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
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Average size of firms
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Average size firms (Manufacturing)
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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
Typical average and marginal cost curves
/unit
Relationship between AC and MC
MC
If MC lt AC then AC is falling
AC
If MC gt AC then AC is rising
MC AC at the minimum of the AC curve (efficient
scale)
Quantity
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Economies of scale

• Definition average costs fall with an increase
  in output
• Represented by the scale economy index

AC(Q)
S
MC(Q)

• S gt 1 economies of scale
• S lt 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) Fq2/2
• 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
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Marginal costs and economies of scale

• Steeper marginal cost ? less economies of scale
• Lower efficient scale
• Example C(q) Fq2
• 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
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Economies of Scope

• 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 RD 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

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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, qqMES
• 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