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Introduction to Economics Microeconomics The US Economy Llad Phillips 1 13. Tuesday, Nov. 12, Lecture Thirteen: “Profit maximization, market structure, and perfect competition” Reading Assignment O’Sullivan and Sheffrin, Ch. 9, “Perfect Competition: Short Run and Long Run” Ch. 6, “Market Efficiency and Government Intervention” Problems O & S Text p. 207-208: 1, 2, 3, 4, 5, 6, 7 14. Tuesday, Nov. 14, Lecture Fourteen: “Monopoly and Antitrust Policy” Reading Assignment O’Sullivan and Sheffrin, Ch. 10, “Monopoly” O’Sullivan and Sheffrin, Ch. 13, “Using Market Power: Price Discrimination and Monopoly ” Ch. 14 “Controlling Market Power: Antitrust Policy and Deregulation” Problems O & S Text Llad Phillips p. 232-3: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10 2 Your Readings and the Text’s Slide Shows Llad Phillips 3 Chapter 8 Llad Phillips 4 Outline: Lecture Fourteen The competitive firm the short run, capital fixed the long run, all factors variable The Llad Phillips monopolistic firm 5 Competitive Firm: Short Run Capital, i.e. plant and equipment are fixed hence there are diminishing returns as labor is increased, output increases but less than proportionally so labor costs, i.e. variable costs increase more rapidly than output so average variable cost, i.e. variable cost per unit of output is rising which means marginal cost is rising even faster, bringing up the average Llad Phillips 6 Short Run Average Variable Cost Curve Cost per unit of output marginal cost per unit of output average variable cost per unit of output A output Llad Phillips 7 Behavior of the competitive firm in the short run: shut down decision The firm is one of many firms Hence it has no monopoly power It takes the market price as given; if it tries to charge a higher price nobody buys its output If the market price is less than minimum average variable cost, the firm shuts down Llad Phillips 8 The Shut-Down Decision Cost per unit of output marginal cost per unit of output Average variable cost per unit of output Market price A Shutdown output s Llad Phillips output 9 Behavior of the competitive firm in the short run: the output decision If the market price is above minimum average variable cost, the firm produces It produces the output where the market price equals marginal cost So the value of a unit of output to the consumer is equal to the cost of producing that last unit (marginal cost) the only remaining question is whether the firm is making money Llad Phillips 10 The Output Decision Cost per unit of output marginal cost per unit of output average variable cost per unit of output Market price A Output produced Llad Phillips output 11 Fixed Costs Fixed costs do not vary with output, but are constant for example: rent, insurance etc. Hence average fixed costs fall as output increases This is known as spreading the overhead The sum of average fixed cost and average variable cost equals average total cost Price minus average total cost is the profit per unit of output Llad Phillips 12 Variable Cost $ Variable Cost B Fixed Cost A Fixed Cost $ per unit output Average Variable Cost, AVC Output AVC Marginal Cost, MC Average Fixed Cost, AFC Llad Phillips MC AFC Output 13 Total Cost $ Variable Cost Fixed Cost Total Cost B Variable Cost A Fixed Cost $ per unit output Average Variable Cost, AVC Output ATC AVC Marginal Cost, MC Average Fixed Cost, AFC Llad Phillips MC AFC Output 14 Average Total Cost per unit of output Cost per unit of output marginal cost per unit of output average variable cost per unit of output Market price Average total cost per unit of output A Output produced Llad Phillips Average total cost per unit of output output 15 Profit Margin Per unit of output Cost per unit of output marginal cost per unit of output average variable cost per unit of output Market price Average total cost per unit of output Profit margin A Output produced Llad Phillips Average total cost per unit of output output 16 Competitive Market Structure Firms are motivated by profits (greed) Profits equal revenue minus costs, so firms are motivated to control costs (efficiency) In the long run, profits are competed away by expansion of firms to the optimal size and by free entry of new firms (capital) attracted by the possibility of profits (role of the stock market-initial