Principles of Economics Session 6

Topics To Be Covered  Market Structure  Characteristics of Perfectly Competitive Market  Profit Maximization for a Competitive Firm  Zero-Profit Point and Shut-Down Point  Short-Run Supply Curve  Long-Run Supply Curve  Producer Surplus  Pricing Information

Market Structure  Perfect Competition  Monopoly  Oligopoly  Monopolistic Competition

Characteristics of Perfectly Competitive Market  Many buyers and sellers  Product homogeneity  Free entry and exit  Price taking

Product Homogeneity  The products of all firms are perfect substitutes.  Examples: Agricultural products, oil, copper, iron, lumber

Free Entry and Exit  Buyers can easily switch from one supplier to another.  Suppliers can easily enter or exit a market.

Price Taking  The individual firm sells a very small share of the total market output and, therefore, cannot influence market price.  The individual consumer buys too small a share of industry output to have any impact on market price.  Buyers and sellers in competitive markets are said to be price takers, for they must accept the price determined by the market.

Demand Faced by a Competitive Firm Q P d$4 Firm Industry D $4 P Q

 Individual producer sells all units for $4 regardless of the producer ’ s level of output, so price under $4 is irrational. If the producer tries to raise price, sales are zero.  The price elasticity of demand for products of a single firm is Price Elasticity of Demand E=∞

Revenue of a Perfectly Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR=P×Q

Revenue of a Perfectly Competitive Firm Average revenue tells us how much a firm receives for the typical unit sold.

Revenue of a Perfectly Competitive Firm Marginal revenue is the change in total revenue from an additional unit sold.

Demand, Price, AR, and MR d=P=AR=MR$4 Firm P Q

Profit Maximization for the Perfectly Competitive Firm  The goal of a competitive firm is to maximize profit.  This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

P = AR = MR P=MR 1 MC Profit Maximization for the Perfectly Competitive Firm Quantity 0 Costs and Revenue ATC AVC Q MAX The firm maximizes profit by producing the quantity at which MR=MC. MC 1 Q1Q1 MC 2 Q2Q2

Profit Maximization for the Perfectly Competitive Firm  When MR > MC, Q increase will increase profit  When MR < MC, Q decrease will increase profit  When MR = MC, economic profit is maximized

Profit Maximization for the Perfectly Competitive Firm 0 Revenue ($s per year) Output (units per year) TR Slope of TR = MR

0 Cost $ (per year) Output (units per year) Profit Maximization for the Perfectly Competitive Firm TC Slope of TC = MC

0 Cost, Revenue, Profit ($s per year) Output (units per year) TR TC A B Profit Maximization for the Perfectly Competitive Firm Profit q1q1 MR=MC

0 Cost, Revenue, Profit ($s per year) Output (units per year) TR TC A B Profit Maximization for the Perfectly Competitive Firm Profit q1q1 q3q3 q2q2 Profits are maximized when MC = MR.

The Marginal Principle  The marginal principle is the fundamental notion that people will maximize their income or profits when the marginal costs and marginal benefits of their actions are equal.  A profit-maximizing firm will set its output at that level where marginal cost equals price (MC=P).

Profit P = AR = MR P MC Firms Making Profits Quantity 0 Costs and Revenue ATC AVC Q MAX

Loss P = AR = MR P MC Firms Incurring Losses Quantity 0 Costs and Revenue ATC AVC Q MAX

P = AR = MR P MC Zero-Profit Point Quantity 0 Costs and Revenue ATC AVC Q MAX Zero-Profit Point

 Total cost includes all the opportunity costs of the firm.  In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.  Although the economic profit is zero, the firm has realized its normal profit.

P = AR = MR P MC Shut-Down Point Quantity 0 Costs and Revenue ATC AVC Shut-Down Point Q MAX ●

Shut-Down Point When AVC ＜ P ＜ ATC, why does the firm continue production?

Shutdown vs. Exit  A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.  Exit refers to a long-run decision to leave the market.

Shutdown vs. Exit The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down. u Sunk costs are costs that have already been committed and cannot be recovered.

