Business Economics

Q1: 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 specialised nature of capital equipment K, it takes about a year to increase K; but the rate of labour input, L, can be varied daily. If the wage rate is $ 10 per unit and the price of output is $2 per unit, is the firm operating efficiently in the short run? If not, explain why. Also determine the optimal 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 factor inputs 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 Function

The short run is defined in economics as a period of time where at least one factor of production is assumed to be in fixed supply i.e. it cannot be changed. We normally assume that the quantity of capital inputs (e.g. plant and machinery) is fixed and that production can be altered by suppliers through changing the demand for variable inputs such as labour, components, raw materials and energy inputs. Often the amount of land available for production is also fixed.

The time periods used in textbook economics are somewhat arbitrary because they differ from industry to industry. The short run for the electricity generation industry or the telecommunications sector varies from that appropriate for newspaper and magazine

publishing and small-scale production of foodstuffs and beverages. Much depends on the time scale that permits a business to alter all of the inputs that it can bring to production.

In the short run, the law of diminishing returns states that as we add more units of a variable input (i.e. labour or raw materials) to fixed amounts of land and capital, the change in total output will at first rise and then fall. Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that total output will still be rising – but increasing at a decreasing rate as more workers are employed. As we shall see in the following numerical example, 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 worker employed. At low levels of labour input, the fixed factors of production - land and capital, tend to be under-utilised which means that each additional worker will have plenty of capital to use and, as a result, marginal product may rise. Beyond a certain point however, the fixed factors of production become scarcer and new workers will not have as much capital to work with so that the capital input becomes diluted among a larger workforce. As a result, the marginal productivity of each worker tends to fall – this is known as the principle of diminishing returns.

An example of the concept of diminishing returns is shown below. We assume that there is a fixed supply of capital (e.g. 20 units) available in the production process to which extra units of labour 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 ReturnsCapital Input Labour Input Total Output Marginal

ProductAverage Product of

Labour20 1 5   520 2 16 11 820 3 30 14 1020 4 56 26 1420 5 85 28 1720 6 114 29 1920 7 140 26 2020 8 160 20 2020 9 171 11 1920 10 180 9 1820 11 187 7 17

Average product will continue to rise as long as the marginal product is greater than the average – for example when the seventh worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker employed (where marginal product is only 11) then the average will decline.

This marginal-average relationship is important to understanding the nature of short run cost curves. It is worth going through this again to make sure that you understand it.

Criticisms of the Law of Diminishing Returns

How realistic is this notion of diminishing returns? Surely ambitious and successful businesses do what they can to avoid such a problem emerging.

It is now widely recognised that the effects of globalisation, and in particular the ability of trans-national corporations to source their factor inputs from more than one country and engage in rapid transfers of business technology and other information, makes the concept of diminishing returns less relevant in the real world of business. You may have read about the expansion of “out-sourcing” as a means for a business to cut their costs and make their production 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 and development and investment in capital machinery if a business cannot extract increasing returns and lower unit costs of production from these extra inputs?

Long run production - returns to scale

In the long run, all factors of production are variable. How the output of a business responds to 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

A numerical example of long run returns to scaleUnits of Capital

Units of Labour

Total Output

% Change in Inputs

% Change in Output

Returns to Scale

20 150 3000      40 300 7500 100 150 Increasing60 450 12000 50 60 Increasing80 600 16000 33 33 Constant100 750 18000 25 13 Decreasing 

In the example above, we increase the inputs of capital and labour by the same proportion each time. 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 long run average cost curve.

The effect of an increase in labour productivity at all levels of employment

Productivity may have been increased through the effects of technological change; improved incentives; better management or the effects of work-related training which boosts the skills of the employed labour force.

