ECON 221 ECON 221
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Part 1 Introduction: Chapters 1-3 Definitions: Efficiency- society is getting the max benefits from its scarce resources. Equality- those benefits are distributed uniformly among society’s members. Opportunity cost- what you give up to get Assumptions; normally assume people are rational and they systematically and purposefully do the best they can to achieve their objectives, given the available opportunities. Marginal change- a small incremental adjustment to an existing plan of action. • a rational decision maker takes an action only if the marginal benefit exceeds the marginal cost. Incentives are crucial to analyzing how markets work: -a higher price provides an incentive for buyers to consume less and for sellers to produce more. -when policymakers fail to consider how their policies affect incentives, hey often end up with unintended consequences. i.e. seat belts reduce the benefits of careful driving, so people drive faster/less cautiously b/c they feel safer. Result of seat belt law is more accidents. Trade allows each person to specialize in the activities they do best. By trading, people can buy a greater variety of g/s at lower costs. In a market economy, the decisions of a central planner (communism) are replaced by the decisions of millions of firms/households. They interact in the market where prices & self-interest guide their decisions. -prices are instruments where the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. 2 broad reasons for government to intervene in the economy and change the allocation of resources: (1) to promote efficiency or (2) to promote equality. Market failure-market on its own fails to produce an efficient allocation of resources. • 1 possible cause: externality- the impact of one person’s actions on the well-being of a bystander. i.e. pollution • Another possible cause: market power. Definition- the ability of a single person/firm to unduly influence market prices. Goal of equality: -Many public policies, like income tax & welfare system, aim to achieve a more equal distribution of economic well-being. Inflation Definition- the increase in the overall level of prices in the economy. • Causes of inflation; growth in quantity of money. Short-Run Trade-off between Inflation and Unemployment: • increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for g/s. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce larger quantity of g/s => lower unemployment. • Policymakers can exploit this short-run trade-off by changed the amount the government spends, taxes, and money printed by influencing the overall demand for g/s. Assumptions: for short-run effect of the policy, we assume that prices don’t change much, all prices are completely fixed. Long-run effect of the policy, however, we assume all prices are completely flexible. Circular-flow diagram: 2 decision makers; firms and household. • Firms produce g/s with factors of production (called inputs; land, labor, and capital). • Households own the factors of production and consume all the g/s firms produce. -in the market for g/s, households are buyers and firms are sellers. -in the market for the factors of production, households are sellers and firms are buyers. Product Possibilities Frontier The PPF shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology that firms use to turn these factors into output. Shows one trade-off and the opportunity cost (slope) of 1 good as measured in terms of the other good. • Outcome: efficient if economy is getting all it can from the scarce resources available. The PPF will shift outward if there is a technological advance. Difference between Mico and Macro: • Microecon is the study of how households/firms make decisions and how they interact in specific markets. • Macroecon is the study of economy-wide phenomena. Normative statements are prescriptive. They make a claim about how the world ought to be. Evaluating these involve values as well as facts. Positive statements are descriptive. They make a claim about how the world is. Can confirm of refute by examining evidence. Absolute vs Comparative Advantage • Absolute advantage- producer requires a smaller quantity of inputs to produce a good. •Comparative advantage- producer who gives up less of other goods to produce good X has the smaller opportunity cost of producing good X. -note; it’s impossible for 1 person to have comparative advantage in both goods -when each person specialized in producing the good for which he/she has comparative advantage, total production in the economy rises. Trade -for both parties to gain from trade, the price they trade must lie between the 2 opportunity costs. i.e. Frank & Rose trade at 3 oz for each oz of meat. Roses’s opportunity cost is 2oz of potatoes/oz of meat & Frank’s opportunity cost is 4 oz of potatoes/oz of meat. So price must be somewhere between 2 and 4. Part 2 How Markets Work: Chapters 4-6 Chapter 4 The Market Forces of Supply and Demand Price and quantity are determined by all buyers and sellers as they interact in the marketplace Monopoly-markets that only have 1 seller and that seller sets the price Demand • Quantity demanded: the amount of the good that buyers are willing & able to purchase. • Law of demand: other things being equal, when the price of a good rises, the quantity demanded of the good falls, the quantity demanded rises. • The demand curve slopes downward because a lower price means a greater quantity demanded. market demand: sum of all individual demands for a particular good/service. Shifts in Demand Curve • When quantity demanded changes at every price -normal good: demand for a good falls when income falls -substitute: fall in the price of 1 good reduces the demand for another good -complements: fall in the price of 1 good raises the demand