1 ECON 247: MICROECONOMICS FINAL EXAM NOTES (CH. 13-18) Table of Contents UNIT 6 – THE COSTS OF PRODUCTION .................................................................................................................... 2 CHAPTER 13: THE COSTS OF PRODUCTION..........................................................................................................................2 6.1.1. Opportunity Costs ......................................................................................................................................2 6.1.2. Explicit and Implicit Costs ..........................................................................................................................3 6.1.3. Economic Profit and Accounting Profit ....................................................................................................4 6.2.1. Production Function and Costs ..................................................................................................................4 6.2.2. Production Function Shapes ......................................................................................................................5 6.3.1. Fixed Cost (FC) and Variable Costs (VC) ....................................................................................................6 6.3.2. Average Cost (AC) and Marginal Cost (MC) ..............................................................................................6 6.3.3. Shapes of the Cost Curves .........................................................................................................................7 6.4.1. Cost Curves in the Short Run and in the Long Run....................................................................................8 6.5.1. Economies and Diseconomies of Scale......................................................................................................9 UNIT 7 – FIRMS IN COMPETITIVE MARKETS ......................................................................................................... 10 CHAPTER 14: FIRMS IN COMPETITIVE MARKETS.................................................................................................................10 7.1.1. Characteristics of Purely Competitive Markets ......................................................................................10 7.2.1. Maximizing Profit ....................................................................................................................................11 7.2.2. Marginal Cost Curve ................................................................................................................................12 7.2.3. The Firm’s Decision to Shut Down ...........................................................................................................13 7.2.4. Sunk Costs ................................................................................................................................................14 UNIT 8 – MONOPOLY ........................................................................................................................................... 19 CHAPTER 15: MONOPOLY .............................................................................................................................................19 8.1.1. Examples of Pure Monopoly ...................................................................................................................20 8.1.2. Characteristics of Monopoly ...................................................................................................................20 8.2.1. Monopoly versus Competition ................................................................................................................22 8.2.2. Monopolist Revenue................................................................................................................................23 8.2.3. Profit Maximization.................................................................................................................................24 8.3.1. The Cost of Monopolies to Society ..........................................................................................................25 8.4.1. Four Ways Government Reacts to Monopoly .........................................................................................26 8.5.1. Why Monopolists Practice Price Discrimination .....................................................................................26 UNIT 9 – MONOPOLISTIC COMPETITION AND OLIGOPOLY ................................................................................... 28 CHAPTER 16: MONOPOLISTIC COMPETITION .....................................................................................................................28 9.1.1. Monopolistic Competitive Market ..........................................................................................................28 9.2.1. Monopolistic Competition in the Short Run and the Long Run ..............................................................30 9.3.1. Advertising and Brand Names ................................................................................................................33 CHAPTER 17: OLIGOPOLY ..............................................................................................................................................35 9.4.1. Characteristics of Oligopoly ....................................................................................................................35 9.4.2. Duopoly ....................................................................................................................................................36 9.5.1. The Economics of Cooperation ................................................................................................................38 9.6.1. Public Policies and Controversies ............................................................................................................40 UNIT 10 – THE MARKET FOR THE FACTORS OF PRODUCTION ............................................................................... 41 CHAPTER 18: THE MARKETS FOR THE FACTORS OF PRODUCTION ..........................................................................................41 10.1.1. Production Function and the Marginal Product of Labour ..................................................................42 10.1.2. Shifts in Labour Demand Curve .............................................................................................................44 10.2.1. The Labour Supply .................................................................................................................................45 10.2.2. Equilibrium in the Labour Market .........................................................................................................45 2 Unit 6 – The Costs of Production Chapter 13: The Costs of Production (p. 256-276) Introduction we will look carefully at different cost concepts, both short-run and long-run costs of production Objective is to understand economies and diseconomies of scale How much is one more twinkie? o Have you ever wondered how much it makes to cost? First you need to consider all the ingredients We also need to assess the wages of the workers, the cost of packaging, marketing, etc We then need to figure out how to allocate these costs to a single twinkie and there are 2 ways to do that: 1) Average Cost = Total Cost / Quantity 2) Marginal Cost = △Total Cost / △ Quantity Objectives o 1) explain the meaning of opportunity cost explicit and implicit costs economic profit and accounting profits o 2) explain the production function and total cost. o 3) describe and calculate the specific components in a firm’s short-run production costs: total fixed costs (TFC) total variable costs (TVC) average fixed costs (AFC) average variable costs (AVC) average total costs (ATC) marginal costs (MC) o 4) distinguish between long-run and short-run costs of production o 5) define economies of scale and diseconomies of scale, and explain what causes them. Production and Total Cost All firms in the economy, whether large or small, encounter a number of similar costs, which play major roles in a firm’s decisions in production and pricing. The production function = shows how the amount of output a firm produces depends upon the amount of an input it employs. o Relationship b/w input & output Total Cost = the cost curve illustrates how the firm’s total cost of production varies with the amount of output it produces. the market value of the inputs a firm uses in production. o The amount that the firm pays to buy inputs (flour, sugar, workers, ovens, etc.) Total Revenue = the market value of the inputs a firm uses in production. The amount the firm receives for the sale of its output. To obtain this, you can add total cost to profit. Marginal Product = change in output. the increase in output that arises from an additional unit of input Most production relationships will reflect a phenomenon called diminishing marginal product. o The curve flattens out as more workers are hired. Profit = a firm’s revenue minus total cost 6.1.1. Opportunity Costs Opportunity Cost o the price paid to acquire, produce, accomplish, or maintain anything. o a sacrifice, loss, or penalty. o outlay or expenditure of money, time, labor, trouble, etc. 3 The opportunity cost of an item refers to all those things that must be forgone to acquire that item. o When economists speak of a firm’s cost of production, they include all the opportunity costs of making its output of goods and services. You will notice that according to this definition, cost involves a sacrifice, and this sacrifice allows a person to acquire, produce, accomplish, or maintain something. To an economist, the definition of the word cost is broader. Cost in economics always involves a choice between alternatives. o Example 1: Suppose it is spring, and you have just acquired three acres of land in the country. In the past, one of these acres has been planted in wheat, another in corn, and another in oats. The previous owner has left you enough fertilizer to fertilize only one acre of land. He has told you that if you fertilize the wheat, the dollar value of your yield will increase by $110; if you fertilize your corn, the value of the yield will increase by $80; and if you fertilize the oats, the value of the yield will increase by $50. If you use the fertilizer on the corn, your opportunity cost will be $110—what you would be giving up by not fertilizing the wheat. If you use the fertilizer on oats, the opportunity cost is also $110—what you give up by not applying it to the best alternative use. The opportunity cost is the expense involved in drawing a resource away from its most profitable alternative use, and it is equal to what the resource would earn or produce in its best alternative use. o Example 2: Suppose you want to become an auto mechanic. Your aptitude tests show that you are equally suited for accounting. As an accountant, you could earn $60,000 per year, but as an auto mechanic, you will earn only $50,000 per year. Assume that for either case, your family has agreed to pay your costs of education and the training periods are the same. What will it cost you to become an auto mechanic? In other words, what are the opportunity costs of your decision to become an auto mechanic? The opportunity cost is the $60,000 you could have earned as an accountant. If your decision is logical, then the extra satisfaction or joy you receive from working with cars must be “worth” at least $10,000 to you. o Example 3: When publishers use resources to publish economics textbooks, they are using resources that could also produce English textbooks, magazines, or pocket novels. The publishers incur opportunity costs. The opportunity costs of publishing an economics textbook are equal to the revenue the publishers could generate by using their equipment to publish other material. If economics textbooks are to be produced, the publishers must be able to earn more from the sale of economics textbooks than could be earned by selling some other type of publication; that is, the alternative or opportunity costs of economics textbooks must be covered by the revenue generated from the production and sale of economics textbooks. The opportunity cost of producing economics textbooks or any other good consists of what must be paid to keep those productive materials and services from being used to produce something else. These productive resources include not only what the producer must buy but also what the producer already has and could use for other purposes—both explicit and implicit costs. 6.1.2. Explicit and Implicit Costs Explicit Costs = input costs that require an outlay of money by the firm. payments for inputs from outside the firm Implicit costs = input costs that do not require an outlay of money by the firm. The opportunity costs of inputs owned by the firm. The definition of cost is approached quite differently by an economist than by an accountant. Economic costs include both explicit costs and implicit costs. Accounting costs, on the other hand, include only explicit costs. Example: Suppose the expenses of a new business owner include rent, wages, and cost of raw materials, amounting to $80,000. The owner could also have earned $70,000 had she worked for another company. The accounting costs only include the explicit costs of $80,000, whereas the economic costs equal $150,000 ($80,000 + $70,000). o Economic costs = explicit cost + implicit costs o Accounting costs = explicit costs Example: Suppose George has a pizza shop. o When he pays $500 for flour, that $500 is an opportunity cost. o When he pays wages that are part of the firm’s cost, they are an explicit cost—an actual expenditure George must make in order to make pizza. o George is also skilled as an electrician and could have earned $200 a week at this trade. He forgoes this amount of money to run his shop. This is an implicit cost—the value of the inputs owned by the firm and used for its own production process. Economists put a value on these owned inputs that are implicit and estimated from what they could earn in their best alternative use. Accountants keep a tab on the flow of money in and out of the firm. They measure the explicit costs but fail to impute the implicit costs 4 Now for George, an important cost in his business is the amount of capital that he invested in his pizza shop. George has $5,000 of his own savings invested in the pizza shop—money that could be in a bank earning interest. At 6% per annum, George could have earned $300 from interest alone. This $300 forgone amount is the implicit opportunity cost of George's pizza business. This amount will be recognized by the economist but ignored by the accountant. If George had borrowed the same amount from a bank and paid interest in the amount of $300, then the accountant would have considered it. Example: Mr. Smith owns a downtown parking lot. He paid $50,000 for the land and makes $23,000 per year in revenue. He has annual payments of $1,000 in taxes and $2,000 for the upkeep and heating of his little hut. He must also, of course, pay himself a wage. o He estimates that he could earn about $17,500 at Jo Jones’s parking lot across the street, so his wage cost is $17,500. o Since revenues are only $23,000, Mr. Smith would be better off selling his land, putting the money in the bank, and working for Jo Jones. o Total costs or total opportunity costs are not being covered by Mr. Smith’s revenues. o Resources should move if they are not covering opportunity costs in their current employment. o 6.1.3. Economic Profit and Accounting Profit Economists and accountants each have a different way of calculating costs; therefore, depending on who does the calculations, the profits for a firm will also be different. o Since accountants do not include the implicit opportunity cost, their profit figure will be larger than the economic profits estimated by economists. A firm must make a normal profit to stay in business. o To an economist, normal profits or implicit costs are an integral part of the costs of operating a business and are treated as such. It is only after all costs—implicit and explicit—have been covered that an economist considers that any profit has been made. To be precise, such profit is called economic profit, pure profit, or excess profit. Sometimes, economists will simply use the word profit when they really mean economic profit. Economic Profit = total revenue minus total cost, including both explicit and implicit costs of producing the goods and services sold o Economic profit is an important concept because it is what motivates the firms that supply goods and services. o For a business to be profitable from an economist’s standpoint, total revenue must cover all the opportunity costs, both explicit and implicit. Accounting Profit = total revenue minus total explicit cost 6.2.1. Production Function and Costs Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. Production Function = the relationship between the quantity of inputs used to make a good (including employees) and the quantity of output of that good. Shows how the amount of output a firm produces depends upon the amount of an input it employs. Marginal Product = change in output, more specifically, the increase in output that arises from an additional unit of input Diminishing Marginal Product = the property whereby the marginal product of an input declines as the quantity of the input increases. o Ex. At first, when only a few workers are hired, they have easy access to Caroline’s kitchen equipment. As the number of workers increases, additional workers have to share equipment and work in more crowded conditions. Eventually, the kitchen is so crowded that the workers start getting in each other’s way. Hence, as more and more workers are hired, each additional worker contributes fewer additional cookies to total production. Example Cont: George has to buy inputs to produce the pizza that he plans to sell. In the short run, we assume that it will be difficult for George to expand or immediately buy another shop. But he can increase his output of pizza in the short run by hiring more workers. o The table shows how George’s pizza production depends on the number of people he hires at his shop. o Suppose that George can start hiring people. When there is no labour, obviously there is no pizza. The first worker George hires produces 60 pizzas a day. When there are two workers, they produce 110 pizzas. This continues until he has six workers who are able to make 210 pizzas among them. 5 Now, for George to understand how many workers he should add and how much pizza can be produced, he must understand the concept of “marginal.” When the first worker was hired, the marginal product of labour—that is, the increase or marginal output from the addition of an input—is 60 (the amount of output of one worker minus the output when there was no worker). The marginal product of the second worker will be 110 (pizzas) minus 60, which equals 50. When the sixth worker is hired, the marginal product is only 10 pizzas, which is the difference between the output contributed by six workers and the output contributed by five workers. What we see is that the amount of outputs contributed by each additional worker declines. This property is known as diminishing marginal product As George hires more workers, they have less space and equipment to work with, and therefore fewer pizzas are contributed by each additional worker. The production function represents the relationship between the quantity of inputs (workers) and the quantity of product that can be produced by these inputs. The last three columns show what it costs for George to produce pizzas. Suppose that the cost of George’s shop is $50 per day, and the cost of a worker is $20 per day. When he hires one worker, the total cost is $70; when he hires two, the total cost is $90; and when he hires six, the total cost is $170. The $50 cost of the shop has to be paid regardless of whether the output of pizzas is zero or some other number. o o 6.2.2. Production Function Shapes If we look at the production function curve below (Figure 6.1a), we see that the slope rises to a point and then declines afterwards—the production function gets flatter as output increases. Thus, as George increases the number of pizzas produced, the additional workers required to produce those additional pizzas become crowded in his shop, which means that each extra worker contributes less to total output. o In the short run, there is no change in the size of the shop, so workers must share the resources and work together in the same space. The only option available for George to increase his pizza production is to hire extra workers. Hiring more and more workers continues to increase output, but by successively smaller amounts due to the law of diminishing returns. o According to this law, each additional worker produces a successively smaller addition to output; that is, the marginal product of an additional worker is less than the marginal product of the previous worker. o The average productivity (AP) therefore generally rises until it reaches a maximum point, and then subsequently falls; however, it will always be positive as long as total production remains positive. o Marginal productivity (MP) will reach a maximum before the average productivity will, and then it starts to decline. o It will become zero when total production reaches its maximum and is negative when it starts to decline. o The falling part of the marginal productivity curve shows the law of diminishing returns. 