Finance 30210: Managerial Economics

Finance 30210: Managerial Economics Supply, Demand, and Equilibrium

If we can’t have everything we want, so we need to decide what to do with the limited resources we do have. Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare Under certain circumstances, the competitivemarket process guarantees this Can we trust markets to produce a desirable outcome?

Under what circumstances does the market process result in efficient outcomes? #1: Many buyers and sellers – no individual buyer/firm has any real market power #2: Homogeneous products – no variation in product across firms #3: No barriers to entry – it’s costless for new firms to enter the marketplace #4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers #5: No Externalities –ALL costs/benefits of the product are absorbed by the consumer/producer #6: Transactions are costless – buyers and sellers incur no costs in an exchange (i.e. no taxes) Can you think of situations where all these assumptions hold?

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Lets try an example…suppose that you are a fisherman. To catch larger quantities of fish, you have to go farther from shore and your catch per hour drops • You bought a boat for $1,000 • Maintenance on the boat is $50/Day • You pay $16/hour in labor costs • You pay $20/hour for fuel and other expenses What costs are fixed, sunk, and variable?

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone A

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Dollars Dollars AC TC VC = $.72*F $50 FC $.72 MC # of Fish # of Fish 0 0

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone B

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day TC Dollars Dollars VC =$216 + $1.20*F $266 FC $1.20 MC $50 AC $.88 # of Fish # of Fish 300 300

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone C

Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day TC Dollars Dollars VC =$576 + $1.80*F $626 $50 FC $1.80 MC AC $1.04 # of Fish # of Fish 600 600

Zone A Zone B Zone C All together… 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Dollars Dollars TC Slope = 1.80 Slope = 1.20 MC $1.80 Slope = .72 AC $50 FC $1.20 $.72 # of Fish # of Fish 0 300 600 0 300 600

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $1.20.

We are looking to maximize profits where profits are the difference between total revenues and total costs Dollars Dollars TC $94 TR $0 # of Fish $50 Slope = 1.80 Profit -$50 Slope = 1.20 Slope = .72 # of Fish 0 300 600 0 300 600 Profits are increasing Profits are maximized Profits are decreasing Profits are increasing Profits are maximized Profits are decreasing

We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.

Lets plot out marginal revenues and costs rather than total costs and revenues… Dollars Dollars $94 MC $1.80 $0 # of Fish $1.20 MR Profit -$50 $.72 0 300 600 0 300 600 Marginal revenue is greater than marginal cost Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are increasing Profits are maximized Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars MC $1.80 $1.20 MR $1.20 $.72 # of Fish 0 300 600 0 300 600 At a market price of $1.20, this firm will be willing to supply any quantity of fish between 300 and 600 At a market price of $1.20, MR = MC for any quantity of fish between 300 and 600

Now, suppose that the market price is $0.72.

Again, lets plot revenues, costs, and profits… Dollars Dollars $0 # of Fish TC Slope = 1.80 -$50 Slope = 1.20 Slope = .72 TR $50 Profit # of Fish 0 300 600 0 300 600 Profits are maximized (losses are minimized) Profits are maximized (losses are minimized) Profits are decreasing Profits are decreasing

We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.

Again, lets plot marginal revenues, marginal costs, and profits… Dollars Dollars $0 -$50 MC $1.80 $1.20 $.72 MR Profit 0 300 600 0 300 600 Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are maximized Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars MC $1.80 $1.20 $1.20 $.72 MR $.72 # of Fish 0 300 600 0 300 600 At a market price of $.72, this firm will be willing to supply any quantity of fish between 0 and 300 At a market price of $.72, MR = MC for any quantity of fish between 0 and 300

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars $1.80 MC $1.80 MR $1.20 $1.20 $.72 $.72 # of Fish 0 300 600 0 300 600 At a market price of $1.80, this firm will be willing to supply any quantity of fish between 600 and 760 At a market price of $1.80, MR = MC for any quantity of fish between 600 and 760

What if the prevailing market was $1.35? Dollars Dollars MC $1.35 $1.35 MR # of Fish 0 300 600 0 300 600 At a market price of $1.35, this firm will be willing to supply exactly 600 fish. At a market price of $1.35, 600 fish are profitable to supply, but the 601st is not!

