Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134

The University of Akron Administration This Week’s Assignments Farnham Chapter 7 (Perfect competition) Homework 5 Next Week’s Assignments Farnham Chapter 8 (Monopoly) Farnham Chapter 9 (Oligopoly) Homework 6 (Essay) 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

The University of Akron Introduction We have seen that the production function and input prices determine the firm’s costs The market structure in which the output is sold determines the firm’s revenue 4/6/2019 The University of Akron Decision Tree

The University of Akron Introduction Market Structure Continuum between the two theoretical extremes Perfect Competition Pure Monopoly Industry concentration Price-cost margin (Lerner index=[p-mc]/p) Four-firm (Eight-firm) ratio (Sale4/TotalSale) 4/6/2019 The University of Akron Decision Tree

The University of Akron Introduction 4/6/2019 The University of Akron Decision Tree

The University of Akron Introduction Firm Behavior Firms maximize profits Could be multi-objective function Profit = Total Revenue – Total Cost P = TR – TC At what output level is Profit maximized Produce each unit for which additional revenue >= additional cost MR = MC 4/6/2019 The University of Akron Decision Tree

Market Structure - summary Common behavior Firms estimate marginal costs and marginal revenues and then try to sell all units of output for which expected MR > expected MC Price takers The price out of control of firm: P = MR Thus they only need to determine the level of output for which MC = P = MR Price seekers (makers) Firms have some market power and choice in the price they charge. Thus they try to set prices that enable them to sell all units of output for which expected MR > expected MC 4/6/2019 The University of Akron

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

The University of Akron Description - PC Perfect Competition Many firms Behavior of one has “no” impact on market Selling identical (undifferentiated or homogeneous) product Consumers do not care (or know) which firm produces the product No barriers to entry Anyone can become producer 4/6/2019 The University of Akron Decision Tree

The University of Akron Description - PC Since the behavior on one firm has no impact on the market, each firm can sell as much output as it wants at the market price 4/6/2019 The University of Akron Decision Tree

The University of Akron Description - PC Figure 7.1 Industry/Market Individual Firm Q P Q1 MC Q2 ATC D=P=MR B A PE Q QE D S 4/6/2019 The University of Akron

The University of Akron Description - Revenue Perfect Competition Total Revenue = Price * Quantity TR = P * Q Average Revenue = Price TR = P * Q = AR * Q Price is constant Marginal Revenue DTR / DQ = Price = AR 4/6/2019 The University of Akron Decision Tree

The University of Akron Description - PC Total Revenue Price Average Rev Slope of line from origin to total Marginal Rev Slope of total $ TR P = AR = MR 1 Q 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

Firm Behavior – SR, profit Firms maximize profits Could be multi-objective function Profit = Total Revenue – Total Cost P = TR – TC 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit TC Profit = TR - TC At what level of output is profit max? $ TR Q* Q 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit Finding where the slopes of two curves are equal is difficult! Is there an easier alternative? Profit is maximized when firm produces each unit for which additional revenue >= additional cost MR = MC 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit $ MC MR=P Q Q* 4/6/2019 The University of Akron

Firm Behavior – SR, profit Profit is maximized when firm produces each unit for which additional revenue >= additional cost MR = MC Therefore, the quantity supplied is found along the MC for each possible price 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit $ MC P4 P3 P2 P1 Q Q1 Q2 Q3 Q4 4/6/2019 The University of Akron

Firm Behavior – SR, profit $ Supply MC P4 P3 P2 P1 Q Q1 Q2 Q3 Q4 4/6/2019 The University of Akron

Firm Behavior – SR, profit Is this firm making a profit? How do we find out? P = TR – TC If TR > TC, P > 0 If TR = TC, P = 0 If TR < TC, P < 0 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit TC Profit = TR - TC Is TR > TC at Q*? Not in this example $ TR Q* Q 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, profit $ Is TR > TC at Q*? How do we know? MC ATC AVC Net operating loss Total Cost MR = P Total Revenue Q Q* 4/6/2019 The University of Akron

Firm Behavior – SR, profit P = TR – TC TR = AR x Q* = P x Q* TC = ATC x Q* P = (AR x Q*) – (ATC x Q*) P = (AR – ATC) x Q* Profit: If AR > ATC, P > 0 Loss: If AR < ATC, P < 0 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

Firm Behavior – SR, supply Should this firm operate, or shut down? What are the alternatives in the short run? Operate at a loss of TR – TC = (AR – ATC) x Q* Shut down and incur a cost of FC = (AFC) x Q* 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, supply TC Operating loss = TR - TC Shut down cost = FC $ TR Operating Loss FC Loss Q* Q 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, supply Operating loss = (ATC – AR) x Q* FC = (ATC – AVC) x Q* $ ATC MC AVC Operating loss MR = AR FC loss Q Q* 4/6/2019 The University of Akron

Firm Behavior – SR, supply If Price < AVC Firm will not operate and quantity supplied is zero If AVC < Price < ATC Firm will operate at a loss and quantity supplied is found on MC If Price > ATC Firm will operate at a profit and quantity supplied is found on MC 4/6/2019 The University of Akron Decision Tree

Firm Behavior – SR, supply $ Price < AVC; Q = 0 Price > AVC; Q found on MC MC Supply ATC P4 AVC P3 P2 P1 Q Q2 Q3 Q4 4/6/2019 The University of Akron

Firm Behavior – SR, supply If Price < AVC Firm will not operate and quantity supplied is zero If Price > AVC Firm will operate and quantity supplied is found on MC Therefore, the firm’s short run supply curve is the MC above minimum AVC 4/6/2019 The University of Akron Decision Tree

