Changes in Demand and Market Processes

Profits and Avocadoes Firms will grow avocadoes only if they can make a profit To make a profit, price must cover the cost of growing them Revenue above production costs is considered profit from an accounting viewpoint

Profits and Avocadoes (Continued) BUT firms must also get a return on investment –ROI must at least equal what they could make if they did not grow avocadoes –The opportunity cost of producing SO a firm will not grow avocadoes unless price exceeds the production cost + opportunity cost –TC=prod cost + opportunity cost –Economic Profit=TR-TC –Profit is over and above ROI could get elsewhere

Avocadoes and Demand Low-calorie avocados increase demand At any price people will buy more of them Note fluctuations within a year in reaction to price $ D 2007 (low-calorie come out).69 D

Demand, Price, and Supply Change An increase in demand means individuals bid up price As price goes up, firms have an incentive to grow more avocadoes Increased price means profit Profit means firms already producing avocadoes (AHS) will produce more AND other firms will start to grow avocadoes

Firms Respond to Profit/Price Firms respond only to the increase in P which leads to an increase in profit $1.09 S D 2007 (low-calorie come on) D What about revenue and profit next year?

No Profits Once Markets Adjust Firms want to make a profit If firms make profits selling avocadoes, other firms will start growing them—enter the market (increase in supply) Increased supply (shift in the supply curve) lowers price Lower price removes the profit Firms enter the market until profits go to 0 (opportunity cost of investment included in costs)

Avocadoes and Supply Adjustment Profits provide an incentive for firms to start producing avocadoes, which increases supply This means price will fall $1.09 S 2006, S increase D 2007 (low-calorie come on).69 D

Competition

What is a Competitive Market? Large number of buyers Large number of sellers Free entry and exit (firms can come and go) Products are alike (don’t care if you buy your avocadoes from AHS, Pierce, Buchannan, Fillmore)

What are the Outcomes? Firms take price as given by market Zero profits (remember opportunity cost!) Consumers get lowest possible price Everyone that wants the good at the selling price gets it; firms sell all they want at that price Efficient (low price, no shortages or surpluses)

Firms in Competitive Markets are Price Takers Because each firm is a small part of the market, it cannot influence market price A firm can only sell the number of avocadoes that will maximize its profit The firm is a “price taker” and sets quantity (how much it will sell) to maximize profit

Profit Goes to Zero in Competitive Markets Firms set output where total revenue exceeds total cost by the greatest amount (profit max) If profit exists –New firms enter the market –Supply increases –Prices fall and profits to go away

Profit Goes to Zero in Competitive Markets (continued) If total costs exceed total revenue (losses) –Firms quit growing avocadoes –Supply decreases –Price increases and losses to go away Competition forces price to the point it just covers cost –No profit –Price is as low as possible

Say it with Numbers Total RevenueTotal CostProfit P*QC*QTR-TC 2006 (baseline) Q Q Q Q (low fat) Q Q Q Q (the competition) Q Q Q Q Numbers are in thousands

Competitive Markets in Equilibrium No profit –Entry of firms with profit and the exit of firms with losses eliminates –Firm gets a return on investment (opportunity cost!) Consumers get the lowest price possible Shortages eliminated with price increases Surpluses eliminated with price decreases

Advantages of Competitive Market Its efficient: Society’s resources could not be rearranged to have more goods and services produced Competition forces firms to operate at the lowest possible per unit cost The consumer gets the good for the lowest possible price

Disadvantages of a Competitive Market No profits means no money for research and development Doesn’t consider social costs and benefits (only “private” costs considered) –Smoke pollutes the air –Pretty avocado trees benefit all Inequality not a concern of the market –More productive people command higher prices –Nonproductive resources command no price

Monopolies

What is a Monopoly? Single seller (ONLY ONE) A unique product with no close substitutes (no one else can produce avocadoes without the patent) Entry into the market completely blocked (government regulation, including patents, is one way)

What are the Outcomes? The monopoly cuts back on production and increases price Most monopolies make a profit (increased price) Price is above the cost of production (AHS: cost=.3; P=.69) Firms want to enter because of the profits, which would increase supply, but are prohibited Inefficient: people value the good more than it costs to make it (indicates more should be produced)

Firms in Monopoly Markets are Price Makers With only one firm in the market, the monopoly must lower price to sell more goods Competitive firms can sell all they want at the market price –If it lowers price it will not be able to increase sales –If it raises price it will not be able to sell anything at all A monopoly is constrained by the demand for the product: the law of demand

Profit Can Occur with Blocked Entry Firms set output where total revenue exceeds total cost by the greatest amount (profit max)—just firms with competition BUT, if profit exists no firms can enter With blocked entry, profit can exist

Say it with Numbers Numbers in thousandsPriceCost Quantity (AHS)Profit 2006 (baseline) Q Q Q Q (low fat) Q Q Q Q (competition) Q Q Q Q (monopoly) Q1-Q

A Monopoly Market At Rest Produce where total revenue exceeds by total costs by the most (i.e. profit maximization) Sets price based on demand curve (i.e. how much are consumers willing to pay for that much output) Monopoly output is lower (than competitive markets), allowing price increase Prices above competitive levels, creates profits Although other firms want to enter, entry is blocked (by the patent) Bottom line: quantity is decreased and price increased over competitive markets

Graphically P P* mc mr D Q* Q

Advantages of Monopolies Monopoly profits provide funds to engage in research and development Under some circumstances, monopolies are more efficient than smaller firms –High start up costs –Small marginal costs –Economies of scale

Disadvantages of Monopolies Price increased and quantity lowered over competitive market levels –Less produced than a competitive market –Price higher than the per unit cost of producing Monopolies inefficient –Some people willing and able to pay a higher price for the good but cannot –Some firms willing and able to produce at a lower price but cannot

Patents: Sell Out or Rewards for Entrepreneurs

Patents Make a Monopoly Patents grant an exclusive right to produce Patents create monopolies: entry completely blocked Monopoly profits provide an incentive to do research and development (R&D) –R&D is costly with payoff uncertain –Competition removes all profit preventing R&D –Patents provide the incentive to bear R&D costs –Corporations, with potential to raise $, have incentives to engage in R&D –Entrepreneurs have incentive to bear risk of R&D

Some Monopoly Profit is Good: Government Should Support Little incentive in market economies to engage in R&D –Questions efficiency of competition in the long run –Competition removes profit, which is what creates incentives for R&D Patents reward the entrepreneurial spirit, which leads to innovation New products would not exist without a profit incentive

Monopoly Profit is Bad: Government Should Stay Out Monopolies increase price and reduce the quantity compared to a competitive market Profits go to business and shareholders while consumers pay high prices The inequality is unfair Blocked entry leads to inefficiency (price is higher than production costs suggesting people value the good more than it costs)

Are the Costs of Creating a Monopoly Worth the Benefits of R&D? For you to decide