PRODUCTION, COST, AND MARKET STRUCTURE

1. PRODUCTION, COST, AND MARKET STRUCTURE SIXTH LECTURE February 28, 2012 William R. Eadington, Ph.D. Professor of Economics, College of Business Director, Institute for the Study of Gambling and Commercial Gaming University of Nevada, Reno www.unr.edu/gaming

2. COST CONCEPTS Total cost relation between total cost and output Marginal cost change in total cost when output rises one unit Average cost total cost divided by total output Opportunity cost value of a resource in terms of its next best alternative

3. RETURNS TO A FACTOR The relation between output and the variation in only one input, holding all other inputs constant Total product - amount of output, Q, obtained when an input, L, increases Average product Q/L Marginal product Q/L

4. RETURNS TO A FACTOR Production function: Q=S1/2A1/2

5. RETURNS TO A FACTOR:A COMMON CASE Q Total product Quantity of auto parts S Q/S Quantity of auto parts per unit of steel Average product Marginal product S S2 S1 Quantity of steel Law of diminishing returns – at some point, S1, the marginal product of a variable factor will decline as its use is increased

6. OPTIMAL INPUT MIX Equilibrium occurs when the iso-profit curve is tangent to the iso-cost curve Optimal solution is technologically efficient and cost efficient If the price of one input increases, the firm will reduce its use and substitute relatively cheaper inputs in its place

7. COST MINIMIZATION A’ A* Quantity of aluminum Q* S S’ S* Quantity of steel

8. OPTIMAL INPUT MIXINPUT PRICE CHANGES A2 Quantity of aluminum A1 Q* Low steel price High steel price S S2 S1 Quantity of steel

9. PROFIT MAXIMIZATION A firm should increase output as long as marginal revenue exceeds marginal cost A firm should not increase output if marginal cost exceeds marginal revenue At the profit-maximizing level of output, MR=MC

10. OPTIMALITY CONDITIONS • At optimum (cost minimization for a given level of output), the following conditions must hold: • Marginal Cost = Marginal Benefit • VMPX = MCX or P*MPX = MCX • Value of Marginal ProductX/CostX = Value of Marginal Producty/Costy , or MPX/PX = MPY/PY

11. PROBLEM OF THE WEEK: 5:16 Mountain Springs Water Company produces bottled water. Internal consultants estimate the company’s production function to be Q = 300L2K, where Q is the number of bottles of water produced each week, L is the hours of labor per week, and K is the number of machine hours per week. Each machine can operate 100 hours a week. Labor costs $20/hour, and each machine costs $1000 per week. • Suppose the firm has 20 machines and is producing its current output using an optimal K/L ratio. How many people does Mountain Springs employ? Assume each person works 40 hours a week. With 20 machines, K = 2,000 hours/week. MPK = 300L2 and MPL = 600LK. MPK/rK = MPL/wL or MPK/MPL = rK/wL; 300L2/600LK = 10/20 => L/2K = ½ or L = K. Therefore, K = 2,000 hours and L = 2,000 hours, or 20 machines and 50 workers at 40 hours each b. Recent technological advancements have caused machine prices to drop. Mountain Springs can now lease each machine for $800 a week. How will this affect the optimal K/L ratio (i.e., will the optimal K/L ratio be smaller or larger)? Show why. K/L will increase to the ratio MPK/MPL = rK/wL= $20/$8. K/L = 5/4

12. COST CURVES $ Total cost $ Total costs (in dollars) Marginal cost Cost per unit of output (in dollars) Average cost Q Q Q1 Q2 Quantity of output

13. FIXED VERSUS VARIABLE COSTS • Fixed costs • incurred even if firm produces nothing; not avoidable • Variable costs • change with the level of output

14. SHORT RUN VERSUS LONG RUN Short run at least one input is fixed cost curves are operating curves Long run all inputs are variable cost curves are planning curves

15. SHORT-RUN COST CURVES $ Total cost Total costs (in dollars) Total variable cost $ Average total cost Marginal cost Average variable cost Cost per unit of output (in dollars) Average fixed cost Q Q2 Q3 Q1 Quantity of output

16. LONG-RUN AVERAGE COSTenvelope of short-run average cost curves $ SRAC5 SRAC1 SRAC5 SRAC2 SRAC4 SRAC3 Q

17. COST CONCEPTS Economies of scale Average costs fall as output expands Economies of scope cost of producing a joint set of products is less than cost of producing separately in separate firms Examples: Casino-hotel complexes in Las Vegas or Reno Scale => size of facility (# of tables & slots, number of hotel rooms, # & capacity of restaurants, etc.) Scope => facility offers gaming, lodging, cuisine, lounges, entertainment, night clubs, retail shopping, convention facilities Internal decision as to whether to offer such services within the company, or to franchise out the space to other operators Economies of scale at the corporate level: Caesars, MGM => own multiple casinos with different price/quality characteristics

18. OPTIMAL OUTPUT AND CHANGES IN MARGINAL COST $ MC0 MC1 Cost/revenue per unit (in dollars) MR Q Q0 Q1 Quantity of output

