Micro Review Day 3 and 4

Perfect Competition

14 A Perfectly Competitive Market For a market to be perfectly competitive, six conditions must be met: 1.Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given 2.The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms A perfectly competitive market is a market in which economic forces operate unimpeded 14-3

Perfect Competition 14 A Perfectly Competitive Market 3.There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market 4.Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output 5.There is complete information – all consumers know all about the market such as prices, products, and available technology 6.Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit 14-4

Perfect Competition 14 The Firm’s Supply Curve is the MC Curve above AVC McGraw-Hill/Irwin Colander, Economics 5 MC Q P AVC Supply Curve

Perfect Competition 14 Profit Maximizing Level of Output Marginal revenue (MR) is the change in total revenue associated with a change in quantity A firm maximizes profit when marginal revenue equals marginal cost The goal of the firm is to maximize profits, the difference between total revenue and total cost Marginal cost (MC) is the change in total cost associated with a change in quantity 14-6

Perfect Competition 14 Profit Maximizing Level of Output If MR < MC, a firm can increase profit by decreasing its output If MR > MC, a firm can increase profit by increasing output The profit-maximizing condition of a competitive firm is: MR = MC For a competitive firm, MR = P A firm maximizes total profit, not profit per unit 14-7

Perfect Competition 14 Determining Profits Graphically: A Firm with Profit AVC MC Q P ATC Find output where MC = MR, this is the profit maximizing Q P = D = MR MC = MR Q profit max Find profit per unit where the profit max Q intersects ATC ATC at Q profit max P ATC Profits Since P>ATC at the profit maximizing quantity, this firm is earning profits 14-8

Perfect Competition 14 A Firm With A Loss McGraw-Hill/Irwin Colander, Economics 9 When the ATC curve is above the MR curve, the firm incurs a loss

Perfect Competition 14 A Firm With Zero Economic Profit McGraw-Hill/Irwin Colander, Economics 10 When the MC curve intersects the min point of the ATC at the profit maximizing output MR=MC=ATC (min)

Perfect Competition 14 Determining Profits Graphically: The Shutdown Decision AVC MC Q P ATC Q profit max P Shut down P = D = MR The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business If P>min of AVC, then the firm will still produce, but earn a loss If P<min of AVC, the firm will shut down If a firm shuts down, it still has to pay its fixed costs 14-11

Perfect Competition 14 ATC Profits Short-Run Market Supply and Demand Graph P Q Market Supply P Market Demand P Q P P = D = MR MC ATC Q profit max MarketFirm 14-12

Perfect Competition 14 Long-Run Competitive Equilibrium Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made At long run equilibrium, economic profits are zero The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero 14-13

Perfect Competition 14 Long Run Competitive Equilibrium McGraw-Hill/Irwin Colander, Economics 14

Perfect Competition 14 Long-Run Competitive Equilibrium Normal profit is the amount the owners would have received in their next best alternative Zero profit does not mean that the entrepreneur does not get anything for his efforts Economic profits are profits above normal profits 14-15

Perfect Competition 14 Monopoly McGraw-Hill/IrwinColander, Economics16

Monopoly 15 A Monopolistic Market Barriers to entry into the market prevent competition Monopoly is a market structure in which one firm makes up the entire market There are no close substitutes for the monopolist’s product Barriers to entry can be: Legal Sociological Natural Technological 15-17

Monopoly 15 The Key Difference Between a Monopolist and a Perfect Competitor A monopolistic firm’s marginal revenue is not its price Marginal revenue is always below its price Marginal revenue changes as output changes and is not equal to the price A monopolistic firm’s output decision can affect price There is no competition in monopolistic markets so monopolists see to it that monopolists, not consumers, benefit 15-18

Monopoly 15 Profit Maximizing Level of Output If MR < MC, The monopoly can increase profit by decreasing its output If MR > MC, The monopoly can increase profit by increasing output The profit-maximizing condition of a monopolistic firm is: MR = MC For a monopolistic firm, MR < P A monopolistic firm maximizes total profit, not profit per unit 15-19

Monopoly 15 Monopolistic Profit Maximization Graph MC Q P Find output where MC = MR, this is the profit maximizing Q D MC = MR 4 = Q profit max D at Q profit max P = $24 Marginal revenue is not constant as Q increases because: revenue increases as the monopolist sells more revenue decreases because the monopolist must lower the price to sell more Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price MR 15-20

Monopoly 15 Monopoly Compared to Perfect Competition Graph Outcome: Monopoly output is lower and price is higher than perfect competition In a monopoly, P>MR, In perfect competition, P=MR=D MR=MC is the profit max rule for both First find the monopoly Q and P Then find the perfectly competitive Q and P D PC = MR PC MC Q P DMDM QMQM PMPM MR M P PC Q PC 15-21

