Microeconomic Theory: Costs, Perfect Competition, and Monopoly – Exam 2 Study Guide

Costs of Production

Accounting Costs vs. Economic Costs

Understanding the distinction between accounting and economic costs is fundamental in microeconomic analysis of the firm.

• Accounting Costs: The explicit monetary payments a firm makes to resource owners outside the firm. These are the costs recorded in the firm's financial statements (e.g., wages, rent, materials).

• Economic Costs: The sum of explicit costs and implicit costs (the opportunity costs of using resources owned by the firm, such as the owner's time or capital).

• Example: If a business owner uses their own building, the accounting cost may be zero for rent, but the economic cost includes the forgone rental income.

Sunk Costs

Sunk costs are expenditures that have already been incurred and cannot be recovered.

• Key Point: Sunk costs should not affect current or future economic decisions, as they cannot be changed by any action taken now.

• Example: Money spent on specialized equipment that cannot be resold or repurposed.

Short Run Cost Curves

In the short run, some inputs are fixed, leading to various cost measures:

• Total Fixed Cost (TFC): Costs that do not vary with output (e.g., rent).

• Total Variable Cost (TVC): Costs that change with the level of output (e.g., raw materials).

• Average Fixed Cost (AFC): $AFC = \frac{TFC}{Q}$

• Average Variable Cost (AVC): $AVC = \frac{TVC}{Q}$

• Average Total Cost (ATC): $ATC = \frac{TC}{Q} = AFC + AVC$

• Short-run Marginal Cost (SMC): $SMC = \frac{\Delta TC}{\Delta Q}$

• Example: If TFC = $100, TVC = $200 at Q = 10, then AFC = $10, AVC = $20, ATC = $30.

Production and Short Run Costs

The nature of the production process affects the shape and behavior of short run cost curves.

• Increasing marginal returns initially lower marginal and average costs, while diminishing returns eventually raise them.

• Changes in input productivity directly impact variable and marginal costs.

Isocost and Isoquant Analysis

Isocost and isoquant lines are tools for finding the least-cost combination of inputs to produce a given output.

• Isoquant: A curve showing all combinations of inputs that yield the same output.

• Isocost: A line showing all combinations of inputs that cost the same total amount.

• Equilibrium: The cost-minimizing input combination is where the isoquant is tangent to the isocost line.

• Mathematical Condition: $\frac{MP_L}{w} = \frac{MP_K}{r}$, where $MP_L$ and $MP_K$ are marginal products of labor and capital, $w$ is wage, $r$ is rental rate of capital.

• Types of Production Functions:

  • Multiplicative: $Q = A L^\alpha K^\beta$

  • Additive: $Q = aL + bK$

  • Fixed Factor: Output limited by the smallest input (e.g., $Q = \min\{aL, bK\}$)

• Input Price Changes: A change in input prices rotates the isocost line, altering the cost-minimizing input mix.

Economies of Scope

Economies of scope occur when it is less costly to produce multiple products together than separately.

• Key Point: Firms can share resources or technologies across products, reducing total costs.

• Example: A dairy producing both milk and cheese from the same facility.

Long Run Cost Curves

In the long run, all inputs are variable, and firms can adjust their scale of operation.

• Long Run Average Cost (LRAC): Shows the lowest possible average cost for each output level when all inputs are variable.

• Shape: Typically U-shaped due to economies and diseconomies of scale.

Perfect Competition

Characteristics of Perfectly Competitive Firms

Perfect competition describes a market structure with many small firms selling identical products.

• Many buyers and sellers

• Homogeneous (identical) products

• Free entry and exit

• Perfect information

• Firms are price takers

Profit Maximization in the Short Run

Firms maximize profit by producing the output where marginal cost equals marginal revenue.

• Condition: $MR = MC$

• If price falls below average variable cost, the firm will shut down in the short run.

Marginal Revenue for a Perfectly Competitive Firm

Marginal revenue (MR) is the additional revenue from selling one more unit.

• For a perfectly competitive firm, $MR = P$ (market price).

Number of Firms in the Industry

The number of firms is determined by market demand, cost conditions, and the process of entry and exit.

• In the long run, firms enter or exit until economic profit is zero.

Short Run Supply Curve

The firm's short run supply curve is the portion of its marginal cost curve above average variable cost.

• The industry supply curve is the horizontal sum of all firms' supply curves.

Calculating Profits

Profit is the difference between total revenue and total cost.

• Formula: $\text{Profit} = TR - TC$

• Where $TR = P \times Q$

Short Run to Long Run Adjustment

Economic profits or losses in the short run lead to entry or exit in the long run, driving profits to zero.

• Entry shifts supply right, lowering price and profit.

• Exit shifts supply left, raising price and reducing losses.

Profit Maximization in the Long Run

In the long run, firms produce where price equals minimum long run average cost, earning zero economic profit.

• Condition: $P = LRMC = LRAC$

Long Run Supply Curve

The long run supply curve for the industry depends on cost conditions:

• Constant Cost Industry: Entry or exit does not affect input prices; LR supply is perfectly elastic.

• Increasing Cost Industry: Entry raises input prices; LR supply is upward sloping.

• Decreasing Cost Industry: Entry lowers input prices; LR supply is downward sloping.

Efficiency in Perfect Competition

Perfect competition achieves several forms of efficiency:

• Allocative Efficiency: Resources are allocated where they are most valued ($P = MC$).

• Productive Efficiency: Goods are produced at the lowest possible cost ($P = \\min LRAC$).

• Economic Welfare: Total surplus (consumer plus producer surplus) is maximized.

Monopoly

Characteristics of Monopoly

A monopoly is a market with a single seller of a unique product with no close substitutes.

• Single firm supplies the entire market

• Significant barriers to entry

• Firm has market power (can set price)

Barriers to Entry

Barriers to entry prevent new firms from entering the market and competing with the monopolist.

• Types:

  • Legal barriers (patents, licenses)

  • Control of essential resources

  • Economies of scale (natural monopoly)

  • Strategic actions (predatory pricing)

• Example: Utility companies often have government-granted monopolies.

Demand Curve Facing a Monopolist

The monopolist faces the market demand curve, which is downward sloping.

• To sell more, the monopolist must lower the price.

Marginal Revenue for the Monopolist

Marginal revenue is less than price for a monopolist because lowering price to sell more units reduces revenue on all units sold.

• Formula: $MR = P + \frac{\Delta P}{\Delta Q} \times Q$

• For linear demand $P = a - bQ$, $MR = a - 2bQ$

Elastic Portion of the Demand Curve

A monopolist will only operate on the elastic portion of the demand curve, where marginal revenue is positive.

• If demand is inelastic, lowering price reduces total revenue and profit.