Firms can operate in one or more markets and not always on the same side of the market. General Motors is a buyer in the resource market and a seller in the automotive market.
In the next four chapters we will be looking at the output market for four market structures. You will look at the way a firm is structured and their ability to make revenues (sales). Then we will combine the revenues with the cost curves studied in the last chapter to determine profitability.
The four market structures are:
1. Perfect Competition
2. Monopoly
3. Monopolistic Competition
4. Oligopoly
Why the different market structures? They are divided by power - the power to generate revenues - leading to higher profits. The first two market structures are very rare, but are used to help us understand the two extreme market conditions and then it will help us understand the two most prevalent structures; Monopolistic Competition and Oligopoly
It is also necessary to understand that when profits are discussed they are economic profits.
Economic profits take into consideration opportunity cost. It is the opportunity cost of capital.
For example if the normal cost of capital (return on equity [ROE]) is 10% then we would determine profit as follows:
Economic Profit = Accounting profit - Opportunity Cost or you can state as: Accounting profit - Normal Rate of Return (NROR)
Accounting profit = 10%
Example one
Economic profit = 10% - 10% = 0
Therefore, zero economic profit states the firm is making a positive profit which is the average for the industry. This is good - the firm is operating very efficiently.
Example two
Economic profit = 12% -10 = +2% Very positive. The firm is making above the average for theindustry or is operating very efficiently.
Example Three
Economic profit = 10% - 12% = -2%his firm is still making an accounting profit , but it is below the average for the industry. We can state this firm is not as efficient as the rest of the firms in the industry. Is this a problem?
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Economist Milton Friedman has a good analogy for this condition:
If there were a flock of sheep in the meadow and a wolf came along, which sheep would the wolf attack? The slowest one, the sickest one, etc.
Meaning if you are not operating efficiently and a recession comes along then which business will go bankrupt first - the least efficient. A firm may be satisfied to make a lower profit, but if there is a market downturn they may be in trouble. So you can see that it is important to measure the firm against other firms in the industry.
When you see that a firm is operating at the break- even point and making zero economic profit, it is positive. In the short run a firm can operate at a loss if it is covering variable costs, however, in the long run they must break-even.
I. If the normal rate of return is 8% for the industry what can be stated about the three firms below in terms of accounting profit and efficiency.
1) Firm one is making 6% economic profit
2) Firm two is making 11% economic profit
3) Firm three is making 8% economic profit
II. Complete the chart below
[Do the following problem: Remember price never changes in Perfect Competition]
Price Q Total Revenue Average Revenue Marginal Revenue
$3 5 $15 $3 $3
6 18
7 21
8 24
9 27
Total revenue = Price X output (Q), Aver Rev = total Rev/output (Q),
Marginal revenue = Change in total revenue/change in output (Q)
A. What does price, average revenue and marginal revenue have in common?
III. A firm is producing at 100 units and has the following costs at this output level:
average price = $20 , average total cost = $30, average variable costs = $22.
A. In the short run should this firm operate at a loss or close down?
B. If Price rose to $25 would your answer change? Why?