Theory of the Firm Graphs

01/12/2012 § Leave a comment

Screen shot 2012-12-01 at 4.22.26 PM

The graph above shows the abnormal profit of an imperfectly competitive firm (so of a monopoly, monopolistic competition, or an oligopoly, but not a perfect competition). At Price C, the marginal revenue intersects marginal cost at a point lower then the average total costs. This means that the firm is earning a revenue and profit that is covering all the necessary costs. All revenue above that point (up until the average revenue, of course) is more than enough to cover for the costs, which makes it abnormal profit.

Screen shot 2012-12-01 at 4.54.16 PM

The shut down price is the average variable cost (AVC) and marginal cost (MC) equal each other. At this point, not all of the total costs are being covered but the important variables (i.e. rent, electricity, your own labour pay, etc.) are being covered, therefore there is no reason to shut down the company quite yet above this point. Below this point, the important variables are not being covered, therefore it would be time to shut down that firm and do something else with your life. The break-even price is the point at which average total cost (ATC) and marginal cost (MC) equal each other. At this point, all costs are equal, even the price of the additional unit of output, and after this point, the costs (marginal and average) start to increase again. This is therefore the point where the costs are at the best level for the firm.

Screen shot 2012-12-01 at 4.22.07 PM

In the short run, the main factor of production that can be changed is labour, among other things. The firm starts off with a high cost because it takes money to start any firm and proportionally, the costs outweigh what little profit they have at the beginning. Gradually, the costs diminish as the firm produces more output and additional factors of production to their output. These are economies of scale and are advantageous for the firm. At the bottom of the blue curve (Long Run Average Total Costs), the costs are at their lowest and the minimum efficient scale is obviously the point where the firm is at minimum efficiency – meaning that it is efficient but it can be more efficient. As the firm continues to produce more output, the law of diminishing marginal returns applies and the costs start to increase again. These are diseconomies of scale and are disadvantageous for the firm.

Screen shot 2012-12-01 at 4.22.34 PM

The above graph displays a kinked demand curve that can be used to explain collusions (when firms raise their prices together to increase their revenue – and FYI governments don’t like that) and price discrimination (where firms offer many different services to attract different groups of consumers). At higher prices (above the stable price), demand will become elastic because consumers will react by choosing between cheaper and more expensive firms that sell the same product (think: airplane tickets). When the price decreases from the stable point, demand is inelastic because, in collusion, cheaper prices won’t matter when all the firms selling the same product are selling at the same, low prices. This means that the point at which the price is stable (indicated by the green box) is the best point for the firms.

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