Principles of Microeconomics

12. Production Costs, Free Market and Monopoly*

Akos LadaAugust 7th, 2014

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Contents

1. Review of previous lecture

2. The Production Function and the MPL

3. Marginal Costs of Production

4. Fixed Costs, Variable Costs, and Total Costs

5. How Competitive Firms Maximize Profits

6. Monopolies

1. Review

The Different Kinds of Goods

ExcludableNot

excludable

Rival Private goodse.g. food

Common resources

e.g. fish in the ocean

Not RivalNatural

monopoliese.g. cable TV

Public goodse.g. national

defense

Public Goods

• Are goods that are non-excludable and non-rival

• Some important public goods are:• National defense• Knowledge created

through basic research• Fighting poverty

• Public goods are difficult for private markets to provide because of the free-rider problem.

• If the benefit of a public good exceeds the cost of providing it, government should provide the good and pay for it with a tax.

• Economists use cost-benefit analysis to determine how much to provide of a public good.

• Cost-benefit analysis is imprecise because benefits are hard to measure.

Common Pool Resources

• Are goods that are at the same time not excludable but rival.

• Some important Common Resources are:• Clean air and water• Congested roads• Fish, whales, and other wildlife

• Leads to the overconsumption of the resource (e.g. the tragedy of the commons).

• Possible policies available to the government to address this issue include:• Regulate use of the resource• Impose a corrective tax• Auction off permits allowing use of the resource• If the resource is land, convert to a private good

by dividing and selling parcels to individuals

Economic Profit vs. Accounting Profit

• Accounting profit = total revenue minus

total explicit costs

• Economic profit= total revenue minus

total costs (including explicit and implicit costs)

• Accounting profit ignores implicit costs, so it’s higher than economic profit.

2. The Production Function and the

MPL

Total, average, marginal

2

3

7

8

20

+

+

+

2

1

4

1

0

The Production Function

• A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.

• It can be represented by a table, equation, or graph.

• Example:• Farmer Golib grows Cotton. • He has 5 acres of land. • He can hire as many workers as he wants.

• To build Golib’s Production Function we need to determine how many additional bags of cotton he would produce each time he hires one additional worker for his farm.

0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Q

uan

tity

of

ou

tpu

t

EXAMPLE: Farmer Golib’s Production Function

30005

28004

24003

18002

10001

00

Q

(bags of cotton)

L(no. of

workers)

Marginal Product

• If Golib hires one more worker, his output rises by the marginal product of labor.

• The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant.

• Notation: ∆ (delta) = “change in…”Examples: ∆Q = change in output, ∆L = change in labor

• Marginal product of labor (MPL) =

∆Q∆L

30005

28004

24003

18002

10001

00

Q (bags

of cotton)

L(no. of

workers)

EXAMPLE: Farmer Golib’s Total & Marginal Product

200

400

600

800

1000

MPL

∆Q = 1000∆L = 1

∆Q = 800∆L = 1

∆Q = 600∆L = 1

∆Q = 400∆L = 1

∆Q = 200∆L = 1

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.

0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Q

uan

tity

of

ou

tpu

t

MPL = Slope of Production Function

30005200

28004400

24003600

18002800

10001

1000

00

MPL

Q(bags

of cotton)

L(no. of

workers)

Why MPL Is Important

• Recall one of the Principles of Economics: Rational people think at the margin.

• When Farmer Golib hires an extra worker, • his costs rise by the wage he

pays the worker• his output rises by MPL

• Comparing them helps Golib decide whether he would benefit from hiring the worker.

3. Marginal costs of production

Why MPL Diminishes

• Farmer Golib’s output rises by a smaller and smaller amount for each additional worker. Why?

• As Golib adds workers, the average worker has less land to work with and will be less productive.

• In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.).

• Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)

EXAMPLE: Farmer Golib’s Costs

• Farmer Golib must pay $1000 per month for the land, regardless of how much cotton he grows.

