2.
11 Market failure – market power (HL)
Rational producer behaviour
Remember that our job as economists is slightly different from the job of a business
owner. We are not studying how businesses can make more profit. We want to know
what conditions allow eficient economic decisions to be made, and if we assume that
all firms practice profit maximisation, then we know that this motivation is central to
market eficiency. When firms act as profit maximisers, we say that they are behaving
rationally – they have studied their costs and acted in a way that will minimise those
and make the most profit for their owners.
An accountant may say to the company's owner, 'you should be happy, this year you
have achieved a total profit of USD 100000'. However, an economist may look at the
same evidence and say: 'you should be satisfied, but only just!'
How is this possible?
For economists, the calculation of profits follows this formula:
Total profit = total revenue – total costs
where,
Total costs = fixed costs + variable costs + opportunity costs
The opportunity cost (also called implicit cost) accounts for the second best
alternative for the resource being used in the production of a good or service.
Those could be the earnings that a firm could have had if it had employed its factors
in another use or if it had hired out or sold them to another firm. For example, the
owner of a firm may be able to earn USD 130000 per year in her next best alternative
job, as an IT manager in the USA. Another example, a building that is used to produce
goods could be rented out to other firms for USD 20000 per month.
Economic costs are defined as the sum of implicit and explicit costs, with
implicit costs being the opportunity cost of the business decision and
explicit costs being the costs of production itself. A person in business is only Take a tour Free 30-Day
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concerned with covering the explicit costs (any costs to a firm that involve the direct
payment of money), but economists are also interested in the implicit costs. For
economists, costs are called economic costs (explicit + implicit costs).
If a firm only covers its economic costs (explicit + implicit costs), the firm is said to be
making a normal profit. Once a firm surpasses this level, it is said to be making an
economic or abnormal profit.
Costs of production
Be aware
Please be advised that while the syllabus does not explicitly outline the various
categories of production costs, familiarizing yourself with these cost types is highly
recommended. This knowledge will significantly enhance your comprehension of
revenue and profit concepts in the subsequent chapters.
Employing factors of production in an attempt to produce something useful and
sellable will cost firms money. The costs of production can be broken down in
terms of total, average and marginal costs.
In the short term, there will be some fixed costs that do not change. Fixed costs are
the costs that do not vary when output changes. An example of a fixed cost is rent.
Variable costs are those costs that do vary when output changes. An example of a
variable cost is the materials and components for production.
Figure 1. Total cost, total variable cost and total fixed cost.
More information for figure 1
Figure 1 Description:
The image is a graph demonstrating the relationships between Total Cost (TC),
Total Variable Cost (TVC), and Total Fixed Cost (TFC) relative to Output. The X-axis
represents Output, while the Y-axis represents Costs. The graph features three
curves:
1. The Total Cost (TC) curve, which starts at a higher point on the Y-axis than
the other curves and increases at an increasing rate as output rises.
2. The Total Variable Cost (TVC) curve, which begins from the origin and
increases, representing costs that vary with output.
3. The Total Fixed Cost (TFC), depicted as a horizontal line indicating
constant costs that do not change with output.
The vertical distance between the TC and TVC curves represents the TFC,
showing that TC equals the sum of TVC and TFC at all output levels.
Figure 1 outlines the relationships between the total cost, the total variable cost and
the total fixed cost. You will notice that the vertical distance between the total cost
and the total variable cost is the total fixed cost. In other words:
Total cost = total variable cost + total fixed cost
We can also calculate the cost per worker and the additional cost per worker, which
are shown in Figure 2. The average cost is the cost per unit of output. This can be
broken down into the average fixed cost and the average variable cost. The marginal
cost is the additional cost that an additional unit of output incurs. The marginal cost
curve intersects the average cost curve (in this case both average total and average
variable costs) at the lowest point of the average cost curve.
Figure 2. Marginal and average cost curves.
