Managerial Economics
Meaning of the different return to scales
(1) Economies of scale = increasing return to scale as LR ATC falls as Q increases (2) Constant return to scale = LR ATC stays the same as Q increases (3) Diseconomies of scale = decreasing return to scale as LR ATC rises as Q increases
Three important properties of cost curves?
(1) MC eventually rises with the Q of output (2) ATC curve is U-shaped (3) MC crossed ATC at ATC lowest point
Attributes of a market with monopolistic competition
(1) Many firms (2) Product differentiation (3) Free entry E.g. books, restaurants, clothes, furniture, haircuts
What market types are there?
(1) Perfect competition: many firms, identical products (wheat) (2) Monopoly: many firms, different products (soft drinks) (3) Oligopoly: few firms (beer) (4) Monopolistic competition: one firm (tap water)
What are the common features for cost curves?
(1) Rising MC = diminishing marginal product (2) U-shaped ATC: at low Q VC/Q is low FC high, but spread evenly as Q increases, until VC gets higher at higher Q. Bottom of ATC curve = efficient scale (3) The relationship between MC and ATC: MC<ATC = ATC will fall, MC>ATC ATC will rise, MC crosses ATC at efficient scale
How can policy makers solve the monopoly problem?
- By trying to make the industry more competitive: with anti-trust laws - By regulating behaviour of monopolies: government decides price - By turning some private monopolies into public enterprises - By doing nothing at all
Production isoquant definition
A function which represents all the possible combinations of factor inputs that can be used to produce a given level of output. Firms often look at the option of substituting labour for capital e.g. replacing workers with machines = new cost occurs The isoquant shows how we can substitute labour for capital and stay at the same production level
What is a natural monopoly?
A monopoly that arises because a single firm can supply a good to an entire market at a smaller cost than could two or more firms and arises when there are economies of scale over relevant range of output
What weights heavier; economist or accountants measure?
Accountants weight more
Definition TR
Amount a firm receives for the sale of its output
When a firm experiences increasing returns to scale...
An increase in inputs leads to an increase in the average products of inputs
Effects on total revenue if monopoly increases the amount it sells
Output effect: Q is higher, tends to increase TR Price effect: P is lower, tends to decrease TR >> TR may either increase or decrease as MR can be positive or negative
A firm should produce no output in the SR if:
P < AVC
In LR equilibrium a perfectly competitive firm will operate where the price is
P=MR=MC=minimum ATC
Why economies of scale?
Specialization and technology due high production levels. Allows workers to become better at their tasks. Large scale firms benefit from grossest dealing (big order = discount)
If a firm's rent increases, it will affect its cost structure in the following way
TFC will increase
Arguments against advertising
• manipulates peoples' tastes • psychological rather than informational • creates a desire that otherwise might not exist • reduces competition by making consumers perceive products more different than they really are (→ markets become monopolistically competitive instead of competitive)
A firm's shut down and exit decisions
(1) Shut down (SR-decision): to not produce during specific period due market conditions = still has fixed costs and sunk costs (2) Exit (LR-decision): to leave the market completely
How to study a monopolistic competition
- Analyse decisions of individual firm - Examine what happens in the LR who new firms enter/exit - Compare outcome to perfect competition - Is outcome desirable for society as a whole?
Perfect competition characteristics (assumptions)
- Many buyers and sellers in the market - The goods are largely the same - Firms can freely enter or exit the market - High degree of information available Example: milk, coffee, gold, silver
European anti-trust policy central rules
1. Agreements between two or more market operators, which restrict competition are prohibited 2. Abusing one's dominant position in a market is prohibited >> Aim to grow competition - costs and benefits
Monopoly definition
A firm that is the only seller of a product without close substitutes = dominant seller, who is able to exert some control over the market. Price maker = has power to influence the market price (market power)
What do cost curves of typical firms look like in reality?
Berit's cost curve: like a snake, first kind of flat, then steep
How is the supply curve given for a competitive market?
By its MC curve, whilst the demand is given by the MR curve
Firms' production decisions
Can choose between different ratios of factor inputs in the production process. Need to address the question on how to organise the factors of production to maximise output at minimum cost
Real world examples of perfect price discrimination
Cinema tickets for students, airline prices, discount coupons
How to determine which quantity a monopoly should produce
Compare MR to MC. Intersection point MR and MC determines the profit-maximizing quantity and then the demand curve shows the price consistent with this quantity P>MR=MC
What is a consumer's optimum?
