jump to first page costs, competition & organization of the business firm
TRANSCRIPT
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Costs, Competition & Organization of the Business Firm
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Utility
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Utility
• Utility• Satisfaction or pleasure derived from
consuming a good or service.• Law of Diminishing Utility
• Added satisfaction declines as additional units are used or consumed
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Substitution Effect
• Effect of a change in price on the relative utility of a product and the quantity demanded.
• MUA/PA = MUB/PB
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Prospect Theory• Behavioral analysis of negative
occurrences.• Factors
• Status quo• Loss Aversion
• Market applications• Package sizing• Framing• Anchoring
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Types of BusinessStructures
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Three Types of Business Firms
• Proprietorship: • owned by a single individual• make up 72% of the firms in the market, but
account for only 4% of total business revenue
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Three Types of Business Firms
• Partnership: • owned by two or more persons• 8% of the firms; 12% of business
revenues
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Three Types of Business Firms
• Corporation: • owned by stockholders• In contrast to the unlimited liability of
proprietorships and partnerships, the owners’ liability is limited to their explicit investment.
• 20% of the firms; 84% of business revenue
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The Economic Way of Thinking about Costs
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Implicit & Explicit Costs
• Explicit• Monetary Payments• Accounting Profits
• Implicit• Opportunity Costs• Economic Profits
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Sunk Costs
• Sunk Costs are historical costs associated with past decisions that can’t be changed.• Sunk costs may provide information, but are
not relevant to current choices.• Current choices should be made on current
and expected future costs and benefits.
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• As output (plant size) is increased, per-unit costs will follow one of three possibilities:• Economies of Scale:
Reductions in per unit costs as output expands. This can occur for three reasons:
• mass production• specialization• improvements in production
as a result of experience• Diseconomies of Scale:
increases in per unit costs as output expands • Constant Returns to Scale:
unit costs are constant as output expands
Economies of Scale
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Short-Run and Long-RunTime Periods
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The Short Run
• The short run is a period of time so short that the firm’s level of plant and heavy equipment (capital) is fixed.
• In the short run, output can only be altered by changing the usage of variable resources such as labor and raw materials.
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The Long Run
• The long run is a period of time sufficient for the firm to alter all factors of production.
• In the long run, firms can freely enter and exit the industry.
• The time duration of the short run and the long run will differ across industries.
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Categories of Cost
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Fixed & Variable Costs
• Fixed Costs : costs that remain unchanged regardless on the amount produced.• EG – Rent or the purchase of
machinery.• Variable Costs:
Fixed costs depend on the amount produced.• EG – Electricity to run a machine or
inputs for production
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Total and Average Fixed Costs• Total Fixed Costs (TFC):
costs that remain unchanged in the short run when output is altered• Examples:
• insurance premiums • property taxes• the opportunity cost of fixed assets
• Average Fixed Costs (AFC): Fixed costs per unit (i.e. FC / output).• decline as output expands
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Total and Average Variable Costs• Total Variable Costs (TVC):
sum of costs that increase as output expands• Examples:
• cost of labor• raw materials
• Average Variable Costs (AVC): variable costs per unit (i.e. TVC / output)
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Total Cost
• Total Costs (TC): Total Fixed Cost + Total Variable Cost
• TC=FC+VC
• Average Total Costs (ATC): Average Fixed Cost + Average Variable Cost
• ATC=AVC+AFC
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Marginal Cost
• Marginal Cost (MC): the increase in Total Cost associated with a one-unit increase in production
• Typically, MC will decline initially, reach a minimum, and then rise.
• MC = (Change in TC)/(Change in Q)
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Revenues
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Revenues
• TR = Total Revenue
• AR = Average Revenue• AR = TR / Q
• Marginal Revenue is the added revenue associated with an increase of one unit of output • MR = TRN – TRN-1
• MR = ∆TR / ∆Q
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Profits & Equilibrium
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Profits & Equilibrium• Profits
• Π = TR – TC• Π = (P – ATC) * Q
• Equilibrium Pricing• MC = MR
• Shut-down price• P < AVCMIN
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Cost and Supply
• When making output decisions in the short run, it is the firm’s marginal costs that are most important.• Additional units will not be supplied if they
do not generate additional revenues that are sufficient to cover their marginal costs.
• For long-run output decisions, it is the firm’s average total costs that are most important.• Firms will not continue to supply output in
the long run if revenues are insufficient to cover their average total costs.
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Q
P
• Average Total Costs: will be a U-shaped curve since AFC will be high for small rates
of output and MC will be high as the plant’s production capacity (q) is approached.
