Finance 510: Microeconomic Analysis Technology, Cost, and Price

Oil prices are currently hovering around $60/barrel Oil prices are currently hovering around $60/barrel. This is a 50% increase from one year ago! How will this rise impact the prices of final goods? Production Decisions Product Markets Factor Markets Factor Usage/Prices Determine Production Costs Supply/Demand determine markup over costs Supply/Demand Determines Factor prices

Production theory begins with the assumption that every producer has a technology available to convert various inputs into output. Its usually convenient to represent this technology with a production function Set of inputs Output

Short Run vs. Long Run It is important in production theory to distinguish the short run from the long run. In the short run, some of the inputs into production are fixed. In the long run, all inputs are changeable. “Fixed” Inputs Output Inputs Output Variable Inputs Long Run Short Run

Properties of Production Labor Output Capital (Fixed in the Short Run) for all (Output is positive) for all (Production is increasing in all factors) (Factors are complements in production) for all

Short Run Properties: Marginal Returns is fixed As labor increases (given a fixed capital stock), labor productivity decreases As labor increases (given a fixed capital stock), labor productivity increases

Long Run Properties is variable Marginal Product of Capital Marginal Product of Labor The Technical rate of substitution (TRS) measures the amount of labor required to replace each unit of capital and maintain constant production

Long Run Properties is variable If you have a lot of capital relative to labor, then TRS is low)!

Long Run Properties is variable The elasticity of substitution measures curvature

Long Run Properties is variable Increasing Returns to Scale Constant Returns to Scale Decreasing Returns to Scale

Cost Minimization The cost function for the firm can be written as Given the costs of the firm’s inputs, the problem facing the firm is to find the lowest cost method of producing a fixed amount of output

Cost Minimization: Short Run Fixed Cost is fixed

Cost Minimization: Short Run is fixed First Order Necessary Conditions

Cost Minimization: Short Run is fixed Recall that lambda measures the marginal impact of the constraint. In this case, lambda represents the marginal cost of producing more output Marginal costs are increasing Marginal costs are decreasing

Marginal Cost vs. Average Cost Costs ATC Minimum ATC MC AVC

Marginal Cost vs. Average Cost Costs ATC AVC MC

Cost Minimization: Long Run is variable

Cost Minimization: Long Run is variable First Order Necessary Conditions

Elasticity of Substitution

Marginal Cost vs. Average Cost MC Costs AC

Marginal Cost vs. Average Cost Costs MC = AC

Marginal Cost vs. Average Cost Costs AC MC

Estimating Production Functions Labor Growth Capital Growth Output Growth Productivity Growth

Example: Estimating Production Functions A Cobb-Douglas Production function was estimated for the aggregate production sector of the US Average Annual Growth = 1.5%

Industry Food/Beverage .555 .439 .076 1.070 Textiles .121 .549 .335 Example: Estimating Production Elasticities Non-Production Labor Production Labor Industry Food/Beverage .555 .439 .076 1.070 Textiles .121 .549 .335 1.004 Furniture .205 .802 .103 1.109 Petroleum .308 .546 .089 .947 Stone, Clay, etc. .632 .032 .366 1.029 Primary Metals .371 .077 .509 .958

Profit Maximization and Industry Dynamics After the determination of optimal production, the firm is faced with a cost function… Further, the firm faces a demand for its product…

A quick diversion… Demand refers to output as a function of price Inverse demand refers to price as a function of output

Profit Maximization and Industry Dynamics After the determination of optimal production, the firm is faced with a cost function… Further, the firm faces an inverse demand for its product… A firm needs to choose output to maximize profits…

Profit Maximization First Order Necessary Conditions Marginal Cost (MC)

First Order Condition Multiply and divide the first term by p A little rearranging Now, solve for price

Initially, you are charging price (P) and generating sales equal to Y Revenue = P*Y To increase sales, you must lower your price D

Cost, Price, and Market Structure Market Structure Spectrum Monopoly Perfect Competition The market is supplied by many producers – each with zero market share One Producer Supplies the entire Market

Measuring Market Structure – Concentration Ratios Suppose that we take all the firms in an industry and raked them by size. Then calculate the cumulative market share of the n largest firms. Cumulative Market Share 100 A C 80 B 40 20 Size Rank 1 2 3 4 5 6 7 10 20

Measuring Market Structure – Concentration Ratios Cumulative Market Share 100 A C 80 B 40 20 Size Rank 1 2 3 4 5 6 7 10 20 Measures the cumulative market share of the top four firms

Concentration Ratios in US manufacturing; 1947 - 1997 Year 1947 17 23 30 1958 38 1967 25 33 42 1977 24 44 1987 43 1992 32 1997 40 Aggregate manufacturing in the US hasn’t really changed since WWII

Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i Rank Market Share 1 25 625 2 3 4 5 6 7 8 HHI = 2,000

The HHI index penalizes a small number of total firms Cumulative Market Share 100 A 80 HHI = 500 B HHI = 1,000 40 20 1 2 3 4 5 6 7 10 20

The HHI index also penalizes an unequal distribution of firms Cumulative Market Share 100 80 HHI = 500 HHI = 555 A 40 B 20 1 2 3 4 5 6 7 10 20

Concentration Ratios in For Selected Industries Industry CR(4) HHI Breakfast Cereals 83 2446 Automobiles 80 2862 Aircraft 2562 Telephone Equipment 55 1061 Women’s Footwear 50 795 Soft Drinks 47 800 Computers & Peripherals 37 464 Pharmaceuticals 32 446 Petroleum Refineries 28 422 Textile Mills 13 94

Perfect Competition MC ATC D Perfectly competitive firms are so small relative to the market that they can’t influence market price – they face a perfectly elastic demand curve MC ATC D

Perfect Competition MC = AC As we move from the short run to the long run, firms adjust their capital structure (move from short run cost functions to long run cost functions) MC = AC

Monopoly Monopolies by definition face the entire market demand. Therefore, monopolies charge a markup over marginal cost – as the elasticity of demand increases, the markup decreases. MC Example ATC MC D MR

Monopoly As we move from the short run to the long run, firms adjust their capital structure (move from short run cost functions to long run cost functions). Typically, demand also becomes more elastic as consumers find substitute products MC Example D MC MR

Higher market concentration offers the potential for market power Higher market concentration offers the potential for market power. However, does high market concentration guarantee market power? The Lerner index measures the percentage of a product’s price that is due to the markup Perfect Competition Monopoly

Lerner index in For Selected Industries Industry LI Communication .972 Paper & Allied Products .930 Electric, Gas & Sanitary Services .921 Food Products .880 General Manufacturing .777 Furniture .731 Tobacco .638 Apparel .444 Motor Vehicles .433 Machinery .300

Cost Structure and Market Structure – Does it pay to be big? The output elasticity of costs is defined as the percentage increase in total costs for every 1% increase in production If the output elasticity is less than one, then total costs are growing at a rate that is lower than output (Average Costs are declining) – It pays to be big!! A scale economy index larger than one indicates the potential for a monopoly!

Cost Structure and Market Structure – Does it pay to be big? ATC If market demand is always below y*, than this industry could become monopolistic!! MC

Globally scale economies Globally scale economies (S>1 for all y) are known as natural monopolies (the market should – and will – be serviced by one producer). This can happen if production exhibits increasing returns to scale, or if there are large fixed costs. Costs Costs ATC ATC MC MC

Monopoly Market Characteristics Scale economies (Natural Monopolies) Small market size Network Externalities Government Policy (Protected Monopolies) Any one of these characteristics suggest that the long run market structure should be monopolistic.