6 6.3.1. Fixed Cost (FC) and Variable Costs (VC) Variable costs = costs that do vary with the quantity of output produced. o These costs change as the firm alters the quantity of output produced. o Ex. Conrad’s variable costs include the cost of coffee beans, milk, sugar, and paper cups: The more cups of coffee Conrad makes, the more of these items he needs to buy. Similarly, if Conrad has to hire more workers to make more cups of coffee, the salaries of these workers are variable costs. Fixed costs = costs that do not vary with the quantity of output produced o These costs are incurred even if the firm produces nothing at all. o Conrad’s fixed costs include any rent he pays because this cost is the same regardless of how much coffee Conrad produces. Similarly, if Conrad needs to hire a full-time bookkeeper to pay bills, regardless of the quantity of coffee produced, the bookkeeper’s salary is a fixed cost. Suppose that George’s friend Bill produces chairs. The different costs for Bill are shown in Table 6.3 o Bill has to pay fixed costs, which include the rent for the shop and wages paid to his managerial staff, even if no chairs are produced. o In Bill’s case, the fixed cost is $60 irrespective of the number of chairs he produces. o Bill also incurs costs that vary according to the number of chairs produced. The variable costs include the materials (such as Rattan poles, teak wood, and natural fibre) and wages for workers. His variable cost will be zero when output is zero, but when his output is one, his variable cost is $25; when he increases his output to two, the variable cost goes up to $50. When he produces seven chairs, the variable cost goes up to $225. Bill’s total cost (column 2) is the sum of the fixed cost (column 3) and variable cost (column 4) as shown in Table 6.3. o Figure 6.2 represents the shape of total fixed cost, total variable cost, and total cost curves. The total fixed cost (TFC) is a straight horizontal line because as quantity produced increases, there is no change in fixed cost. The total variable cost (TVC) increases as output increases, first at a decreasing rate and then at an increasing rate. The total cost (TC) curve is a sum of both the fixed cost and the variable cost; therefore, it is parallel to the total variable cost, and the distance between the two is the total fixed cost. 6.3.2. Average Cost (AC) and Marginal Cost (MC) Average Total Cost = total cost divided by the quantity of output. Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Average Fixed Cost = fixed costs divided by the quantity of output Average Variable Cost = variable costs divided by the quantity of output Marginal Cost = the increase in total cost that arises from an extra unit of production. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output. o 7 Example Cont.: Now Bill has to decide how many chairs he should produce. He wants to know the average cost of producing a chair and the incremental cost of producing each additional chair. o The average cost of a chair is total cost divided by output. When Bill produces three chairs, the cost of each chair is $135 ÷ 3, which is $45. Even though Bill has an idea of the average cost of a chair, he would want to know how much his total cost will change when he changes his level of production. T he last column in Table 6.3 gives him his marginal cost. When Bill produces one chair, the marginal cost is the difference between total cost at zero and one chair, divided by the change in output. This can be shown as follows: o When bill increases his output from zero to one, then o When he increases his output from two to three chairs, then o If he increases his output from six to seven chairs, then o As we now see, average cost tells Bill the cost of a typical chair spread out over all the chairs that he produces, whereas marginal cost tells him the amount his total cost would change when he wants to produce one more chair. 6.3.3. Shapes of the Cost Curves These cost curves generally have features common to other producing units in an economy. The marginal cost (MC) curve tells us how total cost changes as output changes. o The MC curve is U-shaped because when Bill hires a second worker, marginal cost decreases; when he hires a third, a fourth, and a fifth worker, the work space gets crowded and equipment must be shared, so the marginal product of an extra worker is lower. This increases the marginal cost. The average total cost (ATC) curve is U-shaped. o The average total cost is the sum of the average fixed cost (AFC) and average variable cost (AVC). The average fixed cost keeps declining as output increases. The average variable cost increases as output increases, so when we combine the two inputs, the average total cost curve appears as a U shape. Average fixed cost always declines as output rises because the fixed cost is spread over a larger number of units. Average variable cost typically rises as output increases because of diminishing marginal product. o Efficient Scale = the quantity of output that minimizes average total cost The relationship between the marginal cost curve and the average total cost curve is such that when marginal cost is less than average total cost, the average total cost will fall. When the marginal cost is higher than the average total cost, the average total cost will increase. o The marginal-cost curve crosses the average-total-cost curve at its minimum. Why? At low levels of output, marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost. For the reason we have just discussed, average total cost must start to rise at this level of output. Hence, this point of intersection is the minimum of average total cost. o Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising Average total cost is like your cumulative grade point average. Marginal cost is like the grade in the next course you will take. If your grade in your next course is less than your grade point average, your grade point average will fall. If your grade in your next course is higher than your grade point average, your grade point average will rise. 8 The mathematics of average and marginal costs is exactly the same as the mathematics of average and marginal grades. o This can be illustrated as follows: When a basketball team scores fewer baskets in one match than the average number of baskets it shot in previous matches, then the average baskets for all matches will fall. On the other hand, if the number of baskets it scores in one match is greater than the average number of baskets scored in the previous matches, then the average will go up. Similarly, when the marginal cost curve moves up, it cuts the average total cost curve at its minimum point. This happens because when the marginal cost curve is below the average total cost curve, it keeps on falling, but when the marginal cost curve cuts the average total cost curve and moves up, the average total cost will also start to go up. Therefore, the point of crossing over by the marginal cost curve is at the minimum of the average cost curve. The shapes of these cost curves are shown in Figure 6.3. In certain cases, the property of diminishing marginal product does not start immediately. It is possible that when the first few workers are hired, they divide the work among themselves efficiently. In these cases, marginal product will initially increase but ultimately will decline. Cost curves share a number of properties: o Ultimately, the marginal cost increases with an increase in output. o Average total cost curves are U-shaped. o The marginal cost curve cuts the average total cost at its minimum. 6.4.1. Cost Curves in the Short Run and in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon. o Consider, for instance, a car manufacturer, such as Ford Motor Company. Over a period of only a few months, Ford cannot adjust the number or sizes of its car factories. The only way it can produce additional cars is to hire more workers at the factories it already has. The cost of these factories is, therefore, a fixed cost in the short run. By contrast, over a period of several years, Ford can expand the size of its factories, build new factories, or close old ones. Thus, the cost of its factories is a variable cost in the long run. o How long does it take a firm to get to the long run? The answer depends on the firm. It can take a year or longer for a major manufacturing firm, such as a car company, to build a larger factory. By contrast, a person running a coffee shop can buy another coffee maker within a few days. There is, therefore, no single answer to the question of how long it takes a firm to adjust its production facilities. Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves. The segregation of a firm’s fixed costs and variable costs depends on the time period under consideration. o Consider an organization that, in the short run, is unable to expand its factories but will be able to do so in the long run. For this organization, the cost of the factories in the long run becomes a variable cost. o The long-run average cost curve is the relationship between the lowest attainable average total cost and total output when both plant size and labour change, and is referred to as the planning curve. Remember that the long-run average cost is derived from the short-run average total cost curves. The long-run average total cost (LRATC) curve has a slightly flattened U shape. o All short-run cost curves will lie within the long-run cost curve because the short-run cost curves decrease first but will go up due to the law of diminishing returns. o For the long run, there will be no fixed inputs, and the shape of the longrun cost curve will depend on the economies and diseconomies of scale (more on these in the next section). When output increases because of initial increasing returns to scale, the long-run cost curve falls. Subsequently, as output keeps increasing through diseconomies of scale, the long-run cost curve will start to go up. o This property is illustrated in Figure 6.4. It shows quantity on the x-axis and cost in terms of tonne for steel on the y-axis. The short-run cost curves for three alternative scales of the use of steel are shown in the figure. The LRATC shows the minimum per unit cost of producing the different levels of steel when any of three desired sizes of plants can be built. Therefore, the LRATC is the curve that is touching the minimum points of the short-run cost curves as shown in the figure. 9 6.5.1. Economies and Diseconomies of Scale Economies of Scale = the property whereby long-run average total cost falls as the quantity of output increases o Ex. A firm that manufactures heavy equipment has decided to expand its plant capacity so that more assembly line equipment can be installed. The average costs per unit of output decrease once the new plant is in operation. The managers reason that this decrease in average costs has happened because more specialization was made possible by the expansion. As more workers and machines were used to perform certain tasks, it was possible to subdivide the tasks and to allow still more input of both people and machines to specialize. The larger plant allowed the use of new, more efficient techniques not possible in the smaller plant. This is an example of economies of scale. Diseconomies of Scale = the property whereby long-run average total cost rises as the quantity of output increases o Ex. A very large producer of steel has noted that in the past, as plant size increased, the average costs of production declined. The decision is made to expand again. Instead of the expected decrease in average costs, however, the firm finds that average costs have gone up. This increase probably occurred because of the increased challenges of coordinating activities in a large plant and conveying information promptly and accurately What might cause economies or diseconomies of scale? o Economies of scale often arise because higher production levels allow specialization among workers, which permits each worker to become better at a specific task. For instance, if Ford hires a large number of workers and produces a large number of cars, it can reduce costs with modern assembly-line production. o Diseconomies of scale can arise because of coordination problems that are inherent in any large organization. The more cars Ford produces, the more stretched the management team becomes, and the less effective the managers become at keeping costs down. Constant Returns to Scale = the property whereby long-run average total cost stays the same as the quantity of output changes In the News – Cost of Minimization the Key to Ikea’s Success o The following article shows how focusing on cost minimization has catapulted IKEA into one of the world’s most recognizable brands. However, as the article discusses, some of the approaches that IKEA and other corporations employ in this regard are coming under increased scrutiny. Summary Whether returns increase or decrease when a plant is enlarged depends on the particular situation, such as the particular range of output considered, the production function, management, and technology. Usually, there are decreasing costs over a range of output and then constant costs over another range of output. The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firm’s behaviour, it is important to include all the opportunity costs of production. o Some of the opportunity costs, such as the wages a firm pays its workers, are explicit. o Other opportunity costs, such as the wages the firm owner gives up by working in the firm rather than taking another job, are implicit. o Economic profit takes both explicit and implicit costs into account, whereas accounting profit considers only explicit costs. A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of an input increases, displaying the property of diminishing marginal product. As a result, a firm’s total-cost curve gets steeper as the quantity produced rises. A firm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that do not change when the firm alters the quantity of output produced. Variable costs are costs that do change when the firm alters the quantity of output produced. From a firm’s total cost, two related measures of cost are derived. o Average total cost is total cost divided by the quantity of output. o Marginal cost is the amount by which total cost rises if output increases by 1 unit. When analyzing firm behaviour, it is often useful to graph average total cost and marginal cost. o For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginal-cost curve always crosses the average-total-cost curve at the minimum of average total cost. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run. As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run. 10 Unit 7 – Firms in Competitive Markets Chapter 14: Firms in Competitive Markets (p. 277-299) Introduction Competitive markets are sometimes called perfectly competitive markets Unit 7 covers three main concepts. o 1) Purely competitive markets describe the purely competitive market and its specific characteristics. o 2) Profit maximization and supply decision calculate revenue for a purely competitive firm. describe how a purely competitive firm would determine its profit-maximizing output. draw the marginal cost curve. describe how competitive firms decide when to temporarily shut down production. define sunk costs. explain how competitive firms decide whether to exit or enter a market. o 3) Supply curve in the short run and the long run draw a graph that describes the short-run supply curve for a purely competitive firm. draw a graph that describes the long-run supply curve for a purely competitive firm. explain why competitive firms stay in business if they make zero profit. explain why a long-run supply curve might slope upward. Summary o Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue. o To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal-cost curve is its supply curve. o In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. o In a market with free entry and exit, profits are driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. o Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium. 7.1.1. Characteristics of Purely Competitive Markets Competitive Market = a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. It has 4 characteristics o 1) there are many buyers and many sellers in the market o 2) the goods offered by the various sellers are largely the same (homogenous) o 3) both the buyers and sellers have complete knowledge of prices and technology o 4) firms can freely enter or exit the market If, for instance, anyone can decide to start a dairy farm, and if any existing dairy farmer can decide to leave the dairy business, then the dairy industry satisfies this condition. Much of the analysis of competitive firms does not need the assumption of free entry and exit because this condition is not necessary for firms to be price takers. Yet, when there is free entry and exit in a competitive market it is a powerful force in shaping the long-run equilibrium. 11 As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given. o For example, a farmer selling wheat has little control over its price as other farmers are selling identical wheat. Therefore, both buyers and sellers are said to be price takers. Firms in a perfectly competitive market have no control over price, but they can determine the level of output that will earn maximum profits. It is, therefore, crucial that they understand how to maximize their profit. 7.2.1. Maximizing Profit The primary goal of a firm operating within a competitive market is to maximize its profit, which is simply the difference between total revenue and total cost (TR – TC). Class Example: Recall that firms operating in a purely competitive market are price takers. These firms will maximize profits or minimize losses by producing the output where MR = MC, provided that marginal revenue (MR) is greater than, or equal to, the minimum average variable cost (AVC). This statement is known as the profit-maximizing rule for a firm in pure competition. In pure competition, price = MR, so the profit-maximizing rule can also be written as P = MC, as long as P ≥ minimum AVC. Here is the demand (revenue) schedule for an individual firm. o The firm’s total revenue (TR) for a given output is arrived at by multiplying the number of units sold by the price at which they are sold ($5). This can be expressed as TR = P × Q. o Average revenue (or price) is determined by dividing total revenue by the number of units sold; thus, o o o This leads us to the fact that price = AR. For this perfectly competitive firm, AR for all units sold, no matter how many, is $5. The term average revenue is used by producers, whereas price is the term used by consumers. Both refer to the same thing. Marginal revenue (MR) is an extremely important concept. MR is computed by finding the change (∆) in TR that results from the sale of one more unit of the commodity. Since each additional unit sells for the same price in perfect competition, MR is the same as price and is constant for all additional units sold by the perfectly competitive firm. Therefore, marginal revenue equals the price of the product. The demand curve is perfectly horizontal and P = AR = MR. o TR is a straight line increasing by constant amounts—the price of the product—as output increases. o In Figure 7.1, the demand curve facing this firm is a horizontal straight line, so this is a firm operating in a purely competitive market. Suppose the market price is $5. A purely competitive firm can sell as much or as little as it wants at the price established by the market. By definition, a purely competitive firm is not big enough to affect the market price. Textbook Example: The Smith farm produces a quantity of milk, Q, and sells each unit at the market price, P. The farm’s total revenue is P x Q. For example, if a 4-L jug of milk sells for $6 and the farm sells 1000 jugs, its total revenue is $6000. o Because the Smith farm is small compared to the country’s market for milk, it takes the price as given by market conditions. This means, in particular, that the price of milk does not depend on the quantity of output that the Smith farm produces and sells. If the Smiths double the amount of milk they produce to 2000 jugs, the price of milk remains the same, and their total revenue doubles to $12 000. As a result, total revenue is proportional to the amount of output. 12 Table 14.1 shows the revenue for the Smith Family Dairy Farm. The first two columns show the amount of output the farm produces and the price at which it sells its output. The third column is the farm’s total revenue. The table assumes that the price of milk is $6 per jug, so total revenue is simply $6 times the number of jugs. The concepts of average and marginal are also useful when analyzing revenue. To see what these concepts tell us, consider these two questions, which can be answered in the last two columns of table 14.1. How much revenue does the farm receive for the typical jug of milk? How much additional revenue does the farm receive if it increases production of milk by 1 jug? The fourth column in the table shows average revenue, which is total revenue (from the third column) divided by the amount of output/quantity sold (from the first column). Average revenue tells us how much revenue a firm receives for the typical unit sold. In Table 14.1, you can see that average revenue equals $6, the price of a jug of milk. This illustrates a general lesson that applies not only to competitive firms but to other firms as well. Total revenue is the price times the quantity (P x Q) , and average revenue is total revenue (P x Q) divided by the quantity (Q). Therefore, for all firms, average revenue equals the price of the good. The fifth column shows marginal revenue, which is the change in total revenue from the sale of each additional unit of output. In Table 14.1, marginal revenue equals $6, the price of a jug of milk. This result illustrates a lesson that applies only to competitive firms. Total revenue is P x Q, and P is fixed for a competitive firm. Therefore, when Q rises by 1 unit, total revenue rises by P dollars. For competitive firms, marginal revenue equals the price of the good. o o o 7.2.2. Marginal Cost Curve Let's examine marginal cost by highlighting important details from Figure 7.2 o The figure shows that when John is producing Q 1 amount of books, marginal revenue is greater than marginal cost, so if he increases his production, he will increase his profit. If John increases his production to Q2, his marginal cost will be greater than his marginal revenue; therefore, he should reduce his production. John should ultimately adjust his production to QMAX, which is the profit-maximizing level. At this level, marginal revenue is exactly equal to marginal cost. o Now John can decide how many books he can produce in a competitive market. Because he is a price taker, he will maximize his profit when marginal cost is equal to price, as price is equal to marginal revenue. So the condition for profit maximization is MC = MR (= P). Any time there is an increase in price, John will respond by increasing his supply of books by an amount that is equal to his marginal cost. Whenever price increases, the marginal revenue will be greater than marginal cost, so the production will increase. The new production level will be where the marginal cost is equal to the higher price. Thus John’s marginal cost curve will decide how many books he will supply. This makes his marginal cost curve his supply curve. o An increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing quantity from Q1 to Q2 . Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm’s supply curve o In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down. This analysis yields three general rules for profit maximization: 1) If marginal revenue is greater than marginal cost, the firm should increase its output. 2) If marginal cost is greater than marginal revenue, the firm should decrease its output. 3) At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. o These rules are the key to rational decision making by a profit-maximizing firm. They apply not only to competitive firms but, as we will see in the next chapter, to other types of firms as well. 13 because the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, it is the competitive firm’s supply curve. 7.2.3. The Firm’s Decision to Shut Down In some circumstances, however, the firm will decide to shut down and not produce anything at all. o Here we need to distinguish between a temporary shutdown of a firm and the permanent exit of a firm from the market. o A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. o Exit refers to a long-run decision to leave the market. o The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. That is, a firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all, fixed or variable. Example: It is possible that John may not want to produce any books due to certain circumstances. o He may want to temporarily shut down and not produce any books because of market conditions. Or he may want to exit completely from the market. If he wants to shut down for a limited period, he still faces his fixed costs. o On the other hand, if he decides to exit the market, then he can sell his shop. o If John decides not to produce anything in his shop, he will lose all the revenue from the sales of his product, and his costs will fall by the amount of his variable costs. o When making the short-run decision whether to shut down for a season, the fixed cost of land is said to be a sunk cost. By contrast, if the farmer decides to leave farming altogether, he can sell the land. When making the long-run decision whether to exit the market, the cost of land is not sunk o For John, it might be better to produce if he can recover his variable costs (TR > VC) and to shut down if his total revenue from production is less than his variable costs (TR < VC). But for a graph such as Figure 7.3 (below), which has different prices per unit on the vertical axis and has curves showing cost per unit, it might be helpful to express this shutdown rule in per unit terms. o Now let’s consider what determines a firm’s shutdown decision. If the firm shuts down, it loses all revenue from the sale of its product. At the same time, it saves the variable costs of making its product (but must still pay the fixed costs). Thus, the firm shuts down if the revenue that it would earn from producing is less than its variable costs of production. o If TR stands for total revenue, and VC stands for variable costs, then the firm’s decision can be written as Shut down if TR < VC. o The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by the quantity Q, we can write it as Shut down if TR/Q < VC/Q. o In a competitive market, TR/Q is revenue per unit (which equals price P), and VC/Q is the firm’s average variable cost (AVC). Therefore, the shutdown rule can be restated as Shut down if P < AVC. That is, a firm chooses to shut down if the price of the good is less than the average variable cost of production. o This criterion is intuitive: When choosing to produce, the firm compares the price it receives for the typical unit to the average variable cost that it must incur to produce the typical unit. If the price doesn’t cover the average variable cost, the firm is better off stopping production altogether. The firm still loses money (because it has to pay its fixed costs), but it would lose even more money by staying open. o Thus, the price that coincides with the minimum point on the average-variable-cost curve is sometimes referred to as the shutdown price. If the market price is less than the shutdown price, the firm shuts down and ceases production. If conditions change in the future so that the price exceeds the shutdown price, the firm can reopen. Of course we could just as easily refer to it as the start-up price. o Now we can apply the shutdown rule to John’s book production company. John will not produce anything if the price of a book is less than his average cost of producing it. The price at the minimum point on the average variable cost curve is thus called the shutdown price. So if the market price of books is below the minimum of the average variable cost curve, John will not produce and will instead wait for better times. o A firm’s short-run supply curve has, then, two distinct parts. From prices of zero up to the shutdown price, there is zero supply. For prices that are above the shutdown price, the marginal cost curve above the average variable cost is also the firm’s supply curve. 14 o We can summarize this as follows: If the firm produces anything, it produces the quantity at which marginal cost equals the good’s price, which the firm takes as given. Yet if the price is less than average variable cost at that quantity, the firm is better off shutting down and not producing anything. These results are illustrated in Figure 14.3. The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost. Let’s look at another producer, Ruth, who produces widgets as shown in Figure 7.3 (below). o Suppose the initial market price is $27.50 per dozen widgets. For a purely competitive firm, price and marginal revenue are equivalent, so the marginal revenue is $27.50. Marginal cost comes closest to being equal to marginal revenue at an output of two, where MC is $25 and MR is $27.50. At an output of three, where MC is greater than MR, the firm incurs more in costs than it gains in revenue, so it would not produce at an output level of three. In this case, therefore, the firm should choose an output of two, at which point MR is greater than MC. However, as you may note, the price of $27.50 is below the average variable cost figure of $37.50. At an output of two, the firm will in fact minimize its losses by closing down. If the firm were to produce the two units, it would incur total costs of $225 and total revenue of only $55. The firm is clearly better off producing nothing and losing only its fixed costs of $150. o Suppose the price is $60 per dozen widgets. At five units of output, MC is $55 and price is $60. At six units of output, MC is $70. Thus five units are the profit-maximizing or loss-minimizing output. Which is it? At a price of $60 and output of five, the firm is covering its average variable costs ($40) but not its average total costs ($70), so this is a loss-minimizing position for the firm. The firm will lose $10 for each of the five units it produces, for a total loss of $50. If, however, it were to close down completely, its losses would be $150 (the total fixed costs). o Suppose the price of widgets increases to $100 per dozen. Now the output that comes closest to satisfying the MR = MC rule is seven. At this output, with a price of $100, average variable cost and average total costs are being covered. In fact, the producer will be making a profit of $27 on each of the seven units sold (price – average total costs (ATC) = profit per unit). o At a price of $27.50, MR is equal to MC at an output of two dozen. This point is clearly below AVC and ATC, so the firm would be better off to close down and experience only its fixed costs as losses (see point A). At a price of $62.50, MR equals MC at an output of five dozen units. Here the firm is clearly covering part, but not all, of its ATC. It is minimizing its losses by producing five dozen units of output and covering all of its average variable costs and part of its average fixed costs (see point B). At a price of $102.50, MR equals MC at seven dozen units of output: all costs are covered and a profit is being made (see point C). 7.2.4. Sunk Costs Sunk Cost = a cost that has already been committed and cannot be recovered o Because nothing can be done about sunk costs, you can ignore them when making decisions about various aspects of life, including business strategy. o The sunk cost is a cost that has already been committed for a project, whether any subsequent production takes place or not. It is primarily a fixed cost that cannot be avoided. For example, consider John's case, in which the cost of his equipment is $30,000. If the equipment cannot be resold and has no alternative use, the $30,000 is a sunk cost and the opportunity cost is $0. In the short run, the fixed cost is sunk and has no bearing on any supply decision. We assume that the firm cannot recover its fixed costs by temporarily stopping production. That is, regardless of the quantity of output supplied (even if it is zero), the firm still has to pay its fixed 15 costs. As a result, the firm’s fixed costs are sunk in the short run, and the firm can safely ignore these costs when deciding how much to produce. The firm’s short-run supply curve is the part of the marginal-cost curve that lies above average variable cost, and the size of the fixed cost does not matter for this supply decision. Many firms face this problem. Consider the case of a restaurant owner whose fixed costs cannot be reduced by closing down. He will continue to serve until his variable costs are being recovered. This will be true for other firms whose total costs are not being recovered. Thus, business will continue to operate where average revenue is greater than average variable costs. Case Study – Near-Empty Restaurants and Off-Season Miniature Golf: In making the decision whether to open for lunch, a restaurant owner must keep in mind the distinction between fixed and variable costs. Many of a restaurant’s costs—the rent, kitchen equipment, tables, plates, silverware, and so on—are fixed. o Shutting down during lunch would not reduce these costs. In other words, these costs are sunk in the short run. When the owner is deciding whether to serve lunch, only the variable costs—the price of the additional food and the wages of the extra staff—are relevant. The owner shuts down the restaurant at lunchtime only if the revenue from the few lunchtime customers fails to cover the restaurant’s variable costs. o An operator of a miniature-golf course in a summer resort community faces a similar decision. Because revenue varies substantially from season to season, the firm must decide when to open and when to close. Once again, the fixed costs—the costs of buying the land and building the course—are irrelevant. The miniature-golf course should be open for business only during those times of year when its revenue exceeds its variable costs. 7.2.5. The Firm’s Long-Run Decision A firm’s long-run decision to exit the market is similar to its shutdown decision. If the firm exits, it again will lose all revenue from the sale of its product, but now it will save not only its variable costs of production but also its fixed costs. Thus, the firm exits the market if the revenue it would get from producing is less than its total costs. Example cont.: At times, John may feel like exiting the book production market. If he does, he will lose the revenue, but he will also save on both the fixed and variable costs. Therefore, a firm exits when total revenue is less than total cost. o If TR stands for total revenue, and TC stands for total cost, then the firm’s rule can be written as Exit if TR < TC. o The firm exits if total revenue is less than total cost. By dividing both sides of this inequality by quantity Q, we can write it as Exit if TR/Q < TC/Q, o We can simplify this further by noting that TR/Q is average revenue, which equals the price P, and that TC/Q is average total cost ATC. Therefore, the firm’s exit criterion is Exit if P < ATC. o Thus, John will exit if the book price per unit is less than his average total cost. Furthermore, he will return to production only when the price he receives per unit is greater than his average total cost. o Let’s now help John determine his firm’s profit. We already know that profit is equal to total revenue minus total cost (Profit = TR – TC). o If we multiply and divide the right hand side of the equation by Q, we get Profit = (TR/Q – TC/Q) × Q, o and we already know that TR/Q is average revenue AR, which is equivalent to price P, and TC/Q is average total cost ATC. Simply put, Profit = (AR – ATC) × Q = (P – ATC) × Q. o Therefore, a firm’s profit is the difference between the price and the average total cost multiplied by the quantity that is sold. o If John discovers that the difference between price and average total cost is positive, his firm will remain in the market, and this will induce other firms to enter the market. If the difference between price and average total cost is negative (which implies the firm is losing money), then John’s firm will exit the market. a competitive firm’s long-run profit-maximizing strategy. If the firm produces anything, it chooses the quantity at which marginal cost equals the price of the good. Yet if the price is less than the average total cost at that quantity, the firm chooses to exit (or not enter) the market. o These results are illustrated in Figure 14.4. The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost. 16 Once we know how many firms there are in a market and what each firm’s supply curve looks like, we can easily determine the market supply curve. To determine the market supply curve, we add the quantity supplied by each firm in the market at every given price. Each firm's short-run supply curve is its marginal cost curve, which is above the average variable cost. Each firm will supply as long as its marginal cost equals price. In the short run, it will be difficult for firms to enter or exit this market because the period is too short, so the number of firms will remain fixed. o In the long run, firms can enter or exit the market. All firms will have access to the same technology, so their costs will be the same as well. Firms will enter the competitive market if the existing firms are making an economic profit, and if firms in an industry are incurring economic losses, firms will exit the market. Competitive firms will stay in a business as long as they are making zero economic profit. Remember, though, that zero economic profit is not the same as zero accounting profits—when a firm is making zero economic profit, it is still making some accounting profit. Measuring Profit in Our Graph for the Competitive Firm As we study exit and entry, it is useful to analyze the firm’s profit in more detail. Recall that profit equals total revenue (TR) minus total cost (TC): o We can rewrite this definition by multiplying and dividing the right-hand side by Q: o But note that TR/Q is average revenue, which is the price P, and TC/Q is average total cost ATC. Therefore, o This way of expressing the firm’s profit allows us to measure profit in our graphs. o Panel (a) of Figure 14.5 shows a firm earning positive profit. As we have already discussed, the firm maximizes profit by producing the quantity at which price equals marginal cost. Now look at the shaded rectangle. The height of the rectangle is P - ATC, the difference between price and average total cost. The width of the rectangle is Q, the quantity produced. Therefore, the area of the rectangle is (P-ATC), which is the firm’s profit. o Similarly, panel (b) of this figure shows a firm with losses (negative profit). In this case, maximizing profit means minimizing losses, a task accomplished once again by producing the quantity at which price equals marginal cost. Now consider the shaded rectangle. The height of the rectangle is ATC - P, and the width is Q. The area is (ATC-P) x Q, which is the firm’s loss. Because a firm in this situation is not making enough revenue on each unit to cover its average total cost, it would choose to exit the market in the long run. The Supply Curve in a Competitive Market When looking at the supply curve for a market, there are 2 cases to consider: o First, we examine a market with a fixed number of firms. Second, we examine a market in which the number of firms can change as old firms exit the market and new firms enter. Both cases are important, for each applies over a specific time horizon. Over short periods of time, it is often difficult for firms to enter and exit, so the assumption of a fixed number of firms is appropriate. But over long periods of time, the number of firms can adjust to changing market conditions. The Short Run: Market Supply with a Fixed Number of Firms Consider first a market with 1000 identical firms. For any given price, each firm supplies a quantity of output so that its marginal cost equals the price, as shown in panel (a) of Figure 14.6. That is, as long as price is above average variable cost, each firm’s marginal-cost curve is its supply curve. The quantity of output supplied to the market equals the sum of the quantities supplied by each of the 1000 individual firms. Thus, to derive the market supply curve, we add the quantity supplied by each firm in the market. As panel (b) of Figure 14.6 shows, because the firms are identical, the quantity supplied to the market is 1000 times the quantity supplied by each firm. 17 The Long Run: Market Supply with Entry and Exit Now consider what happens if firms are able to enter or exit the market. Let’s suppose that everyone has access to the same technology for producing the good and access to the same markets to buy the inputs into production. Therefore, all current and potential firms have the same cost curves. o Decisions about entry and exit in a market of this type depend on the incentives facing the owners of existing firms and the entrepreneurs who could start new firms. If firms already in the market are profitable, then new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. o Conversely, if firms in the market are making losses, then some existing firms will exit the market. Their exit will reduce the number of firms, decrease the quantity of the good supplied, and drive up prices and profits. o At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. Recall that we can write a firm’s profits as o o This equation shows that an operating firm has zero profit if and only if the price of the good equals the average total cost of producing that good. If price is above average total cost, profit is positive, which encourages new firms to enter. If price is less than average total cost, profit is negative, which encourages some firms to exit. The process of entry and exit ends only when price and average total cost are driven to equality. o if price is to equal both marginal cost and average total cost, these two measures of cost must equal each other. Marginal cost and average total cost are equal, however, only when the firm is operating at the minimum of average total cost. Recall from the preceding chapter that the level of production with lowest average total cost is called the firm’s efficient scale. Therefore, the long-run equilibrium of a competitive market with free entry and exit must have firms operating at their efficient scale. Panel (a) of Figure 14.7 shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost MC, so the firm is maximizing profits. Price also equals average total cost ATC, so profits are zero. New firms have no incentive to enter the market, and existing firms have no incentive to leave the market. o From this analysis of firm behaviour, we can determine the long-run supply curve for the market. In a market with free entry and exit, there is only one price consistent with zero profit—the minimum of average total cost. o As a result, the long-run market supply curve must be horizontal at this price, as in panel (b) of Figure 14.7. Any price above this level would generate profit, leading to entry and an increase in the total quantity supplied. Any price below this level would generate losses, leading to exit and a decrease in the total quantity supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost, and there are enough firms to satisfy all the demand at this price. Why Do Competitive Firms Stay in Business if they Make Zero Profit? To understand the zero-profit condition more fully, recall that profit equals total revenue minus total cost, and that total cost includes all the opportunity costs of the firm. In particular, total cost includes the time and money that the firm owners devote to the business. In the zero-profit equilibrium, the firm’s revenue must compensate the owners for these opportunity costs. o o 18 Ex. Suppose that a farmer had to invest $1 million to establish his farm, which otherwise he could have deposited in a bank and earned $50 000 a year in interest. In addition, he had to give up another job that would have paid him $30 000 a year. Then the farmer’s opportunity cost of farming includes both the interest he could have earned and the forgone wages—a total of $80 000. Even if his profit is driven to zero, his revenue from farming compensates him for these opportunity costs. Keep in mind that accountants and economists measure costs differently. As we discussed in the previous chapter, accountants keep track of explicit costs but not implicit costs. That is, they measure costs that require an outflow of money from the firm, but they fail to include opportunity costs of production that do not involve an outflow of money. As a result, in the zero-profit equilibrium, economic profit is zero, but accounting profit is positive. Our farmer’s accountant, for instance, would conclude that the farmer earned an accounting profit of $80 000, which is enough to keep the farmer in business. A Shift in Demand in the Short Run and Long Run Because firms can enter and exit a market in the long run but not in the short run, the response of a market to a change in demand depends on the time horizon. Ex. Suppose the market for milk begins in long-run equilibrium. Firms are earning zero profit, so price equals the minimum of average total cost. o The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. o Panel (b) shows what happens in the short run when demand rises from D1 to D2 . The equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold in the market rises from Q1 to Q2. Because price now exceeds average total cost, firms make profits, which over time encourages new firms to enter the market. This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel (c). In the new long-run equilibrium, point C, price has returned to P1 but the quantity sold has increased to Q3. Profits are again zero, price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand. o Now suppose scientists discover that milk has