Download Microeconomics 1 Chapter 2: Production, costs, demand and profit

Microeconomics 1
Chapter 2: Production, costs, demand and profit maximization
2.1 Introduction
Short run: some inputs are variable and others are fixed.
Long run: all inputs are variable.
Law of Diminishing Returns: governs the short-run relationship between inputs, output and
production costs (also called Law of Diminishing Marginal Product).
(Dis)economies of scale: governs the long-run relationship between inputs, output and production
costs.
Price elasticity of demand: standard measure of the responsiveness of quantity demanded to a
change in price.
2.2 Production and costs
General expression for the long run production function of a firm that uses a labour and a capital
input: q = f(L, K)
L = units of labour employed (short-run variable) | K = units of capital employed (short-run fixed,
long-run variable) | q = units of output produced.
Short run production function: q = g(L)
2.2.1 Short-run production and costs
Production theory
As increasing quantities of labour are used together with a fixed quantity of capital, eventually the
additional contribution that each successive unit of labour makes to total output starts to decline.
Marginal Product of Labour (MPL): the quantity of additional output the firm obtains by
employing each additional worker. The marginal contribution to total output of the last worker
employed.
Average Product of Labour (APL): the ratio of total output to quantity of labour employed. The
average output per worker.
As more and more workers are employed, the point is eventually reached when each additional
worker’s contribution to total output start’s to fall. Once the full contingent of workers that the factory
can comfortably accommodate and occupy has been hired, employing even more workers will not
result in very much more output = the law of diminishing (verminderende) returns.
Relationship MPL and APL:
 APL is increasing whenever MPL > APL: if the marginal contribution to total output of the last
worker employed is higher than the average output per worker, the last worker must be
pulling the average up;
 APL is decreasing whenever MPL < APL: if the marginal contribution to total output of the last
worker employed is lower than the average output per worker, the last worker must be
pulling the average down;
 APL reaches maximum value at MPL = APL.
Cost theory
Owners of a business will soon contemplate the closure of the business if the reward or profit from
such a personal investment is insufficient to compensate them for their own time and effort and
match the opportunity cost of the financial investment.
Opportunity cost: the return that owners could have achieved if they had invested their financial
resources elsewhere.
Normal profit: the reward the firm’s owners require in order to remain in business.
Abnormal profit: any additional return over and above the normal profit.
* Abbreviations:
 Marginal Product of Labour = MPL;
 Average Product of Labour = APL;
 Variable cost = VC;
 Fixed cost = FC;
 Average variable cost = AVC;
 Average fixed cost = AFC;






Short-run total cost = SRTC;
Short-run marginal cost = SRMC;
Short-run average cost = SRAC;
Long-run total cost = LRTC;
Long-run marginal cost = LRMC;
Long-run average cost = LRAC.
Marginal cost: additional cost the firm incurs in order to produce one additional unit of output.
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑖𝑛𝑔 𝑒𝑎𝑐ℎ 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑤𝑜𝑟𝑘𝑒𝑟
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡:
𝑡ℎ𝑒 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑏𝑦 𝑒𝑎𝑐ℎ 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑤𝑜𝑟𝑘𝑒𝑟 (𝑀𝑃𝐿)
When MPL is rising, SRMC is falling. But once diminishing returns set in MPL is falling and SRMC is
rising. The increase in SRMC beyond this point is a direct consequence of the Law of Diminishing
Returns. As each additional worker employed becomes less productive, the cost to the firm of
producing each additional unit of output inevitably increases.
𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡:
𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
When APL is rising, AVC is falling, but when APL starts falling, AVC is rising: if the average productivity
of labour is rising, the average labour cost incurred per unit of output produced must be falling.
AFC falls as q increases.
𝑆ℎ𝑜𝑟𝑡 𝑟𝑢𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡: 𝐴𝑉𝐶 + 𝐴𝐹𝐶
As q increases, a point is eventually reached at which the downward pull of AFC on SRAC is exceeded
by the upward pull of AVC on SRAC. Before this point SRAC is decreasing and after SRAC is increasing.
Relationship AVC and SRMC:
 If the marginal cost of producing the last unit of output is lower than the average labour cost
per unit of output (SRMC < AVC), the cost of producing the last unit must be bringing the
average down: AVC is decreasing;
 If the marginal cost of producing the last unit of output is higher than the average labour cost
per unit of output (SRMC > AVC), the cost of producing the last unit must be pulling the
average up: AVC is increasing;
 AVC reaches it minimum value at SRMC = AVC.
2.2.2 Long-run production and costs
In the long run, the firm has the opportunity to overcome the short-run constraint on production that
is imposed by the Law of Diminishing Returns, by increasing its usage of all inputs: it can alter the
scale of production.
Returns to scale: governs the long-run relationship between the firm’s inputs and output. Three
types of returns to scale:
 Increasing returns to scale: occurs when output increases more than proportionately to
the increase in inputs. A doubling of all inputs leads to more than a doubling of output:
economies of scale;
 Constant returns to scale: occurs when output increases proportionately with an increase
in inputs. A doubling of all inputs leads to a doubling of output;
 Decreasing returns to scale: occurs when output increases less than proportionately to the
increase in inputs. A doubling of all inputs leads to less than a doubling of output:
diseconomies of scale.
LRAC: the lowest cost of producing any given output level when the firm can vary both the capital and
labour inputs in the long run.
Only if the firm selects the output level on the lowest point on LRAC does it also operate at the
minimum point on the corresponding SRAC function.
The firm’s total cost and LRAC functions can also be derived more directly from the production
function, using the apparatus of isoquants and isocost functions. This apparatus emphasizes the fact
that in order to produce any given quantity of output at the lowest possible cost, the firm needs to
select the most cost-effective combination of inputs. There’s both a technological dimension and an
economic dimension to the firm’s decision as to its choice of inputs.
