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Theory of the firm IB Cheat Sheet by

Theory of the firm IB

Main equations

Profit maximi­zation → MR = MC
Normal profit → AR = AC
Supern­ormal profit → AR > AC
Economic losses → AR < AC
Revenue maximi­zation → MR = 0
Productive efficiency → MC = AC
Allocative efficiency → MC = AR

Perfect compet­ition

Perfect compet­ition markets are those in which each firm has a small market share, They are powerless to determine price and they charge prices that are set by the market
many buyers and sellers
Freedom of entry and exit
Perfect knowledge
Homoge­neous products
Profit maximi­zation
Firms are price takers
Marginal cost: cost added by producing 1 extra unit of a product
Average cost: the average cost of each unit
Average revenue: the revenue gained per unit sold
Marginal revenue: increase in revenue from the sale of one extra unit
short run
long run
Profit maximi­zation: earn maximum profit with low costs
normal profit: difference between total revenue and costs are equal to zero
Supern­ormal profits: excess profit a firm makes above the minimum return necessary
Economic loss: circum­stances when individual or firm loses money
Revenue max: firm attempts to sell at a price that achieves the highest sales revenue
Productive efficiency: economy cant produce more of a good without sacrif­icing another good
Allocative efficiency: all goods and services are optimally distri­buted among buyers

Monopo­listic compet­ition

Structure with many small firms selling similar products
Large amount of small firms
No barriers
Large number of buyers and sellers
Product differ­ent­iation
Each firm has the same ability to set prices


Monopolies are an extreme conseq­uence of free-m­arket economics and are often used to identify an individual that has complete or near-c­omplete dominance of a market
unfair edge over their compet­itors
High barriers to entry
Price makers
Economies of scale
One dominant firm
Unique products with no close substi­tutes
High barriers
Price makers
Economies of scale
Economies of scale
Legal barriers (patents, copyright, licenses)
Control of resources
Aggressive tactics

Risks of one or few dominant firms

lack of compet­ition
Rigid prices
Higher prices
Reduced output
Reduced options for consumers


Market structure with small amount of firms and where each firm is interd­epe­ndent, creating uncert­ainty
Few dominant firms
Interd­epe­ndent firms
Homoge­neous or differ­ent­iated products
High barriers
Firms set prices
Firms in oligop­olistic compet­ition partic­ipate in various price compet­iti­veness strategies
price wars
Predatory pricing
Limit pricing
Increase consumer appetite and develop brand loyalty
collusive: agreement between firms to limit compet­ition by restri­ctive trade practices;
Non collusive: These do not collude and act indepe­ndently but are aware of other firms prices but not others decisions
Cartels: An agreement between oligop­olistic firms in the same industry to collude in fixing prices or to restrict the level of output in the market, thereby effect­ively acting as a monopo­list.
Informal collusion: Smaller firms could collude by following prices of larger firms. This limits compet­ition and sets high prices

Game theory

What a firm does if the other firm changes the price

Kinked demand curve (non collusive)

This model assumes that there will be intervals of relative price stabil­ization under inflation. Firms will not follow if prices rise

Government interv­ention to market power abuse

Legisl­ation: used to prohibit things such as takeovers or mergers that can occur among firms which would end up giving one firm more than a certain percentage of the market share.
Regulation: markets setting up anti-m­onopoly commis­sions with the purpose of invest­igating markets and ensure that monopoly power is not being used against public interests
Nation­ali­zation. when a government takes control of a private sector industry in order to run it as part of the public sector for the best interests of the public

Rational producer behaviour - profit max

Profit maximi­zation refers to the level at which a firm will produce the greatest amount of profit this is the output level at which marginal costs equal marginal revenue.
TR - TC → Profit is maximum at the level of output where TR - TC is greatest
MR = MC → Profit is maximum at the level of output where MR = MC.
Abnormal profit → AR > AC
Normal profit → AR = AC
Losses → AR < AC

Degrees of market power

Market power refers to the ability a firm has to increase its profits by setting a price that is higher than the marginal cost.
Degree of market power: The degree to which an individual firm is able to set prices will determine how compet­itive the market is
Economies of scale and investment
Research and develo­pment and innovation
The natural monopoly justif­ication
Monopo­listic corpor­ations as agents of common good


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