MICROECONOMICS TOPIC 3.

THE COMPANY: PRODUCTION AND COSTS

THE PRODUCTION FUNCTION

Production function: relationship between inputs and outputs a firm produces. Y = f (K, L)

Production: transformation of factors.

K: capital

L: labour

key measures of productivity

f (K , L)
Average productivity: the productivity of an output per unit of input. AP L=
L
Marginal productivity: marginal change in production for a unitary change of a factor, Additional
∆ Y ∂( K , L)
output produced by adding one more unit of input. MP L= =
∆L ∂L
LAW OF DIMINISHING MARGINAL PRODUCTIVITY
Law of diminishing marginal productivity: total productivity increases at a decreasing marginal rate. As more
units of a variable input are added to fixed inputs, the additional output from each extra unit of input eventually
decreases.

RETURNS TO SCALE
Returns to scale: how production changes when all factors vary in the same proportion.

Constant Returns to Scale (CRS): doubling inputs doubles outputs. f (t K, L) = t . f (K, L)

Increasing returns to scale (IRS): doubling inputs more than doubling outputs. f (t K, L) > t . f (K,
L)

Decreasing returns to scale (DRS): doubling inputs less than doubles outputs. f (K, L) < t . f (K, L)

SHORT RUN VERSUS LONG RUN PRODUCTION

Short run production: at least one input is fixed. Y = f (K (fixed), L)

Long run production: all inputs are variable. Y = f (K, L)

Short run total productivity: total output produced. TP =Y =Q

TP
Short run average productivity: output per unit of labour. APL=
L
∆Y ∂Y
Short run marginal productivity: additional output from one more unit. MP L= =
∆L ∂ L
ECONOMIES AND DISECONOMIES OF SCALE
Economies of scale: when average total cost declines as output increases, decreasing TC.
Increasing returns to scale. Y =L β ; β >1; f ( t . L )=t β f ( t . L ) >t . f ( L ) ; t 2

Diseconomies of scale: when average total cost increases as production also increases, increasing
ATC. Decreasing returns to scale. ¿ L β ; β <1 ; f ( t . L )=t β f ( t . L ) <t . f ( L ) ; √ t
 COST CONCEPTS
Fixed costs: costs that do not vary with output.

Variable costs: costs that vary with output.

Total costs: Sum of fixed and variable costs. TC = FC + VC

Average fixed costs: AFC = FC/Q

Average variable costs: AVC = VC/Q

Average total costs: ATC = TC/Q = AFC + AVC

∆ TC
Marginal cost: cost of producing one additional unit of output. MC = =∂TC
∆Q
COST CURVES
MC intersects ATC and AVC at their minimum points.

When MC<ATC, ATC is decreasing.

When MC>ATC, ATC is increasing.

U-shaped ATC curve: results from the interaction between AFC, which decreases as output
increases, and AVC, which eventually increases with output.

Minimum cost-output: point at which ATC is minimized, where MC intersects ATC.

cost function in the short and long run

Cost function in the short run: min cost necessary to obtain a given level of production by
adjusting only the variable factors.

Cost function in the long run: min cost necessary to obtain a given level of production by
adjusting all factors.

PROFIT MAXIMIZATION RULE

∂ TR ∂ TC
Profit maximization: IT = TR – TC —> – =¿ 0 —> MR – MC = 0 —> MR = MC
∂Q ∂Q
PERFECT COMPETITION
Perfect competition: many buyers and sellers, homogeneous products, no entry/exit barriers and
perfect information.

Perfect competition profit maximization: MR = MC —> in pc P=MR —> P = MC

Short run supply curve: upward-sloping portion of its MC curve above the min AVC

Long run profits: if firms earn economic profits in the short run, new firms enter the market,
increasing supply and lowering prices until profits are zero. IT=0

Short run profits: TR > TC

Short run losses: TR < TC

Short run equilibrium: quantity demanded equals quantity supplied at the market price, given the
fixed number of firms

Long run equilibrium: firms make zero profits, as P = ATC

SHUT DOWN, BREAK EVEN, PRODUCTION AND PROFITABILITY CONDITIONS

Break even point: where P = ATC, the firm earns zero profits.

