Topic 3A: Extremely Competitive Closed Markets
LECTURE NOTES
I. Price in Extremely Competitive Markets:
Firms in extremely competitive markets are price takers. They take price as given and
choose to produce output Q such that at Q, their marginal cost of producing Q = market
price P, i.e. MC(Q) = P. This is the profit maximizing price for a firm in this type of
market.
II. Overview of Various Measures of Cost:
1. Fixed cost F: cost that does not vary with the level of output, i.e. does not depend on
Q.
2. Sunk cost: portion of fixed cost that is not recoverable, that is cannot be recovered if
the firm stops operating. Examples: incorporation fee, legal expenses associated with
setting up a business, commission paid to real estate agent. Sunk cost is like spilt
milk: once it is sunk there is no use worrying about it (pour yourself another glass)
and it should not affect subsequent decisions.
3. Variable cost VC(Q): cost that varies or changes with changes in output. Example:
labor, cost of inputs, operations and maintenance costs.
4. Total cost TC(Q): Fixed cost + variable cost = F + VC(Q)
5. Average fixed cost AFC(Q): F/Q
6. Average variable cost AVC(Q): VC(Q)/Q
7. Average total cost ATC(Q): TC(Q)/Q.
Note: ATC(Q) is also = AFC(Q) + AVC(Q) = F/Q + VC(Q)/Q
8. Marginal cost MC(Q): change in total cost associated with a small change in the
level of output. MC(Q) = TC(Q)/Q
III. Economies of Scale
Scale economies exist if the average cost of production ATC(Q) falls as output Q
increases, i.e.: TC(Q+n)/(Q+n) < TC(Q)/Q, n = 1,2,3…..
ATC : the cost function exhibits economies of scale, i.e. the average cost per unit of
output decreases as the level of output increases.
ATC is constant: the cost function exhibits constant returns to scale
ATC: the cost function exhibits diseconomies of scale.
Causes for Economies of Scale:
 Increase in capacity with less than proportional rise in equipment cost. Many
examples of this in plant engineering and manufacturing processes.
 Fixed costs spread over a larger level of output: if fixed costs are a very large part
of the production cost, since they do not vary with the level of output, when the level
of output increases, the fixed costs will be spread over a larger output and the AC
will decline (as long as the variable costs do not increase drastically or the plant
reaches a point where output cannot be increased because the fixed plant has reached
its full productive capacity.)
 Economies of massed reserves: Manufacturing plants as well as most other
production facilities are configured to have extra capacity (or reserve capacity) in
case of breakdown. The larger the level of output or services produced the less
reserve capacity may be needed as a proportion of the total output. For example, the
number of repairmen a company must employ to maintain a certain level of service
in the case of a breakdown usually rises proportionately less than the increase in the
number of machines employed in the production process.
 Attract managers of higher ability
 Work force specialization: With a larger level of output, the production process can
be divided into specialized tasks and workers can be trained in those tasks. Example:
automobile assembly line. It’s the concept behind Adam Smith’s “division of labor”:
workers specialize in a certain type of labor and become very proficient at it. (But,
there may be drawbacks. See Charlie Chaplin in “Modern Times”)
Checks on Economies of Scale:
 Minimum efficient scale of technology
 Managerial diseconomies and higher monitoring costs when production increases
beyond a certain level.
IV. Economies of Scope
Definition: Are present if it is cheaper to produce 2 or more different products together
than separately.
Contributing Factors: Use of common inputs. For example, for a car manufacturer there
may be substantial economies of scope in producing small and large cars in the same
division. The manufacture of small and large cars uses many same inputs, including the
skills required to build the cars. On the other hand, manufacturing of trucks is often
handled in a separate division. An important common input is knowledge (information
about one product is relevant for the production of another closely-related product), using
same marketing and distribution skills, same accounting dept., etc.
Suppose:
Cost of producing 2 goods y1 and y2 together = C(y1,y2)
Cost of producing y1 alone = C(y1)
Cost of producing y2 alone = C(y2)
The measure or degree of economies of scope from producing both goods together is:
[C(y1) + C(y2)] – C(y1,y2)
C(y1,y2)
This is a measure of the relative increase in cost that would result if the products were
produced separately.