See figure 2.6 on page 33 !
Production function: q = f(K, L)
Isoquant for q units of output: K = h(L, q)  identifies a relationship between all the combination of
L and K that could be combined in order to produce q units of output.
Each isocost function shows all combinations of L and K the firm can hire which incur an identical
total cost. The position and slope of the isocost functions depend on the prices per unit of L and K,
which can be denoted w (wage rate per unit of labour) and r (rental per unit of capital).
Relationship LRAC and LRMC:
 LRAC is decreasing when LRMC < LRAC. If the marginal cost of producing the last unit of
output is lower than the average cost per unit of output, the cost of producing the last unit
must be pulling the average down: economies of scale;
 LRAC is increasing when LRMC > LRAC. If the marginal cost of producing the last unit of
output is higher than the average cost per unit of output, the cost of producing the last unit
must be pulling the average up: diseconomies of scale;
 LRAC reaches its minimum value at LRMC = LRAC: constant returns to scale.
Economies of Scale
Two sorts of economies of scale:
 Real;
 Pecuniary (financieel).
As a firm increases its scale of production, it can benefit from specialization through a greater division
of labour or management  average costs are reduced.
Real economies of scale
Savings in average costs due to changes in the quantities of physical inputs.
Arise from various technological relationships between inputs and output that underlie the firm’s longrun production function:
 Large-scale production may simply be more cost-effective than small-scale production;
 Indivisibilities of capital and labour inputs: as the scale of production increases, the total cost
of each indivisible input is spread over a larger volume of output  average costs fall;
 Learning economies are another important source of cost savings. Over time, workers and
managers become more skilled as they repeat the same tasks  the length of the production
is an important determinant of the extent to which the firm may benefit from learning
economies;
 Geometric relationships between inputs and outputs can result in cost savings as the scale of
production increases. Costs may be proportional to surface area while outputs are
proportional to volume.
Pecuniary economies of scale
Savings in average costs due to changes in the prices paid by the firm for its inputs or factors of
production.
Arise if large firms find it easier than small firms to raise finance:
 Stronger security guarantees;
 Access to sources of finance unavailable to small firms;
 Lenders may believe a large firm poses a lower risk, because it can spread risks;
 Reputation.
Large firms can buy and sell in bulk: purchasing and marketing economies. Discounts for large-scale
orders, favourable terms or service to a large-scale producer.
Large firm can benefit from using large-scale forms of advertising (tv).
Large firms can realize transport economies, by operating separate plants that produce and sell in
different regions.
All above economies of scale (real and pecuniary) are internal economies of scale: cost savings are
generated directly by the firm through its own decision to increase its scale of production.
External economies of scale: cost savings that are generated through the expansion of all of the
industry’s member firms collectively. The size of an industry increases. As the scale of the industry’s
aggregate production increase, external economies of scale tend to reduce average costs for all of the
industry’s member firms, large and small.
Diseconomies of scale
Arise when long-run average costs tend to increase as output increases for plants or firms operating
beyond a certain scale.
Managerial diseconomies arise from difficulties encountered in managing large organizations
effectively. Sources:
 Strained communications between different tiers of management, or between different parts
of the organization in general;
 Long chains of command and complex organizational structures;
 Low morale among the workforce, who may sense a lack of personal involvement or interest
in the performance of the organization;
 Poor industrial relations, due to the complexity of relationships between the workforce and
management, or between different groups of workers.
Williamson: much of the firm’s activity requires teamwork  opportunistic behaviour like shirking or
free-riding  need to monitor the performance, this is traditionally the role of the entrepreneur, but
now it has been replaced by salaried managers  hierarchical structure, with on top the firm’s
owners.
Essential function of hierarchy: handle, transmit and process or interpret information as it flows
between different levels of the organization. Two distortions:
 Deliberate distortion (information impactedness), occurs when managers, supervisors and
team members at lower levels misrepresent their efforts or abilities, so as to appear in the
best possible light;
 Accidental distortion (serial reproduction), occurs whenever information has to flow through
many channels.
If decision makers do not have access to accurate information, errors tend to occur and the firm’s
average cost tends to increase.
As the firm/plant expands, transport costs may tend to increase. Maybe the firm has to ship their
materials in from further away, or, in order to find sufficient customers, the firm’s end product may
need to be transported further away.
External diseconomies of scale might also arise, if the expansion of all of the industry’s member firms
causes all firms’ average costs to increase. This could happen if growth of the industry leads to
shortages of raw materials or specialized labour, putting upward pressure on the costs of these
essential factors of production.
The development of decentralized organizational structures, with managers of separate divisions
within the firm given considerable individual responsibility and decision-making autonomy, can be
interpreted as an attempt to avoid managerial diseconomies that might otherwise arise under a
structure of excessive centralized control.
Economies of scope
Cost savings that arise when a firm produced two or more outputs using the same set of resources.
Diversification causes average costs to fall if the total cost of producing several goods or services
together is less than the sum of the costs of producing them separately.
Economies of scope can be realized by:
 Bulk-purchasing inputs that are used in the production of several different products;
 Spreading the costs of specialist functions over a range of products or services.
Important source: computing and telecommunications.
Minimum efficient scale (MES)
The output level beyond which the firm can make no further savings in LRAC through further
expansion. MES is achieved when all economies of scales are exhausted.
Firms encounter constant returns to scale over all possible output levels they can choose. It is
sometimes convenient to simplify the assumed cost structure by ignoring (dis)economies of scale. The
LRAC and LRMC functions are identical and horizontal.
For any firm seeking to minimize its costs over the long term, it is important to be able to identify the
shape of the LRAC function, or at least identify the output level at which MES is achieved and all
possible cost savings arising from economies of scale have been realized.
