Analysis of Perfectly Competitive Markets

A. Supply Behavior of the Competitive Firm

1. A perfectly competitive firm sells a homogeneous product and is too small to affect the market price. Competitive firms are assumed to maximize their profits. To maximize profits, the competitive firm will choose that output level at which price equals the marginal cost of production, that is, P = MC. Diagrammatically, the competitive firm's equilibrium will come where the rising MC supply curve intersects its horizontal demand curve.


2. Variable costs must be taken into consideration in determining a firm's short-run shutdown point. Below the shutdown point, the firm loses more than its fixed costs. It will therefore produce nothing when price falls below the shutdown price.


3. A competitive industry's long-run supply curve, S_L S_L, must take into account the entry of new firms and the exodus of old ones. In the long run, all of a firm's commitments expire. It will stay in business only if price is at least as high as long-run average costs. These costs include out-of-pocket payments to labor, lenders, material suppliers, or landlords and opportunity costs, such as returns on the property assets owned by the firm.

Analysis of Costs

A. Economic Analysis of Costs

1. Total cost (TC) can be broken down into fixed cost (FC) and variable cost (VC). Fixed costs are unaffected by any production decisions, while variable costs are incurred on items like labor or materials which increase as production levels rise.


2. Marginal cost (MC) is the extra total cost resulting from 1 extra unit of output. Average total cost (AC) is the sum of ever-declining average fixed cost (AFC) and average variable cost (AVC). Short-run average cost is generally represented by a U-shaped curve that is always intersected at its minimum point by the rising MC curve.


3. Useful rules to remember are
   
   

Production and Business Organization

A. Theory of Production and Marginal Products

1. The relationship between the quantity of output (such as wheat, steel, or automobiles) and the quantities of inputs (of labor, land, and capital) is called the production function. Total product is the total output produced. Average product equals total output divided by the total quantity of inputs. We can calculate the marginal product of a factor as the extra output added for each additional unit of input while holding all other inputs constant.


2. According to the law of diminishing returns, the marginal product of each input will generally decline as the amount of that input increases, when all other inputs are held constant.


3. The returns to scale reflect the impact on output of a balanced increase in all inputs. A technology in which doubling all inputs leads to an exact doubling of outputs displays constant returns to scale. When doubling inputs leads to less than double (more than double) the quantity of output, the situation is one of decreasing (increasing) returns to scale.

Demand and Consumer Behaviour

1. Market demands or demand curves are explained as stemming from the process of individuals' choosing their most preferred bundle of consumption goods and services.


2. Economists explain consumer demand by the concept of utility, which denotes the relative satisfaction that a consumer obtains from using different commodities. The additional satisfaction obtained from consuming an additional unit of a good is given the name marginal utility, where "marginal" means the extra or incremental utility. The law of diminishing marginal utility states that as the amount of a commodity consumed increases, the marginal utility of the last unit consumed tends to decrease.


3. Economists assume that consumers allocate their limited incomes so as to obtain the greatest satisfaction or utility. To maximize utility, a consumer must satisfy the equimarginal principle that the marginal utilities of the last dollar spent on each and every good must be equal.
   

Basic Elements of Supply and Demand

1. The analysis of supply and demand shows how a market mechanism solves the three problems of what, how, and for whom. A market blends together demands and supplies. Demand comes from consumers who are spreading their dollar votes among available goods and services, while businesses supply the goods and services with the goal of maximizing their profits.

A. The Demand Schedule

2. A demand schedule shows the relationship between the quantity demanded and the price of a commodity, other things held constant. Such a demand schedule, depicted graphically by a demand curve, holds constant other things like family incomes, tastes, and the prices of other goods. Almost all commodities obey the law of downward-sloping demand, which holds that quantity demanded falls as a good's price rises. This law is represented by a downward-sloping demand curve.


3. Many influences lie behind the demand schedule for the market as a whole: average family incomes, population, the prices of related goods, tastes, and special influences. When these influences change, the demand curve will shift.

The Modern Mixed Economy

A. The Market Mechanism

1. In an economy like the United States, most economic decisions are made in markets, which are mechanisms through which buyers and sellers meet to trade and to determine prices and quantities for goods and services. Adam Smith proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. And while markets are far from perfect, they have proved remarkably effective at solving the problems of how, what, and for whom.


2. The market mechanism works as follows to determine the what and the how: The dollar votes of people affect prices of goods; these prices serve as guides for the amounts of the different goods to be produced. When people demand more of a good, its price will increase and businesses can profit by expanding production of that good. Under perfect competition, a business must find the cheapest method of production, efficiently using labor, land, and other factors; otherwise, it will incur losses and be eliminated from the market.


3. At the same time that the what and how problems are being resolved by prices, so is the problem of for whom. The distribution of income is determined by the ownership of factors of production (land, labor, and capital) and by factor prices. People possessing fertile land or the ability to hit home runs will earn many dollar votes to buy consumer goods. Those without property or with skills, color, or sex that the market undervalues will receive low incomes.

The Central Concepts of Economics

A. Why Study Economics?

1. What is economics? Economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. We study economics to understand not only the world we live in but also the many potential worlds that reformers are constantly proposing to us.



2. Goods are scarce because people desire much more than the economy can produce. Economic goods are scarce, not free, and society must choose among the limited goods that can be produced with its available resources.



3. Microeconomics is concerned with the behavior of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. Through all economics, beware of the fallacy of composition and the post hoc fallacy, and remember to keep other things constant.

