THEORY OF THE FIRM

The firm’s objective

What is a firm??

A firm is an economic unit that produces goods and services.

Firms go into production with the main motive to earn profits.

From ECO111, we know that Profit= Total Revenue-Total Costs.

In order to maximize profit, there is a need to minimize costs.

Cost minimization however, does not mean that profits are being maximized.
• This is because some firms aim to minimize costs without necessarily maximizing profits. E.g.
non-profit organizations.

Therefore, even though profit maximization required costs to be minimized, the reverse is not
true.
The production process
The production process involves the transformation of inputs into
output.
• Input: anything that goes into the production process (also
known as factors of production. E.g. land, labor, capital,
technology, entrepreneurial ability.
• Output: the end product of a production process.

There are two categories of inputs: Fixed and Variable Inputs.

• Fixed input: a factor of production whose quantity does not
change as output changes.
• Variable input: the quantity of the input changes with the level
of production.
The Short-Run vs the Long-Run
Classifying inputs as either fixed or variable depends on the
length of time under consideration i.e. whether it is the short run
or the long run.
The Short-Run
• This is a period of time in which some of the firm’s inputs are fixed.
• The cost of quickly adjusting some inputs may be too high, making it
impractical or uneconomical to make the change.
• The SR may be a week, a month, a year and so on.
The Long-Run
• This is a period of time in which all factors of production are variable.
• Here, the firm can vary all of inputs without increasing per-unit cost of
production.
• It is different for each industry.
Question: Why is it possible to take in more gym members in a
relatively short period of time than it is to build another power
plant to accommodate increased electricity consumption?
• Taking in more gym members involves hiring more gym
instructors and maybe renting a bigger gym space. All these
changes can take place in a matter of months.

• By contrast, building a new power plant could take years. It

requires requires lengthy inspections, contractors and
machinery. That is, it is more capital intensive and capital
cannot be altered within a short period of time.
The Short-Run Production Function
The production function for any good or service is simply the
relationship between the quantities of various inputs employed
in a given period of time, and the maximum quantity of the good
that can be produced over the same period.

i.e. the production shows the maximum output that can be

produced from any specified combination of inputs.
Consider a production process that employs 2 inputs, labour (L)
and capital (K), to produce output Q.
In the SR, capital is assumed to be fixed while labour can be
varied.
Then the SR production is written as:

Where:
= fixed amount of capital,
= variable amount of labour,
Q= output
Properties of the SR production function
1. It passes through origin, implying that no output is produced if
zero units of the variable input are employed. i.e. Q=0 when L=0.
2. Adding an extra unit of the variable input to the fixed input
initially causes output to increase at an increasing rate.
3. However, beyond some point, additional units of the variable
input results in smaller and smaller increases in output. This is
known as the Law of Diminishing Returns.

Formally, the law of diminishing returns is stated as follows:

As equal amounts of a variable input are progressively added while
other inputs are fixed, the resulting increments to output will
eventually diminish.
TOTAL, MARGINAL & AVERAGE PRODUCTS
Total Product: it shows how total output varies relative to the
variable input.

Marginal Product: It is the change in TP due to a one unit chan

in the variable input.

The MP at any point is equal to the slope of the TP curve at tha

point.

Average Product: It is the TP divided by the quantity of the

variable input.
The Relationship Between TP, MP and AP

Labor input TP AP=TP/L MP=

0 0 - -
1 60 60 60
2 135 67.5 75
3 210 70
4 280 70
5 340 68
6 380 63.3
7 380 54.3
8 370 46.3 Fill in the rest of the
MPL column
Graphically,
Features of the Diagram
i. As long as MP is positive, TP is rising. TP reaches a maximum
when MP=0 and begins to fall thereafter.
ii. When MPL is greater than APL, the AP is rising and the MP lies
above it.
iii. When MPL is less than APL, the AP is falling and the MP curve
lies below it.
iv. The MPL intersects the APL at the maximum point of the AP
curve. Thus, the two are equal at the maximum of the AP curve.
v. MPL is equal to zero when the TP is at a maximum.
vi. Where the MP curve is at a maximum, the corresponding point
on the TP curve, A is an inflexion point. Point A is where
diminishing returns set in, i.e. it is the point where the TP curve
switches from increasing at an increasing rate to increasing at a
decreasing rate.
vii. Point B lies on the line which is from the origin and tangent to
the TP curve. This point is the maximum of the AP curve.
Stages of Production
The relationships between TP, MP and AP curves are useful for dictating the stages of
production.
STAGE I:
• APL is rising; MPL rises, reaches a maximum and then begins to fall.
• Since MPL is positive, TP is increasing.
• The firm should therefore continue to increase output.

STAGE II:
• Both APL and MPL are declining, but since MPL is still positive, it implies that TP is still rising.
• This is the economic region, it is the ideal stage of production.