More information for figure 2
Figure 2 Description:
The graph displays cost curves, including marginal cost (MC), average total cost
(ATC), average variable cost (AVC), and average fixed cost (AFC), against output.
The x-axis represents the output starting from zero, and the y-axis represents
costs with no specific units indicated. The marginal cost curve (MC) is shown
intersecting the average cost curve at its lowest point. Each curve is labeled: MC
in blue, ATC in yellow, AVC in red, and AFC in light blue. The AFC curve decreases,
while the ATC, AVC, and MC curves are U-shaped, indicating an initial decrease in
cost with increased output, followed by an increase after reaching a minimum
point. The U-shaped nature of the ATC and AVC curves suggests that costs initially
decline due to economies of scale, after which they rise as production increases,
highlighting diseconomies of scale.
Be aware
The marginal cost curve must always intersect both average cost curves (average total
and average variable) at their lowest points.
Figure 3 only shows the marginal and average cost curves. The cost values for a firm
exhibit diminishing marginal returns once productivity per worker begins to slow
down and costs begin to rise. This concept describes the relationship between
inputs and outputs, as a firm employs more variable units of inputs in
the short run (when one factor of production is fixed). Wages need to be paid per
worker, and as we employ more labour, the relative gains in output will decrease.
This is because, after a certain point, each time an additional worker is added, it will
increase output by a smaller and smaller amount. There may even be a point
at which each additional worker decreases overall output. This will mean that the
marginal cost will start to increase relative to the increase in output. At some point
the cost per worker, or average cost, will also begin to rise.
Economists often say that the marginal pulls the average up or down. For
example, if a fishing boat catches another tuna fish which is large, the average
weight of all caught tuna will go up. If the tuna fish was small, then the average
weight of the entire catch would go down.
The formulae for average cost and marginal cost are given by:
MC = ΔTC
Δ
Marginal cost is equal to the change in total cost divided by the change in
quantity.
AC = TC
Average cost is equal to total cost divided by quantity.
Figure 3. The law of diminishing marginal returns (DMR) with MP (marginal
product), AP (average product), MC (marginal cost), AC (average cost).
More information for figure 3
Figure 3 Description:
The image consists of two graphs explaining the Law of Diminishing
Marginal Returns (DMR).
On the left: - The X-axis is labeled 'Variable input (labour),' starting at 0. -The
Y-axis is labeled 'Product,' starting at 0. - The blue curve labeled 'MP' (marginal
product) shows a rise and then a decline, representing the increase and then
decrease in output with added labor. A point labeled 'DMR' marks where the
decline begins. - The red curve labeled 'AP' (average product) shows a gradual rise
and then a decline, intersecting with the MP curve at the highest AP point. - Text
annotations indicate 'DMR' and 'Intersection occurs at highest AP.'
On the right: - The X-axis is labeled 'Output,' starting at 0. - The Y-axis is labeled
'Cost,' starting at 0. - The red curve labeled 'MC' (marginal cost) starts high, dips,
and then rises again, showing the cost per additional unit of output. - The blue
curve labeled 'AC' (average cost) starts high, dips more gradually, and then
increases, intersecting with the MC curve at the lowest point of AC. - Text
annotations indicate 'DMR' and 'Intersection occurs at lowest AC.'
c
The diminishing marginal returns of making paper chains
Figure 4. Making paper chains in groups is a good way to get an
understanding of the principle of diminishing marginal returns. Credit:
Getty Images Vstock
This is an activity that is really helpful to see how the law of diminishing returns
works. Your teacher needs to supply the class with plenty of paper, scissors and
glue. You may only cut the paper with the scissors, no tearing the paper.
In the first round, you will work as individuals to make paper chains. How many
links in a chain can you make in a minute?
In the second round, you will make paper chains in pairs, but with only one set of
scissors and glue between you. How many links in your chain this time?
Continue completing rounds of paper chains, each time with an additional person in
the group, but with only one set of tools between you. After how many team
members do you start becoming less productive?
