principles of microeconomics 13. industrial organization and welfare*
DESCRIPTION
Principles of Microeconomics 13. Industrial Organization and Welfare*. Akos Lada August 8th, 2011. * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint. Contents. Review of previous lecture Competitive firms in the short and the long run - PowerPoint PPT PresentationTRANSCRIPT
Principles of Microeconomics
13. Industrial Organization and Welfare*
Akos LadaAugust 8th, 2011
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of previous lecture
2. Competitive firms in the short and the long run
3. The monopolist’s profit-maximizing decision
4. Monopoly, welfare, and public policy
1. Review
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Q
uan
tity
of
ou
tpu
t
Production Function and the MPL
30005200
28004400
24003600
18002800
10001
1000
00
MPLQL
The relationship between the quantity of inputs used to produce a good and the quantity of output of that good.
MPL is the slope
of the Productio
n Function
Production Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$1000
TCVCFCQ
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Costs
FC
VC
TC
Average and Marginal costs
AFC
AVC
ATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Costs
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
Refer to the table below. The average total cost of producing five units of
output is
Quantity of Output Fixed Costs Variable Costs0 $20 $01 20 52 20 103 20 154 20 205 20 251. $2.
2. $5.
3. $9.
4. $45.
Refer to the table below. The marginal cost of producing the fifth unit of
output is
Quantity of Output Fixed Costs Variable Costs0 $10 $01 10 42 10 93 10 154 10 225 10 401. $8.
2. $18.
3. $40.
4. $58.
P1 MR
Profit-maximization rule
At Qa, MC < MR.
So, increase Q to raise profit.
At Qb, MC > MR.
So, reduce Q to raise profit.
At Q1, MC = MR.
Changing Q would lower profit.
Q
Costs
MC
Q1Qa Qb
Rule: MR = MC at the profit-maximizing Q.
2. Competitive firms in the short and the long
run
Firms’ Shutdown and Exit
• Shutdown: A short-run decision not to produce anything because of market conditions.
• Exit: A long-run decision to leave the market.
• A key difference: • If shut down (short run), must
still pay FC.• If exit (long run), zero costs.
A Firm’s Short-run Decision to Shut Down
• Cost of shutting down: revenue loss = TR
• Benefit of shutting down: cost savings = VC (firm must still pay FC)
• So, shut down if TR < VC
• Divide both sides by Q: TR/Q < VC/Q
• So, firm’s decision rule is:
Shut down if P < AVC
A Competitive Firm’s SR Supply Curve
The firm’s SR supply curve is the portion of its MC curve above AVC.
Q
Costs
MC
ATC
AVC
If P > AVC, then firm produces Q where P = MC.
If P < AVC, then firm shuts down (produces Q = 0).
The Chocolate Moose Ice Cream Store is a business that closes from November to April each year. The best explanation for
closing during these months is that the store’s
1. revenues are insufficient to cover total costs.
2. total fixed costs are less than marginal fixed cost.
3. revenue per unit is less than average variable cost.
4. marginal costs are less than the revenues.
The Irrelevance of Sunk Costs
• Sunk cost: a cost that has already been committed and cannot be recovered
• Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice.
• In the short run FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down.
• So, FC should not matter in the decision to shut down (that is, in the short run).
A Firm’s Long-Run Decision to Exit
• Cost of exiting the market: revenue loss = TR
• Benefit of exiting the market: cost savings = TC (zero FC in the long run)
• So, firm exits if TR < TC
• Divide both sides by Q to write the firm’s decision rule as:
Exit if P < ATC
A New Firm’s Decision to Enter Market
• In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC.
• Divide both sides by Q to express the firm’s entry decision as:Enter if P > ATC
Note: if P=ATC,
then firm’s profit is zero
The firm’s LR supply curve is the portion of
its MC curve above LRATC.
Q
Costs
The Competitive Firm’s Supply Curve
MC
LRATC
Entry & Exit in the Long Run, and the Zero-Profit
Condition• In the LR, the number of
firms can change due to entry & exit.
• If existing firms earn positive economic profit, • new firms enter, SR
market supply shifts right.
• P falls, reducing profits and slowing entry.
• If existing firms incur losses, • some firms exit, SR market
supply shifts left. • P rises, reducing remaining
firms’ losses.
• Long-run equilibrium: when the process of entry or exit is complete – remaining firms earn zero economic profit.
• Why do firms stay in business with profit zero?!
• Recall, economic profit is revenue minus all costs – including implicit costs, like the opportunity cost of the owner’s time and money.
• In the zero-profit equilibrium,
• firms earn enough revenue to cover these costs
• accounting profit is positive
STUDENT’S TURNSTUDENT’S TURN
Identifying a firm’s profitIdentifying a firm’s profit
20
Determine this firm’s total profit.
Identify the area on the graph that represents the firm’s profit. Q
Costs, P
MC
ATCP = $10
MR
50
$6
A competitive firm
AnswersAnswers
21
profit
Q
Costs, P
MC
ATCP = $10
MR
50
$6
A competitive firm
Profit per unit = P – ATC= $10 – 6 = $4
Total profit = (P – ATC) x Q = $4 x 50= $200
The LR Market Supply Curve
MCMarket
Q
P
(market)
One firm
Q
P
(firm)
In the long run, the typical firm
earns zero profit.