for another good • Demand shifts based on a change of; consumer tastes, expectations about future, & number of buyers. Supply • Quantity supplied: amount that sellers are willing & able to sell • Law of supply: ceteris paribus, when the price of a good rises, the quantity supplied of the good also rises, when the price falls, the quantity supplied falls as well. • The supply curve slopes upward because a higher price means a greater quantity supplied. -market supply: sum of the supplies of all sellers Shifts in supply curve • Any change that raises the quantity supplied at every price shifts the curve to the right (increase in supply) • Supply shifts based on a change of; input prices, technology, expectations, & number of sellers. Law of supply and demand- the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance. Supply and demand together determine the prices of the economy’s many different g/s; prices in turn are the signals that guide the allocation of resources. THERE IS A DIFFERENCE: A shift in the supply curve = “change in supply” A movement along a fixed supply curve = “a change in quantity supplied” -the same goes for demand and quantity demanded Chapter 5 Elasticity Elasticity is used to measure how much consumers respond to changes in these variables Definition: the price elasticity of demand measures how much the quantity demanded responds to a change in price. elastic = quantity demanded responds substantially to change in price inelastic = quantity demanded responds only slightly to change in price What influences the price elasticity of demand: -availability of close substitutes; good w/ close subs have more elastic demand b/s easy to switch to other goods. -necessities vs luxuries; necessities tend to be more inelastic. -definition of the market; narrowly defined markets have more elastic demand than broadly defined markets b/c it’s easier to find substitutes for narrowly defined markets. -time horizon; good are more elastic over longer time horizons. Price elasticity of demand = % in quantity demanded / % in price midpoint method to calculate % in elasticities. Divide the change by the midpoint (avg) of the initial and final levels. Used when calculating the price elasticity of demand between 2 points. What elasticity represents- the responsiveness of quantity demanded to a change in price. Demand Curves; demand is elastic when elasticity > 1 (quantity moves proportionately more than the price) inelastic when elasticity < 1 (quantity moves proportionately less than the price) unit elasticity when = 1 -the flatter the demand curve, the greater the price elasticity of demand. The steeper, the smaller the price elasticity. -perfectly inelastic when demand curve is vertical Total revenue = amount paid by buyers and received by sellers. P x Q. Graphically, it’s the height of the box under the curve (P) and the width (Q), the area of the box is the total revenue -inelastic means price and revenue move in same direction; price , revenue . Elastic = opposite directions. Even though the slope of a linear curve is constant, the elasticity is not. At points w/ low P and high Q, demand curve is inelastic. Points w/ high P and low Q, demand curve is elastic. Other Demand Elasticities: income elasticity of demand = % in Q demanded / % in income -normal goods have positive income elasticities while inferior goods have negative income elasticities. Cross-price elasticity of demand measure how the Q demanded of 1 good responds to a in the P of another good. cross-price elasticity of demand = % in Q demanded of good 1 / % in P of good 2 -substitutes = cross-price elasticity is positive -complements = cross-price elasticity is negative The Price elasticity of supply measures how much the quantity supplied responds to changes in the price. Elasticity depends on the flexibility of sellers to change the amount of the good they produce. Also depends on the time period being considered; supply is usually more elastic in the long run than short run. Price elasticity of supply = % in Q supplied / % in P i.e. Increase in milk from $2.85 to $3.15 a gallon raises the amount produced from 9,000 to 11,000 gallons/month. % change in price = (3.15- 2.85) / 3 x 100 = 10 % change in Q supplied = (11,000 – 9,000) / 10,000 x 100 = 20 price elasticity of supply = 20 percent / 10 percent = 2 Supply Curves; as elasticity rises the supply curve gets flatter, which shows that the quantity supplied responds more to changes in P. -elasticity of supply is not constant but caries over the curve. i.e. factories w/ a limited capacity for production; low levels of Q supplied (high supply elasticity) indicated that firms respond substantially to changes in the price. Firms have capacity for production no being used (plants, equipment, etc), so small increases in P make it profitable for firms to begin using this idle capacity. As Q supplied rises, firms begin to reach capacity. Chapter 6 Supply, Demand, & Government Policies Price ceiling •Definitions: the legislated maximum; price not allowed to rise above. If the ceiling is above/higher than equilibrium, it’s not binding and thus has no effect. But if it’s below equilibrium, there will be a shortage; binging constraint on the market. Sellers must ration the scarce g/s among the large number of potential buyers. -Could be inefficient and/or unfair. -The more elastic, the greater the shortage. Price floor Definition: the legislated minimum. If below equilibrium, floor has no effect. Above it (a binding price floor) results in a surplus. Taxes: • Tax incidence: refers to how the burden of a tax is distributed among the various people who make up the economy (consumers/suppliers) • How taxes on sellers affect market outcome: Supply shifts left because taxes means less profit since the government is taking from a firm’s profits. -because sellers