Chapter 3
The Firm Makes Choices,
Costs & The Market
3.1 INDUSTRIES AND
PRODUCTION PROCESSES
Industry
– It consists of a firm or a number of firms that
use like processes to produce their outputs.
Production
– Value added
– Production tree
– inputs processes or activities outputs
3.2 COST FACIG THE
FIRM
Factors of production
Natural
Resources
Human Resources
(manual functions)
Human Resources
(mental functions)
Manufactured
Resources
Raw materials,
Fuel,
Property on
which
activities take
place
Production work,
Clerical work,
Cleaning work
Management,
Marketing,
Commercial
advice
Process
machinery,
Machinery
parts,
Office
equipment
3.2.1 Total Revenue,Total
Cost,and Profit
Total Revenue
– the amount a firm receives for the sale of its
output.
Total Cost
– the market value of the inputs a firm uses in
production.
Profit
– Profit = Total revenue - Total cost
Cost as Opportunity Cost
Explicit Costs
– input cost that require an outlay of money by the firm
Implicit Costs
– input costs that do not require an outlay of money by the
firm
Choice 1
– deposit=$300,000 (interest rate=5%)
Choice 2
– deposit=$100,000
– borrowed capital=$200,000
Economic Profit versus
Accounting Profit
Economic Profit
– total revenue minus total cost,including
both explicit and implicit costs.
Accounting Profit
– total revenue minus total explicit cost.
Economists vs Accountants
Economic
profit
Implicit
costs
Explicit
costs
Accounting
profit
Explicit
costs
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue Revenue
Total costs
3.3 PRODUCTION AND COST
Assumption
– size of the cake factory is fixed
– quantity of cakes varies only by changing
the number of workers.
realistic in the short run,but not in
the long run.
3.3.1 Production Function
production function
– the relationship between quantity of inputs used to make
a good and the quantity of output of that good.
marginal product
– the increase in output that arises from an additional unit
of input.
diminishing marginal product
– the property whereby the marginal product of an input
declines as the quantity of the input increases.
Susan' s Production Function 1
Numbers
of
Workers
Output
(cakes/hour)
Marginal
Product of
Labor
Cost of
Factory
Cost of
Workers
Total Cost
of Inputs
0 0
50
40
30
20
10
$30 $0 $30
1 50 30 10 40
2 90 30 20 50
3 120 30 30 60
4 140 30 40 70
5 150 30 50 80
Marginal Change
small incremental adjustments to a
plan of action.
Examples
– education
– air plane company
– bread…
Susan' s Production Function 2
0
20
40
60
80
100
120
140
160
0 1 2 3 4 5 6
Quantity
of Output
Number of
Worker Hired
Production
function
Susan' s Total- cost Curve
0
10
20
30
40
50
60
70
80
90
100
0 50 90 120 140 150 200
Quantity
of Output
Total Cost
Total-cost Curve
3.3.2 Various Measures of Cost
Fixed Costs
– costs that do not vary with the quantity
of output produced.
Variable Costs
– costs that do vary with the quantity of
output produced.
Average and Marginal Cost
average total cost
– total cost divided by the quantity of output.
average fixed cost (FC/Q)
– fixed costs divided by the quantity of output.
average variable cost (VC/Q)
– variable costs divided by the quantity of output.
marginal cost
– the increase in total cost that arises from an extra unit of
production.
ATC= TC/ Q,MC= ⊿ TC/ ⊿ Q
Cost Curves and Their Shapes
Quantity of Output
Cost
MC
ATC
AVC
AFC
Efficient Scale,
the quantity of
output that
minimizes
average total
cost
Cost in the Short Run
and in the Long Run
ATC in short
run with small
factory
ATC in short run
with medium
factory
ATC in short run
with large
factory
ATC in long run
Economies of
scale Constant
returns to
scale
Diseconomies
of scale
Quantity of
Cars per Day
Average
Total
Cost
1000 1200
12000
10000
Cost in the Short Run
and in the Long Run
the long-run average-total-cost
curve is a much flatter U-shape
than the short-run average-total-
cost curve.
all the short-run curves lie on or
above the long-run curve.
Economies and
Diseconomies of Scale
economies of scale
– the property whereby long-run average total
cost falls as the quantity of output increases.
diseconomies of scale
– the property whereby long-run average total
cost rises as the quantity of output increases.
constant returns to scale
– the property whereby long-run average total
cost stays the same as the quantity of output
changes.
