be reduced by making and selling that extra unit. (c) If the extra cost of making an extra unit of output is exactly equal to the extra revenue obtainable from selling it, bearing in mind that economic cost includes an amount for normal profit, it will be worth the firm's while to make and sell the extra unit. And since the extra cost of yet another unit would be higher due to the law of diminishing returns, whereas extra revenue per unit from selling

extra units is never higher: this extra unit would generate a loss. Therefore, the profit-maximizing output is reached where MC = MR.

Given the objective of profit maximisation there are three possibilities:

(a) If MC is less than MR, profits will be increased by making and selling more. (b) If MC is greater than MR, profits will fall if more units are made and sold, and a profit-maximising firm would not make the extra output. In other words, if MC > MR a firm will look to reduce output. (c) If MC = MR, the profit-maximizing output has been reached, and so this is the output quantity that a profit-maximizing firm will decide to supply. Question Eg; The following data refer to the revenue and costs of a firm. Output Total revenue Total costs $ $ 0 110 1 50 140 2 100 162 3 150 175 4 200 180 5 250 185 6 300 194 7 350 229 8 400 269 9 450 325 10 500 425 Required (a) Calculate the marginal revenue for the firm. (b) Calculate the firm's fixed costs and the marginal cost at each level of output. (c) What level of output will the firm aim to produce and what amount of profit will it make at this level?

EQUILIBRIUM UNDER MARKET STRUCTURES

Mainly four type of market structures 1. 2. 3. 4. Perfect competition market Monopoly market Monopolistic competition market Oligopoly market

Perfect competition
Perfect competition: a theoretical market structure in which no supplier has an advantage over another.

Characteristics of perfect competition

I. II. There are a large number of buyers and sellers in the market. Firms are 'price takers', unable to influence the market price individually. Buyers and sellers can trade as much as they want at the prevailing market price, as determined by the interaction of supply and demand. Producers and consumers have the same, perfect, information about the product and the market. The product is homogeneous: one unit of the product is the same as any other unit. There is free entry of firms into and free exit of firms out of the market: there are no barriers to entry. There are also no restrictions on the mobility of factors of production. There are no transport costs or information gathering costs. Producers and consumers act rationally. This means that producers will always try to maximise profits. Normal profits are earned in the long run

III. IV. V. VI. VII. VIII. IX.

Equilibrium in the short run

Above Figure also shows the average total cost curve (ATC) and the marginal cost curve (MC), with the MC cutting the ATC at the lowest point of the ATC. Given these cost curves and the demand curve D1, the firm will produce the output Q1, where the MC curves cuts the MR horizontal curve at the point C. This is the profit maximising level of output (MC = MR)

Note, however, that the profit maximising level of output is not the same as the level of technical efficiency. This would occur at output E, where average cost (ATC) is at its minimum. By definition, technical efficiency is achieved when a firm is producing the level of output at which its average costs are minimised. At Q1, on Figure , average revenue is greater than average cost, so the firm is making supernormal profits indicated by the rectangle ABCD. These supernormal profits will attract new firms into the industry and the price will be bid down. This new position is illustrated in following Figure, where the new price is P2. Here, instead of making a profit, the firm makes a loss shown by the rectangle WXYZ. Once again the firm produces where MC = MR giving an output of Q2. A firm could choose to do this for a short period so long as revenues covered its variable costs; in this case MC=MR is the loss minimizing position rather than the profit maximising position.

Equilibrium in the long run

This long-term position is illustrated in above Figure . Note the following points about Figure. (a) The market price, P, is the price which all individual firms in the market must take. (b) If the firm must accept a given MR (as it must in conditions of perfect competition) and it sets MR = MC, then the MC curve is in effect the individual firm's supply curve. The market supply curve in Figure is derived by aggregating the individual supply curves of every firm in the industry. (c) Consumer surplus is represented by the area to the left of the demand curve above P. (d) The firm is operating at its most cost-effective point (the lowest point on the AC curve).

In the long run, all firms in the industry will have MR = MC = AC = AR = price, as at output Qf in Figure . Because this position earns the entrepreneur the desired return on their capital (normal profit), ensures allocative efficiency, and means that firms operate their most cost-effective point, long-run equilibrium under perfect competition is held to be a desirable model for an economy.

The monopoly market

In a monopoly, there is only one firm, the sole producer of a good which has no closely competing substitutes. A firm's monopolistic position may result from some natural factor which makes it too costly for another firm to enter the industry. For example, in the domestic water supply industry it will normally be too costly for a second firm to lay a second water supply system to compete for part of the business of an existing sole supplier: the sole supplier enjoys a natural monopoly. A monopolist can either be a price maker (and thus a quantity taker) or set quantity (and take the equilibrium price which results). However, it cannot fix both price and quantity because it cannot control market demand. If price must be reduced to increase unit sales, average revenue is falling and marginal revenue will always be lower than average revenue. If the monopolist increases output by one unit, the price per unit received will fall, so the extra revenue generated by the sale of the extra unit of the good is less than the price of that unit. The monopolist therefore faces a downward sloping AR curve with an MR curve below the AR curve. For any given price, AR is double the MR on straight-line average revenue curves.

Profit-maximising equilibrium of a monopoly The condition for profit maximisation is, as we have seen, that marginal revenue should equal marginal cost (MC = MR). This is true for any firm. As long as marginal revenue exceeds marginal cost, an increase in output will add more to revenues than to costs, and therefore increase profits. A monopolist will have the usual U-shaped cost curves.

Price discrimination
Price discrimination occurs when a firm sells the same product at different prices in different markets.

Four basic conditions are necessary for price discrimination to be effective and profitable.
(a) The seller must be able to control the supply of the product and keep out any competitors who could undercut the premium price. To this extent, the market must be imperfect. (b) There must be at least two distinct markets with no cross-over between them. For example, a rail fare will either be for a peak time or off-peak. If a customer buys an off-peak fare he or she cannot use it during a peak period.

(c) The seller must be able to prevent the resale of the good by one buyer to another. The markets must, therefore, be clearly separated so that those paying lower prices cannot resell to those paying higher prices (d) There must be significant differences in the willingness to pay among the different classes of buyers. In effect this means that the elasticity of demand must be different in at least two of the separate markets so that total profits may be increased by charging different prices.

Monopolistic competition
Monopolistic competition is a market structure in which firms' products are comparable rather than homogeneous. Product differentiation gives the products some market power by acting as a barrier to entry. Monopolistic competition is a market structure which combines features of perfect competition and monopoly.