Understanding the cost of acquiring the inputs used to produce outputs is part of every firm’s
strategy. This chapter focuses on how cost is defined, how cost varies with the output
produced, and how cost can be empirically estimated. An intuitive rule for minimizing the cost
of producing a given output is also developed.
8.1 The Nature of Cost
Cost is an important concept in both economics and accounting, but the definition of cost differs in the two
disciplines.
1. To an accountant, the cost of a resource is the actual cash outlay sexpended on it;
2. to an economist, the cost of a resource is the value of the resource in its next best alternative use.
That is, to an economist all costs are opportunity costs, which includeexplicit and implicit costs.
a. For a sole proprietorship an important implicit cost is the owner's time, which is equal
to the amount the owner could have earned working as an employee. For a corporation,
the key implicit cost is the opportunity cost of its capital.
8.2 Short-Run Cost of Production
The distinction between the long run and the short run in analyzing
1. production also applies to cost analysis. There are several measures of short run costs.
2. Total fixed cost (TFC) is the cost incurred by the firm that does not depend on how much output
it produces. For example, even if output is equal to zero, the firm still has to pay for its rent and
capital. Fixed costs are assumed to be equal to sunk costs.
3. Total variable cost (TVC) is the cost incurred by the firm that depends on how much output it
produces. For example, the more the firm produces, the more raw materials and labor it will
employ, which will lead to an increase its costs.
4. Total cost (TC) is the sum of total fixed and total variable cost at each output level.
5. Marginal cost (MC) is the change in total cost that results from a one-unit change in output.
6. Average fixed cost (AFC) is total fixed cost divided by the amount of output.
7. Average variable cost (AVC) is total variable cost divided by the amount of output.
8. Average total cost (ATC) is total cost divided by the output.
9. The firm's costs are determined by the production function and the prices of the inputs. Figure
8.1 in the text shows how the TP curve is transformed to the TVC curve simply by multiply the
variable input amount by the input price. Therefore, the slope of the TVC curve is determined
by the slope of the TP curve. Since the TP curve shows diminishing marginal returns, the
TVC curve shows diminishing returns as well.
10.
11.
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8.3 Short-Run Cost Curves
Figure 8.3(a) in the text depicts some important relationships. First, the TFC curve is a
horizontal line. This is because TFC are constant and not a function of output. Second, the TC
curve is derived by summing the TFC and TVC curves. Notice how the TC curve has the same
slope as the TVC. However, since TC include TFC, the TC curve starts at the FC intercept.
Figure 8.3(b) shows the relationship between average and marginal costs. It is important to
understand how these curves relate to one another. First, the AFC curve is declining
throughout. Since FC are constant, increases in output lead to a decrease in AFC. Second, the
ATC and AVC curves are shaped like a wide U. The ATC curve will always lie above AVC
because ATC includes AFC. The minimum point on the AVC curve will always be slightly to
the left of the minimum point on the ATC curve. Third, the MC curve is shaped like a wide J,
which reflects the presence of diminishing marginal returns. In other words, when an input such
as labor is initially hired, output increases at an increasing rate implying per unit costs are
falling. However, at some point labor units increase output at a decreasing rate implying per
unit costs are increasing. In sum, the MC curve is determined by the shape of the Marginal
Product (MP) curve. When MP is increasing, MC is falling, and when MP is decreasing, MC is
rising. The MC curve will always intersect the minimum points on the ATC and AVC curves.
8.4 Long-Run Cost of Production
In the long run, all inputs can be varied, so the firm can find the optimal combination of inputs
for a specific level of output. As we saw in the last chapter, isoquants are analogous to
indifference curves. Similarly, the isocost line is analogous to a consumer's budget line.
However, one important difference is that the firm is not constrained to stay within a specific
isocost line. The total costs of production can be chosen by the firm, whereas total income is
not selected by the consumer. The firm wants to maximize profits, rather than output.
