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Chapter 14-23

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Department
Economics
Course
ECON 1B03
Professor
Hannah Holmes
Semester
Fall

Description
CHAPTER FOURTEEN What Is A Competitive Market? The Meaning of Competition  Competitive market: market with many buyers and sellers trading identical products so that each buyer and seller is a price taker  Actions of single buyer/seller do not have impact on price  Firms can freely enter or exit market in the long run The Revenue of a Competitive Firm  Firms try to maximize profit  Average revenue: TR/Q  Marginal revenue: change in total revenue from an additional unit sold  Marginal revenue always equals the price of the good The Marginal-Cost Curve and the Firm’s Supply Decision  MC curve is upward sloping  ATC curve is U-shaped  MC curve crosses ATC curve at minimum ATC  Price line is horizontal because firm is a price taker  P = MR = AR  Profit-maximizing quantity is where P = MC = MR  MC curve determines quantity firm is willing to supply at any price  MC curve is the firm’s supply curve Profit Maximization And The Competitive Firm’s Supply Curve A Simple Example of Profit Maximization  As long as MR > MC increasing quantity produced will raise profit  Will not produce more if MR < MC  Will be led to produce profit-maximizing quantity The Firm’s Short-Run Decision to Shut Down  Shutdown: short-run decision to not produce anything during a period of time because of current market conditions  Exit: long-run decision to leave the market  Firm that shuts down temporarily still has to pay fixed costs  Firm will shut down if P < AVC  If firm does not cover AVC it is best to stop production altogether  Shutdown price: price at minimum point on ACT curve  Prices below shut down price: short-run supply curve is along vertical axis  Prices above shut down price: short-run supply curve is MC curve above AVC Spilt Milk and Other Sunk Costs  Sunk cost: cost that has already been committed and cannot be recovered  Cannot be avoided regardless of choices you make  Fixed costs are sunk costs  Can be ignored when firm is deciding how much to produce The Firm’s Long-Run Decision to Exit or Enter a Market  Firm exits if revenue is less than total costs  Avoids fixed and variable costs of production  Firm will exit it P < ATC  Exit price: price at minimum point on ATC curve  Entrepreneur would enter market if P > ATC  Prices below exit price: long-run supply curve is along vertical axis  Price above exit price: long-run supply curve is MC curve that lies above ATC Measuring Profit in Our Graph for the Competitive Firm  Profit = (P – ATC) x Q  Area of the rectangle on the graph The Supply Curve In A Competitive Market The Short Run: Market Supply with a Fixed Number of Firms  Sum of quantities supplied by all firms is quantity supplied to the market  Add up quantity supplied of all firms to find market supply curve  Firms all produce same quantity  Supply of market = number of firms x quantity supplied The Long Run: Market Supply with Entry and Exit  P > ATC: firms in market are profitable new firms will want to enter  Entry will increase quantity of good supplied and decrease price and profits  P < ATC: firms in market are making losses existing firms will want to exit  Exit will decrease quantity of good supplied and increase prices and profits  Firms that remain in market must be making zero economic profit  Firm has zero profit if P = ATC  Long-run equilibrium of competitive market must have firms operating at efficient scale (P = MC = ATC)  LR supply curve is horizontal at price that is consistent with zero profit Why Do Competitive Firms Stay in Business If They Make Zero Profit?  Zero economic profit = positive accounting profit  Include implicit and explicit costs of running business A Shift in Demand in the Short Run and Long Run  Shift in demand in market means price rises  Existing firms raise amount they produce  Firms are now making positive profit  Profit encourages new firms to enter so short-run supply curve shifts to the right  Price eventually driven back down to minimum ATC where profits are zero  Market reaches new long-run equilibrium with a higher quantity Why the Long-Run Supply Curve Might Slope Upward 1. Some resource used in production is available in limited quantities o Increase in demand for product cannot increase quantity supplied without increasing costs of firm o There will be a rise in price so curve is upward sloping 2. Firms have different costs o Firms with lower costs more likely to enter than firms with higher costs o In order for firms with high costs to want to enter, price must rise to make it profitable for them  Price in market reflects ATC of marginal firm  Marginal firm: firm that would exit the market if price was any lower  Upward sloping supply curve means higher price is