Module 3
Economics
Module 3: Costs and Revenue in Firms
Revenue Concepts
1. Total Revenue (TR): Price per unit times quantity sold (TR = P *
Q).
2. Average Revenue (AR): Revenue per unit (AR = TR/Q).
3. Marginal Revenue (MR): Additional revenue from selling one more
unit (MR = ∆TR/∆Q).
Cost Concepts
1. Fixed Costs (FC): Costs that do not vary with output, e.g., rent.
2. Variable Costs (VC): Costs that vary directly with the level of
production, e.g., raw materials.
3. Total Costs (TC): Sum of fixed and variable costs (TC = FC + VC).
4. Average Costs (AC):
Average Fixed Cost (AFC): FC divided by output.
Average Variable Cost (AVC): VC divided by output.
Average Total Cost (ATC): TC divided by output.
5. Marginal Cost (MC): The increase in total cost from producing
one more unit (MC = ∆TC/∆Q).
Market Structures
1. Perfect Competition:
Many buyers and sellers, identical products, price takers, and no
barriers to entry.
Firms can enter and exit the market freely, and prices are
determined by supply and demand.
In the long run, firms make normal profits (zero economic profit).
2. Competitive Markets (Perfect Competition)
A competitive market, also called a perfectly competitive market, has
several defining features:
Large number of buyers and sellers: Goods are identical, and individual
buyers or sellers have no control over the price.
Price Taker: No single buyer or seller can influence the market price.
Free entry and exit: Firms can easily enter or leave the market.
Perfect information: Both buyers and sellers have complete information
about the price and quality of the product.
Revenue of a Competitive Firm
Profit = Total Revenue (TR) – Total Cost (TC)
TR = Price (P) × Quantity (Q): Firms treat the price as fixed since they are
price-takers.
Average Revenue (AR): AR = TR / Q. For all firms, AR equals the product
price.
Marginal Revenue (MR): MR = Change in TR / Change in Q. In a perfectly
competitive market, P = MR.
Profit Maximization by Competitive Firms
Rational people think at the margin: Firms will increase output if MR >
MC (Marginal Cost) since each additional unit adds more to revenue than
to cost.
Firms will reduce output if MC > MR.
The profit-maximizing level occurs where MR = MC.
In a competitive market, P = MC = MR = AR at equilibrium.
Example of Perfect Competition
Wet Markets: Sellers have homogenous products, information flows
freely, and prices are nearly uniform due to the close competition. Sellers
must accept market prices or slightly undercut to attract customers.
2. Monopoly Markets
A monopoly occurs when:
A single firm is the sole seller of a product with no close substitutes.
The firm is a price maker due to a lack of competition.
Barriers to Entry:
Monopolies remain dominant due to entry barriers:
1. Monopoly resources: A firm controls a critical resource needed
for production.
2. Government regulation: A firm may be granted exclusive rights
by the government to sell a good (e.g., patents, copyrights).
3. Production process: A single firm can produce at a lower cost
than multiple firms, making it hard for others to compete.
How Monopolies Are Created:
Exclusive ownership of a key resource: For example, if only one person
has access to underground water in a town, they control the entire water
supply.
Government-created monopolies: Governments grant exclusive rights to
firms (e.g., patent protection for pharmaceutical companies or copyright
protection for authors).
Government-Created Monopolies:
Patents give firms the right to exclusively produce and sell a new product
(e.g., pharmaceutical drugs for 20 years).
Copyrights allow authors to control the sale of their work (e.g., books).
These legal protections lead to higher prices but encourage innovation
(e.g., by allowing drug companies to earn more profit from new
discoveries).
3. Natural Monopolies
A natural monopoly arises when a single firm can supply a good or service
at a lower cost than multiple firms could. This is often due to high fixed
costs involved in infrastructure.
Characteristics:
High fixed costs: The market discourages new entrants because it
requires large capital investment, making it difficult to compete.
Lower costs for a single provider: For example, building water pipes in a
town is expensive. If multiple firms tried to provide water, the overall cost
would be much higher because each firm would need to install its own
infrastructure.
Natural monopolies include industries like telecommunications, utilities,
aircraft manufacturing, and waste management.
1. Price Discrimination
Price Discrimination occurs when a firm charges different prices to
different consumers for the same product, based on their willingness to
pay. There are three degrees of price discrimination:
First Degree (Perfect Price Discrimination):
The firm charges each consumer exactly according to their willingness to
pay.
This is the most efficient form of price discrimination as the firm
captures the entire consumer surplus.
Example: Personalized pricing where each customer pays a different
price based on individual negotiations.
Second Degree (Non-linear Pricing):
Price varies depending on the quantity purchased, but it’s the same for all
consumers.
Bulk Pricing: Consumers pay less per unit when buying in large
quantities, like wholesale or volume discounts.
Example: A customer buying more units of a product receives a discount.
Third Degree (Group Pricing):
Different consumer groups are charged different prices, but each
member within a group pays the same price.
Prices are set based on consumer demographics such as age,
occupation, or student status.
Example: Student discounts at movie theaters or senior citizen discounts
in public transport.
2. Spatial Discrimination:
Geographical-based price variation: Prices for the same product vary
between countries, regions, or neighborhoods.
Factors include differences in exchange rates, taxes, transportation
costs, and competition.
Demand differences across regions can also drive spatial discrimination,
as consumers in different areas have varying preferences and
willingness to pay.
