Managerial Economics Session V
Market Structures
Market In an economic sense, a market is a system by which buyers and sellers bargain for the price of a product, settle the price and transact their business buy and sell a product. Personal contact between the buyers and sellers is not necessary. In some cases, e.g., forward sale and purchase, even immediate transfer of ownership of goods is not necessary. Market does not necessarily mean a place. The market for a commodity may be local, regional, national or international. What makes a market is a set of buyers, a set of sellers and a commodity. While buyers are willing to buy and sellers are willing to sell, and there is a price for the commodity.
Market Structures Type of market structure influences how a firm behaves: Pricing Supply Barriers to Entry Efficiency Competition
Market Structures Degree of competition in the industry High levels of competition Perfect competition Limited competition Monopoly Degrees of competition in between
Market Structure Determinants of market structure Freedom of entry and exit Nature of the product homogenous (identical), differentiated? Control over supply/output Control over price Barriers to entry
The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly Oligopoly Monopolistic Competition Perfect Competition Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk
Market Structure Market structure identifies how a market is made up in terms of: The number of firms in the industry The nature of the product produced The degree of monopoly power each firm has The degree to which the firm can influence price Profit levels Firms behaviour pricing strategies, non-price competition, output levels The extent of barriers to entry The impact on efficiency
Market Structure Perfect Competition Pure Monopoly More competitive (fewer imperfections)
Market Structure Perfect Competition Pure Monopoly Less competitive (greater degree of imperfection)
Market Structure Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly Duopoly Monopoly The further right on the scale, the greater the degree of monopoly power exercised by the firm.
Market Structure Importance: Degree of competition affects the consumer will it benefit the consumer or not? Impacts on the performance and behaviour of the company/companies involved
Market Structure Characteristics of each model: Number and size of firms that make up the industry Control over price or output Freedom of entry and exit from the industry Nature of the product degree of homogeneity (similarity) of the products in the industry (extent to which products can be regarded as substitutes for each other) Diagrammatic representation the shape of the demand curve, etc.
A monopoly is a firm that is the sole seller in its market.
Monopolistic or Imperfect Competition In each case there are many firms in the industry Each can try to differentiate its product in some way Entry and exit to the industry is relatively free Consumers and producers do not have perfect knowledge of the market the market may indeed be relatively localised. Can you imagine trying to search out the details, prices, reliability, quality of service, etc for every plumber in the UK in the event of an emergency??
Oligopoly Competition between the few May be a large number of firms in the industry but the industry is dominated by a small number of very large producers Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms: A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry
Oligopoly Example: Music sales The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this independents group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers. Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
Duopoly Market structure where the industry is dominated by two large producers Collusion may be a possible feature Price leadership by the larger of the two firms may exist the smaller firm follows the price lead of the larger one Highly interdependent High barriers to entry Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market share and normal profit made In reality, local duopolies may exist
Monopoly Pure monopoly where only one producer exists in the industry In reality, rarely exists always some form of substitute available! Monopoly exists, therefore, where one firm dominates the market Firms may be investigated for examples of monopoly power when market share exceeds 25% Use term monopoly power with care!
