Download ESSENTIALS OF MICROECONOMICS ECON 201

Chapter 7
The Firm
Business Firm
• Employs factors of production
• Produces goods and services
• Sells to consumers, other firms, or the
government
• We work for and buy from firms
Market
• Two sides
– Buyers
• Utility is major decision making device
– Sellers
• How do they make decisions
How do the two sides come
together?
• Market Coordination
– Invisible Hand (Adam Smith)
– Market guides individuals into activities at which
they are the most efficient
– Pushes sellers to produce certain things and buyers
to instruct what to produce
– Equates supply and demand
How does the firm decide what to
produce?
• Managerial Coordination
– Guides individual firm production decisions
– Thus…invisible hand of the firm
Why follow this invisible hand?
• Firms are formed because greater benefits of
working as a team than working as individuals
Problem with teamwork
• Shirking
– Putting forth less effort than your originally agreed
to
– Problem because shirker gains ALL benefits from
shirking but costs are spread over the entire team
Can shirking increase or decrease?
• Yes!!
• As the benefits of shirking increase so does the
amount
• If the shirker must bear the full cost of shirking
then shirking will decrease
How can we decrease shirking?
•
•
•
•
Manager’s duty or MONITORING
Reward productive workers and punish shirkers
Preserves the benefit of team production
Reduces the benefits of shirking
Who monitors the monitor?
• Salary usually tied into production
• Called Residual Claimant
– Person who shares in the profits of the firm
– More shirkers?? Less Production…so less
pay for monitor
Another way to ward off shirking?
• Pay higher than equilibrium wages
• Decreases shirking because cost of losing job
is greater.
• Don’t need monitor because high wage makes
worker monitor themselves
• Called efficiency wage theory
Why do people submit to being
monitored??
• Monitoring decreases shirking
• Monitoring increases benefits of teamwork
• Monitoring maximizes benefits that can be
achieved
Objective of the firm
• Profit Maximization
• Now…want to move to the Firm to see how
they achieve this objective
Chapter
8
Production
and Costs
© South-Western College Publishing 1998
Cost Side
• Explicit Cost
– Actual money is exchanged
– COST
• Implicit Cost
– Value of resources used in the production
or acquisition of a good
– No monetary payment
– OPPORTUNITY COST
Sacrifice
• In order to have a cost, sacrifice must have
taken place
• Forfeited something else
• No money must change hands for sacrifice to
take place
Profit
• Two types
– Accounting
• Difference between total revenue and explicit
costs
• Acct Profit = TR – EXPLICIT COSTS
– Economic
• Difference between total revenue and total cost
(implicit and explicit)
• Econ Profit = TR – Explicit Cost – Implicit Cost
Which do you think is lower??
•
•
•
•
Economic Profit
Usually lower but never higher
How can it be “usually” lower?
Implicit cost can equal 0 so accounting and
economic profit would be equal
Accounting and Economic
Profit
To tal
Re ve nue
–
Explic it
Co s ts
= Accounting
Profit
(a)
Implic it
Co s ts
To tal
Re ve nue
–
(b)
Explic it
Co s ts
=
Ec o no mic
Pro fit
Zero Economic Profit
• Total Revenue-explicit cost-implicit costs =
0
• Also called NORMAL PROFIT
• Equilibrium of profit for the firm
• Would we want zero accounting profit?
• NO!!! Implicit costs would not be covered
Sunk versus Fixed Costs
• Sunk
– Incurred in the past
– Cannot be changed by a current decision
– Cannot be recovered
– Example: Time spent in school
– Can’t recover so let it go…Release it
• Fixed
– Possibility of recovering some money for selling
the good
– Example: Land, equipment…
Production
• Takes time to produce
• Costly to produce
• Direct link between production, costs,
and time
Two types of time
• Short Run
– Fixed and variable inputs
• Long Run
– All inputs are variable
Short Run
• Fixed input
– Quantity can not be changed
– Independent of output produced
– Example: Building, land…
• Variable input
– Quantity can be changed as output
changes
– Example: Labor
Costs
• Fixed Cost (FC)
– Associated with fixed inputs
– Do not change with output
– Example: Insurance premiums
• Variable Costs (VC)
– Associated with variable inputs
– Changes as output changes
– Example: Hire more people and must pay
more wages
(1)
QUANTITY
OF
OUTPUT, Q
(units )
(2)
TOTAL
FIXED
COS T
(TFC)
0
$100
1
100
2
100
3
100
4
100
5
100
6
100
7
100
8
100
9
100
10
100
Total
Fixed
Cost
TFC (do llars )
TFC
100
0
1 2 3 4 5 6 7 8 9 10
Q
(1)
QUANTITY
OF
OUTPUT, Q
(units )
(4)
TOTAL
VARIABLE
COS T (TVC)
Total
Variable
Cost
TVC (do llars )
500
0
$ 0
1
50
2
3
80
100
4
110
5
130
6
160
200
7
8
9
10
250
310
380
400
TVC
300
200
100
0
1 2 3 4 5 6 7 8 9 10
Q
Periods of Production, Inputs,
and Costs
Short Run
Long Run
INPUTS US ED
1. Fixed
2. Variable
INPUTS US ED
1. Variable
COSTS ASS OCIATED
WITH INPUTS
1. Fixed Co s ts
2. Variable Cos ts
COSTS ASS OCIATED
WITH INPUTS
1. Variable Co s ts
DEFINITION OF COSTS
1. Fixed Co s ts : Co s ts that
do no t c hange as
o utput c hange s .
