Llad Phillips1 Introduction to Economics Microeconomics The US Economy

Llad Phillips2

3 Your Readings and the Text’s Slide Shows

Llad Phillips4 Chapter 8

Llad Phillips5 Outline: Lecture Fourteen The competitive firm The competitive firm  the short run, capital fixed  the long run, all factors variable The monopolistic firm The monopolistic firm

Llad Phillips6 Competitive Firm: Short Run Capital, i.e. plant and equipment are fixed Capital, i.e. plant and equipment are fixed hence there are diminishing returns hence there are diminishing returns as labor is increased, output increases but less than proportionally as labor is increased, output increases but less than proportionally so labor costs, i.e. variable costs increase more rapidly than output so labor costs, i.e. variable costs increase more rapidly than output so average variable cost, i.e. variable cost per unit of output is rising so average variable cost, i.e. variable cost per unit of output is rising which means marginal cost is rising even faster, bringing up the average which means marginal cost is rising even faster, bringing up the average

Llad Phillips7 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Short Run Average Variable Cost Curve

Llad Phillips8 Behavior of the competitive firm in the short run: shut down decision The firm is one of many firms The firm is one of many firms Hence it has no monopoly power Hence it has no monopoly power It takes the market price as given; if it tries to charge a higher price nobody buys its output It takes the market price as given; if it tries to charge a higher price nobody buys its output If the market price is less than minimum average variable cost, the firm shuts down If the market price is less than minimum average variable cost, the firm shuts down

Llad Phillips9 Cost per unit of output output A marginal cost per unit of output Average variable cost per unit of output Market price s Shutdown output The Shut-Down Decision

Llad Phillips10 Behavior of the competitive firm in the short run: the output decision If the market price is above minimum average variable cost, the firm produces If the market price is above minimum average variable cost, the firm produces It produces the output where the market price equals marginal cost It produces the output where the market price equals marginal cost So the value of a unit of output to the consumer is equal to the cost of producing that last unit (marginal cost) So the value of a unit of output to the consumer is equal to the cost of producing that last unit (marginal cost) the only remaining question is whether the firm is making money the only remaining question is whether the firm is making money

Llad Phillips11 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced The Output Decision

Llad Phillips12 Fixed Costs Fixed costs do not vary with output, but are constant Fixed costs do not vary with output, but are constant  for example: rent, insurance etc. Hence average fixed costs fall as output increases Hence average fixed costs fall as output increases This is known as spreading the overhead This is known as spreading the overhead The sum of average fixed cost and average variable cost equals average total cost The sum of average fixed cost and average variable cost equals average total cost Price minus average total cost is the profit per unit of output Price minus average total cost is the profit per unit of output

Llad Phillips13 A B Variable Cost Fixed Cost Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Variable Cost $ per unit output $

Llad Phillips14 A B Variable Cost Fixed Cost Total Cost Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Total Cost ATC Variable Cost $ $ per unit output

Llad Phillips15 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced Average total cost per unit of output Average total cost per unit of output Average Total Cost per unit of output

Llad Phillips16 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced Average total cost per unit of output Average total cost per unit of output Profit Margin Per unit of output Profit margin

Llad Phillips17 Competitive Market Structure Firms are motivated by profits (greed) Firms are motivated by profits (greed) Profits equal revenue minus costs, so firms are motivated to control costs (efficiency) Profits equal revenue minus costs, so firms are motivated to control costs (efficiency) In the long run, profits are competed away by expansion of firms to the optimal size and by free entry of new firms (capital) attracted by the possibility of profits (role of the stock market-initial public offerings (IPO’s) In the long run, profits are competed away by expansion of firms to the optimal size and by free entry of new firms (capital) attracted by the possibility of profits (role of the stock market-initial public offerings (IPO’s) Each firm is only one of many and hence is a price taker not a price setter. Thus each firm only adjusts output to maximize profit Each firm is only one of many and hence is a price taker not a price setter. Thus each firm only adjusts output to maximize profit

