1. Microeconomics II Georgi Georgiev November 2014

2. Production, Costs, Revenue and Profit Main topics 1. Production - TP, AP and MP 2. Costs - FC and VC - TC, AC and MC 3. Revenue - TR, AR and MR 4. Profit – economic and accounting profit and Profit maximization

3. Production The total amount of output produced by a firm is a function of the levels of input/factors of production/ usage by the firm The total amount of output produced by a firm is a function of the levels of input/factors of production/ usage by the firm Usually the amount of output is a function of two inputs/production factors/ – Capital and Labour. Usually the amount of output is a function of two inputs/production factors/ – Capital and Labour. Total Product (TP) function - a short-run relationship between the amount of Labour and the level of output, ceteris paribus. Total Product (TP) function - a short-run relationship between the amount of Labour and the level of output, ceteris paribus.

4. Total product (TP)

5. Law of diminishing returns As the level of a variable input rises in a production process in which other inputs are fixed, output ultimately increases by progressively smaller increments.

6. Average product (AP) AP = TP / amount of input/ Quantity of labour TPP APP 0 5 10 15 20 25 30 35 40 45 0 50 120 180 220 250 270 275 270 - 10 12 11 10 9 7.86 6.88 6

7. Marginal product (MP) the additional output that results from the use of an additional unit of a variable input, holding other inputs constant measured as the ratio of the change in output (TP) to the change in the quantity of labor (or other input) used

8. Computation of MP and AP Note that the MP is positive when an increase in labour results in an increase in output; a negative MP occurs when output falls when additional labour is used. Quantity of labour TP AP 0 5 10 15 20 25 30 35 40 45 MP 0 50 120 180 220 250 270 275 270 - 10 12 11 10 9 7.86 6.88 6 10 14 12 8 6 4 1 0

9. TP

10. Shape of MP curve MP rises when TP increases at an increasing rate, and declines when TP increases at a decreasing rate. MP is negative if TP declines when labor use rises

11. Relationship of AP and MP AP rises when MP > AP AP falls when MP < AP AP is maximized when MP = AP

12. Cost - Total Costs Types of costs according to the change in quantity produced: fixed costs – costs that do not vary with the level of output. Fixed costs are the same at all levels of output (even when output equals zero). variable costs – costs that vary with the level of output (= 0 when output is zero)

13. Example

14. Overall Total Costs - TC

15. Fixed costs

16. Variable costs

17. TC, TVC, and TFC

18. Average fixed cost Average fixed cost (AFC) = TFC / Q

19. Average variable cost Average variable cost (AVC) = TVC / Q

20. Average total cost Average total cost (ATC) = TC / Q ATC = AFC + AVC (since TFC + TVC = TC)

21. Marginal cost Marginal cost (MC) = cost of an additional unit of output

22. Average fixed cost

23. AVC, ATC, and MC Note that the MC curve intersects the AVC and ATC at their respective minimum points

24. Long-run costs In the long run, a firm may change not only the level of Labour employed but also its level of Capital, and will select a size of firm that provides the lowest level of ATC.

25. Economies and diseconomies of scale – producing at lowest ATC Economies of scale – factors that lower average cost as the size of the firm rises in the long run Sources: specialization and division of labor, indivisibilities of capital, etc. Diseconomies of scale – factors that raise average cost as the size of the firm rises in the long run Sources: increased cost of managing and coordination as firm size rises Constant returns to scale – average costs do not change as firm size changes

26. Long-run average total cost (LRATC)

27. Minimum efficient scale Minimum efficient scale = lowest level of output at which LRATC is minimized

28. Revenue Total Revenue – the overall revenue received from the sale of output Total Revenue – the overall revenue received from the sale of output TR = Q x p Average Revenue = the revenue received from the sale of an unit of output Average Revenue = the revenue received from the sale of an unit of outputAR=TR/q

29. Marginal revenue Marginal revenue = additional revenue received from the sale of an additional unit of output. Marginal revenue = additional revenue received from the sale of an additional unit of output. In mathematical terms: In mathematical terms:

30. MR & MC the additional revenue resulting from the sale of an additional unit of output is called marginal revenue (MR) the additional revenue resulting from the sale of an additional unit of output is called marginal revenue (MR) the additional cost resulting from the sale of an additional unit of output is called marginal cost (MC) the additional cost resulting from the sale of an additional unit of output is called marginal cost (MC)

31. MR > MC If marginal revenue exceeds marginal cost, the production of an additional unit of output adds more to revenue than to costs. If marginal revenue exceeds marginal cost, the production of an additional unit of output adds more to revenue than to costs. In this case, a firm is expected to increase its level of production to increase its profits. In this case, a firm is expected to increase its level of production to increase its profits.

32. MR < MC If marginal cost exceeds marginal revenue, the production of the last unit of output costs more than the additional revenue generated by the sale of this unit. If marginal cost exceeds marginal revenue, the production of the last unit of output costs more than the additional revenue generated by the sale of this unit. In this case, firms can increase their profits by producing less. In this case, firms can increase their profits by producing less. A profit-maximizing firm will produce more output when MR > MC and less output when MR MC and less output when MR < MC.

