Business economics

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Business economics

  1. 1. Business EconomicsQ1: The marginal product of labour in a production process is statistically estimated asMPL = 10(K/L)0.5Currently the process is using 100 units of K and 121 units of L. Given the Very specialisednature of capital equipment K, it takes about a year to increase K; but the rate of labourinput, L, can be varied daily. If the wage rate is $ 10 per unit and the price of output is $2 perunit, is the firm operating efficiently in the short run? If not, explain why. Also determine theoptimal rate of labour input. On what factors does the labour efficiency depend?The concept of a production functionThe production function is a mathematical expression which relates the quantity of factorinputs to the quantity of outputs that result. We make use of three measures of production /productivity. Total product is simply the total output that is generated from the factors of production employed by a business. In most manufacturing industries such as motor vehicles, freezers and DVD players, it is straightforward to measure the volume of production from labour and capital inputs that are used. But in many service or knowledge-based industries, where much of the output is “intangible” or perhaps weightless we find it harder to measure productivity Average product is the total output divided by the number of units of the variable factor of production employed (e.g. output per worker employed or output per unit of capital employed) Marginal product is the change in total product when an additional unit of the variable factor of production is employed. For example marginal product would measure the change in output that comes from increasing the employment of labour by one person, or by adding one more machine to the production process in the short run.The Short Run Production FunctionThe short run is defined in economics as a period of time where at least one factor ofproduction is assumed to be in fixed supply i.e. it cannot be changed. We normally assume thatthe quantity of capital inputs (e.g. plant and machinery) is fixed and that production can bealtered by suppliers through changing the demand for variable inputs such as labour,components, raw materials and energy inputs. Often the amount of land available forproduction is also fixed.The time periods used in textbook economics are somewhat arbitrary because they differ fromindustry to industry. The short run for the electricity generation industry or thetelecommunications sector varies from that appropriate for newspaper and magazinepublishing and small-scale production of foodstuffs and beverages. Much depends on the timescale that permits a business to alter all of the inputs that it can bring to production.
  2. 2. In the short run, the law of diminishing returns states that as we add more units of a variableinput (i.e. labour or raw materials) to fixed amounts of land and capital, the change in totaloutput will at first rise and then fall. Diminishing returns to labour occurs when marginalproduct of labour starts to fall. This means that total output will still be rising – but increasing ata decreasing rate as more workers are employed. As we shall see in the following numericalexample, eventually a decline in marginal product leads to a fall in average product.What happens to marginal product is linked directly to the productivity of each extra workeremployed. At low levels of labour input, the fixed factors of production - land and capital, tendto be under-utilised which means that each additional worker will have plenty of capital to useand, as a result, marginal product may rise. Beyond a certain point however, the fixed factors ofproduction become scarcer and new workers will not have as much capital to work with so thatthe capital input becomes diluted among a larger workforce. As a result, the marginalproductivity of each worker tends to fall – this is known as the principle of diminishingreturns.An example of the concept of diminishing returns is shown below. We assume that there is afixed supply of capital (e.g. 20 units) available in the production process to which extra units oflabour are added from one person through to eleven. Initially the marginal product of labour is rising. It peaks when the sixth worked is employed when the marginal product is 29. Marginal product then starts to fall. Total output is still increasing as we add more labour, but at a slower rate. At this point the short run production demonstrates diminishing returns.The Law of Diminishing Returns Capital Input Labour Input Total Output Marginal Product Average Product of Labour 20 1 5 5 20 2 16 11 8 20 3 30 14 10 20 4 56 26 14 20 5 85 28 17 20 6 114 29 19 20 7 140 26 20 20 8 160 20 20 20 9 171 11 19 20 10 180 9 18 20 11 187 7 17 Average product will continue to rise as long as the marginal product is greater than theaverage – for example when the seventh worker is added the marginal gain in output is 26 andthis drags the average up from 19 to 20 units. Once marginal product is below the average as it
