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Lecture 4: Costs
We will now turn our attention to businesses. Although we will cover topics that are very important in running a business, this is not a class on the details of running a business from the inside. Economics looks at businesses from the outside to see what impact businesses have on society. We will generally describe business behavior as making decisions based on what makes the most profit.
Profit = Total Revenue – Total Cost
It is very important in running a business that you seek to maximize the difference between total revenues and total costs, which is NOT the same thing as maximizing revenue or minimizing costs. Sometimes, business leaders get this wrong. For example, Sizzler and Boston Market opened up many stores and had huge revenue. What was the problem? Their costs were even higher and they went bankrupt. A former CEO of Starbucks said that if you had to walk 3 blocks to a Starbucks, that was too far. He set them on a path of overexpansion (with the running joke that when Starbucks opened up a Starbucks within another Starbucks, that may have been too much) and is no longer with the company.
So, maximizing revenue should not be the goal, unless you believe it is a path to maximizing profit. Likewise, minimizing costs should also not be the goal. Shutting down your business would minimize the costs. But also, if your goal is to pay workers as little as you possibly can, this can result in higher employee turnover, a less motivated workforce, and lower profits. So, it is important to keep your eye on total profit.
There may be other goals that business leaders have. Market share, for example, might be a goal. Your own personal salary could be a goal in making business decisions. Doing good for the community might be a goal. And certainly, a non-profit business will have other goals. But, even with a non-profit, it is very important to balance revenues and costs.
At any rate, we will generalize in describing businesses as seeking to maximize profits. And, over the next several weeks, we will look at how businesses go about maximizing profits and then see what impact this has on society.
Most businesses have similar cost structures. They may be at very different points of those cost structures. So, one business might be very large and has already used up cost advantages of increasing size while another business might be quite small with lots of room to grow to lower per unit costs. But, we can describe overall businesses with one type of cost structure. And that will be what this section is all about.
On the revenue side, however, that is not at all true. Revenues depend very much on pricing and a business’ ability to price depends very much on how much competition it faces. Therefore, in order to talk about revenues and prices, we will need to look at the amount of competition that businesses face. In order to do this, we will first look at the most competitive situation, which is called Perfect Competition. Next, we will look at the other extreme, where there is no competition, which is called a Monopoly. And then we will look at market structures in between Perfect Competition and Monopoly, called Monopolistic Competition and Oligopoly. But first, we will look at costs.
Economists often separate out the short run from the long run. The distinction between the two in economics has to do with whether one of the factors of production is fixed or not. The factors of production include labor, capital (machines and factories), and land and raw materials. In the short run, at least one of the factors of production, usually capital is fixed. So, in the short run, you might have one factory to work with. You can hire more workers and buy more materials, but you cannot alter the amount of space that you have rented out, at least in the short run. In the long run, everything is variable. You can rent out another factory. The exact time between the short run and long run depends on what industry we are looking at. The airplane manufacturing business would have a long short run since it takes a long time to build a factory. A flower shop, on the other hand, might have a fairly short short run.
In order to talk about costs, we first need to look at production. For short run production, at least one resource is fixed. What happens to production as you hire more workers? Production should increase. But, the rise in production as you hire more and more workers is not necessarily a fixed rate of increase. When you first hire workers, the increase in production might be quite a lot. If you have a 2-person machine, for example, hiring the second worker will really bump up production. You can start specializing workers, running an assembly-line, for example. Production may very well rise at an increasing rate at the start. This is called increasing marginal returns.
However, every business will reach a point in the short run where adding more workers will start increasing production at a decreasing rate. You might have filled up your fixed number of machines, for example (remember that some resources are fixed). Maybe your assembly-line is all filled up—hiring another worker might increase production some, but not as much as the previous workers. So, for virtually all businesses, there will come a point of diminishing marginal production, referred to as the Law of Diminishing Marginal Returns: an additional worker (or other resource) will add to production at a diminishing rate. You might even reach a point where there are so many workers that hiring another worker will actually lead to decreased production. But, you would want to stop long before that point.
Let’s now use this information to talk about costs in the short run. You have at least one fixed resource, such as the factory space. What happens to your costs as you hire more workers? Initially, the workers add a lot to production. Therefore, your costs may increase, but not very rapidly relative to production. (This will lower your costs per unit, as we will see in a minute). However, once you hit the point of diminishing marginal returns, then hiring more workers will only increase production a little bit but increase costs a lot. So, at some point, your per unit costs will start to go back up. This is due to the Law of Diminishing Marginal Returns. And, when we graph per unit costs in the short run, we will first decrease them as production increases but then hit a point where they start to go back up—so we get U-shaped per unit cost curves.
We will now look at the different types of costs. My strategy, as we look at costs, is to first define the cost. We will then see how the cost is calculated in a table. And finally, I will graph the cost. First, total costs. We will divide total costs up in to total fixed costs and total variable costs:
Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)
Fixed costs are costs that do not vary with the level of production. Rent is often used as an example of a fixed cost. You have to pay for the rent of the building regardless of how much you produce. Perhaps a part of your utility bill is fixed and not dependent on your level of production. Variable costs, on the other hand, change with the level of production. As your production increases, so do your total variable costs. Examples include labor costs, most utility costs, and materials costs.
