Firm Behavior and the Organization of Industry
1. The Costs of Production
Total revenue: the amount a firm receives for the sale of its output
Total cost: the market value of the inputs a firm uses in production
Profit = Total revenue - Total cost
Explicit costs: input costs that require an outlay of money by the firm
- wage
Implicit costs: input costs that do not require an outlay of money by the firm
- opportunity cost of time
- opportunity cost of money
Accounting Profit = Total Revenue - Explicit Cost
Economic Profit = Total Revenue - Explicit Cost - Implicit Cost
1.1 Production and Costs
Production Function: Quantity of output - Quantity of inputs
Marginal Product (of Labour) (MPL): \(\text{MPL} = {\Delta Q \over \Delta L}\)
MPK (Marginal Product of Capital)
Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases
1.2 The Various Measures of Cost
Total-Cost Curve: Total Cost - Quantity of Output
Total Cost = Fixed Cost + Variable Costs
Average Total Cost = Total Cost / Quantity
Average Fixed Cost = Fixed Cost / Quantity
Average Variable Cost = Variable Cost / Quantity
Marginal Cost: \(\text{MC} = {\Delta TC \over \Delta Q}\)
Two features:
- Rising Marginal Cost
- U-Shaped Average Total Cost
- efficient scale: the quantity of output that minimizes average total cost
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost (efficient scale: the quantity of output that minimizes average total cost).
Understanding:
-
if MC < ATC, ATC decreases; if MC > ATC, ATC increases
-
Consider TC-Q curve:
1.3 Costs in the Short Run and in the Long Run
Many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.
Different production scale and choice:
Economies of Scale: the property whereby long-run average total cost falls as the quantity of output increases
Diseconomies of Scale: the property whereby long-run average total cost rises as the quantity of output increases
Constant Returns to Scale: the property whereby long-run average total cost stays the same as the quantity of output changes
2. Firms in Competitive Markets
Average Revenue: total revenue / the quantity sold = TR / Q = Price (for firms of all types)
Marginal Revenue: \(MR = {\Delta TR \over \Delta Q}\)
For competitive firms, price is determined by demand-supply curve of the market, and it must accept it.
⇒ Price is constant, \({\Delta TR = P \cdot \Delta Q}\) ⇒ MR = AR = P
2.1 Profit Maximization
MR > MC, increase the production of milk
MR < MC, decrease
- (Horizontal Price Line: a competitive firm is the price taker)
- Equilibrium ⇒ MR = MC ⇒ P = AR = MR = MC
- For any given price, the profit-maximizing quantity of output is found by looking at the intersection of the price with the MC curve. ⇒ MC Curve is also Supply Curve
2.2 Short-Run and Long-Run Decisions
- Shutdown (short term):
- pay fixed costs
- lose total revenue
- save variable costs
- TR < VC ⟺ AR = TR/Q < VC/Q ⟺ P < AVC
- compares {the price it receives for the typical unit} to {the average variable cost that it must incur to produce the typical unit}
- The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.
- sunk cost: a cost that has already been committed and cannot be recovered
-
Exit / Enter a Market (Long-Run Decision)
-
Exit if TR < TC ⟺ TR/Q < TC/Q ⟺ P < ATC
-
Enter if P > ATC
-
Equilibrium: P = ATC (efficient scale) ⇒ Profit = PQ - TC = (P - ATC) × Q = 0
-
The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.
-
The Short Run
- Market Supply with a Fixed Number of Firms
- The quantity of output supplied to the market equals the sum of the quantities supplied by each firms.
The Long Run
- Market Supply with Entry and Exit
- At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. Profit = (P - ATC) × Q = 0
- P = ATC, P = MC ⇒ P = MC = ATC (efficient scale)
- The long-run market supply curve must be horizontal at the price with zero economic profit—the minimum of ATC.
Explanation: A Shift in Demand
Entry and exit can cause the long-run market supply curve to be perfectly elastic.
However, Long-Run Supply Curve Might Slope Upward (price may rise)
- some resources used in production may be available only in limited quantities
- firms may have different costs
- For any given price, those with lower costs are more likely to enter than those with higher costs.
- To increase the quantity supplied, additional entrants must be encouraged to enter the market.
- New entrants have higher costs, so the price must rise to make entry profitable for them.
- Some firms earn profit even in the long run
- The price in the market reflects the average total cost of the marginal firm—the firm that would exit the market if the price were any lower.
- Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market.
- Higher-cost firms will enter only if the price rises, making the market profitable for them.
3. Monopoly
Perfect Competition
- Many sellers
- Identical products
- Free entry and exit
Monopoly
- Single seller
- Barriers to entry
Oligopoly
- A few sellers
- Identical or similar products
Monopoly Competition
- Many sellers
- Similar products (slight difference)
- Each seller can control the price
- Free entry and exit
3.1 Barriers to Entry & Reasons
-
Monopoly resources: own a key resource
-
Government regulation: exclusive right to produce
-
Natural Monopolies ⟺ A firm’s average-total-cost curve continually declines.
A single firm can produce output at a lower cost than can a larger number of firms.
A single firm can supply a good or service to an entire market at a lower cost than could two or more firms.
3.2 Decisions Making
Supply Curve: None
- A supply curve tells us the quantity that firms choose to supply at any given price.
- But a monopoly firm is a price maker, not a price taker.
Demand Curve:
The monopolist can choose any point on the demand curve, but it cannot choose a point off the demand curve.
P = AR ⇒ The demand curve is also the AR curve
How to choose the quantity of output?
When a monopoly increases the amount it sells, this action has two effects on total revenue (P × Q):
- The output effect: More output is sold, so Q is higher, which tends to increase total revenue.
- The price effect: The price falls, so P is lower, which tends to decrease total revenue.
When a monopoly increases production by 1 unit, it must reduce the price it charges for every unit it sells (the monopoly has to accept a lower price if it wants to sell more output)
⇒ MR < Price = AR
For the first unit of production, MR = AR ⇒
Profit Maximization
 |
 |
|---|---|
- If MC < MR, increase Q ⇒ increase TR
- If MC > MR, increase Q ⇒ decrease TR
- ⇒ MC = MR
3.2.1 The Relationship between MR and Price Elasticity of Demand
3.3 Welfare Cost
Note that:
- Monopoly Profit is not a social problem
- The transfer from the consumers of the good to the owners of the monopoly does not affect the market’s total surplus—the sum of consumer and producer surplus.
- The monopoly profit itself represents not a reduction in the size of the economic pie.
- The deadweight loss means the economic pie shrinks
- The problem stems from the inefficiently low quantity of output.
3.4 Price Discrimination
4. Monopolistic Competition
A market structure in which many firms sell products that are similar but not identical.
(Between Monopoly and Perfect Competition)
Each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.
4.1 Competition in the Short Run
- Determine the quantity of output by finding intersection MC = MR
4.2 The Long-Run Equilibrium
- Profit encourages entry, and entry shifts the demand curves to the left.
- Losses encourage exit, and exit shifts the demand curves to the right.
- Equilibrium: Demand curve and ATC curve are tangent
- As in a monopoly market: P > MC = MR (eager to get another customer)
- As in a competitive market: P = ATC ⇒ zero economic proft
- This particular quantity maximizes profit and the maximum profit is exactly zero in the long run.
4.3 Welfare
Inefficiency:
-
the markup of price over marginal cost (always has P > MC = MR)
-
the number of firms in the market may not be “ideal”:
The entry of a firm in monopolistic competition market:
- The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, the entry of a new firm conveys a positive externality on consumers.
- The business-stealing externality: Because other firms lose customers and profits when faced with a new competitor, the entry of a new firm imposes a negative externality on existing firms.
Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets.
The invisible hand does not ensure that total surplus is maximized.
The inefficiencies are subtle, hard to measure, and hard to fix ⇒ there is no easy way for public policy to improve the market outcome.
4.4 Advertising
Advertising is a natural feature of monopolistic competition (as well as some oligopolistic industries).
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise to attract more buyers to its particular product.
The Critique of Advertising:
- manipulate people’s tastes
- psychological rather than informational
The Defense of Advertising
- provide information to customers ⇒ fosters competition
Advertising as a Signal of Quality
The existence of brand names
5. Oligopoly
Collusion: an agreement among firms in a market about quantities to produce or prices to charge
Cartel: a group of firms acting in unison
Nash equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen
5.1 The Economics of Coorperation
Oligopolists maximize their total profits by forming a cartel and acting like a monopolist.
5.2 Public Policy toward Oligopolies
Controversies over Antitrust Policy (some behavior that can appear to reduce competition may in fact have legitimate business purposes):
Resale Price Maintenance
Predatory Pricing
Tying