19. MARKET STRUCTURE What is a market? All firms and individuals willing and able to buy or sell a particular product or product type What is market structure? Defined by attributes of the market environment => ease of entry/exit, closeness of substitutes

20. MAIN CATEGORIES OF MARKET STRUCTURE Perfect competition Consider soybeans, corn, laptop computers, retail gasoline, gold, silver Monopoly Consider DeBeers, the Post Office, Microsoft, the cable company, NV Energy, Facebook (?) Monopolistic competition Consider supermarkets, restaurants, wines, retail outlets, cable television channels, bars and taverns Oligopoly Consider pharmaceuticals, automobile manufacturers, TV networks, hotel chains, major casino companies

21. PERFECT COMPETITIONCHARACTERISTICS Many buyers and sellers Product homogeneity Low cost and accurate information Free entry and exit Not often encountered in reality, but best regarded as a benchmark

22. FIRM DEMAND CURVEPERFECT COMPETITION $ $ Market Firm S P* P* Di = MRi = ARi Price (in dollars) D Q Qi Quantity (market) Quantity (firm i)

23. FIRM SUPPLY IN A COMPETITIVE MARKET Short run Marginal cost curve above average variable cost => if below, better to shut down P* = SRMC => optimal profit position Long run Long-run marginal cost curve above long-run average cost

24. THE FIRM’S SHORT-RUN SUPPLY CURVE $ ATCi SRMCi AVCi Costs per unit of output (in dollars) Qi Quantity (firm i)

25. THE FIRM’S LONG-RUN SUPPLY CURVE $ LRMCi LRACi Cost per unit of output (in dollars) Qi Quantity (firm i)

26. COMPETITIVE EQUILIBRIUM: THE INVISIBLE HAND $ $ LRMCi S0 LRACi P*0 P*0 Price and cost per unit of output (in dollars) S1 P*1 P*1 D0 Qi Q Q*1 Q*0 Q*i1 Q*i0 Quantity Quantity (firm i)

27. MONOPOLY Single seller in an industry Strong barriers to entry Profit maximization faces market demand and sets MR=MC Unexploited gains from trade

28. MONOPOLIST: FIRM DEMAND IS SAME AS MARKET DEMAND $ Profits P*= 105 Lost gains from trade Price and cost per unit of output MC = AC D Q Q*=95 MR Quantity

29. MONOPOLISTIC COMPETITION Multiple firms produce similar products Each firm has a “monopoly” on its own product Differentiation exists in the eyes of he consumer Firms face downward sloping demand curves Profit maximization occurs where MC=MR With free entry and exit, firms compete away economic profits => Invisible hand again Examples – toothpaste, shampoo, restaurants, clothing brands, realtors, attorneys, dentists, golf balls, ski areas, brands of skis

30. MONOPOLISTIC COMPETITOR IN THE LONG RUN LRACi LRMCi Price and cost per unit of output (in dollars) P*i Di Qi Q*i MRi Quantity (firm i)

31. OLIGOPOLY A few firms produce most of the market output Products may or may not be differentiated Effective entry barriers protect firm profitability Firm interdependence requires strategic thinking Examples – steel, autos, colas, airlines

32. BARRIERS TO ENTRY: COMP. & MON. COMP V. MON. & OLIGOPOLY Incumbent reactions Specific assets Economies of scale Excess capacity Reputation effects Incumbent advantages Pre-commitment contracts Licenses and patents Learning-curve effects Pioneering brand advantages

33. NASH EQUILIBRIUM ASSUMPTIONS: An oligopolist does the best it can, given expectations of rival’s behavior Behaviors are noncoöperative Example: Duopolists considering a low price or a high price must consider rival’s response Nash equilibrium occurs when each firm does the best it can given rival’s actions

34. DETERMINING THE NASH EQUILIBRIUM: PROFITS BASED ON PRICING Low Price High Price ALPINE $50 $100 Low Price $100 $50 SQUAW $200 $500 High Price $250 $200

35. THE COURNOT MODEL Duopolists A and B face industry demand P=100-Q, Q=QA+QB Each firm takes the other’s output as fixed E.g., PA=(100-QB*)-QA Marginal revenue for A is MRA=(100-QB*)-2QA If MC=0, the optimal output for A for the given output for B is QA=50-.5QB which is the reaction curve for firm A

36. COURNOT EQUILIBRIUM QB 100 a = Competitive equilibrium b = Cournot equilibrium c = Collusive (monopoly) equilibrium Firm A’s reaction curve Quantity of output by Firm B a 50 b 33.33 c Firm B’s reaction curve 25 QA 33.33 50 100 Quantity of output by Firm A

37. STRATEGIC POSITIONING FOR EACH FIRM IN A DUOPOLY • “Follower”: Take the competitor’s output decision as a given, and maximize profit accordingly • “Leader”: Assume the competitor will be a follower, and maximize profits under that condition • Possible outcomes: Follower-Follower; Leader-Follower; Leader-Leader; Collusion