See figure 2.8 on page 39 !
2.3 Demand, revenue, elasticity and profit maximization
2.3.1 Demand, average revenue and marginal revenue
Market demand function for a product/service shows the relationship between market price and
the number of units of the product or service consumers wish to but at that price.
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒: 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒:
=
= 𝑝𝑟𝑖𝑐𝑒
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Average revenue shows the average revenue per unit of output sold.
Marginal revenue shows the additional revenue generated by the last unit of output sold.
Δ𝑇𝑅
1
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 =
= 𝑃 (1 −
)
Δ𝑄
𝑃𝐸𝐷
2.3.2 Elasticity
Price elasticity of demand (PED)
 If the (positive) quantity effect dominates the (negative) price effect, TR increases as P falls;
 If the quantity effect just balances the price effect, TR remains unchanged as P falls;
 If the quantity effect is dominated by the price effect, TR decreases as P falls.
The effect of a reduction in P on TR depends upon the responsiveness of quantity demanded to a
change in price. Price elasticity of demand provides a convenient measure of this responsiveness.
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 Δ𝑄
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑖𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑:
=
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Δ𝑃
The values P and Q are usually taken as the values midway between the two points on the market
demand function over which PED is being calculated.
ΔQ 𝑃
𝑃𝐸𝐷:
Δ𝑃 𝑄
Mathematical notation: |PED|=|-2|=2
 If |PED| > 1, TR increases as P falls. The quantity effect dominates the price effect. The
demand function is price elastic. Quantity demanded is sensitive to the change in price;
 If |PED| = 1, TR remains unchanged as P falls. The quantity effect just balances the price
effect. The demand function exhibits unit price elasticity;
 If |PED| < 1, TR decreases as P falls. The quantity effect is dominated by the price effect. The
demand function is price inelastic. Quantity demanded is insensitive to the change in price.
 If |PED| > 1, 1/|PED|<1 and MR > 0. When the demand function is price elastic, MR > 0;
 If |PED| = 1, 1/|PED|=1 and MR = 0. When the demand function exhibits unit elasticity, MR
= 0;
 If |PED| <1, 1/|PED|>1 and MR < 0. When the demand function is price inelastic, MR < 0.
It is possible to define price elasticity of demand at market and at firm level. In a competitive market
in which an identical product is sold by many firms, there might be a big difference between the
sensitivity of the total quantity demanded to a change in the market price (all firms make the same
price adjustment) and the change in its own price (other firms keep their prices unchanged).
Price elasticity of demand is only one of several elasticity’s used by economists to measure the
sensitivity of one variable to changes in other variable.
Cross-price elasticity of demand (CED)
Measures the sensitivity of the quantity demanded of Good 1 to a change in the price of Good 2. It
provides an indication of whether Good 1 and 2 are substitutes or complements in consumption,
or whether the demand for Good 1 is unrelated to the price of Good 2.
ΔQ1 𝑃2
𝐶𝐸𝐷:
𝑥
Δ𝑃2 𝑄1
 If CED > 0, an increase in P2 leads to an increase in Q1  Goods 1 and 2 are substitutes: as
the price of Good 2 increases, consumers tend to switch to Good 1;
 If CED < 0, an increase in P2 leads to a decrease in Q1  Goods 1 and 2 are complements:
as the price of Good 2 increases, consumers also reduce their consumption of Good 1;
 If CED = 0, an increase in P2 has no effect on Q1  Goods 1 and 2 are neither substitutes
nor complements: the demand for Good 1 is independent of the price of Good 2.
Advertising elasticity of demand (AED)
Measures the sensitivity of quantity demanded to a change in advertising expenditure.
AED is a measure of the effectiveness of advertising. Normally it should be positive: increase in
advertising  increase in quantity demanded. AED might be an important indicator of the level of
resources the firm should allocate to its advertising budget.
AED = large  advertise heavily.
AED = small  look for alternative methods of increasing the demand for the product.
ΔQ 𝐴
𝐴𝐸𝐷:
𝑥
Δ𝐴 𝑄
Price Elasticity of Supply (PES)
Measures the sensitivity of quantity supplied to market price.
While an increase in price should be associated with a decrease in quantity demanded, an increase in
price should be associated with an increase in quantity supplied  PED: negative | PES: positive.
ΔQs 𝑃
𝑃𝐸𝑆:
𝑥
Δ𝑃 𝑄𝑠
* Abbreviations:
 Total revenue = TR;
 Total cost = TC;
 Average revenue = AR;
 Marginal revenue = MR;
 Price elasticity of demand = PED;
 Cross price elasticity of demand = CED;
 Advertising expenditure = A;
2.3.3 Profit maximization
Profit (denoted pi) = TR – TC.
Maximize in short run: monopolist select output level so that marginal revenue = short-run marginal
cost. It is worthwhile to increase output as long as the additional revenue gained by doing so exceeds
the additional cost incurred. When additional revenue = additional cost, the firm should not increase
its output any further.
This rule not only applies to monopolists but also to firms operating in markets as perfect competition
and monopolistic competition. It’s also valid for profit maximization in the long run (MR = LRMC).
Chapter 3: The neoclassical theory of the firm
3.1 Introduction
The models of perfect competition, monopoly and monopolistic competition describe how firms should
set their output levels and prices to maximize their profits, under various sets of assumptions
concerning market structure.
Two most extreme cases considered by neoclassical theory of the firm:
 Perfect completion (most competitive);
 Monopoly (least competitive).
Monopolistic competition: an industry with large numbers of sellers and no entry barriers (like perfect
competition), but some product differentiation affording the firms some discretion over their own
prices (like monopoly).
3.2 The neoclassical theory of the firm: historical development
Neoclassical theory of the firm: explains determination of price and output for industry and individual
firm, based on assumptions of profit maximization.
