Principles of Microeconomics

13. Industrial Organization and Welfare*

Akos LadaAugust 8th, 2011

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Contents

1. Review of previous lecture

2. Competitive firms in the short and the long run

3. The monopolist’s profit-maximizing decision

4. Monopoly, welfare, and public policy

1. Review

MPL equals the slope of the production function.

Notice that MPL diminishes as L increases.

This explains why the production function gets flatter as L increases.

0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Q

uan

tity

of

ou

tpu

t

Production Function and the MPL

30005200

28004400

24003600

18002800

10001

1000

00

MPLQL

The relationship between the quantity of inputs used to produce a good and the quantity of output of that good.

MPL is the slope

of the Productio

n Function

Production Costs

7

6

5

4

3

2

1

620

480

380

310

260

220

170

$100

520

380

280

210

160

120

70

$0

100

100

100

100

100

100

100

$1000

TCVCFCQ

$0

$100

$200

$300

$400

$500

$600

$700

$800

0 1 2 3 4 5 6 7

Q

Costs

FC

VC

TC

Average and Marginal costs

AFC

AVC

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

When MC < ATC,

ATC is falling.

When MC > ATC,

ATC is rising.

The MC curve crosses the ATC curve at the ATC curve’s minimum.

Refer to the table below. The average total cost of producing five units of

output is

Quantity of Output Fixed Costs Variable Costs0 $20 $01 20 52 20 103 20 154 20 205 20 251. $2.

2. $5.

3. $9.

4. $45.

Refer to the table below. The marginal cost of producing the fifth unit of

output is

Quantity of Output Fixed Costs Variable Costs0 $10 $01 10 42 10 93 10 154 10 225 10 401. $8.

2. $18.

3. $40.

4. $58.

P1 MR

Profit-maximization rule

At Qa, MC < MR.

So, increase Q to raise profit.

At Qb, MC > MR.

So, reduce Q to raise profit.

At Q1, MC = MR.

Changing Q would lower profit.

Q

Costs

MC

Q1Qa Qb

Rule: MR = MC at the profit-maximizing Q.

2. Competitive firms in the short and the long

run

Firms’ Shutdown and Exit

• Shutdown: A short-run decision not to produce anything because of market conditions.

• Exit: A long-run decision to leave the market.

• A key difference: • If shut down (short run), must

still pay FC.• If exit (long run), zero costs.

A Firm’s Short-run Decision to Shut Down

• Cost of shutting down: revenue loss = TR

• Benefit of shutting down: cost savings = VC (firm must still pay FC)

• So, shut down if TR < VC

• Divide both sides by Q: TR/Q < VC/Q

• So, firm’s decision rule is:

Shut down if P < AVC

A Competitive Firm’s SR Supply Curve

The firm’s SR supply curve is the portion of its MC curve above AVC.

Q

Costs

MC

ATC

AVC

If P > AVC, then firm produces Q where P = MC.

If P < AVC, then firm shuts down (produces Q = 0).

The Chocolate Moose Ice Cream Store is a business that closes from November to April each year. The best explanation for

closing during these months is that the store’s

1. revenues are insufficient to cover total costs.

2. total fixed costs are less than marginal fixed cost.

3. revenue per unit is less than average variable cost.

4. marginal costs are less than the revenues.

The Irrelevance of Sunk Costs

• Sunk cost: a cost that has already been committed and cannot be recovered

• Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice.

• In the short run FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down.

• So, FC should not matter in the decision to shut down (that is, in the short run).

A Firm’s Long-Run Decision to Exit

• Cost of exiting the market: revenue loss = TR

• Benefit of exiting the market: cost savings = TC (zero FC in the long run)

• So, firm exits if TR < TC

• Divide both sides by Q to write the firm’s decision rule as:

Exit if P < ATC

A New Firm’s Decision to Enter Market

• In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC.

• Divide both sides by Q to express the firm’s entry decision as:Enter if P > ATC

Note: if P=ATC,

then firm’s profit is zero

The firm’s LR supply curve is the portion of

its MC curve above LRATC.

Q

Costs

The Competitive Firm’s Supply Curve

MC

LRATC

Entry & Exit in the Long Run, and the Zero-Profit

Condition• In the LR, the number of

firms can change due to entry & exit.

• If existing firms earn positive economic profit, • new firms enter, SR

market supply shifts right.

• P falls, reducing profits and slowing entry.

• If existing firms incur losses, • some firms exit, SR market

supply shifts left. • P rises, reducing remaining

firms’ losses.

• Long-run equilibrium: when the process of entry or exit is complete – remaining firms earn zero economic profit.

• Why do firms stay in business with profit zero?!

• Recall, economic profit is revenue minus all costs – including implicit costs, like the opportunity cost of the owner’s time and money.

• In the zero-profit equilibrium,

• firms earn enough revenue to cover these costs

• accounting profit is positive

STUDENT’S TURNSTUDENT’S TURN

Identifying a firm’s profitIdentifying a firm’s profit

20

Determine this firm’s total profit.

Identify the area on the graph that represents the firm’s profit. Q

Costs, P

MC

ATCP = $10

MR

50

$6

A competitive firm

AnswersAnswers

21

profit

Q

Costs, P

MC

ATCP = $10

MR

50

$6

A competitive firm

Profit per unit = P – ATC= $10 – 6 = $4

Total profit = (P – ATC) x Q = $4 x 50= $200

The LR Market Supply Curve

MCMarket

Q

P

(market)

One firm

Q

P

(firm)

In the long run, the typical firm

earns zero profit.

