Costs and Profit Maximization Under Competition

Costs and Profit Maximization Under Competition
Chapter 11 Costs and Profit Maximization Under Competition

Chapter Outline What price to set? What quantity to produce?
Profits and the average cost curve Entry, exit, and shutdown decisions Entry, exit, and industry supply curves

Introduction Imagine that you are the owner of a stripper oil well. You must answer three questions: What price to set? What quantity to produce? When to enter and exit the industry? In this chapter will answer these questions for a competitive industry

What Price to Set? In a competitive market you are a “price-taker”
As an oil producer your price is the world price. If you set the price higher, no one will buy your oil. Why would you set the price lower? Elasticity of demand for your oil is perfectly elastic Let’s see what this means.

What Price to Set? World Market for Oil Demand for Your Oil
P ($/barrel) P ($/barrel) Market supply Demand for your oil $50 Demand demand 82 Quantity Quantity (millions of barrels) (barrels)

The Perfectly Elastic Demand Curve
A perfectly elastic demand curve is a reasonable assumption under the following conditions: Product being sold is similar across sellers. There are many buyers and sellers, each small relative to the total market. There are many potential sellers.

The Perfectly Elastic Demand Curve
Demand curves are most elastic in the long run Long run – the time after all exit or entry has occurred. Short run – the time period before exit or entry can occur

What kind of demand elasticity does the competitive firm face?
In a competitive market, what happens when a firm prices its product above the market price? Below the market price? What kind of demand elasticity does the competitive firm face? How can a firm that produces oil face a very elastic demand curve when the demand for oil is inelastic? To next Try it!

What Quantity to Produce?
We assume the objective is to maximize profit. Total revenue is price x quantity = P x Q Total cost is the cost of producing a given quantity of output Profit = p = Total Revenue – Total Cost

Don’t Forget: Opportunity Cost!
Total cost = Explicit cost + Implicit cost Explicit cost is cost that requires a money outlay Implicit cost is an opportunity cost that does not require an outlay of money Economic profit includes implicit costs Accounting profit = Total revenue – explicit costs Output decisions should be based on economic profit

Maximizing Profit From now on our measure of total costs includes implicit costs. Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC) Fixed Costs are costs that do not vary with output (Q) Variable Costs are costs that do vary with output (Q)

Maximizing Profit Marginal revenue (MR) = Change in TR from selling one more unit. Marginal cost (MC) = Change in TC from producing one more unit. Profits are maximized at the level of output where MR = MC If MR > MC → ↑profits from ↑Q If MR < MC → ↓profits from ↑Q Let’s look at some hypothetical data

Profit Maximization Let’s show this with our model.

Maximizing Profit P ($/barrel)
Note: In a competitive market, price does not vary with the firm’s output. This implies: $150 Marginal cost 100 At Q = 8: P = MR = MC Profits are maximized World Market price→ 50 MR = P Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

Maximizing Profit: Effect of an Increase in the Market Price
($/barrel) $150 Marginal cost 100 MR = P As P↑, the firm expands production along its MC curve World Market price→ 50 MR = P Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

Profits and the Average Cost Curve
Average cost is the cost per unit of output, i.e. the total cost divided by Q We can now add a column to our table showing AC at each level of output. At the profit maximizing quantity, is AC at its lowest value?

Profits and the Average Cost Curve
Let’s see how profits are measured in our model.

Maximizing Profit P ($/barrel) P = AR = $50
Profits are maximized at Q = 8 At Q = 8, AC = $25.75 Profit = (P – AC) x Q or, Profit = ($50 - $25.75) x 8 = $194 Maximizing profits ≠ minimum AC $150 Marginal cost 100 Average Cost (AC) World Market price→ 50 MR = P 25.75 17 Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

Maximizing Profit P ($/barrel)
MR = MC doesn’t necessarily mean the firm makes a profit P = $17 is the minimum price the firm will accept P > $17 → P > AC → Profits P < $17 → P < AC → Losses $150 Marginal cost 100 Average Cost (AC) 50 17 Quantity (barrels) 1 2 3 4 5 6 7 8 9 10 Let’s look at this a little closer.