STAGE III:
• APL continues to decline; MPL becomes negative therefore TP declines.
• This stage of production should be avoided.
Which is the ideal stage of production?
No firm will want to produce in Stage III. In this stage, further
increments of the variable input reduce output. TP can therefore be
raised by reducing the use of the variable input. In this case, MP will
become zero and eventually positive, therefore TP will increase.

Limiting production to Stage I however is disadvantageous to the

firm. Here, even though the MPL is declining, it is still positive.
Therefore TP can still be increased by employing more of the variable
input.

The ideal stage of production is Stage II. Even though TP is increasing

at a decreasing rate, it is still increasing, hence it is still worthwhile to
produce. This is known as the economic region of production.
The Long-Run Production Function
In the LR, all factors of production can be varied.
The LR production is therefore written as:

Where:
= variable amount of capital,
= variable amount of labour,
Q= output
When producing a given amount of output in the LR, the firm
can choose between different production processes i.e. different
combinations of labour and capital.
These different combinations can be shown graphically using
ISOQUANTS.

An isoquant is a curve which shows various combinations of

inputs that produce the same level of output.
 The firm may choose between
process A which involves using 18
K units of capital and 4 units of
labour; or process B which uses 12
units of capital and 8 units of
18 •A labour to produce an output of 100
units.

12 •B Therefore along an isoquant,

Q=100 output does not change, only the
combination of inputs changes.
4 8 L
The properties of a production process can be represented by an isoquant map.

K An input combination on an
isoquant will yield a higher level of
output than any combination that
lies below that isoquant.
Similarly, any input combination
on an isoquant will yield a lower
output than any that lies above it.
Q=120
Q=80 Higher isoquants represent higher
Q=40 levels of output.
L
Properties of Isoquants
1. Isoquants are downward sloping to the right.
• This shows that to maintain a constant level of output, an increase in
one input must be matched by a corresponding decrease in the other
input. i.e. there is diminishing marginal rate of technical substitution.
2. Isoquants further away from origin represent higher levels of
output.

3. Isoquants from the same isoquant map can never cross.

• Otherwise this would mean that two different output amounts are the
maximum attainable from a given combination of resources.
The Marginal Rate of Technical Substitution (MRTS)
The MRTS is the rate at which one input can be exchanged for
another, without altering the level of output.

K ∆𝐾 𝑑𝐾
𝑀𝑅𝑇𝑆 𝐿 , 𝐾 = =−
∆𝐿 𝑑𝐿

∆K The MRTS at any point is – the

value of the slope of the isoquant at
∆L that point.

So the MRTS of labour for capital is

Q0
the amount of capital that should
be reduced when an extra worker
is employed, to still achieve the
L same level of output.
Marginal Productivity & Factor Substitution
There is a relationship between the marginal productivity of
factors of production and the MRTS.

Given the LR production function:

Totally differentiating equation (1)

By definition:
This implies that:

Along an isoquant, output does not change i.e. herefore:

Transposing:

Dividing both sides by and :

By definition:

Therefore,

So,
 Types of Isoquants
• Convex Isoquants • These have a diminishing
MRTS as you move
downward and to the right
K along the isoquant.
• This shows some degree of
substitution but inputs are
not perfect substitutes.
• Also known as a variable
Q3 proportions production
Q2 function.
Q1
L
 Types of Isoquants
• Linear Isoquants • These represent infinite/
perfect substitution between
inputs.
K
• i.e. one input may be
substituted for another
A
completely, therefore output
can be produced using only
one input.
• E.g. at point A, the firm only
uses capital in production.
Q1 Q2 Q3

L
Types of Isoquants
• L-Shaped Isoquants • Here inputs must be used in
fixed proportions.
K
• There is no substitution
between K and L, the two are
perfect complements.
•B
• Also called a fixed
Q3 proportions production
•A
Q2 function.
Q1

L
Returns to Scale
RTS tell us the proportionate change in output as inputs change.

There are 3 types of returns to scale:

1. Increasing Returns to Scale (IRS)
2. Constant Returns to Scale (CRS)
3. Decreasing Returns to Scale (DRS)
Increasing Returns to Scale (IRS)
A firm is said to experience IRS if a given increase in every input
leads to a more than proportional increase in output.
i.e. Doubling the employment of all inputs causes output to more
than double.

Example:
4 workers using 1 machine harvesting 100 bags of maize.
8 workers using 2 machines harvesting 350 bags of maize.
Constant Returns to Scale (CRS)
A firm is said to experience CRS if a given increase in every input
leads to a an equal/ proportional increase in output.
i.e. Doubling the employment of all inputs causes output to also
double.

Example:
4 workers using 1 machine harvesting 100 bags of maize.
8 workers using 2 machines harvesting 200 bags of maize.
Decreasing Returns to Scale (DRS)
A firm is said to experience DRS if a given increase in every input
leads to a less than proportional increase in output.
i.e. Doubling the employment of all inputs causes output to less
than double.