The length of time required for the long run varies from sector to sector. In the nuclear power industry for 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 goods and services in proper quantity and of the right quality which is a given period. The ability can be measured in terms of number of units of a commodity produced by a worker with in a given period. Thus, one factor worker producing more number of a commodity with in a given time than the other worker is considered more efficient. Efficiency of labour is thus an important determinant of the study of labour in a productive sense. It determines the size of real productive labour force in a country. A country labour supply will be substantially augmented if it 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 conductive to very hard work. In hot climate, labourers cannot work as hand as labourer in cool climate can. 4.Hours to Work: -The efficiency of labour is affected by the working hours. If a labourer works for long hours, work becomes monotonous and the labourers worse only half heartily. He cannot give the best.5.Working Conditions: - If the factory building is dirty and not well-ventilated workers cannot hard work. However, if factory building is clean and well ventilated and if the atmosphere is pleasant, workers like to work hard.

6.Education and Training: - Education and Training impact technical knowledge, sense of responsibility and improve the efficiency of labour. Trained labourer can use modern machinery efficiency. 7.Welfare Activities: - Social security measures like medical facilities and maternity benefits help 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 and betterment in working living conditions. Thus, labour efficiency can be improved with respect of following points:- 1. By linking about labour efficiency and by wages and incentive bonus, it is possible to motivate labour. 2. Labour efficiency can be raised by mutual argument between management and workers regarding 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 production and in cost control, that efficiency can be raised. 5.Bringing improvement in plan lay out material handling and better internal management in a factory has positive effect on labour efficiency.6.By providing modern training course to those in personnel department who handle worker such 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

Q2: Explain how equilibrium of the firm is achieved. Also, explain (along with examples) how profit maximizing output is determined in short run and long run for:

A: Perfect Competitive market Monopoly market Monopolistic market Oligopoly market

Market equilibrium in economics refers to level of prices at which the quantity demanded by the customers is same as the quantity offered for for supply by the suppliers. Thus the market equilibrium has two dimensions.

(1) price, and (2) quantity sold and purchased. Here we are talking about quantity actual sold and purchased. Unlike quantities demanded and quantity offered for supply, the actual quantity 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 a horizontal line at the level of the market price. Thus same price is applicable to firm level equilibrium. However the quantity supplied by each firm at this equilibrium price depends on the cost structure of the firm. The firm can supply as much as it wishes, therefore it supplies a quantity that maximizes its profit. This occurs when the marginal cost of the firm just equals the marginal revenue. In a perfectly competitive market the marginal cost and revenue at this point are also same as the market price. Since marginal cost for every firm operating in a perfect

competition is same as market price, the combined marginal cost for all the firms in a perfectly competitive 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 individual firms as it is dependent on actions of competitor firms and may change from time to time in response 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 of the total quantity produced. Average fixed cost is simply this fixed cost divided by total quantity produced.

Thus: Average Fixed Cost = AFC = Fixed cost/Total quantity produced.

In the above equation for AFC we see that numerator (fixed cost) is constant, while denominator (total quantity produced) is variable. Therefore, AFC reduces with increasing production quantity. As a result AFC curve, which is a graph showing AFC on y-axis and production of x-axis, is a downward sloping curve.

How equilibrium is achieved depends on what is being equalized. Equilibrium means balance or equality 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 side does not contain more than the other side. Any changes made to the sides are done to both sides

MARKET EQUILIBRIUM:

The state of equilibrium that exists when the opposing market forces of demand and supply achieve a balance with no inherent tendency for change. Once achieved, a market equilibrium persists unless or until it is disrupted by an outside force, especially the demand and supply determinants. A market equilibrium is indicated by equilibrium price and equilibrium quantity.

In general, equilibrium is the balance of opposing forces. For market equilibrium, the opposing forces are demand and supply. Buyers seeking to buy at a lower price and sellers seeking to sell at a higher price. The balance of these two forces generates a price and a quantity that are mutually agreeable to both sides.

The Imperial Forces of Demand and Supply

A market equilibrium is comparable to a robust tug-of-war between two equally matched teams of burly lumberjacks, such as those employed by the Natural Ned Lumber Company. On one end of the rope is a group of ten burly lumberjacks in red plaid shirts. On the other end is a

group of ten burly lumberjacks in blue plaid shirts. As the red burly team tugs and pulls they are matched tug for tug and pull for pull by the blue burly team. The yellow flag marking the center of the rope budges nary an inch. The two opposing forces of burly red and burly blue balance out. 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.

