market structure and the behavior of firms perfect competition vs monopoly
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Market Structures
Many Number of Competitors One
Less Market Control More
PerfectCompetition
MonopolyMonopolisticCompetition
Oligopoly
Assume firms want to maximize profit
= TR – TC
Behavior of Firms
TR = Total Revenue = P∙qTC = Total Economic Cost
Economic Cost = Explicit Cost + Implicit CostEconomic Cost = Explicit Cost + Implicit Cost
Technological ConstraintsProduction Function
q = F(L, K)
q = outputL = laborK = capitalF(·) represents technology
Lab Experiment 3: Widget Production
_
Variable input Fixed input
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.
∆q
∆L
Productivity Graphs
labor
output
labor
q/L
TP
MP
AP
L1L1
DMR
L2
L2
Slope = MPL = ∆q/ ∆L
When MP > AP then AP will riseWhen MP < AP then AP will fall
Short Run Costs
TC = FC + VC
Does not vary with output:RentUtilitiesSalariesProperty taxesInsurance premiums
Varies with output:Labor Raw materials
Short Run Cost Curve Family
output
$
output
$
FC
VC
TC
AFC
MC
AVC
ATC
TC = FC + VC ATC = AFC + AVC
ΔTCMC=
Δq
Properties of the Cost Curves
“Ross Perot” Equation
Short Run Cost Curve Shifters Change in price of labor Change in price of capital Change in amount of capital Change in technology
LMP
wMC
output
$ MC
labor
q/L
MP
output
$
AFC
MC
AVC
ATC
Long Run Average Cost Curve
output
$
ATC3
LRAC
qMES
EOS: double the inputs, output more than doubles
DOS: double the inputs, output less than doubles
LRAC falls
LRAC rises
SpecializationSpecialization Coordination/Communication Problems
Coordination/Communication Problems
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
Characteristics of the Industry Large number of small buyers/sellers Homogeneous product Free entry/exit Perfect information
firms are price takers
S
D
PP1
Q1Quantity quantity
$
Industry Firm
= MR
MR = ΔTR / Δq$
Maximizing Profit
= TR – TC = Pq - [FC + VC]
What output should the firm produce? produce until MR = MC
If MR > MC produce moreIf MR < MC produce less
What output should the firm produce? produce until MR = MC
If MR > MC produce moreIf MR < MC produce less
MR
MC
quantity
$
q1 = 300
$60 = P1
I want you to maximize profit
What is TR = ?What is TC = ?What is TR = ?What is TC = ?
Profit and Loss Diagrams
MC
quantity
$
q1 = 300
$60 = P1
ATC
MR1
$50 = ATC
Positive Profit: > 0 = Pq – (ATC)q = (P-ATC)q = (60-50)300 = $3000
Negative Profit = (35-50)250 = -$3750
Zero Profit?
MR2$35 = P2
q2 = 250
Sometimes it’s better to stay open and lose a little bit…
Temporary Shut Down: q = 0 = Pq – (FC +VC) = 0 – (FC + 0) = - FC
Stay open if TR > VC Shut down if TR < VC
MC
quantity
$
q1 = 2000
$25 = P1
ATC
MR1
$35 = ATC1
AVC
$20 = AVC1
Stay open: = -$20,000
Shut down: = -$30,000
Fixed Cost = $30,000
Shutdown recap
Shut down if TR < VC Pq < (AVC)(q) P < AVC
MC
quantity
$
qSD
ATC
AVC
PSD = Min AVC
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
quantity
$
q1
P1
ATC
MR1
AVC
Long Run Equilibrium
• A = TR – Explicit Costs
• E = A - Implicit Costs
A= 6%
A= 6%
A= 6%A= 9%E= 3%
if E > 0 entry occurs
if E < 0 exit occurs
Economy
E= 0%
E= 0%
E= 0%
7%
7%
7%
7%0%
Firm =
LRE: E = 0
Long Run Adjustment Process
MC
quantity
$
q1
P1
ATC
MR1
MR2
D1
S1
Q1
At P1: each firm produces q1 and earns E = 0
Demand rises to D2:
D2
S2
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
q2Q3
Industry Firm
Quantity
$
LRS
Long run supply curvefor a constant cost
industry is horizontal
causes price to rise to P2
MES and Market Structure
D
Output
$
Q1
P1
⅛Q1 ¼Q1 ½Q1
ATC1
ATC2 ATC3
ATC4
The greater MES is as a share of market demand, the fewer the number of firms
Industry 1: room for 8 firmsIndustry 2: room for 4 firms Industry 3: room for 2 firms Industry 4: room for 1 firm
“natural monopoly”
MES Plant Size Versus Market Concentration
Industry MES/S4x(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
Refrigerators and freezers 14.1 56.4 73
Storage batteries 1.9 7.6 61Source: Stephen Martin, “Industrial Economics,” 2e, MacMillan (1994), p240.
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)CellophaneFlexible wrapping paper
Alcoa (1945)Primary aluminumAll aluminum
Flexible Wrapping Paper20%
Cellophane75%
AluminumFoil
ButcherPaper
Newspaper
All Aluminum33%
Primary90%
Secondary
Imported
Barriers to Entry Economies of Scale
“natural monopoly” Control over key inputs
Alcoa--bauxite DeBeers
GE Superabrasives (Diamond Innovations)
LRAC
Quantity
$
…more barriers to entryGovernment restrictions
Patents20 year duration
CopyrightsLife of artist plus 70 years
Licenses Occupational licenses: doctors, lawyers, accountants,
engineersFor what purpose: Public health or private interest?
FranchisesTaxi 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
π = TR – TC π = P(Q)*Q – TC
MR = ∆TR/ ∆Q
$
$40
$30
500 700
D
TR = $20,000
TR = $21,000
MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q
Loss
Gain
MR = [6000 – 5000]/200 = $1000 / 200
MR = $5 MR < P
Quantity
MR
MR, P, and Elasticity
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]
MR = P [ 1 – 1/E ]MR = P [ 1 – 1/E ]
MR = ∆TR / ∆Q = [∆Q*P - ∆P*Q] / ∆Q
Optimal Output and Price
π-max rule: Set output where MR = MC Set price off of demand curve
$
$20
$30
700
D
Quantity
MR
MC
ATC
TR = P*Q = ($30)(700) = $21,000
TC = ATC*Q = ($20)(700) = $14,000
π = TR - TC = $ 7,000
Optimal Output and Price
π-max rule: Set output where MR = MC Set price off of demand curve
How will monopolist react to: an increase in marginal cost? an increase in fixed cost? an increase in demand?
$
$20
$30
700
D
Quantity
MR
MC
ATC
Welfare Comparison: PC vs. Monop
Perfect Competition: PC, QC
Monopoly: PM, QM
$
D
Quantity
MR
MC = ATC
QcQM
PM
PC
A
B C
PC Monop
CS
PS
Social Welfare
DWL
A+B+C
A+B+C
---
---
A
B
A+B
C
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
Segment the market Demographics Usage rates
Prevent resale Movie theatres Röhm-Haas: plastic molding compound
Industrial: $0.85/lb
Dentists: $22/lb
Arsenic ?
Types of Price Discrimination
First Degree Charge each buyer their WTP Captures all CS and DWL
Second Degree Quantity discounts
Third Degree Set prices according to price
elasticity Movie Theatre
MRA = MRK = MC
$
D
Quantity
MR
QcQM
PM
PC MC
MC = $4
EA = 2
EK = 5
MRA = PA[1 – 1/EA]
MRA = MC
PA[1 – 1/2] = 4 PA = $8Charge higher price
to more inelastic group
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