Example:
4 workers using 1 machine harvesting 100 bags of maize.
8 workers using 2 machines harvesting 150 bags of maize.
The difference between Diminishing Returns and Decreasing
Returns to Scale
•In the case of diminishing returns, we observe the effect on
output of leaving one of the inputs fixed (K), while the other
input varies (L).
•In the case of decreasing returns to scale, we observe the effect
on output of varying all inputs (K and L).

Diminishing returns in a short run concept, while DRS are

applicable in the long run.
Optimal Input Combination
Recall that:
•The firm’s objective is to maximize profits, to do this, it will either
minimize the cost of producing, or maximize the output derived from
a given amount of costs faced by the firm.
•The resources available to the firm for production (K and L) are
represented by a production function or an isoquant.
•The next step is to determine what combinations of inputs (K and L) a
profit maximizing firm should use given the amount of costs the firm
faces.
•The optimal input combination is therefore the combination of
inputs which maximizes output given the costs faced by the firm.
•To find the combination, we make use of the ISOCOST LINE.
The isocost curve shows all combinations of inputs that cost the firm the same.

For a firm using L and K, the isocost curve is represented as:

TC=wL+rK………………..(1)

Where:
TC=Total cost
w= price of labour (wages)
r= price of capital (interest rate)
L= amount of labour employed
K= amount of capital employed.
Solving for K from equation (1),

TC/r

Therefore,

TC/w L
The optimal input combination refers
to that combination of inputs that K
maximizes output given the costs
faced by the firm.

This refers to the input combination

that lies at the point where the firm’s Q3
highest possible isoquant is tangent to •A
its isocost line. Q2

Q1
This occurs at input combination A as
it simultaneously lies of the isocost L
line and the highest possible isoquant
Q2.
Characteristics of the Optimal Input Combination
1.Optimal input combination occurs at the point where the slope
of the isoquant is equal to the slope of the isocost line.
i.e.
2.Optimal input combination must satisfy the condition that the
ratio of marginal products must be equal to the MRTSL,K.
i.e.
3.From conditions (1) and (2), it must be the case that the ratio of
marginal products must be equal to the ratio of input prices.
i.e.
Example
Given the following production function for tables:

Where:
=quantity of tables produced
L= amount of labour employed
K= amount of capital employed.

If the price of capital is r, the price of labour is w and the firm’s total expenditure is TC,
i. State the firm’s optimization problem.
ii. Set up the Lagrangian function.
iii. Obtain the first order conditions for optimization.
iv. Derive the optimal combination of inputs.
Solution
i. State the firm’s optimization problem.
The firm’s problem is to:
Maximize
Subject to: wL+rK=TC

ii. Set up the Lagrangian function.

iii. Obtain the F.O.Cs

1. ………………………………(1)
2. ………………..…………..(2)
3. …………………....…………..(3)
From equations (1) and (2):

Multiply by r both sides,

Divide by 15 both sides,

Multiply by and then both sides,

Therefore,
……………………………..(4)
Substitute equation (4) into (3):

Simplify and solve for K*

Therefore :

…....................................(5)
Substitute equation (5) into (4) and solve for L*:

Therefore:

…....................................(6)
Homework
The output of a brick maker can be determined by the following production function:

Where:
B=number of bricks produced in a given period
L= amount of labour employed
K= amount of capital employed.

If the price of capital is PK, the price of labour is PL and the firm’s total expenditure is E,
i. State the firm’s optimization problem.
ii. Set up the Lagrangian function based on the information provided.
iii.Obtain the first order conditions for optimization.
iv. Derive the optimum combination of inputs.
v. If the price of capital is P20, the price of labour is P30 and the brick maker’s total expenditure on inputs in
P120, calculate the firm’s output maximizing input combination.
vi. How may bricks will the brick layer produce in a given period?
THEORY OF COSTS
ACCOUNTING & ECONOMIC PROFITS (Brief Recap)
Accounting profits are measured by the difference between a firm’s revenue and explicit
costs.

Accounting profit=Total Revenue-Explicit Costs

Explicit costs reflect ordinary expenses such as the firm’s payroll, payments for raw
materials, depreciation of capital etc.
Economic profits are measured by the difference between a firm’s revenue and costs,
including implicit costs or opportunity costs.

Economic profit=Total Revenue-[Explicit Costs+ Implicit Costs]

Implicit costs include the costs of the resources owned and used by the firm’s owner.
Short Run Cost Functions
Cost functions show the various relationships between the costs of production and the level of output over the
short-run and the long-run.

The short-run is a time period within which the firm cannot alter the quantity of some of its inputs. Here, the
firms total costs consist of variable and fixed costs.

i.e. TC=TFC+TVC

Total Fixed Costs(TFC)

• These are costs of fixed inputs and they do not vary with changes in the output level.
• i.e. since the quantity of fixed inputs does not change in the SR, TFC are also constant regardless of output
levels.

