Split (1)

train · 11.7k rows

text stringlengths 204 3.13k
of 21 from 1 less T-shirt, but gain of 23 from two more movies, for a net utility gain of 2 0 from 0 T-shirts + 100 from 8 movies = 100 Loss of 22 from 1 less T-shirt, but gain of 19 from two more movies, for a net utility loss of 3 S is preferred over R S is preferred over T Table 6.4 A Step-by-Step Approach to Maximizing Utility Decision Making by Comparing Marginal Utility José could use the following thought process (if he thought in utils) to make his decision regarding how many T-shirts and movies to purchase: Step 1. From Table 6.2, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the fourth T-shirt, then he loses 18 utils. Step 2. Giving up the fourth T-shirt, however, frees up $14 (the price of a T-shirt), allowing José to buy the first two movies (at $7 each). Step 3. José knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils (from the T-shirt), but gains 31 utils (from the movies). Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total utility at Q (94 according to the last column in Table 6.3) is 13 more than the total utility at P (81). Step 5. Thus, for José, it makes sense to give up the fourth T-shirt in order to buy two movies. José clearly prefers point Q to point P. Now repeat this step-by-step process of decision making with marginal utilities. José thinks about giving up the third T-shirt and surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise a combined marginal utility of 27. José prefers point R to point Q. What if José thinks about going beyond R to point S? Giving up the second T-shirt means a marginal utility loss of 21, and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23, so José prefers point S to R. However, if José seeks to go beyond point S to point T, he finds that the loss of marginal utility from giving up the first T-shirt is
22, while the marginal utility gain from the last two movies is only a total of 19. If José were to choose point T, his utility would fall to 100. Through these stages of thinking about marginal tradeoffs, José again concludes that S, with one T-shirt and six movies, is the choice that will provide him with the highest level of total utility. This step-by-step approach will reach the same conclusion regardless of José’s starting point. We can develop a more systematic way of using this approach by focusing on satisfaction per dollar. If an item costing $5 yields 10 utils, then it’s worth 2 utils per dollar spent. Marginal utility per dollar is the amount of additional utility José receives divided by the product's price. Table 6.5 shows the marginal utility per dollar for José's T shirts This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 139 and movies. marginal utility per dollar = marginal utility price If José wants to maximize the utility he gets from his limited budget, he will always purchase the item with the greatest marginal utility per dollar of expenditure (assuming he can afford it with his remaining budget). José starts with no purchases. If he purchases a T-shirt, the marginal utility per dollar spent will be 1.6. If he purchases a movie, the marginal utility per dollar spent will be 2.3. Therefore, José’s first purchase will be the movie. Why? Because it gives him the highest marginal utility per dollar and is affordable. Next, José will purchase another movie. Why? Because the marginal utility of the next movie (2.14) is greater than the marginal utility of the next T-shirt (1.6). Note that when José has no T- shirts, the next one is the first one. José will continue to purchase the next good with the highest marginal utility per dollar until he exhausts his budget. He will continue purchasing movies because they give him a greater "bang for the buck" until the sixth movie which gives the same marginal utility per dollar as the first T-shirt purchase. José has just enough budget to purchase both. So in total, José will purchase six movies and one T-shirt. Quantity of TShirts Total Utility Marginal Utility 1 2 3 4 5 6 7 22 43 63 81 97 111 123 22 21 20 18 16 14 12 Marginal Utility per Dollar 22/$14=1
.6 21/$14=1.5 20/$14=1.4 18/$14=1.3 16/$14=1.1 14/$14=1 12/$14=1.2 Quantity of Movies Total Utility Marginal Utility 1 2 3 4 5 6 7 16 31 45 58 70 81 91 16 15 14 13 12 11 10 Marginal Utility per Dollar 16/$7=2.3 15/$7=2.14 14/$7=2 13/$7=1.9 12/$7=1.7 11/$7=1.6 10/$7=1.4 Table 6.5 Marginal Utility per Dollar A Rule for Maximizing Utility This process of decision making suggests a rule to follow when maximizing utility. Since the price of T-shirts is twice as high as the price of movies, to maximize utility the last T-shirt that José chose needs to provide exactly twice the marginal utility (MU) of the last movie. If the last T-shirt provides less than twice the marginal utility of the last movie, then the T-shirt is providing less “bang for the buck” (i.e., marginal utility per dollar spent) than José would receive from spending the same money on movies. If this is so, José should trade the T-shirt for more movies to increase his total utility. If the last T-shirt provides more than twice the marginal utility of the last movie, then the T-shirt is providing more “bang for the buck” or marginal utility per dollar, than if the money were spent on movies. As a result, José should buy more T-shirts. Notice that at José’s optimal choice of point S, the marginal utility from the first T-shirt, of 22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice, the marginal utility per dollar is the same for both goods. This is a tell-tale signal that José has found the point with highest total utility. We can write this argument as a general rule: If you always choose the item with the greatest marginal utility per dollar spent, when your budget is exhausted, the utility maximizing choice should occur where the marginal utility per dollar spent is the same for both goods. A sensible economizer will pay twice as much for something only if, in the marginal comparison, the item confers MU1 P1 = MU2 P2 140 Chapter 6 \| Consumer Choices twice as much utility. Notice that the formula for the table
above is: = 11 22 $14 $7 1.6 = 1.6 The following Work It Out feature provides step by step guidance for this concept of utility-maximizing choices. Maximizing Utility The general rule, MU1 P1 = MU2 P2, means that the last dollar spent on each good provides exactly the same marginal utility. This is the case at point S. So: Step 1. If we traded a dollar more of movies for a dollar more of T-shirts, the marginal utility gained from Tshirts would exactly offset the marginal utility lost from fewer movies. In other words, the net gain would be zero. Step 2. Products, however, usually cost more than a dollar, so we cannot trade a dollar’s worth of movies. The best we can do is trade two movies for another T-shirt, since in this example T-shirts cost twice what a movie does. Step 3. If we trade two movies for one T-shirt, we would end up at point R (two T-shirts and four movies). Step 4. Choice 4 in Table 6.4 shows that if we move to point R, we would gain 21 utils from one more T-shirt, but lose 23 utils from two fewer movies, so we would end up with less total utility at point R. In short, the general rule shows us the utility-maximizing choice, which is called the consumer equilibrium. There is another equivalent way to think about this. We can also express the general rule as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities. When we divide the price of good 1 by the price of good 2, at the utility-maximizing point this will equal the marginal utility of good 1 divided by the marginal utility of good 2. P1 P2 = MU1 MU2 Along the budget constraint, the total price of the two goods remains the same, so the ratio of the prices does not change. However, the marginal utility of the two goods changes with the quantities consumed. At the optimal choice of one T-shirt and six movies, point S, the ratio of marginal utility to price for T-shirts (22:14) matches the ratio of marginal utility to price for movies (of 11:7). Measuring Utility with Numbers This discussion of utility began with an assumption that it is possible to place numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for
measuring temperature at the hardware store, but what store sells an “utilimometer” for measuring utility? While measuring utility with numbers is a convenient assumption to clarify the explanation, the key assumption is not that an outside party can measure utility but only that individuals can decide which of two alternatives they prefer. To understand this point, think back to the step-by-step process of finding the choice with highest total utility by comparing the marginal utility you gain and lose from different choices along the budget constraint. As José compares each choice along his budget constraint to the previous choice, what matters is not the specific numbers that he places on his utility—or whether he uses any numbers at all—but only that he personally can identify which choices he prefers. In this way, the step-by-step process of choosing the highest level of utility resembles rather closely how many people make consumption decisions. We think about what will make us the happiest. We think about what things cost. We think about buying a little more of one item and giving up a little of something else. We choose what provides us This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 141 with the greatest level of satisfaction. The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner. It is welcome news that specific utility numbers are not central to the argument, since a good utilimometer is hard to find. Do not worry—while we cannot measure utils, by the end of the next module, we will have transformed our analysis into something we can measure—demand. 6.2 \| How Changes in Income and Prices Affect Consumption Choices By the end of this section, you will be able to: • Explain how income, prices, and preferences affect consumer choices • Contrast the substitution effect and the income effect • Utilize concepts of demand to analyze consumer choices • Apply utility-maximizing choices to governments and businesses Just as we can use utility and marginal utility to discuss making consumer choices along a budget constraint, we can also use these ideas to think about how consumer choices change when the budget constraint shifts in response to changes in income or price. Because we can use the budget constraint framework to analyze how quantities demanded change because of price movements, the budget constraint model can illustrate the underlying logic behind demand curves. How Changes in Income Affect Consumer Choices Let�
�s begin with a concrete example illustrating how changes in income level affect consumer choices. Figure 6.3 shows a budget constraint that represents Kimberly’s choice between concert tickets at $50 each and getting away overnight to a bed-and-breakfast for $200 per night. Kimberly has $1,000 per year to spend between these two choices. After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products, Kimberly chooses point M, with eight concerts and three overnight getaways as her utility-maximizing choice. Figure 6.3 How a Change in Income Affects Consumption Choices The utility-maximizing choice on the original budget constraint is M. The dashed horizontal and vertical lines extending through point M allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint. On the new budget constraint, Kimberly will make a choice like N if both goods are normal goods. If overnight stays is an inferior good, Kimberly will make a choice like P. If concert tickets are an inferior good, Kimberly will make a choice like Q. Now, assume that the income Kimberly has to spend on these two items rises to $2,000 per year, causing her budget constraint to shift out to the right. How does this rise in income alter her utility-maximizing choice? Kimberly will 142 Chapter 6 \| Consumer Choices again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her utility-maximizing choice on the new budget line, but how will her new choice relate to her original choice? We can replace the possible choices along the new budget constraint into three groups, which the dashed horizontal and vertical lines that pass through the original choice M in the figure divide. All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line, like choice P with two overnight stays and 32 concert tickets, involve less of the good on the horizontal axis but much more of the good on the vertical axis. All choices to the right of the vertical dashed line and above the horizontal dashed line—like choice N with five overnight getaways and 20 concert tickets—have more consumption of both goods. Finally, all choices that are to the right of the vertical dashed line but below the horizontal dashed line, like choice Q with four concerts and nine overnight getaways, involve less of the good
on the vertical axis but much more of the good on the horizontal axis. All of these choices are theoretically possible, depending on Kimberly’s personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods. When income rises, the most common reaction is to purchase more of both goods, like choice N, which is to the upper right relative to Kimberly’s original choice M, although exactly how much more of each good will vary according to personal taste. Conversely, when income falls, the most typical reaction is to purchase less of both goods. As we defined in the chapter on Demand and Supply and again in the chapter on Elasticity, we call goods and services normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed. However, depending on Kimberly’s preferences, a rise in income could cause consumption of one good to increase while consumption of the other good declines. A choice like P means that a rise in income caused her quantity consumed of overnight stays to decline, while a choice like Q would mean that a rise in income caused her quantity of concerts to decline. Goods where demand declines as income rises (or conversely, where the demand rises as income falls) are called “inferior goods.” An inferior good occurs when people trim back on a good as income rises, because they can now afford the more expensive choices that they prefer. For example, a higher-income household might eat fewer hamburgers or be less likely to buy a used car, and instead eat more steak and buy a new car. How Price Changes Affect Consumer Choices For analyzing the possible effect of a change in price on consumption, let’s again use a concrete example. Figure 6.4 represents Sergei's consumer choice, who chooses between purchasing baseball bats and cameras. A price increase for baseball bats would have no effect on the ability to purchase cameras, but it would reduce the number of bats Sergei could afford to buy. Thus a price increase for baseball bats, the good on the horizontal axis, causes the budget constraint to rotate inward, as if on a hinge, from the vertical axis. As in the previous section, the point labeled M represents the originally preferred point on the original budget constraint, which Sergei has chosen after contemplating his total utility and marginal utility and the tradeoffs involved along the budget constraint. In this example, the units along the horizontal and vertical axes are not numbered, so the
discussion must focus on whether Sergei will consume more or less of certain goods, not on numerical amounts. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 143 Figure 6.4 How a Change in Price Affects Consumption Choices The original utility-maximizing choice is M. When the price rises, the budget constraint rotates clockwise. The dashed lines make it possible to see at a glance whether the new consumption choice involves less of both goods, or less of one good and more of the other. The new possible choices would be fewer baseball bats and more cameras, like point H, or less of both goods, as at point J. Choice K would mean that the higher price of bats led to exactly the same quantity of bat consumption, but fewer cameras. Theoretically possible, but unlikely in the real world, we rule out choices like L because they would mean that a higher price for baseball bats means a greater consumption of baseball bats. After the price increase, Sergei will make a choice along the new budget constraint. Again, we can divide his choices into three segments by the dashed vertical and horizontal lines. In the upper left portion of the new budget constraint, at a choice like H, Sergei consumes more cameras and fewer bats. In the central portion of the new budget constraint, at a choice like J, he consumes less of both goods. At the right-hand end, at a choice like L, he consumes more bats but fewer cameras. The typical response to higher prices is that a person chooses to consume less of the product with the higher price. This occurs for two reasons, and both effects can occur simultaneously. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price. The income effect is that a higher price means, in effect, the buying power of income has been reduced (even though actual income has not changed), which leads to buying less of the good (when the good is normal). In this example, the higher price for baseball bats would cause Sergei to buy fewer bats for both reasons. Exactly how much will a higher price for bats cause Sergei's bat consumption to fall? Figure 6.4 suggests a range of possibilities. Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats, but cutting his camera consumption. This choice is the point K on the
new budget constraint, straight below the original choice M. Alternatively, Sergei might react by dramatically reducing his bat purchases and instead buy more cameras. The key is that it would be imprudent to assume that a change in baseball bats will only or primarily affect the good's price whose price is changed, while the quantity consumed of other goods remains the same. Since Sergei purchases all his products out of the same budget, a change in the price of one good can also have a range of effects, either positive or negative, on the quantity consumed of other goods. In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well. Read this article (http://openstaxcollege.org/l/vending) about machines. the potential of variable prices in vending 144 Chapter 6 \| Consumer Choices The Foundations of Demand Curves Changes in the price of a good lead the budget constraint to rotate. A rotation in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change. In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. Figure 6.5 (a) shows a budget constraint with a choice between housing and “everything else.” (Putting “everything else” on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good.) We label the preferred choice on the original budget constraint that provides the highest possible utility M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint rotates in, and in, and in again, we label the utility-maximizing choices M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 145 Figure 6.5 The Foundations of a Demand Curve: An Example of Housing (a) As the price increases from P0 to P1 to P2 to P3, the budget constraint on the upper part of the diagram rotates clockwise. The utility-maximizing choice changes from M0 to M1 to M2
to M3. As a result, the quantity demanded of housing shifts from Q0 to Q1 to Q2 to Q3, ceteris paribus. (b) The demand curve graphs each combination of the price of housing and the quantity of housing demanded, ceteris paribus. The quantities of housing are the same at the points on both (a) and (b). Thus, the original price of housing (P0) and the original quantity of housing (Q0) appear on the demand curve as point E0. The higher price of housing (P1) and the corresponding lower quantity demanded of housing (Q1) appear on the demand curve as point E1. Thus, as the price of housing rises, the budget constraint rotates clockwise and the quantity consumed of housing falls, ceteris paribus (meaning, with all other things being the same). We graph this relationship—the price of housing rising from P0 to P1 to P2 to P3, while the quantity of housing demanded falls from Q0 to Q1 to Q2 to Q3—on the demand curve in Figure 6.5 (b). The vertical dashed lines stretching between the top and bottom of Figure 6.5 show that the quantity of housing demanded at each point is the same in both (a) and (b). We ultimately determine the shape of a demand curve by the underlying choices about maximizing utility subject to a budget constraint. While economists may not be able to measure “utils,” they can certainly measure price and quantity demanded. Applications in Government and Business The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of 2005, costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita. Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways, too. As you learned in the chapter on Elasticity, the short run demand for home heating is generally inelastic. Each 146 Chapter 6 \| Consumer Choices household cut back on what it valued least on the margin. For some it might have been some dinners out, or a