Adam Smith: value of firm’s output is related to its costs of production. Costs include allowance for
profit. Owners maximize profit by trying to minimize the other costs incurred by the firm.
Critics on this view  new view: value of product determines the rewards paid to the factors of
production. Firms earning high profit by selling expensive products (with a lot of demand) can pay
higher rents, wages and interest. The price and therefore the value of the product depends ultimately
on the level of demand.
Stanley Jevons: the value a consumer places on a product depends on utility at the margin: value is
judged against all other past units of the product consumed. If marginal utility declines as
consumption increases, price reductions are required to induce an increase in the quantity demanded.
Excess (overvloed) supply  price falls  more buyer into market, some firms have to leave the
market because they can’t cover the costs.
Excess demand  price rises  less buyers in market, some incumbent (zittende) firms increase their
production, some entrants are attracted to the market for the first time.
Rivalry is important, creates a potential for collusion.
Perfect competition
 No buyer/seller is sufficiently powerful to influence prices;
 Entry barriers don’t disturb the flow of resources into the market;
 Everyone has perfect knowledge;
 Marginal revenue = price;
 High employment.
Perfect competition doesn’t necessarily eliminate abnormal profit in situation of uncertainty.
Uncertainty implies the probabilities that should be assigned to possible future events are unknown.
Risk describes the case where the probabilities are known and future events can be insured against.
Even in long-run equilibrium, firms might earn an abnormal profit as a payoff for dealing with
uncertainty.
Imperfect competition:
 The middle ground between perfect completion and monopoly;
 Marginal revenue function is downward sloping.
 Subdivides into two cases
o Monopolistic competition:
 Market in which many firms produce goods that are similar but not identical;
 Firms have some discretion in setting prices;
 More competitive variant.
o Oligopoly:
o Oligopolist’s actions are interdependent: a change in output by one firm
alters the profits of rival firms, causing them to adjust their output too;
o Less competitive variant.
3.3 Theories of perfect competition and monopoly
Characteristics market structure:
 Number of firms;
 Extent of barriers to entry;
 Degree of product differentiation.
Perfect competition
Imperfect competition:
- Monopolistic competition
- Oligopoly
Monopoly
Perfect competition


Number of firms
Many
Entry conditions
Free entry
Product differentiation
Identical products
Many
Few
One
Free entry
Barriers to entry
No entry
Some differentiation
Some differentiation
Complete differentiation
Large number of buyers and sellers. Actions of individual buyer/seller have no influence on
market price. They’re both price takers and atomistic;
Firms are free to enter/exit, that decision doesn’t impose any additional costs to the firm
concerned;




Goods are identical (homogeneous). No product differentiation;
Buyers and sellers have perfect information. No transaction costs (like costs in searching for
information or in negotiating or monitoring contracts between buyers and sellers);
No transport costs  geographical locations of buyers and sellers don’t influence decisions on
where to buy/sell;
Firms act independently of each other, each firm seeks to maximize its own profit.
In an atomistic market, each seller's size is so small, relative to the market as a whole, that it has
no appreciable effect on price. As a result, such sellers have no market power.
Price taking behaviour:
 Buyer/seller operates under the assumption that the current market price is beyond personal
control. Any attempt to increase/decrease its own price directly would be ineffective:
o Higher  customers will switch to competitors  quantity of output will be 0;
o Lower = pointless: firm can already sell as much output as it wishes at current price.
 Horizontal firm-level demand function, located at market price. PED is infinite (∞): small
reduction in price  large increase in quantity demanded;
 Demand function = AR function = MR function.
The section of the SRMC function above the intersection of SRMC with SRAC is the firm’s supply
function: to produce any output at all, a firm must at least cover its SRAC.
The availability of abnormal profits attracts entrants, so if there are abnormal profits, there’s no final
or stable equilibrium. If more firms enter, the market price will fall through increase of supply, which
eliminates the pre-entry abnormal profit. Post-entry each firm produces less than pre-entry, but total
post-entry output increases due to the increase in the number of firms.
Monopoly






Large number of atomistic buyers, only one seller. Selling firm’s demand function = market
demand function. Firm’s output decision determines market price;
No entry. If monopolist earns abnormal profit there’s no threat that entrants will be attracted
to the industry;
Good produced is unique, no substitutes. Complete product differentiation;
Buyers/seller may have perfect or imperfect information;
Geographical location could be the defining characteristic which gives the selling firm its
monopoly position. Spatial (ruimtelijk) monopoly: transport costs sufficiently high to prevent
buyers from switching to alternative sellers located in other regions/counties;
Selling firm seeks to maximize its own profit.
3.4 Efficiency and welfare properties of perfect competition and monopoly
Competition is good, monopoly must be avoided if possible.
Perfect competition: supply function = horizontal summation of firms’ horizontal LRMC function.
Abnormal profit is zero. Produces at minimum LRAC. Price = MR  the degree to which price excees
marginal costs provides a useful indicator or measure of market power.
Monopoly: abnormal profit is positive. Market price is higher and output is lower than under perfect
competition. In the long run monopolist fails to produce as MES, and therefore fails to produce at
minimum of LRAC.
Lerner index: measure of market power.
𝑃 − 𝑀𝐶
𝐿:
𝑃
Perfect competition: P = MC  L = 0
Monopoly: P > MC  MC > 0  0 < L < 1.
For a profit-maximizing firm, MR = MC:
1
𝐿:
|𝑃𝐸𝐷|
Lerner index = identical to firm’s price elasticity of demand.
Perfect competition: |PED|=∞  L = 0
Monopoly: MC > 0  MR > 0  |PED| > 1  0 < L < 1.
Lerner index provides a convenient measure of a firm’s market power based on the relationship
between price and marginal cost.