Make sure you recycle the paper in a recycling bin, or use your paper chains to
decorate your classroom!
Revenues
As you know from previous discussions about price elasticity of demand, total
revenue is given by the formula:
Total revenue = price × quantity
Like we did with production and costs, we need to further define revenues in
terms of their average and their marginal rates. These are given by the following
formulas:
MR = ΔTR
Δ
Marginal revenue is equal to the change in total revenue divided by the change in
quantity.
TR
AR = =P
Average revenue is equal to total revenue divided by quantity, which is equal to
price.
Marginal revenue is the additional of revenue from each additional unit of output,
and is calculated by dividing the change in total revenue by the change in output.
Average revenue is just another term for the selling price per unit, so the average
revenue curve for the firm is also the demand curve for the firm. The relationship
between MR and AR is the same as the tuna example explained previously. A lower
MR will bring AR down, but a higher MR will increase AR.
Profit maximisation
Figure
5. Firms are always keen to know when they start making a profit.
Credit: Getty Images Virojt Changyencham
In order to understand the next diagrams, you could jump to the next section where
we talk about the market structure of Perfect Competition but here we have an
introduction to the supply and demand curves in a perfectly competitive market.
The diagrams below represent the whole industry (Figure 6a) and one individual
firm in that industry (Figure 6b).
Imagine that the market supply curve (Figure 6a) includes all individual firms in the
market, so a single firm alone has no influence on the market price. For that reason,
the price of equilibrium in the market (Figure 6a) is transferred to the individual
firm. That is the reason why a single firm in a perfectly competitive market
structure is called a price-taker.
For that reason, a single firm in the market would face a perfectly elastic demand
curve (Figure 6b) . In this case, the price of the product would be equal to the AR
(average revenue) as well as the MR (marginal revenue).
Figure 6. A perfectly competitive market.
More information for figure 6
Figure 6 Description:
The image depicts two side-by-side graphs labeled as 'a' and 'b'.
Graph 'a' is a typical supply and demand curve: - The X-axis is labeled
'Quantity (millions)', and the Y-axis is 'Price'. - The supply curve (S) and
demand curve (D) intersect at a point marked as 'Pₑ', indicating the
equilibrium price.
Graph 'b' shows a perfectly elastic demand curve: - The X-axis is labeled 'Quantity
(thousands)', and the Y-axis is 'Revenue'. - It features a horizontal line labeled 'D =
AR = MR', representing a perfectly elastic demand at a fixed price where average
revenue equals marginal revenue. - The horizontal line indicates that any quantity
can be sold at this price, typical in perfectly competitive markets.
There are many advantages to firms trying to maximise profits. First, maximum
profits mean that the owners or shareholders get the most back on their original
investment. Entrepreneurs are rewarded with profits. Second, firms can use these
profits to fund research and development, thereby securing a place in the market.
Third, maximising profits is a very clear goal for employees and managers, which
allows targets to be set, and wages can be tied to profits as an extra incentive.
There is a simple way of finding the point where profit is maximised, and that
involves looking at the difference between the total revenue and the total cost,
which will give us the profit for the firm.
There is another way of figuring out the level that the firm should produce if its
aim is to maximise profits, and that requires us to look at marginal revenue and
marginal cost. In a simple way, if a firm would like to maximize its profits, it
should produce when MC = MR. This is an important method.
It is important to remember that both the marginal revenue and marginal cost are
the gradients for total revenue and total cost respectively. In other words, they are
the rates of change of total revenue and total cost.
Figure 7. Marginal cost and marginal revenue for a perfectly competitive firm
More information for figure 7
Figure 7 Description:
This graph illustrates the marginal cost (MC) and marginal revenue (MR) for a
perfectly competitive firm. On the vertical axis, the graph shows costs with no
specified values. The horizontal axis represents output, with a point labeled
Q_max indicating the maximum output. The MC curve is upward sloping and
intersects the horizontal MR curve at Q_max. To the left of Q_max, the MR
exceeds MC, suggesting an area of increasing profit with additional output. To the
right of Q_max, MC exceeds MR, indicating a
decrease in profit with additional output. The MR curve is also labeled as AR
(Average Revenue) and D (Demand).