Consumers want to get the combination of goods on the highest possible indifference curve, but is limited by the budget constraint. The combination of these two factors lead to optimal choice; the tangent of the highest indifference curve and the budget constraint
The welfare cost of monopoly
Consumers' standpoint: monopoly is undesirable because it charges high prices Producer's standpoint: monopoly is desirable because it allows high profits >> Total surplus can be used as a measure of a society's economic well being
Public policy towards monopolies
Contrarily to competitive markets, monopolies don't lead to an optimal allocation of resources (social welfare not maximised)
The law of diminishing marginal product of labour occurs when every additional worker hired...
Contributes a smaller increase in production than previously hired worker
Why diseconomies of scale?
Coordination and communication problems inherent to any large organization
Economies of scale is indicated by
Declining LR ATC
How do monopolies make production and pricing decisions?
Demand not perfectly elastic, so monopoly faces the market demand (downward sloping)
If the marginal product of labour is 1 and when going from 9 to 10 workers,
Employing the 10th worker will increase output by 1
When should a firm decide to exit or enter a market?
Exit in LR if: TR < TC TR/Q < TC/Q P < ATC Enter in LR if: TR > TC TR/Q > TC/Q P > ATC
Economic profit
Explicit + Implicit costs: economists are interested in how firms make production and pricing decisions
Accounting profit
Explicit: accountants are keeping track of in and out flows of money
What are sunk costs?
For SR-decision to shut down, there are sunk costs. These are costs that have already been committed and cannot be recovered. They should be ignored when making decisions. E.g. rent for a factory in the SR is a sunk cost = Fixed costs in general
LR equilibrium (monopolistic competition)
Free entry = if firms on the market are making profits, new firms will enter the market. Customers will have to chose between more similar products, and demand shifts to left as profits fall. If firms are making losses = exit, rise in demand to profit increase Process continues until P=ATC (zero economic profit)
Why do monopolies arise?
Fundamental cause is barriers to enter due: - key resource (e.g. alcohol, or diamonds) - government gives single firm exclusive rights (e.g. to favour friends like king-salt-selling or to serve public interest like alcohol) - cost of production such that single producer is more effective (bridge - economies of scale) - external growth (firm is able to gain control of other firms in the market and thus grow in size e.g. AB InBev)
Give an example of the relationship between production function and the total cost curve
Gets steeper as the amount produced rises, whereas the production function gets flatter as the production rises. E.g. when the kitchen is crowded each additional worker adds less to production (= diminishing MP) so producing an additional pizza requires a lot of additional labour which is very costly
Accounting profit is generally_____ than economic profit, because accountants_____ implicit costs in their calculations
Greater, don't consider
What is an average cost?
How much is costs to produce a typical unit of output ATC = TC/Q
What is the firms objective?
In order to take optimal decisions, managers need to look at different measures of the firm's cost
Explicit costs
Input costs requiring a payment of money by the firm e.g. wage of an employee
Implicit costs
Input costs that do not require a payment of money by the firm e.g. income that the firm owner could have earned by doing something else
What is a production function?
It shows the relationship between the quantity of inputs used to produce a good and the quantity of that good. Q = f(K,L)
When a firm experiences increasing returns to scale and increases its production...
Its average total cost will decrease, due costs distributed for more products
A competitive firm produces 100 000 chocolate bars, which sell for €4 per piece. Production is currently such that MR=MC, VC are €3 per piece, and the FC is €150 000. In the SR, the firm should
Keep producing 100 000 pieces as R>VC (4>3)
The prevalence of monopoly
Leads to inefficient resource allocation, which can get less severe by public policies or price discrimination. Most firms have some control over the price they charge because the goods they produce are not identical to those offered by competitors. Many firms have some extent of market power, but fe have substantial market power due few goods are truly unique.
Which point indicates the efficient scale?
Lowest point on ATC curve
When a firm increases its output by one unit, its average total cost decreased. This implies that...
MC < ATC
How to decide on production level according "rational people think at the margin"?