The calculation for total costs are shown below. Since total fixed costs are fixed, you only need to be given one fixed cost to be able to fill in the rest of the table. Given one fixed cost plus the variable cost column, you would then be able to calculate the total cost column by adding fixed costs and variable costs. Also note that the only total cost at a production of 0 is the fixed cost. Therefore, if you only have the total cost column, you can actually recreate the fixed and variable cost columns by first finding the fixed cost and then filling in the TVC column as the difference between TC and TFC.
The graph of the total costs is shown below. Total fixed costs is just a horizontal line: fixed costs are fixed; they do not change with the level of production. Total variable costs increase with the level of production—you have to hire more workers (or buy more materials) to produce more. However, variable costs do not increase at a constant rate, due to the Law of Diminishing Marginal Returns. Initially, variable costs increase at a decreasing rate. Once you pass the point of Diminishing Marginal Returns, variable costs increase at an increasing rate. And, for the total cost curve. Total costs also increase with the level of production. Since total costs are the sum of variable costs plus fixed costs, we add the two curves vertical. This just shifts up total costs “parallel” to the variable cost curve. So, the shape of total costs will be similar to the shape of variable costs.
Often in economics (and business) it is more useful to look, not at totals, but at averages. So, we can look at the averages of the three types of costs. To find average, we just divide the total by the number of units.
Average Fixed Cost (AFC) = TFC/Q
Average Variable Cost (AVC) = TVC/Q
Average Total Cost (ATC) = TC/Q
Also, there is a second way to calculate average total cost. Since total costs are equal to total fixed cost plus total variable cost, the sum of average fixed cost plus average variable cost should equal average total cost.
ATC = AFC + AVC
Your cost per unit (average total cost) will give you very important information. For one thing, you will need to charge a price for your product that is greater than your cost per unit if you want to make a profit. We will use that comparison, price and average total cost, to quickly determine if the firm is making a profit. If price is greater than average total cost, the firm is making a profit. If price is below average total cost, the firm is making a loss. The calculation for average costs are shown below. Note that the first row is left blank because we do not divide by 0. Also note that you can calculate the ATC numbers by either adding AFC + AVC or by dividing TC by Q.
The graph for averages is shown below. For average fixed costs = total fixed costs/Q, since total fixed costs are fixed, the average fixed cost will keep decreasing as quantity increases. The average variable cost increases, first at a decreasing rate and then at an increasing rate. The average total curve is the sum of the first two curves (and will always be higher). Average total costs initially decrease as production increases. However, at some point, the rising average variable costs will overpower the falling average fixed costs and average total costs will start to rise. So, we get a U-shaped ATC curve.
One final type of cost can also give us very important information and that is how total costs change when we change the level of production.
Marginal Cost MC = (Change in Total Cost)/(Change in Quantity)
Although this definition is very similar to average total cost, we are now looking at the CHANGES in total cost and quantity. Also, in a principles class, we often just change quantity one unit at a time. This means that the denominator for the calculation (the change in quantity) will usually be 1. We can then ignore the denominator and focus on the change in total costs. If you are running a business and thinking about changing your level of production, the impact that this will have on your total costs will be very important. The calculation for MC is shown in the last column. It is simply the change in the TC column.
The graph for marginal cost is shown below, relative to average total cost. The marginal cost curve should be drawn so that it intersects the ATC curve at the minimum of the ATC curve. Explanation: suppose that you are taking this class in a classroom and we calculate average height for everyone in the room: we total up height and divide by the number of people. Now, suppose that a new person walks in to the room—the marginal person—and suppose that person is very short (it might be my wife!). What will happen to the average height? The average height will decrease. So, when the average is decreasing, the marginal must lie below the average. And, going the other direction, if a tall person walks in to the room, this will pull up the average. So, when average is increasing, the marginal must lie above it. How do we get from below the ATC curve to above it? If a person walks in to the room who is exactly the average height, then the average will not increase or decrease—that is the flat part or the bottom of the curve. The marginal cost curve will cross the average cost curve right at the lowest point on the average cost curve. Not sure if that explanation helped you understand why it is drawn like that, but remember to draw it like that: MC and ATC intersects at minimum of ATC curve. That information actually becomes quite important when we look at the impact that competitive businesses have on society in the next chapter.
In the long run, everything is variable. All costs become variable. That does not mean that you do not have to pay rent if you operate. It just means that it becomes a variable cost—in the long run, you can choose to close down or you can rent out more factories. Even in the long run, however, we still end up drawing U-shaped average total cost curves. This is due to economies and diseconomies of scale. Initially, there may be some cost savings to expanding your business. Going from one factory to two factories, for example, does not necessarily double your costs. You might save on your accounting workforce, for example. You probably do not need twice as many CEO’s and vice-presidents. So, as you expand production in the long run, your average costs initially decrease. There might come a time, however, that you get so big that your average costs start to go back up. This might be because you have gotten so large and bloated that your costs become quite high. You have too many vice-presidents. When Coke, for example, had a bottling problem in Europe, it took them so long to respond and to change the line of production that it was very costly. So, very large corporations can become very bureaucratic and inefficient. It is at this point where their average costs may start to go up in the long run.
