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How Firms Behave (and what it means for competition)

Session 5 – Thinking Like an Economist – Prof. Carlos Serrano

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OPENING STORY: BACK TO OIL

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A 2016 QUESTION: WHO WILL SURVIVE?

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A 2016 QUESTION: WHO WILL SURVIVE?

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A 2016 QUESTION: WHO WILL SURVIVE?

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REVISITING SUPPLY

The curve is about a go/no-go decision

Those who decide to supply have costs that are lower (or equal to) the market price.

In fact, in the generic sense, the supply curve addresses the following question: “If the price is p for a given period, how many firms will produce and in what quantity?” In deciding whether to produce or not at a given price, each firm will compare that price to the “cost of production” – though this cost of production may need to be defined.

In the short run, the question is, if the market price is p, how much q will existing units produce at a given time horizon?

In the long run, the question is, if the market price is durably equal to p, how much q will existing and future units produce?

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REVISITING SUPPLY

The curve is about a go/no-go decision

There is a direct link between price and cost of production as a result.

That “cost” will be the main driver of a go/no-go decision of a typical firm. But there may be many production costs, all calculated in different ways. Which benchmark will a typical firm choose?

We’ll describe a typical firm and explain how it is likely to behave – independent of the market structure. This will help us determine how it might react in different competitive settings.

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LEARNING OBJECTIVES

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WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be able to…

Define the costs that matter most to economists

Describe the process through which a firm decides to continue to produce or not according to microeconomics

Understand the meaning of the marginal cost and its potential implications for business strategy

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THE THEORY

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MEET THE FIRM

How the typical actor is supposed to behave

Here’s a question:

At what time did you wake up?

Microeconomics is interested in trade-offs, that is, in measuring the relative values of different alternatives:

Sleep vs. Waking up earlier
Working vs. Leisure time

In deciding whether or not to undertake an action, actors will assess costs and benefits at the margin. This means conduct marginal analysis: would (starting) or continuing what you are doing increase your payoffs? When should you stop?

This is how rational actors are expected to behave.

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DO YOU REMEMBER WAL-MART

Putting yourself in Sam Walton’s shoes

Wal-Mart started with its first store in Bentonville, Ark. in 1962. The diffusion radiating out from this point was very gradual, in all directions.

What did Sam Walton wonder, in your opinion, when he was planning the location strategy for its stores?

Wal-mart’s decision whether to open an additional store and location primarily relied on a solid understanding of consumer preferences and responsiveness of demand as well as its cost structure.

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MEET THE FIRM

How the typical actor is supposed to behave

Now transpose this reasoning to the firm.

A rational firm is one which maximizes its profits over time. This is not an unreasonable assumption: those firms not maximizing profits are unlikely to sustain over time (unless they benefit from subsidies, which do not fully solve the sustainability question).

In practice, this means whether or not it should actually produce, and (once it has decided to produce) whether or not it should continue to produce. Would an extra unit lead to it to make money?

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MEET THE FIRM

How the typical actor is supposed to behave: Key concepts

For the purpose of this class, we’ll reason in a long-term world (in which there are no fixed costs). We need to introduce two key, microeconomic concepts: marginal cost (MC) and marginal revenue (MR).

Marginal revenue and cost are the value associated with the (single) extra unit produced or to be produced:

Marginal revenue = How much do I earn from producing one additional unit?
Marginal cost = How much does it cost do produce one additional unit?

Mathematically, marginal revenue is given by the differentiation of the revenue function of a firm with regards to quantity – that is, the principal lever of action of the firm. For instance, when price P is independent of the number of units sold, marginal revenue is equal to P.

Mathematically, marginal cost is given by the differentiation of the cost function of a firm with regards to quantity.

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Learning by doing and task specialization lead a firm to become more efficient at what it does

The minimum efficiency scale defines the output (or range of output) where the firm has reached the lowest feasible cost per unit given its cost structure.

To study in more detail how marginal analysis influences the firm in its actions, I will soon make the simplifying assumption that MC is constant. But before I do this, I want you to understand the general cost structure of a firm and some insights associated with it, and how can you this knowledge to your advantage when running or managing a business.

Economies of scale can be consistent with:

1. If the firm operates on a larger scale, workers can specialize in the activities at which they are most productive.

2. Scale can provide flexibility. By varying the combination of inputs utilized to produce the firm’s output, managers can organize the production process more effectively.

3. The firm may be able to acquire some production inputs at lower cost because it is buying them in large quantities and can therefore negotiate better prices.

AC(Q) = average cost of production. The MES is the Q of minimizes the AC(Q). The minimum of AC(Q) is where MC((Q) crosses the AC(Q).

Economies of scale = per-unit cost of production decrease when output is increased.

Minimum efficient scale affects the number of firms that can operate in a market, and the structure of markets. When minimum efficient scale is low, relative to the size of the whole industry, a large number of firms can operate efficiently, as in the case of most retail businesses, like corner shops and restaurants.

�As a company grows, the inability to control larger companies and the increased costs of operation results in diseconomies of scale. An organization cannot experience economies of scale beyond the point of the minimum efficient scale. The minimum efficient scale affects the structure of the market.

The concept of minimum efficient scale is useful in determining the likely market structure of a market. For instance, if the minimum efficient scale is small relative to the overall size of the market (demand for the good), there will be a large number of firms. The firms in this market will be likely to behave in a perfectly competitive manner due to the large number of competitors.^[3]However, if the minimum efficient scale can only be achieved at a significantly high levels of output relative to the overall size of the market, the number of firms will be small, the market is likely to be a oligopoly or monopoly market.