MR > MC = increase production MR < MC = decrease production MR = MC = production level is optimal
Relation Marginal revenue and average (demand) revenue for monopoly
MR always lower than demand curve.
Division between SR and LR costs
Many costs are fixed in SR, but variable in LR, so depends on time horizon. (1) ATC SR = Economies of scale = downward slope, as lower-per-unit-cost (2) ATC MR = Constant return to scales = horizontal slope (3) ATC LR = Diseconomies of scale = upward slope, as higher-per-unit-cost
Two main differences between monopolistic and perfect competition
Mark-up: with monopolistic competition, price exceeds MC (mark-up = P-MC) Excess capacity: with monopolistic competition, quantity produced by each firm is below the efficient scale (Efficient scale - Quantity produced)
Definition TC
Market value of the inputs used for producing the output
What is total surplus
Measure of society's economic wellbeing: consumer surplus + producer surplus Consumer: willingness to pay for a good vs amount they actually pay Producer: amount received vs cost of producing it Value to consumer (demand) > cost of producing it (MC) Optimal output level D=MC
What does the market type depend on?
Number of firms (one, few or many) Type of products (identical or differntiated)
Which are the two types of imperfect competition
Oligopoly: few firms offer similar products (airplanes, beer) Monopolistic competition: many firms offer similar products (restaurants, novels)
Cost of capital as an opportunity cost?
Opportunity cost of the financial capital invested in the business (implicit) - decide what to invest in
Relationsship monopoly output level and optimal output level
Optimal: D=MC Monopoly: MR=MC Quantity produced and sold is below the socially optimal level. Since a monopoly charges a P>MC, not all consumers who value the good at more than its cost buy it
Is the outcome in a monopolistically competitive market desirable from the standpoint of society as a whole?
P>MC → some consumers value the good at more than the marginal cost of production but will not buy it → outcome is not efGicient (as with monopolistic markets)
Behavioural difference: "Would you like see another customer come through and buy from you at your current price?"
Perfect competition: "I don't care" as profit: P-MC=0 Monopolistic competition: "YES!" as profit: P-MC>0
The demand faced by an individual perfectly competitive firm is:
Perfectly elastic at the price determined by the market forces (price taker)
Which is the closest to the model of perfect competition; potato, t-shirt, cars or airplanes
Potatoes
Is a competitive firm a price taker or maker and why?
Price taker, as its revenue is proportional to the amount output it produces
Firms behaviour in SR (monopolistic competition)
Product different from other firms': - Downward sloping demand curve (like monopoly) - monopoly's rule for profit maximisation: producer Q such that MR=MC and use demand to find the price consistent with that quantity
Least cost input combination
Provides maximum efficiency at minimum cost and there is no incentive to change the combination of the factors of production employed. Occurs where the isocost line is tangential to the production isoquant curve. This is where the marginal rate of substitution is equal to the ratio of the prices of the factors. MRTS = P(L)/P(K) or MP(L)/MP(K) = P(L)/P(K) or MP(L)/P(L) = MP(K)/P(K)
Isocost lines definition
Represents the different combination of factor inputs which can be purchased with a given budget TC = P(K)K + P(L)L
In the LR, a firm is said to be experiencing decreasing returns to scale if a 10 percent increase in inputs results in:
Requirement for decreasing return to scale: output < input, so only option is all increases below 10%
What is the SR vs LR supply curve?
SR: the portion of its MC curve that lies above AVC curve LR: the MC curve above minimum point of its ATC curve
Can policymakers improve the market outcome?
Should policy makers impose P=MC to all firms? many firms → high administrative burden profits already zero in long run → firms will make losses if lower P It may be better to accept inefficiencies of monopolistic pricing than to pay the high administrative burden to enforce P=MC for all firms and to raise taxes to subsidize all firms. No easy way for policymakers to improve market outcomes
What is the total cost curve and is it important?
Shows the relationship between the quantity a firm produces and the cost of producing that quantity, which is important as it determines the firm's production and pricing decisions. It is the "opposite side of same coin" with production function.
When should a firm decide to shut down, not considering FC?
Shut down in SR if: TR < VC TR/Q < VC/Q P < AVC Continue produce in SR if: P > AVC Continue produce with profit if: P > ATC
What is the firm's cost?