miraculous health benefits. As a result, the quantity of milk demanded at every price increases, and the demand curve for milk shifts outward from D1 to D2 , as in panel (b). The shortrun equilibrium moves from point A to point B; as a result, the quantity rises from Q1 to Q2, and the price rises from P1 to P2 . All of the existing firms respond to the higher price by raising the amount produced. Because each firm’s supply curve reflects its marginal-cost curve, how much they each increase production is determined by the marginal-cost curve. In the new short-run equilibrium, the price of milk exceeds average total cost, so the firms are making positive profit. o 19 Over time, the profit generated in this market encourages new firms to enter. Some farmers may switch to milk from other farm products, for example. As the number of firms grows, the quantity supplied at every price increases, the short-run supply curve shifts to the right from S1 to S2, as in panel (c), and this shift causes the price of milk to fall. Eventually, the price is driven back down to the minimum of average total cost, profits are zero, and firms stop entering. Thus, the market reaches a new long-run equilibrium, point C. The price of milk has returned to P1, but the quantity produced has risen to Q3. Each firm is again producing at its efficient scale, but because more firms are in the dairy business, the quantity of milk produced and sold is higher. Why the Long-Run Supply Curve Might Slope Upward two reasons why the long-run market supply curve might slope upward. o The first is that some resources used in production may be available only in limited quantities. For example, consider the market for farm products. Anyone can choose to buy land and start a farm, but the quantity of land is limited. As more people become farmers, the price of farmland is bid up, which raises the costs of all farmers in the market. Thus, an increase in demand for farm products cannot induce an increase in quantity supplied without also inducing a rise in farmers’ costs, which in turn means a rise in price. The result is a long-run market supply curve that is upward sloping, even with free entry into farming. o A second reason for an upward-sloping supply curve is that firms may have different costs. For example, consider the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs. Costs vary in part because some people work faster than others and in part because some people have better alternative uses of their time than others. For any given price, those with lower costs are more likely to enter than those with higher costs. To increase the quantity of painting services supplied, additional entrants must be encouraged to enter the market. Because these new entrants have higher costs, the price must rise to make entry profitable for them. Thus, the market supply curve for painting services slopes upward even with free entry into the market the long-run supply curve in a market may be upward sloping rather than horizontal, indicating that a higher price is necessary to induce a larger quantity supplied. Nonetheless, the basic lesson about entry and exit remains true: Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve. Unit 8 – Monopoly Chapter 15: Monopoly (p. 300-329) Introduction Unit 8 examines the market structure known as pure monopoly. A monopoly is said to exist when only one firm supplies a good or service to the marketplace. We must understand the structure of pure monopoly in order to understand the more common oligopolistic and monopolistic competition models that we will study in Unit 9. In this current unit, we will study monopoly by asking the questions: o Why do some markets have only one seller? o How does a monopoly determine what quantity to produce and what price to charge? o How do a monopoly’s decisions affect economic well-being? o What are the various public policies aimed at solving the problem of monopoly? o Why do monopolies try to charge different prices to different customers? After completing Unit 8, you should be able to o explain why monopolies occur in the economy, and describe the characteristics of a monopoly. o evaluate the economic effects of a monopoly in terms of revenue, profit maximization, and a monopoly's profit. o describe how a monopoly's decisions affect economic well-being. o distinguish among the different public policies that aim to solve the inefficiencies caused by monopolies. o describe and calculate price discrimination. We will see that market power alters the relationship between a firm’s costs and the price at which it sells its product. A competitive firm takes the price of its output as given by the market and then chooses the quantity it will supply so that price equals marginal cost. o 20 By contrast, a monopoly charges a price that exceeds marginal cost. This result is clearly true in the case of Microsoft’s Windows. The marginal cost of Windows—the extra cost that Microsoft would incur by printing one more copy of the program onto a CD—is only a few dollars. The market price of Windows is many times its marginal cost. 8.1.1. Examples of Pure Monopoly Example 1: Toll Bridges and Ferries o In the mid-1800s, large numbers of people migrated from the east to the west coast of the United States. At that time, travelling was very difficult and was made even more difficult by the operators of toll bridges and ferries, who charged large fees to wagon trains. Because there was no other way to get across rivers and streams, there was no way to avoid paying. These toll keepers were monopolists in the purest sense Example 2: A Drugstore o A single drugstore by itself in a university town has all the characteristics of a monopoly. Most of the students have no cars, so they must get their drugs, etc., at this particular store. Because the market is not big enough to encourage any other store to come into the town, this one is relatively free to charge whatever it can get for its goods. Extremely high prices may, in the long run, cause another store to enter the market or cause students to have supplies sent in from elsewhere Example 3: Public Utilities o Many basic utilities in North America were, until recently, examples of monopoly. It was common to have a single provider for each main utility (e.g., telephone, electricity, gas, and water). This occurred because it was assumed that these services were characterized by economies of scale; that is, average unit cost fell as output increased over any relevant range of output. o In such a situation, the only way of ensuring that average costs were as low as possible was to create a monopoly, permitting only one firm to provide the service. Government regulation was usually required to guarantee the firm protection from competition. This usually meant that the government had to regulate prices or profits in some way to make sure that the protected monopolist did not use the monopoly position to charge unduly high prices to consumers In recent years, technological changes have led many to conclude that the economies of scale no longer exist and that competitive markets are possible and preferable. Efforts to deregulate these sectors usually aim to replace regulated monopoly markets with competitive markets. 8.1.2. Characteristics of Monopoly Monopoly = a firm that is the sole seller of a product without close substitutes. There are 4 characteristics of a monopoly o 1) A monopolist is the single seller or producer of a specific good or service in the marketplace, so a monopolist is the industry that has control over the quantity of output or service available for sale. o 2) The monopolist offers a unique product or service to a large number of buyers, with no close substitutes available. o 3) The monopolist is the price maker. We would expect the monopolist to charge a higher price and produce at a lower level of output than a producer in a perfect competitive market. o 4) Entry into the monopolist's market is totally blocked. There may be legal barriers such as patents, copyright, licences, and economies of scale so that there are no competitors. The fundamental cause of monopoly is barriers to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources: o 1) Monopoly resources: A key resource is owned by a single firm. Owning a natural resource is one way of being a monopolist. Ex. If Ben owns the only water well in a village, he can charge a price that is higher than his marginal cost. Ben is a monopolist, and he has greater market power than a firm operating in a competitive market. Generally, it is difficult to own the only resource, due to large economies and trade taking place. Ex. consider the market for water in an early Canadian small town. If dozens of town residents have working wells, the competitive model describes the behaviour of sellers. As a result of competition among water suppliers, the price of a litre of water is driven to equal the marginal cost of pumping an extra litre. o But if there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist could command quite a high price, even if the marginal cost is low. 21 Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large, and resources are owned by many people. Indeed, because many goods are traded internationally, the natural scope of their markets is often worldwide. There are, therefore, few examples of firms that own a resource for which there are no close substitutes. 2) Government regulation: The government gives a single firm the exclusive right to produce some good or service. Government-Created Monopolies: In certain cases, monopolies are created when government grants licences for specific products and services. Some of these monopolies serve the public interest through patent and copyright laws; for example, pharmaceutical companies are given patents that give them exclusive rights over a new drug for 20 years. This allows them to sell it at a high price, which is justified due to the high research expenditure already incurred and as an incentive for further research. In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be monopolist. The patent and copyright laws are two important examples. When a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the government deems the drug to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work without the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel. Because these laws give one producer a monopoly, they lead to higher prices than would occur under competition. o But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behaviour. Drug companies are allowed to be monopolists in the drugs they discover to encourage research. Authors are allowed to be monopolists in the sale of their books to encourage them to write more and better books. Thus, the laws governing patents and copyrights have benefits and costs. The benefits of the patent and copyright laws are the increased incentive for creative activity. This benefits are offset, to some extent, by the costs of monopoly pricing 3) The production process: A single firm can produce output at a lower cost than can a large number of producers. A company's cost of production is such that it is the most efficient producer compared to other producers, thus becoming a natural monopoly o o Natural Monopolies Natural Monopoly = a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms o A natural monopoly arises when there are economies of scale over the relevant range of output. o When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. o When production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost. A natural monopoly exists when a firm can supply a product or provide a service to the entire market at a cost lower than what can be provided by two or more firms—for example, industries that supply public utilities such as natural gas, garbage collection, and electric power. There is a continuous fall in the firm’s average total cost as output increases. If there are two firms, then each firm produces less and at a higher average total cost. o As the economy grows bigger, one service provider may be inadequate for providing the service and a natural monopoly may move toward a more competitive market. A natural monopoly occurs when there are economies of scale, implying that average total cost falls as the firm's scale becomes larger. An example of a natural monopoly is the distribution of water. o To provide water to residents of a town, a firm must build a network of pipes throughout the town. o If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market. Some public goods and common resources are examples of natural monopolies When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. 22 Normally, a firm has trouble maintaining a monopoly position without ownership of a key resource or protection from government. The monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. o By contrast, entering a market in which another firm has a natural monopoly is unattractive. Would-be entrants know that they cannot achieve the same low costs that the monopolist enjoys because, after entry, each firm would have a smaller piece of the market. In some cases, the size of the market is one determinant of whether an industry is a natural monopoly. o Consider a bridge across a river. When the population is small, the bridge may be a natural monopoly. A single bridge can satisfy the entire demand for trips across the river at lowest cost. Yet as the population grows and the bridge becomes congested, satisfying the entire demand may require two or more bridges across the same river. Thus, as a market expands, a natural monopoly can evolve into a competitive market. An example of a near-monopoly bridge relevant to Canada is the Ambassador Bridge between Windsor, Ontario, and Detroit, Michigan. It is the busiest international border crossing in North America, accounting for over 20 percent of the trade flow between Canada and the United States, and it is owned and operated by a private U.S. company, Detroit International Bridge Company. o Ex. If Ben starts to supply water through pipes to the homes in the village, he will put in a network of pipes, which is largely a fixed cost. Now, if Joe discovers another well in the village and wants to supply water to the village, he would also have to lay down a network of pipes. In this case, both Ben and Joe would have to pay for a network of pipes (a fixed cost), but they would each get only a portion of the proceeds of the supply of water to the houses in the village. This would increase the average total cost for providing the services. o 8.2.1. Monopoly versus Competition The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. o A competitive firm is small relative to the market in which it operates and, therefore, has no power to influence the price of its output. It takes the price as given by market conditions. o By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. The monopolist is the only supplier and its demand curve will be the industry curve. o It is a price maker (as opposed to the competitive firm, which is a price taker) and faces a downward-sloping curve. Thus, if the monopolist increases its price, the demand for its product decreases, but when it reduces its price, the demand goes up. o For the monopolist, the downward-sloping demand curve is a constraint on its ability to increase its price while at the same time selling more of its product. By changing the price level, the monopolist takes a combination of price and output from any point on the demand curve. One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. o When we analyzed profit maximization by competitive firms in the preceding chapter, we drew the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve, as in panel (a) of Figure 15.2. In effect, because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm faces is perfectly elastic. o By contrast, because a monopoly is the sole producer in its market, its demand curve is the market demand curve. Thus, the monopolist’s demand curve slopes downward for all the usual reasons, as in panel (b) of Figure 15.2. If the monopolist raises the price of its good, consumers buy less of it. Looked at another way, if the monopolist reduces the quantity of output it sells, the price of its output increases. The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. A monopolist would prefer, if it were possible, to charge a high price and sell a large quantity at that high price. The market demand curve makes that outcome impossible. In particular, the market demand curve describes the combinations of price and quantity that are available to a monopoly firm. By adjusting the quantity produced (or, equivalently, the price charged), 23 the monopolist can choose any point on the demand curve, but it cannot choose a point off the demand curve. As with competitive firms, we assume that the monopolist’s goal is to maximize profit. Because the firm’s profit is total revenue minus total costs, our next task in explaining monopoly behaviour is to examine a monopolist’s revenue. Although the costs for all three firms in Figure 8.1 are identical, prices and outputs are not. Market structure, therefore, influences market behaviour. o Firm A is a monopolistically competitive firm. It faces an elastic, downward-sloping demand, which implies that if there is a price increase, the firm will lose a substantial portion of its market. Likewise, if the firm reduces price, some people will switch to this product from other products that are close substitutes. As a result of the downward-sloping demand, MR is less than price. Since MC must equal MR for a firm to maximize profit, marginal cost will also be less than price. Marginal cost shows the opportunity cost of producing the last unit of the commodity. Price indicates what consumers are willing to pay for the last unit of the commodity they purchase. When price is equal to MC, consumers’ satisfaction is just equal to the cost to society of producing the good; therefore, resources have been allocated in the most efficient way possible. In monopolistic competition, a price that is above marginal cost indicates an under-allocation of resources from the point of view of society. o Compare Firm A to Firm B. Firm B is facing a horizontal or perfectly elastic demand curve and must, therefore, be operating in a purely competitive industry. The firm can sell all it wants at the market price P2. Price equals MC in pure competition, so consumers get satisfaction from the purchase of the good that is just equal to the cost to society of producing the good. Resources have been allocated efficiently. The purely competitive firm (Firm B) will produce more of the good for a lower price than will Firm A. o Now compare Firm A to Firm C. Firm C has the monopolist’s demand curve—the demand curve is more inelastic than that of the monopolistic competitor. There are no substitutes for the firm’s product. The monopolist charges a price well above MC. Resource misallocation is least efficient under conditions of monopoly. Firm C produces less of a good for a higher price than does Firm A. 8.2.2. Monopolist Revenue Ex. Cont.: Ben, the sole supplier of water in his village. We are interested in how his revenue depends upon the quantity of water supplied. o In Table 8.1, if Ben supplies one litre of water, he can sell it for $14, providing him a total revenue of $14. If he wants to sell two litres of water, he can get $13 a litre for total revenue of $26. If he wants to sell 10 litres of water, he can get $5 a litre, for a total revenue of $50. The average revenue is calculated by dividing the total revenue by the amount produced, which is simply the price of the product. o The last column shows the marginal revenue. Marginal revenue is the change when an additional litre of water is being supplied. When one litre of water is supplied, the total revenue is $14, and when the supply is two litres, the total revenue is $26, for marginal revenue of $12. An interesting result shown by the table is that the marginal revenue is always less than the price of water being supplied. When Ben increases his supply of water from, say, five litres to six litres, the price at which he sells is $9 even though the additional increase in the 24 marginal revenue is only $4. This means that to increase the quantity Ben wants to sell, he will have to lower the price. Thus, when a monopoly increases the amount it sells, there will be two effects on total revenue (P×Q): More output is sold, so Q will be higher (the output effect). Price falls, so P is lower (the price effect). In the competitive market, where the firm is a price taker, it does not receive any amount less for the units it was already selling. Thus the marginal revenue is equal to its price. In the case of a monopoly, there is a price reduction for all the units if an additional unit is sold, so its marginal revenue is less than its price. o To illustrate, TR = Q × P And AR = TR/Q, which can be restated as TR = AR × Q, o which implies that P = AR. o This tells us that price is equal to average revenue; thus, the demand curve is also the average revenue curve. A monopolist’s marginal revenue is always less than the price of its good. Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, it has two effects on total revenue : o The output effect: More output is sold, so Q is higher, which tends to increase total revenue. o The price effect: The price falls, so P is lower, which tends to decrease total revenue. Marginal revenue is negative when the price effect on revenue is greater than the output effect 8.2.3. Profit Maximization one of the ten principles of economics is that rational people think at the margin. This lesson is as true for monopolists as it is for competitive firms. Now that we understand the relationship between the output and revenue for a monopolist, the monopolist that seeks to maximize profit produces the quantity of output at which MR = MC and the MC curve crosses the MR curve from below. o To find the monopoly’s MC curve, first recall that in a perfectly competitive market, the industry supply curve is the sum of the supply curves of all the firms in the industry and each firm’s supply curve is its MC curve. Now all the industry is controlled by a single firm; the competitive industry’s supply curve becomes the monopoly’s MC curve (remember the supply curve is also the MC). In o Figure 8.2, the marginal cost curve crosses the marginal revenue curve, MR = MC (point A, at just over four units of output). o The profit-maximizing output will be four units, because at five units, MC is greater than MR. To find the price, follow a vertical line from four units up to the demand curve (point B), and then go horizontally to the left to read the corresponding price from the price per unit axis. The profit-maximizing price is $63. At an output of four units and a price of $63, the ATC is $52.50 (point C). The shaded area represents the company’s total profits of $42 ([$63 – $52.50]×4). A Monopolist’s Profit – o it can be expressed as follows: Profit = TR – TC, which can be rewritten as (TR/Q – TC/Q) × Q. Since TR/Q = P and TC/Q = ATC, see that 25 Profit = (P – ATC) × Q. o If we look at the Figure 8.3, we see that 0Q1 is the output produced at 0P2 prices. The shaded rectangle gives the monopolist’s profits. This area is the difference between price and average cost multiplied by the total output. For a firm in perfect competition, the price would have been lower at 0P1 and the output would have been higher at 0Q2. o The monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal-revenue curve and the marginal-cost curve. The marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is, o The equality of marginal revenue and marginal cost determines the profit-maximizing quantity for both types of firms. What differs is how the price is related to marginal revenue and marginal cost. In competitive markets, price equals marginal cost. In monopolized markets, price exceeds marginal cost FYI: Why a Monopoly Does Not Have a Supply Curve = Although monopoly firms make decisions about what quantity to supply (in the way described in this chapter), a monopoly does not have a supply curve. o A supply curve tells us the quantity that firms choose to supply at any given price. This concept makes sense when we are analyzing competitive firms, which are price takers. But a monopoly firm is a price maker, not a price taker. It is not meaningful to ask what amount such a firm would produce at any price because the firm sets the price at the same time as it chooses the quantity to supply o Indeed, the monopolist’s decision about how much to supply is impossible to separate from the demand curve it faces. The shape of the demand curve determines the shape of the marginal-revenue curve, which in turn determines the monopolist’s profit-maximizing quantity. o In a competitive market, supply decisions can be analyzed without knowing the demand curve, but that is not true in a monopoly market. Therefore, we never talk about a monopoly’s supply curve 8.3.1. The Cost of Monopolies to Society From society’s point of view, it appears that the monopoly fails to maximize total economic well-being because the allocation of resources in a monopoly is different than in a competitive market. In fact, Ben will produce less than he would have in a competitive market; he will also sell his product at a higher price than what he would have charged in a competitive market. We can also show the inefficiency of monopoly through the deadweight loss. o In deadweight loss, the demand curve shows the value to the consumers and the marginal cost curve shows the costs to the monopolist. Therefore, the area of the deadweight loss triangle in the demand curve and the marginal cost curve is equal to the total surplus lost due to the pricing of the monopolist, as illustrated in Figure 8.4 (adapted from textbook, p. 313) o the socially efficient quantity is found where the demand curve and the marginal-cost curve intersect. o like a competitive firm and unlike a profit-maximizing monopoly, a social planner would charge a price equal to marginal cost o The monopolist produces less than the socially efficient quantity of output. o The problem in a monopolized market arises because the firm produces and sells a quantity of output below the level that maximizes total surplus. The deadweight loss measures how much the economic pie shrinks as a result. This inefficiency is connected to the monopoly’s high price: Consumers buy fewer units when the firm raises its price above marginal cost. But keep in mind that the profit earned on the units that continue to be sold is not the problem. The problem stems from the inefficiently low quantity of output. Put differently, if the high monopoly price did not discourage some consumers from buying the good, it would raise producer surplus by exactly the amount it reduced consumer surplus, leaving total surplus the same as could be achieved by a benevolent social planner. o There is, however, a possible exception to this conclusion. Suppose that a monopoly firm has to incur additional costs to maintain its monopoly position. For example, a firm with a government-created monopoly might need to hire lobbyists to convince lawmakers to continue its monopoly. In this case, the monopoly may use up some of its 26 monopoly profits paying for these additional costs. If so, the social loss from monopoly includes both these costs and the deadweight loss resulting from a price above marginal cost. The monopolist earns a monopoly profit by having a price greater than its marginal cost. o Apparently, economic analysis does not seem to think that monopoly’s profit by itself is a problem for society. o When a consumer buys a litre of water from Ben, the consumer gives a dollar and Ben is happier by a dollar. The exchange of goods and money does not affect the monopoly’s market total surplus. The monopolist profit by itself does not shrink the market—it just takes a bigger portion of the cake. The problem is basically that a monopolist produces a level of output that is below the level where surplus total is maximized. 8.4.1. Four Ways Government Reacts to Monopoly Competition Law o The public policy to curb monopoly power has been done through legislation. Governments pass laws preventing mergers or acquisitions that could lead to a less competitive market and reduce the economic welfare of the people. o Canada has a long history of competition law starting in 1889. The initial laws were not very effective in their applications, but in 1986, the competition law was replaced by two new statutes, the Competition Act and the Competition Tribunal Act Regulation o Another action the government takes to deal with monopolies is to regulate their activities. This type of action is effective for such natural monopolies as water and electricity companies. o Generally, the government regulates the pricing behaviours of these companies so that they cannot charge the customers whatever they want. o The problem for the government is deciding what price should be set for Ben’s well water. Since the average cost is declining, the marginal cost is less than average total cost. If the government sets the price at the marginal cost level, that price will be less than Ben’s average total cost. Rather than losing money, Ben will simply exit and stop supplying water to the village. Public Ownership o Another policy for dealing with monopolies is public ownership. o In the United States, very few monopolies are publicly owned; in Europe and Canada, it tends to be relatively common. o In general, economists prefer private ownership of natural monopolies to public ownership. If the government does a poor job of running the company, the taxpayers and customers lose out, whereas in a privately owned company, managers that don’t do a good job can be fired. Doing Nothing o Sometimes the costs of government regulation outweigh the benefits. Therefore, some economists believe that it is best for the government to leave monopolies alone instead of trying to solve the inefficiencies of monopoly pricing. 8.5.1. Why Monopolists Practice Price Discrimination Price Discrimination = the business practice of selling the same good at different prices to different customers price discrimination will be successful if o the seller has a degree of monopoly power. o the seller is able to segregate buyers into distinct groups based on their ability to pay. o the nature of the product or service does not allow for its resale to others. With an objective of profit maximization, a monopoly firm can increase its level of profits through the use of price discrimination. To analyze the effects of price discrimination, the table 8.2 presents data for a monopolist. You can use Table 8.2 to verify for yourself that a non-discriminating monopolist would produce three units at a price of $7 and earn zero profit (breakeven). However, in Table 8.3, observe the difference in total revenue when a monopolist engages in perfect price discrimination. Perfect price discrimination involves charging different prices to each buyer, based upon their willingness to pay maximum possible price. o The third column shows the total revenue without price discrimination is 9, 16, 21, 24, 25, and 24. 27 Now, let’s find out how a monopolist discriminates consumers, based on their willingness to pay, by charging different prices to different groups of customers. The fourth column shows that the total revenue with price discrimination is 9, 17, 24, 30, 35, and 39. The first buyer is willing to pay $9, so TR with price discrimination is equal to $9 x 1 = $9. You then have one more buyer (Qd = 2 – 1) willing to pay $8, so we just add the TR from this buyer to the previous TR and get 9 + 8 = $17. Then add one more buyer willing to pay $7 (Qd = 3 – 2) so the TR from this group is $7 x 1 = $7 plus the previous total revenue, so the total TR is $17 + 17 = $24, and so on. From the above calculation, we can see that TR without price discrimination is lower than TR with price discrimination, because without price discrimination, you must lower the price for all units sold if you want to expand sales. Lessons about price discrimination o The first and most obvious lesson is that price discrimination is a rational strategy for a profit-maximizing monopolist. In other words, by charging different prices to different customers, a monopolist can increase its profit. In essence, a price-discriminating monopolist charges each customer a price closer to her willingness to pay than is possible with a single price. o The second lesson is that price discrimination requires the ability to separate customers according to their willingness to pay. A corollary to this second lesson is that certain market forces can prevent firms from price-discriminating. In particular, one such force is arbitrage, the process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference. o The third lesson from our parable is the most surprising: Price discrimination can raise economic welfare o Analytics of Price Discrimination Perfect Price Discrimination = describes a situation in which the monopolist knows exactly the willingness to pay each customer and can charge each customer a different price. Aka First-degree price discrimination o In reality, of course, price discrimination is not perfect. Customers do not walk into stores with signs displaying their willingness to pay. Instead, firms price-discriminate by dividing customers into groups: young versus old, weekday versus weekend shoppers, Canadians versus Australians, and so on. Imperfect Price Discrimination = comes in two forms, referred to as second- and third-degree price discrimination o Second-degree price discrimination involves charging different prices to the same customer for different units that the customer buys. Quantity discounts are often a successful way of price-discriminating because a customer’s willingness to pay for an additional unit declines as the customer buys more units. o Third-degree price discrimination can be achieved when the market can be segmented and when the segments have different elasticities of demand. Ex. movie tickets and charging differently for children, seniors, and adults 28 Unit 9 – Monopolistic Competition and Oligopoly Objectives After completing Unit 9, you should be able to o describe the characteristics of oligopoly. o explain how the "prisoners' dilemma" can be used to capture oligopoly pricing strategies. o describe how competition laws try to foster competition in oligopolistic markets. o describe the characteristics of monopolistic competition. o draw a graph that shows how a monopolistically competitive firm would determine its short-run profit-maximizing or loss-minimizing price and output, and its long-run equilibrium position. o discuss the debate over the effects of advertising and the role of brand names. Chapter 16: Monopolistic Competition (p. 330-347) Summary A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two related ways. First, each firm in a monopolistically competitive market has excess capacity. That is, it operates on the downwardsloping portion of the average-total-cost curve. Second, each firm charges a price above marginal cost. Monopolistic competition does not have all the desirable properties of perfect competition. There is the standard deadweight loss of monopoly caused by the markup of price over marginal cost. In addition, the number of firms (and thus the variety of products) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited. The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition. Defenders of advertising and brand names argue that firms use them to inform consumers and to compete more vigorously on price and product quality. 9.1.1. Monopolistic Competitive Market many industries fall somewhere between the polar cases of perfect competition and monopoly. Economists call this situation imperfect competition. There are two examples of this: o 1) One type of imperfectly competitive market is an oligopoly, a market with only a few sellers, each offering a product that is similar or identical to the products offered by other sellers in the market. in choosing how much to produce and what price to charge, each firm in an oligopoly is concerned not only with what its competitors are doing but also with how its competitors would react to what it might do. Economists measure a market’s domination by a small number of firms with a statistic called the concentration ratio, which is the percentage of total output in the market supplied by the four largest firms. In the Canadian economy, most industries have a four-firm concentration ratio under 50 percent, but in some industries, the biggest firms play a more dominant role. Highly concentrated industries include breakfast cereal (which has a concentration ratio of 78 percent), aircraft manufacturing (81 percent), electric lamp bulbs (89 percent), household laundry equipment (93 percent), and cigarettes (95 percent). These industries are best described as oligopolies. o 2) Monopolistic Competition = a market structure in which many firms sell products that are similar but not identical In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers. In a monopolistically competitive market, each firm sells a good or service that is, to some limited extent, unique. However, there are numerous close substitutes around. The local hairdressing shop is an example. Customers have their favourite hairdressers, so the services of one shop are not regarded as being identical to the services of another. 29 Monopolistic competition is true to its name: It is a hybrid of monopoly and competition. Like a monopoly, each monopolistic competitor faces a downward-sloping demand curve and, as a result, charges a price above marginal cost. Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of perfect competition and monopoly. But oligopoly and monopolistic competition are quite different. o Oligopoly departs from the perfectly competitive ideal because there are only a few sellers in the market. The small number of sellers makes rigorous competition less likely and strategic interactions among them vitally important. o By contrast, a monopolistically competitive market has many sellers, each of which is small compared to the market. It departs from the perfectly competitive ideal because each of the sellers offers a somewhat different product. o When determining the type of market structure, the first question to ask about any market is how many firms there are. If there is only one firm, the market is a monopoly. If there are only a few firms, the market is an oligopoly. If there are many firms, we need to ask another question: Do the firms sell identical or differentiated products? o If the many firms sell differentiated products, the market is monopolistically competitive. If the many firms sell identical products, the market is perfectly competitive. The three defining characteristics of monopolistic competition are o a relatively large number of sellers = there are many firms competing for the same groups of customers o differentiated products = Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. o ease of entry into, and exit from, the industry (free entry and exit) = Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero. competition occurs when there are many firms in a market offering essentially identical products; monopoly occurs when there is only one firm in a market. Example – Women’s Clothing: o The women’s clothing industry is an example of a monopolistically competitive industry. There are many firms producing products that, while different, are still close substitutes for one another. Many clothing manufacturers are so small that they are completely independent of, and not even noticed by, other firms in the same industry. Because they are small and require relatively little capital, smaller clothing manufacturers are starting up and closing down frequently. In other words, resources are constantly moving into and out of the clothing industry. o Even though there are many close substitutes, each clothing firm produces products that are unique. Each manufacturer has a certain amount of monopoly power because of his or her product lines or the services he or she provides to customers. This “monopoly-like” feature means that each firm faces a downward-sloping demand curve. (Recall that a downward-sloping demand curve means that in order for a firm to sell more of its product, it must lower its price. The marginal revenue schedule for such a firm will lie below its average revenue schedule). The extent and strength of the monopoly power is, however, quite limited, because other firms are producing products that are close substitutes. If one manufacturer raises prices, it can expect to lose some customers to less expensive substitutes. o The firms in the women’s clothing industry must remain aware of changing consumer preferences in order to stay in business and retain their market position. For example, one clothing firm might detect a new trend developing in women’s blouses. It might then convince a certain store to stock some of these items. The result is that the new blouses sell very well. This particular firm can then manufacture and sell many such blouses before other firms in the industry have time to gear up for production of similar styles. o Rivalry is keen in monopolistic competition, so firms have a strong incentive to keep costs down. Profits in the long run are usually low. o Some other examples of monopolistically competitive industries include retail outlets such as grocery stores. Repairmen, doctors, and lawyers may also operate in a market that closely approximates monopolistic competition. They all sell slightly differentiated products. Differentiation can arise from location, service, or packaging, and it may be real or imaginary. Differentiation is often merely the result of successful advertising, which convinces customers of product differences. 