Multiple-Output Cost Functions
• Multiproduct cost function defines the cost of producing given levels
of two or more types of outputs assuming all inputs are used efficiently
• Economies of scope exist when the total cost of producing and
together is less than the total cost of producing and separately
• Cost complementarities exist in a multiproduct cost function when the
marginal cost of producing one output is reduced when the output of
another product is increased
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Multiple-Output Cost Functions
If the multiproduct cost function is of the form
then
• When a < 0, an increase in Q2 reduces the marginal cost of
producing product 1.
• If a < 0, this cost function exhibits cost complementarity
• The cost function exhibits economies of scope when > 0 i.e.,
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Problem
Suppose the cost function of firm A, which produces two goods, is given by
The firm wishes to produce 5 units of good 1 and 4 units of good 2.
• Do cost complementarities exist?
• Do economies of scope exist?
• Firm A is considering selling the subsidiary that produces good 2 to firm B,
in which case it will produce only good 1. What will happen to firm A’s
costs if it continues to produce 5 units of good 1?
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EC ON OM IC S IN PRACTIC E
Flying Standby
In January 2013, a one-way ticket from New York to San Diego, California cost
about $500 on one of the major airlines. Alternatively, you could buy a Standby
ticket for $50 and wait around JFK airport hoping for a seat to San Diego. Why
would an airline offer a $50 seat for this flight? The answer has to do with
marginal costs.
THINKING PRACTICALLY
1. Thinking back to the lessons on opportunity cost earlier in the book, who do you expect
to see waiting in airports for a Standby seat?
2. And this harder question: Is there any business danger to the airline of having Standby
tickets?
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EC ON OM IC S IN PRACTIC E
The Fortunes of the Auto Industry
In 2010 the U.S. government was a “reluctant shareholder” in General Motors
to help the firm move out of the bankruptcy that it entered in 2009.
By 2010, General Motors had returned to profitability. The demand for autos
shifted right as the recession eased, and this allowed GM to raise prices and
sell more vehicles.
Improved sales also helped on the cost side. The auto industry exhibits large
economies of scale due in part to the large capital investment of the assembly
lines. In the 2008–2009 recession, the auto industry found itself with excess
capacity, and the per-unit costs of cars rocketed up. By using more of its
capacity, average costs fell, making for better profitability.
THINKING PRACTICALLY
1. How did this change the long-run AC curve?
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EC ON OM IC S IN PRACTIC E
Economies of Scale in the World Marketplace
In a world economy in which trade occurs across geographical boundaries, if
economies of scale exist, it is possible to exploit those economies across a very
large output base.
A single plant in Dongguan, China, produces more than 30 percent of the
world’s magnetic recording heads used in hard disk drives. Another plant in the
same city produces 60 percent of the electronic learning devices sold in the
United States, while a third plant produces 30 million mobile phones, again all in
one plant.
Clearly, the scale economies in these three sectors must be very large indeed.
Notice in the case of all three examples that products are also light and cost
very little to ship.
THINKING PRACTICALLY
1. Why is steel production much less concentrated than computer chips even though there
are large economies of scale in both industries?
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Perfect Competition
Market
• Market refers to the collective activity of buyers and sellers for a
particular product or service
• Economists usually classify market structures into four main types:
− perfect competition
− monopoly
− monopolistic competition
− oligopoly
• These classifications are based on characteristics like number of
sellers, type of product, barriers to entry, power to affect price and the
extent and type of non-price competition
Perfect Competition
• Competition is absence of monopoly power
• Perfect competition: markets where none of the participant have any
power to influence product price or quality
• Market situation where competition is at maximum
• Perfect competition is an ideal type of market structure
• It acts as theoretical framework helpful for understanding real-world
markets and a yardstick against which real-world situations can be
evaluated
Perfect Competition: Characteristics
• Price Taking
− Large number of buyers and sellers
− Each firm (consumer) sells (buys) a small proportion of total output
− Firms' decisions have no impact on the market price
• Product Homogeneity
− All the firm produce an identical product
− Products are perfectly substitutable
− Ensures single market price
• Free Entry and Exit
− No special costs that act as entry or exit barrier
− Allows consumers to switch to rival firm in case a supplier increases price
− Firm can enter (exit) if there is profit (loss)
FIGURE 8.9 Demand Facing a Single Firm in a Perfectly Competitive Market
If a representative firm in a perfectly competitive market raises the price of its output
above $5.00, the quantity demanded of that firm’s output will drop to zero.
