IIB Review AP Econ - Micro II B Mr. Griffin MHS

Know These! Economic Profit & Accounting profit Short Run & Long Run Profit = TR – TC MR = MC: profit maximization Total, Average, Marginal product Total, Marginal, Average cost Law of Diminishing returns Economics / Diseconomies of scale

Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE Profits to an Economist Profits to an Accountant ECONOMIC COSTS

Short-run versus Long-run Costs The Economic Short Run vs the Long Run –Short run a period of time during which some of the firm’s cost commitments will not have ended. In the short run, output can change but production processes are fixed.

Short-run versus Long-run Costs The Economic Short Run vs the Long Run –Long run a period of time long enough for all of the firm’s commitments to come to an end. In the long run, all inputs can be varied and production processes can be changed.

Short-run versus Long-run Costs Fixed Costs and Variable Costs –Fixed costs = costs that cannot be changed –Variable costs = costs that can be changed –In the short run, some costs are fixed. In the long run, all costs are variable.

Average Product (AP) Total Product (TP) Marginal Product (MP) SHORT-RUN PRODUCTION RELATIONSHIPS Marginal Product = Change in Total Product Change in Labor Input Average Product = Total Product Units of Labor

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns

Fixed Costs Total Fixed Costs Average Fixed Costs = Total Fixed Costs Quantity Variable Costs Total Variable Costs Average Variable Costs = Total Variable Costs Quantity SHORT-RUN PRODUCTION COSTS

Total Cost Total Fixed and Variable Costs Average Total Cost = Total Costs Quantity Marginal Cost Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity SHORT-RUN PRODUCTION COSTS

SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost

SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) AFC AVC ATC MC Plotting Average and Marginal Costs

PRODUCTIVITY AND COST CURVES Costs (dollars) Average Product and Marginal Product Quantity of labor Quantity of output MP AP MC AVC

LONG-RUN PRODUCTION COSTS The long-run ATC just “envelopes” all of the short-run ATC curves. Unit Costs Output

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale Diseconomies of scale Constant returns to scale

Profit Maxim: Another Graphical Interpretation Output, Garages per Year (a) Marginal Revenue and Marginal Cost 5 MR and MC per Garage per Year (thousands $) – MR MC E

Profit Maximization TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

Profit Maximization 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Marginal Analysis and Maximization of Total Profit Finding the Optimal Price from Optimal Output –MR = MC: rule for determining the level of output –Demand curve  price buyers will pay to purchase that level of output –Both output and price are now determined for the profit maximizing firm.

Final Thoughts on The Producer Firm Inputs  Costs –How much does one more unit of input change output? Input Costs  Output –Will one more unit of output increase MR? Output  Profit –Will one more unit of output increase or decrease profit? –If MR > MC,  production   profits –If MR < MC,  production   profits Profit maximizing level output: MR = MC –TR – TC = TP

Market Structure Continuum FOUR MARKET MODELS Pure Competition

Market Structure Continuum Pure Competition FOUR MARKET MODELS Imperfect Competition All Markets that are Not Purely Competitive

Market Structure Continuum Pure Competition FOUR MARKET MODELS Pure Monopoly

Market Structure Continuum Pure Competition Pure Monopoly FOUR MARKET MODELS Monopolistic Competition

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition FOUR MARKET MODELS Oligopoly

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Pure Competition: - Very Large Numbers - Standardized Product - “Price Takers” - Free Entry and Exit

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Pure Monopoly: - Single Seller - No Close Substitutes - Price Maker - Blocked Entry - Nonprice Competition

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Monopolistic Competition: - Relatively Large Number of Sellers - Differentiated Products - Easy Entry and Exit

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Oligopoly: - A Few Large Producers - Homogeneous or Differentiated Products -Control Over Price, But Mutual Interdependence -Strategic Behavior -Entry Barriers

Comparing the Four Market Forms Perfect competition and pure monopoly are uncommon in reality. Many monopolistically competitive firms exist. Oligopoly firms account for the largest share of the economy’s output.

Comparing the Four Market Forms Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit. Consequently, AC = AR in long-run equilibrium under these two market forms.

Comparing the Four Market Forms In equilibrium, MC = MR for the profit- maximizing firm under any market form. In the equilibrium of the oligopoly firm, MC may be unequal to MR.

Comparing the Four Market Forms Perfectly competitive firm and industry theoretically  efficient allocation of resources. Monopoly and monopolistic competition are likely  inefficient allocation of resources. Under oligopoly, almost anything can happen,  impossible to generalize about its vices or virtues.

RELATIONSHIP ECONOMIC INTERPRETATION MR = MC The firm has chosen the output that maximizes profits. P > ATC Firm is earning Economic Profits P = ATC Firm is earning NORMAL PROFIT (Break-Even Point) (EP = 0) P < ATC; P > AVC Loss Minimization P = AVC SHUTDOWN POINT (firm cannot cover its AVC) P < AVC Firm does not produce

PURE COMPETITION P = MR The firm’s DEMAND CURVE is infinitely ELASTIC MR = MC MR = MC The firms maximizes profit. P= ATC Long Run (NORMAL PROFITS) PRODUCTIVE EFFICIENCY P = min ATC P = min ATC Firm is forced to operate with maximum productive efficiency. (Least-Cost Method Production) ALLOCATIVE EFFICIENCY P = MC There is an optimal allocation of resources. MONOPOLY P > MR The firm’s DEMAND CURVE is relatively INELASTIC. MR = MC MR = MC The firms maximizes profit. P > ATC P > ATC Long Run ECONOMIC PROFITS. PRODUCTIVE INEFFICIENCY PRODUCTIVE INEFFICIENCY P > min ATC Firm is not forced to operate with maximum productive efficiency. Firm is not forced to operate with maximum productive efficiency. (Least-Cost Method Production not necessary) (Least-Cost Method Production not necessary) ALLOCATIVE INEFFICIENCY ALLOCATIVE INEFFICIENCY P > MC There is an UNDERALLOCATION of resources. There is an UNDERALLOCATION of resources.