An isocost line identifies the combination of labor and capital that can be purchased at a given
total cost. The slope of the isoquant curve equals the ratio of the input prices, just as the slope
of the consumer's budget line equals the ratio of the prices of the goods. As long as the prices
are constant, the isocost lines will be straight lines parallel to each other.
Figure 8-1 illustrates two ways to view the manner in which the firm determines the optimal
combination of inputs. First, the firm can maximize output for a given total cost. If the firm
decides it is willing to spend TC2 dollars, it will seek to produce the most output possible given
its cost constraint. In Figure 8-1, the firm must stay on or within the isocost line for TC2.
Hence the isoquant labeled Q4 is not attainable. Isoquant Q1, is attainable, but so are Q2 and
Q3. Of these, Q3 is the maximum output that can be produced for TC2 dollars. Again, a
tangency point determines the optimum. At point B, isoquant Q3 is tangent to the isocost line
for TC2.
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The second way to view the firm's optimization problem is in terms of cost minimization. This
means the firm wants to produce Q1 units of output, what is the least costly way of producing
them? At point C, Q1 units are produced at a cost of TC2. However, this is not the least costly
combination of inputs. The Q1 units of output can be produced for TC1 dollars at point A. This
is the least costly method of producing Q1 units of output. Point A shows the point of tangency
between the isoquant and the isocost line.
The slope of the isoquant measures the marginal rate of technical substitution (MRTSLK), and
the slope of the isocost line is the ratio of the input prices (w/r). At a tangency point, their
slopes are equal, or:
MRTSLK = w/r.
Since MRTSLK = MPL/MPK, it is true that MPL/MPK = w/r, or MPL/w = MPK/r. The last
equality is referred to as the golden rule of cost minimization. This rule says that in order for
the firm to minimize cost, it should employ inputs such that the marginal product per dollar
spent on each input is equal. The least costly input combination for each output is identified
by the firm’s expansion path.
8.5 Input Price Changes and Cost Curves
Up to this point, we have held input prices constant in order to identify the effects of output
changes on costs. Of course, if the price of an input used to produce the firm's output changes,
costs will change too. If the price of an input changes, the slope of the isocost line will change,
and there will be a new optimal combination of inputs. This is graphically depicted by Figure
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8.5 (a) in the text. The input substitution effect is the effect of a change in the price of an
input on a firm’s relative use of the input to produce a given level of output. If input prices
change, average and marginal costs will change as well. Figure 8.5 (b) shows how an increase
in the price of an input will cause an upward shift in both the MC and ATC curves.
8.6 Long-Run Cost Curves
There are three long-run cost curves. These include total cost, average cost, and marginal cost.
Every point on a long-run cost curve reflects a tangency between an isocost line and an
isoquant, and therefore represents the least costly combination of inputs. The shape of the
long-run cost curves are determined by the production process as well. It is especially
important to understand how the production process affects the long run average total cost
curve (LAC). In the short run we know cost curves are dominated by the law of diminishing
marginal returns. In the long run, cost curves are dominated by returns to scale. As discussed in
Chapter 7, returns to scale shows how the level of output is effecting when the firm doubles its
inputs.
Economies of scale represent a situation in which the firm’s output increases more than
proportionally to its input costs. Since long run average total cost is equal to TC/q, increases in
output that are greater than the increase in cost implies the firm’s long run average costs are
declining. Diseconomies of scale occur when a firm’s output increases less than proportionally
to its input costs. If costs are increasing by more than output, it implies the firm’s long run
average total cost curve is increasing. Finally, if output and costs increase in proportion to one
another, long run average total costs are constant and therefore represented as a horizontal line
in cost-output space. It is also possible for long run average costs to be U-shaped in the long
run. This would be a situation where the firm experiences economies of scale at low levels of
output, and the diseconomies of scale at higher levels of output.
