Profit Equation
Profits = TR - TC
Profits = P*Q - C(Q)
Profits = (P-ATC)*Q
Marginal Revenue
-Change in Total Revenue generated by selling one additional unit of output
-MR = (change in TR)/(change in quantity of output)
Marginal Cost
-The additional cost incurred by producing an additional unit of output
-MC = (change in TC)/(change in quantity of output)
Profit Maximizing Condition
-In order to maximize profits, a firm should continue to produce as long as the additional revenue from an additional unit of output is greater than the additional cost from an additional unit of output
-Keep producing as long as MR>MC
-Profit maximizing
In the long run, when should a firm shutdown?
TR<TC
In the short run, when should a firm shutdown?
TR<VC
Price-Taker
Takes the market price that's given and has no individual impact on market price
Price-Taking Producer
Producer whose actions have no effect on the market price of the good it sells
Price-Taking Consumer
Consumer whose actions have no effect on the market price of the good he or she buys
Perfectly Competitive Market
Market in which all market participants are price-takers
Perfectly Competitive Industry
Industry in which producers are price-takers
What are two key conditions for perfect competition?
1. For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share
2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent (homogeneous product)
T/F: A producer's market share is the fraction of the total industry output accounted for by the producer's output
True
Homogeneous product
Consumers regard the products of different producers as the same good
Free entry and exit ensures:
-The number of producers in an industry can adjust to changing market conditions
-Producers in an industry cannot artificially keep other firms out
Average Revenue (AR)
Revenue per unit of output
What is the relationship between MR, AR, and Price under perfect competition?
AR = MR = Price
T/F: A price-taking firm's profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price
True
What is the production decision in the short run of a firm in a perfectly competitive market?
Produce quantity where Price (MR) = MC
What is the shutdown decision in the short run of a firm in a perfectly competitive market?
Shutdown if Price < AVC
In the short run, when is a firm profitable?
Price > ATC
In the short run, when does a firm break even?
Price = ATC
In the short run, when does a firm incur a loss?
Price < ATC
What is the production decision in the long run of a firm in a perfectly competitive market?
Produce quantity where Price (MR) = MC
What is the shutdown decision in the long run of a firm in a perfectly competitive market?
-Shutdown if Price < ATC
-All costs are avoidable in the long run
T/F: Perfectly competitive firms earn zero economic profit in the long run
True - due to free entry and exit
When will firms enter a market?
-When profits > 0
-Leads to an increase in supply putting downward pressure on prices
When will firms exit a market?
-When profits < 0
-Leads to a decrease in supply putting upward pressure on prices
T/F: There is no incentive for firms to enter or exit when Profits = 0
True
Price Searcher
-Firms that have at least some influence on market price
-I.e. Monopoly and Oligopoly
Market Power
The ability of a firm to raise its price above the competitive level
What does the demand curve look like for a price taker?
-Horizontal demand curve - it can't affect the market price of the good
-Therefore, each additional unit sold provides additional revenue (marginal revenue) equal to the market price
What does the demand curve look like for a price searcher?
-Downward sloping demand curve - it can affect the market price so that in order to sell more output, it must lower the price and by reducing output, it raises the price
-Therefore, marginal revenue will not equal price
Monopoly
-Market with a single supplier of a good
-Choose price and quantity to maximize profits
-Constrained by the downward sloping Demand Curve
Profit Maximizing Condition for a Monopolist
-Keep producing as long as MR>MC
-Profit maximizing where MR=MC
T/F: In order to attract new customers, the monopolist must lower price
True
What effects does an increase in production by a monopolist have?
-Quantity effect
-Price effect
Quantity effect
One more unit sold increases total revenue by the price at which the unit is sold
Price effect
In order to sell the last unit, the monopolist must cut the market price on all units sold decreasing total revenue
T/F: For a monopolist, at any given quantity, marginal revenue will be less than price
True - therefore, the Marginal Revenue Curve will be lower than the Demand Curve at any given quantity produced
T/F: At low levels of output, the quantity effect is stronger than the price effect
True - as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small
T/F: At high levels of output, the price effect is stronger than the quantity effect
True - as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large
If demand for a good is elastic (quantity demanded will change with price):
-The quantity effect will dominate the price effect
-A decrease in price will increase total revenue
-If total revenue is increasing, marginal revenue must be positive
If demand for a good is inelastic (quantity demanded won't change with price):
-The price effect will dominate the quantity effect
-A decrease in price will decrease total revenue
-If total revenue is decreasing, marginal revenue must be negative
If demand for a good is unit elastic:
-The price and quantity effects will offset
-Marginal revenue will be zero
Monopolies produce when
Price > MR = MC
Compared with a competitive industry, a monopolist
-Produces a smaller quantity
-Charges a higher price
-Earns a profit in both short run and long run
T/F: Monopolist profits are the highest profits that can exist
True
What is the shutdown decision in the short run of a monopolist?