Maximizing Profit P ($/barrel) Marginal cost Loss Average Cost (AC) 25
50 Loss Average Cost (AC) P < AC is a loss P < AC is a profit 25 17 P = MR Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

price is less than average cost. price is equal to average cost.
If a firm is earning positive economic profit, it must be the case that price is less than average cost. price is equal to average cost. price is equal to total cost. price is greater than average cost. To next Try it!

Marginal and Average Cost Curve
The MC curve intersects the AC curve at its minimum point. When marginal cost is just below average cost, the AC curve is falling. When marginal cost is just above average cost, the AC curve is rising. So, AC and MC curves must meet at the minimum of the AC curve.

Entry, Exit, and Shutdown Decisions
When should a firm enter or exit an industry? Long run Firms will enter the industry when P > AC Firms will exit the industry when P < AC When P = AC Profits are zero No incentive to either leave or enter the industry

Entry, Exit, and Shutdown Decisions
Why would firms remain in an industry if profits are zero? Zero profits – means at the market price the firm is covering all of its costs including enough to pay labor and capital their ordinary opportunity cost. When economists say zero profits, they mean what people mean by normal profits.

The Short-Run Shutdown Decision
Sometimes it makes sense to continue running a business even if P < AC. A ski resort is an example If it shuts down during the summer… Revenue = 0, but… They still have fixed costs to cover Insurance, security, payments to the bank… If it stays open Revenue is positive Ski lift for hikers and bikers Restaurants and hotel If TR > VC they are better off staying open The following table provides some numbers to help us.

The Short-Run Shutdown Decision
A Firm Should Stay Open in the Short Run if it Can Cover its Variable Costs Decision Fixed Costs Variable Costs Summer Revenues Profits Shut Down 100 -100 Stay Open 50 75 -75 Note: By staying open, the firm still loses money, but it loses less than if it shuts down for the summer

Entry and Exit with Uncertainty and Sunk Costs
In the real world firms must modify the entry and exit rules. P > AC → Firm should enter only if the price is expected to be above AC for a long time. P < AC → Firm should exit only if the price is expected to below AC for a long time. Let’s return to our oil firm as an example.

Entry means drilling an oil well. Costs of drilling an oil well are sunk costs. Sunk costs – A cost that once incurred can never be recovered. Unless long enough to cover sunk costs, the well won’t be drilled.

It doesn’t always make sense to exit an industry immediately when P < AC High entry and exit costs Long-term it may be best to “weather the storm” Only if For an extended period of time will the firm exit

Firms must base their exit or entry decisions on lifetime expected profit when… It is costly to enter or exit There is uncertainty about future prices Uncertainty about the national economy can cause many firms to reduce investment simultaneously.

Entry, Exit, and Industry Supply Curves
Industry supply curve depends on how costs change as industry output ↑ or ↓ Constant cost industry – Industry costs do not change with greater output Increasing cost industry - Industry costs ↑ with greater output Decreasing cost industry – Industry cost ↓ with greater output We discuss each of these in turn.

Constant Cost Industries
Domain name registration industry has two characteristics: Satisfies all the conditions for a competitive industry Major input , bank of computers, is small compared to the world supply of computers. Implications Price is quickly driven down to AC ($6.99). Price doesn’t change much. Let’s see how this works.

Constant Cost Industry
P P Market Firm SSA MC B SSB B $7.99 AC C LRS C $6.99 A A DB DA q Q QA QB QC qA qB ↑ Market demand → ↑ market price → ↑ profits ↑ profits → Existing firms ↑ q → ↑ Q ↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑Q Profits return to normal

Increasing Cost Industries
Industry costs rise as industry output increases. The oil industry is an increasing cost industry Greater quantities of oil can only be obtained by using more expensive methods Drilling deeper Drilling in more inhospitable spots Extracting oil from tar sands We can use the following example to illustrate.