33. MR = MC If MR = MC, however, the firm has no incentive to produce either more or less output. If MR = MC, however, the firm has no incentive to produce either more or less output. The firm's profits are maximized at the level of output at which MR = MC. The firm's profits are maximized at the level of output at which MR = MC.

34. Profit maximization Profit = (profit per unit) x No of units = (P – ATC) x Q Or Profit = (TR – TC)

35. Profit maximization Economic profit = total revenue - all economic costs Economic profit = total revenue - all economic costs Economic costs include all opportunity costs (explicit and implicit). Economic costs include all opportunity costs (explicit and implicit).

36. Economic vs. accounting profit economic profit = total revenue - all economic costs economic profit = total revenue - all economic costs accounting profit = total revenue - all accounting costs accounting profit = total revenue - all accounting costs accounting costs include only current or historical explicit costs, not implicit costs accounting costs include only current or historical explicit costs, not implicit costs

37. Economic vs. accounting profit the difference between economic cost and accounting cost is the opportunity cost of resources supplied by the firm's owner. the difference between economic cost and accounting cost is the opportunity cost of resources supplied by the firm's owner. the opportunity cost of these owner-supplied resources is called normal profit. the opportunity cost of these owner-supplied resources is called normal profit. normal profit is a cost of production. normal profit is a cost of production.

38. Economic vs. accounting profit If the owners of a firm gain economic profits, they are receiving a rate of return on the use of their resources that exceeds that which can be received in their next-best use. If the owners of a firm gain economic profits, they are receiving a rate of return on the use of their resources that exceeds that which can be received in their next-best use. In this situation, we'd expect to see other firms entering the industry (unless barriers to entry exist). In this situation, we'd expect to see other firms entering the industry (unless barriers to entry exist).

39. Economic vs. accounting profit If a firm is receiving economic losses (negative economic profits), the owners are receiving less income than could be received if their resources were employed in an alternative use. If a firm is receiving economic losses (negative economic profits), the owners are receiving less income than could be received if their resources were employed in an alternative use. In the long run, we'd expect to see firms leave the industry when this occurs. In the long run, we'd expect to see firms leave the industry when this occurs.

40. Economic profits = 0 If economic profits equal zero, then: If economic profits equal zero, then: owners receive a payment equal to their opportunity costs (what could be received in their next-best alternative), owners receive a payment equal to their opportunity costs (what could be received in their next-best alternative), no incentive for firms to either enter or leave this industry, no incentive for firms to either enter or leave this industry, accounting profit = normal profit. accounting profit = normal profit.

41. Economic profit Economic profit = total revenue - economic costs Economic profit = total revenue - economic costs when output rises, both total revenue and total costs increase (with a few exceptions that will be discussed in later chapters) when output rises, both total revenue and total costs increase (with a few exceptions that will be discussed in later chapters) profits increase when output increases if total revenue rises by more than total costs. profits increase when output increases if total revenue rises by more than total costs. profits decrease when output rises if total costs rise by more than total revenue profits decrease when output rises if total costs rise by more than total revenue

42. Demand and MR for a firm facing a downward sloping demand curve

43. Profit maximization

44. Main Types of Market Structures Main topics 1. Perfect competition 2. Monopoly 3. Monopolistic competition 4. Oligopoly

45. Perfect competition – main characteristics a very large number of buyers and sellers, a very large number of buyers and sellers, easy entry, easy entry, a standardized product, and a standardized product, and each buyer and seller has no control over the market price (this means that each firm is a that faces a horizontal demand curve for its product). each buyer and seller has no control over the market price (this means that each firm is a price taker that faces a horizontal demand curve for its product).

46. Demand curve facing a single firm no individual firm can affect the market price demand curve facing each firm is perfectly elastic

47. Profit maximization produce where MR = MC

48. P = MR

49. Profit-maximizing level of output

50. Economic Profits > 0 Economic profit

51. Loss minimization and the shut-down rule Suppose that P < ATC. Since the firm is experiencing a loss, should it shut down? Loss if shut down = fixed costs Shut down in the short run only if the loss that occurs where MR = MC exceeds the loss that would occur if the firm shuts down (= fixed cost) Stay in business if TR > VC. This implies that P > AVC. Shut down if P < AVC.

52. Economic loss (AVC<P< ATC)

53. Loss if shut down

54. Break-even price If price = minimum point on ATC curve, economic profit = 0. Owners receive normal profit. No incentive for firms to either enter or leave the market.

55. Long run Firms enter if economic profits > 0 market supply increases price declines profit declines until economic profit equals zero (and entry stops) Firms exit if economic losses occur market supply decreases price rises losses decline until economic profit equals zero

56. Monopoly – main characteristics a single seller producing a product with no close substitutes, a single seller producing a product with no close substitutes, effective barriers to entry into the market, effective barriers to entry into the market,and the firm is a price maker, also called a price searcher because it faces a downward sloping demand curve for its product (in fact, note that this demand curve is the market demand curve). the firm is a price maker, also called a price searcher because it faces a downward sloping demand curve for its product (in fact, note that this demand curve is the market demand curve).

