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Market and Production Analysis
Market and Production Analysis
Theory of production
Average product is obtained by dividing the total product by the amount of input used.
Marginal product is the change in the total product of input, corresponding to an additional unit change in its labour.
Marginal product is the addition to total output when one more unit of labour is employed.
MPL= ∆TP/ ∆ L
MPK= ∆TP/∆K
Law of Variable Proportion
This law basically explains the behavior of production function in the short run.
The output can be varied by changing the quantities of variable factors only.
The law of diminishing returns states that if quantities of certain factors are increased
while the quantities of one or more factors are held constant beyond a certain level of
production the rate of increase in output will decrease and eventually the marginal
product declines.
Capital Labour Total product Marginal product Average product
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
10 10 50 -4 5
Relation between TP and MP
When MP is increasing, TP will increase at an increasing rate
Stage II: AFC continues to decline and when firms produce the optimum output, SATC will
reach its minimum. AC remains constant at this stage since the falling effect of AFC and the
rising effect of AVC are in balance.
Stage III: AFC will fall slowly due to the production with a negative MP for variable input.
AVC increases quickly due to diminishing returns of the variable factors. The falling effect of
AFC is lower than the rising effect of AVC.
Long run cost curves
•The long run is a period which involves only variable factors and not
fixed cost.
•A firm can alter its scale of operation; i.e. expand its plant if demand is
high.
•Long run total cost start from the origin, due to the absence of any
total cost.
•A long run average cost curve is a curve that shows the minimum cost
of producing any given output, when all inputs are variable.
LRAC curve is U shaped due to law of returns to scale.
As the firm expands in size or scale of production, its LRAC curve will
decrease and increase at a later stage.
Internal diseconomies of scale are those factors which arise the cost of
production of a firm as the firm expands. Internal diseconomies of scale show
the upward sloping of the long run average cost.
Labour diseconomies
Management problems
Technical difficulties
External diseconomies of scale
Average revenue: is defined as the total revenue per unit output sold.
AR= TR/Q
Marginal revenue: refers to the change in total revenue, resulting from a one unit increase in quantity
sold.
MR= ∆TR/ ∆Q
Relationship between price, AR and
MR (Perfect competition)
Quantity Price TR AR MR
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
Imperfect competition
Quantity Price TR AR MR
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Firm
A firm is an institution that buys or hires factors of production and organize them
to produce and then sell goods and services.
Objective of firm
Minimize cost
Maximize profits (Profit= TR-TC)
Equilibrium of Firm
A firm will be in equilibrium when it has no tendency to change output.
Total approach
Marginal approach
Market structure
MC=MR
MC cuts the MR curve from below
Short run equilibrium (Supernormal
profit)
Normal profit
Shut down point
Short run supply curve
More firms will enter the market, hoping to obtain similar profits.
The equilibrium market price will fall and the individual firms will lower their
prices until profit is eliminated.
In the long run can earn normal profit or zero profit due to free entry.
Monopoly
Monopoly is made up of the word mono which means single and poly means
sellers.
Monopolist will fix a higher price if demand is inelastic and lower price if the demand is
elastic.
mu i rb i l i uq e n u r t r o hS
Mutual interdependence
Barriers to entry
Kinked demand curve
Kinked demand curve was given by Sweezy.
If an oligopolist increases the price of his products, his rivals will not increase their
prices but instead maintain the same prices, thereby gaining customers from firms
which increase their price.
Why price rigidity under oligopoly?
Since the oligopolist will not gain a large share of the market by
reducing his price below the prevailing level, and will have a
substantial reduction in sales by increasing his price above the
prevailing level, he will be extremely reluctant to change the
prevailing price.
Price leadership model