Market Behavior – SR, supply If input prices in the market (industry) are constant as firms change production The market (industry) supply curve is the horizontal sum of individual firms’ supply (MC) curves This is the source of the idea that market price in competitive markets equal the MC of production 4/6/2019 The University of Akron Decision Tree

Market Behavior – SR, supply 4/6/2019 The University of Akron

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

The University of Akron Firm Behavior – LR Even though a firm may operate at a loss in the short run, they will not do so in the long run As leases and contracts expire, as their fixed costs become variable, firm’s with losses will tend to close and leave the market (industry) 4/6/2019 The University of Akron Decision Tree

The University of Akron Firm Behavior – LR Thus in the long run Only firms with ATC <= price will stay in the market Firms will seek to make long run adjustments to reduce ATC Firms that find the MES first will have an advantage Eventually, all surviving firms will operate at minimum ATC 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

The University of Akron Market Behavior – LR Long run adjustment in Perfect Competition – search for equilibrium Consider if market price is below ATC Consider if market price is above ATC Condition for market equilibrium 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR $ Market price is below ATC Some firms leave the industry MC ATC P1 Q Q1 4/6/2019 The University of Akron

The University of Akron Market Behavior – LR S2 As firms leave the market, supply will fall (fewer firms to sum) Firms stop leaving market if P=ATC Price S1 P2 P1 D1 Quantity 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR $ Firms stop closing if P=ATC MC ATC P2 P1 Q Q1 Q2 4/6/2019 The University of Akron

The University of Akron Market Behavior – LR Long run adjustment in Perfect Competition – search for equilibrium Consider if market price is below ATC Some firms close Fewer firms: surviving firms slightly larger, but total market output is lower 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR $ Market price is above ATC Some firms enter the industry MC ATC P4 Q Q4 4/6/2019 The University of Akron

The University of Akron Market Behavior – LR S4 S2 As firms enter the market, supply will increase (more firms to sum) Firms stop entering market if P=ATC Price P4 P2 D1 Quantity 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR $ Firms stop entering if P=ATC MC ATC P4 P2 Q Q2 Q4 4/6/2019 The University of Akron

The University of Akron Market Behavior – LR Long run adjustment in Perfect Competition – search for equilibrium Consider if market price is above ATC Firms enter the market More firms: surviving firms slightly smaller, but total market output is higher 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR Long run adjustment in Perfect Competition – search for equilibrium Consider if market price is below ATC Consider if market price is above ATC Condition for market equilibrium Price = ATC = MC Profit = 0 4/6/2019 The University of Akron Decision Tree

The University of Akron Market Behavior – LR $ LR equilibrium P=ATC=MC Profits = 0 MC ATC P2 Q Q2 4/6/2019 The University of Akron

The University of Akron Market Behavior – LR $ MC LRAC SRATC P2 LR equilibrium P=ATC=MC Profits = 0 Q Q2 4/6/2019 The University of Akron

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

Market Behavior – LR Supply Long run market supply indicates the total industry output levels at various market prices, after market adjustments Begin in LR equilibrium (P1, Q1) 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply Begin in LR equilibrium (P1, Q1) Market demand increases How will market react? Price S1 P1 D2 D1 Q1 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply Market demand increases How will market react? Market price increases Firms P=MC Price S1 P2 P1 D2 D1 Q1 Q2 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply $ MC Market price increases Firms P=MC Output increases along SR market supply ATC P2 P1 Q q1 q2 4/6/2019 The University of Akron

Market Behavior – LR Supply $ MC But now each firm is making an economic profit Which attracts entry and increases market supply ATC P2 P1 Q q1 q2 4/6/2019 The University of Akron

Market Behavior – LR Supply Firms enter the market and increase market supply New equilibrium price (P3) Price S1 S2 P2 P3 P1 D2 D1 Q1 Q2 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply In this case P3 = P1 Constant cost industry Industry expansion does not affect AC Price S1 S2 P2 P3 P1 D2 D1 Q1 Q2 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply In this case P3 = P1 Constant cost industry Industry expansion does not affect AC Price S1 S2 LR Supply P1 D2 D1 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply If P3>P1 Increasing cost industry As industry expands, AC increase Price S1 S2 P2 P3 P1 D2 D1 Q1 Q2 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply If P3>P1 Increasing cost industry As industry expands, AC increase Price S1 S2 LR Supply D2 D1 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply If P3<P1 Decreasing cost industry As industry expands, AC decrease Price S1 S2 P2 P1 P3 D2 D1 Q1 Q2 Quantity 4/6/2019 The University of Akron Decision Tree

Market Behavior – LR Supply If P3<P1 Decreasing cost industry As industry expands, AC decrease Price S1 S2 LR Supply D2 D1 Quantity 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion

The University of Akron Discussion Condition for market equilibrium Price = ATC = MC Profit = 0 Why would any firm operate at zero profit? 4/6/2019 The University of Akron Decision Tree

The University of Akron Discussion Under what conditions might input prices in the market (industry) remain constant as firms change production? If industry is one of many consumers of the input The industry as a whole does not represent a major market segment Examples? 4/6/2019 The University of Akron Decision Tree

The University of Akron Discussion Under what conditions might input prices in the market (industry) change as firms change production? If industry is major consumer of the input The industry as a whole represents a major market segment Examples Impact on market supply? 4/6/2019 The University of Akron Decision Tree

The University of Akron Discussion In what sense does Perfect Competition lead to efficient production? Output is produced at minimum SRATC and LRAC Price to consumer is equal to MC Thus MB to consumer = MC of production No LR economic profits 4/6/2019 The University of Akron Decision Tree

Introduction Description (PC) Short run Profit max output Supply Decision Tree Introduction Description (PC) Short run Profit max output Supply Long run Profit max output Adjustment Supply Discussion