9 Competitive Firm Firm sells any quantity wants at going market price Classic example farmSmall part of market served by each firmHorizontal demand curveProducts are interchangeableBuyers can easily buy from another producer
13 Firm’s Supply Decision Produce good until MR = MCCompetitive firm produces a quantity where P = MCNote: P ≡ MRSupply curveMC and supply are inverse functionsSupply curve looks like upward sloping portion of MC curve as long as MC curve upward slopingSR and LR supply curves exist for the firm
16 Shutdowns and Exits Does the producer want to produce the good? Two distinctionsShutdown: firm stops producing the good but still pays fixed costsExit: firm leaves the industry entirely and no longer faces any costsFirms, in SR, can shutdown but not exitRemains operational if P > AVCIn LR, can exit
18 Short-Run Supply Curve Firms SR supply curve identical to part of SRMC curve that lies above AVC curveShutdown otherwiseUpward sloping due to AC and MC U-shapeDiminishing marginal returns to variable factors of productionElasticity of supplyPercent change in quantity supplied resulting from a 1% change in price
20 The competitive industry in the short run Section 7.2The competitive industry in the short run
21 Competitive Industry in the SR All firms in industry competitiveSR is period of time in which no firm can enter or exit the industryNumber of firms cannot changeLR is period of time in which any firm can enter or leave the industryIndustry’s SR supply curveSum of SR individual firm supply curvesMore elastic than individual supply curves
23 Supply, Demand, and Equilibrium Each firm operates where supply meets demandIndustry equilibrium consequence of optimizing behavior on part of individuals and firmsIntersecting industry wide supply and industry wide demand
24 Competitive Equilibrium Firms produces where supply (or MC) curve crosses horizontal line at market going priceIncrease in FCPrice and quantity remain unchangedIncrease in VCRaises firms MC curveCauses some firms to shutdownHigher market equilibrium priceFirm’s output could go up or downIncrease in industry demandIncrease in firm’s output
31 Industry’s Costs Sum of total cost of all individual firms To minimize cost of all firms, use equimarginal principleInsure that MC same for all producers in industryAutomatic because all firms have same price
32 The competitive firm in the long run Section 7.3The competitive firm in the long run
33 Competitive Firm in the LR Some fixed cost in SR become variable cost in the LRFirms can enter and exit in the LR
34 Profit and the Exit Decision Profit = TR – TCCosts includes all foregone opportunitiesSR versus LR supply responseFirm LR supply curve more elastic than SR supply curveShuts down if price of output falls below average variable costExits if price of output falls below average cost
38 The competitive industry in the long run Section 7.4The competitive industry in the long run
39 Competitive Industry in the LR Firms wishing to enter or exit the market do so in the LR, flatting out the LR supply curveSo unlike the case in the SR, the LR supply curve is a horizontal line.Important assumption: all firms are identical in costsBreak-even price plays an important role here (1) all firms produce at the break-even price; (2) it determines the level of LR supply curve
41 Zero Profit Condition Economic versus accounting profit Accounting profit refers to total revenue minus total financial costEconomic profit refers to accounting profit minus the value of the best foregone opportunity
43 Industry’s LR Supply Curve All firms identicalIndustry supply curve flat at the break-even priceBreak-even price and the LR supplyBreak-even price (P = AC) at which a seller earns zero profitLR supply curve identical with part of firm’s LRMC curve lying above LRAC curve
44 Flat LR Supply Curve Flatness based on entry and exit P < AC, all firms exitP > AC, unlimited number of firms enterLR zero profit equilibrium almost never reachedDemand and cost curves shift so often that entry and exit never settles downApproximation to the truth
45 Equilibrium LR same as SR between firm and industry Market price determined by intersection of industrywide demand and supplyFirms face flat demand curves at market priceAnalysis of changes to equilibriumChanges in FCChanges in VCChanges in demand
49 Application: Government as a Supplier In SR, government policy to build and operate apartment complex increasing housingIn LR, supply curve does not shiftDetermined by break-even priceNumber of privately owned apartments withdrawn from the market equals number of apartments built by government
51 Relaxing the Assumptions Assumption 1: All firms are identical, have identical cost curvesTrue in industries that do not require unusual skillsAssumption 2: Cost curves do not change as industry expands or contractsTrue in industries not large enough to affect input pricesWithout these assumptions, all firms do not have the same break-even price
