Market Structure and the Behavior of Firms Perfect Competition vs Monopoly

Market Structures Many Number of Competitors One Less Market Control More Perfect Competition Monopoly Monopolistic Competition Oligopoly

 Assume firms want to maximize profit  = TR – TC Behavior of Firms TR = Total Revenue = P∙q TC = Total Economic Cost Economic Cost = Explicit Cost + Implicit Cost

Technological Constraints  Production Function q = F(L, K) q = output L = labor K = capital F(·) represents technology Lab Experiment 3: Widget Production _ Variable inputFixed input

Measures of Productivity  Total Product q = F(L, K)  Average Product AP = q/L  Marginal Product MP = Δq/ ΔL Note: Diminishing Marginal Returns (DMR) When there is at least one fixed input, eventually a point is reached at which the marginal product of an additional worker begins to fall.

∆q∆q ∆L∆L Productivity Graphs labor output labor q/L TP MP AP L1L1 L1L1 DMR L2L2 L2L2 Slope = MP L = ∆q/ ∆L When MP > AP then AP will rise When MP < AP then AP will fall

Measuring Marginal Product  Batting Averages  GPAs GPA FallSpringCumulative First Year Second Year Third Year Fourth Year When MP > AP then AP will rise When MP < AP then AP will fall

Short Run Costs TC = FC + VC Does not vary with output: Rent Utilities Salaries Property taxes Insurance premiums Varies with output: Labor Raw materials

Short Run Cost Curve Family output $ $ FC VC TC AFC MC AVC ATC TC = FC + VCATC = AFC + AVC

Properties of the Cost Curves  “Ross Perot” Equation  Short Run Cost Curve Shifters Change in price of labor Change in price of capital Change in amount of capital Change in technology output $ MC labor q/L MP output $ AFC MC AVC ATC

Long Run Costs  What is the optimal size for a factory? output $ ATC 1 ATC 2 ATC 3 ATC 4 q2q2 LRAC

Long Run Average Cost Curve output $ ATC 3 LRAC q MES EOS: double the inputs, output more than doubles DOS: double the inputs, output less than doubles  LRAC falls  LRAC rises Specialization Coordination/Communication Problems

Perfect Competition: Price Taker Model  Characteristics of the Industry Large number of small buyers/sellers Homogeneous product Free entry/exit Perfect information  firms are price takers  Characteristics of the Industry Large number of small buyers/sellers Homogeneous product Free entry/exit Perfect information  firms are price takers S D PP1P1 Q1Q1 Quantityquantity $ IndustryFirm = MR MR = ΔTR / Δq $

Maximizing Profit  = TR – TC  = Pq - [FC + VC] What output should the firm produce?  produce until MR = MC  If MR > MC  produce more  If MR < MC  produce less What output should the firm produce?  produce until MR = MC  If MR > MC  produce more  If MR < MC  produce less MR MC quantity $ q 1 = 300 $60 = P 1 I want you to maximize profit What is TR = ? What is TC = ? What is TR = ? What is TC = ?

Profit and Loss Diagrams MC quantity $ q 1 = 300 $60 = P 1 ATC MR 1 $50 = ATC  Positive Profit:  > 0  = Pq – (ATC)q  = (P-ATC)q  = (60-50)300  = $3000  Negative Profit  = (35-50)250  = -$3750  Zero Profit? MR 2 $35 = P 2 q 2 = 250

Sometimes it’s better to stay open and lose a little bit…  Temporary Shut Down: q = 0  = Pq – (FC +VC)  = 0 – (FC + 0)  = - FC Stay open if TR > VC Shut down if TR < VC MC quantity $ q 1 = 2000 $25 = P 1 ATC MR 1 $35 = ATC 1 AVC $20 = AVC 1 Stay open:  = -$20,000 Shut down:  = -$30,000 Fixed Cost = $30,000

Shutdown recap  Shut down if TR < VC Pq < (AVC)(q) P < AVC MC quantity $ q SD ATC AVC P SD = Min AVC Note: The portion of the MC curve above the shutdown point is the firm’s supply curve

How should a business react if…  Price rises?  Marginal costs rise?  Fixed costs rise? MC quantity $ q1q1 P1P1 ATC MR 1 AVC

Long Run Equilibrium  A = TR – Explicit Costs  E =  A - Implicit Costs  A = 6%  A = 9%  E = 3% if  E > 0  entry occurs if  E < 0  exit occurs Economy  E = 0% 7% 0% Firm = LRE:  E = 0