8.7 Learning by Doing
Long-run costs also are affected by the amount of time the firm has utilized its production
process. As the firm gains experience with its production process, the costs of production often
fall. This is known as learning by doing. Workers may become more skilled at their tasks or
little improvements in the organizing of production may be found. In general, the gains the
firm realizes from learning by doing decrease over time. This implies the downward shift in
the long run average total cost curve will get smaller over time
8.8 Importance of Cost Curves to Market Structure
The structure of an industry is ultimately determined by the costs of production. The scale of
operations at which average cost per unit reaches a minimum is minimum efficient scale.
Achieving minimum efficient scale depends on the technology that governs the production of a
particular good. Therefore, the minimum efficient scale will differ between goods. Minimum
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efficient scale influences industry structure. When production is characterized by increasing
returns to scale over larger ranges of output, the industry will tend to be made up of a few large
firms. When decreasing returns to scale set in at low levels of output, the industry tends to be
made up of many small firms.
8.9 Using Cost Curves: Controlling Pollution
The problem of controlling pollution can be analyzed in terms of marginal costs. Figure 8.10 in
the text shows the optimal level of pollution abatement for two different firms. The figure
shows that the cost of pollution abatement should be equal for both firms. To reduce pollution
in the least costly way, Firm A should reduce pollution by 150 units and Firm B by 50 units. In
theory, using marginal cost to analyze pollution abatement works out nicely. However, in
reality governments do not know the firm’s marginal cost curves, and therefore have difficulty
imposing optimal pollution abatement requirements on individual firms.
8.10 Economies of Scope
Many firms produce more than one product. Economies of scale apply to the production of a
single product. However, it may be the case that production of one good enables the firm to
produce another good at a lower cost than if production of the two goods were totally separate.
Suppose an auto firm also produces trucks. Let TC(a) be the total costs of producing autos if
the firm produced only autos, and TC(t) be the total costs of producing trucks if the firm
produced only trucks. If TC(a,t) are the total costs of producing trucks and autos, then
economies of scope exist if TC(a,t) < TC(a) + TC(t). If it is cheaper for separate products to be
produced independently, then there are diseconomies of scope.
8.11 Estimating Cost Functions
Cost functions can be empirically estimated in several ways. One technique is called the new
entrant/survivor technique. This method deals with determining the minimum efficient scale
of production in an industry based on investigating the size of the plant being built or used by
firms in the industry.
Another technique used to estimate cost functions is regression analysis. Cost functions can
take on different forms. For example, a cubic total cost function can be represented by:
TC = a + bq + cq2 + dq3.
In the above function, q represents output, and a, b, c, and d are the variables that will be
estimated. The total cost function is used to derive the average total cost and marginal cost
functions.
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8.12 The Mathematics Behind Production Cost
The key points about production cost can be explored using mathematics.
The relationship between the average and marginal cost curves can be derived mathematically.
Average cost (AC) is equal to total cost (C) divided by output (Q): .
AC = C/Q.
Taking the derivative of average cost with respect to output, we have:
dAC/dQ = [d(C/Q)]/dQ = [Qd(dC/dQ) - C)]/dQ2.
Factoring out 1/Q gives:
dAC/dQ = 1/Q[(dC/dQ) – (C/Q)] = (1/Q)(MC - AC).
The above equation shows that the slope of the AC curve is negative when marginal cost is less
than average cost. It also shows that the slope of the average cost curve is positive when
marginal cost is greater than average cost.
We can also use mathematics to show cost minimization. Suppose a firm has a fixed sum Co to
spend on labor and capital available at per unit costs of w and r. The firm wants to maximize
output Q(L,K).
We can form a Lagrangian expression:
Z = Q(L,K) + λ(Co – wL - rK).
Setting the three partial derivatives to zero:
∂Z/∂L = (∂Q/∂L) – λw = 0;
∂Z/∂K = (∂Q/∂K) – λr = 0;
and
∂Z/∂λ = Co - wL – rK = 0.
