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GWU / Economics / ECON 1011 / What is the slope of the total product curve?

# What is the slope of the total product curve? Description

##### Description: This study guide essentially covers the key points covered in Chapters 9, 11, 12, 13, 14, and 15-- Includes photos and graphs to assist with understanding. Source: Microeconomics Paul Krugman 2013
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CHAPTER 11-

## What is the slope of the total product curve?

The Production Function

A firm is an organization that produces goods or services for sale. - To produce goods or services to sell, a firm must transform inputs into  outputs.

A production function is the relationship between the quantity of inputs a firm uses  and the quantity of output it produces.

Inputs and Outputs

George and Martha’s farm sits on 10 acres of land—no more, no less because they  cannot increase or decrease the size of their land by selling, buying, or leasing. - In this example, land is considered a fixed input—an input whose quantity is fixed for a period of time and cannot be varied.

But, George and Martha are free to decide in how many workers they can hire.  - The labor from these workers is considered to be a variable input- an input  whose quantity the firm can vary at any time.

## How do you find the marginal cost?

Whether or not the quantity of an input is fixed depends on the time horizon. In the long run, all inputs can become varied.

- For e.g. George and Martha can vary the amount of land they farm by buying  or selling land.

In the short run, at least one input is fixed.

The total product curve shows how the quantity of output depends on the  quantity of the variable input, for a given quantity of the fixed input.

## When is production profitable?

Don't forget about the age old question of What is sales revenue?
Don't forget about the age old question of What is orientalism?

Although the total product curve slopes upward, it begins to plateau as the quantity  of labor increases. This is because of the change in the quantity of output, or the  marginal product—the additional quantity of output that is produced by using one more unit of that input.

OR We also discuss several other topics like What are the 3 factors that contribute to the weakened family support system?

The significance of the slope of the total product curve is that it is equal to the  marginal product of labor.

In the example for George and Martha’s farm, we can see how the marginal product  of labor steadily declines as more workers are hired—each successive worker adds  less to output than the previous worker.

In other words, as employment increases, the total product curve gets flatter.

Figure 11-2

The next curve  Don't forget about the age old question of How valid are iq tests?

shows how the

marginal product

of labor depends

on the number of

workers employed

on the farm.

In this example, the marginal product of labor falls as the number of workers  increases.

There are diminishing returns to an input—when an increase in the quantity of  that input, holding the levels of all other inputs fixed, leads to a decline in the  marginal product of that input.

- Due to the diminishing returns to labor the MPL curve is negatively sloped.

Coming back to George and Martha, if they add more workers without increasing the number of acres of land, the land is farmed more intensively and the number of  bushels produced increases.

But, each additional worker is working with a smaller share of the 10 acres in total— the fixed input—than the previous worker.

So, the additional worker cannot produce as much output as the previous worker  could. This leads to a fall in the marginal product of the additional worker falls.

The crucial point about diminishing returns is that it is an “other things equal”  proposition: each successive unit of an input will raise production by less than the  last if the quantity of all other inputs is held fixed.

If the levels of other inputs were allowed to change, the marginal product of  each worker would become higher when the fixed cost (the land) would vary  (increase in size).  Don't forget about the age old question of What is chemoreceptors?

Both curves slope downward because, in each case, the amount of land is fixed,  albeit at different levels but the MPL20 lies everywhere above MPL10 which shows the fact that the marginal product of the same worker is higher when he or she has  more of the fixed input to work with.

The position of the total product curve of a given input depends on the quantities of  other inputs.

If you change the quantity of the other inputs, both of the total product curve and  the marginal product curve of the remaining input will shift.

From the Production Function to Cost Curves

A fixed cost is a cost that does not depend on the quantity of output produced.  ∙ It is the cost of the fixed input.

A variable cost is a cost that depends on the quantity of output produced. ∙ It is the cost of the variable input.

The total cost of producing a given quantity of output is the sum of the fixed cost  and the variable cost of producing that quantity of output.

The total cost curve slopes upward:

due to the variable cost, the more

output produced, the higher the farm’s

total cost.

Unlike the total product curve, which

gets flatter as employment rises, the

total cost curve gets steeper.

The slope of the total cost curve is

greater as the amount of output

produced increases.

Marginal Cost

∙ Marginal cost is the change in total cost generated by producing one  more unit of output.

The formula for marginal cost:

∙ The marginal cost curve slopes upward because there are diminishing  returns to inputs in the example of Selena and her gourmet salsas. o Marginal cost at Selena’s Gourmet Salsas rise as output  increases

In the case of Selena’s Gourmet Salsas, the marginal cost curve slopes  upward because there are diminishing returns to inputs.

As output increases, the marginal product of the variable input  declines. This implies that more and more of the variable input must be used  to produce each additional unit of output as the amount of output already  produced rises.

Since each unit of the variable input must be paid for, the additional  cost per additional unit of output also rises.

**Recall that the flattening of the total product curve is also due to  diminishing returns: the marginal product of an input falls as more of that  input is used if the quantities of other inputs are fixed.

The flattening of the total product curve as output increases and the  steepening of the total cost curve as the output increases are the same  phenomenon.

As output increases, the marginal cost of output also increases because the  marginal product of the variable input decreases.

Average Total Cost

∙ The average total cost is the total cost divided by the quantity of  output produced—it is equal to total cost/unit of output.

The average total cost is important because it tells the producer how  much the average or typical unit of output costs to produce.

In the case of Selena’s Gourmet Salsas, the average total cost curve has a  distinctive U-shape that corresponds to how average total cost first falls and  then rises as output increases.

U-shaped average total cost curve falls at low levels of output, then rises at higher levels.

The average total cost

curve is U-shaped because

of its underlying

components, average

fixed cost and average

variable cost.

Average fixed cost is the

fixed cost per unit of

output.

Average variable cost is

the variable cost per unit

of output.

Average total cost is the sum of average fixed cost and average variable  cost.