  3. 3. is with the ninth worker employed (where marginal product is only 11) then the average willdecline.This marginal-average relationship is important to understanding the nature of short run costcurves. It is worth going through this again to make sure that you understand it.Criticisms of the Law of Diminishing ReturnsHow realistic is this notion of diminishing returns? Surely ambitious and successful businessesdo what they can to avoid such a problem emerging.It is now widely recognised that the effects of globalisation, and in particular the abilityof trans-national corporations to source their factor inputs from more than one country andengage in rapid transfers of business technology and other information, makes the concept ofdiminishing returns less relevant in the real world of business. You may have read about theexpansion of “out-sourcing” as a means for a business to cut their costs and make theirproduction processes as flexible as possible.In many industries as a business expands, it is more likely to experience increasing returns.After all, why should a multinational business spend huge sums on expensive research anddevelopment and investment in capital machinery if a business cannot extract increasingreturns and lower unit costs of production from these extra inputs?Long run production - returns to scaleIn the long run, all factors of production are variable. How the output of a business respondsto a change in factor inputs is called returns to scale. Increasing returns to scale occur when the % change in output > % change in inputs Decreasing returns to scale occur when the % change in output < % change in inputs Constant returns to scale occur when the % change in output = % change in inputs
  4. 4. A numerical example of long run returns to scaleUnits of Units of Total % Change in % Change in Returns to ScaleCapital Labour Output Inputs Output20 150 300040 300 7500 100 150 Increasing60 450 12000 50 60 Increasing80 600 16000 33 33 Constant100 750 18000 25 13 DecreasingIn the example above, we increase the inputs of capital and labour by the same proportion eachtime. We then compare the % change in output that comes from a given % change in inputs. In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% - there are increasing returns to scale. In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.As we shall see a later, the nature of the returns to scale affects the shape of a business’s longrun average cost curve.The effect of an increase in labour productivity at all levels of employmentProductivity may have been increased through the effects of technological change; improvedincentives; better management or the effects of work-related training which boosts the skills ofthe employed labour force.
  5. 5. The length of time required for the long run varies from sector to sector. In the nuclear power industryfor example, it can take many years to commission new nuclear power plant and capacity.Normally though efficiency of labour means the ability or4 fitness of a worker to produce goodsand services in proper quantity and of the right quality which is a given period. The ability canbe measured in terms of number of units of a commodity produced by a worker with in a givenperiod. Thus, one factor worker producing more number of a commodity with in a given timethan the other worker is considered more efficient. Efficiency of labour is thus an importantdeterminant of the study of labour in a productive sense. It determines the size of realproductive labour force in a country. A country labour supply will be substantially augmented ifit possesses a relatively small labour force possessing a high degree of efficiency.Factors affecting the efficiency of labour are as follows:-1.Racial Stock: - Man acquires some physical qualities from the racial stock to which he belongs.The Sikhs and Jats are very strong and are capable of hard work.2. Wages: - If a labourer get a low wage, he can’t maintain his efficiency, if wages are low,labour productivity will also be low.3.Climate: -In temperate and cold climate, people can work hard. Hot climate is not conductiveto very hard work. In hot climate, labourers cannot work as hand as labourer in cool climatecan.4.Hours to Work: -The efficiency of labour is affected by the working hours. If a labourer worksfor long hours, work becomes monotonous and the labourers worse only half heartily. Hecannot give the best.5.Working Conditions: - If the factory building is dirty and not well-ventilated workers cannothard work. However, if factory building is clean and well ventilated and if the atmosphere ispleasant, workers like to work hard.6.Education and Training: - Education and Training impact technical knowledge, sense ofresponsibility and improve the efficiency of labour. Trained labourer can use modern machineryefficiency.7.Welfare Activities: - Social security measures like medical facilities and maternity benefitshelp laborer to maintain their health and efficiency. Measures to improve efficiency of labour:-Efficiency of labour can be improved by eradicating the cause of low efficiency.This can be done particularly through proper education, training improvement in machines andbetterment in working living conditions. Thus, labour efficiency can be improved with respect offollowing points:- 1. By linking about labour efficiency and by wages and incentive bonus, it is possible tomotivate labour.2. Labour efficiency can be raised by mutual argument between management and workersregarding distribution of benefits of raising labour productivity.3.Improving industrial relations can raise labour efficiency.4.Comprehensive planning and introducing input is creating quality consciousness in productionand in cost control, that efficiency can be raised.
