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Principles of Microeconomics 12. Production Costs, Free Market and Monopoly* Akos Lada August 7th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint Contents 1. Review of previous lecture 2. The Production Function and the MPL 3. Marginal Costs of Production 4. Fixed Costs, Variable Costs, and Total Costs 5. How Competitive Firms Maximize Profits 6. Monopolies 1. Review The Different Kinds of Goods Rival Not Rival Excludable Not excludable Private goods e.g. food Common resources e.g. fish in the ocean Natural monopolies Public goods e.g. cable TV e.g. national defense Public Goods • Are goods that are nonexcludable and non-rival • If the benefit of a public good exceeds the cost of providing it, government • Some important public goods should provide the good and are: pay for it with a tax. • National defense • Economists use cost-benefit • Knowledge created through basic research analysis to determine how • Fighting poverty much to provide of a public good. • Public goods are difficult for private markets to provide • Cost-benefit analysis is because of the free-rider imprecise because benefits problem. are hard to measure. Common Pool Resources • Are goods that are at the same time not excludable but rival. • Some important Common Resources are: • Clean air and water • Congested roads • Fish, whales, and other wildlife • Leads to the overconsumption of the resource (e.g. the tragedy of the commons). • Possible policies available to the government to address this issue include: • • • • Regulate use of the resource Impose a corrective tax Auction off permits allowing use of the resource If the resource is land, convert to a private good by dividing and selling parcels to individuals Economic Profit vs. Accounting Profit • Accounting profit = total revenue minus total explicit costs • Economic profit = total revenue minus total costs (including explicit and implicit costs) • Accounting profit ignores implicit costs, so it’s higher than economic profit. 2. The Production Function and the MPL Total, average, marginal 0 2 + 3 + 7 + 8 20 2 1 4 1 The Production Function • A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good. • It can be represented by a table, equation, or graph. • Example: • Farmer Golib grows Cotton. • He has 5 acres of land. • He can hire as many workers as he wants. • To build Golib’s Production Function we need to determine how many additional bags of cotton he would produce each time he hires one additional worker for his farm. EXAMPLE: Farmer Golib’s Production Function Q (no. of (bags of workers) cotton) 3,000 Quantity of output L 2,500 0 0 1 1000 2 1800 3 2400 500 4 2800 0 5 3000 2,000 1,500 1,000 0 1 2 3 4 No. of workers 5 Marginal Product • If Golib hires one more worker, his output rises by the marginal product of labor. • The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. • Notation: ∆ (delta) = “change in…” Examples: ∆Q = change in output, ∆L = change in labor • Marginal product of labor (MPL) = ∆Q ∆L EXAMPLE: Farmer Golib’s Total & Marginal Product L Q (no. of (bags workers) of cotton) ∆L = 1 ∆L = 1 ∆L = 1 ∆L = 1 ∆L = 1 0 0 1 1000 2 1800 3 2400 4 2800 5 3000 MPL ∆Q = 1000 1000 ∆Q = 800 800 ∆Q = 600 600 ∆Q = 400 400 ∆Q = 200 200 MPL = Slope of Production Function L Q MPL 3,000 0 0 1 1000 2 1800 3 2400 4 2800 5 3000 1000 800 600 400 200 Quantity of output MPL (no. of (bags workers) of cotton) equals the slope of the 2,500 production function. 2,000 Notice that MPL diminishes 1,500 as L increases. 1,000 This explains why the 500 production function gets flatter 0 as L0increases. 1 2 3 4 No. of workers 5 Why MPL Is Important • Recall one of the Principles of Economics: Rational people think at the margin. • When Farmer Golib hires an extra worker, • his costs rise by the wage he pays the worker • his output rises by MPL • Comparing them helps Golib decide whether he would benefit from hiring the worker. 