- It has a U-shape because these components move in opposite  directions as output rises

Average fixed cost falls as more output is produced because the numerator  (the fixed cost) is a fixed number but the denominator increases as more is  produced.

As more output is produced, the fixed cost is spread over more units of  output; the end result is that the cost per unit of output falls.

Average variable cost rises as output increases.

Reflects diminishing returns to the variable input: each additional unit  of output incurs more variable cost to produce than the previous unit.

Increasing output has two opposing effects on average total cost  ∙ Spreading effect: The larger the output, the greater the quantity of  output over which fixed cost is spread, leading to lower average fixed  cost.

o At low levels of output, the spreading effect is powerful because  even small increases in output cause large reductions in average  fixed cost.

 Spreading effect dominates the diminishing returns effect

and causes the average total cost curve to slope

downward.

∙ Diminishing returns effect: The larger the output, the greater the  amount of variable input required to produce additional units, leading  to higher average variable cost.

o Diminishing returns usually grow increasingly important as  output rises.

 When output is large, the diminishing returns effect

dominates the spreading effect, causing the average total  cost curve to slope upward.

Figure 11-8

The marginal cost curve

slopes upward- the result of

diminishing returns that

output costlier to produce

than the one before.

Average variable cost also

slopes upward- again, due to

diminishing returns- but is

flatter than the marginal cost

curve.

 This is because the

high cost of an

output is averaged

across all units.

Average fixed cost slopes

downward because of the

Minimum Average Total Cost

For a u-shaped average total cost curve, average total cost is at its minimum level  at the bottom of the U. This quantity of output corresponds to the minimum average total cost—economists call this the minimum-cost output.

The general principles that are always true about a firm’s marginal cost and  average total cost curves are:

1. At the minimum-cost output, average total cost is equal to marginal cost. 2. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling.

3. At output greater than the minimum-cost output, marginal cost is greater  than average total cost and average total cost rising.

An example to understand these principles would be to think about how your grade  in one course—say it is a 3.0 in Economics- affects your overall grade point average.

- If marginal cost is less than average total cost, producing that extra unit  lowers average total cost.

Does the Marginal Cost Curve Always Slope Upward? Economists believe that marginal cost curves often slope downward as a firm  increases its production from zero up to some low level, sloping upward only at  higher levels of production.

At low levels of output there are often increasing returns to the variable input due to the benefits of specialization, making the marginal cost curve “swoosh”- shaped:  initially sloping downward before sloping upward.

Short Run versus Long-Run Costs

In the long run, firms choose fixed cost according to expected output. Higher fixed  cost reduces average total cost when output is high. Lower fixed cost reduces  average total cost when output is low.

Long-run average total cost curve shows the relationship between output and  average total cost when fixed cost has been chosen to minimize average total cost  for each level of output.

A firm that has fully adjusted its fixed cost for its output level will operate at a point  that lies on both its current short-run and long-run average total cost curves.

A change in output moves the firm along its current short-run average total cost  curve. Once it has readjusted its fixed cost, the firm will operate on a new short-run  average total cost curve and on the long-run average total cost curve.

Returns to Scale

Increasing returns to scale when long-run average total cost declines as output  increases.

- Tend to make firms larger.

Decreasing returns to scale when long-run average total cost increases as  output increases.

- Tend to limit the size of firms

Constant returns to scale when long-run average total cost is constant as output  increases.

- Tend to have no effect

CHAPTER 12- Perfect Competition and the Supply Curve Perfect Competition

Price-taking producer is a producer whose actions have no effect on the market  price of the good or service it sells.

- A price-taking producer considers the marker price as given. When there is  enough competition—then ever producer is a price-taker.

Price-taking consumer is a consumer whose actions have no effect on the market price of the good or service he or she buys.

Defining Perfect Competition

In a perfectly competitive market, all market participants, both consumers and  producers, are price-takers.

- The market price of the good is not affected by consumption decisions or  production decisions.

A perfectly competitive industry is an industry in which producers are price takers.

- Some industries aren’t perfectly competitive.

Two Necessary Conditions for Perfect Competition

First, for an industry to be perfectly competitive, it must contain many producers,  none of whom have a large market share.

- A producer’s market share is the fraction of the total industry output  accounted for by that producer’s output.

Standardized product, also known as a commodity, is when consumers regard  the products of different producers as the same good.

The second necessary condition for a competitive industry is that the industry  output is a standardized product.

Free Entry and Exit

All perfectly competitive industries have many producers with small market shares,  producing a standardized product.

Most perfectly competitive industries are also characterized by one or more feature: it is easy for new firms to enter the industry or for firms that are currently in the  industry to leave. No obstacles in the form of government regulations or limited  access to key resources prevent new producers from entering the market. – And no  additional costs are associated with shutting down a company and leaving the  industry.

Economists refer to the arrival of a new firms into an industry as entry: they refer  to the departure of firms from an industry as exit.

Free entry and exit is not strictly necessary for perfect competition.  TO SUM UP: Perfect competition depends on two necessary conditions.

1. The industry must contain many producers, each having a small  market share.

2. The industry must produce a standardized product.

Perfectly competitive industries are normally characterized by free entry  and exit.

Production and Profits

Total Revenue is equal to the market price Profit is equal to total  revenue

multiplied by the quantity of output. minus total cost.

Using Marginal Analysis to Choose the Profit-Maximizing Quantity of  Output

Marginal revenue is the change in total revenue generated by an additional unit  of output.

Optimal output rule: Profit is maximized by producing the quantity of output at  which the marginal revenue of the last unit produced is equal to its marginal unit.

- Profit equals marginal cost (P = MC) at the price-taking firm’s optimal  quantity of output.

- In the case of a price-taking firm, marginal revenue is equal to the market  price. MR = MP

A price-taking firm cannot influence the market price by its actions. It always takes  the market price as given because it cannot lower the market price by selling more  or raise the market price by selling less.

