Theory of the Firm: Costs, Revenue and Market Structures
This is the most technical domain in the paper. Questions combine short-run cost curves, the profit-maximising rule and the four market structures, often with a numerical part (find output and profit) and a discursive part (compare outcomes, evaluate whether a market is contestable). It also carries a strong Cyprus applied angle: telecoms, banking, fuel retailing and audit services are all oligopolistic.
Short-run costs
- TC = TFC + TVC; AC = TC ÷ Q; MC = change in TC ÷ change in Q.
- The law of diminishing marginal returns explains why MC eventually rises and why both MC and AC are U-shaped. MC cuts AC at AC's minimum point.
- The shut-down point is where price falls below minimum average variable cost.
Long-run costs
- In the long run all factors are variable. Internal economies of scale are technical, managerial, marketing, financial and risk-bearing; external economies arise from the industry's growth. Diseconomies arise from coordination and control problems.
- The long-run average cost curve is the envelope of short-run curves.
Revenue and profit
- TR = P × Q. A price taker has MR = AR = price. A price maker faces a downward-sloping AR with MR below it, and MR may become negative.
- Profit is maximised where MR = MC with MC rising. Supernormal profit exists when AR exceeds AC at that output.
Market structures
- Perfect competition: many firms, homogeneous product, free entry, price taker; long-run supernormal profit is competed away.
- Monopolistic competition: differentiated products, some price-setting, free entry, excess capacity in the long run.
- Oligopoly: few interdependent firms, kinked demand curve, temptation to collude, game-theoretic behaviour.
- Monopoly: one seller, barriers to entry, output where MR = MC, deadweight loss and the potential for price discrimination.
Worked example
A firm has TC = 200 + 20Q + 2Q², so MC = 20 + 4Q. As a price taker at €100: 20 + 4Q = 100, Q = 20. TR = €2,000; TC = 200 + 400 + 800 = €1,400; supernormal profit = €600. If the market price falls to €60: 20 + 4Q = 60, Q = 10. TR = €600 and TC = 200 + 200 + 200 = €600, so the firm earns only normal profit and is at its long-run break-even point.
Traps that cost marks
- Maximising profit where MR equals AR, or where AC is lowest, instead of MR = MC.
- Confusing marginal cost with average cost when computing profit.
- Asserting perfect competition yields zero profit in the short run; only the long run guarantees normal profit only.
- Treating all large firms as monopolies - size is not the test; barriers to entry and market share are.