The last few sections of the course focus on the variety of market structures that can exist in an economy: perfect competition, monopoly, oligopoly, and monopolistic competition. Market structures differ depending on the degree of competition: are there many firms producing an identical good? or, are there many firms producing a slightly differentiated good? or, is there a single producer of the good? or, are there just a few producers competing over market share?
Our study will focus on the factors that lead to different competitive market structures, as well as the implications for prices and quantities sold in market equilibrium. There are also important policy implications that differ depending on the degree of competition in markets.
In order to study markets, we need to better understand firm behavior. In particular, firms maximize profits. That is, they will choose to produce at the point where profits are greatest, i.e. where revenue exceeds costs at the highest point.
To understand how firms maximize profits -- which depends, of course, on how much competition they face from other firms -- we first have to understand the types of costs firms incur. That is the subject of this interactive page.
Below, there is a brief introduction to the costs -- definitions, mostly -- before the interactive graphs. This page, more than the others, is a supplement to the lecture videos and reading. It is designed entirely to give you hands on experience at seeing how changing a few factors affects all of the firm's cost curves. This section of the course is foundational for the remaining weeks' material.
Cost Curves Definitions
- Total Revenue: price times quantity.
- Total Cost: Market value of the inputs used in production.
- This is economic cost, it includes opportunity costs.
- Total Cost=Fixed Costs + Variable Costs.
- There is a close relationship between the production function and the total cost function. That is, firms that can produce more with a given level of input have lower costs of production, i.e. they are more efficient.
- Fixed costs: costs that are incurred that are independent of the level of production, i.e. building a factory.
- Variable costs: costs that are incurred that vary with the level of production, i.e. labor.
- Marginal costs: answers the question, how much does it cost to to increase production by 1 unit?
- Average costs: answers the question, how much does it cost to produce a typical unit of the good?
- Average Total Cost (ATC): Total Cost/Quantity.
- Average Variable Cost (AVC): Variable Cost/Quantity.
- Average Fixed Cost (AFC): Fixed Cost/Quantity.
Slopes of the Cost Curves
- Marginal Cost eventually is increasing in production -- recall diminishing marginal returns means that a firm needs more inputs to produce an extra unit of the good as the firm produces more and more.
- Average Fixed Costs are decreasing in production: it is a fixed cost divided by quantity.
- Average Variable Costs, for the same reason as marginal cost, is eventually increasing in production.
- Average Total Cost is decreasing for low production levels but eventually is increasing in production:
- At low quantity levels, Total Costs are mostly made up of fixed costs, so the ATC curve is very close to the AFC for low quantity.
- At high quantity levels, Total Costs are mostly made up of variable costs, so the ATC curve is very close to the AVC for high quantity.
- Marginal Cost crosses the ATC at the minimum of ATC.
The following interactive graphs are designed to give you hands-on practice at how the graphs can change with a variety of factors.
Changing Fixed v. Variable Costs
In the following graph, there are two costs that you can change: a fixed and a variable cost. In the example, the fixed cost is the rental price of capital. Capital -- e.g. machines, factories, etc. --is a fixed cost in the short-run since it takes time to build or acquire new capital. The rental price of capital is the term economists use to describe the cost of capital, it includes both explicit and implicit costs. The implicit cost would include the opportunity cost of funds used to acquire capital such as other investments that the firm could have made. The variable cost in the example is labor, with the cost of labor being the wage rate.
Taxes and Production Costs
Here we consider two different types of taxes levied on firms:a lump-sum per-firm tax, and a per-unit sales tax. The former affects firms' fixed costs, while the latter affects their marginal and variable costs. Check out the interactive graphic for how it affects their cost curves.