Exam II
Production, Cost and Market Structures
Short Run Production
 Fixed Inputs
 Do not change with quantity produced
 Variable Inputs
 Do change with quantity produced
 This will be number of workers in our examples
Short Run Production
 Short Run
 At least one input is fixed
 Long Run
 All inputs are variable
Short Run Production
 Consider the following
example…
 Q measures production
 Marginal Product

ΔTP/
ΔL
 Average Product
 TP/L
L
Q
MPL
APL
0
0
---
---
1
3
3
3
2
8
5
4
3
15
7
5
4
20
5
5
5
23
3
4.6
Short Run Production
 These are the “typically shaped curves”
 Teamwork and Specialization
 Increasing MPL
 Steepening TP
 Crowding of the Fixed Input
 Decreasing MPL
 Flattening TP
Short Run Production
 Marginals and Totals
 Marginal is the slope of the total
 Works with any value (product, cost, etc.)
 Example…
Short Run Costs
 Fixed Costs (FC)
 Tied to Fixed Inputs
 Will not vary with quantity
 Variable Costs (VC)
 Tied to Variable Inputs (Labor)
 Will vary with quantity
 FC + VC = Total Costs (TC)
Suppose my fixed input costs $20
Costs of Production
Suppose each worker costs $10
L
Q
FC
VC
TC
MC
AFC
AVC
ATC
0
0
20
0
20
---
---
---
---
1
3
20
10
30
3.33
6.67
3.33
10
2
8
20
20
40
2
2.50
2.50
5
3
15
20
30
50
1.43
1.33
2
3.33
4
20
20
40
60
2
1
2
3
5
23
20
50
70
3.33
0.87
2.17
3.04
Costs of Production
 FC, VC, and TC
TC
$
VC
Difference here is FC
FC
Q
Costs of Production
 AFC
$
AFC
Q
Costs of Production
 MC, AVC, and ATC
$
MC
ATC
AVC
Difference is AFC
Difference is AFC
Minimum of
ATC and
AVC
Q
Short Run Production
 Now look at the AVC and ATC curves
 Also look at the value of the MC curve
 Marginal pulls the average
 Only crossing point is at minimum/maximum of the average
MPL and MC
 Look again at the table
 Note that as MPL increases, MC decreases
 MC and MPL are “opposites”
 As you get more production out of each worker, your
additional cost per unit decreases (and vice versa)
Putting the curves together
 If we use these two facts
 Marginal cost (or product) is the slope of total cost (or product)
 Marginal cost and marginal product are “opposites”
 We can use this to determine the shape of MC, TC, MP, and
TP if we only know one
 For example…
Profit
 When economists say “zero profit”, the definition is slightly
different
 Economic Profit = TR – EC – IC
 TR = Total Revenue
 EC = Explicit Costs
 IC = Implicit Costs
 Accounting Profit = TR – EC
Profit
 Explicit Costs
 Any cost that causes money to change hands
 Taxes/Wages/Utilities/Supplies
 Depreciation
 Interest on a loan (not the principle)
 Implicit Costs
 Value of “lost opportunities”
 Lost income from a job
 Lost interest
 Money you “Could Have Earned”
Profit
 Example…
 Economic Profit < Accounting Profit
 Econ. Profit tells Rate of Return
 EP > 0 → Above Normal
 EP = 0 → Normal
 EP < 0 → Below Normal
Market Structures
 Perfect Competition
 Monopolistic Competition
 Oligopoly
 Monopoly
Perfect Competition
 Characteristics
 Very small firm
 Large number of firms
 Identical (homogeneous) product
 Free entry and exit
 Industry-Level advertising
 Example: Agriculture
Perfect Competition
 The goal of firms is to maximize profit
 How to maximize profit?
 MR=MC
 Need to find marginal revenue
 Finding marginal revenue in PC…
Perfect Competition
TR=P*q=MR*q
Total Profit is the difference, or
the area that is in one but not
both…
TC=ATC*q
P
S
$
MC
This is negative,
so this firm is
losing money
ATC
AVC
Pe
MR=d
D
Q
q*
Q
Perfect Competition
 Since this firm is losing money, it should shut down right?
 “Not so fast!”
 What do you lose if you shut down?