Dividing the first by the second generates:
(∂Q/∂L)/ (∂Q/∂K) = w/r.
In the above expression, the left hand side of the equation is the ratio of marginal products of
inputs and the right hand side of the equation is the ratio of input prices. These ratios represent
the slopes of the isoquant and isocost lines.
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We can also rearrange the two equations to show that the firm should be allocating its funds so
that the marginal products per dollar’s worth of all inputs are equal:
(∂Q/∂L)/ w = (∂Q/∂K)/r = λ.
We can also formulate the problem as a constrained minimization problem. Suppose the firm
wants to minimize its total cost:
Q0 = Q(L,K).
The Lagrangian expression is:
Z = wL + rK + λ[Q0 - Q(L,K)].
Setting the three partial derivatives equal to zero:
∂Z/∂L = w – λ(∂Q/∂L) = 0;
∂Z/∂K = r - λ(∂Q/∂K) = 0;
and
∂Z/∂λ = Q0- Q(L,K) = 0.
Dividing the first by the second:
w/r = (∂Q/∂L)/ (∂Q/∂K).
The above expression again shows that the firm should select a point of tangency between the
isoquant and isocost line.
The Lagrangian technique can also be used to see how a firm can minimize the cost of pollution
abatement. Assume two firms, A and B, both with cost functions for providing pollution
abatement CA(PAA) and CB(PAB).
We need to minimize the sum of the costs:
C = CA(PAA) + CB(PAB).
Since only a certain quantity of pollution is permitted, pollution abatement is equal to:
PAA + PAB = PA*.
The Lagrangian function becomes:
Z = CA(PAA) + CB(PAB) + λ(PA* - PAA - PAB).
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The first order conditions are:
∂Z/∂ PAA = (∂CA /∂PAA) – λ = 0;
∂Z/∂ PAB = (∂CB /∂PAB) – λ = 0;
and
∂Z/∂ λ = PA* - PAA - PAB = 0.
In the above expressions both marginal costs equal the same Lagrangian multiplier. Therefore,
the marginal cost of each firm must be equal to each other.
ILLUSTRATIONS
Cost Curves and Market Structure
The key determinant of whether an industry is made up of many relatively small firms or a few
relatively large firms is the long-run average cost curve. An industry can expand its output at
lower cost by having one firm expand, if the firm's long-run average cost curve (LRAC) is still
sloping downward. However, if the firm is at the minimum of its LRAC, then the industry can
expand output at lower cost by having a new firm enter the industry. As long as increasing
returns to scale are available, it is cheapest to have a single firm expand. When there are no
longer increasing returns to scale, it is cheapest to have new firms produce the additional
output.
Since increasing returns to scale are a technological phenomenon, industries characterized by
increasing returns to scale in this country will also be characterized by increasing returns to
scale in other countries. The automobile industry is made up of a few giant firms in the United
States, but the same is true in Japan, Great Britain, France, and Germany. Empirical studies
have found that industries that are highly concentrated (made up of a few large firms) in the
United States tend to be highly concentrated in other industrial nations as well.
[See Frederick Pryor, An International Comparison of Concentration Ratios," Review of Economics and
Statistics,
54 (May 1972), pp. 130-140.]
The Survivorship Principle
The survivorship principle is simple. Firms that are too large or too small will lose business to
firms that are the optimal size. George Stigler used this principle to measure economies of
scale in the steel industry. He described the technique:
Classify the firms in an industry by size, and calculate the share of industry
output coming from each class over time. If the share of a given class falls, it is
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relatively inefficient, and in general is more inefficient the more rapidly the
share falls.
Fixed costs
1. Cost of setting up operations
2. 0 output but still have to pay to buy land to produce cars
Variable costs
1.
Produce 1 unit. Have to pay 30.00 to person to produce good
Total cost
1.
Add total fix and variable cost together
•
•
•
When marginal cost is below average (total or variable) cost, average cost will decline.
