SECTION 1.5 THEORY OF THE FIRM
AND MARKET STRUCTURES (HL ONLY)
REVENUE, PROFIT, THE GOALS OF THE
FIRM, AND PERFECT COMPETITION
1. Distinguish between total revenue,
average revenue and marginal revenue.
Total revenue (TR)
 Total revenue is the total receipts of a firm from the sale of any given
quantity of output.
 It can be calculated as the selling price of the firm's product times the
quantity sold, i.e. total revenue = price × quantity
Average revenue (AR)
 Average revenue is the total revenue divided by total quantity sold.

AR=TR/Q
Marginal Revenue (MR)
 Marginal revenue (MR) is the amount of extra revenue which is generated
by selling one more unit of a product in a given time period.

MR=Change in TR/Change in quantity
2. Draw diagrams illustrating the relationship between
total revenue, average revenue and marginal revenue.
When the AR curve is a 'normal' downward sloping demand curve
2. Draw diagrams illustrating the relationship between total
revenue, average revenue and marginal revenue.
When the AR curve is a flat demand curve
3. Calculate total revenue, average revenue and marginal
revenue from a set of data and/or diagrams.
HOW TO:
 Total revenue (TR) = price X quantity
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
Average revenue (AR) is simply the price of the good. The demand
curve can be labelled “D=AR=P” to help you remember this. AR =
TR/Q
Marginal revenue (MR) = the change in total revenue divided by the
change in quantity. This is the change in total revenue resulting from the
last unit sold.

For a PC firm, MR is constant and equal to the market price (since the
firm is a price taker and can sell additional units for the same price.)
 But for an imperfectly competitive firm, MR is lower than price
beyond the first unit of output, since the firm must lower its price to sell
additional units of output. MR fall twice as steeply as the D=AR=P curve in
an imperfect competitor diagram.
3. Calculate total revenue, average revenue and
marginal revenue from a set of data and/or diagrams.
a flat demand curve
downward sloping demand curve
4. Describe economic profit (abnormal profit) as the
case where total revenue exceeds economic cost.
Super-normal (economic) profit
If a firm makes more than normal profit it is called super-normal
profit. Supernormal profit is also called economic profit, and
abnormal profit, and is earned when total revenue is greater than
the total costs.
Total costs include a reward to all the factors, including normal profit.
This means that, when total revenue equals total cost, the
entrepreneur is earning normal profit, which is the minimum reward
that keeps the entrepreneur providing their skill, and taking risks.
The level of super-normal profits available to a firm is largely
determined by the level of competition in a market – the more
competition the less chance there is to earn super-normal profits.
Super-normal profits = Price > ATC
4. Describe economic profit (abnormal profit) as the
case where total revenue exceeds economic cost.
Super-normal profit can be derived in three general cases:
 By firms in perfectly competitive markets in the short run,
before new entrants have eroded their profits down to a normal
level.
 By firms in less than competitive markets, like firms operating
under monopolistic competition and competitive oligopolies,
by innovating or reducing costs, and earning head start profits.
These will eventually be eroded away, providing further
incentive to innovate and become more cost efficient.
 By firms in highly uncompetitive markets, like collusive
oligopolies and monopolies, who can erect barriers to entry
protect themselves from competition in the long run and earn
persistent above normal profits.
5. Explain the concept of normal profit (zero economic profit) as the amount of revenue
needed to cover the costs of employing self-owned resources (implicit costs, including
entrepreneurship) or the amount of revenue needed to just keep the firm in business.
In markets which are perfectly competitive, the profit available to a
single firm in the long run is called normal profit. This exists when
total revenue, TR, equals total cost, TC.
Normal profit is defined as the minimum reward that is just sufficient
to keep the entrepreneur supplying their enterprise. In other words,
the reward is just covering opportunity cost - that is, just better than
the next best alternative.
To the economist, normal profit is a cost and is included in total costs
of production.
Total revenue just covers both explicit and implicit cost.
Normal Profit: Price = ATC
6. Explain that economic profit (abnormal profit) is profit over and above normal
profit (zero economic profit), and that the firm earns normal profit when
economic profit (abnormal profit) is zero.
Normal profits reflect the opportunity cost of using funds to finance a business. Because we
treat normal profit as an opportunity cost of investing financial capital in a business, we
include an estimate for normal profit in the average total cost curve, thus, if the firm covers its
ATC then it is making normal profits.). Zero Economic profit


