1. Principles of Microeconomics 12
Principles of Microeconomics Production Costs, Free Market and Monopoly*
Akos Lada
August 7th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents Review of previous lecture
The Production Function and the MPL
Marginal Costs of Production
Fixed Costs, Variable Costs, and Total Costs
How Competitive Firms Maximize Profits
Monopolies

3. 1. Review

4. The Different Kinds of Goods
Excludable
Not excludable
Rival
Private goods
e.g. food
Common resources
e.g. fish in the ocean
Not Rival
Natural monopolies
e.g. cable TV
Public goods
e.g. national defense
Using the two characteristics on the preceding slide, we can classify most goods in one of the four categories on this slide.
As each example displays, explain why it belongs to its category/classification.
E.g., food is a private good because:
1) It is excludable: you cannot have any unless you buy it.
2) It is rival in consumption: if you eat that fish taco, I won’t be able to eat it. 4

5. Public Goods
Are goods that are non- excludable and non-rival
Some important public goods are:
National defense
Knowledge created through basic research
Fighting poverty
Public goods are difficult for private markets to provide because of the free-rider problem.
If the benefit of a public good exceeds the cost of providing it, government should provide the good and pay for it with a tax.
Economists use cost-benefit analysis to determine how much to provide of a public good.
Cost-benefit analysis is imprecise because benefits are hard to measure.

6. Common Pool Resources
Are goods that are at the same time not excludable but rival.
Some important Common Resources are:
Clean air and water
Congested roads
Fish, whales, and other wildlife
Leads to the overconsumption of the resource (e.g. the tragedy of the commons).
Possible policies available to the government to address this issue include:
Regulate use of the resource
Impose a corrective tax
Auction off permits allowing use of the resource
If the resource is land, convert to a private good by dividing and selling parcels to individuals 6

7. Economic Profit vs. Accounting Profit
Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher than economic profit.
Accountants keep track of how much money flows into and out of the firm, so they ignore implicit costs.
Economists study the pricing and production decisions of firm, which are affected by implicit as well as explicit costs. 7

8. 2. The Production Function and the MPL

9. Total, average, marginal
“Count” is the number of observations, then:
AVERAGE = TOTAL / COUNT
Call each of these numbers an “observation”… 2 1 4
“Marginal” is the observation added most recently
How many units are added by the “marginal observation”?
The answer is different for each “marginal observation”… +
AVERAGE = 20/ 4 = 5
TOTAL 20

10. 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:
Farmer Golib grows Cotton.
He has 5 acres of land.
He can hire as many workers as he wants.
To build Golib’s Production Function we need to determine how many additional bags of cotton he would produce each time he hires one additional worker for his farm.
In the following slides, Example 1 will be used to illustrate the production function, marginal product, and a first look at the costs of production. 10

11. EXAMPLE: Farmer Golib’s Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output Q
(bags of cotton)
L (no. of workers)
1000 1
1800 2
2400 3
2800 4
3000 5 11

12. Marginal Product
If Golib hires one more worker, his output rises by the marginal product of labor.
The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q ∆L 12

13. EXAMPLE: Farmer Golib’s Total & Marginal Product
3000 5
2800 4
2400 3
1800 2
1000 1
Q (bags of cotton)
L (no. of workers)
MPL
∆Q = 1000
∆L = 1
1000
∆Q = 800
∆L = 1
800
∆Q = 600
∆L = 1
600
∆Q = 400
∆L = 1
400
∆Q = 200
∆L = 1
200 13

14. MPL = Slope of Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
L (no. of workers)
Q (bags of cotton)
MPL
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
1000 1
1000
800 2
1800
600 3
2400
400 4
2800
200 5
3000 14

15. Why MPL Is Important
Recall one of the Principles of Economics: Rational people think at the margin.
When Farmer Golib hires an extra worker,
his costs rise by the wage he pays the worker
his output rises by MPL
Comparing them helps Golib decide whether he would benefit from hiring the worker.
Thinking at the margin helps not only Golib, but all managers in the real world, who make business decisions every day by comparing marginal costs with marginal benefits. 15

16. 3. Marginal costs of production

17. Why MPL Diminishes
Farmer Golib’s output rises by a smaller and smaller amount for each additional worker. Why?
As Golib 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) 17