30 9.2.1. Monopolistic Competition in the Short Run and the Long Run In a perfectly competitive market, sellers offer standardized products. In a monopolistically competitive market, firms offer a product or service that is slightly different from others in the market; that is, each firm’s offering is a close substitute, but not a perfect substitute, for the other competitors’ offerings. o Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) o Thus, the monopolistically competitive firm follows a monopolist’s rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity. Equilibrium in the Short Run o A firm in monopolistic competition makes its output and price decision the same way a firm in a monopoly does. It faces a downward-sloping demand curve and follows the monopolist rule of profit maximization to reach equilibrium. o The short-run equilibrium for the firm will be reached where the short-run marginal cost curve intersects the marginal revenue. o In Figure 9.1, the vertical line crosses the equilibrium point of MC = MR and moves up to cut ATC and the demand curve. This gives us the equilibrium level of quantity 0Q1 and the price 0P1. o The two panels in this figure show different outcomes for the firm’s profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best the firm can do is to minimize its losses. The profit-maximizing quantity is found at the inter section of the marginal-revenue and marginal-cost curves. monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. Equilibrium in the Long Run o Recall that one of the characteristics of monopolistic competition is ease of entry into the market. Thus, when existing firms are making profits, other firms have an incentive to enter. When this occurs, each firm has a smaller share of the market and this pushes the demand curve downward. Each firm’s products would have a lower price and, therefore, a lower profit level. For the industry in which firms are making losses, there would be exits. There would then be less differentiated products available, and this would increase the market share and shift the demand curve upward. The result would be an increase in price and a decrease in losses. The process of entry and exit would be such that firms would make zero economic profit. This would be the long-run equilibrium. o When firms are making profits, new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products fall, these firms experience declining profit. Conversely, when firms are making losses, firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profit (that is, declining losses). This process of entry and exit continues until the firms in the market are making exactly zero economic profit. Once the market reaches this equilibrium, new firms have no incentive to enter, and existing firms have no incentive to exit. o o o 31 Figure 9.2 shows what the demand and cost curves might look like for a barber shop operating in a monopolistically competitive market. The same profit-maximizing decision rule we applied in pure competition and pure monopoly still holds. It is advantageous for the firm to expand production until MR = MC, as long as price is greater than AVC. As you can see, the firm depicted in Figure 9.2 will produce 4700 units for a price of $3.80 per unit. At this price and output, the price lies above the average total cost per unit; hence, in the short run, the barber is making an economic profit (see the shaded area of Figure 9.2). At an output of 4700, the ATC per unit is $3.20, so the firm is making a profit of $.60 per unit, or a total profit of $2820. Now let’s imagine the output has decreased as in Figure 9.3 The decision on price and output is still determined by the MC = MR rule, but now the profit-maximizing output is 4400 haircuts per month at a price of $3.20. At this output, the price is just equal to ATC, so there are no excess profits, and there will be no incentive for more firms to enter or leave the industry. The firm and the industry are said to be in long-run equilibrium. It is also possible that after a long-run expansion of the industry, a firm will find itself in the position of making short-run losses as shown in the figure 9.4. Figure 9.4 shows that at the profit-maximizing output of 3000, where MR = MC, ATC is $3.30 and price is $3.10. The barber will therefore lose $0.20 on each of the 3000 haircuts he or she provides. Even though the barber was the first in the area and gives good haircuts, he or she could still go out of business. The entry of the other barber shops spreads the limited demand too thin, making failure of one or more of the shops inevitable. In the long run, we see that the price of the product is greater than its marginal cost, just as in the case of monopoly. But because of free entry and exit, the price equals average total cost as in a competitive market. In the monopolistic market structure, the demand curve of a firm is tangential to its average total cost. As the demand curve slopes downward, the point of tangency will be to the left of the lowest point on the firm’s average total cost, as illustrated in Figure 9.4. In the long run, there are two key differences between perfect competition and monopolistic competition (see Figure 16.4, textbook p. 336): Excess capacity. A firm is said to have excess capacity if it produces below its efficient scale. Perfectly competitive firms produce at their efficient scale (where ATC is minimized), whereas monopolistically competitive firms produce at less than the efficient scale. Each monopolistically competitive firm tries to gain market share by building more outlets and advertising heavily. o You can see excess capacity in many places, such as a restaurant with many empty tables. The only option for these firms is to increase their sales by cutting prices, but they would then incur losses. Restated, these firms operate at a point to the left of the minimum point on their long-run average cost curve. o Panel A shows that the quantity of output at this point is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on o 32 the downward-sloping portion of their average-total-cost curves. In this way, monopolistic competition contrasts starkly with perfect competition o Panel B shows how free entry in competitive markets drives firms to produce at the minimum of average total cost. The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the average total cost of production. The firm forgoes this opportunity because it would need to cut its price to sell the additional output. It is more profitable for a monopolistic competitor to continue operating with excess capacity. Markup over marginal cost. A firm's markup is the amount by which price exceeds its marginal cost. In perfect competition, prices always equal marginal cost and there is no markup; however, in monopolistic competition, buyers pay a price that is higher the marginal cost, which is also higher than the price would be in perfect competition. o A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. For a competitive firm, such as that shown in panel (b), price equals marginal cost. For a monopolistically competitive firm, such as that shown in panel (a), price exceeds marginal cost because the firm always has some market power. o How is this markup over marginal cost consistent with free entry and zero profit? The zero-profit condition ensures only that price equals average total cost. It does not ensure that price equals marginal cost. Indeed, in the long-run equilibrium, monopolistically competitive firms operate on the declining portion of their average-total-cost curves, so marginal cost is below average total cost. Thus, for price to equal average total cost, price must be above marginal cost. Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. o Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition. To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market: 1) As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price. 2) As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero. The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero. Monopolistic Competition and the Welfare of Society Is Monopolistic Competition Good for Society? o When the price of a product is greater than the marginal cost, resources are under-utilized. Resources are used efficiently when marginal benefit equals marginal cost. Recall that price measures marginal benefit One source of inefficiency is the markup of price over marginal cost. Because of the markup, some consumers who value the good at more than the marginal cost of production (but less than the price) will o o o 33 be deterred from buying it. Thus, a monopolistically competitive market has the normal deadweight loss of monopoly pricing. This outcome is undesirable compared with the efficient quantity that arises when price equals marginal cost, but there is no easy way for policymakers to fix the problem. To enforce marginal-cost pricing, they would need to regulate all firms that produce differentiated products. Because such products are so common in the economy, the administrative burden of such regulation would be overwhelming. Regulating these firms by forcing them to decrease their prices is not a good strategy because they are already making zero economic profits. One potential problem of monopolistic competition is an overcrowded market. Moreover, regulating monopolistic competitors would entail all the problems of regulating natural monopolies. In particular, because monopolistic competitors are making zero profits already, requiring them to lower their prices to equal marginal cost would cause them to make losses. To keep these firms in business, the government would need to help them cover these losses. Rather than raising taxes to pay for these subsidies, policymakers may decide it is better to live with the inefficiency of monopolistic pricing. Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be “ideal.” That is, there may be too much or too little entry. One way to think about this problem is in terms of the externalities associated with entry. Whenever a new firm considers entering the market with a new product, it takes into account only the profit it would make. Yet its entry would also have the following two effects that are external to the firm: 1) The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. 2) The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms. When new firms enter the market, consumers benefit because of new product, but the existing firms lose their market share. Thus, there are both positive and negative externalities associated with another firm entering the market Both of these externalities are closely related to the conditions for monopolistic competition. The productvariety externality arises because new firms offer products that differ from those of the existing firms. The business-stealing externality arises because firms post a price above marginal cost and, therefore, are always eager to sell additional units. Conversely, because perfectly competitive firms produce identical goods and charge a price equal to marginal cost, neither of these externalities exists under perfect competition. In the end, we can conclude only that monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. That is, the invisible hand does not ensure that total surplus is maximized under monopolistic competition. 9.3.1. Advertising and Brand Names Advertising is a signal to the consumer of a high-quality product. A signal is an action taken by an informed person to send a message to uninformed people. At times, advertising may be excessive, and this adds to the cost of selling the product. o Since firms are selling differentiated products above their marginal cost, each firm can advertise and give the consumer a greater choice. Firms that sell highly differentiated products (like soft drinks and pet foods) have a relatively high advertising budget, whereas firms whose products are nearly homogeneous commodities (like crude oil or wheat) spend little or no money on advertising. o Such behaviour is a natural feature of monopolistic competition (as well as some oligopolistic industries). When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise to attract more buyers to its particular product. Sometimes, firms use advertising to tout the quality of their product. Firms with brand names usually spend more on advertising and charge higher prices for their products, but because they are willing to spend so much money, consumers perceive that the brand-name product is of better quality than its no-name counterpart (page 343 in the textbook) The monopolistic market structure provides insight into strategies for selling differentiated products. In markets with many small sellers and low differentiation of products, the demand curve would be nearly horizontal. In markets with strong brands, the market would tend towards a monopoly structure. Advertising is a selling expense that is an important tool for firms. In the News: Less Product Variety and Higher Prices in Canada Due to Lack of Competition o In a 2014 study, University of Toronto economist Nicholas Li argues that the price gap between Canada and U.S. goods is due in large part to lower competition in Canada. He also finds that product variety in Canada is much lower than in the United States. Critique of advertising 34 Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Critics also argue that advertising impedes competition. Advertising often tries to convince consumers that products are more different than they truly are. By increasing the perception of product differentiation and fostering brand loyalty, advertising makes buyers less concerned with price differences among similar goods, thereby making the demand for a particular brand less elastic. When a firm faces a less elastic demand curve, it can increase its profits by charging a larger markup over marginal cost. Defence of advertising o Defenders of advertising argue that firms use advertising to provide information to customers. Advertising conveys the prices of the goods offered for sale, the existence of new products, and the locations of retail outlets. This information allows customers to make better choices about what to buy and, thus, enhances the ability of markets to allocate resources efficiently. o Defenders also argue that advertising fosters competition. Because advertising allows customers to be more fully informed about all the firms in the market, customers can more easily take advantage of price differences. Thus, each firm has less market power. In addition, advertising allows new firms to enter more easily, because it gives entrants a means to attract customers from existing firms. Over time, policymakers have come to accept the view that advertising can make markets more competitive. One important example is the regulation of advertising for certain professions, such as lawyers, doctors, and pharmacists. In the past, these groups succeeded in getting governments to prohibit advertising in their fields on the grounds that advertising was “unprofessional.” In recent years, however, the courts have concluded that the primary effect of these restrictions on advertising was to curtail competition. They have, therefore, overturned many of the laws that prohibit advertising by members of these professions. Case Study: Canada Goose Flying High = Marketing campaigns can help differentiate a product from the competition. An example of such a product is the distinctive Canadian goose down–filled parkas made by Canada Goose, the Canadian maker of outdoor apparel. Whether Canada Goose continues to fly high or goes the way of other must-have products of the past remains to be seen. But the recent success of the company shows how important product differentiation supported by innovative marketing geared toward social media can be. Advertising as a signal of quality o Defenders of advertising argue that even advertising that appears to contain little hard information may in fact tell consumers something about product quality. The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered. Brand names o Advertising is closely related to the existence of brand names. In many markets, there are two types of firms. Some firms sell products with widely recognized brand names, while other firms sell generic substitutes. For example, in a typical drugstore, you can find Bayer aspirin on the shelf next to a generic aspirin. In a typical grocery store, you can find Pepsi next to less familiar colas. Most often, the firm with the brand name spends more on advertising and charges a higher price for its product. o Critics argue that brand names cause consumers to perceive differences that do not really exist. In many cases, the generic good is almost indistinguishable from the brand-name good. Consumers’ willingness to pay more for the brand-name good, these critics assert, is a form of irrationality fostered by advertising. o More recently, economists have defended brand names as a useful way for consumers to ensure that the goods they buy are of high quality. There are two related arguments. First, brand names provide consumers with information about quality when quality cannot be easily judged in advance of purchase. Second, brand names give firms an incentive to maintain high quality, because firms have a financial stake in maintaining the reputation of their brand names. o Critics argue that brand names are the result of an irrational consumer response to advertising. Defenders argue that consumers have good reason to pay more for brand-name products because they can be more confident about the quality of these products. o o 35 Chapter 17: Oligopoly (p. 348-369) Introduction Oligopolies would like to act like monopolies, but self-interest drives them closer to competition. Thus, oligopolies can end up looking either more like monopolies or more like competitive markets, depending on the number of firms in the oligopoly and how cooperative the firms are. o The story of the prisoners’ dilemma shows why oligopolies can fail to maintain cooperation, even when cooperation is in their best interest. Policymakers regulate the behaviour of oligopolists through the anticompetition laws. The proper scope of these laws is the subject of ongoing controversy. o Although price-fixing among competing firms clearly reduces economic welfare and should be illegal, some business practices that appear to reduce competition may have legitimate if subtle purposes. As a result, policymakers need to be careful when they use the substantial powers of the anticompetition laws to place limits on firms’ behaviour. Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. o Yet, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the closer the quantity and price will be to the levels that would prevail under perfect competition. The prisoners' dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual interest. The logic of the prisoners' dilemma applies in many situations, including advertising, commonresource problems, and oligopolies. Policymakers use the anticompetition laws to prevent oligopolies from engaging in behaviour that reduces competition. The application of these laws can be controversial, because some behaviour that may seem to reduce competition may in fact have legitimate business purposes. 9.4.1. Characteristics of Oligopoly There are three defining characteristics of oligopoly: o few sellers and many buyers o identical or similar products o significant barriers for entry into the industry Oligopoly is a market structure dominated by a few large firms. o A key characteristic of oligopolistic markets is mutual interdependence. o Because each firm controls a significant share of total market output, a firm must take the likely reactions of the other firms into account before it changes its price or makes other major decisions. Products that are difficult to brand—like crude oil, cement, and steel—are examples of products sold in oligopolistic markets. A number of products that carry branding but may not be highly differentiated—like cigarettes, beer, tires, and soft drinks—are also part of oligopolies. You will probably discover that it can be very difficult to put a particular product into a specific market structure. For example, cars are similar products, but a high-end BMW is very different from a low-end Hyundai. Note that oligopolies may either produce a standardized product, as in a competitive market, or they may produce differentiated products, which is true in monopolistically competitive markets. Oligopolies, like monopolies, lead to an inefficient allocation of resources, primarily because competition is weak or limited. Increased globalization has permitted many markets to be penetrated by new firms from abroad. This has, in many instances, reduced the losses or potential losses that might arise from imperfectly competitive markets. the actions of any one seller in the market can have a large impact on the profits of all the other sellers. Oligopolistic firms are interdependent in a way that competitive firms are not. Game theory = the study of how people behave in strategic situations. o By “strategic,” we mean a situation in which a person, when choosing among alternative courses of action, must consider how others might respond to the action she takes. Strategic thinking is crucial not only in checkers, chess, and tic-tac-toe but also in many business decisions. o Because oligopolistic markets have only a small number of firms, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms in the market. o Game theory is not necessary for understanding competitive or monopoly markets. 36 In a market that is either perfectly competitive or monopolistically competitive, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. But, as we will see, game theory is useful for understanding oligopolies and many other situations in which a small number of players interact with one another. Game theory helps explain the strategies that people choose, whether they are playing hockey or selling hockey skates. o 9.4.2. Duopoly Duopoly = an oligopoly with only two firms o The textbook tells us that an oligopoly has few sellers. It might be easier to understand their behaviour if we examine an oligopoly with only two firms in it: a duopoly. Oligopolies with three or more members face the same problems as duopolies, so we do not lose much by starting with the case of duopoly. Example: Let’s suppose that Ben the monopolist finds another source of water located on the other side of his village. He now has two wells as sources of water, and he gives one to each of his two children, Kane and Amr. Thus, there are two firms selling a homogeneous commodity produced at zero cost. o The marginal cost of producing water for Kane and Amr is zero. They can keep on producing water without any cost. The villagers who will use the water will buy a certain quantity at a specific price. At a high price level, water will be used sparingly, while at low prices, it will be used much more freely, for watering gardens and so on. Thus, the aggregate demand for water at high prices will be low and will increase as the price declines. Kane and Amr, therefore, face a downward-sloping demand curve. As the cost is zero for both of them, their profits will equal total revenue. o To restate this: Profit = TR - TC But since the total cost is zero, Profit = TR – zero So, Profit = TR And TR – P x Q Therefore, whatever is sold multiplied by its price will give total revenue, which is equal to its profit P x Q = TR = profit o The first column of Table 9.1 shows the quantity of water required by the villagers. The second column shows the price, and the third shows the total revenue and total profits. The quantity demanded is zero litres when the price is $10. When the price is decreased to $9, the quantity demanded is 2 L, and the total revenue will be 2 × 9 = $18. o Competition, Monopolies and Cartels Collusion = an agreement among firms in a market about quantities to produce or prices to charge Cartel = a group of firms acting in unison Once a cartel is formed, the market is in effect served by a monopoly Each firm in a perfectly competitive or a monopolistic market acts independently without considering the actions or reactions of other firms in the industry, whereas in the oligopolistic market, each firm must anticipate the reactions of its rivals when making a decision about prices. Let’s use figures from Table 9.1 to see how the decisions differ when made under perfect competition and oligopoly. Suppose that Kane and Amr, our duopolists, are part of a perfectly competitive market. As such, Kane and Amr are price takers—both suppliers will maximize their profits where MR = MC, which in this case occurs at the demand level of 10 L and the price of $5. At this level, total revenue equals total profit equals $50. Therefore, a monopolist would charge $5/L, which exceeds the marginal cost. 37 Suppose that Kane and Amr are the only water suppliers in the village. In an oligopoly, we cannot use the MR = MC rule we used in perfect competition. Kane and Amr have to agree on how much water has to be supplied and what the price will be. If they decide to work together (i.e., they collude), they have formed a cartel, which is, in effect, a monopoly. Kane and Amr can decide together on the monopoly level of price, quantity, and profit. They also have to decide how much water each of them will supply. Since they are siblings, they might decide to split the monopoly’s market equally and supply 5 L of water each at $5, for a total profit of $25 each. Let’s try to get into Kane’s mind and access his decision-making process. Kane may think, “Amr will be producing 5 L, but what should I do? Should I continue to go along with Amr and also produce 5 L? What if I produce 7 L and Amr keeps producing only 5 L? Between us, we will produce a total of 12 L, which will be sold at $4/L. Then my profit will increase to 7 L multiplied by $4 equals $28. The problem is that Amr may also think like this. If we both produce 7 L for a total of 14 L, then the selling price will be $3. Our total revenue will be $42, which will be split equally at $21. Each of us will then have a profit of $21.” Now that both are producing 7 L each for a total of 14, does Kane want to further increase his output? “What if I increase my output to 9 L, and Amr does the same? We will have a total output of 16 L! But wait! According to the table, at this output level, we can sell the water for only $2/L. This means that our profit will actually decline to $18 (9 L multiplied by $2) each. It looks like we cannot increase output further than 7 L.” It appears that the best strategy for Kane and Amr is to produce 7 L each, and this is their equilibrium level. At this level, neither Kane nor Amr has an incentive to change his level of output. Kane and Amr have reached a situation known as Nash equilibrium. Kane and Amr will waver between cooperation and self-interest. If they cooperate and fix the level of output with no intention to change it, then they will reach the monopoly levels. If they pursue their profits, then the movement is toward a competitive level. However, they will not reach the competitive level, since they realize that beyond a certain level, their profits will decline and reach zero. Therefore, Kane and Amr will generally produce at a level that is between the monopoly level and the competitive level of output and price. As technology improves, more people may try to supply water. If other people besides Kane and Amr supply water, how will this affect output and price? The demand for water will remain the same, so all the suppliers will have to split their supplies. If they all agree to cooperate, they will maximize their profits at the monopoly levels. However, as the number of suppliers increases, the possibility of cooperation decreases and this market for water will move toward a competitive market. The Equilibrium for an Oligopoly Oligopolists would like to form cartels and earn monopoly profits, but that is often impossible. o Squabbling among cartel members over how to divide the profit in the market sometimes makes agreement among them impossible. Nash Equilibrium = a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen o There is tension between cooperation and self-interest. Oligopolists would be better off cooperating and reaching the monopoly outcome. Yet because they pursue their own self-interest, they do not end up reaching the monopoly outcome and maximizing their joint profit. Each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total production rises and the price falls. o At the same time, self-interest does not drive the market all the way to the competitive outcome. Like monopolists, oligopolists are aware that increasing the amount they produce reduces the price of their product, which in turn affects profits. Therefore, they stop short of following the competitive firm’s rule of producing up to the point where price equals marginal cost. In summary, when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). 