Market Structure:

Combining Costs and Revenues

Concepts you will be expected to be familiar with:
1. Profit maximization
2. Producer surplus
3. Market power
4. Competitive supply
- elasticity
- individual supply to market supply
6. Short run equilibrium -- equating supply and demand
7. Long run competitive supply
8. Who bears the burden of a marginal cost increase?

1. Profit = Total Revenue - Total Cost

Profits are maximized when we adjust
output so that the marginal increase in
revenue is just offset by the marginal
increase in costs.
Mathematically:
d(Profit)/dQ = d(TR)/dQ - d(TC)/dQ = 0.

Marginal Revenue, Marginal Cost and Profit

Maximization

We can then rewrite this as:

d(TR)/dQ = d(TC)/dQ
Recall: Marginal Revenue is the additional revenue the firm
generates by increasing output by one more unit:
MR = d(TR)/dQ.
Marginal Cost is the additional expense the firm incurs by
increasing output by one more unit:
MC = d(TC)/dQ.
So we can rewrite our profit-maximization formula as:
MR = MC
By setting these equal, we can then identify the profit
maximizing quantity which, after entered into the demand
equation gives us the profit maximizing price.

Graphically
MC

P*

Q*

MR

What is the blue

shaded region called?
MC

P*

Q*

MR

2. Producer Surplus
Just as we defined consumer surplus as the
difference between what a consumer actually
pays for a good and the value of the good to
the consumer, we can define producer surplus
as:
Producer surplus: the difference between the
price received for a good and the marginal
cost of producing that unit

Graphically
MC

P*

This shaded area

is the Producer
Surplus

Q*

MR

Consumer Surplus and Producer

Surplus
Consumer surplus represents the gains to trade
from the consumers perspectives.
Why?
Producer surplus represents the gains to trade
from the producers perspective given they
are producing any at all.
Why?
What does the sum of producer surplus and
consumer surplus equal?

Producer Surplus
Since producer surplus is the price minus the
marginal cost of producing each unit, could a
producer have positive producer surplus but
still be losing money?

3. Social cost of market power

We can use the concepts of producer surplus
and consumer surplus to determine the social
cost associated with market power.

Market power is when a single producer faces a

downward sloping demand curve.
A firm has market power when the firm knows
that by changing its output, it can change the
price it receives.

Social cost of market power

$

What are the maximum possible gains from trade?

P*

MC

Q*

MR

Social cost of market power

$

maximum possible total surplus where

the blue region is consumer surplus
and the green region is producer
surplus
MC

P*

Pc

D
Qc

Q*
MR

Social cost of market power

$

P*

Of the maximum possible gains, note that

we lose both red triangles as a result of the
fact that the producer has market power.
The bottom (darker) triangle is a loss of
producers surplus and the top triangle is a
loss of consumers surplus. We call this
social loss Dead-weight loss.

MC
Pc

Q*

MR

Social cost of market power

$

P*

The producer, though it loses some surplus

(relative to the surplus maximizing
solution) gains on net because of a transfer
from consumers to producers equal to the
blue shaded region.
MC

Pc

Q*

MR

Social cost of market power

In sum, as a result of market power, the
producer loses the lower, dark red
shaded triangle, and the consumers lose
the upper red shaded triangle. Since
there is no compensating gain for either
of these losses, these represent the
social loss. Producers gain the blue
rectangle but consumers lose it.
Therefore the rectangle is not a social
loss it is a transfer.
MC

P*

Pc

Q*

MR

4. Accounting profits vs. economic profits

Suppose a farmer in Iowa owns the best land for
growing corn, and as such can grow corn at a lower
cost than anyone else. Since he gets the same price
for corn as every other farmer, can he reap profits
even in the LR?
Yes, he will earn LR accounting profits. This is pretty
straightforward to see.
No, he will not earn LR economic profits. Why?
Because he faces an opportunity cost on using this
very fertile land. The fertility of the land will be
reflected in its market value, and by using the land
he faces a very high opportunity cost.

5. Competitive supply
Define a competitive industry as one in which all
firms have the following characteristics:
they produce a perfectly homogeneous
product, like wheat;
each firm is so small in relation to the industry
that its production decisions have no effect on
the market price (they are price takers); and
in the long run there is free entry and exit
by new and incumbent firms alike.