needed to induce larger quantity supplied  LR supply curve more elastic than SR supply curve CHAPTER FIFTEEN Monopoly  Competitive firm is a price taker  Monopoly firm is a price maker  Market power alters relationship between firm’s costs and price it sells product at  Competitive firm takes price of market and decides quantity from that price  Monopoly: price exceeds marginal cost  Control prices of goods but profits are not unlimited  Outcome in a market with a monopoly is not in best interest of society  Government must stop monopolies from taking over too much of market Why Monopolies Arise  Monopoly: a firm that is the sole seller of a product without close substitutes  Cause of monopoly is barriers to entry  Remains only seller because other firms cannot enter and compete  Causes of barriers to entry: o Monopoly resources: key resource owned by single firm (ex. De Beers owns 80% of world’s diamond production) o Government-created monopolies: government gives single firm exclusive right to produce good/service (ex. Patent and copyright laws) o Natural monopolies: single firms can produce output at lower cost than large number of producers Natural Monopolies  Natural monopoly: monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms  Happens when economies of scale are over relevant range of output  No other firms want to enter market  Natural monopoly can change to competitive market if market expands How Monopolies Make Production and Pricing Decisions Monopoly versus Competition  Monopoly alters price of good by altering quantity supplied  Competitive firm takes market price  Demand curve of ONE competitive firm is perfectly elastic (horizontal)  Demand curve of monopoly is market demand curve  Market demand curve puts constraint on monopoly  Cannot charge really high price and produce a lot  Must choose point on demand curve A Monopoly’s Revenue  Total revenue = quantity sold x price  Average revenue: amount of revenue received per unit sold  Average revenue = total revenue/quantity of output  Average revenue always equals price of the good  Marginal revenue: amount of revenue the firm receives for each additional unit of output  Monopolist’s marginal revenue is always less than price of its good  Effect of increasing the amount sold: 1. The output effect: more output is sold so Q is higher which increases total revenue 2. The price effect: price falls so P is lower which decreases total revenue  Competitive: increases production by 1 unit, does not receive any less for units it was already selling  Monopoly: increases production by 1 unit, must reduce price charged for every unit  Marginal revenue is negative when price effect is greater than output effect  Firm is selling more units but total revenue declines Profit Maximization  When marginal cost is less than marginal revenue: firm can increase profit by producing more units  When marginal cost is greater than marginal revenue: firm can raise profit by reducing production  Maximum profit where marginal revenue curve and marginal cost curve intersect  Competitive firm’s marginal revenue equals price: P = MR = MC  Monopoly’s marginal revenue is less than price: P > MR = MC  Competitive market: price equals marginal cost  Monopolize market: price greater than marginal cost A Monopoly’s Profit  Profit = (P – ATC) x Q  Same as profit for competitive firms  Allows us to measure profit in the graph The Welfare Cost of Monopoly  Monopoly is not desirable from standpoint of consumers  Monopoly is very desirable from standpoint of firms  TS = CS + PS  Monopoly outcome does not maximize total economic well-being  Leads to allocation of resources different from that of competitive market The Deadweight Loss  Total surplus = value of good to consumers – cost of making good to monopoly producer  Demand curve represents value of good to consumers  Marginal cost curve reflects costs of monopolist  Socially efficient quantity found where demand curve and marginal cost curve intersect  Below quantity: D > MC so increasing output would raise total surplus  Above quantity: MC > D so decreasing output would raise total surplus  Optimal quantity: value of an extra unit to consumers equals marginal cost of production  Monopolist produces less than the socially efficient quantity of output (where MR = MC)  A price above MC takes away customers that value good more than MC but less than monopolist’s price  Prevents mutually beneficial trades from taking place  DWL: area between D curve and MC curve from efficient to monopoly Q  DWL cause quantity sold to fall short of social optimum The Monopoly’s Profit: A Social Cost?  