SECOND MEETING PJJ ECN3101: MICROECONOMICS SEMESTER 2, 2011/2012

1. SECOND MEETING PJJ ECN3101: MICROECONOMICSSEMESTER 2, 2011/2012

2. Chapter 8 Perfect Competition Market Structure, Profit Maximization and Competitive Supply

3. Topics to be Discussed • Perfectly Competitive Markets • Profit Maximization • Marginal Revenue, Marginal Cost, and Profit Maximization • Choosing Output in the Short-Run • The Competitive Firm’s Short-Run Supply Curve • Short-Run Market Supply • Choosing Output in the Long-Run Chapter 8

4. Perfectly Competitive Markets Basic assumptions of perfectly competitive markets • Many buyers and sellers • Each buys and sells only a small fraction of the total amount exchanged in the market • Standardized or homogeneous product • Buyers and sellers are fully informed about the price and availability of all resources and products • Firms and resources are freely mobile • Individual firms have no control over the price • Price is determined by market supply and demand • Firm is free to produce whatever quantity maximizes profit Chapter 8

5. Perfectly Competitive Markets 1.Price Taking • The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. • Each firm takes market price as given – price taker • The individual consumer buys too small a share of industry output to have any impact on market price. Chapter 8

6. Perfectly Competitive Markets 2. Product Homogeneity • The products of all firms are perfect substitutes. • Product quality is relatively similar as well as other product characteristics • Agricultural products, oil, copper, iron, lumber 3. Free Entry and Exit • There is no barriers or special costs that make it difficult for a firm to enter (or exit) an industry • Buyers can easily switch from one supplier to another. • Suppliers can easily enter or exit a market. Chapter 8

7. Marginal Revenue, Marginal Cost, and Profit Maximization • Profit maximizing output for any firm whether perfectly competitive or not basically focuses on • Profit () = Total Revenue - Total Cost • Total Revenue (R) = Pq • Costs of production depends on output • Total Cost (C) = Cq • Profit for the firm, , is difference between revenue and costs Chapter 8

8. Marginal Revenue, Marginal Cost, and Profit Maximization • Total revenue curve shows that a firm can only sell more if it lowers its price • Slope in total revenue curve is the marginal revenue • Slope of total cost curve is marginal cost • As output rises, revenue rises faster than costs leading to increasing profit • Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal Chapter 8

9. C(q) A R(q) B q* q0 (q) Profit Maximization – Short Run Profits are maximized where MR (slope at A) and MC (slope at B) are equal Cost, Revenue, Profit ($s per year) Profits are maximized where R(q) – C(q) is maximized 0 Output Chapter 8

10. Marginal Revenue, Marginal Cost, and Profit Maximization • Profit is maximized at the point at which an additional increment to output leaves profit unchanged Chapter 8

11. Price $ per bushel Price $ per bushel S $4 d $4 D Output (bushels) Output (millions of bushels) 100 200 100 The Competitive Firm Demand curve faced by an individual firm is a horizontal line – implies that firm’s sales have no effect on market price Demand curve faced by whole market is downward sloping Firm Industry Chapter 8

12. The Competitive Firm • The competitive firm’s demand • Individual producer sells all units for $4 regardless of that producer’s level of output. • MR = P with the horizontal demand curve • For a perfectly competitive firm, profit maximizing output occurs when Chapter 8

13. Choosing Output: Short Run • The point where MR = MC, the profit maximizing output is chosen • MR=MC at quantity, q*, of 8 • At a quantity less than 8, MR>MC so more profit can be gained by increasing output • At a quantity greater than 8, MC>MR, increasing output will decrease profits Chapter 8

14. MC Price Lost Profit for q2>q* 50 Lost Profit for q2>q* AR=MR=P 40 ATC AVC 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q1 q* q2 A Competitive Firm A The point where MR = MC, the profit maximizing output is chosenq*= 8 q1 : MR > MC q2: MC > MR q0: MC = MR Chapter 8

15. MC Price 50 A D AR=MR=P 40 ATC AVC 30 C 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q1 q* q2 A Competitive Firm – Positive Profits Total Profit = ABCD Profits are determinedby output per unit times quantity B Profit per unit = P-AC(q) = A to B Chapter 8

16. MC ATC B C D P = MR A AVC q* A Competitive Firm – Losses Price At q*: MR = MC and P < ATC Losses = (P- AC) x q* or ABCD Output Chapter 8

