Market Structure and the Behavior

of Firms

Market Structures

Benchmark models Perfect Competition Monopoly

Behavior of Firms

What is the objective of a business? 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

0% 0%0%0%

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)

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

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

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

0% 0%0%0%

1. The fourth2. The fifth3. The sixth4. The seventh

1. The fourth2. The fifth3. The sixth4. The seventh

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

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

2. the local property tax on the building owned by the Texaco operator.

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

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

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

2. the local property tax on the building owned by the Texaco operator.

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

4. 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?

1 2 3 4

0% 0%0%0%

1 2 3 4 5

Oscar has negotiated a lease for his sporting goods store where he is required to pay $2,500 per month in rent. Oscar pays his staff $9 per hour to sell sporting goods and his monthly electricity bill averages $700, depending on his total hours of operation. Oscar's fixed costs of production equal:

$2,500 permonth.

$3,200 permonth.

$9 per hourmultipliedby totalhours of

work plus$700.

$9 per hourmultipliedby totalhours of

work plus$3,200.

0% 0%0%0%

1. $2,500 per month. 2. $3,200 per month. 3. $9 per hour multiplied by

total hours of work plus $700. 4. $9 per hour multiplied by

total hours of work plus $3,200.

1. $2,500 per month. 2. $3,200 per month. 3. $9 per hour multiplied by

total hours of work plus $700. 4. $9 per hour multiplied by

total hours of work plus $3,200.

1 2 3 4 5

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

Austyn's total 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?

1. $0.202. $53. $2404. $720

1. $0.202. $53. $2404. $720

0.2 5 240 720

0% 0%0%0%

512

60

LMP

wMC

1 2 3 4 5

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

0% 0%0%0%

1. $252. $503. $604. $300

1. $252. $503. $604. $300

1 2 3 4 5

Long Run Costs

What is the optimal size for a factory?

output

$

ATC1 ATC2

ATC3

ATC4

q2

LRAC

LRAC 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

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

1. Diminishing returns2. Economies of scale3. Diseconomies of scale4. Constant returns to scale

1. Diminishing returns2. Economies of scale3. Diseconomies of scale4. Constant returns to scale

0% 0%0%0%TCATC=

q

1 2 3 4 5

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 = 600

$20 = P1

I want you to maximize profit

What is TR = ?What is TC = ?What is TR = ?What is TC = ?

1. expand output 2. reduce output3. leave output

unchanged4. decrease its price

1. expand output 2. reduce output3. leave output

unchanged4. 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:

0% 0%0%0%

1 2 3 4 5

Profit and Loss Diagrams

MC

quantity

$

q1 = 300

$60 = P1

ATC

MR1

$50 = ATC1

Positive Profit = Pq – (ATC)q = (P-ATC)q = (60-50)300 = $3000

Negative Profit = (35-50)250 = -$3750

Zero Profit?

MR2$35 = P2

q2 = 250

1. $5,000 2. $25,000 3. $45,000 4. It is impossible to

determine with the information given.

1. $5,000 2. $25,000 3. $45,000 4. 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?

5000 25000 45000 impossible

0% 0%0%0%

1 2 3 4 5

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

1 2 3 4

0% 0%0%0%

1. average fixed cost is equal to $1.50.

2. profit per bushel is equal to $2.75.

3. average variable cost is equal to $1.25.

4. economic profit is equal to $250.

1. average fixed cost is equal to $1.50.

2. profit per bushel is equal to $2.75.

3. average variable cost is equal to $1.25.

4. economic profit is equal to $250.

1 2 3 4 5

Sometimes it’s better to stay open and lose a little bit…

= TR – (FC +VC)

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

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 $300 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 $300 and total costs of $600,000 at this output level.

TR =

TC =

=

FC =

VC =

ATC =

AFC =

AVC =

MR =

MC =

SD =

$480,000

$700

$420,000

$180,000

-$120,000

$800

$300

$600,000

$1,000

$800

-$180,000

Firm should stay open since TR > VC

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%E= 0%A= 9%E= 3%

if E > 0 entry occurs

if E < 0 exit occurs

Economy

E= 0%

E= 0%

E= 0%

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

price rises to P2

Price(dollars per cassette)

Quantity Demanded(thousands per week)

3.65 500

5.20 450

6.80 400

8.40 350

10.00 300

11.60 250

13.20 200

14.80 150

Output(cassettes per week) MC AVC ATC

150 6.00 8.80 15.47

200 6.40 7.80 12.80

250 7.00 7.00 11.00

300 7.65 7.10 10.43

350 8.40 7.20 10.06

400 10.00 7.50 10.00

450 12.40 8.00 10.22

500 12.70 9.00 11.00

Market Demand Firm’s Cost

1000 firms in the industry