  6. 6. 5.Bringing improvement in plan lay out material handling and better internal management in afactory has positive effect on labour efficiency.6.By providing modern training course to those in personnel department who handle workersuch trained personnel will be able to create an atmosphere of better effort by workers.7. Providing training to workers and taking measures to improve labour welfare.8.By introducing modern methods of organization, labour efficiency can be raised
  7. 7. Q2: Explain how equilibrium of the firm is achieved. Also, explain (along with examples) howprofit maximizing output is determined in short run and long run for:A: Perfect Competitive market Monopoly market Monopolistic market Oligopoly marketMarket equilibrium in economics refers to level of prices at which the quantity demanded bythe customers is same as the quantity offered for for supply by the suppliers. Thus the marketequilibrium has two dimensions.(1) price, and (2) quantity sold and purchased. Here we are talking about quantity actual soldand purchased. Unlike quantities demanded and quantity offered for supply, the actualquantity sold and purchased is always equal.In a monopoly market, the entire market supply is accounted by one firm. Therefore,equilibrium point for the market and for the firm is the same. In a perfectly competitive market,individual firms have no influence on the market price as the demand curve for the firm is ahorizontal line at the level of the market price. Thus same price is applicable to firm levelequilibrium. However the quantity supplied by each firm at this equilibrium price depends onthe cost structure of the firm. The firm can supply as much as it wishes, therefore it supplies aquantity that maximizes its profit. This occurs when the marginal cost of the firm just equals themarginal revenue. In a perfectly competitive market the marginal cost and revenue at this pointare also same as the market price. Since marginal cost for every firm operating in a perfectcompetition is same as market price, the combined marginal cost for all the firms in a perfectlycompetitive market is also same as market equilibrium price.In an oligopoly it is not possible to give a fixed formula for the equilibrium point for individualfirms as it is dependent on actions of competitor firms and may change from time to time inresponse to changing competitive action and the competitive strategy of the firm itself.Average Fixed Cost:Fixed cost refers to the minimum fixed cost that a firm incurs for manufacturing irrespective ofthe total quantity produced. Average fixed cost is simply this fixed cost divided by total quantityproduced.Thus: Average Fixed Cost = AFC = Fixed cost/Total quantity produced.In the above equation for AFC we see that numerator (fixed cost) is constant, whiledenominator (total quantity produced) is variable. Therefore, AFC reduces with increasing
  8. 8. production quantity. As a result AFC curve, which is a graph showing AFC on y-axis andproduction of x-axis, is a downward sloping curve.How equilibrium is achieved depends on what is being equalized. Equilibrium means balance orequality between two opposing forces. When those forces are equal, there is rest.Equilibrium is achieved when both sides are effectively in balance. In other words, one sidedoes not contain more than the other side. Any changes made to the sides are done to bothsidesMARKET EQUILIBRIUM:The state of equilibrium that exists when the opposing market forces of demand and supplyachieve a balance with no inherent tendency for change. Once achieved, a market equilibriumpersists unless or until it is disrupted by an outside force, especially the demand and supplydeterminants. A market equilibrium is indicated by equilibrium price and equilibrium quantity.In general, equilibrium is the balance of opposing forces. For market equilibrium, the opposingforces are demand and supply. Buyers seeking to buy at a lower price and sellers seeking to sellat a higher price. The balance of these two forces generates a price and a quantity that aremutually agreeable to both sides.The Imperial Forces of Demand and SupplyA market equilibrium is comparable to a robust tug-of-war between two equally matchedteams of burly lumberjacks, such as those employed by the Natural Ned Lumber Company. Onone end of the rope is a group of ten burly lumberjacks in red plaid shirts. On the other end is agroup of ten burly lumberjacks in blue plaid shirts. As the red burly team tugs and pulls they arematched tug for tug and pull for pull by the blue burly team. The yellow flag marking the centerof the rope budges nary an inch. The two opposing forces of burly red and burly blue balanceout. The result is equilibrium.Except for the plaid shirts, market equilibrium works in much the same way. Demand: Wearing red flannel, the demand "force" is buyers seeking to pay the lowest possible price for a good. In particular, the demand force is the demand curve, which embodies the law of demand. However, it is not just the demand curve that is this force, but the whole demand space beneath the demand curve. Buyers are willing to go as high as the demand curve, but would really, really prefer to go lower. Supply: In the blue corner, the supply "force" is sellers seeking to receive the highest possible price. This is best indicated by thesupply curve, which embodies the law of supply. And like demand, it is not the supply curve itself, but the entire supply space above the curve. Sellers are willing to go as low as the supply curve, but would really, really prefer to go higher.