17. Choosing Output in the Short Run • Summary of Production Decisions • Profit is maximized when MC = MR • If P > ATC the firm is making profits. • If P < ATC the firm is making losses Chapter 8

18. Short Run Production • Firm has two choices in short run • Continue producing • Shut down temporarily • Will compare profitability of both choices • When should the firm shut down? • If AVC < P < ATC the firm should continue producing in the short run • Can cover some of its variable costs and all of its fixed costs • If AVC > P < ATC the firm should shut-down. • Can not cover even its fixed costs Chapter 8

19. MC ATC Losses B C D P = MR A AVC F E q* A Competitive Firm – Losses Price • P < ATC but • AVC so firm will continue to produce in short run Output Chapter 8

20. Competitive Firm – Short Run Supply • Supply curve tells how much output will be produced at different prices • Competitive firms determine quantity to produce where P = MC • Firm shuts down when P < AVC • Competitive firms supply curve is portion of the marginal cost curve above the AVC curve Chapter 8

21. S ATC P2 AVC P1 P = AVC q1 q2 A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) The firm chooses the output level where P = MR = MC, as long as P > AVC. Supply is MC above AVC MC Output Chapter 8

22. S MC1 MC2 MC3 P3 P2 P1 2 4 7 8 10 15 21 5 Market Supply in the Short Run The short-run industry supply curve is the horizontal summation of the supply curves of the firms. $ per unit Q Chapter 8

23. Choosing Output in the Long Run • In short run, one or more inputs are fixed • Depending on the time, it may limit the flexibility of the firm • In the long run, a firm can alter all its inputs, including the size of the plant. • We assume free entry and free exit. • No legal restrictions or extra costs Chapter 8

24. Long-run Profit Maximization • In the short run a firm faces a horizontal demand curve • Take market price as given • The short-run average cost curve (SAC) and short run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD) • The long run average cost curve (LRAC) • Economies of scale to q2 • Diseconomies of scale after q2 Chapter 8

25. LMC LAC SMC SAC A D $40 P = MR C B $30 q1 q2 q3 Output Choice in the Long Run Price In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. Output Chapter 8

26. LMC LAC SMC SAC A D $40 P = MR C B G F $30 q1 q2 q3 Output Choice in the Long Run In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD. Price E q3 is profit-maximizing output Output Economies of scale Diseconomies of scale Chapter 8

27. Long-run Competitive Equilibrium • Entry and Exit • The long-run response to short-run profits is to increase output and profits. • Profits will attract other producers. • More producers increase industry supply which lowers the market price. • This continues until there are no more profits to be gained in the market – zero economic profits Chapter 8

28. S1 LMC $40 P1 LAC S2 P2 $30 D q2 Q1 Q2 Long-Run Competitive Equilibrium – Profits • Profit attracts firms • Supply increases until profit = 0 $ per unit of output $ per unit of output Firm Industry Output Output Chapter 8

29. S2 LMC $30 P2 LAC S1 P1 $20 D Q2 Q1 q2 Long-Run Competitive Equilibrium – Losses • Losses cause firms to leave • Supply decreases until profit = 0 $ per unit of output $ per unit of output Firm Industry Output Output Chapter 8

30. Long-Run Competitive Equilibrium • All firms in industry are maximizing profits • MR = MC • No firm has incentive to enter or exit industry • Earning zero economic profits • Market is in equilibrium • QD = QD Chapter 8

31. Chapter 10 Market Power: Monopoly

32. Topics to be Discussed • Characteristics • Average and Marginal Revenue • Monopolist’s output decision • Measuring monopoly power • The Social Costs of Monopoly Power • Regulating monopoly Chapter 10

33. Monopoly • One seller (but many buyers), one product (no substitutes), there are barriers to entry and price maker • The monopolist is the supply-side of the market and has complete control over the amount offered for sale. • Monopolist controls price but must consider consumer demand • Profits will be maximized at the level of output where MC = MR • For monopolist’s P = AR = DD • Its MR curve always below the demand curve Chapter 10

34. Total, Marginal, and Average Revenue 1. Revenue is zero when price is $6 - nothing is sold 2. At lower prices, revenue increases as quantity sold increases 3. When demand is downward sloping, the price (average revenue) is greater than marginal revenue 4. For sales to increase, price must fall 5. When MR is positive, TR is increasing with quantity but when MR is negative, TR is decreasing Chapter 10