So, for a price taking firm, the additional revenue generated by producing one more  unit is always the market price.

Firms are not price-takers when an industry is not perfectly competitive. Marginal revenue curve shows how marginal revenue varies as output varies.

Note: Whenever a firm

is a price-taker, its

marginal revenue

curve is a horizontal

line at the market

price: it can sell as

much as it likes at the

market price.

In effect, the

individual firm faces a

horizontal, perfectly

elastic demand curve

for its output—an

individual demand

curve for its output

that is equivalent to

its marginal revenue

curve.

When is Production Profitable?

A firm’s decision whether or not to stay in a given business depends on its  economic profit—the measure of profit based on the opportunity cost of resources  used in the business.

In contrast, accounting profit is profit calculated using only the explicit costs  incurred by the firm.

This means that economic profit incorporates the opportunity cost of resources  owned by the firm and used in the production of output, while accounting profit  does not.

A firm may make positive accounting profit while making zero or even negative  economic profit.

A firm’s decision to produce or not, to stay in business or to close down  permanently, should be based on economic profit, not accounting profit.

To see how these curves can be

used to decide whether

production is profitable or

unprofitable, recall that

PROFIT = TOTAL REVENUE –

TOTAL COST.

This means:

 If the firm produces a

quantity at which TR >

TC, the firm is profitable.

 If the firm produces a

quantity at which TR =

TC, the firm breaks even.

 If the firm produces a

quantity at which TR <

TC, the firm incurs a loss.

We can also express this idea in terms of revenue and cost per unit of output. If we  divide profit by the number of units of output, Q.

TR/Q is average revenue, which is the market price. TC/Q is average total cost.

A firm is profitable if the market price for its product is more than the average total  cost of the quantity the firm produces; a firm loses money if the market price is less  than average total cost of the quantity the firm produces.

 If the firm produces a quantity at

which P > ATC, the firm

is profitable.

 If the firm produces a

quantity at which P =

ATC, the firm breaks

even.

 If the firm produces a

quantity at which P <

ATC, the firm incurs a

loss.

Figure 12-3 shows this result,

illustrating how the market price

determines whether a firm is

profitable.

Each panel shows the marginal cost

curve, MC, and the short-run

average total cost curve, ATC.

Average total cost minimized at

point C. Panel (a) shows the case we

have already analyzed, in which the

market price of trees is \$18 per tree.

Panel (b) shows the case in which

the market price of trees is lower,

\$10 per tree.

Noelle’s total profit when the market

price is \$18 is represented by the

area of the shaded rectangle in

panel (a).

Or equivalently,

How does a producer know, in general, whether or not its business will be  profitable?

- The crucial test lies in a comparison of the market price to the producer’s  minimum average total cost.

Whenever the market price exceeds minimum average total cost, the producer can  find some output level for which the average total cost is less than the market price; aka, the producer can find a level of output at which the firm makes a profit.

Conversely, whenever the market price exceeds minimum average total cost, the  producer can find some output level for which the average total cost is less than the market price.

The minimum average total cost of a price-taking firm is called its break-even  price, the price at which it earns zero profit. ~~ Economic profit, that is.

The rule for determining whether a producer of a good is profitable depends on a  comparison of the market price of the good to the producer’s breakeven price—its  minimum average total cost.

- Whenever the market price exceeds minimum average total cost, the  producer is profitable.

- Whenever the market price equals minimum average total cost, the  producer breaks even.

- Whenever the market price is less than minimum average total cost, the  producer is unprofitable.

The Short-Run Production Decision

If a firm is unprofitable because the market price is below its minimum average total cost, it shouldn’t produce any output… FALSE.

In the short run, sometimes the firm should produce even if price falls below  minimum average total cost.

- The reason is that total cost includes fixed cost—cost that does not depend  on the amount of output produced and can only be altered in the long run.

In the short run, fixed cost must still be paid, regardless of whether or not a firm  produces.

If a producer rents a piece of equipment for the year, the producer has to pay the  rent on the equipment regardless of whether the production continues. Since it  cannot be changed in the short run, her fixed cost is irrelevant to her decision about whether to produce or shut down in the short run.

Although fixed cost should play no role in the decision about whether to produce in  the short run, other costs—variable costs—do matter.

- An example of variable costs is the wages of workers who must be hired to  help.

Variable costs can be saved by not producing; so they should play a role in  determining whether or not to produce in the short run.

Because the marginal

cost curve has a “swoosh”

shape—falling at first before

rising—the short-run average

variable cost curve is U-shaped:

the initial fall in marginal cost

causes average variable cost to

fall as well, before rising

marginal cost eventually pulls it

up again.

When the market price is

below minimum average

variable cost, the price the firm

receives per unit is not covering

its variable cost per unit.

 A firm in this situation

should cease production

immediately. Why?

Because there is no level

of output at which the

firm’s total revenue

covers its variable costs—

the costs it can avoid by

not operating.

 In this case, the firm

maximizes its profits by

not producing at all—by,

in effect, minimizing its

losses.

- This means that the minimum average variable cost is equal to the shut down price—the price at which the firm ceases production in the short run.

When the price is greater than minimum average variable cost, however, the firm  should produce in the short run. In this case, the firm maximizes profit- or minimizes

loss—by choosing the output quantity at which its marginal cost is equal to the  market price.

Short-run individual supply curve shows how an individual producer’s profit maximizing output quantity depends on the market price, taking fixed cost as given.

To sum up:

- Fixed cost is irrelevant to the firm’s optimal short-run production decision. - When price exceeds its shut-down price, minimum average variable cost,  the price-taking firm produces the quantity of output at which marginal cost  equals price.

- When price is lower than its shut-down price, it ceases production in the  short run. This defines the short-run individual supply curve.

Changing Fixed Cost

Over time, fixed cost matters.

If price consistently falls below minimum average total cost, a firm will exit the industry.

If price exceeds minimum average total cost, the firm is profitable and will  remain in the industry; other firms will enter the industry in the long run.

