Class 2 and 3Class 2 and 3

Figure 2.1  Short-run relationship between total, marginal and average product of labour

Figure 2.2  Short-run total cost, marginal cost, average variable and fixed cost, and short-run average cost

Figure 2.3  Increasing, constant and decreasing returns to scale

Figure 2.4  Long-run average cost and long-run marginal cost

Figure 2.5  Short-run and long-run average cost functions

Figure 2.6  Isoquant and isocost functions

Figure 2.7  Surface area and volume of small and large storage tanks

Figure 2.8  Long-run average cost functions with constant returns to scale

Figure 2.9  Total, average and marginal revenue

Theory of Perfect Competition and Theory of Perfect Competition and MonopolyMonopoly

Theory of the firmTheory of the firm

Edwin Chamberlein and Joan Robinson Edwin Chamberlein and Joan Robinson (1939)(1939)

Alfred Marshall (1890)Alfred Marshall (1890)

Augustin Cournot (1830)Augustin Cournot (1830)

Adam Smith (1770)Adam Smith (1770)

Developments in theory was built on the Developments in theory was built on the preceding analysis.preceding analysis.

Profit Maximization Profit Maximization

The coherent body of theory that explains The coherent body of theory that explains the determination of price and output for the determination of price and output for both the industry and the firm based on both the industry and the firm based on the assumption of profit maximization: the assumption of profit maximization: Neoclassical theory of the firm.Neoclassical theory of the firm.

Two most extreme cases: Two most extreme cases: – Perfect competitionPerfect competition– MonopolyMonopoly

The Neoclassical Theory of the The Neoclassical Theory of the FirmFirm

Perfect CompetitionPerfect Competition– Many firms, free entry, identical productsMany firms, free entry, identical products

Imperfect CompetitionImperfect Competition

Monopolistic CompetitionMonopolistic Competition– Many firms, free entry, some differentiationMany firms, free entry, some differentiation

OligopolyOligopoly– Few firms, barriers to entry, some differentiationFew firms, barriers to entry, some differentiation

MonopolyMonopoly– One firm, no entry, complete differentiationOne firm, no entry, complete differentiation

Perfect CompetitionPerfect Competition

Large numbers of buyers and sellers: Large numbers of buyers and sellers: AtomisticAtomistic

Firms are free to enter and exitFirms are free to enter and exit

Identical goodsIdentical goods

Perfect informationPerfect information

No transport costsNo transport costs

Firms act independentlyFirms act independently

Price taking behavior, i.e. horizontal firm-Price taking behavior, i.e. horizontal firm-level demand function, located at the level demand function, located at the current market price. Perfectly elastic current market price. Perfectly elastic demand. demand.

Firm’s demand function is its average Firm’s demand function is its average revenue function. AR=P.revenue function. AR=P.

Given that the firm’s demand or AR function Given that the firm’s demand or AR function is horizontal, AR=MR=Pis horizontal, AR=MR=P

Figure 2.10  Short-run pre-entry and post-entry equilibrium in perfect competition

Figure 2.11  Long-run post-entry equilibrium in perfect competition

MonopolyMonopoly

Large number of atomistic buyers, there is only Large number of atomistic buyers, there is only one seller.one seller.The selling firm’s demand function is the market The selling firm’s demand function is the market demand function and firm’s output decision demand function and firm’s output decision determine the market price.determine the market price.There are barriers to entryThere are barriers to entryGood or service produced and sold is uniqueGood or service produced and sold is uniqueBuyers and sellers have imperfect informationBuyers and sellers have imperfect informationGeographical locationGeographical locationSeek to max prifit.Seek to max prifit.

Figure 2.12  Long-run equilibrium in monopoly

Mathematical RepresentationMathematical Representation

For profit maximizing equilibrium for the For profit maximizing equilibrium for the case where LRAC and LRMC are case where LRAC and LRMC are horizontal (and equal): constant returns to horizontal (and equal): constant returns to scale.scale.

