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University of Texas at Austin
ECO 304K
Thomas Wiseman

EXAM 2 Study Guide Chapter 11: Costs and Profit Maximization under Competition Imagine that you are the owner of a stripper oil well and that you want to maximize your profit. What price to set? What quantity to produce? When to enter and exit the industry? What price to set? Sometimes the firm doesn’t set prices – sometimes simply accepts price that is given by the market If oil is $50 a barrel, can’t sell for $100 and why would you sell lower? You cant sell any oil at a price above the market price and you can sell all your oil at the market price. Thus to maximize profit, you sell at the market price. The more and the better the substitutes, the more elastic the demand. 400,000 oil wells – demand for oil is perfectly elastic (flat) A perfectly elastic demand curve for firm output is a reasonable approximation when the product being sold is similar across different firms and there are many buyers and sellers, each small relative to the total market Demand curves are more elastic in the long run Long run: the time after all exit or entry has occurred Short run: period before exit or entry can occur Imagine you’re owner of the only grocery store in a small town. Can you raise prices? In short run you could. But if raise prices too high, other sellers will set up shop. *An industry is competitive when firms don’t have much influence over the price of their product IF 1) product being sold is similar across sellers 2) there are many buyers/sellers, each small relative to total market 3) there are many potential buyers --A firm who sells unique items or who has a large share of the market for a homogenous product will have influence on the price of product What quantity to produce? Profit = pi = total revenue – total cost Total revenue = P X Q (price times quantity sold) Total costs is the cots of producing a given quantity of output (include opportunity costs, not just money costs) (average costs, marginal costs, fixed costs) ^include opportunity costs, costs of foregone alternatives An explicit cost is a cost that requires a money outlay Ex: lian runs a flower shop. Each month she spends money buying flowers from whole sellers. The cost of flowers is an explicit cost of running her shop, like rent and electricity, which she pays out of pocket by writing a check An implicit cost is a cost that does not require an outlay of money ^giving up something of a value when she works as a florist – a cost of running a flower shop, even though she is not writing anybody a check Economic profit is total revenue minus total costs including implicit costs Accounting profit is total revenue minus explicit costs ^Economic profits are typically less than accounting profits. Firms want to maximize economic profit, not accounting profit. Accountants typically don’t take into account of all opportunity costs. What am I giving up by following this strategy? Could these assets be used to make more profit if I used them in another way? Maximizing profit Fixed costs are costs that do not vary with output Ex: must pay to drill the well (had to borrow money to start the well); no matter how many barrels of oil it produces, still has to pay Variable costs are costs that do vary with output Ex: electricity, maintenance, costs for the barrels to store the oil, trucking costs to deliver oil Total Cost = Fixed Costs + Variable Costs Marginal Revenue is the change in total revenue from selling an additional unit MR = change in TR / change in Q For a firm in a competitive industry (the price of oil doesn’t change as the firm sells more barrels): MR = Price The owner of a small oil well has more choice from producing an additional barrel of oil Notice that the profit maximizing quantity is where MR = MC and MR = P so therefore, to maximize profit, a firm in a competitive industry increases output until P = MC ^ just right point between too little and too much (students are often confused by why economists say that the profit maximizing output is 8 instead of 7 barrels. Why produce the eighth barrel where P = MC and therefore no addition to profit?) Profits and the Average Cost Curve ^just because the firm is doing the best it can doesn’t mean that it is doing very well the average cost of production is simply the cost per barrel, that is, the average cost of producing Q barrels of oil divided by Q: AC = (TC)/Q Profit = Total Revenue – total cost = TR – TC Profit = (TR/Q – TR/Q) X Q Or Profit = (P – AC) X Q ^used two equations to get this LOOK ON PAGE 201 If P < AC then the firm is taking a loss If P > AC then the firm is making a profit When marginal cost is just below average cost, the average cost curve is falling, and when marginal cost is just above average cost, the average cost curve is rising, so AC and MC must meet at the minimum of the AC curve Entry, Exit, and Shutdown Decisions In the long run, firms will enter profitable industries (P>AC) and exit unprofitable industries. Notice that at the intermediate point, when P = AC, profits are zero and there is neither entry nor exit. Zero profits or normal profits occur when P = AC. At this price the firm is covering all of its costs, including enough to pay labor and capital their ordinary opportunity costs. No incentive to either enter or exit the industry. The short-run shutdown decision: When should a firm shut down? IN the long run, a firm will exit an industry if price falls below average costs, but exit typically takes a long time. Surprisingly, a firm may not want to shut down even when P < AC. The shutdown does not immediately eliminate all costs (fixed costs) Like ex: shutting down hotel in winter is less profitable than keeping it open with few tourists Entry and Exit with Uncertainty and Sunk Costs: A firm should exit when P < AC only if it expects P to remain below AC for a substantial period of time and it should enter only if P > AC and it expects P to stay above AC for a substantial period The costs of drilling an oil well are sunk costs (a cost that once incurred can never be recovered). Thus, for entry to be profitable, the firm must expect the price to stay above $17. So if you expect your firm to be profitable in the future, it can sometimes make sense to keep workers on, even when it is no profitable to do so today. *firms must estimate the effect of their decisions on their lifetime expected profit. A short delay has small costs but big benefits if a short delay will reveal more info about future process. Entry, Exit, and Supply Curves We will show how the slope of the supply curve can be explained by how costs change as industry output increases or decreases. Increasing cost industry: an industry in which industry costs increase with greater output; shown with an upward sloped supply curve Constant cost industry: an industry in which industry costs do not change with greater output; shown with a flat supply curve Decreasing cost industry: an industry with an increase in output; shown with a downward sloped supply curve Constant Cost industries: Ex: industry of domain name registrars (every website url is registered with DNA and assigned IP address) Many competitors in industry (product being sold is similar across sellers) There are many buyers and sellers, each small relative to the total market There are many potential sellers So, the domain name registration can expand without pushing up the price of its major inputs and thus without raising its own costs. An industry that can expand or contract without changing the prices of its input is called a constant cost industry. 1. price is driven down to the average cost of managing – normal levels 2. doesn’t change much when the industry expand sor contracts so the long-run supply curve is very elastic When an increase in demand hits a constant cost industry, the price rises in the short run as each firm moves up its MC curve. But the expansion of old firms and the entry of new firms quickly push the price back down to average cost. READ PAGE 207 GRAPHS First response to an increase in demand – the price rises and every firm in industry responds by increasing producing The second response is that the above-normal profits attract new investment and entry Increasing Cost Industries Costs rise as industry output increases. The oil industry is an increasing cost industry because greater quantities of oil can only be produced by using more expensive methods such as drilling deeper, drilling in more inhospitable spots, or extracting oil from tar sands. Page 209 graph At any price below $17, the quantity supplied is zero. Industry supply at any price is found by adding up the quantity supplied by each firm at that price. As the price increases, each firm expands output by moving along its marginal cost curve. As the price of oil rises, it becomes fortiable to supply oil from north sea, Athabasca tar sands, and other higher cost sources. (Chapter 3 – higher price encourages entry from higher-cost productions) *any industry that buys a large fraction of the output of an increasing cost industry will also be an increasing cost industry. *greater demand for gas will push up the price of oil, which in turn raises the price of gas. (electricity industry is also increasing cost industry) A special case: the decreasing cost industry Could firms costs decrease as the industry expands creating a decreasing cost industry with a downward sloping supply curve? Ex: carpets in Dalton, Georgia, computer technology Silicon Valley, Aalseemer flower market/distribution Once the cluster is established, constant or increasing costs are the norm. Resulting virtuous circle made Dalton the cheapest place to make carpet in US – not because Dalton had natural advantages but because it was cheaper to make carpets in a place where there were already a lot of carpet makers *rare and temporary TAKEAWAY What price to set? Set price at market price What quantity to produce? Maximize profit by producing quantity that makes P = MC When to exit and enter an industry? In long run, firm enter if P > AC and exit if P < AC A competitive industry 1) product being sold is similar across sellers 2) there are many buyers/sellers, each small relative to total market 3) there are many potential buyers Constant cost industry, increasing cost industry, decreasing cost industry. Chapter 12:Competition and the Invisible Hand With the right institutions, individuals acting in their self-interest can generate outcomes that are neither part of their intention nor design but that nevertheless have desirable properties. We will show: how the conditions for profit maximization under competition lead entrepreneurs to produce outcomes that they neither intend nor design but that nevertheless have desirable outcomes We show that P = MC condition for profit maximization in a competitive market balances production across firms in an industry in just the way that minimizes the total industry costs of production. Second, we show that the entry (P > AC) and exit (P < AC) signals balance production across different industries in just the way that maximizes the total value of production. Invisible Hand Property 1: The mimization of total industry costs of production Every firm in the same industry faces the same price. Thus, in a competitive market with N firms (free market), this is true: P = MC1 = MC2 = … = MCn MC1: marginal cost of firm 1, MC2: marginal cost of firm 2 So produce less on Farm 2 and more on farm 1 if MC2 > MC1 and the opposite if MC1 > MC2 So it follows that the way to minimize the total costs of production is to produce just so much on each farm so that the marginal costs are equalized MC1 = MC2 What if two different people own the farms? Is there still a way to organize if so that the marginal costs could be equal? Yes Each farmer chooses the output levels that minimize total costs because