Cost To Oligopoly

1 CHAPTER VI. PRODUCTION AND COSTS OBJECTIVES At the end of the lesson, the student will be able to 1. 2. 3.
Distinguish, discuss, and explain the different classifications of costs and their effects on profit and revenue. Explain the interaction of the different classes of costs and their effect on productivity. Discuss the differences of short-run and of the long-run costs and their effect on production. TOPICS FOR DISCUSSION 1. 2. 3. 4. 5. 6. Explicit and implicit costs Economic and normal profit Increasing and diminishing returns Short-run costs Long-run costs Economies and diseconomies of scale Implicit costs Revenue Long-run Marginal product Economies scale Returns to scale Accounting profit Profit Inputs Marginal cost of Planning curve curve/envelope
KEY WORDS AND TERMS Costs Explicit costs Economic profit Short-run Production function
COSTS
2 When we use the resources of others we pay the owners
approximately the opportunity cost the possible earning of the resource had they been employed for the other best alternative. Were we to use our own resources, a building, for example, we still incur opportunity cost even if we do not pay the rent. That is because, the building can be used to earn profit by being rented to others. Explicit costs Payment for resources secured or bought from nonowners of the business firm. Among these are wages for labor, cost of utilities (water, light and power, telephone services), materials, medical services, and others. These resources are owned by persons and organizations outside the firm and thus payments (or out-of-the-pocket expenses) are made to outsiders (Tucker, 2008). Implicit costs Implicit Costs These costs refers to the opportunity costs that business owners give up for using the resources of the business firm. A person who decides to put up a business and runs it gives up the opportunity cost of earning salaries as an employee. If he uses his own land and building to house his business, he gives up the opportunity to earn rent from outsiders (Tucker). There is no actual payment of these costs because what is actually lost is the opportunity from an alternative choice. No outlay of money is required for implicit costs. PROFITS Accounting profits refer to the profits recorded by accountants and are based on total revenues and explicit costs. The implicit costs are not included. Accounting profit is expressed by the formula: Accounting profit = total revenue total explicit cost
3 Economic profit, on the other hand, is total revenue minus explicit and implicit costs. Instead of accounting profits, economists use the concept of economic profits because economic decisions involve explicit as well as implicit costs. It is expressed in the formula: Economic profits = total revenue total opportunity costs, or Economic profits = total revenue (explicit costs + implicit costs) Exhibit 6.1. Comparison of Economic Profit and Accounting Profit ITEM ACCOUNTING ECONOMIC
PROFIT PROFIT Total revenue Php 400,000 Php 400,000 Less explicit costs: Salaries and wages 300,000 300,000 Supplies and materials 30,000 30,000 Interests expense 6,000 6,000 Miscellaneous Exp. 4,000 4,000 Less implicit costs: Foregone salary 0 40,000 Foregone rent 0 12,000 Foregone interest 0 4,000 Profit Php 60,000 Php 4,000 Reference: Tucker, Irvin B. (2008). Economics for Today, USA: Thomson South-Western, 164. COSTS, PROFITS, AND REVENUE At production level q, profits constitute the revenue, R(q) minus costs, C(q): (q) = R(q) C(q) On the other hand, revenue is simply price times quantity, R(q) = p(q) (Economides, 2010).
COST OF PRODUCTION Cost and production decisions are distinguished by economists between the short-run and the long-run. However, for economists, shortrun and long-run do not refer to number of days or months or years. Instead, they refer to the ability to vary the quantity of inputs or resources used in production (Tucker, 2008, 165). Exhibit 6.2. Total Reven
Economic Profits
ue
Economic Implicit Costs Costs
Accounting Profits
Accounting Costs Explicit Costs Explicit Costs
Short-run refers to a period that is too short or too brief for some inputs to be varied. A firm cannot secure equipment in a day or two nor make immediate alteration on the size of its plant. Long-run refers to a period during which a firm can make adjustments on all its inputs. Note that in the long-run, all inputs are variable. They change as output changes. TWO TYPES OF INPUTS
5 Fixed inputs are resources the quantity of which cannot be changed in the short-run. They do not change with output. An example of fixed inputs is heavy machineries, the production capacity of which cannot be changed in a short period of time. Another example is the size of the plant. Variable inputs are resources for which the quantity can change during the period of time under consideration (Tucker, 2008, 165). PRODUCTION FUNCTION N. Gregory Mankiw states that the production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. It is the relationship between the maximum amount of outputs a firm can produce at various quantities of inputs. In Exhibit 6.3, assume that technology and factors of production, except labor, are held constant and that labor is the only input where the skills of workers are the same. Exhibit 6.3 below shows the concept of production function, marginal productivity, and total output. MARGINAL PRODUCT As more inputs are applied, at any given additional unit of input there will be an increase in output. This additional output arising from each unit of additional input is the marginal product of labor (MPL) defined by the formula: MPL = Q/L Exhibit 6.3. Total, Marginal, and Average Products of Labor Exhibit 6.4. Total, Marginal, and Average Product Curves
Quantity of Labor 1 worker 2 3 4 5 6 7 8 9 Total Product 10baskets 25 45 60 70 75 77 77 75 Marginal Product of Labor 10 baskets per worker 15 20 15 10 5 2 0 -2 Average Product of
Labor 10 baskets per worker 12.50 15 15 14 12.5 11 9.62 8.33
6 a) Total Product Curve
Total product
80 75 70 65 60 55 50 45 40 35 30 25 20 15 10 5 0
Labor per day
b) Marginal Product and Average Product Curves
7
per Marginal produce
25
(units day)
Increasing MR
Decreasing but positive MR
20 15
Average Product Marginal Product

Negative MR
10
(MP)
0 1 2 3 4 5 6 7 8 9
Labor per day
Exhibits 6.3 and 6.4a and 6.4b, with the first three workers the firm experienced an increasing marginal returns. From the 4th worker the law of diminishing marginal returns came into effect as each additional worker contributed less than the one it followed until on the 9th worker the contribution is negative. The law of diminishing marginal returns states that the extra production obtained from increases in a variable input will eventually decline as more of the variable input is used together with the fixed inputs (Hyman, 1994). Total product (TP) is the quantity of output a firm produces in a given time period. As can be seen from the above exhibit, it depends upon
8 the number of laborers (inputs) the firm takes in subject to the law of diminishing marginal returns. Average product is the total product divided by the number or workers (inputs). THE AVERAGE-MARGINAL RULE OF PRODUCTION The average-marginal rule shows the relationship between the average product and marginal product (Exhibit 6.3). 1. When the marginal product of a laborer (an input) is greater than the average product, adding that laborer (input) increases the average product. 2. When the marginal product of a laborer (an input) is less than the average product, adding that laborer (input) causes the average product to fall. MEASURES OF COSTS Production costs are divided into fixed costs and variable costs (Mankiw). Fixed Costs, sometimes called set up costs are costs which do not vary with the level of production. These are the costs that must be paid even if there is no output. Among these are property taxes, rent, insurance, and interest on loans. Variable costs are the costs that vary with the level of output or production. These costs are not incurred when there is no production. Among these are raw materials, wages of workers, and electricity.
SHORT-RUN COSTS Total cost is the sum of the total variable cost and fixed cost at every level of output. It is defined by the formula:
9 TC =TFC + TVC Average cost is the cost of each unit of product. It is obtained or determined by dividing the total cost (whether fixed cost or variable cost) by the number of units of output. Thus Average fixed cost: AFC = TFC/Q, Average variable cost: AVC = TVC/Q Average total cost: ATC = TC/Q Marginal Costs or Incremental Costs (MC) is the measure of the increase in total cost arising from an extra unit of production. It is the cost associated with the last unit of product of an activity. It is derived by the formula MC = Change in Total Cost/Change in Quantity = TC/Q. Extra production does not affect fixed cost, therefore the increase in total cost is equal to or the same as the increase in variable cost, such that MC = TC/Q = TVC/Q MARGINAL-AVERAGE RULE OF COST The marginal-average rule states that when marginal cost is below average cost, average cost falls. When marginal cost is above average cost, average cost rises (Tucker, 2008, 173). This rule which applies to any average figure such as grades and weights is shown in the intersection of the marginal cost (MC) curve with the AVC curve and the ATC curve at their minimum points. Exhibit 6.5 shows the cost schedule of a theoretical firm while Exhibit 6.6 shows its total cost, total variable cost, fixed cost, and marginal cost curves.
10 Exhibit 6.5. Short-Run Cost Schedule.

(1) Total Product (Units hour (Q) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 (TFC) 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 per (2) Total Fixed Cost (3) Total Variabl e Cost (TVC) 0 1.00 1.80 2.40 2.80 3.20 3.80 4.60 5.60 6.80 8.20 9.80 11.60 13.60 (TC) 2.00 3.00 0.80 3.80 0.60 4.40 0.40 4.80 0.40 5.20 0.60 5.80 0.80 6.60 1.00 7.60 1.20 8.80 1.40 10.20 1.60 11.80 1.80 13.60 2.00 15.60 2.20 14 2.00 15.80 17.80 0.14 1.13 1.27 Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub. 0.15 1.05 1.20 0.17 0.97 1.13 0.18 0.89 1.07 0.20 0.82 1.02 0.22 0.75 0.98 0.25 0.7 0.95 0.29 0.66 0.94 0.33 0.63 0.96 0.40 0.64 1.04 0.50 0.70 1.20 0.67 0.80 1.47 1.00 0.90 1.90 (MC) 1.00 (AFC) 2.00 (4) Total Cost (5) Marginal Cost (6) Average Fixed Cost (7) Averag e Variabl e Cost (AVC) 1.00 (ATC) 3.00 (8) Average Total Cost
Exhibit 6.6. Total Cost, Total Variable Cost, Fixed Cost, and Marginal Cost Curves.
11
Cost per unit
18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
per
unit
TC TVC
M C
9 10 11 12
1 3
FC 14
Product per unit (Quantity)
12 RELATIONSHIP BETWEEN MARGINAL COSTS AND AVERAGE COSTS Exhibit 6.7 shows the relationships of the different measures of cost where the following can be observed (Mankiw). 1. At first the marginal cost curve (MC) declines and will subsequently goes up at a certain point and intersect the average total cost and the average variable cost curves at their minimum points. 2. The average variable cost (AVC) curve will go down not as steep as the marginal cost curve and then will rise. This will not go up as fast and as steep as the marginal cost curve. 3. As additional units of output are produced, the average fixed cost (AFC) curve will decline with each unit produced. 4. The average total cost (ATC) curve will initially decline as fixed costs are spread over a larger number of units. It will go up subsequently as marginal costs increase due to the law of diminishing returns. Exhibit 6.7. Relationship Between Marginal Costs And Average Costs. 2.40
2.20 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20
13 RELATIONS
MC
ATC
AVC
Marginal Product
Units per hour
AFC
0 12
1 13
10
11
OUTPUT (Units per period of time)
HIP BETWEEN MARGINAL PRODUCT AND MARGINAL COST