Normal profit occurs at the level of output where total revenue = total cost (TR =
TC). At this point, average revenue = average cost as well. In other words, the firm
is at break-even point. Where total revenue just equals its explicit and implicit
cost.
Sub-normal profit , (Economic Loss) is profit less than normal
(P < average total cost)
Abnormal profit - is any profit achieved in excess of normal profit - also known as
supernormal profit. When firms are making abnormal profits, there is an incentive
for other producers to enter a market to try to acquire some of this profit. Abnormal
profit persists in the long run in imperfectly competitive markets such as oligopoly
and monopoly where firms can successfully block the entry of new firms.
7. Explain why a firm will continue to operate even when it earns
zero economic profit (normal profit).
Normal profit
In markets which are perfectly competitive, the profit available to
a single firm in the long run is called normal profit. This exists
when total revenue, TR, equals total cost, TC.
Normal profit is defined as the minimum reward that is just
sufficient to keep the entrepreneur supplying their enterprise. In
other words, the reward is just covering opportunity cost - that is,
just better than the next best alternative.
Accounting profit occurs when revenues are greater than costs,
and not equal, as in the case of normal profit.
To the economist, normal profit is a cost and is included in total
costs of production.
( P = ATC)
8. Explain the meaning of loss as negative economic
profit arising when total revenue is less than total cost.
When the implicit cost exceeds the accounting profit,
firms have what's known as a "negative economic profit."
This means that a firm can have a positive accounting
profit and a negative economic profit simultaneously.
Economic profit, however, provides a means for
coordinating economic activity. Positive economic profits
attract more investors, while negative economic profit
drive away investors, who then search for more
productive firms and sectors in which to invest their money.
A negative economic profit implies that you could be
doing better by pursuing an alternative opportunity.
9. Calculate different profit levels from a
set of data and/or diagrams.
HOW TO:
 Economic profit is usually found by the following
equation. Profit = (P-ATC)Q. Find the per-unit profit
(P-ATC) and multiply it by the quantity of output
(Q).
 If you are given total revenue (TR) and total cost
(TC) data, then economic profit > TR-TC.
 If ATC>P or if TC>TR, then the firm’s profit is
negative, and it is earning losses.
10. Explain the goal of profit maximization where the difference between total
revenue and total cost is maximized or where marginal revenue equals marginal
cost.
Marginal profit is the additional profit from selling one
extra unit.
A profit per unit will be achieved when marginal
revenue (MR) is greater than marginal cost (MC).
At profit maximization, marginal profit is zero
because MC = MR.
MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
Costs
At Qa, MC < MR.
So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower profit.
MC
MR
P1
Q a Q1 Q b
Q
MC and the Firm’s Supply Decision
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
P2
MR2
The MC curve
determines the
firm’s Q at any price.
P1
MR
Costs
MC
Hence,
the MC curve is the
firm’s supply curve.
Q1
Q2
Q
As Moses Said
Profit maximization occurs at the quantity where
marginal revenue equals marginal cost.
The Golden Rule!!!
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When MR > MC , thou shalt increase Q
When MR < MC , thou shalt decrease Q
thus MR = MC , Profit is maximized.
10. Explain the goal of profit maximization where the difference between
total revenue and total cost is maximized or where marginal revenue equals
marginal cost.
One way that a firm might work out the
level of output where profits are
maximized is to find the level of output
where the difference between total
revenue and total cost is largest.
As one would expect, given the fixed
costs, a firm actually makes a loss at low
levels of output. It only starts to make a
profit after the level of output rises above
Q1 (which is a break-even level of output).
The distance between the total revenue
curve and the total cost curve is greatest
at Qmax, so this is the profit maximizing
level of output. Profits fall after this point,
reaching another break-even level of
output at Q2, after which point the firm is
again making a loss, given the
acceleration of marginal costs due to
diminishing marginal returns.
10. Explain the goal of profit maximization where the difference between
total revenue and total cost is maximized or where marginal revenue equals
marginal cost.
The marginal cost curve (MC) and the marginal
revenue curve (MR).
Profit maximization occurs at the level of output
where MC = MR. So why are profits maximized
when this occurs?
Let's think of a level of output below Qmax. At Q3,
marginal revenue is greater then marginal cost.
This means that the extra revenue gained through
the sale of that unit is greater than the cost of
making it. The firm is making a profit on that unit.
But this does not mean that the firm is
maximizing total profit. What happens if the
firm makes one more unit, taking it to the level of
output Q4?
Marginal revenue is still greater than marginal
