MODULE 56 LONGRUN COSTS AND ECONOMIES OF SCALE

MODULE 56: LONG-RUN COSTS AND ECONOMIES OF SCALE Duffka School of Economics

Key Economic Concepts For This Module: All markets can be broadly classified into one of four principle market structures: perfect competition, monopoly, oligopoly, and monopolistic competition. Both perfect competition and monopoly are rare in the real world. These models are studied because they serve as benchmarks for the many realworld industries that lie between these two extremes. Perfect competition is a structure that has many price-taking firms that produce a standardized product and there are no barriers to entry or exit. Monopoly is a structure in which only one firm produces a product with no close substitutes and there exists at least one barrier to entry. Oligopoly is a structure that has only a few large firms in the market. These firms may produce either standardized or differentiated products. Barriers to entry exist and the firm engages in strategic behavior. Monopolistic competition is a structure in which many firms produce a differentiated product. There are no barriers to entry or exit.

Module Format & Topics I. Types of Market Structure II. Perfect Competition A. Defining Perfect Competition B. Two Necessary Conditions for Perfect Competition C. Free Entry and Exit III. Monopoly A. Defining Monopoly B. Why Do Monopolies Exist? IV. Oligopoly A. Is It an Oligopoly or Not? V. Monopolistic Competition

I. Types of Market Structure

I. Types of Market Structures Economists broadly define all industries as having one of four different market structures. These four structures include: perfect competition, monopoly, oligopoly, and monopolistic competition. There are many ways to separate markets into one of these four structures, but two important characteristics stand out. • How many firms are in the market? • Do they produce a differentiated or a standardized (identical) product?

I. Types of Market Structures Perfect competition: all firms produce a standardized product (soybeans) Monopolistic competition: products are differentiated (clothing) Oligopoly: both standardized (oil) and differentiated (soft drinks) exist. Monopoly: only one producer of a product with no close substitutes.

II. Perfect Competition A. Defining Perfect Competition No individual firm, or consumer, can affect the market price of the product being sold, or bought. The basic model of supply and demand assumes price-taking behavior. The equilibrium price is determined in the market and firms sell as much as they want at that price. Suppose the market price was $5. • If you could sell all you want at $5, raising your price to $5. 05 would be illogical when 1000’s of other identical sellers are charging $5. • If you lower your price to $4. 95, and you can sell all you want at $5, you’re losing profit. How could this situation arise? Two important characteristics are necessary.

II. Perfect Competition B. Two Necessary Conditions for Perfect Competition Why can’t firms control the price of the product? 1. Thousands of firms so NO market power. Market share for Firm Z = (Firm Z’s output)/(total combined output for all firms) If this market share is essentially zero, Firm Z could double or triple their output and total output in the market, and thus market price, would still be unaffected. 2. The product is identical. Imagine the many 1000 s of soybean farmers in the U. S. Each farmer produces a crop of soybeans that is identical to the crop of each of the other farmers. To a customer like General Foods, these soybeans are perfectly substitutable. If farmer Z tried to raise the price of his soybeans, General Foods would walk away and buy from any number of other identical soybean farmers.

II. Perfect Competition C. Free Entry and Exit It is easy for new firms to enter the industry or firms that are currently in the industry to leave. Freedom of entry and exit means that there are no significant obstacles preventing firms from entering or leaving the industry. Insures that the market will adjust quickly to the presence of economic profits or losses. If economic profits exist, new firms will enter the market and drive profits downward to zero. If economic losses are being incurred, existing firms will exit the market and drive losses upward to zero.

III. Monopoly WINNER OF MONOPOLY? All other players go bankrupt and forfeit properties, cash, and other assets to the lone remaining player. In other words, the winner is the only owner of real estate left standing. He or she is the monopolist. What does it mean to be a monopolist? How does a monopoly exist?

III. Monopoly A. Defining Monopoly A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly.

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. Examples: • Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication. • International Nickel Co. of Canada controlled about 90 percent of the world’s nickel reserves. • De. Beers of South Africa controls most of world’s diamond supplies. • Professional sports leagues control player contracts and leases on major city stadiums. • Brush Wellman controls the largest share of the world’s known sources of beryllium, a metal used in, among other things, the Space Shuttle and Hubble Telescope.

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. Examples: • Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication. • International Nickel Co. of Canada controlled about 90 percent of the world’s nickel reserves. • De. Beers of South Africa controls most of world’s diamond supplies. • Professional sports leagues control player contracts and leases on major city stadiums. • Brush Wellman controls the largest share of the world’s known sources of beryllium, a metal used in, among other things, the Space Shuttle and Hubble Telescope.

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. De. Beers would manipulate the supply of diamonds to keep the price high:

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. 2. Economies of scale The lowest LRATC and, therefore, low unit prices for consumers depend on the existence of a small number of large firms or, in the case of monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Public utilities are known as natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existing demand.

