Krugman Economics 6e Lecture Slides Ch 11 PDF

WHAT YOU WILL LEARN IN THIS CHAPTER 11 What is the firm’s production function? Why is production often subje...

WHAT YOU WILL LEARN IN THIS CHAPTER 11 What is the firm’s production function? Why is production often subject to diminishing returns to inputs? What types of costs does a firm face, and how does the firm generate its marginal and average cost curves? Why do the firm’s costs differ in the short run and in the long run? Behind the Supply Curve: What is increasing returns to scale, and what advantage does it give? Inputs and Costs Revised by Vitaly Terekhov Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE PRODUCTION FUNCTION INPUTS AND OUTPUT A firm is an organization that produces goods or services for sale. The long run is the period in which all inputs can be varied. Production is the process of turning inputs into outputs. The short run is the period in which at least one input is fixed. A production function is the relationship between the quantity The total product curve shows how the quantity of output of inputs a firm uses and the quantity of output it produces. depends on the quantity of the variable input for a given quantity A fixed input is an input whose quantity is fixed for a period of of the fixed input. time and cannot be varied. A variable input is an input whose quantity the firm can vary at any time. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PRODUCTION FUNCTION AND TOTAL PRODUCT PRODUCTION FUNCTION AND TOTAL PRODUCT CURVE (1 of 2) CURVE (2 of 2) Figure 11-1 The marginal product of an input is the additional quantity of output that is produced by using one more unit of that input. Marginal product of labor (MPL) is the change in output resulting from a one-unit increase in the amount of labor input (ΔQ/ΔL) MPL equals the slope of the total product curve. In Figure 11-1, MPL declines as more workers are hired. As employment increases, the total product curve gets flatter. Figure 11-2 shows how MPL depends on the number of workers: The curve slopes upward because more wheat is produced as more workers are employed. It becomes flatter because the marginal product of labor declines as more workers are employed. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers DIMINISHING RETURNS TO AN INPUT LEARN BY DOING: PRACTICE QUESTION 1 Diminishing returns to an input: an increase in the quantity of that input, holding the levels of all other inputs fixed, reduces that input’s marginal product. If one worker makes 14 baskets, two workers make 34 baskets, three workers make 45 baskets, and four workers make 50 baskets, which worker yielded the highest marginal product? a) the first worker b) the second worker c) the third worker d) the fourth worker Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 1 (Answer) LEARN BY DOING: PRACTICE QUESTION 2 If one worker makes 14 baskets, Marginal product is the slope of the: two workers make 34 baskets, three workers make 45 baskets, and a) marginal cost curve. four workers make 50 baskets, which worker yielded the highest marginal product? b) total product curve. a) the first worker c) long-run average total cost curve. b) the second worker (correct answer) c) the third worker d) total cost curve. d) the fourth worker Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING: PRACTICE QUESTION 2 (Answer) TOTAL PRODUCT, MARGINAL PRODUCT, AND FIXED INPUT Figure 11-3 Marginal product is the slope of the: a) marginal cost curve. b) total product curve. (correct answer) c) long-run average total cost curve. d) total cost curve. With more land (fixed input) each worker can produce more. This shifts the total product curve up. So the MPL of each worker is higher when the farm is larger; the MPL curve shifts up, too. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PITFALLS: WHAT’S A UNIT? LEARN BY DOING: DISCUSSION QUESTION 1 Thomas Malthus (1766–1834) predicted that as population grew, the The MPL is defined as the increase in the quantity of output when you economy’s diminishing ability to produce food from a given set of increase the quantity of that input by one unit. resources would necessarily lead to insufficient food. However, What do we mean by a unit of labor? Is it an additional hour of labor, population continues to grow, and so does food production. an additional week, or a person-year? What aspect of food production did Malthus fail to anticipate? The answer is that it doesn’t matter, as long as you are consistent. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers FROM THE PRODUCTION FUNCTION TO COST CURVES LEARN BY DOING: PRACTICE QUESTION 3 A fixed cost is a cost that does not depend on the quantity You own a deli. Which of the following is most likely a fixed input at your deli? of output produced. It is the cost of the fixed input. a) the dining room A variable cost is a cost that depends on the quantity of b) the bread used to make sandwiches output produced. It is the cost of the variable input. c) the tomato base used to make soups d) the employees Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 3 (Answer) TOTAL COST CURVE The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output. You own a deli. Which of the following is most likely a fixed input TC = FC + VC at your deli? The total cost curve shows how total cost depends on the quantity of a) the dining room (correct answer) output. b) the bread used to make sandwiches The total cost curve becomes steeper as more output is produced, a result of diminishing returns. c) the tomato base used to make soups d) the employees With diminishing returns, additional units of output require more and more labor; therefore the cost increases. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers MARGINAL COST TOTAL COST CURVE The marginal cost is the change in total cost generated by one additional unit of output. Figure 11-4: MC = ΔTC/ΔQ The curve gets where Δ = change, TC = total cost, and Q = quantity of output steeper as output increases due to diminishing returns to labor. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  MARGINAL COST EXAMPLE MARGINAL COST GRAPHS TABLE 11-1 Costs at Selena’s Gourmet Salsas Figure 11-6 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers WHY IS THE MARGINAL COST CURVE UPWARD SLOPING? AVERAGE COST Because there are diminishing returns to inputs in this Average total cost (often referred to simply as average cost) = total cost example. As output increases, the marginal product of the per unit of output produced. variable input declines. ATC = TC/Q This implies that more and more of the variable input must be used to produce each additional unit of output as the amount Average fixed cost = fixed cost per unit of output produced. of output already produced rises. AFC = FC/Q And since each unit of the variable input must be paid for, the Average variable cost = variable cost per unit of output produced. cost per additional unit of output also rises. AVC = VC/Q Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 4 LEARN BY DOING: PRACTICE QUESTION 4 (Answer) You produce widgets. Currently you produce 4 widgets at a total cost You produce widgets. Currently you produce 4 widgets at a total cost of $40. of $40. Suppose you could produce one more widget (the fifth) at a marginal Suppose you could produce one more widget (the fifth) at a marginal cost of $5. If you do produce that fifth widget, what will your cost of $5. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or average total cost be? Has your average total cost increased or decreased? decreased? a) Your average total cost has decreased to $11. a) Your average total cost has decreased to $11. b) Your average total cost has decreased to $9. b) Your average total cost has decreased to $9. (correct answer) c) Your average total cost has increased to $9. c) Your average total cost has increased to $9. d) Your average total cost has increased to $11. d) Your average total cost has increased to $11. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers AVERAGE COSTS FOR SELENA’S GOURMET SALSAS AVERAGE TOTAL COST CURVE FOR SELENA’S GOURMET SALSAS TABLE 11-2 Average Costs for Selena’s Gourmet Salsas Quantity Average total cost of Average variable cost of Figure 11-7 Total cost Average fixed cost of case of salsa case case TC AFC = FC/Q Q (cases) ATC = TC/Q AVC = VC/Q 1 $120 $120.00 $108.00 $12.00 2 156 78.00 54.00 24.00 3 216 72.00 36.00 36.00 4 300 75.00 27.00 48.00 5 408 81.60 21.60 60.00 6 540 90.00 18.00 72.00 7 696 99.43 15.43 84.00 8 876 109.50 13.50 96.00 9 1,080 120.00 12.00 108.00 10 1,308 130.80 10.80 120.00 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  AVERAGE TOTAL COST CURVE PUTTING THE FOUR COST CURVES TOGETHER Increasing output has two opposing effects on average total Note that: cost: 1. Marginal cost slopes upward because of diminishing returns. – The spreading effect: The larger the output, the more output 2. Average variable cost also slopes upward but is flatter than the over which fixed cost is spread, leading to lower average fixed cost. marginal cost curve. – The diminishing returns effect: The larger the output, the 3. Average fixed cost slopes downward because of the spreading more variable input required to produce additional units, which effect. leads to higher average variable cost. 4. The marginal cost curve intersects the average total cost curve from below, crossing it at its lowest point. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers MARGINAL COST AND AVERAGE COST CURVES FOR LEARN BY DOING: PRACTICE QUESTION 5 SELENA’S GOURMET SALSAS Figure 11-8 At high levels of output the spreading effect is: a) stronger than the diminishing returns effect. b) weaker than the diminishing returns effect. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 5 (Answer) MINIMUM AVERAGE TOTAL COST At high levels of output the spreading effect is: The minimum-cost output is the quantity of output at which a) stronger than the diminishing returns effect. average total cost is lowest—the bottom of the U-shaped b) weaker than the diminishing returns effect. (correct average total cost curve. answer) Three general principles are always true about a firm’s marginal cost and average total cost curves: 1. At the minimum-cost output, average total cost is equal to marginal cost. 2. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling. 3. At output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers DOES THE MARGINAL COST CURVE ALWAYS SLOPE THE RELATIONSHIP BETWEEN THE AVERAGE TOTAL UPWARD? (1 of 2) COST AND THE MARGINAL COST CURVES Figure 11-9 Marginal cost curves often slope downward as the output goes from zero up to some low level, and they slope upward at higher levels of production. The initial downward slope occurs when employing more workers allows them to specialize in various tasks. This specialization leads to increasing returns to the hiring of additional workers and results in the marginal cost curve sloping downward. Once enough workers exhaust the benefits of specialization, diminishing returns to labor set in and the marginal cost curve slopes upward. Typical marginal cost curves have the “swoosh” shape. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  DOES THE MARGINAL COST CURVE ALWAYS SLOPE SHORT-RUN VERSUS LONG-RUN COSTS UPWARD? (2 of 2) Figure 11-10 All inputs are variable in the long run. This means that in the long run, fixed cost (like factory size) may also vary. The firm will choose its fixed cost in the long run based on the level of output it expects to produce. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers Figure 11-11 THE LONG-RUN AVERAGE TOTAL COST CURVE CHOOSING THE LEVEL OF FIXED COST The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been There is a trade-off chosen to minimize average total cost for each level of output. between higher – (We assume the firm has chosen the cheapest plant size for fixed cost and lower each output level.) variable cost for any given output level, and vice versa. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  SHORT-RUN AND LONG-RUN AVERAGE TOTAL COST CURVES RETURNS TO SCALE Short-run and long-run average total cost curves differ Figure 11-12 because a firm can choose its fixed cost in the long run. There are increasing returns to scale (economies of scale) when long-run average total cost declines as output increases. If the firm chooses the fixed There are decreasing returns to scale (diseconomies of cost that minimizes short-run scale) when long-run average total cost increases as output ATC at an output of 6, and produces 6, it’s at point C. increases. If it produces only 3, it’ll move There are constant returns to scale when long-run average to point B. total cost is constant as output increases. If the firm expects to produce 3 cases for a long time, it’ll reduce its fixed cost and move to point A. If it produces 9 (point Y) and expects to continue this for a long time, it’ll increase its fixed cost and move to point X. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  WHAT YOU WILL LEARN IN THIS CHAPTER 12 What is perfect competition and why do economists consider it an important benchmark? What factors make a firm or an industry perfectly competitive? How does a perfectly competitive industry determine the profit- maximizing output level? Perfect Competition and the What determines if a firm is profitable or unprofitable? Why does it make sense for a firm to behave differently in the Supply Curve short run versus the long run? How does the short-run industry supply curve differ from the long-run industry supply curve? Revised by Vitaly Terekhov Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers DEFINING PERFECT COMPETITION LEARN BY DOING: PRACTICE QUESTION 1 All market participants, both consumers and producers, are price-takers. 