Firm 1 – oil is near the surface Firm2 – oil is located deeper SIndustry P Firm 1 MC1 P Firm 2 P Industry MC2 $50 AC2 AC1 $29 $17 q1 4 6 8 5 7 q2 4 11 15 Q P < $17 → Q = 0 P = $17 → Q = q1 + q2 = 4 P = $29 → Q = q1 + q2 = 11 P = $50 → Q = q1 + q2 = 15

Any industry that buys a large fraction of the output of and increasing cost industry will also be an increasing cost industry. Three examples: Gasoline industry - ↑demand for gas → ↑ price of oil → ↑ price of gas Electricity - ↑ demand → ↑ demand for coal Coal – for the same reasons as oil

Decreasing Cost Industry: A Special Case
Industry clusters can create decreasing cost industries As one industry grows, suppliers of inputs move to be close → ↓ costs Examples: Dalton Georgia – “Carpet Capital of the World” Silicon Valley – Computer technology Hollywood – Movies Aalsmeer, Holland – Flower distribution Cost reductions are temporary

Is the automobile manufacturing industry a constant cost, increasing cost, or decreasing cost industry? Why? Where are most U.S. films made? Why do you think the film industry is concentrated in such a small town? At the end of every year, Alex pockets $5,000 ($15,000 in revenue minus $10,000 in interest cost), while Tyler pockets $15,000. It’s tempting to conclude that Tyler’s well is more profitable, but that would be a mistake. Tyler could have left his $200,000 in the bank, and at a 5% rate of interest, he would have earned $10,000 a year in income. Tyler’s opportunity cost is the $10,000 in income he gave up when he invested his money in drilling the oil well. Thus, once we take into account all costs, including opportunity costs, Alex and Tyler’s wells are equally profitable To next Try it!

Industry Supply: Summary
Constant cost industry Industry is small relative to its input markets… It can expand without ↑ costs → flat supply curve. (Constant cost industry) Increasing cost industry Expansion → ↑ costs → supply curve slopes upward Decreasing cost industry Expansion → ↓ costs → supply curve slopes downward Rare and temporary

Takeaway We answered the following 3 questions
What price to set?: P = market price What quantity to produce?: P = MC When to enter and exit an industry? In the long-run Enter if P > AC Exit if P < AC Increasing cost industry: LRS slopes up Constant cost industry: LRS flat Decreasing cost industry: LRS slopes down

End of Chapter 11

Competition and The Invisible Hand
Chapter 12 Competition and The Invisible Hand

Introduction In this chapter we return to the “invisible hand”
With the right institutions, individuals acting in their self-interest can generate outcomes that… are neither part of their intention nor design. have desirable properties.

Chapter Outline Invisible Hand Property 1:The minimization of total industry costs of production Invisible Hand Property 2: The balance of industries Creative destruction The invisible hand works with competitive markets

Introduction We will show that:
Competitive markets balance production across firms in a given industry so that… total industry costs are minimized. Entry (P > AC) and exit (P < AC) result in balanced production across different industries so that… Total value of production is maximized.

In a competitive market with N firms…
Invisible Hand Property 1: The Minimization of Total Industry Costs of Production In a competitive market with N firms… All firms face the same market price To maximize profits each firm adjusts its output until P = MC Therefore, the following will be true: This results in minimizing total costs for the industry To see how, lets use an example

Invisible Hand Property 1: The Minimization of Total Industry Costs of Production
Assume: You own two farms. Each has a different MC curve. You wish to produce a total of 200 bushels of wheat. You should produce all 200 bushels on the farm with the lowest MC. Right? Not necessarily. To see why, lets use a diagram.

Farm 1 Farm 2 $ $ Total cost of producing 200 bushels on farm 1 Total cost of producing 200 bushels on farm 2 MC1 MC2 200 Bushels of corn 200 Bushels of corn It costs less to produce all 200 bushels on farm 2.

What if we produce a little less on farm 2 and a little more on farm 1? $ $ ↓ Cost due to producing less on farm 2 Net result: ↓total cost of producing 200 bushels MC1 MC2 ↑ Cost due to producing More on farm 1 Bushels of corn 200 Bushels of corn

Only when MC1 = MC2 is it not possible to reallocate production and reduce costs. $ $ MC1 MC2 MC Less More 75 Bushels of corn 125 200 Bushels of corn

Summary: If MC1 > MC2 → ↓Q1, ↑Q2 → ↓ Total Costs Costs saved by ↓Q1 > costs increased by ↑Q2 If MC1 < MC2 → ↑Q1, ↓Q2 → ↓Total Costs Costs increased by ↑Q1 < costs saved by ↓Q2 If MC1 = MC2 → Total costs are minimized. Costs increased by ↑Q1 = Costs decreased by ↓Q2 Costs increased by ↓Q1 = Costs decreased by ↑Q2