38 How the Size of an Oligopoly Affects the Market Outcome Suppose, for instance, that John and Joan suddenly discover water sources on their property and join Jack and Jill in the water oligopoly o If the sellers of water could form a cartel, they would once again try to maximize total profit by producing the monopoly quantity and charging the monopoly price. Just as when there were only two sellers, the members of the cartel would need to agree on production levels for each member and find some way to enforce the agreement. As the cartel grows larger, however, this outcome is less likely. Reaching and enforcing an agreement becomes more difficult as the size of the group increases. o If the oligopolists do not form a cartel—perhaps because the competition laws prohibit it—they must each decide on their own how much water to produce. o To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each well owner has the option to raise production by 1 litre. In making this decision, the well owner weighs two effects: 1) The Output Effect = Because price is above marginal cost, selling 1 more litre of water at the going price will raise profit. 2) The Price Effect = raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other litres sold. If the output effect is larger than the price effect, the well owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. (In fact, in this case, it is profitable to reduce production.) Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms’ production as given. We can now see that a large oligopoly is essentially a group of competitive firms. o A competitive firm considers only the output effect when deciding how much to produce: Because a competitive firm is a price taker, the price effect is absent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. 9.5.1. The Economics of Cooperation Prisoners’ Dilemma = a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. o This provides insight into why cooperation is difficult. o Many times, in life, people fail to cooperate with one another even when cooperation would make them all better off. An oligopoly is just one example. The story of the prisoners’ dilemma contains a general lesson that applies to any group trying to maintain cooperation among its members. o The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Bonnie and Clyde. The police have enough evidence to convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a bank robbery together, but they lack hard evidence to convict them of this major crime. The police question Bonnie and Clyde in separate rooms and they offer each of them the following deal: “Right now, we can lock you up for one year. If you confess to the bank robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of eight years.” If Bonnie and Clyde, heartless bank robbers that they are, care only about their own sentences, what would you expect them to do? Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy he or she chooses and the strategy chosen by his or her partner in crime. o Consider first Bonnie’s decision. She reasons as follows: “I don’t know what Clyde is going to do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of what Clyde does, I am better off confessing.” a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Bonnie. She spends less time in jail if she confesses, regardless of whether Clyde confesses or remains silent. 39 Now consider Clyde’s decision. He faces the same choices as Bonnie, and he reasons in much the same way. Regardless of what Bonnie does, Clyde can reduce his time in jail by confessing. In other words, confessing is also a dominant strategy for Clyde. In the end, both Bonnie and Clyde confess, and both spend eight years in jail. This outcome is a Nash equilibrium: Each criminal is choosing the best strategy available, given the strategy the other is following. Yet, from their standpoint, the outcome is terrible. If they had both remained silent, both of them would have been better off, spending only one year in jail on the gun charge. By each pursuing his or her own interests, the two prisoners together reach an outcome that is worse for each of them. You might have thought that Bonnie and Clyde would have foreseen this situation and planned ahead. But even with advance planning, they would still run into problems. o Imagine that, before the police captured Bonnie and Clyde, the two criminals had made a pact not to confess. Clearly, this agreement would make them both better off if they both live up to it, because they would each spend only one year in jail. But would the two criminals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. o Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational. Game theory studies how people behave in strategic situations. Game theorists make assumptions about how people will behave, and then they examine the consequences of different choices. o We saw that when Kane and Amr each produce 7 L of water, they have reached an equilibrium, and neither has any incentive to change that level. Nash equilibrium is the situation in which Kane and Amr each chose his own best strategy based on the strategy chosen by the other. Game theory is largely a study of how firms, individuals, or countries would react in strategic situations, given the action of the other key participant(s) in the market. Communication and cooperation between individuals and firms is an important part of a game. o Many economic “games” assume that the actors are caught in something similar to what is called the “prisoner's dilemma.” The textbook (pp. 354–355) develops a “game” about Bonnie and Clyde that many argue captures the reality facing oligopolists. Oligopolies as a Prisoners’ Dilemma o It turns out that the game oligopolists play in trying to reach the monopoly outcome is similar to the game that the two prisoners play in the prisoners’ dilemma. o oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices, and monopoly profits. Case Study: OPEC and the World Oil Market = Much of the world’s oil is produced by a few countries, mostly in the Middle East. These countries together make up an oligopoly. Their decisions about how much oil to pump are much the same as Jack and Jill’s decisions about how much water to pump. Prisoner’s Dilemma in Advertising o When two firms advertise to attract the same customers, they face a problem similar to the prisoners’ dilemma. For example, consider the decisions facing two beer companies, Molson and Labatt. If neither company advertises, the two companies split the market. If both advertise, they again split the market, but profits are lower, since each company must bear the cost of advertising. Yet if one company advertises while the other does not, the one that advertises attracts customers from the other. Prisoner’s Dilemma in Common Resources o people tend to overuse common resources. One can view this problem as an example of the prisoners’ dilemma. o Imagine that two oil companies—Shell and Esso (Imperial Oil)—own adjacent oil fields. Under the fields is a common pool of oil worth $12 million. Drilling a well to recover the oil costs $1 million. If each company drills one well, each will get half of the oil and earn a $5-million profit ($6 million in revenue minus $1 million in costs). Because the pool of oil is a common resource, the companies will not use it efficiently. Suppose that either company could drill a second well. If one company has two of the three wells, that company gets two-thirds of the oil, which yields a profit of $6 million. The other company gets one-third of the oil, for a profit of $3 million. Yet if each company drills a second well, the two companies again split the oil. In this case, each bears the cost of a second well, so profit is only $4 million for each company. People often need an incentive to maintain cooperation o 40 Case Study: The Prisoners’ Dilemma Tournament = Imagine that you are playing a game of prisoners’ dilemma with a person being “questioned” in a separate room. Moreover, imagine that you are going to play not once but many times. Your score at the end of the game is the total number of years in jail. You would like to make this score as small as possible. What strategy would you play? Would you begin by confessing or remaining silent? How would the other player’s actions affect your subsequent decisions about confessing? o The tit-for-tat strategy has a long history. It is essentially the biblical strategy of “an eye for an eye, a tooth for a tooth.” The prisoners’ dilemma tournament suggests that this may be a good rule of thumb for playing some of the games of life. 9.6.1. Public Policies and Controversies One of the ten principles of economics is that governments can sometimes improve market outcomes. This principle applies directly to oligopolistic markets. o As we have seen, cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high. o To move the allocation of resources closer to the social optimum, policymakers should try to induce firms in an oligopoly to compete rather than cooperate When firms cooperate with each other in an oligopoly, society faces high prices and low amounts of some resources. In such cases, the government would want to change the allocation of resources to levels that are nearer to a social optimum. o The strategy, therefore, is to make these firms compete, not cooperate, with each other; the results would be higher production and lower prices. Even though businesses would like to have profitable agreements with each other, Canadian authorities have refused to enforce agreements in which there are possibilities of price fixing, as such agreements are not in the best interest of society. In fact, Canada’s Competition Act codifies a number of activities and has both civil and criminal provisions. o There have been numerous debates on what types of business activities should be prohibited by the antitrust laws. Resale price maintenance, tying, and predatory pricing are presumably controversial business activities. But at times, it is very difficult to pinpoint the exact business activity that encourages collusion and reduces welfare, making it hard to enforce laws. Over time, much controversy has centred on the question of what kinds of behaviour the competition laws should prohibit. Most commentators agree that price-fixing agreements among competing firms should be illegal. Yet the competition laws have been used to condemn some business practices whose effects are not obvious. Here we consider three examples. o Resale Price Maintenance = Imagine that Superduper Electronics sells Blu-ray Disc players to retail stores for $100. If Superduper requires the retailers to charge customers $150, it is said to engage in resale price maintenance. Any retailer that charged less than $150 would have violated its contract with Superduper. At first, resale price maintenance might seem anticompetitive and, therefore, detrimental to society. Like an agreement among members of a cartel, it prevents the retailers from competing on price. For this reason, the courts have often viewed resale price maintenance as a violation of the competition laws. Yet some economists defend resale price maintenance on two grounds. First, they deny that it is aimed at reducing competition. To the extent that Superduper Electronics has any market power, it can exert that power through the wholesale price, rather than through resale price maintenance. o Moreover, Superduper has no incentive to discourage competition among its retailers. Indeed, because a cartel of retailers sells less than a group of competitive retailers, Superduper would be worse off if its retailers were a cartel. Second, economists believe that resale price maintenance has a legitimate goal. Superduper may want its retailers to provide customers with a pleasant showroom and a knowledgeable sales force. o Yet, without resale price maintenance, some customers would take advantage of one store’s service to learn about the Blu-ray player’s special features and then buy the item at a discount retailer that does not provide this service. To some extent, good service is a public good among the retailers that sell Superduper products. The example of resale price maintenance illustrates an important principle: Business practices that appear to reduce competition may in fact have legitimate purposes. This principle makes the application of the competition laws all the more difficult. The economists, lawyers, and judges in charge of enforcing these laws must determine what kinds of behaviour public policy should prohibit as impeding competition and reducing economic well-being. o Predatory Pricing = Selling a product below cost to drive competitors out of the market. Firms with market power normally use that power to raise prices above the competitive level. But should policymakers ever be concerned that firms with market power might charge prices that are too low? 41 Imagine that a large airline, call it Coyote Air, has a monopoly on some route. Then Roadrunner Express enters and takes 20 percent of the market, leaving Coyote with 80 percent. In response to this competition, Coyote starts slashing its fares. Some competition analysts argue that Coyote’s move could be anticompetitive: The price cuts may be intended to drive Roadrunner out of the market so Coyote can recapture its monopoly and raise prices again. Such behaviour is called predatory pricing. o Tying = A form of price discrimination in which one good, called the base good, is tied to a second good called the variable good. The practice of tying is banned under the civil provisions of the Competition Act. The commonly used justification for the ban goes as follows: Imagine that The Avengers is a blockbuster, whereas Hamlet is an unprofitable art film. By tying, the studio could use the high demand for The Avengers to force theatres to buy Hamlet. It seems that the studio could use tying as a mechanism for expanding its market power. Many economists are skeptical of this argument. Imagine that theatres are willing to pay $20 000 for The Avengers and nothing for Hamlet. Then the most that a theatre would pay for the two movies together is $20 000—the same as it would pay for The Avengers by itself. Forcing the theatre to accept a worthless movie as part of the deal does not increase the theatre’s willingness to pay. Make money cannot increase its market power simply by bundling the two movies together. In the News: Bid-Rigging in Sewers is Dirty Business = Another type of noncompetitive business practice is known as bidrigging. Bid-rigging occurs when several parties agree to a predetermined set of bids on a contract to give the appearance of a competitive bidding process. It is a form of price-fixing and collusion that is illegal in most countries, including Canada. This article discusses a recent bid-rigging case in Canada. It also illustrates the prisoners’ dilemma at work, as firms involved in a bid-rigging collusion have an incentive to rat out their co-conspirators. Case Study: Is More Always Better? = As suggested above, public policy regarding oligopolies can be complicated, and overly simplistic analysis can lead to questionable conclusions. o A recent example of this in Canada is the federal government’s approach to the wireless industry. Currently the wireless market in Canada is dominated by the “big three”: Rogers, Telus, and Bell. Critics of the structure of the wireless industry in Canada point to our high average revenue per user and the low wireless penetration rate (mobile connections per capita) as evidence of insufficient competition. They say that the low penetration rate is due to high prices, and that those prices are high because of a cozy oligopoly. The solution to this problem, they say, is to encourage more entry into the industry: “More is surely better.” o They conclude that while consumers might gain in the short run from lower prices, everyone is likely worse off in the long run from the misallocation of spectrum, the reduction in scale of carriers, and the associated reduction in incentives to invest in expanding the network. Unit 10 – The Market for the Factors of Production Chapter 18: The Markets for the Factors of Production (p. 370-390) Introduction The three most important factors of production are labour, land, and capital. o Production of commodities requires inputs, and these inputs have to be paid for—wages are paid for labour, interest is paid on capital, and rent is paid on land. The prices of these inputs are determined by the interaction of their market demand and supply. o In Unit 10, we will gain an understanding of the basic theory for the analysis of factor markets and how the prices of these factors are determine The supply and demand for labour, land, and capital determine the prices paid to workers, landowners, and capital owners. To understand why some people have higher incomes than others, therefore, we need to look more deeply at the markets for the services they provide. Factors of Production = the inputs used to produce goods and services 42 o Labour, land, and capital are the three most important factors of production In many ways factor markets resemble the markets for goods and services we analyzed in previous chapters, but they are different in one important way: The demand for a factor of production is a derived demand. That is, a firm’s demand for a factor of production is derived from its decision to supply a good in another market. o Most labour services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. To understand labour demand, we need to focus on the firms that hire the labour and use it to produce goods for sale. By examining the link between the production of goods and the demand for labour to make those goods, we gain insight into the determination of equilibrium wages. We assume that a typical firm is: o Competitive - A competitive firm is a price taker. The firm takes the price and the wage as given by market conditions. o Profit-Maximizing - the firm does not directly care about the number of workers it has or the number of a good it produces. It cares only about profit, which equals the total revenue from the sale of the good minus the total cost of producing them. The firm’s supply of goods and its demand for workers are derived from its primary goal of maximizing profit. Neoclassical Theory of Distribution = the amount paid to each factor of production depends on the supply and demand for that factor o The demand, in turn, depends on that particular factor’s marginal productivity. In equilibrium, each factor of production earns the value of its marginal contribution to the production of goods and services. o The neoclassical theory of distribution is widely accepted. Most economists begin with the neoclassical theory when trying to explain how the Canadian economy’s $1.9 trillion of income is distributed among the economy’s various members. Objectives o discuss the demand for labour and the marginal product of labour, and explain what causes shifts in the labour demand curve. o discuss the supply of labour and the shift in the labour supply curve, and explain how the labour market reaches equilibrium. o explain the link between labour productivity and wages. o discuss how the other factors of production-land and capital-are compensated for their roles in the production process and how a change in any of these factors will affect the other factors of production. Summary o The economy's income is distributed in the markets for the factors of production. The three most important factors of production are labour, land, and capital. o The demand for factors, such as labour, is a derived demand that comes from firms that use the factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. o The supply of labour arises from individuals' tradeoff between work and leisure. An upward-sloping labour supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. o The price paid to each factor adjusts to balance the supply and demand for that factor. Because factor demand reflects the value of the marginal product of that factor, in equilibrium, each factor is compensated according to its marginal contribution to the production of goods and services. o Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors. 10.1.1. Production Function and the Marginal Product of Labour Labour markets perform the same function as product or commodity markets. They allow buyers and sellers to interact to establish an equilibrium price and quantity. Firms have to decide how many workers to hire. If a firm hires too many workers, then it is spending more money than it needs to, and if it hires too few workers, then it is losing out on additional output that could be profitable to produce. o To make its hiring decision, the firm must consider how the size of its workforce affects the amount of output produced. The demand for factors of production, including labour, is a derived demand; that is, the demand for labour and other factors of production depends on the demand for the goods and services produced by these factors. In equilibrium, each factor is compensated according to its marginal contribution to the production of final goods and services. 