principles of economics session 6. topics to be covered market structure characteristics of...

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