The Market Individual firm MR=D=AR=P S P pepepepe qeqeqeqe D Q P Q D2D2D2D2 p2p2p2p2 MR=D=AR=P 2 q2q2q2q2 Pure Competition

MC Firm showing Economic Profit Q1Q1Q1Q1 P Total Revenue ATCATC ATCATC MR=MC Per unit profit Q ATC AVC Economic Profit MR=D=AR=P $131 $97.78

ATC MC Firm showing Economic Loss Q2 P Total Revenue ATCATC ATCATC MR=D=AR=PMR=MC Per unit loss Economic Loss AVC $81 Q

ATC MC Firm showing Shutdown position PMR=D=AR=PAVC At no level of output does the firm cover the Average Variable Costs. Q $71

PePePePe MR=D=AR=PMR=D=AR=P QeQeQeQe MC ATC Quantity Price Price = MC = MR = Minimum ATC (normal profit) Price = MC = MR = Minimum ATC (normal profit) Long-run Equilibrium For A Competitive Firm Long-run Equilibrium For A Competitive Firm

ATC MC Competitive Firm Supply Curve P AVC Q MR 1 MR 2 MR 3 MR 4 MR 5 Shutdown point Breakeven point— normal profit

Single Price Profit-Maximizing Monopoly Q P MR MC D QeQe PePe ATC Economic Profit ATCMR=MC

Q D MC ATC P Q1Q1Q1Q1 Price and Costs PRICE DISCRIMINATION Q2Q2Q2Q2 A perfectly discriminating monopolist has MR=D, producing more product and more profit! MR=D

REGULATED MONOPOLY Q D MR MC ATC P Price and Costs MR = MC Fair-Return Price Socially-Optimum Price QmQm QfQf QrQr Dilemma of Regulation Which Price? PmPm PfPf PrPr

D MR P1P1 ATC Price and Costs Q1Q1 Short-Run Economic Profits Expect New Competitors PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity AC 1 MC

D MR MC P2P2 ATC Price and Costs Q2Q2 Short-RunEconomicLosses PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity AC 2

D MR MC P 3 = AC 3 ATC Price and Costs Q3Q3 PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity Long-Run Equilibrium NormalProfitOnly

Oligopoly The Game-Theory Approach –Each oligopolist is seen as a competing player in a game of strategy. –Managers act as though their opponents will adopt the most profitable countermove to any move they make.

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Greatest Combined Profit

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Independent Actions Stimulate Response

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Independent Actions Stimulate Response Gravitating to the Worst Case

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Collusion Invites a Different Solution

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 Collusion Invites a Different Solution

OLIGOPOLY BEHAVIOR A Game-Theory Overview High Low HighLow Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12$15 $12$6 $8 $15 But, the incentive to cheat is very real Collusion Invites a Different Solution

Oligopoly The Game-Theory Approach –Games with dominant strategies Dominant strategy = an option that is better than any alternative option regardless of what the other firm does “Prisoners’ Dilemma”

Oligopoly The Game-Theory Approach –Games with dominant strategies A market with a duopoly serves the public interest better than a monopoly because of the competition created between the duopolists. It is damaging to the public to allow rival firms to collude on what prices to charge for their products and what quantity of product to supply.

Oligopoly The Game-Theory Approach –Games without dominant strategies Maximin = a strategy in which one seeks the maximum of the minimum payoffs to the available strategies.

Oligopoly The Game-Theory Approach –Other strategies: Nash Equilibrium Nash equilibrium = an outcome from which neither firm wants to deviate (once achieved, it is stable and lasting.) Often, no such mutually accommodating solution is possible.

Oligopoly The Game-Theory Approach –Zero-sum games Zero-sum game = one party’s gain equals the other party’s loss

Oligopoly The Game-Theory Approach –Repeated games Most markets feature repeat buyers. Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. Threats and credibility –Induce rivals to change their behavior –Threat must be credible

Using Game Theory Game theory can be used to describe a game when:Game theory can be used to describe a game when: –There are rules which govern actions; –There are two or more players; –There are choices of action where strategy matters; –The game has one or more outcomes; –The outcome depends on the strategies chosen by all players, i.e., there is strategic interaction.

Advertising Game COMPANY Y COMPANY Y COMPANY X Don’t Adv. Advertise 10,10 10,10 2,15 2,15 Advertise 15,2 15,2 7,7 7,7 Dominant strategies? Nash equilibrium?

Advertising Game COMPANY Y COMPANY Y COMPANY X Don’t Adv. Advertise 10,10 10,10 2,15 2,15 Advertise 15,2 15,2 7,7 7,7  Dominant strategies: Strategy 1 dominates Strategy 2 if every payoff from 2 is dominated by the respective payoff from 1. Nash equilibrium: a set of strategies, one for each player, such that no player has an incentive (in terms of improving his own payoff) to deviate from his strategy, i.e., each player can do no better given what the opposing player(s) does.

If a few firms face identical or highly similar demand and costs... Oligopoly is conducive to collusion. they will tend to seek joint profit maximization. CARTELS AND OTHER COLLUSION Graphically…

Colluding Oligopolists Will Split the Monopoly Profits D MC ATC MR Economic Profit MR = MC Price and costs Q0Q0 P0P0 A0A0 CARTELS AND OTHER COLLUSION