Transcript Introduction to Economics

Introduction to Economics
Microeconomics
The US Economy
Llad Phillips
1
13. Tuesday, Nov. 12, Lecture Thirteen: “Profit maximization,
market structure, and perfect competition”
Reading Assignment
O’Sullivan and Sheffrin, Ch. 9, “Perfect Competition:
Short Run and Long Run”
Ch. 6, “Market Efficiency and Government Intervention”
Problems O & S Text
p. 207-208: 1, 2, 3, 4, 5, 6, 7
14. Tuesday, Nov. 14, Lecture Fourteen: “Monopoly and
Antitrust Policy”
Reading Assignment
O’Sullivan and Sheffrin, Ch. 10, “Monopoly”
O’Sullivan and Sheffrin, Ch. 13, “Using Market Power:
Price Discrimination and Monopoly ”
Ch. 14 “Controlling Market Power: Antitrust Policy and
Deregulation”
Problems O & S Text
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Your Readings and the Text’s Slide
Shows
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Chapter 8
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Outline: Lecture Fourteen
 The
competitive firm
the
short run, capital fixed
the long run, all factors variable
 The
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monopolistic firm
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Competitive Firm: Short Run
Capital, i.e. plant and equipment are fixed
 hence there are diminishing returns
 as labor is increased, output increases but
less than proportionally
 so labor costs, i.e. variable costs increase
more rapidly than output
 so average variable cost, i.e. variable cost
per unit of output is rising
 which means marginal cost is rising even
faster, bringing up the average

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Short Run Average Variable Cost Curve
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
A
output
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Behavior of the competitive firm in
the short run: shut down decision
The firm is one of many firms
 Hence it has no monopoly power
 It takes the market price as given; if it tries
to charge a higher price nobody buys its
output
 If the market price is less than minimum
average variable cost, the firm shuts down

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The Shut-Down Decision
Cost per unit
of output
marginal cost per unit of output
Average variable cost
per unit of output
Market price
A
Shutdown output
s
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output
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Behavior of the competitive firm in
the short run: the output decision
If the market price is above minimum
average variable cost, the firm produces
 It produces the output where the market
price equals marginal cost
 So the value of a unit of output to the
consumer is equal to the cost of producing
that last unit (marginal cost)
 the only remaining question is whether the
firm is making money

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The Output Decision
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
A
Output produced
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output
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Fixed Costs

Fixed costs do not vary with output, but are
constant
 for
example: rent, insurance etc.
Hence average fixed costs fall as output
increases
 This is known as spreading the overhead
 The sum of average fixed cost and average
variable cost equals average total cost
 Price minus average total cost is the profit
per unit of output

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Variable Cost
$
Variable Cost
B
Fixed Cost
A
Fixed Cost
$ per unit output
Average
Variable
Cost, AVC
Output
AVC
Marginal
Cost, MC
Average Fixed
Cost, AFC
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MC
AFC
Output
13
Total Cost
$
Variable Cost
Fixed Cost
Total Cost
B
Variable Cost
A
Fixed Cost
$ per unit output
Average
Variable
Cost, AVC
Output
ATC
AVC
Marginal
Cost, MC
Average Fixed
Cost, AFC
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MC
AFC
Output
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Average Total Cost per unit of output
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
Average total cost
per unit of output
A
Output produced
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Average total
cost per unit
of output
output
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Profit Margin Per unit of output
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
Average total cost
per unit of output
Profit margin
A
Output produced
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Average total
cost per unit
of output
output
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Competitive Market Structure
Firms are motivated by profits (greed)
 Profits equal revenue minus costs, so firms
are motivated to control costs (efficiency)
 In the long run, profits are competed away
by expansion of firms to the optimal size
and by free entry of new firms (capital)
attracted by the possibility of profits (role of
the stock market-initial public offerings
(IPO’s)
 Each firm is only one of many and hence is
a price taker not a price setter. Thus each
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firm only adjusts output to maximize profit

Behavior of the Firm
Marginal cost curve is the supply curve of
the firm, because price equal to marginal
cost maximizes profits
 Firm takes the market price, sets this price
equal to its marginal cost to determine how
much to produce (output decision)
 If marginal cost equals average total cost at
this output, the firm breaks even
 If marginal cost exceeds average total cost
at this output, the firm makes a profit (short
run)
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
Policy Implications of Market
Structure
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Market Power and Monopoly
Compare and Contrast: Competition and
Monopoly
 Is monopoly a good thing or not?
 How about Microsoft, is this firm good or
bad for consumers?