V. Choice of Plant Size and Type of Technology
What do costs depend on? The type and size of equipment and staff, technology
adopted, managerial skill, etc.
How do the managers/owners decide how large a plant to build and what type of
technology to adopt?
- Their assessment of present and future demand for their product;
- The cost of different size plants and technologies;
- The time and cost associated with training or hiring new people if a new technology is
adopted;
- What they expect their competitors to do;
- The firm’s objective;
- The time horizon
Individual Plant-Size ATC: This figure shows the ATC curve for 3 different plant sizes.
For low levels of output the smallest plant size is the cheapest. For larger sizes of output
the largest plant size is the cheapest. Which size plant the firm decides to build will
depend on all the things we mentioned above. Decisions regarding capital investments
are made in the short-term with expectations about the long term. Those
expectations may be correct or not. If they are correct the investment decisions will be
appropriate. If they are not the firm will find itself with obsolete equipment, too much
inventory, too little productive capacity or of the wrong kind, etc. and it will be at a
disadvantage relative to its competitors unless its competitors have made the same or
other mistakes and consumers don’t have other alternatives.
READINGS
1. Google, Facebook, Amazon, Ebay: Is the Internet Driving Competition or Market
Monopolization? International Economics and Economic Policy, February 2014, Vol.11,
Issue 1-2, pp. 49-61.
http://www.biblio.liuc.it:2383/ehost/pdfviewer/pdfviewer?vid=5&sid=4d926e25-3be64230-8a91-9f8ef772c2f1%40sessionmgr4002&hid=4109
2. (Optional Reading) Overemphasis on Perfectly Competitive Markets in
Microeconomics Textbooks, Journal of Economics Education, Volume 38, Issue 1,
Winter 2007, pp. 58-77
http://www.biblio.liuc.it:2383/ehost/pdfviewer/pdfviewer?vid=11&sid=4d926e25-3be64230-8a91-9f8ef772c2f1%40sessionmgr4002&hid=4109
SAMPLE PROBLEMS
Castellanza Movies is a movie theatre geared primarily to LIUC students. It has two
evening shows with ticket price of $10/movie. Since some students have free time during
the day, Castellanza Movies also offers one matinee show at 2pm for a reduced rate of
$6/movie. The total fixed costs of running the movie theatre are $500/day. The variable
costs associated with showing a movie is $300/movie. Ticket sales average 120 total
tickets/evening and 40 tickets/matinee.
a. Using the cost estimates and movie attendance figures, determine whether or not the
owner should continue its two evening shows and its matinee show.
b. What is the minimum ticket price that must be charged for matinee movies so that the
theatre will not lose money on these showings? (Assume that a small increase in the
matinee ticket price (less than 30%) will not affect matinee attendance.)
Answer:
a. In order to determine if the theatre should continue showing movies in the evening or
during the day (in the short run), compare the variable costs incurred for these movies
with the revenues they generate. Fixed costs are already considered sunk costs and
should not be factored into Castellanza Movies management’s decision.
Evening movies
Variable Cost of one movie = $300
Total Variable Cost for one evening (2 evening movies) = 2 x $300 = $600
Revenues generated from evening movies = tickets purchased x price/ticket = 120 x $10
= $1200
$1200 > $600, revenues exceed variable costs, therefore evening movies should continue.
Matinees
Total Variable Cost for matinee = $300
Revenues generated from matinee movie = tickets purchased x price/ticket = 40 x $6 =
$240
$240 < $300, variable costs exceed matinee revenues. Therefore, matinee movies
should be discontinued.
b. In order to continue the matinee showings, the theatre must charge enough per ticket
so that the revenues for a matinee are at least equal to the variable costs associated with
showing that movie.
Variable Cost for matinee = $300
So revenues generated from a matinee movie must at least equal $300.
So minimum matinee ticket price = $300/40 = $7.50.