Market Structure and the Behavior of

Firms

Market Structures

Benchmark models Perfect Competition Monopoly

It’s registration time…how about economics?It’s registration time…how about economics?

MajorMajor Econ 211 (Micro I)Econ 211 (Micro I) Econ 212 (Macro I)Econ 212 (Macro I) Econ 349 (Micro II)Econ 349 (Micro II) Econ 375 (Macro II)Econ 375 (Macro II) Math 123 (Stats)Math 123 (Stats) Econ 420 (Regression)Econ 420 (Regression) Econ 421 (Empirical Research)Econ 421 (Empirical Research) 12 additional hours in Econ12 additional hours in Econ

33-34 hours33-34 hours

MajorMajor Econ 211 (Micro I)Econ 211 (Micro I) Econ 212 (Macro I)Econ 212 (Macro I) Econ 349 (Micro II)Econ 349 (Micro II) Econ 375 (Macro II)Econ 375 (Macro II) Math 123 (Stats)Math 123 (Stats) Econ 420 (Regression)Econ 420 (Regression) Econ 421 (Empirical Research)Econ 421 (Empirical Research) 12 additional hours in Econ12 additional hours in Econ

33-34 hours33-34 hours

MinorMinor Econ 211Econ 211 Econ 212Econ 212 Math 123Math 123 9 additional hours in Econ9 additional hours in Econ

18 hours18 hours

MinorMinor Econ 211Econ 211 Econ 212Econ 212 Math 123Math 123 9 additional hours in Econ9 additional hours in Econ

18 hours18 hours

Fall 2008• Econ 325 (Gender Econ)• Econ 350 (Environmental Econ)• Econ 360 (Law & Econ)• Econ 420 (Regression)

Spring 2009• Econ 301 (Money & Banking) • Econ 340 (Sports Econ)• Econ 349 (Micro II)• Econ 414 (Int’l Econ)

Behavior of Firms

What is the objective of a business? Assume firms maximize profit = TR – TC TR = Total Revenue = Pq

TC = Total Economic CostsTR = Total Revenue = PqTC = Total Economic Costs

Economic Cost = Explicit Cost + Implicit CostEconomic Cost = Explicit Cost + Implicit Cost

1. $107,0002. $113,0003. $149,0004. $185,300

1. $107,0002. $113,0003. $149,0004. $185,300

Suppose that a young chef opened his own restaurant. To do so, he quit his job, which was paying $36,000 per year; cashed in a $6,000 certificate of deposit that was yielding 5% (to purchase equipment); and took over a building owned by his wife which had been rented out for $3,000 per month. His expenses for the first year amounted to $60,000 for food, $40,000 for extra help, and $7,000 for utilities. The chef is trying to figure out whether he would have been better off not being in business last year. He knows how to calculate his revenues, but he needs help with the cost side of the picture. What were the chef's total economic costs?

107000 113000 149000 185300

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Explicit Costs Implicit Costs

$60,000 (food)

$40,000 (extra help)

$7,000 (utilities)

$6,000 (equipment)

$113,000 $72,300

Total Economic Cost = $185,300

$36,000 (foregone job)

$300 (foregone interest)

$36,000 (foregone rent)

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Technological Constraints Production Function

q = F(L, K)

q = outputL = laborK = capitalF(·) represents technology

Lab Experiment 3: Widget Production

_

Variable input Fixed input

Other 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

Measuring Marginal Product

Batting Averages GPAs

GPA

Fall Spring Cumulative

First Year

Second Year

Third Year

Fourth Year

4.0 2.0 3.0

3.0 3.5 3.125

When MP > AP then AP will riseWhen MP < AP then AP will fall

a) The fourthb) The fifthc) The sixthd) The seventh

a) The fourthb) The fifthc) The sixthd) The seventh

Which worker at Decent Donuts has the highest marginal product?