Total Variable Costs (TVC)

• These are costs of variable inputs and they vary with changes in the output level.
• TVCs increase with output because firms employ more variable inputs if they are to produce larger amounts
of output.

Total Costs (TC)

• These include all the costs that a firm faces in production, they are the sum of TFCs and TVCs.
To illustrate:
We note that:
• The TC & TVC functions will same
shape since they differ by a constant
Q TFC TVC TC amount equal to the fixed cost.
• When Q=0, TVC=0 but TFC>0 i.e. the
0 30 0 30
total cost of producing no output is
1 30 10 40 equal to the fixed cost.
2 30 20 50 • Output can only be increased by
employing more units of the variable
3 30 30 60
input (labour)
4 30 40 70
5 30 50 80
6 30 60 90
7 30 70 100
8 30 80 110
Average Fixed Costs (AFC)
• The AFC of any output level is given by TFC divided by output.

Average Variable Costs (AVC)

• The AVC of any output level is given by TVC divided by output.

Average Total Costs (ATC)

Marginal Cost (MC)
• It is the additional cost of producing one more unit of output.

Since TFC do not vary with output levels, the change in TC as a result of the
change in output is the same as the change in TVC.
i.e. MC can also be calculated from TVC since the only difference between
TC and TVC is a constant.
Therefore the change in TC and the change in TVC associated with each
additional unit of output are always the same.
MC is also equal to the slopes of the TC and TVC curves at that level of
output.
i.e.
Review Question: Complete the table by calculating the TC,
TVC, TFC, AFC, AVC and the MC.

Quantity TFC TVC TC AFC AVC ATC MC

(bread loaves) B C D=B+ B/A C/A D/A ∆D/∆A
A C

0 120 0 - - - -
10 120 20
20 120 30
30 120 50
40 120 80
50 120 130
60 120 230
70 120 380
80 120 690
Graphical Representation of the SR Average & MC Curves.
Features of the diagram
AVC initially declines with increases in output, then reaches a minimum, and
then AVC increase with output. This is due to the Law of Diminishing
Returns.

ATC also declines, reaches a minimum and then rises with output. The
minimum point of the AVC occurs earlier than the minimum point of the
ATC. This is because AFC declines continuously, therefore ATC continues to
fall even after AVC has begun to rise.

AFC declines steadily as output increases since TFC do not vary with output.

The vertical distance between ATC and AVC is the AFC. This distance
approaches zero as output increases.
The Relationship Between Cost & Production
Functions
1. AVERAGE COSTS & AVERAGE PRODUCT
Recall that:

Since TVC are the costs associated with the variable input labour,
Where: w= price of labour and L= quantity of labour.

Equation (1) can therefore be re-written as:

By definition,

Which implies that:

Substituting (4) into (2),

Equation (5) shows that there is an inverse relationship between AVC and the
APL. When APL is rising, AVC is falling and vice versa. The AVC rise as a
result of the diminishing returns to a variable input (L).
2. MARGINAL COSTS & MARGINAL PRODUCT
Recall that:

The change in TC in the SR is due to the change in the costs of the variable
input.
Therefore,

But , TVC=wL
Therefore,
Assuming that wages are fixed, equation (3) becomes:

By definition,

Which implies that

Substituting equation (6) into (4),

Equation (7) shows an inverse relationship between MC and the MPL.

Graphical Representation of Cost and Product curves
As long as AP is rising,
MP lies above it.
Similarly, as long as AVC
is falling, the MC curve
lies below the AVC
curve.

The MP curve intersects

the AP curve at its
maximum.
Similarly, the MC curve
intersects the AVC at its
minimum point.

The MC & AC curves are

the mirror images of the
MP & AP curves
respectively.
 Falling LAC Economies of
LONG RUN COST FUNCTIONS Scale.
Rising LAC Diseconomies of
Scale.
In the LR, all inputs are variable and there are no
fixed costs.
The LR average cost function (LAC) shows the
minimum cost per unit of producing each output
level, when any desired scale of plant can be built.

The LAC is therefore a series of SR average cost

curves (SAC). More precisely, it is an envelope of of
SACs.

The LAC is tangent to each of the SACs at the

output level/ plant size corresponding to optimal
point of the SAC.
The LAC is not tangent to the SACs at their
minimum points. There is only one SAC curve
whose min point coincides with the min of the LAC
curve.
At this point: LAC=LMC=SAC=SMC
MARKET STRUCTURES
Market Structures: Introduction
In order to determine the price & profit maximizing output levels
for a particular firm, it is important to establish the market
structure in which the firm operates.

i.e. a firm’s decisions concerning price & production depends on

the characteristics of the market structure in which it operates.

There is no “average” or “typical” market. At one extreme, there

is a single producer that dominates the market, at the other end
are industries with thousands of firms, each producing a tiny
fraction of market supply.
 Remember the four market structures we learnt in ECO111?