Marginal Cost
A definite relationship exists Marginal Product (MP) cost and marginal between marginal product. Assuming that labor is the only variable input, as a firm adds more workers, the marginal product of that labor will tend to rise. This rising 0 Number of Workers marginal product will result to a decreasing marginal cost because each additional worker will add more to the total product than the previous worker (Sexton).
Marginal Cost (MC)
Exhibit 6.8.Relationship Between Marginal Cost and Marginal Product.
(Pesos)
Quantity of Output
14
When the marginal product begins to decline, marginal cost begins to rise because each additional worker will add less to the total output than the previous worker. This inverse relationship between marginal product and marginal cost is shown in Exhibit 6.8. Ceteris paribus, as the marginal product (MP) curve rises, the marginal cost (MC) curve falls. As the MP curve reaches its maximum, MC curve is at its minimum. When diminishing marginal returns sets in the MP curve falls and the MC curve rises. LONG-RUN COSTS Long-run, for a firm, is a period during which all quantities of resources utilized (inputs) in production, including plant capacity, can be adjusted. It is thus a period during which all inputs, the choice of input combinations, are
15 variable or flexible. It is, therefore, a period where no resource or costs are fixed (Tucker). Long-run Average Total Cost Long-run operation results from a firms successful operation and expanding larger plant sizes with larger output capacities. As shown in exhibit 6.9, the adjustment of the firm, from a single plant size to varying plant sizes in the long-run reflects the average total cost curve (ATC). Exhibit 6.9 shows the short-run plant sizes. The long-run average cost (LRAC) curve shows the lowest average short-run average total cost (SRATC) at which any output can be produced after the firm was able to make all necessary adjustments in plant size. By connecting the points on the shortrun average cost curves representing the lowest per unit cost for each output level, a long run average cost curve can be created . In Exhibit 6.10 the long-run average total cost (LRATC) curve is a smooth curve representing large possible plant sizes. The resulting long-run average cost curve is called the planning curve, or envelope curve of the firm (McConnell et al).
Exhibit 6.9. Short-run Average Total Cost Curve in Five possible Plant Sizes
16
Average total cost (pesos)
12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 SRATC SRATC SRATC

1 2 3 4 5
SRATC
SRATC
Quantity of output per period Exhibit 6.10. Long-Run Average Cost Curve In An Unlimited Number Of Plant Sizes
17
Cost per unit (pesos)

12 Short-run average total cost curves 10 8 6 4 2 Long-run curve 2 4 6 8 10 12 14 16 average cost 0
Quantity of output per period Economies of Scale While in the short-run, ATC is primarily determined by the law of diminishing marginal returns, presuming one resources as fixed in supply, in the long-run all resource inputs are variable. As the size of a plant increases and output expands, average cost of production decreases. The firm, thus,
18 experiences economies of scale or economies of mass production.
Economies of scale exists when the long-run average total cost declines as output increases (Exhibit 6.11). Exhibit 6.11.
Cost per unit (Pesos)
Increasing returns to scale (Economies of Scale)
Decreasing returns to scale (Diseconomies of scale)
Constant returns to scale 0 Q1 Q2
Quantity of output
Reference: Tucker, Irvin B. (2008). Economics for Today, USA: Thomson SouthWestern, 17
Constant Returns to Scale (CRS) Returns to scale is constant when a certain increase in input produces the same increase in output. In this, the marginal cost is equal to
19 average cost. The same amount of labor needs to be put in for every unit, particularly in handmade products (Economides). Decreasing Returns to Scale (DRS) Decreasing returns to scale is a production function where increasing input by a certain amount results to a lesser amount of output. This is usually the case in traditional manufacturing where initially, the incremental costs decreases but later on increases (Economides). NOTE: Diminishing marginal product or diminishing marginal returns should not be confused with decreasing returns to scale. The concepts are different in two ways: 1. Diminishing marginal returns (DMR) is a short-run concept which describes the effect on output when one input is increased, ceteris paribus. Decreasing returns to scale (DRS) is a long-term concept. It describes the effect on output when all inputs are increased in the same proportion. 2. Diminishing marginal returns (DMR) deals with marginal quantities and decreasing returns to scale (DRS) deals with total and average quantities (Lansburg, 166).
20 STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus). 1. Define cost and cite some examples. 2. When are explicit costs incurred? 3. When are implicit costs incurred? 4. Differentiate accounting profits and economic profits. 5. Explain the short-run and long-run concept of production. 6. Give examples of fixed inputs and variable inputs. Why are they classified as such? 7. Explain the concept of marginal product and give an example. 8. Explain the relationship between total product, marginal product and average product. 9. What causes marginal product to decline as more and more of a given input is added into the production process? 10. Explain the different categories or kinds of costs and give examples. 11. Explain and illustrate the marginal average rule of costs. 12. 13. Explain the relationship between marginal cost and marginal Differentiate economies of scale, constant returns to scale, and product. diseconomies of scale. 14. Differentiate diminishing marginal returns and decreasing returns to scale.
21 TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the statement is false. Assume that other things are held constant. If your answer is false, explain why. ____ 1. When we acquire and pay for resources purchased or secured from others the payment represents the possible earnings they will earn had they used the resources for other endeavor. The payment we make in this case is for ____ 2. ____ 3. ____ 4. ____ 5. ____ 6. opportunity cost. Payment for laborers, utilities, supplies and materials that go into production is implicit cost. An engineer who gives up his salary in order to engage in business incurs an implicit cost. No money outlay is necessary for the payment of explicit costs. Profits derived from the difference between explicit costs and total revenue are accounting profits. During certain short-term periods of production some
resources are either increased or decreased. These inputs ____ 7. ____ 8. are called variable inputs. The period in production that is too short to vary some production inputs is called the short-term period. Assuming that labor is the only input, by dividing change in quantity byt the change in labor will give us the marginal ____ 9. ____ 1 0. ____ 1 1. ____ 1 2. ____ 1 3. productivity of labor. At the point where total revenue begins to decrease, average product is zero. Profits which cover both explicit and implicit costs are accounting profits. Marginal product declines or decreases faster than average product. The period when all inputs, whether variable or fixed input, are variable is the short-term period. Assuming that labor is the only input, when the marginal product is less than the average product, an additional unit
22 of labor will cause the average product curve to rise. When the average cost is higher than the marginal cost the average cost will fall. When the marginal cost is above average cost average cost will rise. Economies of scale exists when the long-run average total cost declines as output increases When an increase input results to a decrease in output the firm experiences an increasing returns to scale. Diminishing marginal product means decreasing returns to scale. In the manufacture of hand-made products the same amount of labor is put into the production of every unit. This is an example of a constant returns to scale. Economies of scale is economies of mass production.
____ 1 4. ____ 1 5. ____ 1 6. ____ 1 7. ____ 1 8. ____ 1 9. ____ 2 0.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that complete each statement. Assume that all other things are held constant. _______________ 1. When a business firm pay others or outsiders for inputs secured or purchased from the latter, such _______________ 2. payments are called __________ costs. The cost for which there are no cash disbursements in the present or in the future but are nevertheless incurred because of missed opportunity to use them for other alternative economic choices are _______________ _______________ _______________ _______________ _______________ 3. 4. 5. 6. 7. called __________ costs. Profit over and above explicit and implicit costs is __________. Profit over and above explicit cost is __________. Building, plants, machinery are __________ inputs. Raw materials and supplies are __________ inputs. When more and more inputs are put into production, the output for every unit of additional
23 input is called __________. The law of __________ exhibits the decreasing output for every additional variable output added with the _______________ 9. fixed input in production. The relationship between the marginal product and marginal cost is the basis for the __________ _______________ _______________ relationship between the two. 10 Set-up costs do not vary with production. They are . called __________ costs. 11 There are costs that are not incurred when there is . _______________ _______________ _______________ _______________ _______________ no production. They rise or fall with the level of production. These are __________ costs. 12 At every level of production, the sum of the variable . cost and fixed cost is __________ cost. 13 The increase total cost associated with an
_______________
8.
. additional unit of production is __________ cost. 14 By dividing change in total cost by change in . quantity, __________ cost is obtained. 15 The relationship between marginal cost and
. average cost is the basis for the __________ rule. 16 As marginal cost increases marginal product . __________.
24
ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris paribus). 1. Hypothetical table of production and costs. Quantity of labor (Q L) and QL 0 1 2 3 4 5 Q/day 6 12 16 19 21 FC 400 VC 120 210 358 TC 610 686 758 MC 20 15 24 25 Production (Q/day) are in units. Costs are in pesos.
a. Fill the blank boxes on the table with the correct amounts. b. What is the marginal cost for the 3rd unit of labor? c. What is the average total cost when the output is 21 units? d. Graph the FC, VC, TC, and MC. 2. Romeo rented a stall in front of SPCT for Php72,000 annually to put up an internet shop and offer other computer services. He hired an assistant for Php36,000 a year. He spends Php60,000 a year for utilities, supplies and materials, and other miscellaneous expenses. He turned down a job offer that will pay him Php60,000 a year as computer programmer. He estimates his talent to be Php12,000 a year. He expects an annual revenue of Php185,000. Compute for the accounting profit and accounting profit of Romeo.
25
26
PART 2. MARKET STRUCTURES, PRICING, AND, MARKET POWER

CHAPTER VII. PERFECT COMPETITION OBJECTIVES This lesson which explores the perfectly competitive market will enable the student to 1. 2. 3. 4. Understand and explain the features that determine the classification markets. Enumerate and discuss the characteristics of a perfectly competitive market. Evaluate how a perfectly competitive firm can generate revenue and maximize profits. Evaluate how a perfectly competitive firm can minimize losses, when to shut down or exit from the industry. TOPICS FOR DISCUSSION 1. 2. 3. 4. 5. 6. 7. 8. Market structures Price taker Marginal revenue Golden rule of profit maximization Loss minimization Firms short-run supply curve Competition and efficiency Producer surplus. Perfectly competitive market Profit maximization Exit point Price taker Zero economic profit
KEY WORDS AND TERMS Industry Revenue Shutdown point
27 INDUSTRY AND MARKET An industry is a collection of firms, all firms, supplying products or output to a particular market, such as the lumber market, oil market, grains market. The terms market and industry are used interchangeably (McEachern). MARKET STRUCTURE Market structure refers to the features that characterize a market (McEachern). Among these are 1. The number of firms. (Many or few?) 2. The degree of uniformity of their products? (Are their products similar (uniform) or different?) 3. The ease of entry into the market (Is there free or easy entry? Is entry blocked by natural or artificial, such as government imposed barriers?) 4. The forms or types of competition among the firms in industry or market. (Does competition among the firms involve only pricing? Are there other means of competition such as advertising, branding, product differentiation?) PERFECTLY COMPETITIVE MARKET A perfectly competitive market is a market structure with the following characteristics (Sexton): There are many sellers and buyers in the market. Each buyer or seller buys or sells only a fraction of the amount of goods sold or exchanged in the market. Products produced by the firms and sold in the market are standardized (homogeneous). Buyers and sellers are fully informed about the prevailing prices and availability of the products.
28 Firms can enter into or exit from the market freely. There are no artificial or natural barriers and no obstacles to exit. As a result of its characteristics, the perfectly competitive market has the following outcomes (Sexton): A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. No single seller or buyer can significantly influence the price. The market price is considered by every buyer and seller as a given factor. Buyers and sellers must accept the price determined by the market. Exhibit 7.1. A Firms Demand Curve and Market Equilibrium in Perfect Competition.
29
Price per unit
a. Firms demand
b. Market equilibrium S D
P10
Quantity period
per
100,000 Quantity per period
DEMAND UNDER PERFECT COMPETITION 1. Under a perfectly competitive market, price is determined by the equilibrium of the market price and quantity. At this point, a firm can sell as much of the good as he wants (Sexton). 2. Since the firms demand curve is horizontal, perfectly elastic, it cannot charge a price higher than the market price. Otherwise, buyers will go to other suppliers who are selling identical products (Exhibit 7.1a and Exhibit 7.1b). 3. It is for that reason that a firm in a perfectly competitive market is called a price taker.
30 It is usually said that In perfect competition there is no competition. That is because although firms are selling identical product, each of them supplies only an insignificant amount in the market, insufficient to influence the market. REVENUE OF A COMPETITIVE FIRM Total revenue for a competitive firm is derived by multiplying the selling price by the quantity sold. TR = (P Q) Therefore, total revenue is proportional to the amount of output. Average revenue is the amount of revenue that a firm receives from each unit sold. Average revenue is derived by dividing total revenue by the quantity sold. Therefore average revenue in a perfect competition equals the price of the good.
31
T o t a nl ur e v e e r va eg ne= u R e e Q u a n t i t y = P r i cQ e u a n t i t y Q u a n t i t y r i c e
= P
Marginal revenue is the change in total revenue derived from the sale of an additional unit. It is derived from the formula: = TR/ Q Marginal revenue is the price of the good sold by a competitive firm. Exhibit 7.2. Competitive Firms Total, Average, and Marginal Revenue Quantity (units) 1 2 8 8 Price Total Revenue (TR = PxQ) 8 16 Average Revenue (AR = TR/Q 8 8 Marginal Revenue (MR = TR/Q) 8 8 MR
32 3 4 5 6 7 8 8 8 8 8 8 8 24 32 40 48 56 64 8 8 8 8 8 8 8 8 8 8 8 8
PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE 1. 2. Profit maximization is the objective or goal of a competitive firm. It is concerned with the production of the quantity from which it gets the maximum difference between total revenue and total cost (Total revenue minus total cost). Exhibits 7.3 show an example of schedule showing the short-run costs, revenue, and profit in a profit maximizing firm. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE Another way of maximizing profit is through the golden rule of profit maximization. Profit maximization is attained at the quantity where marginal revenue is equal to marginal cost (Exhibit 7.4). At this level of output, they are getting what economists call the normal rate of return on the resources they invested on the firm. Such profit-maximizing output generates zero economic profit because it does not provide for the opportunity cost (Sexton, 2003, 209). Exhibit 7.3. Profit Maximization: Short-run Costs, Revenue and Profit.
Quantity (units) (Q) Marginal Revenue (MR = TR/Q) Total Revenue (TR) Total Cost (TC) Marginal Cost (MC = (TC/Q Average Total Cost (ATC= TC/Q Profit (or Loss) (TR TC)
0 1 2 3
8 8 8
8 16 24
4 6 9 13
2 3 4
6 4.5 4.33
-4 2 7 11
33 4 5 6 7 8 8 8 8 8 8 32 40 48 56 64 18 24 31 39 48 5 6 7 8 9 4.5 4.8 5.17 5.57 6 14 16 17 17 16
Exhibit 7.4. Profit Maximization. Revenue and Average Costs Curves.