When marginal cost is above average cost, average cost rises.
When average cost is at a minimum, marginal cost is equal to average cost.
•
LTC shows the minimum cost at which each rate of output may be produced, just as the
expansion path does.
LMC and LAC are derived from the LTC in the same way that the short-run marginal and
average curves are derived from the short-run total cost curve.
•
•
•
Economies of scale – a situation in which a firm can increase its output more than
proportionally to its total input cost
Diseconomies of scale – a situation in which a firm’s output increases less than proportionally
to its total input cost
Short and Long run average cost
Assumptions of Perfect Competition
• Large numbers of buyers and sellers
• Free entry and exit
• Homogeneous products
• Perfect information
Profit Maximization
• ASSUMPTION: firms select an output level so as to maximize profit, defined as the difference
between revenue and cost
• “Survivor Principle” – the observation that in competitive markets, firms that do not
approximate profit-maximizing behavior fail, and that survivors are those firms that,
intentionally or not, make the appropriate profit-maximizing decisions.
The Demand Curve Facing The Competitive Firm
• Price taker – a firm that takes prices as given and does not expect its output decisions to affect
price
• Total revenue – price times the quantity sold
• Average revenue (AR) – total revenue divided by output
• Marginal revenue (MR) – the change in total revenue when there is a one-unit change in output
The Competitive Firm’s Demand Curve
[Figure 9.1]
Short-Run Profit Maximization
• Total profit (π) – the difference between total revenue and total cost
Figure 9.2
Short-Run Profit Maximization Using Per-unit Curves
• Average profit per unit (π/q) – total profit divided by number of units sold
• Figure 9.3
Operating at a Loss in the Short-Run
The Perfectly Competitive Firm’s Short-Run Supply Curve
• Short-run firm supply curve – a graph of the systematic relationship between a product’s price
and a firm’s most profitable output level
• Shutdown point – the minimum level of average variable cost below which the firm will cease
operations
• Figure 9.5
Output Response to a Change in Input Prices
What if Congress
passes the Farm
Bill it is sitting on
and subsidizes
seed loans?
[Figure 9.6]
The Short-Run Industry Supply Curve
• Short-run industry supply curve – the horizontal sum of the individual firms’ marginal cost
curves
• Assumption – variable input prices remain constant at all levels of industry output
Long-Run Competitive Equilibrium I
• Zero economic profit – the point at which total profit is zero since price equals the average cost
of production; “normal” economic return
Long-Run Competitive Equilibrium II
• Characteristics:
– The firm is maximizing profit and producing where LMC=price.
– There is no incentive for firms to enter or leave the industry.
– The combined quantity of output of all the firms at the prevailing wage equals
the total quantity consumers wish to purchase at that price.
Long-Run Competitive Equilibrium [Figure 9.9]
Industrial Organization
Assumptions of Perfect Competition
• Large numbers of buyers and sellers
• Free entry and exit
• Homogeneous products
• Perfect information
The Competitive Firm’s Demand Curve
Suppose that a firm’s product price in a competitive market
Is $12. The firm’s costs are noted below.
Short-Run Profit Maximization
• Total profit (π) – the difference between total revenue and total cost
Notice that the “slopes” (i.e.,
the marginals are equal at 8)
Short-Run Profit Maximization Using Per-unit Curves
• Average profit—”per unit profit” (π/q) – total profit divided by number of units sold
• Total profit is Avg. profit times quantity sold, i.e., area of blue box.
Operating at a Loss in the Short-Run
Here the total profit is actually a total loss
The Perfectly Competitive Firm’s Short-Run Supply Curve
•
•
Short-run firm supply curve – a graph of the systematic relationship between a product’s price
and a firm’s most profitable output level
Shutdown point – the minimum level of average variable cost below which the firm will cease
operations
Output Response to a Change in Input Prices
What if Congress passes the Farm Bill it is sitting on and subsidizes seed loans?