Welfare in monopolized market includes welfare of consumers + producers  Monopoly profit does not represent decrease in welfare  It represents smaller CS and bigger PS  Problem only occurs because firm produces Q below level that maximizes TS  Only loss is because lose some consumers with the high price  Exception: if monopoly firm has to raise costs to maintain monopoly position  Ex. Government-created monopoly Price Discrimination  Price discrimination: selling the same good at different prices to different consumers  Not possible in a competitive market  If try to charge higher price in competitive market will just go to another firm A Parable about Pricing  Price discriminating raises profit by selling to two different markets  Sell at higher price to people willing to pay more  Sell at lower price to people willing to pay less  Ex. Sell textbooks for different prices in Canada and Europe  Ex. Put out hard-cover book before soft-cover book  Can make profit from both markets and no one is left out The Moral of the Story  Price discrimination is a rational strategy for a profit-maximizing monopolist  Can increase profit by satisfying different willingness’s-to-pay  Price discrimination requires ability to separate customers according to willingness-to-pay  Can separate geographically, by age, income, etc.  Price discrimination can raise economic welfare (eliminates DWL)  Sells to different willingness’s-to-pay so everyone gets what they want  Increase in welfare shows up as higher PS  Arbitrage prevents price discrimination  Arbitrage: buying a good in one market at low price and selling it in another market at higher price for profit The Analytics of Price Discrimination  Perfect price discrimination: monopolist knows willingness to pay of each consumer (can charge each customer different price)  Also referred to as first-degree price discrimination  Monopolist gets entire surplus in market (TS = PS)  Perfect price discrimination is impossible  Imperfect price discrimination forms: 1. Second-degree price discrimination: charging different prices to same customer for different units that customer buys (ex. Buying large quantities) 2. Third-degree price discrimination: achieved when market can be segmented and different segments have different elasticities of demand (ex. Movie tickets – senior and child discount)  Will be kink in D and MR curves where demands change  Decides how many tickets to sell by drawing horizontal line through MC = MR point  Where it intersects different curves represents different prices/quantities Examples of Price Discrimination  Airline Prices o Price discriminate between business and pleasure flyers o Business people more willing-to-pay for business class because need immediate seating o Pleasure flyers are more relaxed and have lower willingness-to-pay  Discount Coupons o Coupons allow price discrimination o Not all people willing to spend time clipping out coupons o Willingness to clip coupons is related to willingness-to-pay  Financial Aid o Wealthy have higher willingness-to-pay for school o Financial aid allows less affluent people to go to school o Only allowed financial aid if need it  Quantity Discounts o Charge different prices to same customer for different amounts bought o Lower price for buying larger quantities o Pay higher price for first unit bought than for twelfth Public Policy Toward Monopolies  Policymakers in government respond to problem of monopoly by: 1. Trying to make monopolized industries more competitive 2. Regulating behavior of monopolies 3. Turning some private monopolies into public enterprises 4. Doing nothing at all Increasing Competition with Competition Law  Government could pass laws to prevent mergers between companies  Want to prevent one company from having all of market power  Government can also make companies give up some of assets  Competition law in Canada prevents anticompetitive practices  Synergies: benefits of greater efficiency as result of mergers  Competition laws can prevent synergies  Competition laws meant to raise social welfare  Government if merger is desirable or not  Compare social benefit from synergies to social cost of reduced competition Regulation  Government agencies regulate some monopolies prices  Have trouble deciding what price monopolies should charge  Cannot set P = MC because ATC is declining  Price will be less than ATC and firm will lose money  Will not chose low price will just exit industry  Solutions: 1. Subsidize monopolist: government picks up losses from MC = P (government must tax now though which raises DWL) 2. Average-cost pricing: allow monopolist to charge P = MC (still leads to DWL because P not equal to MC)  Give monopolist no incentive to reduce costs  Regulators will reduce price when cost falls  Monopolist will not benefit from lower costs  Regulators allow monopolists to keep some of benefits from lower costs Public Ownership  Government runs monopoly itself  Occurs at federal and provincial/territorial levels  Economists prefer private ownership of natural monopolies  Private owners want to minimize costs if get benefit of higher profit  Private