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economic costs
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are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall the opportunity-cost concept)
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explicit costs
answer
Payments to non-owners of a firm for their resources
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implicit costs
answer
money payments the self-employed resources could have been earned in their best alternative employment includes forgone interest, forgone rent, forgone wages and forgone entrepreneurial income
includes a normal profit
includes a normal profit
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accounting profit
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revenue - explicit costs
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economic profit
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accounting profit - implicit costs
revenue - economic costs
revenue - explicit costs - implicit costs
revenue - economic costs
revenue - explicit costs - implicit costs
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economic profit vs accounting profit
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Economic profit is equal to total revenue less economic costs. Economic costs are the sum of explicit and implicit costs and includes a normal profit to the entrepreneur. Accounting profit is equal to total revenue less accounting (explicit) costs.
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short run
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period of time that is too brief for a firm to alter its plant capacity, but can change output somewhat by increasing or decreasing its variable inputs.
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long run
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a period of time that is long enough for the firm to adjust the plant size as well as enter or leave the industry. All inputs are variable in the long run
enough time for firms to enter and exit the industry
enough time for firms to enter and exit the industry
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total product
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total quantity produced
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marginal product
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the amount that a total product changes when labor changes by one unit
change in total product/change in labor product
change in total product/change in labor product
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average product
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output that is produced per unit of labor
total product/units of labor
total product/units of labor
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law of diminishing returns
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As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will decrease. Essentially the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource, when there isn't any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of labor, the machinery is still underused - there is machinery that is often idle as that one unit of labor has to perform all of the tasks. As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used more and more to its capacity. However, at some point there will be so much labor that the fixed resources are over utilized and the individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns - where the TP is still increasing when hiring one more unit of labor, but it doesn't increase as much as it did with the previous unit of labor.
•Resources are of equal quality
•Technology is fixed
•Variable resources are added to fixed resources
•At some point, marginal product will fall
•Resources are of equal quality
•Technology is fixed
•Variable resources are added to fixed resources
•At some point, marginal product will fall
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fixed costs (TFC)
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short-run cost type
costs that do not vary with output
costs that do not vary with output
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variable costs (TVC)
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short-run cost type
costs that do vary with output
costs that do vary with output
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total cost (TC)
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short-run type cost
sum of TFC and TVC
sum of TFC and TVC
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short run cost curve
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Total fixed cost (TFC) is independent of the level of output. Total cost is the sum of fixed cost and variable cost. Total variable cost (TVC) changes with output.
Since the only thing that differentiates the TC and TVC is the constant fixed costs, the TC and TVC look very similar and are parallel to each other. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that output.
Since the only thing that differentiates the TC and TVC is the constant fixed costs, the TC and TVC look very similar and are parallel to each other. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that output.
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average fixed cost AFC
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AFC=TFC/Q
Average fixed costs reflect the fixed costs per unit produced
Average fixed costs reflect the fixed costs per unit produced
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average variable cost AVC
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TVC/Q
average variable costs reflect the variable costs per unit produced
average variable costs reflect the variable costs per unit produced
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average total cost
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TC/Q
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marginal cost
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change in total cost / change in quantity
Marginal costs play an extremely important role in the firm's decision-making about how much they will produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of change in the total costs.
Marginal costs play an extremely important role in the firm's decision-making about how much they will produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of change in the total costs.
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average cost curves
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AFC falls as a given amount of fixed costs is apportioned over a larger and larger output. AVC initially falls because of increasing marginal returns but then rises because of diminishing marginal returns. Average total cost (ATC) is the vertical sum of average variable cost (AVC) and average fixed cost (AFC). The only difference between the ATC and AVC is the AFC (remember ATC = AFC + AVC or AFC = ATC - AVC), so the vertical distance between the ATC and AVC is the AFC. You want to get used to measuring AFC in this way because at some point the AFC will no longer be included in the graphs.
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Marginal cost and marginal product curves
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The marginal-cost (MC) curve and the average-variable-cost (AVC) curve are mirror images of the marginal-product (MP) and average-product (AP) curves. Assuming that labor is the only variable input and that its price (the wage rate) is constant, then when MP is rising, MC is falling, and when MP is falling, MC is rising. Under the same assumptions, when AP is rising, AVC is falling, and when AP is falling, AVC is rising.
