INTRODUCTION

This course covers the field of microeconomics. Microeconomics addressesindividual behavior in markets and the interrelationships between markets. This isquite different from macroeconomics, which focuses on economy-wide issues. As wewill see, microeconomics focuses on how prices determine resource allocation. Accordingly, microeconomics is also referred to as price theory.

Resource allocation addresses the following questions: (1) What’s produced?,(2) How to produce?, and (3) Who gets it? Consider the “who gets it?” question. What systems could be used to answer this question?

Two uses of price theory:

1. Descriptive (Positive Theory)

2. Prescriptive (Normative Theory)

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Underlying our discussions will be the Fundamental Premise of Economics,which simply means that individuals are rational to the extent that they can weigh thebenefits and costs of various options and pick that option which gives them thehighest net benefit (Net Benefit = Benefit - Cost).

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DEMAND AND SUPPLY

What determines the price of a product? The demand and supply model is asimple way of answering this question.

Consumer Side:

Demand refers to the relationship between the quantity of a good or servicethat consumers are willing and able to buy during a specific time period and thedeterminants of that amount. Depending on the issue, we may look at individual,group, or market demand.

Let’s look at some of the determinants of the quantity consumers are willingand able to buy. We invoke “ceteris paribus”.

[1] Price

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Other determinants: (These shift the demand curve.)

[2] Income

[3] Prices of Related Goods

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[4] Tastes and Preferences

[5] Price and Income Expectations

[6] Population of Buyers

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Demand Function:

Example: = 100 - 2PA + ½I + 2PB

Generalize:

Market Demand = Horizontal sum of all individual consumer demands.

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Producer Side:

Supply refers to the relationship between the quantity of a good or service thatproducers are willing and able to sell during a specific time period and thedeterminants of that amount. Similar to demand, we may speak of an individual firm,a group of firms, or a market supply.

Some determinants:

[1] Price

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Other determinants: (These shift the supply curve.):

[2] Input Prices and Technology

[3] Prices of Related Goods or Services

[4] Price Expectations

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[5] Environment

[6] Population of Sellers

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Supply Function:

Example: = 10 + 2PA + 3PB - ½W

Generalize:

Market supply = horizontal sum of individual firm supplies.

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What are the market price and quantity? We determine this by solving for the marketequilibrium.

Equilibrium = A condition, which once achieved, tends to persist.

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Comparative Statics: What happens if demand and/or supply shift?

Consider some different scenarios:

[1] Drought in California: impacts on water and tomato markets

[2] Increase in the price of beef: impact on pork market (assuming beef and porkare substitutes in consumption)

[3] Increase in the price of soybeans: impact on the corn market (assumingsoybeans and corn are substitutes in production)

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Consider a numerical example: Suppose the market demand and supply of beef aregiven by the following:

Demand:

Supply:

where and are the quantities demanded and supplied of beef (in pounds),

respectively. PB is the price of beef (in dollars), I is per capita consumer income (indollars), and PC is the price of corn (in dollars).

A. Currently, per capita consumer income is $50,000 and the price of corn is $4. Let’s sketch the current market demand and supply curves for beef (being careful todetermine the values of the horizontal- and vertical-axis intercepts) and determine themarket equilibrium price and quantity of beef.

B. Now, suppose per capita consumer income doubles to $100,000. Let’sillustrate the impact on the beef market.

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What if both demand and supply change? Then it gets a little more difficultpredicting the outcome. Consider:

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How can governments influence a market? Consider two cases:

[1] Price Controls

[2] Taxes (we’ll focus on the consumer side)

Excise Tax - In this case, consumers are charged $t per unit consumed.

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ELASTICITY

A very useful tool to a decision-maker is elasticity. Elasticity provides us witha tool to measure the effect of different factors on demand and/or supply. Considerthe function: Y = f(X). In general, the elasticity of Y with respect to X equals:

with

and

such that

Interpretation:

Consider: Y = 10 - 2X.

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One problem is that the elasticity value depends on whether we move up ordown the curve. To get around this problem, we will calculate the point elasticity.

Point elasticity - rather than deal with large changes in X and Y, we deal withinfinitesimally small changes, which in effect calculates the elasticity at a point on thecurve.

In this case,

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Demand Elasticities:

Price Elasticity of Demand

åp =

Point:

Consider: Q = 100 - 2P

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Categories of elasticity:

A. Elastic: åp < -1

B. Inelastic: -1 < åp < 0

C. Unit Elastic: åp = -1

D. Perfectly Elastic: åp = -4

E. Perfectly Inelastic: åp = 0

Notice, with the linear demand equation above, the price elasticity varies alongthe curve. In the upper half, it is elastic. In the lower half, it is inelastic. At center,it is unit elastic.

