Microeconomics: Market Structures, Costs, and Firm Strategies

Economic Profits

Total revenue minus total costs including implicit opportunity costs. Economic Profit = TR - (Explicit + Implicit).

Normal Profit

Normal Profit = 0 economic profit. Firm is doing 'just okay' (stays in market).

Explicit Costs

A cost that requires a money outlay (wages, rent, materials paid in cash).

Implicit Costs

A cost that does not require an outlay of money (opportunity cost of owner's time, forgone interest on own capital, etc).

Short Run

The period before exit and entry can occur (at least one input is fixed).

Long Run

The time after all exit and entry has occurred (all inputs are variable).

Marginal Product

Additional output produced by adding one more unit of an input (ex, one more worker).

Division of Labor & Specialization

Breaking production into small tasks and assigning workers to specialize; gains come from differences in skill, less time switching tasks, learning-by-doing, and innovation.

Law of Diminishing Returns

If capital and technology are fixed (short run), adding more workers eventually causes smaller and smaller increases in output.

Marginal Cost

A change in total cost from producing an additional unit.

Average Cost of Production

The average cost of producing Q barrels of oil is the total cost of producing Q barrels divided by Q.

Fixed Cost

Costs, such as rent, that do not vary with output.

Variable Costs

Costs that do vary with output.

Economies of Scale

The advantages of large-scale production that reduce average cost as quantity increases.

Diseconomies of Scale

Average cost rises as output increases (coordination problems, bureaucracy, etc).

Minimum Efficient Scale

The lowest output level at which long-run average cost is minimized (bottom of the LRAC curve).

Market Structures

Organizational features of a market: number of firms, product type (identical or differentiated), barriers to entry, and interdependence.

Perfect Competition

Many firms making identical products.

Marginal Revenue

The change in total revenue from selling an additional barrel of oil.

Profit Maximizing Rule

Produce the quantity where Marginal Revenue = Marginal Cost (MR = MC).

Sunk Costs and Uncertainty

Sunk cost is a cost that once incurred cannot be recovered (affects entry/exit decisions because of uncertainty).

Break Even Point

Output level where price = ATC (economic profit = 0).

Shut Down Point

Output level where price = minimum AVC. If P < minimum AVC, the firm shuts down in the short run.

Increasing Cost Industry

Industry costs rise as total industry output increases -> Long-run supply curve slopes upward.

Constant Cost Industry

An industry in which costs of production do not change with greater industry output; shown with a flat supply curve.

Decreasing Cost Industry

An industry in which the costs of production decrease with an increase in industry output; shown with a downward-sloped supply curve.

Industry Clusters

Geographic concentrations of related firms, suppliers, and institutions that lower costs through knowledge spillovers and specialized labor.

Creative Destruction

New innovative firms displace old firms, driving economic progress (Schumpeter's idea).

Monopoly

A market structure in which there is one firm.

Market Power

The power to raise prices above marginal cost without fear that other firms will enter the market.

Barriers to Entry

Things that make it difficult for other firms to jump in the market and compete (legal, natural, strategic).

Deadweight Loss

The reduction in total surplus caused by a market distortion or inefficiency.

Rent Seeking

Using resources to obtain or maintain monopoly power (lobbying, lawsuits, political favors) instead of producing better products.

Natural Monopoly

A situation when a single firm can supply the entire market at a lower cost than two or more firms.

Patents

Temporary legal monopoly (usually 20 years) granted to inventors to encourage innovation.

Price Discrimination

Selling the same good to different customers at different prices.

Arbitrage

The practice of taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market.

Oligopoly

A market structure in which there are a few interdependent firms.

Game Theory

The study of strategic decision making in interactive situations (used in oligopoly, war, business, etc).

Nash Equilibrium

A situation in which no player has an incentive to change strategy unilaterally.

Collusion

Attempts to reduce competition and increase profits by acting as one firm.

Cartel

A group of suppliers that tries to act as if they were a monopoly.

Price Fixing

Illegal agreement among competitors to set the same (usually high) price.

Network Good

A good that increases in value to a given person the more other people use the good.

Switching Costs

Costs (time, money, learning) that make it hard for consumers to switch from one product to another.

Monopolistic Competition

Many firms making differentiated products.

Product Differentiation

Making products slightly different (taste, style, features, location, branding) so each firm faces a downward-sloping demand curve.

Excess Capacity

In long-run monopolistic competition, firms produce less than the output that minimizes ATC (they have unused capacity).

Efficiency / Variety Tradeoff

Monopolistic competition gives consumers more variety but at the cost of higher prices and inefficiency (excess capacity and markup).

Non-Price Competition

Competing through advertising, quality, features, location, etc., instead of lowering price.

Advertising

Spending to shift demand right or make demand less elastic (signals quality or differentiates product).

Signaling

An expensive action that is taken to reveal information (e.g., heavy advertising signals the firm believes the product will be successful).