 Fixed costs
Perfect Competition
Clearly, the loss from producing is
smaller than shutting down
This is what the firm loses if it
produces…
P
S
Firm loses FC if it shuts down…
$
MC
ATC
AVC
Pe
MR=d
This is AFC
And FC=AFC*Q
D
Q
q*
Q
Perfect Competition
 Positive Profit → Continue to Produce
 Zero Profit → Continue to Produce
 Negative Profit
 If P (or MR) ≥ AVC → Continue to Produce
 This means covering some of FC
 If P (or MR) < AVC → Shut Down
Perfect Competition
 What happens in the Long-Run if firms are making a loss?
 Some firms will shut down because of free exit
 Market Supply decreases, shifting supply to the left
 Drives price upwards to a particular point…
Perfect Competition
Now there are no losses driving firms out
of the market
P
S
$
MC
ATC
ATC=AVC
AVC
Pe
MR=d
D
Q
q*
Q
Perfect Competition
 What if there is positive profit?
 This will attract new firms, and they will enter because of free
entry
 Increase supply, shift to the right
 Drives price down to a particular point…
Perfect Competition
If positive profit attracts firms, and negative profit drives firms
away, what must profit be to be stable?
LR Profit = 0
How do we achieve this?
PeLR = minimum of ATC
Monopoly
 P.C. is one extreme, monopoly is the other
 Most markets fall somewhere in between
 Monopolistic Competition
 Oligopoly
Monopolistic Competition
 Characteristics
 Fairly small firms
 Fairly large number of firms
 Mildly differentiated product
 Small barriers to entry
 Advertising at firm level
 Example: Walk around the mall
Oligopoly
 Characteristics
 Fairly large firms
 Fairly small number of firms
 Somewhat unique product
 Higher barriers to entry
 Advertising at firm level
 Example: Automobiles
Monopoly
 Characteristics
 Large-sized firm
 Single firm
 Unique product
 No entry
 P.R. advertising
 Example: AmerenUE
Monopoly
 How does a monopolist find the profit-maximizing quantity?
 Same way as anyone else
 Produce where MR=MC
 Finding MC
 Market Supply
 Only producer
 Finding MR
 Example…
Monopoly
S =MC
P
Markup = P – MC
Measures Market
Power
Markup
PM
RM and DWL?
MC
RM
QM
MR
Qe
D
Q
Monopoly
 Only firm that can earn positive profit (above normal rate of
return) in long-run
 “No Entry”
 Where does monopoly derive its market power?
 Barriers to entry are insurmountable
Barriers to Entry
 Control of Resource
 OPEC, DeBeers
 Government Creation/License
 High Fixed Costs
 Copyright Protection
 Patents
 These are how all markets (not PC) restrict to at least some
degree entry/exit by other firms
Monopoly
 Problems with Monopoly
 RM, DWL, and higher prices
 Less product innovation
 Less customer service
 Simply put, if you’re the “only game in town”, you have no
incentive to improve.
Monopoly
 Advantage of Monopoly
 Natural Monopoly
 High Fixed Costs relative to Variable Costs
 Example…
 Patent Protection
 Recoup costs of R&D
 “To promote the Progress of Science and useful Arts, by securing for
limited Times to Authors and Inventors the exclusive Right to their
respective Writings and Discoveries;” -Article I, US Constitution
 House, MD
 Copyright
 Incentive to Create
Oligopolies
 Characterized by a few sellers
 Each firm’s decision affects other firms
 P.C. – Firms too small
 Mono. – Only one firm
 Would prefer the cartel outcome
 This is where the “two” act as a monopoly
Oligopolies
 This outcome is unstable
 Why don’t all of you get together and bomb the exam to build
up the curve?
 Both sides have incentive to cheat
 Oligopolistic decisions can be modeled using Game Theory
 Study of how people make strategic decisions
 Ocean’s Twelve
Elements of Game Theory
 Players or actors
 Strategies
 Payoffs or outcomes
 With these, we can set up a Payoff Matrix
Game Theory Terms
 Dominant Strategy
 Move that is best for an actor regardless of other actors choices
 This results in a most-likely outcome
 Does Linas/Basher have D.S.?
 Nash Equilibrium
 Outcome where neither side has incentive to “move”
 Does N.E. exist for this situation?
Prisoners’ Dilemma
 Classic example of game theory
 Case where the most-likely outcome is not the best overall
outcome for both parties
 Is Linas and Basher’s situation a Prisoners’ Dilemma?
 Yep.
Other Games
 Matching Pennies Game
 Telephone Game
 Advertising Game