Llad Phillips18 Behavior of the Firm Marginal cost curve is the supply curve of the firm, because price equal to marginal cost maximizes profits Marginal cost curve is the supply curve of the firm, because price equal to marginal cost maximizes profits Firm takes the market price, sets this price equal to its marginal cost to determine how much to produce (output decision) Firm takes the market price, sets this price equal to its marginal cost to determine how much to produce (output decision) If marginal cost equals average total cost at this output, the firm breaks even If marginal cost equals average total cost at this output, the firm breaks even If marginal cost exceeds average total cost at this output, the firm makes a profit (short run) If marginal cost exceeds average total cost at this output, the firm makes a profit (short run)

Llad Phillips19 Policy Implications of Market Structure

Llad Phillips20 Market Power and Monopoly Compare and Contrast: Competition and Monopoly Compare and Contrast: Competition and Monopoly Is monopoly a good thing or not? Is monopoly a good thing or not? How about Microsoft, is this firm good or bad for consumers? How about Microsoft, is this firm good or bad for consumers?

Llad Phillips21 Market Power & Market Structure No market power: competition No market power: competition  many producers  firms are price takers  no excess profit  price to consumer = long run average cost Market power: monopoly Market power: monopoly  one producer  monopolist is price setter  monopolist makes profits at expense of the consumer

Llad Phillips22 The Brief for Competition.... and against monopoly.... and against monopoly

Llad Phillips23 Competition Competitive Industries Competitive Industries  agriculture  construction Market Supply in the Short Run Market Supply in the Short Run The Optimal Plant Size The Optimal Plant Size Market Supply in the Long Run Market Supply in the Long Run

Llad Phillips24 Competitive Industries: Agriculture source: Census of Agriculture, 1987

Llad Phillips25 Competitive Industries sources: Census of Manufactures, 1987 Census of Construction Industries, 1987

Llad Phillips26 Short Run: Firm Supply and Market Supply Plant Size of a firm is fixed Plant Size of a firm is fixed

Llad Phillips27 AVC I MC I AVC II MC II QIQI Q II Q I + Q II Market Supply Quantity MC, AVC Short Run Market Supply: Two Firm Industry

Llad Phillips28 Market Supply and Demand in the Short Run Consumer Demand Supply MC, Market Price Quantity pMpM QMQM

Llad Phillips29 AVC I MC I AVC II MC II QIQI Q II Q I + Q II Market Supply Quantity MC, AVC, ATC Short Run Market Supply: Two Firm Industry PMPM Market Demand In the short run, both firms are making excess profits. This may motivate them to find the lowest cost size for plant and equipment. ATC I ATC II

Llad Phillips30 Chapter 9, Figure 9-02

Llad Phillips31 Short Run* World Supply: Copper * Existing Mines Fixed Source: Minerals Yearbook, 1985

Llad Phillips32 Zaire Zambia Chile US Peru Canada

Llad Phillips33 Zaire Zambia Chile US Peru Canada Demand for copper in a recession

Llad Phillips34 Long Run What is the optimal plant size? What is the optimal plant size?  constant returns to scale: inputs and output increase proportionally  increasing, then decreasing returns  increasing returns to scale

Llad Phillips35 Competitive Markets In the long run, resources will flow to a competitive market if firms are making excess profits In the long run, resources will flow to a competitive market if firms are making excess profits  new firms will enter the industry  if returns to scale are constant, then price will be driven down to long run average total cost  if returns to scale first increase and then decrease, price will be driven down to minimum long run average cost Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Excess Profits are driven to Zero Excess Profits are driven to Zero

Llad Phillips36 SMC I SMC II Quantity MC,, ATC Optimal Size of the Firm: Constant Returns to Scale If market price is above long run marginal cost, the firm will make the same excess profit per unit of output in a large plant as in a small plant. The firm may prefer larger to smaller. As long as firms are making excess profits, other firms will enter the industry, increasing supply, and driving price down to LMC. SATC I SATC II LATC, LMC pMpM

Llad Phillips37 Demand Long Run Equilibrium Supply with the Free Entry of Firms: Constant Returns to Scale PMPM Market Price Short Run Supply P M = LMC = LATC Supply after Entry of Profit Seeking Firms Quantity Long Run Supply

