Micro 1 Exam II Ch. 13-17 Ch.13 The Costs of Production Profit = Total revenue Total cost TR= amt a firm receives from the sale of its output TC= the market value of the inputs a firm uses in production Explicit costs require an outlay of money (e.g. paying wages to workers, rent, cost of material) Implicit costs do not require a cash outlay (e.g. the opt cost of the owner's time, effort) Accounting profit total revenue minus total explicit costs Economic profit total revenue minus total costs (including explicit and implicit costs) The Production Function -shoes the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good. Marginal Product -of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Marginal product of labor (MPL) = Q/L Why MPL is Important --Rational ppl think at the margin. When X hires an extra worker, his costs rise by the wage he pays the worker and his output rises by MPL. Diminishing marginal product: The marginal product of an input declines as the quantity of the input increases (other things =) In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc) Marginal Cost (MC) The increase in Total Cost from producing one more unit MC = TC/Q Why MC is important? X is rational and wants to maximize his profit. To increase profit, should he produce more product, or less? If the cost of additional product (MC) is less than the revenue he would get from selling it, then X's profits rise if he produces more. Fixed costs (FC) do not vary with the quantity of output produced. Variable costs (VC) vary with the quantity produced. Total cost (TC) = FC + VC Average total cost (ATC) = total cost divided by the quantity of output ATC = TC/Q ATC = AFC + AVC Why ATC is Usually U-shaped As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up.
2 ATC and MC When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curve's minimum. Costs in the Short Run & Long Run Short run: Some inputs are fixed. The costs of these inputs are FC. Long run: All inputs are variable. ATC at any Q is cost per unit using the most efficient mix of inputs for that Q. LRATC with 3 Factory Sizes Factories come in many sizes, each with its own SRATC curve. How ATC Changes as the Scale of Production Chnages Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases. Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on the narrow task. More common when Q is low. Diseconomies of scale are due to coordination problems in large organizations. More common when Q is high. Ch.14 Firms in Competitive Markets 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. The Revenue of a Competitive Firm Total revenue (TR) = P x Q Average revenue (AR) = TR/Q = P Marginal revenue (MR) = TR/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 P, ie, MR = P MR = P is only true for firms in competitive markets. Profit Maximization If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit. At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit. MC and the Firm's Supply Decision Rule: MR = MC at the profit-maximizing Q.
3 MC curve is the firm's supply curve in a perfect competition market. Shut down vs. Exit Shut down short run decision not to produce anything b/c of market conditions. Exit a long run decision to leave the market. o A firm that shuts own temporarily must still pay its fixed costs. A firm that exists the market does not have a to pay any costs at all, fixed or variable. A Firm's Short-Run Decision to Shut Down If firm shuts down temporarily, -revenue falls by TR -costs fall by VC So, the firm should shut down if TR < VC Divide both sides by Q: TR/Q < VC/Q So we can write the firm's decision as: Shut down if P < AVC A Competitive Firm's SR Supply Curve If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0) Irrelevance of Sunk Costs Sunk cost: a cost that has already been committed and cannot be recovered. Sunk cost should be irrelevant to decisions; you must pay them regardless of your choice. FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. So, FC should not matter in the decision to shut down. A Firm's Long Run Decision to Exit If firm exits the market, Revenue falls by TR Costs fall by TC So, the firm should exit if TR < TC Divide both sides by Q to rewrite the firm's decision as Exit if P < ATC A New Firm's Decision to Enter the Market In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC Divide both sides by Q to express the firm's entry decision as Enter if P > ATC Competitive Firm's LR Supply Curve The firm's LR supply curve is the portion of its MC curve above LRATC. Market Supply: Assumptions 1. All existing firms and potential entrants have identical costs. 2. Each firm's costs do not change as other firms enter or exit the market. 3. The # of firms in the market is -fixed in the short run (due to fixed costs) -variable in the long run (due to free entry and exit)