Shut down price: where P = AVC, below this point the firm ceases production in the short run.

Production conditions in the short run:

- P > AVC: firm produces in the short run

- P < ATC: firm covers variable costs and some fixed costs, loss
- P > ATC: firm covers costs and makes profits
- P = AVC: firm indifferent of producing, just covers variable costs
- P < AVC: firm shuts down as it does not cover variable costs

Profitability conditions in the long run:

- P > ATC: firm produces, survives and is profitable

- P = ATC: firm breaks even, profits = 0
- P < ATC: firm does not survive, exits industry, is unprofitable

INDUSTRY SUPPLY CURVE

Industry supply curve: relationship between the price and the total output of the industry as a
whole

Short run industry supply curve: how quantity supplied by an industry depends on the market
price given a fixed number of producers. Qs (p) = sum individual firm supply curve

Long run industry supply curve: more elastic (flatter) because more companies can enter and is
based on the industry’s existing price.

MARKET EQUILIBRIUM
IT* (Q*/m) = 0 —> because individual IT* (q*) = 0 as p* = pbe = min ATC

Short run market equilibrium: when the quantity supplied equals the quantity demanded, taking
the number of producers given.

Long run market equilibrium: when quantity supplied equals quantity demanded, giving time for
entry into and exit from the industry.

Perfectly competitive industry: as there is free-entry and exit from the industry, each firm will
have zero economic profits in long run equilibrium
 MICROECONOMICS TOPIC 4. IMPERFECT COMPETITION

MARKET STRUCTURES
Imperfect competition: situation where producers/sellers have some market power

Market power: power to influence the market price

Characteristics: relatively small number of companies, differentiated product, limited entry to

industry

MONOPOLY
Characteristics: unique firm that produces only good that has no close substitutes

Market power (price taker): ability to raise its price above the competitive level by reducing
output. By increasing prices and reducing output it generated profits in the short and long run.

Barriers to entry: control of natural resources and inputs, increasing returns to scale,
technological advantage, government created barriers (patents, copyright, state concessions,
licenses)

Elimination of competition: mergers and/or acquisitions, tacit or explicit collusion (carters)

Monopoly model: π=TR ( q )−TC ( q )= p ( q ) .q−TC ( q )

Optimal q*: MR(q)=MC(q)

Demand curve of a monopolist: p ( q )=a−bq

Total revenue: T R ( q )= p ( q ) . q=( a−bq ) . q=aq−bq 2

Marginal revenue: MR ( q )=a−2 bq

TR ( q )
Average revenue: AR ( q )= = p ( q )=a−bq=D
q
If quantity increase, price decreases: the more I want to sell the lower price I need to put

p*: max price the consumer is willing to pay for the output of q*. Obtained by substituting q* in
the Demand function

Profit method 1: π=TR ( q )−TC ( q )= p ( q ¿ ) . q¿ −TC ( q¿ )

Profit method 2: π=q [ p− ATC ( q ) ]

¿ ¿

Profit maximization: by producing at level MC(q) = MR(q)

Elasticity: |ε|=
∂q p
.  p ( q ) 1−
∂p q [ ]
1
|ε|
 If |ε| > 1 (elastic): MR (q) > 0, TR increases
 If |ε| = 1 (indifferent): MR (q) = 0, TR =0
 If |ε| < 1 (inelastic): MR (q) < 0, TR decreases

 Perfect competition Monopoly
Rule of profit maximization P = MR = MC P > MR = MC
Market equilibrium Lower quantity: Qm < Qpc
High quantity: Pm > Ppc
Efficiency No DWL DWL = TSpc – TSm > 0

Inefficiency in monopoly: DWL due to the production level being lower than under competitive
conditions. The profits imply a decrease in consumer surplus and increase in producer surplus.

Natural monopoly: exists when increasing returns to scale provide a large cost advantage to a
single firm that produces all the industry output: AVC is declining over the output range relevant
for the industry. Creates a barrier of entry because an established monopolist has lower ATC
than a smaller firm.