Shutdown if Price < AVC
What is the shutdown decision in the long run of a monopolist?
Shutdown if Price < ATC
T/F: Monopolist can charge a higher price than a perfectly competitive firm
True
Welfare Effects
-Monopolist charges a price higher than marginal cost and produces output at a level lower than the efficient, perfectly competitive output level
-As a result, monopolies cause deadweight loss to
Reason Monopolies Exist
Monopolist has market power:
-Charges a higher price than perfectly competitive outcome
-Produces a lower quantity than the perfectly competitive outcome
-Creates deadweight loss
-Generates economic profits for the firm
In order for profits to persist in
Barriers to Entry:
1. Control of scarce resources or input
2. Cost advantage - large fixed costs
3. Government created monopoly - government license and patents and copyrights
Government Regulation
-Break-up Monopoly (Anti-trust legislation)
-Price Regulation (Price Ceiling)
-Increase Competition (Grant more licenses)
Price Discrimination
Charging different prices to different consumers for the same good
T/F: Price Discrimination is profitable when consumers differ in their sensitivity to the price
True
What is the key element to Price Discrimination?
Elasticity: it is profit maximizing to charge a higher price to consumers who are relatively more price inelastic and charge a lower price to consumers who are more price sensitive (elastic)
What conditions are necessary for Price Discrimination?
1. Firms must have market power (Monopoly or Oligopoly)
2. Firm must be able to identify differences in willingness to pay between consumers
3. Firms must be able to limit resale of product
What are the types of Price Discrimination?
1. Perfect Price Discrimination
2. Quantity Discrimination
3. Multi-Market Price Discrimination
4. Two-Part Tariff
Perfect Price Discrimination
-Charge the maximum amount each consumer is willing to pay (Price = MV) and will continue to sell the good as long as Price exceeds the MC of producing an additional unit
What are the results when there is a Perfect Price Discrimination Monopolist?
-Net benefits to society are maximized (no deadweight loss)
-Same quantity produced with perfect competition
-All benefits go the the producer
Quantity Discrimination
-Firm charges a different price for large quantities than for small quantities of a good
-All customers who buy a given quantity pay the same price
-Takes advantage of downward sloping demand curves
Multi-Market Price Discrimination
-Firm charges different groups different prices according to willingness to pay for the group
-Most common type of Price Discrimination
How to identify different groups of customers for Multi-Market Price Discrimination?
1. Observable characteristics (I.e. age, location, etc.)
2. Get consumers to "self-select" themselves into different groups (I.e. coupon cutting, airline ticket purchases)
Two-Part Tariff
A pricing system in which the firm charges a customer a lump-sum fee for the right to buy as many units of the good as the consumer wants at a specified price
Imperfect Competition
-Competition among firms who have some market power
-Decisions made by each firm has an impact on the market
Types of Imperfect Competition
1. Non-Cooperative
2. Cooperative
3. Collusion
Non-Cooperative Imperfect Competition
Each firm makes decisions about output and price without consulting each other and these decisions impact each other
Cooperative Imperfect Competition
Decisions about output and price are made jointly
Collusions
Two or more firms acting together to set prices or quantity rather than competing
Cartel
Firms acting together as if a monopoly and split monopoly outputs and profits
What are the elements of game theory?
-Players (decision makers)
-Number of Periods
-Order of Play (simultaneous or sequential)
-Strategies
-Payoffs
-Equilibrium
Nash Equilibrium
-Occurs when, holding the strategies of all other players constant, no player can obtain a higher payoff by choosing a different strategy
-Given what the other players are currently doing, no player can gain by altering their own strategy
Dominant Strategy
-Strategy that gives the player a higher payoff no matter what strategy the opponent is playing
-Not all games have a dominant strategy
Ways to overcome the Prisoner's Dilemma
-Tit for Tat strategy
-Repeated games
-Enforceable contract
-Trust
Tit for Tat Strategy
Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period
Repeated Games
-If a game is played repeatedly, cooperation may occur
-Can work if long term gains from acting cooperatively outweigh the short term gain from not acting cooperatively
Enforceable Contract
Both sides sign an enforceable contract to take the mutually beneficial action
Oligopoly
-Market structure characterized by having a small number of producers
-Decisions made by each firm has an impact on the market
-Firms face downward sloping demand curve
Herfindahl-Hirschman Index (HHI)
-Measure of market concentration used by the Justice Department when evaluating potential mergers
-Calculated by squaring each firm's share of market sales and adding them together
HHI below 1,500
Unconcentrated, strongly competitive market
HHI between 1,500 and 2,500
Moderately concentrated market
HHI above 2,500
Highly concentrated market (Oligopoly)
General Standards for Mergers
1. Small change in concentration: mergers involving an increase in HHI of less than 100 points
2. Mergers in moderately concentrated markets: mergers involving an increase in HHI of more than 100 points
3. Mergers in highly concentrated markets: mergers i
T/F: If firms collude, they want to collectively produce the monopoly outcome
True
Why does a colluding Duopolist have an incentive to change production levels when a monopolist does not?