4 SR Market Supply Curve As long as P > AVC, each firm will produce its profit-maximizing quantity, where MR = MC. (recall) At each price, the market quantity supplied is the sum of quantity supplied by each firm. Entry & Exit in the Long Run In the LR, the # of firms can change due to entry & exit. If existing firms earn positive economic profit, -new firms enter -SR market supply curve shifts right -P falls, reducing firm's profits -Entry stops when firms' economic profits have been driven to zero. In the LR, the # of firms can change due to entry & exit. If existing firms incur losses, -Some will exit the market -SR market supply curve shifts left -P rises, reducing remaining firm's losses. -Exit stops when firm's economic losses have been driven to zero. The Zero-Profit Condition LR EQ The process of entry or exit is complete remaining firms earn zero economic profit. Zero economic profit occurs when P = ATC Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC. Recall that MC intersects ATC at minimum ATC. Hence, in the long run, P = minimum ATC. The LR Market Supply Curve In the long run, the typical firm earns zero profit. LR supply curve is horizontal at P = min ATC. Why do Firms Stay in Business if Profit = 0 ? Economic profit is revenue minus all costs including implicit costs, like the opt cost of the owner's time and money. In the zero-profit EQ, firms earn enough revenue to cover these costs. SR & LR effects of an Increase in Demand ---
Why the LR Supply Curve Might Slope Upward? The LR market supply curve is horizontal if 1. all firms have identical costs, and 2. costs do not change as other firms enter or exit the market. If either of these assumptions is not true, then LR supply curve slopes upward. 1. Firms have Diff Costs As P rises, firms with lower costs enter the market before those with higher costs. Further increases in P make it worthwhile for higher cost firms to enter the market, which increases market quantity supplied. Hence, LR market supply curve slopes upward At any P,
5 -For the marginal firm, P = min ATC and profit = 0 -For lower-cost firms, profit > 0 2. Costs Rise as Firms Enter the Market In some industries, the supply of a key input is limited. The entry of new firms increases demand for this input, causing its price to rise. This increases all firm's costs. Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping. Ch. 15 Monopoly Monopoly: a firm that is the sole seller of a product without close substitutes. 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. 3 sources of barriers to entry 1. A single firm owns a key resource. 2. The govt gives a single firm the exclusive right to produce the good. 3. Natural monopoly: a single firm can produce the entire market Q at lower than ATC could several firms. ATC is lower if one firm services all 1000 homes than if 2 firms each service Q of X. Monopoly vs. Competition: Demand Curves 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. 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 is NOT equal P. Understanding the Monopolist's MR Increasing Q has 2 effects on revenue: The output effect: more output is sold, which raises revenue The price effect: the price falls, which lowers revenue To sell a larger Q, the monopolist must reduce the price on all the units it sells. Hence, MR < P. MR could even be negative if the price effect exceeds the output effect Profit-Maximization Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC. Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity. A Monopoly Does Not Have an S curve A competitive firm Takes P as given
6 Has a supply curve that shows how its Q depends on P A monopoly firm Is a price-maker, not a price-taker Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and demand curve. So there is no supply curve for monopoly. The Welfare Cost of Monopoly In a competitive market EQ, P = MC and total surplus is maximized. In a monopoly EQ, P > MR = MC The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC) The monopoly Q is too low--could increase total surplus with a larger Q. Thus, monopoly results in a DWL. Public Policy Toward Monopolies Increasing competition with antitrust laws--ban certain anticompetitive practices, allow govt to break up monopolies. Regulation--govt agencies set the monopolist's price, for natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit. Public ownership--public ownership is usually less efficient since no profit motive to minimize costs Doing nothing--the foregoing policies all have drawbacks, so the best policy may be no policy. Price Discrimination: The business practice of selling the same good at different prices to different buyers. The characteristic used in price discrimination is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP. Perfect price discrimination The monopolist produces the competitive quantity, but charges each buyer their WTP. The monopolist captures all CS as profit. But there's no DWL. In the real world, perfect price discrimination is not possible: -no firm knows every buyer's WTP -buyers do not announce it to sellers So, firms divide customers into groups based on some observable trait that is likely related to WTP, such as age. Ch. 16 Oligopoly Two extremes Competitive markets: many firms, identical products Monopoly: one firm In between these extremes Oligopoly: only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products. Measuring Market Concentration % of the market's total output supplied by its 4 largest firms. The higher the concentration ratio, the less competition. (ie video games, tennis balls) One possible duopoly outcome: collusion
