© Economics Online 2011. 3 Alternative motives.

3 Alternative motives

6 Which motive?

8 Types of revenue

Revenue Quantity © Economics Online 2011 11 Total Revenue MR AR = D Total, average and marginal revenue curves

13 Inputs – the factors of production

17 The laws of production in the short run

© Economics Online 2011 18 Example of diminishing marginal returns Consider the total output produced by workers and calculate: 1. Average product - product per worker. 2. Marginal product - the additional product from adding one extra worker.

22 Costs of production +=

Cost Revenue Quantity © Economics Online 2011 23 Total cost curves Total Fixed Costs Total Variable Costs Total Costs

© Economics Online 2011 24 Average fixed costs  To find average fixed costs we divide total fixed costs by output.  As fixed cost is divided by an increasing output, average fixed costs will continue to fall. TFC Q TFC Q

Cost Revenue Quantity © Economics Online 2011 25 Graph to show average fixed costs Average Fixed Costs

Cost Revenue Quantity © Economics Online 2011 27 Graph to show average variable costs Average Variable Costs

Cost Revenue Quantity © Economics Online 2011 29 Graph to show average total costs Average Variable Costs Average Fixed Costs Average Total Costs

Cost Revenue Quantity © Economics Online 2011 30 The areas for total costs  If we take a given level of output, Q, we can see the areas representing total variable costs and total fixed costs.  The two areas added together represent total costs. AVC ATC Q Total variable costs Total fixed costs Average variable costs x quantity = total variable cost Quantity The greater the output the smaller the significance of fixed costs The greater the output the smaller the significance of fixed costs TVC TFC

Cost Revenue Quantity © Economics Online 2011 32 The marginal cost curve  The marginal cost curve falls briefly at first, then rises. Marginal Costs Average Total Costs Marginal cost (MC) cuts average total cost (ATC) at its lowest point on the ATC curve

Cost Revenue Quantity © Economics Online 2011 33 The relationship between ATC and MC Marginal Costs Average Total Costs

© Economics Online 2011 35 Profit maximising  Profits are maximised at 4 units (supernormal profits are at £80,000). Sales revenue maximising  6 units - in this case there are zero supernormal profits.Efficiency  At profit max, ATC is £50,000 – the lowest possible is £48,000 – there is a loss of productive efficiency.  The price, of £70,000, is greater than the marginal cost, of £30,000, hence there is allocative inefficiency.

© Economics Online 2011 36 1. Complete all the missing figures and plot ATC, MC, AR and MR. (Do not plot the figures for output 0 and 1). Figures are in £000s. 2. What is the profit maximising output? 3. What is sales revenue maximising output?

© Economics Online 2011 37 2. The the profit maximising output is 4 units 3. Show the area representing super-normal profits. 4. The sales revenue maximising output is 5 units 5. Efficiency at profit maximising output: a. It is productively inefficient (the lowest ATC is at output 5) b. It is allocatively inefficient (at output 4 price is greater than marginal cost (P=12, MC =6)

39 The firm’s short run supply curve

Cost Revenue Quantity © Economics Online 2011 40 The firm’s supply curve Marginal Costs ATC AVC Q P P Q1 P1 Total variable cost Total revenue

© Economics Online 2011 Marginal Cost Output Cost 41  In the following example marginal returns start to diminish after the addition of the fifth worker.  The marginal cost of the extra output created will, in contrast, rise as the marginal returns fall.  For example, if each worker gets a wage of £1000, the labour cost of the marginal output created in one week by the fifth worker is £5, (£1000/200) and the labour cost of the marginal output created by the sixth worker is £5.56 (£1000/180). As marginal returns start to fall marginal costs start to rise Marginal Cost Output Cost

43 The importance of efficiency

Cost Revenue Quantity © Economics Online 2011 44 Productive and allocative efficiency MC ATC 0 MR AR = D ATC = MC P = MC P

Cost Revenue Quantity © Economics Online 2011 46 ‘X’ inefficiency Average cost (actual) Average cost (lowest possible)

48 Profits

50 Profit maximisation

Cost Revenue Quantity © Economics Online 2011 51 Diagram to show profit maximisation MC ATC Q P C 0 A MR AR = D First, the cost curves go in Next, the revenue curves Profit maximisation output occurs where MC = MR B Super normal profits

Cost Revenue Quantity © Economics Online 2011 52 Why is profit maximisation at MC=MR? MC ATC Q Q2 Q10 MR AR = D Profits could have been greater – there is a loss of potential profits. This area represents a loss of potential profits caused by producing too much

Cost Revenue Quantity © Economics Online 2011 53 Competitiveness and profits MC ATC Q P C 0 A B MR AR = D More profit