sell less and buyers buy less in the new equilibrium, the tax reduced the size of the market since taxes discourage market activity. -buyers and sellers share the burden of taxes, buyers pay more, sellers receive less. Even if the tax is on one or the other, they both share the burden. •How taxes on buyers affect the market outcome: demand curve shifts left. Same thing, both buyers and sellers suffer burden. -taxes levied on sellers and buyers are equivalent How the burden of a tax is divided: a tax burden falls more heavily on the side of the market that is less elastic. Results of Rental-Control Laws • Landlords provide less maintenance under rent control and are unlikely to upgrade their units because they cannot pass on these costs to tenants through higher rents. Because of reduced maintenance, quality suffers and housing units deteriorate more quickly. • Because the profitability of owning and renting apartment units decreases with rent control, landlords construct fewer new units and may even convert existing apartments to more profitable uses. This decreases the number of units available to renters in the future. • A shortage (excess demand) of housing units may lead renters to make under-the-table payments to secure an apartment. This can lead to the development of a black market for rental units. • Because price is no longer an effective mechanism of rationing apartments, alternative methods of rationing will emerge, such as screening processes or personal networking connections. Part 3 Markets and Welfare: Chapters 7 & 8 Chapter 7 Consumers, Producers, & the Efficiency of Markets Welfare economics- study of how the allocation of resources affects economic well- being Consumer Surplus- benefits buyers receive from participating in a market. Each buyer’s max is called willingness to pay; measures how much the buyer values the g/s. consumer surplus = amount willing to pay – amount actually paid marginal buyer: buyer who would leave the market first if the price were any higher. -area below demand curve and above price measures the consumer surplus in a market. The height of the D curve measures the value buyers place on the g/s. Consumer surplus measures the benefit that buyers receive from a good as the buyer themselves perceive it. It’s a good measure of economic well-being if policymakers respect the preferences of buyers. Producer Surplus = amount a seller is paid – cost of production -Product surplus measures the benefit sellers receive from participating in the market. -Cost is the suppliers’ opportunity cost: it includes the suppliers’ out-of-pocket expenses and the value of their own time. Cost is the lowest price acceptable, measured by willingness to sell p/s. -height of S curve relate to the sellers’ costs. Marginal seller- seller who would leave the market first if the price were any lower. -producer surplus is the area below the price and above the S curve Sum of consumer & producer surplus (total surplus) helps measure economic well- being of a society. Total surplus = value to buyers – cost to sellers Efficiency- allocation of resources maximizes total surplus Free Markets -allocate supply of goods to buyers who value them most -maximize sum of consumer & producer surplus •At a quantity below equilibrium level, value to the marginal buyer exceeds the cost to the marginal seller, which increase the quantity produced & consumed raises total surplus until equilibrium reached •Market power & externalities are examples of a general phenomenon called market failure- the inability of some unregulated markets to allocate resources efficiently. Chapter 8 The Costs of Taxation Because of the tax wedge, the quantity sold falls below the level that would be sold without a tax. So a tax on a good causes the size of the market for the good to shrink. To analyze how taxes affect economic well-being, we use the government’s tax revenue to measure the public benefit from the tax. Total Tax Revenue = size of tax x quantity of good sold; How tax affects welfare; •Taxes make buyers/sellers worse off and the government better off. The losses to buyers/sellers from a tax exceed the revenue raised by the government. •Deadweight loss- the fall in total surplus that results when a tax (or some other policy) distorts a market outcome. (C+ E) •Because taxes distort incentives, they cause markets to allocate resources inefficiently. Dead Weight Loss Properties •Taxes cause DWL because the increase in price due to the tax is more expensive than the value buyers put on a good and the sellers receive less than their opportunity cost. •The size of DWL depends on the elasticity of S & D; •DWL is larger when the curve is more elastic b/c the more responsive buyers/sellers are to changes in price, the more the equilibrium quantity shrinks. •DWL of a tax rises even more rapidly than the size of the tax. As the size increases, the tax revenue eventually decreases because the higher tax drastically reduces the size of the market. Part 4 The Economies of the Public Sector: Chapters 10 & 11 Ch. 10 Externalities Externality •Arises when a person engages in an activity that influences the well-being of a bystander but neither pays not receives compensation for that effect: market failures. -equilibrium fails to maximize the total benefit to society as a whole Externalities and Market Inefficiency The Q produced and consumed at equilibrium is efficient since it maximizes the sum of PS and CS. Negative Externalities: •for each unit sold, the social cost includes the private costs of the good plus the cost to those bystanders affects adversely by the negative externality. The difference between the 2 curves (social cost above private cost) reflects the cost of the negative ext. -planner should choose level of production where demand curve crosses with social cost curve because it determines the optimal amount of production from the standpoint of society as a whole. To achieve optimal outcome, tax. -internalizing the externality: use of a tax that gives buyers and sellers in the market an incentive to take into account the external effects of their actions. Positive Externalities: i.e. better education leads to; lower crime rates, technological development which leads to higher productivity and wages for everyone, more informed voters which leads to a better government. -the social value exceeds the private value so the optimal quantity is larger than the equilibrium quantity. -to move market equilibrium closer to the social optimum, the pos ext requires a subsidy from the gov. Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities. Public Policies • all share the goal of moving the allocation of resources closer to the social optimum Command-and-control policies – regulate behavior directly. i.e. regulations by requiring or forbidding certain behaviors. It is a crime to dump poisonous chemicals into the water supply. Market-based policies – provide incentives so that private decision makers will choose to solve the problem on their own. -preferred method to regulation because they can deal with the externality at a lower cost to society and are better for the environment since firms have an incentive to develop cleaner technologies to reduce the amount of tax. • Corrective taxes: taxes enacted to deal with the effects of negative ext. They should equal the external cost from an activity with negative externalities. -an ideal corrective subsidy would equal the external benefit from an activity with positive externality. -a corrective tax allocates pollution to those factories that face the highest cost of reducing -however, while corrective taxes raise revenue for the government, they also enhance economic efficiency. • Tradable Pollution Permits: an advantage of allowing a market for pollution permits is that the initial allocation of pollution permits among firms does not matter from the standpoint of economic efficiency. -Those firms that can reduce pollution at a low cost will sell whatever permits they get, and firms that can reduce pollution only at a high cost will buy whatever permits they need. As long as there is a free market for the pollution rights, the final allocation will be efficient regardless of the initial allocation. The Coase theorem Says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient The Efficient Level of Output: (for socially efficient; maximizes total surplus) Chapter 11: Public Goods & Common Resource Excludable: people can be prevented from using it. Rival in Consumption: one person’s use of the good diminishes the other people’s use of it. Rival in Consump. Not Rival in Consump. Excludable Private Goods i.e. ice Club Goods i.e. fire cream cone, clothing protection, cable TV Not Excludable Common Resources i.e. Public Goods i.e. tornado fish in the ocean, the siren, national defense environment Public Good example; fire work b/c you can’t exclude someone from seeing the fireworks and one person’s enjoyment of them doesn’t reduce anyone else’s enjoyment of them. Free rider- person who receives the benefit of a good but does not pay for it. B/c public goods (like fireworks) are not excludable, people have an incentive to be free riders. Thus, the market would fail to provide the efficient outcome. -the free rider problem prevents the private market from supplying them. The government, however, can potentially remedy the problem (i.e. w/ taxes). Important Public Goods: -National Defense -Basic Research; not patented ideas, but a mathematical theorem. Governments subsidize basic research in medicine, math, physics, chem, bio, and econ. -Fighting Poverty; welfare system provides small income for poor families, food stamps, housing programs, etc. Cost-Benefit Analysis- estimates the total cost and benefits of a project to society as a whole. The efficient provision of public goods is intrinsically more difficult than that of private goods because price signals from S & D are not present. Common Resources Tragedy of the Commons- when one person uses a common resource, she/he diminishes the other people’s enjoyment of it. Negative externality -> common resources used excessively. Government can solve problem by using regulation or taxes to reduce consumption or turn it into a private good. Important Common Resources: -clean air and water -congested roads; when one person drives on the road, it becomes more crowded and other people must drive slower. Fixed by implementing a toll or tax on gas. -fish, whales, and other wildlife. Fixed by requiring fishing/hunting licenses, restrict hunting season •In these cases, the market fails to allocate resources efficiently because property rights are not well established, which causes a market failure which mainly the government can potentially solve. Part 5 Firm Behavior and Organization of Industry: Chapters 13-17 Chapter 13 The Costs of Production industrial organization: the study of how firms’ decisions about prices and quantities depend on the market conditions they face. Total Revenue, Total Cost, and Profit total rev- amount firm receives for the sale of its output. Quantity of output times the price. total cost- amount firm pays to buy inputs profit- total rev minus total cost. PROFIT = TOTAL REV – TOTAL COST Costs as Opportunity Costs opportunity cost of an item refers to all those things that must be forgone to acquire that item. Cost of production includes all the opportunity costs of making its output of g/s. Explicit costs- opportunity costs require the firm to pay out some money i.e. employee wages Implicit costs- do not require a cash outlay. i.e. own is skilled w/ computers and could earn $100/hr working as a programmer. So that $100 forgone income