vacation, or postponing buying a new refrigerator or a new car. Sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy. A similar issue arises when the government imposes taxes on certain products, such as on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store. The higher price of alcohol causes the budget constraint to pivot left, and alcoholic beverage consumption is likely to decrease. However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. Read the next Clear It Up to learn about how who controls the household income influences buying decisions. The Unifying Power of the Utility-Maximizing Budget Set Framework An interaction between prices, budget constraints, and personal preferences determine household choices. The flexible and powerful terminology of utility-maximizing gives economists a vocabulary for bringing these elements together. Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall, accept a job, or make a deposit in a savings account. However, economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another. If we accept these assumptions, then the idea of utility-maximizing households facing budget constraints becomes highly plausible. Does who controls household income make a difference? In the mid-1970s, the United Kingdom made an interesting policy change in its “child allowance” policy. This program provides a fixed amount of money per child to every family, regardless of family income. Traditionally, the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage earner—typically the father in this time period. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the mother's purse than in the father's wallet. Should this change in policy alter household consumption patterns? Basic models of consumption decisions, of the sort that we examined in this chapter, assume that it does not matter whether the mother or the father receives the money
, because both parents seek to maximize the family's utility as a whole. In effect, this model assumes that everyone in the family has the same preferences. In reality, the share of that the father or mother controls does affect what the household consumes. When the mother controls a larger share of family income a number of studies, in the United Kingdom and in a wide variety of other countries, have found that the family tends to spend more on restaurant meals, child care, and women’s clothing, and less on alcohol and tobacco. As the mother controls a larger share of household resources, children’s health improves, too. These findings suggest that when providing assistance to poor families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which family member actually receives the money. The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 147 6.3 \| Behavioral Economics: An Alternative Framework for Consumer Choice By the end of this section, you will be able to: • Evaluate the reasons for making intertemporal choices • • Analyze why people in America tend to save such a small percentage of their income Interpret an intertemporal budget constraint As we know, people sometimes make decisions that seem “irrational” and not in their own best interest. People’s decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time. The traditional economic models assume rationality, which means that people take all available information and make consistent and informed decisions that are in their best interest. (In fact, economics professors often delight in pointing out so-called “irrational behavior” each semester to their new students, and present economics as a way to become more rational.) However, a new group of economists, known as behavioral economists, argue that the traditional method omits something important: people’s state of mind. For example, one can think differently about money if one is feeling revenge, optimism, or loss. These are not necessarily irrational states of mind, but part of a range of emotions that can affect anyone on a given day. In addition, actions under these conditions are
predictable, if one better understands the underlying environment. Behavioral economics seeks to enrich our understanding of decision-making by integrating the insights of psychology into economics. It does this by investigating how given dollar amounts can mean different things to individuals depending on the situation. This can lead to decisions that appear outwardly inconsistent, or irrational, to the outside observer. The way the mind works, according to this view, may seem inconsistent to traditional economists but is actually far more complex than an unemotional cost-benefit adding machine. For example, a traditional economist would say that if you lost a $10 bill today, and also received an extra $10 in your paycheck, you should feel perfectly neutral. After all, –$10 + $10 = $0. You are the same financially as you were before. However, behavioral economists have conducted research that shows many people will feel some negative emotion, such as anger or frustration, after those two things happen. We tend to focus more on the loss than the gain. We call this loss aversion, where a $1 loss pains us 2.25 times more than a $1 gain helps us, according to the economists Daniel Kahneman and Amos Tversky in a famous 1979 article in the journal Econometrica. This insight has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains. This behavior looks irrational to traditional economists, but is consistent once we understand better how the mind works, these economists argue. Traditional economists also assume human beings have complete self control, but, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by establishing ways for people to keep themselves free of these temptations. This includes what we call “nudges” toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they “opt out.” Almost no-one opts out in this program and employees begin saving at the early years, which are most critical
for retirement. Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to be fungible, or having equal value to the individual, regardless of the situation. You might, for instance, think of the $25 you found in the street differently from the $25 you earned from three hours working in a fast food restaurant. You might treat the street money as “mad money” with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the “easy come-easy go” mentality replaces the rational economizer because of the situation, or context, in which you attained the money. 148 Chapter 6 \| Consumer Choices In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of $1,000 that has a 15% yearly interest cost, and simultaneously have a $2,000 savings account that pays only 2% per year. That means she pays $150 a year to the credit card company, while collecting only $40 annually in bank interest, so she loses $130 a year. That doesn’t seem wise. The “rational” decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. Curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. They do not treat the dollars as fungible so it looks irrational to traditional economists. Which view is right, the behavioral economists’ or the traditional view? Both have their advantages, but behavioral economists have at least identified trying to describe and explain behavior that economists have historically dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place. "Eeny, Meeny, Miney, Moe"—Making Choices In what category did consumers worldwide increase their spending during the Great Recession? Higher education. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), enrollment in colleges and universities rose one-third in China and almost two-thirds in Saudi Arabia, nearly doubled in Pakistan, tripled in Uganda, and surged by
three million—18 percent—in the United States. Why were consumers willing to spend on education during lean times? Both individuals and countries view higher education as the way to prosperity. Many feel that increased earnings are a significant benefit of attending college. U.S. Bureau of Labor Statistics data from May 2012 supports this view, as Figure 6.6 shows. They show a positive correlation between earnings and education. The data also indicate that unemployment rates fall with higher levels of education and training. Why spend the money to go to college during recession? Because if you are unemployed (or underemployed, working fewer hours than you would like), the opportunity cost of your time is low. If you’re unemployed, you don’t have to give up work hours and income by going to college. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 149 Figure 6.6 The Impact of Education on Earnings and Unemployment Rates, 2012 Those with the highest degrees in 2012 had substantially lower unemployment rates; whereas, those with the least formal education suffered from the highest unemployment rates. The national median average weekly income was $815, and the nation unemployment average in 2012 was 6.8%. (Source: U.S. Bureau of Labor Statistics, May 22, 2013) 150 Chapter 6 \| Consumer Choices KEY TERMS behavioral economics a branch of economics that seeks to enrich the understanding of decision-making by integrating the insights of psychology and by investigating how given dollar amounts can mean different things to individuals depending on the situation budget constraint (or budget line) consumer’s limited income shows the possible combinations of two goods that are affordable given a consumer equilibrium point on the budget line where the consumer gets the most satisfaction; this occurs when the ratio of the prices of goods is equal to the ratio of the marginal utilities. diminishing marginal utility the common pattern that each marginal unit of a good consumed provides less of an addition to utility than the previous unit fungible the idea that units of a good, such as dollars, ounces of gold, or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual income effect a higher price means that, in effect, the buying power of income has been reduced, even though actual income has not changed; always happens simultaneously with a substitution effect marginal utility the additional utility provided by one additional unit of consumption marginal utility per dollar the additional satisfaction gained from purchasing a good given
the price of the product; MU/Price substitution effect when a price changes, consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price; always happens simultaneously with an income effect total utility satisfaction derived from consumer choices KEY CONCEPTS AND SUMMARY 6.1 Consumption Choices Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction. Individuals are the only judge of their own utility. In general, greater consumption of a good brings higher total utility. However, the additional utility people receive from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility. We can find the utility-maximizing choice on a consumption budget constraint in several ways. You can add up total utility of each choice on the budget line and choose the highest total. You can select a starting point at random and compare the marginal utility gains and losses of moving to neighboring points—and thus eventually seek out the preferred choice. Alternatively, you can compare the ratio of the marginal utility to price of good 1 with the marginal utility to price of good 2 and apply the rule that at the optimal choice, the two ratios should be equal: MU1 P1 = MU2 P2 6.2 How Changes in Income and Prices Affect Consumption Choices The budget constraint framework suggest that when income or price changes, a range of responses are possible. When income rises, households will demand a higher quantity of normal goods, but a lower quantity of inferior goods. When the price of a good rises, households will typically demand less of that good—but whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences. Also, a higher price for one good can lead to more or less demand of the other good. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 151 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice People regularly make decisions that seem less than rational, decisions that contradict traditional consumer theory. This is because traditional theory ignores people’s state of mind or feelings, which can influence behavior. For example, people tend to value a dollar lost more than a dollar gained, even though the amounts are the same. Similarly, many people over withhold on their taxes, essentially giving the government a free loan until they file their tax returns, so that they are more likely to get money
back than have to pay money on their taxes. SELF-CHECK QUESTIONS 1. Jeremy is deeply in love with Jasmine. Jasmine lives where cell phone coverage is poor, so he can either call her on the land-line phone for five cents per minute or he can drive to see her, at a round-trip cost of $2 in gasoline money. He has a total of $10 per week to spend on staying in touch. To make his preferred choice, Jeremy uses a handy utilimometer that measures his total utility from personal visits and from phone minutes. Using the values in Table 6.6, figure out the points on Jeremy’s consumption choice budget constraint (it may be helpful to do a sketch) and identify his utility-maximizing point. Round Trips Total Utility Phone Minutes Total Utility 10 Table 6.6 0 80 150 210 260 300 330 200 180 160 140 0 20 40 60 80 100 120 140 160 180 200 0 200 380 540 680 800 900 980 1040 1080 1100 2. Take Jeremy’s total utility information in Exercise 6.1, and use the marginal utility approach to confirm the choice of phone minutes and round trips that maximize Jeremy’s utility. 3. Explain all the reasons why a decrease in a product's price would lead to an increase in purchases. 4. As a college student you work at a part-time job, but your parents also send you a monthly “allowance.” Suppose one month your parents forgot to send the check. Show graphically how your budget constraint is affected. Assuming you only buy normal goods, what would happen to your purchases of goods? REVIEW QUESTIONS 5. Who determines how much utility an individual will receive from consuming a good? 6. Would you expect total utility to rise or fall with additional consumption of a good? Why? 152 Chapter 6 \| Consumer Choices 11. As a general rule, is it safe to assume that a change in the price of a good will always have its most significant impact on the quantity demanded of that good, rather than on the quantity demanded of other goods? Explain. 12. Why does a change in income cause a parallel shift in the budget constraint? 15. Income effects depend on the income elasticity of demand for each good that you buy. If one of the goods you buy has a negative income elasticity, that is, it is an inferior good, what must be true of the income elasticity of the other good you buy? 7. Would you expect
marginal utility to rise or fall with additional consumption of a good? Why? Is it possible for total utility to increase while 8. marginal utility diminishes? Explain. 9. If people do not have a complete mental picture of total utility for every level of consumption, how can they find their utility-maximizing consumption choice? 10. What is the rule relating the ratio of marginal utility to prices of two goods at the optimal choice? Explain why, if this rule does not hold, the choice cannot be utility-maximizing. CRITICAL THINKING QUESTIONS 13. Think back to a purchase that you made recently. How would you describe your thinking before you made that purchase? 14. The rules of politics are not always the same as the rules of economics. In discussions of setting budgets for government agencies, there is a strategy called “closing the Washington Monument.” When an agency faces the unwelcome prospect of a budget cut, it may decide to close a high-visibility attraction enjoyed by many people (like the Washington Monument). Explain in terms of diminishing marginal utility why the Washington Monument strategy is so misleading. Hint: If you are really trying to make the best of a budget cut, should you cut the items in your budget with the highest marginal utility or the Washington Monument strategy cut the items with the highest marginal utility or the lowest marginal utility? the lowest marginal utility? Does This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 6 \| Consumer Choices 153 17. If a 10% decrease in the price of one product that you buy causes an 8% increase in quantity demanded of that product, will another 10% decrease in the price cause another 8% increase (no more and no less) in quantity demanded? PROBLEMS 16. Praxilla, who lived in ancient Greece, derives utility from reading poems and from eating cucumbers. Praxilla gets 30 units of marginal utility from her first poem, 27 units of marginal utility from her second poem, 24 units of marginal utility from her third poem, and so on, with marginal utility declining by three units for each additional poem. Praxilla gets six units of marginal utility for each of her first three cucumbers consumed, five units of marginal utility for each of her next three cucumbers consumed, four units of marginal utility for each of the following three cucumbers consumed, and so on, with marginal utility declining by one for every three cucumbers
consumed. A poem costs three bronze coins but a cucumber costs only one bronze coin. Praxilla has 18 bronze coins. Sketch Praxilla’s budget set between poems and cucumbers, placing poems on the vertical axis and cucumbers on the horizontal axis. Start off with the choice of zero poems and 18 cucumbers, and calculate the changes in marginal utility of moving along the budget line to the next choice of one poem and 15 cucumbers. Using this step-bystep process based on marginal utility, create a table and identify Praxilla’s utility-maximizing choice. Compare the marginal utility of the two goods and the relative prices at the optimal choice to see if the expected relationship holds. Hint: Label the table columns: 1) Choice, 2) Marginal Gain from More Poems, 3) Marginal Loss from Fewer Cucumbers, 4) Overall Gain or Loss, 5) Is the previous choice optimal? Label the table rows: 1) 0 Poems and 18 Cucumbers, 2) 1 Poem and 15 Cucumbers, 3) 2 Poems and 12 Cucumbers, 4) 3 Poems and 9 Cucumbers, 5) 4 Poems and 6 Cucumbers, 6) 5 Poems and 3 Cucumbers, 7) 6 Poems and 0 Cucumbers. 154 Chapter 6 \| Consumer Choices This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 155 7 \| Production, Costs, and Industry Structure Figure 7.1 Amazon is an American international electronic commerce company that sells books, among many other things, shipping them directly to the consumer. Until recently there were no brick and mortar Amazon stores. (Credit: modification of work by William Christiansen/Flickr Creative Commons) Amazon In less than two decades, Amazon.com has transformed the way consumers sell, buy, and even read. Prior to Amazon, independent bookstores with limited inventories in small retail locations primarily sold books. There were exceptions, of course. Borders and Barnes & Noble offered larger stores in urban areas. In the last decade, however, independent bookstores have mostly disappeared, Borders has gone out of business, and Barnes & Noble is struggling. Online delivery and purchase of books has overtaken the more traditional business models. How has Amazon changed the book selling industry? How has it managed to crush its competition? A major reason for
the giant retailer’s success is its production model and cost structure, which has enabled Amazon to undercut the competitors' prices even when factoring in the cost of shipping. Read on to see how firms great (like Amazon) and small (like your corner deli) determine what to sell, at what output, and price. Introduction to Production, Costs, and Industry Structure In this chapter, you will learn about: • Explicit and Implicit Costs, and Accounting and Economic Profit • Production in the Short Run 156 Chapter 7 \| Production, Costs, and Industry Structure • Costs in the Short Run • Production in the Long Run • Costs in the Long Run This chapter is the first of four chapters that explores the theory of the firm. This theory explains how firms behave. What does that mean? Let’s define what we mean by the firm. A firm (or producer or business) combines inputs of labor, capital, land, and raw or finished component materials to produce outputs. If the firm is successful, the outputs are more valuable than the inputs. This activity of production goes beyond manufacturing (i.e., making things). It includes any process or service that creates value, including transportation, distribution, wholesale and retail sales. Production involves a number of important decisions that define a firm's behavior. These decisions include, but are not limited to: • What product or products should the firm produce? • How should the firm produce the products (i.e., what production process should the firm use)? • How much output should the firm produce? • What price should the firm charge for its products? • How much labor should the firm employ? The answers to these questions depend on the production and cost conditions facing each firm. That is the subject of this chapter. The answers also depend on the market structure for the product(s) in question. Market structure is a multidimensional concept that involves how competitive the industry is. We define it by questions such as these: • How much market power does each firm in the industry possess? • How similar is each firm’s product to the products of other firms in the industry? • How difficult is it for new firms to enter the industry? • Do firms compete on the basis of price, advertising, or other product differences? Figure 7.2 illustrates the range of different market structures, which we will explore in Perfect Competition, Monopoly, and Monopolistic Competition and Oligopoly. Figure 7.2 The Spectrum of Competition Firms face different competitive situations.