cost, so the firm again makes profit on that unit.
This will be true for every unit that they produce
up to Qmax, so they should make all of these units.
10. Explain the goal of profit maximization where the difference between
total revenue and total cost is maximized or where marginal revenue equals
marginal cost.
At Q5, marginal revenue is less
than marginal cost. The firm is
making a loss on that unit.
This is true of all units made after
Qmax. This does not necessarily
mean that the firm is making a loss
overall (what about all the profit
made up to Qmax?), but it does
mean that overall profit will be
maximized at Qmax.
Even if the firm makes just one
extra unit, where marginal cost is
only a little bit bigger than
marginal revenue, the overall
profit will fall, however small.
10. Explain the goal of profit maximization where the difference between
total revenue and total cost is maximized or where marginal revenue equals
marginal cost.
Q1 and Q2 are the break-even levels of output. Notice
that these are the levels of output where profit = 0 in
the top diagram and TR = TC in the middle diagram.
Qmax is the profit maximizing level of output.
Notice that this is the level of output where the profit
curve is at its highest in the top diagram, the gap
between TR and TC is greatest in the middle diagram
and MC = MR in the bottom diagram.
It is important to understand that, while profits are no
longer maximized if production rises above Qmax, total
profit is still positive, even though it is falling.
Just because MC is greater than MR for each unit
produced after Qmax, so losses are made on each unit,
it does not mean that the firm is making a loss overall.
This only happens when the firm's output rises above
Q2.
11. Explain alternative goals of firms, including revenue maximization,
growth maximization, satisficing and corporate social responsibility.
Maximizing total revenue means gaining the maximum possible
revenue from selling a product. Economic theory suggest that a
price can be identified which achieves this goal.
Revenue maximization (sales revenue): where MR = zero
Firms often seek to increase their market share – even if it means
less profit. This could occur for various reasons:
 Increased market share increases monopoly power and may
enable the firm to put up prices and make more profit in the
long run.
 Managers prefer to work for bigger companies as it leads to
greater prestige and higher salaries.
 Increasing market share may force rivals out of business. E.g.
supermarkets have lead to the demise of many local shops.
11. Explain alternative goals of firms, including revenue maximization,
growth maximization, satisficing and corporate social responsibility.
Growth Maximization
This is similar to sales maximization and may involve
mergers and takeovers. With this objective, the firm may
be willing to make lower levels of profit in order to
increase in size and gain more market share.
Market share
Some firms may wish to increase their share of a market.
This motive is significant for firms operating in markets
with a few large competitors, called oligopolies, and
where winning market share from rivals is less risky and
costly than trying to win brand new customers.
11. Explain alternative goals of firms, including revenue maximization,
growth maximization, satisficing and corporate social responsibility.
Satisficing means attempting to take into account a number of different
and competing objectives, without attempting to ‘maximize’ any single
one. For example, managers may first try to ensure that shareholder's get
a reasonable rate of return first, and then seek to reward themselves.
Satisficing can also be referred to as 'profit satisficing'.
Profit Satisficing
 In many firms there is separation of ownership and control. Those who
own the company (shareholders) often do not get involved in the day to
day running of the company.
 This is a problem because although the owners may want to maximize
profits, the managers have much less incentive to max profits because
they do not get the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the
shareholders happy, but then maximize other objectives, such as
enjoying work, getting on with other workers. (e.g. not sacking them)
This is the problem of separation between owners and managers.
11. Explain alternative goals of firms, including revenue maximization,
growth maximization, satisficing and corporate social responsibility.
Social/ Environmental concerns
 A firm may incur extra expense to choose products which
don’t harm the environment or products not tested on
animals.
 Alternatively, firms may be concerned about local
community / charitable concerns.
 Many companies who have adopted such strategies have
been quite successful. This has encouraged more firms to
consider these over objectives, but a cynic may argue they
see it as another opportunity to increase profits rather
than a genuine sacrificing of profits in order to promote
other objectives.
11. Explain alternative goals of firms, including revenue maximization,
growth maximization, satisficing and corporate social responsibility.
12. Describe, using examples, the assumed characteristics of perfect competition:
a large number of firms; a homogeneous product; freedom of entry and exit;
perfect information; perfect resource mobility.
Perfectly competitive markets exhibit the following characteristics:

