Week 6 PDF - Revenue Concepts & Factors Affecting Supply

Compulsory Reading Material- Week 6 Revenue Concepts Total Revenue (TR) and Average Revenue (AR) Total Revenue (TR) is the total amount of money received by a firm from goods sold (or services provided) during a certain time period. TR = Q*P, where Q is the quantity sold and P is the price per unit....

Compulsory Reading Material- Week 6 Revenue Concepts Total Revenue (TR) and Average Revenue (AR) Total Revenue (TR) is the total amount of money received by a firm from goods sold (or services provided) during a certain time period. TR = Q*P, where Q is the quantity sold and P is the price per unit. This gives us the total revenue that a producer will be able to earn by selling Q units of his goods at a price of P Average Revenue (AR) is the revenue earned per unit of output sold. AR=TR/Q =P This tells us the average amount a producer would earn by selling Q units of his goods at a price of P. Technically, the AR is the same as the price. Marginal Revenue (MR) Marginal Revenue (MR) is the Revenue a firm gains in producing one additional unit of a commodity. This is calculated by determining the difference between the total revenues produced before and after a unit increase in production. MRQ= TRQ – TRQ-1; or MR= dTR/ dQ The marginal concept is extremely important, and a producer compares the MR with the MC to see if he/ she should continue production or no. Figure: Graph of TR, AR and MR We now put the values you have calculated on a graph and the slide in front of you shows the graphs (these are the graphs for a perfect competition market): The TR Curve is an upward sloping curve (as TR is increasing at a constant rate) The AR and MR curves are a horizontal line parallel to the X-Axis This happens because the firm is able to sell all the units of a good at the same price Hence, there is no need for any price reduction to sell a larger quantity Thus, the TR increases at a constant rate and the AR & MR remain the same throughout. Factors Affecting Supply and the Law of Supply Supply is defined as the ability and willingness of a producer to sell or produce a particular product and services in a given period of time at a particular price, ceteris paribus. The factors affecting supply are: 1. Price of the commodity 2. Cost of Production 3. Expectation about future prices 4. Technological Advancement 5. Number of Sellers 6. Government Policies 7. Goals of firms 8. Price of related goods 9. Improvement in Infrastructure 1. Price of the commodity One of the most important factors that affect the supply is the Price of the commodity. As the price of a good increases so does its supply since the producers get better returns, i.e. if the price is higher the producer will be able to generate more revenue and vice- versa.Thus, the price of a good and its supply are directly related. 2. The cost of production The cost of production also directly impact the level of profits. If the cost of production is lesser, it would imply greater profits and vice – versa. Thus, as the cost of production goes down, the supply goes on increasing and vice – versa 3. Expectations about future prices affect the supply Expectation about future price plays a very important role in determining supply. If the prices are expected to go up, the producers will supply lesser goods in the current times to make more profits when the prices go up in the future and vice – versa. It is this behaviour of the producers that actually drives the price up and down 4. Technological advance and supply With technological advancement, there is either an increase in level of output or there is a lesser need of inputs for the same level of output. In both the cases the revenues and the profits would go up. Hence, with technical advancement the supply tends to increase. 5. Number of sellers in the market As the number of sellers for a product go on increasing, its supply will also go on increasing. On the other hand, if the number of sellers declines for some reason, the supply would also decline.  6. Government Policies The government plays a very important role in determining Supply in an Economy. This is done through the Policy Making tool and especially the Fiscal Policy (taxation and expenditure policy of the government). Industries that receive subsidy can supply more, while industries that pay higher taxes supply lesser. Also, the government may change the tax structure to impact the price of the goods and services and thus their supply. Goods that are generally considered good and are important for the public is taxed lesser and hence prices are lesser, like food/ clothing/ etc.On the other hand, goods that are not considered good or are not desirable are taxed much higher, like imported good/ alcohol/ etc. 7. Goal of a Firm If the goal of a Firm is to increase sales revenues, they may supply a greater quantity. However, if the goal is wealth maximization/ profit maximization, they may consider other strategies and not necessarily supply more. In this case the supply may be lesser 8. Price of other goods If the price of other goods in the market increases, firms may decide to move into the production of that good, and reduce the production of the current good.Thus, the supply of the current good would go down and that of the other good would increase and vice – versa.Producers would generally produce good and supply goods that will give them better sales and hence better profits. 9. Infrastructure As the infrastructure becomes better, the wastage due to transportation/ communication/ etc. becomes lesser and hence supply increases. Better infrastructure enable quicker and more convenient movement of goods and services, thereby motivating producers to produce more and supply more. The Law of Supply: Law of supply states that the higher the price of a good, the greater is the quantity supplied for that good and the lower the price of a good, the lower is the quantity supplied, ceteris paribus (keeping other things constant).Thus, there is a Direct Relationship between the prices of a good and the quantity supplied of that good. Individual supply curve Individual Supply is the relationship between the quantity of a product supplied by a single seller and its price.  