# Market Structure and the Behavior of Firms

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Market Structure and the Behavior of Firms

Market Structures Benchmark models Perfect Competition Monopoly

Major Econ 211 (Micro I) Econ 212 (Macro I) Econ 349 (Micro II) Econ 375 (Macro II) Math 123 (Stats) Econ 420 (Regression) Econ 421 (Empirical Research) 12 additional hours in Econ 33-34 hours Minor Econ 211 Econ 212 Math 123 9 additional hours in Econ 18 hours Fall 2008 Econ 325 (Gender Econ) Econ 350 (Environmental Econ) Econ 360 (Law & Econ) Econ 420 (Regression) Spring 2009 Econ 301 (Money & Banking) Econ 340 (Sports Econ) Econ 349 (Micro II) Econ 414 (Int’l Econ)

Behavior of Firms What is the objective of a business?
Assume firms maximize profit  = TR – TC TR = Total Revenue = Pq TC = Total Economic Costs Economic Cost = Explicit Cost + Implicit Cost

Suppose that a young chef opened his own restaurant
Suppose that a young chef opened his own restaurant. To do so, he quit his job, which was paying \$36,000 per year; cashed in a \$6,000 certificate of deposit that was yielding 5% (to purchase equipment); and took over a building owned by his wife which had been rented out for \$3,000 per month. His expenses for the first year amounted to \$60,000 for food, \$40,000 for extra help, and \$7,000 for utilities. The chef is trying to figure out whether he would have been better off not being in business last year. He knows how to calculate his revenues, but he needs help with the cost side of the picture. What were the chef's total economic costs? \$107,000 \$113,000 \$149,000 \$185,300 Explicit Costs Implicit Costs \$60,000 (food) \$36,000 (foregone job) \$40,000 (extra help) \$300 (foregone interest) \$7,000 (utilities) \$36,000 (foregone rent) \$6,000 (equipment) \$113,000 \$72,300 Total Economic Cost = \$185,300 1 2 3 4 5

Technological Constraints
Production Function q = F(L, K) _ q = output L = labor K = capital F(·) represents technology Variable input Fixed input Lab Experiment 3: Widget Production

Other measures of productivity
Total Product q = F(L, K) Average Product AP = q/L Marginal Product MP = Δq/ ΔL Note: Diminishing Marginal Returns (DMR) When there is at least one fixed input, eventually a point is reached at which the marginal product of an additional worker begins to fall.

Productivity Graphs DMR TP AP L1 L2 L1 L2 MP output
Slope = MPL = ∆q/ ∆L q/L ∆q TP ∆L AP labor L1 L2 L1 labor L2 MP

Measuring Marginal Product
Batting Averages GPAs GPA Fall Spring Cumulative First Year Second Year Third Year Fourth Year 4.0 2.0 3.0 3.0 3.5 3.125 When MP > AP then AP will rise When MP < AP then AP will fall

Which worker at Decent Donuts has the highest marginal product?
Number of Workers 1 2 3 4 5 6 7 8 9 10 Total Donuts Produced Daily 12 26 44 64 86 110 122 125 127 128 Which worker at Decent Donuts has the highest marginal product? The fourth The fifth The sixth The seventh 1 2 3 4 5

Short Run Costs TC = FC + VC Does not vary with output: Rent Utilities
Salaries Property taxes Insurance premiums Varies with output: Labor Raw materials

Short Run Cost Curve Family
\$ VC \$ MC ATC AVC FC AFC output output TC = FC + VC ATC = AFC + AVC

Which of the following would be classified as a variable cost for the local Texaco gasoline station?
interest payments to a local bank for a loan. the local property tax on the building owned by the Texaco operator. the premiums paid for liability insurance, which are fixed at about \$30,000 per year. the federal excise tax paid on each gallon of Texaco gasoline sold. 1 2 3 4 5

Properties of the Cost Curves
“Ross Perot” Equation Short Run Cost Curve Shifters Change in price of labor Change in price of capital Change in amount of capital Change in technology \$ MC \$ MC ATC output AVC q/L AFC output MP labor

Austyn's fixed cost is \$3,600. Austyn’s employs 20 workers and pays each worker \$60. The average product of labor is 30, the marginal product of the 20th worker is 12. What is the marginal cost of the last unit produced by the last worker Austyn’s hired? \$0.20 \$5 \$240 \$720 1 2 3 4 5

Long Run Costs What is the optimal size for a factory? \$ LRAC output
ATC1 ATC2 ATC4 LRAC ATC3 q2 output

Long Run Average Cost Curve
\$ LRAC ATC3 Diseconomies of Scale Economies of Scale Specialization Coordination/Communication Problems qMES output EOS: double the inputs, output more than doubles  LRAC falls DOS: double the inputs, output less than doubles  LRAC rises

When all inputs increase by 40% and output rises by 30%, the firm is experiencing:
Diminishing returns Economies of scale Diseconomies of scale Constant returns to scale 1 2 3 4 5

Perfect Competition: Price Taker Model
Characteristics of the Industry Large number of small buyers/sellers Homogeneous product Free entry/exit Perfect information  firms are price takers MR = ΔTR / Δq \$ \$ S P1 P = MR D Q1 Quantity quantity Industry Firm

Maximizing Profit  = TR – TC  = P  q - [FC + VC]
\$ MC MR \$60 = P1 q1 = 300 quantity What output should firm produce?  produce until MR = MC If MR > MC  produce more If MR < MC  produce less I want you to maximize profit What is TR = ? What is TC = ?

leave output unchanged decrease its price
In a perfectly competitive industry, the market price of the product is \$12. Firm A is producing the output at which average total cost equals marginal cost, both of which are \$10. To maximize its profits, Firm A should: expand output reduce output leave output unchanged decrease its price 1 2 3 4 5