Sandy chooses P = MC1 and Pat chooses P = MC2 (most profitable for them) so then MC1 = MC2 Adam Smith: “each individual is led by an invisible hand to promote an end which was no part of his intention” Suppose they live in two different countries with no free trade between them so they face different prices for corn  MC1 does not equal MC2  total costs cant be at a minimum Indivisible Hand Property 2: The Balance of Industries Its this property that ensures that the right amount of corn is produced (could minimize total costs of producing and still have too much or too little corn). Recall that our condition to enter an industry is P > AC, which is equivalent to TR > TC. So, in a competitive market, the incentives that entrepreneurs have to seek profit and avoid losses align with the social incentive to move labor and capital out of low-value industries and into high-value industries. Notice that profits encourage entry, but what happens to price and profits when firms enter an industry? As firms enter, supply increases and the price declines, which reduces profits. *shows how the self-interest of entrepreneurs causes them to enter and exit the car, computer, corn, apple, and other industries in such a way that the total value of all production is maximized. An implication is that the profit rate in all competitive industries tends toward the same level. Creative Destruction According to the elimination principle, above-normal profits are eliminated by entry and below- normal profits are eliminated by exit. The elimination principle says that above-normal profits are temporary. Great ideas are soon adopted by others. Since no one profits from the commonplace to earn above-normal profits, an entrepreneur must innovate. ^serves as both a warning and an opportunity to entrepreneurs. In a dynamic economy, there is a constant dance between elimination and innovation. The Invisible Hand Works with Competitive Markets Competitive markets do a good job of aligning self-interest with the social interest, but not all markets are competitive. If markets are competitive, the invisible hand doesn’t work well. Page 229 – the “takeaway” helps to read Chapter 13: Monopoly Reason why HIV drugs (or other expensive things) are priced well above cost. 1. market power 2. the “you cant take it with you” effect a. both these phrases effects make consumers with serious diseases insensitive to thep rice of life-saving pharmaceuticals – that is, they will continue to buy in lage quantities even when the price increases 3. the “other people’s money” effect a. access to public or private health insurance b. both phrases effect make the demand curve more inelastic *the more inelastic the demand curve, more a monopolist will raise its price above marginal cost Market power is the power to raise price above marginal cost without fear that other firms will enter the market (ex: patented products can be duplicated)  patents, government regulations other than patents, economies of scale, exclusive access to an important input, and technological innovation A monopoly is a firm with market power. Even a firm with no competitiors faces a demand curve, so as it raises its price, it will sell fewer units. So what is the profit-maximizing price? Produce until marginal revenue equals marginal cost Marginal Revenue, MR, is the change in total revenue from selling an additional unit If the demand curve is a straight line, then the marginal revenue curve is a straight line that begins at the same point on the vertical axis as the demand curve but with twice the slope. (PAGE 235 explains how to find marginal revenue) (revenue gain plus the revenue lost) Marginal Cost, MC, is the change in total cost from producing an additional unit. To maximize profit, a firm increases output until MR = MC. Profit --- (P – AC) X Q Example on page 236-237 *Recall that a competitive firm earns zero or normal profits but a monopolist uses its market power to earn positive or above-normal profits. *recall that the fewer substitutes that exist for a good, the more inelastic the demand curve (like the airplane example in the book – Washington, San Francisco, Dallas) The Costs of Monopoly: Deadweight Loss The monopolist gains less from monopoly pricing than the consumer loses. Monopolies are bad, because when compared to compeititon, monopolies reduce total surplus (total gains from trade) Competition maximizes total surplus, monopolies do not PICTURE 13.5 – page 240 Some of the consumer surplus has been transferred to the monopolist as profit. But some of the consumer surplus is not transferred (neither to consumers nor monopolist – deadweight loss) The costs of Monopoly: Corruption and Inefficiency In a monopolized economy, each firm wants to raise its prices, and the resulting cost increases are spread throughout the economy, resulting in poverty and stagnation. *good institutions channel self-interest toward social prosperity The benefits of Monopoly: Incentives for Research and Development In the US, researching, development, and successful testing the average new drugs costs a lot of money (expectation of enjoying the monopoly profit that encourages firms to research and save lives) Monopolies when it increases innocation may increase economic growth (example with viodeo games and how people will research new games) Is there a way to eliminate the deadweight loss without reducing the invenctive to innovate? Michael Kremer has an idea on page 243 Economies of scale are the advantages of large-scale production that reduce average cost as quantity increases. Is there a way to have prices equal to marginal costs and to take advantage of economies of scale? Yes, but not easy. When a monopolist sets the market price, a price control can increase output. ***Economies of scale mean that a monopoly producer can have lower costs of production than competitive firms. Its cheaper to produce electricity for 100,000 with one large dam than with a