• Marginal Costs: rise sharply as the plant’s production capacity (q) is approached.
Q
P
MC
qATC
q
Short-Run Cost Curves
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Output and CostsIn the Short Run
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Total Cost Schedule• Output TFC TVC TC• 0 50 0 50• 1 50 15 65• 2 50 25 75• 3 50 34 84• 4 50 42 92• 5 50 52 102• 6 50 64 114• 7 50 79 129• 8 50 98 148• 9 50 122 172• 10 50 152 202
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TFC
TC
TVC
0
Totalcosts
42
50
100
150
200
6 8 10
TCTVCTFCOutputper day
2 4 6 8
10
02542
64 98152
• Note that total fixed costs are flat – they are constant at all output levels.
Output
=+505050505050
507592
114148202
• Note that total variable costs increase as more variable inputs are utilized.• As total costs are the combination of TVC and TFC, they are everywhere positive and increase sharply with output
Short Run Total Cost Curves
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Average Cost Schedule• Output AFC AVC ATC• =(TFC/Output) =(TVC/Output) =(TC/Output)
• 1 50 15 65• 2 25 12.5 37.5• 3 16.7 11.3 28• 4 12.5 10.5 23• 5 10 10.4 20.4• 6 8.3 10.7 19• 7 7.1 11.3 18.4• 8 6.25 12.25 18.5• 9 5.6 13.6 19.2• 10 5 15.2 20.2
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AFC
Costper unit
42 6 8 10Output
20
40
60
AVCTVC Outputper day =/
AVC
0 1 2 4 6 8
10
----$ 15.00$ 12.50$ 10.50
$ 10.67$ 12.25$ 15.20
0152542
64 98152
• The average variable cost curve (AVC) is the total variable cost (TVC) divided by the output level. It is higher either for a few or a lot of units and has some minimal point between the two where, when graphed later, marginal costs (MC) will cross.
Short Run Cost Curves
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Marginal Cost Schedule• Output VC ∆VC=MC• 0 0• 1 15 =15-0 15• 2 25 =25-15 10• 3 34 =34-25 9• 4 42 =42-34 8• 5 52 =52-42 10• 6 64 =64-52 12• 7 79 =79-64 15• 8 98 =98-79 19• 9 122 =122-98 24• 10 152 =152-122 30
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AFC
Costper unit
42 6 8 10Output
20
40
60
AVC
=/TC TC Output MC
MC
$ 15.00$ 10.00$ 8.00
$ 12.00
$ 19.00
$ 30.00
5065758492
102114129148
172202
• Note that MC starts low and increases as output increases. It also crosses AVC at its minimum point.
10
8
12
19
30
15 1 1
1
1
1
1
• To calculate the marginal cost curve (MC) we take the change in TC (TC) and divide that by the change in output. Note: our increments for increasing output here are 1 ( 1).
Note: MC always crosses AVC at its minimum point.
Short Run Cost CurvesShort-Run Cost Curves
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ATCTC Outputper day =/ 0 1 2 4 6 8
10
----$ 65.00$ 37.50$ 23.00
$ 19.00$ 18.50$ 20.20
• When output is low, ATC is high because AFC is high. Also, ATC is high when output is large as MC grows large when output is high.
50657592
114148202
• These two relationships explain the distinct U–shape of the ATC curve.
• The average total cost curve (ATC) is simply TC divided by the output.
ATC
Note: MC always crosses ATC at its minimum point.
Short Run Cost Curves
AFC
Costper unit
42 6 8 10Output
20
40
60
AVC
MC
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MarginalRevenue =(MR)
Marginal Revenue• Marginal Revenue is the change in total
revenue divided by the change in output.
• In a perfectly competitive market, marginal revenue (MR) = market price, because all units are sold at the same price (market price).
Change in Revenue TRi-TR(i-1)
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• In the short run, the price taker will expand output until the marginal revenue (MR) is just equal to marginal cost (MC).
• When P > MC, production of the unit adds more to revenues than costs. In order for the firm to maximize its profits it will expand output until MC = P.
• This will maximize the firm’s profits (rectangle PBAC).
d (P = MR)
q
Price
Output
ATC
MC
• When P < MC, the unit adds more
to costs than revenues. A profit maximizing firm will not produce in this output range. It will reduce output until MC = P.