Characteristics natural monopoly: one producer that covers the whole market demand.
Advantage of infrastructure and/or technology with larger fixed costs.

TC(q) < TC(q1) + TC(q2) + … + TC(qn): a single firm can produce the total output of a
market at a lower cost than two or more firms because of economies of scale and scope,
resulting in a decreasing ATC.

Minimum efficient scale (MES): smallest level of production at which a firm can achieve the
lowest possible ATC of production. If the MES is large with respect to the size of the market and
the market cannot expand, it is likely that the market is monopolistic.

Regulation of monopoly: two methods to regulate the monopolistic price

Marginal cost pricing: Pc*: p =MC. The result is the perfect competition solution (max total
surplus)  efficiency. Since at this level of output p = MC < ATC, the firm incurs a loss. This loss
has to be covered by additional funds, or the firm will shut down.

Average cost pricing: Pr*: p =AC. Allows the firm to just cover its costs (IT=0). Efficient
outcome not attended as Pr*>Pc and qr*<qc

Price discrimination: sell a product at a different price depending on the consumer and/or
depending on the number of units sold- The typology of the consumer must be identifiable and
separable, and resale must be difficult.

First degree price discrimination or perfect discrimination: the monopolist charges each
consumer according to their willingness to pay. Different prices for each consumer and for each
unit purchased, extracting all consumer surplus- There is no DWL. CS = 0, PS = TS, DWL = 0

Second degree price discrimination: the unit varies depending on the amount purchased,
but not on the identity of the consumer (volume discounts/block pricing). Ex. BOGOF.

Third degree price discrimination: different consumer groups have different prices. CS > 0,
PS > 0, DWL > 0.
  max π ( q 1 , q 2 )=TR ( q 1 )+TR ( q 2 )−TC ( q 1+ q 2 )= p 1 ( q 1 ) . ( q 1 )+ p 2 ( q 2 ) . q 2−TC ( q 1+q 2 )
∂π ∂π
 =MR ( q 1 ) −MC ( q 1+ q 2 )=0 ; =MR ( q 2 )−MC ( q 1+q 2 )=0
∂q1 ∂q2
 optimality : MR ( q 1 ) =MR ( q 2 ) =MC ( q 1+ q 2 )  marginal cost must be equal to marginal
revenue in each of the markets

Price discrimination and elasticity: set a lower price for the group with higher price elasticity
(more sensitive) and higher price for the group with lower price elasticity (less sensitive). p ¿

OLIGOPOLY
Characteristics: only a few companies and each one is able to influence the market price
(market power)

Duopoly: only two companies competing in the market

Interdependence: the actions and decisions of a company affect and are affected by the
actions and decisions of other firms.

Non cooperative competition:

 Non price competition

o Cournot model: simultaneous quantity competition
o Stackelberg model: sequential quantity competition
o Advertising competition
 Price competition
o Bertrand model: price competition
o Hotelling and salop’s model: price leadership with differentiated products

Cooperative behavior

 Informed collusion or tacit collusion (without a formal agreement)

Game theory: study of behavior in situations of strategic interactions. Inmates by John Von
Neuman, Oscar Morgenstern and John Nash in the 50’.

Dominant strategy: when the action is a player’s best strategy regardless of the action taken
by the other player

Nash equilibrium: combination of mutually optimal strategies, each player chooses their best
strategy given the other player’s strategies

Compete: each player maximizes their short-term benefit at the other’s expense. Results in
both players being worked off.

Cooperate: both players achieve better outcomes. In repeated games often happens because
players prefer long term benefits.

Tit-for-tat: a player mimics the other’s previous action, encourages cooperation by rewarding
good behavior and punishing bad one, leading to stable collusion over time.

Cournot model: two companies that produce a homogeneous good and have constant marginal
cost equal to c compete.