Price Prod. A Prod. B 1 2 3 2 4 6 3 6 9 4 8 12 5 10 15 The table shows a tabulation with the price of a good and the various quantities supplied by two different producers. At the same price they are willing to supply different quantities; this is referred to an individual supply schedule. Also, you can see the individual supply graph of the producers which is based on their respective supply schedules. The slope of the lines (graph) are different, however, they are both positively/ directly related with the price. Market supply schedule and the market supply graph The relationship between the price of a good and the quantity supplied of a good by the entire Market (adding all the quantities supplied by all sellers in the market).  Price Prod. A Prod. B Market 1 2 3 5 2 4 6 10 3 6 9 15 4 8 12 20 5 10 15 25 The table shows a tabulation with the price of a good and the various quantities supplied by two different producers and we have also added a market column, which is the addition of the two individual producers at each price level. Also, you can see the market supply graph for the good which is based on market supply schedule. So, the market supply is determined by vertical addition of all the individual supplies at various prices. Exceptions to the Law of Supply and Elasticity of Supply The exceptions to the Law of Supply are : 1. Backward Bending Labor Supply Curve 2. Perishable goods 3. Monopoly 4. Stock Clearance 5. Closure of firm 6. Monetization and exit of firm 1. The Backward bending Labor Supply Curve Figure: Graph of backward bending labour supply curve As shown in the graph, labor supply is on the X-axis and the price of labor/ wages is on the Y- axis. As the price increases supply of labour increases initially till ‘A’. As the price increases further, the supply of labour begins to decrease: beyond point ‘A’. This happens due to the following: Initially since the price of labour (wages) are low, they have to put in extra effort to maintain/ attain a particular standard of living. As a result they are willing to work more and supply more labour, as the price (wages) increases. Once their expected standard of living is attained (which is at point ‘A’, then with further increase in prices (wages) they prefer to supply lesser labour (work less) and have more leisure time.Hence, beyond ‘A’ with further increase in price (wages) the supply of labor begins to decline instead of increasing. 2. The case of perishable goods In the case of perishable goods like fruits and vegetables, the supply goes on increasing even when the price is declining. This happens especially in the harvest season, since all the farmers bring their produce to the market, and with every passing day the supply goes on increasing. Hence, the producers compete among themselves to sell more and this leads to a fall in price. If they do not sell at the existing price, the product will go bad (in a day or two) and they will not be able to command even the ongoing price in the market, since there would be more fresh stock that would have arrived in the market. As a result, the supply goes on increasing as the prices go on declining; you must recall that the prices of tomatoes had crashed about 2 years back and they were being sold at Rs. 3 a kg. 3. The case of monopoly In the case of Monopoly, the Monopolist may not increase the supply even if the prices are increasing. This could be his strategy of charging a higher price. If the supply increases, the prices may go down, hence, he is better of charging higher price and supplying lesser quantity. Since the monopolist is making good profit by selling lesser quantity, he need not increase the supply even as prices rise. 4. The case of Stock Clearance Sometimes firms have to clear the old stock in order to make space for the new stock. Discounts maybe offered and the supply goes on increasing even at lower prices till the stocks last. Firms have to do this to continue the production process, if they do not then there would be no place to keep the new stock. As a result they may be forced to stops production, hence, it is obviously better to sell off the old stock at a lower price. 5. The case of closure of firm If a firm decides to close down, it would prefer to sell all its inventory. In this case, they would sell the inventory at takeaway prices and supply everything that is available. The idea is they would make at least some money from the inventory that is available. 6. The case of Monetization There are cases where firms are in dire need of liquid cash. One way to do this is to monetize on the products manufactured. In such cases the firm would be willing to sell of everything at lower prices, hence, supply goes on increasing as prices decline. Elasticity of supply Elasticity of Supply measures the degree of responsiveness of the quantity supplied due to a change in the price of a product or service. This is similar to the case of elasticity of demand that we had done earlier. Here, we are able to measure the magnitude of the change in supply as a result of a change in the price of the commodity The formula for elasticity is given as: 𝑄2 − 𝑄1 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑄1 𝐸𝑠 = = 𝑃2 − 𝑃1 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑃1 𝑄2 − 𝑄1 𝑃1 ∆𝑄 𝑃 = ∗ = ∆𝑃 ∗ 𝑄1 𝑃2 − 𝑃1 𝑄1 1 ∆𝑄 𝑃 Thus: 𝐸𝑠 = ∆𝑃 ∗ 𝑄1 1 Where: ∆𝑄 = Change in Quantity Supplied ∆𝑃 = Change in Price 𝑃1 = Initial Price 𝑄1 = Initial Quantity Supplied Market A market is a place for the interaction between buyers and sellers of a good (or service) at a mutually agreed upon price. Such interaction may be at a place/ over telephone/ through the Internet. Sellers and buyers may or may not meet each other personally. Thus, market may be defined as a place, a function, a process. Market equilibrium The Market Equilibrium is the point where the Demand Curve and the Supply Curve meet and the equilibrium Price and Quantity is Determined. It is a point at which no seller or no buyer will have any incentive to demand more or supply sell, hence the market clears out. The demand curve It is a relationship between price & quantity demanded. Law of Demand states that there is an inverse relationship between the price and quantity demanded. When price goes up quantity demanded goes