Profit
AC
PB
increase q
P > MC
decrease q
P < MC
Profit Maximization when the Firm is a Price Taker
P = MC
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MC
0 2
8 10 12 14 15 16 18 20
---- 5
5 5
----$ 3.95
$ 1.50$ 1.00
- 25.00- 23.75
1
3
7
9
5
5 5 5 5 5
5
$ 1.75$ 3.50$ 4.75$ 6.00$ 8.25
$ 13.00
- 8.00- .25 6.75 10.75 11.00
10.00 4.50 - 8.00
MR
. . . . . .
. . . . . .
MarginalRevenue
(MR) Output
MarginalCost(MC)
Profit
(TR - TC)Price and cost per Unit
108642 12 14 16 18 20
Output
MR / MC Approach• At low output levels MR > MC. • After some point, additional units cost more than the
MR realized from selling them.• Profit is maximized where P = MR = MC.
Profit MaximumP = MR = MC
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MC=MR• Output MC MR• 0 • 1 15 10• 2 10 10• 3 9 10• 4 8 10• 5 10 10• 6 12 10• 7 15 10• 8 19 10• 9 24 10• 10 30 10
MC=MR
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Profits (π)• Output TR=Q*P TC π=TR-TC• 0 • 1 10 65 (55)• 2 20 75 (55)• 3 30 84 (54)• 4 40 92 (52)• 5 50 102 (52)• 6 60 114 (54)• 7 70 129 (59)• 8 80 148 (68)• 9 90 172 (82)• 10 100 202 (102)
Max. π
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• If MC = MR at a fractional point, always choose the last level of output where MR > MC.
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Output and CostsIn the Long Run
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Short-Run & Long-Run Cost Curves
• Each potential plant has a cost curve (SRAC).• The choices of each plant’s short-run curves
combine to create a long-run curve (LRAC).
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Market Structures
1 – Perfectly Competitive Markets2 – Monopolies3 – Monopolistic Competition4 – Oligopolies
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1 – Perfectly Competitive Markets
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Perfectly Competitive Markets
• Perfect Competition
• Many buyers & sellers• No single buyer or seller exerts
influence on the market• Informed buyers• Identical products• Easy market entry & exit
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Demand from Seller’s Perspective
• Perfectly elastic
• P = MR = AR = D
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Firm vs. Industry in Perfect Competition
Single Firm Industry
P P
Q Q
P
QFirm QIndustry
MCΣMC
D=MR=AR=P
D
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Short-Run in Perfectly Competitive Markets• MC = MR
• Provided MR > Minimum AVC• Loss Minization
• MR > AVC but MR < ATC
• Operation reduces losses• Shut-down Situation
• If MR < AVCmin, operating increases losses
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Long-Run in Perfectly Competitive Markets
• If there are profits• New companies enter market b/c no
barriers to entry• Drives profits towards zero• Eventually, ATC = Price (zero profits)
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Long-Run effects on π Perfect Competition
Single Firm Industry
P P
Q Q
P2
QFirm2QIndustry2
MCΣMC1
D
D
ΣMC2
P1
QFirm1QIndustry1
ATC
Π @ P1
Π adds new entrantsIncreasing supply to ΣMC2
Drives Q↑ & P↓
Eliminates Π
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2 – Monopolies
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Monopolies
• Price maker
• Single seller
• No close substitutes
• Difficult market entry
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Monopolies – Entry Barriers
• A few examples of factors that may serve as ‘barriers’ to free entry into a market:• economies of scale• government licensing• patents• control over an essential resource
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Demand & MR • Demand is downward
sloping• MR is lower than demand
• NB to lower price the Monopoly must lower price on all units sold therefore MR associated with increased sales reduces revenues on a per unit basis.
P
Q
MR D
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Demand, MR & TR
TR
MR
Q
Q
P
P
D
ElasticInelastic
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Price
Quantity/time
d
P
MR
q
MC
ATC
C B
A and price P (along the demand curve) will be charged.
Price and Output Under Monopoly• The monopolist will reduce price and expand output as long as MR > MC.
MR > MCMR < MC
• The monopolist will raise price and reduce output whenever MR < MC.• Output level q will result …
• At output q the average total cost is C.• As P > C (price > ATC) the firm
is making economic profits equal to the area PABC.
Economicprofits
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Efficiency & Monopolies
MC = S
MR D
Q
P
QM QE
PM
PE
a
b
c
∆abc represents efficiency loss
MC=MR @ point bresult is point a for P & Q
Monopolies lead to higher Price & lower Q
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Price Discrimination
• Conditions• Monopoly Power• Market Segregation• No Resale
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Price Regulation
P
Q
MR
MC
ATC
D
Monopoly Price
Fair-return Price
Socially-optimal Price
PM
PF
PS
QM QSQF
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Effects of Monopolies• Market Inefficiency• Higher Prices
• Monopolies P > MR = MC• Perfect Competition P = MR = MC
• Lower Quantities• Income Transfer
• From Buyers to Seller• X-inefficiency
• Higher costs due to outdated plants/equipment
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Market Regulation
• American history & big business
• Anti-trust legislation
• Modern application:• Was Microsoft a monopoly?