Market demand: P ( Q )=a−bQ=Q−b ( q 1+ q 2 )

Market price: p=P ( Q ) =P ( q 1+ q 2 )

Problem of firm 1:

 ¿=P ( q 1+q 2 ) . q 1−C ( q 1 )

 Constant MC (MC = AC = C): C ( q 1 )=q 1 . C
 ¿=( a−b ( q 1+q 2 ) ) .q 1 . Cq1
dIT
 FOC: =0 →−bq 1+ a−bq 2−bq 1−C=a−2 bq 1−bq 2−C=0
dq 1
Reaction function: show the level of production that maximizes the profits of firm 1 for each
level of production of firm 2 (negative relation ship: when q2 increases, q1 decreases).
a−bq 2−C a−C q 2
a−bq 2−C=2bq 1 → q 1= → q 1 ( q 2 )= −
2 2b 2
Problem of firm 2 (same as firm 1):

 ¿=P ( q 1+q 2 ) . q 2−C ( q 2 )=( a−b ( q 1+ q 2 ) ) . q 2 .Cq 2

dIT
 FOC: =0 →−bq 2+ a−bq 1−bq 2−C=a−2bq 2−bq 1−C=0
dq 2
a−bq 1−C a−C q 1
 Reaction function: a−bq 1−C=2bq 2 → q 2= → q 2 ( q 1 )= −
2 2b 2
Reaction curve: shows the level of production that maximizes the profit of each company,
given the level of production of its competitors.

Cournot-Nash equilibrium: intersection between reaction curves.

a−c
 q 1 ( q 2 ) =q 2 ( q 1 )=
3b

2 ( a−c )
The total production level: Qc=
3b

The equilibrium price: Pc=P (QC )=P ¿

The profit of each firm: ¿ 1∗¿2∗¿ q∗ ( p∗−c ) =

3b (
a−c a+2 c
3
−c = )3b 3(
a−c a+2 c−3 c
)
=( a−c )2

Monopoly Perfect competition

Inverse demand P = a-bq Companies operate P = MC = C
function where
Total revenue TR = (a-bq) . q Demand function Qpc= (a-c)/b
Monopolist MR = MC —> MR = a - Level of production Q = (a-c)/b
equalizes 2q = c = MC for each firm
Maximizing level of Qm = (a+c)/2b Profits for each firm ITpc = (p-c)qpc =0
production
Price Pm(qm)=a-bqm=a-b((a-
c)/2b)=(a-a)/2+(c/
2)=(a+c)/2
Profits ITm=Qm(pm-c)=(a-c)/
2b(a+c/2 – c) = (a-
c)^2/4b

Monopoly Oligopoly Perfect

 competition
q Qm = (a-c)/2b < q*= (2/3)((a-c)/b) < Qpc = (a-c)/b

p Pm = (a+c)/2 > P*= (a+2c)/3 > Ppc = c

IT (a-c)^2/ab > IT* = (a-c)^2/qb > IT pc = 0

MONOPOLISTIC COMPETITION
Characteristics: many competing producers. Each producer sells a differentiated product. Free
entry and exit from the industry in the long run

Product differentiation: by style, type, location, quality and creation of brands

Short term monopolistic competition: negatively sloping demand curve, implies a

decreasing marginal income curve. Marginal cost curve has a decreasing part but is mainly
increasing. Because of fixed costs, ATC curve is U-shaped. Maximizes profits by producing the
amount for which MC = MR. Companies may face losses or profits.

Individual demand: P (qi)

qi*: MR (qi) = MC (qi)

IT(qi) > 0 —> P(qi) > ATC (qi)

Effects of entry: inward shift of D and MR. IT= 0

Effects of exit: outward shift of D and MR

Long term: each company maximizes profits given the demand curve (MC = MR). There will be
market entries and exits until the profits equal 0 for all companies. The company still has
monopolistic power; its long term demand curve has a negative slope, as its brand remains
unique. The long term demand curve Dlr is exactly tangent to the AC cost of the company.

Sources of inefficiency:

 P > MC; when price exceeds marginal cost some mutually beneficial trades are
unexploited
 Firms in a monopolistically competitive industry have excess capacity: they produce less
than the output at which ATC is minimized.

In monopolistic com. Quantity produced different from min efficient scale

In perfect com. Quantity produced equal min efficient scale