Market Structure and
the Behavior of Firms
Perfect Competition vs Monopoly
Market Structures
Many
Perfect
Competition
Less
Number of Competitors
Monopolistic
Competition
Market Control
Oligopoly
One
Monopoly
More
Behavior of Firms
Assume firms want to maximize profit
 = TR – TC
TR = Total Revenue = P∙q
TC = Total Economic Cost
Economic Cost = Explicit Cost + Implicit Cost
Technological Constraints
 Production Function
_
q = F(L, K)
Variable input
q = output
L = labor
K = capital
F(·) represents technology
Fixed input
Lab Experiment 3: Widget Production
Measures of Productivity
 Total Product
q = F(L, K)
Average Product
AP = q/L
Marginal Product
MP = Δq/ ΔL
Note: Diminishing Marginal Returns (DMR)
When there is at least one fixed input,
eventually a point is reached at which the
marginal product of an additional worker
begins to fall.
Productivity Graphs
DMR
output
Slope = MPL = ∆q/ ∆L
∆q
q/L
TP
∆L
AP
L1
L2 labor
labor
L1
L2
When MP > AP then AP will rise
When MP < AP then AP will fall
MP
Short Run Costs
TC = FC + VC
Does not vary with output:
Rent
Utilities
Salaries
Property taxes
Insurance premiums
Varies with output:
Labor
Raw materials
Short Run Cost Curve Family
TC
$
VC
$
MC
ATC
AVC
FC
AFC
output
TC = FC + VC
output
ATC = AFC + AVC
MC =
ΔTC
Δq
Properties of the Cost Curves
 “Ross Perot” Equation
$
MC
w
MC 
MPL
$
MC
ATC
output
 Short Run Cost Curve Shifters




Change
Change
Change
Change
in
in
in
in
price of labor
price of capital
amount of capital
technology
AVC
q/L
AFC
output
MP
labor
Long Run Costs
What is the optimal size for a factory?
$
ATC1
ATC2
ATC4
ATC3
q2
LRAC
output
Long Run Average Cost Curve
$
ATC3
LRAC
Coordination/Communication
Problems
Specialization
qMES
output
EOS: double the inputs, output more than doubles LRAC falls
DOS: double the inputs, output less than doubles  LRAC rises
Perfect Competition: Price Taker Model
 Characteristics of the Industry
 Large number of small buyers/sellers
 Homogeneous product
 Free entry/exit
 Perfect information
 firms are price takers
$
S
MR = ΔTR / Δq
$
P1
P = MR
D
Q1
Industry
Quantity
quantity
Firm
Maximizing Profit
 = TR – TC
 = Pq - [FC + VC]
$
MC
MR
$60 = P1
What output should the firm produce?
 produce until MR = MC
 If MR > MC  produce more
 If MR < MC  produce less
q1 = 300
quantity
I want you
to maximize profit
What is TR = ?
What is TC = ?
Profit and Loss Diagrams
 Positive Profit:  > 0








=
=
=
=
Pq – (ATC)q
(P-ATC)q
(60-50)300
$3000
$
MC
ATC
$60 = P1
MR1
$50 = ATC
$35 = P2
MR2
 Negative Profit
  = (35-50)250
  = -$3750
 Zero Profit?
q2 = 250
q1 = 300
quantity
Sometimes it’s better to stay open and lose a little bit…
 Temporary Shut Down: q = 0
  = Pq – (FC +VC)
  = 0 – (FC + 0)
  = - FC
$
MC
ATC
AVC
$35 = ATC1
Fixed Cost = $30,000
 Stay open if TR > VC
 Shut down if TR < VC
$25 = P1
$20 = AVC1
MR1
q1 = 2000
quantity
Stay open:  = -$20,000
Shut down:  = -$30,000
Shutdown recap
$
MC
ATC
AVC
PSD = Min AVC
qSD
 Shut down if TR < VC
Pq < (AVC)(q)
P < AVC
quantity
Note:
The portion of the
MC curve above
the shutdown
point is the firm’s
supply curve
How should a business react if…
Price rises?
Marginal costs rise?
Fixed costs rise?
$
MC
ATC
AVC
P1
MR1
q1
quantity
Long Run Equilibrium
• A = TR – Explicit Costs
Firm =
Economy
• E = A - Implicit Costs
A= 9%
7%
E= 3%
0%
A= 6%
7%
E= 0%
A= 6%
7%
E= 0%
A= 6%
7%
E= 0%
LRE: E = 0
if E > 0  entry occurs
if E < 0  exit occurs
Long Run Adjustment Process
$
$
S1
P2
MC
ATC
S2
MR2
LRS
P1
D1
Q1
Q3
MR1
D2
Quantity
Industry
q1 q2
quantity
Firm
At P1: each firm produces q1 and earns E = 0
Demand rises to D2: causes price to rise to P2
At P2: each firm produces q2 and earns E > 0
Since E > 0 , new firms will enter: supply shifts to S2
Price will fall back to P1 and E = 0
Long run supply curve
for a constant cost
industry is horizontal
MES and Market Structure
$
Industry 1: room for 8 firms
Industry 2: room for 4 firms
Industry 3: room for 2 firms
Industry 4: room for 1 firm
“natural monopoly”
ATC1
ATC2
ATC4
ATC3
P1
D
⅛Q1 ¼Q1
½Q1
Q1
Output
The greater MES is as a share of market demand, the fewer the number of firms
MES Plant Size Versus Market Concentration
Industry
MES/S
4x(MES/S)
CR4
Beer Brewing
3.4
13.6
40
Cigarettes
6.6
26.4
81
Broad-woven cotton and synthetic fabrics
0.2
0.8
36
Paints, varnishes, and lacquers
1.4
5.6
22
Petroleum refining
1.9
7.6
33
Shoes (other than rubber)
0.2
0.8
26
Glass containers
1.5
6.0
60
Cement
1.7
6.8
29
Integrated wide-strip steel works
2.6
10.4
48
Ball and roller bearings
1.4
5.6
54
14.1
56.4
73
1.9
7.6
61
Refrigerators and freezers
Storage batteries
Source: Stephen Martin, “Industrial Economics,” 2e, MacMillan (1994), p240.
Monopoly
A Price Searcher Model
Monopoly
 Pure monopolist has no close
substitutes
 Sherman Act (1890) “anti-trust” law
 Section 1: Every contract,
combination…or conspiracy, in restraint
of trade…is declared to be illegal"
 Section 2: "Every person who shall
monopolize, or attempt to
monopolize…shall be deemed guilty of a
felony”
Relevant Market
 Product Market
 DuPont (1956)
 Cellophane
 Flexible wrapping paper
 Alcoa (1945)
Cellophane
75%
 Primary aluminum
 All aluminum
Butcher
Paper
Primary
90%
Aluminum
Foil
Newspaper
Flexible
Wrapping Paper
Secondary
20%
Imported
All Aluminum
33%
Relevant Market
 Geographic Market