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Consider some price elasticities:

Product Price ElasticityCigarettes -0.50Beer -0.83Marijuana -0.30Horse Racing -1.02Fresh Tomatoes -4.60Housing -1.00

Factors affecting åp:

1. Number and closeness of substitutes

2. The degree of necessity

3. The percentage of overall consumer expenditure dedicated to the good

4. Length of time over which consumers respond to price changes

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One use of the price elasticity of demand is to infer the effect on total revenue(P x Q), which is the same as total expenditure of consumers, of a price change. Fora firm, is it always best to increase its price? A knee-jerk reaction might be to say“yes”, but the answer depends on åp.

Scenarios:

1. åp < -1

2. -1 < åp < 0

3. åp = -1

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These three situations suggest a relationship between Q and TR, which is givenbelow:

For a firm interested in maximizing its profit, it should never operate in the inelasticregion of its demand. Why?

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Other Demand Elasticities:

Cross Elasticity of Demand

Point:

Cases:

Application: Market Definition and Antitrust - Du Pont (1947)

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Income Elasticity of Demand

åI =

Point:

Cases:

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Consider a demand function:

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Supply Elasticities:

Price Elasticity of Supply (åS)

åS =

Point:

Similar categories with demand: Elastic, Inelastic, and Unit Elastic.

Examples:

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What Affects the Value of çS?

1. Length of time over which producers respond to price changes

2. Substitutability of Inputs (Resources) across Production:

3. Possibilities of Storing the Product

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THEORY OF THE CONSUMER

Since demand addresses consumer behavior, several theories have been offeredto explain consumer behavior. Consumer theory focuses on preferences. Also,consumers derive satisfaction (utility) from the consumption of goods or services. Three key assumptions:

• Completeness

• Transitivity

• Non-Satiation

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Now, there are two approaches to address the theory. One is the cardinalapproach, while the other is the ordinal approach. We will focus on the ordinalapproach. Key to the ordinal approach is to model preferences with indifferenceschedules and indifference curves.

Indifference schedule = Listing of different bundles that bring an individual the samesatisfaction (i.e., utility).

Consider an individual who can consume either milk and/or bread:

Group 1 Indifference Schedule Group 2 Indifference Schedule

Bundle Milk Bread Bundle Milk Bread A 10 qts 0 loaves E 12 qts 0 loaves B 7 1 F 10 1 C 5 2 G 8 2 D 4 4 H 6 4

Graph:

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Properties:

[1] Provided we are looking at two goods (i.e., two products for which more ispreferred to less (non-satiation), then bundles on higher indifference curves coincidewith greater utility. That is, utility higher indifference curves correspond to higherutility.

[2] For two goods, indifference curves have a negative slope (due to non-satiation).

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[3] Indifference curves cannot intersect each other (due to transitivity).

[4] Indifference curves must pass through every point in the commodity space (dueto completeness).

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[5] Indifference curves are convex to the origin (due to the Law of DiminishingMarginal Utility).

From the cardinal approach:

According to the Law of Diminishing Marginal Utility, although totalsatisfaction increases as more of a good is consumed (i.e., non-satiation), theincreases in satisfaction associated with additional consumption must eventuallydiminish. Consider:

Number of times eat chicken for dinner per week Total Utility Marginal Utility 0 0 utils ---

1 100 100 2 180 80

3 240 60 4 280 40 5 300 20

Now,

Marginal Rate of Substitution (MRS) = The rate at which a consumer is willing totrade the consumption of one commodity for another, while maintaining satisfaction. It is an indication of the relative importance the consumer attaches to one commodityrelative to another commodity.

MRS = slope of the indifference curve < 0

Or,

So, if indifference curves are convex, then MRS (in absolute value) falls as we slidedown the indifference curve.

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It turns out:

How much bread and milk will the individual consume? We need to bring in theconsumer’s budget constraint. That is,

I = “income” = “budget” =

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Equilibrium of the consumer:

Following the Fundamental Premise of Economics, consumers seek tomaximize their satisfaction subject to the budget constraint. That is,

• Given a budget and prices, consumers will choose to consume somewhere ontheir budget line. Why?

• Where is the best point? That is, given the consumer will lie on the budgetline, which bundle yields the highest satisfaction?

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That is, the budget line will be tangent to the indifference curve at the best bundlepossible. Or,

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What happens if income or prices change? Price-Consumption Curve and Income-Consumption Curve:

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Recall when the price changes, the consumer changes consumption because ofthe substitution effect and the income effect. Let’s formalize this in terms of ordinalutility theory. Suppose the price of bread increases, graphically

• The substitution effect is the change in quantity purchased attributable to thechange in price, independent of the gain of loss in utility.