At one extreme—perfect competition—many firms are all trying to sell identical products. At the other extreme—monopoly—only one firm is selling the product, and this firm faces no competition. Monopolistic competition and oligopoly fall between the extremes of perfect competition and monopoly. Monopolistic competition is a situation with many firms selling similar, but not identical products. Oligopoly is a situation with few firms that sell identical or similar products. Let's examine how firms determine their costs and desired profit levels. Then we will discuss the origins of cost, both in the short and long run. Private enterprise, which can be private individual or group business ownership, characterizes the U.S. economy. In the U.S. system, we have the option to organize private businesses as sole proprietorships (one owner), partners (more than one owner), and corporations (legal entitles separate from the owners. When people think of businesses, often corporate giants like Wal-Mart, Microsoft, or General Motors come to mind. However, firms come in all sizes, as Table 7.1 shows. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 157 Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Table 7.1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn. Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment) Total 0–9 10–19 20–99 5,734,538 112.0 million 4,543,315 (79.2%) 12.3 million (11.0%) 617,089 (10.8%) 8.3 million (7.4%) 475,125 (8.3%) 18.6 million (
16.6%) 100–499 81,773 (1.4%) 15.9 million (14.2%) 500 or more 17,236 (0.30%) 50.9 million (49.8%) Table 7.1 Range in Size of U.S. Firms (Source: U.S. Census, 2010 www.census.gov) 7.1 \| Explicit and Implicit Costs, and Accounting and Economic Profit By the end of this section, you will be able to: • Explain the difference between explicit costs and implicit costs • Understand the relationship between cost and revenue Each business, regardless of size or complexity, tries to earn a profit: Profi = Total Revenue – Total Cost Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold: Total Revenue = Price × Quantity We will see in the following chapters that revenue is a function of the demand for the firm’s products. Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs. We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work It Out feature for an extended example.) These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on 158 Chapter 7 \| Production, Costs, and Industry Structure its
accounting profit, whether or not it is economically successful depends on its economic profit. Calculating Implicit Costs Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he establishes himself. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. He could hire a law clerk for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable? Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them: Office ental : Law clerk's salary : Total explicit costs : $50,000 +$35,000 ____________ $85,000 Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit. Revenues : Explicit costs : Accounting profi : $200,000 –$85,000 ____________ $115,000 However, these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm. Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit: Economic profi = total revenues – explicit costs – implicit costs = $200,000 – $85,000 – $125,000 = –$10,000 per year Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm. Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits. Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections. 7.2 \| Production in the Short Run By the end of this section, you will be able to: • Understand the concept of
a production function • Differentiate between the different types of inputs or factors in a production function • Differentiate between fixed and variable inputs • Differentiate between production in the short run and in the long run • Differentiate between total and marginal product • Understand the concept of diminishing marginal productivity In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 159 producing that output. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost. We can answer the former question by looking at the firm’s production function. Figure 7.3 The production process for pizza includes inputs such as ingredients, the efforts of the pizza maker, and tools and materials for cooking and serving. (Credit: Haldean Brown/Flickr Creative Commons) Production is the process (or processes) a firm uses to transform inputs (e.g. labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool-- to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza? Economists divide factors of production into several categories: • Natural Resources (Land and Raw Materials) - The ingredients for the pizza are raw materials. These include the flour, yeast, and water for the dough, the tomatoes, herbs, and water for the sauce, the cheese, and the toppings. If the pizza place uses a wood-burning oven, we would include the wood as a raw material. If the establishment heats the oven with natural gas, we would count this as a raw material. Don’t forget electricity for lights. If, instead of pizza, we were looking at an agricultural product, like wheat, we would
include the land the farmer used for crops here. • Labor – When we talk about production, labor means human effort, both physical and mental. The pizzaiolo was the primary example of labor here. He or she needs to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven, but he or she also needs to know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making. The business may also have one or more people to work the counter, take orders, and receive payment. • Capital – When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, the machines, equipment, and buildings that one uses to produce the product. In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs). • Technology – Technology refers to the process or processes for producing the product. How does the pizzaiolo combine ingredients to make pizza? How hot should the oven be? How long should the pizza cook? What is the best oven to use? Gas or wood burning? Should the restaurant make its own dough, sauce, cheese, toppings, or should it buy them? • Entrepreneurship – Production involves many decisions and much knowledge, even for something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur, the person who creates the business, 160 Chapter 7 \| Production, Costs, and Industry Structure whose idea it is to combine the inputs to produce the outputs. The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. Let’s explore these ideas in more detail. We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs: Q = f ⎡ ⎣NR, L, K, t, E⎤ ⎦ The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs? Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little
differently. One pizza restaurant may make its own dough and sauce, while another may buy those pre-made. A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant. We can describe inputs as either fixed or variable. Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the pizza example, the building is a fixed input. Once the entrepreneur signs the lease, he or she is stuck in the building until the lease expires. Fixed inputs define the firm’s maximum output capacity. This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e. the maximum quantities of outputs a society can produce at a given time with its available resources. Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well. Economists often use a short-hand form for the production function: Q = f ⎡ ⎣L, K ⎤ ⎦, where L represents all the variable inputs, and K represents all the fixed inputs. Economists differentiate between short and long run production. The short run is the period of time during which at least some factors of production are fixed. During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building—the owner can’t choose a larger or smaller building. The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place. Let’s explore production in the short run using a specific example: tree cutting (for lumber) with a two-person crosscut saw. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 161 Figure 7.4 Production in the short run may be explored through the example of lumberjacks using a two-person saw. (Credit: Wknight94/Wikimedia Commons) Since by definition capital is fixed in the short run, our production function becomes − Q = f [L, K ] or Q = f [L] This equation simply indicates
that since capital is fixed, the amount of output (e.g. trees cut down per day) depends only on the amount of labor employed (e.g. number of lumberjacks working). We can express this production function numerically as Table 7.2 below shows. # Lumberjacks # Trees (TP) MP 1 4 4 2 10 6 3 12 2 4 13 1 5 13 0 Table 7.2 Short Run Production Function for Trees Note that we have introduced some new language. We also call Output (Q) Total Product (TP), which means the amount of output produced with a given amount of labor and a fixed amount of capital. In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour. We should also introduce a critical concept: marginal product. Marginal product is the additional output of one more worker. Mathematically, Marginal Product is the change in total product divided by the change in labor: MP = ΔTP / ΔL. In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day. Why might that be the case? It’s because of the nature of the capital the workers are using. A two-person saw works much better with two persons than with one. Suppose we add a third lumberjack to the story. What will that person’s marginal product be? What will that person contribute to the team? Perhaps he or she can oil the saw's teeth to keep it sawing smoothly or he or she could 162 Chapter 7 \| Production, Costs, and Industry Structure bring water to the two people sawing. What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output. This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run. Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice. Both concepts are examples of the more general concept of diminishing marginal returns. Why does diminishing marginal productivity occur? It�
�s because of fixed capital. We will see this more clearly when we discuss production in the long run. We can show these concepts graphically as Figure 7.5 and Figure 7.6 illustrate. Figure 7.5 graphically shows the data from Table 7.2. Figure 7.6 shows the more general cases of total product and marginal product curves. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 163 Figure 7.5 164 Chapter 7 \| Production, Costs, and Industry Structure Figure 7.6 7.3 \| Costs in the Short Run By the end of this section, you will be able to: • Understand the relationship between production and costs • Understand that every factor of production has a corresponding factor price • Analyze short-run costs in terms of total cost, fixed cost, variable cost, marginal cost, and average cost • Calculate average profit • Evaluate patterns of costs to determine potential profit We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm. The firm’s production function tells us how much output the firm will produce with given amounts of inputs. However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost. Let’s move to the second This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 165 factor we need to determine. For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production. From the firm’s perspective, factor payments are costs. From the owner of each factor’s perspective, factor payments are income. Factor payments include: • Raw materials prices for raw materials • Rent for land or buildings • Wages and salaries for labor • Interest and dividends for the use of financial capital (loans and equity investments) • Profit for entrepreneurship. Profit is the residual, what’s left over from revenues after the firm pays all the other costs. While it may seem odd to treat profit as a “cost”, it is what entrepreneurs earn for
taking the risk of starting a business. You can see this correspondence between factors of production and factor payments in the inside loop of the circular flow diagram in Figure 1.6. We now have all the information necessary to determine a firm’s costs. A cost function is a mathematical expression or equation that shows the cost of producing different levels of output. Q Cost 1 $32.50 2 $44 3 $52 4 $90 Table 7.3 Cost Function for Producing Widgets What we observe is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire. What is the origin of these cost figures? They come from the production function and the factor payments. The discussion of costs in the short run above, Costs in the Short Run, was based on the following production function, which is similar to Table 7.3 except for "widgets" instead of trees. Workers (L) Widgets (Q) 1 0.2 2 0.4 3 0.8 3.25 1 4.4 2 5.2 3 6 3.5 7 3.8 8 3.95 9 4 Table 7.4 We can use the information from the production function to determine production costs. What we need to know is how many workers are required to produce any quantity of output. If we flip the order of the rows, we “invert” the production function so it shows L = f ⎛ ⎠. ⎝Q⎞ Widgets (Q) Workers (L) 0.2 1 0.4 2 0.8 3 1 3.25 2 4.4 3 5.2 3.5 6 3.8 7 3.95 8 4 9 Table 7.5 Now focus on the whole number quantities of output. We’ll eliminate the fractions from the table: Widgets (Q) 1 2 3 4 Table 7.6 166 Chapter 7 \| Production, Costs, and Industry Structure Workers (L) 3.25 4.4 5.2 9 Table 7.6 Suppose widget workers receive $10 per hour. Multiplying the Workers row by $10 (and eliminating the blanks) gives us the cost of producing different levels of output. Widgets (Q) Workers (L) × Wage Rate per hour = Cost Table 7.7 1.00 3.25 $10 2.00 4.4 $10 3.00 5
.2 $10 4.00 9 $10 $32.50 $44.00 $52.00 $90.00 This is same cost function with which we began! (shown in Table 7.3) Now that we have the basic idea of the cost origins and how they are related to production, let’s drill down into the details. Average and Marginal Costs The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals. We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost. Average cost is the cost on average of producing a given quantity. We define average cost as total cost divided by the quantity of output produced. AC = TC / Q If producing two widgets costs a total of $44, the average cost per widget is $44 / 2 = $22 per widget. The other way of measuring cost per unit is marginal cost. If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced. More formally, marginal cost is the cost of producing one more unit of output. Mathematically, marginal cost is the change in total cost divided by the change in output: MC = ΔTC / ΔQ. If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is $44 − $32.50 = $11.50. We can see the Widget Cost table redrawn below with average and marginal cost added. Q Total Cost Average Cost Marginal Cost 1 $32.50 $32.50 $32.50 2 $44.00 $22.00 $11.50 3 $52.00 $17.33 $8.00 4 $90.00 $22.50 $38.00 Table 7.8 Extended Cost Function for Producing Widgets Note that the marginal cost of the first unit of output is always the same as total cost. Fixed and Variable Costs We can decompose costs into fixed and variable costs. Fixed costs are the costs of the fixed inputs (e.g. capital). Because fixed inputs
do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 167 on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed. Variable costs are the costs of the variable inputs (e.g. labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials. Total costs are the sum of fixed plus variable costs. Let's look at another example. Consider the barber shop called “The Clip Joint” in Figure 7.7. The data for output and costs are in Table 7.9. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost: 2 × $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost
is: $160 + $160 = $320. Labor Quantity Fixed Cost Variable Cost Total Cost 1 2 3 4 5 6 7 16 40 60 72 80 84 82 $160 $160 $160 $160 $160 $160 $160 Table 7.9 Output and Total Costs $80 $160 $240 $320 $400 $480 $560 $240 $320 $400 $480 $560 $640 $720 Figure 7.7 How Output Affects Total Costs At zero production, the fixed costs of $160 are still present. As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two. At zero production, the fixed costs of $160 are still present. As production increases, we add variable costs to fixed 168 Chapter 7 \| Production, Costs, and Industry Structure costs, and the total cost is the sum of the two. Figure 7.7 graphically shows the relationship between the quantity of output produced and the cost of producing that output. We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs. You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity which we discussed earlier in the Production in the Short Run section of this chapter, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12. To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal
productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of Table 7.9 shows. This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g. water) contributes less to overall production. Average Total Cost, Average Variable Cost, Marginal Cost The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of Table 7.10 duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in Figure 7.8. Figure 7.8 Cost Curves at the Clip Joint We can also present the information on total costs, fixed cost, and variable cost on a per-unit basis. We calculate average total cost (ATC) by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. We calculate average variable cost (AVC) by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is also typically U-shaped. We calculate marginal cost (MC) by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping. This
OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 169 Labor Quantity Fixed Cost Variable Cost Total Cost Marginal Cost Average Total Cost Average Variable Cost 1 2 3 4 5 6 16 40 60 72 80 84 $160 $160 $160 $160 $160 $160 $80 $160 $240 $320 $400 $480 $240 $15.00 $15.00 $320 $3.33 $400 $4.00 $480 $6.67 $560 $10.00 $640 $20.00 $8.00 $6.67 $6.67 $7.00 $7.62 $5.00 $4.00 $4.00 $4.44 $5.00 $5.71 Table 7.10 Different Types of Costs Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40, or $8 per haircut. Average cost curves are typically U-shaped, as Figure 7.8 shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect. We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80, or $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as Figure 7.8 shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows,
fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost. Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. We can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet, as the following Clear it Up feature discusses. Where do marginal and average costs meet? The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of $6.60 in Figure 7.8. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downwardsloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above 170 Chapter 7 \| Production, Costs, and Industry Structure the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve. This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent
quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up. The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change. Lessons from Alternative Measures of Costs Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm. Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter Choice in a World of Scarcity, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises. Why are total cost and average cost not on the same graph? Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced. We measure these costs in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, we measured them as dollars per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since we measure them in different units ($ versus $ per unit of output). It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. However, the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show. Average cost tells a firm whether it can earn profits
given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives: average profi = profi quantity produced = total revenue – total cost quantity produced total revenue quantity produced – = total cost quantity produced = average revenue – average cost This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 171 However, note that: Thus: average revenue = price × quantity produced quantity produced = price average profi = price – average cost This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive. If price is below average cost, then profits will be negative. We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits. A Variety of Cost Patterns The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space. For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to
transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment. Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective. 7.4 \| Production in the Long Run By the end of this section, you will be able to: • Understand how long run production differs from short run production. In the long run, all factors (including capital) are variable, so our production function is Q = f ⎡ ⎦. ⎣L, K ⎤ Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital. To start, the firm has just enough business for one typist and one PC to keep busy for a day. Say that’s five documents. Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow. Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents. However, in the short turn, the firm has fixed capital, i.e. only one PC. The table below shows the situation: 172 Chapter 7 \| Production, Costs, and Industry Structure # Typists (L) Letters/hr (TP) MP For K = 1PC Table 7.11 Short Run Production Function for Typing In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers. What could the second worker do? What can they contribute to the firm? Perhaps they can answer the phone, which is a major impediment to completing the typing assignment. What about a third worker? Perhaps he or she could bring coffee to the first two workers. You can
see both total product and marginal product for the firm above. Now here’s something to think about: At what point (e.g. after how many workers) does diminishing marginal productivity kick in, and more importantly, why? In this example, marginal productivity starts to decline after the second worker. This is because capital is fixed. The production process for typing works best with one worker and one PC. If you add more than one typist, you get seriously diminishing marginal productivity. Consider the long run. Suppose the firm’s demand increases to 15 documents per day. What might the firm do to operate more efficiently? If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as Table 7.4 below shows. # Typists (L) Letters/hr (TP) MP Letters/hr (TP) MP 1 5 5 5 5 2 6 2 10 5 3 8 1 15 5 4 8 0 17 2 5 8 0 18 1 5 8 0 18 0 For K = 1PC For K = 3PC Table 7.12 Long Run Production Function for Typing With more capital, the firm can hire three workers before diminishing productivity comes into effect. More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output. 7.5 \| Costs in the Long Run By the end of this section, you will be able to: • Calculate long run total cost • • • Analyze cost and production in the long run and short run Identify economies of scale, diseconomies of scale, and constant returns to scale Interpret graphs of long-run average cost curves and short-run average cost curves The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes). This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 173 In this context, technology refers