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There is perfect knowledge, with no information failure or time
lags. Knowledge is freely available to all participants, which means that risktaking is minimal and the role of the entrepreneur is limited.
There are no barriers to entry into or exit out of the market.
Firms produce homogeneous, identical, units of output that are not branded.
Each unit of input, such as units of labor, are also homogeneous.
No single firm can influence the market price, or market conditions. The single
firm is said to be a price taker, taking its price from the whole industry.
There are a very large numbers of firms in the market.
There is no need for government regulation, except to make markets more
competitive.
There are assumed to be no externalities, that is no external costs or benefits.
Firms can only make normal profits in the long run, but they can make abnormal
profits in the short run.
13. Explain, using a diagram, the shape of the perfectly competitive firm’s
average revenue and marginal revenue curves, indicating that the assumptions
of perfect competition imply that each firm is a price taker.
Every firm is a price taker setting their
price at the market price of P. Each firms'
demand curve is perfectly elastic.
This means that they can sell as much as
they want at the given market price. If
one of the firms were to raise its price
above P, their sales would plummet to
zero because the buyers would go to one
of the other numerous firms selling the
identical good at P. Each firm can sell as
much as they want at price P.
Finally, notice that the firms' demand
curve has also been labelled AR = MR.
The demand curve is the average
revenue curve, and average revenue =
marginal revenue when AR is constant.
As the all the firms produce
homogenous products and
moreover, consumers have perfect
knowledge of producers who can
supply goods at lower prices.
14. Explain, using a diagram, that the perfectly competitive firm’s average
revenue and marginal revenue curves are derived from market equilibrium for
the industry.
In perfect competition, the industry will face normal demand
and supply curve i.e. demand curve slopes downwards and
supply curve is upward sloping.
The reason being suppliers are willing to supply more at higher
prices and consumers are willing to buy more at lower prices.
Thus the price in the industry is the equilibrium point.
In perfect competition, a firm is price taker, thus it has to adopt
the prevalent price in the industry.
The single firm takes its price from the industry, and is,
consequently, referred to as a price taker. The industry is
composed of all firms in the industry and the market price is
where market demand is equal to market supply. Each single firm
must accepts this price and cannot diverge from it.
15. Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic
profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short
run based on the marginal cost and marginal revenue profit maximization rule.
Profit maximization level of output for a firm is where
MC=MR:
15. Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic
profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short
run based on the marginal cost and marginal revenue profit maximization rule.
In the short run, a firm in perfect
competition can make abnormal
profits. It may be due to some cost
advantages due to technological
changes or some production
innovation. This means the firm will
be covering more than the economic
cost (total cost + opportunity cost)
The diagram illustrates that firm is
producing at Q which is the profit
maximization level of output
(MC=MR).
At this output the firms Average Total
Cost (AC) is at C and its Average
Revenue is at P, thus leading to
abnormal profit for the firm P-C.
(Shaded blue region)
15. Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic
profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short
run based on the marginal cost and marginal revenue profit maximization rule.
There may be cases, when
a firm may not be able to
cover its Total cost due to
some inefficiency in their
production process. As the
diagram show the firm is
producing at Profit
Maximization level of
output (MC=MR), its AC is
C which is more than its AR
(at P), thus leading to a
loss C-P (Shaded in blue).
16. Explain, using a diagram, why, in the long run, a perfectly