is part of his/her costs. Total cost of firm = explicit + implicit costs The Cost of Capital as an Opportunity Cost Important implicit cost = financial capital invested. The opp cost of the $300,000 invested in firm A is the 5% interest ($15,000) Sam would have earned had he left it in a savings account. Economic Profit vs Accounting Profit: economic profit = total rev – explicit + implicit costs accounting profit = total rev – explicit costs • Economic profit is an important concept because it is what motivates the firms that supply goods and services. Production and Costs (short-run; when things are more fixed) production function- relationship between the quantity of inputs (workers) and quantity of output (cookies). -The production function gets flatter as the number of workers increases, reflecting diminishing marginal product. -The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. Marginal product: • An increase in the Q of output obtained from 1 additional unit. • Diminishing marginal product: as the number of workers increases, the marginal product declines. Total-cost curve shows the quantity produced on the y-axis and total cost on the x-axis. - These two curves (total-cost curve & production function) are opposite sides of the same coin. The total-cost curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. The Various Measures of Cost •Fixes costs- do not vary with the Q of output produced. i.e. rent, salary of full-time bookkeeper •Variable Costs- change as the firm alters the Q produced. i.e. cost of sugar, milk, paper cups, salary of new employees needed to make more coffee total cost = fixed + variable Average & Marginal Cost average total cost = total cost/quantity of output -or can be expresses as sum of average fixed cost & average variable cost average fixed cost = fixed cost/quantity of output average variable cost = variable cost/quantity of output Marginal cost- shows the amount that total cost rises when the firm increases production by 1 unit of output. Marginal cost = change in total cost/change in quantity. - Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output Cost Curves and Their Shapes. -Marginal cost rises with the quantity of output. -The average-total-cost curve is U-shaped. -The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. This figure shows the: average total cost (ATC) average fixed cost (AFC) average variable cost (AVC) marginal cost (MC) Rising Marginal Cost: Marginal cost rises as the Q produced increases. Reflects diminishing marginal product. -For example, when A is producing small amounts of coffee, an extra worker will put his resources (equipment) to use and the marginal product of an extra worker is large while the marginal cost of extra coffee is small. But when he produces large amount of coffee, extra workers will make for crowded conditions and inefficient workers so the MP of an extra worker is low and the MC of more coffee is large. U-Shaped Average Total Cost: Average fixed cost always declines as output rises because the fixed cost is spread over a larger number of units. Average variable cost typically rises as output increases because of diminishing marginal product. -The tug of war between average fixed cost and average variable cost generates the U-shape in average total cost. -efficient scale- the bottom of the U-shape at the Q that minimizes average total cost. Relationship Between MC & ATC: Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. The marginal-cost curve crosses the average-total-cost curve at its minimum. -it’s like your GPA (ATC) and grade in your next class (MC), if that grade is lower than your GPA, it’ll lower your GPA, but it it’s higher, the grade will pull your GPA up. Typical Cost Curves Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves U-shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise. Despite these difference, the cost curves share these 3 properties: -Marginal cost eventually rises with the quantity of output. -The average-total- cost curve is U- shaped. -The marginal-cost curve crosses the average-total- cost curve at the minimum of average total cost. Relationship between Short-Run & Long-Run Average Total Cost - Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves since firms have greater flexibility in the LR. i.e. size of factory is fixed in short-run, but variable in long-run if firm wants to expand. Properties: -long-run is flatter -short-run curves lie on or above the long-run curve • The figure shows an example of how a change in production alters costs over different time horizons. I.e. When Ford wants to increase production from 1,000 to 1,200 cars per day, it has no choice in the short run but to hire more workers at its existing medium-sized factory. Because of diminishing marginal product, average total cost rises from $10,000 to $12,000 per car. In the long run, however, Ford can expand both the size of the factory and its workforce, and average total cost returns to $10,000. Economies and Diseconomies of Scale •economies of scale: When long-run average total cost declines as output increases. •diseconomies of scale: When long-run average total cost rises as output increases. •constant returns of scale: When long-run average total cost does not vary with the level of output. - This analysis shows why long-run average-total-cost curves are often U-shaped. At low levels of production, the firm benefits from increased size because it can take advantage of greater specialization. Coordination problems, meanwhile, are not yet acute. By contrast, at high levels of production, the benefits of specialization have already been realized, and coordination problems become more severe as the firm grows larger. Thus, long-run average total cost is falling at low levels of production because of increasing specialization and rising at high