Striking A Balance

Market equilibrium is the balance between buyers trying to move the price down and sellers trying to move the price up. When the two forces are in balance, the "yellow flag" or price does not budge. The unmoving price is not actually yellow, but it is the equilibrium 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 and quantity than yellow flags. The equilibrium price is also equal to BOTH the demand price andsupply price. Moreover, the equilibrium quantity is equal to BOTH thequantity demanded and quantity supplied.

As a matter of fact, equilibrium price and equilibrium quantity result when the demand and supply prices are equal AND the quantities demanded and supplied are equal. And this is ONLY achieved at the intersection of the demand and supply curves. This market equilibrium is illustrated in the accompanying market diagram.

Efficiency and the Invisible Hand of Competition

Market Equilibrium

Economists like market equilibrium almost as much as a box of Double-Dot Caramel Nougat Clusters. The reason is efficiency. The forces of demand and supply, almost as if guided by an invisible hand, efficiently allocate society's scarce resources when they achieve market equilibrium. Efficiency, however, requires a competitive market--a market with large numbers of buyers and sellers such that neither side is able to influence the price or exchange process and 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 hundred thousand flannel-shirted lumberjacks. Should any single lumberjack from either side leave their team to climb a pine tree, fell a redwood, or pursue other lumberjacking activities, then the tug-of-war is unaffected. One lumberjack, one buyer, one seller, does not affect a competitive market.

If, however, the tug-of-war teams consist of only three lumberjacks each, then the absence or presence of a one can make a difference. Likewise the efficiency balance in a market can be easily comprised if the number of competitors is limited.

Those Disrupting Determinants

Market equilibrium perpetually persists unless or until disrupted by an outside force.

The demand determinants and supply determinants are the prime disrupters of market equilibrium. When they change, the demand and supply curves shift, the original equilibrium price and quantity are no longer equilibrium, and the market is out of balance with surpluses and shortages.

Fortunately, a market equilibrium is a stable equilibrium. Any determinant-triggered disruption that results in a surplus or shortage induces the price to change to restore equilibrium. If the market wavers from equilibrium, the demand and supply forces bring it back. If the price is too high or too low, that is, above or below the equilibrium price, then the price automatically returns 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 Market

A perfectly competitive firm with rising marginal costs maximizes profit by producing up until the point at which marginal cost is equal to marginal revenue. The marginal revenue for a perfectly competitive firm is the market price determined by the intersection of the supply and demand curves, as shown in the panel on the left. The panel on the right shows the orange

price line intersecting the purple marginal cost curve at the profit maximizing quantity, . The per 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 profit times and is represented by the shaded rectangle. If the price is below the average total cost, 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

Π (Q )=TR(Q )−TC (Q ) =PQ−TVC (Q )−TFC

Note: 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 of the owner’s investment), so an economic profit of zero actually corresponds to a “normal” rate of 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

Π (Q )>Π (Q=0)

TR (Q )−TVC (Q )−TFC >−TFC

TR (Q )>TVC (Q )

Alternatively, we can rewrite this as:

TR(Q )Q

¿TVC (Q )Q

PQQ

¿TVC (Q )Q

P > AVC(Q ) for some Q>0

(or)

P > min AVC(Q )

Intuition:

Fixed costs are irrelevant for the shut down decision since they must be paid whether the firm remains open or not.

However, as long as TR > TVC for some Q > 0 (alternatively, P > min AVC), the firm can increase profits by producing Q > 0 (since additional revenue earned on these units exceeds the cost of producing them).

Conversely, if TR < TVC for all Q > 0 (alternatively, P < min AVC), then the firm loses money on each 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 their profits are negative.

This is because

Π (q )=TR (Q )−TVC (Q )−TFC < 0

even 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 firm produce 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!)