• The income effect is the change in quantity purchased that is attributable solelyto the gain or loss in utility.

Graphically,

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Derivation of individual demand:

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THEORY OF THE FIRM

In this next section of the course we will get behind the supply curve. That is,we will address the production of a good or service. A firm is an organization that uses inputs to produce outputs. What are the goals of a firm?

But the choices available to a firm are limited. For example, profit isconstrained by market demand, input supply, and technology.

Now, as we said, firms use inputs to produce output. This is reflected in theproduction function, given by:

Example:

Q = 10 + 2X1 + 3X2

Note: Just like demand and supply, the time period is important. Key to the timeissue is the substitutability of inputs.

Couple assumptions:

1. Technology is given.2. Firms operate efficiently.

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Role of time:

Depending on the time frame, some inputs may be fixed. For example,consider weekly production of a textile mill. It must make choices knowing that thenumber of looms it has are fixed. Yet labor may be variable. If, instead, we lookedat production on a minute-by-minute basis, all inputs may be fixed.

We capture the role of time by splitting it into two periods: the short run (SR)and the long run (LR).

SR = a period of time short enough that at least one input is fixed.

LR = a period of time sufficiently long that all inputs are variable.

So, we have fixed and variable inputs, depending on the period of time we arelooking at.

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For simplicity, let’s collapse all of our inputs down to just two: capital (K) andlabor (L). Let’s look at a fictitious newspaper company.

Start with daily production, assuming this is the short run.

So,

Q = number of newspapers produced per dayL = number of workers employed per dayK = number of printing presses used per day - assume fixed at 3

Q (TP) L K AP MP0 0 3 - -1000 1 3 1000 10003000 2 3 1500 20006000 3 3 2000 300010000 4 3 2500 400013000 5 3 2600 300015000 6 3 2500 200016000 7 3 2286 100015000 8 3 1875 -1000

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General shapes:

1. If MP > AP, AP is rising.2. If MP < AP, AP is falling. 3. MP = AP at maximum of AP.4. It is irrational to operate where MP < 0. 5. Law of Diminishing Marginal Returns:

As additional units of a variable input are combined with a fixed input, at somepoint the additional output (MP) must diminish. In our case, diminishing returnsbegins with the hiring of the 5th worker.

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We can use production functions to help us figure out the optimal amount ofan input to use. Consider a cement company interested in hiring the optimal numberof workers per day. Currently, it receives $15/ton for its cement (output price), andpays a typical worker $30/day (input price). Suppose it is currently employing 20workers, and the marginal product of the 21st worker is 4 tons of cement. Should ithire the 21st worker?

Instead, suppose the firm is employing 30 workers, and the marginal productof the 30th worker is 1. What should it do?

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Define:

Marginal Revenue Product = change in total revenue due to a change in an input.

In our first example, MRP = $60.

In our second example, MRP = $15.

Rule:

If PINPUT < MRPINPUT, then hire more of the input.

If PINPUT > MRPINPUT, then hire less of the input.

So, to maximize profit, the firm should hire to the point where PINPUT = MRPINPUT. In our example, the marginal revenue product of labor equals (Note: This assumesthat the firm is purely competitive (also called perfectly competitive), which we willaddress later.):

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Long Run Production:

Now, let’s suppose that the time interval for production decisions is sufficientlylong that all inputs are variable (i.e., the long run). Consider an example of a firmthat cuts chords of wood. It is interested in daily production, which is sufficientlylong that its inputs (chain saws (K) and labor (L)) are both variable. Let’s look at theproduction table:

Notice: There are more choices on how to produce a given output. That is,when we move the long run, the there are less constraints on production. Consider,for example, that K were fixed at 6, then there would be only one way to produce 16chords of wood (hire 2 workers). Now, with K and L variable, there are two ways toproduce 16 chords of wood.

So, the key to the long run is the substitutability of inputs. If one chooses tomaintain production, they can trade off one input for another. What should guideyour decision? Should you be “labor-intensive” or “capital-intensive”?

Notice that the table does illustrate some short run issues. Namely, if we holdone input fixed and vary the other input, then marginal product is positive and thefirm is encountering diminishing returns.

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Let’s graph the production table:

This leads to a series of isoquants (“same quantity”). Each isoquant represents adifferent level of production.

Properties of isoquants:

• Higher isoquants yield greater output. Why? MP’s > 0 (rational firms)

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• Isoquants have a negative slope. Why? MP’s > 0

• Isoquants are convex to the origin. Why? Law of Diminishing MarginalReturns.

Define:

Marginal rate of technical substitution (MRTS) = slope of the isoquant.

The MRTS represents the rate of tradeoff of one input for another, such thatproduction is maintained at a certain level.