Cost Revenue Quantity © Economics Online 2011 54 Total costs and total revenue Q0 Total Revenue Total Costs + - Profits (profit function) Normal profit Maximum super-normal profit

Cost Revenue Quantity © Economics Online 2011 56 Sales revenue maximisation MC ATC Q P 0 MR AR = D TR

Cost Revenue Quantity © Economics Online 2011 58 Sales maximisation Q MC ATC Q P 0 MR AR = D AR = ATC

Cost Revenue Quantity © Economics Online 2011 59 Review questions  Identify the points, A - E: 1. Profit max 2. Sales Revenue max 3. Allocative efficiency 4. Productive efficiency 5. Sales max MR AR = D ATC Marginal Cost E E A A B B C C D D

61 Introduction

© Economics Online 2011 62 Market structures Perfect Competition Monopolistic Competition Oligopoly Monopoly Duopoly Maximum competition Maximum concentration These structures have varying degrees of competition and concentration. The most extreme form of competition – very large numbers of firms selling identical products The most extreme form of concentration – only one firm exists, selling a unique product.

64 What is perfect competition?

72 Monopolistic competition

Cost Revenue Quantity © Economics Online 2011 75 The firm is a price maker Q P 0 AR = D P1 Q1 If the firm reduces price, quantity demanded will increase

82 Oligopoly

95 Game theory

© Economics Online 2011 Prisoner’s dilemma 99 TOM ROBIN Confess Deny Confess Deny The pay-off in games can be represented in a pay-off matrix. A (Robin) gets 3 years B (Tom) gets 3 years A (Robin) gets 1 years B (Tom) gets 8 years A (Robin) gets 2 years B (Tom) gets 2 years A (Robin) gets 8 years B (Tom) gets 1 year The dominant strategy - which is one that gives an individual player the best pay-off no matter what the other player chooses - is to confess. In this case both players will confess, and this is a dominant strategy equilibrium. This means players are worse off than if they co-operated and both agreed to deny. Confess/confess is also a Nash equilibrium, which exists when each player’s strategy is the best available, given the other players’ strategies. If Tom denies, Robin should confess, and if Tom confesses, Robin should confess.

© Economics Online 2011 Advertising decisions 100 Virgin BA Raise Hold Raise Hold The following hypothetical pay-off matrix shows the profits for two airlines, BA and Virgin, if they choose to increase spending on advertising (raise) or hold current spending (hold). BA gets £20m Virgin gets £30m BA gets £60m Virgin gets £20m BA gets £40m Virgin gets £10m Virgin gets £40m BA gets £30m BA raises, and gets £20m, Virgin raises, and gets £30m BA raises, and gets £60m, Virgin holds, and gets £20m BA holds, and gets £30m, Virgin raises, and gets £40m BA holds, and gets £40m, Virgin holds, and gets £10m Summary Virgin’s dominant strategy is clearly to raise spending – it would be better off whatever BA does. Assuming BA knows this, it will hold its spending, and gain £30. Neither party has an incentive to move. This is a ‘Nash equilibrium’ BA raises, and gets £20m, Virgin raises, and gets £30m BA raises, and gets £60m, Virgin holds, and gets £20m BA holds, and gets £30m, Virgin raises, and gets £40m BA holds, and gets £40m, Virgin holds, and gets £10m Nash equilibrium exists when each player’s strategy is the best available, given the other players’ strategies. A dominant strategy is one that gives the best pay-off no matter what the other player chooses.

© Economics Online 2011 Equilibrium – Cartels, and collusion 101 Y OIL X OIL Raise Hold Raise Hold X gets £30m Y gets £30m X gets £10m Y gets £60m X gets £25m Y gets £25m Y gets £10m X gets £60m X OIL raises, and gets £30m, Y OIL raises, and gets £30m X OIL raises, and gets £10m, Y OIL holds, and gets £60m X OIL holds, and gets £60m, Y OIL raises, and gets £10m X OIL holds, and gets £25m, Y OIL holds, and gets £25m Summary However, if they reach an agreement to form a cartel and collude, they can agree to raise price together, and increase revenues, from £25m to £30m. This only works with a price agreement. Nash equilibrium exists when each player’s strategy is the best available, given the other players’ strategies. The dominant strategy for X and Y Oil is to hold prices steady. The revenue for two petroleum producers, X Oil and Y Oil, if they choose to increase their prices, or keep them the same. Currently, they achieve revenues of £25m per year each. PED for oil is assumed to be inelastic.

