ECO 171: Costs and Market Structure 1 Costs and Market Structure

ECO 171: Costs and Market Structure 2 Basic ideas Determinants of market structure: how many firms in an industry? Economies of scale – Cost functions Minimum efficient scale Role of demand Other determinants

ECO 171: Costs and Market Structure 3 Size distribution U.S. Businesses: 2003

ECO 171: Costs and Market Structure 4 Average size of firms

ECO 171: Costs and Market Structure 5 Average size firms (Manufacturing)

ECO 171: Costs and Market Structure 6 Observations Huge variation in firm size Causes? Economies of scale Market size

ECO 171: Costs and Market Structure 7 Cost functions Cost = C(q) Implicit technology and input prices AC(q) = C(q)/q MC(q) = dC/dq Typical case: C(q) = VC(q) + F

ECO 171: Costs and Market Structure 8 Cost curves: an illustration $/unit Quantity AC MC Typical average and marginal cost curves Relationship between AC and MC If MC < AC then AC is falling If MC > AC then AC is rising MC = AC at the minimum of the AC curve (efficient scale)

ECO 171: Costs and Market Structure 9 Economies of scale Definition: average costs fall with an increase in output Represented by the scale economy index S = AC(Q) MC(Q) S > 1: economies of scale S < 1: diseconomies of scale S = 1 at point of Min avg cost Minimum efficient scale: smallest output level at which economies of scale are exhausted

ECO 171: Costs and Market Structure 10 Economies of scale Sources of economies of scale –“the 60% rule”: capacity related to volume while cost is related to surface area –product specialization and the division of labor –“economies of mass reserves”: economize on inventory, maintenance, repair –Indivisibilities

ECO 171: Costs and Market Structure 11 Fixed costs and economies of scale Larger fixed costs  larger economies of scale Larger efficient scale Example: C(q) = F+q 2 /2 –MC = q –AC = F/q + q/2 –Min AC : q = F/q +q/2 q/2 = F/q  q 2 = 2F  q = sqrt (2F) Min AC = Min MC also equal sqrt (2F) Min efficient scale increases with F

ECO 171: Costs and Market Structure 12 Fixed costs and Economies of Scale

ECO 171: Costs and Market Structure 13 Marginal costs and economies of scale Steeper marginal cost  less economies of scale Lower efficient scale Example: C(q) = F+q 2 –MC = q –AC = F/q + q –Min AC : 2q = F/q +q q = F/q  q 2 = F  q = sqrt (F) Min AC = Min MC = 2q MES = 2 sqrt(F) Minimum efficient scale smaller than before

ECO 171: Costs and Market Structure 14 Marginal costs and Economies of scale

ECO 171: Costs and Market Structure 15 Producing goods jointly is cheaper Similar to economies of scale Sources of economies of scope shared inputs –same equipment for various products –shared advertising creating a brand name –marketing and R&D expenditures that are generic cost complementarities –producing one good reduces the cost of producing another –oil and natural gas –oil and benzene –computer software and computer support –retailing and product promotion Economies of Scope

ECO 171: Costs and Market Structure 16 Market Structure Economies of scale and scope affect market structure but cannot be looked at in isolation. They must be considered relative to market size. Should see concentration decline as market size increases –Entry to the medical profession is going to be more extensive in Chicago than in Oxford, Miss –Find more extensive range of financial service companies in Wall Street, New York than in Frankfurt

ECO 171: Costs and Market Structure 17 Number of firms in Competitive Industry p = A – BQ Firms are price takers In long run equilibrium no further incentives to enter the industry. If firms are homogeneous, zero profits. Implies p = min AC, q=q MES Number of firms N so that: p = A-BNq MES N = (A – p)/Bq MES –Higher demand (higher A or lower B)  more firms –Lower q MES  more firms –Lower min AC  lower p  more firms

ECO 171: Costs and Market Structure 18

ECO 171: Costs and Market Structure 19

ECO 171: Costs and Market Structure 20 Other determinants of Market structure Network externalities –willingness to pay by a consumer increases as the number of current consumers increase telephones, fax, Internet, Windows software utility from consumption increases when there are more current consumers These markets are likely to contain a small number of firms –even if there are limited economies of scale and scope

ECO 171: Costs and Market Structure 21 Other determinants of Market structure Policy Government can directly affect market structure –by limiting entry taxi medallions in Boston and New York airline regulation –through the patent system –by protecting competition e.g. through the Robinson-Patman Act