What happens to price when Jim grows 10,000

bushels of corn, up from 8,000 last year?
$

Market Demand
4.00

100 200

300

400 500 600 700 800

900

Quantity
(Millions of
Bushels)

Jims Demand
(Calculated from the market demand)
$

Jims Demand
4.00

Quantity
(Thousands
of Bushels)

Jims Marginal Revenue

(Calculated from the market demand)
$

Jims Demand
4.00
Total Revenue
= 8000*$4
= $32,000

TR =
$40K

10

Quantity
(Thousands
of Bushels)

For a competitive firm, MR is

the same as Price

What is the effect of an increase in output on earlier units

when a firm faces a downward sloping demand curve?
Following our earlier results, this means the firm operating in
a perfectly competitive environment will price such that:

P=MC
The rule that always applies is still:
MR=MC

Competitive Firm Profit Maximization

P

At this quantity, total

revenues are
qi*x P*

Total costs are

qi* x AC (qi*)

Profits are
qi*(P* - AC (qi*))

MC
AC
P*=MR

TR
Profits

TC
q i*

qi

Individual Firm Decisions

P
P3=MR3

MC

AC
AVC
P1=MR1

P2=MR2

q2 q1 q3

Suppose the market

price is P1
What quantity will
this firm choose to
produce?
Now suppose the
market price is P2
What quantity will
this firm choose to
produce?
Now suppose the
market price is P3

Now What?

MC
AC
AVC

P*=MR

q*

Now suppose market

price P* => how much
should you produce?

At least you are

covering your
variable costs (and
remember since
this is short run,
fixed costs will be
incurred anyhow).

The Shut-down Decision

MC
AC
AVC

What happens if the

market price is P*?
At MR = P* = MC, the
price is below AVC =>
produce q* or nothing?
You would have
saved this much if
you stayed in bed
that day.

P*=MR
q*

Short-run Firm Level Supply

P

Firm
Supply

MC

The individual firms

supply curve in the
short run is MC above
Min AVC!

For P < MinAVC, the

supply curve is at Q=0
(the firm shuts down)

AC
AVC

Short-Run Operating Decision

Rule of thumb:
Stay open if P >= AVC (even if P < ATC)
Shut down if P < AVC

May accept lower prices in the short run due to:

Economies of scope
Network and/or learning economies
Contractual obligations
Government regulation
Large shut-down and start-up costs (e.g. steel mills)
Etc.

What happens to the firms AVCs and

MCs when one of its variable inputs
increases in price?
Decreases in price?

In general, what sorts of things move the firm along Its

supply curve and what sorts of things shift the firms
supply curve?

An increase in wage rates will . . . .

A decrease in materials costs will . . . .
An increase in fixed costs will . . . (in the
short run)
An increase in the price of the product
will . . .
And so forth ...

Individual supply to market

supply
The firms supply curve might look something like this ...

qs = 10 + 2.5P

How do we find the market supply?

In the short run, we simply aggregate across all firms.

So if there are ten firms each

with a supply curve that looks
like:
qs = 10 + 2.5P

Then the market supply curve will

be:
Qs = 100 + 25P

Elasticity of Supply ...

We define the elasticity of supply as the
percentage change in quantity supplied in
response to a one percent change in price:
Es = (%DQ)/(%DP)

= (DQ/Q)/(DP/P)
= (P/Q)(DQ/DP) 0

So the formula looks identical, except that we

are looking at supply rather than demand
responses. And all of the intuition remains as
before.

6. Short run equilibrium

$
Supply

P*

Demand

Quantity
Q*

How do we get to equilibrium? Suppose P > P* ...

$
Supply

P
P*

Demand

Quantity
?

Q*

Alternately, suppose P < P* ...

$
Supply

P*
P
Demand

Quantity
?

Q*

Equilibrium
What is likely to happen when the quantity of output
does not equal the quantity determined by Supply =
Demand?

Equilibrium holds when no one has the incentive to

deviate from that output once it is reached.
An equilibrium is stable if there are forces that move
market participants toward the equilibrium when
the market is not at the equilibrium.

The market mechanism: using prices to

allocate resources
The equilibrium price is often referred to as
the market-clearing price.
Supply and demand may not always be in
equilibrium, and some markets may not clear
as fast as others when conditions change
suddenly.
The assertion here is that there is a tendency
for markets to clear over time.

Other mechanisms that allocate resources

Consider a restaurateur finds that her establishment
has long lines waiting to eat. The reason? Possibly
that she underestimated demand. She might then
consider raising her prices.
Our hypothetical restaurateur may reduce portion size
or the quality of ingredients; or she may cram in more
tables (thereby reducing sq. ft. per diner). etc.
This can still be explained using the same analysis. It is
the quality controlled price that we are considering. To
lower the quality is to raise the quality controlled price.

7. Long run competitive supply

Recall what distinguishes short run from long run.
Recall that one of the defining characteristics of a
competitive industry was free entry and free exit.
So ... what sorts of things might happen in the long
run in industries where firms are incurring losses?
What about in industries where firms are reaping
large profits?
Is supply more or less elastic in the long run than in
the short run?