2. Variable Co s ts : Cos ts that
c hang e as output c hange s .
DEFINITION OF COSTS
1. Variable Co s ts : Co s t
that c hange as
o utput c hange s .
Total Costs
• Variable Cost + Fixed Cost
TC  TVC  TFC
(1)
QUANTITY
OF
OUTPUT, Q
(units )
(6)
TOTAL COS T
(TC)
TC = TFC + TVC
= (2) + (4)
0
1
150.00
180.00
4
5
6
7
8
9
10
TC (do llars )
500
$100.00
2
3
Total
Cost
200.00
210.00
TC
400
300
200
100
230.00
260.00
300.00
350.00
410.00
480.00
0
1 2 3 4 5 6 7 8 9 10
Q
Other costs of importance…
• Average Variable Cost (AVC)
• Average Fixed Cost (AFC)
• Average Total Cost (ATC)
TVC
Q
TFC
Q
TC
Q
(1)
QUANTITY
OF
OUTPUT, Q
(units )
(5)
AVERAGE
VARIABLE
COS T (AVC)
AVC = TVC/Q
= (4)/(1)
Average
Variable
Cost
AVC (do llars )
0
1
2
$50.00
3
4
33.33
5
26.00
6
26.67
7
28.57
31.25
8
9
10
40.00
27.50
34.44
38.00
100
50
0
AVC
1 2 3 4 5 6 7 8 9 10
Q
(1)
QUANTITY
OF
OUTPUT, Q
(units )
(3)
AVERAGE
FIXED COS T
(AFC)
AFC = TFC/Q
= (2)/(1)
Average
Fixed
Cost
AFC (do llars )
0
1
2
$100.00
50.00
100
3
4
33.33
25.00
50
5
20.00
6
7
16.67
14.28
8
9
12.50
11.11
10
10.00
AF
0
1 2 3 4 5 6 7 8 9 10
Q
(1)
QUANTITY
OF
OUTPUT, Q
(un its )
(7)
AVERAGE
TOTAL COS T
(ATC)
ATC = TC/Q
= (6)/(1)
Average
Total
Cost
ATC (dollars)
150
0
1
2
3
4
$15 0.00
90.00
66.67
46.00
43.33
7
42.86
43.75
10
50
ATC
52.50
5
6
8
9
100
45.56
48.00
0
1 2 3 4 5 6 7 8 9 10
Q
Marginal Cost
• Change in TC that results from a change in
output
• Additional cost of producing an additional unit of
output
TC TVC
MC 
or
Q
Q
Why Change in Total Cost or Total
Variable Cost????
• Since total fixed cost doesn’t change the
“additional” total fixed cost is zero
(1)
(8)
QUANTITY MARGINAL COS T (MC)
OF
MC = TC/Q
OUTPUT, Q
= (6)/(1), o r
(un its )
= TVC/Q
= (4)/(1)
Marginal
Costs
MC (dollars)
0
1
$50 .00
2
30.00
3
20.00
4
10.00
5
20.00
6
30.00
7
40.00
8
50.00
9
60.00
10
70.00
100
MC
50
0
1 2 3 4 5 6 7 8 9 10
Q
In-class exercise #9
Using the knowledge
Shapes of Curves
• Law of diminishing marginal returns
– As larger amounts of a variable input are combined
with fixed inputs eventually the Marginal Physical
Product (MPP) declines
Marginal Physical Product (MPP)
output Q
MPPl 

labor
L
What is the variable
input?
•
• What is the variable cost?
So…
• As more labor (VARIABLE INPUT) are added to
land (FIXED INPUT) the variable inputs would
yield smaller and smaller additions to output
Marginal Physical Product
Part (a)
(1)
VARIABLE
INPUT,
LABOR
(wo rke rs )
(2)
FIXED
INPUT,
CAPITAL
(units )
(3)
QUANTITY OF
OUTPUT, Q
(units )
0
1
0
1
2
1
1
18
37
3
4
1
1
57
76
5
1
94
6
7
1
1
111
127
(4)
MARGINAL
PHYS ICAL
Marg inal Phys ic al Pro duc t
PRODUCT OF 20
VARIABLE
INPUT (units ) 19
(3)(1)
18
18
19
17
16
MP
20
19
18
17
16
0
1
2 3 4 5 6 7
Numbe r o f Wo rke rs
Crowding Problem
• The point at which MPP declines
• Shows the law of diminishing returns
Average Physical Productivity
• Output divided by Inputs (usually labor)
Q
APP 
L
• Good for comparing firms or countries.
So find that…
• MC and MPP are related
• What is the relationship?