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Note:

So, by being convex to the origin, the MRTS (in absolute value) falls as we slidedown the isoquant. Also,

Let’s see why. Consider the isoquant below:

• Imagine moving from point A to point B. But do it in two steps, via point C.

• Consider step 1: Holding K constant, we increase L, leading to a higherisoquant (and therefore a higher production).

•

• Consider step 2: Holding L constant, we decrease K, leading us back to theoriginal isoquant (and therefore a lower production).

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• So, it must be that the increase in Q in step 1 (+) is offset by the decrease in Qin step 2 (-). Or,

+ -

Or,

Or,

So, why is the isoquant convex? Diminishing returns.

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When we speak of long run production, we characterize production by returnsto scale. Three types:

Increasing returns to scale (economies of scale)

Decreasing returns to scale (diseconomies of scale)

Constant returns to scale

Cobb-Douglas Production Function:

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How should we select the optimal combination of capital and labor? Inaddition to the isoquant (production), we will need to look at the relative costs of thetwo inputs. This is captured by the isocost (“same cost”) line

Isocost = all combinations of variable inputs that yield the same cost (outlay).

Note:

M = total outlay =

Example:

Monthly outlay with PL = 1000 and PK = 500 (price per input per month)

So,

M = 1000L + 500K

Now, what if we had $10,000 allocated in expenditure? What combinations of K andL could spend $10,000? Graph:

In general, for a given M, the equation of the isocost is:

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What happens when M, PL, or PK change?

How select the inputs? Note: This assumes a purely competitive firm.

Two approaches:

A. Minimize the expenditure given some output. That is, produce an output ascheaply as possible.

B. Maximize the output given some expenditure. That is, produce the most fromsome given outlay.

Both A and B are centered on maximizing profit.

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Let’s simply consider A. Both A and B lead to the same input combination. Lookat the following graph:

The best combination of K and L is where the (given) isoquant is tangent to theisocost. That is, they have the same slope.

Slope of Isoquant =

Slope of Isocost =

So, the best combination of K and L is where

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That is, equate the marginal products per dollar.

If , then increase L and decrease K.

If , then decrease L and increase K.

So, if you have many inputs, determine optimal mix by finding:

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Cost:

How are production and cost related? Intuitively, greater production coincideswith greater cost. Now, economists view costs differently from accountants.

Two types of costs:

1. Accounting Cost (Explicit Cost)

Accounting profit (Að) = total revenue - accounting cost

2. Opportunity Cost (Implicit Cost)

Economic cost = accounting cost + opportunity costEconomic profit (Eð) = total revenue - economic cost

= total revenue - (accounting cost + opportunity cost) = Að - opportunity cost

Economic profit guides decisions. Consider a farmer. The farmer can grow corn orwheat. By growing corn, the farmer gives up the opportunity to grow wheat. So,imagine that the farmer’s opportunity cost of growing corn is the accounting profitshe gives up by not growing wheat (Aðwheat). Suppose:

Aðwheat = $30,000Aðcorn = $20,000

What should the farmer do?

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Let’s look more closely at the relationship between production and cost. Consider an example of a golf ball company. It produces golf balls with labor (L) andmachinery (K), with the following Cobb-Douglas production function:

, where Q is the number of cases produced, L is the number of

workers hired, and K is the number of machines utilized.

Now suppose this is the short run (e.g., daily), with K fixed at 4, such that the shortrun production function becomes:

Further, let PL = $30 and PK = $1000. Think of the price of capital as perhaps thedaily lease on a golf ball machine. What is the total cost per day?

TC = 1000K + 30L = 4000 + 30L (Same as total outlay from before)

Consider different scenarios:

L = 4

L = 16

L = 1

Let’s derive the short run total cost function:

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Notice that short run total cost consists of two parts:

Total fixed cost = cost associated with the fixed input(s). It is the portion of total cost that does not vary with output.

Total variable cost = cost associated with the variable input(s). It is the portion of total cost that does vary with output.

Let’s graphically derive these curves using another example:

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Back to our newspaper example:

Suppose PK = $100 and PL = $50

Q (TP) L K AP MP TVC TFC TC

0 0 3 - - $0 $300 $3001000 1 3 1000 1000 $50 $300 $3503000 2 3 1500 2000 $100 $300 $4006000 3 3 2000 3000 $150 $300 $45010000 4 3 2500 4000 $200 $300 $50013000 5 3 2600 3000 $250 $300 $55015000 6 3 2500 2000 $300 $300 $60016000 7 3 2286 1000 $350 $300 $650

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Other short run costs:

= change in TC or TVC due to a change in Q

Q L K AP MP TVC TFC TC AVC AFC ATC MC

0 0 3 - - $0 $300 $300 _________________________

1000 1 3 1000 1000 $50 $300 $350 _________________________

3000 2 3 1500 2000 $100 $300 $400 _________________________

6000 3 3 2000 3000 $150 $300 $450 _________________________

10000 4 3 2500 4000 $200 $300 $500 __________________________

13000 5 3 2600 3000 $250 $300 $550 __________________________

15000 6 3 2500 2000 $300 $300 $600 __________________________

16000 7 3 2286 1000 $350 $300 $650 __________________________

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Let’s put it all together:

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One more illustration of the linkage between cost and production. Suppose we havea firm operating in the short run with two inputs, capital (K) and labor (L), where Kis fixed and L is variable. Accordingly,

[1]

[2]

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What about long run cost? In the long run all inputs are variable. Often, thelong run is viewed as a planning horizon, in the sense that firms decide on a particularproduction level and then build a plant to meet that desired level.

Let’s see (Derivation of long run average cost):

The shape of the long run average cost curve is linked to returns to scale. When LR average cost is declining, the firm operates under economies of scale. When LR average cost is rising, the firm operates under diseconomies of scale.

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Adhering to the Fundamental Premise of Economics, firms wish to maximizeprofit. So, let’s determine the price and quantity that will maximize profit. Ultimately, as we will see later, this depends upon the market in which the firmoperates. Yet we can discuss some preliminary concepts at this point. Recall:

Recall, Profit (ð) = Total Revenue (TR) - Total Cost (TC)

Example: Suppose you own an ice cream shop. How much ice cream should you sellper day and at what price?

• Suppose you are currently producing 100 gallons a day at a price of $10 pergallon, such that TR = $1000. Moreover, suppose TC = $900. Next, supposeto sell one more gallon (Q = 101) you must drop the price to $9.99 (recall thedemand curve). Also, by producing more, your total cost increases to $905. Should you produce and sell 101 units?

• Suppose you are currently at Q = 100 and P = $10, with TC = $900. What ifyou cut Q to 99? Suppose by doing this, TR becomes $995 and TC becomes$850. Should you cut production?

Definitions:

Marginal Revenue (MR) = change in TR due to a change in Q

Marginal Cost (MC) = change in TC due to a change in Q

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Rules:

If MR > MC, firm should produce and sell more to increase profit.

IF MR < MC, firm should produce and sell less to increase profit.

Hence, profit is maximized at the quantity where MR = MC. This is the profitmaximizing rule we will follow.

Graphically:

MR = slope of TRMC = slope of TC

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STRUCTURE, CONDUCT, PERFORMANCE

So far we have not incorporated market structure into our analysis. We haveessentially assumed the firm is not affected by rival behavior. Obviously, this is notthe case - in many markets firms behave according to the perceived behavior of rivals. Traditionally, the approach to analyze such issues is captured by the structure-conduct-performance paradigm (SCPP). According to the SCPP, market structureaffects firm conduct which ultimately affects the performance of the market.

Elements of Market Structure:

1. Concentration - focuses on the number and size distribution of firms in amarket.

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Some other elements of market structure -

2. Product Differentiation -

3. Entry and Exit Conditions -

A barrier to entry is anything that limits the entry of firms into a market. Or,by the same token, any cost that must be encountered by entrants but not by existingfirms.

4. Cost structures -

5. Level of integration - mergers and acquisitions

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Elements of Firm Conduct:

1. Pricing behavior -

2. Product strategy and advertisement -

3. Research and development -

4. Plant investment -

5. Legal tactics -

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Elements of Market Performance:

1. Profit -

2. Equity -

3. Employment -

4. Quality -

5. Market Welfare -

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Consider some market structures:

Perfect Competition:

Market Structure -

• Many buyers and sellers

• Firms sell a homogeneous product

• Perfect knowledge of existing market conditions

• Free entry and exit

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Implications:

SR Conduct - Goal is to maximize profit.

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Consider a loss situation:

Example: At P = MC,

P Q TFC TVC TC

10 100 400 800 1200

What should the firm do?

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Instead, what if at P = MC:

TR TFC TVC TC

1000 100 1100 1200

What should the firm do?

Short run Supply:

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What about long run conduct in perfect competition?

The essence of the long run is the growth and decline of industries. Industriesgrow by firms entering or existing firms expanding their capital stock. Industriesdecline by firms exiting or existing firms reducing their capital stock. In both cases,the capital stock of the industry changing, which is a long run issue.

What prompts entry?

What prompts exit?

Implications:

So, what we get out of a perfectly competitive market are the following:

1. price taking - no control over price - very intense competition.2. economic profits driven away in the long run.

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Monopoly:

Market Structure -

A. Single seller

B. Significant barriers to entry

Three Types

1. Natural Barriers: Advantages held by incumbents not owing to actions takenby them or the government to deter entry.

Absolute cost advantages

Economies of scale

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2. Government Imposed Barriers: Actions taken by the government to limitthe number of firms in the market.