Perfect Competition Monopolistic Competition Oligopoly Monopoly

Many buyers and sellers Many buyers and sellers Many buyers, few sellers A single seller and many
buyers
Products are Slightly differentiated Products are close
homogeneous and are products (products are substitutes No close substitutes
close substitutes substitutes) Firms have some The single firm sets the
Firms are price takers, no Firms have some influence over the price price
influence over the price influence over the price Demand curve is Demand curve is
Demand curve is Demand curve is downward sloping downward sloping
horizontal downward sloping

Street vendors Petrol stations Mascom and Orange BPC, UB bar at UB

PERFECT COMPETITION
CHARACTERISTICS
1. There is a large number of firms.
i.e. there are many independently acting sellers in the industry.

2. Firms sell a homogenous/standardized product.

The product sold by one firm is assumed to be a perfect
substitute for the product sold by other firms in the market.
3. Free entry & exit conditions with perfect factor mobility.
Firms are able to enter & leave the industry easily, and resources are also able to
move with ease among alternative uses.

4. Firms are price takers.

Individual firms treat the market price as given, i.e. they cannot influence the price.
Each firm produces such a small fraction of total output that it cannot affect the
market price by altering its supply.

5. Firms and consumers have perfect information.

Buyers and sellers have perfect information about prices and demand and supply
conditions.

Examples of real life competitive industries that approximate pure competition??

Demand Faced by the Competitive Firm
The individual competitive firm is
a price taker, therefore it faces a
perfectly elastic demand schedule
at the market price.
i.e. the firm is able to sell as much
as it wants at the market price.
The market demand curve
however is downward sloping
since all the firms, acting
independently but
simultaneously, can alter the
market price through their output.
The Competitive Firm’s Revenue
Recall that:
Total Revenue =Price*Quantity
Since the price is constant, TR is proportional to the
amount of output.
Average revenue (AR) is the amount the firm receives
for each unit of output it sells.
i.e.
For a P.C firm, the change in TR for each extra unit is
equal to the price i.e. each additional unit sold
changes TR by P.
i.e. MR=AR=P
Therefore, the firm’s demand schedule is also equal to
its AR schedule.
 MR, MC & Profit Maximization
The firm’s objective is to produce a level of output
that will maximize its economic profit.

Where
The cost structure of the firm is the same as before:
i.e.
What’s the difference between TFC & TVC?
Since the competitive firm takes price as given, i.e. price does not
change, TR varies proportionally with output.
i.e. TR(Q)=P.Q
Where TR(Q) is a function of output.
The slope of the TR curve is the marginal revenue which is
equal to the price.

i.e.  the slope of the TR curve.

Similarly, TC are a function of output i.e. TC(Q).
The slope of the TC curve is marginal cost i.e. the change in total
cost from producing an additional unit of output.
Recall that the TC>0 even when Q=0. Why is that?
i.e. --> the slope of the TC curve.
Quick Review
1. If price = P75.
• Find TR, MR and AR.

2. Suppose that market demand and supply are follows:

QD=6500-100P and QS=1200P
• Find TR, MR and AR.

3. Suppose that a firms sells 8 units of output. If price is equal

to P5, how much is TR? Now suppose that the firms sells 10
units, find MR and AR.
• what do you notice about the r/ship between TR, AR and MR for
the competitive firm?
Since the PC firm is a price taker, it can maximize its economic
profit only by adjusting its output.
Remember the two ways of determining the level of output that
will maximize the firm’s profit:
1. The Totals Approach i.e. (TR-TC Approach)
2. The Marginal Approach (MR-MC Approach)
 Profit max: where the
TR TC TR vertical distance
TC between TR and TC
curves is greatest.
The firm maximizes
profit at the point where
the slope of the TR curve
us equal to the slope of
Max profit
the TC curve.
MR=MC*

*But remember for the P.C firm, MR=P

P=MR=MC. We’ll discuss this in more
detail in the next few slides.

Q
 Provided the output price (P) is greater than the minimum of the AVC curve, the
firm should produce a level of output for which MR=MC* on the rising portion of
the MC curve.
Costs From the diagram:
Revenue
• Point A is not the profit max level
of output even though MR=MC.
This is because it’s on the declining
MC AVC portion of the MC curve.
• The firm can still increase its
revenue by producing more
output.
• Point B is the profit max level of
A B
output since MR=MC and it is on
MR=P the rising portion of the MC curve.

At output Q*, MR=P=MC.

Q* Q
Formal derivation of profit max rule for the P.C firm.

Formally,

The firm’s objective is to:

Maximize

First Order Condition for Profit Maximization:

Totally differentiate the objective function and set the derivative
to zero.
This implies that:

From equation (2), by definition:

Substituting into equation (2),

Which implies that:

………………………(4)

Recall that

However, in a perfectly competitive market, price is fixed. Therefore,

Which implies that,

Substituting this result into equation (4), we obtain the profit
maximizing rule for the competitive firm as:

Or simply,

N:B equation (3) is the universal definition of MR, it is applicable to

all the market structures. However, under P.C, since price is
constant, MR=P, implying that P=MC.
Based on the Cost-Benefit principle, the firm should keep
producing as long as P>MC. That is, for any quantity where
P>MC, the first can increase profit by increasing output.