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Market Power & Market Structure

No market power: competition
 many
producers
 firms are price takers
 no excess profit
 price to consumer = long run average cost

Market power: monopoly
 one
producer
 monopolist is price setter
 monopolist makes profits at expense of the
consumer
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The Brief for Competition

.... and against monopoly
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Competition

Competitive Industries
 agriculture
 construction
Market Supply in the Short Run
 The Optimal Plant Size
 Market Supply in the Long Run

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Competitive Industries: Agriculture
Product
cattle
corn
soybeans
wheat
dairy products
tobacco
peanuts
rice
# of Firms Producing
1176346
789326
441899
352237
162555
136682
18905
12013
source: Census of Agriculture, 1987
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Competitive Industries
Product
# of Firms Producing
contract construction
1951509
apparel
22872
millwork, plywood
7930
household furniture
5606
book publishers
2856
computer/office Equip
2134
knitted textiles
2130
iron/steel foundry Pdt
1231
footwear
479
petroleum refining
331
sources: Census of Manufactures, 1987
Census of Construction Industries, 1987
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Short Run:
Firm Supply and Market Supply

Plant Size of a firm is fixed
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Short Run Market Supply: Two Firm Industry
MC,
AVC
MCII
MCI
AVCI
QI
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Market
Supply
AVCII
QII
QI + QII
Quantity
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Market Supply and Demand in the Short Run
MC,
Market
Price
pM
Consumer Demand
QM
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Supply
Quantity
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MC,
AVC,
ATC
PM
Short Run Market Supply: Two Firm Industry
ATCI
MCII
MCI
AVCI
ATCII
AVCII
Market
Supply
Market
Demand
Quantity
QI
QII
QI + QII
In the short run, both firms are making excess profits. This may
motivate them to find the lowest cost size for plant and
equipment.
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Chapter 9, Figure 9-02
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Short Run* World Supply: Copper
Country Marginal Cost
Zaire
0.49 $ per #
Zambia
0.54 $ per #
Chile
0.58 $ per #
US
0.68 $ per #
Peru
0.79 $ per #
Canada
0.88 $ per #
Metric Tons, 000
560.0
363.0
1356.4
1007.3
397.2
724.4
* Existing Mines Fixed
Source: Minerals Yearbook, 1985
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Short Run Supply of World Copper, 1985 .
0.9
Canada
0.8
Peru
Marginal Cost, $ per # .
0.7
US
0.6
Chile
0.5
Zaire
0.4
Zambia
0.3
0.2
0.1
0
0
1000
2000
3000
4000
5000
Production, Thousands of Metric T ons .
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Short Run Supply of World Copper, 1985 .
0.9
Canada
0.8
Peru
Marginal Cost, $ per # .
0.7
US
0.6
Chile
0.5
Zaire
0.4
Zambia
0.3
Demand for copper
in a recession
0.2
0.1
0
0
1000
2000
3000
4000
5000
Production, Thousands of Metric T ons .
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Long Run

What is the optimal plant size?
 constant
returns to scale: inputs and output
increase proportionally
 increasing, then decreasing returns
 increasing returns to scale
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Competitive Markets

In the long run, resources will flow to a
competitive market if firms are making
excess profits
 new
firms will enter the industry
 if
returns to scale are constant, then price will be
driven down to long run average total cost
 if returns to scale first increase and then decrease,
price will be driven down to minimum long run
average cost
Consumers benefit from the efficient, lowest
cost use of resources and the lowest price
for the product