18. EXAMPLE: Farmer Golib’s Costs
Farmer Golib must pay $1000 per month for the land, regardless of how much cotton he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Golib’s costs are related to how much cotton he produces…. 18

19. EXAMPLE: Farmer Golib’s Costs
L (no. of workers)
Q (bags of cotton)
Cost of land
Cost of labor
Total Cost
$1,000
$10,000
$8,000
$6,000
$4,000
$2,000 $0
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000 1
1000 2
1800 3
2400 4
2800 5
3000 19

20. EXAMPLE: Farmer Golib’s Total Cost Curve
Q (bags of cotton)
Total Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000 20

21. Marginal Cost ∆TC MC = ∆Q
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
We can calculate in the table the marginal cost of producing each additional unit, one at the time
∆TC ∆Q
MC = 21

22. EXAMPLE: Total and Marginal Cost
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
Q (bags of cotton)
Marginal Cost (MC)
∆Q = 1000
∆TC = $2000
$2.00
∆Q = 800
∆TC = $2000
$2.50
∆Q = 600
∆TC = $2000
$3.33
∆Q = 400
∆TC = $2000
$5.00
∆Q = 200
∆TC = $2000
$10.00 22

23. EXAMPLE: The Marginal Cost Curve
Q (bags of cotton) TC MC
MC usually rises as Q rises, as in this example.
$1,000
$10.00
$5.00
$3.33
$2.50
$2.00
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000 23

24. Why MC Is Important
Farmer Golib is rational and wants to maximize his profit. To increase profit, should he produce more or less cotton?
To find the answer, Farmer Golib needs to “think at the margin.”
If the cost of additional cotton (MC) is less than the revenue he would get from selling it, then Golib’s profits rise if he produces more.
In the next chapter, we will learn more about how firms choose Q to maximize their profits. 24

25. 4. Fixed costs, variable costs and total costs

26. Fixed and Variable Costs
Fixed costs (FC) do not vary with the quantity of output produced.
For Farmer Golib, FC = $1000 for his land
Other examples: cost of equipment, loan payments, rent
Variable costs (VC) vary with the quantity produced.
For Farmer Golib, VC = wages he pays workers
Other example: cost of materials
Total cost (TC) = FC + VC
If you did Active Learning 1 and created a class-generated list of General Motors’ costs, you might return to that list and ask students which of the costs on their list are fixed and which are variable. 26

27. EXAMPLE 2
Our second example is more general, applies to any type of firm producing any good with any types of inputs.
Think of an example, and keep it in mind as we calculate the different costs of production…. 27

28. EXAMPLE 2: Costs Q FC VC TC 100 $100 520 380 280 210 160 120 70 $0 620
$800 FC Q FC VC TC VC
$700
100
$100
520
380
280
210
160
120 70 $0
620
480
380
310
260
220
170
$100 TC
$600 1
$500 2
Costs
$400 3
$300 4
$200 5
Point out that the TC curve is parallel to the VC curve but is higher by the amount FC.
$100 6 $0 7 1 2 3 4 5 6 7 Q 28

29. EXAMPLE 2: Marginal CostQ TC MC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
$100
$70 1
170
∆TC ∆Q
MC = 50 2
220 40 3
260
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.) 50 4
310 70 5
380
100 6
480
140 7
620 29

30. EXAMPLE 2: Average Fixed CostQ FC
AFC
Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
$100
14.29
16.67 20 25
33.33 50
$100
n/a 1
100 2
100 3
100
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 4
100 5
Most students quickly grasp the following example.
Suppose FC = $1 million for a factory that produces cars.
If the firm produces Q = 1 car, then AFC = $1 million.
If the firm produces 2 cars, AFC = $500,000.
If the firm produces 5 cars, AFC = $200,000.
If the firm produces 100 cars, AFC = $10,000.
The more cars produced at the factory, the smaller is the cost of the factory per car.
100 6
100 7
100 30

31. EXAMPLE 2: Average Variable CostQ VC
AVC
Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q $0
74.29
63.33
56.00
52.50
53.33 60
$70
n/a 1 70 2
120 3
160
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 4
210 5
280 6
380 7
520 31

32. EXAMPLE 2: Average Total CostQ TC
ATC
74.29
14.29
63.33
16.67
56.00 20
52.50 25
53.33
33.33 60 50
$70
$100
n/a
AVC
AFC
Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
$100
88.57 80 76
77.50
86.67
110
$170
n/a 1
170 2
220 3
260 4
310
Also,
ATC = AFC + AVC
Many students have heard the terms “cost per unit” or “unit cost” in other business courses. ATC means the same thing. 5
380 6
480 7
620 32