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long run production costs
answer
•The firm can change all input amounts, including plant size
•All costs are variable in the long run
•Long run ATC
•Now consider costs in terms of average total costs
•All costs are variable in the long run
•Long run ATC
•Now consider costs in terms of average total costs
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economies of scale
answer
•Labor specialization
•Managerial specialization
•Efficient capital
•Other factors
for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. Efficient capital leads to economies of scale because high volume production warrants the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.
•Managerial specialization
•Efficient capital
•Other factors
for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. Efficient capital leads to economies of scale because high volume production warrants the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.
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constant returns to scale
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occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output.
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diseconomies of scale
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occur if a firm becomes too large, as illustrated by the rising part of the long run ATC curve. As the firm expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will cause a less than proportionate increase in output.
Reasons that diseconomies of scale occur include the difficulty in controlling and coordinating large scale operations; large bureaucracies lead to communication problems; workers may feel alienated and therefore may not work efficiently; and shirking, or work avoidance, may be easier in a larger firm.
Reasons that diseconomies of scale occur include the difficulty in controlling and coordinating large scale operations; large bureaucracies lead to communication problems; workers may feel alienated and therefore may not work efficiently; and shirking, or work avoidance, may be easier in a larger firm.
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minimum efficient scale
answer
occurs on an industry's long-run ATC determines if there will be many or few producers and whether they will be large, small, or different sizes. A natural monopoly is a rare situation where economies of scale extend beyond the market size. Therefore, one large firm can provide the product more cheaply than a multi-firm market.
•Lowest level of output at which long run average costs are minimized
•Can determine the structure of the industry
•Lowest level of output at which long run average costs are minimized
•Can determine the structure of the industry
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natural monopoly
answer
•Long run costs are minimized when only one firm produces the product
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the long run in pure competition
answer
•In the long run
•Firms can expand or contract capacity
•Firms can enter or exit the industry
•Decisions are based on the incentives of profits or losses
Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run, all of these limits are relaxed. Firms will chose to expand or enter an industry that is experiencing profits, while firms will chose to contract or exit industries experiencing losses
•Firms can expand or contract capacity
•Firms can enter or exit the industry
•Decisions are based on the incentives of profits or losses
Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run, all of these limits are relaxed. Firms will chose to expand or enter an industry that is experiencing profits, while firms will chose to contract or exit industries experiencing losses
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long run supply curve
answer
is defined as a curve showing the prices at which a purely competitive industry will make various quantities of the product available in the long run when all inputs are variable.
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profit maximization in the long run
answer
•Easy entry and exit
•The only long run adjustment we consider in this analysis
•Identical costs
•All firms in the industry have identical costs
•The only long run adjustment we consider in this analysis
•Identical costs
•All firms in the industry have identical costs
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constant-cost industry
answer
Entry and exit of firms does not affect resource prices
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long run adjustment process
answer
As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero and only a normal profit is realized for the firm and Price = minimum ATC.
If the industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC.
Once the industry has completed the long-run adjustment process, it is in long-run equilibrium
If the industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC.
Once the industry has completed the long-run adjustment process, it is in long-run equilibrium
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long run equilibrium
answer
•Entry eliminates profits
•Firms enter
•Supply increases
•Price falls
•Exit eliminates losses
•Firms leave
•Supply decreases
•Price rises
•Firms enter
•Supply increases
•Price falls
•Exit eliminates losses
•Firms leave
•Supply decreases
•Price rises
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increasing-cost industry
answer
entry or exit of firms does affect costs. Input costs will increase as firms enter the industry and input costs will fall as firms exit the industry. The long run supply curve is upsloping.
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decreasing-cost industry
answer
, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry causing input costs to rise. If demand for the product increases, firms will enter the industry causing input costs to fall. The long run supply curve is downsloping. Examples include the personal computer industry and the shoe manufacturers in America.