Lecture 3: Supply and Demand
The structure of Lecture 3 is (1) demand, (2) supply, (3) equilibrium, (4) shifts in supply and demand, (5) solving supply and demand equations, and (6) government price controls.
Supply and Demand
We are now turning our attention from the overall economy (macroeconomics) to individual markets (microeconomics). Supply and demand is one of the most useful tools in economics for understanding how the market system works. It is important to keep in mind, however, that the supply and demand framework requires that there be a many sellers and many buyers in the market that we are looking at. In other words, using the demand and supply framework to analyze the market for computer operating systems (that Microsoft dominates) would not be appropriate. However, it is a very good tool for looking at agricultural products, the stock market, cereals, and many other types of products. In order to understand how a market works, we first need to separate out the two components: buyers (demand) and sellers (supply). However, the most important part occurs when we put the two components back together (equilibrium).
Demand. We will first look at a market from the standpoint of the buyers. What is the most important factor that influences how many units of a good are sold? Price. This is what the demand curve is all about. The demand curve looks at the quantities of a good buyers are willing and able to buy at various market prices. Note that we are looking at various possible prices, not just the current market price. This would also be very important for a business person to think about before increasing or decreasing prices. Also note that demand occurs if the buyers would actually buy the product. In other words, the demand for diamonds is not necessarily high just because lots of people want diamonds. Demand only counts if people would buy it at the price.
Let’s look at a particular market: the market for gasoline. Demand for gas looks at the relationship between the price of gas and quantity demanded. As the price decreases, quantity demanded will increase. Basically, consumers will buy more gas when the price is lower. On the other hand, as the price increases, quantity demanded will decrease. The demand curve simply plots out this relationship. Price is put on the vertical axis and quantity goes onto the horizontal axis. Figure 3.2 is shown below. The demand curve is downward sloping, showing this negative relationship between price and quantity demanded. When there is a change in the price, this will move us along the demand curve (as opposed to shifting the demand curve.)
While price is the most important influence over demand, there are other factors as well. When these other factors change this will cause the demand curve to shift.
Demand Shifters:
- Change in Income. For most goods, called normal goods, a change in income will cause demand to change in the same direction. For example, when the economy is running well and incomes are up, demand for most goods will increase. This includes cars, furniture, food, gas, airplane trips, etc. An increase in demand is represented by a shift to the right. When the economy goes into a recession, demand for most goods decreases, some more than others.
There are a few goods that move in the opposite direction of the economy. These are called inferior goods. Examples include powdered milk, top ramen, and dollar stores. When the economy is running poorly, with incomes falling, demand for these products increase. On the other hand, when the economy picks back up, demand for inferior goods decreases. Community college education would be another example of an inferior good. When the economy goes down and people are laid off, more people head for community colleges. The unfortunate side of this is that when state governments (including Washington!) face budget problems in recessions, they know that demand for college education actually increases and they often take advantage of this by increasing tuition.
- Change in tastes or preferences. This can refer to a long run trend, a seasonal trend, or simply the influence of advertising. Items that are increasing in preference might include winter coats in November, high-definition televisions, or organic vegetables. The demand curves for these products increases, which is a shift to the right.
On the other hand, some items are decreasing in preference, such as swimsuits in November, VCRs, beanie babies, (gold and bitcoins), etc. This decrease in demand is represented by a shift to the left.
- Change in prices of related goods. Here it matters whether the goods are substitutes or complements. Substitutes are goods that you buy one or the other of, such as Coke and Pepsi or butter and margarine. If the price of a substitute good increases (price of Coke) the demand for the other good will increase (demand for Pepsi).
Complements, on the other hand, are goods that you consume together, such as peanut butter and jelly or milk and cereal. If the price of a complement increases (price of peanut butter) the demand for the other good will decrease (demand for jelly).
Supply. Now we will turn our attention to the other side of a market—the suppliers. Again we will first look at the impact that price has on supply decisions. The supply curve looks at the various quantities of a good that suppliers are willing and able to supply at various market prices.
Suppose that we are looking at the market for gasoline. What would be quantity supplied if the price of gas were expected to be very low, such as $.10 per gallon? You might at first think that supply would be high because consumers would want to buy a lot of gas. However, a business person thinking in those terms would quickly go bankrupt. $.10 per gallon would probably not even cover your costs. What lies behind supply decisions are the costs of production. You want to compare prices with your costs. So, quantity supplied would in fact be very low at low prices because it just would not be profitable to be in this business.
As the expected price of a product increases, businesses would now have a greater incentive to supply the product. Thus, as price increases, quantity supplied increases. If the expected price increases from $1.00 to $1.60, then you would supply more. The supply curve graphs this relationship between price and quantity supplied. As the price increases, businesses have a greater incentive to supply the product. Thus, we get an upward sloping supply curve.