Summery of the Cost
Term Definition Mathematical
Description
Explicit costs Costs that require an outlay of money
by the firm
--
Implicit costs Costs that not require an outlay of
money by the firm
--
Fixed costs Cost that do not vary with the
quantity of output produced
FC
Variable costs Cost that do vary with the quantity of
output produced
VC
Total cost The market value of all the inputs
that a firm uses in production
TC = FC + VC
Average fixed cost Fixed costs divided by the quantity of
output
AFC = FC/Q
Average variable cost Variable costs divided by the quantity
of output
AVC = VC/Q
Average total cost Total cost divided by the quantity of
output
ATC = TC/Q
Marginal cost The increase in total cost that arises
from an extra unit of production
MC= ⊿ TC/⊿ Q
3.4 MARKET STRUCTURE
In the short run
– prices they choose to charge
– quantities of product they choose to sell
In the long run
– selling out
– closing down
– buying out the opposition
– forming collaborative arrangement with other firms
– changing product or product range
– building new plant
3.4.1 COMPETITION
1,Meaning
competitive market
– a market with many buyers and sellers trading
identical products so that each buyer and
seller is a price taker,
conditions
– large numbers of buyers and sellers
– a homogeneous product
– perfect information and uniform technology
– no transport cost
– no barriers to the entry of new firms
2,Revenue of a Competitive
Firm
Average Revenue
– total revenue divided by the quantity sold
Marginal Revenue
– the change in total revenue from an
additional unit sold
Example of Milk ($6/gallon)
Q TR TC Profit AR MR MC
P × Q TR-TC TR/Q ⊿ TR/⊿ Q ⊿ TC/⊿ Q
0
1
2
3
4
5
6
7
8
0
6
12
18
24
30
36
42
48
3
5
8
12
17
23
30
38
47
-3
1
4
6
7
7
6
4
1
6
6
6
6
6
6
6
6
6
6
6
6
6
6
6
2
3
4
5
6
7
8
9
3,Profit Maximization
for a Competitive Firm
Costs
and
Revenue
Quantity
AVC
ATC
MC
P=AR=MRP=MR1=MR2
MC2
MC1
Q1 QMAX Q2
4,Marginal Cost as the
Competitive Firm’s Supply Curve
Price
Quantity
AVC
ATC
MC
P1
P2
Q1 Q2
An increase in the
price from P1 to P2
leads to an increase in
the firm’s profit-
maximizing quantity
from Q1 to Q2,
Because the marginal-
cost curve shows the
quantity supplied by
the firm at any given
price,it is the firm’s
supple curve
5,Short-run Decision to Shut Down
vs Long-run Decision to Exit or
Enter a Market
Price
Quantity
AVC
ATC
MC
P1
P2
Q1 Q2
Firm exits
if P<ATC
Firm shuts
down if
P<AVC
Supply Curve
Sunk Cost
a cost that has already been committed and
cannot be recovered.
Example in personal decisions
– movie,value=$5
– ticket costs $4
– you lose it
choice 1,go home and refuse to pay a total $8 to
see the movie?
choice 2,buy another ticket?
6,Measuring Profit in the
Graph for Competitive Firm
ATC
P
(a) A Firm with Profits (b) A Firm with Losses
P
Q
P=AR=MR
MC
ATCProfit
P
ATC
0 Q
(profit-maximizing quantity)
P
Q
P=AR=MR
MC
Loss
ATC
0
(loss-minimizing quantity)
Q
Profit = TR- TC = ( TR/ Q- TC/ Q) × Q = (P- ATC) × Q
Why do competitive firms
stay in business if they
make zero profit?
a farmer invested $1 million to open
his farm.
he could have deposited in a bank to
earn $50,000 a year in interest.
he had to give up another job that
would have paid him $30,000 a year.
3.4.2 MONOPOLY
News of Microsoft Corporation
– 1994,prevented from buying Intuit;
– 1998,objected the plan of integrating
Internet browser into Windows.
– 2002,suit settled.
monopoly
– a firm that is the sole seller of a product
without close substitutes
1,Source of Monopolies
a,Monopoly Resources
– a key resource is owned by a single firm,
b,Government-Created Monopolies
– the government gives a single firm the
exclusive right to produce some good or
service.
c,Natural Monopolies
– the cost of production make a single producer
more efficient than a large number of
producers.
b,Government-Created Monopolies
patent
– the government approves it to give the
company the exclusive right to manufacture
and sell the product.
copyright
– the right guaranteed by the government that
no one can print or sell the work without the
author’s permission.
c,Natural Monopolies
a monopoly that arises because a single firm can
supply a good or service to an entire market at a
smaller cost than could two or more firms.
Cost
Quantity of
Output
Average
total cost
Economies of Scale as a Cause
of Monopoly
When a firm’s average-total-
cost curve continually declines,
the firm has what is called a
natural monopoly,In this case,
when production is divided among
more firms,each firm produces
less,and average total cost rises,
As a result,a single firm can
produce any given amount at the
smallest cost.
