Question

Discuss the following as they relate to profit maximization. 1) cost curve 2) elasticity 3) pure competition 4) monopoly 5)monopolistic competition 6) oligopoly

Answer 1

1) Cost curve: Cost curve is a graph which shows the cost of production as a function of total quantity produced. Firms use cost curves to find the optimal point of production (to minimize cost). It helps in deciding the quantity of output to be produced. Firms also use it to find profit maximizing quantities. There are various types of cost curves.

The average variable cost curve (AVC): It is the variable cost (generally labor cost) per unit of quantity. It will go down & then go up. It plots the short-run average variable cost against the level of output. The formula is AVC= wL/Q where w is wage rate, L is quantity of labor & Q is quantity of output.

Short run marginal cost curve (MC) represents relationship between marginal cost incurred by firm in the short run & quantity of output produced. It is generally U shaped. It will first decline then go up at some point & will intersect the average total cost and average variable cost curves at their minimum points.

Average fixed cost curve (AFC) is derived from costs that do not vary with output. It will go down as additional units are produced & continue to decline.

Average total cost curve represents relationship between cost per unit of output & the level of output. It will initially decline as fixed cost are spread & will go up as marginal cost increase.

There are two ways of profit maximization using cost curves given in the image below.

2) Elasticity:

Elasticity is the measure of responsiveness in supply or demand of a good to a change in price is called as elasticity. As demand & supply of good varies with change in price & price in turn varies with changes in quantity. So we can say that elasticity is measurement of one variable’s responsiveness to a change in another. In mathematical terms it’s a ratio of the percentage change in one variable to the percentage change in another variable.

Price elasticity has an effect on profit. Because if demand is price elastic an increasing sales revenue can be achieved by lowering prices & raising sales. Though higher sales require higher costs. In this case higher profits will be achieved when increase in sales revenue is greater than increase in costs.

If demand is price inelastic an increase in price will lead to lower sales but increase in sales revenue. Here sales are lower so costs are lower hence profit will increase from lower costs & higher sales revenue.

4) Monopoly:

Monopoly arises due to high fixed costs or high startup cost of operation relative to the size of market in an industry. It can also occur in industries which require specific technology, raw material or other factors to operate. Monopolies take advantage of high barriers to entry in an industry to protect its operations. Natural monopolies require extremely high fixed costs of distribution, & large-scale infrastructure to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These costs are also sunk costs, and they deter entry and exit.

Utility companies like water supply, electricity & gas distribution companies are best example of natural monopolies in some countries. Railways is a typical example of natural monopoly. Government regulates these monopolies through different laws & regulating bodies in order to ensure consumer welfare & protect them from exploitation.

There are two types of profit regulation for natural monopolies which most of the regulators use.

Cost plus regulation: In this regulator sets the price which firm can charge by analyzing firm’s accounting costs & then adding a normal rate of profit. It’s like calculating average cost of production & adding a normal profit then set the price for consumers.

Price cap regulation: This method gained popularity in 1990’s. In this method regulator sets the price for several years in advance. Regulators used to set the price which declined over time. In this case if company is able to produce at lower cost or sell higher quantity it can make high profits. If company suffers high cost of production or sells low quantity over time, it will result in losses. So this method is a delicate one which requires deep study & realistic approach.