Researching Price and Profits in the Economics

Isoquant

An isoquant is a curve showing all combinations of inputs that a firm will use to produce the same output level factoring in technological efficiency (Lipsey & Harbury 2007, p.515). For instance getting the maximum output with the least combination of inputs namely capital and labour (L, K). The slope of an isoquant indicates the marginal rate of substitution (MRS). It measures the rate at which additional input is substituted with another output. The isoquant convex shape indicates the diminishing rate of substitution. The production must be held constant in all cases.

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Quantity

The budget line

Also known as the price line, the budget line indicates the consumer budget in terms of goods X and Y. The budget line shows how much a consumer can buy between these two goods with limited or constant income (McEachern 2010, p.194). The budget line basic properties include:

  1. Sloping downwards indicating that more of one commodity is only possible if combined with less of another commodity
  2. Straight line showing that one product can be substituted with another at a constant rate.

The budget line

Production process

The production process is the conversion of various raw materials into outputs (Hall & Lieberman 2009, p.222). It involves the transformation of raw materials into complete products and embroils a series of the production chain with stages that are linked together. In each production stage, value is added to make the product more desirable to the final consumer. The law of production or law of variable proportions states that as the proportion of solitary factor of production is increased to a particular constant point, the marginal product (MP) will increase to a certain point then begin to decline due to the diminishing marginal rate of production. The law of increasing returns states that as the proportions of one factor of production increases MP also increases. The law of constant returns states that as the production increases MP remains constant within a very short period. The law of diminishing returns states that as the proportion of one factor of production increases the total product increases but at a decreasing rate.

Production stages

The three main stages of production include the primary, secondary and tertiary stages. In the primary stage, raw materials are extracted with little value addition and the producer aims at maximizing quantity at minimum cost. Secondary production involves transforming raw materials into finished products while in tertiary production the provision of services is involved. In secondary production stage, value is added and it thus represents the stage where the equilibrium must be achieved in production (Lipsey & Harbury 2007, p.409).

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The long-run average cost curve

In the long-run, the unit cost of production is variable. In the long-run the average cost is determined by the returns to scale. The economies of scale together with the returns to scale produce a U-shaped average cost curve in the long run (Lipsey & Harbury 2007, p.393). For the smaller quantities of output the long-run average cost curve is negatively sloped. For the larger quantities the curve is sloped positively.

Quantity

Price determination under monopoly

Monopoly signifies the outright power to create and equally sell products that have no close proxies or substitutes. Economists refer monopoly to as a market condition where only a single seller is present, there are hardly any close substitutes to the commodities being produced and barriers to market entry are also present. It is clear that under monopoly, the production and selling of a given product occur under a sole producer and product rivalry is not apparent (Bakos & Brynjolfsson 1999, p.1620). The demand curve for a firm that operates under a monopoly equally constitutes the demand curve for the entire industry. This signifies that the monopolist’s demand curve is similar to the average revenue curve. However, the marginal revenue (MR) curve and the average revenue (AR) curve are distinct from each other. The AR curve is always above the MR curve whose slope is twice the AR curve slope (Armstrong et al 1995, p.40).

Both the marginal revenue and average revenue curves are negatively sloped under monopoly. Despite this, the marginal revenue might sometimes be negative or even zero but the average revenue cannot be zero. Based on the variable aspects, a monopolist usually attains an equilibrium position which assists in determining the prices levels to be charged for each product. A monopolist who is at the equilibrium position tends to produce the quantity of output that generates maximum earnings

(Bakos & Brynjolfsson 1999, p.1621). To generate normal profits under short-run equilibrium, a monopolist usually sets the average revenue (price) to be equal to average costs (AC) as indicated in the following diagram.

Revenue and cost

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To earn normal profits, monopolists often set prices such that AR = AC. Nevertheless, to earn maximum profits, a monopolist sets marginal revenue to be equal to marginal cost. This implies that the marginal cost (MC) curve cuts the marginal revenue (MR) curve from beneath under the condition of increasing costs. The price that is set based on such a condition makes marginal revenue = marginal cost as subsequently explained.

Price & Supernormal profit

To earn supernormal profits, monopolists often set prices such that AR > AC.

On the other, monopolists generate losses when prices or average revenue is set below-average cost as illustrated in the diagram below.

Revenue and cost

Therefore, it is clear that price determination under monopoly follows three conditions that relate to the levels at which both the average cost and average revenue are set by the firms that operate in a given market.

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Conditions that lead to price discrimination

Businesses tend to charge, unlike prices to various groups of clients for commodities that are either less or more but which are of a similar kind. Also referred to as “yield management”, the price discrimination merely ensues in periods when dissimilar rates are charged by a business entity to diverse customer groups for indistinguishable commodities but for motives that are not related to the incurred outlays (Bhaskar & To 2004, p.770). In essence, price discrimination works under two main conditions.

In the first case, discriminatory pricing takes place when demand price elasticity differs between markets. For price discrimination to occur, the demand price elasticity must differ from each consumer group. The firm will be capable of charging higher prices to consumer groups that have more demand than is price inelastic but comparatively lower prices to consumers that exhibit additional elastic demand (Armstrong et al 1995, p.39). When a corporation embraces this policy, it stands a chance of accumulating its ensuing aggregate returns as well as proceeds to realize an advanced manufacturer surplus level. However, to maximize profits, the firm marginal cost= marginal revenue in every separate market segment. An implicit illustration of this is customarily found in the air company as well as hotel commerce where auxiliary orchestras and accommodations become traded on the basis of the latest minute reserves. The fixed production costs are usually high while the marginal costs appear to be petite and predictable. Thus, these industries mostly offload spare capacities at discounted pricing to cover each unit of the marginal cost.

The second instance appertains to a situation where a firm sets barriers that deter consumers from shifting to a particular supplier from the other. In fact, this condition stipulates that firms should devise ways of preventing “consumer-switching” or “market-seepage”. If market seepage is allowed, clients will be able to purchase commodities at lower prices and resell them to clients who might opt to pay higher prices (Bakos & Brynjolfsson 1999, p.1627). To achieve this, consumers and resellers usually provide unique services at different and unique points in time. For example, if a market seems to be alienated either by time or geography, exporters might be able to charge greater prices within the overseas souks provided the market demand appears to be likely inelastic when compared to the home markets.

References

Armstrong, M, Cowan, S & Vickers, J 1995, ‘Nonlinear pricing and price cap regulation’, Journal of Public Economics, vol. 58, no.1, pp.33-55.

Bakos, Y & Brynjolfsson, E 1999, ‘Bundling information goods: Pricing, profits and efficiency’, Management Science, vol. 45, no.12, pp.1613-1630.

Bhaskar, V & To, T 2004, ‘Is perfect price discrimination really efficient? An analysis of free entry’, Rand Journal of Economics, vol. 35, no.4, pp.762-776.

Hall, RE & Lieberman, M 2009, Microeconomics: Principles and Applications, Cengage Learning, Farmington Hills.

Lipsey, RG & Harbury, C 2007, First-principles of economics, Oxford University Press, Great Clarendon Street.

McEachern, WA, 2010, Microeconomics. Cengage Learning, Farmington Hills.

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