Long Run Adjustment Process MC quantity $ q1q1 P1P1 ATC MR 1 MR 2 D1D1 S1S1 Q1Q1 At P 1 : each firm produces q 1 and earns  E = 0 Demand rises to D 2 : D2D2 S2S2 P2P2 At P 2 : each firm produces q 2 and earns  E > 0 Since  E > 0, new firms will enter: supply shifts to S 2 Price will fall back to P 1 and  E = 0 q2q2 Q3Q3 Industry Firm Quantity $ LRS Long run supply curve for a constant cost industry is horizontal causes price to rise to P 2

MES and Market Structure D Output $ Q1Q1 P1P1 ⅛Q1⅛Q1 ¼Q1¼Q1 ½Q1½Q1 ATC 1 ATC 2 ATC 3 ATC 4 The greater MES is as a share of market demand, the fewer the number of firms Industry 1: room for 8 firms Industry 2: room for 4 firms Industry 3: room for 2 firms Industry 4: room for 1 firm “natural monopoly”

MES Plant Size Versus Market Concentration IndustryMES/S4x(MES/S)CR4 Beer Brewing Cigarettes Broad-woven cotton and synthetic fabrics Paints, varnishes, and lacquers Petroleum refining Shoes (other than rubber) Glass containers Cement Integrated wide-strip steel works Ball and roller bearings Refrigerators and freezers Storage batteries Source: Stephen Martin, “Industrial Economics,” 2e, MacMillan (1994), p240.

Monopoly A Price Searcher Model

Monopoly  Pure monopolist has no close substitutes  Sherman Act (1890) “anti-trust” law Section 1: Every contract, combination…or conspiracy, in restraint of trade…is declared to be illegal" Section 2: "Every person who shall monopolize, or attempt to monopolize…shall be deemed guilty of a felony”

Relevant Market  Product Market DuPont (1956)  Cellophane  Flexible wrapping paper Alcoa (1945)  Primary aluminum  All aluminum Flexible Wrapping Paper 20% Cellophane 75% Aluminum Foil Butcher Paper Newspaper All Aluminum 33% Primary 90% Secondary Imported

Global Relevant Market  Geographic Market Local Regional National Global Local Regional National

Barriers to Entry  Economies of Scale “natural monopoly”  Control over key inputs Alcoa--bauxite DeBeers  GE Superabrasives (Diamond Innovations) LRAC Quantity $

…more barriers to entry  Government restrictions Patents  20 year duration Copyrights  Life of artist plus 70 years Licenses  Occupational licenses: doctors, lawyers, accountants, engineers  For what purpose: Public health or private interest? Franchises  Taxi medallions: 12,779  $336,000 per medallion

Source: The New York City Taxicab Fact Book, Schaller Consulting, March Available at

Profit Maximizing Behavior Assume that Monopolist charges single price to all buyers π = TR – TC π = P(Q)*Q – TC MR = ∆TR/ ∆Q $ $40 $ D TR = $20,000 TR = $21,000 MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q Loss Gain MR = [6000 – 5000]/200 = $1000 / 200 MR = $5 MR < P Quantity MR

MR, P, and Elasticity  Note: If E > 1 then MR > 0 If E < 1 then MR < 0 If E = 1 then MR = 0 If E = ∞ then MR = P [Perfect Competition] MR = P [ 1 – 1/E ] MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q

Optimal Output and Price  π-max rule: Set output where MR = MC Set price off of demand curve $ $20 $ D Quantity MR MC ATC TR = P*Q = ($30)(700) = $21,000 TC = ATC*Q = ($20)(700) = $14,000 π = TR - TC = $ 7,000

Optimal Output and Price  π-max rule: Set output where MR = MC Set price off of demand curve  How will monopolist react to: an increase in marginal cost? an increase in fixed cost? an increase in demand? $ $20 $ D Quantity MR MC ATC

Welfare Comparison: PC vs. Monop  Perfect Competition: P C, Q C  Monopoly: P M, Q M $ D Quantity MR MC = ATC QcQc QMQM PMPM PCPC A B C PCMonop CS PS Social Welfare DWL A+B+C --- A B A+B C

Price Discrimination  Definition: price differentials that do not reflect cost differentials  Motivation: to increase profits by capturing more consumer surplus  Necessary Conditions Market Power  Downward sloping demand curve Segment the market  Demographics  Usage rates Prevent resale  Movie theatres  Röhm-Haas: plastic molding compound Industrial: $0.85/lb Dentists: $22/lb Arsenic ?

Types of Price Discrimination  First Degree Charge each buyer their WTP Captures all CS and DWL  Second Degree Quantity discounts  Third Degree Set prices according to price elasticity Movie Theatre  MR A = MR K = MC $ D Quantity MR QcQc QMQM PMPM PCPC MC MC = $4 E A = 2 E K = 5 MR A = P A [1 – 1/E A ] MR A = MC P A [1 – 1/2] = 4P A = $8 Charge higher price to more inelastic group

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