to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less. Choice of Production Technology A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other. Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in Table 7.13. The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines. Production technology 1 Production technology 2 Production technology 3 Table 7.13 Three Ways to Clean a Park 10 workers 7 workers 3 workers 2 machines 4 machines 7 machines Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery. Table 7.14 outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery. Example A: Workers cost $40, machines cost $80 Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × $40 = $400 2 × $80 = $160 Cost of technology 2 7 × $40 = $280 4 × $80 = $320 Cost of technology 3 3 × $40 = $120 7 × $80 = $560 $560 $600 $680 Example B: Workers cost $55, machines cost $80 Labor Cost Machine Cost Total Cost Cost of technology 1 10 × $55 = $550 2 × $80 = $160 Cost of technology 2 7 × $55 = $385 4 × $80 = $320 Cost of technology 3 3 × $55 = $165 7 × $80 = $560 $710 $705 $725 Table 7.14 Total Cost with Rising Labor Costs 174 Chapter 7 \| Production, Costs, and Industry Structure Example C: Workers cost $90, machines cost $80 Labor Cost Machine Cost Total Cost Cost of technology 1 10 × $90 = $900 2 × $80 = $160 $1,060 Cost of technology 2 7 × $90 = $630 4 × $80 = $320 Cost of technology 3 3 × $90 = $270 7 × $80 = $560 $950 $830 Table 7.14 Total Cost with Rising Labor Costs Example A shows the firm’s cost calculation when wages are $40 and machines costs are $80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to $55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to $90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as example C shows. This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more
workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa. Economies of Scale Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory. Figure 7.9 illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is $12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to $4 per alarm clock. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 175 Figure 7.9 Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. Economies of scale exist when the larger scale of production leads to lower average costs. The average cost curve in Figure 7.9 may appear similar to the average cost curves we presented earlier in this chapter, although it is downward-sloping rather than U-shaped. However, there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. The short-run average cost curves we presented earlier in this chapter assumed the existence of fixed costs, and only variable costs were allowed to change. One prominent example of economies of scale occurs in the chemical industry. Chemical plants have many pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the cross-section area of the pipe
determines the volume of chemicals that can flow through it. The calculations in Table 7.15 show that a pipe which uses twice as much material to make (as shown by the circumference) can actually carry four times the volume of chemicals because the pipe's cross-section area rises by a factor of four (as the Area column below shows). Circumference ( 2πr ) Area ( πr 2 ) 4-inch pipe 8-inch pipe 16-inch pipe 12.5 inches 25.1 inches 50.2 inches 12.5 square inches 50.2 square inches 201.1 square inches Table 7.15 Comparing Pipes: Economies of Scale in the Chemical Industry A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. However, the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much. Shapes of Long-Run Average Cost Curves While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output. Figure 7.10 shows how we build the 176 Chapter 7 \| Production, Costs, and Industry Structure long-run average cost curve from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite
number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future. Figure 7.10 From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different shortrun average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other SRAC curves, not in the diagram, lie between the ones that are here. The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. If a firm wished to produce quantity Q3, it would choose the fixed costs associated with SRAC3. The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result. The shape of the long-run cost curve, in Figure 7.10, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in Figure 7.9. In the middle portion of
the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 177 How do economies of scale compare to diminishing marginal returns? The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has economies of scale when all inputs change together to produce a larger-scale operation. Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. We call this situation diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses. Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large
to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level. Visit this website (http://openstaxcollege.org/l/Toobig) to read an article about the complexity of the belief that banks can be “too-big-to-fail.” The Size and Number of Firms in an Industry The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size. For example, say that the appliance industry sells one million dishwashers every year at a price of $500 each and the long-run average cost curve for dishwashers is in Figure 7.11 (a). In Figure 7.11 (a), the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above $500, and the firms would not be able to compete. 178 Chapter 7 \| Production, Costs, and Industry Structure Figure 7.11 The LRAC Curve and the Size and Number of Firms (a) Low-cost firms will produce at output level R. When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. In this case, a firm producing at a quantity of 10,000 will produce at a lower average cost than a firm producing, say, 5,000 or 20,000 units. (b) Low-cost firms will produce between output levels R and S. When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. In this case, any firm producing a quantity between 5,000 and 20,000 can compete effectively, although firms producing less than 5,000 or more than 20,000 would face higher average costs and be unable to compete. How can we view cities as examples of economies of scale? Why are people and economic activity concentrated in cities, rather than distributed evenly across a country? The fundamental reason must be related to the idea of economies of
scale—that grouping economic activity is more productive in many cases than spreading it out. For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what appeals to many shoppers. These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area. Cities are sometimes called “agglomeration economies.” These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. In the United States, about 80% of the population now lives in metropolitan areas (which include the suburbs around cities), compared to just 40% in 1900. However, in poorer nations of the world, including much of Africa, the proportion of the population in urban areas is only about 30%. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise. If cities offer economic advantages that are a form of economies of scale, then why don’t all or most people live in one giant city? At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel. High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded. There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones. The future of cities, both in the United States and in other countries around the world, will be determined by their ability to benefit This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 179 from the economies of agglomeration and to minimize or counterbalance the corresponding diseconomies. We illustrate a more
common case in Figure 7.11 (b), where the LRAC curve has a flat-bottomed area of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at about the same level of average cost. Given that the market will demand one million dishwashers per year at a price of $500, this market might have as many as 200 producers (that is, one million dishwashers divided by firms making 5,000 each) or as few as 50 producers (one million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. However, firms that produce below 5,000 units or more than 20,000 will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in Figure 7.11 (a). However, if the long-run average cost curve has a wide flat bottom like Figure 7.11 (b), then firms of a variety of different sizes will be able to compete with each other. We can interpret the flat section of the long-run average cost curve in Figure 7.11 (b) in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5,000 has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20,000. The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,000, while another firm owns four separate manufacturing plants, which each produce a quantity of 5,000. This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm. At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result. In the examples to this point, the quantity demanded in the market is quite large (one million) compared with the quantity produced at the bottom of the long-run average cost curve (5,000,
10,000 or 20,000). In such a situation, the market is set for competition between many firms. However, what if the bottom of the long-run average cost curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower? Return to Figure 7.11 (a), where the bottom of the long-run average cost curve is at 10,000, but now imagine that the total quantity of dishwashers demanded in the market at that price of $500 is only 30,000. In this situation, the total number of firms in the market would be three. We call a handful of firms in a market an “oligopoly,” and the chapter on Monopolistic Competition and Oligopoly will discuss the range of competitive strategies that can occur when oligopolies compete. Alternatively, consider a situation, again in the setting of Figure 7.11 (a), where the bottom of the long-run average cost curve is 10,000, but total demand for the product is only 5,000. (For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.) In this situation, the market may well end up with a single firm—a monopoly—producing all 5,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 5,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The chapter on Monopoly discusses the situation of a monopoly firm. Thus, the shape of the long-run average cost curve reveals whether competitors in the market will be different sizes. If the LRAC curve has a single point at the bottom, then the firms in the market will be about the same size, but if the LRAC curve has a flat-bottomed segment of constant returns to scale, then firms in the market may be a variety of different sizes. The relationship between the quantity at the minimum of the long-run average cost curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC, a few firms will compete. If the
quantity demanded in the market is less than the quantity at the minimum of the LRAC, a singleproducer monopoly is a likely outcome. Shifting Patterns of Long-Run Average Cost New developments in production technology can shift the long-run average cost curve in ways that can alter the size distribution of firms in an industry. 180 Chapter 7 \| Production, Costs, and Industry Structure For much of the twentieth century, the most common change had been to see alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the long-run average cost curve, the downward-sloping economies of scale portion of the curve stretched over a larger quantity of output. However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-size tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but did so at a lower average cost than a traditional mid-sized tire plant. Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state, or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create “winner-take-all” markets where one large company will tend to command a large share of total sales, as Microsoft has done producing of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across
the country or around the world, and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers. Amazon Traditionally, bookstores have operated in retail locations with inventories held either on the shelves or in the back of the store. These retail locations were very pricey in terms of rent. Until recently, Amazon had no retail locations. It only sold online and delivered by mail. Amazon now has retail stores in California, Oregon and Washington State and retail stores are coming to Illinois, Massachusetts, New Jersey, and New York. Amazon offers almost any book in print, convenient purchasing, and prompt delivery by mail. Amazon holds its inventories in huge warehouses in low-rent locations around the world. The warehouses are highly computerized using robots and relatively low-skilled workers, making for low average costs per sale. Amazon demonstrates the significant advantages economies of scale can offer to a firm that exploits those economies. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 181 KEY TERMS accounting profit total revenues minus explicit costs, including depreciation average profit profit divided by the quantity of output produced; also known as profit margin average total cost total cost divided by the quantity of output average variable cost variable cost divided by the quantity of output constant returns to scale expanding all inputs proportionately does not change the average cost of production diminishing marginal productivity general rule that as a firm employs more labor, eventually the amount of additional output produced declines diseconomies of scale the long-run average cost of producing output increases as total output increases economic profit total revenues minus total costs (explicit plus implicit costs) economies of scale the long-run average cost of producing output decreases as total output increases economies of scale the long-run average cost of producing output decreases as total output increases explicit costs out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials factors of production (or inputs) resources that firms use to produce their products, for example, labor and capital firm an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs. fixed cost cost of the fixed inputs; expenditure that a firm must make before production starts and that does not change regardless of the production level fixed inputs factors of production that can’t be easily increased or decreased in a short period of time implicit
costs opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned long run period of time during which all of a firm’s inputs are variable long-run average cost (LRAC) curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology marginal cost the additional cost of producing one more unit; mathematically, MC = ΔTC / ΔL marginal product change in a firm’s output when it employees more labor; mathematically, MP = ΔTP / ΔL private enterprise the ownership of businesses by private individuals production the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs production function mathematical equation that tells how much output a firm can produce with given amounts of the inputs production technologies alternative methods of combining inputs to produce output revenue income from selling a firm’s product; defined as price times quantity sold 182 Chapter 7 \| Production, Costs, and Industry Structure short run period of time during which at least one or more of the firm’s inputs is fixed short-run average cost (SRAC) curve the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs total cost the sum of fixed and variable costs of production total product synonym for a firm’s output variable cost cost of production that increases with the quantity produced; the cost of the variable inputs variable inputs factors of production that a firm can easily increase or decrease in a short period of time KEY CONCEPTS AND SUMMARY 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs. 7.2 Production in the Short Run Production is the process a firm uses to transform inputs (e.g. labor, capital, raw materials, etc.) into outputs. It is not possible to vary fixed inputs (e.g. capital) in a short period of time. Thus, in the short run the only way to change output is to change the variable inputs (e.g. labor). Marginal product is the additional output a firm obtains by employing more labor in production. At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor
. Mathematically, marginal product is the slope of the total product curve. 7.3 Costs in the Short Run For every input (e.g. labor), there is an associated factor payment (e.g. wages and salaries). The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment. In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises. We calculate marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit. We calculate average total cost by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits. We calculate average variable cost by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture. 7.4 Production in the Long Run In the long run, all inputs are variable. Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run. Firms can choose the optimal capital stock to produce their desired level of output. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 183 7.5 Costs in the Long Run A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production. In the long run, firms
can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost. Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases. Diseconomies of scale refers to a situation where as output increases, average costs also increase. The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom, so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand in conjunction with the long-run average cost curve determines how many firms will exist in a given industry. If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the long-run average cost curve, where the cost of production is lowest, the market will have many firms competing. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm. SELF-CHECK QUESTIONS 1. A firm had sales revenue of $1 million last year. It spent $600,000 on labor, $150,000 on capital and $200,000 on materials. What was the firm’s accounting profit? 2. Continuing from Exercise 7.1, the firm’s factory sits on land owned by the firm that it could rent for $30,000 per year. What was the firm’s economic profit last year? 3. The WipeOut Ski Company manufactures skis for beginners. Fixed costs are $30. Fill in Table 7.16 for total cost, average variable cost, average total cost, and marginal cost. Quantity Variable Cost Fixed Cost Total Cost Average Variable Cost Average Total Cost Marginal
Cost 0 $10 $25 $45 $70 $100 $135 $30 $30 $30 $30 $30 $30 $30 0 1 2 3 4 5 6 Table 7.16 184 Chapter 7 \| Production, Costs, and Industry Structure 4. Based on your answers to the WipeOut Ski Company in Exercise 7.3, now imagine a situation where the firm produces a quantity of 5 units that it sells for a price of $25 each. a. What will be the company’s profits or losses? b. How can you tell at a glance whether the company is making or losing money at this price by looking at average cost? c. At the given quantity and price, is the marginal unit produced adding to profits? If two painters can paint 200 square feet of wall in an hour, and three painters can paint 275 square feet, what is 5. the marginal product of the third painter? 6. Return to the problem explained in Table 7.13 and Table 7.14. If the cost of labor remains at $40, but the cost of a machine decreases to $50, what would be the total cost of each method of production? Which method should the firm use, and why? 7. Suppose the cost of machines increases to $55, while the cost of labor stays at $40. How would that affect the total cost of the three methods? Which method should the firm choose now? 8. Automobile manufacturing is an industry subject to significant economies of scale. Suppose there are four domestic auto manufacturers, but the demand for domestic autos is no more than 2.5 times the quantity produced at the bottom of the long-run average cost curve. What do you expect will happen to the domestic auto industry in the long run? REVIEW QUESTIONS 9. What are explicit and implicit costs? 10. Would you consider an interest payment on a loan to a firm an explicit or implicit cost? 20. Are there fixed costs in the long-run? Explain briefly. 21. Are fixed costs also sunk costs? Explain. 11. What is the difference between accounting and economic profit? 22. What are diminishing marginal returns as they relate to costs? 12. What is a production function? 13. What is the difference between a fixed input and a variable input? 14. How do we calculate marginal product? 15. What shapes would you generally expect a total product curve and a marginal product curve to have? 16. What are the factor payments for land, labor, and capital? 17
. What is the difference between fixed costs and variable costs? 18. How do we calculate each of the following: marginal cost, average total cost, and average variable cost? 19. What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs? 23. Which costs are measured on per-unit basis: fixed costs, average cost, average variable cost, variable costs, and marginal cost? 24. What is a production technology? In choosing a production technology, how will if one input becomes relatively more 25. firms react expensive? 26. What is a long-run average cost curve? 27. What is the difference between economies of scale, constant returns to scale, and diseconomies of scale? 28. What shape of a long-run average cost curve illustrates economies of scale, constant returns to scale, and diseconomies of scale? 29. Why will firms in most markets be located at or close to the bottom of the long-run average cost curve? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 7 \| Production, Costs, and Industry Structure 185 CRITICAL THINKING QUESTIONS 30. Small “Mom and Pop firms,” like inner city grocery stores, sometimes exist even though they do not earn economic profits. How can you explain this? 31. A common name for fixed cost is “overhead.” If you divide fixed cost by the quantity of output produced, you get average fixed cost. Supposed fixed cost is $1,000. What does the average fixed cost curve look like? Use your response to explain what “spreading the overhead” means. 32. How does fixed cost affect marginal cost? Why is this relationship important? 33. Average cost curves (except for average fixed cost) tend to be U-shaped, decreasing and then increasing. Marginal cost curves have the same shape, though this may be harder to see since most of the marginal cost curve is increasing. Why do you think that average and marginal cost curves have the same general shape? PROBLEMS 39. A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment
? Show your work. 40. Return to Figure 7.7. What is the marginal gain in output from increasing the number of barbers from 4 to 5 and from 5 to 6? Does it continue the pattern of diminishing marginal returns? 41. Compute the average total cost, average variable cost, and marginal cost of producing 60 and 72 haircuts. Draw the graph of the three curves between 60 and 72 haircuts. 34. What is the relationship between marginal product and marginal cost? (Hint: Look at the curves.) Why do you suppose that is? Is this relationship the same in the long run as in the short run? It is clear that businesses operate in the short run, 35. but do they ever operate in the long run? Discuss. 36. Return to Table 7.2. In the top half of the table, at what point does diminishing marginal productivity kick in? What about in the bottom half of the table? How do you explain this? 37. How would an improvement in technology, like the high-efficiency gas turbines or Pirelli tire plant, affect the long-run average cost curve of a firm? Can you draw the old curve and the new one on the same axes? How might such an improvement affect other firms in the industry? 38. Do you think that the taxicab industry in large cities would be subject to significant economies of scale? Why or why not? 42. A small company that shovels sidewalks and driveways has 100 homes signed up for its services this winter. It can use various combinations of capital and labor: intensive labor with hand shovels, less labor with snow blowers, and still less labor with a pickup truck that has a snowplow on front. To summarize, the method choices are: Method 1: 50 units of labor, 10 units of capital Method 2: 20 units of labor, 40 units of capital Method 3: 10 units of labor, 70 units of capital If hiring labor for the winter costs $100/unit and a unit of capital costs $400, what is the best production method? What method should the company use if the cost of labor rises to $200/unit? 186 Chapter 7 \| Production, Costs, and Industry Structure This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 187 8 \| Perfect Competition Figure 8.1 Depending upon the competition and prices offered, a wheat farmer may choose to grow a different crop.