2,Demand Curve for
Competitive and Monopoly Firms
Price
Quantity of
Output
Demand
Price
Quantity of
Output
Demand
(a) A Competitive Firm’s
Demand Curve
(b) A Monopolist’s
Demand Curve
Marginal Revenue
3,Profit Maximization for a
Monopoly
Costs
and
Revenue
Quantity
A
B
Marginal
cost Marginal
revenue
Demand
Average
total cost
1.The intersection of the
marginal-revenue curve and
the marginal-cost curve
determines the profit-
maximizing quantity…
2…,and then the
demand curve
shows the price
consistent with
this quantity.
For a competitive firm,
P=MR=MC
For a monopoly firm,
P>MR=MC
Q1 Qmax Q2
Monopoly
price
4,A Monopoly’s Profit
Average total cost
Costs
and
Revenue
Quantity
Marginal
cost
Marginal revenue
Demand
Qmax
Monopoly
price Monopoly
profit
Average
total cost
B
CD
E
Profit = TR-TC = (TR/Q-TC/Q) × Q = (P-ATC) × Q
Case Study
Monopoly drugs vs Generic drugs
Cost and
Revenue
Price
during
patent life
Price after
patent life MR Demand
MC
QuantityMonopoly
quantity
Competitive
quantity
The Market for Drugs
When a patent gives a firm a
monopoly over the sale of a
drug,the firm charges the
monopoly price,which is well
above the marginal cost of
making the drug.
When the patent on a drug
runs out,new firms enter the
market,making it more
competitive,As a result,the
price falls from the monopoly
price to marginal cost.
Others
Antitrust laws
Allocation efficiency
Price discrimination
Rent seeking
3.4.3 OLIGOPOLY
a market structure in which only a
few sellers offer similar or identical
products
e.g.,World’s oil reserves by a few
Middle East countries.
Four Types of Market Structure
Number of Firms?
Monopoly Oligopoly Monopolistic
Competition
Perfect
Competition
Type of Products?
Many
firms
One
firm
Few
firms
Differentiated
products
Identical
product
Cartels
Collusion
– an agreement among firms in a market
about quantities to produce or prices to
change.
Cartel
– a group of firms acting in union
3.4.4 MONOPOLISTIC
COMPETITION
Definition
– a market structure in which many firms sell products
that are similar but not identical.
Attributes
– Many sellers competing for the same group of customers
– Product differentiation
– Free entry
E.G.
– Books,CDs,movies,computer games,restaurants,
furniture…
1,Monopoly Competitors
in the Short Run
Demand
P
Q
MC
ATC
MR
Price
Average
total
cost
Profit
Profit-
maximizing
quantity
P
Q
MC
ATC
MR
Demand
Average
total
cost
Price
Losses
Loss-
minimizing
quantity
(a) Firm Makes Profit (b) Firm Makes Losses
2,A Monopolistic Competitor
in the Long Run
P
Q
MC
ATC
MR
Demand
P=ATC
Profit-maximizing
quantity
In a monopolistically
competitive market,if firms
are making profit,new firms
enter,and the demand
curves for the incumbent
firms shift to the left,
Similarly,if firms are making
losses,old firms exit,and
the demand curves of the
remaining firms shift to the
right,Because of these
shifts in demand,a
monopolistically competitive
firm eventually finds itself in
the long-run equilibrium
shown here,In this long-run
equilibrium,price equals
average total cost,and the
firm earns zero profit.
Long Equilibrium of
Monopolistic Competition
As in a monopoly market
– P>MC,as in a monopoly market
– MR<P
As in a competitive market
– P=AVC,as in a competitive market
– Economic profit=0
Advertising
Critique
– manipulate people’s tastes
– impede competition
– by increasing the perception of product differentiation
and fostering brand loyalty,make buyers less concerned
with price differences among similar goods
Defense
– provide information to allocate market resource
efficiently
– foster competition
– customers can easily take advantage of price differences
– allow new firms to enter more easily
Brand Names
Critique
– cause consumers to perceive differences that do not
really exist.
Defense
– help consumers to ensure that the goods the buy are
of high quality.
1,provide consumers with information about quality when
quality cannot be easily judged in advance of purchase.
2,give firms an incentive to maintain high quality because
of financial stake in maintaining the reputation of
their brand names.