Monopoly Monopoly power refers to cases where firms influence the market in some way through their behaviour determined by the degree of concentration in the industry Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation encourages unwanted entrants to the market Sometimes seen as a case of market failure
Monopoly Origins of monopoly: Through growth of the firm Through amalgamation, merger or takeover Through acquiring patent or license Through legal means Royal charter, nationalisation, wholly owned plc
Monopoly Characteristics of firms exercising monopoly power: Price could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficient due to lack of competition (X- inefficiency) or could be higher due to availability of high profits
Monopoly Innovation - could be high because of the promise of high profits, Possibly encourages high investment in research and development (R&D) Collusion possible to maintain monopoly power of key firms in industry High levels of branding, advertising and non-price competition
Monopoly Problems with models a reminder: Often difficult to distinguish between a monopoly and an oligopoly both may exhibit behaviour that reflects monopoly power Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation Degree of contestability of the market may influence behaviour Monopolies not always bad may be desirable in some cases but may need strong regulation Monopolies do not have to be big could exist locally
Market Structure Oligopoly Competition amongst the few Industry dominated by small number of large firms Many firms may make up the industry High barriers to entry Products could be highly differentiated branding or homogenous Non price competition Price stability within the market - kinked demand curve? Potential for collusion? Abnormal profits High degree of interdependence between firms
Market Structure Examples of oligopolistic structures: Supermarkets Banking industry Chemicals Oil Medicinal drugs Broadcasting
Market Structure Measuring Oligopoly: Concentration ratio the proportion of market share accounted for by top X number of firms: E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share 3 firm CR of 72% - top 3 firms account for 72% of market share
Market Structure Duopoly: Industry dominated by two large firms Possibility of price leader emerging rival will follow price leaders pricing decisions High barriers to entry Abnormal profits likely
Market Structure Monopoly: Pure monopoly industry is the firm! Actual monopoly where firm has >25% market share Natural Monopoly high fixed costs gas, electricity, water, telecommunications, rail
Figure 1 The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly Oligopoly Monopolistic Competition Perfect Competition Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk
A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.
Market Structure Monopoly: High barriers to entry Firm controls price OR output/supply Abnormal profits in long run Possibility of price discrimination Consumer choice limited Prices in excess of MC
A firm is considered a monopoly if... it is the sole seller of its product. its product does not have close substitutes.
WHY MONOPOLIES ARISE The fundamental cause of monopoly is barriers to entry. Barriers to entry have three sources: Ownership of a key resource. The government gives a single firm the exclusive right to produce some good. Costs of production make a single producer more efficient than a large number of producers
WHY MONOPOLIES ARISE Barriers to entry have three sources: Ownership of a key resource. The government gives a firm the exclusive right to produce some good. Costs of production make one producer more efficient than a large number of producers.
Monopoly Resources Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. Example: The DeBeers Diamond Monopoly
Government-Created Monopolies Governments may restrict entry by giving one firm the exclusive right to sell a particular good in certain markets. Example: Patent and copyright laws are two important examples of how governments create monopoly to serve the public interest.
Natural Monopolies An industry is a natural monopoly when one firm can supply a good or service to an entire market at a smaller cost than could two or more firms. Example: delivery of electricity, phone service, tap water, etc.
Natural Monopolies Cost A natural monopoly arises when there are economies of scale over the relevant range of output. Average total cost 0 Quantity of Output
HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS Monopoly versus Competition Monopoly Is the sole producer Faces a downward-sloping demand curve Is a price maker Can reduce its sales to increase price Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price taker Sells as much or as little as it wants at market price
A Firm s Revenue Total Revenue TR = P Q Average Revenue AR = TR/Q = P Marginal Revenue MR = DTR/DQ
Profit Maximization For any firm, the profit-maximizing quantity is that at which marginal revenue equals marginal cost; MR = MC. A monopoly firm then uses the demand curve to find the price that will induce consumers to buy the profit-maximizing quantity.
A monopolist will exit when P < ATC at all Q Costs and Revenue Average total cost Demand 0 Quantity
The Market for Drugs (Pharmaceutical) Costs and Revenue P > MC; monopoly Price during patent life P = MC; perfect competition Price after patent expires Marginal revenue Demand Marginal cost 0 Monopoly quantity Competitive quantity Quantity
PUBLIC POLICY TOWARD MONOPOLIES Governments may respond to the problem of monopoly in one of four ways. Making monopolized industries more competitive. Regulating the behavior of monopolies. Turning some private monopolies into public enterprises. Doing nothing at all.
Increasing Competition with Antitrust Laws Antitrust laws are laws aimed at curbing monopoly power. Antitrust laws give government various ways to promote competition. They allow government to prevent mergers. They allow government to break up companies. They prevent companies from performing activities that make markets less competitive.
