Costs and Market Structure

1. Costs and Market Structure ECO 171: Costs and Market Structure

2. Basic ideas • Determinants of market structure: how many firms in an industry? • Economies of scale – Cost functions • Minimum efficient scale • Role of demand • Other determinants ECO 171: Costs and Market Structure

3. Size distribution U.S. Businesses: 2003 ECO 171: Costs and Market Structure

4. Average size of firms ECO 171: Costs and Market Structure

5. Average size firms (Manufacturing) ECO 171: Costs and Market Structure

6. Observations • Huge variation in firm size • Causes? • Economies of scale • Market size ECO 171: Costs and Market Structure

7. Cost functions • Cost = C(q) • Implicit technology and input prices • AC(q) = C(q)/q • MC(q) = dC/dq • Typical case: C(q) = VC(q) + F ECO 171: Costs and Market Structure

8. Cost curves: an illustration Typical average and marginal cost curves $/unit Relationship between AC and MC MC If MC < AC then AC is falling AC If MC > AC then AC is rising MC = AC at the minimum of the AC curve (efficient scale) Quantity ECO 171: Costs and Market Structure

9. Economies of scale • Definition: average costs fall with an increase in output • Represented by the scale economy index AC(Q) S = MC(Q) • S > 1: economies of scale • S < 1: diseconomies of scale • S = 1 at point of Min avg cost • Minimum efficient scale: smallest output level at which economies of scale are exhausted ECO 171: Costs and Market Structure

10. Economies of scale • Sources of economies of scale • “the 60% rule”: capacity related to volume while cost is related to surface area • product specialization and the division of labor • “economies of mass reserves”: economize on inventory, maintenance, repair • Indivisibilities ECO 171: Costs and Market Structure

11. Fixed costs and economies of scale • Larger fixed costs  larger economies of scale • Larger efficient scale • Example: C(q) = F+q2/2 • MC = q • AC = F/q + q/2 • Min AC : q = F/q +q/2 q/2 = F/q  q2 = 2F  q = sqrt (2F) Min AC = Min MC also equal sqrt (2F) • Min efficient scale increases with F ECO 171: Costs and Market Structure

12. Fixed costs and Economies of Scale ECO 171: Costs and Market Structure

13. Marginal costs and economies of scale • Steeper marginal cost  less economies of scale • Lower efficient scale • Example: C(q) = F+q2 • MC = q • AC = F/q + q • Min AC : 2q = F/q +q q = F/q  q2 = F  q = sqrt (F) Min AC = Min MC = 2qMES= 2 sqrt(F) • Minimum efficient scale smaller than before ECO 171: Costs and Market Structure

14. Marginal costs and Economies of scale ECO 171: Costs and Market Structure

15. Economies of Scope • Producing goods jointly is cheaper • Similar to economies of scale • Sources of economies of scope • shared inputs • same equipment for various products • shared advertising creating a brand name • marketing and R&D expenditures that are generic • cost complementarities • producing one good reduces the cost of producing another • oil and natural gas • oil and benzene • computer software and computer support • retailing and product promotion ECO 171: Costs and Market Structure

16. Market Structure • Economies of scale and scope affect market structure but cannot be looked at in isolation. • They must be considered relative to market size. • Should see concentration decline as market size increases • Entry to the medical profession is going to be more extensive in Chicago than in Oxford, Miss • Find more extensive range of financial service companies in Wall Street, New York than in Frankfurt ECO 171: Costs and Market Structure

17. Number of firms in Competitive Industry • p = A – BQ • Firms are price takers • In long run equilibrium no further incentives to enter the industry. If firms are homogeneous, zero profits. • Implies p = min AC, q=qMES • Number of firms N so that: p = A-BNqMES • N = (A – p)/BqMES • Higher demand (higher A or lower B)  more firms • Lower qMES more firms • Lower min AC  lower p  more firms ECO 171: Costs and Market Structure

18. ECO 171: Costs and Market Structure

19. ECO 171: Costs and Market Structure

20. Other determinants of Market structure • Network externalities • willingness to pay by a consumer increases as the number of current consumers increase • telephones, fax, Internet, Windows software • utility from consumption increases when there are more current consumers • These markets are likely to contain a small number of firms • even if there are limited economies of scale and scope ECO 171: Costs and Market Structure

21. Other determinants of Market structure • Policy • Government can directly affect market structure • by limiting entry • taxi medallions in Boston and New York • airline regulation • through the patent system • by protecting competition e.g. through the Robinson-Patman Act ECO 171: Costs and Market Structure