Reading 12

In economics, we define the short run for a firm as the time period over which some factors of production are fixed. Typically, we assume that capital is fixed in the short run so that a firm cannot change its scale of operations (plant and equipment) over the short run. All factors of production (costs) are variable in the long run. The firm can let its leases expire and sell its equipment, thereby avoiding costs that are fixed in the short run.

Shutdown and Breakeven Under Perfect Competition

As a simple example of shutdown and breakeven analysis, consider a retail store with a one-year lease (fixed cost) and one employee (quasi-fixed cost), so that variable costs are simply the store's cost of merchandise. If the total sales (total revenue) just cover both fixed and variable costs, price equals both average revenue and average total cost—so we are at the breakeven output quantity, and economic profit equals zero.

During the period of the lease (the short run), as long as items are being sold for more than their variable cost, the store should continue to operate to minimize losses. If items are being sold for less than their average variable cost, losses would be reduced by shutting down the business in the short run.

In the long run, a firm should shut down if the price is less than average total cost, regardless of the relation between price and average variable cost.

For a firm under perfect competition (a price-taker), we can use a graph of cost functions to examine the profitability of the firm at different output prices. At price \(P_1\), price and average revenue equal average total cost. At the output level of Point A, the firm is making an economic profit of zero. At a price above \(P_1\), economic profit is positive, and at prices less than \(P_1\), economic profit is negative (the firm has economic losses).

Because some costs are fixed in the short run, it will be better for the firm to continue production in the short run as long as average revenue is greater than average variable costs. At prices between \(P_1\) and \(P_2\), the firm has losses, but the losses are smaller than would occur if all production were stopped. As long as total revenue is greater than total variable cost, at least some of the firm's fixed costs are covered by continuing to produce and sell its product. If the firm were to shut down, losses would be equal to the fixed costs that still must be paid. As long as price is greater than average variable costs, the firm will minimize its losses in the short run by continuing in business.

If average revenue is less than average variable cost, the firm's losses are greater than its fixed costs, and it will minimize its losses by shutting down production in the short run. In this case (a price less than \(P_2\)), the loss from continuing to operate is greater than the loss (total fixed costs) if the firm is shut down.

In the long run, all costs are variable, so a firm can avoid its (short-run) fixed costs by shutting down. For this reason, if price is expected to remain below minimum average total cost (Point A) in the long run, the firm will shut down rather than continue to generate losses.

To sum up:

• If \(AR \ge ATC\), the firm should stay in the market in both the short and long run.
• If \(AR \ge AVC\), but \(AR < ATC\), the firm should stay in the market in the short run but will exit the market in the long run.
• If \(AR < AVC\), the firm should shut down in the short run and exit the market in the long run.

The short-run shutdown point is where \(AR = AVC\). If average revenue is less than average variable cost in the short run, the firm should shut down. The long-run shutdown point is where \(AR = ATC\). The firm's breakeven point is where average revenue just equals average total cost (total revenue equals total economic cost).

Shutdown and Breakeven Under Imperfect Competition

For price-searcher firms (those that face downward-sloping demand curves), we could compare average revenue to ATC and AVC, just as we did for price-taker firms, to identify shutdown and breakeven points. However, marginal revenue is no longer equal to price.

We can still identify the conditions in terms of total costs and total revenue:

• TR = TC: break even
• TC > TR > TVC: firm should continue to operate in the short run but shut down in the long run
• TR < TVC: firm should shut down in the short run and the long run

Because price does not equal marginal revenue for a firm in imperfect competition, analysis based on total costs and revenues is better suited for examining breakeven and shutdown points.

Economies and Diseconomies of Scale

While plant size is fixed in the short run, in the long run, firms can choose their most profitable scale of operations. Because the long-run average total cost (LRATC) curve is drawn for many different plant sizes or scales of operation, each point along the curve represents the minimum ATC for a given plant size or scale of operations.

We draw the LRATC curve as U-shaped. Average total costs first decrease with larger scale, but eventually begin to increase with larger scale. The lowest point on the LRATC corresponds to the scale or plant size at which the average total cost of production is at a minimum. This scale is sometimes called the minimum efficient scale. Under perfect competition, firms must operate at minimum efficient scale in long-run equilibrium, and LRATC will equal the market price. Firms that have chosen a different scale of operations with higher average total costs will have economic losses and must either leave the industry or change to the minimum efficient scale.

The downward-sloping segment of the LRATC curve indicates that economies of scale (or increasing returns to scale) are present. Economies of scale result from factors such as labor specialization, mass production, and investment in more efficient equipment and technology. In addition, the firm may be able to negotiate lower input prices with suppliers as it increases in size and purchases more resources.

The upward-sloping segment of the LRATC curve indicates that diseconomies of scale are present. Diseconomies of scale may result as the increasing bureaucracy of larger firms leads to inefficiency, problems with motivating a larger workforce, and greater barriers to innovation and entrepreneurial activity. The U.S. auto industry is an example of an industry that has exhibited diseconomies of scale.