owners can fire managers if doing a bad job  Public customers can only vote for government to try to change taxes Conclusion: The Prevalence of Monopoly Competitive Monopoly Market Market Similarities Goal of firms Maximize Maximize profits profits Rule for maximizing MR = MC MR = MC Can economic profits be earned in the Yes Yes short run? Differences Number of firms Many One Marginal Revenue MR = P MR < P Price P = MC P > MC Produces welfare-maximizing level of Yes No output? Entry in long run? Yes No Can earn economic profits in long No Yes run? Price discrimination possible? No Yes CHAPTER SIXTEEN Between Monopoly and Perfect Competition  Competition and monopoly are extreme forms of market structure  Most markets include elements of both  Imperfect competition: not complete market power but not complete price taker (can set own price to some extent)  Oligopoly: o A market structure in which only a few sellers offer similar or identical products o Ex. Cigarette industry has concentration ratio of 99% o Not very competitive o Firms usually interact strategically o Different from perfectly competitive: few sellers in market  Concentration ratio: percentage of total output in market supplied by four largest firms  Most industries have four-firm concentration ratio under 50%  Monopolistic competition: o A market structure in which many firms sell products that are similar but not identical o Each firm has monopoly over it’s own product o Different from perfectly competitive: sellers have different products o Many sellers: there are many firms competing for the same group of customers o Product differentiation: each firm produces product that is a bit different from other firms (has downward-sloping demand curve) o Free entry and exit: firms can enter/exit market without restrictions (number of firms adjust until economic profits are zero) Competition With Differentiated Products The Monopolistically Competitive Firm in the Short Run  Faces a downward-sloping demand curve  Profit maximization: where MR = MC and use D curve to find price  If price exceeds ATC firm will make a profit  If price is less than ATC firm is unable to make positive profit  Short run market structure is similar to that of a monopoly The Long-Run Equilibrium  Profit: o New firms want to enter market if firms are making a profit o Entry increases products for consumers to choose from o Reduces demand for each firm already in market o Entry shifts demand curve to the left o Firms experience declining profit  Losses: o Firms have incentive to exit o Customers have fewer products to choose from o Demand rises for firms that stay in market o Shifts demand curve to the right o Firms experience rising profit (declining losses)  Entry and exit continues until there is zero economic profit  In long run equilibrium: o No firms want to exit or enter o Maximum profit is zero when demand curve and ATC curve are tangent to each other o P > MC o Downward sloping demand curve makes MR < P o P = ATC  Monopolies can earn positive economic profit in long run  Monopolistic competition has zero economic profit in long run Monopolistic versus Perfect Competition  Excess Capacity: o Monopolistic competition: firms produce on downward-sloping portion of ATC curves o Competitive markets: firms produce at minimum of ATC o Efficient scale: quantity that minimizes ATC o Perfectly competitive firms produce at efficient scale in LR o Monopolistically competitive firms produce below in LR o Could increase quantity it produces and lower ATC o Has excess capacity o More profitable to have excess capacity than to cut price  Markup over Marginal Cost: o Competitive firm: P = MC o Monopolistically competitive firm: P > MC o Operate on declining portion of ATC curve o MC is below ATC on curve o For P to equal ATC, must be above MC o Competitive firm will not profit from another unit sold o Monopolistically competitive firm will profit o Try to attract more customers only if P > MC Monopolistic Competition and the Welfare of Society  Has the same deadweight loss of a monopoly  Customers who value good more than MC but less than price will not buy  No easy way for policymakers to fix problem  Will not want to lower prices since they are already making zero economic profit  May be socially inefficient because number of firms in market is not ideal  Effects of a new firm entering market: 1. Product-variety externality: consumers get some CS from a new product so entry of new firm is positive externality to consumers 2. Business-stealing externality: entry of new firm is negative externality on existing firms who lose customers and profits  Could have too few or too many products depending on which externality is greater  Externalities do not exist in perfect competition because P = MC and all firms have identical goods  Monopolistically competitive markets are less desirable