 MPP  MC
 MPP  MC
Law of Diminishing Marginal
(2)
(3)Returns
(4)
(1)
VARIABLE
INPUT,
LABOR
(Wo rke rs )
FIXED
QUANTITY OF
INPUT,
OUTPUT, Q
CAPITAL (units )
(units )
0
1
0
1
1
18
2
1
37
3
4
1
1
57
76
5
1
94
6
1
111
7
1
127
8
9
1
1
137
133
10
1
125
MARGINAL PHYS ICAL
PRODUCT OF VARIABLE
INPUT (units )
(3)(1)
18
19
20
19
18
17
16
10
–4
–8
Marginal Cost
Part (b)
(5)
TOTAL
FIXED
COS T
(dollars )
(6)
TOTAL
VARIABLE
COS T
(do llars )
(7)
TOTAL
COS T
(do llars )
(5) + (6)
$40
$0
$40
40
20
60
40
40
80
40
60
100
40
80
120
40
100
140
40
120
160
40
140
180
(8)
Marg inal Co s t (do llars )
MARGINAL
COS T
(do llars )
1.25
(7)(3)
or
1.17
(6)(3)
1.11
$1.11
$1.05
MC
1.05
1.00
$1.00
$1.05
$1.11
$1.17
$1.25
0
18 37 57 76 94 111 127
Quantity o f Output
Does this relationship make sense?
• Yes..
• If productivity increases what would happen to
costs??
– Decrease (MPP increase & MC decrease)
• Productivity decreases??
– Increase (MPP decreases & MC increases)
MPP determines shape of MC
• MPP must have a declining part because of
diminishing returns
• Can also define MC as:
wage
MC 
MPP
In-class exercise 11
How do we calculate these
costs??
Give two ways to get to the cost…
Average-Marginal Rule
• Can use to see what the ATC and AVC curve
look like
• Tells us what happens when MC is above or
below the “average” curves
• If MC is above AVC and ATC
– AVC and ATC are rising
• If MC is below AVC and ATC
– AVC and ATC are falling
From Average-Marginal Rule can
infer…
• MC intersects the AVC and ATC curves at their
MINIMUM POINTS
• Cannot infer anything about AFC
Average and Marginal Cost Curves
Part (b)
Co s t
MC
ATC
L
Re g io n
1
0
Re g io n
2
Quantity o f Output
Average and Marginal Cost Curves
Co s t
Part (a)
MC
AVC
L
Re g io n
1
0
Re g io n
2
Quantity o f Output
So…
• MC gains it shape from???
– MPP and law of diminishing marginal returns
• MC below ATC: What is ATC curve doing?
– Falling
• MC above ATC: What is ATC curve doing?
– Rising
Average and Marginal Cost Curves
Part (c )
Co s t
MC
ATC
AVC
AFC
0
Quantity o f Output
MC c urve c uts
bo th AVC and
ATC c urve s at
the ir re s pe c tive
lo w po ints .
Tying Products to Costs
A CLOSER LOOK
MPP
Variable Input
MC
When MC is below
ATC, AVC
Production in the
short run: at
least one fixed input
MPP
Variable Input
MC
When MC is above
ATC, AVC
Now switching to the Long Run
• When does Long Run start?
– As soon as all inputs (costs) are VARIABLE
– No fixed costs
• Important curves
– LRTC
– LRATC
– LRMC
Short Run vs. Long Run
• Short Run assumes FIXED plant size
• Each plant size has a unique ATC curve
associated with it
– SRATC
• LRATC combines all the SRATC curves
• Which points of the SRATC???
• Minimum points
Why minimum?
• LRATC shows the lowest average cost at which
a firm can produce any given level of output
• LRATC is the lower ENVELOPE of the SRATC
curves
• Called envelope curve
Long-Run Average Total Cost Curve
(LRATC)
Part (a)
Ave rag e Co s t (do llars )
S RATC2
S RATC1
B
6
5
A
S RATC3
D
C
LRATC
(blue
c urve )
0
Q1
Q2
Quantity o f Output
Isn’t the LRATC curve smooth??
• Yes!!
• Have infinitely many SRATC curves so it would
be smooth if use all curves
• Each SRATC curve touches the LRATC curve
only once
Shape of LRATC
• U-shaped
• Decreasing, Flat, then Increasing
• Important when finding optimal long run output
level
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Economies of Scale
• Downward part of LRATC
• Average costs decrease as output increases
• If have a 1% increase in input usage what
happens to output??
– Increases by MORE than 1%
• Specialization
Constant Returns to Scale
• Flat portion of LRATC
• Costs remain the same as increase output
• If have a 1% increase in input usage what
happens to output??
– Output increases by EXACTLY 1%
• First point of constant returns to scale is called
MINIMUM EFFICIENT SCALE
Diseconomies of Scale
• Upward sloped portion of LRATC
• Costs are rising as we increase output
• If have a 1% increase in input usage what
happens to output?
– Increases by LESS THAN 1%
• Why???
– Firm too large (bad communication or coordination
problems)
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Are economies, diseconomies, and
constant returns to scale in SR, LR, or
both???
• LONG RUN ONLY!!!
• Why?
– Inputs necessary for production are able to be
changed
– No fixed inputs
Is this the same as diminishing
returns?
