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Intermediate Micro Exam III Review

Cost Minimization
Cost Function: c(w1,w2,y)  measures the minimum costs of producing a given level of output at given factor costs Isocost Lines: every point on an isocost curve has the same cost (c)

c = w1x1 + w2x2

Cost minimization problem: find the point on the isoquant that has the lowest possible isocost curve associated with it Tangency Condition: slope of isoquant = slope of isocost lines Average Cost Function: cost per unit to produce y units of output

AC = c(w1,w2,y)/y

Relationship b/w returns to scale and cost function: Constant returns to scale: AC(w1,w2,y) = c(w1,w2,1)  constant AC Decreasing returns to scale: AC(w1,w2,y) > c(w1,w2,1)  constant AC Increasing returns to scale: AC(w1,w2,y) < c(w1,w2,1)  constant AC Short-run Cost Function: minimum cost of producing output y = cost associated with using the costminimizing choice of inputs, where factor 2 is fixed

( ̅ )





Long-run Cost Function: minimum cost of producing output y = cost associated with using the cost-minimizing choice of inputs ( ) ( ) ( ) Relationship b/w long-run and short-run cost functions: ( ) ( ( )) ( ) ( ( ) )  The cost-minimizing amount of the variable factor in the long run is that amount that the firm would choose in the short run if it happened to have the cost-minimizing amount of the fixed factor Fixed Costs: costs associated w/ the fixed factors  there are no fixed costs in the long run At the given level of output, a profit-maximizing firm will always minimize costs because: Profits = TR−TC  if the firm wasn’t minimizing costs, it would always be able to increase profits

Cost Curves
( ) ( )
( ) ( ) ( )

( )  MC(1) = AVC(1)

Properties:  AVC curve may initially slope down, but need not, however, it will eventually rise, as long as there are fixed factors that constrain production  AVC will initially fall due to declining AFC, but then will rise due to increasing AFC  U-shape  MC curve passes through the minimum of both the AC and AVC curve:

( ) ( )

( )

 

( )
( )

( )

( )

( ) 

( )

 MC = AC at minimum of AC

( )

( ) ( ( )

( )

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 MC = AVC at minimum of AVC

The area under the MC curve = Total Variable Costs

The optimal division of output between two plants must have the MC of producing output at plant 1 = MC of producing output at plant 2 MCP1 = MCP2 Long-run cost function = Short-run cost function adjusted to/evaluated at the optimal choice of fixed factors: c(y) = cs(y,k(y)) At y*: c(y*) = cs(y*,k*)  optimal choice of plant size is k* Hence: short-run cost curve must be tangent the long-run cost curve: Relationship b/w long-run and short-run cost curves with continuous levels of the fixed factor:

Firm Supply
Firm faces:  Technological Constraints (production function)  Economic Constraints (cost function) Perfect competition: market structure with many firms same exact product  Firm = Price Taker: price independent of own level of output Demand Curve faced by competitive firm:

In a perfectly competitive industry, supply decision =  p = MC(y)  MC curve of a competitive firm is precisely its supply curve Two exceptions:

When there are two levels of output where p=MC, the profit-maximizing quantity supplied can lie only on the upward sloping part of the MC curve  Shutdown Condition: The firm is better off going out of business when:
 

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 – ( )– In the short-run: the supply curve is the upward-sloping part of the MC curve that lies above the AVC curve

Profits: Total Revenue – Total Costs Given the market price, we can now compute the optimal operating condition from the condition that p = MC(y)  Given the optimal operating condition, we can compute the profits of the firm In this graph…  The area of the box is just p*y*, or total revenue  The area y*AC(y*) is total costs since

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Producer’s surplus is equal to revenue minus variable costs, or equivalently, profit plus the fixed costs:  profits = ( ) ( ) 3 ways to calculate producer’s surplus:  1) Total revenue – total variable costs  2) Area above MC curve and below the price  3) Area to the left of the supply curve

producer’s surplus =

Long-run supply curve

p =MC1(y) = MC(y,k(y))

Industry Supply

Industry supply curve = sum of individual supply curves

Short-Run Industry Equilibrium  If p* = AC → 0 profits  If p* < AC → negative profits (loss)  If p* > AC → positive profits  Long-Run Industry Equilibrium (given free entry & exit)  If positive profits made in the short run, new firms will enter  Driving down prices until p* = AC → 0 profits  If negative profits made in the short run, some firms will exit  So prices rise until p* = AC → 0 profits  If there is free entry and exit, then the long-run equilibrium will involve the maximum # of firms consistent with nonnegative profits  Approximate long-run supply curve

We can eliminate portions of the supply curves that can never be intersections with a downward sloping market demand curve in the long run → If there are a reasonable number of firms in the long run, the equilibrium price cannot get far from minimum average costs

The more firms there are in a given industry, the flatter is the long-run industry supply curve  Hence – in the long-run, in a perfectly competitive industry w/out barriers to entry, profits cannot go far from 0  If a firm is making positive profits, it means that people value the output of the firm more highly than they value the inputs  If there are forces preventing the entry of firms into a profitable industry, the factors that prevent entry will earn economic rents  The rent earned is determined by the price of the output of that industry  Economic Rent: Payments to a factor of production that are in excess of the minimum payment necessary to have that factor supplied

 Rent p*y* cv(y*) = PS  equilibrium rent will adjust to whatever it takes to drive profits down to 0

Monopoly: when there is only one supplier in the industry  Price Maker  monopolist recognizes its influence over the market price and chooses that level of price and output that maximized its overall profits  Properties:  Monopolist faces the total market demand curve, which slopes downward due to diminishing marginal utility  Monopolist has to take into account the effect of its changes in output on the inframarginal units, which could have been sold at the old price  Entry into the industry is completely blocked; barriers to entry can include:  patents  extensive economies of scale  control over supplies or outlets through vertical integration  Therefore, while a perfectly competitive firm has the condition MR=p because it behaves as if the impact of its output (qi) decision on price (p) was 0  A monopolist takes into account that increasing q brings about a fall in p, hence MR<p (demand) ( ) ( )   ( ) ( ) ( ) ( ) ( )  

Monopolist produces less than competitive amount of output (QM rather than Q*) at a higher price (PM rather than P*) and is therefore Pareto inefficient  Total Welfare (Economic Surplus) = Consumer Surplus + Producer Surplus  maximized when p=MC  BUT the monopolist produces where p>MC → deadweight loss due to monopoly
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Summary: Why Does a Monopolist Always Set Its Price Above MC ? ( ) ( ) ( )    Hence ( ) ( ) where ( )  ( ) Economic & technological conditions that are conducive to the formation of monopolies:  large fixed costs and small marginal costs  large minimum efficient scale relative to the market  ease of collusion (cartels)

Monopoly Behavior

Monopolists have an incentive to use their market power for Price Discrimination  charging different prices for different units/customers in order to increase profits