Increasing Competition with Antitrust Laws Two Important Antitrust Laws Sherman Antitrust Act (1890) Reduced the market power of the large and powerful trusts of that time period. Clayton Act (1914) Strengthened the government s powers and authorized private lawsuits.
Regulation Government may regulate the prices that the monopoly charges. The regulator may force the monopolist to implement the efficient outcome Recall that the allocation of resources is efficient when price is set to equal marginal cost (P = MC). But it might be difficult for government regulators to force the monopolist to set P = MC
PRICE DISCRIMINATION Price discrimination is the business practice of selling the same good at different prices to different customers, even though the cost of production is the same for all customers. What do you think of this practice?
PRICE DISCRIMINATION Price discrimination is not possible in a competitive market as there are many firms all selling the same product at the market price. In order to price discriminate, the firm must have some market power. That is, it must have the ability to set its prices without being afraid that its customers will go to competing firms. Price discrimination won t work if resale is easy
Perfect Price Discrimination Perfect price discrimination refers to the situation when the monopolist knows each customer s willingness to pay, and can charge each customer exactly what he/she is willing to pay. Example: Suppose the Cable TV industry is a monopoly Suppose you are willing to pay up to $200 per month for a cable connection Suppose the cable company knows this and accordingly charges you $200 per month All other customers are also being charged the maximum they are willing to pay What do you think of this state of affairs?
PRICE DISCRIMINATION Important effects of price discrimination: It increases the monopolist s profits. It reduces the consumer surplus. Under perfect price discrimination, consumer surplus is zero It reduces the deadweight loss. Under perfect price discrimination, deadweight loss is zero, Exactly as under perfect competition.
PRICE DISCRIMINATION Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Perfect Price Discrimination Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.
PRICE DISCRIMINATION Two important effects of price discrimination: It can increase the monopolist s profits. It can reduce deadweight loss.
PRICE DISCRIMINATION Examples of Price Discrimination Movie tickets Airline prices Discount coupons Financial aid Quantity discounts
Any firm with market power (such as a monopolist) has an incentive to capture (obtain) consumer surplus in order to increase its profits Consumer surplus can be captured though: -Price Discrimination -Tie-In s and Bundling -Advertising -Often capturing surplus is disguised as (or intended as) a beneficial program
PRICE DISCRIMINATION is the act of charging different prices to different consumers in order to capture consumer surplus. Like burns, three basic types of price discrimination exist: First Degree Second Degree Third Degree
In order for price discrimination to take place: 1) A firm must have market power -a PC firm that raises price will get zero sales 2) The firm must be able to distinguish between consumers -the firm must know consumer demand or elasticity of demand 3) The firm must be able to prevent resale
In first degree price discrimination, the monopolist charges each consumer their maximum willingness to pay (ie: each quantity is sold at its intersection on the demand curve) Examples: -Auctions (higher willingness to pays will push up price) -Sizing up customers (asking questions relating to living arrangements and work, evaluating dress and speech patterns)
First Degree Price Discrimination ELIMINATES consumer surplus (each consumer pays their maximum amount) First Degree Price Discrimination ELIMINATES deadweight loss (monopolists are able to provide goods to more consumers) FDPD is hard to accomplish and VERY vulnerable to resale
For the monopolist, MR=P+(ΔP/ΔQ)Q But since increased sales do not affect the price of any other goods sold, (ΔP/ΔQ)Q=0 Therefore, MR=P=D (The MR curve is the demand curve)
Second degree price discrimination deals with price discounts: -Selling at a discount price after a certain number of goods are purchased Second degree price discrimination also involves offering separate membership and per unit price plans that consumers CHOOSE between -ie: Cell phones, club memberships, bus pass
In block pricing the first block of goods is sold at a given price, and the next block of goods is sold at a lower price A consumer pays P 1 for the first Q 1 good, then P 2 for any goods above Q 1 There can be more than 2 different blocks of prices
Third degree price discrimination charges different prices to different consumer groups, or segments of society (each with different demand schedules) Examples: -Student and seniors movie prices -Regular and farm gasoline -Bus passes - Customer Appreciation Days -Tuesday deals at restaurants
First Degree -Each consumer pays their maximum willingness to pay Second Degree -Consumers sort themselves into different price categories (quantity discounts or plans) Third Degree -Firms sort consumers into different price categories
The basics of Game Theory
The basics of Game Theory Game theory is the study of the strategic behaviour of agents Not just useful in economics, but also in international relations, games of money, etc.