- 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

Π (Q )=(P−ATC (Q¿

))Q¿

=(P−TC (Q¿

)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

Π (Q¿

)=(P−ATC (Q¿

))Q¿

<0

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+Q2

MC=2QP=$60

1) Should the firm stay open (produce Q > 0)?

TVC=Q2 ⇒ AVC=Q2

Q=Q

Clearly, 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?

Π (Q¿

)=TR (Q¿

)−TC (Q¿

) =PQ

¿

−TC (Q¿

)

Π (30)=60(30)−100−(30 )2

=1800−100−900 =$800

Application: Two Misconceptions about Short-Run Profit Maximization

a) 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 = $15,000,000

Proposed Project (to be housed in unused basement):TR = $2,000,000TVC = $1,000,000

Rejected because it was assigned a 10% share of the existing fixed costs ($1,500,000).

The Firm’s Short-Run Supply Curve

The two conditions for profit maximization define the firm’s short-run supply curve (see diagram)

Q={ 0 if P<min AVC

MC (Q ) if P≥min AVC

where 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.

Note: Firm’s short-run supply curve is upward sloping because it is equal to the upward-sloping portion of the MC curve.

Short-Run Industry Supply

Short-run Industry Supply Curve – The horizontal sum of the short-run supply curves of all firms in the industry.

Example: Identical firms

Suppose an industry has 200 identical firms, each with the short-run supply curve

P=100+1000QiQuestion: 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.

Qi=P

1000− 1

10

With 200 firms, summing the above supply curve is equivalent to multiplying it by 200, i.e.

Q=200Qi

=200 [P1000−1

10 ] =P

5−20

Finally, rearrange so P is on the left-hand side

P=100+5Q

Long-Run Profit Maximization

In the long run, firms can adjust fixed inputs (capital) to minimize the costs of producing the desired level of output.

Firms operate on their long-run average and marginal cost curves

In 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

Π (Q )=(P−LRAC (Q ))Q≥0

then 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 highly valued 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

Fact 1: Entry and exit by firms guarantees that in long-run competitive equilibrium economic profits 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 driving down the price.

If P < min LRAC, economic profits would be negative and firms would exit, thereby driving up the price.

Application – Reparations for Slavery

Q: Who should pay? (Robert Fogel’s argument).

Example: Calculation of Long-Run Equilibrium

Consider 4 identical firms, each with the cost curves shown below

LRTC=4Q2−2Q3

LRMC=8Q−6Q2

LRAC=4Q−2Q2

min LRAC occurs at Q=1

Note: 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.

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?

Π (Q )=PQ−TC (Q ) =2(1)−4(1)2+2(1)2

=2−4+2 =0

as must be true in long-run competitive equilibrium.

Efficiency Properties of Long-Run Competitive Equilibrium

1) 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).

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 analyzed directly with economic profit, by identifying the greatest difference between total revenue and total 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 level of economic profit given existing market conditions and production cost. For a monopoly, this entails adjusting the price and corresponding production level to achieved the desired match between total revenue and total cost.

Three Views

Profit-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 revenue and 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 the deadly (but hypothetical) foot ailment known as amblathanitis. Feet-First Pharmaceutical is the

Profit MaximizationProfit CurveTotal Curves

Marginal Curves

exclusive producer of Amblathan-Plus, meaning that it is a price maker and the demand curve it faces is the market demand curve.

The top panel presents the profit curve. The middle panel presents total revenue and total cost curves. The bottom panel presents average revenueand average total cost curves. In all three panels, 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 profit curve is at its peak, then profit is maximized. In the top panel, the profit curve achieves its highest 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 of total revenue and total cost. The quantity of output that achieves the greatest difference of total revenue over total cost is profit maximization. In the middle panel, the vertical gap between 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 the total revenue curve.

Marginal Revenue and Marginal Cost: Third, profit maximization can be identified by a comparison of marginal revenue and marginal cost. If marginal revenue is equal to marginal cost, then profit cannot be increased by changing the level of production. Increasing production adds more to cost than revenue, meaning profit declines. Decreasing production subtracts more from revenue than from cost, meaning profit also declines. In the bottom panel, the marginal revenue and marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger or smaller output levels, marginal cost exceeds marginal revenue or marginal revenue exceeds marginal 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.