The “really important part”:
Invisible Hand Property 1: The Minimization of Total Industry Costs of Production The “really important part”: As owner of the farms you can allocate your production across farms so that MC1 = MC2. What if the farms are owned by different people in different states? Each farmer faces the same market price. Each maximizes profits by producing where: P = MC Therefore, P = MC1 = MC2

Invisible Hand Property 2: The Balance of Industries
Entry or exit work to ensure that… Labor and capital move across industries Production is optimally balanced Greatest use is made of our limited resources. It is possible to minimize the cost of producing any given level of output but… To minimize cost across industries: Each industry should produce the “right” quantity. Invisible Hand Property 2 makes this happen. Let’s see how markets do this.

Invisible Hand Property 2: The Balance of Industries
Profit is the signal that allocates capital and labor among industries. They need to flow from low-profit industries to high industries. If P > AC, profits are above normal. Capital and labor enter the industry. If P < AC, profits are below normal. Capital and labor exit the industry. Profit rate in all competitive industries tends toward the same level.

Creative Destruction Elimination Principle – above-normal profits are eliminated by entry, and below-normal profits are eliminated by exit. Resources move toward an increase in the value of production. Entrepreneurs move resources from unprofitable industries to profitable industries. Implication of this principle: Above normal profits are temporary. To earn above-normal profits, entrepreneurs must innovate.

Creative Destruction Joseph Shumpeter (1883-1950)
“This process of creative destruction is the essential fact about capitalism” The kind of competition that counts: “…the new commodity, the new technology, the new source of supply, the new type of organization…which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives”

The Invisible Hand Works with Competitive Markets
The invisible hand will not work if… Prices do not accurately signal costs and benefits. Result: no optimal balance between industries Markets are not competitive. Result: Monopolists and oligopolists produce less than the ideal amount Firms make above normal profits, and entry is limited. Commodities are public goods. Result: Self interest does not align with social interest

Takeaway Invisible Hand Property 1 Invisible Hand Property 2
P = MC results in minimization of total industry cost. Invisible Hand Property 2 Entry and exit result in the best use of limited resources. Elimination principle Above normal profits are temporary. To earn above normal profits, a firm must innovate

End of Chapter 12

Chapter 13 Monopoly

Chapter Outline Market Power
How a Firm Uses Market Power to Maximize Profit The Costs of Monopoly: Deadweight Loss The Costs of Monopoly: Corruption and Inefficiency The Benefits of Monopoly: Incentives for Research and Development Economies of Scale and the Regulation of Monopoly Other Sources of Market Power

Introduction AIDS has killed more than 28 million people.
In the U.S, deaths from AIDS dropped by 50% due to drugs like Combivir. Price of one pill is about 25 times higher than cost. Why? Market power The “you can’t take it with you” effect The “other people’s money” effect

Market Power Market Power – the power to raise price above marginal cost without fear that other firms will enter the market. GlaxoSmithKline owns the patent on Combivir. Monopoly – a firm with market power. A simple test: India does not recognize the patent Price of the drug in India = $0.50 per pill = MC.

Market Power Sources of market power: We look at these later Patents
Government regulations other than patents Economies of scale Exclusive access to an important input Technological innovation We look at these later

How a Firm Uses Market Power to Maximize Profit
Marginal revenue (MR) – the change in total revenue from selling an additional unit of output. Marginal cost (MC) – the change in total cost from producing an additional unit. To maximize profit, firms produce at the level of output where:

Firm with market power: Faces a downward sloping demand curve. If it sells an additional unit… It had to lower the price. Additional revenue per unit < current price. In other words: Let’s show this.