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MEET THE FIRM

How the typical actor is supposed to behave: Key concepts (side note)

So, in theory, we expect the marginal cost (MC) curve to be U-shaped like the average total cost (AC) curve (for the exact same reasons: initial economies of scale are likely to phase out as a business grows).

In this class, in order to simplify and to get to the point, we’ll assume that MCs are constant. This means that technology remains stable. And in the long run, with no fixed costs, the average total cost (AC) is equal to the marginal cost independent of how much it is produced.

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Learning by doing and task specialization lead a firm to become more efficient at what it does

The minimum efficiency scale defines the output (or range of output) where the firm has reached the lowest feasible cost per unit given its cost structure.

Cost

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MEET THE PROFIT-MAXIMIZING FIRM

The firm’s roadmap

How will this influence the firm in its actions?

The Excel way:

Profit is a straightforward notion and is the value we seek to maximize. The most basic definition is: π = Revenues – Costs = P(Q)*Q – C(Q)

Marginal profit is the profit generated by the sale of one extra unit. It is given by the difference between marginal revenue and marginal cost. Equivalently, it is obtained by differentiating the profit function with regards to quantity.

At each stage of the production process, a positive marginal profit contributes to overall profits. A marginal profit equal to 0 does not mean profits are equal to 0 but that they are not increasing anymore. That’s the point at which the firm stops.

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MEET THE PROFIT-MAXIMIZING FIRM

The firm’s roadmap

How will marginal analysis influence the firm in its actions?

Next, a graphical way: Imagine that a firm faces the following demand curve: P = 45 – 2Q. This means that for every additional unit it sells, the price drops by 2. This has a contradictory effect on revenues: quantities sold increase yet the price at which it sold decreases. The profit-maximizing firm needs to strike the right balance.

Let’s also assume that it faces a constant marginal cost of 10. It faces no fixed costs and it incurs a cost of 10 for each additional unit it produces.

The profit function is given by:

π = (45 – 2Q)*Q – 10 Q;
It displays a maximum we can see in Excel and we can compute using differentiation.

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The derivative of a function provides the slope of the function at a given point

This is the maximum of the function. What is special about the slope of the curve at this point?

Derivatives can be a very useful tool to resolve many of our profit-maximizing issues

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Finding this point means answering the question: When is the derivative of this function equal to 0? Or: When are marginal revenue and marginal costs equal?

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MEET THE PROFIT-MAXIMIZING FIRM

The firm’s roadmap

How will this influence the firm in its actions?

The mathematical way:

Remember, the profit function is given by:

π = (45 – 2Q)*Q – 10 Q = 45Q – 2Q² – 10 Q = 35Q – 2Q²

It displays a maximum we can see in Excel. In this problem, the firm needs to decide how much to produce in order to maximize its profits – Q is the variable it chooses.

The firm will continue to produce until profits have reached a maximum, that is, until marginal profit does not contribute to profits anymore – namely when it is equal to 0.

If we differentiate with regards to Q, we get an expression for marginal profit:

mπ = 35 – 4Q

Marginal profit ceases to contribute to overall profits when it’s equal to 0, that is when the firm has produced 8.75 units of goods. Producing this amount will maximize the firm’s profits.

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WHY THIS MATTERS

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MEET THE PROFIT-MAXIMIZING FIRM

The bottom line on the firm’s roadmap

A firm continues to operate so long as marginal profits are positive, that is, so long as marginal revenue exceeds marginal cost and until marginal revenue equals marginal cost. In other words, a firm continues to produce so long as an extra sale generates a revenue greater than the cost of producing that extra unit, the firm produces

This is an essential result regarding the profit-maximizing firm behavior:

It will look to set MR == MC;
This is the equivalent of saying it produces until marginal profit reaches 0.

The marginal cost is therefore the benchmark that drives the decision of a firm to continue to produce or to stop. It is a measure of the firm’s competitiveness.

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MEET THE PROFIT-MAXIMIZING FIRM

Use of marginal analysis

Marginal analysis can be used to create controlled experiments to learn about firm’s cost structure…

For example, the tool can be used to evaluate the impact of increasing production at a given percentage on cost and revenues.

A positive result is achieved when the marginal cost is reduced or the increased revenues cover the higher production costs, i.e., MR(Q)>MC(Q). If the experiment yields a positive result, incremental steps will be taken until it yields a negative outcome.

Source: Freepik.com

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MEET THE PROFIT-MAXIMIZING FIRM

The bottom line on the firm’s roadmap

In addition…

What is the lowest bound possible for MC?

When does this occur?

This opens up a whole new avenue when it comes to new business models…

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HOW COULD THIS END UP ON THE FINAL TEST

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MEET THE PROFIT-MAXIMIZING FIRM

The firm’s roadmap

How will this influence the firm in its actions?

The mathematical way:

Remember, the profit function is given by:

π = (45 – 2Q)*Q – 10 Q = 45Q – 2Q² – 10 Q = 35Q – 2Q²

It displays a maximum we can see in Excel. In this problem, the firm needs to decide how much to produce in order to maximize its profits – Q is the variable it chooses.

The firm will continue to produce until profits have reached a maximum, that is, until marginal profit does not contribute to profits anymore – namely when it is equal to 0.

If we differentiate with regards to Q, we get an expression for marginal profit:

mπ = 35 – 4Q

Marginal profit ceases to contribute to overall profits when it’s equal to 0, that is when the firm has produced 8.75 units of goods. Producing this amount will maximize the firm’s profits.

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KEY TAKE-AWAYS

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WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be able to…

Define the costs that matter most to economists

Describe the process through which a firm decides to continue to produce or not according to microeconomics

Understand the meaning of the marginal cost and its potential implications for business strategy

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