Fluent Essays

1. Elasticity question 1           a. What, in general, does elasticity measures?           b. Who might care about the price elasticity of demand and why?           c. Who might care about the price elasticity of supply and why?           d. Who might care about the cross elasticity of demand and why?           e. Who might care about the income elasticity of demand and why?           f. The formula to calculate the coefficient of elasticity of demand is (percentage change in quantity demanded of product X) / (percentage change in the price of product X). If your boss tells you she is planning a price increase in product X and wants to know how many units will be purchased after the price change, does the formula give you enough info to answer the question? If yes, why? If no, why not?                 i. Hint:                 ii. Think about what the formula really says.                 iii. Can you as the analyst actually collect all the information required to calculate the answer?                 iv. what degree does it give you information about what might happen in the future?           g. List and explain all the measures of elasticity that were covered in the slides, including Elasticity of Demand, Supply, Income, and Cross Elasticity of Demand.                 i.Please refer to the slides and audio to prepare this answer.                         1. Elasticity of demand and supply should both have 5 interpretations of Elasticity. Income Elasticity should have 2 interpretations, and Cross Elasticity of Demand should have 3.    2. Elasticity question 2               a. Total Revenue Test                     i. Explain the Total Revenue Test                     ii. How might the info help the firm make better decisions?                b. List and explain in detail, the determinants of price elasticity of demand and give 2 examples for each one (do not use examples from the slides).                c. There are 4. Please refer to the slides and audio as you prepare your answer.                d. Relative to Elasticity of Supply, please explain the importance of time to the tomato farmer discussed in the slides and audio. How does time impact elasticity and the input utilization choices available to the tomato farmer? Please review the slides and listen to the lecture before you answer this question.                e. Cross elasticity of demand - 1                      i. Explain what cross elasticity of demand actually tells us.                     ii. Explain why a PepsiCo Executive would benefit from understanding cross elasticity of demand when evaluating a recommendation to lower the price of Doritos.                     iii. How does understanding cross elasticity of demand support better decision-making?                f. Cross elasticity of demand – 2                      i. Explain why an Analyst working for the Anti-Trust Division of the Justice Dept. (what is the job of the Anti-Trust Division of the Justice Dept.?) would benefit from understanding cross elasticity of demand when evaluating the proposed merger of Coca Cola Company and Pepsi.    3. Cost of Production 1                a. Explicit and implicit costs.                      i. Explain the difference between explicit costs and implicit costs.                      ii. Explain who would care about them and why.                b. The production function.                      i. What does the production function tell us?                      ii. What questions can it help a business answer?                      iii. What information would you need if you were asked to construct your company production function?                              1. Please remember, the production function will include much greater detail than just labor and capital.                      iv. What departments would you call to get that info and why? (look at the organization chart of a typical business to get some insight into this.)                c. Short Run Production Relationships                       i. List and explain each of the 3 Short Run Production Relationships discussed in the slides and audio and explain who in a business would care about each of them and explain how each might be used.    4. Cost of Production 2                 a. Law of Diminishing Returns.                       i. Explain the Law of Diminishing Returns, including the assumptions.                       ii. Explain how understanding that law might help a business manager make better business decisions.                 b. Short run production costs. There are 7 of these. Please review the slides and lecture to prepare your answer.                       i.Explain each of the short run production costs and tell me how a business manager might use each of them.                 c. Long Run ATC Please focus on the slides and audio to get the story on this.  What does the Long Run ATC tell us?                       i. Explain how the long run ATC curve is derived.                       ii. Explain how understanding that concept might help a business manager make better decisions.                       iii. Where along the LRATC would a firm want to operate and why?                  d. Economies of Scale                       i.Explain economies of scale, constant returns to scale, and dis-economies of scale.                       ii.Explain how understanding each of these concepts might help a business manager improve their decision-making.  5.For the Pure Competition Market Structure1                    a. List and explain each of the characteristics of pure competition and why we study that market structure.                    b. List and explain the 3 decision process questions confronting the producer in pure competition.                          i. Please refer to the slide that discusses the 3 decision process questions under the total revenue total cost approach and listen to the audio to prepare your answer.                    c. From the point of view of the business manager, explain the Total Revenue Total Cost approach to determining the profit maximizing level of output for the purely competitive firm, and how that info can help a business manager.                          i.Please refer to the Total Revenue Total Cost Approach slide and the audio to prepare your answer.    6.For the Pure Competition Market Structure2                 a. List and explain the three characteristics of the MR-MC approach to determining the profit maximizing output and price for the purely competitive firm.                        i.Please refer to the slide that discusses short run profit maximization Key Rule regarding the MC – MR approach and the audio to prepare the answer.                  b. From the point of view of the business manager of a purely competitive firm in the short run, please explain the steps involved in using the MR MC approach to determining the firm’s:  optimal level of output,                        i. the corresponding price,                        ii.the firm has achieved a maximum profit,                        iii. the firm has achieved a minimum loss, or                        iv. the firm has achieved a shut-down condition.                                                    Please include the roles of ATC and AVC.  7. You are a business manager working for a firm in a purely competitive market and you just hired a summer intern who does not understand how to derive the firms’ short run supply curve from the firms’ marginal cost curve.                a. Please explain to the intern how the short run supply curve is derived from the firm’s marginal cost curve. Be specific.                b. Please explain to the intern the characteristics of long run equilibrium of a purely competitive firm and how operating in a purely competitive market might impact the decision-making of the firm in the long run. Please include the implications of long-run equilibrium for productive and allocative efficiency.                       i.Please refer to the slides and audio to prepare the answer. Please include the 3 assumptions, as well as the implications for economic profit, productive efficiency and allocative efficiency.  8.For the Pure Monopoly Market Structure1                a. List and explain the characteristics of pure monopoly and how they differ from the characteristics of the pure competition market structure.                       i.Please include all 6                b. List and explain how a monopolist would use each of the barriers to entry and include how using that barrier would actually accomplish the monopolists’ objective. Be specific.                c.  You are a business manager and you are considering lowering the price of your product. How will knowing where your firm is currently operating on its demand curve help you make a sound business decision?                       i.Please refer to the slides and audio to prepare your answer. The monopoly revenue and cost slide should help.  9.For the Pure Monopoly Market Structure2                                a. For the monopolist, using the MR MC approach, please explain in detail the steps required to determine:                       i. The firm’s optimal level of output.                       ii.The firm’s product price that would correspond to that optimal level of output.                       iii.the firm has achieved maximum profit                        iv. the firm has achieved minimum profit                                    b. You are employed by a firm with monopoly power. The boss wants to increase profits.                        i.Explain the power of price discrimination to your boss.                        ii.Explain the requirements and assumptions for successfully implementing this approach.                        iii.Explain 2 things that would prevent this approach from being successful.                  c. You work for the government in the department that is responsible for dealing with Monopoly issues (the Antitrust Division of the Justice Dept.). Please read through the slides, listen to the audio lectures, then:                         i.Explain the dilemma of regulation.                         