57. Barriers to entry economies of scale/economic barriers/ actions by firms actions by government/legislative barriers/

58. Natural monopoly a monopoly that arises because of the existence of economies of scale over the entire relevant range of output. a monopoly that arises because of the existence of economies of scale over the entire relevant range of output. a larger firm will always be able to produce output at a lower cost than could a smaller firm. a larger firm will always be able to produce output at a lower cost than could a smaller firm. only a single firm can survive in a long-run equilibrium. only a single firm can survive in a long-run equilibrium.

59. Economies of scale – natural monopolies Natural monopolies are often regulated monopolies

60. Actions by firms to create and protect monopoly power patents and copyrights, high advertising expenditures result in high sunk costs (costs that are not recoverable on exit), and illegal actions designed to restrict competition

61. Monopolies created by government action patents and copyrights, government created franchises, and licensing.

62. Local monopoly Local monopoly – a monopoly that exists in a local geographical area (e.g., local newspapers)

63. Price elasticity and MR As noted earlier, since the demand curve facing a monopoly firms is downward sloping, MR < P MR > 0 when demand is elastic MR = 0 when demand is unit elastic MR < 0 when demand is inelastic

64. Average revenue As in all other market structures, AR=P (note that AR = TR/Q = (PxQ) / Q = P) The price given by the demand curve is the average revenue that the firm receives at each level of output.

65. Monopolist receiving positive profits

66. Monopoly price setting There is a unique profit-maximizing price and output level for a monopoly firm. It is optimal to produce at the level of output at which MR = MC and to charge the price given by the demand curve at this output level. Charging a higher (or lower) price results in lower profits.

67. Monopolistic competition – main characteristics a large number of firms, a large number of firms, the product is differentiated (i.e., each firm produces a similar, but not identical product), the product is differentiated (i.e., each firm produces a similar, but not identical product), entry is relatively easy, and entry is relatively easy, and the firm is a price maker that faces a downward sloping demand curve. the firm is a price maker that faces a downward sloping demand curve.

68. Relationship to other market models Monopolistic competition is similar to perfect competition in that: There are many buyers and sellers There are no barriers to entry or exit Monopolistic competition is similar to monopoly in that: Each firm is the sole producer of a particular product (although there are close substitutes) The firm faces a downward sloping demand curve for its product

69. Demand curve facing a monopolistically competitive firm

70. The firm’s demand curve and entry and exit As firms enter a monopolistically competitive market, the demand facing a typical firm declines and becomes more elastic.

71. Short-run equilibrium in a monopolistically competitive industry Economic profits lead to entry and a reduction in the demand facing a typical firm.

72. Long-run equilibrium in a monopolistically competitive industry Entry continues until economic profit equals zero for a typical firm. This equilibrium is often referred to as a “tangency equilibrium.”

73. Monopolistic competition vs. perfect competition A monopolistically competitive firm, in the long run, has “excess capacity” – (i.e., it produces a level of output that is below the least-cost level). This is a cost of product variety.

74. Monopolistic competition and efficiency As the number of firms rises, a monopolistically competitive firm’s demand curve becomes more elastic. As the number of firms in a market expands, the market approaches a perfectly competitive market. Thus, economic inefficiency may be smaller when there is a large number of firms in a monopolistically competitive market.

75. Product differentiation and advertising Monopolistically competitive firms may receive short-run economic profit from successful product differentiation and advertising. These profits are, however, expected to disappear in the long run as other firms copy successful innovations.

76. Location decisions Monopolistically competitive firms often locate near each other to appeal to the “median” customer in a geographical region. (e.g., fast food restaurants and car dealerships)

77. Oligopoly – main characteristics a small number of firms produce most output, a small number of firms produce most output, the product may be either standardized or differentiated, the product may be either standardized or differentiated, there are significant barriers to entry, and there are significant barriers to entry, and recognized interdependence exists (i.e., each firm realizes that its profitability depends on the actions and reactions of rival firms). recognized interdependence exists (i.e., each firm realizes that its profitability depends on the actions and reactions of rival firms).

78. Real-world markets Most output is produced and sold in oligopoly and monopolistically competitive industries. Most output is produced and sold in oligopoly and monopolistically competitive industries.

79. Strategic behaviour Strategic behaviour occurs when the best outcome for one party depends upon the actions and reactions of other parties.

80. Game theory – prisoners’ dilemma Examines the payoffs associated with alternative choices of each participant in the “game.”

81. Game theory examples Prisoners’ dilemma Duopoly pricing game

82. Dominant strategy A dominant strategy is one that provides the highest payoff for an individual for each and every possible action by rivals. Confession is the dominant strategy in the prisoners’ dilemma game. A low price is the dominant strategy in the duopoly pricing game It is more difficult to predict the outcome when no dominant strategy exists or when the game is repeated with the same players.

83. Cartels Cartels are legal in some countries A cartel arrangement can maximize industry profits Each firm can increase its profits by violating the agreement Cartel agreements have generally been unstable.

84. Imperfect information Brand name identification – serves as a signal of product quality. Customers are willing to pay a higher price for products produced by firms that they recognize. Product guarantees also serve as a signal of product quality