levels of production because of the increasing prevalence of coordination problems. Chapter 14: Firms in Competitive Markets A market is competitive if each buyer and seller is small compared to the size of the market and, therefore, has little ability to influence market prices. • if a firm can influence the market price of the good it sells, it is said to have market power Competitive market characteristics: -There are many buyers and many sellers in the market. -The goods offered by the various sellers are largely the same. -Price takers: buyers and sellers in competitive markets must accept the price the market determines. - Firms can freely enter or exit the market Average revenue = total revenue/amount of output •tells how much revenue a firm receives for the typical unit sold. So average revenue equal the price of the good. Marginal revenue- change in total revenue from the sale of each additional unit of output. For competitive firms, marginal revenue equals the price of the good. Profit-Maximization -Find the profit-maximizing quantity by comparing the marginal revenue and marginal cost from each unit produced. -if marginal revenue if greater than marginal cost, firms should increase production. But it MR is less than MC, they should decrease production. -a firm’s price equals both its average revenue and its marginal revenue Three general rules for profit maximization: 1. If marginal revenue is greater than marginal cost, the firm should increase its output. 2. If marginal cost is greater than marginal revenue, the firm should decrease its output. 3. At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. •In essence, because the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve. Stay Open vs Shutdown •shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market. - The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. -the firm shuts down if the revenue that it would earn from producing is less than its variable costs of production since it would save the variable cost (but still pay fixed cost) Shut down is TR < VC or restated as P < AVC (shut down if price of good is less than the average variable cost of production) In the short run, the competitive firm’s supply curve is its marginal-cost curve above average variable cost. If the price falls below average variable cost, the firm is better off shutting down temporarily. • sunk cost when it has already been committed and cannot be recovered. Because nothing can be done about sunk costs, they should be ignored them when making decisions. In the Long Run • the firm exits the market if the revenue it would get from producing is less than its total costs: -Exit if TR < TC OR/AND exit if P < ATC (price less than average total cost of production) -Enter if P > ATC The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost. -In the long run, the competitive firm’s supply curve is its marginal-cost curve above average total cost. If the price falls below average total cost, the firm is better off exiting the market. Measuring Profit in our Graph for Competitive Firms profit = TR – TC Profit = (P-ATC) x Q The area of the shaded box between price and average total cost represents the firm’s profit. The height of this box is price minus average total cost, and the width of the box is the quantity of output. In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm incurs a loss. Supply Curve in Competitive Market: The Short Run: Market Supply w/ a Fixed Number of Firms -In the short run, the number of firms in the market is fixed. As a result, the market supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm. The Long Run: Market Supply w/ Entry and Exit -in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. -In the long run, firms will enter or exit the market until profit is driven to zero. As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b). Two reasons that the long- run market supply curve might slope upward: 1. resources in production may be available only in limited quantities 2. firms may have different costs •Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve. CONCLUSION: -if firms are competitive and profit maximizing, the price of a good equals the marginal cost of making that good. In addition, if firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production. SUMMARY: -Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue. -To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal-cost curve is its supply curve. -In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. -In a market with free entry and exit, profit is driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. -Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium. Chapter 15: Monopoly Whereas a competitive firm is a price taker, a monopoly firm is a price maker. A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes. Barriers to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. 3 main sources of barriers; 1. Monopoly resources: A key resource required for production is owned by a single firm. 2. Government regulation: The government gives a single firm the exclusive right to produce some good or service. i.e. patent & copyright laws. By allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies are allowed to be monopolists in the drugs they discover to encourage research. 3. The production process: A single firm can produce output at a lower cost than can a larger number of firms. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. Cause; economies of scale, ATC curve continually declines. i.e. bridge How monopolies make production and pricing decisions Monopoly vs Competition -key diff; monopoly has ability to influence the price of its output. - as price takers, competitive firms face horizontal D curves -as sole producer, monopoly firm face a downward-sloping market D curve. (must accept lower price if it wants to sell more) -> The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. A Monopoly’s Revenue - average revenue, the amount of revenue the firm receives per unit sold. We compute average revenue by taking the number for total revenue and dividing it by the quantity of output. Avg rev = price of good (same for competitive and monopoly firms) - marginal revenue, the amount of revenue that the firm receives for each additional unit of output. We compute marginal revenue by taking the change in total revenue when output increases by 1 unit. -> A monopolist’s marginal revenue is always less than the price of its good (b/c of the downward sloping D curve). Effect on TR when Q sold increases; -The output effect: More output is sold, so Q is higher, which tends to increase total revenue -The price effect: The price falls, so P is lower, which tends to decrease total revenue. Because a competitive firm can sell all it wants at the market price, there is no price effect. When it increases production by 1 unit, it receives the market price for that unit, and it does not receive any less for the units it was already selling. Demand & Marginal-Revenue Curves for a Monopoly - Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. Profit Maximization - when marginal cost is less than marginal revenue, the firm can increase profit by producing more units. -if marginal cost is greater than marginal revenue, the firm can raise profit by reducing production. -the monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal-revenue curve and the marginal-cost curve. -In following this rule for profit maximization, competitive firms and monopolies are alike. But there is also an important difference between these types of firms: Competitive firm: P = MR =MC Monopoly firm: P > MR = MC -In competitive markets, price equals marginal cost. In monopolized markets, price exceeds marginal cost. Measuring A Monopoly’s Profit: Profit = TR – TC rearranged to Profit = (P – ATC) x Q Welfare cost of monopolies; • because a monopoly leads to an allocation of resources different from that in a competitive market, the outcome must, in some way, fail to maximize total economic well-being. -leads to dead weight loss; the socially efficient quantity is found where the demand curve and the marginal-cost curve intersect. The Inefficiency of Monopoly -The monopolist produces less than the socially efficient quantity of output. - monopoly pricing prevents some mutually beneficial trades from taking place. -The inefficiency of monopoly can be measured with a deadweight loss triangle Price discrimination • firms sell the same good to different customers for different prices, even though the costs of producing for the two customers are the same. -price discrimination is not possible when a good is sold in a competitive market. -price discrimination is a rational strategy for a profit-maximizing monopolist. -Price discrimination can raise economic welfare. I.e. DWL arises when Readalot charges a single $30 price because the 400,000 less enthusiastic readers do not end up with the book, even though they value it at more than its marginal cost of production. By contrast, when Readalot price discriminates, all readers get the book, and the outcome is efficient. Thus, price discrimination can eliminate the inefficiency inherent in monopoly pricing. It is higher producer surplus rather than higher consumer surplus. •Perfect price discrimination describes a situation in which the monopolist knows exactly each customer’s willingness to pay and can charge each customer a different price. Welfare w/ and w/out Price Discrimination: Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopoly that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. Examples of Price Discrimination; -movie tickets -airline prices -discount coupons -financial aid -quantity discount Public policy toward Monopolies We have seen that monopolies, in contrast to competitive markets, fail to allocate resources efficiently. Monopolies produce less than the socially desirable quantity of output and charge prices above marginal cost. Policymakers in the government can respond to the problem of monopoly in one of four ways: • By trying to make monopolized industries more competitive. • By regulating the behavior of the monopolies. • By turning some private monopolies into public enterprises. • By doing nothing at all. Increasing Competition w/ Antitrust Laws- a collection of statutes aimed at curbing monopoly power. i.e. Sherman Antitrust Act, which Congress passed in 1890 to reduce the market power of the large and powerful “trusts” that were viewed as dominating the economy at the time. The Clayton Antitrust Act, passed in 1914, strengthened the government’s powers and authorized private lawsuits. Regulation -This solution is common in the case of natural monopolies, such as water and electric companies - If regulators were to set price equal to marginal cost that price would be less than the firm’s average total cost and the firm would lose money. •Solution; subsidize the monopolist. But would lead to taxes, which involved DWL Public Ownership -government run i.e. postal service -problem; no incentive to keep costs low (thus profits higher) Conclusion: From the standpoint of public policy, a crucial result is that a monopolist produces less than the socially efficient quantity and charges a price above marginal cost. Result = DWL. Chapter 16: Monopolistic Competition Imperfect competition- many industries fall somewhere between the polar cases of perfect competition and monopoly oligopoly, a market with only a few sellers, each offering a product that is similar or identical to the products offered by other sellers in the market. Monopolistic Competition This describes a market structure in which there are many firms