Summery
Character Perfect
Competition
Monopolistic
Competition
Oligopoly Monopoly
Quantity of firms great great less 1
Product identical different identical/
different
no
substitute
Entry restriction no a little scale scale/
legislation
Price control
(0-100)
0 low high 100
E.G,cotton,
wheat
food,dress car,oil telephone
service
3.5 GAME THEORY
Game Theory
– the study of how people behave in
strategic situations
Prisoners’ Dilemma
– a particular,game” between two
captured prisoners that illustrates why
cooperation is difficult to maintain even
when it is mutually beneficial
3.5.1 Prisoners’ Dilemma
Jerry gets 8 years Jerry goes free
Jerry gets 20 years Jerry gets 1 years
Tom gets 8 years Tom gets 20 years
Tom goes free Tom gets 1 years
Tom’s Decision
Jerry’s
Decision
Confess Remain Silent
Confess
Remain
Silent
In this game between two criminals suspected of
committing a crime,the sentence that each receives
depends both on his or her decision whether to confess
or remain silent and on the decision made by the other.
Nash equilibrium (John Nash,1994 Nobel Prize)
– a situation in which economic actors interacting
with one another each choose their best
strategy given the strategies that all the other
actors have chosen
Dominant strategy
– a strategy that is best for a player in a game
regardless of the strategies chosen by the
other players
3.5.2 A Duopoly Game
Iran gets $40 billion Iran gets $60 billion
Iran gets $30 billion Iran gets $50 billion
Iraq gets $40 billion Iraq gets $30 billion
Iraq gets $60 billion Iraq gets $50 billion
Iraq’s Decision
Iran’s
Decision
High Production Low Production
High
Production
Low
Production
3.5.3 An Advertising Game
Pepsi gets
$3 billion profit
Pepsi gets
$5 billion profit
Pepsi gets
$2 billion profit
Pepsi gets
$4 billion profit
Coca gets $3 billion
profit
Coca gets $2 billion
profit
Coca gets $5 billion
profit
Coca gets $4 billion
profit
Coca cola’s Decision
Pepsi’s
Decision
Advertise Don’t Advertise
Advertise
Don’t
Advertise
3.5.4 Cooperation
Time cooperation tit-for-tat strategyA’s profit B’s profit A’s profit B’s profit
1
2
3
4
:
2
2
2
2
:
2
2
2
2
:
2
4.5
-1
2
:
2
-1
4.5
2
:
3.5.1 Prisoners’ Dilemma
Jerry gets 8 years Jerry goes free
Jerry gets 20 years Jerry gets 1 years
Tom gets 8 years Tom gets 20 years
Tom goes free Tom gets 1 years
Tom’s Decision
Jerry’s
Decision
Confess Remain Silent
Confess
Remain
Silent
In this game between two criminals suspected of
committing a crime,the sentence that each receives
depends both on his or her decision whether to confess
or remain silent and on the decision made by the other.
Dominant strategy
a strategy that is best for a player in
a game regardless of the strategies
chosen by the other players
3.5.2 A Duopoly Game
Iran gets $40 billion Iran gets $60 billion
Iran gets $30 billion Iran gets $50 billion
Iraq gets $40 billion Iraq gets $30 billion
Iraq gets $60 billion Iraq gets $50 billion
Iraq’s Decision
Iran’s
Decision
High Production Low Production
High
Production
Low
Production
3.5.3 An Advertising Game
Pepsi gets
$3 billion profit
Pepsi gets
$5 billion profit
Pepsi gets
$2 billion profit
Pepsi gets
$4 billion profit
Coca gets $3 billion
profit
Coca gets $2 billion
profit
Coca gets $5 billion
profit
Coca gets $4 billion
profit
Coca cola’s Decision
Pepsi’s
Decision
Advertise Don’t Advertise
Advertise
Don’t
Advertise
3.5.4 Cooperation
Time cooperation tit-for-tat strategyA’s profit B’s profit A’s profit B’s profit
1
2
3
4
:
2
2
2
2
:
2
2
2
2
:
2
4.5
-1
2
:
2
-1
4.5
2
:
3.5.5 Battle of the Sex Game
2,1 0,0
0,0 1,2
Victoria
Beckham
Football Concert
Football
Concert
Nash equilibrium
John Nash,1994 Nobel Prize
a situation in which economic actors
interacting with one another each
choose their best strategy given the
strategies that all the other actors
have chosen
Adjustment
2,1 0,0
-1,-1 1,2
Victoria
Beckham
Football Concert
Football
Concert
Revelation
-4,-4 2,3
3,2 1,1
Della
Jim
hair for chain not haircut
not sell watch
watch for comb
3.5.6 Clever Pigs Game
5,1 4,4
9,-1 0,0
Small Pig
Big Pig
Push Wait
Push
Wait
Armament Game
-2000,-2000 8000,-∞
-∞,8000 0,0
U.S.S.R
U.S.A
Disarmament
Disarmament
Expanding
armament
Expanding
armament
The Firm Makes Choices,
Costs & The Market
3.1 INDUSTRIES AND
PRODUCTION PROCESSES
Industry
– It consists of a firm or a number of firms that
use like processes to produce their outputs.