Supply Shifters:
- Change in costs (or input prices). In the gasoline example, suppose that the cost of turning oil in to gas decreases. This means that you will be willing to supply more gas at any given price. The supply curve has increased, which is represented by a shift to the right. (Note that increases to either demand or supply are represented by a shift to the right. A common mistake with supply is to think of this as a downward shift. However, pay attention to the quantity axis. An increase in supply is increasing quantity.) Thus, a decrease in costs shifts supply to the right. An increase in costs, on the other hand, leads to a decrease in supply, which is a shift to the left.
- Change in technology. This is very similar to a decrease in costs…the technological advance hopefully will result in products being produced at a lower cost. Since costs are decreasing, supply will shift to the right.
- Change in taxes. This can also be fit into the change in cost category. An increase in taxes, such as an increase in the gas tax, increases costs. Thus, we can analyze the impact of this by thinking of it as a shift to the left of the supply curve.
Equilibrium. Now we will put supply and demand together to see how a market functions. The equilibrium price is the price where quantity demanded is equal to quantity supplied. The quantity is referred to as the equilibrium quantity. The equilibrium price occurs at the point of intersection between the demand and supply curves. The equilibrium price is the price that we tend to see in the market place. For example, the equilibrium price of gasoline in our example is $1.40 per gallon. The equilibrium quantity is 600 million gallons of gas.
Why don’t we see a higher price? If price is higher than the equilibrium price, quantity demanded will be lower—fewer people will buy gas if the price is $1.80. On the other hand, quantity supplied might be higher—suppliers would have greater incentive to supply gas if they could get a higher price. However, this results in a surplus of gas—quantity supplied is greater than quantity demanded. What will happen? As long as the market is competitive, sellers will start lowering their prices to sell their surplus. This will continue until we move back to the equilibrium price.
What if price were below the equilibrium price? Quantity demanded would be very high, but quantity supplied would be low. This would result in a shortage. The way that the market system solves a shortage is for the price to be bid up. As the price rises, quantity demanded starts to fall and businesses have a greater incentive to increase quantity supplied. Price will continue to increase until we reach the equilibrium price.
From now on we will focus on the equilibrium price, which is the price that we tend to see in the market place.
Examples of Shifts in Supply and Demand.
The most important thing in these examples, which you will see on homework 5 and Exam 3, is to think about whether the demand or supply curve is shifting. The supply curve is mainly shifting when costs are changing. Demand, on the other hand, shifts when there is a change in income, tastes or preferences, and the prices of related goods.
- What happens in the wood market in Miami when it is reported that a hurricane is approaching? To show this, draw in the initial demand and supply curves (D and S in the graph below.) As the hurricane approaches, there is an increase in preferences for wood to protect homes. Thus, the key change is coming from the demand side of the market. Nothing is causing the costs of producing wood to change, so the supply curve does not shift. The demand curve increases, shifting to the right.
What happens to the price and quantity of wood? If price stayed the same there would be a large shortage of wood in the Miami area. However, this shortage pushes up the price. The equilibrium moves from the lower point of intersection to the higher point of intersection. The quantity of wood increases as we move to the right and the price of wood increases as we move up.
This, in a nutshell, is how the market system functions and why it is efficient. People want more wood and they get more wood. The reason they get more wood is because the price is bid up, which gives businesses a greater incentive to bring wood into the Miami area.
In this particular example, we could imagine other methods for getting wood to Miami. For example, someone from Georgia, out of the kindness of their heart, might truck more wood (or water or chainsaws) into the Miami area. However, in all of the billions of normal day-to-day transactions that take place around the world, this is not going to happen. If demand for chocolate ice-cream in St. Louis increases, for example, you are probably not going to find someone in New York who will drive the ice-cream to St. Louis out of kindness. You might also imagine the government being involved in helping to move resources down into Miami. However, if the government tried to coordinate all resource moves in every day-to-day transaction, it would be a bureaucratic nightmare. Just in the ice-cream example, not only would a government bureaucrat have to have the ice-cream shipped from New York to St. Louis, they would have to have more ice-cream ingredients shipped from many different places to New York. This would quickly become a bureaucratic mess.
The market system, on the other hand, moves resources around based on the interaction of thousands of individual sellers (supply) and buyers (demand). The rise in price is the key signaling mechanism of the market economy, giving businesses an incentive to provide more of the product. The market system tends to be much more efficient than a government controlled economy, meaning that we see few shortages or surpluses.
So, the market system is efficient. However, do you see any potential problems in this example; is anyone hurt? If the price of wood did not increase, quantity demanded would have been much higher. However, as the price increases, some people are priced out of the market. This may particularly hurt the poor. The market system is efficient in the sense that price adjusts to clear the market and we do not get shortages and surpluses, but there is nothing necessarily fair about the market system.
Some people have equated the market system to democracy. However, the difference is that in a democracy it is one person one vote. In the market system it is one dollar one vote. Thus, people with a lot of dollars get a lot of votes. People without many dollars do not get as many votes.
- What is the impact of increased security costs in the market for air travel? The key here is that costs are changing. There is an increase in cost for providing air travel. Since costs are rising, this will lead to a decrease in supply, which is a shift to the left. The new intersection point moves us up and to the left. As the price goes up, quantity will drop. Demand is affected in the sense that we move to the left on the demand curve, but demand itself does not shift. As the price rises, quantity demanded decreases. So, an increase in the cost of production shifts supply to the left, but the demand curve stays the same. This will cause equilibrium price to increase and equilibrium quantity to decrease.