The basics of Game Theory The prisoner s dilemma Nash equilibrium and welfare Mixed strategy equilibria Retaliation
The prisoner s dilemma The prisoner s dilemma is the historical game that founded game theory as a specific area of study: This is because the solution to this game is sub-optimal from the point of view of the players. This means that there is a solution that makes both players better off, but the rationality of the agents does not lead to it. The prisoner s dilemma shows quite elegantly how difficult it is to get agents to cooperate, even when this cooperation is beneficial to all agents.
The prisoner s dilemma A typical prisoner s dilemma: Two suspected criminals are caught by the police, but the police lacks the hard evidence to charge them. They can only sentence them to 1 year for minor misdemeanours. The police needs to get them to confess their crimes in order to be able to charge them both to 20 years. How do the police get the suspects to confess?
The prisoner s dilemma They offer the criminals a deal... If one of them spills the beans on his colleague, he gets a reduced sentence (6 months), and the other guys gets a extended one (25 years) Payoff Matrix 1 st criminal Confess Deny 2 nd criminal Confess Deny 20 20 0.5 25 25 0.5 1 1
The prisoner s dilemma The prisoner s dilemma applied to a duopoly Two firms competing on a market can: Compete (This leads, for example, to the Cournot solution) Collude and share monopoly profits (cartel). Profit in a cartel > profit in a duopoly. If collusion is not illegal, then it is clearly the optimal situation from the point of view of these two firms. But is it the equilibrium the market ends up in?
The prisoner s dilemma 2 players : 2 firms (A and B) producing the same good (Airbus/Boeing fits well!!) 2 strategies : Produce at the duopoly level Produce at the cartel level (which is lower) Given 2 players and 2 strategies, there are 4 possible market configurations These are listed in the payoff matrix
The prisoner s dilemma Let s put some numbers on the different possible profits: For the Cartel case: Each firm earns a share of the monopoly profits: Π c = 10 For the duopoly competition case : Each firm earns duopoly profits, which are lower: Π d = 2 For the cheating case: The firm producing at duopoly level captures the market share of the other firm, and makes very high profits : Π t = 15 The other firm is penalised and earns minimum profits : Π m = 0
The prisoner s dilemma Payoff Matrix Q d Firm B Q c What is the best strategy for each firm? Firm A Q d 2 2 0 15 For firm A: Q d if firm B chooses Q d Q d if firm B chooses Q c Q c 15 0 10 10 For firm B: Q d if firm A chooses Q d Q d if firm A chooses Q c Note: the game is symmetric, so the dominant strategy is to produce the duopoly quantity.
The basics of Game Theory The prisoner s dilemma Nash equilibrium and welfare Mixed strategy equilibria Retaliation
Nash equilibrium and welfare Definition of a Nash equilibrium: A situation where no player can improve his outcome by unilaterally changing his strategy Central properties: The Nash equilibrium is generally stable Every game has at least one Nash equilibrium: Either in pure strategies : Players only play a single strategy in equilibrium Or in mixed strategies : Players play a combination of several strategies with a fixed probability The proof of this result is the main contribution of John Nash (and the reason why it is called a Nash equilibrium)
Nash equilibrium and welfare Let s go back to the Duopoly example: Payoff Matrix Firm A Firm B Q d Q d 2 2 Q c 15 0 Q c 0 15 10 10 Is the Qd-Qd equilibrium a Nash equilibrium? Can firm A or B improve their outcome by shifting alone to the cartel quantity Q c? Qd-Qd is indeed a Nash equilibrium
Nash equilibrium and welfare Payoff Matrix Firm A Firm B Q d Q d 2 2 Q c 15 0 Q c 0 15 10 10 So the dominant strategy is to produce Qd But the Qd-Qd equilibrium is not socially optimal With a small number of agents, individual rationality does not necessary lead to a social optimum
The basics of Game Theory The prisoner s dilemma Nash equilibrium and welfare Mixed strategy equilibria Retaliation
Mixed strategy equilibria A pure-strategy Nash equilibrium does not exist for all games Example of a penalty shoot-out: 2 players: a goal-keeper and a striker 2 strategies : shoot / dive to the left or the right We assume that the players are talented: The striker never misses and the goalkeeper always intercepts if they choose the correct side. This is not required for the game, but it simplifies things a bit! What is the payoff matrix?