selling products that are similar but not identical. In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers. -Many sellers: There are many firms competing for the same group of customers. -Product differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. -Free entry and exit: Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero. The Monopolistically Competitive Firm in the Short Run monopolistically competitive firm follows a monopolist’s rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity. The Long-Run Equilibrium losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profits (that is, declining losses). Continues ‘til the firms in the market are making exactly zero economic profit. -D & ATC are tangent Because profit per unit sold is the diff between price and ATC, the max profit is zero only if these two curves touch each other w/out crossing - Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost. It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run. Characteristics of LR Equilibrium; -As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price. -As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero. Ch. 17 Oligopoly Oligopoly Characteristics -a few large sellers -either homogeneous or differentiated products -mutual interdependence -difficult entry Oligopolistic market has only a small group of sellers. Are best off when they cooperate and act like a monopolist—producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome. • duopoly: an oligopoly w/only 2 members • collusion: agreement among firms over production and price • cartel: group of firms acting in unison, agreeing on total level of production and amount produced by each member. Once a cartel is formed, the market is in effect served by a monopoly and outcome would maximize the total profit achievable from market. The Equilibrium for an Oligopoly -if the duopolists individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit. -Although the logic of self-interest increases the duopoly’s output above the monopoly level, it does not push the duopolists all the way to the competitive allocation. If a producer can make more (at a lower price), but he won’t make as much profit, he will decide not to make more. Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen. Once nash is reached, neither firm will have an incentive to make a different decision. -when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by perfect competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). How the Size of an Oligopoly Affects the Market Outcome -Reaching and enforcing an agreement (cartel) becomes more difficult as the size of the group increases. -2 effects of deciding how much to produce on their own and raising production by one gallon; -> the output effect: Because price is above marginal cost, selling one more gallon of water at the going price will raise profit. -> the price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold. -If the output effect is larger than the price effect, the well owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. Each oligopolist continues to increase production until these two marginal effects exactly balance. -as the oligopoly grows in size, the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether. The production decision of an individual firm no longer affect the market price. Each firm may take the market price when deciding how much to produce. Increase production as long as P > MC -as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. The Economics of Cooperation -prisoners’ dilemma, which provides insight into why cooperation is difficult. - a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. -when both parties choose the dominant strategy, it results in the inferior outcome and lower profits for both. Prisoners’ Dilemma and the Welfare of Society; Bad for society; -arms race game between US and Soviet Union -common resource game (results in waste) Good for society; -oligopolistis trying to maintain monopoly profits; more competitive -> maximizes total surplus Why People Sometimes Cooperate -cooperation is easier to enforce in repeated games. The threat of profit-penalty may be all that is needed to maintain cooperation. Public Policy toward Oligopolies Restraint of Trade & the Antitrust Laws -The Sherman Antitrust Act of 1890: elevated agreements among oligopolists from unenforceable contracts to criminal conspiracies. -The Clayton Act of 1914: further strengthened the antitrust laws. According to this law, if a person could prove that she was damaged by an illegal arrangement to restrain trade, that person could sue and recover three times the damages she sustained. - these laws are used to prevent mergers that would lead to excessive market power in any single firm. In addition, these laws are used to prevent oligopolists from acting together in ways that would make their markets less competitive. Controversies over Antitrust Policy -price fixing deemed illegal. 3 examples of controversial business practices; 1. Resale Price Maintenance: company sells product to retail store and requires them to sell at a certain price point. Illustrates principle that business practices that appear to reduce competition may in fact have legitimate purposes. 2. Predatory Pricing: one company cuts prices to drive another company out of the market 3. Tying: a company sells two products together at a single price. Conclusion: Oligopolies would like to act like monopolies, but self-interest drives them toward competition. Where oligopolies end up on this spectrum depends on the number of firms in the oligopoly and how cooperative the firms are. The story of the prisoners’ dilemma shows why oligopolies can fail to maintain cooperation, even when cooperation is in their best interest.
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