Figure 7 shows a marginal cost curve plotted with a horizontal marginal revenue
curve. A horizontal MR curve means that revenue, and so price per unit, is constant
with output. Initially, when the firm adds a unit of output, it gains more revenue for
that unit than that unit costs to make. Therefore, profits will have grown and logic
tells us that we have not yet reached the level of highest profit. The firm will
continue to make more profit as it produces more output if marginal revenue
exceeds marginal cost.
Be aware
Both the marginal revenue and marginal cost are the gradients for total revenue and
total cost, respectively. In other words, they are the rates of change of total revenue
and total cost.
The profit-maximising level of output for any firm is therefore the point when
marginal revenue equals marginal cost. Have a look at Table 1, which gives the
revenues and costs for a firm facing imperfect competition.
Table 1. Revenues and costs for a firm facing imperfect competition (in
USD). Note that the marginal figures (marginal revenue and marginal cost) occur
'between' the other figures, and therefore indicate change.
Output Price/unit Total Marginal Total Cost Margina
Revenue Revenue l Cost
1 10 10 1
Marginal figure =
Change
8 2
2 9 18 3
Marginal figure =
Change
6 2
3 8 24 5
Marginal figure =
Change
4 4
4 7 28 9
Marginal figure =
Change
2 5
5 6 30 14
Marginal figure =
Change
0 6
6 5 30 20
Marginal figure =
Change
-2 7
7 4 28 27
Marginal figure =
Change
-4 8
8 3 24 35
Worked example 1
For the values in Table 1, work out the total profit earned for each unit of
output and compare that to the difference between marginal revenue and
marginal cost.
For output from 1 through to 8 inclusively, total profit is:
USD 9, USD 15, USD 19, USD 19, USD 16, USD 10, USD 1, –USD 11.
With the fourth unit of output added to production, marginal revenue is
USD 4 and marginal cost is USD 4.
At the point where marginal revenue equals marginal cost, total profit will have
stopped growing. Therefore, total profit will have reached its highest point; total
profit has been maximised. Beyond this point, as you can clearly see from your
calculations above, total profit starts to fall from USD 19 to USD 16 and
downwards.
In the worked example, there were two levels of output that each gave us a total
profit of USD 19. This might seem confusing at first, and you may wonder why the
fourth unit gives us the profit maximising level of output. It is between the third
and fourth unit that profit is maximised, and if we plotted our results on a graph
profit would peak between those numbers. Over larger ranges of output, this
would be more obvious – for example, between 3000 and 4000 units of output.
Important
The profit maximising level of output is found when the difference between total
revenue and total cost is greatest, or when marginal revenue equals marginal cost or
MR = MC.
We are going to use Figure 8, which shows the marginal costs (MC), the average
total costs (ATC) and the average variable costs (AVC) at different levels of output, to
discuss different situations in which a firm may, or may not, make economic profit.
Figure 8 the company would have to sell its goods/services at P5 in order to cover
the ATC (average total costs). Remember that for an individual firm in a perfectly
competitive market, the price is derived from the industry's equilibrium price. In this
case, the perfectly elastic demand curve would be at P5, and so it would be its MR
(marginal revenue) curve.
As you learned before, the profit maximizing point for a firm is where MC = MR,
which means that this firm would be producing at Q5. At this point, the AR
(average revenue) or the price per unit is exactly the same as the ATC (average
total cost).
Figure 8. Marginal and average costs.
Figure 8 Description:
The image is a graph illustrating the relationships between different cost
curves and output levels.
X-axis: Represents "Output" with labeled intervals from Q1 to Q6.
Y-axis: Represents "Cost, Revenue" with labeled intervals from P1 to P6.