Summing Up: The Perfectly Competitive Firm’s Profitability and  Production Conditions

The Industry Supply Curve

The industry supply curve shows the relationship between the price of a good  and the total output of the industry as a whole.

The Short-Run Industry Supply Curve

The short-run industry supply curve shows how the quantity supplied by an  industry depends on the market price given a fixed number of producers.

- This is shown as S, in Figure 12-5. This curve shows the quantity that  producers will supply at each price, taking the number of producers as given.

The demand curve D in Figure 12-5

crosses the short run industry

supply curve at EMKT

- This point is a short-run

market equilibrium: the

quantity supplied equals the

quantity demanded, taking

the number of producers as

given.

- But in the long-run, farms

may enter or exit the

industry.

The Long-Run Industry Supply Curve

Whenever existing producers are making a profit—that is, whenever the market  price is above the break-even price, the minimum average total cost of production.

What happens as additional producers enter the

industry?

- The quantity

supplied at any

given price will

increase.

- The short-run

supply curve will

shift to the right,

which will, in turn,

alter the market

equilibrium and

result in a lower

market price.

- Existing firms will

respond to the

lower market price

by reducing their

output, but the

total industry output will increase because of the larger number of firms in  the industry.

A market is in long-run market equilibrium when the quantity supplied equals  the quantity demanded, given that sufficient time has elapsed for entry into and  exit from the industry to occur.

The long-run industry supply curve shows how the quantity supplied responds  to the price once producers have had time to enter or exit the industry.

Regardless of whether the long-run industry supply curve is horizontal or upward  sloping or even downward sloping, the long-run price elasticity of supply is higher than the short-run price elasticity whenever there is free entry and exit.

As shown in Figure 12-8, the long-run

industry supply curve is always

flatter than the short-run industry

supply curve.

- The reason is entry and

exit: a high price caused

by an increase in demand

attracts entry by new

producers, resulting in a

rise in industry output and

an eventual fall in price; a

low price caused by a

decrease in demand

induces existing firms to

industry output and an

eventual increase in price.

The Cost of Production and Efficiency in Long-Run Equilibrium

1. In a perfectly competitive industry in equilibrium, the value of marginal cost  is the same for all firms.

a. That’s because all firms produce the quantity of output at which  marginal cost equals the market price, and as price-takers they all face the same market price.

2. In a perfectly competitive industry with free entry and exit, each firm will  have zero economic profit in long-run equilibrium.

a. Each firm produces the quantity of output that minimizes its average  total cost—corresponding to point Z in panel ( c ) of Figure 12-7.  b. The exception is an industry with increasing costs across the industry.  Given a sufficiently high market price, early entrants make positive  economic profits, but the last entrants, as the industry reaches the  long-run equilibrium, but not necessarily for the early ones.

So the total cost of production of the industry’s output is minimized in a perfectly  competitive industry.

3. The long-run market equilibrium of a perfectly competitive industry is  efficient: no mutually beneficial transactions go exploited.

a. Recall, all consumers who have a willingness to pay greater than or  equal to sellers’ costs actually get the good.

b. We have also learned that when a market is efficient, the market  price matches all consumers with a willingness to pay greater than or  equal to the market price to all seller who have a cost of producing the  good less than or equal to the market price.

In the long-run market equilibrium of a perfectly competitive industry, each firm  produces at the same marginal cost, which is equal to the market price, and the  total cost of production of the industry’s output is minimized. It’s also considered  efficient.

CHAPTER 9- DECISION MAKING BY INDIVIDUALS AND  FIRMS

Costs, Benefits, and Profits

When making decisions, it is crucial to think in terms of opportunity cost, because  the opportunity cost of an action is often considerably more than the cost of any  outlays of money.

Economists use the concepts of explicit costs and implicit costs to compare the  relationships between opportunity costs and monetary outlays.

Explicit versus Implicit Costs

An explicit cost is a cost that requires an outlay of money. For e.g. the explicit cost  of the additional year of schooling includes tuition.

An implicit cost does not require an outlay of money. It is measure by the value, in  dollar terms, of benefits that are forgone. For e.g. the implicit cost of the year spent  in school includes the income you would have earned if you had taken a job instead.

A common mistake is to ignore implicit

costs and focus exclusively on explicit

costs. But often, the implicit cost of an

activity is quite substantial—indeed,

sometimes it is much larger than the

explicit cost.

In Table 9-1, the forgone salary is the cost

in going to school rather than working. The

use of your time for more schooling,

despite the fact that you don’t have to spend any money on it, is still costly to you.

The opportunity cost: in considering the cost of an activity, you should include the  cost of using any of your own resources for that activity. You can calculate the cost  of using your own resources by determining what they would have earned in their  next best use.

Accounting Profit versus Economic Profit

Accounting profit is equal to revenue minus explicit cost.

Economic profit is equal to revenue minus the opportunity cost of resources used.  It is usually less than the accounting profit.

In general, the economic profit of a given project will be less than the accounting  profit because there are almost always implicit costs in addition to explicit costs.

When economists refer to the term profit, they are referring to economic  profit, not accounting profit.

Capital is the total value of assets owned by an individual or firm—physical asset  plus financial assets.

- An individual’s capital usually consists of cash in the bank, stocks, bonds, and the ownership value of real estate such as a house.

The implicit cost of capital is the opportunity cost of the use of one’s own capital —the income earned if the capital had been employed in its next best alternative  use.

Making “Either-Or” Decisions

An “either-or” decision Is one in which you must choose between two activities.

The best way to make an “either-or” decision, the method that leads to the best  possible economic outcome, is the straightforward principle of “either-or”  decision making.

- According to this principle, when making an “either-or” choice between two  activities, choose the one with the positive economic profit.

Marginal Cost

Marginal cost of producing a good or service is the additional cost incurred by  producing one more unit of that good or service.

Production of a good or service has increasing marginal cost when each  additional unit costs more to produce than the previous one.