Llad Phillips38 Demand Long Run Equilibrium Supply with the Free Entry of Firms: Constant Returns to Scale PMPM Market Price Short Run Supply P M = LMC = LATC Supply after Entry of Profit Seeking Firms Quantity Long Run Supply Increased demand Increased supply

Llad Phillips39 SMC I SMC II Quantity MC,, ATC Optimal Size of the Firm: Constant Returns to Scale If market price is above long run marginal cost, the firm will make the same excess profit per unit of output in a large plant as in a small plant. The firm may prefer larger to smaller. As long as firms are making excess profits, other firms will enter the industry, increasing supply, and driving price down to LMC. SATC I SATC II LATC, LMC pMpM

Llad Phillips40 Chapter 9, Figure 9.10

Llad Phillips41 LATC Optimal Size of Plant with Variable Returns to Scale SATC I SATC III SATC IV SATC II SMC IV LMC If market price is above long run average cost, then firms with efficient scale of plant, SATC III,will make an excess profit. In the long run other firms in the industry will move to this efficient size plant. As long as there are excess profits to be made, new firms will enter the industry, driving market price down to minimum long run average total cost, LATC. Market Price Quantity pMpM LATC SMC III

Llad Phillips42 Competitive Markets In the long run, resources will flow to a competitive market if firms are making excess profits In the long run, resources will flow to a competitive market if firms are making excess profits  new firms will enter the industry  if returns to scale are constant, then price will be driven down to long run average total cost  if returns to scale first increase and then decrease, price will be driven down to minimum long run average cost Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Consumers benefit from the efficient, lowest cost use of resources and the lowest price for the product Excess Profits are driven to Zero Excess Profits are driven to Zero

Llad Phillips43 Natural Monopoly Increasing Returns to Scale Increasing Returns to Scale  optimal size of the firm  larger is better Constant Returns to Scale Constant Returns to Scale  optimal size of the firm: indeterminate  LAC = LMC = same at all outputs Increasing then Decreasing Returns to Scale Increasing then Decreasing Returns to Scale  optimal size of the firm: minimum LAC  minimum LAC where LAC = LMC

Llad Phillips44 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better SATC I SATC II Price Quantity LATC LMC

Llad Phillips45 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better SATC I SATC II Price Quantity LATC LMC Price Price equal marginal cost

Llad Phillips46 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better SATC I SATC II Price Quantity LATC LMC Price Subsidy

Llad Phillips47 Optimal Size of Plant with Increasing Returns to Scale: Bigger is Better SATC I SATC II Price Quantity LATC LMC Regulated Price

Llad Phillips48 Market Power: Size in 1994 source: World Bank & Fortune 500

Llad Phillips49 Market Power: Market Share

Llad Phillips50 Monopoly Technology: Natural Monopoly Technology: Natural Monopoly  Increasing Returns to Scale  output increases more than proportionally with inputs  i.e. cost per unit of output falls with increasing output Monopoly Monopoly  sets price to maximize profits  exploits consumers  wastes resources

Llad Phillips51 How does a monopolist use power to maximize profits? marginal principle: increase output until marginal revenue = marginal cost marginal principle: increase output until marginal revenue = marginal cost

Llad Phillips52 Monopoly Sales Price Market Demand Quantity 0 0 Revenue $25,000 $10 0 A B A B

Llad Phillips53 Monopoly Profits with Increasing Returns to Scale Price Quantity Market Demand MR

Llad Phillips54 Long Run Total Costs Increasing Returns to Scale and Long Run Total Costs $ Quantity

Llad Phillips55 LTC $ LTC R Quantity Revenue Maximum Monopoly Profits: Marginal Revenue = Marginal Cost $ Excess Profit 0 Quantity

Llad Phillips56 Monopoly Profits with Increasing Returns to Scale Price Quantity LATC LMC Market Demand MR QQ PMPM