• NO
• Diminishing returns is from using ONE plant
size intensely
– Short run
• Economies of scale is from CHANGING plant
size
– Long run
Review
• Economies of Scale
– LRATC falling
• Constant Returns to Scale
– LRATC flat
• Diseconomies of Scale
– LRATC rising
Why does economies of scale
exist?
• Large firms offer more opportunity for workers
to specialize
• Growing firms can take advantage of efficient
mass production techniques
– Smooth cost over more units produced
Why does diseconomies of scale
exist?
• Communication problems
• Shirking
• Management problems
Why is minimum efficient scale
important?
• Lowest output level at which ATC are minimized
• Which has a cost advantage??
– Small firm at minimum efficient scale point
– Larger firm producing more output but still within
constant returns to scale area
– Neither
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Minimum Efficient Scale for Six Industries
INDUS TRY
Re frig e rato rs
Cig are tte s
Be e r bre wing
Petro le um refining
Paints
S ho e s
MES AS A
PERCENTAGE
OF U.S .
CONS UMPTION
14.1 %
6.6
3.4
1.9
1.4
0.2
S OURCE: F. M. S c he re r, Alan
Be c he ns te in, Eric h Kaufe r, and R. D.
Murphy, The Ec o no mic s o f Multiplant
Ope ratio n (Cambridg e , Mas s .: Harvard
Unive rs ity Pre s s , 1975), p. 80.
Where would you expect to find less
firms? (using MES)
• Firms with higher MES
• Why??
– Produce until MES
– If MES is higher then each firm will be producing more…so
need less firms to cover quantity wanted by economy
• Many SHOE companies (MES = .2)
• Few REFRIGERATOR companies (MES = 14)
Efficient Number of Firms
• 100 divided by MES
• 100% of goods are wanted by consumers
• MES is the percentage of consumption each firm will
provide
• Cigarette firm’s MES = 6.6
– Need 15 firms
• Petroleum firm’s MES = 1.9
– Need 52 firms
• Thus a larger MES means less firms needed
What cause SRTC, LRTC, and MC
to shift?
• Taxes
– Does it affect FC??
• Only if it is a lump sum tax (tax for existing)
• If it is a per unit tax then FC doesn’t change
– How does it change curves??
• Input prices
– How does it change curves??
• Technology
– Either improves production process (use less
inputs) or lower input prices
– How does it change curves??
Homework due Monday May
19th
• Chapter 8
– Questions: 3, 5, 10, and 11
• Working with numbers and graphs
– Questions 3, 6, and 7
In-class exercise 12
Do we understand Chapter 8??
Chapter 9
Perfect
Competition
Assumptions
•
Many buyers and sellers
– None powerful enough to alter price
•
•
•
Homogenous good
Full information
Easy entry and exit
Price Takers
• Those who can’t influence price
• Why can’t they??
– Just a small fish in a large sea
• Who sets the price then??
– The market
Examples
•
•
•
•
Agriculture market
Milk Market
Pork Market
Beef Market
Demand Curve
• Individual Market
– Perfectly Horizontal
– Horizontal where??
• At the market price
• Industry
– Downward Sloping
Pric e (do llars )
Pric e (do llars )
S
Marke t
s upply
5
Market &
Firm Demand
in Perfect
Competition
d
5
De mand c urve fac ing
a s ing le pe rfe c tly
c o mpe titive firm.
Marke t
de mand
D
0
500,000
Quantity
(a)
Marke t
0
100
Quantity
(b)
S ing le Firm
Why???
• Price Taker
• Horizontal Demand means…
– At price lower firm would sell ALL its output
– At price higher firm would sell NOTHING
Would a firm sell at price lower than
market price?
• No!!
• Why??
– Wouldn’t maximize profit
– Could increase price and not lose customers
Why horizontal though??
• What happens to elasticity as increase the
number of substitutes for the good?
– Increases
• How many substitutes exist for a
homogenous good?
– Many
• What type of elasticity does this demand
have?
– Perfectly elastic
Does this go against the Law of
Demand?
• What is the Law of Demand??
– Increases in the price decrease the quantity
demanded for the good
• Go against??
• NO!!
• Just pricing situation a single firm finds themselves in
• Each firm produces small amount so can’t change price
Total Revenue
• Price * Quantity
• Marginal Revenue (MR)
TR
MR 
Q
• For a perfectly competitive firm
=> MR = Price
• Why???
– Price won’t change as output changes
• Why???
– Each firm is a PRICE TAKER
TR P * Q
MR 

Q
Q
P * Q
MR 
Q
MR  P
So…
• For perfectly competitive the MR curve
is the same as the Demand curve
– MR = D
• Since price taker – Demand horizontal
at the market price
– D = price
• So…MR = D = P
Example
Price
Quantity
5
1
5
2
5
3
TR
MR
Demand Curve and Marginal Revenue
Curve for a Perfectly Competitive Firm
Pric e (do llars )
(1)
P
(2)
Q
(3)
(4)
TR
MR
= (1) x (2) = TR/Q
= (3)/(2)
$5
1
$5
$5
5
2
10
5
5
3
15
5
5
4
20
5
Plo tting c o lum ns 1 and 2
g ive s us the de mand c urve ;
plo tting c o lum ns 2 and 4
g iv e s us the m arg inal
re v e nue c urv e .
