2.3 Marginal Cost and Marginal Revenue

Average Fixed Cost

Total cost of employing the fixed factors of production to produce a particular level of output, divided by the size of output: AFC = TFC / Q.

Average Variable Cost

Total cost of employing the variable factors of production to produce a particular level of output, divided by the size of output: AVC = TVC / Q.

Long-run average cost

Total cost of producing a particular level of output divided by the size of output when all the factors of production are variable.

Average Total Cost

Total cost of producing a particular level of output, divided by the size of output; often called average cost: ATC = AFC + AVC.

Average Revenue

Total revenue divided by output. Average Revenue = Total Revenue / Output AR = TR / Q

Price-maker

When a firm faces a down-ward sloping demand curve for its product, it possesses the market power to set the price at which it sells the product.

Quantity-setter

When a firm faces a downward-sloping demand curve for its product, it possesses the market power to set the quantity of the good it wishes to sell.

Marginal Revenue

Addition to total revenue resulting from the sale of one more unit of the product. Marginal Revenue = Change in Total Revenue = Change in Output MR = CHANGE IN TR / CHANGE IN Q

Total Revenue

All the money received by a firm from selling its total output.

Long-run marginal cost

Addition to total cost resulting from producing one additional unit of output when all the factors of production are variable.

What are the conditions of a perfectly competitive market?

- Very large number of buyers and sellers. - All buyers and sellers possess perfect information about what is going on in the market. - Consumers can buy as much as they wish to purchase and firms can sell as much as they wish to supply at the ruling market price set in the market as a whole. - Individual consumer/supplier cannot affect the ruling market price through its own actions. - An identical, uniform of homogenous product. - No barriers to entry into, or exit from, the market in the long run.

Price-taker

A firm which is so small that it has to accept the ruling market price. If the firm raises its price, it loses all its sales; if it cuts its price, it gains no advantage. The assumption that a perfectly competitive firm can sell whatever qty desired at market price P1, but that it cannot influence ruling market price, means that all firms in perfectly competitive markets are passive price-takers.

Marginal Cost

Addition to total cost resulting from producing one additional unit of output.

Draw a diagram to derive the MC and AVC curves from short-run production theory.

[Figure 2.11] Short-run marginal costs are determined solely by changes in variable costs of production. For the sake of simplicity, assuming labour is the only variable factor of production, variable costs are simply wage costs. If all workers receive the same hourly wage, total wage costs rise in exact proportion to the no of worker employed. However, if to start with the firm is benefiting from increasing marginal returns to labour, the total variable cost of production rises at a slower rate than output. This causes the marginal cost of producing an extra unit of output to fall. In the diagram, the increasing marginal returns of labour (shown by +ve slope of MR curve in upper graph) cause marginal costs to fall (shown by -ve slope of MC curve in lower graph. However, once law of diminishing returns has set in, short-run marginal costs rise as output increases. Wage cost of employing an extra worker is still the same, but each extra worker is now less productive than the previous worker. Total variable costs rise faster than output, so short-run marginal costs also rise. In the diagram, diminishing marginal returns of labour (shown by -ve slope of MR curve in right-hand side of upper graph) cause marginal costs to rise.

Relate marginal cost to average variable cost and average total cost. Draw a diagram to display the relationship between marginal cost, average variable cost and average total cost.

[Figure 2.12] Firm's short-run MC curve is derived from the marginal returns of the variable factors of production, so the firm's average variable cost (AVC) curve is explained by the average returns curve. When increasing average returns are experienced, with the labour force on average becoming more efficient and productive, the AVC per unit of output must fall as output rises. But once diminishing average returns set in at point B in figure 2.11, the AVC curve begins to rise with output.

Draw and explain a diagram to display the long-run marginal cost curve cutting through a U-shaped LRAC curve.

[Figure 2.13] If the LRAC curve is U-shaped, as in Figure 2.13, the long-run marginal cost curve cuts through the lowest point of the LRAC curve.

Draw and explain how to derive a perfectly competitive firm's average and marginal revenue curves.

[Figure 2.14] Demand curve located at the ruling market price, P1, which itself is determined through the interaction of market demand and market supply in panel (b) of the diagram. Horizontal axis in panel (b) shows millions of units of output being produced. (b) depicts the whole market, comprising very large numbers of both consumers and firms. In equilibrium, where market demand equals market supply, the ruling market price is P1, and the equilibrium qty is Q1 millions of units. In panel (a), the horizontal axis is labeled 'hundreds', to reflect that in perfect competition a single firm is only a tiny part of the total market. Horizontal price line in (a) is also the perfectly elastic demand curve for the firm's output, it is perfectly elastic because the good produced by all the firms in the market, being uniform or homogenous, are perfect substitutes for each other. In summary, for a firm, D = AR = MR, as depicted in (a). (Same as in first book).

Draw a diagram to display the price equalling average revenue curve in monopoly

[Figure 2.15] Shows two prices, £1 and £0.60, which can be charged by a monopolist for the good it produces. At the price of £1, 1,000 units are demanded. At this price, the monopolist's total revenue is £1000. AR, or total revenue divided by output, is £1, which is of course the same as price. The price charged for all units of the good and average revenue are always the same. EG, if the monopolist sets the price at £0.60, 2,500 units are demanded; total sales revenue is £1500 and AR is £0.60. Down-ward sloping market demand curve facing the monopolist is therefore the firm's average revenue curve.

Draw and explain a diagram displaying the choice between price making and quantity setting facing a monopolist.

[Figure 2.16] The downward-sloping AR curve can affect the monopoly in two different ways. If the monopolist is a price-maker, choosing the set the price at which the product is sold the demand curve dictates the maximum output that can be sold at this price. Alternatively, if the monopolist is a quantity-setter rather than a price-maker, the demand curve dictates the maximum price at which a chosen quantity of the good can be sold. For any one good it produces, a firm cannot be a price-maker and a quantity-setter simultaneously.

Draw and explain a diagram to illustrate monopoly average revenue and marginal revenue curves.

[Figure 2.17] To understand why MR and AR are not the same in monopoly, you must remember that when the marginal value of a variable is less than the average value of the variable, the average value falls. Because the market demand curve/AR curve falls as output increases, the monopolist's marginal revenue curve must be below its average revenue curve. Diagram shows rel/ship between the AR and MR curves. MR curve is below AR and twice as steep. This is always the case whenever the AR curve is downward-sloping straight line.

Draw and explain a diagram to illustrate a monopolist's marginal revenue curve.

[Figure 2.18] Monopolist initially charges P1 and sells at level out output Q1. However, to incr sales by an extra unit to Q2, downward sloping AR curve forces monopolist to reduce selling price to P2. Reduces price at which all units of output are sold. Total sales revenue increases by the area K in diagram, by decreases by the area H. Areas K and H respectively show the revenue gain - the extra unit sold multiplied by price P2 - and the revenue loss resulting from the fact that, in order to sell more, the price has to be reduced for all units of output, not just the extra unit sold. MR, which is the revenue minus revenue loss (K-H) must be less than price or AR at the new level of output.

Draw and explain a diagram of price elasticity of demand and a monopolist's demand or average revenue curve.

[Figure 2.19] In monopoly, providing the demand curve is a straight line as well as downward sloping, price elasticity of demand falls moving down the demand curve. Demand for the monopolist's output is elastic in the top half of the curve, falling to be unit elastic exactly half way down the curve, and inelastic in the bottom half of the curve. Shown in the diagram. Demand is elastic between A and B, unit elastic at B, and inelastic between B and C.