Profits are driven to Zero
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
Optimal Size of the Firm: Constant Returns to Scale
MC, ,
ATC
pM
SMCI
SATCI
SMCII
SATCII
LATC, LMC
Quantity
If market price is above long run marginal cost, the firm will
make the same excess profit per unit of output in a large plant as
in a small plant. The firm may prefer larger to smaller. As long as
firms are making excess profits, other firms will enter the industry,
increasing supply, and driving price down to LMC.
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Long Run Equilibrium Supply with the Free Entry of Firms:
Constant Returns to Scale
Market
Price
Demand
Short Run Supply
Supply after
Entry of Profit
Seeking Firms
PM
PM = LMC =
LATC
Long Run Supply
Quantity
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Long Run Equilibrium Supply with the Free Entry of Firms:
Constant Returns to Scale
Market
Price
PM
Demand
Increased Short Run Supply
demand
Supply after
Entry of Profit
Seeking Firms
Increased
supply
PM = LMC =
LATC
Long Run Supply
Quantity
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Optimal Size of the Firm: Constant Returns to Scale
MC, ,
ATC
SMCI
SATCI
SMCII
SATCII
LATC, LMC
pM
Quantity
If market price is above long run marginal cost, the firm will
make the same excess profit per unit of output in a large plant as
in a small plant. The firm may prefer larger to smaller. As long as
firms are making excess profits, other firms will enter the industry,
increasing supply, and driving price down to LMC.
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Chapter 9, Figure 9.10
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Optimal Size of Plant with Variable Returns to Scale
LMC
LATC
Market
LATC
Price
SMCIV
SATCI
SATCIV
SATCII
SMCIII
pM
SATCIII
Quantity
If market price is above long run average cost, then firms with
efficient scale of plant, SATCIII ,will make an excess profit. In the
long run other firms in the industry will move to this efficient size
plant. As long as there are excess profits to be made, new firms
will enter the industry, driving market price down to minimum
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long
run average total cost, LATC.
Competitive Markets

In the long run, resources will flow to a
competitive market if firms are making
excess profits
 new
firms will enter the industry
 if
returns to scale are constant, then price will be
driven down to long run average total cost
 if returns to scale first increase and then decrease,
price will be driven down to minimum long run
average cost
Consumers benefit from the efficient, lowest
cost use of resources and the lowest price
for the product

Profits are driven to Zero
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
Natural Monopoly

Increasing Returns to Scale
 optimal
 larger

is better
Constant Returns to Scale
 optimal
 LAC

size of the firm
size of the firm: indeterminate
= LMC = same at all outputs
Increasing then Decreasing Returns to Scale
 optimal
size of the firm: minimum LAC
 minimum
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LAC where LAC = LMC
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Optimal Size of Plant with Increasing Returns to Scale:
Bigger is Better
Price
LATC
SATCI
SATCII
LATC
Quantity
LMC
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Optimal Size of Plant with Increasing Returns to Scale:
Bigger is Better
Price
LATC
SATCI
SATCII
LATC
Quantity
LMC
Price
Price equal marginal cost
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Optimal Size of Plant with Increasing Returns to Scale:
Bigger is Better
Price
LATC
SATCI
SATCII
Price
Subsidy
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LATC
Quantity
LMC
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Optimal Size of Plant with Increasing Returns to Scale:
Bigger is Better
Price
LATC
SATCI
SATCII
Regulated
Price
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LATC
Quantity
LMC
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Market Power: Size in 1994
Country
Sweden
Corporation GDP, $B Sales, $B
169
GM
155
Taiwan
150
Ford
129
Norway
105
Exxon
101
Toyota
95
Hong Kong
91
Wal-Mart
83
ATT
75
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source: World Bank & Fortune 500
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Market Power: Market Share
Product
inst. breakfast
tennis balls
disp. diapers
breakfast cereal
video game
player
cameras, film
car rental
credit cards
beer
detergent
records & tapes
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Firms
Mkt Shr
Carnation, Pillsbury
100/3
Gen Corp, Pepsico
100/4
P&G, Kimberly
99/4
Kellogg, Gen Mills
98/4
Nintendo, Sega
98/2
Kodak, Polaroid
Hertz, Avis
VISA, MasterCard
Anheuser-Busch
P&G, Lever Bros
Time-Warner, Sony
98/4
95/4
92/3
90/4
86/3
77/4
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Monopoly

Technology: Natural Monopoly
 Increasing
 output
Returns to Scale
increases more than proportionally with
inputs
 i.e. cost per unit of output falls with increasing
output

Monopoly
 sets
price to maximize profits
 exploits
consumers
 wastes resources
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How does a monopolist use
power to maximize profits?