Costs And Revenue
Profit
maximizing
MC
quantity (MC = MR)
MC2 P MC1
ATC P=AR=M AVC R
1 HOW A FIRM CAN MAXIMIZE MAX PROFIT 2
Q Q
Quantity
When marginal revenue is greater than marginal cost (MR > MC) quantity should be increased. When marginal revenue is less than marginal cost (MR < MC)quantity should be decreased. When marginal revenue equals marginal cost (MR = MC) profit is maximized. From the foregoing, it can be seen that to attain maximized profits, a firms supply curve should be identical to the part of the marginal cost curve that lie above the average cost curve as shown in Exhibit 7.5 (Mankiw, 2003). Exhibit 7.5. Marginal Cost is the Competitive Firms Supply Curve
34
Price
Competitive firms curve supply

MC
P2 P1
ATC
AVC
Q
1
Q2
Quantit y
Short-Run Profits And Losses In order to determine the viability of going on with the operation, a firm has to determine if it is generating economic profits, economic loses, or zero economic profits. It has to be noted that the cost curves include not only the explicit costs but also the implicit costs. Economic Profit A firm is generating economic profits if the total revenue (TR) is greater than total costs at a certain quantity of output (q): TR > TC (Sexton,2005). In contrast with profit-maximizing output where the firm derives zero economic profits (MR = MC), to attain economic profit, the price should be more than the average total cost (P > ATC)
Price
at a certain level of output Q (Exhibit 7.6). MC
P > ATC Profit Exhibit 7.6. Economic at Q (Profit-Maximizing Output)

ATC P=AR=M R
P ATC
Total Profit
Quantity
35
Economic Loss (Loss-Minimizing Output) A firm incurs economic losses when total revenue (TR) is less than total cost(TC) at a given output Q (TR < TC). In this situation, price is less than the average total cost at that given output Q (P < ATC) (Sexton, 2005). However, to minimize the losses, the firm should produce at a level of output where the price equals marginal cost such that P = MR = AR (Exhibit 7.7).
Exhibit 7.7. Economic Loss (Loss-Minimizing Output)
Price
MC
P < ATC at Q
ATC P=AR=M Total Loss R
ATC P
Quantity
36
Exhibit 7.8. Zero Economic Profit Price P = ATC at Q MC
ATC P = ATC P=AR=MR
0 Zero Economic Profit
Quantity
A firm is generating zero economic profits if it is not able to cover the implicit costs, the opportunity cost. Recall that opportunity cost is the highest or foregone opportunity resulting from a decision (Sexton, 2005, 29). For a firm operating at a level where it generates zero economic profit, the price is just equal to average total cost (P = ATC) at that level of output (Exhibit 7.8 and Exhibit 7.6). It is able to recover accounting costs but not opportunity costs. SHUT DOWN AND EXIT POINTS IN THE SHORT RUN Losses Short of Shutting Down A shutdown is a short-run decision during a certain period when a firm should not produce anything because of prevailing market conditions. If each unit produced cannot cover the variable cost per unit because the price is below the minimum point on the average
37 variable cost curve (AVC) continuing the operation will increase the firms losses. It will be better for the firm to shut down and produce zero output. While hoping for higher prices in the near future it can keep its plant, pay fixed cost (Tucker, 2008). In a shutdown decision, the fixed costs do not figure because the firm pays for them whether it operates or not. However, if the price is higher than the average variable cost, it is still better to operate. Thus, a firm may operate if TR TC > FC Substituting TC = FC VC: TR (FC VC) > FC Therefore: TR > VC Since TR = P x Q, P x Q > VC By dividing each side of the equation by Q, P = AVC. In this situation the firm should decide against shutting down (Exhibit 7.9) because it can afford to pay the variable cost and the point of shutting down is precisely to avoid paying variable costs (Lansburg, 2005). On the contrary however, Sexton states that to decide against shutting down while incurring some losses, the price should be higher than average variable cost (P > AVC)and lower than average total cost (P < ATC). P = AVC. Firm does Exhibit 7.9. Short-run Losses Short of Shutting Down not shutdown
Price ATC
MC
AVC
P = MR =AR 0
Quantity
38
Shutdown Point On the other hand, a firm may decide to shut down (Exhibit 7.10) if the revenue it gets from producing is less than the variable cost of production (Mankiw, 2003): if TR < VC if TR/Q < VC/Q P < AVC In this situation (Exhibit 7.10), the price at all levels of output is less than the average cost. It is therefore necessary that the firm shuts down to cut its losses.
Exhibit 7.10. Short-Run Losses and Shutdown Point Price

P < AVC. Firm has to shut down. Short-run supply MC
curve
ATC AVC
P = MR = AR Shutdown Point
Quantity
39
LONG-RUN EXIT POINT Exit is a long-run decision to leave the market. When a firm incurs negative economic profits, it has to exit the industry. This is because it is unable to recover accounting costs as well as opportunity costs (Sexton). Sunk costs are costs that have been incurred and can never be recovered. Thus, they are not considered; they are irrelevant in making decisions (McEachern). Thus a firm will decide to exit when TR < TC TR/Q < TC/Q P < ATC In the long-run, a firm will enter the industry if TR > TC TR/Q > TC/Q P > ATC Exhibit 7.11. A Competitive Firms Long-Run Supply Curve
Costs
When P>ATC firm enter a the may
Long
run
MC
supply curve
Along portion where P<ATC
the
industry.
ATC
firm will exit the industry.