LRATC

long-runsupply

P = min. ATC

The LR market supply curve is horizontal at P = minimum ATC.

S1

Profit

D1

P1

long-runsupply

D2

SR & LR effects of an Increase in Demand

MC

ATC

P1

Market

Q

P

(market)

One firm

Q

P

(firm)

P2P2

Q1 Q2

S2

Q3

A firm begins in long-run equilibrium…

…but then an increase in demand raises P,…

…leading to SR profits for the firm.

Over time, profits induce entry, shifting S to the right, reducing P……driving profits to zero and restoring long-run equilibrium.

A

B

C

3. The monopolist’s profit-maximizing

decision

A monopoly is different…

• For a competitive firm:• At a given quantity,

what is the revenue it makes, on average, per each unit sold?• AR = P

• If it wants to increase this quantity by one unit, what is the additional revenue it can expect to receive?• MR = P

• So: MR=AR=P

• For a monopoly:• At a given quantity,

what is the revenue it makes, on average, per each unit sold?• AR = P

• If it wants to increase this quantity by one unit, what is the additional revenue it can expect to receive?• MR < P !!!

• Why???• Because to be able to

sell more, it needs to reduce the price.

Monopoly vs. Competition: Demand Curves

In a competitive market, the market demand curve slopes downward.

But the demand curve for any individual firm’s product is horizontal at the market price.

The firm can increase Q without lowering P,so MR = P for the competitive firm.

D

P

Q

A competitive firm’s demand curve

A monopolist is the only seller, so it faces the market demand curve.

To sell a larger Q, the firm must reduce P.

Thus, MR < P.

A monopoly’s demand curve

D

P

Q

Understanding the Monopolist’s MR

• Increasing Q has two effects on revenue:• Output effect: higher output

raises revenue• Price effect: lower price

reduces revenue

• To sell a larger Q, the monopolist must reduce the price on all the units it sells.

• Hence, MR < P

• MR could even be negative if the price effect exceeds the output effect!

STUDENT’S TURNSTUDENT’S TURN

A monopoly’s revenueA monopoly’s revenue

28

Q P TR AR MR

0 $4.50

1 4.00

2 3.50

3 3.00

4 2.50

5 2.00

6 1.50

n.a.Common Grounds is the only seller of cappuccinos in town.

The table shows the market demand for cappuccinos.

Fill in the missing spaces of the table.

What is the relation between P and AR? Between P and MR?

AnswersAnswers

29

Here, P = AR, same as for a competitive firm.

Here, MR < P, whereas MR = P for a competitive firm.

1.506

2.005

2.504

3.003

3.502

1.50

2.00

2.50

3.00

3.50

$4.00

4.001

n.a.

9

10

10

9

7

4

$ 0$4.5

00

MRARTRPQ

–1

0

1

2

3

$4

Common Grounds’ D and MR Curves

-3

-2-1

0

12

3

45

0 1 2 3 4 5 6 7 Q

P, MR

MR

$

Demand curve (P)

1.506

2.005

2.504

3.003

3.502

4.001

$4.50

0

MRPQ

–1

0

1

2

3

$4

Monopolist Profit-Maximization

1. The profit-maximizing Q is where MR = MC.

2. Find P from the demand curve at this Q.

Quantity

Costs and Revenue

MR

D

MC

Profit-maximizing output

P

Q

• Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC.

• Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity.

• It finds this price from the D curve.

A Monopoly Does Not Have a Supply Curve!

A competitive firm • takes P as given• has a supply curve that shows

how its Q depends on P.

A monopoly firm• is a “price-maker,” not a “price-

taker” • Q does not depend on P;

rather, Q and P are jointly determined by MC, MR, and the demand curve.

So there is no supply curve for monopoly.

4. Monopoly, welfare, and public policy

The Welfare Cost of Monopoly

• Recall: In a competitive market equilibrium, P = MC and total surplus is maximized.

• In the monopoly equilibrium, P > MR = MC• The value to buyers of an

additional unit (P)exceeds the cost of the resources needed to produce that unit (MC).

• The monopoly Q is too low – could increase total surplus with a larger Q.

• Thus, monopoly results in a deadweight loss.

P = MC

Deadweight loss

P

MC

The Welfare Cost of Monopoly

Competitive equilibrium:

quantity = QC

P = MC

total surplus is maximized

Monopoly equilibrium:

quantity = QM

P > MC

deadweight loss Quantity

Price

D

MR

MC

QM QC

In comparison to a perfectly competitive firm, a monopolist charges

a

1. higher price and produces a higher quantity.

2. higher price and produces a lower quantity.

3. lower price and produces a higher quantity.

4. lower price and produces a lower quantity.

Refer to the figure below. The deadweight loss for a profit-maximizing

monopolist is the area

Q

$

MC

D

Q2 Q3 Q1

P2

P4

P1

P5

P3

ATC

MR

A

FB

GE

C

Public Policy Toward Monopolies

• Increasing competition with antitrust laws• Ban some anticompetitive practices,

allows government to break up monopolies.

• Regulation• Government agencies set the monopolist’s

price.

• Public ownership• Example: U.S. Postal Service• Problem: Public ownership is usually less

efficient since no profit motive to minimize costs

• Doing nothing?• The foregoing policies all have drawbacks,

so the best policy may be no policy (if costs exceed benefits)