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3 – Monopolistic Competition
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Monopolistic Competition
Major differences from perfectly Competitive Market
• Products not identical (variation)
• Non price competition
• Profits• Short-term economic profits• Long-term normal or accounting profits
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Price and Output
• A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost.
• Price will be lowered and output expanded until MR = MC.
• The price charged by a price searcher will be greater than its marginal cost.
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Price
d
MR
MC
ATC
Price and Output: Short-Run Profit
Quantity/timeq
P
C
EconomicProfits
• A competitive market maximizes profits by producing where MR = MC, at output level q … and charges a price P along the demand curve for that output level.
• At q the average total cost is C.• Because the price is greater than the
average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] x q ) • What impact will economic profits have if this is a typical firm?
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Long-Run• Similar to perfect Competition• Economic efficiency
• P (MR) = MC = ATC• Efficiency
• Productive Efficiency• Relationship between price & costs• P = ATCmin
• Allocative Efficiency• Supply & Demand• MC = D
• Is monopolistic competition efficient?
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Price• Because entry and exit are free, competition will eventually drive prices down to the level of ATC.
Quantity/timeq
P
d
MR
MC
ATC
Price and Output – Long Run in aCompetitive Markets
• When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored.• The companies establishes its output level where MC = MR.• At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present.
C = P
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Excess Capacity
ATC
D
MR
MC
P1
P
QQ1 Qe
ExcessCapacity Productive inefficiency
Allocative EfficiencyMC = D
Productive EfficiencyP = ATCmin
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Differentiation• Location
• Advertising
• Brand Loyalty
• Service
• Quality
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4 – Oligopoly
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Oligopolies
• Few large companies• Identical or similar products• Difficult market entry• Non price compitetion
• Price leadership• Collusion (cartels) vs. price war
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Terms
• Collusion
• Tacit Collusion
• Cartel
• Prisoner’s Dilemma
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Prisoner’s DilemmaCheat
Cheat
Don’t Cheat
Don’t CheatProfit $200M, then $160M
Profit $160M
Profit $150M, then $160M
Profit $150M, then $160M
Profit $160M
Profit $200M, then $160M
Profit $180M
Profit $180M
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Price & Output Under Oligopoly
• No general theory exists for price and output under oligopoly.• If the firms operated independently, they
would drive down the price to the per-unit cost of production.
• If the firms colluded perfectly, the price would rise to the monopoly price.
• The outcome is usually between these two extremes.
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Product Differentiation
• Price searchers produce differentiated products – products that differ in design, dependability, location, ease of purchase, etc.
• Rival firms produce similar products (good substitutes) and therefore each firm confronts a highly elastic demand curve.
• Result is attempt to compete on non-price factors.
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Incentive to Collude Prisoner’s Dilemma
• Oligopolists have a strong incentive to collude and raise their prices.
• However, each firm also has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve.
• This conflict makes collusive agreements that are difficult to maintain.
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Price
Quantity/time
PriceIndustry Firm
DiMRi
Pf
qf
Pi
Qi
MC
dfMRf
MC
Pi
Gaining from Cheating• Using industry demand Di and marginal revenue MRi,
oligopolists maximize their joint profit where MRi = MC – at output Qi and price Pi .
• The demand facing each firm df (where no other firms cheat) would be much more elastic than the industry demand Di .
• The firm maximizes its profit where MRf = MC by expanding output to qf and lowering its price to Pf from Pi .
Individual firms havean incentive to cheat by cutting price to
expand output
Quantity/time
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Kinked-Demand CurveP
P1
QQ1
D2
D1
MR1
MR2
Price DecreasesCompetition matches price
Price increaseCompetition does not match
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Kinked-Demand CurveP
P1
QQ1
Dmp
MRmp
Incentives to - lower prices - collusion
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Monopolistic Competition vs. Oligopilies
• MP (many firms) vs. Oligopilies (a few firms)• 2 measures
• 4 firm concentration ratio• (output of 4 largest)/Total output• Low (MP) to high (Oligopoly)
• Herfindahl index• Σ(market shares for each firm)2
• Low (MP) to high (Oligopoly)
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