Licenses

Government franchise

Patents

3. Strategic Barriers: Actions taken by incumbents to deter entry

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Suppose that barriers to entry are such that the market can only sustain one firm(i.e., monopoly). In this case, the market demand is the firm demand. That is, in theshort run:

Numerical:

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Similar to any market in the short run, as long as price exceeds average variablecost the firm should produce. If price drops below average variable cost, the firmshould shutdown production. That is,

In the long run, there is no threat of entry. Consequently, long run profit canbe sustained.

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Compare monopoly to perfect competition:

The perfectly competitive market leads D = S, or P = MC. In monopoly,however, price exceeds marginal cost. Hence, the monopolist will tend to restrictoutput below the competitive level and as a result raise price. Graph:

Market Welfare = sum of net gains to consumers and producers in a market.

Consumer surplus (CS) = net gains to consumers in a market.

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Producer surplus (PS) = net gains to producers in a market.

Market welfare is higher under perfect competition than under monopoly.

Indeed, the monopolist tends to “win” (higher profit) at the consumer’s “loss”(higher price). This criticism of monopoly is the basis for antitrust law. Antitrustlaws are designed to limit behavior that would increase the likelihood of monopoly.

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Consider an alternative pricing scenario: Price Discrimination

In many situations, it is more profitable for a firm to charge different prices todifferent consumers.

Price Discrimination: Charging different prices to different consumers, not owingto cost differences.

Scenarios:

Senior discountsQuantity discountsCar dealerships

Consider a car dealership. How does price discrimination emerge? Why is itprofitable to price discriminate?

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This is known as First Degree Price Discrimination. In this case, the pricediscriminator extracts all consumer surplus from the market. Accordingly, CS = 0and W = PS.

Now, for price discrimination to be profitable, two things must occur:

1. Price arbitrage must be prevented

2. Different consumers must be willing to pay different prices. This is equivalentto consumers facing different price elasticities.

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First degree price discrimination is very difficult to do, since the firm mustknow the reservation price of every consumer. More commonly what we see is ThirdDegree Price Discrimination. This is the case when the firm segments its market intotwo or more groups, charging each group a different price. Consider the graphsbelow:

Note: MRT is the “total marginal revenue”, which is the horizontal sum of the groupA and B marginal revenue curves.

Three questions that must be answered to maximize profit:

• How much to produce overall?

• How should this overall amount be allocated across the two groups?

• What price to charge each group?

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The group charged the higher price is that which faces the less elastic demand. Why?

Alternative Markets:

Consider some examples -

Local Fast food

Auto industry

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Monopolistic Competition:

The vast majority of markets are neither perfectly competitive nor monopoly. Consider monopolistic competition:

Market Structure:

• Many sellers in the market

• Firm produce slightly differentiated products

Product differentiation: When buyers perceive differences among the brandsof a product. This creates brand loyalty, leading to firms facing downward slopingdemand curves. Examples: physical attributes, location, service.

An implication: Firms advertise in this type of market to further differentiate theirproduct from the competition.

• Easy entry and exit

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Short run profit maximizing behavior:

Long run profit maximizing behavior:

Advantages: Advertising and product innovationWeaknesses: Price higher than under perfect competition. Also, advertising raisesprice.

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Oligopoly:

Market Structure:

• Few firms 6 High concentration

• Mutual interdependence

• Substantial barriers to entry

government imposednaturalstrategic

Threat of Predatory PricingProduct DifferentiationControl of Inputs

• Identical or differentiated products

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Many different models to explain behavior. They differ in terms of how firmsreact to mutual interdependence. Due to mutual interdependence, firms must formexpectations of how rivals will react to chosen actions.

Examples of Beliefs:

Two firms: A and B

1. Maximin Belief - Each believes the other firm’s sole objective is to cause themost damage.

2. Cournot Belief - Each believes whatever it does the other firm will not respond.

Let’s look at it from the perspective of choosing a quantity. Example:

Firms produce a product, dump it on the market, and receive a price. Thiswould apply in situations where inventory holdings are not feasible. For example, thecorn wet milling industry has been determined to follow this situation.

In terms of quantity, a Cournot belief is such that each firm treats the otherfirm’s production as given when making its quantity choice.

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Consider the market demand given by Q = 500 - P:

Define:

Firm (Residual) Demand = Market Demand - other firm production

Suppose each firm has a total cost given by: TCA = 100qA and TCB = 100qB

Thus, each firm has a marginal cost which is constant at 100.

What if A believes B will produce zero?

What if A believes B will produce 100?

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What if A believes B will produce 200?