0
(a)
d, MR
5
1
2
3
4
Qu antity
(b)
What if assumptions don’t hold?
• Depends on degree to which assumptions don’t
hold
• Difference small?
– Will approximately act like a perfectly competitive
market
• Difference big?
– Will be categorized as a different “type” of market
When will firm produce??
•
•
•
•
Produce as long as MC < MR
Do not produce if MC > MR
Maximize profit where MC = MR
Remember if Maximize profit you implicitly
mean you minimize costs
Profit Maximization Rule
• Produce at the quantity where MR just equals
MC
• True for all market types not just perfect
competition
• Point we are interested in
– MR = MC
Since…
• P = MR
• Profit Maximization is MR = MC
• Can rewrite profit maximization rule as
– P = MC
Quantity of Output the Perfectly Competitive
Firm Will Produce
Pric e and Co s t (do llars )
MC
MR = MC
d, MR
5
Quantity o f o utput
firm will pro duc e
0
50
100
Quantity
125 140
Four Cases: Produce or not?
•
•
•
•
•
Price equals ATC
Price above ATC
Price below AVC
Price below ATC but above AVC
Each case must start with profit
maximization rule
• What was that rule???
– Price = MC = MR
Price equals ATC
• Called Normal profit or Zero Economic Profit
• Breakeven point
• No profit or loss
Price above ATC
•Profit
Profits in Perfect Competition
Part (a) Cas e 1
Pric e and Co s t (dollars )
MC
15
PROFITS
11
d 1 , MR1
ATC
AVC
7
0
P > ATC (>AVC)
TR =
TC =
TVC =
TFC =
$1,500
$1,100
$700
$400
Pro fits = $400
Co ntinue to
pro duc e in
the s ho rt run.
100
Quantity
Price below AVC
• Loss
• Firm fails to cover even variable costs of firm
• Should Shut Down!!
Shut Down Rule
• If P < AVC should shut down
• Why?
– Minimize loses
– If continue to produce have to pay variable and
fixed costs
– If shut down have to pay only fixed costs
Loss and Shut down
Part (b) Cas e 2
Pric e and Co s t (do llars )
MC
P < AVC (<ATC)
ATC
13
LOS S ES
AVC
5
4
0
d 2 , MR2
50
Quantity
TR =
TC =
TVC =
TFC =
$200
$650
$250
$400
Lo s s e s = –$450
S hut do wn
in the
s ho rt run.
Price below ATC but above AVC
• Loss
• Continue to operate
– Covering variable costs and some fixed
costs
– Minimize losses by continuing operation
• Overtime alter production to cover all
fixed costs
Loss but continue to operate
Part (c ) Cas e 3
Pric e and Co s t (dollars )
10
9
MC
ATC
TR =
TC =
TVC =
TFC =
d 3 , MR3
AVC
Lo s s e s = –$80
LOS S ES
5
0
ATC > P >AVC
$720
$800
$400
$400
Co ntinue to
pro duc e in
the s ho rt run.
80
Quantity
What Should a Firm Do in the Short
Run?
Yes
Continue to
produce
Is it above
ATC?
No
Price
Yes
Continue to
produce
No
Shut down
Is it above
AVC?
Can we do this with
numbers too?????
In-class exercise 13
Now..
Firm Supply Curve
What is the shut down rule??
• Shut down if Price < AVC
•
•
•
•
So…produce if Price > AVC
Supply Curve is portion of MC above the AVC
Why??
Indicates quantities at which the firm would
consider producing
Perfectly Competitive Firm's
Short-Run Supply Curve
Co s t
MC
Firm’s
S ho rt-run
S upply Curve
0
Quantity
AVC
How find the market supply curve?
• What is the individual firm’s supply curve?
– MC above AVC
• Horizontally sum all individual supply curves to
get the market supply curve
• Why are market supply curves upward
sloping??
– Horizontal sum of upward sloped curves
– Law of diminishing marginal returns
Pric e
Pric e
S1
P1
0
(a)
+
0
8
Quantity
Firm B
Pric e
=
P1
0
(b)
Marke t
S upply
P1
18 Quantity 0
Firm C
36 Quantity
Marke t S upply
Marke t
De mand
0
Pric e
S3
+
P1
10 Quantity
Firm A
Pric e
S2
Quantity
The Marke t
Deriving the
Market
(Industry)
Supply Curve
Job Security and fixed costs?
• Is this the Short Run or Long Run?
– Short because have fixed costs
• Increases in FC/TC ratio means more job
security
• Why?
– If true … FC is a larger portion of TC
– TR can fall more before firm shuts down
Which firm has more job security?
Firm X
Firm Y
TC
600
600
TVC
400
500
TFC
200
100
Firm X has more job security!!
• Unions know this so usually negotiate more
benefits for workers before wages
• Why??
– Benefits are a fixed cost
– Must pay for them even if workers aren’t using the
benefit
Will there be the same number of
firms in the short and long runs?
• Probably not!!