public offerings (IPO’s) Each firm is only one of many and hence is a price taker not a price setter. Thus each Llad Phillips 17 firm only adjusts output to maximize profit Behavior of the Firm Marginal cost curve is the supply curve of the firm, because price equal to marginal cost maximizes profits Firm takes the market price, sets this price equal to its marginal cost to determine how much to produce (output decision) If marginal cost equals average total cost at this output, the firm breaks even If marginal cost exceeds average total cost at this output, the firm makes a profit (short run) Llad Phillips 18 Policy Implications of Market Structure Llad Phillips 19 Market Power and Monopoly Compare and Contrast: Competition and Monopoly Is monopoly a good thing or not? How about Microsoft, is this firm good or bad for consumers? Llad Phillips 20 Market Power & Market Structure No market power: competition many producers firms are price takers no excess profit price to consumer = long run average cost Market power: monopoly one producer monopolist is price setter monopolist makes profits at expense of the consumer Llad Phillips 21 The Brief for Competition .... and against monopoly Llad Phillips 22 Competition Competitive Industries agriculture construction Market Supply in the Short Run The Optimal Plant Size Market Supply in the Long Run Llad Phillips 23 Competitive Industries: Agriculture Product cattle corn soybeans wheat dairy products tobacco peanuts rice # of Firms Producing 1176346 789326 441899 352237 162555 136682 18905 12013 source: Census of Agriculture, 1987 Llad Phillips 24 Competitive Industries Product # of Firms Producing contract construction 1951509 apparel 22872 millwork, plywood 7930 household furniture 5606 book publishers 2856 computer/office Equip 2134 knitted textiles 2130 iron/steel foundry Pdt 1231 footwear 479 petroleum refining 331 sources: Census of Manufactures, 1987 Census of Construction Industries, 1987 Llad Phillips 25 Short Run: Firm Supply and Market Supply Plant Size of a firm is fixed Llad Phillips 26 Short Run Market Supply: Two Firm Industry MC, AVC MCII MCI AVCI QI Llad Phillips Market Supply AVCII QII QI + QII Quantity 27 Market Supply and Demand in the Short Run MC, Market Price pM Consumer Demand QM Llad Phillips Supply Quantity 28 MC, AVC, ATC PM Short Run Market Supply: Two Firm Industry ATCI MCII MCI AVCI ATCII AVCII Market Supply Market Demand Quantity QI QII QI + QII In the short run, both firms are making excess profits. This may motivate them to find the lowest cost size for plant and equipment. Llad Phillips 29 Chapter 9, Figure 9-02 Llad Phillips 30 Short Run* World Supply: Copper Country Marginal Cost Zaire 0.49 $ per # Zambia 0.54 $ per # Chile 0.58 $ per # US 0.68 $ per # Peru 0.79 $ per # Canada 0.88 $ per # Metric Tons, 000 560.0 363.0 1356.4 1007.3 397.2 724.4 * Existing Mines Fixed Source: Minerals Yearbook, 1985 Llad Phillips 31 Short Run Supply of World Copper, 1985 . 0.9 Canada 0.8 Peru Marginal Cost, $ per # . 0.7 US 0.6 Chile 0.5 Zaire 0.4 Zambia 0.3 0.2 0.1 0 0 1000 2000 3000 4000 5000 Production, T housands of Metric Tons . Llad Phillips 32 Short Run Supply of World Copper, 1985 . 0.9 Canada 0.8 Peru Marginal Cost, $ per # . 0.7 US 0.6 Chile 0.5 Zaire 0.4 Zambia 0.3 Demand for copper in a recession 0.2 0.1 0 0 1000 2000 3000 4000 5000 Production, T housands of Metric Tons . Llad Phillips 33 Long Run What is the optimal plant size? constant returns to scale: inputs and output increase proportionally increasing, then decreasing returns increasing returns to scale Llad Phillips 34 Competitive Markets In the long run, resources will flow to a competitive market if firms are making excess profits new firms will enter the industry if returns to scale are constant, then price will be driven down to long run average total cost if returns to scale first increase and then decrease, price will be driven down to minimum long run average cost Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Profits are driven to Zero LladExcess Phillips 35 Optimal Size of the Firm: Constant Returns to Scale MC, , ATC pM SMCI SATCI SMCII SATCII LATC, LMC Quantity If market price is above long run marginal cost, the firm will make the same excess profit per unit of output in a large plant as in a small plant. The firm may prefer larger to