  9. 9. Striking A BalanceMarket equilibrium is the balance between buyers Market Equilibriumtrying to move the price down and sellers trying tomove the price up. When the two forces are inbalance, the "yellow flag" or price does not budge.The unmoving price is not actually yellow, but it is theequilibrium price. Specifically equilibrium price is the price that exists when the market is in equilibrium. Paired with the equilibrium price, is the equilibrium quantity, which is the quantity exchanged between buyers and sellers when the market is in equilibrium.There is more, however, to equilibrium price andquantity than yellow flags. The equilibrium price is also equal to BOTH the demandprice andsupply price. Moreover, the equilibrium quantity is equal to BOTH thequantitydemanded and quantity supplied.As a matter of fact, equilibrium price and equilibrium quantity result when the demand andsupply prices are equal AND the quantities demanded and supplied are equal. And this is ONLYachieved at the intersection of the demand and supply curves. This market equilibrium isillustrated in the accompanying market diagram.Efficiency and the Invisible Hand of CompetitionEconomists like market equilibrium almost as much as a box of Double-Dot Caramel NougatClusters. The reason is efficiency. The forces of demand and supply, almost as if guided byan invisible hand, efficiently allocate societys scarce resources when they achieve marketequilibrium. Efficiency, however, requires a competitive market--a market with large numbersof buyers and sellers such that neither side is able to influence the price or exchange processand the absence of market failures such as externalities.A competitive market is comparable to a tug-of-war in which each team consists of a hundredthousand flannel-shirted lumberjacks. Should any single lumberjack from either side leave theirteam to climb a pine tree, fell a redwood, or pursue other lumberjacking activities, then thetug-of-war is unaffected. One lumberjack, one buyer, one seller, does not affect a competitivemarket.If, however, the tug-of-war teams consist of only three lumberjacks each, then the absence orpresence of a one can make a difference. Likewise the efficiency balance in a market can beeasily comprised if the number of competitors is limited.
  10. 10. Those Disrupting DeterminantsMarket equilibrium perpetually persists unless or until disrupted by an outside force.The demand determinants and supply determinants are the prime disrupters of marketequilibrium. When they change, the demand and supply curves shift, the original equilibriumprice and quantity are no longer equilibrium, and the market is out of balance with surplusesand shortages.Fortunately, a market equilibrium is a stable equilibrium. Any determinant-triggered disruptionthat results in a surplus or shortage induces the price to change to restore equilibrium. If themarket wavers from equilibrium, the demand and supply forces bring it back. If the price is toohigh or too low, that is, above or below the equilibrium price, then the price automaticallyreturns it to the equilibrium. A high price creates a surplus, which means sellers are not able to sell all that they want at the existing price. To eliminate this surplus, they force the price lower. A low price creates a shortage, which means buyers are not able to buy all that they want at the existing price. To eliminate this shortage, they force the price higher.In either situation, the price returns to the equilibrium.Perfect Competitive MarketA perfectly competitive firm with rising marginal costs maximizes profit by producing up untilthe point at which marginal cost is equal to marginal revenue. The marginal revenue for aperfectly competitive firm is the market price determined by the intersection of the supply anddemand curves, as shown in the panel on the left. The panel on the right shows the orangeprice line intersecting the purple marginal cost curve at the profit maximizing quantity, . Theper unit profit is represented by the distance between the price line and the point on the U-shaped average total cost curve corresponding to .The total profit is the per unit profittimes and is represented by the shaded rectangle. If the price is below the average totalcost, the profit is negative and can be interpreted as the loss minimizing level of output.Short-Run Profit Maximization- Since firms take price as given, the only decision they have to make is how much output to produce (if any).- Choose output “Q” to maximize economic profits
  11. 11. (Q) TR(Q) TC(Q) PQ TVC(Q) TFCNote: TC(Q) already incorporates the firm’s cost-minimizing input choices for each Q.Note: Economic profits include all relevant opportunity costs (including the opportunity cost ofthe owner’s investment), so an economic profit of zero actually corresponds to a “normal” rateof return on one’s investment.- Two components to firm’s decision: (Part 1) Should they produce any output at all? (Part 2) If so, how much?(Part 1) Should the firm produce Q > 0 or shut down (produce Q = 0)?The firm should stay open if there exists a positive output level Q such that (Q) (Q 0) TR(Q) TVC(Q) TFC TFC TR(Q) TVC(Q)Alternatively, we can rewrite this as: TR(Q) TVC(Q) Q Q PQ TVC(Q) Q Q P AVC(Q) for some Q 0 (or)
  12. 12. P min AVC(Q)Intuition:Fixed costs are irrelevant for the shut down decision since they must be paid whether the firmremains open or not.However, as long as TR > TVC for some Q > 0 (alternatively, P > min AVC), the firm can increaseprofits by producing Q > 0 (since additional revenue earned on these units exceeds the cost ofproducing them).Conversely, if TR < TVC for all Q > 0 (alternatively, P < min AVC), then the firm loses money oneach unit it produces so it is better off not producing any output.Observation: In the short run, it may well be in the firm’s interest to remain open even if theirprofits are negative.This is because (q) TR(Q) TVC(Q) TFC 0even if TR(Q) TVC(Q) 0(Part 2) Given that it is in the firm’s interest to produce Q > 0, how much output should the firmproduce in order to maximize profits?- Easiest to see graphically…(see diagram)- Observe that profits are maximized (the difference between TR and TC is the greatest) at the point where slope of TR = slope of TC P = MC(in region where MC (slope of TC) is increasing!)