35. $ per unit of output 7 6 5 Average Revenue (Demand) 4 3 2 Marginal Revenue 1 Output 0 1 2 3 4 5 6 7 Average and Marginal Revenue • Observations: • 1. To increase sales the price must fall • 2. MR < P • 3. Compared to perfect competition MR = P Chapter 10

36. Monopolist’s Output Decision 1. Profits maximized at the output level where MR = MC 2. Cost functions are the same Chapter 10

37. MC P1 P* AC P2 Lost profit D = AR Lost profit MR Q* Q2 Q1 Monopolist’s Output Decision $ per unit of output • At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). • 2. At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) MC=MR Quantity Chapter 10

38. $ C = TOTAL COST r' R = TOTAL REVENUE 400 300 c’ r 200 Profits 150 100 50 c Quantity 0 5 10 15 20 Example of Profit Maximization When profits are maximized, slope of rr’ and cc’ are equal: MR=MC Chapter 10

39. $/Q 40 MC P=30 AC Profit 20 AR AC=15 10 MR 0 5 10 15 20 Profit Maximization Profit = (P - AC) x Q = ($30 - $15)(10) = $150 Quantity Chapter 10

40. Monopoly • Monopoly pricing compared to perfect competition pricing: • Monopoly • P > MC • Price is larger than MC by an amount that depends inversely on the elasticity of demand • Perfect Competition • P = MC • Demand is perfectly elastic so P=MC Chapter 10

41. Monopoly • If demand is very elastic, Ed is a large negative number thus price will be close to MC – monopoly will look much like a perfectly competitive market. So there is little benefit to being a monopolist. • Note also that a monopolist will never produce a quantity in the inelastic portion of demand curve (Ed < 1) • In inelastic portion, can increase revenue by decreasing quantity and increasing price Chapter 10

42. $/Q $/Q P* MC MC P* P*-MC D P*-MC MR D MR Q* Q* Quantity Quantity Elasticity of Demand and Price Markup The more elastic is demand, the less the Markup – little monopoly power. The more inelastic is demand, the more the Markup – more monopoly power. Chapter 10

43. Monopoly Power • Pure monopoly is rare. • However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost. • Firms often product similar goods that have some differences thereby differentiating themselves from other firms Chapter 10

44. Measuring Monopoly Power • How can we measure monopoly power to compare firms • What are the sources of monopoly power? Chapter 10

45. Measuring Monopoly Power • An important distinction between Perfect Competition and Monopoly: PC : P = MC ; Monopoly : P > MC • To measure monopoly power – look the extent to which profit maximizing P exceeds MC • Use the markup ratio of P – MC / P as the rule of thumb for pricing • This measure of monopoly power is called as Lerner Index of Monopoly Power : L = (P-MC) / P • The Lerner Index always has a value between 0 to 1 • The larger the value of L the greater the monopoly power Chapter 10

46. The Social Costs of Monopoly • Monopoly power results in higher prices and lower quantities. • Perfectly competitive: produce where MC = D  PC and QC • Monopoly produces where MR = MC  PM and QM • There is a loss in consumer surplus when going from perfect competition to monopoly • A deadweight loss is also created • The incentive to engage in monopoly practices is determined by the profit to be gained. • The larger the transfer from consumers to the firm, the larger the social cost of monopoly. Chapter 10

47. Lost Consumer Surplus MC Deadweight Loss Pm PC C AR=D MR Qm QC Deadweight Loss from Monopoly Power $/Q Because of the higher price, consumers lose A+B and producer gains A-C. B A Quantity Chapter 10

48. Regulating Monopoly • Government can regulate monopoly power through price regulation. • Price regulation can eliminate deadweight loss with a monopoly. • Some countries use antitrust law to prevent firms from obtaining excessive market power Chapter 10

49. Natural Monopoly • A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. • Usually arises when there are large economies of scale • We can show that splitting the market into two firms results in higher AC for each firm than when only one firm was producing Chapter 10

50. Pm AC Pr MC PC AR MR Qm Qr QC Regulating the Price of a Natural Monopoly Unregulated, the monopolist would produce Qm and charge Pm. $/Q If the price were regulate to be Pc, the firm would lose money and go out of business. Can’t cover average costs Setting the price at Pr giving profits as large as possible without going out of business Quantity Chapter 10