-Duopolist will face a much smaller Price Effect
-MR<MC for a monopolist lowering profits
-MR>MC for a colluding duopolist
Conditions for Cooperation
1. Repeated Interactions over time
2. Easy to monitor other firms
3. Entry by non-colluding firms is difficult
4. Merge
Antitrust Legislation
1. Restrict the formation of cartels and prohibit other collusive practices regarded as being in restraint of trade
2. Restrict mergers and acquisitions of organizations which could substantially lessen competition
3. Restrict the creation of a monopoly a
Sherman Antitrust Act
-Law attempts to prevent artificial raising of prices by restriction of trade or supply (conspiracy)
-Led to largest wave of mergers in U.S. history
Clayton Act
-Prohibited price discrimination and tying if substantially lessen competition or tends to create a monopoly
-Prohibits sales on the condition that buyer not transact with seller's competitors
-Prohibits mergers and acquisitions if substantially lessen co
Predatory Pricing
-Firm deliberately sets price below own average variable cost with the intent of driving rivals from the market
-Firm takes short term loss in order to drive competitors out of business
-Firm sets prices below own costs
U.S. Supreme Court Two Part Test
-Must be established that production costs are greater than market price
-Must be established that a "dangerous probability" exists that will subsequently raise prices sufficiently to recover losses
Market Failure
-The failure of a market to reach an efficient outcome where all gain from trade are exhausted
-Occurs when the quantity transacted differs from the efficient (welfare maximizing) quantity
-Results in deadweight loss
Externality
-When the activity of one entity (individual or firm) directly impacts the welfare of another in a way that is not reflected in the price
-"External" to the market
-Unintended impacts not taken into account by the individual decision makers
Negative Externality
-An action that imposes net costs on others without their being compensated
-The individual decision maker does not have to pay these costs, so does not take them into account when making decisions
-I.e. pollution, smoking, etc.
Private Cost
Cost incurred by the individual decision maker only
Marginal Private Cost
Incremental costs to private owner
Marginal External Cost
Uncompensated marginal costs imposed on others as a result of actions taken by individual decision maker
Social Cost
Total costs incurred by society
Marginal Social Cost
-Total marginal costs to society
-MPC + MEC = MSC
Positive Externality
-An action that provides net benefits to others without their having to pay for it
-The individual decision maker does not receive compensation for these benefits, so does not take into account when making decisions
-I.e. education, vaccines, etc.
Private Benefit
Benefits enjoyed by the individual decision maker only
Marginal Private Benefit
-Incremental benefits to private owner
-Individual marginal willingness to pay
Marginal External Benefit
Uncompensated marginal benefits provided to others as a result of actions taken by individual decision maker
Social Benefit
Total benefits enjoyed by society
Marginal Social Benefit
-Total marginal benefits to society
-MPB + MEB = MSB
What is the source of the problem of externalities?
-There is a lack of clearly defined Property Rights
-If Property Rights were clearly delineated then all costs and benefits of an action would be fully internalized
Legal Property Rights
Rights recognized and enforced by the government
Economic Property Rights
-Individual's ability to exercise control over the use of a good
-Includes exclusivity, ownership of income, and transferability
What is the private solution to an externality problem?
Coase Theorem
Coase Theorem
-If property rights are clearly defined and transaction costs are low then can get an efficient outcome through bargaining regardless of who owns the property rights
-Not necessarily equitable because whoever is assigned the property rights will influence
Transaction Costs
-Costs, other than price, associated with exercising economic property rights
-I.e. gathering information, costs of making legally binding agreements, costs of communication among interested parties, etc.
What is the government solution to an externality problem?
-Positive Externality: subsidy
-Negative Externality: tax and policies for pollution and tolls for traffic congestion