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Frequently Asked Questions - Theory of firm

FAQs - Theory of firm

You are expected to:

Explaint that profit maximizing output is where MC = MR and if , at this output, AC is greater than AR, the firm will make a loss in the short run.

Illustrate this point using the standard perfect competition diagram.

Label the diagram and explain it properly

You are expected to

Define

  • short-run
  • marginal cost (MC)
  • average total cost (ATC)

Explain the concept of diminishing returns

Draw diagram showing marginal cost (MC) and average total cost (ATC). Label it properly and explain it

Explain MC cuts ATC at lowest point

Explain the impact of marginal cost (MC) changes on average total cost (ATC)

Expalin that  MP cuts AP at highest point.

You are expected to 

Start with definitions of allocative and productive efficiency

Explain perfect competition

Explain that a firm in perfect competition in long-run is allocatively and productively efficient

Support your answer with correctly drawn and labelled diagram

Explain monopoly

The firm in monopoly in long-run is neither allocatively nor productively efficient

Support your answer with correctly drawn and labelled diagram

However there is higher output and lower prices in monopoly than in perfect competition due to economies of scale

You are expected to

Define allocative and productive efficiency.

Draw the standard perfect competition equilibrium diagram showing and explaining that in perfect competition output will occur on the lowest point of the ATC curve (productive efficiency), and that price will be equal to MC (allocative efficiency).

Label your diagram properly and explain it.

You are expected to

Define monopoly

Explain that a monpolist strives to proudce at the revenue maximizing level of output (MR = 0) and the profit maximizing level of output (MC = MR)

Support your answer with an accurately labelled diagram showing the levels of price and output when profit is maximized and when revenue is maximized.

Explain the fact that when the change from revenue maximization to profit maximization is made, output will fall and price will rise.

You are expected to

Define short run and long run

Explain the concepts of

  • law of diminishing returns
  • economies of scale

Draw a properly labelled diagram of product curves and/or short run cost curve showing law of diminishing returns

Support your answer with a diagram illustrating economies of scale using long run cost curves

Explain the linkage between the two concepts

You are expect to 

Explain the concept of profit maximization (MC=MR) with the help of properly labelled diagram

Explain that many firms may have profit maximization as a goal.

Explain the concept of Sales revenue maximization (MR=0), or where TR is at its maximum 

Explain that sales revenue maximization may be a goal of the firm.

You are expected to 

Define monopoly

Distinguish between revenue and profit

Draw a diagram should show profit maximizing level of output (MC = MR)

Draw a diagram should show revenue maximizing level of output (MR = 0)

These diagrams should include AR(D), MR and MC curve

Support your diagram with an explanation that when there is a move from profit maximization to revenue maximization, output will increase and the price of the good will fall.

You are expected to

Explain the characteristics of monopolistic competition

Support with an example of monopolistic competition, e.g. food, clothing, restaurants

Draw a diagram illustrating a short-run profit maximizing position, e.g. abnormal profits or losses

Explain your diagram.

Draw a diagram illustrating the long-run profit maximizing position, i.e. normal profits

Explain long-run profit maximizing position and how it differs from the short-run profit maximizing position.

Define price discrimination

Explain that an airline would want to practice price discrimination in order 

to earn higher revenues and earn greater economic (supernormal) profits through the capture of consumer surplus

to drive higher cost competitors out of the market by lowering prices for some consumer groups, and therefore it can increase its monopoly power

You answer should also include an explanation about how an airline can practice price discrimination:

It may do so by spliting the market and discriminate between different buyers: they can charge the elderly lower prices on certain days, give discounts for students' weekend travel, offer lower fares to travellers who make advance bookings and charge higher fares to those making their travel plans closer to the day of travel

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