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Principles of Economics
Session 6
Topics To Be CoveredMarket StructureCharacteristics of Perfectly Competitive
MarketProfit Maximization for a Competitive
FirmZero-Profit Point and Shut-Down PointShort-Run Supply CurveLong-Run Supply CurveProducer SurplusPricing Information
Market Structure
Perfect CompetitionMonopolyOligopolyMonopolistic Competition
Characteristics of Perfectly Competitive Market
Many buyers and sellersProduct homogeneityFree entry and exitPrice 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 Facedby a Competitive Firm
Q
P
d$4
FirmIndustry
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.
P=Q
QP=
Q
TR=AR
Revenue of a Perfectly Competitive Firm
Marginal revenue is the change in total revenue from an additional unit sold.
PQ
TRMR
Demand, Price, AR, and MR
d=P=AR=MR$4
Firm
P
Q
Profit Maximization for the Perfectly Competitive Firm
The goal of a competitive firm is to maximize profit.
This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.
P = AR = MR
P=MR1
MC
Profit Maximization for the Perfectly Competitive Firm
Quantity0
Costsand
Revenue
ATC
AVC
QMAX
The firm maximizes profit by producing the quantity at which MR=MC.
MC1
Q1
MC2
Q2
Profit Maximization for the Perfectly Competitive FirmWhen MR > MC,
Q increase will increase profit
When MR < MC, Q decrease will increase profit
When MR = MC,economic profit is maximized
Profit Maximization for the Perfectly Competitive Firm
0
Revenue($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($s per year)
Output (units per year)
TR
TC
A
B
Profit Maximization for the Perfectly Competitive Firm
Profitq1
MR=MC
0
Cost,Revenue,
Profit($s per year)
Output (units per year)
TR
TC
A
B
Profit Maximization for the Perfectly Competitive Firm
Profitq1 q3q2
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
Quantity0
Costsand
Revenue
ATC
AVC
QMAX
Loss
P = AR = MR
P
MC
Firms Incurring Losses
Quantity0
Costsand
Revenue
ATC
AVC
QMAX
P = AR = MR
P
MC
Zero-Profit Point
Quantity0
Costsand
Revenue
ATC
AVC
QMAX
Zero-Profit Point
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
Quantity0
Costsand
Revenue
ATC
AVC
Shut-Down Point
QMAX
●
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.
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
Quantity0
Costsand
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.
MC3
Industry Supply in the Short Run
$ perunit
0 2 4 8 105 7
MC1
The short-runindustry supply curve
is the horizontalsummation of the supply
curves of the firms.
Quantity
MC2
15 21
SS
P2
P1
MC
Output in the Long Run
Quantity0
Costsand
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 exitsif 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
Quantity0
Price
P = AR = MR
ATCMC
P
ATC
Profit-maximizing quantity
Loss
Long-Run Loss of the Competitive Firm
Quantity0
Price
P = AR = MR
ATCMC
P
QLoss-minimizing quantity
ATC
The Long Run: Market Supply with Entry and Exit
Firms will enter or exit the market until profit is driven to zero.
In the long run, price equals the minimum of average total cost.
The 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.
S1
Long-Run Competitive Equilibrium
Output Output
$ per unit ofoutput
$ per unit ofoutput
$40LAC
LMC
D
S2
P1
Q1q2
Firm Industry
$30
Q2
P2
Profit attracts firms, and supply increases until profit = 0
AP1
AC
P1
MC
q1
D1
S1
Q1
C
D2
P2P2
q2
B
S2
Q2
Economic profits attract new firms.
Long-Run Supply in aConstant-Cost Industry
Output Output
$ per unit ofoutput
$ per unit ofoutput
SL
Long-run supply curve
Long-Run Supply in anIncreasing-Cost Industry
Output Output
$ per unit ofoutput
$ per unit ofoutput S1
D1
P1
LAC1
P1
SMC1
q1 Q1
A
Due to the increase in input prices, long-run equilibrium occurs at a higher price.
SSLL
P3
SMC2LAC2
B
S2
P3
Q3q2
P2 P2
D1
Q2
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
Quantity0
Costsand
Revenue
ATC
QMAX
Priceof Steel
0 Quantityof Steel
Domesticdemand
Producer Surplus in an Exporting Country
Domesticsupply
Worldprice
Price after trade
Exports
Domesticquantity
demanded
Domesticquantity supplied
Price before trade
Priceof Steel
0 Quantityof Steel
Worldprice
Domesticdemand
Producer Surplus in an Exporting Country
Domesticsupply
Price after trade
Price before trade
A
B
C
D
Exports
Priceof Steel
0 Quantityof Steel
Worldprice
Domesticdemand
Producer Surplus in an Exporting Country
Domesticsupply
Price after trade
Price before trade
A
Consumer surplusbefore trade
B
C
Producer surplusbefore trade
Priceof Steel
0 Quantityof Steel
Worldprice
Domesticdemand
Producer Surplus in an Exporting Country
Domesticsupply
Price after trade
Price before trade
A
Consumer surplusafter trade
C
B
Producer surplusafter trade
D
Exports
Producer Surplus in an Importing Country
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domestic demand
World Price
Price after trade
Domesticquantity
demanded
Domesticquantitysupplied
Price before trade
Imports
Producer Surplus in an Importing Country
Priceof Steel
0 Quantityof Steel
Domesticsupply
World Price
Domestic demand
Price after trade
Price before trade
A
B
C
D
Imports
Producer Surplus in an Importing Country
Priceof Steel
0 Quantityof Steel
Domesticsupply
World Price
Domestic demand
Price after trade
Price before trade
A
Consumer surplusbefore trade
C
B
Producer surplusbefore trade
Producer Surplus in an Importing Country
Priceof Steel
0 Quantityof Steel
Domesticsupply
World Price
Domestic demand
Price after trade
Price before trade
A
Consumer surplusafter trade
B D
CProducer surplus
after trade
Imports
Tax Revenue (T x Q)
Producer Surplus and Tax
Price
0 QuantityQuantity without tax
Supply
Demand
Price without
tax
Price buyers
pay
Quantity with tax
Size of tax
Price sellers
receive
The Effects of a Tax
A tax places a wedge between the price buyers pay and the price sellers receive.
Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax.
The size of the market for that good shrinks.
Consumer Surplus and Tax
Quantity0
Price
Demand
Supply
Q1
A
BC
F
D E
Q2
Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)
Tax revenue = (B+D)
Deadweight Loss = (C+E)
Price buyerspay = PB
P1
Price without tax
=
PSPrice sellers receive
=
Effect of Tax upon Welfare
The change in consumer surplus, The change in producer surplus, The change in tax revenue. The losses to buyers and sellers exceed
the revenue raised by the government. This fall in total surplus is called the
deadweight loss.
Determinants of Deadweight Loss
The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.
That, 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 moreelastic than demand...
2. ...theincidence of thetax falls moreheavily onconsumers...
3. ...than onproducers.
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 moreelastic than supply...
2. ...theincidence of the tax falls more heavily on producers...
3. ...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 y
ourself from the competition
Achieve cost leadership through economies o
f scale and scope
Personalize Your Product
Personalize product, personalize price PointCast Personalized ads
Hot words (in cents/view) DejaNews: 2.0 4.0 Excite: 2.4 4.0 Infoseek: 1.3 5.0 Yahoo: 2.0 3.0
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 CurvePrice(Dollars)
Quantity (Millions)
$20
$40
$60
1 2 3
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 8Answer questions on P153Preview Chapter 9
Thanks