If P<MC, then the competitive firm should decrease output.

Therefore, profit will only be maximized when P=MC, for the

competitive firm.
Independent Reading:
Profit maximization for the competitive firm: an illustration.

In the figure above, when the firm follows the profit maximizing rule, it must
produce 260 bottles per day, because this is the quantity where P=MC.
Let’s see why any other quantity is not profit maximizing:

Scenario A: The firm sells 200 bottles at P2 each

When output is 200, the corresponding MC is P1 and the MR is P2. Therefore, if the firm increases
output by one bottle it would increase revenue by P2 while costs will only increase by P1.
Therefore, by selling the 201st bottle for P2, the firm will increase its profit by P2-P1= P1 per day.
That is, for any quantity where P>MC, the firm can boost its profits by expanding output.

Scenario B: The firm sells 300 bottles at P2 each

When the output is 300, MC is P4 and MR is P2. This means that if the firm reduces output by one
bottle, it will cut its costs by P4 and only lose P2 in revenues, as a result, profit would grow by P4-
P2 = P2. Therefore, by reducing output by one bottle, the firm can reduce its losses by P2.
That is, for any quantity where P<MC, the firm can boost its profits by reducing output.

We have therefore established that if the firm produces less than 260 bottles per day (where
P>MC), it should increase output to increase profits. If it produces more than 260 bottles per day
(MC<P), it should reduce output to reduce losses.

This means that, the PC firm maximizes profit by producing output where P=MC, this is 260
bottles per day.
SR Supply Curve for the Competitive
Firm
Recall that:
1. P must equal MC on the rising portion of
the MC curve &,
2. P must be greater than the AVCmin,
These two conditions together define the SR
supply curve for the PC firm. It is therefore
given by the MC curve above the minimum
of the AVC.
Since we have established that the
competitive firm will not produce below the
shut down point, i.e. the minimum of the
AVC curve.
The SR supply curve shows the quantities of
goods supplied at different prices.
 Short Run Competitive Equilibrium
The individual competitive firm chooses the most profitable level of output to
produce at a given market price.
The price is determined by the intersection of the market demand and market
supply curves.
P P MC
𝐒=𝚺𝐌𝐂

Pe P=MR

Q* Q q* Q
Recall that the demand curve facing the individual competitive
firm is a horizontal line, implying that the firm can sell any
quantity of output it chooses at the market price.

To determine the amount of economic profit or loss a competitive

firm makes at a given price, we compare price in relation to the
ATC.
Case 1: P>ATC i.e. the firm is making economic profits in the
SR.
When P>ATC, TR>TC which implies that the
firm is making economic profit.

From the diagram:

The firm maximizes profit by equating
Pa=MC at an output level q1.
At this level of output,
TR=Pa.q1
TC=ATC.q1
The firm’s economic profit is given by:
TR-TC=shaded area
The firm should continue to operate.
Case 2: P=ATC i.e. the SR break-even point
In the SR, when P=ATC, the firm is said to break-even.
At this point, TR=TC.
This is the point where the firm is making zero
economic profit.