• If there is a profit
– More firms will be in the long run
• If there is a loss
– Less firms will be in the long run
• If there is normal profit
– The same amount of firms will be in the long run
Long Run Competitive
Equilibrium
• Zero Economic Profit (normal profit)
– P = SRATC
– Incentive for no firms to enter or exit
• Produce where P = MC
• No incentive to change plant size
– SRATC = LRATC where P = MC
– Production is at optimal scale
Long-Run Competitive Equilibrium
P = MC = S RATC = LRATC
Price and Co s t
MC S RATC
Pric e
S
LRATC
P1
d , MR
P1
D
0
Q1
Quantity
(a)
The Marke t
0
q1
Quantity
(b)
The Firm
Summary of Incentives present at
Long Run Equilibrium
• No incentive for firms to enter or exit
• No incentive for firms to produce more or less
• No incentive to change plant size
Perfect Competition
• Resource Allocative Efficiency
– Value of product to consumers =
opportunity cost of resources
– P = MC
• Productive Efficiency
– Producing at the lowest per unit cost
– Long run equilibrium ATC = P at minimum
point of ATC curve
– Efficiently using resources (not wasting)
Do we understand
Chapter 9???
In-class exercise 14
Homework
due Friday May 30th
Chapter 9
Questions 1, 6, 16
Working with Graphs and
Numbers
Questions 1 and 9
Chapter 10
MONOPOLY
Assumptions
• One seller
– Firm is the industry
• No substitutes for good
• Many barriers to entry
Government can “grant”
monopoly power in three ways…
• Public franchise
– Exclusive provider
• Power companies, water companies
• Patents
– Exclusive provider for 17 years
– Encourages people to invent new things
• Zantac, Tagament
• Licenses
– Must have to operate
• Cabs in New York City
Monopolies exist because:
• Legal mandate
– Government allows or doesn’t allow you to
operate
• Economic rational
– Natural Monopolies
• One firm can produce more efficiently than
many
– Exclusive ownership of resource to make
the good
Two types of Monopolies
• Government monopolies
– Legally protected from competition
• Market monopolies
– Protected from competition due to economies of
scale
Price maker
• Firm is the market
• Firm has some control over the price it sets
• Law of Demand still hold
– Price increases leads to less quantity demanded
Demand Curve
• Remember the individual firm is the market
• What does the demand curve look like??
– Downward sloped
– Want to sell more must lower the price
Example
Price
Quantity
10
2
9.75
3
TR
MR
What differs here from Perfect
Competition??
• Price doesn’t equal MR!!!
– Price > MR
• Monopolist’s demand curve and marginal
revenue curves are DIFFERENT
• After the first point Marginal Revenue falls twice
as fast as Demand
Example
Price
10
Quantity
Deman
d
1
9
2
8
3
7
4
TR
MR
Demand and Marginal
Revenue Curves
Price or Marginal Revenue
For a monopolist,
the marginal
revenue curve
lies below the
demand curve.
MR
0
Quantity
D
Goal
• Profit Maximization
• What is the profit maximization rule?
– MR = MC
• Want to charge the highest price per unit of
quantity sold
Price
and Cost
Profit-maximizing
price (highest
price per unit at
which Q1 can be
sold).
MC
Monopolist'
s ProfitMaximizing
At Q1, P > MC Price and
Quantity of
Output
P1
MC1
MR = MC
MR
0
Q1
Profit-maximizing
quantity of output
D
Quantity
Three cases
• P > ATC
• P < ATC
• P=ATC
• Where is AVC??
– Since monopoly is the industry no need to segment total
cost
– If suffer a loss can just increase prices to cover the loss
Monopoly Profits and Losses
Price
Price
MC
MC
ATC
B
C
B
P1
PROFITS
C
ATC
LOSSES
P1
A
A
D
D
MR
0
Quantity
Q1
(a) Monopoly Profits
MR
0
Quantity
Q1
(b) Monopoly Losses
Differences between monopoly and
perfect competition
• P = MR for perfect competition but P > MR for
monopoly
• P = MC for perfect competition but P > MC for
monopoly
• Monopolist can change prices
Similarities
• Both try to maximize profits
• Both are constrained by their demand curves
• Both equate MR and MC
Long Run Profits
• Perfect Competition
– Zero Economic Profit (normal profit)
• Monopoly
– No entry
– Profits can be reduced in two ways
• Capitalization of profits
• Monopoly rent seeking
Capitalization of Profits
• Firm owner eventually may sell the business
• When sell…include profits into the price
– Include in TFC
• New owner will face a higher ATC than
previous owner
– Includes old owner’s profits
• Increase in ATC eliminates profit for new
owner
Capitalization
of
Profits
Price
MC
ATC (new owners
of monopoly)
Profits of
former owners
of monopoly
firm.