competitive firm will make normal profit (zero economic profit).
16. Explain, using a diagram, why, in the long run, a perfectly
competitive firm will make normal profit (zero economic profit).
With perfect competition there are no barriers to entry or exit. This
means that new firms will be attracted, in quite large numbers, into the
market (In the Long Run) if there are economic profits in the short run.
This will increase market supply, shifting the supply curve to the right.
This will keep happening until the given price is such that all firms in the
market earn only normal profit. All of the super normal profit will have
been competed away.
Some firms will leave the industry if they are at a loss, causing the
market supply curve to shift to the left. This will keep happening until the
given price is such that all firms in the market earn only normal profit.
Once the supply curve has shifted in, then every firm in the industry will
be earning normal profit and there will be no incentive for any firm to
enter or leave the industry. This is, therefore, the long run equilibrium.
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
Moving from short run abnormal profit to long run normal profit
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
In the diagram, the industry price is P and the firm takes its price from the industry
price. The firm is making abnormal profits by producing at q (Profit Maximization
level) and is having an abnormal profit P-C.
On the industry graph, more firms are attracted, which results in a increase in
supply (shift of supply curve from S to S1). This leads to a lower in the industry
price to P1. The firm has to take this price P1 and its demand curve shifts
downwards i.e. D1=AR1=MR1
At this point the existing firms will not leave the industry as they can cover their
economic cost and new firms will stop entering the industry as there is no more
abnormal profits. The industry has reached long term equilibrium.
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
In the short run a firms in a perfectly competitive market might make losses. In this
case the firms will start shut down as there is no sunk cost. The supply in the
industry will go down pushing the prices up and the firms will start making
normal profits in the long run.
Looking at the firm diagram, we see the firm producing at profit maximizing level
q is making a loss (C-P)as its AC is above the AR. However, as more and more
firms start leaving the industry the industry supply curve shifts to the left to S1.
This raises the price in the industry. Due to the fact that the firm is a ‘price taker’ it
will lead to the upward movement of firm’s demand curve from D to D1 resulting
in reduction of losses. The process will continue until firms in the industry are no
longer making losses.
17. Explain, using a diagram, how a perfectly competitive market will
move from short-run equilibrium to long-run equilibrium.
The industry has reached its long term equilibrium where no more firms
will enter or exit the industry and all the firms will be making normal
profits.
18. Distinguish between the short run shut-down
price and the break-even price.
Breakeven point is the point
where price is equal to
average total cost or P=ATC
At this price the firm is
covering all of its economic
costs (recall this is accounting
cost plus opportunity cost)
In economics when a firm is at
a breakeven point it is said
to be earning a normal
profit.
Breakeven price is when P = ATC
18. Distinguish between the short run shut-down
price and the break-even price
Shutdown point:
Recall that Total Cost =FC + VC
If a firm can’t even receive a price
to cover the Variable Cost of
producing a good then it should
shutdown.
In this case though it will still have to
pay its fixed costs
At any price point between
shutdown (above AVC) and
breakeven (ATC) at least the firm
will receive a contribution to cover
Fixed Cost so it will continue to
operate.
SHUTDOWN is where P < AVC
Shutdown vs. Exit
Shutdown:
A short-run decision not to produce anything because
of market conditions.
Exit:
A long-run decision to leave the market.
A firm that shuts down temporarily must still pay its
fixed costs. A firm that exits the market does not have
to pay any costs at all, fixed or variable.
A Firm’s Short-run Decision to Shut Down