Graphically, the break even point is shown by the

minimum point of the ATC curve.
From the diagram:
The firm maximizes profit by equating Pa=MC at an
output level q1.
At this level of output,
TR=Pa.q1, since ATC=Pa, then TC=Pa..q1
The firm’s economic profit is given by:
TR-TC=0
The firm is still able to cover all its costs and therefore
should continue to operate.
Case 3: AVCmin<P<ATC i.e. the firm is making economic losses
in the SR.
If the firm charges a price that is below the minimum
of the ATC BUT above the minimum of the AVC i.e.
AVCmin<P<ATC, the firm should continue to operate.
This is because in this region, the firm can still cover its
variable costs and part of its fixed costs and variable
costs, even though it is making economic losses.
From the diagram:
The firm maximizes profit by equating Pa=MC at an
output level q1.
At this level of output,
TR=Pa.q1
TC=ATC.q1
The firm’s economic loss is given by:
TR-TC=shaded area
The firm should continue to operate.
Case 4: P<AVCmin i.e. the SR shut-down point.
If price falls below the minimum of the AVC, i.e.
P<AVCmin then the firm is not able to cover both its
fixed and variable costs.
The minimum of the AVC is therefore SR shut-down
point for the firm.
From the diagram:
The firm maximizes profit by equating Pa=MC at an
output level q1.
At this level of output,
TR=Pa.q1
TC=ATC.q1
The firm’s economic loss is given by:
TR-TC=shaded area
The loss is so great that the firm cannot cover both its
fixed and variable costs. Therefore, the firm should
cease production and shut down.
Review Question
1. Given that P=P80 and TC=Q2+16, calculate the profit max
output level, and the profit for the firm.
2. Suppose that QD=6500-100P and QS=1200P, where QD and QS
are market demand and supply functions. TC=Q2
• Calculate the profit max level of output.
• Find the level of profit.
3. Suppose that the market demand curve is P=200-Q. The
competitive firms faces fixed costs equal to 10 and variable costs
equal to 20Q.
• Calculate the profit max level of output.
• Find the firm’s profit.
Long Run Competitive Equilibrium
The LR competitive equilibrium is characterized by zero economic profits.
The adjustment process:
If the firms in the industry are make positive economic profits, this will act as
a signal for firms in the industry to expand their operations. It is also an
incentive for firms outside the industry to enter.
Industry supply increases and eventually drives the price down.
Entry into the market and expansion of operations will continue until the
industry supply and demand curves intersect at the LR equilibrium price.
This is the LR equilibrium position for the market.
Once it is reached, there is no further incentive for new firms to enter since
existing firms will be making zero economic profits.
On the other hand, if the firms in the industry are make negative economic profits
(economic losses), this will act as a signal for firms in the industry to reduce their
operations. It is also an incentive for firms inside the industry to exit.
Industry supply decreases and eventually drives the price up.
Exit out of the market and contraction of operations will continue until the industry
supply and demand curves intersect at the LR equilibrium price.
The LR equilibrium position is where the firm makes neither positive economic
profits nor losses.
i.e. At the point where: P=min SAC= min LAC= SMC=LMC
Graphically, the LR competitive equilibrium is shown as below, where Q* is the
profit maximizing output level for the market, and q* is the profit maximizing
output level for the individual firm.
Review Questions
Suppose that the objective of a perfectly competitive firm is to
maximize the profit function:

i. State the first order condition for profit maximization.

ii. Derive the profit maximizing rule for the competitive firm.

Suppose that C=50+4q+2q2 and P=P20.

iii. If the firm is selling 5 units, is it maximizing profit?
iv. What quantity of output should the firm produce?
MONOPOLY
A monopoly is an imperfect market type.

It is a market structure in which a single seller of a product with

no close substitutes serves the entire market.

Examples?
Characteristics of a Monopoly
1. Single seller
• The monopolist faces the entire market demand by itself, so it sets both
the price and quantity.
• Market demand is downward sloping because higher price lower
quantity demanded.
2. There are barriers to entry-
• i.e. no freedom of entry & exit for potential competitors.
3. Price maker
• Since a monopoly is able to influence the price, it is said to have some
market power and this is reflected by a downward sloping demand
curve.
4. Product with no close substitutes
Causes of a Monopoly
1. Exclusive control over important inputs
• A single firm may have control over an input that is essential for
the production of some good.

2. Government created monopolies

• i.e. patents, copyright protection, franchises, licenses etc.
• By issuing these, the government gives firm exclusive rights to
produce certain goods or to use certain processes.
3. Economies of scale
• Recall that economies of scale arise when the average cost of
production declines as the amount of output increases.
• A firm may face high initial start-up costs, but as it expands,
average costs start to decline.
• Since costs are low with increasing output, the already
established firm can compete out any rival firms by setting lower
prices, forcing them to exit the industry.
• Examples?
Total Revenue, Average Revenue & Marginal Revenue
for the Monopolist
Since the monopolist faces a downward sloping demand curve, the market
price is not constant. Therefore TR does not vary linearly with output, rather
TR rises, reaches a maximum and then declines as output increases.
P

The downward sloping demand

curve also implies that in order for
the monopolist to increase sales, it
has to cut the price, therefore MR<P
for every output level except the
Q
TR first.

TRmax Q
Consider a monopolist with the demand function: P=6-Q.
TR, AR and MR data will be as follows:

Price Quantity Total Marginal Average • Output sold increases as

Revenue Revenue Revenue price falls.
6 0 0 - - • TR rises, reaches a max and
5 1 5 5 5 then falls.
• AR=P>MR
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
The monopolist’s average revenue (= price of the good) is
the market demand curve.

However the marginal revenue for the monopolist is lower

MR<P.
The monopolist faces a downward sloping demand curve,
implying that in order to increase the quantity sold, it must
lower the price of the good.
The monopolist MR curve lies below the AR. Once again, MR<P
(=AR).
(P,MR,AR)
7

4 Average Revenue (Demand)

2
Marginal
1 Revenue

0 1 2 3 4 5 6 7 Output
 Profit Maximization for a Monopoly
i.e what quantity of output should the monopolist produce?

The monopolist’s profit

maximizing output level is
P
determined by the
MC intersection of the MR and
MC curves.

P*
ATC

i.e. in the SR, a profit

maximizing monopolist
will choose an output D = AR
level for which: MR=MC
MR
Q* is the output level for
which MR=MC. Q* Quantity
Formal derivation of profit max rule for the Monopolist.