0
Quantity
40
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
The competitive firms long-run supply curve (Exhibit 7.11) is the portion of its marginal-cost curve that lies above average total cost. Note that in the short-run, a competitive firms supply curve is the portion of the marginal-cost curve that lies above average variable cost curve (Exhibit 7.10) (Mankiw, 2003). THE SUPPLY CURVE IN A COMPETITIVE MARKET The short-run supply curve in a competitive market is the summation of individual firms supply curves in the market (Exhibit 7.12). It is the portion of the firms marginal costs (MC) above the average variable costs (AVC). (Sexton, 2005, 211-212) The long-run supply curve is the portion of the marginal cost (MC) curve above the minimum point of its average total cost (ATC) curve (Exhibit 7.11).
Exhibit 7.12. Market Supply in a Competitive Market Price MC Supply
Price
P2 P1 10 20 Quantity(firm )
P2 P1 100 20 0 Quantity(mrket) a
41
Exhibit 7.13a. An Increase in Demand in the Short Run and Long Run FIRM MC ATC A P1 Demand D1 Quantity(firm ) Q1 Quantity(mrket) a Short run supply, S1 MARKET
Price
Price
Long-run Supply
42
Exhibit 7.13a shows a theoretical initial condition of a firm operating in a market. Its ATC is equal to price, thus, is operating at a profit-maximizing output (See also Exhibit 7.6). An increase in demand (Exhibit 7.13b) generates an increase in price. Exhibit 7.13b Short-run Response
Price Profit P2 P1
MC ATC S1
Price
P2
A
P1 D1 Quantity(firm )
Long-run supply D2
Quantity(mrket) Q1 a Q2 Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College
Pub.
As the information about the profitability of the theoretical firm gets out, more suppliers will respond by entering the market thereby increasing the supply or shifting the supply curve to the right as shown in Exhibit 7.13c. Exhibit 7.13c Long-run Response Price Profit P2 P1 MC ATC S1 P2 P1
D1
Price
S2 Long-run supply
D2
Quantity(firm ))
Q1
Q2
Quantity(mrket) a
43
If the supply response pushes the price of the commodity down, the firm will revert to the situation (Exhibit 7.13a) where he will be making zero economic profit (P1 = ATC) from markets short-run response (Exhibit 7.13b) where he was producing profit-maximizing output and making economic profit (P2 > ATC) THE COMPETITIVE FIRMS LONG-RUN EQUILIBRIUM Exhibit 7.14. Long-Run Competitive Equilibrium.
SRATC MC LRATC P e P = MR = AR
Note that the long-run average total cost and the short-run average total cost are equal at the equilibrium point e where marginal cost (MC) equals marginal revenue (MR). The equilibrium point is at the lowest point on the average total cost curve. This is because the marginal
44 cost (MC) curve must intersect the average total cost (ATC) curve at the lowest point of the latter (Exhibit 7.13a). This point (equilibrium) in the long-run requires each firm to produce at an output level that keeps the average total cost at a minimum or what is called minimum efficient scale. At this point, there is no incentive for new firms to enter the industry and no existing firm has the inducement to exit. (Sexton, 2005).
45 STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus). 1. Enumerate the characteristics of a market structure. 2. Enumerate and explain the characteristics of a perfectly competitive market. 3. Explain why a seller in a perfectly competitive market is a price taker. 4. Why is it not possible for a firm in a perfectly competitive market to charge a price other than the market price? 5. Explain and illustrate the golden rule of profit maximization. 6. 7. 8. When should a firm in a perfectly competitive market increase its When should a firm in a perfectly competitive market decrease its Explain how a firm in a perfectly competitive market can generate output in relation to marginal cost and marginal revenue? output in relation to marginal cost and marginal revenue? economic profit. 9. How can a firm in a perfectly competitive market minimize its losses? Illustrate your answer. 10. At what point in its operation should a firm in a perfectly competitive market shut down? 11. At what point in its operation should a firm in a perfectly competitive market exit the industry or market? 12.Explain the concept of minimum efficient scale.
46
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the statement is false. Assume that other things are held constant. If your answer is false, explain why. ____ 1. A group of firms supplying the same products and/or services to a particular market is an industry. Therefore, the term industry cannot be used to signify a market. ____ 2. A market where there are many sellers and the price is considered as a given factor by both sellers and sellers is a ____ 3. perfectly competitive market. No single seller or buyer can influence the price in a perfectly competitive market. ____ 4. The individual demand for the product of a firm in a perfectly competitive market is perfectly elastic. ____ ____ ____ ____ 5. 6. 7. 8. The demand for the product in a perfectly competitive market is inelastic. Products in a perfectly competitive market are homogeneous. The marginal revenue is the price of the good sold by a competitive firm. When marginal revenue is equal to marginal cost in a competitive firm, it is getting or earning normal rate of return ____ 9. but not economic profit. When a firm earns a normal rate of return it is able to recover only what it invests in the business. ____ 10. When the marginal revenue of a competitive firm is more than its marginal cost, it must decrease its production. ____ 11. When the marginal revenue of a competitive firm is less than marginal cost its output should be decreased.
47 ____ 12. To be able to attain economic profit, a competitive firms price for the product should be more than its average total cost ____ 13. (ATC). When the total revenue (TR) is less than total cost (TC) or the price is less than the average total cost (ATC) the firm is ____ 14. incurring economic loss. It is better for the firm to shut down than to operate when the price is below the lowest point on the average cost curve. ____ 15. In a shut down decision, fixed costs should also be taken into consideration because they are incurred whether they operate ____ 16. or not. When a firm is not able to recover economic costs and implicit costs, it has to exit the industry. ____ 17. A competitive firm may earn incur profit in the short-run. In the long run, as other firms get to know about it they contribute to the increase in supply bringing back the original firm to its ____ 18. previous situation. To be able to achieve maximum efficient scale in the long-run, a competitive firm must produce at the point where the marginal cost (MC) intersects the average total cost (ATC) at its lowest point. FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that complete each statement. Assume that all other things are held constant. _______________ _______________ _______________ 1. 2. 3. A group of firms supplying products to a market of a specific commodity is a/an __________. In a perfectly competitive market products are standardized or _________. Since the price in a perfectly competitive market is considered by both sellers and buyers as a given factor, such buyers and sellers are __________
48 takers. Price in
_______________
4.
perfectly
competitive
market
is
determined by the __________ of the market price _______________ 5. and quantity. The demand curve of a firm in a perfectly competitive market is __________ due to the price _______________ 6. elasticity of the demand. Price times quantity equals competitive market. _______________ _______________ _______________ 7. 8. 9. Total revenue divided by quantity or price times quantity divided by quantity is equal to __________ or __________ The production quantity where marginal revenue is equal to marginal cost is the means by which a competitive firm can maximize profit. This is the __________ of profit maximization for a firm under _______________ perfectly competitive market. 10 __________ does not include economic profit because . _______________ _______________ _______________ _______________ _______________ this just represents the recovery of the resources invested in the firm. 11 When marginal cost is more than marginal revenue, . quantity sold should be __________. 12 When marginal revenue is less than marginal cost, . quantity sold should be __________. 13 When marginal cost is less than marginal revenue . quantity produced or sold should be__________. 14 When marginal revenue is more than marginal cost, . quantity sold or produced should be __________. 15 A shut down decision is another way of waiting for . better market conditions and better prices in the future. Output is zero but the firm has to pay for _______________ __________ costs. 16 When the total revenue from production is less than . the variable cost of production it is better to _________ in a
49 __________. 17 When the firm is unable to recover both accounting . and implicit costs it should __________. 18 There is no incentive for new firms to enter the . industry and no existing firm has he motivation to exit when the output level keeps the total average cost at a minimum. This is the __________.
_______________ _______________
50
51 ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris paribus). 1. Cost data in the short-run for a perfectly competitive firm (in pesos). Total Output (Q) (units) 1 2 3 4 5 a. Total Fixed Cost (TFC) 200 200 200 200 200 Variable Cost (TVC) 240 400 580 860 1,180 Total Cost (TC) Total Revenue (TR) PROFIT
To maximize profit in the short-run, how many units must the firm
produce at the price of Php300.00? b. How many units of output should the firm produce to break even? c. Fill the blank boxes on the table and specify the economic profit or loss. 2. A short-run graph for a perfectly competitive firm. ATC
Price per unit
MC AVC MR3 MR2 MR1 Units of output per hour
52 a. With MR3 as the firms demand curve, does the firm incur a loss or earn and economic profit? b. Indicate or identify the firms short-run supply curve. c. With which demand curve should the firm shut down?
53 CHAPTER VIII. MONOPOLY OBJECTIVES: After taking this lesson the student will understand and be able to 1. 2. 3. 4. 5. 6. 7. 1. 2. 3. 4. 5. Explain the characteristics of a monopoly. Compare monopoly with a perfectly competitive firm. Discuss monopoly pricing and its profit maximization. Appreciate and explain the justification and impact of patents and copyrights on consumers, producers and the society. Analyze the arguments for and against monopoly. Analyze and evaluate monopoly practices and their impact on consumers and society. Explain government policies governing monopolies. Barriers to entry Price elasticity and marginal revenue Economic profit in the short-run and in the long-run Welfare cost of monopoly Price discrimination Barriers to entry Price effect Price discrimination Natural monopoly Patent TOPICS FOR DISCUSSION
KEY WORDS AND TERMS Monopoly Output effect Copyright
MONOPOLY
54 When there is only one seller of a product that has no substitutes and there are natural and/or legal barriers to entry in the industry, there is a true or pure monopoly . Unlike firms in a perfectly competitive market which are price takers, monopolists are price makers that can and try to pick or set the price that will maximize their profits (Sexton). BARRIERS TO ENTRY Barriers to entry are the principal causes for the existence of monopoly (Tucker). These barriers are the results of 1. Government impositions that prevent the entry of other firms in the monopoly firms market. Among government impositions that give rise to monopolies are o Franchises o Licensing o Patents o Copyrights Government impose licenses, patents, copyrights and other restrictions to protect public interest. 2. Control or ownership of a key resource or the entire supply of an input resource. In practice, monopolies barely arise because of control or ownership of a resource. 3. Large scale operations which have cost advantages, such as economies of scale. NATURAL MONOPOLIES
55 When a single firm is capable of supplying a good or service to an entire market at a lower cost than two or more firms, the industry is a natural monopoly (Tucker). The presence of economies of scale over the relevant range of output gives rise to a natural monopoly. Exhibit 8.1. Economies of Scale: Cost Comparison of a Small and a Large Firm
Cost CSF
CLF
ATC
Quantity (small firm)
Quantity (large firm)
Exhibit 8.1 shows a large firm with economies of scale over a range of output with declining costs. The small firm has higher costs and thus will be driven out of the market resulting to a natural monopoly by the large firm (Sexton). MONOPOLY COMPARED WITH A COMPETITIVE FIRM (Mankiw) A monopoly (Exhibit 8.2b) o Is the sole producer of a product or service. o Is a price maker because it can dictate the price of its product o Reduces price to increase its sales
56 o Faces a downward-sloping demand curve Competitive Firm (Exhibit8.2a) o o o Is only one of many producers Is a price taker because it has no control over the market price Sells as much or as little at same price which is dictated by market forces such as supply and demand. o Faces a horizontal demand curve because demand is perfectly elastic and sensitive to even a slight change in price.
Exhibit 8.2. Demand Curves for Competitive and Monopoly Firms Price a) firm Competitive Price b)Monopoly
Demand
Demand
Quantity of Output REVENUE OF A MONOPOLY ( Exhibit 8.3 and 8.4)
Quantity of Output
Total Revenue of a monopoly is equal to price times the quantity: P Q = TR Its average revenue is equal to total revenue divided by quantity. Average revenue is also equal to its price. TR/Q = AR = P
57 A monopolys marginal revenue is derived by dividing the change in total revenue by the change in quantity: TR/Q = MR
Marginal Revenue of a Monopoly 1. The demand curve for the product of a monopoly is downward sloping because the demand curve for its products declines as more are placed on the market (McEachern). Exhibit 8.3. Revenues of a Monopoly
Price = Quantity (Q) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Ave. Revenue (P) 8.75 8.50 8.25 8.00 7.75 7.50 7.25 7.00 6.75 6.50 6.25 6.00 5.75 5.50 5.25 5.00 4.75 4.50 4.25 4.00 3.75 Total Revenue (TR = PxQ) 0.00 8.50 16.50 24.00 31.00 37.50 43.50 49.00 54.00 58.50 62.50 66.00 69.00 71.50 73.50 75.00 76.00 76.50 76.50 76.00 75.00 Average Revenue (AR = TR/Q) 0.00 8.50 8.25 8.00 7.75 7.50 7.25 7.00 6.75 6.50 6.25 6.00 5.75 5.50 5.25 5.00 4.75 4.50 4.25 4.00 3.75 Marginal Revenue (MR= TR/Q) 0.00 7.50 8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 -0.50 -1.00
2.
Dropping the price to sell one more unit, the revenue received from previously sold units also decreases.
58 3. The marginal revenue of a monopoly is always less than the price of its good, thus, the marginal revenue curve will always lie below the demand curve. 4. Increasing the amount a monopoly sells has two effects on total revenue (P Q): The output effect which results to more quantity sold or a higher Q The price effect which results to a reduction in price or a lower P. These effects of increasing the amount to be sold is due to the downward sloping demand for the monopolys products. Exhibit 8.4. A Monopolys Demand and Marginal Revenue Curve.
Pesos per unit
8.75
4.2 5 D = AR = P
34 0 Quantity per period 1 8

MR
59 Exhibit 8.5. Short-run Costs and Revenue for a Monopoly

Price = Quantity Ave. Revenue Total Revenue Margina l Revenu (Q) (P) (TR = PxQ) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 8.75 8.50 8.25 8.00 7.75 7.50 7.25 7.00 6.75 6.50 6.25 6.00 5.75 5.50 5.25 5.00 4.75 4.50 4.25 4.00 3.75 0.00 8.50 16.50 24.00 31.00 37.50 43.50 49.00 54.00 58.50 62.50 66.00 69.00 71.50 73.50 75.00 76.00 76.50 76.50 76.00 75.00 e (MR = TR/Q ) _ 7.50 8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 -0.50 -1.00 16.00 20.75 24.50 27.50 30.00 32.00 33.50 34.75 36.25 38.25 41.00 44.2 5 49.00 55.50 65.00 78.50 97.00 122.0 0 150.5 0 182.5 0 219.0 0 (TC) (MC = TC/Q) _ 4.75 3.75 3.00 2.50 2.00 1.50 1.25 1.50 2.00 2.75 3.25 4.75 6.50 9.50 13.5 18.5 25.00 28.50 32.00 36.50 (ATC = TC/Q _ 20.75 12.25 9.17 7.50 6.40 5.58 4.96 4.53 4.25 4.10 4.02 4.08 4.27 4.64 5.23 6.06 7.18 8.36 9.60 10.95 -16.00 -12.25 -8.00 -3.5 1.00 5.50 10.50 14.25 19.75 20.25 21.25 21.75 20.00 16.00 8.50 -3.50 -21.00 -45.50 -74.00 -106.00 -144.00 (TR-TC) Total Cost Marginal Cost Averag e Total Cost Total Profit or Loss
PROFIT MAXIMIZATION A monopoly maximizes profits in two ways, by the Total RevenueTotal Cost Method and the Marginal Revenue Equals Marginal Cost Method (Tucker).
60 1. Total revenue-total cost method. This is done by producing the quantity where the vertical distance between the total revenue curve and the total cost curve is widest (Exhibit 8.6). Exhibit 8.6. Profit Maximization: Total Revenue-Total Cost Method. T
Total revenue and total cost
C Maximu m Profit 66.00 44.2 5 Output: maximum profit 0 11 TR
24 Quantity of output per period
Exhibit 8.7. Profit Maximization: Marginal Revenue = Marginal Cost.
Peso per unit
MC 6.00 C AA B
4.02
ATC D = Marginal revenue MR
11
24
Quantity of output per period
61 2. Marginal Revenue = Marginal Cost Method. With this method, the firm produces the quantity where the marginal cost curve and the marginal revenue curve intersect. It then uses the demand curve to find the price and quantity that is higher than the average total cost curve Exhibit 8.6). In Exhibit 8.7 area ABCD represents the monopolys profit. LOSS MINIMIZATION A monopoly minimizes loss through the Marginal Revenue = Marginal Cost Method. Exhibit 8.8 shows how a monopoly whose demand (demand curve) lie below the average total cost (ATC) curve minimizes its losses. At the level of output where marginal revenue equals marginal cost and equals quantity demanded (MR = MC = Q) such that revenue is equal to price times quantity but more than average cost and less than average total costs (R = P x Q > AVC < ATC), the firm is able to minimizes its losses because it is able to pay for the VC and part of FC. Area ABCD represents the monopolys loss (Tucker). Exhibit 8.8. LOSS MINIMIZATION OF A MONOPOLY
Price and cost per unit
MC
C D
ATC
AVC
D 0
Quantity of output(units per time period)
MR Q
62
PROFIT MAXIMIZATION: MONOPOLY VS A COMPETITIVE FIRM A competitive firm maximizes profit when P = MR = MC (Exhibit 7.6 and 7.7). On the other hand, a monopoly maximizes profits when P > MR = MC. (Exhibit 8.6 and 8.7) A monopolys profit equals total revenue minus total costs as shown below (Mankiw). Profit = TR TC Profit = (TR/Q - TC/Q) Q Profit = (P - ATC) Q
The monopolist will receive economic profits as long as price is greater than average total cost (Exhibit 8.9). Exhibit 8.9. The Economic Profit of a Monopoly
Cost and Revenue Monopoly A Price Monopolys profit Average total cost
D C
ATC
MC
D MR
Maximum Q
Quantity
63
Exhibit 8.10. Patents: Duration and Expiration.
Cost and revenue
Price during patent effectivity Price after patent Monopoly