Solving Supply and Demand Equations
Suppose you are given the following demand and supply equations:
Demand: Qd = 100 – 5P
Supply: Qs = 10 + P
Each equation makes quantity a function of the price: a negative function for demand and a positive function for supply. The equilibrium price occurs when the two curves cross: when quantity demanded Qd equals quantity supplied Qs. Since the left-hand sides of the equations are equal in equilibrium, the right sides of the equations must also be equal. We set the right sides equal and solve for P:
100 – 5P = 10 + P
Subtracting 10 and adding 5P yields:
90 = 6P
Dividing by 6:
P = $15
The equilibrium price is often written with the asterisk, so P* = $15. We can then solve for the equilibrium quantity by plugging the P = 15 in to either equation:
Demand: Q = 100 – 5(15) = 100 – 75 = 25
Or Supply: Q = 10 + 15 = 25, which checks.
Government Price Controls
In the previous section on supply and demand we looked at how the market system functions without government. We will now bring the government into the picture to see how the government can either increase prices or decrease prices.
Price Floor. In this case, the government (on behalf of the public, or at least some segment of the population) is saying that prices are too low. A price floor is a minimum price set by the government that is above the market equilibrium price. (A common mistake is to reverse price floors and price ceilings. A floor pushes up the price. A ceiling brings the price down.)
Why would the government do this? Who are they trying to help? They are clearly trying to help the seller of the product. Who are they hurting? They are certainly hurting the consumer since prices will be higher. Examples of price floors often occur with agricultural products. The government tries to help farmers by increasing prices in many areas.
What is the impact of a price floor? The graph shows the price floor set above the equilibrium price. This has two affects. First, quantity demanded will drop; consumers will not buy as much of the good at the higher price. Second, quantity supplied may also increase. For example, if the government has a price floor for wheat but not corn, more farmers may switch over into wheat production.
As quantity demanded decreases and quantity supplied increases, we are left with a surplus. So, not only do consumers have to pay higher prices but now we are left with a surplus to deal with. What should we do with the surplus? If the point of the price floor is to help farmers then the government (through taxes) might buy up the extra surplus. So, we not only end up paying higher prices, we end up paying higher taxes. Once the surplus is bought up, what should we do with it? Sometimes the government gives it away, both domestically and internationally. Sometimes the government sells it. Sometimes the government burns it. And sometimes, in anticipation of creating a surplus, the government pays wheat farmers not to plant wheat.
Most economists tend to be against price controls, where the government is artificially changing the price in a market. With price floors, the government is causing agricultural prices to be higher as well as taxes in buying up the surplus. In addition, the justification for agricultural price supports is often to help the small family farmer. However, most of the money is not going to small farmers, but to large farming corporations.
Price Ceiling. With a price ceiling, the government (again, hopefully on behalf of some group) is saying that the price in the market is too high. A price ceiling is a maximum price set by the government that is below the market equilibrium price. An example of a price ceiling is rent control. There are a number of cities, including parts of Seattle, Berkeley, and New York, which have rent control laws. The government is saying that apartment rents are too high, particularly for the poor, and they impose price ceilings to lower apartment rents.
What is the impact of a price ceiling? First of all, quantity demanded will increase. When I lived in Berkeley, for example, many people from the surrounding cities would look for apartments in Berkeley because rents were lower with rent control. Second, quantity supplied will be lower, both in the short run as well as the long run. In the short run, some of the possible places to rent out will drop out of the market, such as in-law apartments or rooms in houses. In the long run, if you are thinking about building an apartment building, where are you going to build it? In Berkeley? Probably not since you are not able to charge the rents that you want. So, quantity supplied is lower.
Since quantity demanded is greater than quantity supplied we end up with a shortage. What happens? Normally, the market system solves shortages by allowing prices to increase. The higher prices give businesses an incentive to produce more of the product (as well as reduce quantity demanded). However, in this case, the government is holding the price down and some other mechanism must determine who gets the apartments.
Long lines will form for goods that are in short supply. With a shortage of apartments, the long lines might take the form of hundreds of applications whenever an apartment becomes available. Black markets might also develop. Clearly, some people are willing to pay a higher price to get an apartment. They might pay the owner an amount under the table. Or, if you have a rent-controlled apartment and are thinking about moving out, maybe you will sell this information or sublet out your apartment.
Sometimes, new markets will develop to try to solve the problem. So, apartment rental agencies will spring up to try to help renters find apartments. Another response is that landlords might let the apartments deteriorate if they are not able to get the rent that they want.
Like with price floors, most economists tend to be against price ceilings. If the purpose of rent control is to help the poor, one problem is that it does not target the poor very well. Anyone can get a rent controlled apartment. Students at Berkeley are similar to students at UW Seattle in that average family income is above average. So, many of the people living in rent controlled apartments are not coming from poor families. In fact, when Patty Hearst (not poor) was abducted it was from her rent controlled Berkeley apartment.