• The market wage for a farm worker is $2000 per month.

• So Farmer Golib’s costs are related to how much cotton he produces….

EXAMPLE: Farmer Golib’s Costs

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total Cost

30005

28004

24003

18002

10001

$10,000

$8,000

$6,000

$4,000

$2,000

$0

$1,000

$1,000

$1,000

$1,000

$1,000

$1,00000

Cost of labor

Cost of land

Q(bags

of cotton)

L(no. of

workers)

EXAMPLE: Farmer Golib’s Total Cost Curve

Q (bags of cotton)

Total Cost

0 $1,000

1000 $3,000

1800 $5,000

2400 $7,000

2800 $9,000

3000 $11,000

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

0 1000 2000 3000

Tota

l co

st

Bags of cotton

Marginal Cost

• Marginal Cost (MC) is the increase in Total Cost from producing one more unit:

• We can calculate in the table the marginal cost of producing each additional unit, one at the time

∆TC∆Q

MC =

EXAMPLE: Total and Marginal Cost

$10.00

$5.00

$3.33

$2.50

$2.00

Marginal Cost (MC)

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total Cost

3000

2800

2400

1800

1000

0

Q(bags of cotton)

∆Q = 1000

∆TC = $2000

∆Q = 800

∆TC = $2000

∆Q = 600

∆TC = $2000

∆Q = 400

∆TC = $2000

∆Q = 200

∆TC = $2000

MC usually rises as Q rises, as in this example.

EXAMPLE: The Marginal Cost Curve

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

TC

$10.00

$5.00

$3.33

$2.50

$2.00

MC

3000

2800

2400

1800

1000

0

Q(bags of cotton)

$0

$2

$4

$6

$8

$10

$12

0 1,000 2,000 3,000Q

Mar

gin

al C

ost

($)

Why MC Is Important

• Farmer Golib is rational and wants to maximize his profit. To increase profit, should he produce more or less cotton?

• To find the answer, Farmer Golib needs to “think at the margin.”

• If the cost of additional cotton (MC) is less than the revenue he would get from selling it, then Golib’s profits rise if he produces more.

4. Fixed costs, variable costs and

total costs

Fixed and Variable Costs

• Fixed costs (FC) do not vary with the quantity of output produced. • For Farmer Golib, FC = $1000 for his land• Other examples:

cost of equipment, loan payments, rent

• Variable costs (VC) vary with the quantity produced. • For Farmer Golib, VC = wages he pays workers• Other example: cost of materials

• Total cost (TC) = FC + VC

EXAMPLE 2

• Our second example is more general, applies to any type of firm producing any good with any types of inputs.

• Think of an example, and keep it in mind as we calculate the different costs of production….

EXAMPLE 2: Costs

7

6

5

4

3

2

1

620

480

380

310

260

220

170

$100

520

380

280

210

160

120

70

$0

100

100

100

100

100

100

100

$1000

TCVCFCQ

$0

$100

$200

$300

$400

$500

$600

$700

$800

0 1 2 3 4 5 6 7

Q

Costs

FC

VC

TC

Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:

Usually, MC rises as Q rises, due to diminishing marginal product.

Sometimes (as here), MC falls before rising.

(In other examples, MC may be constant.)

EXAMPLE 2: Marginal Cost

6207

4806

3805

3104

2603

2202

1701

$100

0

MCTCQ

140

100

70

50

40

50

$70

∆TC∆Q

MC =

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Co

sts

EXAMPLE 2: Average Fixed Cost

1007

1006

1005

1004

1003

1002

1001

14.29

16.67

20

25

33.33

50

$100

n/a$10

00

AFCFCQ Average fixed cost (AFC)

is fixed cost divided by the quantity of output:

AFC = FC/Q

Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Co

sts

EXAMPLE 2: Average Variable Cost

5207

3806

2805

2104

1603

1202

701

74.29

63.33

56.00

52.50

53.33

60

$70

n/a$00

AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:

AVC = VC/Q

As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7Q

Co

sts

EXAMPLE 2: Average Total Cost

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

6207

4806

3805

3104

2603

2202

1701

$100

0

74.2914.2

9

63.3316.6

7

56.0020

52.5025

53.3333.3

3

6050

$70$100

n/an/a

AVCAFCTCQ

Average total cost (ATC) equals total cost divided by the quantity of output:

ATC = TC/QAlso,

ATC = AFC + AVC

Usually, as in this example, the ATC curve is U-shaped.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

EXAMPLE 2: Average Total Cost

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

6207

4806

3805

3104

2603

2202

1701

$100

0

TCQ

EXAMPLE 2: The Various Cost Curves Together

AFCAVCATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

Why ATC Is Usually U-Shaped?

As Q rises:

Initially, falling AFC pulls ATC down.

Eventually, rising AVC pulls ATC up.

Efficient scale:The quantity that minimizes ATC.

ATC and MC

ATCMC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

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.

5. How Competitive Firms Maximize

Profits

Characteristics of Perfect Competition

1. Many buyers and many sellers.

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

1. Many buyers and many sellers.

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.

The Revenue of a Competitive Firm

• Total revenue (TR)

• Average revenue (AR)

• Marginal revenue (MR):The change in TR from selling one more unit.

∆TR∆Q

MR =

TR = P x Q

TRQ

AR = = P

MR = P for a Competitive Firm

• A competitive firm can keep increasing its output without affecting the market price.

• So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P.

MR = P is only true for firms in competitive

markets.

MR = P is only true for firms in competitive

markets.

Profit Maximization

• What Q maximizes the firm’s profit?

• To find the answer, “think at the margin.” If increase Q by one unit,revenue rises by MR,cost rises by MC.

• If MR > MC, then increase Q to raise profit.

• If MR < MC, then reduce Q to raise profit.

• Therefore, the Q that will give the firm the maximum profit it can make in the market, is the Q at which….

P1 MR

MC and the Firm’s Supply Decision

At Qa, MC < MR.

So, increase Q to raise profit.

At Qb, MC > MR.

So, reduce Q to raise profit.

At Q1, MC = MR.

Changing Q would lower profit.

Q

Costs

MC

Q1Qa Qb

Rule: MR = MC at the profit-maximizing Q.

P1 MR

P2 MR2

MC and the Firm’s Supply Decision

If price rises to P2,

then the profit-maximizing quantity rises to Q2.

The MC curve determines the firm’s Q at any price.

Hence,

Q

Costs

MC

Q1 Q2

the MC curve is the competitive firm’s supply curve.

6. Monopolies

Monopolies

• A monopoly is a firm that is the sole seller of a product without close substitutes.

• In this chapter, we study monopoly and contrast it with perfect competition.

• The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power.

Why Monopolies Arise

The main cause of monopolies is barriers to entry – other firms cannot enter the market.

Three sources of barriers to entry:

1. A single firm owns a key resource.E.g., DeBeers owns most of the world’s diamond mines

2. The government gives a single firm the exclusive right to produce the good.E.g., patents, copyright laws

Why Monopolies Arise

3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms.

Q

Cost

ATC

1000

$50

Example: 1000 homes need electricity

Electricity

ATC slopes downward

due to huge FC and

small MC

ATC is lower if one firm services

all 1000 homes than if two firms

each service 500 homes.

500

$80

Monopoly vs. Competition: Demand Curves

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.

D

P

Q

A competitive firm’s demand curve

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.

A competitive firm’s demand curve

D

P

Q

The Monopolist Profit

• Profit maximization golden rule:• MR = MC

• For competitive firms• MR = P, therefore,• Profit Maximization Condition:

P=MC

• For monopolies, however….• MR ≠ P• Then, how do monopolies

maximize their profits?