Production
– Value added
– Production tree
– inputs processes or activities outputs
3.2 COST FACIG THE
FIRM
Factors of production
Natural
Resources
Human Resources
(manual functions)
Human Resources
(mental functions)
Manufactured
Resources
Raw materials,
Fuel,
Property on
which
activities take
place
Production work,
Clerical work,
Cleaning work
Management,
Marketing,
Commercial
advice
Process
machinery,
Machinery
parts,
Office
equipment
3.2.1 Total Revenue,Total
Cost,and Profit
Total Revenue
– the amount a firm receives for the sale of its
output.
Total Cost
– the market value of the inputs a firm uses in
production.
Profit
– Profit = Total revenue - Total cost
Cost as Opportunity Cost
Explicit Costs
– input cost that require an outlay of money by the firm
Implicit Costs
– input costs that do not require an outlay of money by the
firm
Choice 1
– deposit=$300,000 (interest rate=5%)
Choice 2
– deposit=$100,000
– borrowed capital=$200,000
Economic Profit versus
Accounting Profit
Economic Profit
– total revenue minus total cost,including
both explicit and implicit costs.
Accounting Profit
– total revenue minus total explicit cost.
Economists vs Accountants
Economic
profit
Implicit
costs
Explicit
costs
Accounting
profit
Explicit
costs
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue Revenue
Total costs
3.3 PRODUCTION AND COST
Assumption
– size of the cake factory is fixed
– quantity of cakes varies only by changing
the number of workers.
realistic in the short run,but not in
the long run.
3.3.1 Production Function
production function
– the relationship between quantity of inputs used to make
a good and the quantity of output of that good.
marginal product
– the increase in output that arises from an additional unit
of input.
diminishing marginal product
– the property whereby the marginal product of an input
declines as the quantity of the input increases.
Susan' s Production Function 1
Numbers
of
Workers
Output
(cakes/hour)
Marginal
Product of
Labor
Cost of
Factory
Cost of
Workers
Total Cost
of Inputs
0 0
50
40
30
20
10
$30 $0 $30
1 50 30 10 40
2 90 30 20 50
3 120 30 30 60
4 140 30 40 70
5 150 30 50 80
Marginal Change
small incremental adjustments to a
plan of action.
Examples
– education
– air plane company
– bread…
Susan' s Production Function 2
0
20
40
60
80
100
120
140
160
0 1 2 3 4 5 6
Quantity
of Output
Number of
Worker Hired
Production
function
Susan' s Total- cost Curve
0
10
20
30
40
50
60
70
80
90
100
0 50 90 120 140 150 200
Quantity
of Output
Total Cost
Total-cost Curve
3.3.2 Various Measures of Cost
Fixed Costs
– costs that do not vary with the quantity
of output produced.
Variable Costs
– costs that do vary with the quantity of
output produced.
Average and Marginal Cost
average total cost
– total cost divided by the quantity of output.
average fixed cost (FC/Q)
– fixed costs divided by the quantity of output.
average variable cost (VC/Q)
– variable costs divided by the quantity of output.
marginal cost
– the increase in total cost that arises from an extra unit of
production.
ATC= TC/ Q,MC= ⊿ TC/ ⊿ Q
Cost Curves and Their Shapes
Quantity of Output
Cost
MC
ATC
AVC
AFC
Efficient Scale,
the quantity of
output that
minimizes
average total
cost
Cost in the Short Run
and in the Long Run
ATC in short
run with small
factory
ATC in short run
with medium
factory
ATC in short run
with large
factory
ATC in long run
Economies of
scale Constant
returns to
scale
Diseconomies
of scale
Quantity of
Cars per Day
Average
Total
Cost
1000 1200
12000
10000
Cost in the Short Run
and in the Long Run
the long-run average-total-cost
curve is a much flatter U-shape
than the short-run average-total-
cost curve.
all the short-run curves lie on or
above the long-run curve.
Economies and
Diseconomies of Scale
economies of scale
– the property whereby long-run average total
cost falls as the quantity of output increases.
diseconomies of scale
– the property whereby long-run average total
cost rises as the quantity of output increases.
constant returns to scale
– the property whereby long-run average total
cost stays the same as the quantity of output
changes.
