MICROECONOMI CS TOPIC 3.

THE COMP ANY: 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. APL=
𝐿

Marginal productivity: marginal change in production for a unitary change of a factor, Additional output produced by adding one
∆𝑌 𝜕 (𝐾,𝐿)
more unit of input. MPL= =
∆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. MPL= ∆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 =
𝐿𝛽 ; 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. = 𝐿𝛽 ; 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 = ∆𝑄
= 𝜕𝑇𝐶

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: 𝑻𝑅(𝑞) = 𝑝(𝑞). 𝑞 = (𝑎 − 𝑏𝑞). 𝑞 = 𝑎𝑞 − 𝑏𝑞2

Marginal revenue: 𝑀𝑅(𝑞) = 𝑎 − 2𝑏𝑞

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)

𝜕𝑞 𝑝 1
Elasticity: |𝜀| = 𝜕𝑝 . 𝑞 → 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(𝑞1, 𝑞2) = 𝑇𝑅 (𝑞1) + 𝑇𝑅 (𝑞2) − 𝑇𝐶 (𝑞1 + 𝑞2) = 𝑝1(𝑞1). (𝑞1) + 𝑝2(𝑞2). 𝑞2 − 𝑇𝐶 (𝑞1 + 𝑞2)
𝜕𝜋 𝜕𝜋
• = 𝑀𝑅(𝑞1) − 𝑀𝐶(𝑞1 + 𝑞2) = 0; = 𝑀𝑅(𝑞2) − 𝑀𝐶(𝑞1 + 𝑞2) = 0
𝜕𝑞1 𝜕𝑞2
• 𝑜𝑝𝑡𝑖𝑚𝑎𝑙𝑖𝑡𝑦: 𝑀𝑅(𝑞1) = 𝑀𝑅(𝑞2) = 𝑀𝐶(𝑞1 + 𝑞2) → 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 (𝑞1 ∗) > 𝑝(𝑞2 ∗)−→ | 𝜀1 ∗| < |𝜀2 ∗|
 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(𝑞1 + 𝑞2)

Market price: 𝑝 = 𝑃(𝑄) = 𝑃(𝑞1 + 𝑞2)

Problem of firm 1:

• 𝐼𝑇 = 𝑃(𝑞1 + 𝑞2) . 𝑞1 − 𝐶(𝑞1)

• Constant MC (MC = AC = C): 𝐶(𝑞1) = 𝑞1 . 𝐶
• 𝐼𝑇 = (𝑎 − 𝑏(𝑞1 + 𝑞2)). 𝑞1 . 𝐶𝑞1
𝑑𝐼𝑇
• FOC: 𝑑𝑞1 = 0 → −𝑏𝑞1 + 𝑎 − 𝑏𝑞2 − 𝑏𝑞1 − 𝐶 = 𝑎 − 2𝑏𝑞1 − 𝑏𝑞2 − 𝐶 = 0

Reaction function: show the level of production that maximizes the profits of firm 1 for each level of production of firm 2
𝑎−𝑏𝑞2−𝐶 𝑎−𝐶 𝑞2
(negative relation ship: when q2 increases, q1 decreases). 𝑎 − 𝑏𝑞2 − 𝐶 = 2𝑏𝑞1 → 𝑞1 = → 𝑞1(𝑞2) = −
2 2𝑏 2
Problem of firm 2 (same as firm 1):

• 𝐼𝑇 = 𝑃(𝑞1 + 𝑞2) . 𝑞2 − 𝐶(𝑞2) = (𝑎 − 𝑏(𝑞1 + 𝑞2)). 𝑞2 . 𝐶𝑞2

𝑑𝐼𝑇
• FOC: 𝑑𝑞2 = 0 → −𝑏𝑞2 + 𝑎 − 𝑏𝑞1 − 𝑏𝑞2 − 𝐶 = 𝑎 − 2𝑏𝑞2 − 𝑏𝑞1 − 𝐶 = 0
𝑎−𝑏𝑞1−𝐶 𝑎−𝐶 𝑞1
• Reaction function: 𝑎 − 𝑏𝑞1 − 𝐶 = 2𝑏𝑞2 → 𝑞2 = → 𝑞2(𝑞1) = −
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
• 𝑞1(𝑞2) = 𝑞2(𝑞1) = 3𝑏

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

𝑐 2(𝑎−𝑐) 𝑎+2𝑐
The equilibrium price: 𝑃𝑐 = 𝑃(𝑄𝐶) = 𝑃(𝑞1 ∗ +𝑞2 ∗) = 𝑎 − 𝑏 . 𝑄 ∗ = 𝑎 − 𝑏 (2. 𝑎 − 3𝑏) = 𝑎 − =
3 3

𝑎−𝑐 𝑎+2𝑐 𝑎−𝑐 𝑎+2𝑐−3𝑐

The profit of each firm: 𝐼𝑇1 ∗= 𝐼𝑇2 ∗ = 𝑞 ∗ (𝑝 ∗ −𝑐) = ( 3 − 𝑐) = ( 3 ) = (𝑎 − 𝑐)2
3𝑏 3𝑏

Monopoly Perfect competition

Inverse demand function P = a-bq Companies operate where P = MC = C
Total revenue TR = (a-bq) . q Demand function Qpc= (a-c)/b
Monopolist equalizes MR = MC —> MR = a -2q = c = Level of production for Q = (a-c)/b
MC 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