0 Margin revenu al e
Marginal cost
Deman d
Competitive quantity
quantity
PATENTS A patent or copyright is a means by which the government empowers a patent holder to exclusively produce a certain product or provide a service to the exclusion of everybody else. The duration of a patent or copyright is usually 20 years (Sicat). A patent allows the firm to charge a price far above the marginal cost. At the expiration of the patent, other firms are allowed entry, making the price competitive (Exhibit 8.10). THE CASE FOR AND AGAINST MONOPOLY
64 For monopoly: Where patents and copyrights are granted, inventors have the incentives to spend large amounts for the invention and development of new products and services. Writers and film makers are encouraged to produce outstanding literary works. Against Monopoly: The high price that monopoly charges makes it undesirable to consumers (Mankiw). DEADWEIGHT LOSS In evaluating the deadweight loss due to a monopoly, the firm has to be compared with a firm under perfect competition. Exhibit 8.11 illustrates the deadweight loss due to a monopoly and perfect competition. Under perfect competition, consumer surplus is equal to ABCDE while producer surplus is FGHI. In a monopoly consumer surplus is AB and producer surplus is CDFGI. From this information it is clear that the consumers are losers. The dead weight loss is EH which, unlike a tax, does not go to the government but to the firm under monopoly (Sexton). Exhibit 8.11. Deadweight Loss and Efficient Level of Output Under a Monopoly and Perfect Competition.
65
Price
MC A Monopoly price C B D E
G
SUPPLY
Monopolys deadweight loss
Perfect Competition price
Marginal cost monopoly
F of I
MR
Monopol
0
PC/Efficient quantity
y quantity
Quantity
PUBLIC POLICY ON
MONOPOLIES Government attitude towards monopolies range from regulation to just letting them operate freely (Mankiw). Among the actions the government takes are 1. Imposition of anti-trust laws which result to the following: Prevention of mergers that tend to make giant companies that lead to monopolies. Breaking up of monopolistic firm to break their control of the market. Prevention of companies from gaining control of the market through the stifling of competition.
66 2. Price regulation which prevents the monopoly from charging any price it wants. 3. Conversion of monopolies into public corporations. This is done to protect the public from the adverse practices of monopolies. 4. Let monopolies operate without doing anything.
When the perceived imperfections of government policies are deemed too inconsequential or too minimal compared to the advantages of monopolies, the government is unable to do anything to control or regulate them. PRICE DISCRIMINATION When a monopoly sells identical items at different prices to different consumers, it engages in price discrimination. The firm sells the same goods to different consumers at different prices although the production cost for all is the same (Landsburg). Exhibit 8.12 shows the different prices which consumers pay for the commodity supplied by the monopoly. There is no consumer surplus because each of them is willing to pay the marginal value that the goods possess.
EFFECTS OF PRICE DISCRIMINATION 1. 2. Price discrimination results to increase in monopoly profits and Price discrimination reduces deadweight loss but all the profit goes to the monopolist and there is no consumer surplus. (Exhibit 8.11). DEGREES OF PRICE DISCRIMINATION Price discrimination comes in three degrees. 1. First degree is when the monopoly charges each customer the most he would be willing to pay for each item that he
67 buys. This kind of price discrimination is said to be perfect because the monopolist knows exactly the price each customer is willing to pay and charge each in accordance with that knowledge (Exhibit 8.11). Exhibit 8.12. Price Discrimination
Price 40 35 30 25 20 15 10 5 0 A B D D MR Quantity C MC
2.
Second degree is when the monopoly charges the same customer different prices for identical items.
3.
Third
degree is charging different prices in different
markets (Lansburg, 2005) EXAMPLES OF PRICE DISCRIMINATION Airline tickets
68 Discount coupons College and university tuitions Quantity discounts Movie tickets
STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus). 1. Enumerate and explain the characteristics of a monopolistic market. 2. Name some government impositions that serve as barriers to entry into a market and give rise to monopolies. Explain each. 3. What is a natural monopoly? 4. What makes it difficult for a new entrant in a monopoly market to stay in such market.
69 5. Compare the characteristics of a monopoly with a firm in a perfectly
competitive market. 6. Explain and illustrate the total revenue-total cost method of maximizing profit in a monopoly. 7. Explain and illustrate the marginal revenue-marginal-cost method of maximizing profit in a monopoly. 8. Explain and illustrate how a monopoly can minimize its losses. 9. 10. Under what situation relative to price and average total cost can a Explain and illustrate how a market responds to the duration and monopoly earn economic profits. expiration of a patent. 11. Cite an argument for and against monopoly and briefly explain. 12. Explain how deadweight loss can result from a monopoly. 13. What are some of the actions that government take to control or regulate monopolies. 14. Explain the concept of price discrimination and give examples. 15. Briefly explain the three degrees of price discrimination.
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the statement is false. Assume that other things are held constant. If your answer is false, explain why. ____ 1. 2. ____ ____ 3. Monopolies are price takers because consumers have no choice but buy their goods or products. There are firms who cannot enter a monopolistic market because of barriers to entry. . A true or pure monopoly refers to a single firm which sells a product that has no substitute. ____ 4. Legal barriers are government regulations that prevent firms from price manipulation in monopolies. ____ 5. Patents are meant to protect the rights of consumers to return
70 defective products. ____ 6. Monopolies always control or exclusively own input resources because they such resources cannot be purchased or secured ____ ____ 7. 8. from other sources. Small firms cannot compete with monopolies because of the economies of scale. When a monopoly increases quantity sold the price increases because of the price effect . ____ 9. Maximum profit can e attained by a monopoly at the production level where total revenue is equal to total cost. ____ 10. Another way of maximizing profit for a monopoly is by determining the quantity where the marginal revenue and marginal cost intersect and project the intersection upward to ____ ____ 11. 12. the demand curve and then to the vertical axis for the price. When the price is greater than ATC, a monopoly gains economic profits. After the expiration of a patent the price of the commodity will be higher because of a shortage in supply. ____ 13. Patents and copyrights discourage inventors from developing new products because such government impositions are forms ____ ____ ____ 14. 15. 16. of control in the manufacture or invention of new products. In a monopoly, deadweight loss is not really lost because it accrues to the monopolist. When firms selling the same product join together to control a market, the merged firms become a monopoly. A consumer who is charged a price higher than the market price, but nevertheless is willing to pay is subjected to price discrimination. FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that complete each statement. Assume that all other things are held constant.
71 _______________ 1. When there are barriers to the entry of other firms in an industry or market and there is only one seller selling a product that has no substitute, there is a _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ 2. 3. 4. 5. 6. 7. 8. 9. __________. Government impositions that serve as legal barriers to entry are __________, __________, __________, and __________. A monopoly can dictate the price of its product. It is thus a price __________. The effects of a monopolys increase in the amount it sells are __________ and __________. Producing the quantity where the vertical distance between total revenue and total cost is widest is the __________ method of maximizing profit in a _______________ _______________ monopoly. 10 At a price higher than the average total cost a . monopoly gains __________ profits. 11 The right to exclusively produce or invent a gadget . or a consumer product or service is protected by a __________. _______________ _______________ 12 Selling identical items to different consumers at . different prices is __________. 13 Monopolists who are charging different prices for . identical products in different markets commit __________.
ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris paribus). 1. The following is a hypothetical schedule of a monopolist.
72 Price 200 180 160 140 120 100 80 60 40 Quantity 0 1 2 3 4 5 6 7 8 Fixed Costs 120 120 120 120 120 120 120 120 120 Variable Costs 0 50 80 100 140 200 280 380 500
Using the above data, determine the level of output at which the monopoly can maximize profits.
2. Profit maximization for a monopoly.
73
Price, cost, and revenue (in pesos)
MC 80 60 40 20 0 ATC AV C
MR 100 200 300
D 400 500
Quantity of outputs (units per day) a. Determine profit maximizing or loss minimizing output for the monopoly in the above graph. Explain. b. Is the monopoly earning economic profit or incurring losses? Explain. c. What price should it charge to maximize profit? Why? d. If the monopoly operates at the profit maximizing output, is it able to cover all fixed costs? Explain.
74
CHAPTER IX. MONOPOLISTIC COMPETITION AND OLIGOPOLY OBJECTIVES: The lesson will enable the student to 1. 2. 3. 4. 5. 6. 7. 8. 9. Discuss and the characteristics of a firm under monopolistic competition. Analyze and evaluate the operation of a monopolistically competitive firm in order to maximize profit and/or minimize losses. Compare a monopolistically competitive firm with one under perfect competition. Analyze, evaluate, and explain the welfare effects of monopolistic competition. Appreciate the merits and demerits of advertising and brand names. Make critical analyze and evaluation of oligopoly market structure. Explain the reasons for the emergence of oligopolies. Discuss and explain the different models of oligopolies and their impact on consumers, the firms, and the society. Explain the different practices of oligopolies and how the government intervenes to control and moderate their effects on consumers and the society. TOPICS FOR DISCUSSION 1. 2. 3. Monopolistic competition Product differentiation Models of Oligopoly
75 4. Mergers Monopolistic competition Pure oligopoly Price leadership Cooperative games Nash equilibrium Horizontal merger Price discrimination Predatory pricing Mark up Differentiated oligopolies Game theory Non-cooperative games Prisoners dilemma Vertical merger Exclusive dealing Interlocking directorates Resale Maintenance Price
Key Words and Terms Imperfect competition Oligopoly Cartel Cost-plus pricing Maximin/Dominant strategy Kinked demand curve Conglomerate merger Tying contracts
76 CHAPTER IX. MONOPOLISTIC COMPETITION MONOPOLISTIC COMPETITION Imperfect competition is a market structure or situation where a number of sellers gain control over the outcome of quantity and equilibrium prices in the market. It exists when sellers with similar products, each of which have control over price, compete for sales (Hyman, 1994). Firms under imperfect competition fall between perfect competition and monopoly. The two types of imperfectly competitive market are monopolistic competition and oligopoly. Monopolistic competition is a market structure with the following characteristics: 1. Numerous small participants (buyers and sellers): Many sellers compete for the same group of customers. Some businesses under this structure are restaurants, professional games, and entertainment. 2. Free entry and exit: There is no restriction to entry or exit. However, the number of firms adjust to the point where economic profit is zero. 3. Perfect information: There is perfect information due to massive information campaign in the form of advertising to attract customers. 4. Differentiated products: Each firm produces a product which serves the same purpose as that of other firms but with some slight difference such as brand name and packaging. MONOPOLISTICALLY COMPETITIVE FIRMS AND PROFIT MAXIMIZATION
77 A firm under monopolistic competition has some similarity with a monopoly where MR = MC. The free entry and free exit attribute which, however does not prevail in a monopoly, will, in the long-run push economic profit to zero. Exhibit 9.1. Profit Maximization in Monopolistic Competition
MC
A P B C D
ATC
MR 0 Q (Profit maximizing quantity) Quantity
Exhibit
9.1
illustrates the short-run profit maximization under monopolistic competition. Note that the MC curve intersects the MR curve at a point below ATC curve. The price and the demand curve intersect at a point above the intersection of marginal revenue (MR) and marginal cost (MC) curves and above average total cost curves (ATC). In this short-run situation the firm is earning economic profits because total revenue, AP0Q is greater than total cost, CBQ0. A lower price will increase the quantity demanded while a higher price will reduce it below the profit maximization quantity (Mankiw). LOSS MINIMIZATION IN A MONOPOLISTIC COMPETITIVE MARKET
78 In Exhibit 9.2, the firms average total cost curve lies above the demand curve so that at any level of output the firm could not breakeven. The decision whether to stop producing or to shut down faces the firm. As in a firm in a competitive market, as long as the price is above the average variable cost, the firm should continue producing in the short run and be able to cover a part of the fixed cost. If, however, the firm fails to cover the variable cost, it has to shut down to avoid further losses (Sexton). Exhibit 9.2. Losses in a Monopolistic Competitive Market Price
MC
AT C
Average total cost P
MR 0 Loss quantity
D QUANTITY
minimizing