solar panel for each home. If economies of scale are large enough, the monopoly price can be lower than the competitive price and the monopoly output can be higher than the competitive output. A natural monopoly is said to exist when a single firm can supply the entire market at a lower cost than two or more firms. The monopolist produces more as the government-regulated price of its output falls. So what price should the government set? Natural answer would be Pr = MC, but really it should be Pr = AC (the monopolist would just break even, output would then be larger than the monopoly quantity but less than the optimal quantity). When the monopolist’s profits are regulated, it doesn’t have much incentive to increase quantity with innovative new products or to lower costs. I Want my MTV Section page 246 Electric Shock Section and California’s Perfect Storm  government ownership is another potential solution the natural monopoly problem  new technologies meant that the generation of electricity was no longer a natural monopoly; argue than unbundling generation from transmission and distribution could open up electricity generation to competitive forces, and thereby, reducing costs  hoping to benefit from lower costs and greater innovation, CA deregulated wholesale electricity prices in 1998  ^mother nature was not the only one to blame; increased demand, reduced supply, and a poorly designed dereguatliation plan had create perfect opportunity for generators of electricity to exploit market power (faced elastic demand for product in 1999)  What happens to the incentive to increase price when demand becomes elastic?  *demonstrated that unbundling generation from transmission and distribution, which remain natural monopolies, is tricky Monopolies may be created when there is a significant barrier to entry Barriers to entry are factors that increase the cost to new firms of entering an industry. Table 13.1 is really helpful  Brands/Trademarks can give a firm market power; monopolies can arise when a firm innovated a product that no other firm can immediately duplicate (etc) “Takeaway”  should be able to find marginal revenue given either a demand curve or a table of prices and quantities  given a demand and marginal cost curve, you should be able to find and label the monopoly price, the monopoly quantity, and deadweight loss.  With the addition of an average cost curve, you should be able to find and label monopoly profit  Also be able to demonstrate why the markup of price over marginal cost is large the more inelastic the demand  Are monopolies good or bad? Faced with a series of trade-offs o Patent monopolies create a trade-off between deadweight loss and innovation. The monopolist prices its product above marginal cost, but without the prospect of monopoly profits, there might be no product at all. o Natural monopolies also have trade-offs, this time between deadweight loss and economies of scale Deadweight loss means that monopoly is not optimal, but when economies of scale are large, competitive outcomes aren’t optimal either.  Instead monopolies are created to transfer wealth to politically powerful elites  Many monopolies are “unnatural” and neither support innovation nor take advantage of economies of scale Chapter 14: Price Discrimination Price discrminiation: is selling the same product at different prices to different customers Ex: the GSK reduced the price of Combivir in Africa for humanitarian reasons, but lowering prices in poor countries can also increase profit The principles of Price Discrminiation 1. (a) if the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets i. example with Europe and Africa; if there was a single world price, the profit in Europe and Africa would both be less (GSK would be getting less in Europe and people in Africa wouldn’t buy it as much – more expensive) 2. (b) to maximize profit, the firm should set a higher price in markets with more inelastic demand i. Remember: the more inelastic the demand curve, the higher the profit-maximizing price ii. Ex: the demand for combivir is more inelastic (less sensitive to price) in the European market (so price is higher in eurpoe) 3. Arbritrage makes it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination i. Arbitrage: is taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market (smuggling is a special example) The first principle tells us that a firm wants to set different prices in different markets. The second principle tells us that a firm may not be able to set different prices in different markets. To succeed at price discrimination, the monopolist must prevent arbitrage. Preventing arbitrage. If it wants to profit from price discrimination, GSK must prevent Combivir that it sends to Africa from being resold in Europe. They have a number of tools to discourage smuggling. (white and red pills etc). Markets can differ in more ways than geographically. Services are difficult to arbitrage (massages) The government taxes alcohol but subsidizes ethanol fuel. To prevent, to prevent entrepreneurs from buying ethanol fuel and converting it to drinkable alcohol. The government requires that ethanol fuel be poisoned. Price Discrminination is common  In the movie theater, they charge more for young people (inelastic demand) than for seniors  In the airlines, the business people (more inelastic) are typically less sensistive to the price so they usually pay more; they might discover they have to fly out tomorrow so the ticket is $600 instead of $200 (what a vactionner probably payed months in advance)  Harry potter fans – at first $35 hardback then $10 paperback (hardback doesn’t cost that much more but the writer knows his fans will pay more once it first comes out)  “willingness to pay” Universities and Perfect Price Discrimination  student aid is a way of charging different students different prices for the same good  perfect price
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