So we can get an individual firm’s supply curve by following marginal costs! Suppose that there are 1000 fishermen in the village – all with the same costs. Dollars Dollars $1.80 $1.80 $1.20 $1.20 $.72 $.72 # of Fish # of Fish 0 300 600 0 300,000 600,000 Individual Supply Market Supply Market supply adds up the decisions of each individual firm at each prevailing market price

So where do prices come from? We need to know how many fish people are actually willing to buy at any prevailing market price. Dollars $1.80 $1.20 $.72 # of Fish 0 150,000 500,000 900,000 A demand curve is just a record of how much the market collectively is willing to buy at any given market price

In equilibrium, total supply should equal total demand. If not, the price will adjust. Dollars Supply At a $1.80 price, fishermen will bring at least 600,000 fish to the market, but only 150,000 will get sold – the price needs to drop $1.80 $1.20 At a $.72 price, fishermen will bring at most 300,000 fish to the market, but 600,000 are demanded– the price needs to rise $.72 Demand # of Fish 0 300,000 600,000 500,000

In equilibrium, total supply should equal total demand Individual Market Dollars Dollars Supply $1.80 MC $1.80 $1.20 $1.20 MR $.72 $.72 Demand 0 300 600 0 300,000 600,000 500,000 The market determines the equilibrium price of $1.20 and 500,000 fish sold by the 1,000 fishermen At the prevailing market price of $1.20, each fisherman supplies between 300 and 600 fish

Boat = $50 Labor = $16/hr Gas = $20/hr A Few Diagnostics… Dollars Price= $1.20 - Gas Cost = $0.67 Labor’s Value Added= $0.53 * Labor Productivity = 30 Fish/Hr $16/hr = hourly wage MC $1.80 Producer Surplus = $144 $1.20 MR - Fixed Cost = $50 $144 Accounting Profit= $94 $.72 $94 *100 = 9.4% Return 0 300 600 $1,000 Is this fisherman earning economic profits?

Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. Dollars Supply $1.80 $1.20 $.72 Demand # of Fish 0 300,000 600,000 540,000 1,080,000 1,368,000

In equilibrium, total supply should equal total demand Individual Market Dollars Dollars Supply $1.80 MC $1.80 $1.20 $1.00 $1.00 MR $.72 $.72 Demand 0 300 600 0 300,000 600,000 540,000 The market determines the equilibrium price of $1.00 and 540,000 fish sold by the 1,800 fishermen At the prevailing market price of $1.00, each fisherman supplies 300 fish

Boat = $50 Labor = $16/hr Gas = $20/hr A Few Diagnostics… Dollars Price= $1.00 - Gas Cost = $0.40 Labor’s Value Added= $0.60 * Labor Productivity = 50 Fish/Hr MC $30/hr > hourly wage $1.80 Producer Surplus = $84 $1.00 MR $84 - Fixed Cost = $50 $.72 Accounting Profit= $34 0 300 600 $34 *100 = 3.4% Return $1,000

Let’s see if we can’t generalize this a bit. We want marginal costs to be increasing – this reflects decreasing productivity at the margin TC Dollars Dollars MC $1.80 $50 $1.20 FC $.72 # of Fish 0 300 600 0 300 600

We are still looking for where marginal revenue equals marginal costs (i.e. the slopes are the same) Dollars Dollars TC $94 TR Slope = P $0 # of Fish F* Profit -$50 # of Fish 0 300 F* 600 0 300 600

We are still looking for where marginal revenue equals marginal costs Dollars Dollars MC $0 F* P* MR Profit -$50 0 F* 0 300 600

We are still looking for where marginal revenue equals marginal costs Dollars Dollars Supply MC P* P* MR=P # of Fish 0 F* 0 F* That optimizing quantity becomes a point on that firms supply curve For any market price (which equals marginal revenue for a perfectly competitive firm, there is a profit maximizing quantity where MR = MC

We still aggregate decisions across individual suppliers to get market supply (again, assume 1,000 fishermen) Dollars Dollars Supply Supply P* P* # of Fish # of Fish 0 F 0 1000*F Individual Supply Market Supply

In equilibrium, total supply should equal total demand Individual Market Dollars Dollars Supply MC $1.44 $1.44 MR Demand 0 400 0 400,000* The market determines the equilibrium price of $1.44 and 400,000 fish sold by the 1,000 fishermen At the prevailing market price of $1.44, each fisherman supplies 400 fish

Boat = $50 Labor = $16/hr Gas = $20/hr We can still perform whatever diagnostics we want… Price= $1.44 For this calculation to work, labor productivity must be 25 fish per hour - Gas Cost = $.80 Labor’s Value Added= $0.64 * Labor Productivity = 25 Fish/Hr $16/hr = hourly wage Dollars MC PS = (1/2)(400)(1.44)=288 Producer Surplus = $288 - Fixed Cost = $50 Accounting Profit= $238 $1.44 MR $288 $238 *100 =23.8% Return $1,000 0 400 Is this fisherman earning economic profits?

Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. Dollars Dollars Supply $1.44 $1.44 $1.03 Demand # of Fish 0 320 400 0 400,000 576,000 720,000

Boat = $50 Labor = $16/hr Gas = $20/hr We can still perform whatever diagnostics we want… At 320 fish, your productivity is 35 Fish/hour Price= $1.03 - Gas Cost = $.57 Labor’s Value Added= $0.46 Dollars * Labor Productivity = 35 Fish/Hr $16/hr = hourly wage MC PS = (1/2)(320)(1.03)=165 Producer Surplus = $165 - Fixed Cost = $50 Accounting Profit= $115 $1.03 MR $165 $115 *100 =11.5% Return $1,000 0 320

Suppose that we have three fishermen with different productivities. Each bought a boat for $1,000 and have the same costs as before. Boat = $50 Labor = $16/hr Gas = $20/hr 30 Fish/hr 300 Max/Day 20 Fish/hr 200 Max/Day 10 Fish/hr 100 Max/Day $3.60 per fish $1.20 per fish $1.80 per fish Each of the above fishermen will provide fish to the marketplace as long as the market price is equal to or greater to their marginal cost

All a supply curve really does is order production from lowest cost to highest cost Dollars $3.60 $1.80 $1.20 Fish 0 300 500 600 For a market price that is at least $3.60, fisherman #1 sells 300 fish, fisherman #2 sells 200 fish and fisherman #3 sells 100 fish For a market price that is at least $1.80, but below $3.60, fisherman #1 sells 300 fish and fisherman #2 sells up to 200 fish. For a market price that is at least $1.20, but below $1.80, only fisherman #1 sells fish. He can supply up to 300

Adding a demand curve will give us the equilibrium price and identify the fisherman who participate in the market as well as the fisherman’s economic profits Boat = $50 Labor = $16/hr Gas = $20/hr Fisherman #1 Producer Surplus = $540 - Fixed Cost = $50 Dollars Accounting Profit= $490 Supply $490 *100 = 49% Return $1,000 $3.60 Fisherman #2 $3.00 PS= $240 $1.80 Producer Surplus = $240 PS= $540 Demand - Fixed Cost = $50 $1.20 Accounting Profit= $190 Fish $190 0 300 500 600 *100 = 19% Return $1,000

A Supply Function represents the rational decisions made by a profit maximizing firm(s). “Is a function of” Quantity Supplied Market Price (+) As you move up the supply curve, the rise in price encourages increased production of existing producers (intensive margin) as well as the entry of new producers (extensive margin) Price S High marginal costs are in this portion – they will make the lowest profits (if they are sold) Lower marginal costs are in this portion – they will make the largest profits Quantity

Everything we talked about on the supply side is mirrored on the demand side. Just at producers are maximizing profits, consumers maximize their welfare. Welfare = Total Utility – Total Cost Dollars Welfare 0 Q F* P* MC MU Q 0 F* Most consumers experience diminishing marginal utility – each successive item consumed is worth less in terms of satisfaction

By the same token, a demand curve naturally ranks potential consumers from highest valuation to lowest valuation. Suppose that we have three potential consumers. Would pay up to $2/fish. Can consume 100 fish per week. Would pay up to $1/fish. Can consume 50 fish per week. Would pay up to $.50/fish. Can consume 20 fish per week. What would this demand curve look like?

Dollars If fish cost more than $2, nobody buys them! $2 If fish cost between $2 and $1, only Captain buys them! $1 If fish cost between $.50 and $1, Captain AND Andrew Zimmern buy them! $.50 If fish cost more less than $.50 , EVERYBODY buys them! Fish 0 100 150 170

For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus) • At a market price of $1.50 • Captain buys 100 fish for $1.50 apiece. He saves $.50 per fish for a total of $50 in savings (surplus) • Neither the baby of Andrew Zimmern are willing to buy fish for $1.50. Dollars $2 CS = $50 $1.50 $1 $.50 Fish 0 100 150 170

For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus) • At a market price of $.75 • Captain buys 100 fish for $.75 apiece. He saves $1.25 per fish for a total of $125 in savings (surplus) • Andrew Zimmern buys 50 fish for $.75. He saves $.25 per fish for a total of $12.50 in surplus • The baby still is unwilling to buy fish! Dollars $2 CS = $125 $1 CS = $12.50 $.75 $.50 Fish 0 100 150 170

A Demand Function represents the rational decisions made by a representative consumer(s) “Is a function of” Quantity Demanded Market Price (-) Price high marginal valuations are located here lowmarginal valuations are located here D As you move down the demand curve, the lower price encourages increased consumption by existing customers (intensive margin) as well as attracting new consumers (extensive margin) Quantity

Finance 30210: Managerial Economics