If firm shuts down temporarily,
 revenue falls by TR
 costs fall by VC
So, the firm should shut down if TR < VC.
Divide both sides by Q: TR/Q < VC/Q
So we can write the firm’s decision as:
Shut down if P < AVC
A Competitive Firm’s SR Supply Curve
The firm’s SR
Costs
supply curve is the
portion of
its MC curve
If PAVC.
> AVC, then
above
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
MC
ATC
AVC
Q
Short Run Rules
If Price > ATC, Stay Open with an
Economic Profit. (P> ATC)
 If Price = ATC, Stay Open with a

Normal Profit. (P=ATC)
If AVC < price < ATC, Stay Open with a
loss.
 If Price <AVC, Shut down.

19. Explain, using a diagram, when a loss-making
firm would shut down in the short run.
If price is less than average
variable cost, a firm does
not receive enough revenue
to pay variable cost let
alone any part of fixed cost.
As such, the economic loss of
operating is GREATER than
total fixed cost. A firm is
better off shutting down
production in the short run,
producing zero output, and
awaiting a higher price.
19. Explain, using a diagram, when a loss-making
firm would shut down in the short run.
19. Explain, using a diagram, when a loss-making
firm would shut down in the short run.
20. Explain, using a diagram, when a loss-making firm
would shut down and exit the market in the long run.
Firms can take a reasonable sized loss in the short run,
but this is not sustainable as we move into the long run.
Again, there are no barriers to exit, so some firms will
leave the industry, causing the market supply curve to
shift to the left. This will keep happening until the given
price is such that all firms in the market earn only
normal profit. Once the market supply curve has shifted
all the way to new market equilibrium, then every firm in
the industry will be earning normal profit and there will
be no incentive for any firm to enter or leave the
industry. This is, therefore, the long run equilibrium.
20. Explain, using a diagram, when a loss-making firm
would shut down and exit the market in the long run.
The Irrelevance of Sunk Costs
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Sunk cost: a cost that has already been committed
and cannot be recovered
Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed costs
whether it produces or shuts down.
So, FC should not matter in the decision to shut
down.
A Firm’s Long-Run Decision to Exit
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If firm exits the market,
 revenue falls by TR
 costs fall by TC
So, the firm should exit if TR < TC.
Divide both sides by Q to rewrite the firm’s decision
as:
Exit if P < ATC
A New Firm’s Decision to Enter Market
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
In the long run, a new firm will enter the market if it
is profitable to do so: if TR > TC.
Divide both sides by Q to express the firm’s entry
decision as:
Enter if P > ATC

If P = ATC, Firms will remain in business with a
Normal Profit (P = ATC)
Long Run Rules
If Price > ATC, Firms Enter
 If Price = ATC, There is no entry nor
exit. All firms remain.
 If Price < ATC, Firms Exit

The Competitive Firm’s Supply Curve
The firm’s
LR supply curve is
the portion of
its MC curve
above LRATC.
Costs
MC
LRATC
Q
Entry & Exit in the Long Run
In the Long Run, the number of firms can change due to
entry & exit.
 If existing firms earn positive economic profit,
 New firms enter.
 Short Run market supply curve shifts right.
 Price falls, reducing firms’ profits.
 Entry stops when firms’ economic profits have been
driven to zero. (MC = ATC)
 All firms remaining are earning a normal Profit.
(P=ATC)
Entry & Exit in the Long Run
In the Long Run, the number of firms can change due to
entry & exit.
 If existing firms incur losses,
• Some will exit the market.
• Short Run market supply curve shifts left.
• Price rises, reducing remaining firms’ losses.
• Exit stops when firms’ economic losses have
been driven to zero. (MC = ATC)
• All firms remaining are earning a normal
Profit. (P=ATC)
The Zero-Profit Condition
Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
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Zero economic profit occurs when P = ATC.
Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
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Recall that MC intersects ATC at minimum ATC.

Hence, in the long run, P = minimum ATC.

