1. Finance 510: Microeconomic Analysis
Technology, Cost, and Price

2. Oil prices are currently hovering around $60/barrel
Oil prices are currently hovering around $60/barrel. This is a 50% increase from one year ago! How will this rise impact the prices of final goods?
Production Decisions
Product Markets
Factor Markets
Factor Usage/Prices Determine Production Costs
Supply/Demand determine markup over costs
Supply/Demand Determines Factor prices

3. Production theory begins with the assumption that every producer has a technology available to convert various inputs into output. Its usually convenient to represent this technology with a production function
Set of inputs
Output

4. Short Run vs. Long Run
It is important in production theory to distinguish the short run from the long run. In the short run, some of the inputs into production are fixed. In the long run, all inputs are changeable.
“Fixed” Inputs
Output
Inputs
Output
Variable Inputs
Long Run
Short Run

5. Properties of Production
Labor
Output
Capital (Fixed in the Short Run)
for all
(Output is positive)
for all
(Production is increasing in all factors)
(Factors are complements in production)
for all

6. Short Run Properties: Marginal Returns is fixed
As labor increases (given a fixed capital stock), labor productivity decreases
As labor increases (given a fixed capital stock), labor productivity increases

7. Long Run Properties is variable Marginal Product of Capital
Marginal Product of Labor
The Technical rate of substitution (TRS) measures the amount of labor required to replace each unit of capital and maintain constant production

8. Long Run Properties is variable
If you have a lot of capital relative to labor, then TRS is low)!

9. Long Run Properties is variable
The elasticity of substitution measures curvature

10. Long Run Properties is variable Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale

11. Cost Minimization The cost function for the firm can be written as
Given the costs of the firm’s inputs, the problem facing the firm is to find the lowest cost method of producing a fixed amount of output

12. Cost Minimization: Short Run
Fixed Cost
is fixed

13. Cost Minimization: Short Run is fixed
First Order Necessary Conditions

14. Cost Minimization: Short Run is fixed
Recall that lambda measures the marginal impact of the constraint. In this case, lambda represents the marginal cost of producing more output
Marginal costs are increasing
Marginal costs are decreasing

15. Marginal Cost vs. Average Cost
Costs
ATC
Minimum ATC MC
AVC

16. Marginal Cost vs. Average Cost
Costs
ATC
AVC MC

17. Cost Minimization: Long Run
is variable

18. Cost Minimization: Long Run is variable
First Order Necessary Conditions

20. Elasticity of Substitution

21. Marginal Cost vs. Average CostMC
Costs AC

22. Marginal Cost vs. Average Cost
Costs
MC = AC

23. Marginal Cost vs. Average Cost
Costs AC MC

24. Estimating Production Functions
Labor Growth
Capital Growth
Output Growth
Productivity Growth

25. Example: Estimating Production Functions
A Cobb-Douglas Production function was estimated for the aggregate production sector of the US
Average Annual Growth = 1.5%

26. Industry Food/Beverage .555 .439 .076 1.070 Textiles .121 .549 .335
Example: Estimating Production Elasticities
Non-Production Labor
Production Labor
Industry
Food/Beverage
.555
.439
.076
1.070
Textiles
.121
.549
.335
1.004
Furniture
.205
.802
.103
1.109
Petroleum
.308
.546
.089
.947
Stone, Clay, etc.
.632
.032
.366
1.029
Primary Metals
.371
.077
.509
.958

27. Profit Maximization and Industry Dynamics
After the determination of optimal production, the firm is faced with a cost function…
Further, the firm faces a demand for its product…

28. A quick diversion… Demand refers to output as a function of price
Inverse demand refers to price as a function of output

29. Profit Maximization and Industry Dynamics
After the determination of optimal production, the firm is faced with a cost function…
Further, the firm faces an inverse demand for its product…
A firm needs to choose output to maximize profits…

30. Profit Maximization First Order Necessary Conditions
Marginal Cost (MC)

31. First Order Condition
Multiply and divide the first term by p
A little rearranging
Now, solve for price

32. Initially, you are charging price (P) and generating sales equal to Y
Revenue = P*Y
To increase sales, you must lower your price D