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. 2. Economies of scale 3. Technological Superiority. One firm controls the knowledge to make a particular product, so they become a monopolist. The text gives Intel as an example, but acknowledges that other companies (AMD to name one) have developed comparable technology in the production of microprocessors so Intel’s nearmonopoly has been eroded. This type of barrier usually doesn’t last because technology changes so rapidly.

III. Monopoly B. Why Do Monopolies Exist? 1. Ownership or control of essential resources. 2. Economies of scale 3. Technological Superiority. 4. Government created. Legal barriers to entry into a monopolistic industry also exist in the form of patents and copyrights. • Patents grant the inventor the exclusive right to produce or license a product for 16 -20 years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. • Copyrights gives the creator of a literary or artistic work the sole right to profit from that work, usually for a period equal to the creator’s lifetime plus 70 years.

IV. Oligopoly Think of an industry that is characterized by just a small number of huge companies. Think of two firms that try to steal customers from each other, maybe with high-profile advertising campaigns. Examples: • Coke and Pepsi • GM and Ford • Nike and Reebok • Apple and Microsoft • United Airlines and Delta These are all oligopolies and these firms are known as oligopolists.

IV. Oligopoly Like a monopolist, these firms have the ability to set the price of their products. In other words, they have some degree of market power. Some key characteristics of oligopolies include: • A few large firms that produce almost all of the total output in the industry. • Strong barriers to entry. • A product that could be identical (like oil) or differentiated (like cars). • Strategic behavior (game theory)—linkand mutual interdependence.

IV. Oligopoly A few large firms that produce almost all of the total output in the industry. Strong barriers to entry. A product that could be identical (like oil) or differentiated (like cars). Strategic behavior and mutual interdependence.

IV. Oligopoly

IV. Oligopoly

IV. Oligopoly A. Is It an Oligopoly or Not? One of the key indicators of an oligopoly is the level of concentration in the market. Essentially concentration describes how much of the market share is concentrated in the hands of the few largest firms in the market. Four-firm Concentration Ratio (CR 4): Add up the market share of the four largest firms in the industry. Example: • The four largest firms in industry A have market shares equal to: 30%, 20%, 10% and 5%. • CR 4 = 65%. The four largest firms have a combined 65% of the market. • Industry B has the four largest firms with market share equal to: 12%, 10%, 8% and 4% • CR 4 = 34%. If we compared these two industries, we would say that industry A has more concentration and is much closer to being an oligopoly than industry B.

IV. Oligopoly Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.

V. Monopolistic Competition Between perfect competition and oligopoly lies monopolistic competition. Characteristics: • Many firms exist in the market, but not as many as perfect competition. Monopolistic competition as measured in dozens of firms, while perfect competition is measured in hundreds of firms. • The product is differentiated. • Each firm has some ability to set the price of their product. • There are no barriers to entry or exit.

Key Economic Concepts For This Module: All markets can be broadly classified into one of four principle market structures: perfect competition, monopoly, oligopoly, and monopolistic competition. Both perfect competition and monopoly are rare in the real world. These models are studied because they serve as benchmarks for the many realworld industries that lie between these two extremes. Perfect competition is a structure that has many price-taking firms that produce a standardized product and there are no barriers to entry or exit. Monopoly is a structure in which only one firm produces a product with no close substitutes and there exists at least one barrier to entry. Oligopoly is a structure that has only a few large firms in the market. These firms may produce either standardized or differentiated products. Barriers to entry exist and the firm engages in strategic behavior. Monopolistic competition is a structure in which many firms produce a differentiated product. There are no barriers to entry or exit.

Practice Question 1 1. Which of the following is true for a perfectly competitive industry? I. There are many firms, each with a large market share. II. The firms in the industry produce a standardized product. III. There are barriers to entry and exit. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 2 2. Which of the following is true for a monopoly? I. There is only one firm. II. The firm produces a product with many close substitutes. III. The industry has free entry and exit. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 3 3. Which of the following is true for an oligopoly? I. There a few firms, each with a large market share. II. The firms in the industry are interdependent. III. The industry experiences diseconomies of scale. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 4 4. Which of the following is true for a monopolistically competitive industry? I. There are many firms, each with a small market share. II. The firms in the industry produce a standardized product. III. Firms are price-takers. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 5 5. Which of the following is an example of differentiated products? a. Coke and Pepsi b. automobiles and bicycles c. trucks and gasoline d. stocks and bonds e. gold and silver

Homogeneous Very easy Many Differentiated Relatively easy Few Either Very many One Price Taker Not easy Only product None Highly Efficient Somewhat. Considerable Some DWL Limited Considerable When More DWL differentiated Price Maker Somewhat Inefficient Impossible 0 Doesn’t exist, agriculture 0 Fast food, retail, cosmetics YES Cars, steel, computers, TV’s High Com. Ed, Ni. Cor