Number of Workers 0 1 2 3 4 5 6 7 8 9 10

Total Donuts Produced Daily 0 12 26 44 64 86 110 122 125 127 128

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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

a) interest payments to a local bank for a loan.

b) the local property tax on the building owned by the Texaco operator.

c) the premiums paid for liability insurance, which are fixed at about $30,000 per year.

d) the federal excise tax paid on each gallon of Texaco gasoline sold.

a) interest payments to a local bank for a loan.

b) the local property tax on the building owned by the Texaco operator.

c) the premiums paid for liability insurance, which are fixed at about $30,000 per year.

d) the federal excise tax paid on each gallon of Texaco gasoline sold.

Which of the following would be classified as a variable cost for the local Texaco gasoline station?

a) b) c) d)

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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

a) $0.20b) $5c) $240d) $720

a) $0.20b) $5c) $240d) $720

Austyn's fixed cost is $3,600. Austyn’s employs 20 workers and pays each worker $60. The average product of labor is 30, the marginal product of the 20th worker is 12. What is the marginal cost of the last unit produced by the last worker Austyn’s hired?

512

60

LMP

wMC

0.2 5 240 720

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Long Run Costs

What is the optimal size for a factory?

output

$

ATC1 ATC2

ATC3

ATC4

q2

LRAC

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 ProblemsCoordination/Communication Problems

a) Diminishing returnsb) Economies of scalec) Diseconomies of scaled) Constant returns to scale

a) Diminishing returnsb) Economies of scalec) Diseconomies of scaled) Constant returns to scale

When all inputs increase by 40% and output rises by 30%, the firm is experiencing:

TCATC=

q

Dim

inis

hing re

turn

s

Eco

nomie

s of s

cale

Dis

econom

ies

of...

Const

ant r

etur

ns...

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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 = P q - [FC + VC]

What output should firm produce? produce until MR = MC

If MR > MC produce more If MR < MC produce less

What output should firm produce? produce until MR = MC

If MR > MC produce more If 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 = ?

a) expand output b) reduce outputc) leave output unchangedd) decrease its price

a) expand output b) reduce outputc) leave output unchangedd) decrease its price

In a perfectly competitive industry, the market price of the product is $12. Firm A is producing the output at which average total cost equals marginal cost, both of which are $10. To maximize its profits, Firm A should:

exp

and

outpu

t

redu

ce o

utput

leav

e out

put .

..

dec

reas

e its

p...

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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

a) $5,000 b) $25,000 c) $45,000 d) It is impossible to determine

with the information given.

a) $5,000 b) $25,000 c) $45,000 d) It is impossible to determine

with the information given.

Juan’s Software Company is a perfect competitor. Juan has total fixed costs of $25,000, average variable costs for 1,000 units of the product of $45, and marginal revenue of $75. What is his total economic profit?

a) b) c) d)

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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

A competitive firm is maximizing profits by producing 600 units of output at the current market price of $800 per unit. The firm has AFC of $150 and total costs of $600,000 at this output level.

A competitive firm is maximizing profits by producing 600 units of output at the current market price of $800 per unit. The firm has AFC of $150 and total costs of $600,000 at this output level.

TR =

TC =

=

FC =

VC =

ATC =

AFC =

AVC =

MR =

MC =

SD =

$480,000

$850

$510,000

$ 90,000

-$120,000

$800

$150

$600,000

$1,000

$800

-$90,000Firm should shut down since TR < VC

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?

I have to remember to think at the

margin!

MC

quantity

$

q1

P1

ATC

MR1

AVC

Long Run Equilibrium

A = TR – Explicit Costs

E = A - Implicit Costs

LRE: E = 0

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 =

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

a) lower price, economic losses by rutabaga farmers, and entry into the market.

b) lower price, economic losses by rutabaga farmers, and exit from the market.

c) higher price, economic profits for rutabaga farmers, and entry into the market.

d) higher price, economic losses by rutabaga farmers, and exit from the market.

a) lower price, economic losses by rutabaga farmers, and entry into the market.

b) lower price, economic losses by rutabaga farmers, and exit from the market.

c) higher price, economic profits for rutabaga farmers, and entry into the market.

d) higher price, economic losses by rutabaga farmers, and exit from the market.

