N.

Gregory Mankiw

Principles of
Economics Sixth Edition

13
The Costs of Production
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 EXAMPLE 1: Farmer Jack’s Production Function

L Q 3,000
(no. of (bushels
workers) of wheat) 2,500

Quantity of output
0 0 2,000

1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
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 Marginal Product
 If Jack hires one more worker, his output rises
by the marginal product of labor.
 The marginal product of any input is the
increase in output arising from an additional unit
of that input, holding all other inputs constant.
 Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
 Marginal product of labor (MPL) = ∆Q
∆L
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 EXAMPLE 1: Total & Marginal Product
L Q
(no. of (bushels
MPL
workers) of wheat)

0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000
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 EXAMPLE 1: MPL = Slope of Prod Function

L Q MPL
3,000 equals the
(no. of (bushels MPL
slope of the
workers) of wheat) 2,500

Quantity of output
production function.
0 0 2,000
Notice that
1000
1 1000 MPL diminishes
1,500
800 as L increases.
2 1800 1,000
600 This explains why
3 2400 the
500 production
400 function gets flatter
4 2800 0
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
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 Why MPL Diminishes
 Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
 As Jack adds workers, the average worker has
less land to work with and will be less productive.
 In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
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 EXAMPLE 2: The Various Cost Curves
Together
$200
$175
$150
ATC
$125

Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
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 EXAMPLE 2: Why ATC Is Usually U-
Shaped
As Q rises: $200

Initially, $175
falling AFC $150
pulls ATC down. $125

Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
Efficient scale:
$25
The quantity that
$0
minimizes ATC.
0 1 2 3 4 5 6 7
Q
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 EXAMPLE 2: ATC and MC
When MC < ATC, $200 ATC
ATC is falling. MC
$175
When MC > ATC, $150
ATC is rising. $125

Costs
The MC curve $100
crosses the $75
ATC curve at
$50
the ATC curve’s
$25
minimum.
$0
0 1 2 3 4 5 6 7
Q
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 EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose
from three factory Avg
sizes: S, M, L. Total
Cost ATCS ATCM
Each size has its ATCL
own SRATC curve.

The firm can

change to a
different factory
size in the long Q
run, but not in the
short run.

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 EXAMPLE 3: LRATC with 3 factory sizes
To produce less
than QA, firm will Avg
Total
choose size S
Cost ATCS ATCM
in the long run. ATCL
To produce
between QA
LRATC
and QB, firm will
choose size M
in the long run.
To produce more Q
QA QB
than QB, firm will
choose size L
in the long run.
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 A Typical LRATC Curve
In the real world,
factories come in ATC
many sizes,
each with its own LRATC
SRATC curve.
So a typical
LRATC curve
looks like this:

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 How ATC Changes as
the Scale of Production Changes

Economies of ATC
scale: ATC falls
as Q increases.
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
Q
scale: ATC rises
as Q increases.

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 N. Gregory Mankiw

Principles of
Economics Sixth Edition

14
Firms in Competitive Markets
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 Profit Maximization
 What Q maximizes the firm’s profit?
 To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
 If MR > MC, then increase Q to raise profit.
 If MR < MC, then reduce Q to raise profit.

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 Profit Maximization
(continued from earlier exercise)

Q TR TC Profit MR MC
Profit =
At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

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 MC and the Firm’s Supply
Decision
Rule: MR = MC at the profit-maximizing Q.

At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
P1 MR
to raise profit.
At Q1, MC = MR.
Changing Q Q
would lower profit. Qa Q1 Qb

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 MC and the Firm’s Supply
Decision
If price rises to P2,
then the profit- Costs
maximizing quantity MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

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 A Firm’s Short-run Decision to Shut
Down
 Cost of shutting down: revenue loss = TR
 Benefit of shutting down: cost savings = VC
(firm must still pay FC)
 So, shut down if TR < VC
 Divide both sides by Q: TR/Q < VC/Q
 So, firm’s decision rule is:

Shut down if P < AVC

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 A Competitive Firm’s SR Supply Curve

The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
If P > AVC, then
above AVC.
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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 The Irrelevance of Sunk Costs
 Sunk cost: a cost that has already been committed and cannot
be recovered
 Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
 FC is a sunk cost: The firm must pay its fixed costs whether it
produces or shuts down.
 So, FC should not matter in the decision to shut down.