With this in mind, now consider this exhibit to the right, which will eventually contain the marginal revenue and marginal cost curves for Feet-First Pharmaceutical's 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 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.

Profit Maximization,The Marginal View

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 firm offers a different type of product, as opposed to perfect competition in which all offer the same product. Each firm, then, has a monopoly in the market of their own product. Thus, the firms try 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. There are too many other businesses in a monopolistic competition to worry about them, you simply try 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 no barriers to entry. Companies can enter the market relatively easily (although, of course, not as perfectly easy as in perfect competition). This makes for a long-term equilibrium competition of no profit. When there is profit to be made, just as in perfect competition, new companies come in and take that profit away through expanded production and dropping prices. Unlike in perfect competition, though, monopolistic competition has a normal downward-sloping demand curve. The competing companies in monopolistic competition are not so much price takers as price setters and thus the demand curve is sloped, not set constant at the market price.

In monopolistic competition, there are many firms vying for control of one market. Each firm offers a different type of product, as opposed to perfect competition in which all offer the same product. Each firm, then, has a monopoly in the market of their own product. Thus, the firms try 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. There are too many other businesses in a monopolistic competition to worry about them, you simply try 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 no barriers to entry. Companies can enter the market relatively easily (although, of course, not as perfectly easy as in perfect competition). This makes for a long-term equilibrium competition of no profit. When there is profit to be made, just as in perfect competition, new companies come in and take that profit away through expanded production and dropping prices. Unlike in perfect competition, though, monopolistic competition has a normal downward-sloping demand curve. The competing companies in monopolistic competition are not so much price takers as price setters and thus the demand curve is sloped, not set constant at the market price.

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

The monopolistically competitive firm's long-run equilibrium situation is illustrated in the Figure below.

Long-run profit maximization by a monopolistically competitive firmThe entry of new firms leads to an increase in the supply of differentiated products, which causes the firm's market demand curve to shift to the left. As entry into the market increases, the firm's demand curve will continue shifting to the left until it is just tangent to the average total cost curve at the profit maximizing level of output, as shown in Figure 1 . At this point, the

firm's economic profits are zero, and there is no longer any incentive for new firms to enter the market. Thus, in the long-run, the competition brought about by the entry of new firms will cause each firm in a monopolistically competitive market to earn normal profits, just like a perfectly competitive firm.

Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale, labeled as point b in Figure 1 . When the firm produces below its minimum efficient scale, it is under-utilizing its available resources. In this situation, the firm is said to have excess capacity because it can easily accommodate an increase in production. This excess capacity is the major social cost of a monopolistically competitive market structure.

Oligopoly Market

An oligopoly is a market dominated by a few producers, each of which has control over the market. 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 a market rather than its market structure.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales.

Price leadership – tacit collusion

Another type of oligopolistic behaviour is price leadership. This is when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes prompted by the dominant firm. We see examples of this with the major mortgage lenders 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 take some time for relative price differences to emerge which might cause consumers to switch their demand.

Firms who market to consumers that they are “never knowingly undersold” or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. Does the consumer really benefit from this?

Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each other’s market

Explicit collusion under oligopoly

It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce market uncertainty and engage in some form of collusive behaviour. When this happens the existing firms decide to engage in price fixing agreements or cartels. The aim of this is tomaximise joint profits and act as if the market was a pure monopoly. This behaviour is deemed illegal by the UK and European competition authorities. But it is hard to prove that a group of firms have deliberately joined together to raise prices.

Price fixing

Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.

To fix prices, the producers in the market must be able to exert control over market supply. In the diagram below a producer cartel is assumed to fix the cartel price at output Qm and price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation.

Although the cartel as a whole is maximising profits, the individual firm’s output quota is unlikely to be at their profit maximising point. For any one firm, within the cartel, expanding output 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 all firms break the terms of their cartel agreement, the result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement might break down.

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.