ii.List and explain each of the 3 options covered in the lecture, along with the impact of each option the monopoly firm and the customers.                         iii.Pick one of the options and explain why you picked it.                       10.For the Monopolistic Competition Market Structure                  a. List and explain the characteristics of monopolistic competition and compare them to the characteristics of pure competition and monopoly.                         i.Please discuss monopolistic competition, list and explain the characteristics.                  b.Product differentiation                         i. List and explain the characteristics of product differentiation.                         ii. Provide 3 examples of companies actually using these product differentiation techniques and how they are using them.                         iii. Explain the impact that product differentiation technique had on the firms’ performance.                  c. You are a business manager at a monopolistically competitive firm. Please explain to one of your newly hired workers how to determine the following:  the optimal level of output?                         i. the price that corresponds to that optimal level of output?                         ii.the firm has achieved maximum profits?                         iii. the firm as achieved minimum losses?                                 Be sure you explain the roles of ATC and AVC.  11.For the Oligopoly Market Structure               a.List and explain the characteristics of oligopoly and compare them to the characteristics of the other 3 market structures using a grid.               b. Explain which oligopoly model best lends itself to the use of the MR MC approach and why.               c. Explain in detail the steps required to determine the optimal level of output for the oligopoly market structure model that best lends itself to the use of the MR MC approach.               d. Explain in detail the steps required to determine the product price that corresponds to that optimal level of output.               e. Explain in detail the steps required to determine if maximum profit or minimum losses have been achieved. Be sure you include the role of ATC and AVC.               f. You work for a firm that is a member of an oligopoly market. Explain in detail the issues of collusion and why collusion would be attractive to those firms.               g. You work for a firm that is a member of an oligopoly market. Explain game theory and how the firm might use this tool to achieve its business goals The Costs of Production Please listen to the audio as you work through the slides. Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC Where are we going? Going forward we will bring product demand, product price, and revenue together and explain how firms compare revenues and costs in determining how much to produce (the profit maximizing level of output). Ultimate goal – to show how those comparisons relate to economic efficiency in various market structures. Learning objectives Students should be able to thoroughly and completely explain: How the long run ATC curve is derived. How the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve. The Short Run Production Relationships The Law of Diminishing Returns Economic Costs From a general economic perspective The measure of economic cost, or opportunity cost, of any resource used to produce a good is – The value or worth the resource would have in its best alternative use. Economic Costs From the firm’s point of view Economic Costs – the payments a firm must make, or the incomes it must provide, to attract the resources it needs away from alternative production opportunities More Specifically we consider: Explicit Costs – actual (payments to resource suppliers) Implicit Costs – opportunity costs of using (self-owned or self-employed) resources. - The money payments those resources could have earned in their best alternative use. Accounting profit versus Economic profit An example: You go from being an employee to a business owner Formerly Earning $22,000 / yr as sales rep for T-shirt mfr. Invest $20,000 of savings that were earning $1000 /yr. Start your own T-shirt company. Use a store that you have been renting out for $5000 / yr. Hire a clerk at $18,000 / yr How successful is this business? Explicit Costs Implicit costs How successful is this business? Treated as a cost Required to attract & retain resources - (entrepreneurial ability) Economic or Pure Profits Economic Profit Total Revenue Economic Cost Normal Profits Economic Costs Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs T O T A L R E V E N U E Profits to an Economist Profits to an Accountant Economic Costs Economic profit = total revenue – economic cost Economic cost = explicit cost + implicit cost Just to be clear Short run and long run: The role of Time When the demand for a firm’s product changes, the firm’s profitability may depend on how quickly it can adjust the amounts of the various resources it employs in the production of that product. Short Run and Long Run Accounting: Short and long run is based upon annual chronology. Economics: Short run has fixed plant capacity. Long run all resources are variable For the industry, the long run includes enough time for firms to enter and exit the industry 12 Short-Run Production Relationships Firm’s costs of producing a specific output are a function of: Resource prices and The quantities of inputs needed to produce a given level of output. Resource demand and supply determine resource prices. The production function: The technological relationship between inputs and output determine the quantities of resources needed: called (Google this to learn more) 3. Average Product (AP) – output per unit of (labor) input (labor productivity) 1. Total Product (TP) – total output of the good produced. 2. Marginal Product (MP) – the extra output that results from adding a unit of a variable resource. Example – the marginal product of labor 3 Short-Run Production Relationships Marginal Product = Change in Total Product Change in Labor Input Average Product = Total Product Units of Labor Concerns of the firm In the short run, a firm can for a time, increase its output by adding units of labor to its fixed plant. But by how much will output rise when the firm adds each unit of labor? How long will the firm be able to get increased output? Why do we say “for a time”? Transition to Law of Diminishing Returns Law of Diminishing Returns Assumptions: Technology is fixed Production techniques do not change. All units of labor are of equal quality. Definition: As successive units of a variable resource are added to a fixed resource, beyond some point the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline. Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) 0 1 2 3 4 5 6 7 8 0 10 25 45 60 70 75 75 70 10 15 20 15 10 5 0 -5 - 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75 ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 0 10 20 30 Total Product, TP 1 2 3 4 5 6 7 8 9 20 10 Marginal Product, MP 1 2 3 4 5 6 7 8 9 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns Q Q 1. Fixed Costs – do not vary with changes in output Total Fixed Costs – rent, insurance, interest Average Fixed Costs = Total Fixed Costs Quantity of output 2. Variable Costs – change with level of output. Total Variable Costs – materials, fuel, transportation, labor Average Variable Costs = Total Variable Costs Quantity of output Short-run Production Costs 3. Total Cost Total of Fixed and Variable Costs at each level of output Average Total Cost = Total Costs Quantity of output 4. Marginal Cost The additional cost of inputs required to produce each successive unit of output. Marginal Cost = Change in Total Costs Change in Quantity of output Short-run Production Costs Fixed costs and variable costs from the point of view of the business manger Variable costs can be controlled in the short-run by changing production levels. Fixed costs are beyond the control of the business manager, in the short run. Those fixed costs must be paid regardless of output level. Marginal Cost = MC = change in TC / change in quantity Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC = TVC / quantity Total Costs = TC = TFC + TVC Average Total Costs = ATC = TC / quantity Average Fixed Costs = AFC = TFC / quantity Summary of Definitions Short-run Production Costs Short-Run Costs Graphically Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost Short-Run Costs Graphically Quantity Costs (dollars) AFC = TFC/ output AVC = TVC/output ATC=TC/output MC= change in TC / change in output Plotting Average and Marginal Costs Productivity and Cost Curves Costs (dollars) Average product and marginal product Quantity of labor Quantity of output MP AP MC AVC If all units of a Variable resource (labor) are the same price, The MC of each extra unit of output will fall as long as the Marginal product of each additional worker is rising. Production Relationships - Summary Marginal cost and diminishing returns The shape of the MC curve is a consequence of the law of diminishing returns. Marginal cost and marginal product As MP increases, MC decreases Marginal cost and average variable cost When AVC is falling, MC is rising Marginal cost and average total cost and AVC MC curve intersects both at their respective minimum points. Productivity curves and cost curves When MP is rising, MC is falling and when MP is falling, MC is rising Shifts in cost curves Changes in either resource prices or technology will cause costs to change and cost curves to shift. Long-Run Production Costs All such plant capacities can be plotted. For every plant capacity size... there is a short-run ATC curve. Long-Run Production Costs Unit Costs Output Long-Run Production Costs Unit Costs Output Long-Run Production Costs The long-run ATC curve just “envelopes” all of the short-run ATC curves. Unit Costs Output Long-Run Production Costs Unit Costs Output long-run ATC Economies of Scale Reductions in the average total cost of producing a product, as the firm expands the size of its plant (its output) in the long run; The economies of mass production Factors that influence Economies of Scale Labor specialization Managerial specialization Efficient use of capital Declining start-up costs Learning by doing All lead to lower long run ATC as the firm expands Diseconomies of Scale Increases in the average total cost of producing a product as the firm expands the size of its plant (its output) in the long run. Factors that influence Diseconomies of Scale Increasing levels of complexity. Increasing # of management levels Worker alienation Constant Returns to Scale The range over which long – run average total cost does not change Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1 q2 8-36 Output Long-run ATC curve where costs are lowest only when high levels of output are achieved Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and become dis-economies of scale. Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-38 Minimum Efficient Scale and Industry Structure Minimum Efficient Scale - MES The lowest level of output at which a firm can minimize long – run average total costs. Why would this be a good level of output to achieve? Economies and Diseconomies of Scale Unit Costs Output long-run ATC Economies of scale Unit Costs Output long-run ATC Economies of scale Constant returns to scale Economies and Diseconomies of Scale Unit Costs Output long-run ATC Where economies of scale are quickly exhausted Case for many Small firms in An industry MES achieved quickly Many retail trades, some farming Economies and Diseconomies of Scale Minimum Efficient Scale and Industry Structure Natural Monopoly A relatively rare situation in which average total cost is minimized when only one firm produces the particular good or service Example: electricity generation The shape of the long-run ATC curve Determined by: Technology – how? Economies of scale – how? Diseconomies of scale – how? Applications & Illustrations Rising Cost of Insurance and Security, the 9/11 case In the short run they are fixed – independent of output levels. Short-run ATC shifted upward. Successful Start-Up Firms Specialization, new technology Short-run cost curves shift downward with output expansion. Economies of scale The Verson Stamping Machine large firm size leads to achievement of economies of scale Aircraft and Concrete Plants MES radically different in the two industries Economies of scale extensive in aircraft manufacture Economies of scale exhausted quickly in cement plants Different geographic market sizes KEY TERMS economic (opportunity) cost explicit costs implicit costs normal profit economic profit short run long run total product (TP) marginal product (MP) average product (AP) law of diminishing returns fixed costs variable costs total cost average fixed cost (AFC) average variable cost (AVC) average total cost (ATC) marginal cost (MC) economies of scale diseconomies of scale constant returns to scale minimum efficient scale natural monopoly Total Sales Revenue 120000 Cost of T-shirts40000 Clerks salary18000 Utilities5000 Total Explicit Costs63000 Accounting Profit57000 Foregone Interest1000 foregone rent5000 foregone wages22000 Total implicit costs 28000 Total Economic Cost91000 Economic profit29000 Sheet1 Total Sales Revenue 120000 Cost of T-shirts 40000 Clerks salary 18000 Utilities 5000 Total Explicit Costs 63000 Accounting Profit 57000 Sheet2 Sheet3 Sheet1 Total Salels Revenue 120000 Cost of T-shirts 40000 Clerks salary 18000 Utilities 5000 Total Explicit Costs 63000 Accounting Profit 57000 Accounting Profit 57000 Foregone Interest 1000 foregone rent 5000 foregone wages 22000 Total implicit costs 28000 Total Economic Cost 91000 Economic profit 29000 Sheet2 Sheet3 Oligopoly Look for: Determination of the profit maximizing price and quantity. Implications for efficiency Issues of Oligopoly Game theory and collusion 3 oligopoly models Profit maximization Efficiency Please listen to the audio as you work through the slides. Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC Learning objectives Students should be able to thoroughly and completely explain: The characteristics of oligopoly The conditions under which the Oligopolist firm achieves profit maximization and loss minimization. Oligopoly Behavior, including collusion and game theory. Some Oligopoly examples In the US, 90\% of the music produced and sold comes from one of 4 studios: Universal, Sony, Warner, or EMI. Limited price competition. Talent search and marketing are critical to gain advantage. The $1 billion stent market is dominated by 3 firms: Boston Scientific, Johnson & Johnson, and Medtronic. Limited price competition. R&D is the competitive advantage tool. Two companies control US grain trading: Cargil – Continental, and Archer, Daniels, Midland (ADM). 3 Companies control 44\% of the global proprietary seed market: Monsanto, DuPont, and Syngenta. Some Oligopoly examples 4 Companies control over 80\% of the US beef market: Tyson, Cargil, Swift, and National Beef Packing Company Airlines – fierce price competition among a small number of firms. Industry consolidation. 4 firms dominate the market for tennis balls – Wilson, Penn, Dunlop, Spalding Oligopolies compete on: price, new product development, marketing, advertising, and development of complements. The market structures – compare the characteristics Type of products Control over price Exit and entry Non price competition Price output determination Efficiency Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Oligopoly: characteristics A Few Large Producers with large market share: – “big 3”, “big 6” Homogeneous (standardized) or Differentiated Products Steel, lead, aluminum, cement – industrial products Automobiles, tires, electronic equipment, breakfast cereals, cigarettes (non-price competition / advertising) – consumer products Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Oligopoly: characteristics Control Over Price – price makers, Mutual Interdependence – profits depend on strategies of others Strategic Behavior – self interested behavior that takes into account the reactions of others. Entry Barriers – Economies of scale – they have it and exploit it Large capital expenditures – refineries, auto assemblers, commercial aircraft, large scale mfg. facilities. Ownership of raw materials – mining, food production Patents – big pharma, electronics, seeds Preemptive and retaliatory pricing and ad strategies Evolution of Oligopolies Growth of dominant firms – they just get big Mergers – auto industry, banking, food manufacturers, airlines, Beer, Pharmacies They attempt to achieve monopoly power – without attracting the attention of the anti-trust division of the Justice Dept. Where do Oligopolies come from? Oligopoly Behavior Game theory – a subfield of economics that analyzes the choices made by rival firms, people, and even governments as they try to maximize their own well-being while anticipating and reacting to the actions of others in their environment. A key tool during the Cold War period. Oligopoly Behavior Game Theory Mutual Interdependence Collusive Tendencies Collusion – cooperation with rivals Independent behavior of firms leads to lower prices – a benefit to consumers Collusive behavior of firms leads to higher prices - a benefit to business Incentive to Cheat Introduction to Game Theory… Oligopoly Behavior – 2 firms, 2 strategies A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Greatest Combined Profit Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Independent Actions Stimulate Response Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Independent Actions Stimulate Response Gravitating to the Worst Case Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Collusion Invites a Different Solution. Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 Collusion Invites a Different Solution. Oligopoly Behavior A Game-Theory Overview High Low High Low Uptown’s Price Strategy RareAir’s Price Strategy B A D C $12 $15 $12 $6 $6 $8 $8 $15 But, the incentive to cheat is very real. Collusion Invites a Different Solution. Diversity of Oligopolies Tight oligopolies – 2 to 3 firms dominate industry Loose oligopolies – 6 to 7 firms share 70\% or more of the market (the smaller firms share the rest) Both sell differentiated or standard products Complications of Interdependence Firms cannot (or have great difficulty) estimate their demand or MR data, and are challenged to determine their profit maximizing price and output Can’t predict the reaction of rivals with certainty. Three Oligopoly Models No Standard Model due to the diversity of oligopoly Three Oligopoly Models Alternative models - Two interrelated characteristics: If the macro economy is stable then prices are typically inflexible When prices do change, firms are likely to change their prices together The 3 Models 1 – Kinked Demand Curve model* 2 – Cartels and Collusion model 3 – Price Leadership model Kinked Demand Curve Theory Assumptions: 3 firms Independent pricing, no collusive behavior Differentiated products What does a firms’ demand curve look like? Location and shape depends on how rivals react to a price change Two plausible assumptions about behavior of rivals. The 2 rivals match price changes of firm #1 Firm 1 cuts price - firm #1 would achieve small sales increase because rivals also cut price to match. Firm 1 raises price – firm #1 has small sales loss because rivals also raise prices to match. The 2 rivals ignore price changes of firm #1 Firm 1 lowers price and rivals don’t. Firm 1 gains sales. Firm 1 raises price and rivals don’t. Firm 1 looses sales. Conclusion about strategy Rival behavior will depend on the direction of firm 1’s price change!! Key point! There exists a price: below which they will match price decreases and above