Summary of Production Decisions  Profit is maximized when MC = MR  If P > ATC the firm is making profits.  If AVC < P < ATC the firm should produce at a loss.  If P < AVC < ATC the firm should shut- down.

The Firm’s Short-Run Supply Curve Quantity 0 Costs and Revenue MC ATC AVC The portion of MC above AVC is the competitive firm’s short-run supply curve.

Production and Supply Curve Quantity ATC AVC 0 Costs If P < AVC, shut down. If P > AVC, keep producing in the short run. If P > ATC, keep producing at a profit. Firm’s short-run supply curve.

The Response of a Firm to a Change in Product Price When the price of a firm ’ s product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.

MC 3 Industry Supply in the Short Run $ per unit MC 1 The short-run industry supply curve is the horizontal summation of the supply curves of the firms. Quantity MC S P2P2 P1P1

MC Output in the Long Run Quantity 0 Costs and Revenue ATC=AVC In the long run all costs are variable

The Firm’s Long-Run Decision to Exit or Enter a Market In the long-run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC

The Firm’s Long-Run Decision to Exit or Enter a Market A firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC

The Competitive Firm’s Long-Run Supply Curve Quantity MC ATC 0 Costs Firm enters if P > ATC Firm exits if P < ATC The portion of MC above ATC is the firm’s long-run supply curve

The Firm’s Short-Run vs. Long-Run Supply Curves  Short-Run Supply Curve  The portion of its marginal cost curve that lies above average variable cost.  Long-Run Supply Curve  The marginal cost curve above the minimum point of its average total cost curve.

Profit Q Long-Run Profit of the Competitive Firm Quantity 0 Price P = AR = MR ATCMC P ATC Profit-maximizing quantity

Loss Long-Run Loss of the Competitive Firm Quantity 0 Price P = AR = MR ATCMC P Q Loss-minimizing quantity ATC

The Long Run: Market Supply with Entry and Exit uFirms will enter or exit the market until profit is driven to zero. uIn the long run, price equals the minimum of average total cost. uThe long-run market supply curve is horizontal at this price if the input prices remains constant, but it will be upward sloping if the input prices rises.

S1S1 Long-Run Competitive Equilibrium Output $ per unit of output $ per unit of output $40 LAC LMC D S2S2 P1P1 Q1Q1 q2q2 FirmIndustry $30 Q2Q2 P2P2 Profit attracts firms, and supply increases until profit = 0

A P1P1 AC P1P1 MC q1q1 D1D1 S1S1 Q1Q1 C D2D2 P2P2 P2P2 q2q2 B S2S2 Q2Q2 Economic profits attract new firms. Long-Run Supply in a Constant-Cost Industry Output $ per unit of output $ per unit of output SLSL Long-run supply curve

Long-Run Supply in an Increasing-Cost Industry Output $ per unit of output $ per unit of output S1S1 D1D1 P1P1 LAC 1 P1P1 SMC 1 q1q1 Q1Q1 A Due to the increase in input prices, long- run equilibrium occurs at a higher price. SLSLSLSL P3P3 SMC 2 LAC 2 B S2S2 P3P3 Q3Q3 q2q2 P2P2 P2P2 D1D1 Q2Q2

The Long Run: Market Supply with Entry and Exit  At the end of the process of entry and exit, firms that remain must be making zero economic profit.  The process of entry & exit ends only when price and average total cost are driven to equality.  Long-run equilibrium must have firms operating at their efficient scale.

Firms Stay in Business with Zero Profit  Profit equals total revenue minus total cost.  Total cost includes all the opportunity costs of the firm.  In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.