marginal principle: increase output until
marginal revenue = marginal cost
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Price
Monopoly Sales
Price
$10
Market Demand
A
B
0
0
10
9
8
7
6
5
4
3
2
1
0
Quantity
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
Revenue
0
9000
18000
21000
24000
25000
24000
21000
18000
9000
0
Marginal Revenue
9000
9000
3000
3000
1000
-1000
-3000
-3000
-9000
-9000
Quantity
Revenue
$25,000
A
0
B
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Quantity
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Monopoly Profits with Increasing Returns to Scale
Price
Market Demand
MR
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Quantity
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Increasing Returns to Scale and Long Run Total Costs
$
Long Run Total Costs
Quantity
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Maximum Monopoly Profits: Marginal Revenue = Marginal Cost
$
LTC
R
Revenue
LTC
Quantity
$
Excess
Profit
0
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Quantity
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Monopoly Profits with Increasing Returns to Scale
Price
LATC
Market Demand
PM
MR
LATC
Quantity
LMC
Q
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Chapter Ten, Figure 10.6
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Monopoly Profits with Increasing Returns to Scale
Price
LATC
Market Demand
PM
Regulated
price
MR
LATC
Quantity
LMC
Q
Regulated price satisfies demand and covers costs
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Chapter Ten, Figure 10.8
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Social Policy

If returns to scale are constant
 regulate
or break up monopoly
 make
the monopolist charge a price equal to
marginal cost
• obtain the competitive solution

If returns to scale are increasing
 regulation
is not so easy
 can
not set monopolist’s price equal to marginal
cost: monopolist will suffer losses
• because marginal cost is less than average cost
 could
socialize the industry and the government
could subsidize the losses
 could live with monopoly
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 set price where average cost crosses demand
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The Social Cost of Monopoly: Example, Constant Returns to Scale
Competition
Monopoly
Market Demand
Market Demand
Consumer Surplus
LATC = LMC
PM
LATC = LMC
PM
MR
QCOMP
QMONOP
Under monopoly, consumers pay a higher price and consume less
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The Social Cost of Monopoly: Example, Constant Returns to Scale
Competition
Monopoly
Market Demand
Market Demand
Consumer Surplus
Dead Weight Loss
PM
Profit
PM
LATC = LMC
LATC = LMC
MR
QCOMP
QMONOP
Under monopoly, some consumer surplus is redistributed to the
monopolist
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Society
How can we control it?
Regulation,
Franchises,
Patents
Higher Prices
Less Goods
Excess Profits
MONOPOLY POWER
Political
Influence
Strategic Planning
Entrepreneurs
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How do we get it?
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Advertising Cost of a Car
company
Mercedes
Nissan
Toyota
GM
Chrysler
Ford
$ per sale
TV, $M, ‘91
620
435
381
198
198
123
49
267
403
978
335
408
source: Fortune
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Strategic Action: Advertising
Company
Proctor & Gamble
Philip Morris
General Motors
Ford Motor Co.
Sears, Roebuck
AT&T
PepsiCo
Chrysler
Disney
Johnson & Johnson
Advertising, ‘94: $B
2.7
2.4
1.9
1.2
1.1
1.1
1.1
1.0
0.9
0.9
source: Advertising Age
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Classification of US Industry
Sector
% Pvt Domestic Output
Ag, Forestry & Fishg
1.9
Mining
0.9
Construction
5.3
Manufacturing
21.0
Transport, Commun
8.6
Wholesale Trade
6.8
Retail Trade
10.2
Finance, Insur, Real
18.6
Services: Pers & Bus
26.8
Total
100.0
source: Survey of Current Business
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The Brief for Monopoly

Increasing productivity, i.e. GDP per capita
 capital
deepening, i.e. capital per worker
 technological change, Research and
Development

Where does the saving for investment come
from?
 a.
consumers?
 b. firms
 monopoly
 c.
government
 research
 d.
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profits
and development
international
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The Brief for Microsoft
The case for monopoly: Joseph Schumpeter
 Growth is the key to social welfare
 Large and growing firms reinvest profits in
future growth

 capital

deepening
Large and growing firms have the resources
to invest in research and development
 technological
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change improves productivity
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The Brief for Microsoft
Industry with Rapidly Changing Technology
 Monopoly is Using Market Power to
Preserve the Status Quo

 creating

Silicon Valley Attracts Brain Power and
Venture Capital
 new

and fortifying barriers to entry
firms and new technologies
So, the Nature of Microsoft’s Industry Was
Competition and Change
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The Brief for Microsoft
Consumers have not been hurt by Microsoft
 In contrast, consumers have benefited
 Any market power Microsoft has is tenuous
in the rapidly growing and changing
software industry

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Summary-Vocabulary-Concepts










average variable cost
marginal cost
average fixed cost
average total cost
price taker
firm’s break even
point
firm’s shut down point
competitive industries
short run
long run
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









free entry
natural monopoly
market share
marginal revenue
monopoly profit
regulation of monopoly
social cost of monopoly
consumer surplus
dead weight loss
brand names
strategic planning
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