Marginal cost curve shows how the cost of producing one more unit depends on  the quantity that has already been produced.

Production of a good or service has constant marginal cost when each additional  unit costs the same to produce as the previous one.

Production of a good or service has decreasing marginal cost when each  additional unit costs less to produce than the previous one.

Marginal Benefit

Marginal benefit of a good or service is the additional benefit derived from  producing one more unit of that good or service.

Decreasing marginal benefit from an activity when each additional unit of the  activity yields less benefit than the previous unit.

- With decreasing marginal benefit, the benefit from producing one more unit  of the good or service falls as the quantity already produced rises. - A downward-sloping marginal benefit curve reflects a decreasing marginal  benefit.

Marginal benefit curve shows how the benefit from producing one more unit  depends on the quantity that has already been produced.

Marginal Analysis

Optimal quantity is the quantity that generates the higher possible total profit.

- With small quantities, the rule for choosing the optimal quantity is: increase  the quantity as long as the marginal benefit from one more unit is greater  than the marginal cost, but stop before the marginal benefit becomes less  than the marginal cost.

Profit-Maximizing Principle of Marginal Analysis—When making a profit maximizing “how much” decision, the optimal quantity is the largest quantity at  which marginal benefit is greater than or equal to marginal cost.

Sunk Cost

A sunk cost is a cost that has already been incurred and is nonrecoverable. A sunk  cost should be ignored in decisions about future actions because they have no  effect on future costs and benefits.

Behavioral Economics

- Behavioral economics combines economic modeling with insights from  human psychology.

Rational, but Human, Too

Rational decision maker chooses the available option that leads to the outcome he  or she most prefers.

- Rational behavior leads to the outcome a person most prefers.

Bounded rationality is making a choice that is close to but not exactly the one  that leads to the highest possible profit because the effort of finding the best payoff  is too costly.

- Bounded rationality is the “good enough” method of decision making.

Risk aversion is the willingness to sacrifice some economic payoff in order to avoid a potential loss.

- Because risk makes most people uncomfortable, it’s rational for them to give  up some potential economic gain in order to avoid it.

Irrationality: An Economist’s View

An irrational decision maker chooses an option that leaves him or her worse off  than choosing another available option.

Mental accounting is the habit of mentally assigning dollars to different accounts  so that some dollars are worth more than others.

Loss aversion is an oversensitivity to loss, leading to unwillingness to recognize a  loss and move on.

The status quo bias is the tendency to avoid making a decision and sticking with  the status quo.

CHAPTER 13- MONOPOLY

The Meaning of Monopoly

A monopolist is a firm that the only producer of a good that has no close  substitutes. An industry controlled by a monopolist is known as a monopoly.

What Monopolists Do

The ability of a monopolist to

raise its price above the

competitive level by reducing

output is known as market

power.

The reason a monopolist

reduces output and raises

prices compared to the

perfectly competitive industry

levels is to increase profit.

Why Do Monopolies Exist?

For a profitable monopoly to persist, something must keep others from going into  the same business; that “something” is known as a barrier to entry – there are  five principal types.

1. Control of a Scarce Resource or Input – A monopolist that controls a  resource or input crucial to an industry can prevent other firms from entering  its market.

2. Increasing Returns to Scale—A monopoly created and sustained by  increasing returns to scale is called a natural monopoly. For e.g. Local gas  supply is an industry in which average total cost falls as output increases.

a. Natural monopoly exists

when increasing returns to

scale provide a large cost

that produces all of an

industry’s output.

3. Technological Superiority—A

firm that maintains a consistent

potential competitors can

establish itself as a monopolist.

4. Network Externality—Network

externality exists when the value of a good or service to an individual is  greater when many other people use the good or service as well. a. The earliest form of network externalities arose in transportation,  where the value of a road or airport increased as the number of people  who had access to it rose. But network externalities are especially  prevalent in the technology and communications sectors of the  economy.

5. Government-Created Barrier—The most important legally created  monopolies today arise from patents and copyrights.

a. Patent—gives an inventor a temporary monopoly in the use or sale of  an invention.

b. Copyright—gives the creator of a literary or artistic work sole rights to  profit from that work.

The Monopolist’s Demand Curve and Marginal Revenue

A monopolist is the sole supplier of its good. So its demand curve is simply the  market demand curve, which slopes downward.

- This downward slope creates a “wedge” between the price of the good and  marginal revenue of the good—the change in revenue generated by  producing one more unit.

The marginal revenue of a monopolist is composed of a quantity effect (the price  received from the additional unit) and a price effect (the reduction in the price at  which all units are sold). Because of the price effect, a monopolist’s marginal  revenue is always less than the market price, and the marginal revenue curve lies  below the demand curve.

At the monopolist’s profit-maximizing output level, marginal cost equals marginal  revenue, which is less than market price. MC = MR; < P.

- At the perfectly competitive firm’s profit-maximizing output level, marginal  cost equals the market price. MC = P.

o Compared to perfectly competitive industries, monopolies produce  less, charge higher prices, and earn profits in both the short run  and the long run.

Since a

monopolist is a

sole supplier of

its good, its

demand curve

is simply the

market demand

curve, which

slopes

downward like

DM in panel (B)

of the figure to

the left.

- This downward

slope creates a

“wedge”

between the prices of the good and the marginal revenue of the good—the  change in revenue generated by producing one more unit.

An increase in production by a monopolist has two opposing effects on revenue:

- A quantity effect: One more unit is sold, increasing total revenue by the price  at which the unit is sold.

- A price effect: In order to sell the last unit, the monopolist must cut the  market price on all units sold. This decreases total revenue.

The quantity effect and the price

effect when the monopolist goes from

selling 9 diamonds to 10 diamonds are

illustrated in the two shaded areas in

the figure to the left.

o Increasing diamond sales from 9

to 10 means moving down the

demand curve from A to B,

reducing the price per diamond

from \$550 to \$500.

represents the quantity effect:

The company sells the 10th

diamond at a price of \$500.

