Transcript Document

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?