MR < P Price MR = $10 Quantity At P = 16: TR = $16 x 2 = $32
Marginal Revenue equals: Revenue loss = - $4 + Revenue gain = $14 x 1 = $14 MR = $14 -$4 = $10 Revenue loss = $2 x 2 = $4 $20 18 16 14 12 10 MR = $10 Revenue gain 8 Demand 6 4 2 Quantity 1 2 3 4 5 6 7 MR

Short-Cut for Finding MR
MR begins at same point on the vertical axis. MR has twice the slope Price a P = a – bQ MR = a – 2bQ Let’s look at some examples. MR Demand Quantity a/2b a/b

Short-Cut for Finding MR
Price Price a a The value of Q where MR= 0 is one half of that where P = 0. Demand Demand MR MR Q 250 500 125 250 Quantity

Price ($/pill) Profit maximizing output = 80 Profit maximizing price = $12.50 Profit per pill = $10.00 Total profit = $10 x 80 = $800 m Demand $12.50 Profit 2.50 AC // 0.50 MC Quantity (millions of pills) 80 MR

The Elasticity of Demand and the Monopoly Markup
The two effects can make the elasticity of demand for pharmaceuticals more inelastic: The “you can’t take it with you” effect People with serious illnesses are relatively insensitive to the price of life saving medicine. The “other people’s money” effect If third parties are paying for the medicine, people are less sensitive to price. Let’s see how this effects the monopoly markup.

The Elasticity of Demand and the Monopoly Markup
Price Price Relatively elastic demand small markup Relatively inelastic demand big markup PI Large markup PE Demand MC MC Demand QE Quantity QI Quantity Small markup MR MR

As a firm with market power moves down the demand curve to sell more units, what happens to the price it can charge on all units? What type of demand curve does a firm with market power prefer to face for its products: elastic or inelastic? Why? At the end of every year, Alex pockets $5,000 ($15,000 in revenue minus $10,000 in interest cost), while Tyler pockets $15,000. It’s tempting to conclude that Tyler’s well is more profitable, but that would be a mistake. Tyler could have left his $200,000 in the bank, and at a 5% rate of interest, he would have earned $10,000 a year in income. Tyler’s opportunity cost is the $10,000 in income he gave up when he invested his money in drilling the oil well. Thus, once we take into account all costs, including opportunity costs, Alex and Tyler’s wells are equally profitable To next Try it!

The Cost of Monopoly: Deadweight Loss
Compared to competition monopolies reduce total surplus (CS+ PS) This implies a deadweight loss. Let’s use a model of a constant cost industry to show this.

Because the profit maximizing monopolist will produce where: And because P > MR: Result: deadweight loss (inefficiency) To show this we will use the monopoly model.

Competition P Monopoly Consumers get this Consumers get this Monopolist gets this PM No one gets this (deadweight loss) CS Profit DWL PC Supply MC = AC Demand Demand Q Q QC = Optimal quantity QM QC MR P = MC P > MC

Deadweight loss in practice GlaxoSmithKline prices Combivir at $12.50 a pill MC = $0.50 Deadweight loss = value of the sales that do not occur because P > MC.

The Costs of Monopoly: Corruption and Inefficiency
Many monopolies are born of government corruption In Indonesia Tommy Suharto, the presidents son, was given the clove monopoly. He bought the entire Lamborghini company with his monopoly profits.

The Costs of Monopoly: Corruption and Inefficiency
Monopolies are especially harmful if they control a good that is used to produce other goods. In Algeria a dozen or so army generals each control a key good People refer to these men as General wheat, General tire…. Each general tries to get a larger share of the economic pie. Result: greater DWL and the “pie” shrinks

The Benefits of Monopoly: Incentives for Research and Development
Drug prices are lower in India and Canada India does not offer strong patent protection. Canada’s government controls drug prices. Should the U.S. government limit patents? It costs $1billion to develop a new drug. Patents are one way of rewarding R&D. Without patents why would firms spend on R&D? Result: Fewer new drugs will be developed.

What the U.S. government opened up the pharmaceutical industry to competition? Competition will drive price down to MC. R&D costs are not included in MC Firms can not cover their R&D costs. Result: Fewer drugs will be created.

Other goods have high development costs. Information goods – goods that are valuable for their content. Examples: Music, movies, computer files, books. Typically MC is very low. High development costs and low MC of production → Need for patent or copyright protection. Policy trade-off: Lower prices today Fewer new ideas in the future

Nobel Prize winner Douglas North, economic historian: “The failure to develop systematic property rights in innovation up until fairly modern times was a major source of the slow pace of technological change.”