 This is offset, however,

by the price effect

represented by the

 In order for the company

to sell that 10th diamond,

it must reduce the price

on all its diamonds from

\$550 to \$500.

o So, it loses 9 x \$50 = \$450 in

area.

o Point C indicates that the total

effect on revenue of selling one

more diamond—the marginal

revenue—derived from an

increase in diamond sales from

9 to 10 is only \$50.

Panel (b) reflects the fact that at low

levels of output, the quantity effect is

stronger than the price effect: as the

monopolist sells more, it has to lower

the price on only very few units, so the

price effect is small.

o As output rises beyond 10

diamonds, total revenue

actually falls. This reflects that

at high levels of output, the

price effect is stronger than the

quantity effect: as the

monopolist sells more, it now

has to lower the price on many

units of output, making the

price effect very large.

The Monopolist’s Profit-Maximizing Output and Price

To maximize profit, the monopolist compares marginal cost with marginal revenue.  If marginal revenue exceeds marginal cost, the diamond company increases profit  by producing more; if marginal revenue is less than marginal cost, the diamond  company increases profit by producing less.

So the monopolist maximizes its profit by using the optimal output rule.

The monopolist’s optimal point

is shown on the left. At point A,

the marginal cost curve, MC,

crosses the marginal revenue

curve, MR. The corresponding

output level, 8 diamonds, is the

monopolist’s profit-maximizing

quantity of output, QM.

The price at which consumers

demand 8 diamonds, is \$600, so

the monopolist’s price, is \$600

—corresponding to point B. The

average total cost of producing

each diamond is \$200, so the

monopolist earns a profit of

\$600 - \$200 = \$400 per

diamond, and total profit is 8 x

\$400 = \$3,200, as indicated by

Monopoly versus Perfect Competition

Compared with a competitive industry, a monopolist does the following:

- Produces a smaller quantity: QM < QC

- Charges a higher price: PM > PC

- Earns a profit

Monopoly: The General Picture

The crucial difference between a firm with market power, such as a monopolist, and  a firm in a perfectly competitive industry is that perfectly competitive firms are  price-takers that face horizontal demand curves, but a firm with market power faces a downward-sloping demand curve.

Due to the price effect of an increase in output, the marginal revenue curve of a  firm with market power always lies below its demand curve. So, a profit-maximizing  monopolist chooses the output level at which marginal cost is equal to marginal  revenue—not to price.

As a result, the monopolist produces less and sells its output at a higher price than  a perfectly competitive industry would. It earns profits in the short run and the long  run.

Monopoly and Public Policy

Welfare Effects of Monopoly

By reducing output and raising price above marginal cost, a monopolist captures  some of the consumer surplus as profit and causes deadweight loss. To avoid  deadweight loss, government policy attempts to curtail monopoly behavior.

Preventing Monopoly

Policy toward monopoly depends crucially on whether or not the industry in  question is a natural monopoly, one in which increasing returns to scale ensure that  a bigger producer has lower average total cost.

- If the industry is not a natural monopoly, the best policy is to prevent  monopoly from arising or break it up if it already exists.

The De Beers monopoly on diamonds didn’t have to happen. Diamond production is  not a natural monopoly: the industry’s costs would be no higher if it consisted of a  number of independent, competing producers (as is the case, for example, in gold  production).

- So, if the South African government has been worried about how a monopoly  would have affected consumers, it could have blocked Cecil Rhodes in his  drive to dominate the industry or broken up his monopoly after the fact.  Today, governments often try to prevent monopolies from forming and break  up existing one.

For complicated historical reasons, it was allowed to remain a monopoly. But over  the last century, most similar monopolies have been broken up. The most  celebrated example in the US is Standard Oil—founded by John D. Rockefeller in  1870. By 1878, Standard oil controlled almost all us oil refining; but in 1911 a court  order broke the company into a number of smaller units, including the companies  that later became Exxon and Mobil.

The government policies used to prevent or eliminate monopolies are known as  antitrust policies ~

Dealing with Natural Monopoly

What can public policy do about breaking up huge monopolies

1. Public ownership—In public ownership of a monopoly, the good is supplied by the government or by a firm owned by the government.

a. Instead of allowing a private monopolist to control an industry, the  government establishes a public agency to provide the good and  protect consumers’ interests.

b. Examples of public ownership in the US is Passenger rail service— which is provided by the public company Amtrak; regular mail delivery  is provided by the U.S. Postal Service; some cities, including LA, have  publicly owned electric power companies.

2. Regulation—Price Regulation limits the price that a monopolist is allowed to  charge.

a. Most local utilities like electricity, land line telephone service, natural  gas, etc.

b. A price ceiling on a monopolist need not create a shortage—in the  absence of a price ceiling, a monopolist would charge a price that is  higher than its marginal cost of production.

i. So if even forced to charge a lower price—as long as that price is above MC and the monopolist at least breaks even on total

Quick Review

output—the monopolist still has an incentive to produce the  quantity demanded at that price.

When monopolies are “created” rather than natural, governments should act to  prevent them from forming and break up existing ones.

Natural monopoly poses a harder policy problem.

- Public Ownership is one answer for policy regulation but publicly owned  companies are often poorly run.

- Price regulation is another answer—A price ceiling imposed on a  monopolist does not create shortages as long as it is not set too low.

There always remains the option of doing nothing, monopoly is a bad thing, but the  cure may be worse than the disease.

A monopsony, when there is only one buyer of a good, also results in deadweight  loss. The monopsonist can affect the price of the good it buys; it captures surplus  from sellers by reducing how much it purchases and thereby lowers the price.

Price Discrimination

A single-price monopolist offers its product to all consumers at the same price.

Sellers engage in price discrimination when they charge different prices to  different consumers for the same good.

