Economics Production Costs, Perfect Competition, Monopoly

Midterm 2 Economics

Technology

any process by which inputs are transformed into outputs (goods or services)

Inputs/Factors of Production

• Labor

• Capital (physical and human)

• Natural Resources

• Entrepreneurship

Short run

at least one input is held fixed

Long run

all inputs are variable

Total Product/Output

“q” i.e. the amount produced

Marginal Product

The additional output produced when more input is used

Marginal Product

MP_L=∆q/∆L where L is labor

Average Product

AP_L= q/L

Specialization

Each worker focuses on a specific task.

The Law of Diminishing Returns

When more variable input is added, while some inputs are fixed, marginal product will eventually fall.

When the Law of Diminishing Returns sets in…

the additional output produced by an additional worker goes down.

Explicit Costs

Accounting Costs

Implicit costs

Opportunity costs

Explicit Costs (accounting costs)

The costs paid by a business that are viewable on accounting statements.

Implicit Costs (opportunity costs)

The costs of using the business’ resources one way, rather than the next best way.

Economic Costs (total costs)

Explicit Costs + Implicit Costs

Accounting Profit

Total Revenues – Explicit Costs

Economic Profit

Total Revenues – Total Costs

Total Costs

Explicit Costs + Implicit Costs

Economic Profit

Accounting Profit – Implicit Costs

Sunk costs

Costs that have already been incurred and cannot be recovered. Should not affect decisions going forward.

Profit

Revenue - Costs

Fixed Cost (FC)

does not change

Variable Cost (VC)

does change

Total cost (TC)

FC + VC

Average Fixed Cost (AFC)

FC/Q

Average Variable Cost (AVC)

VC/Q

MC

(change in TC) / (change in Q) = (ΔTC) / (ΔQ) = (ΔVC + ΔFC) / (ΔQ) = (ΔVC) / (ΔQ)

If marginal > average

then average increases

If marginal < average

then average decreases

If marginal = average

then average doesn’t change

Constant Returns to Scale (CRS)

Average cost doesn’t change.

Decreasing Returns to Scale (DRS)

Diseconomies of Scale

Decreasing Returns to Scale (DRS)

Diseconomies of Scale

Average cost increases.

Increasing Returns to Scale (IRS)

Economies of Scale

Increasing Returns to Scale (IRS)

Economies of Scale

Average cost decreases.

Perfectly Competitive Market

Large number of buyers and sellers, All firms sell identical products, Easy for firms to enter/exit the market

Optimal Production Level

Produce where marginal revenue (MR) equals

marginal cost (MC)

Price takers

sell every unit of output for the same price P=MR

Because P is the same for every unit sold…

P also equals average revenue

Does marginal cost account for fixed cost?

No.

Profit

Total Revenue – Total Costs

Total Revenue

Q * P

Total Costs

Q * ATC

Profit

In the Long run, why is LRATC U shaped?

Economies/Diseconomies of Scale

In the short run, why is the average total cost curve u shaped?

We are constrained by the law of diminishing returns.

Profits if…

P>ATC at the

Q where

MR=MC

Losses if…

P<ATC at the

Q where

MR=MC

The height between ATC and P is…

per-unit profit

How do I find the profit/loss?

Multiply per-unit profit/loss by the number of

units (Q)

Stay open if you can make more than your…

variable costs

Breaking even

zero economic profits

Where do you have zero economic profits?

Where P=ATC

S = MC above intersection with…

AVC

Industry Supply Curve

“horizontal summation” of firm supply curves

Industry Supply Curves are

All upward sloping (diminishing returns)

Why does MC intersect AVC at the lowest point?

Think of midterm grades, the average follows the marginal!

What factors influence Industry Supply?

• Changes in firm productivity

• Changes in resource (input) prices

• Changes in per-unit taxes

• Number of firms in the industry

MR = P = AR for perfect competition. Is this the same for monopolies?

No, they are separate lines for MR and demand

Why would a firm exit the market?

losses

Why would a firm enter a market?

profits

Allocation of capital

Successful firms draw investment money and reinvest their

own funds

If profit > 0, then perfectly competitive firms enter

until profit =

0

f profit < 0, (i.e. loss > 0) then perfectly competitive

firms exit until profit =

0

Firm in Long-Run Equilibrium

AR=P=d=MR=MC=SRATC=LRATC all at the same time!

Long-Run Industry Supply

relationship between price

and quantity supplied by entire industry once firms have

been allowed to enter or exit the industry

Constant Cost Industries - Total output can rise without increase in long-run

per-unit costs so…

LR supply curve is horizontal

In constant cost industries, Long-run supply curve is…

perfectly elastic

Increasing Cost Industries - Increase in industry output leads to increase in long-run

per-unit costs so…

LR supply curve is upward sloping

In Increasing Cost Industries, long-run supply is…

more elastic

Structure of most industries

Increasing Cost Industries

Decreasing

Cost Industry - Increase in industry output leads to decrease in long-run

per-unit costs

LR supply curve is downward sloping

Long-Run Equilibrium in Competitive Markets

• Price driven to minimum per unit cost!

• Only way to make more short-run profits is to innovate

and lower costs

• Profits attract entrants and market price falls

• Consumers win

• Production uses least costly combination of resources

Monopolist

the single supplier of a good or service

for which there is no close substitute.

The monopolist therefore constitutes…

the entire industry

Monopoly

market structure where the firm (monopolist) and

industry are one and the same.

Natural Monopoly

industry where large volume of output can be produced cheapest (lowest per-unit cost) by one firm.

Monopolies and oligopolies result from

high barriers to entry

Barriers to entering an industry for a monopoly

Government action blocks entry of more than 1 firm, One firm controls key resources, Important Network Externalities, Economies of scale

What cost curve might lead to a natural monopoly

Downward sloping LRATC

Why would monopolies occur?

• Legal barriers

• Control of a key resource

• Network effects

• Natural Monopoly

Are Marginal Revenue and Demand the same for a monopolist?

NO

Antitrust (regulation)

stop monopolies from forming in the first place

Marginal cost pricing (regulation)

P = MC

Average Cost Pricing (regulation)

P = ATC

• aka “cost-of-service” regulation

• doesn’t allow for monopoly profits

Necessary conditions for price discrimination

The firm must face a downward-sloping demand curve, The firm must be able to readily (and cheaply) identify buyers

or groups of buyers with predictably different demand curves

(elasticity and/or shift), The firm must be able to prevent resale (aka arbitrage) of the

product or service

First degree (perfect price discrimination)

• Monopolist produces efficient quantity!

• Impossible in practice

• The amazing telepathic monopolist