B
P1
PROFITS
C
ATC (former owners
of monopoly)
A
D
MR
0
Q1
Quantity
Economic Rent
• Profits that can’t be reduced by new
entrants
• Payment in excess of opportunity cost
(profit)
• May bring about Rent Seekers
– Try to find markets that can gain monopoly
status
– Time and resources expended to try to get
monopoly reduces economic rent
Monopolies are inefficient
compared to Perfect Competition
• Welfare cost of monopoly
– Lower levels of output produced with
monopoly than perfect competition
– Perfect competition produce where P=MC
– Monopoly produce where MR=MC and P >
MC
– Welfare cost is about 1% of total output
• Rent seeking is socially wasteful
– Use resources not in production but to gain
Welfare Cost and Rent
SeekingPrice
as Social Costs of
Monopoly
Monopoly profits
subject to
socially wasteful
rent seeking
C
PM
PC
Welfare cost triangle
A
MC = ATC
B
D
MR
0
QM
QC
Quantity
X-inefficiency
• Monopoly has no competition
• No incentive to operate at lowest cost
Does monopolist have to charge
same price to everyone?
• No!!
• Called Price Discrimination
• Three types
– First degree (perfect price discrimination)
– Second degree (bulk pricing)
– Third degree (group pricing)
Perfect Price discrimination
• Highest price willing and able to pay is charged
to each person
• Price determined by placement on demand
curve
• Discrimination among units
– Ex. Schools
Bulk Pricing
• Different prices for different quantities sold
• Discrimination among quantities
• Ex. costco
Group Pricing
• Different prices for different segments of the
market
• Ex. Senior citizen discounts, coupons, different
seats in movie or plane…
Why Price Discriminate?
• To gain some of the consumer surplus lost
when charge everyone the same price
• If successfully perfectly price discriminate
– P=MR for all units sold
– MR and TR increase
– Eliminate consumer surplus
Why doesn’t everyone price
discriminate?
• Seller must be a price maker
• Seller must know each consumer’s willingness
to pay
• Must be impossible for consumers to resell to
others
– Arbitrage
– Buy for a low price and sell at a higher price
Does a monopolist exhibit resource
allocative efficiency?
• Perfect competition does!!
– P = MC
• Monopolist doesn’t!!
– P > MC
• Perfectly Price Discriminating Monopolist does!!
– P = MC
Comparing P. C. Firm, Single-Price Monopolist, &
Perfectly Price-Discriminating Monopolist
Price
Price
MC
Price
MC
PM
PC
d, MR
P > MC
MC
PPD
P = MC
P = MC
D, MR
D
MR
0
qC
Quantity
(a)
Perfectly
Competitive Firm
0
0
QM
Quantity
(b)
Single-Price
Monopolist
QPD
Quantity
(c)
Perfectly
Price-Discriminating
Monopolist
So does one person paying high prices
mean that another can pay low
prices??
• No!!
• Perfect Price Discrimination means that each
person pays the highest price they are willing
and able to pay
Would firms rather be a monopoly?
• Yes!!
• Rent seekers try to “buy” monopoly positions.
• Why?
– Fewer constraints on production behavior
– Ability to charge different prices to different
segments of the population
Homework
Chapter 10
Question 1
Working with graphs and numbers
Questions 5, 6, and 7
Homework
Chapter 10
Questions 1 and 4
Working with graphs and numbers
Questions 4, 5, and 6
Finally Chapter 11
Monopolistic
Competition,
Oligopoly, and Game
Theory
Monopolistic Competition
Four Assumptions
• Many buyers and sellers
• Heterogeneous Products
– Brand names, location, services…
– Real or Imagined
• Easy Entry and Exit
• Some control of prices
Examples
• Retail clothing
• Restaurants
• Textbooks
• Gas Stations
• What about cereals??
– No…many different brands but very few firms that
produce them (GM, Post…)
Monopolistic is combination of
Perfect Competition and
Monopoly
• Downward Sloped Demand Curve
– Price Maker (Searcher)
• Demand Curve more elastic than
Monopoly
– Easy entry limits control over price
– More elastic because more substitutes
• P > MR
– No resource allocative efficiency
• Most likely -- Zero Economic Profit in the
long run
– Not productive efficient
Why most likely????
• Heterogeneous products
• Not differentiated enough
– Entry eats up profits
• Differentiated
– Barriers to entry
– Profits
– Example…7-up “The only uncola”
Still have three cases
• P = ATC
• P > ATC
• P < ATC
Monopolistic Competitor in SR & in LR
Price
Price
MC
MC
ATC
P1
ATC
P1
A
L
PROFITS
MR = MC
d
d
MR
0
q1
(a)
MR
Quantity
At q1, P > MC
0
q1
(b)
Quantity
Differs from perfect competition…
• Produce less than perfectly competitive
• Excess Capacity
– Rid only with min ATC tangent to demand curve
– Possible only with horizontal demand curve
• Higher prices than perfectly competitive
Comparison of Perfect Competition and
Monopolistic
Competition:
Excess Capacity
Price
Price
Monopolistic
competitive firm
operates here.
PMC1
ATC
MC
ATC
A
L
L
PMC2
Lowest point
on ATC curve
qMC
PC1
d
Lowest point
on ATC curve
d
MR
0
Perfectly
competitive firm
operates here.
MC
qMC2
Quantity
Excess Capacity
(a) Monopolistic Competition
0
qC1
Quantity
(b) Perfect Competition
The more we
differentiate our
product the closer
we get to
monopoly. If we
can’t differentiate
our product we
are closer to
perfect
competition.