Perfect competition is usually preferable to monopoly, because the long-run competitive equilibrium
has several desirable properties that aren’t satisfied by the corresponding long-run monopoly
equilibrium.
Efficiency
Allocative efficiency:
 When there’s no possible reallocation of resources that could make one agent
(producer/consumer) better off without making at least one other agent worse off;
 Necessary condition: MR = MC;
 Total quantity of output produces should be such that P = MC
o P > MC: value that society would place on an additional unit of output exceeds the
cost of producing that unit  output too low. Increase welfare by producing more;
o P < MC: value that society places on the last unit of output produces is less than the
cost of producing that unit  output too high. Increase welfare by producing less;
Productive efficiency:
 Technical efficient (x-efficient): producing the maximum quantity of output that is
technologically feasible, given the quantities of the factor inputs it is currently employing. A
technically efficient firm operates on its own production function;
 Economical efficient: the combination of factor inputs enable the firm to produce its
current output level at the lowest possible cost, given the prevailing prices of the factor inputs
available to the firm.
Welfare economics concepts:
 Consumer surplus: sum over all consumers of the difference between the maximum
amount each consumer would be prepared to pay and the price each consumer pays;
 Producer surplus: the total reward produces receive beyond the reward they require to
cover their costs of production, including their normal profit.
Deadweight loss: associated with monopoly. Represents the total welfare loss resulting from the
fact that less output is produced under monopoly than under perfect competition.
A monopolist shielded from competitive pressure may tend to become complacent or lazy 
inefficient in production. He may not strive to make the most efficient use of its factor inputs
(technical inefficiency) or it may not identify its most cost-effective combination of factor inputs
(economic inefficiency).
Natural monopoly: LRAC is decreasing as output increases. There’s insufficient demand for any firm
to produce the output level at which all opportunities for further savings in average costs through
economies of scale are exhausted, or at which the MES is attained.
Monopoly is always a more cost-effective market structure in a natural monopoly than competition.
LRAC is lower if one firm services the entire market than if two would share the market. Industries
where the costs of indivisibilities represent a large proportion of total costs, and where total costs
don’t increase much as output increases, are most likely a natural monopoly.
3.5 Theory of monopolistic competition
Characteristics:
 Large numbers of atomistic buyers and sellers;
 Firms are free to enter or exit the industry, that decision doesn’t impose any additional costs:
no barriers to entry/exit;
 Goods produced are perceived by consumers to be similar, but not identical: some product
differentiation;
 Buyers and sellers may have perfect or imperfect information. If product differentiation is
perceived, not real  information of buyers is in some sense imperfect;

Geographic location could be the characteristic that differentiates the product produced from
those of its competitors: transport costs may deter buyers from switching to alternative sellers
located elsewhere. But any firm that raises prices too far will find that its customers start
switching to other sellers;
 Each selling firm seeks to maximize its own profit.
 each individual firm has some discretion over its own price. Due to product differentiation, each
firm can exercise some market power.
A firm in monopolistic competition that raises its price doesn’t immediately lose all customers, a firm
that lowers price doesn’t immediately acquire all competitors’ customers: non-price taking behaviour.
Demand function is downward sloping.
The firm’s discretion over its own price is limited because its product is quite similar to its competitors’
products. Price increase  lose customers rapidly. Price decrease  attract customers rapidly.
Demand function is relatively price elastic.
Interdependence can be ignored: the possibility that one firm’s profit-maximizing price and output
decisions carries implications for all of the other firms’ decisions.
Each firm sells a differentiated product  no market demand function & no industry-level analysis.
Tangency solution: firm’s AR function is tangential (raakt) to its SRAC function.
The efficiency and welfare properties of the long-run equilibrium under monopolistic competition:
 Firm fails to produce at MES, and therefore fails to produce at minimum attainable LRAC;
 Only a normal profit in long run;
 Price > MC: allocative efficiency. There’s a deadweight loss: firm’s and total industry output is
lower than required for maximization of welfare;
 Market power thanks to differentiated product, might enable the firm to operate without
achieving full efficiency in production. Monopolistic competition might be compatible with
technical inefficiency or economic inefficiency, or both. The monopolistic competitor isn’t fully
shielded from the rigours of competition. If he produces inefficiently he’s vulnerable to the
threat of competition from incumbents or entrants  the degree to which the monopolistic
competitor can operate at less than full efficiency is severely constrained by the lack of entry
barriers and the threat of actual/potential competition.
Chapter 6: Oligopoly: Non-collusive models
The more similar or homogeneous the products of different firms, the greater the awareness of
competitors.
All oligopolistic market: few sellers  substantial proportion of total sales. Central problem:
recognition of the firms’ mutual dependence or interdependence.
Interdependence: a firm is aware that its own actions affect the actions of its rivals and vice versa.
6.2 Interdependence, conjectural variation, independent action and collusion
Interdependence  make guesses / conjectures to the likely actions of rivals.
Conjectural variation: assumptions a firm makes about the reactions it expects from its rivals in
response to its own actions.
Solution to the oligopoly problem is one of two extremes:
 Independent action: each firm reaches a unilateral decision on a course of action, without any
prior contact with its rivals;
 Collusion: two or more rival firms recognize their interdependence, creating the potential for
bargaining to take place with a view to formulating some plan of joint action.
6.3 Models of output determination in duopoly
Cournot, Chamberlin and Stackelberg.
Cournot
Cournot’s duopoly model
First successful attempt to describe an oligopoly equilibrium.
Duopoly: two firm oligopoly.
Assumptions:
 MC = 0;
 Moves are made sequentially;
 When making its own trading plans, each firm expects the other firm to maintain its output at
its current level  reaction is zero = zero conjectural variation;
 AR function is linear, MR too (twice-as-steep rule);
 Both firms maximize profit subject to the zero conjectural variation assumption.