smaller. As long as firms are making excess profits, other firms will enter the industry, increasing supply, and driving price down to LMC. Llad Phillips 36 Long Run Equilibrium Supply with the Free Entry of Firms: Constant Returns to Scale Market Price Demand Short Run Supply Supply after Entry of Profit Seeking Firms PM PM = LMC = LATC Long Run Supply Quantity Llad Phillips 37 Long Run Equilibrium Supply with the Free Entry of Firms: Constant Returns to Scale Market Price PM Demand Increased Short Run Supply demand Supply after Entry of Profit Seeking Firms Increased supply PM = LMC = LATC Long Run Supply Quantity Llad Phillips 38 Optimal Size of the Firm: Constant Returns to Scale MC, , ATC SMCI SATCI SMCII SATCII LATC, LMC pM Quantity If market price is above long run marginal cost, the firm will make the same excess profit per unit of output in a large plant as in a small plant. The firm may prefer larger to smaller. As long as firms are making excess profits, other firms will enter the industry, increasing supply, and driving price down to LMC. Llad Phillips 39 Chapter 9, Figure 9.10 Llad Phillips 40 Optimal Size of Plant with Variable Returns to Scale LMC LATC Market LATC Price SMCIV SATCI SATCIV SATCII SMCIII pM SATCIII Quantity If market price is above long run average cost, then firms with efficient scale of plant, SATCIII ,will make an excess profit. In the long run other firms in the industry will move to this efficient size plant. As long as there are excess profits to be made, new firms will enter the industry, driving market price down to minimum Llad Phillips 41 long run average total cost, LATC. Competitive Markets In the long run, resources will flow to a competitive market if firms are making excess profits new firms will enter the industry if returns to scale are constant, then price will be driven down to long run average total cost if returns to scale first increase and then decrease, price will be driven down to minimum long run average cost Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Profits are driven to Zero LladExcess Phillips 42 Natural Monopoly Increasing Returns to Scale optimal larger is better Constant Returns to Scale optimal LAC size of the firm size of the firm: indeterminate = LMC = same at all outputs Increasing then Decreasing Returns to Scale optimal size of the firm: minimum LAC minimum Llad Phillips LAC where LAC = LMC 43 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better Price LATC SATCI SATCII LATC Quantity LMC Llad Phillips 44 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better Price LATC SATCI SATCII LATC Quantity LMC Price Price equal marginal cost Llad Phillips 45 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better Price LATC SATCI SATCII Price Subsidy Llad Phillips LATC Quantity LMC 46 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better Price LATC SATCI SATCII Regulated Price Llad Phillips LATC Quantity LMC 47 Market Power: Size in 1994 Country Sweden Corporation GDP, $B Sales, $B 169 GM 155 Taiwan 150 Ford 129 Norway 105 Exxon 101 Toyota 95 Hong Kong 91 Wal-Mart 83 ATT 75 Llad Phillips source: World Bank & Fortune 500 48 Market Power: Market Share Product inst. breakfast tennis balls disp. diapers breakfast cereal video game player cameras, film car rental credit cards beer detergent records & tapes Llad Phillips Firms Mkt Shr Carnation, Pillsbury 100/3 Gen Corp, Pepsico 100/4 P&G, Kimberly 99/4 Kellogg, Gen Mills 98/4 Nintendo, Sega 98/2 Kodak, Polaroid Hertz, Avis VISA, MasterCard Anheuser-Busch P&G, Lever Bros Time-Warner, Sony 98/4 95/4 92/3 90/4 86/3 77/4 49 Monopoly Technology: Natural Monopoly Increasing output Returns to Scale increases more than proportionally with inputs i.e. cost per unit of output falls with increasing output Monopoly sets price to maximize profits exploits consumers wastes resources Llad Phillips 50 How does a monopolist use power to maximize profits? marginal principle: increase output until marginal revenue = marginal cost Llad Phillips 51 Price Monopoly Sales Price $10 Market Demand A B 0 0 10 9 8 7 6 5 4 3 2 1 0 Quantity 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 Revenue 0 9000 18000 21000 24000 25000 24000 21000 18000 9000 0 Marginal Revenue 9000 9000 3000 3000 1000 -1000 -3000 -3000 -9000 -9000 Quantity Revenue $25,000 A 0 B Llad Phillips Quantity 52 Monopoly