Profit and Loss Diagrams
Positive Profit:  > 0  = Pq – (ATC)q  = (P-ATC)q  = (60-50)300  = \$3000 Negative Profit  = (35-50)250  = -\$3750 Zero Profit? \$ MC ATC \$60 = P1 MR1 \$50 = ATC \$35 = P2 MR2 q2 = 250 q1 = 300 quantity

It is impossible to determine with the information given.
Juan’s Software Company is a perfect competitor. Juan has total fixed costs of \$25,000, average variable costs for 1,000 units of the product of \$45, and marginal revenue of \$75. What is his total economic profit? \$5,000 \$25,000 \$45,000 It is impossible to determine with the information given. 1 2 3 4 5

Sometimes it’s better to stay open and lose a little bit…
Temporary Shut Down: q = 0  = Pq – (FC +VC)  = 0 – (FC + 0)  = - FC Stay open if TR > VC Shut down if TR < VC \$ MC ATC AVC \$35 = ATC1 Fixed Cost = \$30,000 \$25 = P1 MR1 \$20 = AVC1 q1 = 2000 quantity Stay open:  = -\$20,000 Shut down:  = -\$30,000

A competitive firm is maximizing profits by producing 600 units of output at the current market price of \$800 per unit. The firm has AFC of \$150 and total costs of \$600,000 at this output level. TR = TC =  = FC = VC = ATC = AFC = AVC = MR = MC = SD = \$480,000 \$600,000 -\$120,000 \$ 90,000 \$510,000 \$1,000 \$150 \$850 \$800 \$800 Firm should shut down since TR < VC -\$90,000

Shutdown recap Shut down if TR < VC Pq < (AVC)(q) P < AVC
\$ MC ATC Note: The portion of the MC curve above the shutdown point is the firm’s supply curve AVC PSD = Min AVC qSD quantity Shut down if TR < VC Pq < (AVC)(q) P < AVC

How should a business react if…
Price rises? Marginal costs rise? Fixed costs rise? I have to remember to think at the margin! \$ MC ATC AVC P1 MR1 quantity q1

Long Run Equilibrium A = TR – Explicit Costs E = A - Implicit Costs
Firm = A = TR – Explicit Costs E = A - Implicit Costs LRE: E = 0 Economy A= 6% 7% E= 0% A= 9% 7% E= 3% 0% A= 6% 7% E= 0% A= 6% 7% E= 0% if E > 0  entry occurs if E < 0  exit occurs

\$ \$ MC S1 ATC S2 P2 MR2 LRS P1 MR1 D2 D1 Q1 Q3 Quantity q1 q2 quantity Industry Firm At P1: each firm produces q1 and earns E = 0 Demand rises to D2: causes price to rise to P2 Long run supply curve for a constant cost industry is horizontal At P2: each firm produces q2 and earns E > 0 Since E > 0 , new firms will enter: supply shifts to S2 Price will fall back to P1 and E = 0

The rutabaga market is perfectly competitive
The rutabaga market is perfectly competitive. Research is published claiming that eating rutabagas leads to gaining weight and so the demand for rutabagas permanently decreases. The permanent decrease in demand results in a lower price, economic losses by rutabaga farmers, and entry into the market. lower price, economic losses by rutabaga farmers, and exit from the market. higher price, economic profits for rutabaga farmers, and entry into the market. higher price, economic losses by rutabaga farmers, and exit from the market. 1 2 3 4 5

Suppose that newspaper companies are now required to use recycled paper, which is more expensive than new paper. Which of the following is most likely to result if the newspaper industry is highly competitive? The firms’ costs will rise, resulting in positive economic profit in the short run and, hence, the industry supply curve will shift rightward in the long run The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift rightward in the long run. The firms’ costs will rise, resulting in economic losses in the short run and, hence, the industry supply curve will shift leftward in the long run. The industry supply curve will shift leftward in the short run, causing permanent long-run economic losses 1 2 3 4 5

Ian’s fixed cost of mowing lawns is \$250 and his marginal cost is constant at \$10 per lawn. If Ian mows 5 lawns in one day, what is his average total cost? \$25 \$50 \$60 \$300 1 2 3 4 5

A wheat farmer operating in the short run produces 100 bushels of wheat. Her average total cost per bushel is \$1.75, total revenue is \$450, and (total) fixed costs are equal to \$100. Then average fixed cost is equal to \$1.50. profit per bushel is equal to \$2.75. average variable cost is equal to \$1.25. economic profit is equal to \$250. 1 2 3 4 5

Business people often speak about price elasticity without actually using the term. Which of the following quotations describes an elastic demand for a product? "A price cut won't help me. It won't increase my sales; I'll just get less money for each unit that I was selling before." "I don't think a price cut will help my bottom line any. Sure, I'll sell a bit more, but what I may gain by selling more, I'll more than lose because the price will be lower." "My customers are real shoppers. Since I cut my prices just a few cents below those my competitors charge, customers have been flocking to my store and sales are booming." "The economic expansion has done wonders for my sales. With more people back at work, my sales are taking off, and I don't even have to reduce my prices." 1 2 3 4 5

A group of dairy farmers are trying to raise milk prices by 20%
A group of dairy farmers are trying to raise milk prices by 20%. If the price elasticity of demand for is 0.75, and the price elasticity of supply for milk is 0, then by how much should farmers reduce their milk production to obtain the 20% increase? 2.7% 7.5% 15% 20% 1 2 3 4 5

For which of the following is the cross-price elasticity of demand most likely a large positive number? french fries and onion rings DVDs and milk hockey pucks and hockey sticks All of the above are correct, because the cross-price elasticity is always a positive number. 1 2 3 4 5