A’s Reaction Curve = Relationship between A’s optimal production and B’sproduction. B has a similar reaction curve. Graph:

Can we predict an outcome?

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3. Cooperative Belief - Firms see the market in a similar light and believe thateach recognizes that cooperation is better than competition.

There are two general forms of cooperation:

Explicit Cooperation - Explicit arrangements to limit competition among firmsin the same line of business.

“People of the same trade seldom meet together, even for merriment anddiversion, but the conversation ends in a conspiracy against the public, or in somecontrivance to raise prices.” - Adam Smith (The Wealth of Nations).

Two common forms of explicit cooperation are cartels and price fixingconspiracies. Both yield similar outcomes - supracompetitive profits.

A cartel refers to an agreement to act in unison with the goal of raising thecollective profits of a group of firms.

Price fixing schemes seek to maintain prices above levels they otherwise wouldbe without cooperation.

Implicit Cooperation - Due to market conditions, firms charge similar pricesor otherwise act with the appearance of explicit cooperation.

Examples: Markup Pricing, Price leadership.

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Cartel:

A cartel occurs when firms seek to maximize the joint profits of the membersby using a series of quotas. Consider a market with two firms, A and B. If they forma cartel their goal is to maximize joint (cartel) profit, which is: ðC = ðA + ðB.

• Imagine these two firms pull their resources and effectively act as one firm(monopoly). Then MCC = horizontal sum of MCA and MCB.

• Acting in unison, the monopoly (cartel) output and price is QC and PC,respectively.

• How should the cartel output be distributed? That is, quotas must bedetermined.

• Problem: Incentive to cheat (produce beyond the quota).• Prediction: Cartels are unstable.

If cartels are predicted to break-up, why do they occur? Role of punishments.

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Consider some market structure factors that facilitate or hinder cooperation:

1. Number of Firms (concentration)

2. Mergers

3. Differentiated Products

4. Excess Capacity/High Inventories

5. Industry Council or Trade Association

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Dominant Firm Price Leadership:

In this situation a dominant firm (typically controlling 50 - 90% of the market)sets the price and others (followers) adjust to that price.

Examples: Steel, Cigarettes, Banking

Graph:

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Emphasis of late in studies of oligopoly have focused on the use of gametheory. Game theory is a formal technique of capturing rivalry. It was initiallydeveloped in World War II as a means of predicting Germany’s response to Alliedinvasion plans. In the 1970s it began to gain acceptance as a means of modelingoligopoly behavior. It centers on a game, which has three components:

Rules -

Strategies -

Payoffs -

Example: Rock-Papers-Scissors

Consider an advertising game between two firms: A and B

Rules:

• Both select advertising level at the same time (simultaneous play).• They play once.• They have complete information - each knows the possible moves and payoffs

of each player.• Advertising does not affect the market demand. It only affects the distribution

of market demand. If both select the same advertising level, they distribute themarket demand 50/50. If one advertises more than the other, it receives agreater share of the market.

Strategies:

• Each can select either a low or high advertising level.

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Possible outcomes: Payoffs

Firm A and B select low advertising ðA = $10m, ðB = $10mFirm A and B select high advertising ðA = $5m, ðB = $5mFirm A select high, Firm B select low ðA = $20m, ðB = $3mFirm A select low, Firm B select high ðA = $3m, ðB = $20m

We illustrate this with a payoff matrix:

A

L H

L 10, 10 20, 3

B H 3, 20 5, 5

What do we predict will be the outcome?

Two approaches -

Dominance Arguments -

Equilibrium Arguments -

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Prisoners’ Dilemma:

Consider the Cournot game:

Consider the Cartel game:

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What about a dynamic game? This is where moves are sequential. Withdynamic games, they can be represented with a game tree, which consists of nodesand branches.

Example: Entry Game

As we’ve said, entry drives profits down. Consequently, incumbent firms arehurt when entrant firms come into a market. Can an incumbent deter entry? Onepotential method - threat of predatory pricing.

Consider two firms - entrant (E) and incumbent (I). The entrant must decidewhether or not to enter the market. If the entrant comes into the market, theincumbent must decide to fight (predatory price) or cooperate. This is illustratedbelow:

What will happen?

Backwards Induction -

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Consider the ultimatum game.

Suppose that $100 is to be divided up between two people. One person, theproposer, offers a certain distribution of the $100. The other person, the responder,then must decide to accept or not accept the offer. If the offer is not accepted, eachgets $0. If the offer is accepted, each gets the offered amount. What is the NashEquilibrium?

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INPUT MARKETS

Let’s shift gears. Up to this point, we’ve focused on output markets. However,there are also input markets. Analysis of these markets can help us answer suchquestions:

• What determines an input price?• What determines income?