There are four main curves on the graph:
1. MC (Marginal Cost) curve: A blue, sharply increasing curve that crosses the
D=AR=MR line at point Q5.
2. ATC (Average Total Cost) curve: A yellow curve that is U-shaped, decreasing then
increasing, and intersects the D=AR=MR line at Q5.
3. AVC (Average Variable Cost) curve: A red curved shape below the ATC, also U
shaped, and intersecting below the D=AR=MR line.
4. D=AR=MR line: A blue horizontal line across the graph at level P5, indicating the
Demand, Average Revenue, and Marginal Revenue are equal.
Overall, the graph shows at Q5, the MC curve intersects with the D=AR=MR line,
indicating the profit-maximizing level of output where Marginal Cost equals
Marginal Revenue, and the price per unit is aligned with the Average Total Cost.
Making economic profit
As stated above, the only way a firm can make an economic profit is if the firm
more than covers its economic costs. That is, it has to take in more revenue from
selling its goods or services than it costs to produce them plus any opportunity
cost the entrepreneur incurs by being in that business. As long as the price
remains above average total cost, the firm will make an economic profit.
In Figure 9 below, the perfectly elastic demand curve is at P6. This means that
MC=MR indicates that Q6 is the profit maximizing quantity.
At Q6, AR (average revenue) is greater than ATC (average total costs) resulting in
economic profit (or abnormal profit) represented by the green area.
The purple area represents the total fixed costs. Remember that ATC = AFC
(average fixed costs) + AVC (average variable costs).
Figure 9. A firm earning positive economic profits.
More information for figure 9
Figure 9 Description
The graph illustrates the relationship between cost, revenue, and output in a
firm's profit analysis. The X-axis represents the output with points labeled Q1 to
Q6. The Y-axis represents cost and revenue with levels between P1 and P6.
Several curves are visible: - MC (Marginal Cost) curve is upward sloping. - ATC
(Average Total Cost) curve is depicted with a downward then upward slope. -
AVC (Average Variable Cost) curve also shows a downward then slightly
upward slope.
The area between the ATC and AVC curves is shaded purple, representing total
fixed costs, while the area below the AVC curve is shaded pink, representing
total variable costs. Another highlighted area above ATC, shaded green,
represents economic profit.
The graph includes labels for different curves and costs, illustrating concepts
like economic profit, total fixed costs, and total variable costs. It helps
visualize how these financial concepts interact at various levels of output.
[Generated by AI]
Important
A firm will make economic profit when the price is above average total cost.
Making zero economic profit
If a firm is making zero economic profit, its economic costs are equal to its total
revenue. This will occur when the price equals average total cost. You can see in
Figure 10 that the pink and green shaded areas, representing total economic cost,
are equal to the purple shaded area that represents total revenue. Remember that
for a perfectly competitive firm, the D = MR and the maximizing profit quantity
happens where MC = MR. In this case, the firm would produce at Q5.
Figure 10. A firm making zero economic profit: total revenue equals economic
cost.
Figure 10 Description
The image consists of two graphs side-by-side that collectively illustrate the
concepts of total cost and total revenue in relation to output for a firm making
zero economic profit.
Left Graph: - Axes: The X-axis represents Output, marked from Q1 to Q6. The
Y-axis represents Cost and Revenue, marked from P1 to P6. - Curves and
Lines: - MC (Marginal Cost): The blue curve rises steeply as output increases. -
ATC (Average Total Cost): The yellow curve is downward sloping and then
rises, positioned above the AVC curve. - AVC (Average Variable Cost): The red
curve is a U-shape beneath the ATC. - D=MR
(Demand = Marginal Revenue): A horizontal line intersecting the Y-axis at P5. -
Shaded Areas: - Green Area: Representing total fixed costs above P5. - Pink
Area: Representing total variable costs from P2 to P3.
Right Graph: - Similar Axes and Labels as the left graph. - Shaded Purple Area:
Represents total revenue, extending from the horizontal D = MR line at P5.