Profits with Increasing Returns to Scale Price Market Demand MR Llad Phillips Quantity 53 Increasing Returns to Scale and Long Run Total Costs $ Long Run Total Costs Quantity Llad Phillips 54 Maximum Monopoly Profits: Marginal Revenue = Marginal Cost $ LTC R Revenue LTC Quantity $ Excess Profit 0 Llad Phillips Quantity 55 Monopoly Profits with Increasing Returns to Scale Price LATC Market Demand PM MR LATC Quantity LMC Q Llad Phillips 56 Chapter Ten, Figure 10.6 Llad Phillips 57 Monopoly Profits with Increasing Returns to Scale Price LATC Market Demand PM Regulated price MR LATC Quantity LMC Q Regulated price satisfies demand and covers costs Llad Phillips 58 Chapter Ten, Figure 10.8 Llad Phillips 59 Social Policy If returns to scale are constant regulate or break up monopoly make the monopolist charge a price equal to marginal cost • obtain the competitive solution If returns to scale are increasing regulation is not so easy can not set monopolist’s price equal to marginal cost: monopolist will suffer losses • because marginal cost is less than average cost could socialize the industry and the government could subsidize the losses could live with monopoly Llad Phillips set price where average cost crosses demand 60 The Social Cost of Monopoly: Example, Constant Returns to Scale Competition Monopoly Market Demand Market Demand Consumer Surplus LATC = LMC PM LATC = LMC PM MR QCOMP QMONOP Under monopoly, consumers pay a higher price and consume less Llad Phillips 61 The Social Cost of Monopoly: Example, Constant Returns to Scale Competition Monopoly Market Demand Market Demand Consumer Surplus Dead Weight Loss PM Profit PM LATC = LMC LATC = LMC MR QCOMP QMONOP Under monopoly, some consumer surplus is redistributed to the monopolist Llad Phillipsas profit, and some is lost to society 62 Society How can we control it? Regulation, Franchises, Patents Higher Prices Less Goods Excess Profits MONOPOLY POWER Political Influence Strategic Planning Entrepreneurs Llad Phillips How do we get it? 63 Advertising Cost of a Car company Mercedes Nissan Toyota GM Chrysler Ford $ per sale TV, $M, ‘91 620 435 381 198 198 123 49 267 403 978 335 408 source: Fortune Llad Phillips 64 Strategic Action: Advertising Company Proctor & Gamble Philip Morris General Motors Ford Motor Co. Sears, Roebuck AT&T PepsiCo Chrysler Disney Johnson & Johnson Advertising, ‘94: $B 2.7 2.4 1.9 1.2 1.1 1.1 1.1 1.0 0.9 0.9 source: Advertising Age Llad Phillips 65 Classification of US Industry Sector % Pvt Domestic Output Ag, Forestry & Fishg 1.9 Mining 0.9 Construction 5.3 Manufacturing 21.0 Transport, Commun 8.6 Wholesale Trade 6.8 Retail Trade 10.2 Finance, Insur, Real 18.6 Services: Pers & Bus 26.8 Total 100.0 source: Survey of Current Business Llad Phillips 66 The Brief for Monopoly Increasing productivity, i.e. GDP per capita capital deepening, i.e. capital per worker technological change, Research and Development Where does the saving for investment come from? a. consumers? b. firms monopoly c. government research d. Llad Phillips profits and development international 67 The Brief for Microsoft The case for monopoly: Joseph Schumpeter Growth is the key to social welfare Large and growing firms reinvest profits in future growth capital deepening Large and growing firms have the resources to invest in research and development technological Llad Phillips change improves productivity 68 The Brief for Microsoft Industry with Rapidly Changing Technology Monopoly is Using Market Power to Preserve the Status Quo creating Silicon Valley Attracts Brain Power and Venture Capital new and fortifying barriers to entry firms and new technologies So, the Nature of Microsoft’s Industry Was Competition and Change Llad Phillips 69 The Brief for Microsoft Consumers have not been hurt by Microsoft In contrast, consumers have benefited Any market power Microsoft has is tenuous in the rapidly growing and changing software industry Llad Phillips 70 Summary-Vocabulary-Concepts average variable cost marginal cost average fixed cost average total cost price taker firm’s break even point firm’s shut down point competitive industries short run long run Llad Phillips free entry natural monopoly market share marginal revenue monopoly profit regulation of monopoly social cost of monopoly consumer surplus dead weight loss brand names strategic planning 71