Market equilibrium is reached through a sequence of actions and reactions on the part of the two
films.
Isoprofit curves and reaction functions
Limitation Cournot model = zero marginal cost assumption. Not fundamental limitation  it is
straightforward to rework the model so it can be applied to the case where marginal costs are nonzero  isoprofit diagram.
A firm’s isoprofit curves show all combinations of output which produce identical profit for the firm.
Reaction function: firm A’s reaction function shows for each value of output of firm B (assumed
fixed) the profit-maximizing value of output of firm A.
Cournot-Nash Equilibrium
Both firms seek to operate on their own reaction function.
Cournot-Nash equilibrium: both firms are simultaneously located on their own reaction function:
RFA and RFB intersect.
Formula for market equilibrium in an N-firm model:
𝑁
𝑄𝑛 = 𝑄𝑐
𝑁+1
Qn = total industry output at Cournot-Nash equilibrium.
Qc = total industry output if industry structure was perfectly competitive (P = MC).
Critics Cournot model:
 Based on naive and unrealistic assumption that each firm believes its rival won’t change
output.
Defence: solution to the problem of oligopoly is more important than the story about how this
equilibrium is attained;
 Ignores the possibility that firms may seek cooperative or collusive solutions, in order to
maximize joint profits;
 Focuses on output-setting, ignores price-setting decisions, price adjustments are the
consequence of output decisions, rather than being primary courses of action.
Advocates Cournot model:
 Introduced use of mathematical techniques for the solution of economic problems;
 Provided economists with important tools of analysis (conjectural variation, isoprofit curves,
reaction functions);
 Identifies an oligopoly equilibrium that is located reassuringly between the extremes of
perfect competition and monopoly;
 Can be uses as benchmark for all further discussion of decision making under oligopoly.
Chamberlin
Chamberlin’s solution: Joint profit maximization
Firms recognize their interdependence when making their output decision. The firms recognize it is in
their mutual interest to produce and share equally among themselves the output that would be
delivered if the market was serviced by a single monopolist  firms also share monopoly profit equal.
Chamberlin doesn’t suggest firms achieve this solution through collusion. The outcome rests on the
assumption that each firm recognizes that the monopoly ideal can be achieved through independent
action  Both players have a higher payoff than in Cournot’s formulation.
This solution allows one aggression: cheating / back-sliding on the part of the two firms 
Chamberlin’s solution is always liable to break down, if either or both firms succumb (bezwijken) to
the temptation to act unilaterally (in own interest) and ignore their interdependence.
Stackelberg
Stackelberg’s solution: the leader-follower model
A drops the zero conjectural variation assumption, B still has it  A has insight in B’s behaviour  B
will choose an output on its reaction function  A has to choose the best output for itself on B’s
reaction function  A gets more (is rewarded) B gets less (is punished).
Disequilibrium  price war  corresponds to perfect competition  price driven down to one (equal
to MC)  zero profit.
6.4 Models of price determination in duopoly
Bertrand and Edgeworth.
Bertrand
The Bertrand model: price competition
Price is the key decision variable for most firms.
Each firm sets its own price, and then sells as much output as it can at the chosen price.
Uses a zero conjectural variation assumption concerning prices: each firm assumes its rival will stick to
the its current price.
The output of the two firms is identical and there are no transaction or search costs  customers flow
effortlessly to the firm that is currently offering the lowest price.
Locate




equilibrium:
Firms take their price decisions sequentially;
Firms face a horizontal MC function MCA = MCB;
Identical products;
A locates price at monopoly price, B enters and sets price a bit under that, gets all customers,
A will do the same etc.  when price has fallen to perfectly competitive level (P = MC)
there’s no incentive to cut price any further.
Edgeworth
The Edgeworth model: price competition with a production capacity constraint
Allows for the possibility that the firms are subject to a production capacity constraint.
Each firm assumes its rival will stick to its current price.
 No stable equilibrium solution.
MC is vertical = full-capacity output level.
Critic: Assumption that firms can continually and effortlessly adjust their prices and outputs.
6.5 Price leadership
Price leadership = parallel pricing. Type of oligopoly model in which firms recognize interdependence.
Dominant price leadership



Industry dominated by one firm, owing to its superior efficiency / aggressive behaviour;
One firm sets price, other firms follow passively (convenience, ignorance, fear);
No oligopoly problem: interdependence is absent.
Barometric price leadership
 Firm announces price changes that would in time be set by the forces of competition;
 Leader is not necessarily dominant firm, doesn’t need to have market power;
 Leader changes in time.
Two types:
1. Competitive type:
a. Frequent changes in the identity of the leader;
b. No immediate, uniform response to price changes;
c. Variations in market share.
2. More dangerous monopolistic type: effective or collusive price leadership:
a. Small number of firms, relatively large;
b. Substantial entry barriers;
c. Limited product differentiation, reinforcing the firms’ awareness of interdependence;
d. Low price elasticity of demand, deterring price-cutting;
e. Similar cost functions.
Chapter 7: Oligopoly: collusive models
Reasons for collusion:
 Price-fixing  boost for profitability;
 Dealing with uncertainties that would otherwise arise because they’re interdependent.
Collusion: Eases competitive pressure and creates a manageable operating environment through
unified action.
Tacit collusion: collusive outcome that requires no formal agreement, without having any direct
communication between the firms involved.
Explicit collusion: requires verbal / written agreements.
Various



institutions which aim to promote and organize cooperation between producers:
Cartels;
Trade associations;
Joint ventures.
Cartel: associations of independent firms in the same industry that impose restrain upon competition.