Recall that optimal input usage (i.e., that which maximizes profit) occurs whenthe following holds:

(Note: This assumes that input prices are given. In other words, the input buyers andsellers are price takers).

But this is akin to:

But recall:

So, to maximize profit, firms should select inputs such that:

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Or:

,

,

***

But profit is maximized when MR = MC. So, the above is equivalent to:

,

,

***

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And by rearranging, we get:

,

,

***

Now,

= marginal revenue product of input A (i.e., MRPA).

So,

MRP measures the change in total revenue due to hiring one more unit of the input. Now, in the case of a purely competitive firm, marginal revenue equals price. So,MRP = Poutput * MP, which is the same expression we had before in the notes. In thiscase, with MRP = MR * MP, we generalize to any type of output market, whether itis perfectly or imperfectly competitive.

Example:

A firm currently has 5 machines. It’s contemplating buying a 6th machine, forwhich the marginal product is 1. Also, suppose MR = $80. If the price of the machineis $40, what should the firm do?

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Indeed, from before:

If PINPUT < MRPINPUT, then hire more of the input.

If PINPUT > MRPINPUT, then hire less of the input.

What we want to do is to predict how input markets will behave under differentscenarios.

Case I: Input and Output Market are Competitive

In this case, all prices are taken as given. Buyers and sellers individually haveno influence on input and output prices. So, for example, individual firms can’tinfluence the prices they receive for their produce or the prices they pay for theirinputs.

As before, in terms of input selection, inputs should be hired to the point wherethe following holds:

,

,

**

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Consider a simple scenario, where the firm only has one variable input. Thatis, except for input A, all other inputs are fixed (recall the short run). Go back to acompetitive firm:

In order to maximize profit, the firm will operate under diminishing returns in theshort run. Accordingly, the MRP curve becomes:

Indeed, the MRP curve is the firm’s demand curve for input A.

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Now, if more than one input is variable, it gets a little tricky. First, considerthe case of a multifactor adjustment. This relates to the case where two variableinputs might be substitutes or complements to each other.

Substitutes:

Complements:

Adjusting for this will modify the demand for the input (i.e., long run inputdemand). In particular, this adjustment impacts the marginal productivity of the inputin question, such that:

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Now, previously we dealt with the individual firm demand for an input. Whatif we want the market demand. We might be inclined to simply horizontally add upall the firm demands. However, this would be incorrect, since we need to account forthe industry adjustment. Again, this will change the demand curve (i.e., input marketdemand):

Market Equilibrium:

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Case II: Input Market Competitive but Output Market not Competitive

In this case, individual buyers of inputs take the input price as given, butindividual sellers of outputs have some control over their price. For example, a localbar may operate in a monopolistically competitive output market but takes the priceit pays for liquor as given. In this case, MRP = MR * MP, with Poutput > MR.

Consider the case of a single variable input, A, with all other inputs fixed. Similar to before, the MRP curve is the firm’s demand for the input. Except in thiscase, the graphical derivation of MRP is slightly changed:

Now, if other inputs are variable, then just like before we have to take accountof the multifactor adjustment. Accordingly,

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To get the market demand for the input, then it is very tricky to derive themarket demand, since we have to account for how input buyers compete against eachother in the output market. We’ll leave that for another class!

Case III: Input Market not Competitive but Output Market Competitive

In this case, input buyers (i.e., firms) sell their output in a competitive market. So, they take the price they receive for their product as given. However, they havesome control over the price they pay for their input(s). For example, we might havea singly buyer of an input (i.e., a monopsony), such as a local steel mill. Or theremight be a market with a few input buyers (i.e., oligopsony).

Let’s tackle the case of a monopsony. In this case, since the monopsonist is theonly buyer of the input, the market supply of the input is the one faced buy themonopsonist. That is, in terms of input A:

In the previous cases of competitive input markets, each buyer was so smallthat it simply took the input price as given when making its hiring decisions. This isakin to each firm having a perfectly elastic input supply curve, given by:

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Consider a monopsonist who faces an upward sloping supply curve of input A. The supply schedule is given as:

PA QA Total Cost of Input A Marginal Expenditure for Input A

$5 10 $50 ---

$7 11 $77 $27

$9 12 $108 $31

$11 13 $143 $35

$13 14 $182 $39

The marginal expenditure (ME) is the change in total cost of input A fromhiring one more unit of the input. As you can see, MEA > PA. Graphically,

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Now, how much of input A will the monopsonist wish to employ? If weassume all other inputs are fixed, except for input A, then the firm should hire to thepoint where:

Let’s see:

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And if there are several inputs, then each input should be hired to the pointsuch that the following holds:

,

,

***

Case IV: Both Input and Output Markets not Competitive

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