Mixed strategy equilibria Payoff Matrix Striker L R Goalkeeper L R 1 0 0 1 0 1 1 0 For the striker: R if the keeper goes L L if the keeper goes R For the goalkeeper: L if the striker shoots L R if the striker shoots R Whatever the outcome, one of the players can increase his sucess by changing strategy No pure-strategy Nash equilibrium!
Mixed strategy equilibria Payoff Matrix Goalkeeper L R There is, however, a mixed strategy equilibrium Strategy for both players: Striker L R 1 0 0 1 0 1 1 0 Go L and R 50% of the time (1 out of two, randomly) That way : o Each outcome has a probability of 0.25 o The striker scores one out of two, the other is stopped by the goalkeeper
Mixed strategy equilibria Let s check that this is actually a Nash equilibrium: The goalkeeper plays L and R 50% of the time. Can the striker increase his score by changing his strategy? The striker decides to play 60% left and 40% right. His new success rate is: (0.6 0.5) + (0.4 0.5) = 0.5 (0.3) + (0.2) = 0.5 By choosing 60-40, the striker scores more on the left hand side, but less on the right. His success rate is the same, his situation has not improved. This corresponds to a Nash equilibrium!
The basics of Game Theory The prisoner s dilemma Nash equilibrium and welfare Mixed strategy equilibria Retaliation
Retaliation Finally, the stability of the equilibrium also depends on whether the game is repeated or not. The very concept of a mixed strategy equilibrium depends on the repetition of the game through time. Even for a pure strategy equilibrium, the ability to replay the game can influence the outcome Players can retaliate, and thus influence the decisions of other players
Retaliation Back to the duopoly case: The 2 firms agree to form a cartel, and maximise joint profits. There is, however, the temptation to cheat on this agreement Imagine now that the game is played several times If one firm cheats, it captures all the profits for that period What do you think happens in the next period?
Retaliation Actually, this depends on whether the game is repeated a fixed number of times or indefinitely (open-ended)... Let s say that our 2 firms decide to play the game 5 times (5 years) What is the best strategy on year 5? What about year 4, given what we know about year 5? This process shows that the equilibrium cannot be stable
Retaliation Lets imagine now that our 2 firms have an openended agreement. The threat of retaliation can bring the social optimum The optimal retaliation strategy is also the simplest one: tit for tat Robert Axelrod: just choose what your opponent did last period: cooperate if he cooperated, cheat if he cheated. But the threat needs to be credible i.e. the opponent needs to believe that it will effectively be carried out.
What is a firm? A firm is an entity concerned with the purchase and employment of resources in the production of various goods and services. Assumptions: the firm aims to maximize its profit with the use of resources that are substitutable to a certain degree the firm is" a price taker in terms of the resources it uses.
The Production Function The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time.
The Production Function A production function defines the relationship between inputs and the maximum amount that can be produced within a given time period with a given technology. Mathematically, the production function can be expressed as Q=f(K, L) Q is the level of output K = units of capital L = units of labour f( ) represents the production technology
The Production Function When discussing production, it is important to distinguish between two time frames. The short-run production function describes the maximum quantity of good or service that can be produced by a set of inputs, assuming that at least one of the inputs is fixed at some level. The long-run production function describes the maximum quantity of good or service that can be produced by a set of inputs, assuming that the firm is free to adjust the level of all inputs
Production in the Short Run When discussing production in the short run, three definitions are important. Total Product Marginal Product Average Product
Production in the Short Run Total product (TP) is another name for output in the short run. The marginal product (MP) of a variable input is the change in output (or TP) resulting from a one unit change in the input. MP tells us how output changes as we change the level of the input by one unit.