Producers join cartels mainly to protect themselves, not to exploit their consumers. Most agreements
want to impede entry / the development of new products that might be bad for the profitability or
survival of incumbent firms. Price-fixing supports the less efficient members. Profits aren’t
spectacularly high. They seek to enhance the market power of a group of produces through combined
action.
Trade association: improve economic situation of their members, don’t necessarily require market
power to achieve this (unlike cartels). Function: provide members with industry data on sales,
productive capacity, employment, creditworthiness of customers, quality of products and innovation.
They also promote activities intended to reduce inefficiency and promote better relations with others.
Difficult to know if they’re legal or not. Its impact on competition is uncertain.
Joint venture: association between two or more otherwise competing firms. Might take the form of a
consortium or a syndicate. Syndicate is limited to the fields of banking and insurance. Consortium is
established when firms undertake speculative activities with a too high risk to do it in individually.
Similar to cartels as they unit the interests of several firms and prevent or distort competition as a
consequence. Different because joint ventures may stimulate innovation, by enabling project to
proceed that would not be feasible otherwise. Three reasons for firms to form joint ventures:
 Contribute their resources to increase efficiency;
 Enter a new market;
 Develop joint research and development programmes.
Joint profit maximization is achieved by choosing the industry output at which MR equals MC.
The least efficient producer with the steepest MC function is assigned a smaller quota than the more
efficient producers.
No producer can have any spare capacity.
Free-rider problem of cartel: non-cartel firms earn higher profits than cartel firms, thanks to the
sacrifices made by the cartel firms  bad for viability and stability of cartel.
Every firm would prefer to be the outsider of the cartel, and if enough stay outside, the cartel breaks
down.
Before any defection takes place, the profit of a non-cartel firm always exceeds the profit of a cartel
firm. But it’s possible that the post-defection profit of the cartel firm that defects is less than its predefection profit, still part of the cartel.
 for a firm that wants to leave the cartel or wants to defect, it has to compare between the current
profits of a cartel firm and the adjusted (post-defection) profit of a non-cartel firm.
Two conditions for stability of cartel:
1. Internal stability: no cartel member can increase profit by leaving the cartel;
2. External stability: no non-cartel member can increase profit by joining the cartel.
Can always be achieved if the number of firms is finite.
The greater the number of firms in the industry, the smaller the effect of any one firm’s actions on
price and profits and the greater the likelihood that any cartel agreement will turn out to be unstable.
Difficulties in forming a cartel:
 Problem of potential / actual entry;
 Administrative difficulty: how should the output quotas be determined and profits divided? MC
of all cartel firms is equal  each firm earns different profit  side-payments to compensate
low-profit earners  high costs, may outweigh benefits.
Fundamental reason so many cartels fail to live up to expectation is that what appears optimal for the
group as a whole may not be optimal for each member individually  bargaining.
Chapters: 10/12/19: Pricing
Cost Plus Pricing
Firm calculates/estimates AVC and then sets price by adding a percentage mark-up that includes a
contribution towards the firm’s fixed costs, and a profit margin.
Price = AVC + % mark up.
P = (1 + m)AVC
Advantages for CPP over profit-maximizing rule (MR = MC):
 Simple to understand, uses less information;
 Greater price stability: AVC is relatively flat;
 Sense of fairness: reasonable profit margin, rather than maximum profit. Price changes =
changes in cost.
Price discrimination
= policy of selling different units of output at different prices. Possible only in cases where there are
variations in the prices charged for a product that’s supplied under an identical cost structure no
matter who the buyer is, or how many units are produced and sold.
Three types of price discrimination:
1. First-degree price discrimination (perfect price discrimination): price per unit of output
depends on identity of purchaser and on number of units purchased. Happens rarely. Based
on consumers’ willingness to pay;
2. Second degree price discrimination: price per unit of output depends on number of units
purchased. All consumers who buy a particular number of units pay the same price per unit;
3. Third-degree price discrimination: price per unit of output depends on identity of purchaser.
Any consumer can buy as few or many units as he or she wishes at the same price per unit.
Dumping: charging a lower price to consumers in poorer countries than to those in rich ones.
Two conditions necessary for price discrimination to be possible:
 Price discriminating firm must have market power which leads to discretion to choose own
price structures;
 Market for product must be divisible into sub-markets, with different demand conditions. They
must be physically separate through space or time, so that secondary trade or resale between
consumers in different sub-markets is not possible.
Significant transport costs can also help achieve an effective physical separation of sub-markets.
Two-part tariff: price structure = fixed fee + additional uniform price of each purchased unit.
First degree price discrimination: equilibrium satisfies necessary condition for allocative efficiency
(price last unit of output = MC of last unit). Monopolist takes away all consumer surplus (each
consumer pays a price equivalent to willingness to pay), there’s also no deadweight loss. The
monopolist extracts all of the available surplus and earns an even higher abnormal profit.
Second degree price discrimination: In the case where the monopolist cannot distinguish between
consumers  offer same menu of prices and quantities to all consumers  they can self-select. In
the case where it’s profitable for the monopolist to supply all consumers, the optimal two-part tariff
includes a uniform price > MC. Monopolist can’t extract as much surplus as when using first-degree
price discrimination. Based on imperfect information.
Third-degree price discrimination: monopolist can segment the market by offering different prices to
different consumers, consumers can be divided into groups based on easily identifiable characteristics
(age or being student or pensioner). Monopolist charges same price per unit sold within each group,
but different prices to members of different groups. Producer surplus is always higher than when nondiscriminating. Consumers in the sub-market with the higher price have less consumer surplus and are
always worse off than in the non-discriminating case, and vice versa.
Tying and Bundling
Tying: selling of two or more distinct products, where the sale of one good is conditional on the
purchase of another. Products are distinct if, in the absence of tying arrangements, the products are
purchased in separate markets.