(Credit: modification of work by Daniel X. O'Neil/Flickr Creative Commons) A Dime a Dozen When you were younger did you babysit, deliver papers, or mow the lawn for money? If so, you faced stiff competition from many other competitors who offered identical services. There was nothing to stop others from also offering their services. All of you charged the “going rate.” If you tried to charge more, your customers would simply buy from someone else. These conditions are very similar to the conditions agricultural growers face. Growing a crop may be more difficult to start than a babysitting or lawn mowing service, but growers face the same fierce competition. In the grand scale of world agriculture, farmers face competition from thousands of others because they sell an identical product. After all, winter wheat is winter wheat, but if they find it hard to make money with that crop, it is relatively easy for farmers to leave the marketplace for another crop. In this case, they do not sell the family farm, they switch crops. Take the case of the upper Midwest region of the United States—for many generations the area was called “King Wheat.” According to the United States Department of Agriculture National Agricultural Statistics Service, statistics by state, in 1997, 11.6 million acres of wheat and 780,000 acres of corn were planted in North Dakota. In the intervening 20 or so years has the mix of crops changed? Since it is relatively easy to switch crops, did farmers change what they planted in response to changes in relative crop prices? We will find out at chapter’s end. In the meantime, let's consider the topic of this chapter—the perfectly competitive market. This is a market in 188 Chapter 8 \| Perfect Competition which entry and exit are relatively easy and competitors are “a dime a dozen.” Introduction to Perfect Competition In this chapter, you will learn about: • Perfect Competition and Why It Matters • How Perfectly Competitive Firms Make Output Decisions • Entry and Exit Decisions in the Long Run • Efficiency in Perfectly Competitive Markets Most businesses face two realities: no one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Firms that operate in perfectly competitive markets face this reality. In this chapter, you will learn how such firms make decisions about how much to produce, how much profit they make, whether to stay in business or not, and many others. Industries differ from one another in terms
of how many sellers there are in a specific market, how easy or difficult it is for a new firm to enter, and the type of products that they sell. Economists refer to this as an industry's market structure. In this chapter, we focus on perfect competition. However, in other chapters we will examine other industry types: Monopoly and Monopolistic Competition and Oligopoly. 8.1 \| Perfect Competition and Why It Matters By the end of this section, you will be able to: • Explain the characteristics of a perfectly competitive market • Discuss how perfectly competitive firms react in the short run and in the long run Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market. A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, he or she has to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market. A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why
should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 189 this website (http://openstaxcollege.org/l/commodities) Visit commodities. that reveals the current value of various This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as we discussed in the chapter on Production, Costs and Industry Structure. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest. In the long run, positive economic profits will attract competition as other firms enter the market. Economic losses will cause firms to exit the market. Ultimately, perfectly competitive markets will attain long-run equilibrium when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero. 8.2 \| How Perfectly Competitive Firms Make Output Decisions By the end of this section, you will be able to: • Calculate profits by comparing total revenue and total cost Identify profits and losses with the average cost curve • • Explain the shutdown point • Determine the price at which a firm should continue producing in the short run A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand this, consider a different way of writing out the basic definition of profit: Profi = Total revenue − Total cost = (Price)(Quantity produced) − (Average cost)(Quantity produced) Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits. Determining
the Highest Profit by Comparing Total Revenue and Total Cost A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. The formula above shows that total revenue depends on the quantity sold and the price charged. If the firm sells a higher quantity of output, then total revenue will increase. If the market price of the product increases, then total revenue also increases whatever the quantity of output sold. As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and 190 Chapter 8 \| Perfect Competition so on. If, for example, the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on. Table 8.1 graphically shows total revenue and total costs for the raspberry farm, also appear in Figure 8.2. The horizontal axis shows the quantity of frozen raspberries produced in packs. The vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. All these cost curves follow the same characteristics as the curves that we covered in the Production, Costs and Industry Structure chapter. Figure 8.2 Total Cost and Total Revenue at the Raspberry Farm Total revenue for a perfectly competitive firm is a straight line sloping up. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature. At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. The maximum profit will occur at the quantity where the difference between total revenue and total cost is largest. Quantity (Q) Total Cost (TC) Total Revenue (TR) Profit 0 10 20 30 40 50 60 70 80 90 $62 $90 $110 $126 $138 $150 $165 $190 $230 $296 $0 $40 $80 $120 $160 $200 $240 $280 $320 $360 Table 8.1 Total Cost and Total Revenue at the Raspberry Farm This OpenStax book is available for free at http://cnx.org/content/col12
170/1.7 −$62 −$50 −$30 −$6 $22 $50 $75 $90 $90 $64 Chapter 8 \| Perfect Competition 191 Quantity (Q) Total Cost (TC) Total Revenue (TR) Profit 100 110 120 $400 $550 $715 $400 $440 $480 Table 8.1 Total Cost and Total Revenue at the Raspberry Farm $0 $−110 $−235 Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount. Figure 8.2 shows total revenue, total cost and profit using the data from Table 8.1. The vertical gap between total revenue and total cost is profit, for example, at Q = 60, TR = 240 and TC = 165. The difference is 75, which is the height of the profit curve at that output level. The firm doesn’t make a profit at every level of output. In this example, total costs will exceed total revenues at output levels from 0 to approximately 30, and so over this range of output, the firm will be making losses. At output levels from 40 to 100, total revenues exceed total costs, so the firm is earning profits. However, at any output greater than 100, total costs again exceed total revenues and the firm is making increasing losses. Total profits appear in the final column of Table 8.1. Maximum profit occurs at an output between 70 and 80, when profit equals $90. A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. However, a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest. (Later we will see that sometimes it will make sense for the firm to close, rather than stay in operation producing output.) Comparing Marginal Revenue and Marginal Costs The approach that we described in the previous
section, using total revenue and total cost, is not the only approach to determining the profit maximizing level of output. In this section, we provide an alternative approach which uses marginal revenue and marginal cost. Firms often do not have the necessary data they need to draw a complete total cost curve for all levels of production. They cannot be sure of what total costs would look like if they, say, doubled production or cut production in half, because they have not tried it. Instead, firms experiment. They produce a slightly greater or lower quantity and observe how it affects profits. In economic terms, this practical approach to maximizing profits means examining how changes in production affect marginal revenue and marginal cost. Figure 8.3 presents the marginal revenue and marginal cost curves based on the total revenue and total cost in Table 8.1. The marginal revenue curve shows the additional revenue gained from selling one more unit. As mentioned before, a firm in perfect competition faces a perfectly elastic demand curve for its product—that is, the firm’s demand curve is a horizontal line drawn at the market price level. This also means that the firm’s marginal revenue curve is the same as the firm’s demand curve: Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by exactly the same amount equal to the market price. In this example, every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by $4. Table 8.2 shows an example of this. This condition only holds for price taking firms in perfect competition where: The formula for marginal revenue is: marginal revenue = price marginal revenue = change in total revenue change in quantity 192 $4 $4 $4 $4 Chapter 8 \| Perfect Competition Price Quantity Total Revenue Marginal Revenue 1 2 3 4 $4 $8 $12 $16 - $4 $4 $4 Table 8.2 Notice that marginal revenue does not change as the firm produces more output. That is because under perfect competition, the price is determined through the interaction of supply and demand in the market and does not change as the farmer produces more (keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined). Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes at the market-determined price. We calculate marginal cost, the cost per additional unit sold, by dividing the change in total cost by the
change in quantity. The formula for marginal cost is: marginal cost = change in total cost change in quantity Ordinarily, marginal cost changes as the firm produces a greater quantity. In the raspberry farm example, in Figure 8.3, Figure 8.4 and Table 8.3, marginal cost at first declines as production increases from 10 to 20 to 30 to 40 packs of raspberries—which represents the area of increasing marginal returns that is not uncommon at low levels of production. At some point, though, marginal costs start to increase, displaying the typical pattern of diminishing marginal returns. If the firm is producing at a quantity where MR > MC, like 40 or 50 packs of raspberries, then it can increase profit by increasing output because the marginal revenue is exceeding the marginal cost. If the firm is producing at a quantity where MC > MR, like 90 or 100 packs, then it can increase profit by reducing output because the reductions in marginal cost will exceed the reductions in marginal revenue. The firm’s profit-maximizing choice of output will occur where MR = MC (or at a choice close to that point). This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 193 Figure 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm: Individual Farmer For a perfectly competitive firm, the marginal revenue (MR) curve is a horizontal line because it is equal to the price of the good, which is determined by the market, as Figure 8.4 illustrates. The marginal cost (MC) curve is sometimes initially downward-sloping, if there is a region of increasing marginal returns at low levels of output, but is eventually upwardsloping at higher levels of output as diminishing marginal returns kick in. Figure 8.4 Marginal Revenues and Marginal Costs at the Raspberry Farm: Raspberry Market The equilibrium price of raspberries is determined through the interaction of market supply and market demand at $4.00. Quantity Total Cost Marginal Cost Total Revenue Marginal Revenue Profit 0 10 20 $62 $90 $110 - $2.80 $2.00 $0 $40 $80 $4 $4 $4 Table 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm -$62 -$50 -$30 194 Chapter 8 \| Perfect Competition Quantity Total Cost Marginal Cost Total Revenue Marginal Revenue Profit 30 40 50 60 70 80 90 100 110 120
$126 $138 $150 $165 $190 $230 $296 $400 $550 $715 $1.60 $1.20 $1.20 $1.50 $2.50 $4.00 $6.60 $10.40 $15.00 $16.50 $120 $160 $200 $240 $280 $320 $360 $400 $440 $480 $4 $4 $4 $4 $4 $4 $4 $4 $4 $4 -$6 $22 $50 $75 $90 $90 $64 $0 -$110 -$235 Table 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm In this example, the marginal revenue and marginal cost curves cross at a price of $4 and a quantity of 80 produced. If the farmer started out producing at a level of 60, and then experimented with increasing production to 70, marginal revenues from the increase in production would exceed marginal costs—and so profits would rise. The farmer has an incentive to keep producing. At a level of output of 80, marginal cost and marginal revenue are equal so profit doesn’t change. If the farmer then experimented further with increasing production from 80 to 90, he would find that marginal costs from the increase in production are greater than marginal revenues, and so profits would decline. The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost—that is, where MR = MC. This occurs at Q = 80 in the figure. Does Profit Maximization Occur at a Range of Output or a Specific Level of Output? Table 8.1 shows that maximum profit occurs at any output level between 70 and 80 units of output. But MR = MC occurs only at 80 units of output. How can do we explain this slight discrepancy? As long as MR > MC. a profit-seeking firm should keep expanding production. Expanding production into the zone where MR < MC reduces economic profits. It’s true that profit is the same at Q = 70 and Q = 80, but it’s only when the firm goes beyond that that see that profits fall. Thus, MR = MC is the signal to stop expanding, so that is the level of output they should target. Because the marginal revenue received by a perfectly competitive firm is equal to the price P, we can also write the profit-maximizing rule for a perfectly competitive firm as a recommendation to produce at the
quantity of output where P = MC. Profits and Losses with the Average Cost Curve Does maximizing profit (producing where MR = MC) imply an actual economic profit? The answer depends on the relationship between price and average total cost, which is the average profit or profit margin. If the market price is higher than the firm's average cost of production for that quantity produced, then the profit margin is positive and the firm will earn profits. Conversely, if the market price is lower than the average cost of production, the profit margin is negative and the firm will suffer losses. You might think that, in this situation, the firm may want to shut This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 195 down immediately. Remember, however, that the firm has already paid for fixed costs, such as equipment, so it may continue to produce for a while and incur a loss. Table 8.3 continues the raspberry farm example. Figure 8.5 illustrates the three possible scenarios: (a) where price intersects marginal cost at a level above the average cost curve, (b) where price intersects marginal cost at a level equal to the average cost curve, and (c) where price intersects marginal cost at a level below the average cost curve. Figure 8.5 Price and Average Cost at the Raspberry Farm In (a), price intersects marginal cost above the average cost curve. Since price is greater than average cost, the firm is making a profit. In (b), price intersects marginal cost at the minimum point of the average cost curve. Since price is equal to average cost, the firm is breaking even. In (c), price intersects marginal cost below the average cost curve. Since price is less than average cost, the firm is making a loss. First consider a situation where the price is equal to $5 for a pack of frozen raspberries. The rule for a profitmaximizing perfectly competitive firm is to produce the level of output where Price= MR = MC, so the raspberry farmer will produce a quantity of approximately 85, which is labeled as E' in Figure 8.5 (a). Remember that the area of a rectangle is equal to its base multiplied by its height. The farm’s total revenue at this price will be shown by the rectangle from the origin over to a quantity of 85 packs (the base) up to point E' (the height), over to the
price of $5, and back to the origin. The average cost of producing 80 packs is shown by point C or about $3.50. Total costs will be the quantity of 85 times the average cost of $3.50, which is shown by the area of the rectangle from the origin to a quantity of 90, up to point C, over to the vertical axis and down to the origin. The difference between total revenues and total costs is profits. Thus, profits will be the blue shaded rectangle on top. 196 Chapter 8 \| Perfect Competition We calculate this as: Or, we can calculate it as: profi = total revenue − total cost = (85)($5.00) − (85)($3.50) = $170 profi = (price – average cost) × quantity = ($5.00 – $3.50) × 85 = $170 Now consider Figure 8.5 (b), where the price has fallen to $2.75 for a pack of frozen raspberries. Again, the perfectly competitive firm will choose the level of output where Price = MR = MC, but in this case, the quantity produced will be 75. At this price and output level, where the marginal cost curve is crossing the average cost curve, the price the firm receives is exactly equal to its average cost of production. We call this the break even point. The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 75 packs (the base) up to point E (the height), over to the price of $2.75, and back to the origin. The height of the average cost curve at Q = 75, i.e. point E, shows the average cost of producing this quantity. Total costs will be the quantity of 75 times the average cost of $2.75, which is shown by the area of the rectangle from the origin to a quantity of 75, up to point E, over to the vertical axis and down to the origin. It should be clear that the rectangles for total revenue and total cost are the same. Thus, the firm is making zero profit. The calculations are as follows: Or, we can calculate it as: profi = total revenue – total cost = (75)($2.75) – (75)($2.75) = $0 profi = (price – average cost)×quantity = ($2.75 – $2.75
)×75 = $0 In Figure 8.5 (c), the market price has fallen still further to $2.00 for a pack of frozen raspberries. At this price, marginal revenue intersects marginal cost at a quantity of 65. The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 65 packs (the base) up to point E” (the height), over to the price of $2, and back to the origin. The average cost of producing 65 packs is shown by Point C” or shows the average cost of producing 50 packs is about $2.73. Total costs will be the quantity of 65 times the average cost of $2.73, which the area of the rectangle from the origin to a quantity of 50, up to point C”, over to the vertical axis and down to the origin shows. It should be clear from examining the two rectangles that total revenue is less than total cost. Thus, the firm is losing money and the loss (or negative profit) will be the rose-shaded rectangle. The calculations are: Or: profi = (total revenue – total cost) = (65)($2.00) – (65)($2.73) = –$47.45 profi = (price – average cost) × quantity = ($2.00 – $2.73) × 65 = –$47.45 If the market price that perfectly competitive firm receives leads it to produce at a quantity where the price is greater than average cost, the firm will earn profits. If the price the firm receives causes it to produce at a quantity where price equals average cost, which occurs at the minimum point of the AC curve, then the firm earns zero profits. Finally, if the price the firm receives leads it to produce at a quantity where the price is less than average cost, the firm will earn losses. Table 8.4 summarizes this. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 197 If... Then... Firm earns an economic profit Firm earns zero economic profit Firm earns a loss Price > ATC Price = ATC Price < ATC Table 8.4 Which intersection should a firm choose? At a price of $2, MR intersects MC at two points: Q = 20 and Q = 65. It never makes sense for a firm
to choose a level of output on the downward sloping part of the MC curve, because the profit is lower (the loss is bigger). Thus, the correct choice of output is Q = 65. The Shutdown Point The possibility that a firm may earn losses raises a question: Why can the firm not avoid losses by shutting down and not producing at all? The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs. Therefore when a firm is experiencing losses, it must face a question: should it continue producing or should it shut down? As an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per month. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If the firm shuts down, it must still pay the rent, but it would not need to hire labor. Table 8.5 shows three possible scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of $10,000 equal to the fixed costs. In the second scenario, the Yoga Center has clients that earn the center revenues of $10,000 for the month, but ultimately experiences losses of $15,000 due to having to hire yoga instructors to cover the classes. In the third scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of $5,000. In all three cases, the Yoga Center loses money. In all three cases, when the rental contract expires in the long run, assuming revenues do not improve, the firm should exit this business. In the short run, though, the decision varies depending on the level of losses and whether the firm can cover its variable costs. In scenario 1, the center does not have any revenues, so hiring yoga teachers would increase variable costs and losses, so it should shut down and only incur its fixed costs. In scenario 2, the center’s losses are greater because it does not make enough revenue to offset the increased variable costs, so it should shut down immediately and only incur its fixed costs. If price is below the minimum average variable cost, the firm must shut down. In contrast, in scenario 3 the revenue
that the center can earn is high enough that the losses diminish when it remains open, so the center should remain open in the short run. Scenario 1 If the center shuts down now, revenues are zero but it will not incur any variable costs and would only need to pay fixed costs of $10,000. Table 8.5 Should the Yoga Center Shut Down Now or Later? 198 Chapter 8 \| Perfect Competition profit = otal revenue–(fi ed costs + variable cost) = 0 –$10,000 = –$10,000 Scenario 2 The center earns revenues of $10,000, and variable costs are $15,000. The center should shut down now. profit = otal revenue – (fi ed costs + variable cost) = $10,000 – ($10,000 + $15,000) = –$15,000 Scenario 3 The center earns revenues of $20,000, and variable costs are $15,000. The center should continue in business. profit = otal revenue – (fi ed costs + variable cost) = $20,000 – ($10,000 + $15,000) = –$5,000 Table 8.5 Should the Yoga Center Shut Down Now or Later? Figure 8.6 illustrates the lesson that remaining open requires the price to exceed the firm’s average variable cost. When the firm is operating below the break-even point, where price equals average cost, it is operating at a loss so it faces two options: continue to produce and lose money or shutdown. Which option is preferable? The one that loses the least money is the best choice. At a price of $2.00 per pack, as Figure 8.6 (a) illustrates, if the farm stays in operation it will produce at a level of 65 packs of raspberries, and it will make losses of $47.45 (as explained earlier). The alternative would be to shutdown and lose all the fixed costs of $62.00. Since losing $47.45 is preferable to losing $62.00, the profit maximizing (or in this case the loss minimizing) choice is to stay in operation. The key reason is because price is above average variable cost. This means that at the current price the farm can pay all its variable costs, and have some revenue left over to pay some of the fixed costs. So the loss represents the part of the fixed costs the farm can’t pay, which is less than the entire fixed costs.