Elasticity of Demand

The more and the better the substitutes, the more elastic the demand.

Firm model: Cost Curves

X-axis = Quantity (Q), Y-axis = $ per unit. U-shaped AVC and ATC curves; ATC above AVC. MC curve cuts AVC and ATC at their minimum points. AFC= ATC - AVC (downward sloping, getting flatter).

Firm model: Perfect Competition

Horizontal demand = MR = P line. Firm produces where MR = MC. Short-run profit rectangle if P > ATC; loss rectangle if AVC < P < ATC; shut down if P < AVC. Long-run: P = minimum ATC (zero economic profit).

Firm model: Imperfect Competition

Downward-sloping demand curve. MR curve below demand (steeper). Produce where MR = MC, then charge the price on the demand curve that Q. Monopoly: Positive profit possible long run + deadweight loss triangle. Monopolistic competition: Long-run P = ATC (tangent) but left of minimum ATC (excess capacity).

Total Product (TP)

Total output.

Marginal Product (MP)

Total Product / Input (usually labor).

Average Product (AP)

Total Product / Input.

Total Cost

Total Cost = Fixed Cost + Variable Cost.

Average Total Cost (ATC)

ATC = Total Cost / Q.

Average Variable Cost (AVC)

AVC = Variable Cost / Q.

Average Fixed Cost (AFC)

AFC = Fixed Cost / Q.

Total Revenue

Total Revenue = Price (P) x Quantity (Q).

Marginal Revenue (MR)

MR = Total Revenue / Q.

Average Revenue (AR)

AR = Total Revenue / Q.

Profit-Max Rule

Produce the quantity where MR = MC.

Dominant Strategy

Best strategy no matter what rival does.

Economic Profit Interpretation

Positive economic profit means the firm is doing better than its next-best alternative.

Short Run vs Long Run

Short run: At least one input is fixed. Long run: All inputs are variable.

Gains to Division of Labor

Create gains due to differences in labor traits and skill, decrease in time between tasks, learning by doing, and more innovation.

Effect of Diminishing Returns on Production Cost

As more workers are added to fixed capital, productivity decreases, leading to higher marginal costs.

Fixed Cost vs Variable Cost

Fixed cost does not change with production level; variable cost changes with production level.

Marginal Cost Definition

Rate of change of Total Cost; additional cost from producing one more unit.

Average Cost Definition

Cost per unit produced; key variable for comparing to price for profitability.

Average Cost (ATC)

Total Cost / Q — Cost per unit.

Minimum ATC

Lowest sustainable price for normal profit long-term.

Long-run Average Cost (LRAC) Curve

Slopes downward initially due to economies of scale, allowing firms to lower costs by getting bigger.

Characteristics of Perfect Competition

Product similarity, many buyers/sellers, no barriers to entry.

Short Run Equilibrium

The point where the firm maximizes profit in perfect competition.

Sunk Costs

Irrecoverable past investments that make firms hesitant to exit.

Long Run Equilibrium

The state where firms make zero economic profit.

Elimination Principle

Above-normal profits attract entry, while below-normal losses cause exit.

Monopoly's Quantity to Produce

The quantity that maximizes profits where Marginal Revenue = Marginal Cost.

Monopoly's Price to Charge

The highest price the buyer is willing to pay for the profit maximizing quantity.

Social Costs of Monopoly

Higher prices, lower quantity, deadweight loss, and reduced consumer surplus.

Alternative explanation of rent seeking

Spending resources to protect/maintain monopoly power (lobbying for regulations, lawsuits against competitors) instead of improving products.

Social benefits of monopolies: Innovation

Innovation is the source of market power; monopoly status makes an otherwise unprofitable innovation (with high upfront costs), profitable.

Social benefits of monopolies: Economies of Scale

Monopolies can arise 'naturally' due to large economies of scale, resulting in a lower price than possible in perfect competition.

Tradeoffs with monopolies: Patents

Some deadweight (lower quantity and higher prices during the term of the patent / 20 years) but more innovation.

Example of price discrimination

Student discounts.

Conditions required to price discriminate

1. Firm has Market Power; 2. Different elasticities of demand among consumer groups; 3. Obstacles to arbitrage.

First degree price discrimination

Charging each customer a unique price, also known as 'Perfect price discrimination.'

Second degree price discrimination

Charging different prices for different quantities, known as 'block pricing.'

Third degree price discrimination

Charging different prices to two or more different groups.

Social welfare and price discrimination

Often increases total output, can reduce deadweight loss compared to single-price monopoly.

Tying

A form of price discrimination where one good (base good) is tied to a second good (variable good).

Example of tying

Selling a printer cheaply but requiring the purchase of expensive ink.

Bundling

Selling goods only as a package (e.g., left and right shoes).

Subtle forms of price discrimination

Occurs when firms offer different versions of a product to segment customers into different markets.