  13. 13. - Notice that the slope of the TR curve might also equal the slope of the TC curve in the region where MC (slope of TC) is decreasing.- This would not be the profit-maximizing level of output (in fact, this is the level of output where losses are maximized.)Both components of the firm’s output decision can be summarized in the following graphs:Case 1) Profit > 0 (see diagram)- First, notice that there are many levels of Q for which P > AVC produce Q > 0.- Second, given Q > 0 is optimal, choose output level where P = MC (in region where MC is increasing).- Profits at the optimal output level Q* are given by the area of the shaded rectangle (Q) P ATC(Q* ) Q* TC (Q* ) * P Q Q * PQ* TC (Q*) TR(Q*) TC (Q*)Case 2) Profit < 0; but remain open in short run (see diagram)- Here, P > AVC for many values of Q, so the firm should produce Q > 0.- Profit-maximizing Q is where P = MC (in region of increasing MC).- At Q* , P < ATC (Q*) P ATC(Q* ) Q* 0
  14. 14. Case 3) Profits < 0; firm should shut down (see diagram)- Here there is no Q for which P > AVC (i.e., P < min AVC), so firm should shut down.Numerical Example: TC 100 Q 2 MC 2Q P $601) Should the firm stay open (produce Q > 0)? Q2 TVC Q2 AVC Q QClearly, P > AVC for some Q > 0, so produce Q > 0.2) What is the profit-maximizing level of Q?Set P = MC in region where MC is increasing.MC = 2Q, so MC is always increasing. P MC 60 2Q Q* 303) What are the firm’s economic profits? (Q*) TR(Q*) TC(Q*) PQ* TC(Q*)
  15. 15. (30) 60(30) 100 (30)2 1800 100 900 $800Application: Two Misconceptions about Short-Run Profit Maximizationa) Many companies have a culture that encourages managers to maximize profit margins (see diagram).b) Accounting departments often advise against projects if they can’t “pay their share,” i.e. earn enough revenue to cover some portion of existing fixed costs.Example: Meat packing company my father worked for.Current Production:TR = $30,000,000TVC = $10,000,000TFC = $15,000,000Proposed Project (to be housed in unused basement):TR = $2,000,000TVC = $1,000,000Rejected because it was assigned a 10% share of the existing fixed costs ($1,500,000).The Firm’s Short-Run Supply CurveThe two conditions for profit maximization define the firm’s short-run supply curve (seediagram) 0 if P min AVC Q MC(Q) if P min AVCwhere MC denotes the upward-sloping portion of the marginal cost curve.Thus, the firm’s short-run supply curve is the portion of its MC curve above min AVC.