Oligopoly
Oligopoly
Four assumptions
• Few sellers and many buyers
– Firms mutually interdependent
• Homogeneous or Heterogeneous Goods
• Price Maker (Searcher)
– Limited number of firms
• Barriers to entry
– Economies of scale, patents, legal barriers…
How find???
• Concentration Ratio
– Measures the % of some factor that is controlled by
a certain number of firms in the industry
– Employment, sales, assets, output…
So…
• High concentration ratio?
– Oligopoly likely
– Small number of firms controls much of the output
• Small concentration ratio?
– Oligopoly unlikely
– Large number of firms control the outpu
Question…
How do firms react to
actions of other firms???
Important since they are
interdependent!
Three theories
• Kinked Demand Curve Theory
• Price Leadership Theory
• Cartel Theory
Kinked Demand Theory
• General Theory
– If one firm decreases price all firms will match
– If one firm increases price others many not
match
• So…each firm has a kink in the demand
curve at the prevailing price
– Why???
– That is where decisions must be made
Demand Curve
• Flatter above kink
– More elastic
– Increase price and people freak out
• Steeper below kink
– Less elastic
– Decreases in price won’t increase quantity
demand much
– Why?
– All firms decrease price
Why kinked
• Made up of two separate demand curve with
their own MR curves
• One demand more elastic
• One demand less elastic
• Only use portions of demand curve that is
relevant
– More elastic above price and less elastic below
So…
• MR is not continuous
• Expect price to remain at or near kink
• Called sticky prices
Price
Window
P
K
27 A
25
K
A
MC2
23
d1
B
MC1
C
MR
18
B
0
10
Q
0
C
MR2
d
20 22
Quantity
MR
d2
MR1
Kinked
Demand
Curve
Theory
Criticisms
• Doesn’t say where price comes from
• Real oligopolies don’t behave like this
– Most will follow a price increase by one firm
– Why wouldn’t they match???
– Gain larger portion of market
 P  Qd
Price Leadership Theory
• Tries to explain where kinked price comes
from
• Assumption
– One firm (dominate firm) sets the market price
and other firms (fringe firms) take price as
given
Price Leadership Theory
Price
MCF = S
Price
MCDN
P1
P1
PDN
PDN
D
0
qF Q1 Q2
Supplied Supplied
by
by
Fringe Dominant
Firms
Firm
(a)
Quantity
MRDN
0
qDN
DDN
Quantity
(b)
So…
• Dominate firm
– Sets price to maximize its profits
– Price Maker (Searcher)
– Own supply and demand curve
• Fringe Firm
– Takes price as given
– Price Taker
– MC > AVC is supply curve
Dominate Firm does
not have to be the
largest!!! It could be
the one with the
lowest cost!!
How derive demand curve?
• Dominate firm
– See how much is left over for it to supply at a given
price
Total Demand
- Fringe Supply
Dominate Firm Supply
From Demand Curve
• Find price that will equate MR = MC
• Fringe firms take price as given
• At equilibrium price fringe firms cover all market
demand
Cartel Theory
• Several firms ban together and act as a
monopoly
• Produce less quantity and charge higher prices
than if operated alone
• Gain profits…then split among group members
Benefits of a Cartel (to Cartel
Members)MC
Price
ATC
PC
C
P1
A
PROFITS
B
D
MR
0
QC
Q1
Quantity
Problems for a cartel
• May be illegal
• Expensive to set up
– Free rider
– Own priorities
– Self interest
• Profits may entice other firms to “try” to enter
industry
• Incentive to Cheat
Why Cheat???
• Can increase output to increase individual profit
• If one firm cheats…all will eventually cheat
• Cartels will not stay in tact for long
The Government tries to keep some
cartels together
• Farmers
– Acreage allotment program
• Airlines
• Each tends to increase price, TR, and profits
Game Theory
• Mathematical technique used to analyze
behavior of decision makers
– Each player knows game is interactive
– Needs to anticipate outcomes of other person
• Matter of Trust
Prisoner’s dilemma
• Two prisoners in separate rooms being
questioned
• Two ways to answer
– Confess
– Not confess
• Four outcomes
Prisoner's Dilemma
Nathan’s Choices
Confess
Not Confess
2
1
Not
Confess
Nathan pays $500
Nathan pays $2,000
Bob pays $5,000
Bob pays $2,000
Bob’s
Choices
Confess
4
3
Nathan pays $5,000
Bob pays $500
Nathan pays $3,000
Bob pays $3,000
Cartels and Prisoner's
Dilemma
Hold to
Agreement
Firm A’s Choices
Break
Agreement
1
Hold to
Agreement
A earns $50,000 profits
B earns $50,000 profits
Firm B’s
Choices
Break
Agreement
2
A earns $100,000 profits
B earns $5,000 profits
3
A earns $5,000 profits
B earns $100,000 profits
4
A earns $10,000 profits
B earns $10,000 profits
Do we understand
Chapter 11?
In-class exercise 16
Homework due
Monday June 9th
Chapter 11
Questions 1, 2, 5, and 6