3. Marginal costs of production Why MPL Diminishes • Farmer Golib’s output rises by a smaller and smaller amount for each additional worker. Why? • As Golib adds workers, the average worker has less land to work with and will be less productive. • In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.). • Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal) EXAMPLE: Farmer Golib’s Costs • Farmer Golib must pay $1000 per month for the land, regardless of how much cotton he grows. • The market wage for a farm worker is $2000 per month. • So Farmer Golib’s costs are related to how much cotton he produces…. EXAMPLE: Farmer Golib’s Costs L Q Cost of (no. of (bags land workers) of cotton) Cost of labor Total Cost 0 0 $1,000 $0 $1,000 1 1000 $1,000 $2,000 $3,000 2 1800 $1,000 $4,000 $5,000 3 2400 $1,000 $6,000 $7,000 4 2800 $1,000 $8,000 $9,000 5 3000 $1,000 $10,000 $11,000 EXAMPLE: Farmer Golib’s Total Cost Curve 0 1000 1800 2400 $12,000 Total Cost $1,000 $3,000 $5,000 $7,000 2800 $9,000 3000 $11,000 $10,000 Total cost Q (bags of cotton) $8,000 $6,000 $4,000 $2,000 $0 0 1000 2000 3000 Bags of cotton Marginal Cost • Marginal Cost (MC) is the increase in Total Cost from producing one more unit: ∆TC MC = ∆Q • We can calculate in the table the marginal cost of producing each additional unit, one at the time EXAMPLE: Total and Marginal Cost Q (bags of cotton) 0 ∆Q = 1000 ∆Q = 800 ∆Q = 600 ∆Q = 400 ∆Q = 200 Total Cost Marginal Cost (MC) $1,000 1000 $3,000 1800 $5,000 2400 $7,000 2800 $9,000 3000 $11,000 ∆TC = $2000 $2.00 ∆TC = $2000 $2.50 ∆TC = $2000 $3.33 ∆TC = $2000 $5.00 ∆TC = $2000 $10.00 EXAMPLE: The Marginal Cost Curve 0 TC MC $1,000 1000 $3,000 1800 $5,000 2400 $7,000 2800 $9,000 3000 $11,000 $2.00 $2.50 $3.33 $5.00 $10.00 $10 Marginal Cost ($) Q (bags of cotton) $12 $8 MC usually rises as Q rises, as in this example. $6 $4 $2 $0 0 1,000 2,000 Q 3,000 Why MC Is Important • Farmer Golib is rational and wants to maximize his profit. To increase profit, should he produce more or less cotton? • To find the answer, Farmer Golib needs to “think at the margin.” • If the cost of additional cotton (MC) is less than the revenue he would get from selling it, then Golib’s profits rise if he produces more. 4. Fixed costs, variable costs and total costs Fixed and Variable Costs • Fixed costs (FC) do not vary with the quantity of output produced. • For Farmer Golib, FC = $1000 for his land • Other examples: cost of equipment, loan payments, rent • Variable costs (VC) vary with the quantity produced. • For Farmer Golib, VC = wages he pays workers • Other example: cost of materials • Total cost (TC) = FC + VC EXAMPLE 2 • Our second example is more general, applies to any type of firm producing any good with any types of inputs. • Think of an example, and keep it in mind as we calculate the different costs of production…. EXAMPLE 2: Costs FC VC TC 0 $100 $0 $100 1 100 70 170 2 100 120 220 3 100 160 260 4 100 210 310 5 100 280 380 6 100 380 480 7 100 520 620 FC $700 VC TC $600 $500 Costs Q $800 $400 $300 $200 $100 $0 0 1 2 3 4 Q 5 6 7 EXAMPLE 2: Marginal Cost TC 0 $100 1 170 2 220 3 260 4 310 5 380 6 480 7 620 MC $70 50 40 50 70 100 140 $200 Marginal Cost (MC) Recall, is $175 the change in total cost from producing one more unit: $150 ∆TC MC = ∆Q $100 Usually, MC rises as Q rises, due to $75 diminishing marginal product. Costs Q $125 $50 Sometimes (as here), MC falls before $25 rising. $0 (In other0 examples, 1 2 3MC4 may 5 be 6 constant.) Q 7 EXAMPLE 2: Average Fixed Cost FC 0 $100 AFC n/a 1 100 $100 2 100 50 3 100 33.33 4 100 25 5 100 20 6 100 16.67 7 100 14.29 $200 Average fixed cost (AFC) is$175 fixed cost divided by the quantity of output: $150 Costs Q AFC $125 = FC/Q $100 Notice $75 that AFC falls as Q rises: The firm is spreading its fixed $50 costs over a larger and larger $25 number of units. $0 0 1 2 3 4 Q 5 6 7 EXAMPLE 2: Average Variable Cost VC AVC 0 $0 n/a 