© Economics Online 2011 Other strategies 102 A maximin strategy is a strategy for a zero-sum game, which is chosen when players cannot rely on the other party to keep an agreement. A maximin strategy is pessimistic and assumes only getting the best of the worst. It discourages risk-taking. A maximin strategy is a strategy for a zero-sum game, which is chosen when players cannot rely on the other party to keep an agreement. A maximin strategy is pessimistic and assumes only getting the best of the worst. It discourages risk-taking. A maximax strategy is a strategy for a zero-sum game, where the player chooses the option which provides the chance of achieving the maximum possible pay-off. A maximax strategy is optimistic. A maximax strategy is a strategy for a zero-sum game, where the player chooses the option which provides the chance of achieving the maximum possible pay-off. A maximax strategy is optimistic. A tit-for-tat strategy is one where players co-operate – e.g., to raise price together, in the first instance, and then always copy their rival’s previous move. This is clearly anti-competitive, and would result in legal action if discovered. A tit-for-tat strategy is one where players co-operate – e.g., to raise price together, in the first instance, and then always copy their rival’s previous move. This is clearly anti-competitive, and would result in legal action if discovered.

© Economics Online 2011 Payoffs, rules, and penalties 105 Y OIL X OIL Raise Hold Raise Hold X gets £30m Y gets £30m X gets £10m Y gets £60m X gets £25m Y gets £25m Y gets £10m X gets £60m Nash equilibrium exists when each player’s strategy is the best available, given the other players’ strategies. If a regulator can prove collusion, it can impose a fine of in excess of £5m each (say £6m), which provides the incentive needed to keep prices as they are. Pay-offs can be changed by regulators and courts to alter (uncompetitive) behaviour. This can force two (or more) firms to adopt a different strategy. Pay-offs can be changed by regulators and courts to alter (uncompetitive) behaviour. This can force two (or more) firms to adopt a different strategy. For example, X OIL and Y OIL might form a cartel and co- operate in this game to raise price together – creating a complex monopoly. In this way they increase their pay-off from £25m each – the Nash equilibrium - to £30m each. Y gets £24m (after the fine) X gets £24m (after the fine)

117 Monopoly and monopoly power

Cost Revenue Quantity © Economics Online 2011 119 The monopoly diagram MC ATC Q P C 0 A A B B MR AR = D There is no distinction between the short and long run – the pure monopolist can make supernormal profits into the long run

Cost Revenue Quantity © Economics Online 2011 124 The natural monopoly diagram MC ATC Q P C 0 A A B B MR AR = D LOSSES With natural monopolies, minimum efficient scale (MES) can only be achieved by a single firm – MES means the situation when the available economies of scale in the whole industry have been used up, and none are available for other firms, hence no firms will enter. With natural monopolies, minimum efficient scale (MES) can only be achieved by a single firm – MES means the situation when the available economies of scale in the whole industry have been used up, and none are available for other firms, hence no firms will enter. SNP

Cost Revenue Quantity © Economics Online 2011 127 Dynamic efficiency Monopolist’s supply curve (MC) ATC Q1 P1 Q P 0 MR AR = D Supply curve if industry is competitive

132 The remedies for monopoly power

136 Price discrimination Q Price P1 Q1 Demand curve (AR) Q P A B Supply The firm has ‘captured’ the consumer surplus for itself

© Economics Online 2011 AR 1 MR 1 AR 2 MR 2 AR 3 MR 3 Price discrimination is an effective profit maximising strategy if submarkets with different elasticities can be identified Assuming there are no additional costs associated with separating the market And ATC is constant, and therefore equal to MC, profits will be maximised where MC cuts MR Inelastic market Elastic market Elastic market Combined market ATC = MC P1P1 P2P2 P3P3 High price One price SNP 1 SNP 2 SNP 3 Markets can be separated in a number of ways: PEAK OFF PEAK ADULT CHILD DOMESTIC FOREIGN OFFICE HOME If the profits from the two separated sub-markets (SNP 1 + SNP 2 are greater than the single, un-separated market (SNP 3 ) then discrimination will maximise profits Price discrimination Low price

Cost Revenue Quantity © Economics Online 2011 Economies and diseconomies of scale 141 LRAC Economies of scale Diseconomies of scale Expansion of firm

Cost Revenue Quantity © Economics Online 2011 Minimum efficient scale (MES)  This is the scale at which LRAC first become their lowest.  It can also be seen as the point at which all or most economies of scale are exhausted. 147 LRAC MES ECONOMIES OF SCALE

156 Contestable markets

© Economics Online 2011 Hit and run strategy 157 Super-normal profit IncumbentIncumbent High price Low output Potential entrant HITHITRUNRUN InefficientInefficient Low price High output Normal profit EfficientEfficient Existing market

160 Regulation - alternative approaches

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