The Short-Run Industry Supply Curve
• Short-run industry supply curve – the horizontal sum of the individual firms’ marginal cost
curves
• Assumption – variable input prices remain constant at all levels of industry output
Well…so Browning & Zupan claim. For
perfectly competitive firms, the costs would be
identical, so MCA= MCB= MCC. Thus, SupplyMKT =
3MC.
Long-Run Competitive Equilibrium I
•
Zero economic profit – the
point at which total profit is
zero since price equals the
average cost of production;
“normal” economic return
Long-Run Competitive Equilibrium II
• Characteristics:
– The firm is maximizing profit and producing where LMC=price.
– There is no incentive for firms to enter or leave the industry.
– The combined quantity of output of all the firms at the prevailing wage equals
the total quantity consumers wish to purchase at that price.
Long-Run Competitive Equilibrium
Constant-Cost Industry
Increasing-Cost Industry
Decreasing-Cost Industry
Intel co-founder, Gordon Moore, in a 1965 paper predicted that the number of
solid-state devices on an IC-chip would double every two years, enabling the
Cost of computer and electronics devices to drop, while performance increased
An Osborne Executive portable computer, from 1982 with a Zilog Z80 4MHz CPU, and a
2007 Apple iPhone with a 412MHz ARM11 CPU. The Executive weighs 100 times as much, is nearly 500 times
as large by volume, costs approximately 10 times as much (adjusting for inflation), and has 1/100th the clock
frequency of the phone.
The Evaluation of Gains and Losses
• Consumer surplus – a measure of the net gain to a consumer or group of consumers from
purchasing a good arising from cost being below the maximum that consumers are willing to
pay
• Producer surplus – gains to producers from the sale of output to consumers, arising from price
exceeding the minimum necessary to compensate the seller.
Producer Surplus
Consumer Surplus, Producer Surplus, and Efficient Output
Total surplus – the sum of producer and consumer surplus
Efficiency in output – the condition in which output is expanded to the point where marginal
benefit equals marginal cost
Competition Maximizes Total Surplus
•
•
CS=difference between price paid
and the maximum price consumers
would pay rather than forego consumption=
A the blue area
=a
PS=difference between price received
and the minimum price producers
would accept rather than forego sales
Total Welfare=the
sum of consumers’
and
producers’
surpluses
The Deadweight Loss of a Price Ceiling
• Deadweight loss – also called welfare cost, a measure of the aggregate loss in well-being of
participants in a market resulting from an inefficient output level
A Price Ceiling Reduces Total Surplus
X =transfer of former producers’
surplus to consumers’ surplus;
BEC=deadweight loss triangle; GEC
from PS; BEG from CS
Excise Taxation
• Excise tax – a tax levied on a specific good
– Per unit tax: does not depend on the market price
– Ad valorem tax: an excise tax that is levied as a certain percentage of the
market price
Effects of a Per-Unit Excise Tax
Short-Run Effects
– Firms reduce output.
– Market price rises.
The Consequences of an Excise Tax
• Short-Run Effects
– Firms reduce output.
– Market price rises.
• Long-Run Effects
– Even when the tax is levied on and collected from firms, consumers bear a cost
as a result of the higher price.
– After the long-run adjustment to the tax, firms make zero economic profits.
How Elasticities Affect the Tax Burden
•
Long-Run Effects
– Even when the tax is levied on and collected from firms, consumers bear a cost
as a result of the higher price.
– After the long-run adjustment to the tax, firms make zero economic profits
Who Bears the Burden of the Tax?
• When an excise tax is imposed on a good, elasticity determines how much output falls and how
much the price to consumers rises.