Economists generally argue against government interventions to alter market prices in order to help one group or another, including the poor. If we are concerned about helping the poor, there may be more direct/efficient ways of doing so, such as through the tax system.
Lecture 5: Perfect Competition
The analysis of each industry—perfect competition, monopoly, oligopoly, and monopolistic competition—starts out with the characteristics and ends with the results, particularly with regards to efficiency.
Characteristics:
- Many, small firms
- Same or homogeneous products
- Easy entry and exit
- Perfect information
Examples include agricultural goods (wheat, corn, apples), selling flowers, and the stock market. There are many, small firms in the market, with no one firm having much market power. The products are essentially the same so that the main competition is over the price. So, wheat is wheat. One share of IBM stock is the same as any other share. The industry is relatively easy to get in to. So, farming is relatively easy to get in to. Anyone can sell a share of stock (if you previously have bought one). The airline industry would NOT be easy entry—if would be very expensive to set up your own airplane manufacturing factory. The perfect information means that consumers have good information about the products. An example that would not have perfect information would be the drug industry. Take Advil and generic Advil, for example. By law, Advil and generic Advil are identical (maybe with some minor differences in flavoring). But, largely because of the tremendous amount of money advertising Advil, many consumers assume that Advil is better (when it is not). That allows Advil to charge higher prices. In an industry where products are identical and consumers understand this, every company must charge the same price. If you are an apple producer, you do not set the price of your product. You have to accept the price for apples as given by the market. Firms in a perfectly competitive industry are called price takers.
The graph below right shows the market graph for this industry. Price is determined by the interaction of supply and demand. The market price is given as $131 per unit. The individual firm must accept this price as given. If you try to charge a higher price, say $150, why would anyone buy from you when they can get the identical product from another seller? If the market price of IBM is $131, you either have to accept that price for your stock or not be able to sell your stock. If you charge a price higher than $131, demand for your product will be 0. On the other hand, you would not charge a price less than the market price. You are such a small part of the market, you can sell all you want at the market price of $131. The implication of this is that the individual firm faces a flat demand curve—you cannot charge a price above $131 and you can sell all you want at this price. As we go through each industry structure, we will see how a firm chooses the best price and quantity to maximize profits. For perfect competition, the first part is already done for us since a firm has no control over price. Thus, we need to find out how a perfectly competitive firm decides what level of output to produce that will maximize profits.
The table below is a profit table for perfect competition. If you are given the columns for quantity, price, and total cost, you should be able to fill in the rest of the table. Since the price is fixed at $131, we know that this would be a table for perfect competition (only in the industry of perfect competition is price fixed—given to the individual firm). You should be able to calculate total revenue by multiplying the number of units sold (Q) by the price of the product (P). Note in the total cost column that at a quantity of 0, total cost is $100. What does this imply? Since the only cost when production is 0 is a fixed cost, there must be a fixed cost of $100. And, since there are only fixed costs in the short run, this must be a short run table.
You should be able to calculate total profit by taking total revenue and subtracting total cost. Be sure to include a negative sign for the first few profits. Looking at the table, what is the highest profit possible? The highest profit possible is $299. (If you like bigger numbers, you can think of this as $299 million.) Therefore, you would focus on this row to maximize profits. The profit maximizing level of output would be the quantity of 9. And, the profit maximizing price, which is trivial in perfect competition, would be the $131. So, by charging a price of $131 and producing 9 units of output, you will maximize profits.
Now, on the graphs, we will usually not be focusing on totals (total revenue, total cost, total profit). We will be looking more at averages and marginal. So, the last two columns of the table have calculated the marginal for both revenue and cost. Marginal revenue is the change in total revenue (divided by the change in quantity). Since we are just changing quantity 1 unit at a time, we can ignore the change in quantity. As we go from 0 units to 1 unit, total revenue rises from $0 to $131. So, the change in revenue, or marginal revenue, is $131. As we go from 1 unit to 2 units, total revenue rises from $131 to $262. So, the change in revenue, the marginal revenue, is again $131. In the case of perfect competition, where price is fixed, the marginal revenue will stay fixed at the price, which in this case is $131.
The marginal cost column has also been filled in by using the total cost column. Now, how can we use the marginal revenue and marginal cost information to reach the same conclusion as when we looked at total profit? As a producer, you want to increase your level of production as long as the extra revenue (marginal revenue) is greater than the extra cost (marginal cost). So, you would increase production from 1 unit to 2 units because this would add $131 in revenue and only $80 in cost. So, your profit should increase (by the difference of $51—or at least your loss should fall by $51 in this case). You continue increasing production as long as MR is greater than MC. Therefore, you increase production from 8 units to 9 units because $131 is added to your revenue and only $130 is added to your cost. However, you would stop there. You would not increase production from 9 units to 10 units because the added cost would be more than the added revenue. So, you will make the highest profit at 9 units of output. Again, the profit maximizing level of output is 9 units and the profit maximizing price is $131. The key profit maximizing rule is to increase production as long as marginal revenue is greater than marginal cost. Stop when marginal cost is greater than marginal revenue. On a graph, there will always be a specific point where marginal revenue equals marginal cost (when they cross). This is the point of profit maximization.
