Econ Examples Plus Multimedia

Econ Examples Plus Multimedia

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CREATED BYDr. Kyle Hampton

International Trade (Cowen/Tabarrok Chapter 8 Micro and Chapter 18 Macro)

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Monopoly (Cowen/Tabarrok Chapter 11 Micro)

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Boxes of Peppermint Sticks(in millions)

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Candyline Inc. is a company that makes red and white peppermint sticks. This is very competitive industry with several firms each selling essentially the same product.

Because perfect substitutes for Candyline’s peppermints are readily available to consumers, the demand curve for Candyline peppermints is perfectly elastic with a market price of $6 a box.

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Because, this market is so competitive, Candyline sells every box of peppermint sticks for the same market price of $6.

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Marginal revenue is the addition to total revenue that occurs with every unit sold. Because every unit is sold at the market price of $6, the marginal revenue curve is the same as the demand curve.

= MR

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One day, the scientists at Candyline Inc. devise a new technology that allows them to create a peppermint stick that actually eliminates cavities.

After securing a patent for their new product, Candyline acquires market power in the sale of their new peppermint stick. They are now a monopoly seller of their cavity- eliminating peppermint stick.

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Because they are the only seller of this improved peppermint stick (which they name DecayAwayTM ), the market demand curve is their demand curve.

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And because there are no good substitutes for the DecayAway, that demand curve is downward sloping.

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Because the demand curve for DecayAway is now downward sloping, Candyline can no longer sell as many units as they wish at a single price. If they want to increase the number of units they sell, they will have to decrease the price they are charging for their product.

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And if they want to increase prices, they will have to decrease output.

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Because you must lower price to increase output, the marginal revenue of each unit produced will be less than the price.

To illustrate, take consider the following example. Imagine Candyline is currently selling 60 million boxes of DecayAway sticks for $8 apiece. If they want to increase output from 60 to 100 million units, they will need to lower the price to $6.

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In increasing their output, Candyline does see an increase in revenue from selling the 40 additional units.

The revenue gain is equal to price of each new unit sold multiplied by the number of new units or

$6 x 40 = $240

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This revenue gain is shown as the green shaded area to the right.

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However, in order to increase output, we have to decrease price. And not just the price of the new units we are selling but also the units we were selling before. Those 60 units that we were selling for $8 will now be sold for $6. This results in a loss of $2 per unit and total loss of

$2x 60 = $120

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This revenue loss is shown as the red shaded area to the right.

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The net change in revenue, is the difference in the gain from selling additional output and the loss incurred from decreasing the price on the output we were originally producing.

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This change in revenue (ΔTR) is the area of the new green rectangle to the right.

$3 x 40 = $120

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Marginal revenue is the change in revenue divided by the change in output.

MR = ΔTR/ ΔQ

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In this case the marginal revenue we earn from increasing our output from 60 million to 100 million units is

$120 million / 40 million units = $3

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You can see that – unlike the case of competitive markets – the marginal revenue for a monopolist is always less than price.

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Looking at the effect on revenue of other price and output choices would allow us to build the entire marginal revenue curve.

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The marginal revenue curve has twice the slope of a linear demand curve.

MR

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There are substantial fixed costs involved in the invention and production of DecayAway peppermint sticks, but once these fixed costs are paid, the marginal cost of producing each additional box is only $3.

Therefore the marginal cost curve is flat and is shown to the right.

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120

MR

MC

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MR

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Firms try to maximize profit and Candyline is no exception. As you learned in Chapter 10, firms maximize profit by choosing the output level where marginal revenue equals marginal cost (MR = MC.)

Candyline should produce

a. 60 million boxes.b. 80 million boxes.c. 100 million boxes.d. 120 million boxes.

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No. Sorry. Look at the graph on the right. The marginal revenue we earn on the 60 millionth box is $5.

But each box cost us only $3 to produce.

This means that selling an additional box would earn us more revenue (~$5) than it would cost us to produce it ($3).

Therefore, we should produce more than 60 million boxes.

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120

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No. Sorry. Look at the graph on the right. The marginal revenue we earn on the 100 millionth box is $1.

But each box cost us on $3 to produce.

This means that selling this box would earn us less revenue (~$1) than it would cost us to produce it ($3).

Therefore, we should produce less than 100 million boxes.

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No. Sorry. Look at the graph on the right. The marginal revenue we earn on the 120 millionth box is negative. That is – producing it actually reduces our total revenue.

Disregarding cost, producing this many units actually means our revenue will be below what it would be at a lower level of output.

We would certainly not produce this many boxes.

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120

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That’s right. By producing 80 million units, we maximize our profit. Selling the 80 millionth box nets us an increase in revenue of $3. This is exactly the cost of producing that box.

If we were to sell one additional box, the marginal revenue earned on that box would be less than $3 and not worth the $3 we would spend to produce it.

