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Production, Cost and Market Structures Exam II

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Short Run Production Fixed Inputs Do not change with quantity produced Variable Inputs Do change with quantity produced This will be number of workers in our examples

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Short Run Production Short Run At least one input is fixed Long Run All inputs are variable

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Short Run Production Consider the following example Q measures production Marginal Product TP / L Average Product TP / L 15 0 2 3 4 5 Q 0 3 8 L 20 23 MP L --- 3 5 7 5 3 AP L --- 3 4 5 5 4.6 1

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Short Run Production These are the typically shaped curves Teamwork and Specialization Increasing MP L Steepening TP Crowding of the Fixed Input Decreasing MP L Flattening TP

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Short Run Production Marginals and Totals Marginal is the slope of the total Works with any value (product, cost, etc.) Example

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Short Run Costs Fixed Costs (FC) Tied to Fixed Inputs Will not vary with quantity Variable Costs (VC) Tied to Variable Inputs (Labor) Will vary with quantity FC + VC = Total Costs (TC)

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Costs of Production 15 0 2 3 4 5 Q 0 3 8 L 20 23 1 FCVC MCTCAFCAVCATC 30 20 0 10 20 40 50 20 1.43 20 40 50 60 70 --- 3.33 2 2 30 2 --- 2.50 1.33 1 0.87 --- 3.33 2.50 2 2.17 6.67 3.33 --- 10 5 3 3.04 Suppose my fixed input costs $20 Suppose each worker costs $10

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Costs of Production FC, VC, and TC $ Q FC VC TC Difference here is FC

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Costs of Production AFC $ Q

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Costs of Production MC, AVC, and ATC $ Q MC ATC AVC Minimum of ATC and AVC Difference is AFC

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Short Run Production Now look at the AVC and ATC curves Also look at the value of the MC curve Marginal pulls the average Only crossing point is at minimum/maximum of the average

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MP L and MC Look again at the table Note that as MP L increases, MC decreases MC and MP L are opposites As you get more production out of each worker, your additional cost per unit decreases (and vice versa)

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Putting the curves together If we use these two facts Marginal cost (or product) is the slope of total cost (or product) Marginal cost and marginal product are opposites We can use this to determine the shape of MC, TC, MP, and TP if we only know one For example

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Profit When economists say zero profit, the definition is slightly different Economic Profit = TR EC IC TR = Total Revenue EC = Explicit Costs IC = Implicit Costs Accounting Profit = TR EC

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Profit Explicit Costs Any cost that causes money to change hands Taxes/Wages/Utilities/Supplies Depreciation Interest on a loan (not the principle) Implicit Costs Value of lost opportunities Lost income from a job Lost interest Money you Could Have Earned

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Profit Example Economic Profit < Accounting Profit Econ. Profit tells Rate of Return EP > 0 Above Normal EP = 0 Normal EP < 0 Below Normal

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Market Structures Perfect Competition Monopolistic Competition Oligopoly Monopoly

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Perfect Competition Characteristics Very small firm Large number of firms Identical (homogeneous) product Free entry and exit Industry-Level advertising Example: Agriculture

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Perfect Competition The goal of firms is to maximize profit How to maximize profit? MR=MC Need to find marginal revenue Finding marginal revenue in PC

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Perfect Competition P $ Q Q S D ATC AVC MC PePe MR=d q* TR=P*q=MR*q TC=ATC*q Total Profit is the difference, or the area that is in one but not both This is negative, so this firm is losing money

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Perfect Competition Since this firm is losing money, it should shut down right? Not so fast! What do you lose if you shut down? Fixed costs

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Perfect Competition P $ Q Q S D ATC AVC MC PePe MR=d q* This is what the firm loses if it produces Firm loses FC if it shuts down This is AFC And FC=AFC*Q Clearly, the loss from producing is smaller than shutting down

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Perfect Competition Positive Profit Continue to Produce Zero Profit Continue to Produce Negative Profit If P (or MR) AVC Continue to Produce This means covering some of FC If P (or MR) < AVC Shut Down

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Perfect Competition What happens in the Long-Run if firms are making a loss? Some firms will shut down because of free exit Market Supply decreases, shifting supply to the left Drives price upwards to a particular point

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Perfect Competition P $ Q Q S D ATC AVC MC PePe MR=d q* ATC=AVC Now there are no losses driving firms out of the market

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Perfect Competition What if there is positive profit? This will attract new firms, and they will enter because of free entry Increase supply, shift to the right Drives price down to a particular point

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Perfect Competition If positive profit attracts firms, and negative profit drives firms away, what must profit be to be stable? P e LR = minimum of ATC LR Profit = 0 How do we achieve this?

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Monopoly P.C. is one extreme, monopoly is the other Most markets fall somewhere in between Monopolistic Competition Oligopoly

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Monopolistic Competition Characteristics Fairly small firms Fairly large number of firms Mildly differentiated product Small barriers to entry Advertising at firm level Example: Walk around the mall

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Oligopoly Characteristics Fairly large firms Fairly small number of firms Somewhat unique product Higher barriers to entry Advertising at firm level Example: Automobiles

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Monopoly Characteristics Large-sized firm Single firm Unique product No entry P.R. advertising Example: AmerenUE

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Monopoly How does a monopolist find the profit-maximizing quantity? Same way as anyone else Produce where MR=MC Finding MC Market Supply Only producer Finding MR Example

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Monopoly P Q S D =MC MR QMQM PMPM MC Markup = P MC Measures Market Power Markup RM and DWL? QeQe RM

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Monopoly Only firm that can earn positive profit (above normal rate of return) in long-run No Entry Where does monopoly derive its market power? Barriers to entry are insurmountable

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Barriers to Entry Control of Resource OPEC, DeBeers Government Creation/License High Fixed Costs Copyright Protection Patents These are how all markets (not PC) restrict to at least some degree entry/exit by other firms

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Monopoly Problems with Monopoly RM, DWL, and higher prices Less product innovation Less customer service Simply put, if youre the only game in town, you have no incentive to improve.

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Monopoly Advantage of Monopoly Natural Monopoly High Fixed Costs relative to Variable Costs Example Patent Protection Recoup costs of R&D To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries; -Article I, US Constitution House, MD Copyright Incentive to Create

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Oligopolies Characterized by a few sellers Each firms decision affects other firms P.C. Firms too small Mono. Only one firm Would prefer the cartel outcome This is where the two act as a monopoly

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Oligopolies This outcome is unstable Why dont all of you get together and bomb the exam to build up the curve? Both sides have incentive to cheat Oligopolistic decisions can be modeled using Game Theory Study of how people make strategic decisions Oceans Twelve

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Elements of Game Theory Players or actors Strategies Payoffs or outcomes With these, we can set up a Payoff Matrix

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Game Theory Terms Dominant Strategy Move that is best for an actor regardless of other actors choices This results in a most-likely outcome Does Linas/Basher have D.S.? Nash Equilibrium Outcome where neither side has incentive to move Does N.E. exist for this situation?

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Prisoners Dilemma Classic example of game theory Case where the most-likely outcome is not the best overall outcome for both parties Is Linas and Bashers situation a Prisoners Dilemma? Yep.

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Other Games Matching Pennies Game Telephone Game Advertising Game