Monopoly Finding a Monopolist’s Output, Price, and Profit Price ATC MC Quantity PM 0 MR QM CM A B D Monopolist produces output QM where MR=MC. Monopolist charges price PM from A on the demand curve. Profit is P-ATC (A-B) times total output, QM. Profit

Monopoly Breaking Even Price MC Quantity PM 0 MR D QM ATC Produce QM where MR = MC Price (PM) = ATC Profit = 0

Monopoly Minimizing Losses Price ATC MC Quantity0 MR D QM Loss PM CM B A Price (PM) < Cost (CM) Produce QM, where MR = MC. Loss = CM PMBA

Monopoly 15 The Welfare Loss from a Monopoly MC Q P D QMQM PMPM The welfare loss from a monopoly is represented by the triangles B and D The rectangle C is a transfer of surplus from the consumer to the monopolist The area A represents the opportunity cost of diverted resources, which is not a loss to society MR P PC Q PC A B D C 15-25

Monopoly 15 Efficiency McGraw-Hill/Irwin Colander, Economics 26 Price MC Quantity PM 0 MR D QM ATC

Monopoly 15 Monopoly Compared Perfect Competition McGraw-Hill/Irwin Colander, Economics 27

Monopoly 15 Antitrust and Regulation McGraw-Hill/Irwin Colander, Economics 28

Monopoly 15 Monopolistic Competition McGraw-Hill/IrwinColander, Economics29

Monopolistic Competition and Oligopoly 16 Characteristics of Monopolistic Competition Four distinguishing characteristics: 3.Multiple dimensions of competition make it harder to analyze a specific industry, but these methods of competition follow the same two decision rules as price competition 2.Product differentiation where the goods that are sold aren’t homogenous 1.Many sellers that do not take into account rivals’ reactions 4.Ease of entry of new firms in the long run because there are no significant barriers to entry 16-30

Monopolistic Competition and Oligopoly 16 Output, Price, and Profit of a Monopolistic Competitor Like a monopoly, At profit maximizing output, marginal cost will be less than price Marginal revenue is below price Like a perfect competitor, zero economic profits exist in the long run The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve 16-31

Monopolistic Competition and Oligopoly 16 Q P ATC Break even Q MC D MR A monopolistic firm can earn profits, losses, or break even in the short run Determining Profits Graphically: Monopolistic Competition Losses Break even Profits P ATC Losses ATC Profits ATC L ATC P 16-32

Monopolistic Competition and Oligopoly 16 Advertising and Monopolistic Competition Advertising increases ATC The goals of advertising are to increase demand and make demand more inelastic Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do The increase in cost of a monopolistically competitive product is the cost of “differentness” 16-33

Monopolistic Competition and Oligopoly 16 Oligopoly McGraw-Hill/IrwinColander, Economics34

Monopolistic Competition and Oligopoly 16 Characteristics of Oligopoly Oligopolies are made up of a small number of firms in an industry Oligopolistic firms are mutually interdependent In any decision a firm makes, it must take into account the expected reaction of other firms Oligopolies can be collusive or noncollusive Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making 16-35

Monopolistic Competition and Oligopoly 16 Models of Oligopoly Behavior There is no single model of oligopoly behavior The cartel model is when a combination of firms acts as if it were a single firm and a monopoly price is set An oligopoly model can take two extremes: The contestable market model is a model of oligopolies where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set Other models of oligopolies give price results between the two extremes 16-36

Game Theory, Strategic Decision Making, and Behavioral Economics 11 The Prisoner's Dilemma There is a payoff matrix which is a table that shows the outcome of every choice by every player, given the possible choices of all other players The payoff matrix has three elements: 1.Players 2.Strategies 3.Payoffs The prisoner’s dilemma is a well-known two-person non-cooperative game that demonstrates the difficulty of cooperative behavior in certain circumstances 11-37

Game Theory, Strategic Decision Making, and Behavioral Economics 11 Application: The Prisoner's Dilemma A A B B CONFESS DOESN’T CONFESS Players are A and B…Payoff Matrix… Strategies are to confess or not… Payoffs are jail time or not 5 years for A 5 years for B 6 months for A 6 months for B B goes free A goes free 10 years for B 10 years for A 11-38

Game Theory, Strategic Decision Making, and Behavioral Economics 11 Application: The Prisoner's Dilemma A A B B CONFESS DOESN’T CONFESS 5 years for A 5 years for B 6 months for A 6 months for B B goes free A goes free What is the best strategy for each player given the other player’s choice? What is the outcome? XX X X 10 years for B 10 years for A 11-39

Game Theory, Strategic Decision Making, and Behavioral Economics 11 Dominant Strategies and Nash Equilibrium A Nash equilibrium is a set of strategies for each player in the game in which no player can improve his or her payoff by changing strategy unilaterallyNash equilibrium A dominant strategy is a strategy that is preferred by a player regardless of the opponent’s move A Nash equilibrium doesn’t have to be the solution that is jointly best for all players 11-40