43 Firms try to maximize profits (total revenue – total cost) and will hire additional units of labour until they reach the point at which the extra revenue that comes from labour is equal to the extra cost of hiring that worker. We can say that the firm’s demand for labour depends on its production function or the relationship between the quantity of inputs and the quantity of output. o Ex. Binkle, Inc., which produces and sells bottles in a perfectly competitive market at a price of $0.50. Binkle hires its labour in a perfectly competitive labour market at an hourly wage of $20. The relationship between the quantity of labour hired and the amount of output produced per hour is presented in Table 10.1. o If the wage for workers is $20 per hour, the firm will only hire five workers. For the first five workers, the value of the marginal product is greater than the wage, so the marginal profit from hiring these workers is positive. For the sixth worker, the value of the marginal product is equal to the wage, so the marginal profit from hiring this worker would be zero. o The third column gives the marginal product of labour = the increase in the amount of output from an additional unit of labour o We can see the firm's decision graphically in Figure 10.1 . The value of the marginal product curve will slope downward because of the diminishing marginal product of labour, and the wage is depicted by a horizontal line because the firm is a price taker in the labour market; thus, a competitive, profit-maximizing firm hires workers up to the point at which the value of the marginal product of labour is equal to the wage. Because the firm chooses the quantity of labour at which the value of the marginal product equals the wage, the value-of-marginal-product curve is the firm's labour demand curve. If W is the wage and an extra unit of labour produces MPL units of output, then the marginal cost of a unit of output is MC = W/MPL. A profit-maximizing firm chooses the quantity of labour so that the value of the marginal product (P × MPL) is equal to the wage (W): P x MPL = W Divide both sides by MPL to get P = W/MPL Since W/MPL = MC, we have P = MC Ex. the “input” is the apple pickers and the “output” is the apples. The other inputs—the trees themselves, the land, the firm’s trucks and tractors, and so on—are held fixed for now. This firm’s production function shows that if the firm hires 1 worker, that worker will pick 100 bushels of apples per week. If the firm hires 2 workers, the two workers together will pick 180 bushels per week, and so on. o As the quantity of the input increases, the production function gets flatter, reflecting the property of diminishing marginal product. o Notice that as the number of workers increases, the marginal product of labour declines. That is, the production process exhibits diminishing marginal product. At first, when only a few workers are hired, they can pick the low-hanging fruit. As the number of workers increases, additional workers have to climb higher up the ladders to find apples to pick. Hence, as more and more workers are hired, each additional worker contributes less to the production of apples. For this reason, the production function in the graph becomes flatter as the number of workers rises. 44 The Value of the Marginal Product and the Demand for Labour Our profit-maximizing firm is concerned not about apples themselves but rather about the money it can make by producing and selling them. o As a result, when deciding how many workers to hire to pick apples, the firm considers how much profit each worker would bring in. Because profit is total revenue minus total cost, the profit from an additional worker is the worker’s contribution to revenue minus the worker’s wage. o To find the worker’s contribution to revenue, we must convert the marginal product of labour (which is measured in bushels of apples) into the value of the marginal product (which is measured in dollars). We do this using the price of apples. To continue our example, if a bushel of apples sells for $10 and if an additional worker produces 80 bushels of apples, then the worker produces $800 of revenue. Value of the Marginal Product = the marginal product of an input times the price of the output o Because the market price is constant for a competitive firm while the marginal product declines with more workers, the value of the marginal product diminishes as the number of workers rises. Economists sometimes call this column of numbers the firm’s marginal revenue product: It is the extra revenue the firm gets from hiring an additional unit of a factor of production. o The figure graphs the value of the marginal product. The curve lopes downward because the marginal product of labour diminishes as the number of workers rises. The figure also includes a horizontal line at the market wage. To maximize profit, the firm hires workers up to the point where these two curves cross. Below this level of employment, the value of the marginal product exceeds the wage, so hiring another worker would increase profit. Above this level of employment, the value of the marginal product is less than the wage, so the marginal worker is unprofitable. Thus, a competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. o This figure shows how the value of the marginal product (the marginal product times the price of the output) depends on the number of workers. The curve slopes downward because of diminishing marginal product. For a competitive, profit-maximizing firm, this value-of-marginal product curve is also the firm’s labour demand curve. the value-of-marginal-product curve is the labour demand curve for a competitive, profit-maximizing firm. 10.1.2. Shifts in Labour Demand Curve 3 things that might shift the labour demand curve o The output price. An increase in the price of the product raises the value of the marginal product of labour and, therefore, increases the demand for labour, whereas a decrease in the price of the product lowers the value of the marginal product of labour and, therefore, decreases the demand for labour. The value of the marginal product is marginal product times the price of the firm’s output. Thus, when the output price changes, the value of the marginal product changes, and the labour demand curve shifts. An increase in the price of apples, for instance, raises the value of the marginal product of each worker who picks apples and, therefore, increases labour demand from the firms that supply apples. Conversely, a decrease in the price of apples reduces the value of the marginal product and decreases labour demand. o Technological change. Technological advance raises the marginal product of labour, which in turn raises the value of the marginal product of labour; thus, any new technology will lead to an increase in the demand for labour. It is also possible for technological change to reduce labour demand-for example, the invention of a cheap robot that reduces the marginal product of labour. Economists call this labour-saving technological change. Labour-saving technological change = It is also possible for technological change to reduce labour demand. The invention of a cheap industrial robot, for instance, could conceivably reduce the marginal product of labour, shifting the labour demand curve to the left. History suggests, however, that most technological progress is instead labour augmenting. Such technological advance explains persistently rising employment in the face of rising wages: Even though o 45 wages (adjusted for inflation) increased by over 100 percent during the last half-century, firms nonetheless increased by over 50 percent the amount of labour they employed. The supply of other factors. The quantity available of one factor can affect the marginal product of another; therefore, any change in the availability of another factor will likely affect the demand for labour. 10.2.1. The Labour Supply Let's consider how shifts in the supply of labour impact the hiring of workers and wage levels. The labour supply arises from individuals' tradeoffs between work and leisure. Any hours spent working are hours that could be devoted to something else like studying or watching television. Economists refer to all time not spent working for pay as "leisure," and the opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour had been spent at work. Therefore, as the wage increases, so does the opportunity cost of leisure. The textbook lists three things that might cause a shift in the supply of labour (p. 378): o changes in tastes ex. In 1950, 34 percent of working-age women were employed at paid jobs or looking for work. In 2014, the number had risen to 62 percent. There are, of course, many explanations for this development, but one of them is changing attitudes toward work. A generation or two ago, it was the norm for women to stay at home while raising children. Today, family sizes are smaller, and more mothers choose to work. o changes in alternative opportunities The supply of labour in any one labour market depends on the opportunities available in other labour markets. Ex. If the wage earned by pear pickers suddenly rises, some apple pickers may choose to switch occupations. The supply of labour in the market for apple pickers falls. o Immigration Movement of workers from region to region, or country to country, is an obvious and often important source of shifts in labour supply. When immigrants come to Canada, for instance, the supply of labour in Canada increases and the supply of labour in the immigrants’ home countries contracts. In fact, much of the policy debate about immigration centres on its effect on labour supply and, thereby, equilibrium wages in the labour market. Just like a commodity market, the equilibrium wage of labour and the number of employed workers will depend on the intersection of the demand and supply curve of labour. Each firm's goal is to maximize profit and it will, therefore, hire workers to that level at which marginal revenue is equal to the value of its marginal product. Thus, any event that changes the supply or demand for labour must change the equilibrium wage and the value of the marginal product by the same amount, because these must always be equal. o The labour supply curve reflects how workers’ decisions about the labour– leisure tradeoff respond to a change in that opportunity cost. An upward-sloping labour supply curve means that an increase in the wage induces workers to increase the quantity of labour they supply. Because time is limited, more hours of work means less leisure. That is, workers respond to the increase in the opportunity cost of leisure by taking less of it. It is worth noting that the labour supply curve need not be upward sloping. o Imagine you got that raise from $15 to $20 per hour. The opportunity cost of leisure is now greater, but you are also richer than you were before. You might decide that with your extra wealth you can now afford to enjoy more leisure. That is, at the higher wage, you might choose to work fewer hours. 10.2.2. Equilibrium in the Labour Market So far, we have established two facts about how wages are determined in competitive labour markets: o 1) The wage adjusts to balance the supply and demand for labour. o 2) The wage equals the value of the marginal product of labour. The figure here shows the labour market in equilibrium. o The wage and the quantity of labour have adjusted to balance supply and demand. When the market is in this equilibrium, each firm has bought as much labour as it finds profitable at the equilibrium wage. That is, each firm has followed the rule for profit maximization: It has hired workers until the value of the marginal product equals the wage. Hence, the wage must equal the value of the marginal product of labour once it has brought supply and demand into equilibrium. 46 Any event that changes the supply or demand for labour must change the equilibrium wage and the value of the marginal product by the same amount, because these must always be equal. Shifts in Labour Supply o An upward-sloping labour supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. o Let’s assume that the number of labourers willing to work goes up; the supply of labour curve will then shift to the right, putting pressure on the wage level to decline. This makes it profitable for firms to hire more workers. As firms increase the number of workers, the marginal product will decline and so will the marginal revenue. The additional revenue now being received by the firms will be lower than what was received earlier. o In the figure, the supply of labour shifts to the right from S1 to S2. At the initial wage W1, the quantity of labour supplied now exceeds the quantity demanded. This surplus of labour puts downward pressure on the wage of apple pickers, and the fall in the wage from W1 to W2 in turn makes it profitable for firms to hire more workers. As the number of workers employed in each apple orchard rises, the marginal product of a worker falls, and so does the value of the marginal product. In the new equilibrium, both the wage and the value of the marginal product of labour are lower than they were before the influx of new workers. Shifts in Labour Demand o Let us examine the shifts in labour demand by highlighting important details from Figure 10.2 (adapted from textbook, p. 382). o An increase in the demand for labour will shift the labour demand curve to the right, creating a shortage at the original wage. This will put upward pressure on the equilibrium wage, causing the quantity of labour supplied to increase. The value of the marginal product rises because VMPL = P × MPL (and either P or MPL have risen to cause the demand for labour to rise). This implies that both the wage and the value of the marginal product are now higher. A decrease in the demand for labour will shift the labour demand curve to the left, creating a surplus at the original wage; this will put downward pressure on the equilibrium wage, causing the quantity of labour supplied to decrease. The value of the marginal product falls because VMPL = P × MPL (and either P or MPL has fallen to cause the demand for labour to decline). This implies that both the wage and the value of the marginal product are now lower. Case Study: Productivity and Wages = One of the ten principles of economics in Chapter 1 is that our standard of living depends on our ability to produce goods and services. We can now see how this principle works in the market for labour. In particular, our analysis of labour demand shows that wages equal productivity as measured by the value of the marginal product of labour. Put simply, highly productive workers are highly paid, and less productive workers are less highly paid. o Productivity growth varies over time o Monopsony The previous analysis clearly tells us that wage levels depend on the marginal product of labour; thus, those workers who are highly productive receive a higher wage level and less productive workers receive lower wages. In fact, for many countries, there is a link between productivity growth and increase in wages. Countries that have seen an increase in productivity have also seen an increase in wages. And those countries that have seen a decrease in productivity have seen a decline in wages. Basically, overall productivity increases when workers have access to o more equipment and work space (physical capital), o education and skills training (human capital), and o sophisticated technologies (technological knowledge). A monopsony consists of one buyer in the market and several sellers, as compared to a monopoly, in which there is only one seller and many buyers. For example, a monopsony can exist in a small town that relies on one industry as its main employer. 47 FYI: imagine the labour market in a small town dominated by a single large employer. That employer can exert a large influence on the going wage, and it may well use that market power to alter the outcome. Such a market in which there is a single buyer is called a monopsony. o A monopsony (a market with one buyer) is in many ways similar to a monopoly (a market with one seller). o a monopsony firm in a labour market hires fewer workers than would a competitive firm; by reducing the number of jobs available, the monopsony firm moves along the labour supply curve, reducing the wage it pays and raising its profits. Thus, both monopolists and monopsonists reduce economic activity in a market below the socially optimal level. In both cases, the existence of market power distorts the outcome and causes deadweight losses. The Other Factors of Production: Land and Capital Land and capital are the other factors of production. o For land and capital, as for labour, their marginal product determines their rent and interest payments—these payments depend on their demand and supply. o For a profit-maximizing firm, each factor of production payment will be equal to the value of the marginal product for that factor; thus, each factor of production receives its values of marginal product. Any change in the price of labour, land, or capital will bring about changes in the amount of the other inputs. If office space (land) for a bakery is scarce, the quantity of ovens and workers will also be affected. We can, therefore, understand that the productivity of each factor of production is interdependent—any change in the quantity of one will affect the other factors of production. Capital = the equipment and structures used to produce goods and services o The economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services. o For our apple firm, the capital stock includes the ladders used to climb the trees, the trucks used to transport the apples, the buildings used to store the apples, and even the trees themselves. Equilibrium in the Markets for Land and Capital o What determines how much the owners of land and capital earn for their contribution to the production process? Before answering this question, we need to distinguish between two prices: the purchase price and the rental price. The purchase price of land or capital is the price a person pays to own that factor of production indefinitely. The rental price is the price a person pays to use that factor for a limited period of time. In the figure, the rental price of land, shown in panel (a), and the rental price of capital, shown in panel (b), are determined by supply and demand. Moreover, the demand for land and capital is determined just like the demand for labour. That is, when our apple-producing firm is deciding how much land and how many ladders to rent, it follows the same logic as when deciding how many workers to hire. For both land and capital, the firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. Thus, the demand curve for each factor reflects the marginal productivity of that factor. As long as the firms using the factors of production are competitive and profit-maximizing, each factor’s rental price must equal the value of the marginal product for that factor. Labour, land, and capital each earn the value of their marginal contribution to the production process . Now consider the purchase price of land and capital. The rental price and the purchase price are related: Buyers are willing to pay more for a piece of land or capital if it produces a valuable stream of rental income. And, as we have just seen, the equilibrium rental income at any point in time equals the value of that factor’s marginal product. Therefore, the equilibrium purchase price of a piece of land or capital depends on both the current value of the marginal product and the value of the marginal product expected to prevail in the future. 48 Linkages among the Factors of Production We have seen that the price paid to any factor of production—labour, land, or capital—equals the value of the marginal product of that factor. The marginal product of any factor, in turn, depends on the quantity of that factor that is available. Because of diminishing marginal product, a factor in abundant supply has a low marginal product and thus a low price, and a factor in scarce supply has a high marginal product and a high price. As a result, when the supply of a factor falls, its equilibrium factor price rises. When the supply of any factor changes, however, the effects are not limited to the market for that factor. In most situations, factors of production are used together in a way that makes the productivity of each factor dependent on the quantities of the other factors available for use in the production process. As a result, when some event changes the supply of any one factor of production, it will typically affect not only the earnings of that factor but also the earnings of all the factors as well. An event that changes the supply of any factor of production can alter the earnings of all the factors. The change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor. FYI: What is Capital Income? = o Labour income is an easy concept to understand: It is the paycheque that workers get from their employers. o Capital is paid according to the value of its marginal product, regardless of whether this income is transmitted to households in the form of interest, dividends, or capital gains.