Summery of the Cost
Term Definition Mathematical
Description
Explicit costs Costs that require an outlay of money
by the firm
--
Implicit costs Costs that not require an outlay of
money by the firm
--
Fixed costs Cost that do not vary with the
quantity of output produced
FC
Variable costs Cost that do vary with the quantity of
output produced
VC
Total cost The market value of all the inputs
that a firm uses in production
TC = FC + VC
Average fixed cost Fixed costs divided by the quantity of
output
AFC = FC/Q
Average variable cost Variable costs divided by the quantity
of output
AVC = VC/Q
Average total cost Total cost divided by the quantity of
output
ATC = TC/Q
Marginal cost The increase in total cost that arises
from an extra unit of production
MC= ⊿ TC/⊿ Q
3.4 MARKET STRUCTURE
In the short run
– prices they choose to charge
– quantities of product they choose to sell
In the long run
– selling out
– closing down
– buying out the opposition
– forming collaborative arrangement with other firms
– changing product or product range
– building new plant
3.4.1 COMPETITION
1,Meaning
competitive market
– a market with many buyers and sellers trading
identical products so that each buyer and
seller is a price taker,
conditions
– large numbers of buyers and sellers
– a homogeneous product
– perfect information and uniform technology
– no transport cost
– no barriers to the entry of new firms
2,Revenue of a Competitive
Firm
Average Revenue
– total revenue divided by the quantity sold
Marginal Revenue
– the change in total revenue from an
additional unit sold
Example of Milk ($6/gallon)
Q TR TC Profit AR MR MC
P × Q TR-TC TR/Q ⊿ TR/⊿ Q ⊿ TC/⊿ Q
0
1
2
3
4
5
6
7
8
0
6
12
18
24
30
36
42
48
3
5
8
12
17
23
30
38
47
-3
1
4
6
7
7
6
4
1
6
6
6
6
6
6
6
6
6
6
6
6
6
6
6
2
3
4
5
6
7
8
9
3,Profit Maximization
for a Competitive Firm
Costs
and
Revenue
Quantity
AVC
ATC
MC
P=AR=MRP=MR1=MR2
MC2
MC1
Q1 QMAX Q2
4,Marginal Cost as the
Competitive Firm’s Supply Curve
Price
Quantity
AVC
ATC
MC
P1
P2
Q1 Q2
An increase in the
price from P1 to P2
leads to an increase in
the firm’s profit-
maximizing quantity
from Q1 to Q2,
Because the marginal-
cost curve shows the
quantity supplied by
the firm at any given
price,it is the firm’s
supple curve
5,Short-run Decision to Shut Down
vs Long-run Decision to Exit or
Enter a Market
Price
Quantity
AVC
ATC
MC
P1
P2
Q1 Q2
Firm exits
if P<ATC
Firm shuts
down if
P<AVC
Supply Curve
Sunk Cost
a cost that has already been committed and
cannot be recovered.
Example in personal decisions
– movie,value=$5
– ticket costs $4
– you lose it
choice 1,go home and refuse to pay a total $8 to
see the movie?
choice 2,buy another ticket?
6,Measuring Profit in the
Graph for Competitive Firm
ATC
P
(a) A Firm with Profits (b) A Firm with Losses
P
Q
P=AR=MR
MC
ATCProfit
P
ATC
0 Q
(profit-maximizing quantity)
P
Q
P=AR=MR
MC
Loss
ATC
0
(loss-minimizing quantity)
Q
Profit = TR- TC = ( TR/ Q- TC/ Q) × Q = (P- ATC) × Q
Why do competitive firms
stay in business if they
make zero profit?
a farmer invested $1 million to open
his farm.
he could have deposited in a bank to
earn $50,000 a year in interest.
he had to give up another job that
would have paid him $30,000 a year.
3.4.2 MONOPOLY
News of Microsoft Corporation
– 1994,prevented from buying Intuit;
– 1998,objected the plan of integrating
Internet browser into Windows.
– 2002,suit settled.
monopoly
– a firm that is the sole seller of a product
without close substitutes
1,Source of Monopolies
a,Monopoly Resources
– a key resource is owned by a single firm,
b,Government-Created Monopolies
– the government gives a single firm the
exclusive right to produce some good or
service.
c,Natural Monopolies
– the cost of production make a single producer
more efficient than a large number of
producers.
b,Government-Created Monopolies
patent
– the government approves it to give the
company the exclusive right to manufacture
and sell the product.
copyright
– the right guaranteed by the government that
no one can print or sell the work without the
author’s permission.
c,Natural Monopolies
a monopoly that arises because a single firm can
supply a good or service to an entire market at a
smaller cost than could two or more firms.
Cost
Quantity of
Output
Average
total cost
Economies of Scale as a Cause
of Monopoly
When a firm’s average-total-
cost curve continually declines,
the firm has what is called a
natural monopoly,In this case,
when production is divided among
more firms,each firm produces
less,and average total cost rises,
As a result,a single firm can
produce any given amount at the
smallest cost.