Firm s Inputs Inputs - are resources that contribute in the production of a commodity. Most resources are lumped into three categories: Land, Labor, Capital.
Fixed vs. Variable Inputs Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.
Production Analysis with One Variable Input Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. MP L DTP D L L
Total vs. Marginal Product Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus. MP X DTP D X X
Production Function of a Rice Farmer Units of L Total Product (Q L or TP L ) Marginal Product (MP L) 0 0-1 2 2 2 6 4 3 12 6 4 20 8 5 26 6 6 30 4 7 32 2 8 32 0 9 30-2 10 26-4
Total product Q L 32 30 26 Q L 20 12 6 2 0 1 2 3 4 5 6 7 8 9 10 Labor L FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input (e.g., labor) used in production assuming a certain technological level.
Marginal Product The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula: MP L DTP D L L
Marginal Product Observe that the marginal product initially increases, reaches a maximum level, and beyond this point, the marginal product declines, reaches zero, and subsequently becomes negative. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease"
Total and Marginal Product 35 30 25 20 TP L 15 10 5 0-5 MP L 0 1 2 3 4 5 6 7 8 9-10
Law of Diminishing Marginal Returns As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish.
COSTS OF PRODUCTION Opportunity Cost Principle - the economic cost of an input used in a production process is the value of output sacrificed elsewhere. The opportunity cost of an input is the value of foregone income in best alternative employment. Implicit vs. Explicit Costs Explicit costs costs paid in cash Implicit cost imputed cost of self-owned or self employed resources based on their opportunity costs.
7 Cost Concepts (Short-run) 1. Total Fixed Cost (TFC) 2. Total Variable Cost (TVC) 3. Total Cost (TC=TVC+TFC) 4. Average Fixed Cost (AFC=TFC/Q) 5. Average Variable Cost (AVC=TVC/Q) 6. Average Total Cost (AC=AFC+AVC) 7. Marginal Cost (MC= AVC/ Q
Short Run Analysis Total fixed cost (TFC) is more commonly referred to as "sunk cost" or "overhead cost." Examples: include the payment or rent for land, buildings and machinery. The fixed cost is independent of the level of output produced. Graphically, depicted as a horizontal line
Short Run Analysis Total variable cost (TVC) refers to the cost that changes as the amount of output produced is changed. Examples - purchases of raw materials, payments to workers, electricity bills, fuel and power costs. Total variable cost increases as the amount of output increases. If no output is produced, then total variable cost is zero; the larger the output, the greater the total variable cost.
Short Run Analysis Total cost (TC) is the sum of total fixed cost and total variable cost TC=TFC+TVC As the level of output increases, total cost of the firm also increases.