Advertising  Firms in monopolistic competition advertise to attract buyers to product  Firms that sell highly differentiated consumer goods spend most on ads  Ex. Perfumes, razor blades, soft drinks, dog food  Firms that sell industrial products do not spend much on ads  Ex. Drill presses, communications satellites  Firms that sell homogeneous products do not advertise  Ex. Wheat, peanuts, crude oil The Debate Over Advertising  The Critique of Advertising: o Firms advertise in order to manipulate people’s taste o Ads are psychological not informational o Advertisements usually say nothing about price or quality o Creates desire that would not exist if had not seen ad o Impedes competition: tries to say products are more different than they are o Creates less elastic demand curve so can charge more for goods  The Defense of Advertising o Firms use advertising to provide information to consumers o Ads tell people prices of goods, new products, locations of stores o Consumers can then make better choices about what to buy o Markets able to allocate resources more efficiently o Advertising creates competition which leads to lower prices o Allows new firms to enter more easily Advertising as a Signal of Quality  Willingness of firm to spend a lot of money on advertisement signals to customers about quality of product  A firm who knows product is good will advertise more  They know they will make a larger profit than cost of advertising  Content of ad is not the important part  Willingness to pay for ad is important Brand Names  Firm with brand name spends more on ads and charges more for product  Critics: o Brand names cause consumers to see differences that do not exist o In most cases brand name good is not different from generic good  For: o Brand names are a way consumers can ensure good is high quality o Provide with information about quality when cannot be judged before purchasing o Give firms incentive to maintain high quality to keep reputation CHAPTER SEVENTEEN Oligopoly  Oligopoly: market structure in which only a few sellers offer similar or identical products  Actions of one seller has large impact on profit of others  Game theory: study of hoe people behave in strategic situations  Helps to explain the strategies people choose  Need to consider how others will respond to actions Markets With Only A Few Sellers  Best off cooperating and acting like monopolist  Produce small Q of output and charge P > MC  Incentives for groups of firms to cheat on agreements  Duopoly: oligopoly with only two members (simplest type) Competition, Monopolies and Cartels  Perfect competition: price would equal MC  Monopoly: produce quantity and price that maximizes profit  Duopolists: o Collusion: an agreement among firms in a market about quantities to produce or prices to charge o Cartel: the group of firms acting in unison o Must agree on total level of production and production of each firm o Each member wants a larger share o Must split equally to equally split profit The Equilibrium for an Oligopoly  Competition laws prohibit explicit agreements among oligopolists  Each firm assumes the other firm will produce half the monopoly quantity  Each want to produce larger quantity to make larger profit  Total profit will fall but their own profit will be larger  Will end up both producing quantity greater than monopoly quantity  Price will be lower than monopoly price  Total profit will be less than monopoly profit  Nash equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen  Would be better off cooperating but act in self-interest  Know when to stop so profit does not drop even more  Output is greater than produced by monopoly but less than competition  Price is less than monopoly price but greater than competitive price How the Size of an Oligopoly Affects the Market Outcome  Reaching and enforcing agreement is harder with more firms  Deciding to produce more: 1. Output effect: since P > MC, selling one more unit of good at the going price will raise profit 2. Price effect: raising production will increase total amount sold which will lower price of good and lower profit on all other units sold  If output effect > price effect firm will increase production  If output effect < price effect firm will not raise production  Each oligopolist increases production until two are balanced  Price effect falls the bigger the oligopoly grows (more firms)  Number of sellers grows larger, oligopolistic market looks more like competitive market  Price approaches MC and quantity approaches socially efficient level Economics of Cooperation  Prisoners’ dilemma: a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial The Prisoners’ Dilemma  Robbing bank: both get 1 year automatically  One confess to robbery: get off free but partner gets 20 years  Both confess to robbery: both get 8 years
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