The Logic of Price Discrimination

Price discrimination is profitable when consumers differ in their sensitivity to the  price. A monopolist charges higher prices to low-elasticity consumers and lower  prices to high-elasticity ones.

Perfect Price Discrimination

A monopolist able to charge each consumer his or her willingness to pay for the  good achieves perfect price discrimination and does not cause inefficiency because  all mutually beneficial transactions are exploited.

Monopolists do try to move

in the direction of perfect

price discrimination

through a variety of pricing

strategies. Common

techniques include:

restrictions: Prices are

lower for those who

(or in some cases for

those who purchase at

the last minute).

 Volume discounts: Often

the price is lower if you

a consumer who plans to

consume a lot of good,

the cost of the last unit—

the marginal cost to the

consumer—is

considerably less than

the average price.

- Two-part tariffs: With a two-part tariff, a customer pays a flat fee up-front and  then a per-unit fee on each item purchased.

If sales to consumers formerly priced out of the market but now able to purchase  the good at a lower price generate enough surplus to offset the loss in surplus to  those now facing a higher price and no longer buying the good, then total surplus  increases when discrimination is introduced.

- For e.g. a drug that is disproportionately prescribed to senior citizens, who  are often on fixed incomes and so are very sensitive to price. A policy that  allows a drug company to charge senior citizens a low price and everyone  else a high price may indeed increase total surplus compared to a situation in

which everyone is charged the same price.

- But price discrimination that creates serious concerns about equity is likely to be prohibited—for example, an ambulance service that charges patients  based on the severity of their emergency.

CHAPTER 14- OLIGOPOLY

The Prevalence of Oligopoly

An oligopoly is an industry with only a small number of producers. A producer in  such an industry is known as an oligopolist.

When no one firm has a monopoly, but producers nonetheless realize that they can  affect market prices, an industry is characterized by imperfect competition.

Oligopoly is the result of the same factors that sometimes produce monopoly, but in somewhat weaker form.

- The most important source of oligopoly is the existence of increasing returns  to scale, which give bigger producers a cost advantage over smaller ones.  When these effects are very strong, they lead to monopoly; when they are

not that strong, they lead to an industry with a small number of firms.  o For e.g., larger grocery stores typically have lower costs than smaller  ones. But the advantages, of large scale taper off once grocery stores  are reasonably large, which is why two or three stores often survive in  small towns.

A Duopoly Example

We have two firms, ADM and Ajnimoto, producing

lysine—both marginal costs equal zero.

If this were a perfectly competitive industry, each firm  would have an incentive to produce more as long as

the market price was above marginal cost. Since the  marginal cost is assumed to be zero, this would mean

that at equilibrium lysine would be provided free. Firms

would produce until price equals zero, yielding a total

output of 120 million pounds and zero revenue for both

firms.

How much will the two firms produce?

Collusion—the two companies will cooperate to raise their joint profits. The  strongest form of collusion is a cartel, an arrangement between producers that  determines how much each is allowed to produce.

Collusion and Competition

Suppose that the presidents of ADM and Ajinomoto were to agree that each would  produce 30 million pounds of lysine over the next year.

Consider what would happen if Ajinomoto honored its agreement, producing only 30 million pounds, but ADM ignored its promise and produced 40 million pounds. This  increase in total output would drive the price down from \$6 to \$5/lb.—the price at  which 70 million pounds are demanded.

The total revenue of the industry would fall from \$360 million to \$350 million.  However, ADM’s revenue would rise, from \$180 million to \$200 million. Since we are assuming a marginal cost of zero, this would mean a \$20 million increase in ADM’s  profits.

- But if Ajinomoto’s president might make exactly the same calculation. And if  both firms were to produce 40 million pounds of lysine, the price would drop  to \$4/lb. – So each firm’s profits would fall, from \$180 million to \$160 million.

So why do individual firms have an incentive to produce more than the quantity that maximizes their joint profits? Because neither firm has as strong an incentive to  limit its output as a true monopolist would.

Theory of Monopoly

1. A positive quantity effect: one more unit is sold, increasing total revenue by  the price at which that unit is sold.

2. A negative price effect: in order to sell one more unit, the monopolist must  cut the market price on all units sold.

The negative price effect is the reason marginal revenue for a monopolist is less  than the market price.

- In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not  those of its fellow oligopolists.

o Both ADM and Ajinomoto suffer a negative price effect if ADM decides  to produce extra lysine and so drives down the price—But ADM cares  only about the negative price effect on the units it produces, not about  the loss to Ajinomoto.

o But ADM only cares about the negative price effect on the units it  produces, not about the loss to Ajinomoto.

- This tells us that an individual firm in an oligopolistic industry faces a smaller  price effect from an additional unit of output than does a monopolist;  therefore, the marginal revenue that such a firm calculates is higher.

Noncooperative Behavior-- when firms ignore the effects of their actions on each others’ profits.

Overall, each firm has an incentive to cheat—to produce more than it is supposed to under the cartel agreement. So there are two principal outcomes: successful  collusion or behaving noncooperatively by cheating.

The Prisoner’s Dilemma

Game theory deals with any situation in which the reward to any one player—the  payoff—depends not only on his or her own actions but also on those of other  players in the game.

- In oligopolistic firms, the payoff is simply the firm’s profit.

When there are only two players, as in a duopoly, the interdependence between the players can be represented with a payoff matrix like that shown in Figure 14-1.

Each row corresponds to an action by one

player (in this case; ADM); each column

corresponds to an action by the other (in

this case, Ajinomoto).

Each box, divided by a diagonal line,

shows the payoff to the two firms

that results from a pair of choices;

the number below the diagonal

above the diagonal shows

Ajinomoto’s profits.

These payoffs show what we

concluded from our earlier analysis:

the combined profit of the two firms

that results from a pair of choices; the

the number above the diagonal shows

Ajinomoto’s profits.

The payoffs conclude: The profit of the two firms is maximized if they each produce  30 million pounds.