LRATC
long-runsupply
P = min. ATC
The LR market supply curve is horizontal at P = minimum ATC.
S1
Profit
D1
P1
long-runsupply
D2
SR & LR effects of an Increase in Demand
MC
ATC
P1
Market
Q
P
(market)
One firm
Q
P
(firm)
P2P2
Q1 Q2
S2
Q3
A firm begins in long-run equilibrium…
…but then an increase in demand raises P,…
…leading to SR profits for the firm.
Over time, profits induce entry, shifting S to the right, reducing P……driving profits to zero and restoring long-run equilibrium.
A
B
C
3. The monopolist’s profit-maximizing
decision
A monopoly is different…
• For a competitive firm:• At a given quantity,
what is the revenue it makes, on average, per each unit sold?• AR = P
• If it wants to increase this quantity by one unit, what is the additional revenue it can expect to receive?• MR = P
• So: MR=AR=P
• For a monopoly:• At a given quantity,
what is the revenue it makes, on average, per each unit sold?• AR = P
• If it wants to increase this quantity by one unit, what is the additional revenue it can expect to receive?• MR < P !!!
• Why???• Because to be able to
sell more, it needs to reduce the price.
Monopoly vs. Competition: Demand Curves
In a competitive market, the market demand curve slopes downward.
But the demand curve for any individual firm’s product is horizontal at the market price.
The firm can increase Q without lowering P,so MR = P for the competitive firm.
D
P
Q
A competitive firm’s demand curve
A monopolist is the only seller, so it faces the market demand curve.
To sell a larger Q, the firm must reduce P.
Thus, MR < P.
A monopoly’s demand curve
D
P
Q
Understanding the Monopolist’s MR
• Increasing Q has two effects on revenue:• Output effect: higher output
raises revenue• Price effect: lower price
reduces revenue
• To sell a larger Q, the monopolist must reduce the price on all the units it sells.
• Hence, MR < P
• MR could even be negative if the price effect exceeds the output effect!
STUDENT’S TURNSTUDENT’S TURN
A monopoly’s revenueA monopoly’s revenue
28
Q P TR AR MR
0 $4.50
1 4.00
2 3.50
3 3.00
4 2.50
5 2.00
6 1.50
n.a.Common Grounds is the only seller of cappuccinos in town.
The table shows the market demand for cappuccinos.
Fill in the missing spaces of the table.
What is the relation between P and AR? Between P and MR?
AnswersAnswers
29
Here, P = AR, same as for a competitive firm.
Here, MR < P, whereas MR = P for a competitive firm.
1.506
2.005
2.504
3.003
3.502
1.50
2.00
2.50
3.00
3.50
$4.00
4.001
n.a.
9
10
10
9
7
4
$ 0$4.5
00
MRARTRPQ
–1
0
1
2
3
$4
Common Grounds’ D and MR Curves
-3
-2-1
0
12
3
45
0 1 2 3 4 5 6 7 Q
P, MR
MR
$
Demand curve (P)
1.506
2.005
2.504
3.003
3.502
4.001
$4.50
0
MRPQ
–1
0
1
2
3
$4
Monopolist Profit-Maximization
1. The profit-maximizing Q is where MR = MC.
2. Find P from the demand curve at this Q.
Quantity
Costs and Revenue
MR
D
MC
Profit-maximizing output
P
Q
• Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC.
• Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity.
• It finds this price from the D curve.
A Monopoly Does Not Have a Supply Curve!
A competitive firm • takes P as given• has a supply curve that shows
how its Q depends on P.
A monopoly firm• is a “price-maker,” not a “price-
taker” • Q does not depend on P;
rather, Q and P are jointly determined by MC, MR, and the demand curve.
So there is no supply curve for monopoly.
4. Monopoly, welfare, and public policy
The Welfare Cost of Monopoly
• Recall: In a competitive market equilibrium, P = MC and total surplus is maximized.
• In the monopoly equilibrium, P > MR = MC• The value to buyers of an
additional unit (P)exceeds the cost of the resources needed to produce that unit (MC).
• The monopoly Q is too low – could increase total surplus with a larger Q.
• Thus, monopoly results in a deadweight loss.
P = MC
Deadweight loss
P
MC
The Welfare Cost of Monopoly
Competitive equilibrium:
quantity = QC
P = MC
total surplus is maximized
Monopoly equilibrium:
quantity = QM
P > MC
deadweight loss Quantity
Price
D
MR
MC
QM QC
In comparison to a perfectly competitive firm, a monopolist charges
a
1. higher price and produces a higher quantity.
2. higher price and produces a lower quantity.
3. lower price and produces a higher quantity.
4. lower price and produces a lower quantity.
Refer to the figure below. The deadweight loss for a profit-maximizing
monopolist is the area
Q
$
MC
D
Q2 Q3 Q1
P2
P4
P1
P5
P3
ATC
MR
A
FB
GE
C
Public Policy Toward Monopolies
• Increasing competition with antitrust laws• Ban some anticompetitive practices,
allows government to break up monopolies.
• Regulation• Government agencies set the monopolist’s
price.
• Public ownership• Example: U.S. Postal Service• Problem: Public ownership is usually less
efficient since no profit motive to minimize costs
• Doing nothing?• The foregoing policies all have drawbacks,
so the best policy may be no policy (if costs exceed benefits)