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 A Firm’s Long-Run Decision to Exit
 Cost of exiting the market: revenue loss = TR
 Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
 So, firm exits if TR < TC
 Divide both sides by Q to write the firm’s decision rule as:

Exit if P < ATC

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 A New Firm’s Decision to Enter Market
 In the long run, a new firm will enter the market if it is profitable to
do so: if TR > TC.
 Divide both sides by Q to express the firm’s entry decision as:

Enter if P > ATC

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 The Competitive Firm’s Supply Curve

The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC

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 Market Supply: Assumptions
1) All existing firms and potential entrants have identical costs.
2) Each firm’s costs do not change as other firms enter or exit the
market.
3) The number of firms in the market is
 fixed in the short run
(due to fixed costs)
 variable in the long run
(due to free entry and exit)

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 The SR Market Supply Curve
 As long as P ≥ AVC, each firm will produce its profit-maximizing
quantity, where MR = MC.
 Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

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 The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

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 Entry & Exit in the Long Run
 In the LR, the number of firms can change due to entry & exit.
 If existing firms earn positive economic profit,
 new firms enter, SR market supply shifts right.
 P falls, reducing profits and slowing entry.
 If existing firms incur losses,
 some firms exit, SR market supply shifts left.
 P rises, reducing remaining firms’ losses.

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 The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete—
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.

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 Why Do Firms Stay in Business
if Profit = 0?

 Recall, economic profit is revenue minus all costs, including

implicit costs like the opportunity cost of the owner’s time and
money.
 In the zero-profit equilibrium,
 firms earn enough revenue to cover these costs
 accounting profit is positive

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 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
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 SR & LR Effects of an Increase in
Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
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 Why the LR Supply Curve Might Slope
Upward
 The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or exit the market.
 If either of these assumptions is not true,
then LR supply curve slopes upward.

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 N. Gregory Mankiw

Principles of
Economics Sixth Edition

15
Monopoly
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 Common Grounds’ D and MR Curves
P, MR
$5
Q P MR
4
0 $4.50 Demand curve (P)
$4 3
1 4.00 2
3
2 3.50 1
2 0
3 3.00
1 -1 MR
4 2.50
0 -2
5 2.00 -3
–1 0 1 2 3 4 5 6 7 Q
6 1.50
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 Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
 Output effect: higher output raises revenue
 Price effect: lower price reduces revenue
 To sell a larger Q, the monopolist must reduce the price on all the
units it sells.
 Hence, MR < P
 MR could even be negative if the price effect exceeds the output
effect (e.g., when Common Grounds increases Q from 5 to 6).

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 Profit-Maximization
 Like a competitive firm, a monopolist maximizes profit by
producing the quantity where MR = MC.
 Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to pay for that
quantity.
 It finds this price from the D curve.

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 Profit-Maximization

Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
the demand D
curve at this Q. MR

Q Quantity

Profit-maximizing output
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 A Monopoly Does Not Have an S Curve
A competitive firm
 takes P as given
 has a supply curve that shows how its Q depends
on P.
A monopoly firm
 is a “price-maker,” not a “price-taker”
 Q does not depend on P;
Q and P are jointly determined by
MC, MR, and the demand curve.
Hence, no supply curve for monopoly.
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 The Welfare Cost of Monopoly
 Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
 In the monopoly eq’m, P > MR = MC
 The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to produce that unit
(MC).
 The monopoly Q is too low –
could increase total surplus with a larger Q.
 Thus, monopoly results in a deadweight loss.

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 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QC MC
P = MC loss
total surplus is P
P = MC
maximized
MC
Monopoly eq’m:
quantity = QM D
P > MC MR
deadweight loss
QM QC Quantity

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 Price Discrimination
 Discrimination: treating people differently based on some
characteristic, e.g. race or gender.
 Price discrimination: selling the same good
at different prices to different buyers.
 The characteristic used in price discrimination
is willingness to pay (WTP):
 A firm can increase profit by charging a higher price to buyers with
higher WTP.

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 Perfect Price Discrimination vs.
Single Price Monopoly

Here, the monopolist Consumer

Price
charges the same surplus
price (PM) to all Deadweight
buyers. PM
loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

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 Perfect Price Discrimination vs.
Single Price Monopoly

Here, the monopolist

produces the Price
Monopoly
competitive quantity,
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all CS MR
as profit.
Quantity
But there’s no DWL. Q
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 N. Gregory Mankiw

Principles of
Economics Sixth Edition

16
Monopolistic Competition
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 A Monopolistically Competitive Firm Earning Profits
in the Short Run

The firm faces a

downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

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 A Monopolistically Competitive Firm
With Losses in the Short Run

For this firm,

P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm
ATC AVC
can do is to
minimize its losses. P

D
MR
Q Quantity

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 Monopolistic Competition and Monopoly
 Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
 Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
 If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
 If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.
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 A Monopolistic Competitor in the Long Run

Entry and exit

occurs until
P = ATC and Price
profit = zero. MC

Notice that the ATC

firm charges a P = ATC
markup of price markup
over marginal cost
D
and does not MC
produce at MR
minimum ATC. Q Quantity

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 Why Monopolistic Competition Is
Less Efficient than Perfect Competition

1. Excess capacity
 The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
 Under perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
 Under monopolistic competition, P > MC.
 Under perfect competition, P = MC.