See appendix 1 for formal mathematical See appendix 1 for formal mathematical derivation (from the text book)derivation (from the text book)

Efficiency and Welfare PropertiesEfficiency and Welfare Properties

Comparison between long run industry Comparison between long run industry equilibrium under perfect competition and long equilibrium under perfect competition and long run profit maximization under monopoly:run profit maximization under monopoly:– Under monopoly, market price is higher and output is Under monopoly, market price is higher and output is

lower.lower.– The monopolist fails to produce at the minimum The monopolist fails to produce at the minimum

efficient scale and therefore fails tp produce at the efficient scale and therefore fails tp produce at the minimum attinable LRAC. The perfectly competitive minimum attinable LRAC. The perfectly competitive firm produces atthe minimum efficient scale.firm produces atthe minimum efficient scale.

– The monopoly earns an abnormal profit in the long The monopoly earns an abnormal profit in the long run.run.

Lerner Index for Market PowerLerner Index for Market Power

The degree to which price exceeds marginal The degree to which price exceeds marginal cost provides a useful indicator of market power.cost provides a useful indicator of market power.

Lerner IndexLerner Index

L=(P-MC)/PL=(P-MC)/P

In perfect competition P=MC and L=0In perfect competition P=MC and L=0

In monopoly, P>MC and if MC>0, 0>L>1In monopoly, P>MC and if MC>0, 0>L>1

For a profit maximizing firm MR=MC, Lerner For a profit maximizing firm MR=MC, Lerner index can be written as the recipricon of the index can be written as the recipricon of the firm’s price elasticity of demand.firm’s price elasticity of demand.

Welfare Properties of the Two Welfare Properties of the Two ModelsModels

Allocative efficiencyAllocative efficiencyProductive efficiencyProductive efficiency– Technical efficiencyTechnical efficiency– Economic efficiencyEconomic efficiency

Allocative efficiency: AE is achieved when there Allocative efficiency: AE is achieved when there is no possible reallocation of resources that is no possible reallocation of resources that could make one agent better off without making could make one agent better off without making one other worse offone other worse offNecessary condition for allocative efficiency: Necessary condition for allocative efficiency:

MB=MCMB=MC

If market price is considered as a measure If market price is considered as a measure of the value society as a whole places in of the value society as a whole places in the marginal unit of output produced, the marginal unit of output produced,

P=MCP=MC

If P>MC; value (WTP) exceeds cost If P>MC; value (WTP) exceeds cost (produce more)(produce more)

If P>MC; value (WTP) is less than cost If P>MC; value (WTP) is less than cost (produce less)(produce less)

Productive EfficiencyProductive Efficiency

Technical efficiency: Producing maximum Technical efficiency: Producing maximum quantity of output that is technologically quantity of output that is technologically feasible, given the quantities of the factor feasible, given the quantities of the factor inputs it is currently employing (operate on inputs it is currently employing (operate on its production function).. X-efficiency.its production function).. X-efficiency.Economic efficiency: Producing by Economic efficiency: Producing by selecting the combination of factor inputs selecting the combination of factor inputs that enable it to produce its current output that enable it to produce its current output level at the lowest cost. level at the lowest cost.

Figure 2.13  Allocative inefficiency in monopoly

Figure 2.14  Allocative inefficiency and productive inefficiency in monopoly

Figure 2.15  Natural monopoly

Monopolistic CompetitionMonopolistic Competition

Robinson (1933); Chamberlein (1933)Robinson (1933); Chamberlein (1933)Theory of imperfect competitiınTheory of imperfect competitiınMonopolistic competitionMonopolistic competition– Large number of atomistic buyers and sellersLarge number of atomistic buyers and sellers– Firms are free to enter and exit. No additional costFirms are free to enter and exit. No additional cost– Goods and services provided are similar but not Goods and services provided are similar but not

identicalidentical– Perfect or imperfect informationPerfect or imperfect information– GeographyGeography– Each selling firm seek to maximize profit.Each selling firm seek to maximize profit.

Figure 2.16  Short-run pre-entry and post-entry equilibrium in monopolistic competition