Interpretation: - When the firm is producing at Q5, total revenue matches total
economic cost, indicating zero economic profit. At this point, the price equals
the average total cost, and the firm is making a normal profit, covering both
production and implicit costs.
[Generated by AI]
When this occurs, a firm is said to be making a normal profit or enough profit to
cover production costs and the implicit costs of the business decision. We can also
say that the firm is breaking even.
Important
A firm will make zero economic profit when the price equals average total cost. It is
said to be breaking even.
Making negative economic profit
If the price falls below the average total cost, the firm will not be making any profit.
Indeed, the firm will be making zero economic profit or even a loss! Figure 11 shows
us this clearly. On the right-hand diagram, a price and marginal revenue of P4 will
result in an output of Q4 and a total revenue equal to the green shaded area.
Remember that the maximizing profit point is always when MC = MR.
Figure 11. A firm making negative economic profit or a loss.
More information for figure 11
Figure 11 Description
The image consists of two side-by-side diagrams. Each diagram features a cost
and revenue analysis of a firm at various output levels, marked Q1 to Q6 on the
x-axis.
Left Diagram: - The y-axis represents cost and revenue, while the x-axis
represents output. - Curves: The blue line is the marginal cost (MC) curve. The
yellow line is the average total cost (ATC) curve. The red line is the average
variable cost (AVC) curve, and the horizontal blue line is the demand and
marginal revenue (D = MR) curve. - Shaded Areas: The orange shaded area
labeled as total fixed costs lies between P2 and P3 for output Q2 to Q3. The pink
shaded area, labeled as total variable costs, covers up to P2 for the same output
range.
Right Diagram: - Similarly structured to the left, the right diagram shows an
economic scenario where total revenue is insufficient to cover total costs. - At
output Q4, the price (P4) and marginal revenue result in lower revenue than
costs. - Shaded Areas: The green shaded area indicates total revenue at Q4,
covering prices from P2 to P4. Total revenue is lower than total costs, resulting in
an economic loss depicted by the purple shaded area between the ATC and the
revenue line (D = MR).
[Generated by AI]
However, the firm's costs at Q4 (orange + pink areas on the left-hand diagram) will
far exceed the total revenue at Q4 (green area). On the left-hand diagram, for the
quantity of Q4, the ATC would be at P5. On the left-hand diagram, total fixed costs
(orange area) and total variable costs (pink shaded area) when added together, will
be equal to the total cost of production. It is evident that the sum of the
orange and pink shaded areas exceeds the green area on the right-hand side (the
total revenue earned when Q4 is sold for a price of P4), and so there is an economic
loss of the purple shaded area.
Important
A firm will make negative economic profit, or a loss, when the price is below
minimum average total cost.
Summary formula table
You need to make sure that you can remember all the equations for Paper 3.
Table 2. Summary of formulae for costs, revenues and profits.
Concept Words Shorthand
Total Price multiplied by quantity sold P×Q
revenue
Average revenue multiplied by AR × Q
quantity sold
Total Fixed cost plus total variable cost FC + VC
cost
Average total cost multiplied ATC × Q
by quantity sold
(AVC + AFC)×Q
(Average variable cost plus average
fixed cost) multiplied by quantity
sold
Average Total revenue divided by quantity TR
revenue sold Q
Concept Words Shorthand
Average Total cost divided by quantity sold TC
cost Q
Average fixed cost plus average
variable cost AFC + AVC
Marginal Change in revenue divided by ΔTR
revenue change in output ΔQ
Marginal Change in cost divided by ΔTC
cost change in output ΔQ
Total Total revenue minus total cost TR − TC
profit
(Average revenue minus (AR − AC)×Q
average cost) multiplied by
quantity
c
Try to come up with a table of data yourself for a perfectly competitive firm, with values
for marginal cost, average total cost and average variable cost. Use the table to calculate
the break even point, and a few points showing economic profits and losses being made