The rutabaga market is perfectly competitive. Research is published claiming that eating rutabagas leads to gaining weight and so the demand for rutabagas permanently decreases. The permanent decrease in demand results in a

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a) The firms’ costs will rise, resulting in positive economic profit in the short run and, hence, the industry supply curve will shift rightward in the long run

b) The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift rightward in the long run.

c) The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift leftward in the long run.

d) The industry supply curve will shift leftward in the short run, causing permanent long-run economic losses

a) The firms’ costs will rise, resulting in positive economic profit in the short run and, hence, the industry supply curve will shift rightward in the long run

b) The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift rightward in the long run.

c) The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift leftward in the long run.

d) The industry supply curve will shift leftward in the short run, causing permanent long-run economic losses

Suppose that newspaper companies are now required to use recycled paper, which is more expensive than new paper. Which of the following is most likely to result if the newspaper industry is highly competitive?

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a) $25b) $50c) $60d) $300

a) $25b) $50c) $60d) $300

Ian’s fixed cost of mowing lawns is $250 and his marginal cost is constant at $10 per lawn. If Ian mows 5 lawns in one day, what is his average total cost?

25 50 60 300

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a) average fixed cost is equal to $1.50. b) profit per bushel is equal to $2.75. c) average variable cost is equal to $1.25. d) economic profit is equal to $250.

a) average fixed cost is equal to $1.50. b) profit per bushel is equal to $2.75. c) average variable cost is equal to $1.25. d) economic profit is equal to $250.

A wheat farmer operating in the short run produces 100 bushels of wheat. Her average total cost per bushel is $1.75, total revenue is $450, and (total) fixed costs are equal to $100. Then

a) b) c) d)

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Business people often speak about price elasticity without actually using the term. Which of the following quotations describes an elastic demand for a product?

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a) "A price cut won't help me. It won't increase my sales; I'll just get less money for each unit that I was selling before."

b) "I don't think a price cut will help my bottom line any. Sure, I'll sell a bit more, but what I may gain by selling more, I'll more than lose because the price will be lower."

c) "My customers are real shoppers. Since I cut my prices just a few cents below those my competitors charge, customers have been flocking to my store and sales are booming."

d) "The economic expansion has done wonders for my sales. With more people back at work, my sales are taking off, and I don't even have to reduce my prices."

a) "A price cut won't help me. It won't increase my sales; I'll just get less money for each unit that I was selling before."

b) "I don't think a price cut will help my bottom line any. Sure, I'll sell a bit more, but what I may gain by selling more, I'll more than lose because the price will be lower."

c) "My customers are real shoppers. Since I cut my prices just a few cents below those my competitors charge, customers have been flocking to my store and sales are booming."

d) "The economic expansion has done wonders for my sales. With more people back at work, my sales are taking off, and I don't even have to reduce my prices."

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A group of dairy farmers are trying to raise milk prices by 20%. If the price elasticity of demand for is 0.75, and the price elasticity of supply for milk is 0, then by how much should farmers reduce their milk production to obtain the 20% increase?

a) 2.7%b) 7.5%c) 15%d) 20%

a) 2.7%b) 7.5%c) 15%d) 20%

0.02

70.

075

0.15 0.

2

0% 0%0%0%

1 2 3 4 5

%0.75

20%

QE

a) french fries and onion ringsb) DVDs and milkc) hockey pucks and hockey sticks

d) All of the above are correct, because the cross-price elasticity

is always a positive number.

a) french fries and onion ringsb) DVDs and milkc) hockey pucks and hockey sticks

d) All of the above are correct, because the cross-price elasticity

is always a positive number.

For which of the following is the cross-price elasticity of demand most likely a large positive number?

a) b) c) d)

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