  16. 16. Note: Firm’s short-run supply curve is upward sloping because it is equal to the upward-slopingportion of the MC curve.Short-Run Industry SupplyShort-run Industry Supply Curve – The horizontal sum of the short-run supply curves of all firmsin the industry.Example: Identical firmsSuppose an industry has 200 identical firms, each with the short-run supply curve P 100 1000Q iQuestion: What is the short-run industry supply curve?- Must sum firm supply curves horizontally, i.e. must sum quantities at each price. Rearrange supply curves so Q is on the left-hand side. P 1 Q i 1000 10With 200 firms, summing the above supply curve is equivalent to multiplying it by 200, i.e. Q 200Q i P 1 200 1000 10 P 20 5Finally, rearrange so P is on the left-hand side
  17. 17. P 100 5QLong-Run Profit MaximizationIn the long run, firms can adjust fixed inputs (capital) to minimize the costs of producing thedesired level of output. Firms operate on their long-run average and marginal cost curvesIn the long run, all costs are variable. ATC = AVC = LRAC (long-run average cost)Still two components to choosing the profit-maximizing level of output:1) Should we produce any output at all (i.e. remain in the industry)?2) If we remain in the industry, how much output should we produce?1) Should we remain in the industry?If there exists some Q > 0 such that economic profits are greater than or equal to zero, i.e. if (Q) P LRAC (Q) Q 0then the firm should remain in the industry.If not (if economic profits are negative), it means that at least one of the inputs is more highlyvalued in another industry.2) If we remain in the industry, how much output should we produce?The rule is the same as before:Choose the level of output such that P = LRMC (in the region where LRMC is increasing)(see diagram)V) Long-Run Competitive Equilibrium
  18. 18. Fact 1: Entry and exit by firms guarantees that in long-run competitive equilibrium economicprofits must be zero.Fact 2: Firms operate on their long-run cost curves.Facts 1 and 2 imply that in a long-run competitive equilibrium, firms produce where P = LRMC = min LRAC(see diagram)Reason: (see diagram)If P > min LRAC, economic profits would be positive and firms would enter, thereby drivingdown the price.If P < min LRAC, economic profits would be negative and firms would exit, thereby driving upthe price.Application – Reparations for SlaveryQ: Who should pay? (Robert Fogel’s argument).Example: Calculation of Long-Run EquilibriumConsider 4 identical firms, each with the cost curves shown below LRTC 4Q 2 2Q3 LRMC 8Q 6Q 2 LRAC 4Q 2Q 2 min LRAC occurs at Q 1Note: Observe that we don’t require any information on the demand side of the market!Question: What is the long-run equilibrium price and quantity in this market?It helps to draw the picture for a representative firm (see diagram).Since there are 4 identical firms, each producing 1 unit of output, the equilibrium quantity is 4.
  19. 19. To find the equilibrium price, use the fact that, for each firm, P = LRMC = LRAC at the profit-maximizing output level Q = 1.Thus, substitute Q = 1 into either LRMC or LRAC to get P * = 2.Question: What are profits for a representative firm? (Q) PQ TC(Q) Profit Maximization 2(1) 4(1)2 2(1)2 Profit Curve Total Curves 2 4 2 Marginal Curves 0as must be true in long-run competitiveequilibrium.Efficiency Properties of Long-Run CompetitiveEquilibrium1) Pareto Efficiency – all gains from trade are realized (since MB = P = LRMC).2) Productive Efficiency – output is produced at the lowest possible unit cost (since each firm produces at the min of LRAC).
  20. 20. MONOPOLY, PROFIT MAXIMIZATION:A monopoly is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This production decision can be analyzeddirectly with economic profit, by identifying the greatest difference between total revenue andtotal cost, or by the equality between marginal revenue and marginal cost.The profit-maximizing level of output is a production level that achieves the greatest levelof economic profit given existing market conditions and production cost. For a monopoly, thisentails adjusting the price and corresponding production level to achieved the desired matchbetween total revenue and total cost.Three ViewsProfit-maximizing output can be identified in one of three ways--directly with economic profit,with a comparison of total revenue and total cost, and with comparison of marginal revenueand marginal cost.This exhibit illustrates how it can be identified for a monopoly, such as that operated by Feet-First Pharmaceutical, a well-known monopoly supplier of Amblathan-Plus, the only cure for thedeadly (but hypothetical) foot ailment known as amblathanitis. Feet-First Pharmaceutical is theexclusive producer of Amblathan-Plus, meaning that it is a price maker and the demand curve itfaces is the market demand curve.The top panel presents the profit curve. The middle panel presents total revenue and total costcurves. The bottom panel presents average revenueand average total cost curves. In all threepanels, Feet-First Pharmaceutical maximizes when producing 6 ounces of Amblathan-Plus.Profit: First, profit maximization can be illustrated with a direct evaluation of profit. If the profitcurve is at its peak, then profit is maximized. In the top panel, the profit curve achieves itshighest level at 6 ounces of Amblathan-Plus. At other output levels, profit is less.Total Revenue and Total Cost: Second, profit maximization can be identified by a comparison oftotal revenue and total cost. The quantity of output that achieves the greatest difference oftotal revenue over total cost is profit maximization. In the middle panel, the vertical gapbetween the total revenue and total cost curves is the greatest at 6 ounces of Amblathan-Plus.For smaller or larger output levels, the gap is either less or the total cost curve lies above thetotal revenue curve.Marginal Revenue and Marginal Cost: Third, profit maximization can be identified by acomparison of marginal revenue and marginal cost. If marginal revenue is equal to marginalcost, then profit cannot be increased by changing the level of production. Increasing production