33. EXAMPLE 2: Average Total Cost$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs Q TC
ATC
Usually, as in this example, the ATC curve is U-shaped.
$100
n/a 1
170
$170 2
220
110 3
260
86.67 4
310
77.50 5
380 76 6
480 80 7
620
88.57 33

34. EXAMPLE 2: The Various Cost Curves Together$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC
AVC
AFC MC 34

35. Why ATC Is Usually U-Shaped?$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
As Q rises:
Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale: The quantity that minimizes ATC.
In this example, the efficient scale is Q=5, where ATC = $76.
At any Q below or above 5, ATC > $76. 35

36. ATC and MC ATC MC When MC < ATC, ATC is falling. When MC > ATC,
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. $0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC MC
The textbook gives a nice analogy to help students understand this. A student’s GPA is like ATC. The grade she earns in her next course is like MC. If her next grade (MC) is less than her GPA (ATC), then her GPA will fall. If her next grade (MC) is greater than her GPA (ATC), then her GPA will rise.
I suggest letting students read the GPA example in the book and giving them the following example in class:
You run a pizza joint. You’re producing 100 pizzas per night, and your cost per pizza (ATC) is $3. The cost of producing one more pizza (MC) is $2. If you produce this pizza, what happens to ATC? Most students will understand immediately that ATC falls (albeit by a small amount). Instead, suppose the cost of producing one more pizza (MC) is $4. Then, producing this additional pizza causes ATC to rise. 36

37. 5. How Competitive Firms Maximize Profits

38. 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.
“Firms can freely enter or exit the market” means there are no barriers or impediments to entry or exit. E.g., the government does not restrict the number of firms in the market.
Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given. 38

39. 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 = P x Q TR Q
AR =
= P
These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter.
∆TR ∆Q
MR = 39

40. 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. 40

41. Profit Maximization What Q maximizes the firm’s profit?
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.
Therefore, the Q that will give the firm the maximum profit it can make in the market, is the Q at which…. 41

42. MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
So, increase Q to raise profit.
At Qb, MC > MR.
So, reduce Q to raise profit.
At Q1, MC = MR.
Changing Q would lower profit. Q
Costs MC Qb P1 MR Qa Q1
This slide is similar to Figure 1 in the chapter. I’ve omitted the AVC and ATC curves (which appear in Figure 1 in the chapter) because they are not needed at this point. 42

43. MC and the Firm’s Supply Decision
If price rises to P2,
then the profit-maximizing quantity rises to Q2.
The MC curve determines the firm’s Q at any price.
Hence,
Costs MC P2
MR2 Q2 P1 MR Q1
the MC curve is the competitive firm’s supply curve. Q 43

44. 6. Monopolies

45. Monopolies
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.
Most students already know that monopoly means the firm is the only seller of its product. But the definition here has another very important part: In order for the firm to be considered a monopoly, the product it sells must have no close substitutes available from other firms. 45

46. Why Monopolies Arise 1. A single firm owns a key resource.
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 government gives a single firm the exclusive right to produce the good.
E.g., patents, copyright laws 46

47. ATC slopes downward due to huge FC and small MC
Why Monopolies Arise
3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms.
Electricity
Example: homes need electricity Q
Cost
ATC
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.
The horizontal axis of the graph measures number of homes provided electricity. The vertical axis measures the average total cost of providing electricity per home.
500
$80
1000
$50 47

48. Monopoly vs. Competition: Demand Curves
A competitive firm’s demand curve
A competitive firm’s demand curve
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.
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. P Q P Q
A competitive firm is a price-taker, can sell as much as it wants at the market price.
In effect, the competitive firm sells a product for which there are many perfect substitutes, so demand for its product is perfectly elastic; if it raises its price above the market price, demand for its product falls to zero.
The relationship between P and MR is what distinguishes a competitive firm from a monopoly firm, in terms of both firm behavior and welfare implications. D D 48

49. The Monopolist Profit Profit maximization golden rule:
MR = MC
For competitive firms
MR = P, therefore,
Profit Maximization Condition: P=MC
For monopolies, however….
MR ≠ P
Then, how do monopolies maximize their profits?