Microeconomics: Costs, Market Structures, and Game Theory
Chapter 12 — Cost of Production
Cost Definitions and Key Formulas
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC).
Marginal Cost (MC) = ΔTC / ΔQ or ΔVC / ΔQ.
Average Fixed Cost (AFC) = Fixed cost / Quantity.
Average Variable Cost (AVC) = Variable cost / Quantity.
Average Total Cost (ATC) = Total cost / Quantity = AFC + AVC.
Profit Concepts
Accounting profit = Total revenue − Explicit costs.
Economic profit = Total revenue − Explicit costs − Implicit costs. (Economic profit = Accounting profit − Implicit costs.)
Explicit and Implicit Costs
- Explicit costs: Direct payments that require the firm to spend money.
- Implicit costs: Opportunity costs (the value of the next best alternative).
Fixed and Variable Costs
Fixed cost: Costs that remain constant regardless of output in the short run.
Variable cost: Costs that vary depending on the quantity produced.
Total cost = fixed cost + variable cost.
Marginal Product and Its Relation to Cost
Marginal Product (MP): Extra output from one more worker.
Marginal product = ΔQ of output / Δ number of workers.
Note: Marginal product can also be related to variable cost changes per additional output.
The Principle of Diminishing Marginal Product
- MP rises at first → MC falls.
- MP falls later (diminishing MP) → MC rises.
Marginal cost depends only on variable costs; fixed cost doesn’t affect MC.
Another expression: marginal product = change in output per extra worker; as MP falls, MC increases.
Interpreting MC and ATC
MC = cost of the next unit produced.
ATC = average cost per unit so far.
- When MC < ATC, ATC is falling.
- When MC = ATC, ATC is constant.
- When MC > ATC, ATC is rising.
- MC intersects ATC at the minimum of ATC.
In intuitive terms: MC pulls ATC. As marginal product (MP) decreases, MC increases (MP ↓ → MC ↑).
Short Run vs Long Run
Usually the short run has at least one fixed input that cannot be adjusted.
In the long run, firms can vary all inputs and all costs are variable; fixed costs in the short run can be adjusted in the long run.
Economies and Diseconomies of Scale
Economies of scale: ATC decreases as the firm grows.
- Downward slope → economies of scale (bigger firm → lower cost per unit).
- Flat bottom → constant returns to scale (bigger firm → same cost per unit).
- Upward slope → diseconomies of scale (bigger firm → higher cost per unit).
Chapter 13 — Perfect Competition
Basic Characteristics
In perfect competition, the market sets the price and individual firms are price takers: they can sell any quantity at the market price.
Marginal revenue (MR): In perfect competition, MR = P (price).
Profit Maximization and Short-Run Decisions
Firms increase output as long as MR ≥ MC. Profit is maximized where MR = MC, so in perfect competition P = MC at the profit-maximizing output.
Per-unit profit = P − ATC.
Profit outcomes:
- If P > ATC, the firm earns economic profit.
- If P = ATC, the firm earns zero economic profit.
- If P < ATC, the firm earns a loss.
Shutdown Rule
The shutdown point occurs when P = AVC. If P < AVC, the firm should shut down in the short run. If P ≥ AVC, produce where P = MC.
Ignoring Fixed Costs in the Short Run
We often ignore fixed costs when making short-run production decisions because fixed costs are sunk and do not affect marginal decisions.
Long Run in Perfect Competition
In the long run, all costs are variable; firms can enter and exit the market.
Long-run equilibrium: P = MR = MC = minimum ATC. Firms earn zero economic profit, and production is efficient.
Entry and exit: Economic profits cause firms to enter (increasing supply and lowering price); losses cause firms to exit (decreasing supply and raising price).
Firm exit effect: When firms exit a perfectly competitive market, price increases and the profits of remaining firms rise. If firms are earning economic profits, entry will occur, lowering price.
Market Supply
The short-run market supply curve is the horizontal sum of firms’ MC curves above AVC. The long-run supply can be flat at minimum ATC in the simplest model, but is often upward sloping due to cost differences across firms and resources.