7 Collusion: an agreement among firms in a market about quantities to produce or prices to charge. Cartel: a group of firms acting in unison. Collusion vs. Self- Interest Both firms would be better off if both stick to cartel agreement But each firm has incentive to renege on the agreement Lesson: it is difficult for oligopoly firms to form cartels and honor their agreements. Nash eqm: a situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen. A Comparision of Market Outcomes When firms in an oligopoly individually choose production to maximize profit Q is greater than monopoly Q but smaller than competitive market Q P is greater than competitive market P but less than monopoly P The Output & Price Effects Increasing output has two effects on a firm's profits: Output effect: If P > MC, Selling more output raises profits Price effect: raising production increases market quantity which reduces market price and reduces profit on all units sold. If output effect > price effect, the firm increases production. If price effect > output effect, the firm reduces production. Nash Eqm: in an oligopoly, a Nash eqm occurs when no firm has any incentive to cheat by changing output or price. A simple rule is that in this oligopoly situation, OUTPUT = N/ (N+1), percent of the output of a competitive market, where N = # of firms. Ex: if there are 4 firms in the market, output will equal 4/(4+1) = 4/5 = 80% of output of the competitive market. The size of the Oligopoly As the # of firms in the market increases, The price effect becomes smaller The oligopoly looks more and more like a competitive market. P approaches MC Market quantity approaches the socially efficient quantity. Another benefit of international trade: trade increases the # of firms competing, increases Q, keep P closer to MC. Game Theory The study of how ppl behave in strategic situations Dominant strategy A strategy that is best for a player in a game regardless of the strategies chosen by the other players. Prisoner's dilemma A game between 2 capture criminals that illustrates why cooperation is difficult even when it is mutually beneficial. Oligopolies as a Prisoner's Dilemma When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners' dilemma. Prisoners' Dilemma and Society's Welfare The noncooperative oligopoly eqm
8 Bad for oligopoly firms: prevent them from achieving monopoly profits Good for society: Q is closer to the socially efficient output P is closer to MC In other prisoner's dilemmas, the inability to cooperate may reduce social welfare. Why ppl sometimes cooperate When the game is repeated many times, cooperation may be possible. Strategies which may lead to cooperation; If your rival reneges in one round, you renege in all subsequent rounds. Tit-for-tat Whenever your rival does in one round (whether renege or cooperate), you do in following round. Public Policy Toward Oligopolies In oligopolies, production is too low and prices are too high, relative to the social optimum, Role for policymakers: Promote competition, prevent cooperation to move the oligopoly outcome closer to the efficient outcome. Restraint of Trade and Antitrust Laws Sherman Antitrust Act forbids collusion betw competitors Clayton Antitrust Act strengthened rights of individuals damaged by anticompetitive arrangements betw firms Controversies Over Antitrust Policy Most ppl agree that price-fixing agreements among competitors should be illegal Some economists are concerned that policymakers go too far when using antitrust laws to stifle business practices that are not necessarily harmful, and may have legitimate objectives. 1. Resale Price Maintenance (Fair Trade) Occurs when a manufacturer imposes lower limits on the prices retailers can charge Is often opposed b/c it appears to reduce competition at the retail level Yet, any market power the manufacturer has is at the wholesale level; manufacturers do not gain from restricting competition at the retail level. The practice has a legitimate objective: preventing discount retailers from free-riding on the services provided by full-service retailers. 2. Predatory Pricing Occurs when a firm cuts prices to prevent entry or drive a competitor out of the market, so that it can charge monopoly prices later. Illegal under antitrust laws, but hard for the courts to determine when a price cut is predatory and when a price cut is predatory and when it is competitor & beneficial to consumers. Many economists doubt that predatory pricing is a rational strategy: -it involves selling at a loss, which is extremely costly for the firm. -it can backfire. 3. tying occurs when a manufacturer bundles 2 products together and sells them for one price critics argue tying gives tying gives firms more market power by connecting weak products to strong ones. Others counter that tying cannot change market power. Buyers are not willing to pay more for two goods together than for the goods separately.
9 Firms may use tying for price discrimination, which is not illegal, and which sometimes increases economic efficiency.