down and vice-versa. The relationship between the price of a good and the quantity demanded of a good by the entire Market. Figure: Market demand curve As shown in the graph, the market demand curve is the vertical addition of all the individual demand curves. Also, the market demand curve is a downward sloping curve, indicating an inverse relationship between the price of the good (or service) and the quantity demanded of the good (or service). The supply curve shows the relationship between price & quantity supplied. The Law of Supply states that there is a direct relationship between the price and quantity supplied. When price goes up quantity supplied also goes up and vice-versa. Figure: Market supply curve As shown in the graph, the market supply curve is the vertical addition of all the individual supply curves. Also, the market supply curve is an upward sloping curve, indicating a direct relationship between the price of the good (or service) and the quantity supplied of the good (or service). Market equilibrium: Market Equilibrium is a situation where the quantity supplied is exactly equal to the quantity demanded at a particular price. Equilibrium Price is the price that balances the quantity supplied and quantity demanded Equilibrium Quantity is the quantity supplied and the quantity demanded at the equilibrium price. Market Equilibrium Graph Figure: Market Equilibrium Graph As shown in the graph in the market equilibrium graph, the demand curve is downward sloping. The supply curve is upward sloping. The point where the two curves meets is the Market Equilibrium ‘E’. P is the equilibrium Price. Q is the equilibrium quantity. The case of Excess Demand Figure: Graph of Excess Demand If the price is Lower than the equilibrium price ‘P2’ for some reason (as shown in the graph). This will cause the demand to increase (since the price is lower) and the supply to decrease – leading to a case of Excess Demand. Since the Demand is greater than the Supply, the price will start to rise upward to reestablish equilibrium at Price ‘P’. Case of Excess Supply If the price is greater than the equilibrium price ‘P1’ for some reason (as shown in the graph). This will cause the supply to increase (since the price is higher) and the demand to decrease – leading to a case of Excess Supply. Since the Supply is now greater than the Demand, the price will start to fall downward to reestablish equilibrium at Price ‘P’ Market Structures As shown in the graphs, there are two approaches to determining the Profit maximizing equilibrium of a firm: MR & MC Approach Figure: MR and MC approach – MR = MC (necessary condition) – MC cuts MR from below (Sufficient Condition) The point determined by the above conditions gives us the profit maximizing level of output. At the profit maximizing level of output, the same line needs to be extended upwards to the AR line to determine, whether the firm is making profits or losses (if it does not make sense now, just let it be as it will be covered later when we do Market Structures in detail) TR & TC approach Figure: TR and TC approach The place where the Gap between TR & TC is Maximum, gives us profit maximizing level of output. We generally use the MR & MC approach for determining the equilibrium of a firm. The Perfect Competition Market Structure A Perfect Competition Market is one in which there are large number of buyers and sellers, selling homogenous products.Since there are large numbers of small sellers no individual seller has any control over the price and hence firms are price takers. The features of this market include: Presence of large number of buyers and sellers Freedom of entry and exit Homogeneous product Perfect knowledge/ Information Perfectly elastic demand curve Perfect mobility of factors of production No governmental intervention Price determined by market and Firm is a price taker Monopoly market structure A monopoly is a form of market in which there is a single seller for a product (good or service) which has no substitute. E.g. Indian Railway is a monopoly, since there is no other agency in the country that provides railway service. The features of this market include: Single seller No substitutes/ no close substitutes No difference between firm and industry Independent decision making Firm is regarded as a price maker Barriers to entry Price Discrimination Monopolistic Competition market structure It is a market structure where a large number of producers offer similar but not identical products. To some extent it is a combination of perfect competition and monopoly. Perfect competition because a large number of sellers are there in the market and no individual seller has control over the market, just like perfect competition. Monopolistic, because each of these sellers has some degree of control over the price, just like in monopoly. The features of this market include: Large number of buyers and sellers Heterogeneous products – A differentiated product enjoys some degree of uniqueness in the mindset of customers, be it real, or imaginary. Imperfect knowledge Selling costs exist – Advertising and Promotions cost Independent decision making  Unrestricted entry and exit Oligopoly market structure A Market which has a few dominant sellers selling differentiated or homogenous products The simplest Oligopoly is the duopoly, hence we haven’t covered it separately. Products sold may be homogenous or differentiated. There is interdependence of various firms. The features of an Oligopoly Market Structure include: Few Sellers: small number of large firms Product: identical products/ differentiated products. Entry Barriers – Huge investment requirements – Strong consumer loyalty for existing brands – Economies of scale Price and Non-price competition Interdependence between producers Kinked Demand Curve Features Perfect Monopolistic Oligopoly Monopoly Competition Competition Number of Many small Many firms A few large firms One firm firms firms Type of Homogenous Heterogenous/ Homogenous/ Single Product Differentiated Differentiated product Barriers to None None High Very High entry Control over None Slight High Very High price Non-price No Yes and very Yes and very No competition important important Comparison of all the Market Structures.