Ten principles: "The cost of something is what you give up to get it" = Opportunity cost Consists of explicit and implicit costs
Price discrimination
The business practice of selling the same good at different prices to different customers. Only possible for firms who have some market power. E.g. charge for a book or timetravel (1) rational strategy for profit maximising monopolist (2) requires the ability to separate customers according to their willingness to pay (3) can raise economic welfare (higher total surplus)
Monopoly deadweight loss
The difference between the socially optimum surplus and the surplus obtained with monopoly. No deadweight loss in competitive markets as they lead to socially optimal level
What is the marginal product in the production process?
The increase in output that arises from an additional unit of that input MP(L) = ∆Q/∆L
Firm's behaviour in a competitive market example
The milk price in Europe is determined by the total demand of European consumers and the total supply of European producers. If one small farm produces a couple of litres more each week, this doesn't affect the milk price in Europe. So how much is efficient to produce for maximising profit? - Average revenue (AR) : TR/Q = P*Q/Q = P - Marginal revenue (MR): ∆TR/∆Q AR = MR = P
Perfect price discrimination
The monopoly knows exactly the willingness to pay of each customer and can charge each customer a different price >> will do so to earn entire surplus
Long run definition
The period of time in which all factors of production can be altered
Short run definition
The period of time in which some factors of production cannot be changed
When a firm's MC curve shifts to the right it means that...
The productivity of at least one input has increased
Marginal rate of technical substitution (MRTS)
The rate at which one factor input can be substituted for another at a given level of output. In other words the ratio of marginal products of labour and capital. This is illustrated by the negative slope. MRTS = MP(L)/MP(K)
What does the slope measure?
The slope of the production function measures the marginal product of an input (e.g. worker). When the marginal product declines, the slope decreases and the production function becomes flatter, because as the input (e.g. worker) increases, so does the denominator. When the marginal product decreases we have diminishing returns to labour.
What is the average product of an input in the production process?
The units of output produced per unit of input (while keeping other inputs constant) AP(L) = Q/L
Why are perfectly competitive markets important?
They are important as a benchmark to analyse how firms would behave if all the assumptions hold, compared to if they are more relaxed
Fixed cost
Those costs that do no vary with the quantity of output produced, e.g. insurance or rent
Variable cost
Those costs that do vary with the quantity of output produced, e.g. raw material and commissions
What is a firms goal?
To maximize profits
If 10 workers are employed and the average product of labour is 1:
Total output is equal to 10
How can we determine the market supply curve?
We build it from individual firms' supply curves: SR = fixed number of firms (looks same as MC) LR = variable number of firms, due enter/exit possibilities (zero profit results in P=ATC=MC, meaning firms must operate at their efficient scale) --> horizontal supply due above ATC=MC
Why does the marginal product of an input decline as the quantity of the input increases? (= Diminishing marginal product)
When a factor of production is fixed, there is a point at which an increasing volume of variable factors will become less productive, meaning that each additional unit of input will produce less output than the prior unit of input. E.g. equipment is limited. Results from rising short-term average costs. Solution: reducing output to an optimal level or increasing other factors of production.
Law of diminishing marginal productivity occurs
When a firm reduces one unit of a factor and substitutes of for another, it is likely that the addition to total output of each successive unit of the factor employed will diminish
When incentive to advertise?
When firms sell differentiated products and charge P>MC, each firm has incentives to advertise in order to attract more buyers to its particular product. Firms that sell highly differentiated consumer goods (perfumes, breakfast cereal, soft drinks): typically spend 10-20% of revenue on advertising. Firms that sell industrial products (e.g. drill presses): low % of revenue spent on advertising. Firms that sell homogenous products (e.g. wheat, crude oil): no revenue spent on advertising.
What is imperfect competition?
When the 4 assumptions on perfect competition don't hold
When do firm's cost incur?
When they buy inputs to produce the goods and services they plan to sell
When a firm increases its output by one unit, its average cost rose from €45 to €50. This implies that the marginal cost of this last produced unit is:
greater than €50, as ATC adapts after MC and if it rises to 50, then MC must be greater than 50 ATC = TC/Q