COMPETITION WITH DIFFERENTIATED PRODUCTS Because of the prevailing perfect information, new firms get wind of the economic profit in the business and are encouraged to enter. This results to 1. 2. An increase in the number of products in the market resulting to A decrease in the demand for firms already in the market, thus shifting the demand to the left and decline in their profits.
79 3. The chain reaction to this situation is the exit of firms from the market. The departure of firms under monopolistic competition will 1. 2. 3. Result to a decrease in the products available in the market, Increasing the demand for the remaining firms products, a rightward shift of the demand , thus Increasing the profit of the firms that stayed in the market.
DETERMINING ECONOMIC PROFITS AND LOSSES The three-step method is applied in determining whether a firm under monopolistic competition is earning economic profit, zero economic profit, or incurring economic losses. Step 1. On the graph, find the point where MR = MC and proceed downward to the horizontal axis to find Q which is the profit-maximizing output level. Step 2. Move upward to the point on the demand curve and the left to the vertical axis to find the market price. Finding P x Q enables the firm to determine total revenue because TR = P x Q. Step 3. To find the total cost, go to Q and proceed straight up to the ATC curve and leftward to the vertical axis to find the ATC. The TC will be derived by multiplying ATC by Q (TC = ATC x Q). (Sexton, 2005). LONG-RUN EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION Exhibit 9.3. Long-run Equilibrium under Monopolistic competition
80
MC ATC
Price
P =ATC
Deman MR d
Profit quantity
maximizing
Quantity
Producing and selling where price exceeds average costs enables a firm to earn profits which encourages other firms to enter the market which in turn decreases the demand for the firms products. The entry of more firms and the decrease in demand prompts a reduction in price until it reaches a point where it is equal to the ATC that is now tangent to the demand curve (Exhibit 9.3). This is the long-run equilibrium point of a firm under monopolistic competition (Mankiw). At this equilibrium point where there is no economic profit, there is no tendency for sellers to enter or leave the market. MONOPOLISTIC VERSUS PERFECT COMPETITION There are two noteworthy differences between monopolistic and perfect competition in the long-runexcess capacity and markup (Mankiw). These are excess capacity and mark-up over marginal cost (Exhibit 9.4). Exhibit 9.4. Monopolistic Competition, Perfect Competition in the Long-run
81 a) Monopolistic Competition
MC Price P
ATC
MR
Efficient scale
Quantity produced
QUANTITY
Excess Capacity 1. 2. In the long-run, there is no excess capacity in perfect competition. Free entry of firms in a competitive market results to firms producing at efficient scale, the point where average total cost is minimized. 3. In a monopolistic competition, there is excess capacity in the longrun.
82 4. The efficient scale of firms under monopolistic competition is less than that of firms under perfect competition. b)Perfect Competition
Price MC ATC P = MC P = MR Demand curve
Quantity 0 Produced QUANTITY Efficient Scale Markup Above the Marginal Cost 1. 2. 3. For a firm under perfect competition, price is equal to marginal cost. For a firm under monopolistic competition, price is far above marginal cost. With this kind of pricing, an extra unit sold at the posted price means more profit for the firm under monopolistic competition.
Price Mark up P
MC
ATC
Exhibit 9.5. Monopolistic Competition, Perfect Competition and Pricing a) Monopolistic Competition Marginal cost MR D
Quantity Efficient produced Scale Excess capacity
QUANTITY
83
B) Perfect Competition Price MC ATC
P = MC
P = MR Demand curve
Quantity produced Efficient scale
Quantity
WELFARE EFFECTS OF MONOPOLISTIC COMPETITION Under monopolistic competition, the entry of new firms introducing new products benefits the consumers. This is a positive welfare effect for society and a negative one for existing firms (Mankiw).
84 The deadweight loss that prevails in monopoly pricing exists in monopolistic competition due to the mark up of price over and above the marginal cost. Regulation of prices is difficult to enforce. The number of firms in the industry may be too large or too small ADVERTISING Advertising is an important tool for firms under monopolistic competition to attract more consumers to patronize their product. However, opinions about the merits of advertising are varied (Sexton; Tucker). Those arguing for advertising state that 1. Consumers get to know more products and are therefore able to make better decisions about the choices available to them. 2. Advertising informs the consumers about the quality of the products and are helped in making their choices. 3. Consumers are better informed of the quality of the products. Those arguing against advertising state that 1. Advertising manipulates peoples feelings to influence their tastes. 2. The amount spent on advertising contributes to increase in the price of goods. 3. Advertising hinders competition by implying that products are different when in reality they are not.
BRAND NAMES Brand names are means of identifying products which more or less also serve as means of advertising (Mankiw).
85 Critics argue that brand names give consumers the perception that products are different though they are practically the same. However, economists and firms argue that brand names are useful means for consumers to be sure about the quality of their products.
OLIGOPOLY Oligopoly is a market dominated by few sellers that account for more than half of the industrys
86 Oligopolies exist in some localities where there are few firms supplying the needs of the community. For instance, a few gasoline stations, groceries, hardware stores (Mankiw). Characteristics of an Oligopoly Market 1. Few sellers offering similar or identical products 2. Interdependent firms. They are interdependent because they take into consideration the effect of their decisions and actions on other firms and their consequent reactions. 3. Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost VARIETIES OF OLIGOPOLY 1. Pure Oligopolies produce or sell homogeneous products. There is greater interdependence among the firms because each firm is sensitive to the pricing policies of others particularly in pricing. An increase in the price of one firm may drive customers to other firms (Mankiw). 2. Differentiated Oligopolies are those producing or selling products with differentiated features. Examples of these are vehicle manufacturers (Sexton). CAUSES OF THE EMERGENCE OF OLIGOPOLIES (Mankiw) 1. Barriers to entry such as economies of scale(Exhibit 9.6) 2. Legal restrictions 3. Brand names which are developed through years of advertising 4. Control of essential resources
Barriers to Entry
87 Exhibit 9.6. Barriers to Entry: Economies of Scale
Cost per unit
Cn
Po Long-run average cost 0 Qn Qo
Quantity per year
The above figure shows a comparison of the production of a new entrant and a firm already established in the industry. The latter has achieved minimum efficient scale (economies of scale). The new entrant which has a high cost of production has to sell a lot of his products to compete with the firm producing at Qo at lower cost. High Cost of Entry The new entrant is bound to incur enormous setup and promotion cost to be able to compete. If its competitors have established and strong brand names, it will be more difficult for the newcomer to enter the industry. OLIGOPOLY MODELS Oligopolies behavior of interdependence is influenced by the model on which they are categorized (Sexton; Tucker). These models are 1. Cartel 2. Price Leadership 3. Game Theory 4. Kinked demand curve 5. Cost-plus pricing CARTELS AND COLLUSION
88 A cartel is a group of oligopolist firms which, acting in unison, behave like a monopoly. They agree to coordinate their production and pricing decisions. Benefits Provided by a Cartel to Members 1. Each member is certain about the behavior of the other firms in the cartel. 2. 3. There is an organized effort to block new entrants. They can increase prices by collusive reduction of output. Profit Maximization of a Cartel Since a cartel operates like a monopoly, its demand curve is similar to a monopoly as shown in Exhibit 9.7. Exhibit 9.7. Demand, Marginal Revenue, and Marginal Cost Curves of a Cartel MC P
Price per unit
per unit
MR
Quantity period
per
The marginal cost curve in Exhibit 9.7 represents the aggregate marginal costs of all the firms in the cartel. To attain maximum profits price is determined using as base the intersection of the marginal revenue and marginal cost. The output is then divided by the members. PROBLEMS ENCOUNTERED BY CARTEL MEMBERS 1. Differences in Costs
89 A firm with high marginal cost has to sell more than firms with lower marginal cost. This is contrary to the cartel provision that marginal cost be equal for all the firms in the cartel. 2. Difficulty in arriving at a consensus. As the number of firms grow, arriving at a consensus becomes difficult because of the growth in the number of conflicting interests. 3. New Entries That May Push Down The Prices When news spread that a cartel earning, new entrants may enter the industry. This increases the supply and push prices down. 4. Cheating among members. Because oligopolists operate at excess capacity, some find the incentive to raise their prices slightly. This activity comes in the form of rebates, extra services, and other concessions. The incentive to cheat prevails during sales slump. OBSTACLES AND HINDRANCES TO THE ESTABLISHMENT OF AN EFFECTIVE CARTEL 1. 2. 3. Differentiation of products across firms Differences in costs across firms Low entry barriers
PRICE LEADERSHIP Price leadership occurs when a few firms set the price for the rest of the firms in the industry. These few firms are called price leaders." Price leadership give rise to an informal or tacit collusion. OBSTACLES TO PRICE LEADERSHIP 1. It is against anti-trust laws
90 2. There is no guarantee that other firms will follow. When this happens, the leader has to lower its prices or lose sales. 3. Price leadership is less effective as a means of collusion when products are highly differentiated. 4. Firms cheat by lowering their prices to increase sales and profit.
COST-PLUS PRICING Cost-plus pricing is a strategy whereby oligopolists calculate average variable costs per unit and add a certain percentage as a mark up. ATTRACTION OF COST-PLUS PRICING It is a way of coping with uncertainty about the shapes and elasticity of the demand curve. Calculating price based on marginal analysis is complicated and costly. This is especially true for firms producing different products. Firms with similar costs can apply the same percentage of markup. This gives rise to an implied collusion. MARK-UP POLICY PREVALENT AMONG FIRMS Uniform mark-up is not resorted to by firms producing differentiated products. Mark-ups usually vary with the price elasticity of the demand for the product. The more elastic the demand, the lower will be the mark up. GAME THEORY Game theory is an oligopoly model that looks at the behavior of oligopolists as a series of strategic moves and countermoves among rival firms(McEachern, 1997). The theory examines the players incentives to compete or cooperate. Game theory stresses the tendency of firms in oligopoly to act in such a way that the damage that may be caused by a competitor is minimized.
91 1. Cooperative game is one where two firms decide to collude to maximize profits. In this type of game firms can enter into binding contracts. But such contracts which may constitute collusion are violations of antitrust law. Thus, the noncooperative game. 2. Noncooperative games is one where each firm sets its own price without consulting others. Exhibit 9.8. Payoff Matrix
Bs Strategy
As Strategy High Price A earns P80 High Price B earns P80 B earns P100 Low Price A losses P30 Low Price A earns P100 B losses P30 A earns P50 B earns P50
The payoff matrix (Exhibit 9.8) portrays the maximin strategy (dominant strategy) by which the players choose the best payoff for the worst possible outcome. Maximin or Dominant Strategy is a strategy that will be optimal regardless of the opponents action (Sexton, 2005). NASH EQUILIBRIUM Nash equilibrium, named after the mathematician, John Nash, is an outcome from which neither player would want to deviate, taking the other players behavior as given.
92 It is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen. Exhibits 9.9. Pig in a Box Strong Pigs Strategy Push lever Strong pig gets Push lever Weak Pigs Strategy Wait by dispenser Weak pig gets 75 calories Weak pig gets 0 calories 90 calories Weak pig gets -10 calories Strong pig gets 15 calories Wait by Strong pig dispenser gets 100 calories Weak pig gets Strong pig -10 calories gets 0 calories
The above exhibit illustrates the application of Nash equilibrium. Their choices are summarized below (Lansburg, Price Theory ; 2005, 416). SITUATION: Dispenser yields 100 calories. Pushing the lever burns 10 calories. CHOICES: (Upper left-hand box) Both pigs push the lever they both run to the dispenser, strong pig pushes the weak pig and eats all the calories. The strong pig gains 90 calories (100 10 burned by pushing lever).
93 (Upper right-hand box) The weak pig loses 10 calories for pushing the lever. The strong pig waits by the dispenser and the weak pig pushes the lever. The strong pig eats all the calories and the weak pig loses 10 calories. (Lower left-hand box) The strong pig pushes the lever as the weak pig waits by the dispenser. The weak pig consumes 75 calories. The strong pig eats 25 calories but loses 10 calories for pushing the lever. He gains a net of 15 calories. (Lower right-hand box) Both pigs wait by the dispenser. Both pigs eat nothing. Note: The only Nash equilibrium is the lower left-hand box. From any other box, at least one of the pig will want to make a change. THE PRISONERS DILEMMA The prisoners dilemma (Exhibit 9.10) is a dominant strategy which demonstrates the fundamental problem of oligopolists that do not collude (Sexton). It demonstrates why cooperation is difficult to maintain even when it is mutually beneficial. This is because cooperation is not in the interest of the individual player. This situation is often true among people who fail to cooperate even when cooperation would be beneficial to both. Exhibit 9.10. The Prisoners Dilemma
94
Prisoner As Strategy Confess A gets 5 years Confess Prisoner Bs Strategy

