In this deck:
In the short run, some inputs are fixed (usually the plant), so fixed costs must be paid even at zero output. In the long run, every cost is variable.
For a price taker, AR is simply the market price.
A paper mill is a price taker. At its current output of 100,000 units a year:
So the breakeven price is USD 8 and the shutdown price is USD 5. Output is held at 100,000 units to keep the example simple.
If the mill shuts down, it still pays the fixed cost: a loss of USD 300,000. Compare that with operating. Move the price:
| Revenue test | Short run | Long run |
|---|---|---|
| AR ≥ ATC (TR ≥ TC) | Operate | Stay |
| AVC ≤ AR < ATC | Operate | Exit |
| AR < AVC (TR < TVC) | Shut down | Exit |
A firm facing a downward-sloping demand curve (a price searcher) has marginal revenue below price, so use the total form: TR versus TC and TVC.
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In the long run a firm can pick its plant size. The long-run average total cost (LRATC) curve shows the lowest ATC for each scale. It is usually U-shaped:
Lowest ATC by plant size (illustrative)
Economies of scale come from labour specialisation, mass production, better equipment and bulk discounts on inputs.
Diseconomies of scale come from bureaucracy, a harder-to-motivate workforce and less innovation.
The lowest point on the LRATC curve is the minimum efficient scale. Under perfect competition, firms must produce there in long-run equilibrium, where price equals minimum LRATC and economic profit is zero.
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Five factors place a market on the spectrum: the number and size of firms, product differentiation, pricing power, barriers to entry and exit, and non-price competition.
Each firm faces a horizontal (perfectly elastic) demand curve at the market price, such as wheat in a region.
A firm maximises profit where marginal revenue (MR) = marginal cost (MC).
The firm picks the quantity where MR = MC, then charges the highest price the demand curve allows for that quantity.
A toothpaste brand has MC of USD 4 per unit (units in thousands):
Optimal output is 8, at a price of USD 12. Price is above MR and MC.
Profits attract new firms, because barriers to entry are low.
Compared with perfect competition, price is higher and output lower. ATC isn't at its minimum, so firms carry excess capacity. The trade-off is product variety.
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In an oligopoly, firms are interdependent. The kinked demand curve model assumes rivals ignore a price rise but match a price cut.
The kink creates a gap in the MR curve. If MC passes through the gap, the kink price stays optimal even when MC shifts a little.
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Two firms with identical MC each assume the other won't change. In long-run equilibrium they split the market equally. Price is below the monopoly price but above the competitive price, and moves toward it as firms are added.
A Nash equilibrium is reached when no firm can do better by changing its choice alone, given what the others do. Two firms choose a high or low price (profits in USD thousands):
Nash equilibrium: A high, B low. Joint profit is 1,150.
Both charging high earns the most jointly: 800 + 500 = 1,300. If A pays B 150 to price high, A keeps 650 and B gets 650. Both beat their Nash profits of 550 and 600.
Collusion like this is illegal in many countries. A cartel such as OPEC breaks down when members cheat. Collusion lasts longer with fewer firms, similar products and costs, small frequent purchases, sure and severe retaliation, and little outside competition.
Measuring the elasticity of a firm's demand directly is hard, so regulators use market shares instead.
The N-firm concentration ratio adds the market shares of the N largest firms:
The Herfindahl-Hirschman Index (HHI) adds their squared shares:
Shares are 30%, 20%, 15%, 10%, then five firms at 5%. The two largest merge:
HHI = 0.09 + 0.04 + 0.0225 + 0.01 = 0.1625
The ratio barely moves. Squaring weights large firms heavily, so the HHI jumps.
To place a firm, look at the number of firms, barriers to entry, how close the substitutes are, and how firms compete.
Concentration measures help, but:
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That's the reading.
Now test it on exam-style questions while it's fresh.