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productive efficiency
answer
•Producing where P = minimum ATC
is producing goods in the least costly way
is producing goods in the least costly way
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allocative efficiency
answer
•Producing where P = MC
Allocative efficiency is producing the mix of goods most desired by society
Allocative efficiency is producing the mix of goods most desired by society
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triple equality
answer
•P = MC = minimum ATC
The triple equality means that pure competition leads to the most efficient use of society's resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition.
The triple equality means that pure competition leads to the most efficient use of society's resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition.
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consumer surplus and producer surplus are maximized in pure competition and efficiency
answer
Consumer surplus is defined as the difference between the maximum that consumers would be willing to pay and the market price. Producer surplus is the difference between the minimum producers would be willing to accept for their product and the market price.
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dynamic adjustments
answer
occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs. The "invisible hand" works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes.
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technological advance and competition
answer
•Entrepreneurs would like to increase profits beyond just a normal profit
•Decrease costs by innovating
•New product development
•Decrease costs by innovating
•New product development
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creative destruction
answer
the creation of new products and new production methods destroys the market positions of firms committed to existing products and old ways of doing business. An example of creative destruction is the CD (compact disc) being replaced with iPods which in turn are being replaced with smartphones and their ability to play music. Faxes and emails have affected traditional postal service. Online retailers like Amazon have taken business away from traditional brick-and-mortar retailers
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patent failure
answer
•Patents give the inventor exclusive rights to market and sell their product for 20 years
•May hinder "creative destruction"
•Eliminate patents on complicated, hard to copy products
•Speed up innovation by increasing the opportunities of potential new competitors
•May hinder "creative destruction"
•Eliminate patents on complicated, hard to copy products
•Speed up innovation by increasing the opportunities of potential new competitors
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natural monopoly
answer
a market that runs most efficiently when one large firm supplies all of the output
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pure monopoly
answer
that there is only one producer of the good with no close substitutes being produced by any other firms. Since the firm is the industry, they have a great deal of control over the price that is charged for their good. Monopolies are created and sustained due to strong entry barriers which makes it very difficult for new firms to enter the industry. There is very little non-price competition since there are not any rival firms. However, there may be some non-price competition to increase the demand for the good.
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barriers to entry
answer
factors that prevent firms from entering the industry
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economies of scale
answer
barrier to entry
This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Google and Amazon both enjoy economies of scale in their respective markets. Public utilities are often natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying the entire demand. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.
This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Google and Amazon both enjoy economies of scale in their respective markets. Public utilities are often natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying the entire demand. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.
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legal barriers to entry
answer
also exist in the form of patents and licenses. 1. Patents grant the inventor the exclusive right to produce or license a product for twenty years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. 2. Licenses are another form of entry barrier. Radio and TV stations and taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.
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ownership or control of essential resources barrier to entry
answer
International Nickel Co. of Canada (now called Vale Canada Limited) used to control about 90 percent of the world's nickel reserves. Professional sports leagues control player contracts and leases on major city stadiums.
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pricing and other strategic barriers
answer
Monopolists may use pricing or other strategic barriers such as selective price-cutting and advertising. Dentsply, a manufacturer of false teeth, controlled about 80 percent of the market and in 2005 Dentsply was found to have illegally prevented distributors from carrying competing brands. In 2015 American Express was found guilty of restraint of trade when it disallowed merchants that accepted American Express from promoting other credit cards, like Visa and MasterCard.
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monopoly demand
answer
The following analysis of monopoly demand makes three assumptions:
•The monopoly is secured by patents, economies of scale, or resource ownership.
•The firm is not regulated by any unit of government.
•The firm is a single‑price monopolist; it charges the same price for all units of output.
Note: there is not a monopolist supply curve.
•The pure monopolist is the industry
•Monopolist demand curve is the market demand curve
•Demand curve is downsloping
•Marginal revenue is less than price
•Monopolist is a price maker
•Monopolist sets price in the elastic region of the demand curve
MR is less than price after the first unit sold. A price maker is a firm with pricing power, which is the ability of the firm to set its own price. The monopolist sets the price in the elastic region of the demand curve so that revenues will be higher and costs lower. The monopolist avoids setting the price in the inelastic range of demand because doing so would reduce total revenue and increase costs.