which they will ignore price increases. Given a price change by firm 1, Case 1: Rivals will ignore price increases above that price and gain customers. Case 2: Rivals will match price decreases below that price to avoid losing customers D1 MR1 Quantity Case 1. Firm 1’s demand and marginal revenue curves assuming a price decrease by firm 1 and the 2 rivals match the change. Firm 1 receives only a small increase in sales. Kinked Demand Theory: Noncollusive Oligopoly Price MR2 D1 D2 MR1 Quantity Case 2. Firm 1’s Demand and marginal revenue curves assuming a price increase by firm 1 and the 2 rivals ignore the price increase. Firm 1 has only a small sales loss. Kinked Demand Theory: Noncollusive Oligopoly Price MR2 D1 D2 MR1 Quantity Kinked Demand Theory: Noncollusive Oligopoly Price Rivals tend to follow a price cut MR2 D1 D2 MR1 Quantity Kinked Demand Theory: Noncollusive Oligopoly Price Rivals tend to follow a price cut or ignore a price increase MR2 D1 D2 MR1 Quantity Effectively creating a kinked demand curve For firm #1 Kinked Demand Theory: Noncollusive Oligopoly Price D Quantity Effectively creating a kinked demand curve For firm #1 Kinked Demand Theory: Noncollusive Oligopoly Price D MR1 Quantity Effectively creating a kinked demand curve For firm #1 Note: the MR curves Kinked Demand Theory: Noncollusive Oligopoly Price MR2 D Quantity Profit maximization or loss minimization for firm #1 occurs at the kink where MR = MC Kinked Demand Theory: Noncollusive Oligopoly Price MC2 MC1 MR2 MR1 If a few firms face identical or highly similar demand and costs... Oligopoly is conducive to collusion. they will tend to seek joint profit maximization. Cartels and Other Collusion Graphically… 3 similar Colluding Oligopolists Will Split the Monopoly Profits by limiting output and setting a single common price. D MC ATC MR Economic Profit MR = MC Price and costs Q0 P0 A0 Cartels and Other Collusion Overt Collusion Cartels with defined – written agreements The OPEC Cartel Covert Collusion U.S. – It is Illegal Tacit Understandings – gentlemens agreements 1993 Borden, Pet, Dean Foods bid rigging on milk products 1996 ADM and 3 Japanese and South Korean firms price fixing on livestock feed additives. 1960’s - manufacturers of heavy electrical equipment including General Electric Cartels and Other Collusion Obstacles to Collusion Demand and Cost Differences Number of Firms: more firms = less collusion Cheating Recession – pressure to lower prices. Potential Entry – successful collusion requires blocking entry in some way. Antitrust Law Cartels and Other Collusion Price Leadership Model Leadership Tactics - Requires implicit understanding among the players such that they can coordinate prices without engaging in outright collusion based on formal agreements and secret meetings. (General Mill, Post Foods, Kellogs) Infrequent Price Changes Communications – press conferences Limit Pricing They want to keep price below the short run profit maximizing level to discourage new competitors from entering. Breakdowns in Price Leadership - Price Wars Oligopoly and Advertising Product development and advertising are less easily duplicated by rivals Oligopolists typically financially strong – Cash flow, economic profit Positive Effects of Advertising Providing information to consumers Diminishes monopoly power – Toyota and Honda vs the Big 3 of the USA (check out the 1989 pre-launch commercial) Enhance efficiency Greater competition, more technological progress, higher output, lower LR ATC, better able to achieve economies of scale. Potential Negative Effects of Advertising Disinformation to consumers Barrier to entry Brand Development Oligopoly and efficiency Many oligopolists sustain economic profit Production often occurs where price > MC and price > minimum ATC. Production is below the output at which ATC is minimized Neither productive efficiency nor allocative efficiency is achieved. Pure Competition conditions: Productive Efficiency: P = Minimum ATC and Allocative Efficiency: P = MC Oligopoly Situation relative to efficiency: P > Minimum ATC P > MC Output is below the output at which ATC is minimized Oligopoly and efficiency monopolistic competition product differentiation nonprice competition excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence concentration ratio interindustry competition import competition Herfindahl index game-theory model collusion kinked-demand curve price war cartel tacit understandings price leadership KEY TERMS Section 2 topics Elasticity Costs of production Pure Competition Pure Monopoly Oligopoly Monopolistic Competition Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC Elasticity Please listen to the audio as you work through the slides. Microeconomics Looking at the behavior of: Consumers, Businesses, and Resource suppliers In various market structures Elasticity Learning objectives Students should be able to thoroughly and completely explain: What Elasticity measures, who cares, and why. All the measures of elasticity that we covered in class: Elasticity of Demand, Supply, Income, and Cross Elasticity of Demand The determinants of Price Elasticity of Demand. Extend the discussion of demand and supply to look at the concept of Responsiveness. The buying and selling responses of consumers and producers to price changes. The responses of producers of one product when the price of another product changes. The buying responses of consumers when their incomes change. Elasticity Elasticity of: Demand Supply Cross Elasticity Income Elasticity Types of Elasticity (responsiveness) How much more or less? Does it matter? To whom? THE LAW OF DEMAND SAYS... Price Elasticity of Demand Consumers will buy more when prices go down and less when prices go up Price Elasticity Provides an Answer The Price-Elasticity Coefficient and Formula Price Elasticity of Demand Ed = Percentage change in quantity demanded of product X Percentage change in price of product X Or equivalently… Ed = Percentage change in quantity demanded of X Original quantity demanded of X Change in price of X  Original price of X Where will you get this piece of data? Interpretations of Ed Price Elasticity of Demand Demand is Elastic if a specific percentage change in price results in a larger percentage change in quantity demanded. Then Ed will be > 1 What is an example of a product with elastic demand? Vacations, restaurants, movies, concerts, books, etc. If the price rises, you can easily give it up either because they are not necessary or they have substitutes Interpretations of Ed Price Elasticity of Demand Demand is Inelastic if a specific percentage change in price results in a smaller percentage change in quantity demanded. Not very responsive. Then Ed will be < 1 What would be an example of a product with inelastic demand? Gasoline, staple foods, basic clothing, phone, internet or cable service is often seen as a necessity and will not get cut based on a price increase. Interpretations of Ed Price Elasticity of Demand Demand is of Unit Elasticity if a specific percentage change in price results in an equal percentage change in quantity demanded. Then Ed will be = 1 What would be an example of a product with unit elasticity? Interpretations of Ed Price Elasticity of Demand Demand is Perfectly Inelastic if a price change results in no change in quantity demanded. Then Ed will be = 0 Example - A diabetic’s demand for insulin. Other examples? Interpretations of Ed Price Elasticity of Demand Demand is Perfectly Elastic if a small price reduction causes buyers to increase their purchases from 0 to all they can obtain. Then Ed will be =  Example - A firm selling it’s product in a purely competitive market. Elastic Demand - Ed will be > 1 Inelastic Demand - Ed will be < 1 Unit Elastic Demand - Ed will be = 1 Perfectly Inelastic Demand - Ed will be = 0 Perfectly Elastic Demand - Ed will be =  Summary of Price Elasticity of Demand 5 interpretations The percentage change in price The percentage change in quantity .01 .02 Elasticity is .5 Q P P1 P2 Q1 Q2 D Measures Responsiveness to Price Changes Price Elasticity of Demand The percentage change in price The percentage change in quantity Q P P1 P2 Q1 Q2 D Commonly Expressed as… Price Elasticity of Demand  \% P \%  Q d Elasticity is .5 Extreme Cases Price Elasticity of Demand Perfectly Inelastic Demand Perfectly Elastic Demand P 0 P 0 D1 Ed = 0 D2 Ed =  Q Q So, who cares about elasticity? Firms do! Why? Impact on Revenue! Total Revenue Test Demand for a product is elastic if a price change causes total revenue to change in the opposite direction. Price falls and Total Revenue rises Price rises and Total Revenue falls Demand for a product is Inelastic if a price change causes total revenue to change in the same direction. Price falls and Total Revenue falls Price rises and Total Revenue rises ] ] ] ] ] ] ] Elasticity on a Linear Demand Curve It has 3 phases 1 2 3 4 5 6 7 8 $8 7 6 5 4 3 2 1 5.00 2.60 1.57 1.00 0.64 0.38 0.20 $8,000 14,000 18,000 20,000 20,000 18,000 14,000 8,000 Elastic Elastic Elastic Unit Elastic Inelastic Inelastic Inelastic (1) Total Quantity of Tickets Demanded Per Week, Thousands (2) Price Per Ticket (3) Elasticity Coefficient (Ed) (4) Total Revenue (1) X (2) (5) Total-Revenue Test ] ] ] ] ] ] ] Elasticity and the TR Curve 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 Quantity Demanded Quantity Demanded Price Total Revenue (Thousands of Dollars) $20 18 16 14 12 10 8 6 4 2 $8 7 6 5 4 3 2 1 a b c d e f g h Elastic Ed > 1 Unit Elastic Ed = 1 Inelastic Ed < 1 D TR Price Elasticity and Total Revenue Price elasticity is.. Inelastic from 0 to 1 Typical of necessities one must have. Elastic from 1 to infinity Typical of luxuries one wants. Unit elastic when exactly = 1 Price change does not reduce total revenue. Determinants of Price Elasticity of Demand (Generalizations) Substitutability Proportion of Income Luxuries versus necessities Time Determinants of Price Elasticity of Demand Substitutability The larger the number of substitute goods that are