Economics for CFA 2024: level 1 in just one week: CFA level 1, #4

FIRMs AND MARKET STRUCTURES

1: Determine and interpret breakeven and shutdown points of production, as well as how economies and diseconomies of scale affect cost under perfect and imperfect competition.

Short run time period: This is the time in which at least one factor of production for example capital is fixed. We can only increase our production by increasing units of labor, as labor can be changed easily in comparison to capital.

Long run time period: It is the time. In which all factors of production are variable a firm can change its production by increasing units of capital and units of labor.

All costs are variable in this time. For example a firm can increase its production by installing new plant and machinery, hiring new workers or it can reduce its cost by cutting down the plant and machinery.

Fixed cost:  It is the cost which does not change as the production level changes. This is true up to some extent for example rent of factory building. Owner of the factory has to pay fixed amount of rent regardless he produces 1 unit or 100 units.

Variable cost: It is the cost which changes with the change in production level. For example cost of raw material. When we produce more units of shoes we need more leather so the cost of leather increases (so it is variable cost).

Total cost = variable cost +fixed cost

Average cost = Total cost / output

Average variable cost = variable cost / out put

Average fixed cost = Fixed cost / output

We can discuss shut down and break even points under two conditions.;

1. Shutdown and break-even point under perfect competition.

2. Shut down and break-even point under imperfect competition.

Perfect competition is the situation in the market in which there are very large number of buyers and sellers and no one can affect the prevailing prices individually.

Imperfect competition: It is the market situation in which characteristics of perfect competition are not fulfilled. In this type of market structure there are many buyers but sellers are less than buyers. Depending on the degree of competition sellers have control over prices. Imperfect market structures include monopoly (with single seller) monopolistic competition (with many sellers) etc.

In coming LOS we will discuss these structures in detail.

Total revenues are price times quantity sold. TR = PxQ.

Average revenues = TR/Q

Marginal revenues = change in TR by producing one extra output.

Shutdown and break-even point under perfect competition

Under perfect competition Average revenues = TR/Q = P =AR =MR

In short run time period if firm is covering its variable cost it should operate to minimize the cost. It means price is just enough to cover variable costs. If price is below than average variable cost then the firm should shut down temporarily (in short run).

In long run if price is less than its average total cost it should shut it down.

Break even and shout down points by using marginal revenues and marginal cost approach

At point a the price P1 is just covering all costs so it is the breakeven point. At this point and above the firm should operate in short run and in long run. In the area below point a the firm should operate in SR as it is at least covering its variable cost. Below point b the firm should shut down its operations as it cannot cover both variable and total cost.

We can deduce following points from above discussion.

In short run:

If P=>ATC it’s the breakeven

AVC<=P<=ATC firm should operate

P

In long run:

If P=>ATC it’s the breakeven

AVC<=P<=ATC shut down

P

<= means less than or equal to.

Shutdown and break-even point under imperfect competition

The break even and shutdown points can be explained in imperfect competition using MR and MC approach. Remember here we do not have MR =P. We have different curves of MR and AR which are downward sloping (not straight line as in perfect competition).

As shown in the above figure at point a price is equal to AC. At this point the firm is at break even.

If firm is at break even the firm should operate in short run and in long run.

If firm is in (b) figure`s position it should run in short run but should shutdown in long run as price is not covering total average cost but variable cost is being fulfilled.

If even variable cost was not being covered then