1. There are many producers, each with a small market share. Which of the following markets is likely to be the most – Market share: the fraction of the total industry output accounted for by that competitive? producer’s output a) cable television – This means both sellers and buyers are price-takers; their actions have no b) automobiles and trucks effect on price. c) oil refining – Each participant is a drop in the bucket. d) farm commodities 2. Consumers regard the products of all producers as equivalent. – The product is standardized across sellers. – Standardized product (aka commodity): consumers regard different sellers’ products as the same. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 1 (Answer) FREE ENTRY AND EXIT Which of the following markets is likely to be the most 3. Most perfectly competitive industries are also competitive? characterized by free entry and exit: a) cable television b) automobiles and trucks – New producers can easily enter into an industry, and c) oil refining existing producers can easily leave that industry. d) farm commodities (correct answer) Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers ECONOMICS IN ACTION PRODUCTION AND PROFITS (1/2) What’s a standardized product? Are Korean kimchi producers’ claims to be believed? Is Each firm’s total revenue is equal to price × quantity sold, or Japanese kimchi different from (and inferior to) the TR = P × Q Korean “real thing”)? And profit = total revenue − total cost, or As far as economists are concerned, the products are Profit = TR – TC different only if the consumers believe them to be. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PRODUCTION AND PROFITS (2/2) MARGINAL ANALYSIS AND THE PROFIT- When market price = $72, profit is highest at Q = 50. TABLE 12-1 Profit for Noelle’s Farm When Market Price Is $72 MAXIMIZING OUTPUT (1 of 2) Recall the profit-maximizing principle of marginal analysis: the optimal amount of an Quantity of trees Q Total revenue TR Total cost TC Profit TR – TC activity is the level at which marginal benefit equals marginal cost. 0 $0 $560 −$560 Marginal revenue: change in total revenue generated by an additional unit of output – MR = ΔTR/ΔQ 10 720 1,200 −480 – Since the firm is a price-taker, MR equals the price: the firm can sell as much 20 1,440 1,440 0 as it likes at the current market price. Its marginal revenue curve is a horizontal line at the market price. 30 2,160 1,760 400 – Since the firm is a price-taker, the firm faces a horizontal, perfectly elastic demand curve that is equivalent to its marginal revenue curve. 40 2,880 2,240 640 Optimal output rule: profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost 50 3,600 2,880 720 60 4,320 3,680 640 70 5,040 4,640 400 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers TABLE 12-2 Short-Run Costs for Noelle’s Farm MARGINAL ANALYSIS AND THE PROFIT- As long as increasing production by one more unit creates more MR than MC, it MAXIMIZING OUTPUT (2 of 2) makes sense to do it. Quantity of Variable cost Total cost TC Marginal cost Marginal Net gain of a trees VC of a tree revenue of a tree Why is profit maximized where MR = MC? tree Each time the firm produces another unit, there are extra costs and 0 $0 560 extra revenues. If producing another unit adds more to revenue than it costs, profit will 10 640 1,200 64 72 8 increase. – If MR > MC, producing more will add to profit; 20 880 1,440 24 72 48 – If MR < MC, producing less will add to profit. Since MR = P for competitive firms, the profit-maximizing rule is to choose 30 1,200 1,760 32 72 40 the quantity of output where P = MC. 40 1,680 2,240 48 72 24 50 2,320 2,880 64 72 8 60 3,120 3,680 80 72 -8 70 4,080 4,640 96 72 -24 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PITFALLS THE PRICE-TAKING FIRM’S PROFIT-MAXIMIZING QUANTITY OF OUTPUT Figure 12-1 What if marginal revenue and marginal cost aren’t exactly equal? What do you do if there is no output level at which marginal revenue equals marginal cost? In that case, you produce the largest quantity for which marginal revenue exceeds marginal cost. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers WHEN IS PRODUCTION PROFITABLE? COSTS AND PRODUCTION IN THE SHORT RUN Recall that we are using economic profit — the profit that includes the implicit cost (the forgone benefits of the firm’s resources) and the explicit cost (cash outlays). Figure 12-1 ‒ If TR > TC, the firm is profitable. ‒ If TR = TC, the firm breaks even. ‒ If TR < TC, the firm incurs a loss. We can also express this idea in terms of average revenue and cost per unit of output: ‒ If the firm produces a quantity at which P > ATC, the firm is profitable. ‒ If the firm produces a quantity at which P = ATC, the firm breaks even. ‒ If the firm produces a quantity at which P < ATC, the firm incurs a loss. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  Figure 12-3 (a,b) Figure 12-3 (a,b) PROFITABILITY AND PROFITABILITY AND THE MARKET THE MARKET PRICE (1 of 3) PRICE (2 of 3) The farm’s per unit The farm is profit: profitable because P > min ATC ($56). $72.00 – $57.60 = $14.40. Total profit: 50 × $14.40 = $720. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers CALCULATING TOTAL COSTS AND PROFIT LEARN BY DOING PRACTICE QUESTION 2 Profit = TR − TC = (TR/Q − TC/Q) × Q, or If a firm is earning positive economic profit, it must be the case that: Profit = (P − ATC) × Q a) price is less than average cost. The break-even price of a price-taking firm is the b) price is equal to average cost. market price at which it earns zero profit. c) price is equal to total cost. d) price is greater than average cost. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  Figure 12-3 (a,b) LEARN BY DOING PRACTICE QUESTION 2 (Answer) PROFITABILITY AND THE MARKET If a firm is earning positive economic profit, it must be the PRICE (3 of 3) case that: a) price is less than average cost. The farm’s per unit b) price is equal to average cost. loss: $58.67 – $40.00 c) price is equal to total cost. = $18.67. d) price is greater than average cost. (correct answer) Total loss: 30 × $18.67 = $560. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE SHORT-RUN PRODUCTION DECISION LEARN BY DOING PRACTICE QUESTION 3 Losses don’t mean immediate shutdown. If Gnomes-R-Us (a competitive firm) produces where the marginal cost Fixed costs must be paid regardless of whether the firm curve intersects with the average total cost curve at its minimum point, the produces in the short run. firm will earn: Since it cannot be changed, fixed cost is irrelevant to the a) positive economic profits. decision about whether to shut down in the short run. Other costs —variable costs—do matter. b) zero economic profits. When the market price is below minimum average variable cost, c) a short-run loss. a firm should cease production immediately. The minimum average variable cost is equal to the shut-down price. When price is greater than minimum average variable cost, however, the firm should produce in the short run. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING PRACTICE QUESTION 3 (Answer) LEARN BY DOING PRACTICE QUESTION 4 If Gnomes-R-Us (a competitive firm) produces where the marginal cost Should a competitive firm keep producing even if it faces curve intersects with the average total cost curve at its minimum point, the short-run losses and is producing at a point on its MC curve firm will earn: that is above the minimum AVC curve? a) positive economic profits. a) Yes, it is earning normal profits. b) zero economic profits. (correct answer) b) Yes, because it covers its variable costs and some fixed costs. c) a short-run loss. c) No, it should never incur losses. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING PRACTICE QUESTION 4 (Answer) THE SHORT-RUN INDIVIDUAL SUPPLY CURVE Figure 12-4 Should a competitive firm keep producing even if it faces short-run losses and is producing at a point on its MC curve that is above the minimum AVC curve? a) Yes, it is earning normal profits. b) Yes, because it covers its variable costs and some fixed costs. (correct answer) c) No, it should never incur losses. A firm will produce at every price above minimum ATC where price intersects the MC curve … … but will stop producing in the short run if the market price falls below the shut-down price... so the MC curve (above shut-down price) is the firm’s supply curve. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  SUMMING UP CHANGING FIXED COST Profitability condition (minimum ATC = break-even price) Result P > minimum ATC Firm profitable. Entry into industry in the long run. Buying or selling P = minimum ATC Firm breaks even. No entry into or exit from equipment allows a firm to industry in the long run. change its fixed cost. P < minimum ATC Firm unprofitable. Exit from industry in the long run. A firm will choose the level of fixed cost that Profitability condition Result (minimum AVC = shut-down price) minimizes the average total cost for its desired P > minimum AVC Firm produces in the short run. If P < minimum output quantity—and that ATC, firm covers variable cost and some but not all of the fixed cost. If P > minimum ATC, may mean closing down firm covers all variable cost and fixed cost. altogether. P = minimum AVC Firm is indifferent between producing in the short run or not. Just covers variable cost. P < minimum AVC Firm shuts down in the short run. Does not cover variable cost. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE SHORT-RUN INDUSTRY SUPPLY CURVE THE SHORT-RUN MARKET EQUILIBRIUM Figure 12-5 The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole. The short-run The short-run industry supply curve shows how the quantity supplied by market equilibrium: an industry depends on the market price given a fixed number of producers. the quantity There is a short-run market equilibrium when the quantity supplied equals supplied equals the the quantity demanded, taking the number of producers as given. quantity demanded, taking the number of producers as given. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  THE EFFECT OF AN INCREASE IN DEMAND IN THE THE LONG-RUN MARKET EQUILIBRIUM SHORT RUN AND THE LONG RUN Figure 12-6 (a,b) Figure 12-7(a,b,c) New firms enter as long as there is economic profit (P > min ATC). A market is in long-run equilibrium when the quantity supplied equals The LRS shows how the quantity supplied responds to the the quantity demanded, given that sufficient time has elapsed for price (once producers have had time to enter or exit the entry into and exit from the industry to occur. industry). Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE LONG-RUN INDUSTRY SUPPLY CURVE (1/2) COMPARING THE SHORT-RUN AND LONG-RUN INDUSTRY SUPPLY CURVES Figure 12-8 The long-run supply curve is The long-run supply curve is perfectly elastic if costs are constant across flatter than the short-run the industry—if each firm, be it an incumbent or a new entrant, faces the supply curve: same cost structure. Example: agriculture in which there is a perfectly – A higher price attracts elastic supply of inputs. new entrants in the long The long-run industry supply curve slopes upward when producers use an run, raising industry input that is in limited supply. As the industry expands, the price of that output and lowering input goes up, and later entrants have a higher cost structure than early price. entrants. Example: beachfront resort hotels, which compete for a limited quantity of prime property. Such industries are said to have increasing – A fall in price induces costs. existing producers to exit in the long run, reducing industry output and raising price. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE LONG-RUN INDUSTRY SUPPLY CURVE (2/2) PITFALLS: ECONOMIC PROFIT Industry supply curve slopes downward when an industry faces increasing Economic profit, again: returns to scale, in which average costs fall as output rises. Why would a firm want to enter an industry if the market Whether the long-run industry supply curve is horizontal or upward price is only slightly greater than the break-even price? sloping or even downward sloping, the long-run price elasticity of We are using economic profit as our measure, so if the market supply is higher than the short-run price elasticity whenever there is price is above the break-even level (no matter how slightly), the free entry and exit. firm can earn more in this industry than it could elsewhere. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING PRACTICE QUESTION 5 LEARN BY DOING PRACTICE QUESTION 5 (Answer) The long-run market equilibrium in a perfectly competitive industry with The long-run market equilibrium in a perfectly competitive industry with identical firms results in all firms: identical firms results in all firms: a) earning zero economic profit. a) earning zero economic profit. b) producing the quantity associated with their break-even price. b) producing the quantity associated with their break-even price. c) producing the profit-maximizing quantity at which MR = MC. c) producing the profit-maximizing quantity at which MR = MC. d) All of the above statements are true. d) All of the above statements are true. (correct answer) Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  WHAT YOU WILL LEARN IN THIS CHAPTER 13 What is the significance of monopoly, a type of industry in which only one producer, a monopolist, operates? How does being a monopolist affect a firm’s