P= ATC, Normal Profit
21. Calculate the short run shutdown price
and the breakeven price from a set of data.
HOW TO:
 A firm should shut down if the price in the market is
lower than the firm’s minimum average variable cost.
At this point, the firm’s total losses are greater than
its total fixed costs, so it will LOSE LESS by shutting
down!
 A firm will break even when the price in the market
equals the firm’s minimum ATC, or if the TR = TC (see
above). Economic profits at that point is Zero.
22. Explain the meaning of the term allocative
efficiency.
Allocative efficiency is achieved when the value
consumers place on a good or service (reflected in the
price they are willing to pay) equals the cost of the
resources used up in production. Condition required is
that price = marginal cost. When this condition is
satisfied, total economic welfare is maximized.
Pareto defined allocative efficiency as a situation
where no one could be made better off without making
someone else at least as worse off.
There is no deadweight loss as a result.
23. Explain that the condition for allocative efficiency is
P = MC (or, with externalities, MSB = MSC).
Allocative efficiency
This is the socially optimal level of output. At this point it is
impossible to make one person better off without making
someone else worse.
There is pareto optimality. It occurs where MC = AR
In other words, a firm in a perfectly competitive market produces
at the profit maximizing level which is MR=AR. This is also the
point where MC=AR. Thus we conclude that in perfect
competition there is allocative efficiency in the long run.
24. Explain, using a diagram, why a perfectly competitive market
leads to allocative efficiency in both the short run and the long run.
When a firm is making
abnormal profit in the
short-run:
The firm produces at q
which is both profit
maximizing level
[ MC=MR ] and also the
allocative efficient level q2
[MC=AR].
24. Explain, using a diagram, why a perfectly competitive market
leads to allocative efficiency in both the short run and the long run.
When a firm is making
abnormal loss in the shortrun:
The firm produces at q
which is both profit
maximizing level [MC=MR]
and also the allocative
efficient level q2 [MC=AR].
24. Explain, using a diagram, why a perfectly competitive market
leads to allocative efficiency in both the short run and the long run.
In the long run:
A perfectly competitive
market will have both
productive efficiency and
allocative efficiency in the
long run.
25. Explain the meaning of the term
productive/technical efficiency.
Productive efficiency occurs when a firm is combining resources
in such a way as to produce a given output at the lowest possible
average total cost. Costs will be minimized at the lowest point
on a firm's short run average total cost curve.
This also means that ATC = MC, because MC always cuts ATC at
the lowest point on the ATC curve.
Technical efficiency relates to how much output can be obtained
from a given input, such as a worker or a machine, or a specific
combination of inputs. Maximum technical efficiency occurs when
output is maximized from a given quantity of inputs.
The simplest way to differentiate productive and technical
efficiency is to think of productive efficiency in terms of cost
minimization by adjusting the mix of inputs, whereas technical
efficiency is output maximization from a given mix of inputs.
26. Explain that the condition for productive efficiency is
that production takes place at minimum average total cost.
Productive efficiency:
As we know productive
efficiency level of production
is where MC=ATC . That
means it is known to be
productively efficient if it is
producing at a point where
MC=ATC, because MC always
cuts ATC at its lowest point.
In the case of Perfect
Competition, a firm produces
at productive efficient level of
output q as shown in the
diagram
27. Explain, using a diagram, why a perfectly competitive firm will
be productively efficient in the long run, though not necessarily in
the short run.
Productive efficiency refers to a firm's costs of
production and can be applied both to the short and
long run. It is achieved when the output is produced at
minimum average total cost (ATC). For example we
might consider whether a business is producing close to
the low point of its long run average total cost curve.
When this happens the firm is exploiting most of the
available economies of scale. Productive efficiency
exists when producers minimize the wastage of
resources in their production processes.
27. Explain, using a diagram, why a perfectly competitive firm will be
productively efficient in the long run, though not necessarily in the short
run.
EXCESS CAPACITY:
A condition that exists when a firm achieves long-run
equilibrium such that production by each firm is less than
minimum efficient scale.
The implication of this condition is that each firm is not
producing up to its fullest capacity, as would be the case
under perfect competition in the long run, and thus more
firms are need to produce total market output compared
to perfect competition.
Excess capacity results because market is not producing
at the efficiency scale where MC = ATC.
27. Explain, using a diagram, why a perfectly competitive firm will be
productively efficient in the long run, though not necessarily in the short
run.
Time Period
Allocative Efficiency
P=MC
Productive Efficiency
MC = ATC
Short-Run
Yes
Maybe
Long-Run
Yes
Yes
AP Microeconomics (1)
Constant Cost VS Increasing Cost
Constant Cost Industry
As firms enter and exit the firms
cost remain unchanged
Increasing Cost Industry
As firms enter and exit the firms
cost do change
Firms enter: Input cost unchanged
Firms exit: Input cost unchanged
Firms enter: Input cost increase
Firms exit: Input cost decrease
The LR Market Supply Curve (Constant Cost Industry)
The LR market supply
curve is horizontal at
P = minimum ATC.
In the long run,
the typical firm
earns zero profit.
P
One firm
MC
P
Market
LRATC
P=
min.
ATC
long-run
supply
Q
(firm)
Q
(market)
Why the LR Supply Curve Might Slope Upward