Competition in the long run

In the long run, all inputs are variable.
To qualify as a competitive industry, there
must be no legal restrictions or special
costs attending entry or exit. In other
words, free entry and exit.
Firms move to their long run cost curves.

Long run competitive equilibriums three

conditions:
1) All firms in the industry must be
maximizing profit.
2) No firm has an incentive either to enter or
to exit the industry.
3) The price of the product is such that the
quantity supplied by the industry is equal
to the quantity demanded by consumers.

Long run competitive equilibrium

$

ATC

MC
Supply

P
Demand

Qty.
q

Profit-maximizing firms
No incentive for entry or exit
supply = demand

Q
Q

Note the effect on social welfare

$

ATC

MC
Supply

P
Demand

Qty.
q

Q
Q

The industrys long run supply curve

We cannot derive the LR supply curve for the
industry using horizontal summation. Why not?
Because in the LR firms will enter and exit. We
dont know which firms supplies to add.
In the long run, we need to take into account
production technologies and input prices.
Current supply curves may not be relevant.

The industrys long run supply curve:

Lets suppose that an industry is in LR competitive
equilibrium initially:
$

ATC

MC
Supply

P
Demand

Qty.
Q

Here we have firms acting as price takers; we see

them earning zero economic profits; and we see
no incentive either to enter or exit the industry.

The industrys long run supply curve:

But now suppose there is an unanticipated increase in
demand:
$

ATC

New
Demand

MC
Supply

q q

Qty.
Q

Now we are out of equilibrium. The typical firm follows its

SR MC curve and increases output to q, and earns SR
profits. How do we get back to LR equilibrium?

The industrys long run supply curve:

Answer: New firms (in the long run) enter the industry, and they shift
the supply curve to the right.
For us to get back to LR equilibrium, supply must shift until firms are
earning zero economic profit again and there are no incentives to
enter/exit.
At what point will this occur? Well ... it depends upon the cost of the
inputs used to make this product.
In a constant-cost industry, the higher output can be produced without
an increase in the per unit price. This requires that the inputs used
to make this product do not increase in price as the demand for
them increases (e.g., if the primary input is unskilled labor, and the
market wage of such unskilled laborers is unaffected by the higher
output.)
The LR supply curve of a constant-cost industry is a horizontal line at a
price equal to LR minimum ATC.

In an constant-cost industry, the prices of

inputs stay the same as industry output
rises.
What does long run supply look like?

ATC

New
Demand

MC

Short-run
supply

q q

Qty.
In a constant cost industry, the new
short- run supply shifts out to the
point that the old price is the same
as the new price at the point at
which supply equals demand

In an increasing-cost industry, the prices of

some inputs increase as industry output
rises. The input could be the skill of
management at reducing costs.
$

ATC

New
Demand

MC

S1
S2

q q

Qty.
Q

Producer surplus in the long run

Only those on the margin will be at the minimum of
their ATC curve. From the previous slide we can
see that some firms are going to be above their
ATC curve. Or will they? Can you explain what is
going on here?

When can we apply the

competitive model?

It is never completely accurate. But there are many

industries for which it is a good approximation:
agriculture, commodities (excepting oil, diamonds,
and a few others), financial markets.
Many services (e.g., haircuts) also fit the model.
Many intermediate goods may also qualify.
But what about other goods, say fast food, where
the good is not perfectly homogeneous; where
firms are not, strictly speaking, price takers; and
where trademarks and patents throw up barriers?

Returns in LR Competition
In a perfectly competitive market, price
reflects production costs -- including any
opportunity costs that may arise -- and in
the LR, at least, firms earn zero economic
profits.
Note that though firms do not reap
supernormal gains, the owners of the superproductive inputs may earn handsome
returns.

What does price reflect?

Price does not represent any inherent value of
a good -- it only represents the markets
valuation of the good or service given market
conditions.

For example: Consider what would happen to

prices if all teenagers were suddenly given
more wealth.
Is the new pricing system and resulting
distribution of productive resources better or
worse than the previous distribution?

Does this apply? Almonds

(U.S. Farmers Feel Almond Joy, Chicago Tribune)
How would we represent this:
Besides being championed by trendy diets, almonds have benefited from
increasing awareness of their health attributes
What would we expect the result to be in the short run?
Almonds did something you never see in farming production is going up
and so are prices
And in the long run?
Almonds are so hot that California farmers are ripping up apricot orchards
and vineyards to plant almond trees. . . Investors in China are reportedly
testing ground for Almond production.

Does it apply when it is not a commodity?