1 70 $70 2 120 60 3 160 53.33 4 210 52.50 5 280 56.00 6 380 63.33 7 520 74.29 $200 Average variable cost (AVC) is$175 variable cost divided by the quantity of output: $150 Costs Q AVC $125 = VC/Q $100 As$75 Q rises, AVC may fall initially. In most cases, AVC will eventually $50 rise as output rises. $25 $0 0 1 2 3 4 Q 5 6 7 EXAMPLE 2: Average Total Cost Q TC 0 $100 ATC AFC AVC n/a n/a n/a 1 170 $170 $100 $70 2 220 110 50 60 3 260 86.67 33.33 53.33 4 310 77.50 25 52.50 5 380 76 20 56.00 6 480 80 16.67 63.33 7 620 88.57 14.29 74.29 Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Also, ATC = AFC + AVC EXAMPLE 2: Average Total Cost Q TC 0 $100 1 170 ATC $200 Usually, as in this example, $175 the ATC curve is U-shaped. n/a $150 $170 $125 220 110 3 260 86.67 4 310 77.50 5 380 76 $25 6 480 80 $0 7 620 88.57 Costs 2 $100 $75 $50 0 1 2 3 4 Q 5 6 7 EXAMPLE 2: The Various Cost Curves Together $200 $175 Costs ATC AVC AFC MC $150 $125 $100 $75 $50 $25 $0 0 1 2 3 4 Q 5 6 7 Why ATC Is Usually U-Shaped? As Q rises: $200 Initially, falling AFC pulls ATC down. $175 Efficient scale: The quantity that minimizes ATC. Costs Eventually, rising AVC pulls ATC up. $150 $125 $100 $75 $50 $25 $0 0 1 2 3 4 Q 5 6 7 ATC and MC When MC < ATC, $200 When MC > ATC, $175 ATC is rising. $150 The MC curve crosses the ATC curve at the ATC curve’s minimum. $125 Costs ATC is falling. ATC MC $100 $75 $50 $25 $0 0 1 2 3 4 Q 5 6 7 5. How Competitive Firms Maximize Profits Characteristics of Perfect Competition 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given. The Revenue of a Competitive Firm • Total revenue (TR) TR = P x Q • Average revenue (AR) TR =P AR = Q • Marginal revenue (MR): The change in TR from selling one more unit. ∆TR MR = ∆Q MR = P for a Competitive Firm • A competitive firm can keep increasing its output without affecting the market price. • So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets. Profit Maximization • What Q maximizes the firm’s profit? • To find the answer, “think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC. • If MR > MC, then increase Q to raise profit. • If MR < MC, then reduce Q to raise profit. • Therefore, the Q that will give the firm the maximum profit it can make in the market, is the Q at which…. MC and the Firm’s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Qa, MC < MR. So, increase Q to raise profit. At Qb, MC > MR. So, reduce Q to raise profit. At Q1, MC = MR. Changing Q would lower profit. Costs MC P1 MR Q a Q1 Q b Q MC and the Firm’s Supply Decision If price rises to P2, then the profitmaximizing quantity rises to Q2. The MC curve determines the firm’s Q at any price. Hence, the MC curve is the competitive firm’s supply curve. Costs MC P2 MR2 P1 MR Q1 Q2 Q 6. Monopolies Monopolies • A monopoly is a firm that is the sole seller of a product without close substitutes. • In this chapter, we study monopoly and contrast it with perfect competition. • The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the world’s diamond mines 2. The government gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws Why Monopolies Arise 3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms. Example: 1000 homes need electricity ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes. Cost $80 Electricity ATC slopes downward due to huge FC and small MC $50 ATC 500 1000 Q Monopoly vs. Competition: Demand Curves A competitive firm’s demand curve In a competitive market, the market demand curve slopes downward. But the demand curve for any individual firm’s product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. P A competitive firm’s demand curve A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P. P D D Q Q The Monopolist Profit • Profit maximization golden rule: • MR = MC • For competitive firms • MR = P, therefore, • Profit Maximization Condition: P=MC • For monopolies, however…. • MR ≠ P • Then, how do monopolies maximize their profits?