Bundling: supplier offers several goods as a single package. Profitable since customers can be sorted
into different groups with different willingness to pay, and their consumer surplus appropriated
accordingly (bundling can be used as a form of price discrimination). It can also be used as barrier to
entry: a monopolist operating in two markets can bundle the goods, making it difficult for rivals to
enter either market. An entry barrier is created without having to lower prices in either market.
Predatory pricing
Incumbent firm cuts price in an attempt to force a rival firm out of business. When the rival has
withdrawn, the incumbent raises its price. Incumbent = predator, sacrifices profit and has perhaps a
loss in the short run, to protect market power and ability to earn abnormal profit in the long run.
Response of rival firm:
 Rival firm can convince incumbent firm that it’s in their mutual interest to merge, or share the
market;
 Rival might be able to convince customers it’s not in their interest to accept price cuts from
the predator in the short run, if the prices get higher afterwards;
 Rival firm can reduce output  predator has to produce at higher volume than planned to
maintain reduced price  losses increase + length of time it can sustain reduces;
 Rival firm can redeploy assets to some other industry and (temporarily) withdraw, in the
expectation it will return when predator raises its prices.
Chapter14: Product differentiation
Vertical product differentiation: one product differs in overall quality from another. If the prices
are equal, most or all consumers would purchase the high quality product.
Horizontal product differentiation: products are of the same or similar overall quality, but offer
different combinations of characteristics. What the consumers will choose differs with their taste.
Natural product differentiation: distinguishing characteristics arise from natural attributes or
characteristics, rather than having been created through the deliberate actions of suppliers. Sources of
natural product differentiation:
 Geographic variation;
 New technology;
 Brands and trademarks;
 Community or national differences;
 Consumer tastes and preferences.
Strategic product differentiation: distinguishing characteristics are consciously created by
suppliers. Sources of strategic product differentiation:
 Additional services;
 Rate of change of product differentiation;
 Factor variations;
 Consumer ignorance.
Two basic approaches to specification of consumer preferences and modeling of firm behaviour in
case of horizontal product differentiation:
1. Representative consumer models;
2. Spatial/location models.
Representative consumer models: consumers have tastes or preferences for goods, and firms
compete to attract consumers by differentiating the goods they offer. Each firm’s demand is a
continuous function of its own price and the prices set by competing firms. Also when competition is
atomistic.
Spatial/location models: consumers have tastes or preferences for characteristics embodied in
goods or services. Consumer demand for a particular firm’s product might be highly dependent on
small changes in price set by another firm whose product embodies a very similar bundle of
characteristics, but be independent of small changes in the price set by a third firm, whose product
characteristics are further removed.
Hotelling’s location model
Geographical location is characteristic that differentiations one supplier’s product from another.
As k increases consumers become less likely to switch between firms A and B in response to small
changes in PA and PB  k = measure of consumers’ rate of substitution between firms A and B.
Higher k-value  lower rate of substitution and lower intensity of competition between A and B.
The consumer buys from the firm from which he receives the highest surplus (= difference between
utility gained and cost incurred).
 If PA + kd2 < PB + k(1-d)2 and PA + kd2 ≤ 1  consumer buys from A;
 If PA + kd2 > PB + k(1-d)2 and PA + kd2 ≥ 1  consumer buys from B.
When both locations and prices are endogenous and chosen by the firms, there’s no stable equilibrium
solution.
Case 1: locations endogenous, price exogenous (fixed)
Each firm chooses location to maximize its own profit.
Range = 0 – 1. The equilibrium is when they both sit on 0.5 exactly. Than no one would located
somewhere else, because that would mean a lower market share = lower profit.
Case 2: locations fixed (exogenous), prices endogenous
Firm A is located at 0 and firm B at 1.
The joint profit-maximizing price is always the same for both firms.
K = small: transport costs or brand loyalties are low, and rate of substitution is high. The price should
be set so that the most marginal consumer is just willing to stay in the market (=P^).
K = large: transport costs or brand loyalties are high, and rate of substitution is low. The price should
be set higher than P^. Although, then some consumers will withdraw from the market, firms do
increase their joint profit by raising the common price, and exploiting the market power that arise
from the reluctance to switch of those consumers who remain in the market.
Monopoly price is never less than P^, because you can increase it without causing any consumer to
withdraw. Above P^, MR tends to be negative when k is low, but positive when k is high.
Chapter 16: Research and development
Invention: creation of an idea and its initial implementation;
Innovation:
 Product innovation: introduction of a new product;
 Process innovation: introduction of a new piece of cost-saving technology.
Major difference invention and innovation: level of risk: main interests of inventor = generation of
ideas and not production of goods and services.
Technological change: fundamental driving force behind the growth and development of the
capitalist economy. Results in new and improved goods and services being brought to the market, and
more cost effective technologies being used in production. It challenges the market power of
incumbent firms that remain wedded to older, less effective technologies.
Creative destruction: economic impact of technological change. Rewards successful innovators, and
punishes those firms whose technologies are superseded and become obsolete.
Schumpeterian analysis (creative destruction) has several implications:
 Perfect competition is not ideal market structure;
 Large corporations with market power as result of being a successful innovator in the past,
are main drivers of technological change and economic growth;
 Economists should focus less on price competition, and more on other forms of competition
(product & process innovation);
 The conduct of a successful innovator is rewarded with the creation of a (temporary)
monopoly based on sole ownership of the intellectual property rights embodied in the new
technology.
Schumpeter identified 3 R&D stages:
1. Invention;
2. Innovation;
3. Diffusion.
More extensive five-stage classification of R&D is:
1. Basic research (invention);
2. Applied research (innovation);
3. Development (innovation);
4. Commercial production (innovation);
5. Diffusion (diffusion): spread of the new idea through the firm + imitation and adoption of the
innovation by other firms in the same industry.