•The monopoly is secured by patents, economies of scale, or resource ownership.
•The firm is not regulated by any unit of government.
•The firm is a single‑price monopolist; it charges the same price for all units of output.
Note: there is not a monopolist supply curve.
•The pure monopolist is the industry
•Monopolist demand curve is the market demand curve
•Demand curve is downsloping
•Marginal revenue is less than price
•Monopolist is a price maker
•Monopolist sets price in the elastic region of the demand curve
MR is less than price after the first unit sold. A price maker is a firm with pricing power, which is the ability of the firm to set its own price. The monopolist sets the price in the elastic region of the demand curve so that revenues will be higher and costs lower. The monopolist avoids setting the price in the inelastic range of demand because doing so would reduce total revenue and increase costs.
question
misconceptions concerning monopoly pricing
answer
The monopolist does not charge the highest possible price because the monopolist can't sell much output at that price and profits are too low. The monopolist is interested in total profit, not per unit profit. There is always the possibility that the monopolist will earn losses. Monopolists are not protected from changes in demand nor from changes in costs.
question
economic effects of monopoly
answer
•Income transfer
•Cost complications
•. Economies of scale
•. Simultaneous consumption
•. Network effects
•. X-inefficiency
•. Rent-seeking behavior
Technological advance
•Cost complications
•. Economies of scale
•. Simultaneous consumption
•. Network effects
•. X-inefficiency
•. Rent-seeking behavior
Technological advance
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income transfer
answer
Income distribution is more unequal than it would be under a more competitive situation; thus, monopoly power transfers income from the consumers to the business owners which results in a redistribution of income to the higher-income business owners.
question
cost complications
answer
economies of scale, simultaneous consumption, network effects, x-inefficiency, rent-seeking behavior, and technological advance
Costs complications are that costs for monopolies may not be the same as for more competitive firms
Costs complications are that costs for monopolies may not be the same as for more competitive firms
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economies of scale
answer
may lead to just one or two firms operating in an industry; they are experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs. Some firms have been able to achieve extensive economies of scale due to the ability to produce a single product that many consumers can simultaneously enjoy, like products that once produced can be downloaded over the Internet.
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network effects
answer
occur when the value of a product rises as the total number of users rise. An example would be computer software or Facebook. The more people that use it, the more benefits of the product to each person using it. People tend to use products that everyone else is using.
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X-inefficiency
answer
may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs
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rent-seeking behavior
answer
often occurs as monopolies seek to acquire or maintain government‑granted monopoly privileges at someone else's expense. Such rent‑seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient.
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technological advance
answer
Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed. Some monopolies have shown little interest in technological progress. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms.
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antitrust laws
answer
laws that encourage competition in the marketplace
- break up the firm
When monopoly power results in an adverse effect upon the economy, the government may choose to intervene on a case-by-case basis using antitrust laws
- break up the firm
When monopoly power results in an adverse effect upon the economy, the government may choose to intervene on a case-by-case basis using antitrust laws
question
regulate it
answer
If the government feels that it is more beneficial to society to have a monopoly, then government will regulate it.
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ignore it
answer
. Although there are legitimate concerns of the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may initially strengthen monopoly power, over time it is likely to destroy monopoly position.
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price discrimination
answer
charging different prices to different buyers when such price differences are not justified by cost differences.
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monopoly power
answer
means that the firm must have some pricing power. Pricing power is the ability of a firm to set its own price
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market segregation
answer
you have identified your different buyers and can separate your market based on their willingness to pay
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no resale
answer
a low price buyer is prevented from buying at the low price and reselling the good to a high price buyer. Otherwise, the price discrimination scheme would break down.
question
price discrimination examples
answer
•Business travel
•Electric utilities
•Movie theaters
•Golf courses
•Railroad companies
•Coupons
International trade
•Electric utilities
•Movie theaters
•Golf courses
•Railroad companies
•Coupons
International trade
question
socially optimal price
answer
set price equal to marginal cost
question
fair return price
answer
set price equal to average total cost
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