– For a given demand curve and tax per unit, the more inelastic the supply curve:
• the smaller is the tax burden on consumers
• the larger is the tax burden on producers
• the smaller is the output reduction
– For a given supply curve and tax per unit, the more inelastic the demand curve:
• the greater is the tax burden on consumers
• the smaller is the tax burden on producers
• the smaller is the reduction in output
When the Consumer Bears the Entire Burden of the Tax
• Situations of extreme elasticity:
– If the demand is perfectly inelastic, the demand curve is vertical.
– If the supply curve is perfectly elastic, the supply curve is horizontal, which is
the constant-cost case.
• In both cases,
– the price to consumers rises by the amount of the tax.
The Deadweight Loss of Excise Taxation
• Excess burden – another name for the deadweight loss produced by a tax
•
•
Excess burden – another name
for the deadweight loss
produced by a tax
Chapter 11
Terminology
• Monopoly – a market with a single seller
• Monopoly power – some ability to set price above marginal cost
• Price maker – a monopoly that supplies the total market and can choose any price along the
market demand curve that it wants
The Monopolist’s Demand Curve and Total Revenue
The Perfectly Competitive Firm’s Short-Run Supply Curve
Profit-Maximizing Output of a Monopoly
•
•
Marginal revenue is always less than price
when the demand curve slopes
downward.
Profit is maximized where MR=MC.
Profit Maximization
The Monopoly Price and Its Relationship to Elasticity of Demand
P = MC/[1 – (1/η)]
The smaller the demand elasticity, the greater the profit-maximizing price, relative to marginal cost.
The Inverse Elasticity Pricing Rule
Further Implications of Monopoly Analysis
• A monopoly has no supply curve.
• A monopoly does not necessarily make positive economic profit.
• A monopoly’s demand curve is elastic where marginal revenue is positive.
A profit-maximizing monopolist will always sell at a price where demand is elastic
Monopoly Demand, Marginal Revenue, and Total Revenue
Monopoly Power When There are Several Suppliers
Measuring Monopoly Power
• Lerner Index – a means of measuring a firm’s monopoly power that takes the markup of price
over marginal cost expressed as a percentage of a product’s price:
Lerner Index = (P – MC)/P
• The Lerner index varies between zero and one.
• The larger the Lerner index value, the greater a firm’s monopoly power.
Sources of Monopoly Power
• What factors determine the extent to which a firm has monopoly power?
– The elasticity of the market demand curve
• If the market demand curve is perfectly elastic, any individual
supplier has no monopoly power.
– The elasticity of supply by other firms
• The monopoly power of any one firm is more limited when
there is a greater number of rival firms.
Barriers to Entry
• Barrier to entry – any factor that limits the number of firms operating in a market and
thereby serves to promote monopoly power
• Categories:
– Absolute cost advantage
• A situation in which an incumbent firm’s production cost
(long-run average total cost) is lower than potential rivals’
production costs at all relevant output levels
– Economies of scale
• A situation in which the long-run average total cost curve for
all firms slopes downward over the entire range of market
output
• Natural monopoly – an industry in which production cost is
minimized if one firm supplies the entire output.
• Categories (continued):
– Product differentiation
• A means by which consumers may perceive the product sold by an incumbent firm
to be superior to that offered by prospective rivals.
– Regulatory barriers
•
Barriers to entry created by the government through vehicles such as patents,
copyrights, franchises, and licenses
The Efficiency Effects of Monopoly
Public Policy Toward Monopoly
• Antitrust laws – a series of codes and amendments intended to promote a competitive market
environment
• 3 major statutes:
– Sherman Act (1890)
– Clayton Act (1914)
– Federal Trade Commission Act (1914)
Regulation of Price
•
Price ceiling – eliminates the
monopolist’s reason for
restraining output
Price Discrimination
Definition – the practice of charging different prices for the same product when there is no cost difference
to the producer in supplying the product
• Why would a firm want to price discriminate?