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 N. Gregory Mankiw

Principles of
Economics Sixth Edition

17
Oligopoly
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 EXAMPLE: Cell Phone Duopoly in
Smalltown
P Q Revenue Cost Profit Competitive
$0 140 $0 $1,400 –1,400 outcome:
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350 Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = $40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = $1,800
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 T-Mobile Verizon

P Q P1 Q1 Profit P2 Q2 Profit

$40 60 $40 30 $900 $40 30 $900

$35 70 $35 40 $1000 $35 30 $750

$30 80 $30 40 $800 $30 40 $800

$25 90 $25 50 $750 $25 40 $600

$20 100 $20 50 $500 $20 50 $500

$15 110 $15 60 $300 $15 50 $250

$10 120 $10 60 $0 $10 60 $0

Noted: MC = $10
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product or service or otherwise on a password-protected website for classroom use.
 The Equilibrium for an Oligopoly
 Nash equilibrium: a situation in which
economic participants interacting with one another each choose their
best strategy given the strategies that all the others have chosen
 Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
 Given that Verizon produces Q = 40,
T-Mobile’s best move is to produce Q = 40.
 Given that T-Mobile produces Q = 40,
Verizon’s best move is to produce Q = 40.

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product or service or otherwise on a password-protected website for classroom use.
 A Comparison of Market Outcomes
When firms in an oligopoly individually choose production to
maximize profit,
 oligopoly Q is greater than monopoly Q
but smaller than competitive Q.
 oligopoly P is greater than competitive P
but less than monopoly P.

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product or service or otherwise on a password-protected website for classroom use.
 Game Theory
 Game theory helps us understand oligopoly and other situations
where “players” interact and behave strategically.
 Dominant strategy: a strategy that is best
for a player in a game regardless of the strategies chosen by the
other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is mutually beneficial

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product or service or otherwise on a password-protected website for classroom use.
 Example
This table shows a game played between two firms, Firm A and Firm B. In this game
each firm must decide how much output (Q) to produce: 10 units or 12 units. The profit
for each firm is given in the table as (Profit for Firm A, Profit for Firm B).

Firm B
Q=10 Q=12

Q=10 (48, 48) (20, 60)

Firm A
Q=12 (60, 20) (38, 38)

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product or service or otherwise on a password-protected website for classroom use.
 Controversies Over Antitrust Policy
 Most people agree that price-fixing agreements among
competitors should be illegal.
 Some economists are concerned that policymakers go too far
when using antitrust laws to stifle business practices that are not
necessarily harmful, and may have legitimate objectives.
 We consider three such practices…

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product or service or otherwise on a password-protected website for classroom use.
 1. Resale Price Maintenance (“Fair Trade”)
 Occurs when a manufacturer imposes lower limits
on the prices retailers can charge.
 Is often opposed because it appears to reduce
competition at the retail level.
 Yet, any market power the manufacturer has
is at the wholesale level; manufacturers do not
gain from restricting competition at the retail level.
 The practice has a legitimate objective:
preventing discount retailers from free-riding
on the services provided by full-service retailers.

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product or service or otherwise on a password-protected website for classroom use.
 2. Predatory Pricing
 Occurs when a firm cuts prices to prevent entry
or drive a competitor out of the market,
so that it can charge monopoly prices later.
 Illegal under antitrust laws, but hard for the courts
to determine when a price cut is predatory and
when it is competitive & beneficial to consumers.
 Many economists doubt that predatory pricing is a
rational strategy:
 It involves selling at a loss, which is extremely
costly for the firm.
 It can backfire.

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product or service or otherwise on a password-protected website for classroom use.
 3. Tying
 Occurs when a manufacturer bundles two products
together and sells them for one price (e.g., Microsoft
including a browser with its operating system)
 Critics argue that tying gives firms more market
power by connecting weak products to strong ones.
 Others counter that tying cannot change market
power: Buyers are not willing to pay more for two
goods together than for the goods separately.
 Firms may use tying for price discrimination,
which is not illegal, and which sometimes
increases economic efficiency.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
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product or service or otherwise on a password-protected website for classroom use.