Key Profit Maximizing Rule: Increase production up to the point where MR = MC
So, in the graph below, production should be increased up to 9 units, where marginal revenue equals marginal cost. If you are to the left of this point, marginal revenue is greater than marginal cost. You would be able to increase profits by increasing production because revenues would increase more than costs would increase. You increase profits by increasing production up to 9 units. You would not go beyond this, however, because then profits would start to decrease as you add more in costs than you add in revenues.
A couple of notes. First, a common misconception is that producing at the point where MR = MC will yield 0 profits. No. That is just saying that you squeezed out the maximum profit. All the units leading up to that added to profit since marginal revenue was greater than marginal cost. Second, in this case, the graph is slight different from the table. In the graph, there was an exact point where MR = MC. However, in the table, this was not quite true. We got close with MR = $131 and MC = $130, but not quite. And, this is due to the nature of comparing the table of discreet numbers with a graph of continuous numbers. If we graphed the table, it would really be a step function in moving from quantity to quantity. We can make a table where MR = MC, but this results in having two rows with identical profits. Sometimes I will do a table with two possible rows of highest profit (just pick either row) and sometimes I will do a table where MR is almost but not quite equal to MC.
And finally, although we said that a quantity of 9 in the graph above maximizes profits, we did not specify in the graph what those profits are. That is the next step—how to find total profit in a graph that just has average and marginal curves.
Total profit is equal to total revenue minus total cost. First, to find total revenue, we will look to the demand curve. Total revenue is equal to price times quantity P x Q. When we find the point of profit maximization on the demand curve, we can find total revenue because the demand curve will give us both price and quantity. In the graph below, once we know the point on the demand curve, we find price and quantity. Multiplying a price of $131 by the quantity of 9 units will give us the total revenue of $1179. What does this represent on the graph? Multiplying one side of a rectangle by the adjacent side gives us area. Thus, the total revenue of $1179 is represented by the area under the demand curve up to 9 units.
What about total costs? Remember the definition of average total costs ATC = TC/Q. We can rewrite this equation to get an equation for total costs: total costs are equal to per unit costs times quantity TC = ATC x Q. We can use this equation to find total costs from the ATC curve. Once we know where we are on the ATC curve, we can find ATC and Q. Multiplying these two together gives us total costs. In our case, ATC is approximately $97.78 at the profit maximizing level of output 9 units. Multiplying the ATC of $97.78 by the quantity of 9 gives us the total profit of $299 (with some rounding). Since we are multiplying one side of a rectangle by the adjacent side, this is the area under the ATC curve.
Now, putting total revenue and total cost together will show us how to find total profit.
Total Profit = TR – TC
Substituting in the equations for total revenue and total cost gives us:
Total Profit = (P x Q) – (ATC x Q)
Factoring out the Q and rewriting this equation becomes:
Total Profit = (P – ATC) x Q
So, one way to calculation total profit is looking at the difference between price and ATC (which is called profit per unit) and then multiplying by the number of units. In this case, with a price of $131 and an ATC of $97.78, the profit per unit will be $33.22. Multiplying by the 9 units will give us a total profit of $299 (with rounding). Using this method of comparing price and ATC is a quick way to see if a business is making a profit. If price is above per unit costs, you are making a profit. If price is below ATC, you are losing money.
We now combine this information on the graph below. Since price is above ATC, the firm is making a profit. The difference between price ($131) and ATC ($97.78) is profit per unit, which is the vertical distance between the two. Multiplying this by the 9 units, which is the horizontal distance, gives us a total profit of $299. This is also the area of the shaded rectangle. (Another way to think about this is that total revenue is P x Q (the area of the largest rectangle). Total cost is ATC x Q (the lower rectangle. Subtracting the lower rectangle from the large rectangle gives us total profit, which is shaded.
And now, we are able to put all this information together to draw the key short run graph for perfect competition:
To solve a cost curve graph, like the one above, the key is to first find the profit maximizing point: the point where MR equals MC. Then, drop straight down to find Q*, the profit maximizing level of output. Also, draw a point where we hit the ATC curve. And, we already started on the demand curve. So, we can find both the price P* and the ATC*. The difference between P and ATC, multiplied by Q, will give us total profit—the area shaded.
The above graph is the key short run graph for perfect competition. It shows a firm that maximizes profits by producing Q*. We know that profits are positive because price P* is above average costs ATC*. Of course, it is also possible to lose money in the short run. The next two graphs show the other two possibilities, where the firm is losing money:
In the first graph, we know that the firm will make a loss because the price P* is below ATC. (If price were just equal to ATC, profits would be 0, which is why the breakeven price is the point where P=ATC.) But, since P is less than ATC, should the firm shut down? The key here is to remember that you have a fixed cost—you have rented out a building say for the next year. If you shut down, you still have to pay the rent. So, the key question is whether you would lose less money shutting down or operating. And, the key comparison is to compare price with average variable cost. In the first graph, price is above average variable cost. What does that mean? It means that you are paying all of your variable costs—all of your salaries, materials, utilities—plus you must also be paying for some of your fixed costs. Therefore, you will lose less money by operating over the next year. Once your rent contract is up, then you need to reevaluate the situation. If the loss situation is going to continue then you would just shut down and not sign the next contract.