However, if the price declined to $1.50 per pack, as Figure 8.6 shows (b), and if the firm applied its rule of producing where P = MR = MC, it would produce a quantity of 60. This price is below average variable cost for this level of output. If the farmer cannot pay workers (the variable costs), then it has to shut down. At this price and output, total revenues would be $90 (quantity of 60 times price of $1.50) and total cost would be $165, for overall losses of $75. If the farm shuts down, it must pay only its fixed costs of $62, so shutting down is preferable to selling at a price of $1.50 per pack. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 199 Figure 8.6 The Shutdown Point for the Raspberry Farm In (a), the farm produces at a level of 65. It is making losses of $47.50, but price is above average variable cost, so it continues to operate. In (b), total revenues are $90 and total cost is $165, for overall losses of $75. If the farm shuts down, it must pay only its fixed costs of $62. Shutting down is preferable to selling at a price of $1.50 per pack. Looking at Table 8.6, if the price falls below about $1.65, the minimum average variable cost, the firm must shut down. Quantity Q Average Variable Cost AVC Average Cost AC Marginal Cost MC 0 10 20 30 40 50 60 70 80 90 100 110 120 - $2.80 $2.40 $2.13 $1.90 $1.76 $1.72 $1.83 $2.10 $2.60 $3.38 $4.44 $5.44 - $9.00 $5.50 $4.20 $3.45 $3.00 $2.75 $2.71 $2.88 $3.29 $4.00 $5.00 $5.96 - $2.80 $2.00 $1.60 $1.20 $1.20 $1.50 $2.50 $4.00 $6.60 $10.40 $15.00 $31.50 Table 8.6 Cost of Production for the Raspberry Farm 200 Chapter 8 \|
Perfect Competition The intersection of the average variable cost curve and the marginal cost curve, which shows the price below which the firm would lack enough revenue to cover its variable costs, is called the shutdown point. If the perfectly competitive firm faces a market price above the shutdown point, then the firm is at least covering its average variable costs. At a price above the shutdown point, the firm is also making enough revenue to cover at least a portion of fixed costs, so it should limp ahead even if it is making losses in the short run, since at least those losses will be smaller than if the firm shuts down immediately and incurs a loss equal to total fixed costs. However, if the firm is receiving a price below the price at the shutdown point, then the firm is not even covering its variable costs. In this case, staying open is making the firm’s losses larger, and it should shut down immediately. To summarize, if: • price < minimum average variable cost, then firm shuts down • price > minimum average variable cost, then firm stays in business Short-Run Outcomes for Perfectly Competitive Firms The average cost and average variable cost curves divide the marginal cost curve into three segments, as Figure 8.7 shows. At the market price, which the perfectly competitive firm accepts as given, the profit-maximizing firm chooses the output level where price or marginal revenue, which are the same thing for a perfectly competitive firm, is equal to marginal cost: P = MR = MC. Figure 8.7 Profit, Loss, Shutdown We can divide marginal cost curve into three zones, based on where it is crossed by the average cost and average variable cost curves. We call the point where MC crosses AC the break even point. If the firm is operating where the market price is at a level higher than the break even point, then price will be greater than average cost and the firm is earning profits. If the price is exactly at the break even point, then the firm is making zero profits. If price falls in the zone between the shutdown point and the break even point, then the firm is making losses but will continue to operate in the short run, since it is covering its variable costs, and more if price is above the shutdown-point price. However, if price falls below the price at the shutdown point, then the firm will shut down immediately, since it is not even covering its variable costs. First consider the upper zone, where prices are above the level where marginal cost (MC) crosses average cost (AC
) at the zero profit point. At any price above that level, the firm will earn profits in the short run. If the price falls exactly on the break even point where the MC and AC curves cross, then the firm earns zero profits. If a price falls into the zone between the break even point, where MC crosses AC, and the shutdown point, where MC crosses AVC, the firm will be making losses in the short run—but since the firm is more than covering its variable costs, the losses This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 201 are smaller than if the firm shut down immediately. Finally, consider a price at or below the shutdown point where MC crosses AVC. At any price like this one, the firm will shut down immediately, because it cannot even cover its variable costs. Marginal Cost and the Firm’s Supply Curve For a perfectly competitive firm, the marginal cost curve is identical to the firm’s supply curve starting from the minimum point on the average variable cost curve. To understand why this perhaps surprising insight holds true, first think about what the supply curve means. A firm checks the market price and then looks at its supply curve to decide what quantity to produce. Now, think about what it means to say that a firm will maximize its profits by producing at the quantity where P = MC. This rule means that the firm checks the market price, and then looks at its marginal cost to determine the quantity to produce—and makes sure that the price is greater than the minimum average variable cost. In other words, the marginal cost curve above the minimum point on the average variable cost curve becomes the firm’s supply curve. Watch this video (http://openstaxcollege.org/l/foodprice) that addresses how drought in the United States can impact food prices across the world. (Note that the story on the drought is the second one in the news report. You need to let the video play through the first story in order to watch the story on the drought.) As we discussed in the chapter on Demand and Supply, many of the reasons that supply curves shift relate to underlying changes in costs. For example, a lower price of key inputs or new technologies that reduce production costs cause supply to shift to the right. In contrast, bad weather or added government regulations can add to costs of certain goods in a way that causes supply to shift to the left. We
can also interpret these shifts in the firm’s supply curve as shifts of the marginal cost curve. A shift in costs of production that increases marginal costs at all levels of output—and shifts MC upward and to the left—will cause a perfectly competitive firm to produce less at any given market price. Conversely, a shift in costs of production that decreases marginal costs at all levels of output will shift MC downward and to the right and as a result, a competitive firm will choose to expand its level of output at any given price. The following Work It Out feature will walk you through an example. At What Price Should the Firm Continue Producing in the Short Run? To determine the short-run economic condition of a firm in perfect competition, follow the steps outlined below. Use the data in Table 8.7. 202 Chapter 8 \| Perfect Competition Q P TFC TVC TC AVC ATC MC TR Profits 0 1 2 3 4 5 $28 $28 $28 $28 $28 $28 Table 8.7 $20 $20 $20 $20 $20 $20 $0 $20 $25 $35 $52 $80 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Step 1. Determine the cost structure for the firm. For a given total fixed costs and variable costs, calculate total cost, average variable cost, average total cost, and marginal cost. Follow the formulas given in the Production, Costs, and Industry Structure chapter. These calculations are in Table 8.8. Q P TFC TVC TC (TFC+TVC) AVC (TVC/Q) ATC (TC/Q) MC (TC2−TC1)/ (Q2−Q1) 0 1 2 3 4 5 $28 $20 $0 $20+$0=$20 - - - $28 $20 $20 $20+$20=$40 $20/1=$20.00 $40/1=$40.00 $28 $20 $25 $20+$25=$45 $25/2=$12.50 $45/2=$22.50 $28 $20 $35 $20+$35=$55 $35/3=$11.67 $55/3=$18.33 $28 $20 $52 $20+$52=$72 $52/4=$13.00 $72/4=$18.00
$28 $20 $80 $20+$80=$100 $80/5=$16.00 $100/5=$20.00 ($40−$20)/ (1−0)= $20 ($45−$40)/ (2−1)= $5 ($55−$45)/ (3−2)= $10 ($72−$55)/ (4−3)= $17 ($100−$72)/ (5−4)= $28 Table 8.8 Step 2. Determine the market price that the firm receives for its product. Since the firm in perfect competition is a price taker, the market price is constant With the given price, calculate total revenue as equal to price multiplied by quantity for all output levels produced. In this example, the given price is $28. You can see that in the second column of Table 8.9. Quantity Price Total Revenue (P × Q) 0 Table 8.9 $28 $28×0=$0 This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 203 Quantity Price Total Revenue (P × Q) 1 2 3 4 5 Table 8.9 $28 $28 $28 $28 $28 $28×1=$28 $28×2=$56 $28×3=$84 $28×4=$112 $28×5=$140 Step 3. Calculate profits as total cost subtracted from total revenue, as Table 8.10 shows. Quantity Total Revenue Total Cost Profits (TR−TC) 0 1 2 3 4 5 Table 8.10 $0 $28 $56 $84 $112 $140 $20 $40 $45 $55 $72 $100 $0−$20=−$20 $28−$40=−$12 $56−$45=$11 $84−$55=$29 $112−$72=$40 $140−$100=$40 Step 4. To find the profit-maximizing output level, look at the Marginal Cost column (at every output level produced), as Table 8.11 shows, and determine where it is equal to the market price. The output level where price equals the marginal cost is the output level that maximizes profits. Q P TFC TVC TC AVC ATC MC TR Profits 0 1 2 3 4 5 $28 $28 $28 $28 $28 $28 Table 8.11 $20 $20 $20 $
20 $20 $20 $0 $20 $25 $35 $52 $80 $20 $40 $45 $55 $72 - - $20.00 $40.00 $12.50 $22.50 $11.67 $18.33 $13.00 $18.00 $100 $16.40 $20.40 - $20 $5 $10 $17 $28 $0 $28 $56 $84 $112 $140 −$20 −$12 $11 $29 $40 $40 Step 5. Once you have determined the profit-maximizing output level (in this case, output quantity 5), you can look at the amount of profits made (in this case, $40). Step 6. If the firm is making economic losses, the firm needs to determine whether it produces the output level where price equals marginal revenue and equals marginal cost or it shuts down and only incurs its fixed costs. 204 Chapter 8 \| Perfect Competition Step 7. For the output level where marginal revenue is equal to marginal cost, check if the market price is greater than the average variable cost of producing that output level. • • If P > AVC but P < ATC, then the firm continues to produce in the short-run, making economic losses. If P < AVC, then the firm stops producing and only incurs its fixed costs. In this example, the price of $28 is greater than the AVC ($16.40) of producing 5 units of output, so the firm continues producing. 8.3 \| Entry and Exit Decisions in the Long Run By the end of this section, you will be able to: • Explain how entry and exit lead to zero profits in the long run • Discuss the long-run adjustment process It is impossible to precisely define the line between the short run and the long run with a stopwatch, or even with a calendar. It varies according to the specific business. Therefore, the distinction between the short run and the long run is more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production. In a competitive market, profits are a red cape that incites businesses to charge. If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms enter the industry in response to increased industry profits it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will cease production altogether. The long-run process of reducing production in response to a sustained pattern of losses is called exit. The following Clear It Up feature discusses where some of these losses might come from, and the reasons why some firms go out of business. Why do firms cease to exist? Can we say anything about what causes a firm to exit an industry? Profits are the measurement that determines whether a business stays operating or not. Individuals start businesses with the purpose of making profits. They invest their money, time, effort, and many other resources to produce and sell something that they hope will give them something in return. Unfortunately, not all businesses are successful, and many new startups soon realize that their “business venture” must eventually end. In the model of perfectly competitive firms, those that consistently cannot make money will “exit,” which is a nice, bloodless word for a more painful process. When a business fails, after all, workers lose their jobs, investors lose their money, and owners and managers can lose their dreams. Many businesses fail. The U.S. Small Business Administration indicates that in 2011, 534,907 new firms "entered," and 575,691 firms failed. Sometimes a business fails because of poor management or workers who are not very productive, or because of tough domestic or foreign competition. Businesses also fail from a variety of causes. For example, conditions of demand and supply in the market may shift in an unexpected way, so that the prices that a business charges for outputs fall or the prices for inputs rise. With millions of businesses in the U.S. economy, even a small fraction of them failing will affect many people—and business failures can be very hard on the workers and managers directly involved. However, from the standpoint of the overall economic system, business exits are sometimes a necessary evil if a market-oriented system is going to offer a flexible mechanism for satisfying customers, keeping costs low, and inventing new products. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 205 How Entry and Exit Lead to Zero Profits in the Long Run No perfectly competitive
firm acting alone can affect the market price. However, the combination of many firms entering or exiting the market will affect overall supply in the market. In turn, a shift in supply for the market as a whole will affect the market price. Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit. To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation. The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC. This will temporarily make the market price rise above the minimum point on the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits. Short-run losses will fade away by reversing this process. Say that the market is in long-run equilibrium. This time, instead, demand decreases, and with that, the market price starts falling. The existing firms in the industry are now facing a lower price than before, and as it will be below the average cost curve, they will now be making economic losses. Some firms will continue producing where the new P = MR = MC, as long as they are able to cover their average variable costs. Some firms will have to shut down immediately as they will not be able to cover their average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of many firms causes the market supply curve to shift to the left. As the supply curve shifts to the left, the
market price starts rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will push down prices until they reach the zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run, firms will not continually lose money. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost. The Long-Run Adjustment and Industry Types Whenever there are expansions in an industry, costs of production for the existing and new firms could either stay the same, increase, or even decrease. Therefore, we can categorize an industry as being (1) a constant cost industry (as demand increases, the cost of production for firms stays the same), (2) an increasing cost industry (as demand increases, the cost of production for firms increases), or (3) a decreasing cost industry (as demand increases the costs of production for the firms decreases). For a constant cost industry, whenever there is an increase in market demand and price, then the supply curve shifts to the right with new firms’ entry and stops at the point where the new long-run equilibrium intersects at the same market price as before. This is the case of constant returns to scale, which we discussed earlier in the chapter on Production, Costs, and Industry Structure. However, why will costs remain the same? In this type of industry, the supply curve is very elastic. Firms can easily supply any quantity that consumers demand. In addition, there is a perfectly elastic supply of inputs—firms can easily increase their demand for employees, for example, with no increase to wages. Tying in to our Bring it Home discussion, an increased demand for ethanol in recent years has caused the demand for corn to increase. Consequently, many farmers switched from growing wheat to growing corn. Agricultural markets are generally good examples of constant cost industries. For an increasing cost industry, as the market expands, the old and new firms experience increases in their costs of production, which makes the new zero
-profit level intersect at a higher price than before. Here companies may have to deal with limited inputs, such as skilled labor. As the demand for these workers rise, wages rise and this increases the cost of production for all firms. The industry supply curve in this type of industry is more inelastic. For a decreasing cost industry, as the market expands, the old and new firms experience lower costs of production, which makes the new zero-profit level intersect at a lower price than before. In this case, the industry and all the 206 Chapter 8 \| Perfect Competition firms in it are experiencing falling average total costs. This can be due to an improvement in technology in the entire industry or an increase in the education of employees. High tech industries may be a good example of a decreasing cost market. Figure 8.8 (a) presents the case of an adjustment process in a constant cost industry. Whenever there are output expansions in this type of industry, the long-run outcome implies more output produced at exactly the same original price. Note that supply was able to increase to meet the increased demand. When we join the before and after long-run equilibriums, the resulting line is the long run supply (LRS) curve in perfectly competitive markets. In this case, it is a flat curve. Figure 8.8 (b) and Figure 8.8 (c) present the cases for an increasing cost and decreasing cost industry, respectively. For an increasing cost industry, the LRS is upward sloping, while for a decreasing cost industry, the LRS is downward sloping. Figure 8.8 Adjustment Process in a Constant-Cost Industry In (a), demand increased and supply met it. Notice that the supply increase is equal to the demand increase. The result is that the equilibrium price stays the same as quantity sold increases. In (b), notice that sellers were not able to increase supply as much as demand. Some inputs were scarce, or wages were rising. The equilibrium price rises. In (c), sellers easily increased supply in response to the demand increase. Here, new technology or economies of scale caused the large increase in supply, resulting in declining equilibrium price. 8.4 \| Efficiency in Perfectly Competitive Markets By the end of this section, you will be able to: • Apply concepts of productive efficiency and allocative efficiency to perfectly competitive markets • Compare the model of perfect competition to real-world markets When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing
consumers, something remarkable happens: the resulting quantities of outputs of goods and services demonstrate both productive and allocative efficiency (terms that we first introduced in (Choice in a World of Scarcity). Productive efficiency means producing without waste, so that the choice is on the production possibility frontier. In the long run in a perfectly competitive market, because of the process of entry and exit, the price in the market is equal to the minimum of the long-run average cost curve. In other words, firms produce and sell goods at the lowest possible average cost. Allocative efficiency means that among the points on the production possibility frontier, the chosen point is socially preferred—at least in a particular and specific sense. In a perfectly competitive market, price will be equal to the marginal cost of production. Think about the price that one pays for a good as a measure of the social benefit one receives for that good; after all, willingness to pay conveys what the good is worth to a buyer. Then think about the marginal cost of producing the good as representing not just the cost for the firm, but more broadly as the social cost of producing that good. When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where price is equal to marginal cost, they are thus ensuring that the social benefits they receive from producing a good are in line with the social costs of production. To explore what economists mean by allocative efficiency, it is useful to walk through an example. Begin by assuming This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 207 that the market for wholesale flowers is perfectly competitive, and so P = MC. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs will not yet have increased as much, so that price will exceed marginal cost; that is, P > MC. In that situation, the benefit to society as a whole of producing additional goods, as measured by the willingness of consumers to pay for marginal units of a good, would be higher than the cost of the inputs of labor and physical capital needed to produce the marginal good. In other words, the gains to society as a whole from producing additional marginal units will be greater than the costs. Conversely, consider what it would mean if, compared to the level of output at the allocatively efficient choice when P = MC, firms produced a greater quantity of flowers. At a
greater quantity, marginal costs of production will have increased so that P < MC. In that case, the marginal costs of producing additional flowers is greater than the benefit to society as measured by what people are willing to pay. For society as a whole, since the costs are outstripping the benefits, it will make sense to produce a lower quantity of such goods. When perfectly competitive firms maximize their profits by producing the quantity where P = MC, they also assure that the benefits to consumers of what they are buying, as measured by the price they are willing to pay, is equal to the costs to society of producing the marginal units, as measured by the marginal costs the firm must pay—and thus that allocative efficiency holds. We should view the statements that a perfectly competitive market in the long run will feature both productive and allocative efficiency with a degree of skepticism about its truth. Remember, economists are using the concept of “efficiency” in a particular and specific sense, not as a synonym for “desirable in every way.” For one thing, consumers’ ability to pay reflects the income distribution in a particular society. Thus, a homeless person may have no ability to pay for housing because he or she has insufficient income. Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly, which are more frequently observed in the real world than perfect competition, firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency. Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty which may make some people unable to pay for basic necessities of life, government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information. We explore these issues in other chapters. However, the theoretical efficiency of perfect competition does provide a useful benchmark for comparing the issues that arise from these real-world problems. A Dime a Dozen A quick glance at Table 8.12 reveals the dramatic increase in North Dakota corn production—more than double. Taking into consideration that corn typically yields two to three times as many bushels per acre as wheat, it is obvious there has been a significant increase in bushels of corn. Why the increase in corn acreage? Converging prices
. Year Corn (millions of acres) Wheat (millions of acres) 2014 91.6 56.82 Table 8.12 (Source: USDA National Agricultural Statistics Service) Historically, wheat prices have been higher than corn prices, offsetting wheat’s lower yield per acre. However, in recent years wheat and corn prices have been converging. In April 2013, Agweek reported the gap was just 71 cents per bushel. As the difference in price narrowed, switching to the production of higher yield per acre of corn simply made good business sense. Erik Younggren, president of the National Association of Wheat Growers said in the Agweek article, “I don't think we're going to see mile after mile of waving amber fields [of 208 Chapter 8 \| Perfect Competition wheat] anymore." (Until wheat prices rise, we will probably be seeing field after field of tasseled corn.) This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 209 KEY TERMS break even point level of output where the marginal cost curve intersects the average cost curve at the minimum point of AC; if the price is at this point, the firm is earning zero economic profits entry the long-run process of firms entering an industry in response to industry profits exit the long-run process of firms reducing production and shutting down in response to industry losses long-run equilibrium where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC marginal revenue the additional revenue gained from selling one more unit market structure the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold perfect competition each firm faces many competitors that sell identical products price taker a firm in a perfectly competitive market that must take the prevailing market price as given shutdown point level of output where the marginal cost curve intersects the average variable cost curve at the minimum point of AVC; if the price is below this point, the firm should shut down immediately KEY CONCEPTS AND SUMMARY 8.1 Perfect Competition and Why It Matters A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of
sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero. Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers. 8.2 How Perfectly Competitive Firms Make Output Decisions As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price. Profits will be highest (or losses will be smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost. If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is making profits. If the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses. If the market price is equal to average cost at the profit-maximizing level of output, then the firm is making zero profits. We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, the “zero profit point.” If the market price that a perfectly competitive firm faces is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. If the market price that a perfectly competitive firm faces is above average variable cost, but below average cost, then the firm should continue producing in the short run, but exit in the long run. We call the point where the marginal cost curve crosses the average variable cost curve the shutdown point. 210 Chapter 8 \| Perfect Competition 8.3 Entry and Exit Decisions in the Long Run In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms cease production altogether. Through the process of entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where
the marginal cost curve crosses the AC curve at the minimum of the average cost curve. The long-run supply curve shows the long-run output supplied by firms in three different types of industries: constant cost, increasing cost, and decreasing cost. 8.4 Efficiency in Perfectly Competitive Markets Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency. These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society. SELF-CHECK QUESTIONS 1. Firms in a perfectly competitive market are said to be “price takers”—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent? 2. Would independent trucking fit the characteristics of a perfectly competitive industry? 3. Look at Table 8.13. What would happen to the firm’s profits if the market price increases to $6 per pack of raspberries? Quantity Total Cost Fixed Cost Variable Cost Total Revenue Profit 0 10 20 30 40 50 60 70 80 90 100 Table 8.13 $62 $90 $110 $126 $144 $166 $192 $224 $264 $324 $404 $62 $62 $62 $62 $62 $62 $62 $62 $62 $62 $62 - $28 $48 $64 $82 $104 $130 $162 $202 $262 $342 $0 $60 $120 $180 $240 $300 $360 $420 $480 $540 $600 −$62 −$30 $10 $54 $96 $134 $168 $196 $216 $216 $196 This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 211 4. Suppose that the market price increases to $6, as Table 8.14 shows. What would happen to the profit-maximizing output level? Quantity Total Cost Fixed Cost Variable Cost Marginal Cost Total Revenue Marginal Revenue $62 $90 $110 $126 $144 $166 $192 $224 $264 $324 $404 $62 $62 $62 $62 $62 $62 $62 $62 $62 $62 $62 0 10 20 30 40 50 60 70 80 90 100 Table 8.14 - $
28 $48 $64 $82 $104 $130 $162 $202 $262 $342 - $2.80 $2.00 $1.60 $1.80 $2.20 $2.60 $3.20 $4.00 $6.00 $8.00 $0 $60 $120 $180 $240 $300 $360 $420 $480 $540 $600 - $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 5. Explain in words why a profit-maximizing firm will not choose to produce at a quantity where marginal cost exceeds marginal revenue. 6. A firm’s marginal cost curve above the average variable cost curve is equal to the firm’s individual supply curve. This means that every time a firm receives a price from the market it will be willing to supply the amount of output where the price equals marginal cost. What happens to the firm’s individual supply curve if marginal costs increase? If new technology in a perfectly competitive market brings about a substantial reduction in costs of production, 7. how will this affect the market? 8. A market in perfect competition is in long-run equilibrium. What happens to the market if labor unions are able to increase wages for workers? 9. Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. These are the two reasons why we call them “perfect.” How would you use these two concepts to analyze other market structures and label them “imperfect?” 10. Explain how the profit-maximizing rule of setting P = MC leads a perfectly competitive market to be allocatively efficient. REVIEW QUESTIONS 11. A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How “small” is “small”? 12. What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm. 13. What is a “price taker” firm? 212 Chapter 8 \| Perfect Competition 14. How does a perfectly competitive firm decide what price to charge? 21. Should a firm shut down immediately if it is making losses? 22. How does the average variable cost curve help a firm know whether it should shut down immediately? 23. What two lines on a
cost curve diagram intersect at the shutdown point? 24. Why does entry occur? 25. Why does exit occur? 26. Do entry and exit occur in the short run, the long run, both, or neither? 27. What price will a perfectly competitive firm end up charging in the long run? Why? 28. Will a perfectly competitive market display productive efficiency? Why or why not? 29. Will a perfectly competitive market display allocative efficiency? Why or why not? 34. Many firms in the United States file for bankruptcy every year, yet they still continue operating. Why would they do this instead of completely shutting down? 35. Why will profits competitive industry tend to vanish in the long run? firms in a perfectly for 36. Why will losses for firms in a perfectly competitive industry tend to vanish in the long run? 37. Assuming that the market for cigarettes is in perfect competition, what does allocative and productive efficiency imply in this case? What does it not imply? 38. In the argument for why perfect competition is allocatively efficient, the price that people are willing to pay represents the gains to society and the marginal cost to the firm represents the costs to society. Can you think of some social costs or issues that are not included in the marginal cost to the firm? Or some social gains that are not included in what people pay for a good? 15. What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges? 16. How does a perfectly competitive firm calculate total revenue? 17. Briefly explain the reason for the shape of a marginal revenue curve for a perfectly competitive firm. 18. What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output? 19. How does the average cost curve help to show whether a firm is making profits or losses? 20. What two lines on a cost curve diagram intersect at the zero-profit point? CRITICAL THINKING QUESTIONS 30. Finding a life partner is a complicated process that may take many years. It is hard to think of this process as being part of a very complex market, with a demand and a supply for partners. Think about how this market works and some of its characteristics, such as search costs. Would you consider it a perfectly competitive market? Can you name five examples of perfectly 31. competitive markets? Why or why not? 32. Your company operates in a perfectly competitive market. You have been told that advertising can help you increase your sales in the short run. Would
you create an aggressive advertising campaign for your product? 33. Since a perfectly competitive firm can sell as much as it wishes at the market price, why can the firm not simply increase its profits by selling an extremely high quantity? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 8 \| Perfect Competition 213 PROBLEMS 39. The AAA Aquarium Co. sells aquariums for $20 each. Fixed costs of production are $20. The total variable costs are $20 for one aquarium, $25 for two units, $35 for the three units, $50 for four units, and $80 for five units. In the form of a table, calculate total revenue, marginal revenue, total cost, and marginal cost for each output level (one to five units). What is the profit-maximizing quantity of output? On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves. 40. Perfectly competitive firm Doggies Paradise Inc. sells winter coats for dogs. Dog coats sell for $72 each. The fixed costs of production are $100. The total variable costs are $64 for one unit, $84 for two units, $114 for three units, $184 for four units, and $270 for five units. In the form of a table, calculate total revenue, marginal revenue, total cost and marginal cost for each output level (one to five units). On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves. What is the profit maximizing quantity? 41. A computer company produces affordable, easyto-use home computer systems and has fixed costs of $250. The marginal cost of producing computers is $700 for the first computer, $250 for the second, $300 for the third, $350 for the fourth, $400 for the fifth, $450 for the sixth, and $500 for the seventh. a. Create a table that shows the company’s output, total cost, marginal cost, average cost, variable cost, and average variable cost. b. At what price is the zero-profit point? At what c. d. price is the shutdown point? If the company sells the computers for $500, is it making a profit or a loss? How big is the profit or loss? Sketch a graph with AC, MC, and AVC
curves to illustrate your answer and show the profit or loss. If the firm sells the computers for $300, is it making a profit or a loss? How big is the profit or loss? Sketch a graph with AC, MC, and AVC curves to illustrate your answer and show the profit or loss. 214 Chapter 8 \| Perfect Competition This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 9 \| Monopoly 215 9 \| Monopoly Figure 9.1 Political Power from a Cotton Monopoly In the mid-nineteenth century, the United States, specifically the Southern states, had a near monopoly in the cotton that they supplied to Great Britain. These states attempted to leverage this economic power into political power—trying to sway Great Britain to formally recognize the Confederate States of America. (Credit: modification of work by “ashleylovespizza”/Flickr Creative Commons) The Rest is History Many of the opening case studies have focused on current events. This one steps into the past to observe how monopoly, or near monopolies, have helped shape history. In spring 1773, the East India Company, a firm that, in its time, was designated “too big to fail,” was experiencing financial difficulties. To help shore up the failing firm, the British Parliament authorized the Tea Act. The act continued the tax on teas and made the East India Company the sole legal supplier of tea to the American colonies. By November, the citizens of Boston had had enough. They refused to permit the unloading of tea, citing their main complaint: “No taxation without representation.” Several newspapers, including The Massachusetts Gazette, warned arriving tea-bearing ships, “We are prepared, and shall not fail to pay them an unwelcome visit by The Mohawks.” Step forward in time to 1860—the eve of the American Civil War—to another near monopoly supplier of historical significance: the U.S. cotton industry. At that time, the Southern states provided the majority of the cotton Britain imported. The South, wanting to secede from the Union, hoped to leverage Britain’s high dependency on its cotton into formal diplomatic recognition of the Confederate States of America. This leads us to this chapter's topic: a firm that controls all (or nearly all) of the supply of a good or service—a monopoly. How do monopoly firms behave in the marketplace? Do they have “power?�
� Does this power potentially have unintended consequences? We’ll return to this case at the end of the chapter to see how the tea and cotton monopolies influenced U.S. history. 216 Chapter 9 \| Monopoly Introduction to a Monopoly In this chapter, you will learn about: • How Monopolies form: Barriers to Entry • How a Profit-Maximizing Monopoly Chooses Output and Price Many believe that top executives at firms are the strongest supporters of market competition, but this belief is far from the truth. Think about it this way: If you very much wanted to win an Olympic gold medal, would you rather be far better than everyone else, or locked in competition with many athletes just as good as you? Similarly, if you would like to attain a very high level of profits, would you rather manage a business with little or no competition, or struggle against many tough competitors who are trying to sell to your customers? By now, you might have read the chapter on Perfect Competition. In this chapter, we explore the opposite extreme: monopoly. If perfect competition is a market where firms have no market power and they simply respond to the market price, monopoly is a market with no competition at all, and firms have a great deal of market power. In the case of monopoly, one firm produces all of the output in a market. Since a monopoly faces no significant competition, it can charge any price it wishes, subject to the demand curve. While a monopoly, by definition, refers to a single firm, in practice people often use the term to describe a market in which one firm merely has a very high market share. This tends to be the definition that the U.S. Department of Justice uses. Even though there are very few true monopolies in existence, we do deal with some of those few every day, often without realizing it: The U.S. Postal Service, your electric, and garbage collection companies are a few examples. Some new drugs are produced by only one pharmaceutical firm—and no close substitutes for that drug may exist. From the mid-1990s until 2004, the U.S. Department of Justice prosecuted the Microsoft Corporation for including Internet Explorer as the default web browser with its operating system. The Justice Department’s argument was that, since Microsoft possessed an extremely high market share in the industry for operating systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated
the incentive for consumers to explore other browsers and made it impossible for competitors to gain a foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold personal computers. In 2015, a U.S. federal court tossed out antitrust charges that Google had an agreement with mobile device makers to set Google as the default search engine. This chapter begins by describing how monopolies are protected from competition, including laws that prohibit competition, technological advantages, and certain configurations of demand and supply. It then discusses how a monopoly will choose its profit-maximizing quantity to produce and what price to charge. While a monopoly must be concerned about whether consumers will purchase its products or spend their money on something altogether different, the monopolist need not worry about the actions of other competing firms producing its products. As a result, a monopoly is not a price taker like a perfectly competitive firm, but instead exercises some power to choose its market price. 9.1 \| How Monopolies Form: Barriers to Entry By the end of this section, you will be able to: • Distinguish between a natural monopoly and a legal monopoly. • Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies • Analyze the importance of trademarks and patents in promoting innovation • Identify examples of predatory pricing Because of the lack of competition, monopolies tend to earn significant economic profits. These profits should attract vigorous competition as we described in Perfect Competition, and yet, because of one particular characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors from entering a market. Barriers to entry can range from the simple and easily surmountable, This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 9 \| Monopoly 217 such as the cost of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies available for broadcasting. Once an entrepreneur or firm has purchased the rights to all of them, no new competitors can enter the market. In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in markets with significant barriers to entry, it is not necessarily true that abnormally high profits will attract new firms, and
that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run. There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural monopoly, where the barriers to entry are something other than legal prohibition. The other is legal monopoly, where laws prohibit (or severely limit) competition. Natural Monopoly Economies of scale can combine with the size of the market to limit competition. (We introduced this theme in Production, Cost and Industry Structure). Figure 9.2 presents a long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000 planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year. Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC) curve at an output level of 5,000 planes per year and at a price P1, which is higher than P0. In this situation, the market has room for only one producer. If a second firm attempts to enter the market at a smaller size, say by producing a quantity of 4,000 planes, then its average costs will be higher than those of the existing firm, and it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000 planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it produced because of insufficient demand in the market. Figure 9.2 Economies of Scale and Natural Monopoly In this market, the demand curve intersects the long-run average cost (LRAC) curve at its downward-sloping part. A natural monopoly occurs when the quantity demanded is less than the minimum quantity it takes to be at the bottom of the long-run average cost curve. Economists call this situation, when economies of scale are large relative to the quantity demanded in the market, a natural monopoly. Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low, once the fixed costs of the overall system are in place. This results in situations where there are substantial economies of scale. For example, once a water company lays the main water pipes through a neighborhood, the marginal cost of
providing water service to another home is fairly low. Once the electric company 218 Chapter 9 \| Monopoly installs lines in a new subdivision, the marginal cost of providing additional electrical service to one more home is minimal. It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes, or for a second electricity company to enter the market and invest in a whole new set of electrical wires. These industries offer an example where, because of economies of scale, one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments. A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For example, cement production exhibits economies of scale, and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce. Moreover, the costs of transporting cement over land are high, and so a cement plant in an area without access to water transportation may be a natural monopoly. Control of a Physical Resource Another type of natural monopoly occurs when a company has control of a scarce physical resource. In the U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the 1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough aluminum to compete. As another example, the majority of global diamond production is controlled by DeBeers, a multi-national company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It also has exploration activities on four continents, while directing a worldwide distribution network of rough cut diamonds. Although in recent years they have experienced growing competition, their impact on the rough diamond market is still considerable. Legal Monopoly For some products, the government erects barriers to entry by prohibiting or limiting competition. Under U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states or cities have laws or regulations that allow households a choice of only one electric company, one water company, and one company to pick up the garbage. Most legal monopolies are utilities—products necessary for everyday life—that are socially beneficial. As a consequence, the government allows producers to become regulated monopolies, to insure that customers have access to an appropriate amount of
these products or services. Additionally, legal monopolies are often subject to economies of scale, so it makes sense to allow only one provider. Promoting Innovation Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of near ubiquitous information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation. To prevent this from happening, the Constitution of the United States specifies in Article I, Section 8: “The Congress shall have Power... to Promote the Progress of Science and Useful Arts, by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Discoveries.” Congress used this power to create the U.S. Patent and Trademark Office, as well as the U.S. Copyright Office. A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time. In the United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more cheaply once the patent expires. A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. Roughly 1.9 million trademarks are registered with the U.S. government. A firm can renew a trademark repeatedly, as long as it remains in active use. ‘original works of authorship’ A copyright, according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United States for including literary, dramatic, musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce, display, or perform a copyrighted work without the author's permission. Copyright protection ordinarily lasts for the life of the author plus 70 years. Roughly speaking, patent law covers inventions and copyright protects books, songs, and art. However, in certain This OpenStax book is available for free
at http://cnx.org/content/col12170/1.7 Chapter 9 \| Monopoly 219 areas, like the invention of new software, it has been unclear whether patent or copyright protection should apply. There is also a body of law known as trade secrets. Even if a company does not have a patent on an invention, competing firms are not allowed to steal their secrets. One famous trade secret is the formula for Coca-Cola, which is not protected under copyright or patent law, but is simply kept secret by the company. Taken together, we call this combination of patents, trademarks, copyrights, and trade secret law intellectual property, because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property, although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which those in other countries will respect patents and copyrights of those in other countries. Government limitations on competition used to be more common in the United States. For most of the twentieth century, only one phone company—AT&T—was legally allowed to provide local and long distance service. From the 1930s to the 1970s, one set of federal regulations limited which destinations airlines could choose to fly to and what fares they could charge. Another set of regulations limited the interest rates that banks could pay to depositors; yet another specified how much trucking firms could charge customers. What products we consider utilities depends, in part, on the available technology. Fifty years ago, telephone companies provided local and long distance service over wires. It did not make much sense to have many companies building multiple wiring systems across towns and the entire country. AT&T lost its monopoly on long distance service when the technology for providing phone service changed from wires to microwave and satellite transmission, so that multiple firms could use the same transmission mechanism. The same thing happened to local service, especially in recent years, with the growth in cellular phone systems. The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation, starting in the late 1970s and continuing into the 1990s. This wave eliminated or reduced government restrictions on the firms that could enter, the prices that they could charge, and the quantities that
many industries could produce, including telecommunications, airlines, trucking, banking, and electricity. Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies. Vist this website (http://openstaxcollege.org/l/patents) for examples of some pretty bizarre patents. Intimidating Potential Competition Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market. One method is known as predatory pricing, in which a firm uses the threat of sharp price cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove. Consider a large airline that provides most of the flights between two particular cities. A new, small start-up airline decides to offer service between these two cities. The large airline immediately slashes prices on this route to the bone, so that the new entrant cannot make any money. After the new entrant has gone out of business, the incumbent 220 Chapter 9 \| Monopoly firm can raise prices again. After the company repeats this pattern once or twice, potential new entrants may decide that it is not wise to try to compete. Small airlines often accuse larger airlines of predatory pricing: in the early 2000s, for example, ValuJet accused Delta of predatory pricing, Frontier accused United, and Reno Air accused Northwest. In 2015, the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers that encouraged customers to use lower swipe fees on credit transactions. In some cases, large advertising budgets can also act as a way of discouraging the competition. If the only way to launch a successful new national cola drink is to spend more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many companies will try. A firmly established brand name can be difficult to dislodge. Summing Up Barriers to Entry Table 9.1 lists the barriers to entry that we have discussed. This list is not exhaustive, since firms have proved to be highly creative in inventing business practices that discourage competition. When barriers to entry exist, perfect competition is no longer a reasonable description of how an industry works. When barriers to entry are high enough, monopoly can result. Barrier to Entry Government Role? Example Natural monopoly Government often responds with regulation (or ownership) Water and electric companies Control of a physical resource
No Legal monopoly Yes Patent, trademark, and copyright Yes, through protection of intellectual property Intimidating potential competitors Somewhat Table 9.1 Barriers to Entry DeBeers for diamonds Post office, past regulation of airlines and trucking New drugs or software Predatory pricing; well-known brand names 9.2 \| How a Profit-Maximizing Monopoly Chooses Output and Price By the end of this section, you will be able to: • Explain the perceived demand curve for a perfect competitor and a monopoly • Analyze a demand curve for a monopoly and determine the output that maximizes profit and revenue • Calculate marginal revenue and marginal cost • Explain allocative efficiency as it pertains to the efficiency of a monopoly Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need not fear competition from other producers. How will this monopoly choose its profit-maximizing quantity of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to total revenues minus total costs. We can analyze the pattern of costs for the monopoly within the same framework as the costs of a perfectly competitive firm—that is, by using total cost, fixed cost, variable cost, marginal cost, average cost, and average variable cost. However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm. (The Clear It Up feature discusses how hard it is sometimes to define “market” in a monopoly situation.) This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 9 \| Monopoly 221 Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly A perfectly competitive firm acts as a price taker, so we calculate total revenue taking the given market price and multiplying it by the quantity of output that the firm chooses. The demand curve as it is perceived by a perfectly competitive firm appears in Figure 9.3 (a). The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P. Figure 9.3 The Perceived Demand Curve for a Perfect Competitor and a Monopolist firm perceives the demand curve that it faces to be flat. The flat shape means that the firm can sell either a low quantity (Ql) or a high quantity (Qh)
at exactly the same price (P). (b) A monopolist perceives the demand curve that it faces to be the same as the market demand curve, which for most goods is downward-sloping. Thus, if the monopolist chooses a high level of output (Qh), it can charge only a relatively low price (PI). Conversely, if the monopolist chooses a low level of output (Ql), it can then charge a higher price (Ph). The challenge for the monopolist is to choose the combination of price and quantity that maximizes profits. (a) A perfectly competitive What defines the market? A monopoly is a firm that sells all or nearly all of the goods and services in a given market. However, what defines the “market”? In a famous 1947 case, the federal government accused the DuPont company of having a monopoly in the cellophane market, pointing out that DuPont produced 75% of the cellophane in the United States. DuPont countered that even though it had a 75% market share in cellophane, it had less than a 20% share of the “flexible packaging materials,” which includes all other moisture-proof papers, films, and foils. In 1956, after years of legal appeals, the U.S. Supreme Court held that the broader market definition was more appropriate, and it dismissed the case against DuPont. Questions over how to define the market continue today. True, Microsoft in the 1990s had a dominant share of the software for computer operating systems, but in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service. DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry. A small town in the country may have only one gas station: is this gas station a “monopoly,” or does it compete with gas stations that might be 222 Chapter 9 \| Monopoly five, 10, or 50 miles away? In general, if a firm produces a product without close substitutes, then we can consider the firm a monopoly producer in a single market. However,
if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly. Still, arguments over whether substitutes are close or not close can be controversial. While a monopolist can charge any price for its product, nonetheless the demand for the firm’s product constrains the price. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping. Figure 9.3 illustrates this situation. The monopolist can either choose a point like R with a low price (Pl) and high quantity (Qh), or a point like S with a high price (Ph) and a low quantity (Ql), or some intermediate point. Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells. However, why isn’t the perfectly competitive firm’s demand curve also the market demand curve? See the following Clear It Up feature for the answer to this question. What is the difference between perceived demand and market demand? The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. However, the firm’s demand curve as perceived by a monopoly is the same as the market demand curve. The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms. In effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve. In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer. Total Cost and Total Revenue for a Monopolist We can illustrate profits for a monopolist with a graph of total revenues and total costs, with the example of the hypothetical HealthPill firm in Figure 9.4. The total cost curve has its typical shape that we learned about in Production, Costs and Industry Structure, and that we used in Perfect Competition; that is, total costs
rise and the curve grows steeper as output increases, as the final column of Table 9.2 shows. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 9 \| Monopoly 223 Figure 9.4 Total Revenue and Total Cost for the HealthPill Monopoly Total revenue for the monopoly firm called HealthPill first rises, then falls. Low levels of output bring in relatively little total revenue, because the quantity is low. High levels of output bring in relatively less revenue, because the high quantity pushes down the market price. The total cost curve is upward-sloping. Profits will be highest at the quantity of output where total revenue is most above total cost. The profit-maximizing level of output is not the same as the revenue-maximizing level of output, which should make sense, because profits take costs into account and revenues do not. Quantity Q Price P Total Revenue TR Total Cost TC 1 2 3 4 5 6 7 8 1,200 1,100 1,000 900 800 700 600 500 1,200 2,200 3,000 3,600 4,000 4,200 4,200 4,000 500 750 1,000 1,250 1,650 2,500 4,000 6,400 Table 9.2 Total Costs and Total Revenues of HealthPill Total revenue, though, is different. Since a monopolist faces a downward sloping demand curve, the only way it can sell more output is by reducing its price. Selling more output raises revenue, but lowering price reduces it. Thus, the shape of total revenue isn’t clear. Let’s explore this using the data in Table 9.2, which shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output. (In this example, we give the output as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that the pharmaceutical company measures the pharmaceutical company measures these output levels and the corresponding prices per 1,000 or 10,000 pills.) As the figure illustrates, total revenue for a monopolist has the shape of a hill, first rising, next flattening out, and then falling. In this example, total revenue is highest at a quantity of 6 or 7. However, the monopolist is not seeking to

Subsets and Splits

No community queries yet

The top public SQL queries from the community will appear here once available.