2,Demand Curve for
Competitive and Monopoly Firms
Price
Quantity of
Output
Demand
Price
Quantity of
Output
Demand
(a) A Competitive Firm’s
Demand Curve
(b) A Monopolist’s
Demand Curve
Marginal Revenue
3,Profit Maximization for a
Monopoly
Costs
and
Revenue
Quantity
A
B
Marginal
cost Marginal
revenue
Demand
Average
total cost
1.The intersection of the
marginal-revenue curve and
the marginal-cost curve
determines the profit-
maximizing quantity…
2…,and then the
demand curve
shows the price
consistent with
this quantity.
For a competitive firm,
P=MR=MC
For a monopoly firm,
P>MR=MC
Q1 Qmax Q2
Monopoly
price
4,A Monopoly’s Profit
Average total cost
Costs
and
Revenue
Quantity
Marginal
cost
Marginal revenue
Demand
Qmax
Monopoly
price Monopoly
profit
Average
total cost
B
CD
E
Profit = TR-TC = (TR/Q-TC/Q) × Q = (P-ATC) × Q
Case Study
Monopoly drugs vs Generic drugs
Cost and
Revenue
Price
during
patent life
Price after
patent life MR Demand
MC
QuantityMonopoly
quantity
Competitive
quantity
The Market for Drugs
When a patent gives a firm a
monopoly over the sale of a
drug,the firm charges the
monopoly price,which is well
above the marginal cost of
making the drug.
When the patent on a drug
runs out,new firms enter the
market,making it more
competitive,As a result,the
price falls from the monopoly
price to marginal cost.
Others
Antitrust laws
Allocation efficiency
Price discrimination
Rent seeking
3.4.3 OLIGOPOLY
a market structure in which only a
few sellers offer similar or identical
products
e.g.,World’s oil reserves by a few
Middle East countries.
Four Types of Market Structure
Number of Firms?
Monopoly Oligopoly Monopolistic
Competition
Perfect
Competition
Type of Products?
Many
firms
One
firm
Few
firms
Differentiated
products
Identical
product
Cartels
Collusion
– an agreement among firms in a market
about quantities to produce or prices to
change.
Cartel
– a group of firms acting in union
3.4.4 MONOPOLISTIC
COMPETITION
Definition
– a market structure in which many firms sell products
that are similar but not identical.
Attributes
– Many sellers competing for the same group of customers
– Product differentiation
– Free entry
E.G.
– Books,CDs,movies,computer games,restaurants,
furniture…
1,Monopoly Competitors
in the Short Run
Demand
P
Q
MC
ATC
MR
Price
Average
total
cost
Profit
Profit-
maximizing
quantity
P
Q
MC
ATC
MR
Demand
Average
total
cost
Price
Losses
Loss-
minimizing
quantity
(a) Firm Makes Profit (b) Firm Makes Losses
2,A Monopolistic Competitor
in the Long Run
P
Q
MC
ATC
MR
Demand
P=ATC
Profit-maximizing
quantity
In a monopolistically
competitive market,if firms
are making profit,new firms
enter,and the demand
curves for the incumbent
firms shift to the left,
Similarly,if firms are making
losses,old firms exit,and
the demand curves of the
remaining firms shift to the
right,Because of these
shifts in demand,a
monopolistically competitive
firm eventually finds itself in
the long-run equilibrium
shown here,In this long-run
equilibrium,price equals
average total cost,and the
firm earns zero profit.
Long Equilibrium of
Monopolistic Competition
As in a monopoly market
– P>MC,as in a monopoly market
– MR<P
As in a competitive market
– P=AVC,as in a competitive market
– Economic profit=0
Advertising
Critique
– manipulate people’s tastes
– impede competition
– by increasing the perception of product differentiation
and fostering brand loyalty,make buyers less concerned
with price differences among similar goods
Defense
– provide information to allocate market resource
efficiently
– foster competition
– customers can easily take advantage of price differences
– allow new firms to enter more easily
Brand Names
Critique
– cause consumers to perceive differences that do not
really exist.
Defense
– help consumers to ensure that the goods the buy are
of high quality.
1,provide consumers with information about quality when
quality cannot be easily judged in advance of purchase.
2,give firms an incentive to maintain high quality because
of financial stake in maintaining the reputation of
their brand names.
