ECO 171: Costs and Market Structure 1 Costs and Market Structure

ECO 171: Costs and Market Structure

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Costs and Market Structure


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Basic ideas

• Determinants of market structure: how many firms in an industry?

• Economies of scale – Cost functions• Minimum efficient scale• Role of demand• Other determinants


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Size distribution U.S. Businesses: 2003

Estab-lish-

mentsAll firms 5,767,127 7,254,745Firms with no employees (as of March 12) 13.4% 10.6%Firms with 1 to 4 employees 47.4% 37.7%Firms with 5 to 9 employees 17.8% 14.3%Firms with 10 to 19 employees 10.8% 9.0%Firms with 20 to 99 employees 8.9% 9.5%Firms with 100 to 499 employees 1.5% 4.6%Firms with 500 employees or more 0.3% 14.2%

Employment size of enterprise Firms


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Average size of firms

Industry titleAverage

size(with link to definition)

Agriculture, Forestry, Fishing and Hunting 7Real estate & rental & leasing 8Other services (except public administration) 8Construction 9Professional, scientific, & technical services 10Wholesale trade 17Arts, entertainment, & recreation 17All industries 20Retail Trade 20Accommodation & food services 24Mining 25Transportation and Warehousing 25Finance & insurance 26Health care & social assistance 27Administrative & support & waste management & remediation service 28Educational services 40Information 48Manufacturing 48Utilities 95Management of companies & enterprises 104


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Average size firms (Manufacturing)Printing & related support activities 20Apparel mfg 23Miscellaneous mfg 23Textile product mills 27Furniture & related product mfg 27Fabricated metal product mfg 27Leather & allied product mfg 30Wood product mfg 35Nonmetallic mineral product mfg 42Machinery mfg 46Manufacturing 48Beverage & tobacco product mfg 58Food mfg 66Plastics & rubber products mfg 78Textile mills 80Electrical equipment, appliance, & component mfg 85Petroleum & coal products mfg 88Computer & electronic product mfg 88Chemical mfg 89Primary metal mfg 102Paper mfg 140Transportation equipment mfg 155


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Observations

• Huge variation in firm size• Causes?• Economies of scale• Market size


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Cost functions

• Cost = C(q)• Implicit technology and input prices• AC(q) = C(q)/q• MC(q) = dC/dq• Typical case: C(q) = VC(q) + F


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Cost curves: an illustration

$/unit

Quantity

AC

MC

Typical average and marginal cost curvesTypical average and marginal cost curves

Relationship between AC and MC

If MC < AC then AC is falling

If MC > AC then AC is rising

MC = AC at the minimum of the AC curve (efficient scale)


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Economies of scale

• Definition: average costs fall with an increase in output

• Represented by the scale economy index

S =AC(Q)

MC(Q)

• S > 1: economies of scale

• S < 1: diseconomies of scale

• S = 1 at point of Min avg cost

• Minimum efficient scale: smallest output level at which economies of scale are exhausted


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Economies of scale

• Sources of economies of scale– “the 60% rule”: capacity related to volume while cost is

related to surface area– product specialization and the division of labor– “economies of mass reserves”: economize on inventory,

maintenance, repair– Indivisibilities


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Fixed costs and economies of scale

• Larger fixed costs larger economies of scale• Larger efficient scale• Example: C(q) = F+q2/2

– MC = q

– AC = F/q + q/2

– Min AC : q = F/q +q/2 q/2 = F/q q2 = 2F q = sqrt (2F)

Min AC = Min MC also equal sqrt (2F)

• Min efficient scale increases with F


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Fixed costs and Economies of Scale

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

0.2 0.7 1.2 1.7 2.2 2.7 3.2 3.7 4.2 4.7 5.2 5.7 6.2 6.7 7.2 7.7 8.2 8.7 9.2 9.7 10.2 10.7 11.2 11.7 12.2 12.7 13.2 13.7

Output

Av

era

ge

co

sts

F=100

F=25


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Marginal costs and economies of scale

• Steeper marginal cost less economies of scale• Lower efficient scale• Example: C(q) = F+q2

– MC = q

– AC = F/q + q

– Min AC : 2q = F/q +q q = F/q q2 = F q = sqrt (F)

Min AC = Min MC = 2qMES= 2 sqrt(F)

• Minimum efficient scale smaller than before


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Marginal costs and Economies of scale

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

0.2

0.7

1.2

1.7

2.2

2.7

3.2

3.7

4.2

4.7

5.2

5.7

6.2

6.7

7.2

7.7

8.2

8.7

9.2

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10.2

10.7

11.2

11.7

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13.7

Output

Ave

rag

e co

sts

low marginal cost

high marginal cost


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• Producing goods jointly is cheaper• Similar to economies of scale• Sources of economies of scope• shared inputs

– same equipment for various products– shared advertising creating a brand name– marketing and R&D expenditures that are generic

• cost complementarities– producing one good reduces the cost of producing another– oil and natural gas– oil and benzene– computer software and computer support– retailing and product promotion

Economies of Scope


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Market Structure

• Economies of scale and scope affect market structure but cannot be looked at in isolation.

• They must be considered relative to market size.

• Should see concentration decline as market size increases – Entry to the medical profession is going to be more extensive in

Chicago than in Oxford, Miss

– Find more extensive range of financial service companies in Wall Street, New York than in Frankfurt


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Number of firms in Competitive Industry

• p = A – BQ

• Firms are price takers

• In long run equilibrium no further incentives to enter the industry. If firms are homogeneous, zero profits.

• Implies p = min AC, q=qMES

• Number of firms N so that: p = A-BNqMES

• N = (A – p)/BqMES

– Higher demand (higher A or lower B) more firms

– Lower qMES more firms

– Lower min AC lower p more firms


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Other determinants of Market structure

• Network externalities– willingness to pay by a consumer increases as the number of

current consumers increase• telephones, fax, Internet, Windows software

• utility from consumption increases when there are more current consumers

• These markets are likely to contain a small number of firms– even if there are limited economies of scale and scope


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Other determinants of Market structure

• Policy

• Government can directly affect market structure– by limiting entry

• taxi medallions in Boston and New York

• airline regulation

– through the patent system

– by protecting competition e.g. through the Robinson-Patman Act

Documents

ECO 171: Costs and Market Structure 1 Costs and Market Structure