  21. 21. adds more to cost than revenue, meaning profit declines. Decreasing production subtractsmore from revenue than from cost, meaning profit also declines. In the bottom panel, themarginal revenue and marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger orsmaller output levels, marginal cost exceeds marginal revenue or marginal revenue exceedsmarginal cost.More on the Marginal View Further analysis of the marginal approach to analyzing profit maximization provides further insight into the short-run production decision of a monopoly. First, consider the logic behind using marginals to identify profit maximization. Marginal revenue indicates how much total revenue changes by producing one more or one less unit of output. Marginal cost indicates how much total cost changes by producing one more or one less unit of output. Profit increases if marginal revenue is greater than marginal cost and profit decreases if marginal revenue is less than marginal cost. Profit neither increases nor decreases if marginal revenue is equal to marginal cost. As such, the production level that equates marginal revenue and marginal cost is profit maximization. Profit Maximization, The Marginal ViewWith this in mind, now consider this exhibit to theright, which will eventually contain the marginalrevenue and marginal cost curves for Feet-FirstPharmaceuticals Amblathan-Plus production. Average Revenue: First up is the average revenue curve, which can be seen with a click of the [Average Revenue] button. Because Feet-First Pharmaceutical is a monopoly, this average revenue curve is the market demand curve for Amblathan-Plus, which is negatively- sloped due to the law of demand. Marginal Revenue: A click of the [Marginal Revenue] button reveals the greenline labeled MR that depicts the marginal revenue Feet-First Pharmaceutical receives from Amblathan-Plus production. Because Feet-First Pharmaceutical is a price maker, this
  22. 22. marginal revenue curve is also a negatively-sloped line, and it lies beneath the average revenue (market demand) curve. Marginal Cost: The marginal cost curve is U-shaped, reflecting the principles of short-run production. Click the [Marginal Cost] button to add this curve to the diagram. It has a negative slope for small amounts of output, then the slope is positive for larger quantities due to the law of diminishing marginal returns. Profit Maximization: Profit is maximized at the quantity of output found at the intersection of the marginal revenue and marginal cost curves, which is 6 ounces of Amblathan-Plus. Click the [Profit Max] button to highlight this production level. This is the same profit-maximizing level identified using the total revenue and total cost curves and the profit curve. Consider what results if marginal revenue is not equal to marginal cost: If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases. If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than it reduces cost, so profit increases. If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.Monopolistic MarketIn monopolistic competition, there are many firms vying for control of one market. Each firmoffers a different type of product, as opposed to perfect competition in which all offer the sameproduct. Each firm, then, has a monopoly in the market of their own product. Thus, the firmstry to advertise their products so people buy more of their product. At the same time,monopolistic competitors do not try to compete so as to undermine other competitors. Thereare too many other businesses in a monopolistic competition to worry about them, you simplytry to get people to buy your own product as opposed to respond to others tactics.Monopolistic competition, because there are so many relatively weak firms, there are nobarriers to entry. Companies can enter the market relatively easily (although, of course, not asperfectly easy as in perfect competition). This makes for a long-term equilibrium competition ofno profit. When there is profit to be made, just as in perfect competition, new companies comein and take that profit away through expanded production and dropping prices. Unlike inperfect competition, though, monopolistic competition has a normal downward-slopingdemand curve. The competing companies in monopolistic competition are not so much price
  23. 23. takers as price setters and thus the demand curve is sloped, not set constant at the marketprice.In monopolistic competition, there are many firms vying for control of one market. Each firmoffers a different type of product, as opposed to perfect competition in which all offer the sameproduct. Each firm, then, has a monopoly in the market of their own product. Thus, the firmstry to advertise their products so people buy more of their product. At the same time,monopolistic competitors do not try to compete so as to undermine other competitors. Thereare too many other businesses in a monopolistic competition to worry about them, you simplytry to get people to buy your own product as opposed to respond to others tactics.Monopolistic competition, because there are so many relatively weak firms, there are nobarriers to entry. Companies can enter the market relatively easily (although, of course, not asperfectly easy as in perfect competition). This makes for a long-term equilibrium competition ofno profit. When there is profit to be made, just as in perfect competition, new companies comein and take that profit away through expanded production and dropping prices. Unlike inperfect competition, though, monopolistic competition has a normal downward-slopingdemand curve. The competing companies in monopolistic competition are not so much pricetakers as price setters and thus the demand curve is sloped, not set constant at the marketprice.Short-run equilibrium of the firm under monopolistic competition. The firm maximizes itsprofits and produces a quantity where the firms marginal revenue (MR) is equal to its marginalcost (MC). The firm is able to collect a price based on the average revenue (AR) curve. Thedifference between the firms average revenue and average cost, multiplied by the quantity sold(Qs), gives the total profit.The monopolistically competitive firms long-run equilibrium situation is illustrated in theFigure below.