There may be a relatively flat portion at the bottom of the LRATC curve that exhibits constant returns to scale, or relatively constant costs across a range of plant sizes.

Recall from the prerequisite readings that perfect competition results in firm demand that is horizontal (perfectly elastic) at the market price. The firm demand curves for the three other market structures we discuss are all downward sloping. When a firm's demand curve slopes downward, marginal revenue (MR) is less than price. For both horizontal and downward-sloping demand curves, a firm will maximize profits by producing the quantity for which MR is just equal to marginal cost.

We can analyze where a market falls along the spectrum from perfect competition to pure monopoly by examining five factors:

1. Number of firms and their relative sizes
2. Degree to which firms differentiate their products
3. Bargaining power of firms with respect to pricing
4. Barriers to entry into or exit from the industry
5. Degree to which firms compete on factors other than price

Perfect competition refers to a market in which many firms produce identical products, barriers to entry into the market are very low, and firms compete for sales only on the basis of price. Firms face perfectly elastic (horizontal) demand curves at the price determined in the market because no firm has a large enough portion of the overall market to affect the market price of the good. The market for wheat in a region is a good approximation of such a market.

Monopolistic competition differs from perfect competition in that products are not identical. Each firm differentiates its product(s) from those of other firms through some combination of differences in product quality, product features, and marketing. The demand curve faced by each firm is downward sloping. Prices that producers charge are not identical because of perceived differences among their products, and typically, barriers to entry are low. The market for toothpaste is a good example of monopolistic competition.

The most important characteristic of an oligopoly market is that only a few firms are in the industry. In such a market, each firm must consider the actions and responses of other firms in setting price and business strategy—firms are interdependent. Barriers to entry are typically high, often because of economies of scale in production or marketing. The automobile market is dominated by a small number of large firms and can be characterized as an oligopoly.

A monopoly market is characterized by a single seller of a product with no good substitutes. High barriers to entry protect a monopoly producer from competition. One source of monopoly power is the protection offered by copyrights and patents. Most frequently, monopoly power is supported by specific laws or government regulation (e.g., a local electric utility).

Monopolistic competition has the following market characteristics:

• A large number of independent sellers. Each firm has a relatively small market share, so no individual firm has any significant power over price. Firms only need to pay attention to average market price, not the prices of individual competitors. There are too many firms in the industry for collusion (price-fixing) to be possible.
• Differentiated products. Each producer has a product that is, in some way, different from those of its competitors (in the minds of consumers). The competing products are considered close substitutes for one another.
• Firms compete less on price and more on marketing, perceived quality, and differences in features. Firms must make price and output decisions because they face downward-sloping demand curves.
• Low barriers to entry. The cost of entering the market and exiting the market are relatively low.

The price/output decision for monopolistic competition: firms in monopolistic competition maximize economic profits by producing where marginal revenue (MR) equals marginal cost (MC), and by charging the price for that quantity from the demand curve, D. In the short run, the firm earns positive economic profits because price, P*, exceeds average total cost, ATC*. Due to low barriers to entry, competitors can enter the market in pursuit of these economic profits.

In long-run equilibrium, after new firms have entered the market, the demand curve faced by each individual firm shifts down to the point where price equals average total cost (P* = ATC*), such that economic profit is zero. A firm in monopolistic competition continues to produce at the quantity where MR = MC, but it no longer earns positive economic profits. We can get to a similar long-run equilibrium even without entry of new firms if each firm increases its marketing spending until ATC has increased to equal price.

With monopolistic competition, price is greater than MC (i.e., producers can realize an economic profit in the short run), average total cost is not at a minimum for the quantity produced (suggesting excess capacity, or an inefficient scale of production), and the price is slightly higher than under perfect competition.

Compared to monopolistic competition, an oligopoly market has higher barriers to entry and fewer firms. The other key difference is that the firms are interdependent; a price change by one firm can be expected to be met by a price change by its competitors in response. Given this complicating fact, models of oligopoly pricing and profits must make numerous important assumptions. We describe four models:

1. Kinked demand curve model
2. Cournot duopoly model
3. Nash equilibrium model
4. Stackelberg dominant firm model

One traditional model of oligopoly, the kinked demand curve model, is based on the assumption that competitors are unlikely to match a price increase by a competing firm, but very likely to match a price decrease by a competitor. This results in a kink in the demand curves faced by each producer, at the current market price. Each firm believes that it faces a demand curve that is more elastic (flatter) above the current price than it is below the given price.

