Microeconomics Principles: Utility, Costs, and Market Structures

Posted on Dec 1, 2024 in Economy

Total Utility (TU)

The aggregate satisfaction gained from consuming successive quantities of a good or service.

Marginal Utility (MU)

The change in total utility resulting from the consumption of one extra unit of a given commodity.

Law of Diminishing Marginal Utility

As more of a good or service is consumed, the total utility will increase at a decreasing rate (i.e., marginal utility will decrease).

Optimum Purchase Rule

A consumer desiring to maximize total utility should purchase more goods and services until price equals marginal utility (P = MU).

Why Does MU Lead to a Downward-Sloping Demand Curve?

• As consumption increases, MU decreases.
• A consumer attempting to maximize their satisfaction will be prepared to purchase up to where P = MU.
• Consumers will only purchase additional units at a lower price (relationship between price and marginal utility).
• Therefore, the demand curve must slope downwards to the right, with lower prices derived from the MU curve.

Equi-Marginal Rule

Consumer equilibrium is reached when the marginal utility of the last dollar spent on each commodity is equal.

Note:

• If P > MU, consumers should purchase/consume less so MU will increase, and equilibrium (maximum utility) will be restored.
• If P < MU, consumers should purchase/consume more so MU will decrease, and equilibrium (maximum utility) will be restored.

Types of Market Structure

Perfect Knowledge

When one seller raises their prices, everyone will know about it and avoid them.

Collusion

A secret agreement that may exist between oligopolists or duopolists to agree to raise prices in unison.

Price War

Oligopolists or duopolists may try a price war if collusion is not an option.

Monopsony

This market situation is one where there is only one buyer in the market.

Price Competition

• Uses reductions in price to attract sales or gain market share.
• May result in lower prices and a price war but may increase sales and revenue.
• Increases quantity demanded by lowering price, resulting in movement along the demand curve.

e.g., discounts, sales, interest-free terms, trade-ins

Advantages: Increases market share/sales for a short period.

Disadvantages: Could end with market share largely unchanged due to other firms reacting to the price cuts and starting a price war.

Non-Price Competition

• Policies used to attract customers from competitors that do not involve price reductions.
• Firms try to make their products appear different from similar products.
• Increases demand, resulting in movement of the demand curve to the right.

e.g., packaging, competitions, giveaways, location, advertising

Advantages: Reduces the likelihood of a price war while increasing market share/sales, and consumers get better service and quality products.

Disadvantages: Costs can increase, along with the possible loss of profits, and consumers may experience increased product costs to cover the extras.

Product Differentiation

The creation of real or imagined differences in similar products.

e.g., design, quality variation, advertising

Total Revenue (TR)

The total revenue received from all sales.

Revenue Curves

Average Revenue (AR)

The total revenue received from sales divided by the number of units sold.

Marginal Revenue (MR)

The change in total revenue resulting from increasing sales by one unit.

Accounting Costs

These are the actual costs (explicit) involved in production only. Accounting costs will be lower than economic costs.

e.g., mortgage, rents, power, raw materials, wages

Economic Costs

These are the accounting costs plus the implicit costs of production. The implicit costs are the opportunity costs of alternative resources used. For example, the lost rent or earnings from a factory that the firm uses, or interest forgone from funds invested in a business. Economic costs will be higher than accounting costs.

The Law of Diminishing Returns

As more of a variable input is combined with a fixed input, the marginal product of the variable input eventually decreases.

Why Firms Experience Diminishing Returns in the Short Run

Because at least one factor input is fixed in the short run, when variable factors are added to production, the total output will increase at a diminishing rate. This is because each variable factor has less of the fixed factor to work with, reducing its ability to produce additional output.

Why Diminishing Returns Causes a Firm’s Marginal Costs to Increase

When additional variable units are added, diminishing returns occur. Therefore, extra units will require more variable inputs to produce them. This increases the cost of each additional unit produced because more inputs are being used.

Increasing Returns to a Factor

If a firm’s short-run average costs are falling, it means that an increase in input causes a smaller increase in output, or that a decrease in input causes a smaller decrease in output.

Break-Even and Shutdown Points

Break-even: A price at which revenue covers all economic costs.

Shutdown: A price at which revenue only just covers variable costs.

• Firms maximize profits or minimize losses where MR = MC. Any other position will result in a greater loss or smaller profit.
• When MR > MC, to maximize profits or minimize losses, a firm will have to increase output.
  • Perfect competition: Price will remain unchanged.
  • Imperfect competition: Price will decrease.
• When MR < MC, to maximize profits or minimize losses, a firm will have to decrease output.
  • Perfect competition: Price will remain unchanged.
  • Imperfect competition: Price will increase.

Supernormal and Subnormal Profits

Supernormal Profit: A return more than sufficient to keep an entrepreneur in their present activity. At MR = MC, AR > AC.

Subnormal Profit: A return insufficient to keep an entrepreneur in their present activity. At MR = MC, AR < AC.

Why Supernormal Profits Are Not Possible in the Long Run for Perfectly Competitive Firms

In perfect competition, there are no barriers to entry. Other firms see these supernormal profits being made in the short run and enter the market. Their entry involves the reallocation of resources, which increases market supply, causing the price to fall until AR = AC because they are price takers.

How a Perfectly Competitive Firm’s Output Changes in the Long Run with Subnormal Profits

Subnormal profits will cause firms to leave the market until normal profits are made in the long run at the minimum AC level of output, which is above the current level. The profit-maximizing level of output will increase as MR increases as a result of firms leaving the industry.

Why the MC Curve Intersects the AC Curve at Its Minimum Point

Where MC is greater than AC, AC must be rising because the extra cost of producing the next unit is greater than the average. Therefore, where AC = MC, AC is minimized.

Why the Gap Between ATC and AVC Narrows as Output Rises

ATC comprises AFC and AVC. AFC declines with increasing output as fixed costs are spread over a greater number of units. Therefore, a higher amount of ATC is made up of AVC as output increases, narrowing the gap between AVC and ATC.