  24. 24. Long-run profit maximization by a monopolistically competitive firmThe entry of new firms leads to an increase in the supply of differentiated products, whichcauses the firms market demand curve to shift to the left. As entry into the market increases,the firms demand curve will continue shifting to the left until it is just tangent to the averagetotal cost curve at the profit maximizing level of output, as shown in Figure 1 . At this point, thefirms economic profits are zero, and there is no longer any incentive for new firms to enter themarket. Thus, in the long-run, the competition brought about by the entry of new firms willcause each firm in a monopolistically competitive market to earn normal profits, just like aperfectly competitive firm.Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm endsup choosing a level of output that is below its minimum efficient scale, labeled as point b inFigure 1 . When the firm produces below its minimum efficient scale, it is under-utilizing itsavailable resources. In this situation, the firm is said to have excess capacity because it caneasily accommodate an increase in production. This excess capacity is the major social cost of amonopolistically competitive market structure.Oligopoly MarketAn oligopoly is a market dominated by a few producers, each of which has control over themarket. It is an industry where there is a high level of market concentration.However, oligopoly is best defined by the conduct (or behaviour) of firms within amarket rather than its market structure.
  25. 25. The concentration ratio measures the extent to which a market or industry is dominated by afew leading firms. Normally an oligopoly exists when the top five firms in the market accountfor more than 60% of total market demand/sales.Price leadership – tacit collusionAnother type of oligopolistic behaviour is price leadership. This is when one firm has aclear dominant position in the market and the firms with lower market shares follow the pricingchanges prompted by the dominant firm. We see examples of this with the major mortgagelenders and petrol retailers where most suppliers follow the pricing strategies of leading firms.If most of the leading firms in a market are moving prices in the same direction, it can takesome time for relative price differences to emerge which might cause consumers to switch theirdemand.Firms who market to consumers that they are “never knowingly undersold” or who claim to bemonitoring and matching the cheapest price in a given geographical area are essentiallyengaged in tacit collusion. Does the consumer really benefit from this?Tacit collusion occurs where firms undertake actions that are likely to minimise a competitiveresponse, e.g. avoiding price cutting or not attacking each other’s marketExplicit collusion under oligopolyIt is often observed that when a market is dominated by a few large firms, there is always thepotential for businesses to seek to reduce market uncertainty and engage in some form ofcollusive behaviour. When this happens the existing firms decide to engage in price fixingagreements or cartels. The aim of this is tomaximise joint profits and act as if the market was apure monopoly. This behaviour is deemed illegal by the UK and European competitionauthorities. But it is hard to prove that a group of firms have deliberately joined together toraise prices.Price fixingCollusion is often explained by a desire to achieve joint-profit maximisation within a market orprevent price and revenue instability in an industry. Price fixing represents an attempt bysuppliers to control supply and fix price at a level close to the level we would expect from amonopoly.To fix prices, the producers in the market must be able to exert control over market supply. Inthe diagram below a producer cartel is assumed to fix the cartel price at output Qm and pricePm. The distribution of the cartel output may be allocated on the basis of an output quotasystem or another process of negotiation.
  26. 26. Although the cartel as a whole is maximising profits, the individual firm’s output quota isunlikely to be at their profit maximising point. For any one firm, within the cartel, expandingoutput and selling at a price that slightly undercuts the cartel price can achieve extra profits.Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same. If allfirms break the terms of their cartel agreement, the result will be an excess supply in themarket and a sharp fall in the price. Under these circumstances, a cartel agreement might breakdown.Collusion in a market or industry is easier to achieve when: There are only a small number of firms in the industry and barriers to entry protect the monopoly power of existing firms in the long run. Market demand is not too variable Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers in the market Each firm’s output can be easily monitored – this enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

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