Summery
Character Perfect
Competition
Monopolistic
Competition
Oligopoly Monopoly
Quantity of firms great great less 1
Product identical different identical/
different
no
substitute
Entry restriction no a little scale scale/
legislation
Price control
(0-100)
0 low high 100
E.G,cotton,
wheat
food,dress car,oil telephone
service
3.5 GAME THEORY
Game Theory
– the study of how people behave in
strategic situations
Prisoners’ Dilemma
– a particular,game” between two
captured prisoners that illustrates why
cooperation is difficult to maintain even
when it is mutually beneficial
3.5.1 Prisoners’ Dilemma
Jerry gets 8 years Jerry goes free
Jerry gets 20 years Jerry gets 1 years
Tom gets 8 years Tom gets 20 years
Tom goes free Tom gets 1 years
Tom’s Decision
Jerry’s
Decision
Confess Remain Silent
Confess
Remain
Silent
In this game between two criminals suspected of
committing a crime,the sentence that each receives
depends both on his or her decision whether to confess
or remain silent and on the decision made by the other.
Nash equilibrium (John Nash,1994 Nobel Prize)
– a situation in which economic actors interacting
with one another each choose their best
strategy given the strategies that all the other
actors have chosen
Dominant strategy
– a strategy that is best for a player in a game
regardless of the strategies chosen by the
other players
3.5.2 A Duopoly Game
Iran gets $40 billion Iran gets $60 billion
Iran gets $30 billion Iran gets $50 billion
Iraq gets $40 billion Iraq gets $30 billion
Iraq gets $60 billion Iraq gets $50 billion
Iraq’s Decision
Iran’s
Decision
High Production Low Production
High
Production
Low
Production
3.5.3 An Advertising Game
Pepsi gets
$3 billion profit
Pepsi gets
$5 billion profit
Pepsi gets
$2 billion profit
Pepsi gets
$4 billion profit
Coca gets $3 billion
profit
Coca gets $2 billion
profit
Coca gets $5 billion
profit
Coca gets $4 billion
profit
Coca cola’s Decision
Pepsi’s
Decision
Advertise Don’t Advertise
Advertise
Don’t
Advertise
3.5.4 Cooperation
Time cooperation tit-for-tat strategyA’s profit B’s profit A’s profit B’s profit
1
2
3
4
:
2
2
2
2
:
2
2
2
2
:
2
4.5
-1
2
:
2
-1
4.5
2
:
3.5.1 Prisoners’ Dilemma
Jerry gets 8 years Jerry goes free
Jerry gets 20 years Jerry gets 1 years
Tom gets 8 years Tom gets 20 years
Tom goes free Tom gets 1 years
Tom’s Decision
Jerry’s
Decision
Confess Remain Silent
Confess
Remain
Silent
In this game between two criminals suspected of
committing a crime,the sentence that each receives
depends both on his or her decision whether to confess
or remain silent and on the decision made by the other.
Dominant strategy
a strategy that is best for a player in
a game regardless of the strategies
chosen by the other players
3.5.2 A Duopoly Game
Iran gets $40 billion Iran gets $60 billion
Iran gets $30 billion Iran gets $50 billion
Iraq gets $40 billion Iraq gets $30 billion
Iraq gets $60 billion Iraq gets $50 billion
Iraq’s Decision
Iran’s
Decision
High Production Low Production
High
Production
Low
Production
3.5.3 An Advertising Game
Pepsi gets
$3 billion profit
Pepsi gets
$5 billion profit
Pepsi gets
$2 billion profit
Pepsi gets
$4 billion profit
Coca gets $3 billion
profit
Coca gets $2 billion
profit
Coca gets $5 billion
profit
Coca gets $4 billion
profit
Coca cola’s Decision
Pepsi’s
Decision
Advertise Don’t Advertise
Advertise
Don’t
Advertise
3.5.4 Cooperation
Time cooperation tit-for-tat strategyA’s profit B’s profit A’s profit B’s profit
1
2
3
4
:
2
2
2
2
:
2
2
2
2
:
2
4.5
-1
2
:
2
-1
4.5
2
:
3.5.5 Battle of the Sex Game
2,1 0,0
0,0 1,2
Victoria
Beckham
Football Concert
Football
Concert
Nash equilibrium
John Nash,1994 Nobel Prize
a situation in which economic actors
interacting with one another each
choose their best strategy given the
strategies that all the other actors
have chosen
Adjustment
2,1 0,0
-1,-1 1,2
Victoria
Beckham
Football Concert
Football
Concert
Revelation
-4,-4 2,3
3,2 1,1
Della
Jim
hair for chain not haircut
not sell watch
watch for comb
3.5.6 Clever Pigs Game
5,1 4,4
9,-1 0,0
Small Pig
Big Pig
Push Wait
Push
Wait
Armament Game
-2000,-2000 8000,-∞
-∞,8000 0,0
U.S.S.R
U.S.A
Disarmament
Disarmament
Expanding
armament
Expanding
armament