3. Peak-Load Pricing:
Prices fluctuate based on demand variations over time.
Companies with high fixed costs (e.g., power plants or hotels) raise prices
during peak demand times and lower them during off-peak periods to
allocate the cost of capacity efficiently.
Example: Higher hotel prices during tourist seasons or increased
electricity rates during high-demand summer days.
4. Price Skimming:
A strategy where firms set high prices at product launch to maximize
profits from early adopters, then gradually reduce prices over time to
attract more price-sensitive consumers.
Rationale: The high initial price helps recover costs from research and
development (R&D) and production.
Duration: Works until competitors launch similar products, although
dominant firms may continue to benefit from skimming for extended
periods.
Example: Pricing of new smartphones, which are expensive at launch but
drop in price after a few months.
Monopolies
1. Monopoly Overview
Monopoly: A market structure where a single seller controls the entire
supply of a product or service, having significant market power to set
prices.
Characteristics of a Monopoly:
Single seller with high market power.
Monopolist is a price maker (unlike in competitive markets where firms
are price takers).
Downward sloping demand curve, meaning that the monopolist must
lower prices to increase sales.
Price > Marginal Cost (MC), indicating inefficiency.
2. Welfare Costs of Monopolies
Monopolies vs. Competition:
A monopolist charges higher prices than a competitive firm, leading to
higher profits for the monopolist but higher costs for consumers.
Total surplus (consumer surplus + producer surplus) is maximized in
competitive markets, but monopolies fail to maximize total economic
well-being.
Deadweight Loss (DWL): The reduction in economic well-being due to
monopoly pricing.
Deadweight loss occurs because the monopolist produces less than the
socially efficient quantity. The price charged by a monopolist exceeds
the marginal cost (P > MC), meaning some consumers who value the
product more than the cost of production cannot purchase it.
Monopoly profit is not necessarily a loss to society, but it redistributes
surplus from consumers to producers, potentially raising equity
concerns
3. Price Discrimination by Monopolies
Price Discrimination: The practice of selling the same good to different
customers at different prices, despite identical production costs.
Conditions for Price Discrimination:
1. Market Power: The firm must have control over prices (i.e., P >
MC).
2. Ability to Sort Customers: The firm needs to identify different
consumer groups with different willingness to pay.
3. Preventing Resale: The firm must prevent discounted buyers
from reselling the good at higher prices (e.g., through legal
restrictions or product modifications).
Degrees of Price Discrimination:
First-degree: Perfect price discrimination, where each customer pays
exactly what they are willing to pay.
Second-degree: Pricing based on quantity bought (bulk discounts).
Third-degree: Group pricing based on identifiable traits (e.g., student
or senior discounts)
4. Natural Monopolies
Definition: A natural monopoly exists when a single firm can supply the
entire market at a lower cost than multiple firms.
High Fixed Costs: Industries with high fixed costs (e.g., infrastructure or
initial investment) make it impractical for more than one firm to operate
profitably.
Examples: Telecommunications, utilities, railways, oil and gas, aircraft
manufacturing, waste management
Decreasing Average Total Cost: Natural monopolies often exhibit
decreasing average total costs as they produce more, due to high initial
investment but low marginal costs of additional units.
Railways: A typical example, where the cost of building tracks and
maintaining a network is so high that competition would be wasteful
5. Monopoly vs. Competition
Monopoly:
One seller with control over price.
Price > Marginal Revenue (MR) and MR < Price due to the downward-
sloping demand curve.
Profit-maximizing condition: Set quantity where MR = MC, but price is
higher, determined by the demand curve
Competition:
Many sellers, with each firm being a price taker (i.e., the price is set by
the market).
Price = Marginal Cost (P = MC), leading to greater allocative efficiency.
Firms maximize profits by producing where price equals marginal cost.
6. Revenue and Profit Maximization for a Monopoly
Average Revenue (AR) is equal to price (AR = P), while Marginal Revenue
(MR) is less than price (MR < P).
A monopoly’s marginal revenue curve lies below the demand curve
because, to sell an additional unit, the monopolist must lower the price of
all units sold.
Profit-maximizing condition: The monopoly produces the quantity
where MR = MC, and the price is determined from the demand curve
based on this quantity.
The price is higher than MC, leading to allocative inefficiency and
deadweight loss
Monopolistic Competition
Definition: Market structure with many firms selling products that are
similar but not identical.
Many Sellers: Large number of firms competing for the same group of
customers.
Product Differentiation: Each firm’s product is slightly different, with
individual branding, leading to monopolistic control over their own brand.
Free Entry and Exit: Firms can freely enter or leave the market.
Profit Maximization:
Firms follow the monopolist’s rule: MR = MC (Marginal Revenue =
Marginal Cost).
Prices are higher than marginal cost: P > MC.
In the short run:
If Price > Average Total Cost (ATC), the firm makes a profit.
If Price < ATC, the firm minimizes its losses.
Long Run:
Due to free entry and exit, in the long run, firms earn zero economic
profit, where Price = ATC.
Importance of Advertisement:
Incentive: Firms advertise to attract more buyers, emphasizing product
differentiation.
Consumer Influence:
Increases perceived product differences.
Encourages brand loyalty, reducing sensitivity to price.
Allows firms to charge higher prices with less demand fluctuation.
Efficiency: Advertisement provides information, improving consumer
choices and resource allocation.
Encourages price competition, reducing prices.
Signals product quality (costly ads signal high-quality products).