Either the firm can, however, increase its own profits by producing 40 million  pounds while the other produces only 30 million pounds—but if both produce the  larger quantity, both will have lower profits than if they had both held their output  down.

This situation is known as the prisoner’s dilemma—a type of game in which the  payoff matrix implies the following.

- Each player has an incentive , regardless of what the other player does, to  cheat—to take an action that benefits it at the other’s expense.

- When both players cheat, both are worse off than they would have been if  neither had cheated.

An action is dominant strategy when it is the player’s best action regardless of  the action taken by the other player.

In game theory, a Nash equilibrium, also known as a noncooperative equilibrium,  results when each player in a game chooses the action that maximizes his or her  payoff given the actions of other players, ignoring the effects of his or her action on  the payoffs received by those other players.

Overcoming the Prisoner’s Dilemma: Repeated Interaction and Tacit  Collusion

A smart firm will engage in strategic behavior, taking account of the effects of the action it chooses today on the future actions of other players in the game.

A strategy of tit for tat involves playing cooperatively at first, then doing whatever  the other player did in the previous period.

1. If ADM plays tit for tat and so does

Ajinomoto, both firms will make a profit of

\$180 million each year.

2. If ADM plays always cheat but Ajinomoto

plays tit for tat, ADM makes a profit of

\$200 million the first year but only \$160

million per year thereafter.

3. If ADM plays tit for tat but Ajinomoto

plays always cheat, ADM makes a profit of

only \$150 million in the first year, but

\$160 million per year thereafter.

4. If ADM plays always cheat and

Adjinomoto does the same, both firms will

make a profit of \$160 million each year.

When firms limit production and raise prices in a way that raises one another’s  profits, even though they have not made any formal agreement, they are engaged  in tacit collusion.

Oligopoly in Practice

Antitrust policies consist of efforts undertaken by the government to prevent  oligopolistic industries from becoming or behaving like monopolies.

- One of the most striking early actions of antitrust policy was the breakup of  Standard Oil in 1911.

Tacit Collusion and Price Wars

Tacit collusion is limited by a number of factors, including large numbers of firms,  complex products and pricing, differences in interests among firms, and bargaining  power of buyers.

When collusion breaks down, there is a price war—occurs when tacit collusion  breaks down and prices collapse.

To limit competition, oligopolist often engage in product differentiation. When  products are differentiated, it is sometimes possible for industry to achieve tacit  collusion through price leadership.

Product differentiation is an attempt by a firm to convince buyers that its product is  different from the products of other firms in the industry.

- A firm might alter what it actually produces, adding “extras”, or choosing a  different design.

o It may also use advertising and marketing campaigns to create a  differentiation in the minds of consumers, even though its product is  more or less identical to the products of rivals.

Price leadership is when one firm sets its price first, and other firms follow that  price.

Nonprice competition is the use of advertising and other means to try to increase their sales.

CHAPTER 15: MONOPOLISTIC COMPETITION AND PRODUCT  DIFFERENTIATION

The Meaning of Monopolistic Competition

Monopolistic competition is a market structure in which there are many competing  producers in an industry, each producer sells a differentiated product, and there is  free entry into and exit from the industry in the long run.

- Each producer has some ability to set the price of their differentiated product. In a monopolistic competitive industry, there are producers.

- Each producer has a product that consumers view as somewhat distinct from  the product competing firms; at the same time, though, consumer see these  competing products as close substitutes.

Product Differentiation

Three important forms of product differentiation: differentiation by style or type,  differentiation by location, and differentiation by quality.

Differentiation by Style or Type

- The product of different vendors are substitutes, but they aren’t perfect  substitutes—they are imperfect substitutes.

Product differentiation is characteristic of most consumer goods—As long as people  differ in their tastes, producers find it possible and profitable to produce a range of  varieties.

Differentiation by Location

Monopolistically competitive industries supply goods differentiated by location. This  is especially true in service industries, from dry cleaners to hairdressers, where  customers often choose the seller who is closest rather than cheapest.

Differentiation by Quality

Because consumers vary in what they are willing to pay higher quality, producers  can differentiate their products by quality—some offering lower-quality, inexpensive  products and others offering higher-quality products at a higher price.

- Competition among sellers: even though sellers of differentiated products are not offering identical goods, they are to some extent competing for a limited  market.

o If more businesses enter the market, each will find that it sells less  quantity at any given price.

 For e.g. if a new gas station opens along a road, each of the  existing gas stations will sell a bit less.

- Value in diversity: refers to the gain to consumers from the proliferation of  differentiated products.

o For e.g. a food court with eight vendors makes consumers happier than one with only six vendors, even if the prices are the same, because  some customers will get a meal that is closer to what they had in mind.

When a product is available in many different qualities, fewer people are forced to  pay for more quality than they need or to settle for lower quality than they want. ---  There are benefits to consumers from a greater diversity of available products.

Producers compete for the same market, so entry by more producers reduces the  quantity each existing producers sells at any given price. In addition, consumers  gain from the increased diversity of products.

Monopolistic Competition in the Short Run

The key to whether a firm

with market power is

profitable or unprofitable

in the short run, lies in

the relationship between

its demand curve and its

average total cost curve.

Monopolistic Competition in Long Run

Zero-profit

equilibrium—In

the long run, a

monopolistically

competitive

industry—each

firm makes zero

profit at its profit

maximizing

quantity.

In long-run equilibrium, firms in a monopolistically competitive industry sell at a  price greater than marginal cost.

They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive  industry. Whether or not monopolistic competition is inefficient is ambiguous  because consumers value the diversity of products that it creates.

A monopolistically competitive firm will always prefer to make an additional sale at  the going price, so it will engage in advertising to increase demand for its produce  and enhance its market power.

- Advertising and brand names that provide useful information to consumers  are economically valuable.

o But they are economically wasteful when their only purpose is to  create market power.

- In reality, advertising and brand names are likely to be some of both:  economically valuable and economically wasteful.

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