SUBJECT :BUSINESS ECONOMICS Marks : 30
All questions are compulsory
1. Explain how profit maximizing output is determined in a
a. Perfect Competitive market
c. Monopolistic market
2. The estimated total cost function of firms is:
TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210
If the firms decides to produce 50 units of Q, what will be the estimated total,
average and marginal costs of production? Show all the components of economic costs.
Q1 Explain how profit maximizing output is determined in a
* Perfect Competitive market
* Monopolistic market
1. Perfect Competition
In competitive markets there are:
1. Many buyers and sellers – individual firms have little effect on the price.
2. Goods offered are very similar – demand is very elastic for individual firms.
3. Firms can freely enter or exit the industry – no substantial barriers to entry.
Competitive firms have no market power. Recall that businesses are trying to maximize profits.
Profit = Total Revenue (TR) – Total Cost (TC).
Revenue in a Competitive Business
Businesses in competitive markets take the market price (P) as given (price takers). How much does the business receive for a typical unit is known as the “average revenue” (AR) and is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is constant.
How much additional revenue does the firm get if it sells one additional unit? To answer this question, we take a look at “marginal revenue” (MR) which is equal to the change in TR divided by the change in quantity. Note that this too is equal to price, so the marginal revenue is constant as well, and is equal to average revenue.
To maximize profit, we need to know the revenue and costs of the business. Profit is maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why, recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is the additional cost from 1 additional unit.
When MR > MC, revenue is increasing faster than costs and the firm should increase production. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC.
So what happens to output at various prices? Since MC is upward sloping, as price increases, quantity produced will increase too. As price falls, quantity produced falls. In each case, the marginal cost curve determines how much the firm is willing to produce at each price, so it translates into the supply curve.
Consider what results if marginal revenue is not equal to marginal cost:
* If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases.
* If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than to it reduces cost, so profit increases.
* If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.
A market structure characterized by a single seller of a unique product with no close substitutes. This is one of four basic market structures. The other three are perfect competition, oligopoly, and monopolistic competition. As the single seller of a unique good with no close substitutes, a monopoly has no competition. The demand for output produced by a monopoly is THE market demand, which gives monopoly extensive market control. The inefficiency that results from market control also makes monopoly a key type of market failure.
Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control. It is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly. Market control means that monopoly does not equate price with marginal cost and thus does not efficiently allocate resources.
Sources of a monopoly include:
* Ownership/Control of a Key Resource – rainforests, rare minerals (DeBeers diamond monopoly).
* Exclusive Right Given by Government – patents, copyrights, franchises (pharmaceutical companies, research, authors).
* Falling Average Total Cost – making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output.
* Public Utilities – electricity, cable television. and water provision.
The four key characteristics of monopoly are: (1) a single firm selling all output in a market, (2) a unique product, (3) restrictions on entry into the industry, and (4) specialized information about production techniques unavailable to other potential producers.
Revenue for a Monopoly
A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity):
1. Output effect – gains more revenue because it sells more.
2. Price effect – gains less revenue because it gets less from each unit sold because of the lower price.
Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E].
When E > 1, MR > 0 because output effect > price effect
When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect
The profit-maximizing level of output is a production level that achieves the greatest level of economic profit given existing market conditions and production cost. For a monopoly, this entails adjusting the price and corresponding production level to achieved the desired match between total revenue and total cost.
profit maximization can be identified by a comparison of marginal revenue and marginal cost. If marginal revenue is equal to marginal cost, then profit cannot be increased by changing the level of production. Increasing production adds more to cost than revenue, meaning profit declines. Decreasing production subtracts more from revenue than from cost, meaning profit also declines. In the bottom panel, the marginal revenue and marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger or smaller output levels, marginal cost exceeds marginal revenue or marginal revenue exceeds marginal cost.
3. Monopolistic Competition
Monopolistic competition is a market structure with a large number of relatively small firms that sell similar but not identical products. Each firm is small relative to the overall size of the market such that it has some market control, but not much. In other words, it can sell a wide range of output at a narrow range of prices. This translates into a relatively elastic demand curve. If a monopolistically competitive firm wants to sell a larger quantity, then it must lower the price.
Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,
* marginal revenue is always less than demand
* profit is maximized where MR = MC
* profit = (price – average total cost) x quantity
In fact, in the short-run, there is no difference between the behavior of a monopolistically competitive firm and a monopolist. However, in the long-run, an important difference does emerge.
The difference between the short-run and the long-run in a monopolistically competitive market is that in the long-run new firms can enter the market, which is especially likely if firms are earning positive economic profits in the short-run. New firms will be attracted to these profit opportunities and will choose to enter the market in the long-run. In contrast to a monopolistic market, no barriers to entry exist in a monopolistically competitive market; hence, it is quite easy for new firms to enter the market in the long-run.
The entry of new firms leads to an increase in the supply of differentiated products, which causes the firm’s market demand curve to shift to the left. As entry into the market increases, the firm’s demand curve will continue shifting to the left until it is just tangent to the average total cost curve at the profit maximizing level of output, as shown in Figure. At this point, the firm’s economic profits are zero, and there is no longer any incentive for new firms to enter the market. Thus, in the long-run, the competition brought about by the entry of new firms will cause each firm in a monopolistically competitive market to earn normal profits, just like a perfectly competitive firm.
Q2 The estimated total cost function of firms is:
TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210
If the firms decides to produce 50 units of Q, what will be the estimated total, average and marginal costs of production? Show all the components of economic costs.
Total Cost Function:
TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210
TFC = 43210
TVC = Q0 + 2Q1 + 3Q2 + 4Q3
For Q=50, TVC = 1+ 2*50 + 3*50*50 + 4*50*50*50 = 1+100+7500+500000 = 507601
TC = TFC + TVC = 43210 + 507601 = 550811
AC = TC/Q = (Q0 + 2Q1 + 3Q2 + 4Q3 + 43210)/Q
AC = 1/Q + 2 + 3Q + 4Q2 + 43210/Q
Therefore, Average Cost for Q=50 is
AC = 1/50 + 2 + 3*50 + 4*50*50 + 43210/50 = 0.02 + 2 + 150 + 10000 + 864.20
AC = 11016.22
AFC = 43210/Q = 864.20
AVC = 1/Q + 2 + 3Q + 4Q2 = 1/50 + 2 + 3*50 + 4*50*50 = 10152.02
MC = d TC/dQ = 0 + 2 + 6Q + 12Q2
Therefore, Marginal cost for Q=50 is
MC = 2 + 6*50 + 12*50*50 = 30302
SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning
Submitted By: Pardeep Kumar (GR No: D20101100127) Page 1 of 3