Glossary Financial Accounting Terms

account payable an amount due for payment to a supplier of goods or services, also described as a trade creditor.

account receivable an amount due from a customer, also described as a trade debtor.

accountancy firm A business partnership (or possibly a limited company) in which the partners are qualified accountants. The firm undertakes work for clients in respect of audit, accounts preparation, tax and similar activities.

accountancy profession The collective body of persons qualified in accounting, and working in accounting-related areas. Usually they are members of a professional body, membership of which is attained by passing examinations.

accounting The process of identifying, measuring and communicating financial information about an entity to permit informed judgements and decisions by users of the information.

accounting equation The relationship between assets, liabilities and ownership interest.

accounting period Time period for which financial statements are prepared (e.g. month, quarter, year).

accounting policies Accounting methods which have been judged by business enterprises to be most appropriate to their circumstances and adopted by them for the purpose of preparing their financial statements.

accounting standards Definitive statements of best practice issued by a body having suitable authority.

Accounting Standards Board The authority in the UK which issues definitive statements of best accounting practice.

accruals basis The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate (see also matching).

accumulated depreciation Total depreciation of a non-current (fixed) asset, deducted from original cost to give net book value.

acid test The ratio of liquid assets to current liabilities.

Financial Accounting Standards

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.
Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.

Securities and Exchange Commission (SEC)
The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for
publicly traded companies.
The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC.
For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively.
The head of the SEC is appointed by the President of the United States.

When the SEC was formed there was no standards-issuing body.
However, rather than set standards, the SEC encouraged the private sector to set them.
The SEC has stated that FASB standards are considered to have authoritative support.

Committee on Accounting Procedure (CAP)

In 1939, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) formed the Committee on Accounting Procedure (CAP).
From 1939 to 1959, CAP issued 51 Accounting Research Bulletins that dealt with issues as they arose.

Closing Entries | Closing Procedure

Closing entries are journal entries used to empty temporary accounts at the end of a reporting period and transfer their balances into permanent accounts. The use of closing entries resets the temporary accounts to begin accumulating new transactions in the next period. Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period.

The basic sequence of closing entries is:

1. Debit all revenue accounts and credit the income summary account, thereby clearing out the balances in the revenue accounts.
2. Credit all expense accounts and debit the income summary account, thereby clearing out the balances in all expense accounts.
3. Close the income summary account to the retained earnings account. If there was a profit in the period, then this entry is a debit to the income summary account and a credit to the retained earnings account. If there was a loss in the period, then this entry is a credit to the income summary account and a debit to the retained earnings account.

The net result of these activities is to move the net profit or loss for the period into the retained earnings account, which appears in the stockholders' equity section of the balance sheet.

Adjusting Entries

In the accounting process, there may be economic events that do not immediately trigger the recording of the transaction. These are addressed via adjusting entries, which serve to match expenses to revenues in the accounting period in which they occur. There are two general classes of adjustments:

• Accruals - revenues or expenses that have accrued but have not yet been recorded. An example of an accrual is interest revenue that has been earned in one period even though the actual cash payment will not be received until early in the next period. An adjusting entry is made to recognize the revenue in the period in which it was earned.
• Deferrals - revenues or expenses that have been recorded but need to be deferred to a later date. An example of a deferral is an insurance premium that was paid at the end of one accounting period for insurance coverage in the next period. A deferred entry is made to show the insurance expense in the period in which the insurance coverage is in effect.

The Trial Balance

A basic rule of double-entry accounting is that for every credit there must be an equal debit amount. From this concept, one can say that the sum of all debits must equal the sum of all credits in the accounting system. If debits do not equal credits, then an error has been made. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts. The account balances are used because the balance summarizes the net effect of all of the debits and credits in an account. To calculate the trial balance, construct a table in the following format:

Debit and Credits

Debits and Credits are used to track the changes of account values. They can also be thought of as mirror opposites: Each debit to an account must be accompanied by a credit to another account (that's how the phrase "double-entry bookkeeping" gets its name). Understanding debits and credits is essential for bookkeeping and analysis of balance sheets.

Familiarize yourself with the meaning of "debit" and "credit." In bookkeeping, the words "debit" and "credit" have very distinct meanings and a close relationship. Debits and credits balance each other out —if a debit is added to one account, then a credit must be added to the an opposite account.

• In accounting, the debit column is on the left of an accounting entry, while credits are on the right.
• Debits increase asset or expense accounts and decrease liability or equity. Credits do the opposite — decrease assets and expenses and increase liability and equity.
• To make sense of this, take a look at the basic accounting equation, which is Assets = Equity + Liabilities. Assets are paid for by equity and/or liability —you cannot have one without the other. So if you complete a transaction that increases assets (and you debit the asset account), you must also increase the equity or liability (by crediting the equity or liability account) so that Assets remain equal to Equity and/or Liability.

General Ledger

While the journal lists transactions in chronological order, its format does not faciliate the tracking of individual account balances. The general ledger is used for this purpose.

The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a purely mechanical process using information already in the journal entry and requiring no additional analysis.

To understand the posting process, consider a journal entry in the following format:

General Journal Entry

Date	Accounts	Debit	Credit
mm/dd	Account 1	xxxx.xx
	Account 2		xxxx.xx

Journal Entries

After a transaction occurs and a source document is generated, the transaction is analyzed and entries are made in the general journal. A journal is a chronological listing of the firm's transactions, including the amounts, accounts that are affected, and in which direction the accounts are affected. A journal entry takes the following format:

Format of a General Journal Entry

Date	Accounts	Debit	Credit
mm/dd	account to be debited	xxxx.xx
	account to be credited		xxxx.xx

In addition to this information, a journal entry may include a short notation that describes the transaction. There also may be a column for a reference number so that the transaction can be tracked through the accounting system.