Formally,

The firm’s objective is to:

Maximize

First Order Condition for Profit Maximization:

Totally differentiate the objective function and set the derivative
to zero.
This implies that:

From equation (2), by definition:

Substituting into equation (2),

Which implies that:

………………………(4)
Equation (4) is the profit maximizing rule for the monopoly firm.
Comparison with the Competitive Firm
For a competitive firm, P = MR
For a monopolist, P>MR

This means that:

For a competitive firm P =MR =MC
For a monopolist P> (MR = MC)

This shows that:

In both cases, both a perfectly competitive firm and a monopolist
maximize profit where MR = MC, the only difference is that at
the profit maximizing point, a monopolist charges a higher price.
We have established that the MC curve (the rising portion) is the
firm’s supply curve, i.e. MC=S

For a perfectly competitive firm, P = MC, since price is fixed.

• Fixed price implies that MC is also fixed, which means that supply for
the competitive firm is also constant.

For a monopolist, the monopolist can vary the price (i.e. it is not
fixed).
• Since price is not fixed, the MC is also not fixed and consequently
supply is not fixed.
Example
Let TC(Q) =50+Q2;
P(Q)=40-Q

1. Solve for the profit maximizing output for the

monopolist.
2. What is the corresponding price?
Solution
Profit max rule for the monopolist: MR=MC.
and
Lets find TR first:
we know that , therefore

To find MR, we differentiate TR w.r.t Q.

i.e.
Similarly, to find MC, we differentiate TC w.r.t Q.
i.e.
Next, equate MR=MC and solve for Q* :

To solve for the corresponding price, substitute Q*=10 into

the demand function.
Homework
1. From the example, calculate the monopolist’s profit.
2. Use the same information to calculate the profit
maximizing level of output for a competitive firm
3. Find the corresponding price and profit for the
competitive firm.
4. Compare between the monopolist and the competitive
firm.
Short Run Equilibrium for a Monopoly

Economic Profit for the Monopolist i.e. P>ATC The monopolist makes
profit when P>ATC.
The firm maximizes
P
profit by equating
MC MR=MC at an output
Profit>0
level Q*.

P*
ATC

At this level of output,

TR=P*Q*
D = AR TC=ATC.Q*
The firm’s economic
MR profit is given by:
TR-TC=shaded area>0
Q* Quantity
Economic Losses for the Monopolist i.e. P<ATC
The monopolist makes
losses when P<ATC.
The firm maximizes
P
Profit<0 MC profit by equating
ATC
(Econ. loss) MR=MC at an output
level Q*.

P*

At this level of output,

TR=P*Q*
TC=ATC.Q*
The firm’s economic
D = AR
profit is given by:
TR-TC=shaded area<0
MR

Q* Quantity
Long Run Equilibrium for a Monopoly
In the SR, the monopolist can make economic profits or losses,
depending on the price in relation to the ATC.

In the LR, since the monopoly market structure is characterized

by barriers to entry, the monopolist will not be competed out of
the market.
Therefore, unlike the competitive firm which makes zero profits
in the LR, the monopolist can earn positive economic profits.
However, persistent LR economic losses may force a monopolist
to exit the industry.
 Under perfect competition,
Deadweight Loss from Monopoly Power profit maximizing occurs
where P=MR=MC;
Price is Pc and Q is Qc. This
is the socially efficient
P output level

Under Monopoly, profit

maximization occurs where
MC MR=MC;
Deadweight Price is Pm and Quantity is
Loss Qm.
Pm
Thus, Pm > Pc and Qm <
B Qc. Under monopoly, the
PC price charged is too high
C and the quantity produced
AR=D is too little.

This results in a deadweight

loss equal to areas B and C
MR (the shaded triangle)

Qm QC Quantity
PRICE DISCRIMINATION
Price discrimination is the practice of charging different prices to
different consumers for the same/similar goods.
By price discriminating, the monopolist charges each consumer
their reservation price.
Examples?
Conditions Necessary for successful price discrimination
Price discrimination can only occur if certain conditions are met:
1. The firm must be able to identify the different market segments.
2. The firm must have some degree of monopoly power.
3. Different segments or sub-markets must have different price elasticities;
• In other words, consumers in the inelastic sub-market will be charged a higher price
and those in the elastic sub-market will be charged the lower price.

4. There should be no seepage between the two markets. i.e. a consumer

should not be able to purchase at the low price in the elastic sub-market,
and then re-sell to other consumers in the inelastic sub-market, at a
higher price.
Perfect Competition vs Monopoly
Perfect Competition Monopoly
Many sellers (competitors) Single seller
Price takers (Horizontal Price maker (Downward
demand curve) sloping demand curve)
Homogenous products Products have no close
substitutes
Entry is free Entry is blocked
Profit maximization MR = MC Profit maximization MR = MC

At profit maximization P= MR At profit maximization P >

= MC (MR= MC)