– To increase profit
– To increase total surplus (consumer surplus plus producer surplus)
Types of Price Discrimination
First-degree (perfect) price discrimination – a policy in which each unit of output is sold for the maximum
price a consumer will pay
• Second-degree price discrimination (block pricing) – the use of a schedule of prices such that the
price per unit declines with the quantity purchased by a particular consumer
• Third-degree price discrimination (market segmentation) – a situation in which each consumer
faces a single price and can purchase as much as desired at that price, but the price differs among
categories of consumers
First-Degree (Perfect) Price Discrimination
•
•
•
•
Second-Degree Price Discrimination (Block Pricing)
MR curve coincides with the
demand curve.
The price schedule is tailored to
each consumer.
The monopolist captures the
entire consumer surplus.
The profit-maximizing output level
is efficient.
•
•
Consumers are charged a
different price for different
quantities, with the schedule of
prices set to extract the entire
consumer surplus.
The same price schedule
confronts all consumers.
Third-Degree Price Discrimination (Market Segmentation)
The price differs among categories of consumers.
• Examples:
– Faculty discounts at the college bookstore
– Telephone companies charging different monthly rates for business customers
than for residential customers
– Movie theaters charging different prices for a matinee showing than for an
evening showing
Three Necessary Conditions for Price Discrimination
1.
2.
3.
The product seller must possess some degree of monopoly power; that is, a downward-sloping
demand curve.
The seller must have some means of approximating the maximum amount buyers are willing to
pay for each unit of output.
The seller must be able to prevent resale or arbitrage of the product among the market
segments.
The Mathematics behind Price Discrimination
Goal: maximize profit
• Profit-maximizing condition:
MR = MR = MC
A
•
B
Price will be lower in the market with the more elastic demand curve since:
P (1-1/η ) = P (1-1/η )
A
A
B
B
Price and Output Under Monopolistic Competition
Monopolistic competition – a market characterized by:
– unrestricted entry and exit
– a large number of independent sellers producing differentiated products
• Differentiated product – a product that consumers view as different from other similar products.
Determination of Market Equilibrium
•
•
The demand curve facing
each firm is downwardsloping but fairly elastic,
reflecting a firm’s market
power.
Long-run equilibrium is
attained as a result of firms
entering (or leaving) the
industry in response to profit
incentives.
Similarities to Competition and Monopoly
Perfect Competition:
Economic profit = 0
• Monopoly:
Price > MC at equilibrium
Monopolistic Competition and Efficiency
•
Excess capacity – the result
of firms failing to produce at
lowest possible average cost
Is Government Intervention Warranted?
3 reasons why government intervention is probably not warranted:
1. Any deadweight loss is likely to be small, due to the presence of competing firms and free
entry.
2. Any possible inefficiency cost must be weighed against the product variety produced and the
benefits of such variety to consumers.
3. The costs of intervention must be balanced against the potential gain from expanding output.
Oligopoly
•
Oligopoly – an industry structure characterized by:
– a few firms producing all or most of the output of some good that may or many
not be differentiated
– mutual interdependence: a firm’s actions have an effect on its rivals and induce a
react by the rivals
– barriers to entry which can influence pricing behavior
The Cournot Model
•
•
Duopoly – an industry with two
firms
Cournot Model – a model of
oligopoly that assumes each firm
determines its output based on
the assumption that any other
firms will not change their
outputs.
Reaction Curves
•
Reaction Curve – a relationship
showing one firm’s most
profitable output as a function
of the output chosen by other
firms
Evaluation of the Cournot Model
The assumption that each firm takes the output of a rival firm as constant is implausible if the market is adjusting
toward equilibrium. However,
– if equilibrium is established, firms will not see the assumption invalidated.
– the assumption is more plausible the larger the number of firms in the market.
Other Oligopoly Models
•
•
The Stackelberg Model – a model of oligopoly in which a leader firm selects its output first, taking
the reactions of follower firms into account
Dominant Firm Model – a model of oligopoly in which the leader or dominant firm assumes its
rivals behave like competitive firms in determining their output
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