What about in the second graph? In this graph, not only is price below ATC, but price is also below variable costs. That means that you are not even able to pay all of your salaries, let alone any of your fixed costs. Therefore, you will lose less money by shutting down immediately. The minimum of the AVC curve is called the shut down price. If price is lower than AVC then you should shut down. If price is above AVC then you should operate.
Using this information, we are now able to explain where the supply curve comes from. In the graph below, if price is equal to P1, we could draw a flat demand curve and marginal revenue curve that would intersect the MC curve at a quantity of Q1. Thus, if you are presented with a price of P1, you maximize profits by producing Q1. If price increases to P2, you would maximize profits by producing Q2. As price increases, quantity supplied will increase. Does that remind you of anything? That is exactly what the supply curve does. Given the price, the marginal cost curve shows what quantity to supply. Therefore, the supply curve comes from the marginal cost curve, at least the darkened portion that lies above the AVC curve. The supply curve from the supply and demand section comes from the marginal cost curve of perfect competition.
Let’s now turn our attention to the long run of perfect competition. What will happen in the long run? As we transition to the long run, it is important to understand what economists mean by profit. Economic profits are total revenues minus total costs, where total costs include the opportunity cost—the next best alternative. Suppose, for example, that the going rate of accounting profit in farming is 6%. We would call that the normal profit or rate of return. If you were just making the normal rate of return, we would call that a 0 economic profit—you are making the average. However, if wheat farmers were making an economic profit, that would mean that they are making more than the normal rate of return; more than the 6% accounting profit.
Suppose that wheat farmers were making an accounting profit of 10% (or, subtracting out the 6% average rate of return, a 4% economic profit). What would happen in the long run? Recall that the long run is a long enough time for more factories to be build, or in the case of farming, for more farmers to enter the picture. If you were deciding between corn and wheat farming, what would you do? You would most likely go in to wheat farming since the profits are higher. So, the positive economic profits will attract more farmers in to that area. And remember that in perfect competition, it is a relatively easy industry to get in to.
The high profits will attract more farmers, which will increase supply. The market supply curve will shift to the right. As the market supply curve shifts to the right, the price of wheat will be driven down. As the price of wheat is driven down, profits in the wheat industry will decrease. This will continue as long as the profit in the wheat industry is greater than in similar industries.
In the long run, equilibrium will occur when farmers in wheat are just making what farmers are making in other industries—a normal rate of return. In economics, this is called 0 profit. So, the long run equilibrium occurs when farmers are making 0 profit. (Note that this still means that farmers are making accounting profits—it is just that they are not going to make an above normal rate of return.) The long run equilibrium graph is shown below.
This is an important result in economics. Many Nobel Prizes in economics have been won for work around this graph. In many ways, it offers a proof that the market system (at least when it is competitive) is more efficient than a government-controlled economic system. Recall that the underlying goal in microeconomics is that of efficiency. Here is the interpretation of the graph:
Long Run Results for Perfect Competition:
- Productive Efficiency. Algebraically, this means that price is equal to the minimum of the average total cost curve. This is shown in the graph above. Intuitively, this means that competitive firms are forced to their most efficient point, where per unit costs are lowest. In addition, firms must pass the low costs on to consumers in the form of low prices. So, we get low costs and low prices.
- Allocative Efficiency. Algebraically, this means that price is equal to marginal cost, which we can also see from the graph. Intuitively, this means that production is high and at the level that is best for society. (The rationale for the price and marginal cost comparison is a bit harder to explain. Marginal cost measures the extra cost to society of increasing production one more unit. Price measures the extra benefit—if you are willing to pay a particular price for a product, you must be getting at least that much benefit from it. So, we are comparing price and marginal cost. We are squeezing the maximum net benefit to society by increasing production right up to the point where the extra benefit (price) is equal to the extra cost (MC).)
Another way to think about these two efficiencies is to compare the situation to one that is not competitive. If a large corporation bought up all the farmers, what would happen? Two things, first they would raise prices. Second, and essentially the way to drive up prices, is to cut back on production. Thus, in a situation that is not competitive, we would get higher prices and less production. In contrast, competitive markets results in low costs, low prices, and high production, which is essentially what it means to be efficient. What about the impact that competitive markets have on the other goal in microeconomics—that of a fair distribution of income?
- Perfect competition also has an impact on the distribution of income. Under a perfectly competitive system, we end up with a less skewed distribution of income—less of a gap between the top 1% and the middle class. This is due to the low costs being passed on to consumers in the form of low prices. To see this, think about what would happen if one person were to buy up all the firms in a competitive industry—say the Koch Brothers bought up all the apple farms in the country. What would happen? They would raise apple prices (by cutting back on production.) Even a small price increase means that potentially billions of consumers are transferring income to two people. And, not only does this redistribution of income not come from added value to society—society actually is worse off because we get fewer apples. This skews the distribution of income. The farther away from perfect competition an industry is, the more skewed will be the resulting distribution of income. Thus, competition not only results in a more efficient outcome. It also results in a less skewed distribution of income.