Each firm faces a perfectly elastic demand curve, d.
Total Revenue and Marginal Revenue
total revenue (TR) The total amount that a firm takes in from the sale of its
product: the price per unit times the quantity of output the firm decides to
produce (P x q).
total revenue price quantity
TR P q
marginal revenue (MR) The additional revenue that a firm takes in when it
increases output by one additional unit. In perfect competition, P = MR.
The marginal revenue curve and the demand curve facing a competitive firm are
identical. The horizontal line in Figure 8.9(b) can be thought of as both the
demand curve facing the firm and its marginal revenue curve:
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Profit Maximization
• Do all the firms intend to maximize profits??
Profit Maximization
Profit is difference between Total Revenue and Total Cost
Slope of TR: Marginal Revenue (MR)
Slope of TC: Marginal Cost (MC)
Profit Maximization Condition:
Profit Maximization Condition
When is maximum,
Demand and Marginal Revenue: Competitive Firm
• Is demand curve and MR curve the same?
• MR curve, AR curve and demand curve would be the same for a firm in
perfectly competitive market
• What does the price taker feature suggest about the demand curve?
• The demand curve would be a horizontal line
Demand and Marginal Revenue: Competitive Firm
Price Price
Short Run Profit Maximization: Competitive Firm
Short Run Profit Maximization: Competitive Firm
• Perfectly competitive market allows free entry and exit in the long run
• When should a firm choose to shut down its operations?
• In the short run: when Price equals AVC
Supply and Marginal Cost: Competitive Firm
• Is Supply curve and MC
curve the same?
video on perfect competition - Google Search
Industry’s Long Run Supply Curve
• The long run supply curve depends on the nature of the industry
• Constant-cost Industry
• Increasing-cost Industry
• Decreasing-cost Industry
Long Run Supply Curve: Constant Cost Industry
Long Run Supply Curve: Increasing Cost
Industry
Practice Problems
Suppose you are the manager of a watchmaking firm operating in a
competitive market. Your cost of production is given by where q is the
level of output and C is total cost.
• If the price of watches is $100, how many watches should you produce to
maximize profit?
• What will the profit level be?
Practice Problems: Solution
Given:
Profit Maximization condition for perfect competition:
and
Practice Problems
Suppose that a firm’s production function is in the short run , where there
are fixed costs of 1000, and x is the variable input whose cost is 4000 per
unit.
a. Specify the cost function of the firm
b. Write down the equation for the supply curve.
Practice Problems: Solution
Cost function
Practice Problems: Solution
The firm supplies output where P = MC as long as MC > AVC
Here, MC and
AVC
So the entire MC curve is the supply curve.
Supply Curve P =
i.e., q = 0.010125P
Practice Problems
Suppose you are given the following information about a particular industry
Assume that all firms are identical, and that the market is characterized by perfect competition.
a) Find the equilibrium price, the equilibrium quantity, the output supplied by the firm, and the
profit of each firm.
b) Would you expect to see entry into or exit from the industry in the long run? Explain. What
effect will entry or exit have on market equilibrium?
c) What is the lowest price at which each firm would sell its output in the long run? Is profit
positive, negative, or zero at this price? Explain.
d) What is the lowest price at which each firm would sell its output in the short run? Is profit
positive, negative, or zero at this price? Explain.
Practice Problems: Solution
For Price determination:
Industry Output:
Firm Output:
Profit:
Practice Problems: Solution
In the long run – profit equals zero, i.e., Price would be equal to min AC
At min of AC:
At ,
the firm will not sell for any price less than Rs. 3.80 in the long run
Practice Problems: Solution
In the short run: The firm will sell its output if price is above average variable
cost. This implies that firm’s short-run supply curve is the portion of its
marginal cost curve that lies above its average variable cost curve.
In our case, and
So, always.
Therefore, firm will sell its output at any price above zero in the short run
Readings
Microeconomics by Pindyck & Rubinfeld – Chapter 8 (Section 8.1, 8.2, 8.3,
8.4, 8.5, 8.7, 8.8)