Not Confess
Not A Confess gets 10
years A gets 2 B gets 1 year years B gets 2 years
B gets 5 A gets 1 year years B gets 10 years
Oligopolies as a Prisoners Dilemma Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. However, cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to very low production and very high prices as can be seen in Exhibit 9.11 (Mankiw). Exhibit 9.11. A Cooperative Oligopoly Game Matts Decision Sells 50 Units Sells 40 Units
Earns P1,500 Sells 50 Units Earns P1,500 Jeffs Decision
Earns P1,400 Earns P1,900
95
Earns P1,900 Sells 40 Units Earns P1,400
Earns P1,700
Earns P1,700
In the above exhibit, if Matt and Jeff agreed to sell 40 units each, they will each earn P1,700. If Matt decides to cheat and sell 50 units, he will earn P1,900 units and Jeff earns only P1,400.00. However, Once Jeff gets wind of Matts decision, he will also sell 50 units, thus equalizing their profit to P 1,500. Both of them therefore lose P 200.00. It will be to their mutual interest if they sell only 40 units each. The decision to sell 40 units each Matt and Jeffs total earning is P3,400.00 or P42.50 per unit. When Matt was producing 50 units and Jeff was producing 40 units their total earnings was P 3,300.00 or P36.66 per unit. Clearly, when they cooperated to produce, they each earn more than if they compete. KINKED DEMAND CURVE In the kinked demand curve (Exhibit 9.12), D1 represents the elastic demand curve of the firm. Raising the price from 10 to 15 resulted to a reduction in quantity demanded from 1,400 to 900. Competitors did not respond to the price increase. Customers shifted to those competitors/other suppliers.. Reducing the price to 5 resulted to a slight increase in quantity demanded from 1,400 to 1,600. The competitors followed the price reduction and reduced their own prices. Hence the small increase in quantity demanded. Since D2 is inelastic price will be rigid under the kinked demand
96 curve because of the possible and anticipated response of competitors (McEachern). MARGINAL REVENUE UNDER THE KINKED DEMAND CURVE The marginal revenue of the monopoly (oligopolists operate as a monopoly) is D1abM2 since D1a is the marginal revenue curve that applies to DE of the demand curve. Line bM2 is the marginal revenue curve that applies to line ED2 of the kinked demand curve. There is therefore no single marginal revenue curve because of the gap along the quantity produced at 1,400. Thus the marginal curve D1abM2.
Exhibit 9.12. Kinked Demand Curve
D1 E
Price per unit
15 10 5 a b 0 900 1,400 1,600 Quantity period per MR2 MR1 D2
97 PRICE RIGIDITY As is shown in Exhibit 9.13, a monopoly (an oligopolists operate like a monopoly) maximizes its profit using the intersection of the marginal cost and marginal revenue. In Exhibit 9.13, which is derived from Exhibit 9.12, the point where MC crosses the gap in the marginal revenue curve identifies the profit maximizing level of output quantity (Q) and price (P). Even if the marginal cost falls to MC2 there will be no change in price because the firm has to consider the response of other firms. Therefore, unless the MC curve crosses quantity (Q) above point a there will be no change in the equilibrium price and quantity (McEachern).
Exhibit 9.13. Price Rigidity, Marginal Revenue Curves and Demand for the Kinked Demand Model
D1
MC3
MC1
15
Price per unit
MC2 a
D2 b MR2 0 1,400 Quantity period per
HIGHER PRICE UNDER OLIGOPOLY
98 Under oligopoly, industry output will be lower and the price higher than in a perfect competition if the oligopolists engage in some sort of explicit or implicit collusion (McEachern). The average cost of production in an oligopoly will be higher in the long run than with a perfect competition even if oligopolists do not collude but simply operate at excess capacity. If a price war breaks out, prices in an oligopoly will be temporarily lower than in a perfect competition. HIGHER PROFITS UNDER OLIGOPOLY In the long-run, firms under perfect competition cannot earn more than normal profit because of easy entry (McEachern). Under oligopoly, the obstacles to entry allow firms to earn economic profits in the long-run. Some economists view this profit maximizing power of oligopolists as market power. However, others consider it as a result of efficiency due to economies of scale. OLIGOPOLY AND MERGERS Larger firms are more profitable than small ones. Therefore, some firms achieve rapid growth through mergers joining other firms. This joining together creates oligopolies (McEachern). Horizontal Merger Horizontal merger is achieved when a firm joins with another producing the same product. Vertical Merger Vertical merger is done when one firm joins another from which it acquires or purchases production inputs or to which it sells outputs. Conglomerate Merger Conglomerate merger is a merger of different firms producing different products or operating in different industries.
99 PUBLIC POLICY TOWARD OLIGOPOLIES Since cooperation among oligopolists leads to low production and very high prices, such cooperation which practically amounts to collusion is undesirable from the point of view of society. ANTITRUSTLAWS AND RESTRAINT OF TRADE A trust is a combination of firms or cartel that place their assets under the custody of a board of directors. Organizers of trusts which exploited and bullied anyone in their way were called robber barons. John D. Rockefeller who put up Standard Oil is among the famous robber barons (Tucker, 320-323). Antitrust laws prohibits the monopolization and conspiracies that restrain trade that seek to monopolize the market a. Sherman Antitrust Act of 1890 declares as illegal every contract, combinations in the form of trust or otherwise, or conspiracy in restraint of trade or commerce. . . . b. Clayton Act of 1914 is an amendment to the Sherman Act. It makes illegal the following anticompetitive business practices 1. Price discrimination charging different customers different prices for the same products although the price differences are not related to costs. 2. Exclusive dealing A retailer is required by the manufacturer to sign an agreement stipulating the condition that the retailer will not carry rival products. 3. Tying contracts The seller of a product requires the buyer to purchase other products. A firm offers two (or more) of its products together at a single price, rather than separately. 4. Predatory pricing a practice of one or more firm to reduce prices to eliminate competition and them raise them again when the latter is eliminated.
100 5. 6. 7. Acquisition of stock of competing firm a firm buys the stocks of its competitor. Interlocking directorates exists when the directors of one firm serves as directors of another firm in the same industry. Resale Price Maintenance - occurs when suppliers (like wholesalers) require retailers to charge a specific amount.
STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus).
101 1. Under what circumstances does imperfect competition exist? 2. Explain why imperfect competition falls between perfect competition and monopoly. 3. Enumerate and explain the characteristics of a monopolistic competition. 4. How does perfect information prevail in a monopolistic competition? 5. 6. 7. 8. Explain the concept of differentiated products and cite some With regards to profit maximization, in what way is monopolistic Explain how a firm under monopolistic competition can minimize Explain the effects of perfect information on a monopolistically examples. competition similar to monopoly? losses. At what point should it resort to shut down? competitive market structure. 9. Explain the way how a firm in monopolistic competition determines the viability of attaining economic profits, or incurring zero economic profits or economic losses. 10. Explain the differences between firms in perfect competition and monopolistic competition in terms of pricing and excess capacity in the long-run. 11. 12. Discuss and illustrate the welfare effects of monopolistic competition. What are the advantages and disadvantages of advertising? Give some examples. 13. What are the merits and demerits of using brand names? Give some examples. 14. Explain the concept of oligopoly and what gives rise to its emergence. 15. Enumerate and explain the characteristics of an oligopoly. 16. Differentiate pure oligopoly from differentiated oligopoly.
102 17. Enumerate the oligopoly models and briefly explain each. 18. What are the benefits that cartel members get from the organization (cartel)? 19. Explain and illustrate how a cartel maximizes profits. 20. Name and explain the problems encountered by cartel members. 21. What are price leaders and how do they give rise to tacit collusion? 22. What are the hindrances to the emergence of price leaders? 23. What is cost-plus pricing and why is it attractive some oligopolists? 24. Why is cost-plus pricing not advisable for firms offering differentiated products? 25. Briefly explain the game-theory model of oligopoly. 25. Differentiate cooperative and non-cooperative games? 26. Explain and illustrate a payoff matrix. 27. What is a dominant strategy? 28. Briefly explain and illustrate the Nash Equilibrium? 29. Why is cooperation difficult to maintain among oligopolists even when it is apparent that it is beneficial to both parties? 30. Explain why cooperation among oligopolists is undesirable from the point view of society? 31. Why is it not advisable for an oligopolist in a kinked-demand-curve model to raise or lower its prices? 32. Identify and explain the three types of mergers resorted by firms that wish to control the market or resort to oligopolistic practices. 33. What is a trust and how does it operate? 34. Enumerate the business activities considered illegal by the Clayton Act of 1914. TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the statement is false. Assume that other things are held constant. If your answer is false, explain why.
103 ____ 1. When there are sellers selling similar products and each one has control over the price notwithstanding the competition the market structure is said to be perfectly competitive. ____ 2. Perfect information through massive advertising is resorted to by firms under monopolistic competition because the firms are ____ 3. competing for the same group of customers. Firms in a monopolistically competitive market have the same products which serve the same purpose. Therefore, there is not difference between such firms and those under the perfectly ____ 4. competitive market. The free entry and free exit attribute of a monopolistically competitive market will in the long-run result to zero economic ____ 5. profit for the firm. Profit maximization can be attained by a monopolistically competitive firm in the same way as it is done by a monopolistic ____ ____ 6. 7. firm. A monopolistically competitive firm that cannot cover variable cost should continue to operate in order not to incur losses. In a monopolistic competition excess capacity prevails in the long-run because a firm in this market structure limits its ____ 8. production below its efficient scale. Where as price is equal to marginal cost in a perfectly competitive firm, in a monopolistically competitive firm price is ____ 9. above the marginal cost. In spite of the competition in a monopolistically competitive market, deadweight loss still prevails because of the practice of ____ mark-up pricing above the marginal cost. 10 Advertising is not good for consumers because it simply confuses . ____ ____ consumers because of the enormous number of products being about products through advertising help advertised. 11 Being informed
. consumers make decisions about choices. 12 Advertising is a manipulative business practice. However, that is . a debatable opinion against advertising.
104 ____ ____ ____ 13 Advertising does not contribute to price increase because the . firm can get its advertising expenses from increase in its sales. 14 Brand names project similar products as different although in . reality they are the same. 15 Oligopoly market structure is one where few firms cannot control . ____ ____ the market because of steep or intense competition among the firms in the market. 16 Oligopoly firms act unilaterally because of their individual control . of the market. 17 It would be best for oligopolist to put their acts together or . ____ ____ ____ ____ ____ ____ cooperate limiting their output and charge a price above their marginal cost. 18 Pure oligopolies are not sensitive to the pricing policies of other . . similar firms because they have the same or similar products. and sell the same products. 19 Car manufacturers are pure oligopolies because they produce 20 Some of the causes of the emergence of monopolies are also the . causes of the emergence of oligopolies. 21 It is impossible for cartel member to resort to collusion . particularly in pricing. 22 Cartels are organized by oligopolists to block entry of other firms . in the market. 23 A cartel is like a monopoly. It determines a volume of output . ____ ____ ____ ____ below the demand curve and based on the equality or intersection of the marginal cost and marginal revenue. 24 The emergence of many conflicting interests renders it difficult . for a cartel to arrive at a consensus. 25 It is impossible for cartel members to cheat on other members. . 26 Firms who have the power to set the prices for other firms are . price leaders. 27 Price leadership cannot never result to collusion because the . leader has control over the prices.
105 ____ ____ ____ 28 Price leadership is very effective particularly when products are . highly differentiated. 29 The position of a price leader is secured because members . always follow the price it dictates. 30 Cost-plus pricing is based on the determination of average cost . ____ per unit and then add a certain amount. The sum then becomes the price. 31 When firms in an oligopoly engage in cost-plus pricing, they . ____ ____ ____ ____ cannot engage in collusion because each firm will want to set its own price. 32 Game theory is an oligopoly model that is more or less like a . chess game. 33 One of the underlying factors in game theory is minimizing . damage that can be inflicted by a competitor. 34 In cooperative games firms agree to either lower or increase . their production to maximize their profit. 35 The reason why firms engage in non-cooperative games is the . ____ protection of their self-interest and protection of their profit potential. 36 There are times when no matter what strategy is adopted, others . refuse to cooperate and resort to their own strategy until they are all locked into positions where they would not wish to make ____ ____ changes. This is maximin or dominant strategy. 37 The prisoners dilemma shows that people really wish to . cooperate when doing so is beneficial for both players. 38 When oligopolists cooperate, society is benefited because . ____ oligopolists will always promote societys welfare to stay in business. 39 The kinked demand curve model is similar to price leadership . ____ because other firms always follow another who sets a higher or lower price. 40 When firms join another producing the same product there is . vertical merger because together, they can volume of goods or services. produce a high
106 ____ 41 Horizontal merger is when a firm joins another from which it sells . ____ ____ ____ ____ outputs or purchase inputs. It is like buying the firm on the left side and right side of a business transaction. 42 A merger of firms selling or producing different products or services is conglomerate merger. 43 When a board of directors takes over custody of the assets of a . cartel, a trust is established. 44 In a tying contract the retailer is required to agree to the . condition that it will not sell the product of rivals. 45 An oligopolist that sets an extremely low price and raises it after . competitors are eliminated is a predator.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that complete each statement. Assume that all other things are held constant. ______________ 1. A market structure where a number of sellers gain control over the outcome of quantity and prices in ______________ 2. ______________ 3. ______________ 4. ______________ 5. ______________ 6. the market is characterized by __________. __________ and __________ are two types of imperfectly competitive market. Products of firms under monopolistic competition serve the same purpose but are slightly __________ . A firm that fails to recover variable cost has to __________ to avoid further losses. The mark-up pricing policy in monopolistically competitive firm which is similar to monopolies is
socially disadvantageous because it results to a ______________ 7. __________. __________ is an effective tool in informing consumers about the quality, pricing, availability, and uses of a product or service. It is, however, contested because ______________ 8. of the cost involved. Products are identified and differentiated through
107 their __________ names. A market dominated by few sellers but control more and
______________ 9.
than half of it is a/an __________. ______________ 10 Oligopolistic firms that are interdependent .
selling or producing homogeneous products are
__________ oligopolies. ______________ 11 Years of advertising a certain product result to the . development of the products __________name. ______________ 12 Firms that act together like a monopoly . and
coordinate their production and pricing decisions are
called __________. ______________ 13 Few firms setting the price for other firms are called . __________. ______________ 14 The existence of price leaders give rise to __________ . collusion. ______________ 15 Adding a certain percentage to the average variable . cost per unit is called __________ pricing. ______________ 16 The tendency of an oligopolistic firm to examine the . behavior of another with the end in view of minimizing the damage the latter can inflict is the goal of the __________ model. ______________ 17 Under the game theory model colluding to maximize . profit is called __________ game. ______________ 18 Optimal strategy regardless of the opponents action . is a __________ strategy. ______________ 19 The kind of game theory formulated by John Nash is . the __________. ______________ 20 The fundamental problem of oligopolists who do wish . to resort to collusion is demonstrated in it the is __________, a kind of dominant strategy. ______________ 21 In the __________ oligopoly model, .
disadvantageous for a firm to raise its prices because other firms will not follow. It is also not advisable to
lower its prices because other firms will surely follow. ______________ 22 When firms producing the same product or service
108 . join together, firm their from merger which is it a/an ___________ input
merger. ______________ 23 Joining a .
purchases
resources or to which it sells its products is a/an
__________ merger. ______________ 24 The merger of firms selling different products or services is a/an__________ merger. ______________ 25 A combination cartel that places its assets under the . custody of a board of directors is a/an__________. ______________ 26 Charging different customers different prices for the . same product is a/an __________. ______________ 27 Making a retailer sign a contract stipulating that . he/she will not carry the products of a competitor is __________. ______________ 28 An agreement whereby a buyer is required to . purchase two or more products at a single price is called a/an __________. ______________ 29 A powerful firm that lowers its price considerable and . then raises it again after competitors are eliminated as a result commits __________. ______________ 30 __________ is practiced by firms that dictate to . retailers the price that should be charged to consumers. ______________ 31 When there are two or more firms in an industry and . the directors of one also serve as directors in the other or others, there is a/an __________. ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris paribus). 1. Nestle and Alaska are confronted with the decision of whether or not they should promote their milk products with small or large advertising budget. The matrix below show their potential profits in millions of pesos.
109 Alaskas Decision Small Advertising Large Advertising Budget Small Advertising Budget Nestles Decision Large Advertising Budget Alaska earns Php60M. Nestle earns Php60M. Nestle earns Php160M. Alaska earns Php40M. Budget Alaska earns Php 120M. Nestle earns Php 50M. Alaska earns Php170M. Nestle earns Php170M.
Describe and explain the interdependence between the two firms . Determine if there is Nash Equilibrium in their interdependence. 2. There are only two air conditioned jeepney manufacturers in the Philippines, Sarao and Pampanga Built. The latter is certain that Sarao will match any price it sets. From the following information about profit and prices, answers the questions below. All amounts are denominated in pesos. Profits are in millions of pesos. Pampanga sells Sarao sells at at 140,000 140,000 140,000 280,000 280,000 280,000 420,000 420,000 420,000 140,000 280,000 420,000 140,000 280,000 420,000 140,000 280,000 420,000 Pampangas profits 10 14 16 8 12 12 4 8 9 Saraos profits 10 70 4 14 12 8 16 14 9
a. At what price will Pampanga Built sell its jeepneys? b. At what price will Sarao sell, given the price of Pampanga Built? c. What will be Pampanga Builts profit after the response of Sarao?
110 d. Should they cooperate to maximize joint profits, what price would the two set? e. Considering your answer in question d, how can cheating on price cause each manufacturers profit to rise?
3. A monopolistically competitive firm has the following demand, cost, and price schedule. OUTPUT 0 1 2 3 4 5 6 PRICE 100 90 80 70 60 50 40 FC 100 VC 0 50 90 150 230 330 450 TC TR PROFIT/ (LOSS)
111 7 30 590
a. Fill the blank spaces on the table. b. What is the most favorable profit or loss for the firm? c. Will it be wise to shut down or continue operation in the short-run? Explain your answer. d. As the firm increases its output, what are the resulting marginal cost and marginal revenue.