Total Costs of Production Units of Labor Total Product Total Fixed Cost Total Variable Cost Total Cost Marginal Cost Average Cost L TP L TFC TVC TC MC AC 0 0 100 0 100 - - 1 6 100 30 130 30 130 2 10 100 50 150 20 75 3 12 100 60 160 10 53.3 4 13 100 65 165 5 41.25 5 15 100 75 175 10 35 6 19 100 95 195 20 32.5 7 25 100 125 225 30 32.14 8 33 100 165 265 40 33.12 9 43 100 215 315 50 35 10 55 100 275 375 60 37.5
INR TC (Total Cost) TVC (Total Variable Cost) TFC (Total Fixed Cost) 0 TOTAL COST CURVES Q
INR AFC=TFC/Q. As more output is produced, the Average Fixed Cost decreases. AFC (Average Fixed Cost) 0 Q
INR The Average Variable Cost at a point on the TVC curve is measured by the slope of the line from the origin to that point. AVC=TVC/Q TVC (Total Variable Cost) Minimum AVC 0 q1 Q
INR The Average Variable Cost is U shaped. First it decreases, reaches a minimum and then increases. AVC (Average Variable Cost) Minimum AVC 0 q1 Q
INR The Marginal Cost curve passes through the minimum point of the AVC curve. It is also U-shaped. First it decreases, reaches a minimum and then increases. MC (Marginal Cost) AVC (Average Variable Cost) Minimum AVC 0 q1 Q
Average Cost of Production (Q) (TC) (AC) 0 100-1 130 130.00 2 150 75.00 3 160 53.33 4 165 41.25 5 175 35.00 6 195 32.50 7 225 32.14 8 265 33.13 9 315 35.00 10 375 37.50
Average Variable Costs of Production Total Product (Q) Total Variable Cost (AVC) Average Variable Cost (AVC) 0 0 0 1 30 30.0 2 50 25.0 3 60 20.0 4 65 16.3 5 75 15.0 6 95 15.8 7 125 17.9 8 165 20.6 9 215 23.9 10 275 27.5
Long Run Total Cost LTC All inputs are variable in the long run. There are no fixed costs. LTC Total Product Q LONG-RUN TOTAL COST CURVE
The LAC The LAC curve is an envelop curve of all possible plant sizes. Also known as planning curve It traces the lowest average cost of producing each level of output. It is U-shaped because of Economies of Scale Diseconomies of Scale
COST LAC SAC 1 SAC 2 0 Q LONG-RUN AVERAGE COST CURVE
COST SAC 1 LAC 0 Q q 0
COST Building a larger sized plant (size 2) will result in a lower average cost of producing q 0 SAC 1 LAC SAC 2 0 Q q 0
COST Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q 1 SAC 1 LAC SAC 2 SAC 3 0 Q q 0 q 1
Economies and Diseconomies of Scale Economies of Scale- long run average cost decreases as output increases. Technological factors Specialization Diseconomies of Scale: - long run average cost increases as output increases. Problems with management becomes costly, unwieldy
COST LAC SAC 1 SAC 2 Economies of Scale Diseconomies of Scale 0 Q 1 Q LONG-RUN AVERAGE COST CURVE
LAC and LMC Long-run Average Cost (LAC) curve is U-shaped. the envelope of all the short-run average cost curves; driven by economies and diseconomies of size. Long-run Marginal Cost (LMC) curve Also U-shaped; intersects LAC at LAC s minimum point.
Production in the Long Run Isoquant defines cominations of inputs that yield the same level of product In economics, an isoquant (derived from quantity and the Greek word iso, meaning equal) is a contour line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs.
The Isoquant Curve The absolute value of the slope at a point on the isoquant curve equals the ratio of the marginal productivity of labor to the marginal productivity of machines. Slope MP labor MP machine Marginal rate of sub stitution
The Isoquant Curve Isoquant map a set of isoquant curves that show technically efficient combinations of inputs that can produce different levels of output.
An Isoquant Map
The Isocost Line Isocost line a line that represents alternative combinations of factors of production that have the same costs.
The Isoquant Curve Isoquant curve a curve that represents combinations of factors of production that results in equal amounts of output. A point on the isoquant curve is technically efficient.
Production in the Long Run The long run production process is described by the concept of returns to scale. Returns to scale describes what happens to total output as all of the inputs are changed by the same proportion.
Production in the Long Run If all inputs into the production process are doubled, three things can happen: output can more than double increasing returns to scale (IRTS) output can exactly double constant returns to scale (CRTS) output can less than double decreasing returns to scale (DRTS)
The Concept of Profit Profit is the difference between total revenue and total cost. The economic concept of profit takes into account the opportunity cost of capital. Total economic cost includes a normal rate of return. A normal rate of return is the rate that is just sufficient to keep current investors interested in the industry. Breaking even is a situation in which a firm is earning exactly a normal rate of return.
Firm Earning Positive Profits in the Short Run To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.
