1. ECON 101 Tutorial: Week 7 Shane Murphy s.murphy5@lancaster.ac.uk Office Hours: Monday 3:00-4:00 – LUMS C85

2. LUMS Maths and Stats Help (MASH) Centre Are you mystified by maths? Stuck with statistics? The LUMS Maths and Stats Help (MASH) Centre for LUMS undergraduate students opens this week. Every Monday (16.00- 18.00) and Friday (10.00-12.00), you can drop-in to LUMS B38a or book an appointment to see a student mentor and get help with maths and stats

3. Outline Roll Call Problems Discussion

4. Chapter 14: Exercise 8 The Best Computer Company just developed a new computer chip. a)Draw a diagram that shows consumer surplus, producer surplus, and total surplus in the market for this new chip. b)What happens to these three measures if the firm can perfectly price discriminate? What is the change of deadweight loss? What transfer occurs?

5. Chapter 14: Question for Review 9 Describe two problems that arise when regulators tell a natural monopoly that it must set a price equal to marginal cost When regulators tell a natural monopoly that it must set price equal to marginal cost, two problems arise. The first is that, because a natural monopoly’s marginal cost that is always less than its average cost, setting price equal to marginal cost means that the price is less than average cost, so the firm will lose money. The firm would then exit the industry unless the government subsidized it. However, getting revenue for such a subsidy would cause the government to raise other taxes, increasing the deadweight loss. The second problem of using costs to set price is that it gives the monopoly no incentive to reduce costs.

6. Exercise 3 A monopoly sells a product with a total-cost curve TC(Q) = 1200 + Q 2 /2. The market demand is given by the function Q=300-P. Calculate the price and quantity that maximize profits for this monopolist. MC = ? MR = ? MR = MC => Q = ? P = 300 – Q = ?

7. Discussion We don’t want “perfect competition” (profits = 0) even if we do want “free markets” (free entry for new firms and/or products into the market). Perfect competition is not conducive to rapid growth. The story: Growth is ultimately driven by innovation People will innovate if they have incentives to innovate The incentive to innovate comes from economic profits Profits only exist when the innovator or firm has some market power Innovators and/or firms need to charge a price greater than marginal cost to earn profits, otherwise there will be no incentive to innovate, and ultimately no growth. If you allow competitors to copy innovations they will drive the price down to marginal cost, eliminating profits and incentives for innovation. We want free entry of new firms with market power, but not free entry of imitators who produce perfect competition.

8. Discussion But perfect competition does maximize the combined consumer and producer surplus from a given product. So there is a tension here. Perfect competition maximizes the output of *existing* products, but minimizes the output from *potential* products. Example: if we decided that we had all the types of goods and services that we could ever want, then we’d want to enforce perfect competition. We would nullify every patent, and let competition take over to maximize the output of those existing goods and services. This means that it is not obvious what the right policy is for intellectual property rights and competition. It depends on your long-run perspective. – You can trade off long-run growth for a higher level of current output by canceling intellectual property rights. Or you can trade off current output for a higher long-run growth rate by strictly enforcing property rights.

9. Discussion There is no *right* answer here, because it depends on your time preferences. But extreme answers are probably unlikely to be optimal for anyone. – Strict perfect competition – allowing imitators to ensure P=MC – isn’t good because it prevents us from getting new products. – Super strong market power – limiting each good to being produced by a perpetual monopolist, say – would shrink the availability of every existing product, even if it makes the incentive to innovate huge.