available, the greater the Price Elasticity of Demand. In the purely competitive market, the single seller faces a perfectly elastic demand curve. Why? Lowering world trade barriers increases elasticity of demand for most products. Why? Determinants of Price Elasticity of Demand Substitutability The elasticity of demand for a product depends on how narrowly the product is defined. Reeboks – lots of substitutes Shoes – few substitutes for shoes Determinants of Price Elasticity of Demand Proportion of Income Other things equal, the higher the price of a good relative to consumers’ incomes, the greater the Price Elasticity of Demand. A 10\% increase in price of cheap pencils yields a small decline in quantity demanded. Small proportion of income. A 10\% increase in price of cars or housing yields a large decline in quantity demanded. Large proportion of income. Determinants of Price Elasticity of Demand Luxuries versus Necessities In general, the more that a good is considered a “luxury” rather than a “necessity”, the greater is the Price Elasticity of Demand. Food and water - necessities (inelastic) Travel vacations and jewelry – luxuries (elastic) Determinants of Price Elasticity of Demand Time Generally, product demand is more elastic the longer the time period under consideration. Consumers often need time to adjust to price changes. Elasticity of demand for gasoline in the “short run” Ed = .2 more inelastic than… Elasticity of demand for gasoline in the “long run” Ed = .7 Determinants of Price Elasticity of Demand Some Applications Excise Taxes When selecting which goods and services on which to levy excise taxes, the Government needs to pay attention to elasticity of demand. Higher taxes on products with elastic demand will bring in less tax revenue. Why tax the following? Liquor, Gasoline, Cigarettes State the law of supply Price Elasticity of Supply a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price or cost. 5 interpretations If producers are relatively responsive to price or cost changes, supply is elastic If producers are relatively insensitive to price or cost changes, supply is inelastic. The degree of Price Elasticity of Supply depends on how easily – and therefore how quickly – producers can shift resources between alternate uses. *Now, compare the immediate market period, the short-run, and long run impact on elasticity of supply. Supply curve becomes more elastic with time. Price Elasticity of Supply Coefficient of Price Elasticity of Supply Es= Percentage change in quantity supplied of good X Percentage change in the price of good X How does Time impact the Price Elasticity of Supply? Immediate Market period All resources are fixed Perfectly inelastic supply Short run Fixed plant size Inelastic supply Long run Adjustable plant size Supply more elastic 6-33 Time periods The immediate market period The period that occurs when the time immediately after a change in market prices is too short for producers to respond with a change in quantity supplied. The tomato farmer case Supply is perfectly inelastic. Vertical supply curve. Time periods The short run A period of time too short to change plant capacity but long enough to use fixed plant more or less intensively. What could the tomato farmer do? We expect a somewhat greater output in response to a presumed increase in demand. This greater output is reflected in a more elastic supply curve. Time periods The long run A period of time long enough for firms to adjust their plant sizes, adjust other inputs, and for new firms to enter (or existing firms to leave) the industry. We expect the Price Elasticity of Supply to be even more elastic. Po P Q D1 Qo An increase in demand without enough time to change supply causes… Sm Immediate Market period Price Elasticity of Supply Po Pm P Q D1 Qo D2 An increase in demand without enough time to change supply causes… an increase in price with no qty. supply increase. Sm Immediate Market period Price Elasticity of Supply Po P Q D1 Qo Short Run Price Elasticity of Supply An increase in demand with more intense Use of fixed plant causes... Ss Po P Q D1 Qo D2 Short Run Price Elasticity of Supply Ps An increase in demand with more intense Use of fixed plant causes...a smaller increase in price, and a small increase in output Ss Qs Po P Q D1 Qo Long Run Price Elasticity of Supply An increase in demand in the long run allows greater change causing... SL Po P Q D1 Qo D2 Long Run Price Elasticity of Supply PL An increase in demand in the long run allows greater change causing... Supply to become even more elastic smaller price increase -larger Change in output SL QL Applications of Price Elasticity of Supply Antiques - Limited, Inelastic supply, high prices Reproductions – Unlimited, Elastic supply, lower prices Gold – highly inelastic supply, shifting demand Price Elasticity of Supply Cross Elasticity of Demand Producers care about this 3 interpretations Consumption of a good also is affected by a change in the price of a related good. EXY measures how sensitive consumer purchases of one product (X) are to a change in the price of some other Product (Y). Helps quantify and better understand substitute and complementary goods. Cross Elasticity of Demand Exy = Percentage change in quantity demanded of good X Percentage change in the price of good y Cross Elasticity of Demand EXY > 0, sales of good X move in the same direction as a change in price of good Y means the X and Y are substitutes. The larger is EXY, the greater is the substitutability of X and Y. EXY < 0, An increase in the price of one good decreases the demand for the other good. X and Y are complements. The larger is the negative EXY, the greater are X and Y as complements. EXY = 0, the two products are unrelated or independent Cross Elasticity of Demand - Applications Business application: Coca-Cola considering raising the price of Sprite: check out the Coca-Cola product list with Google and note the number of products. What is the Ed of Sprite and what is the EXY of Coke and Sprite? A low EXY between Coke and Sprite means they are weak substitutes. Cross Elasticity of Demand - Applications Government application: Merger analysis by the Justice Dept. Should Coca-Cola and Pepsi be allowed to merge? The EXY between Coca-Cola and Pepsi is high which means? They are strong substitutes! What should the Justice Dept. do? Block the merger because competition will be hurt. Income Elasticity of Demand 2 interpretations Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. We can now take a closer look at Normal goods and Inferior goods. \% change in quantity demand Ei = _______________________ \% change in income Normal Goods Ei > 0, demand increases as income increases Inferior Goods Ei < 0, demand decreases as income increases Income Elasticity of Demand - Insights Helps explain expansion and contraction of industries in the U.S. As income in the USA increases, industries producing products for which demand is quite income-elastic have expanded their level of output. Automobiles: Ei = +3 Housing: Ei = +1.5 During recessions incomes fall. HEB typically does better than Best Buy. Why? KEY TERMS Price Elasticity of Demand elastic demand inelastic demand unit elasticity perfectly inelastic demand perfectly elastic demand total revenue (TR) total-revenue test Price Elasticity of Supply market period short run long run cross elasticity of demand income elasticity of demand Monopolistic Competition closer to reality Please listen to the audio as you work through the slides. Look for: Determination of the profit maximizing price and quantity. Implications for efficiency Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC Learning Objectives Students should be able to thoroughly and completely explain: The characteristics of monopolistic competition. The characteristics of product differentiation in the monopolistic competition case. The conditions under which the monopolistically competitive firm in the short run will: Achieve economic profit Minimize economic loss Monopolistic Competition Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Monopolistic Competition: Characteristics Relatively Large Number of Sellers – competitive aspect - 25 to 70, Each with relatively Small market shares Not price makers No collusion – secret agreement between two or more parties for a fraudulent, illegal, or deceitful purpose Easy Entry and Exit – relative to monopoly and oligopoly, typically smaller firms Economies of scale are fewer, capital requirements lower Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Monopolistic Competition: Characteristics 6. (Non-price competition) Advertising and product differentiation Goal – make price less of a factor in consumer decision and make the differentiation more important 7. Independent action – they make their own independent decisions 8. Differentiated Products, substitutes are available 9. Monopolistically competitive industries more competitive than monopolistic Product Differentiation Production of products with slightly different physical characteristics, attributes Different degrees of customer service, Different numbers of locations for convenience, Different qualities, (good, better, best) Product Attributes – physical or qualitatitive things about the product Many different configurations of the product Computers Smart phones Cars Service – grades or levels of service Many different service levels to pick from Computers Smart phones Characteristics of Differentiated Products Location – store or service locations Convenience stores vs. supermarkets Starbucks Wal-Mart Neighborhood store vs. Supercenters vs. Sams Club Hotels and motels – high end vs low end Brand Names, Bayer, Anacin, Bufferin – are all aspirin Characteristics of Differentiated Products Packaging It’s vodka Characteristics of Differentiated Products CC BY NC Packaging of the World Request sent 8 Trademarks Characteristics of Differentiated Products CC0 9 Celebrity associated: Jeans, Perfume, Clothing Etc. Some Control Over Price – due