33. Cost, Price, and Market Structure
Market Structure Spectrum
Monopoly
Perfect Competition
The market is supplied by many producers – each with zero market share
One Producer Supplies the entire Market

34. Measuring Market Structure – Concentration Ratios
Suppose that we take all the firms in an industry and raked them by size. Then calculate the cumulative market share of the n largest firms.
Cumulative Market Share
100 A C 80 B 40 20
Size Rank 1 2 3 4 5 6 7 10 20

35. Measuring Market Structure – Concentration Ratios
Cumulative Market Share
100 A C 80 B 40 20
Size Rank 1 2 3 4 5 6 7 10 20
Measures the cumulative market share of the top four firms

36. Concentration Ratios in US manufacturing; 1947 - 1997
Year
1947 17 23 30
1958 38
1967 25 33 42
1977 24 44
1987 43
1992 32
1997 40
Aggregate manufacturing in the US hasn’t really changed since WWII

37. Measuring Market Structure: The Herfindahl-Hirschman Index (HHI)
= Market share of firm i
Rank
Market Share 1 25
625 2 3 4 5 6 7 8
HHI = 2,000

38. The HHI index penalizes a small number of total firms
Cumulative Market Share
100 A 80
HHI = 500 B
HHI = 1,000 40 20 1 2 3 4 5 6 7 10 20

39. The HHI index also penalizes an unequal distribution of firms
Cumulative Market Share
100 80
HHI = 500
HHI = 555 A 40 B 20 1 2 3 4 5 6 7 10 20

40. Concentration Ratios in For Selected Industries
Industry
CR(4)
HHI
Breakfast Cereals 83
2446
Automobiles 80
2862
Aircraft
2562
Telephone Equipment 55
1061
Women’s Footwear 50
795
Soft Drinks 47
800
Computers & Peripherals 37
464
Pharmaceuticals 32
446
Petroleum Refineries 28
422
Textile Mills 13 94

41. Perfect Competition MC ATC D
Perfectly competitive firms are so small relative to the market that they can’t influence market price – they face a perfectly elastic demand curve MC
ATC D

42. Perfect Competition MC = AC
As we move from the short run to the long run, firms adjust their capital structure (move from short run cost functions to long run cost functions)
MC = AC

43. Monopoly
Monopolies by definition face the entire market demand. Therefore, monopolies charge a markup over marginal cost – as the elasticity of demand increases, the markup decreases. MC
Example
ATC MC D MR

44. Monopoly
As we move from the short run to the long run, firms adjust their capital structure (move from short run cost functions to long run cost functions). Typically, demand also becomes more elastic as consumers find substitute products MC
Example D MC MR

45. Higher market concentration offers the potential for market power
Higher market concentration offers the potential for market power. However, does high market concentration guarantee market power?
The Lerner index measures the percentage of a product’s price that is due to the markup
Perfect Competition
Monopoly

46. Lerner index in For Selected Industries
Industry LI
Communication
.972
Paper & Allied Products
.930
Electric, Gas & Sanitary Services
.921
Food Products
.880
General Manufacturing
.777
Furniture
.731
Tobacco
.638
Apparel
.444
Motor Vehicles
.433
Machinery
.300

47. Cost Structure and Market Structure – Does it pay to be big?
The output elasticity of costs is defined as the percentage increase in total costs for every 1% increase in production
If the output elasticity is less than one, then total costs are growing at a rate that is lower than output (Average Costs are declining) – It pays to be big!!
A scale economy index larger than one indicates the potential for a monopoly!

48. Cost Structure and Market Structure – Does it pay to be big?
ATC
If market demand is always below y*, than this industry could become monopolistic!! MC

49. Globally scale economies
Globally scale economies (S>1 for all y) are known as natural monopolies (the market should – and will – be serviced by one producer). This can happen if production exhibits increasing returns to scale, or if there are large fixed costs.
Costs
Costs
ATC
ATC MC MC

50. Monopoly Market Characteristics
Scale economies (Natural Monopolies)
Small market size
Network Externalities
Government Policy (Protected Monopolies)
Any one of these characteristics suggest that the long run market structure should be monopolistic.