Indoor Waterparks

Indoor water parks began in Wisconsin in the 1990s

Indoor water parks in 2000: 18

Indoor water parks today: 79

Opened in Sandusky in 2001

Violates PC no entry cost: Development and construction costs
~$40M, but . . .
There will be at least 5 by the end of 2005

The Dells region, 60 miles north of Madison, went from one resort to 18
in a decade.

Number of Water Parks in Mid-West

Number of Indoor Waterparks
State

2002

2003

2004

Wisconsin

25

28

32

Minnesota

10

14

15

Michigan

North Dakota

South Dakota

Montana

Ohio

Source: JLC Hospitality Consulting

Indoor Waterparks opening in 2005

Why might we observe this relationship between

price and occupied room nights?
Trends On The Supply In Wisconsin Dells Based On Seasonal Data
$160.00

$140.00
y = 0.0001x + 6.9658
R2 = 0.9373

Average Room Price ($)

$120.00
These Points Do Not Follow The
Price/Occupied Room Nights Trend.
Probably The Hotels With No Indoor Water
Parks do not want to reduce the price further
due to variable costs.

$100.00

$80.00

$60.00
Hotels With Indoor Water Parks
Hotels With Swimming Pools
Linear (Hotels With Indoor Water Parks)

$40.00

Linear (Hotels With Swimming Pools)

$20.00

$0.00
0

200000

400000

600000
Occupied Room Nights

800000

1000000

1200000

China Looks Beyond U.S. Farmers

To Satiate Its Growing Soybean Appetite
WSJ Aug 21, 2006

Rising prosperity is outstripping (China)s ability to meet demand internally for

certain basic commodities. . . To grow more soybeans, Chinese farmers would
have to buy more land or convert land used for other crops. With land prices
high and the amount of arable land limited, the cost of expanding domestic
production is often too expensive. Chinese farmers can't easily convert
existing crops to soybean production because of climate and weather
conditions. As a result, China is importing soybeans from countries where
they are less-expensive to produce.
U.S. soybean shipments to China had a value of $2.3 billion last year, more than
double the 2001 total . . . According to the U.S. Agriculture Department, U.S.
exports to China during the 2005-06 U.S. soybean marketing year will fall to
9.5 million metric tons from 11.8 million metric tons a year earlier.
Just as U.S. farmers did earlier this decade, South American farmers have stepped
up soybean production and exports. This year, South America will increase
production to 102 million metric tons, up 42% from 2001. South American
soybean exports should reach 39 million metric tons this year, up 50% from
2001.

And Bagels
For Bagel Chains (Wall Street Journal, Dec 30, 1997)

Bagels are booming in popularityThere is just one problem:

No one seems to be making much money selling them
Theres immense competition. Its growing way too fast,
said Bora Sila, an investment bankerEinstein/Noah Bagel
Corp., the nations largest chain of bagel shops in terms of
outletsexpects to incur a substantial loss for the period
because of a restructuring of its franchising systemEarly in
the industrys evolution, chains like Brueggers piled up
successes in part because they caught would-be
competitors unaware*T+oday all manner of vendors, from
Allied Domecq PLCs Dunkin Donuts to Starbucks Corp.,
have bagels on their menus. Even supermarkets in-store
bakeries turn out batches of bagels daily There are few
barriers to entry, said Mr. Sila.

Key Points
1. Setting Marginal Benefits equal to
Marginal Costs is always optimal.
2. A single price monopolist maximizes
producer surplus but is not concerned
with consumer surplus.
3. Surplus is not maximized with a single
price monopolist in the static model.
4. There are dynamic reasons to believe
monopolies are efficient.
5. In a competitive market, the MC curve
above the AVC is the single firm supply
curve (below the AVC, the firm is better
off not producing even in the short run).

Key Points
6.

7.
8.

The short run supply curve in a competitive market:

is the horizontal sum of the individual firm supply curves (MCs).
Is shifted by anything that changes variable costs
Is not affected by changes in fixed costs
Since MR=P for an individual firm in a perfectly competitive market,
P=MC is the profit maximizing solution.
The three conditions for a perfectly competitive market are:
1. Output is homogeneous
2. There are a large number of producers (so each one is a price taker)
3. Entry and exit is free in the long run

Key Points
9. A long run equilibrium exists when:
1. All firms are maximizing profits
2. The quantity demanded equals the quantity supplied
3. There is no incentive to enter or exit
10. In a perfectly competitive market:

total surplus is maximized

Economic profits can be positive in the short run
Economic profits are zero in the long run
11. In a constant cost industry the long run supply curve is flat; in an increasing
cost industry the long run supply curve is upward sloping.
12. Economic profits are the difference between revenues and all opportunity
costs.
13. While few if any markets are perfectly competitive, the model does a
remarkably good job of describing many industries