Cost To Oligopoly

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1 CHAPTER VI. PRODUCTION AND COSTS OBJECTIVES At the end of the lesson, the student will be able to 1. 2. 3.

2 When we use the resources of others we pay the owners

Economic Implicit Costs Costs

Accounting Costs Explicit Costs Explicit Costs

Labor 10 baskets per worker 12.50 15 15 14 12.5 11 9.62 8.33

6 a) Total Product Curve

Labor per day

b) Marginal Product and Average Product Curves

Decreasing but positive MR

Average Product Marginal Product

Labor per day

10 Exhibit 6.5. Short-Run Cost Schedule.

Cost per unit

Product per unit (Quantity)

Units per hour

OUTPUT (Units per period of time)

HIP BETWEEN MARGINAL PRODUCT AND MARGINAL COST

Exhibit 6.8.Relationship Between Marginal Cost and Marginal Product.

Average total cost (pesos)

12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 SRATC SRATC SRATC

Cost per unit (pesos)

18 experiences economies of scale or economies of mass production.

Cost per unit (Pesos)

Increasing returns to scale (Economies of Scale)

Decreasing returns to scale (Diseconomies of scale)

Constant returns to scale 0 Q1 Q2

____ 1 4. ____ 1 5. ____ 1 6. ____ 1 7. ____ 1 8. ____ 1 9. ____ 2 0.

PART 2. MARKET STRUCTURES, PRICING, AND, MARKET POWER

KEY WORDS AND TERMS Industry Revenue Shutdown point

Price per unit

100,000 Quantity per period

33 4 5 6 7 8 8 8 8 8 8 32 40 48 56 64 18 24 31 39 48 5 6 7 8 9 4.5 4.8 5.17 5.57 6 14 16 17 17 16

Exhibit 7.4. Profit Maximization. Revenue and Average Costs Curves.

quantity (MC = MR)

ATC P=AR=M AVC R

1 HOW A FIRM CAN MAXIMIZE MAX PROFIT 2

Competitive firms curve supply

at a certain level of output Q (Exhibit 7.6). MC

P > ATC Profit Exhibit 7.6. Economic at Q (Profit-Maximizing Output)

Exhibit 7.7. Economic Loss (Loss-Minimizing Output)

Exhibit 7.8. Zero Economic Profit Price P = ATC at Q MC

ATC P = ATC P=AR=MR

0 Zero Economic Profit

Exhibit 7.10. Short-Run Losses and Shutdown Point Price

When P>ATC firm enter a the may

Along portion where P<ATC

firm will exit the industry.

Exhibit 7.12. Market Supply in a Competitive Market Price MC Supply

Price per unit

MC AVC MR3 MR2 MR1 Units of output per hour

KEY WORDS AND TERMS Monopoly Output effect Copyright

Quantity (small firm)

Quantity (large firm)

Quantity of Output REVENUE OF A MONOPOLY ( Exhibit 8.3 and 8.4)

Pesos per unit

34 0 Quantity per period 1 8

59 Exhibit 8.5. Short-run Costs and Revenue for a Monopoly

Total revenue and total cost

C Maximu m Profit 66.00 44.2 5 Output: maximum profit 0 11 TR

24 Quantity of output per period

Exhibit 8.7. Profit Maximization: Marginal Revenue = Marginal Cost.

Peso per unit

1 4. 1 5. 1 6. 1 7. 1 8. 1 9. 2 0.