A firm believes that if it raises its price above \(P_K\), its competitors will remain at \(P_K\), and it will lose market share. Above \(P_K\), the demand curve is considered to be relatively elastic. On the other hand, if a firm decreases its price below \(P_K\), other firms will match the price cut, and all firms will experience a relatively small increase in sales relative to any price reduction. Therefore, \(Q_K\) is the profit-maximizing level of output. With a kink in the demand curve, we also get a gap in the associated MR curve. For any firm with a MC curve passing through this gap, the price where the kink is located is the firm's profit-maximizing price.

An early model of oligopoly pricing decisions is the Cournot model. In Cournot's duopoly model, two firms with identical MC curves each choose their preferred selling price based on the price the other firm chose in the previous period. Firms assume that the competitor's price will not change. The long-run equilibrium for an oligopoly with two firms (duopoly) is for both firms to sell the same quantity, dividing the market equally at the equilibrium price. The equilibrium price is less than the price that a single monopolist would charge, but greater than the equilibrium price that would result under perfect competition. With a greater number of producers, the long-run market equilibrium price moves toward the competitive price.

The Stackelberg model assumes pricing decisions are made sequentially. One firm, the "leader," chooses its price first, and the other firm chooses a price based on the leader's price. In long-run equilibrium, the leader charges a higher price and receives a greater proportion of the firms' total profits.

A more general model of strategic games was developed by Nobel Prize winner John Nash, who developed the concept of a Nash equilibrium. A Nash equilibrium is reached when the choices of all firms are such that there is no other choice that makes any firm better off (increases profits or decreases losses). The Cournot model results in a Nash equilibrium. In equilibrium, neither competitor can increase profits by changing the price they charge.

Firm A would not charge the low price (it would earn less regardless of Firm B's decision). Firm B can increase profits to 700 by charging a low price. With Firm A charging a high price and Firm B charging a low price, neither firm can increase profits by unilaterally changing its price strategy. Thus, the Nash equilibrium is: Firm B charges a low price and Firm A charges a high price.

Collusion refers to competitors making a joint agreement to charge a given price—or to agree to specific levels of output. In Figure 12.9, the greatest joint profits (1,600) are earned when both firms charge a high price. Collusion increases the profits of both firms compared to the Nash equilibrium. Such agreements among producers are illegal in many countries because they reduce competition.

An example of a collusive agreement is the OPEC cartel. Cartel-member countries agree to restrict their oil production to increase the world price of oil. Members sometimes choose to "cheat" on the cartel agreement by producing more than the amount they agreed to produce.

In general, collusive agreements to increase price in an oligopoly market will be more successful (have less cheating) under the following conditions:

• There are fewer firms.
• Products are more similar (less differentiated).
• Cost structures are more similar.
• Purchases are relatively small and frequent.
• Retaliation by other firms for cheating is more certain and more severe.
• There is less actual or potential competition from firms outside the cartel.

A final model of oligopoly behavior is the dominant firm model. In this model, a single firm has a significantly large market share because of its greater scale and lower cost structure—the dominant firm (DF). The market price is essentially determined by the DF, and the other competitive firms (CFs) take this market price as given. The DF believes that the quantity supplied by the other firms decreases at lower prices, so that the DF's demand curve is derived from the market demand curve. Based on this demand curve and its associated marginal revenue curve, the DF maximizes profits, and CFs maximize profits by producing where their MC equals the DF's price.

Overall, the resulting oligopoly price will be somewhere between the price based on perfect collusion (which is actually the monopoly price) and the price that would result from perfect competition (generating zero economic profits in the long run).

We can use the characteristics we outlined earlier to identify the type of market structure within which a firm is operating. For an analyst attempting to determine the degree of pricing power that firms in the industry have, the focus is on the number of firms in the industry, its barriers to entry, the nature of substitute products, and the nature of industry competition. Significant interdependence among firm pricing and output decisions is a characteristic of all oligopoly markets.

Regulators often use market shares (percentages of market sales) to measure the degree of monopoly or market power of firms in an industry. Often, mergers or acquisitions of companies in the same industry or market are not permitted by government authorities when they determine that the market share of the combined firms will be too high and, therefore, detrimental to the economy.

Market or industry concentration measures are often used as an indicator of market power. One concentration measure is the N-firm concentration ratio, which is calculated as the sum of the percentage market shares of the largest N firms in a market. While this measure is simple to calculate and understand, it does not directly measure market power or elasticity of demand.

One limitation of the N-firm concentration ratio is that it may be relatively insensitive to mergers of firms within an industry. This problem is reduced by using an alternative measure of market concentration, the Herfindahl-Hirschman Index (HHI). The HHI is calculated as the sum of the squares of the market shares of the largest firms in the market.

A limitation that applies to both of our simple concentration measures is that barriers to entry are not considered in either case. Even a firm with high market share may not have much pricing power if barriers to entry are low and there is potential competition. With low barriers to entry, it may be the case that other firms stand ready to enter the market if firms currently in the market attempt to increase prices significantly. In this case, the elasticity of demand for existing firms may be high, even though they have relatively high market shares and industry concentration measures.