to differentiation Issue of consumer preference – willing to pay a higher price. Still quite limited due to potential substitutes Characteristics of Differentiated Products Examples of monopolistically competitive industries Grocery stores Gas stations, barber shops Dry cleaners Clothing stores Restaurants Medical care providers Legal services Real estate sales Price & output determination in monopolistic competition Assumptions: Each firm produces a specific differentiated product Engages in advertising The monopolistically competitive demand curve is not perfectly elastic Reasons: Fewer rivals than perfectly competitive structure Products are differentiated, so they are not perfect substitutes relative to pure competition. The price elasticity of demand faced by the monopolistic competitor depends on the number of rivals and the degree of product differentiation. The more rivals and less differentiation case means closer to the Perfect Competition model than the monopoly model. D MR P1 ATC Price and Costs Q1 Short-Run Economic Profits Expect New Competitors Price & output determination in monopolistic competition Quantity A1 MC D MR P1 ATC Price and Costs Q1 Expect New Competitors Quantity A1 New competition drives down the price level – leading to economic losses in the short run. MC Short-Run Economic Profits Price & output determination in monopolistic competition D MR MC P2 ATC Price and Costs Q2 Short-Run Economic Losses Quantity A2 Price & output determination in monopolistic competition Short-Run Economic Losses D MR MC P2 ATC Price and Costs Q2 Quantity A2 With economic losses, firms will exit the market – stability occurs when economic profits are zero. Price & output determination in monopolistic competition D MR MC P3 = A3 ATC Price and Costs Q3 Quantity Long-Run Equilibrium Normal Profit Only Price & output determination in monopolistic competition Monopolistic Competition and Efficiency Not Productively Efficient in the long run P > Minimum ATC Not Allocatively Efficient in the long run Price > MC under allocation of resources to the product Excess Capacity – plant and equipment that are under utilized because firms are producing less than the minimum ATC level of output. Pure competition: P = MC = Minimum ATC D MR MC P3 = A3 ATC Price and Costs Q3 Quantity Long-Run Equilibrium Price is Not = Minimum ATC Price  MC Monopolistic Competition and Efficiency Q4 Excess capacity Monopolistic Competition and Efficiency Product Variety and efficiency Firms attempt to achieve economic profit by: Product differentiation and advertising Benefits of Product Variety: Satisfy varied consumer tastes and expands choice Autos Phones Clothes, shoes Tradeoff between consumer choice and productive efficiency. Stronger product differentiation – greater excess capacity - greater productive inefficiency Monopolistic Competition and Efficiency Product Variety and efficiency Firms attempt to achieve economic profit by: Product differentiation and advertising Non - Benefits of Product Variety: Nonprice Competition – adds complexity to the monopolistically competitive firm. How do you measure advertising effectiveness? Trial & Error Search for Maximum Profits Monopolistically competitive firm juggles price, product, and advertising to maximize profits. Questions For the Monopolistic Competition Market Structure List and explain the characteristics of monopolistic competition. List and explain the characteristics of product differentiation. Explain the conditions under which the monopolistically competitive firm in the short run will: Achieve economic profit Minimize economic loss monopolistic competition product differentiation nonprice competition excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence concentration ratio interindustry competition import competition Herfindahl index game-theory model collusion kinked-demand curve price war cartel tacit understandings price leadership KEY TERMS Pure Monopoly Look for: Determination of the profit maximizing price and quantity. Implications for efficiency What should the government do? Study monopoly as a Market Structure To Better Understand monopolistic competition and oligopoly Consist of elements of pure competition and pure monopoly Please listen to the audio as you work through the slides. Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC CC0 1 Learning objectives Students should be able to thoroughly and completely explain: The characteristics of pure monopoly The various barriers to entry that can be exploited by the monopolist. In what region of the demand curve is the monopolist most likely to set price and why. How the monopolist determines the profit maximizing level of output and price. Price Discrimination and discuss the likely outcomes. The dilemma of regulation Summary of topics Characteristics of Pure Monopoly Sources of monopoly power Barriers to entry Model of monopoly demand Analyze price and output decisions Output and price determination At what price – quantity pair will a profit maximizing monopolist choose to operate? Cost considerations Economic effects of pure monopoly Efficiency issues Price Discrimination Regulated Monopoly issues Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Pure Monopoly: Characteristics Single Seller (seller = industry) No Close Substitutes for the product sold Price Maker – controls total quantity supplied and therefore price Faces downward sloping demand curve To increase sales, must lower price Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Pure Monopoly: Characteristics 5. Entry blocked by monopolist Blocking tools: Economic, technological, legal, etc. 6. Pure Monopoly firm sells: Standardized product – natural gas, PR advertising Differentiated product – cars, attribute advertising Monopoly Examples Pure Monopoly Regulated Monopoly local electric utility, cable TV Check Texas PUC Unregulated or near Monopoly Branack Device Company – 80\% Market Luxottica – eyewear multinational (Italy) Intel 90\% market share Barriers to Entry 1. Economies of Scale – declining ATC with increasing firm size - often due to technology, Intel http://dividendmonk.com/7-companies-with-unrivaled-economies-of-scale/ 2. The Natural Monopoly Case – market demand curve cuts the LR ATC curve where ATC are still declining “When long run ATC is declining, only a single producer can produce any particular output at minimum LR ATC.” Key Points: Low unit cost does not equal low price charged P > ATC leads to economic profit increase, and possible regulation – we will see this later Average Total Cost Quantity $20 15 10 0 50 100 200 ATC If ATC declines over extended output range, least-cost production is realized only if there is one producer - a natural monopoly. The Natural Monopoly Case D Barriers to Entry Legal Barriers to Entry (government created) 3. Patents – pharmaceutical industry, R&D 4. Licenses – FCC radio & TV stations, cable TV 5. Ownership or Control of Essential Resources – At one time, International Nickel of Canada controlled 90\% of world’s nickel. At local level – single Cement company may control access to sand and gravel in the area. Barriers to Entry 6. Pricing and Other Strategic Barriers to Entry: In anticipation of a potential competitor: Temporarily cut prices, or Increase advertising, Examples of the use of barriers: 2001 Microsoft – 95\% market share, threatened by Netscape, made IE free bundled with OS, restrict resellers of product, preserve long run near monopoly position 2005 Dentsply – maker of false teeth (70\% market share) - charging higher prices to distributors that sold a competitors product Agenda Monopoly Demand Output and price determination Implications for efficiency Assessment of government policy options Cost considerations Price Discrimination Government approaches to regulating the monopoly Monopoly Demand 3 Basic Assumptions: Monopoly Status is Secured by: patents, economies of scale, resource ownership. No Governmental Regulation Firm Charges the Same Price for all Units Sold The crucial difference between a pure monopolist and a purely competitive seller – demand is elastic versus perfectly elastic!!!! 3 implications of the monopolist’s downward sloping demand curve: Marginal revenue is less than price. The monopolist is a price maker The monopolist sets prices in the elastic region of the demand curve Monopoly demand Monopoly demand The monopolist’s downward sloping demand curve means it can increase sales only by charging a lower price. Consequently marginal revenue is less than price for every level of output except the first. MR < P Marginal revenue is less than price. Monopoly Demand The monopolist is a price maker Firms facing downward sloping demand curves can influence total supply through their own output decisions. The monopolist firm controls output. Each level of output is related to a unique price. Control output, control price Monopoly Demand The monopolist sets prices in the elastic region of the demand curve. When demand is elastic, a decline in price will increase total revenue. When demand is inelastic, a decline in price will reduce total revenue. In the inelastic region: Monopolist must lower price to increase output. Lower price means less total revenue. Increased output means increased total cost Less total revenue and increased total cost means less profit. The monopolist will never choose a price-quantity pair in the inelastic part of the demand curve where total revenue could be reduced. Monopoly Revenues and Costs Dollars Dollars $200 150 200 50 $750 500 250 MR Elastic 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 D Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 TR Q Monopoly Revenues and Costs Q Total Revenue In Dollars Price in Dollars $200 150 200 50 $750 500 250 TR MR D Inelastic Elastic 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Output and Price Determination for the Pure Monopolist At what price quantity combination will monopolist operate? MR = MC Rule – applies to the monopolist Output and Price