Producer Surplus P = AR = MR P MC Producer Surplus Quantity 0 Costs and Revenue ATC Q MAX

Price of Steel 0Quantity of Steel Domestic demand Producer Surplus in an Exporting Country Domestic supply World price Price after trade Exports Domestic quantity demanded Domestic quantity supplied Price before trade

Price of Steel 0Quantity of Steel World price Domestic demand Producer Surplus in an Exporting Country Domestic supply Price after trade Price before trade A B C D Exports

Price of Steel 0Quantity of Steel World price Domestic demand Producer Surplus in an Exporting Country Domestic supply Price after trade Price before trade A Consumer surplus before trade B C Producer surplus before trade

Price of Steel 0Quantity of Steel World price Domestic demand Producer Surplus in an Exporting Country Domestic supply Price after trade Price before trade A Consumer surplus after trade C B Producer surplus after trade D Exports

Producer Surplus in an Importing Country Price of Steel 0Quantity of Steel Domestic supply Domestic demand World Price Price after trade Domestic quantity demanded Domestic quantity supplied Price before trade Imports

Producer Surplus in an Importing Country Price of Steel 0Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A B C D Imports

Producer Surplus in an Importing Country Price of Steel 0Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A Consumer surplus before trade C B Producer surplus before trade

Producer Surplus in an Importing Country Price of Steel 0Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A Consumer surplus after trade B D C Producer surplus after trade Imports

Tax Revenue (T x Q) Producer Surplus and Tax Price 0 Quantity Quantity without tax Supply Demand Price without tax Price buyers pay Quantity with tax Size of tax Price sellers receive

The Effects of a Tax uA tax places a wedge between the price buyers pay and the price sellers receive. uBecause of this tax wedge, the quantity sold falls below the level that would be sold without a tax. uThe size of the market for that good shrinks.

Consumer Surplus and Tax Quantity0 Price Demand Supply Q1Q1 A B C F D E Q2Q2 Tax reduces consumer surplus by (B+C) and producer surplus by (D+E) Tax revenue = (B+D) Deadweight Loss = (C+E) Price buyers pay = PBPB P1P1 Price without tax = PSPS Price sellers receive =

Effect of Tax upon Welfare uThe change in consumer surplus, uThe change in producer surplus, uThe change in tax revenue. uThe losses to buyers and sellers exceed the revenue raised by the government. uThis fall in total surplus is called the deadweight loss.

Determinants of Deadweight Loss uThe magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. uThat, in turn, depends on the price elasticities of supply and demand.

Producer Surplus Loss Elasticity and Producer Surplus Loss Quantity0 Price D S Tax 1. When supply is more elastic than demand the incidence of the tax falls more heavily on consumers than on producers. Price without tax Price buyers pay Price sellers receive

Producer Surplus Loss Elasticity and Producer Surplus Loss Quantity0 Price D S Price without tax Tax 1. When demand is more elastic than supply the incidence of the tax falls more heavily on producers than on consumers. Price buyers pay Price sellers receive

Pricing Information

Information Production Costs  First-copy costs dominate  Sunk costs - not recoverable  Variable costs small;  no capacity constraints  Microsoft has 92% profit margins  Significant economies of scale  Marginal cost less than average cost  Declining average cost

Implications for Market Structure  Cannot be "perfectly competitive"

Strategy  What to do  Differentiate your product Add value to the raw information to distinguish yourself from the competition  Achieve cost leadership through economies of scale and scope

Personalize Your Product  Personalize product, personalize price  PointCast  Personalized ads  Hot words (in cents/view)  DejaNews:  Excite:  Infoseek:  Yahoo:

Know Your Customer  Registration  Required: NY Times  Billing: Wall Street Journal  Know your consumer  Observe Queries  Observe Clickstream

Logic of Pricing  Example ： Quicken  1 million for $60, 2 million for $20?  Demand curve (next slide)  Assumes only one price Price discrimination gives $10 million  Problems How do you know consumer? How do you prevent arbitrage （套利） ?

Demand Curve Price (Dollars) Quantity (Millions) $20 $4 0 $60 123

Forms of Differential Pricing  Personalized pricing  Sell to each user at a different price  Versioning  Offer a product line and let users choose  Group pricing  Based on group membership/identity

Personalized Pricing  Catalog inserts  Market research  Differentiation  Easy on the Internet

Internet  Virtual Vineyards  Auctions  Closeouts, promotions

Group Pricing  Price sensitivity  Network effects, standardization  Lock-In  Sharing

Price Sensitivity  International pricing  US edition textbook: $70  Indian edition textbook: $5  Problems raised by Internet  Localization as solution

Assignment  Review Chapter 8  Answer questions on P153  Preview Chapter 9

Thanks