price and output decisions? Why does the presence of monopoly typically reduce social welfare? What tools do policy makers use to address the problem of monopoly? How do digital giants like Amazon, Google, and Facebook fit into our model of monopoly, and what special challenges do they represent? Monopoly What is price discrimination, and why is it so prevalent in certain industries? Revised by Vitaly Terekhov Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers TYPES OF MARKET STRUCTURE TYPES OF MARKET STRUCTURE, VISUALLY Figure 13-1 In order to develop models and make predictions about how producers will behave, economists have developed four principal models of market structure: – perfect competition – monopoly – oligopoly – monopolistic competition This system of market structures is based on two dimensions: 1. The number of firms in the market (one, few, or many) 2. Whether the goods offered are identical or differentiated Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  THE MEANING OF MONOPOLY WHAT A MONOPOLIST DOES Figure 13-2 Monopolist: a firm that is the only producer of a good A monopolist with no close substitutes reduces the Monopoly: an industry controlled by a monopolist quantity supplied Market power: the ability of a firm to raise prices to QM and moves up the demand curve from C to M, raising the price to PM. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers WHY DO MONOPOLIES EXIST? BARRIER #1: CONTROL OF A SCARCE RESOURCE OR INPUT If a monopolist makes profits, why don’t other firms grab a piece of action and drive prices and profits down? For a monopoly to persist, A monopolist that controls a crucial resource or input can something must keep others from going into the same business: a barrier to entry. prevent other firms from entering its market. There are five principal types of barriers to entry: – Control of a scarce resource or input – Increasing returns to scale – Technological superiority – Network externalities – Government-made barriers Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  BARRIER #2: INCREASING RETURNS TO SCALE BARRIER #2 IN A GRAPH Increasing returns to scale (economies of scale): When average total cost falls Figure 13-3 as output increases, firms tend to grow larger. ‒ The source of increasing returns to scale is large fixed costs. A given quantity ‒ In such an industry, larger companies are more profitable and drive out of output is smaller ones. produced more ‒ Increasing returns to scale can give rise to and sustain monopoly. cheaply by one A monopoly created and sustained by increasing returns to scale is called a natural monopoly. large firm than ‒ The most visible natural monopolies are utilities—water, natural gas, power by two or more generation, and fiber optic cable. smaller firms. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers BARRIER #3: TECHNOLOGICAL SUPERIORITY BARRIER #4: NETWORK EXTERNALITY A firm that maintains a consistent technological advantage Network externality: the value of a good or service to an over potential competitors can establish itself as a individual increases as more individuals use the same good or service monopolist. The firm with the largest network of customers may become a Example: Intel was technologically superior over other monopolist. firms from the 1960s to the 1990s. Examples: eBay, Facebook, Amazon, Netflix, Google, PayPal, and Snapchat. Technological superiority is typically not a barrier to entry over the longer term. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers BARRIER #5: GOVERNMENT-CREATED BARRIER GLOBAL COMPARISON: DRUG PRICES A patent gives an inventor a temporary monopoly in the use or Different drug sale of an invention. prices in different A copyright gives the creator of a literary or artistic work sole countries reflect rights to profit from that work. willingness to pay; The justification for patents and copyrights is a matter of they also reflect incentives: The law allows a monopoly to exist temporarily by that governments granting property rights that encourage invention and creation. in other countries regulate drug prices more actively than the U.S. government does. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers PROFIT- MAXIMIZING RULE HOW A MONOPOLIST MAXIMIZES PROFIT Competitive firms cannot choose price. Monopolists can. All firms follow the same rule: Profit is maximized at Figure 13-4 (a,b) the Q where MR = MC. So what does MR look like? MR = ∆TR / ∆Q Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers MARGINAL REVENUE AND THE DEMAND CURVE DEMAND, TOTAL REVENUE, AND MARGINAL REVENUE MR is below the demand curve … An increase in production by a monopolist has two opposing effects on revenue: TABLE 13-1 Demand, Total – A quantity effect: one more unit is sold, increasing total revenue by Revenue, and Marginal Revenue the price at which the unit is sold. for the De Beers Monopoly – A price effect: to sell the last unit, the monopolist must cut the market price on all units sold; this decreases total revenue. A monopolist’s marginal revenue curve is always below the demand curve because of the price effect: To sell an additional unit, the monopolist must cut the market price on all units sold. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING PRACTICE QUESTION 1 LEARN BY DOING PRACTICE QUESTION 1 (Answer) Suppose that a monopolist can sell 5 units of output at a price of $5, or 6 Suppose that a monopolist can sell 5 units of output at a price of $5, or 6 units of output at a price of $4. What is the marginal revenue of the sixth unit? units of output at a price of $4. What is the marginal revenue of the sixth unit? a) $24 a) $24 b) $49 b) $49 c) –$1 c) –$1 (correct answer) d) $10 d) $10 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  Figure 13-5 (a,b) PROFIT MAXIMIZATION FOR A MONOPOLY A MONOPOLIST’S DEMAND, TOTAL REVENUE, AND Profit maximization consists of two steps: MARGINAL 1. Choosing a quantity REVENUE CURVES Rule: Choose Q where MR = MC 2. Choosing a price ▪ Choose the highest price you can get away with, which is the highest price consumers will pay for that quantity. Rule: Once you’ve picked your quantity, follow the graph to the demand curve, which shows you how much consumers will pay. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers PITFALLS: FINDING THE MONOPOLY PRICE THE MONOPOLIST’S PROFIT-MAXIMIZING OUTPUT AND PRICE Figure 13-6 In order to find the profit-maximizing quantity of output for a monopolist, you look for the point where the MR curve crosses the MC curve. But this isn’t the price the monopolist will choose. The firm will want to charge as much as it can. Why stop at MR if it can charge up to what the demand curve says people will pay? Note: Here the MC curve is simplified to be constant. We will relax this simplification later. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PITFALLS: IS THERE A MONOPOLY SUPPLY CURVE? GRAPHING THE MONOPOLIST’S PROFIT Figure 13-7 As long as the You might be tempted to ask about the supply curve of a monopoly has monopolist. But this is a meaningless question. strong barriers Monopolists don’t have supply curves—since they to entry, profit control prices there is no set relationship between will stay. price and quantity supplied. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING PRACTICE QUESTION 2 LEARN BY DOING PRACTICE QUESTION 2 (Answer) If the market for some good were converted from a competitive industry to a If the market for some good were converted from a competitive industry to a monopoly, which of the monopoly, which of the following would occur as a result? following would occur as a result? a) Prices would fall on the output produced by the monopolist. a) Prices would fall on the output produced by the monopolist. b) Some consumer surplus would be re-allocated to the monopolist as profit. (correct b) Some consumer surplus would be reallocated to the monopolist as profit. answer) c) The overall level of profit earned in the industry would decrease. c) The overall level of profit earned in the industry would decrease. d) More output would be produced by the monopolist. d) More output would be produced by the monopolist. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  MONOPOLY AND PUBLIC POLICY MONOPOLY CAUSES INEFFICIENCY Figure 13-8 A monopolist, by reducing output and raising prices, benefits at the expense of consumers. Monopoly is a source of inefficiency: the losses to consumers from monopoly behavior are larger than the gains to the monopolist. Monopoly leads to net losses to society’s welfare. Governments often try to either prevent or to limit monopolies. Panel (a), perfect competition: since price equals the producer’s ATC, there’s no profit and no producer surplus. Total surplus, equal to consumer surplus, is the entire shaded area. Panel (b), monopoly: the monopolist decreases output to QM and charges PM. The blue area shows consumer surplus; the green area shows profit; and the yellow area is a deadweight loss. As a result, total surplus falls. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021