Patent Buyouts: A Potential Solution
The government could buy the patent for a little more than monopoly profits … then rip it up. Competitors would enter and drive the price of the drug to its MC. What’s the downside? Higher taxes – they also create DWL Difficulty in determining the right price Possible corruption

Economies of Scale and the Regulation of Monopoly
Economies of scale – the advantages of large-scale production that reduce AC as quantity increases. Natural monopoly – is said to exist when a single firm can supply the entire market at a lower cost than two or more firms. Let’s use a model to learn the economics of natural monopoly.

Natural Monopoly P Average costs for small firms
It is possible for PM < PC If economies of scale are large enough Competitive price PC Monopoly price PM AC MC Demand Quantity QC QM Optimal quantity Competitive quantity Monopoly quantity MR

Natural Monopoly A price control can increase output.
What price should the government choose? P = MC → Optimal level of output At P = MC, P < AC due to economies of scale The firm’s profit is less than the normal level. P = AC, is a compromise Profits are normal There is a deadweight loss. Let’s go to our model to take a closer look.

Price Control and Natural Monopoly
Average costs for small firms If the government sets: P = MC Firm loses money Competitive price PC Monopoly price PM AC Loss if P = MC MC Demand Quantity QC QM Optimal quantity Competitive quantity Monopoly quantity MR

Price Control and Natural Monopoly
Average costs for small firms If the government sets: P = AC Profit = normal Results in DWL Competitive price PC Monopoly price PM P = AC AC MC Demand Quantity QC QM Optimal quantity Competitive quantity Monopoly quantity MR

Electric Shock Government ownership is another solution to natural monopoly. Worked well until 1970s when new technologies reduced average costs at small scales. Result: Electric generation was no longer a natural monopoly.

California’s Perfect Storm
California deregulated wholesale electricity prices in 1998. Problems: Transmission and distribution remained natural monopolies. Electricity is difficult to store. Booming economy required importing electricity from other states. Inelastic demand curves Summer-winter 2008 Several factors quadrupled wholesale prices Generators of electricity could exploit market power.

Other Sources of Monopoly Power
Barriers to entry – factors that increase the cost to new firms of entering an industry. Some Sources of Monopoly Power (Barriers to Entry) Sources of Market Power Example Patents GSK’s patent on Combivir Laws preventing entry Indonesian clove monopoly, Algerian wheat monopoly, U.S. Postal service Economies of scale Subways, cable TV, Electricity transmission, major highways Hard to duplicate inputs Oil, diamonds, Brands and trademarks: Rolex watches Innovation Apple’s iPod, Wolfram’s Mathematica software, eBay

Consider ticket prices at major league baseball and professional football parks. How does the term “barrier to entry” help explain their pricing? How permanent are barriers to entry in the following cases: NBA basketball franchises, U.S. Postal Service delivery of first class mail, U.S. Postal Service delivery of parcels? At the end of every year, Alex pockets $5,000 ($15,000 in revenue minus $10,000 in interest cost), while Tyler pockets $15,000. It’s tempting to conclude that Tyler’s well is more profitable, but that would be a mistake. Tyler could have left his $200,000 in the bank, and at a 5% rate of interest, he would have earned $10,000 a year in income. Tyler’s opportunity cost is the $10,000 in income he gave up when he invested his money in drilling the oil well. Thus, once we take into account all costs, including opportunity costs, Alex and Tyler’s wells are equally profitable To next Try it!

Takeaway You should be able to:
Find MR given either a demand curve or a table of prices and quantities. Given demand and MC curves, find and label monopoly price and quantity, and DWL. With the addition of the AC curve Find and label monopoly profit Demonstrate that the markup of price over MC is larger the more inelastic the demand.

Takeaway Monopolies involve trade-offs between DWL and innovation.
Natural monopolies involve trade-offs between DWL and economies of scale. Regulation of monopolies is a challenge Regulation of Cable TV kept prices low but also quality Deregulation of electricity in California left them at the mercy of firms with market power. Many monopolies are created to transfer wealth to politically powerful elites.

End of Chapter 13

Costs and Profit Maximization Under Competition

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