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Market Structure and the Behavior of Firms Perfect Competition vs Monopoly Market Structures Many Perfect Competition Less Number of Competitors Monopolistic Competition Market Control Oligopoly One Monopoly More Behavior of Firms Assume firms want to maximize profit = TR – TC TR = Total Revenue = P∙q TC = Total Economic Cost Economic Cost = Explicit Cost + Implicit Cost Technological Constraints Production Function _ q = F(L, K) Variable input q = output L = labor K = capital F(·) represents technology Fixed input Lab Experiment 3: Widget Production Measures of Productivity Total Product q = F(L, K) Average Product AP = q/L Marginal Product MP = Δq/ ΔL Note: Diminishing Marginal Returns (DMR) When there is at least one fixed input, eventually a point is reached at which the marginal product of an additional worker begins to fall. Productivity Graphs DMR output Slope = MPL = ∆q/ ∆L ∆q q/L TP ∆L AP L1 L2 labor labor L1 L2 When MP > AP then AP will rise When MP < AP then AP will fall MP Short Run Costs TC = FC + VC Does not vary with output: Rent Utilities Salaries Property taxes Insurance premiums Varies with output: Labor Raw materials Short Run Cost Curve Family TC $ VC $ MC ATC AVC FC AFC output TC = FC + VC output ATC = AFC + AVC MC = ΔTC Δq Properties of the Cost Curves “Ross Perot” Equation $ MC w MC MPL $ MC ATC output Short Run Cost Curve Shifters Change Change Change Change in in in in price of labor price of capital amount of capital technology AVC q/L AFC output MP labor Long Run Costs What is the optimal size for a factory? $ ATC1 ATC2 ATC4 ATC3 q2 LRAC output Long Run Average Cost Curve $ ATC3 LRAC Coordination/Communication Problems Specialization qMES output EOS: double the inputs, output more than doubles LRAC falls DOS: double the inputs, output less than doubles LRAC rises Perfect Competition: Price Taker Model Characteristics of the Industry Large number of small buyers/sellers Homogeneous product Free entry/exit Perfect information firms are price takers $ S MR = ΔTR / Δq $ P1 P = MR D Q1 Industry Quantity quantity Firm Maximizing Profit = TR – TC = Pq - [FC + VC] $ MC MR $60 = P1 What output should the firm produce? produce until MR = MC If MR > MC produce more If MR < MC produce less q1 = 300 quantity I want you to maximize profit What is TR = ? What is TC = ? Profit and Loss Diagrams Positive Profit: > 0 = = = = Pq – (ATC)q (P-ATC)q (60-50)300 $3000 $ MC ATC $60 = P1 MR1 $50 = ATC $35 = P2 MR2 Negative Profit = (35-50)250 = -$3750 Zero Profit? q2 = 250 q1 = 300 quantity Sometimes it’s better to stay open and lose a little bit… Temporary Shut Down: q = 0 = Pq – (FC +VC) = 0 – (FC + 0) = - FC $ MC ATC AVC $35 = ATC1 Fixed Cost = $30,000 Stay open if TR > VC Shut down if TR < VC $25 = P1 $20 = AVC1 MR1 q1 = 2000 quantity Stay open: = -$20,000 Shut down: = -$30,000 Shutdown recap $ MC ATC AVC PSD = Min AVC qSD Shut down if TR < VC Pq < (AVC)(q) P < AVC quantity Note: The portion of the MC curve above the shutdown point is the firm’s supply curve How should a business react if… Price rises? Marginal costs rise? Fixed costs rise? $ MC ATC AVC P1 MR1 q1 quantity Long Run Equilibrium • A = TR – Explicit Costs Firm = Economy • E = A - Implicit Costs A= 9% 7% E= 3% 0% A= 6% 7% E= 0% A= 6% 7% E= 0% A= 6% 7% E= 0% LRE: E = 0 if E > 0 entry occurs if E < 0 exit occurs Long Run Adjustment Process $ $ S1 P2 MC ATC S2 MR2 LRS P1 D1 Q1 Q3 MR1 D2 Quantity Industry q1 q2 quantity Firm At P1: each firm produces q1 and earns E = 0 Demand rises to D2: causes price to rise to P2 At P2: each firm produces q2 and earns E > 0 Since E > 0 , new firms will enter: supply shifts to S2 Price will fall back to P1 and E = 0 Long run supply curve for a constant cost industry is horizontal MES and Market Structure $ Industry 1: room for 8 firms Industry 2: room for 4 firms Industry 3: room for 2 firms Industry 4: room for 1 firm “natural monopoly” ATC1 ATC2 ATC4 ATC3 P1 D ⅛Q1 ¼Q1 ½Q1 Q1 Output The greater MES is as a share of market demand, the fewer the number of firms MES Plant Size Versus Market Concentration Industry MES/S 4x(MES/S) CR4 Beer Brewing 3.4 13.6 40 Cigarettes 6.6 26.4 81 Broad-woven cotton and synthetic fabrics 0.2 0.8 36 Paints, varnishes, and lacquers 1.4 5.6 22 Petroleum refining 1.9 7.6 33 Shoes (other than rubber) 0.2 0.8 26 Glass containers 1.5 6.0 60 Cement 1.7 6.8 29 Integrated wide-strip steel works 2.6 10.4 48 Ball and roller bearings 1.4 5.6 54 14.1 56.4 73 1.9 7.6 61 Refrigerators and freezers Storage batteries Source: Stephen Martin, “Industrial Economics,” 2e, MacMillan (1994), p240. Monopoly A Price Searcher Model Monopoly Pure monopolist has no close substitutes Sherman Act (1890) “anti-trust” law Section 1: Every contract, combination…or conspiracy, in restraint of trade…is declared to be illegal" Section 2: "Every person who shall monopolize, or attempt to monopolize…shall be deemed guilty of a felony” Relevant Market Product Market DuPont (1956) Cellophane Flexible wrapping paper Alcoa (1945) Cellophane 75% Primary aluminum All aluminum Butcher Paper Primary 90% Aluminum Foil Newspaper Flexible Wrapping Paper Secondary 20% Imported All Aluminum 33% Relevant Market Geographic Market Local Regional National Global Local Regional National Global Barriers to Entry Economies of Scale $ “natural monopoly” Control over key inputs Alcoa--bauxite DeBeers GE Superabrasives (Diamond Innovations) LRAC Quantity …more barriers to entry Government restrictions Patents 20 year duration Copyrights Life of artist plus 70 years Licenses Occupational licenses: doctors, lawyers, accountants, engineers For what purpose: Public health or private interest? Franchises Taxi medallions: 12,779 $336,000 per medallion Source: The New York City Taxicab Fact Book, Schaller Consulting, March 2006. Available at http://www.schallerconsult.com/taxi/taxifb.pdf Profit Maximizing Behavior Assume that Monopolist charges single price to all buyers $ TR = $20,000 TR = $21,000 π = TR – TC π = P(Q)*Q – TC MR = ∆TR/ ∆Q $40 Loss $30 Gain D MR MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q 500 Quantity 700 MR = [6000 – 5000]/200 = $1000 / 200 MR = $5 MR < P MR, P, and Elasticity MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q MR = P [ 1 – 1/E ] Note: If E > 1 then MR > 0 If E < 1 then MR < 0 If E = 1 then MR = 0 If E = ∞ then MR = P [Perfect Competition] Optimal Output and Price π-max rule: $ Set output where MR = MC Set price off of demand curve MC ATC $30 $20 TR = P*Q = ($30)(700) = $21,000 D TC = ATC*Q = ($20)(700) = $14,000 π = TR - TC = $ 7,000 MR 700 Quantity Optimal Output and Price π-max rule: $ Set output where MR = MC Set price off of demand curve MC ATC How will monopolist react to: an increase in marginal cost? an increase in fixed cost? an increase in demand? $30 $20 D MR 700 Quantity Welfare Comparison: PC vs. Monop Perfect Competition: PC, QC $ Monopoly: PM, QM A PM B C MC = ATC PC PC CS PS Social Welfare DWL A+B+C --A+B+C --- D Monop A B A+B C MR QM Qc Quantity Price Discrimination Definition: price differentials that do not reflect cost differentials Motivation: to increase profits by capturing more consumer surplus Necessary Conditions Market Power Downward sloping demand curve Arsenic ? Segment the market Demographics Usage rates Prevent resale Movie theatres Röhm-Haas: plastic molding compound Industrial: $0.85/lb Dentists: $22/lb Types of Price Discrimination First Degree $ Charge each buyer their WTP Captures all CS and DWL Second Degree Quantity discounts PM Third Degree Set prices according to price elasticity Movie Theatre PC MC D MR MRA = MRK = MC QM MC = $4 Qc MRA = PA[1 – 1/EA] EA = 2 MRA = MC EK = 5 PA[1 – 1/2] = 4 PA = $8 Charge higher price to more inelastic group Quantity United States v. Microsoft (2000) Operating Systems Windows Macs Linux Java 90% 8% --- Application Software Word Excel Powerpoint Outlook Access Internet Explorer “Bundling”