Local
Regional
National
Global
Local
Regional
National
Global
Barriers to Entry
 Economies of Scale
$
 “natural monopoly”
 Control over key inputs
 Alcoa--bauxite
 DeBeers
 GE Superabrasives (Diamond Innovations)
LRAC
Quantity
…more barriers to entry
Government restrictions
 Patents
20 year duration
 Copyrights
Life of artist plus 70 years
 Licenses
Occupational licenses: doctors, lawyers, accountants,
engineers
For what purpose: Public health or private interest?
 Franchises
Taxi medallions: 12,779
$336,000 per medallion
Source: The New York City Taxicab Fact Book, Schaller Consulting, March 2006. Available at http://www.schallerconsult.com/taxi/taxifb.pdf
Profit Maximizing Behavior
Assume that Monopolist
charges single price to all
buyers
$
TR = $20,000
TR = $21,000
π = TR – TC
π = P(Q)*Q – TC
MR = ∆TR/ ∆Q
$40
Loss
$30
Gain
D
MR
MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q
500
Quantity
700
MR = [6000 – 5000]/200 = $1000 / 200
MR = $5
MR < P
MR, P, and Elasticity
MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q
MR = P [ 1 – 1/E ]
 Note:
 If E > 1 then MR > 0
 If E < 1 then MR < 0
 If E = 1 then MR = 0
 If E = ∞ then MR = P
[Perfect Competition]
Optimal Output and Price
 π-max rule:
$
 Set output where MR = MC
 Set price off of demand curve
MC
ATC
$30
$20
TR = P*Q = ($30)(700)
= $21,000
D
TC = ATC*Q = ($20)(700) = $14,000
π = TR - TC
= $ 7,000
MR
700
Quantity
Optimal Output and Price
 π-max rule:
$
 Set output where MR = MC
 Set price off of demand curve
MC
ATC
 How will monopolist
react to:
 an increase in marginal cost?
 an increase in fixed cost?
 an increase in demand?
$30
$20
D
MR
700
Quantity
Welfare Comparison: PC vs. Monop
 Perfect Competition: PC, QC
$
 Monopoly: PM, QM
A
PM
B
C
MC = ATC
PC
PC
CS
PS
Social Welfare
DWL
A+B+C
--A+B+C
---
D
Monop
A
B
A+B
C
MR
QM
Qc
Quantity
Price Discrimination
 Definition: price differentials that do not reflect
cost differentials
 Motivation: to increase profits by capturing more
consumer surplus
 Necessary Conditions
 Market Power
 Downward sloping demand curve
Arsenic ?
 Segment the market
 Demographics
 Usage rates
 Prevent resale
 Movie theatres
 Röhm-Haas: plastic molding compound
Industrial: $0.85/lb
Dentists: $22/lb
Types of Price Discrimination
 First Degree
$
 Charge each buyer their WTP
 Captures all CS and DWL
 Second Degree
 Quantity discounts
PM
 Third Degree
 Set prices according to price
elasticity
 Movie Theatre
PC
MC
D
MR
 MRA = MRK = MC
QM
MC = $4
Qc
MRA = PA[1 – 1/EA]
EA = 2
MRA = MC
EK = 5
PA[1 – 1/2] = 4
PA = $8
Charge higher price
to more inelastic group
Quantity
United States v. Microsoft (2000)
 Operating Systems




Windows
Macs
Linux
Java
90%
8%
---
 Application Software






Word
Excel
Powerpoint
Outlook
Access
Internet Explorer
“Bundling”