Chapter 14 — Monopoly
Monopoly Characteristics
A monopoly is a market with a single seller, no close substitutes, and high barriers to entry.
Firms with monopoly power charge higher prices than would be charged in competitive markets because they have market power; monopolists are price makers.
Monopoly power reduces consumer surplus and total surplus.
Monopolies can earn greater profits than competitive firms and can persist because of barriers to entry such as scarce resources, aggressive business tactics, government intervention, or economies of scale.
Natural monopoly: A market where a single firm can produce the entire market quantity at lower cost than multiple firms.
Monopolist Pricing and Revenue
To sell more units, a monopolist must lower the price; conversely, to raise price, the monopolist must sacrifice some quantity demanded.
The marginal revenue (MR) curve faced by competitive firms is flat (horizontal), while the MR curve faced by a monopolist is downward sloping.
A monopolist should continue increasing production as long as MR ≥ MC.
Efficiency and Policy
Monopolies earn profits in both the short run and potentially the long run; quantity is not allocatively efficient compared to perfect competition.
Public policy solutions include:
- Antitrust laws
- Public ownership
- Regulation
- Vertical or structural separation
Chapter 15 — Monopolistic Competition and Oligopoly
Monopolistic Competition
Monopolistic competition: many firms selling similar but differentiated products, with relatively easy entry and exit.
Product differentiation is commonly achieved through advertising and branding.
In the long run, firms must continue innovating or differentiating to sustain profits; if competitors copy the product, demand for any one firm’s product will decline.
Monopolistically competitive firms behave like monopolies in the short run and like competitive firms in the long run.
Oligopoly
Oligopoly: a market with a few firms producing similar or identical products, where barriers to entry can be significant and firms are interdependent.
Oligopolists make strategic decisions about price and quantity that take into account the expected choices of competitors.
The act of firms working together to make decisions about price and quantity is collusion.
If the game is played repeatedly, firms may form a cartel (mutual agreement), choose to compete, or collude.
Chapter 9 — Game Theory
Simultaneous-Move Games and Nash Equilibrium
Simultaneous-move games: players choose strategies at the same time. A Nash equilibrium occurs when each player’s strategy is the best response to the strategies chosen by others.
A dominant strategy equilibrium is an equilibrium in which every player has a dominant strategy (a best strategy regardless of what others do). All dominant strategy equilibria are Nash equilibria, but not all Nash equilibria are dominant strategy equilibria.
Examples and Key Concepts
Prisoner’s Dilemma: The Nash equilibrium outcome is worse for all players than a cooperative outcome, despite each player acting in their own best interest.
Sequential Games and Backward Induction
Sequential game: a game in which players make some decisions at different times. Backward induction is analyzing the game from the end backward to determine the optimal strategy.
A subgame perfect Nash equilibrium is the outcome found using backward induction; it specifies optimal strategies for every subgame of the original game.
Additional Notes and Clarifications
MC pulls ATC: because marginal cost affects the direction of average total cost (when MC is below ATC, ATC falls; when MC is above ATC, ATC rises).
MC = next unit = cost of the next unit. ATC = average so far = cost per unit to date.
When the market price is below ATC but above AVC, the firm should produce in the short run (it covers variable costs but not all fixed costs).
Core idea in perfect competition: Market sets price; firm sets quantity; firms are price takers and can sell any quantity at the market price.
Profit maximization implications: a decrease in market price lowers the profit-maximizing quantity; if MC decreases, the profit-maximizing price and quantity may change accordingly.
When a competitive firm produces more, total revenue may increase, decrease, or stay the same; the same is true for a monopolist, but their MR and pricing constraints differ.
Long-run truth in perfect competition: firms maximize profit, minimize ATC, and earn zero economic profit in long-run equilibrium.
It is not possible for firms to earn positive economic profit in the long run in a perfectly competitive market, although they can earn profit in the short run; quantity is efficient in long-run equilibrium under perfect competition.