Principles of Microeconomics 13. Industrial Organization and Welfare*

1. Principles of Microeconomics13. Industrial Organization and Welfare* AkosLada August 8th, 2011 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents • Review of previous lecture • Competitive firms in the short and the long run • The monopolist’s profit-maximizing decision • Monopoly, welfare, and public policy

3. 1. Review

4. Production Function and the MPL 3,000 2,500 2,000 Quantity of output 1,500 1,000 500 0 0 1 2 3 4 5 No. of workers 0 The relationship between the quantity of inputs used to produce a good and the quantity of output of that good. 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. L Q MPL 0 0 1000 MPL is the slope of the Production Function 1 1000 800 2 1800 600 3 2400 400 4 2800 200 5 3000

5. Production Costs $100 $0 $100 100 70 170 100 120 220 100 160 260 100 210 310 100 280 380 100 380 480 100 520 620 0 $800 FC Q FC VC TC VC $700 TC 0 $600 1 $500 2 Costs $400 3 $300 4 $200 5 $100 6 $0 7 0 1 2 3 4 5 6 7 Q

6. Average and Marginal costs $200 $175 $150 AFC $125 AVC Costs $100 ATC $75 MC $50 $25 $0 0 1 2 3 4 5 6 7 Q 0 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.

7. Refer to the table below. The average total cost of producing five units of output isQuantity of Output Fixed Costs Variable Costs 0 $20 $0 1 20 5 2 20 10 3 20 15 4 20 20 5 20 25 • $2. • $5. • $9. • $45.

8. Refer to the table below. The marginal cost of producing the fifth unit of output isQuantity of Output Fixed Costs Variable Costs 0 $10 $0 1 10 4 2 10 9 3 10 15 4 10 22 5 10 40 • $8. • $18. • $40. • $58.

9. Profit-maximization rule At Qa, MC < MR. So, increase Qto raise profit. At Qb, MC > MR. So, reduce Qto raise profit. At Q1, MC = MR. Changing Qwould lower profit. Costs MC P1 MR Q Q1 Qa Qb 0 Rule: MR = MC at the profit-maximizing Q.

10. 2. Competitive firms in the short and the long run

11. Firms’ Shutdown and Exit 0 • 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.

12. A Firm’s Short-run Decision to Shut Down 0 • 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

13. Costs MC If P > AVC, then firm produces Q where P = MC. ATC AVC If P < AVC, then firm shuts down (produces Q = 0). Q A Competitive Firm’s SR Supply Curve 0 The firm’s SR supply curve is the portion of its MC curve above AVC.

14. 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 • revenues are insufficient to cover total costs. • total fixed costs are less than marginal fixed cost. • revenue per unit is less than average variable cost. • marginal costs are less than the revenues.

15. The Irrelevance of Sunk Costs 0 • 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 FCis 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).

16. A Firm’s Long-Run Decision to Exit 0 • 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

17. A New Firm’s Decision to Enter Market 0 • 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

18. The firm’s LR supply curve is the portion of its MC curve above LRATC. The Competitive Firm’s Supply Curve Costs MC Q 0 LRATC

19. Entry & Exit in the Long Run, and the Zero-Profit Condition 0 • 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 • 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.

20. Costs, P MC P = $10 MR ATC $6 Q 50 STUDENT’S TURNIdentifying a firm’s profit 0 A competitive firm Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. 20

21. Costs, P MC P = $10 MR ATC profit $6 Q 50 Answers 0 A competitive firm Profit per unit = P – ATC= $10 – 6 = $4 Total profit = (P – ATC) x Q = $4 x 50= $200 21

22. One firm Market P P LRATC MC long-run supply P = min. ATC Q Q (market) (firm) The LR Market Supply Curve 0 The LR market supply curve is horizontal at P = minimum ATC. In the long run, the typical firm earns zero profit.

23. SR & LR effects of an Increase in Demand P P Market S1 MC S2 ATC Profit P2 P2 long-run supply P1 P1 D2 D1 Q Q Q1 Q2 Q3 (market) (firm) 0 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. One firm B A C

24. 3. The monopolist’s profit-maximizing decision

25. A monopoly is different… • 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. • 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

26. P P D Q Q Monopoly vs. Competition: Demand Curves A competitive firm’s demand curve A monopoly’s demand curve 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. 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. D

27. 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!

28. STUDENT’S TURNA monopoly’s revenue 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? n.a. 28

29. $ 0 $4 4 $4.00 3 7 3.50 2 9 3.00 1 10 2.50 0 10 2.00 –1 9 1.50 Answers Q P TR AR MR Here, P = AR, same as for a competitive firm. Here, MR < P, whereas MR = Pfor a competitive firm. 0 $4.50 n.a. 1 4.00 2 3.50 3 3.00 4 2.50 5 2.00 6 1.50 29

30. Common Grounds’ D and MR Curves Q P MR 0 $4.50 Demand curve(P) $4 1 4.00 3 2 3.50 2 3 3.00 1 MR 4 2.50 0 5 2.00 –1 6 1.50 P, MR $ 5 4 3 2 1 0 -1 -2 -3 Q 0 1 2 3 4 5 6 7

31. Costs and Revenue MC P D MR Q Quantity Profit-maximizing output Monopolist Profit-Maximization • 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. 1. The profit-maximizing Q is where MR = MC. 2. Find P from the demand curve at this Q.

32. 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.

33. 4. Monopoly, welfare, and public policy

34. 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.

35. Competitive equilibrium: quantity = QC P = MC total surplus is maximized Monopoly equilibrium: quantity = QM P > MC deadweight loss Deadweight loss Price MC P P = MC MC D MR QM QC Quantity The Welfare Cost of Monopoly

36. In comparison to a perfectly competitive firm, a monopolist charges a • higher price and produces a higher quantity. • higher price and produces a lower quantity. • lower price and produces a higher quantity. • lower price and produces a lower quantity.

37. Refer to the figure below. The deadweight loss for a profit-maximizing monopolist is the area • ABEG. • ABC. • FBE. • GEC.

38. 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)