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120

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MR

MC

The next obvious question is what price should be charge in order to sell our profit maximizing output of 80 million boxes?

a. $3b. $5c. $7d. $9

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No. Sorry. Look at the demand curve.

If we were to charge $3, we would sell 160 million units, which is considerably more than our profit-maximizing quantity of 80 million units.

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If we were to charge $5, we would sell 120 million units, which is considerably more than our profit-maximizing quantity of 80 million units.

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If we were to charge $9, we would sell 40 million units, which is considerably less than our profit-maximizing quantity of 80 million units.

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Absolutely! Check out that demand curve.

If we were to charge $7, we would sell our profit-maximizing quantity of 80 million units.

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Having found Candyline’s profit- maximizing price, we can now calculate the profit Candyline will earn in the market.

In order to calculate total profit, we need to know our the profit earned per unit. We know the revenue earned per unit. That’s price – in this case, $7. But now we need to know our cost per unit.

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As we mentioned earlier, Candyline incurs substantial fixed costs in producing DecayAway peppermint sticks. This is in addition to the $3 per box they pay in marginal cost.

Because of the need to cover fixed costs, the average cost of each box of DecayAway peppermint sticks is greater than the marginal cost. The average cost includes the marginal cost plus some portion of the fixed costs.

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As we produce more and more units, the smaller the share of the fixed costs added to each box we produce.

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MR

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This results in an average cost that decreases as we increase output.

AC

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MR

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What is our average cost per unit at the profit maximizing output?

a. $7b. $3c. $5d. $2

AC

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Sorry. No. $3 is the marginal cost.

Try again.

AC

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Sorry. No. $7 is the price.

Try again.

AC

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Sorry. No. $2 is not correct. Look at the average cost curve.

Try again.

AC

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MR

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That’s right, The average cost of each box of DecayAways at an output of 80 million units is $5 a box.

AC

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MR

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We now have enough information determine the profit Candyline will be earning per unit. This will be the difference between revenue received per unit (P = $7) and the cost of producing each unit (AC = $5).

The profit per unit is

$7 - $5 = $2

AC

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AC

So what is Candyline’s total profit?

a) $320 millionb) $160 millionc) $560 milliond) $240 million

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Sorry, no. Total profit is going to be the profit per unit multiplied by the number of boxes actually sold.

AC

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MR

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Excellent. To find the total profit, we multiply the profit per unit by total output.

$2 x 80 million = $160 million

This profit is given by the area of the purple rectangle on the right. AC

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MR

MC

Candyline is earning a profit on the sale of DecayAway peppermint sticks. And they will be able to earn this profit so long as their patent serves as a barrier to the entry of potential competitors.

This ability to earn monopoly profits is obviously very good for Candyline. But is it good for society? AC

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To answer that question, let’s imagine that instead of restricting their output to 80 million units, Candyline chose to produce one more box of DecayAway sticks.

What would be the cost of producing this extra box?

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To answer that question, let’s imagine that instead of restricting their output to 80 million boxes, Candyline chose to produce 100 million.

How much value would these additional boxes provide to consumers?

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The demand curve tells us how much value our consumers put on those additional 20 million units.

And each of the boxes has a value to some consumer between $7 and $6.

But along with providing value, these boxes also incur a cost to society. What is the value of the resources needed to produce these additional boxes?

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MR

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The value of the resources needed to produce the DecayAway sticks is simply the cost to produce the boxes.

And, as we stated, each of these additional 20 million boxes will cost us $3 apiece to produce.

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MR

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Because the cost of producing these 20 million additional units is less than the value someone puts on their consumption, society be better off if these goods were produced and consumed.

This excess of value over cost is the surplus discussed in previous chapters and is shown as the brown shape on the right. Because Candyline does not produce these units, this surplus is lost.

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You can probably see that the production of additional boxes of DecayAway would provide surplus to society.

If Candyline was trying to maximize surplus rather than profit, how many boxes would they sell?

a) 220 millionb) 180 millionc) 120 milliond) 160 million

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220 million is certainly an increase but is too many. Each unit produced and sold beyond 160 million cost more to produce than the value someone has for it. This result in a loss to society shown as the yellow triangle on the right.

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180 million is certainly an increase but is too many. Each unit produced and sold beyond 160 million cost more to produce than the value someone has for it. This result in a loss to society shown as the yellow triangle on the right.

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MR

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120 million would certain represent an increase in surplus. But it is likely that increased output would result in more.

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That is correct. Producing 160 million boxes would capture all of the available surplus.

Note that this would take place at the level of output where price is equal to marginal cost, one of the defining features of a competitive market.

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MR

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But alas, this is not the level of output chosen by the profit-maximizing monopolist and this surplus is lost to society. The loss that occurs because surplus-generating trades do not take place is called deadweight loss.

The deadweight loss generated by Candyline’s decision to produce 80 million units is the area of the triangle on the right.

($4 x 80 million)/2 = $160 million

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Temp End.

120

Demand

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Econ Examples Plus Multimedia