© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Overview of Market Types E conomics P R I N C I P L E S O F N. Gregory Mankiw

In this section, look for the answers to these questions:  How do costs and market types  Market type overview:  Perfectly competitive market  Monopoly  Oligopoly  Monopolistic Competition 1

FIRMS IN COMPETITIVE MARKETS 2 Introduction: A Scenario  Say you want to start your own business….  You must decide how much to produce, what price to charge, how many workers to hire, etc.  What factors should affect these decisions?  Your costs (studied in preceding chapter)  How much competition you face  We begin by looking at the costs and then different types of market types.

You run General Motors.  List 3 different costs you have.  List 3 different business decisions that are affected by your costs. A C T I V E L E A R N I N G 1 Brainstorming costs 3

THE COSTS OF PRODUCTION 4 Total Revenue, Total Cost, Profit  We assume that the firm’s goal is to maximize profit. Profit = Total revenue – Total cost the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production

THE COSTS OF PRODUCTION 5 Costs: Explicit vs. Implicit  Explicit costs require an outlay of money, e.g., paying wages to workers.  Implicit costs do not require a cash outlay, e.g., the opportunity cost of the owner’s time.  Accounting profit =total revenue minus total explicit costs  Economic profit =total revenue minus total costs (including explicit and implicit costs)

THE COSTS OF PRODUCTION 6 The Production Function  A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.  It can be represented by a table, equation, or graph.  Example 1:  Farmer Jack grows wheat.  He has 5 acres of land.  He can hire as many workers as he wants.

THE COSTS OF PRODUCTION ,000 1,500 2,000 2,500 3, No. of workers Quantity of output Example 1: Farmer Jack’s Production Function Q (bushels of wheat) L (no. of workers)

THE COSTS OF PRODUCTION 8 Why MPL Is Important  Recall one of the Ten Principles: Rational people think at the margin.  When Farmer Jack hires an extra worker,  his costs rise by the wage he pays the worker  his output rises by MPL  Comparing them helps Jack decide whether he would benefit from hiring the worker.

THE COSTS OF PRODUCTION 9 Why MPL Diminishes  Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why?  As Jack adds workers, the average worker has less land to work with and will be less productive.  In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.).  Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)

THE COSTS OF PRODUCTION 10 EXAMPLE 1: Farmer Jack’s Total Cost Curve Q (bushels of wheat) Total Cost 0$1, $3, $5, $7, $9, $11,000

THE COSTS OF PRODUCTION 11 Marginal Cost  Marginal Cost (MC) is the increase in Total Cost from producing one more unit: ∆TC ∆Q∆Q MC =

THE COSTS OF PRODUCTION 12 EXAMPLE 1: Total and Marginal Cost $10.00 $5.00 $3.33 $2.50 $2.00 Marginal Cost (MC) $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 Total Cost Q (bushels of wheat) ∆Q = 1000 ∆TC = $2000 ∆Q = 800 ∆TC = $2000 ∆Q = 600 ∆TC = $2000 ∆Q = 400 ∆TC = $2000 ∆Q = 200 ∆TC = $2000

THE COSTS OF PRODUCTION 13 MC usually rises as Q rises, as in this example. EXAMPLE 1: The Marginal Cost Curve $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 TC $10.00 $5.00 $3.33 $2.50 $2.00 MC Q (bushels of wheat)

THE COSTS OF PRODUCTION 14 Why MC Is Important  Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat?  To find the answer, Farmer Jack needs to “think at the margin.”  If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more.

THE COSTS OF PRODUCTION 15 Fixed and Variable Costs  Fixed costs (FC) do not vary with the quantity of output produced.  For Farmer Jack, FC = $1000 for his land  Other examples: cost of equipment, loan payments, rent  Variable costs (VC) vary with the quantity produced.  For Farmer Jack, VC = wages he pays workers  Other example: cost of materials  Total cost (TC) = FC + VC

THE COSTS OF PRODUCTION 16 EXAMPLE 2: The Various Cost Curves Together AFC AVC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $ Q Costs

THE COSTS OF PRODUCTION 17 EXAMPLE 2: ATC and MC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $ 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.

THE COSTS OF PRODUCTION 18 How ATC Changes as the Scale of Production Changes Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases. LRATC Q ATC

In this section, look for the answers to these questions:  How do costs and market types  Market type overview:  Perfectly competitive market  Monopoly  Oligopoly  Monopolistic Competition 19

Next Section….Market Types!  Perfectly competitive market  Monopoly  Oligopoly  Monopolistic competition 20

FIRMS IN COMPETITIVE MARKETS 21 Characteristics of Perfect Competition 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market.  Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.

FIRMS IN COMPETITIVE MARKETS 22 The Revenue of a Competitive Firm  Total revenue (TR)  Average revenue (AR)  Marginal revenue (MR): The change in TR from selling one more unit. ∆TR ∆Q∆Q MR = TR = P x Q TR Q AR = = P

FIRMS IN COMPETITIVE MARKETS 23 MR = P for a Competitive Firm  A competitive firm can keep increasing its output without affecting the market price.  So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets.

FIRMS IN COMPETITIVE MARKETS 24 Profit Maximization  What Q maximizes the firm’s profit?  To find the answer, “think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC.  If MR > MC, then increase Q to raise profit.  If MR < MC, then reduce Q to raise profit.

FIRMS IN COMPETITIVE MARKETS 25 P1P1 MR MC and the Firm’s Supply Decision At Q a, MC < MR. So, increase Q to raise profit. At Q b, MC > MR. So, reduce Q to raise profit. At Q 1, MC = MR. Changing Q would lower profit. Q Costs MC Q1Q1 QaQa QbQb Rule: MR = MC at the profit-maximizing Q.