The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or exit
the market.

If either of these assumptions is not true,
then LR supply curve slopes upward.
1) Firms Have Different Costs




As P rises, firms with lower costs enter the market before
those with higher costs.
Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
Hence, LR market supply curve slopes upward.
At any P,
 For the marginal firm,
P = minimum ATC and profit = 0.
 For lower-cost firms, profit > 0.
2) Costs Rise as Firms Enter the Market




In some industries, the supply of a key input is limited
(e.g., there’s a fixed amount of land suitable for
farming).
The entry of new firms increases demand for this
input, causing its price to rise.
This increases all firms’ costs.
Hence, an increase in P is required to increase the
market quantity supplied, so the supply curve is
upward-sloping.
AP Microeconomics (2)
Inputs or Factor Costs


Up to now we have assumed that input prices remain
constant. Costs rise and fall strictly because of changes
in productivity not because of changes in factor costs
themselves (wages per hour stay constant for labor).
A rise in the price of any of the inputs will lead to the
whole set of curves shifting upward.
 If
it is a rise in the cost of Capital, then AFC & ATC will
shift up.
 If it is a rise in wages, then AVC, ATC and MC will shift
up.
Inputs or Factor Costs


A fall in the price of inputs leads to a fall in the
curves.
If there is an increase in the amount of Capital,
then productivity will rise and the AVC, ATC and
MC curves will all shift down.
 New
Technology
 More training
Inputs or Factor Costs
Determinates of Supply that shift the
cost curves:
Input
prices (wages)
Productivity (Technology)
Tax & subsidies
AP Microeconomics (3)
Lump Sum VS Per Unit
Lump Sum Tax / Subsidy
Treat as a Fixed Cost
Per Unit Tax / Subsidy
Treat as a Variable Cost
Cost curves that move:
AFC & ATC
Price and Output are NOT
affected
Cost curves that move:
AVC, ATC & MC
Price and Output are affected
lump-sum



A lump-sum tax is a tax that is a fixed amount, no
matter the change in circumstance of the taxed
entity.
It is a regressive tax, such that the lower the income
is, the higher the percentage of income applicable
to the tax. An example is a poll tax to vote, which is
unchanged no matter what the income of the voter.
A lump-sum subsidy is a subsidy that is a fixed
amount, no matter the change in circumstance of the
entity.
Lump Sum Tax / Subsidy





Increase Lump sum tax ~ AFC, ATC shift up
Decrease in Lump sum tax ~ AFC, ATC shift down
Increase Lump sum subsidy ~ AFC, ATC shift down
Decrease in Lump sum subsidy ~ AFC, ATC shift up
Lump sum tax / subsidy do NOT change AVC, MC
Thus, output does not change since MC = MR is not
effected.
Lump Sum Tax / Subsidy
Per Unit Tax / Subsidy




Increase Per Unit tax ~ AVC, ATC, MC shift up
Decrease in Per Unit tax ~ AVC, ATC, MC shift down
Increase Per Unit subsidy ~ AVC, ATC, MC shift
down
Decrease in Per Unit subsidy ~ AVC, ATC, MC shift
up
Thus, since MC changes output changes!
Per Unit Tax / Subsidy