Firm Earning Positive Profits in the Short Run Profit is the difference between total revenue and total cost.
Breakeven Analysis Breakeven analysis (cost-volume-profit analysis): approach to profit planning that requires derivation of various relationships among revenue, fixed costs, and variable costs in order to determine units of production or volume of sales dollars at which firm breaks even (where total revenues equal total of fixed and variable costs)
Assumptions of Breakeven Analysis 1. Costs can be reasonably subdivided into fixed and variable components. 2. All cost-volume-profit relationships are linear. 3. Sales prices will not change with changes in volume.
Breakeven Applications Four major applications: 1. New product decisions 2. Pricing decisions 3. Modernization or automation decisions. 4. Expansion decisions.
Breakeven Applications 1. New product decisions Determine sales volume required for firm (or individual product) to break even, given expected sales and expected costs 2. Pricing decisions Study the effect of changing price and volume relationships on total profits
Breakeven Analysis 3. Modernization or automation decisions Analyze profit implications of a modernization or automation program In this case, firm substitutes fixed costs (i.e. capital equipment costs) for variable costs (i.e. direct labor) 4. Expansion decisions Study aggregate effect of general expansion in production and sales In this case, relationships between total dollar dales for all products and total dollar costs for all products are examined in order to indentify potential changes in these relationships
Pricing of Multiple Products Plant Capacity Utilization A multi-product firm using a single plant should produce quantities where the marginal revenue (MR i ) from each of its k products is equal to the marginal cost (MC) of production. MR1 MR2 MRk MC
Price Discrimination Charging different prices for a product when the price differences are not justified by cost differences. Objective of the firm is to attain higher profits than would be available otherwise.
Price Discrimination 1. Firm must be an imperfect competitor (a price maker) 2. Price elasticity must differ for units of the product sold at different prices 3. Firm must be able to segment the market and prevent resale of units across market segments
First-Degree Price Discrimination Each unit is sold at the highest possible price Firm extracts all of the consumers surplus Firm maximizes total revenue and profit from any quantity sold
Transfer Pricing Pricing of intermediate products sold by one division of a firm and purchased by another division of the same firm Made necessary by decentralization and the creation of semiautonomous profit centers within firms
The Pre-Keynesian Consumption Function - 1 In microeconomic theory, when households have a large number of goods and services to choose from, an important variable influencing the demand for a specific good is its price relative to all other goods and services: Q d = f(p), ceteris paribus
The Pre-Keynesian Consumption Function - 2 When we construct a macroeconomic consumption function, we take the relative price of goods as given. We focus on how households divide their expenditure between consumption of all goods and services and saving. Y C + S
The Pre-Keynesian Consumption Function - 3 Rewriting the identity, we can define planned savings as being that part of income which households do not intend to spend on consumption: S Y - C
The Pre-Keynesian Consumption Function - 4 In the pre-keynesian era, the predominant view was that the rate of interest was the main variable influencing the division of income between C and S. The pre-keynesian savings and consumption functions can be written as: S = f(r) C = f(r)
The Keynesian Consumption Function Keynes accepted that the rate of interest was a variable which influenced consumption decisions, but he believed that the level of income was more important. C = f(y) S = f(y) The fundamental psychological law, upon which we are entitled to depend with great confidence... is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income
The consumption function describes the relationship between consumer spending and income C = C a + by Consumption spending, C, has two parts: C a = autonomous consumption. This is the part of total consumption which does not vary with the level of income. by = income-induced consumption. The product of a fraction, b, called the marginal propensity to consume (MPC) and the level of income, y. The consumption function is a line that intersects the vertical axis at C a. It has a slope equal to b.
Demand The consumption function relates consumer spending to the level of income. Consumption function (C a + by) 0 Output, y
Demand Consumption function (C a + by) C { a autonomous consumption 0 Output, y The consumption function relates consumer spending to the level of income.
The Multiplier The eventual increase in income resulting from the initial injection is the sum of all the stages of income generation The value of the government spending multiplier = Change in income Change in government spending or k = DY D G