Llad Phillips57 Chapter Ten, Figure 10.6

Llad Phillips58 Monopoly Profits with Increasing Returns to Scale Price Quantity LATC LMC Market Demand MR QQ PMPM Regulated price satisfies demand and covers costs Regulated price

Llad Phillips59 Chapter Ten, Figure 10.8

Llad Phillips60 Social Policy If returns to scale are constant If returns to scale are constant  regulate or break up monopoly  make the monopolist charge a price equal to marginal cost obtain the competitive solutionobtain the competitive solution If returns to scale are increasing If returns to scale are increasing  regulation is not so easy  can not set monopolist’s price equal to marginal cost: monopolist will suffer losses because marginal cost is less than average costbecause marginal cost is less than average cost  could socialize the industry and the government could subsidize the losses  could live with monopoly  set price where average cost crosses demand

Llad Phillips61 The Social Cost of Monopoly: Example, Constant Returns to Scale LATC = LMC Market Demand Competition Monopoly Market Demand LATC = LMC PMPM Consumer Surplus MR Q COMP Q MONOP PMPM Under monopoly, consumers pay a higher price and consume less

Llad Phillips62 The Social Cost of Monopoly: Example, Constant Returns to Scale LATC = LMC Market Demand Competition Monopoly Market Demand LATC = LMC PMPM Consumer Surplus MR Q COMP Q MONOP PMPM Under monopoly, some consumer surplus is redistributed to the monopolist as profit, and some is lost to society Profit Dead Weight Loss

Llad Phillips63 MONOPOLY POWER Society How can we control it? Regulation, Franchises, Patents Higher Prices Less Goods Excess Profits Entrepreneurs How do we get it? Political Influence Strategic Planning

Llad Phillips64 Advertising Cost of a Car source: Fortune

Llad Phillips65 Strategic Action: Advertising source: Advertising Age

Llad Phillips66 Classification of US Industry source: Survey of Current Business

Llad Phillips67 The Brief for Monopoly Increasing productivity, i.e. GDP per capita Increasing productivity, i.e. GDP per capita  capital deepening, i.e. capital per worker  technological change, Research and Development Where does the saving for investment come from? Where does the saving for investment come from?  a. consumers?  b. firms  monopoly profits  c. government  research and development  d. international

Llad Phillips68 The Brief for Microsoft The case for monopoly: Joseph Schumpeter The case for monopoly: Joseph Schumpeter Growth is the key to social welfare Growth is the key to social welfare Large and growing firms reinvest profits in future growth Large and growing firms reinvest profits in future growth  capital deepening Large and growing firms have the resources to invest in research and development Large and growing firms have the resources to invest in research and development  technological change improves productivity

Llad Phillips69 The Brief for Microsoft Industry with Rapidly Changing Technology Industry with Rapidly Changing Technology Monopoly is Using Market Power to Preserve the Status Quo Monopoly is Using Market Power to Preserve the Status Quo  creating and fortifying barriers to entry Silicon Valley Attracts Brain Power and Venture Capital Silicon Valley Attracts Brain Power and Venture Capital  new firms and new technologies So, the Nature of Microsoft’s Industry Was Competition and Change So, the Nature of Microsoft’s Industry Was Competition and Change

Llad Phillips70 The Brief for Microsoft Consumers have not been hurt by Microsoft Consumers have not been hurt by Microsoft In contrast, consumers have benefited In contrast, consumers have benefited Any market power Microsoft has is tenuous in the rapidly growing and changing software industry Any market power Microsoft has is tenuous in the rapidly growing and changing software industry

Llad Phillips71 Summary-Vocabulary-Concepts average variable cost average variable cost marginal cost marginal cost average fixed cost average fixed cost average total cost average total cost price taker price taker firm’s break even point firm’s break even point firm’s shut down point firm’s shut down point competitive industries competitive industries short run short run long run long run free entry free entry natural monopoly natural monopoly market share market share marginal revenue marginal revenue monopoly profit monopoly profit regulation of monopoly regulation of monopoly social cost of monopoly social cost of monopoly consumer surplus consumer surplus dead weight loss dead weight loss brand names brand names strategic planning strategic planning