52 Constant CostConstant cost industrySatisfies the 2 assumptions
53 Increasing Cost Increasing cost industry Break-even price for new entrants increases as industry expandsAssumption 1 violated: Less-efficient firmsAssumption 2 violated: Factor-price effectLR industry supply curve slopes upward
67 WelfareAssumption about same industry wide MC curve for competitive and monopolistic industriesSocial welfare loss under monopolyMarginal value exceeds marginal costMonopolist could produce additional good
69 Subsidies and Public Policy Subsidies for monopolistInduce monopolist to provide competitive quantityArises from “ideal” subsidyCould encourage inefficient productionCreates price ceilingsFollows rate-of-return regulation
81 Third-Degree Charging different prices in different markets Groups of consumers identifiableDifferent downward sloping demand curveProducer profitProduction of goods where MR same in both markets and equal to MCMore elastic demand group receives lower price
84 maxy1, y2 (=p1(y1)y1+ p2(y2)y2-c(y1+y2)). Third-degree: the most common form of price discrimination (student discounts, senior citizens’ discounts). Suppose there are two groups of people and there is no resale. Then the monopolist’s profit maximization problem becomesmaxy1, y2 (=p1(y1)y1+ p2(y2)y2-c(y1+y2)).Hence FOC becomesMR1(y1)=MC(y1+y2)=MR2(y2).
85 Since MR1(y1)=p1(y1)[1-1/|1|] and MR2(y2)=p2(y2)[1-1/|2|], hence p1>p2 if and only if |1|<|2|. The market with lower absolute value of elasticity has a higher price. Quite sensible since elasticity measures how sensitive the group is to price changes.There are some other often-observed practices used by firms with monopoly power.
86 Second-degree: also known as non-linear pricing since the price per unit of output is not constant, but depends on how much you buy. The monopolist can offer different price-quantity packages so that the consumers can self select.Note that the low-end consumer’s package is distorted so that the high-end consumer will not choose the low-end package.
88 Compared to perfect price discrimination, without high-end, low-end is offered higher quantity but still ends up with zero surplus. Without low-end, high end gets zero surplus, now gets positive surplus and the quantity offered is the same.Applying this to air travels, by offering a downgraded product, the airlines can charge the consumers who need flexible travel arrangements more for their tickets.
89 Many many examples of PD Coupons, rebates, free delivery, coffee lids……The spirit of PD – to offer lower prices to customers who are more sensitive to price. There is no point to offer coupons if everyone redeemed them, and there is no point to coupons if only a random set of customers redeemed them.Note: almost everything that appears to be price discrimination admits at least one alternative explanation. For example, coupon clippers temp to go shopping when the shop is not crowded.
90 Pricing strategies by monopolist: versioning Versioning is a practice of offering an inferior product to charge differently for different customers. For example, hardcopy and paperback of the same book. Another example is the same printers designed to print slower deliberately.Strictly speaking, versioning should not be considered as a form of PD in some cases as products involved are different.
91 Pricing strategies by monopolist: Two-Part Tariff First partEntry fee allows purchase of goods or servicesMeaning of tariff
92 Pricing strategies by monopolist: Two-Part Tariff Second partCustomers are charged maximum willing to payCharge competitive price as long as no difference in consumersCharge low initial fee and high usage fee
94 Pricing strategies by monopolist: Two-Part Tariff By implementing the two-part tariff, a monopoly firm can produces at the competitive market level, enhancing the efficiency.ExamplesClubs that charge a member fee and an usage feeHealth insurance – copayment increases efficiency.
95 Pricing strategies by monopolist: Bundling packages of related goods are often offered for sale together: software suite (word processor, spreadsheet, presentation tool), cosmetic products, etc.Bundling may be cost saving or it may be due to complementarities among the goods involved. But there can be reasons involving consumer behavior. Consider the following example. Assume the marginal cost of producing is zero.
96 Type of consumersword pro spreadsheetABSuppose the willingness to pay for the bundle is the sum. If each item is sold separately, then revenue will be 400. If instead bundling two goods together, can get the revenue of 440. In other words, the dispersion of willingness to pay may be reduced.