Determination Add production Cost to the analysis: monopolist buys resources in purely competitive market No Monopoly Supply Curve – no unique relationship between price and Quantity supplied. The monopolist does not equate MC to price, therefore it is possible for different demand conditions to bring about different prices for the same output. Monopoly Pricing Misconceptions it’s maximum total profit, Not Highest Price Total, Not Unit Profit Possibility of Losses – monopolists also can minimize losses. Profit Maximization Under Monopoly D MC ATC MR ATC=$94 P=$122 Profit MR = MC Profit Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Remember the MR=MC Rule? Output and Price Determination Profit Maximization Under Monopoly D MC ATC MR $94 $122 Profit MR = MC Profit Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue What About Loss Minimization? Due to cost or demand changes Output and Price Determination Loss Minimization Under Monopoly D MC ATC MR ATC Pricem Loss MR = MC Loss Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue AVC Qm AVC Since Pm exceeds AVC, the firm will produce Output and Price Determination Loss Minimization Under Monopoly D MC ATC MR A Pm Loss MR = MC Loss Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue AVC Qm V What are the Economic Effects of Monopoly? Output and Price Determination Q Inefficiency of Pure Monopoly P D MR S = MC Pc Pm Qc Qm At MR=MC A monopolist will sell less units at a higher price than a firm in pure competition An industry in pure competition sells where supply and demand are equal The efficiency issue In pure competition we had P = MC = minimum ATC P = minimum ATC (productive efficiency) P = MC (allocative efficiency) Monopoly yields neither productive efficiency nor allocative efficiency Monopoly price exceeds minimum ATC Monopoly price exceeds MC The monopolist’s profit maximizing output results in an under allocation of resources. Output is less than that found in the purely competitive model. Not productively efficient - P  Minimum ATC Not allocatively efficient - Price  MC Profit Maximization Under Monopoly D MC ATC MR ATC=$94 P=$122 Profit MR = MC Profit Per Unit Output and Price Determination Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Remember the MR=MC Rule? Q Inefficiency of Pure Monopoly P D MR S = MC Pc Pm Qc Qm At MR=MC A monopolist will sell less units at a higher price than in pure competition Monopoly pricing effectively creates an income transfer from buyers to the seller! Cost Complications Costs may not be the same for purely competitive and monopolistic producers. Reasons for the difference in costs between purely competitive and monopolistic firms. Economies of scale – three factors that contribute Market demand may not be sufficient to support a large number of competing firms each producing at MES. Simultaneous consumption – product’s ability to satisfy a large number of consumers at once. Software, music, etc. ATC decreases as number of customers increase. Network effects – increase in value of a product to each user as the total number of users rises. Buyers tend to purchase the products that everyone else buys. Producers able to expand and achieve economies of scale. Cell phones Cost Complications Costs may not be the same for purely competitive and monopolistic producers. Reasons for the difference: X inefficiency - A firm’s actual cost of producing any output is greater than the lowest possible cost of producing it. why? managers’ goals conflict with cost minimization. firms becomes lethargic and complacent. Cost Complications Graphic Representation Of X-Inefficiency Average total costs Quantity Average Total Costs X X’ Q1 Q2 ATCx ATC1 ATC2 ATCx’ X-Inefficiency Inefficient internal operation leads to higher-than- necessary costs Cost Complications The need for monopoly preserving expenditures Activity designed to transfer income or wealth to a particular firm or resource supplier at someone else’s expense. Monopolist would do anything to maintain a patent, license, or other factor that ensures monopoly position. Cost Complications A pure monopolist will not be technologically progressive! Absence of rivals reduces the motivation to innovate Agenda Price Discrimination Government policy options about Monopolies The regulation dilemma Price Discrimination Under certain conditions the monopolist can increase its profit by charging different prices to different buyers. Forms of Price Discrimination: Charging each customer in a market the maximum price they will pay Charging each customer one price for the first few units and a lower price for subsequent units Charging some customers one price and other customers another price Monopoly Power: Seller must be monopolist, or possess some degree of monopoly power, (some control over price and output) Market Segregation: At relatively low cost to itself, the seller must be able to segregate buyers into distinct classes, each with a different willingness or ability to pay for the product. (different price elasticity of demand) No Resale: The original purchaser cannot resell the product. Some examples: service industries like transportation, legal, medical 3 Price Discrimination Conditions Examples of Price Discrimination Electric utilities (peak and off peak pricing), Movie theaters (time of day pricing) Airlines (buy early or buy late) Golf courses (time of day pricing) Railroads (by type of freight) Discount coupons vs no coupon Outcomes Greater profits and output than a single price monopolist Some consumers pay more and some pay less than the single price case Perfect price discriminating monopolist and pure competition are equally efficient! Price Discrimination Government policy options toward monopoly: Rules of thumb If: Monopoly is achieved / sustained through anticompetitive actions, creates substantial economic inefficiency, or appears to be long lasting. Government would Pursue antitrust action 2. If: It’s a Natural monopoly or there is no emerging competition, Government may regulate prices and operations. 3. If, Monopoly appears to be unsustainable over a long period of time, or competitors might emerge. Leave it alone Natural Monopolies The Dilemma of Regulation: what to do with the Monopoly? Choices Socially Optimum Price P = MC (allocative efficiency) Fair-Return Price P = ATC (productive efficiency) No regulation Monopolist sets price to maximize profits Regulated Monopoly Regulated Monopoly Q D MR MC ATC P Price and Costs Monopoly Price MR = MC Qm Pm The Unregulated Monopoly. P>ATC means economic profit Demand curve cuts LR ATC while it is falling. Achieving economies of scale. Only one seller needed. P>MC means under-allocation of resources to the product Regulated Monopoly Q D MR MC ATC P Price and Costs Socially-Optimal Price model P = MC Qr Pr Can government cause a better allocation of resources? Set price ceiling to eliminate incentive to restrict output to Qm and therefore maximize profits Price is below ATC and the firm incurs a loss Regulated Monopoly Q D MR MC ATC P Price and Costs Fair-Return Price model Normal Profit Only Qf Pf P=ATC Regulated Monopoly Q D MR MC ATC P Price and Costs MR = MC Fair-Return Price Socially-Optimum Price Qm Qf Qr Dilemma of Regulation Which Price to use? Pm Pf Pr pure monopoly barriers to entry simultaneous consumption network effects X-inefficiency rent-seeking behavior Price Discrimination socially optimal price fair-return price KEY TERMS Pure (perfect) Competition Please listen to the audio as you work through the slides. Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC Learning objectives Students should be able to thoroughly and completely explain: The characteristics of pure competition The 3 questions confronting the producer in pure competition. The Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm. The three features of the MR MC approach to determining the profit maximizing output and price for the purely competitive firm. The following cases for the purely competitive firm in the short run: Profit maximization Loss minimization Shut down How is the short run supply curve derived The characteristics of long run equilibrium of a purely competitive firm. The implications for productive and allocative efficiency in pure competition Pure Competition Issues How do firms make decisions in various market structures? How do firms determine the profit maximizing level of output in various market structures? What is the impact of market structure on economic efficiency? Pure Competition Market Structure Continuum Four Market Models Pure (or Perfect) Competition Market Structure Continuum Pure Competition Four Market Models Imperfect Competition All Markets that are Not Purely Competitive Market Structure Continuum Pure Competition Four Market Models Pure Monopoly One seller Market Structure Continuum Pure Competition Pure Monopoly Four Market Models Monopolistic Competition Large # of sellers with differentiated (by brand or quality) products No perfect substitutes Such as: Books, clothing, furniture Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Four Market Models Oligopoly A market dominated by a few sellers of Standardized or differentiated products Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Pure Competition characteristics: Very Large Numbers of buyers and sellers (small market shares) Standardized Product – perfect substitutes (all the same) Examples? “Price Takers” (individual producers and consumers have no control over price or quantity) Free Entry and Exit – from the market Demand as seen by a Purely Competitive Seller The individual seller faces a perfectly elastic demand curve Horizontal Demand Curve A firm cannot obtain a higher price by restricting its output, nor does it need to lower its price to increase its sales volume. The firm can sell all it wants at the equilibrium price. The Price Taker Role of the firm: 3 characteristics to know Total Revenue = price * quantity (TR=P*Q) Average Revenue = price (AR=P) Marginal Revenue = price (MR=P) Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Pure Competition Price and Revenue 2 4 6 8 10 12 131 262 393 524 655 786 917 1048 $1179 Quantity Demanded (Sold) P = MR = AR TR P QD TR MR $131 131 131 131 131 131 131 131 131 131 131 0 1 2 3 4 5 6 7 8 9 10 $0 131 262 393 524 655 786 917 1048 1179 1310 $131 131 131 131 131 131 131 131 131 131 ] ] ] ] ] ] ] ] ] ] 9-11 Short-Run Profit Maximization Two Approaches to determine the profit maximizing level of output... First: Total-Revenue -Total Cost Approach The Decision Rule: Produce in the short-run if the firm can realize: 1- A profit (or) 2- A loss less than its fixed costs The Decision Process: 3 Questions Should the firm produce? What quantity should be produced? What profit or loss will be realized? Total Revenue Total Cost Approach What is the profit maximizing level of output? (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) Price = $131 0 1 2 3 4 5 6 7 8 9 10 $100 100 100 100 100 100 100 100 100 100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Now Let’s Graph The Results… 1 0 2 3 4 5 6 7 8 9 10 11 12 13 14 1 0 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 400 300 200 100 Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Quantity Demanded (Sold) Total Revenue, (TR) Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) Maximum Economic Profit $299 Total Economic Profit $299 P=$131 Total Cost, (TC) Total Revenue Total Cost Approach Short-Run Profit Maximization Two approaches to determine the profit maximizing level of output First: Total-Revenue -Total Cost Approach 3 Characteristics of MR=MC Rule: The rule applies only if producing is preferred to shutting down Rule applies to all market structures Rule can be restated P=MC (price=MR) Second: Marginal-Revenue -Marginal Cost Approach Key Rule: MR = MC Marginal Revenue Marginal Cost Approach (1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) 0 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 75.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 $131 131 131 131 131 131 131 131 131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 No Surprise - Now Let’s Graph It… Do You See Profit Maximization Now? (5) Marginal Cost (MC) $90 80 70 60 70 80 90 110 130 150 Cost and Revenue $200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Economic Profit MR = P MC MR = MC AVC ATC P=$131 A=$97.78 Marginal Revenue Marginal Cost Approach Marginal Revenue - Marginal Cost Approach The Loss Minimization Case Lower the price from $131 to $81… The MR=MC rule still applies But the MR = MC point changes. Assume the cost structure remains the same. $200 150 100 50 0 Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR AVC ATC Economic Loss $81.00 $91.67 Marginal Revenue - Marginal Cost Approach Loss Minimization Case - graphically $200 150 100 50 0 Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR AVC ATC $71.00 Marginal Revenue - Marginal Cost Approach Short-Run Shut Down Case Minimum AVC is the Shut-Down Point Shut Down means a temporary decision not to produce due to current market conditions The firm would shut down if the revenue it would earn from producing is less than its variable costs of production. Agenda Derive the short run supply curve Short – Run Competitive Equilibrium Profit Maximization in the long run Pure competition and Efficiency Deriving the short-run supply curve for the Perfectly Competitive Firm Using the Marginal Cost Curve Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply Price Quantity Supplied Maximum Profit (+) Or Minimum Loss (-) Observe the impact upon profitability as price is changed $151 131 111 P5 91 P3 81 P2 71 P1 61 10 9 8 7 6 0 0 $+480 +299 +138 -3 -64 -100 -100 No production No production Cost and Revenue, (dollars) MC MR1 AVC ATC Marginal Revenue - Marginal Cost Approach Quantity Supplied MR2 MR3 MR4 MR5 P1 P2 P3 P4 P5 Q2 Q3 Q4 Q5 Marginal Cost & Short-Run Supply Do not Produce at price– Below AVC Break-even (Normal Profit) Point Cost and Revenue, (dollars) MC MR1 Marginal Revenue - Marginal Cost Approach Quantity Supplied MR2 MR3 MR4 MR5 P1 P2 P3 P4 P5 Q2 Q3 Q4 Q5 Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply No Production if Price is Below AVC Diminishing returns, production costs, and product supply Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced. Because marginal costs rise with output, a purely competitive firm must get successively higher prices to motivate it to produce additional units of output Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply AVC2 MC2 Higher Costs Move the Supply Curve to the Left Cost and Revenue, (dollars) MC1 AVC1 Quantity Supplied S1 S2 Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply AVC2 MC2 Lower Costs Move the Supply Curve to the Right Cost and Revenue, (dollars) MC1 AVC1 Quantity Supplied S1 S2 Check Your Understanding Explain the TR-TC approach. Explain the MR-MC approach. P Q S=MC AVC ATC 8 D P Q 8000 D S= MCs Industry Competitive Firm (price taker) Economic Profit $111 $111 Short-run Competitive Equilibrium The Competitive Firm “Takes” its Price from the Industry Equilibrium 1000 firms start Output determination in pure competition in the short run Rules of thumb Should the firm produce? Yes, if price is equal to, or greater than, minimum AVC. This means that the firm is profitable or that its losses are less than it’s fixed costs. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized or loss is minimized. Will production result in economic profit? Yes, if price exceeds ATC. No, if ATC exceeds price. Profit Maximization in the Long Run Assumptions... Entry and Exit of firms is the only long run adjustment Identical Costs – all firms in industry face identical cost curves Constant-Cost Industry – entry and exit does not affect resource prices or the location of ATC curves of individual firms Goal of the Analysis Show that Price = Minimum ATC in the long run Long-Run Equilibrium – The Zero Economic Profit Model Temporary profits and the reestablishment of long-run equilibrium S1 MC ATC P Q 100 P Q 100,000 Industry Firm (1000 firms) (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run MR D1 An increase in demand increases economic profits MR D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run D2 Economic Profits S1 New competitors enter the industry. Supply increases. Prices fall. Economic profits fall. MR D1 MC ATC P Q 100 P Q 100,000 Industry Firm (1100 firms) (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run D2 Zero Economic Profits S1 S2 110,000 Decreases in demand, lead to economic losses, and the reestablishment of long-run equilibrium S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run D1 MR Demand falls. Equilibrium price falls. Firms suffer losses. MR D1 MC ATC P Q 100 P Q 100,000 Industry Firm (900 firms) (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run D2 Economic Losses S1 MR D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $60 50 40 $60 50 40 Profit Maximization in the Long Run D2 Return to Zero Economic Profits S1 S3 Competitors with losses leave the industry. Supply falls. Prices return to zero economic profit levels. 90,000 Long-Run Supply in a Constant Cost Industry Constant Cost Industry Characteristics: Industry expansion or contraction does not affect resource prices. Long-run average costs are not changed for the individual firm. The industry represents only a small fraction of total resource demand. Result: Perfectly Elastic Long-Run Supply Graphically... P Q =$50 S D1 Z1 Q1 D2 Z2 Q2 Q3 D3 Z3 100,000 110,000 90,000 Long-Run Supply in a Constant Cost Industry P1 P2 P3 P Q =$50 S D1 Z1 Q1 D2 Z2 Q2 Q3 D3 Z3 100,000 110,000 90,000 Long-Run Supply in a Constant Cost Industry P1 P2 P3 How does an increasing cost industry differ? P Q $55 50 45 S D1 Y1 Q1 D2 Y2 Q2 Q3 D3 Y3 100,000 110,000 90,000 Long-run Supply in an increasing cost industry A perfectly competitive industry with a positively-sloped long-run industry supply curve that results because expansion of the industry causes higher production cost and resource prices. An increasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift upward. P1 P2 P3 Long-run supply in a decreasing cost industry A perfectly competitive industry with a negatively-sloped long-run industry supply curve that results because expansion of the industry causes lower production cost and resource prices. A decreasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift downward. P Q $55 50 45 S D1 Y1 Q1 D2 Y2 Q2 Q3 D3 Y3 100,000 110,000 90,000 P1 P2 P3 What is the long- run competitive equilibrium? LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY P MR Q MC ATC Quantity Price Price = MC = Minimum ATC (normal profit) Long-run equilibrium for a competitive firm Pure Competition and Economic Efficiency Pure Competition yields Economic Efficiency Defined as: Productive Efficiency and Allocative Efficiency Price = Minimum ATC Price = MC Resources are efficiently allocated under competition All Other Market Structures Relative to Economic Efficiency Under Allocation of Resources: Price > MC Or Over Allocation of Resources: Price < MC For the Pure Competition Market Structure List and explain the characteristics of pure competition List and explain the 3 questions confronting the producer in pure competition? Explain the Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm. Explain long run equilibrium in pure competition Explain efficiency in pure competition Explain how the short run supply curve is derived Cost of Production: How is the long run ATC curve derived? How might the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve? List and explain the Short Run Production Relationships Explain the Law of Diminishing Returns pure competition pure monopoly monopolistic competition oligopoly imperfect competition price taker average revenue total revenue marginal revenue break-even point MR = MC rule short-run supply curve long-run supply curve constant-cost industry increasing-cost industry decreasing-cost industry productive efficiency allocative efficiency KEY TERMS