FIRMS IN COMPETITIVE MARKETS 26 P1P1 MR P2P2 MR 2 MC and the Firm’s Supply Decision If price rises to P 2, then the profit- maximizing quantity rises to Q 2. The MC curve determines the firm’s Q at any price. Hence, Q Costs MC Q1Q1 Q2Q2 the MC curve is the firm’s supply curve.

FIRMS IN COMPETITIVE MARKETS 27 The firm’s SR supply curve is the portion of its MC curve above AVC. Q Costs A Competitive Firm’s SR Supply Curve MC ATC AVC If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0).

FIRMS IN COMPETITIVE MARKETS 28 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

FIRMS IN COMPETITIVE MARKETS 29 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

FIRMS IN COMPETITIVE MARKETS 30 Market Supply: Assumptions 1) All existing firms and potential entrants have identical costs. 2) Each firm’s costs do not change as other firms enter or exit the market. 3) The number of firms in the market is  fixed in the short run (due to fixed costs)  variable in the long run (due to free entry and exit)

FIRMS IN COMPETITIVE MARKETS 31 The SR Market Supply Curve  As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC.  Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantities supplied by all firms.

FIRMS IN COMPETITIVE MARKETS 32 Entry & Exit in the Long Run  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.

FIRMS IN COMPETITIVE MARKETS 33 The Zero-Profit Condition  Long-run equilibrium: The process of entry or exit is complete – remaining firms earn zero economic profit.  Zero economic profit occurs when P = ATC.  Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.  Recall that MC intersects ATC at minimum ATC.  Hence, in the long run, P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 34 Why Do Firms Stay in Business if Profit = 0?  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

FIRMS IN COMPETITIVE MARKETS 35 S1S1 Profit D1D1 P1P1 long-run supply D2D2 SR & LR Effects of an Increase in Demand MC ATC P1P1 Market Q P (market) One firm Q P (firm) P2P2 P2P2 Q1Q1 Q2Q2 S2S2 Q3Q3 A firm begins in long-run eq’m… …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 eq’m. A B C

MONOPOLY 36 Monopoly Introduction  A monopoly is a firm that is the sole seller of a product without close substitutes.  In this chapter, we study monopoly and contrast it with perfect competition.  The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power.

MONOPOLY 37 Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1.A single firm owns a key resource. E.g., DeBeers owns most of the world’s diamond mines 2.The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws

MONOPOLY 38 Why Monopolies Arise 3.Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms. Q Cost ATC 1000 $50 Example: 1000 homes need electricity Electricity ATC slopes downward due to huge FC and small MC ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes. 500 $80

MONOPOLY 39 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

MONOPOLY 40 Monopoly vs. Competition: Demand Curves 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. D P Q A monopolist’s demand curve

MONOPOLY 41 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 (e.g., when Common Grounds increases Q from 5 to 6).

MONOPOLY 42 Profit-Maximization  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.

MONOPOLY 43 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

44 The Monopolist’s Profit As with a competitive firm, the monopolist’s profit equals (P – ATC) x Q Quantity Costs and Revenue ATC D MR MC Q P ATC 1.The profit- maximizing Q is where MR = MC. 2.Find P from the demand curve at this Q.

MONOPOLY 45 P = MC Deadweight loss P MC The Welfare Cost of Monopoly Competitive eq’m: quantity = Q C P = MC total surplus is maximized Monopoly eq’m: quantity = Q M P > MC deadweight loss Quantity Price D MR MC QMQM QCQC

MONOPOLY 46 Public Policy Toward Monopolies  Increasing competition with antitrust laws  Regulation  Public ownership  Doing nothing

47 Oligopoly  Oligopoly: a market structure in which only a few sellers offer similar or identical products.  Strategic behavior in oligopoly: A firm’s decisions about P or Q can affect other firms and cause them to react. The firm will consider these reactions when making decisions.  Korean Example: Cell Phone Service Providers

OLIGOPOLY 48 Collusion vs. Self-Interest  Both firms would be better off if both stick to the cartel agreement.  But each firm has incentive to renege on the agreement.  Lesson: It is difficult for oligopoly firms to form cartels and honor their agreements.

OLIGOPOLY 49 The Size of the Oligopoly  As the number of firms in the market increases,  the price effect becomes smaller  the oligopoly looks more and more like a competitive market  P approaches MC  the market quantity approaches the socially efficient quantity Another benefit of international trade: Trade increases the number of firms competing, increases Q, brings P closer to marginal cost

OLIGOPOLY 50 Public Policy Toward Oligopolies  Recall one of the Ten Principles from Chap.1: Governments can sometimes improve market outcomes.  In oligopolies, production is too low and prices are too high, relative to the social optimum.  Role for policymakers: Promote competition, prevent cooperation to move the oligopoly outcome closer to the efficient outcome.

MONOPOLISTIC COMPETITION 51 Characteristics & Examples of Monopolistic Competition Characteristics:  Many sellers  Product differentiation  Free entry and exit Examples:  apartments  books  bottled water  clothing  fast food  night clubs

MONOPOLISTIC COMPETITION 52 profit ATC P A Monopolistically Competitive Firm Earning Profits in the Short Run The firm faces a downward-sloping D curve. At each Q, MR < P. To maximize profit, firm produces Q where MR = MC. The firm uses the D curve to set P. Quantity Price ATC D MR MC Q

MONOPOLISTIC COMPETITION 53 A Monopolistic Competitor in the Long Run Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC. Quantity Price ATC D MR Q MC P = ATC markup