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Second Edition Chapter 11 Costs and Profit Maximization UnderCompetition Competition.

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1 Second Edition Chapter 11 Costs and Profit Maximization UnderCompetition Competition

2 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 2

3 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 3

4 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 Lets see what this means. 4

5 What Price to Set? World Market for OilDemand for Your Oil P ($/barrel) Quantity (millions of barrels) Quantity Demand demand Market supply $50 (barrels) Demand for your oil 82 5

6 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. 6

7 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 7

8 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?

9 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 9 Profit = = Total Revenue – Total Cost

10 Dont 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 10

11 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) 11

12 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 Lets look at some hypothetical data 12

13 Profit Maximization Lets show this with our model. 13

14 Maximizing Profit P ($/barrel) Quantity (barrels) $ MR = P Marginal cost At Q = 8: P = MR = MC Profits are maximized World Market price Note: In a competitive market, price does not vary with the firms output. This implies: 14

15 Maximizing Profit: Effect of an Increase in the Market Price P ($/barrel) Quantity (barrels) $ MR = P Marginal cost As P, the firm expands production along its MC curve World Market price MR = P 15

16 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? 16

17 Profits and the Average Cost Curve Lets see how profits are measured in our model. 17

18 Maximizing Profit P ($/barrel) Quantity (barrels) $ MR = P Marginal cost World Market price Average Cost (AC) 17 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

19 Maximizing Profit P ($/barrel) Quantity (barrels) $ Marginal cost Average Cost (AC) 17 MR = MC doesnt 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 Lets look at this a little closer. 19

20 Maximizing Profit P ($/barrel) Quantity (barrels) Marginal cost Average Cost (AC) 17 Loss P = MR P < AC is a profit P < AC is a loss 20

21 If a firm is earning positive economic profit, it must be the case that a)price is less than average cost. b)price is equal to average cost. c)price is equal to total cost. d)price is greater than average cost.

22 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.

23 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 23

24 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. 24

25 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. 25

26 The Short-Run Shutdown Decision Note: By staying open, the firm still loses money, but it loses less than if it shuts down for the summer 26

27 Entry and Exit with Uncertainty and Sunk Costs 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. Lets return to our oil firm as an example. 27

28 Entry and Exit with Uncertainty and Sunk Costs Entry and Exit with Uncertainty and Sunk Costs 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 wont be drilled. 28

29 Entry and Exit with Uncertainty and Sunk Costs Entry and Exit with Uncertainty and Sunk Costs It doesnt 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 29

30 Entry and Exit with Uncertainty and Sunk Costs 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. 30

31 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. 31

32 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 1)Price is quickly driven down to AC ($6.99). 2)Price doesnt change much. Lets see how this works. 32

33 Constant Cost Industry MarketFirm P P q Q $6.99 SS A DADA AC MC QAQA qAqA A Market demand market price profits profits Existing firms q Q profits Firms enter Short-run supply shifts right P, Q Profits return to normal $7.99 DBDB A QBQB qBqB SS B B B C C QCQC LRS 33

34 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. 34

35 Increasing Cost Industries Firm 1 – oil is near the surface Firm2 – oil is located deeper Firm 2 Industry Firm 1 PPP q2q2 Q q1q1 MC 1 MC 2 AC 2 AC 1 $50 $17 $ S Industry P < $17 Q = 0 P = $17 Q = q 1 + q 2 = 4 P = $29 Q = q 1 + q 2 = 11 P = $50 Q = q 1 + q 2 = 15 35

36 Increasing Cost Industries 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 36

37 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 37

38 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?

39 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 39

40 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 40

41 Second Edition End of Chapter 11

42 Second Edition Chapter 12 Invisible Competition and The InvisibleHand Hand

43 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. 43

44 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 44

45 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. 45

46 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 46 To see how, lets use an example

47 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. 47 To see why, lets use a diagram.

48 Invisible Hand Property 1: The Minimization of Total Industry Costs of Production 48 $$ Bushels of corn Bushels of corn Farm 2 Farm MC 2 MC 1 Total cost of producing 200 bushels on farm 2 Total cost of producing 200 bushels on farm 1 It costs less to produce all 200 bushels on farm 2.

49 Net result: total cost of producing 200 bushels Invisible Hand Property 1: The Minimization of Total Industry Costs of Production 49 $$ Bushels of corn Bushels of corn 200 MC 2 MC 1 What if we produce a little less on farm 2 and a little more on farm 1? Cost due to producing More on farm 1 Cost due to producing less on farm 2

50 Invisible Hand Property 1: The Minimization of Total Industry Costs of Production 50 $$ Bushels of corn Bushels of corn 200 MC 2 MC 1 Only when MC 1 = MC 2 is it not possible to reallocate production and reduce costs Less More MC

51 Invisible Hand Property 1: The Minimization of Total Industry Costs of Production Summary: If MC 1 > MC 2 Q 1, Q 2 Total Costs Costs saved by Q 1 > costs increased by Q 2 If MC 1 < MC 2 Q 1, Q 2 Total Costs Costs increased by Q 1 < costs saved by Q 2 If MC 1 = MC 2 Total costs are minimized. Costs increased by Q 1 = Costs decreased by Q 2 51

52 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 MC 1 = MC 2. 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 = MC 1 = MC 2 52

53 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. 53 Lets see how markets do this.

54 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. 54

55 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. 55

56 Creative Destruction Joseph Shumpeter ( ) This process of creative destruction is the essential fact about capitalism The kind of competition that counts: …the new commodity, 56 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

57 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 57

58 Takeaway Invisible Hand Property 1 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 58

59 Second Edition End of Chapter 12

60 Second Edition Chapter 13 Monopoly

61 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 61

62 Introduction Price of one pill is about 25 times higher than cost. Why? Market power In the U.S, deaths from AIDS dropped by 50% due to drugs like Combivir. AIDS has killed more than 28 million people. 62 The you cant take it with you effect The other peoples money effect

63 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. 63

64 Sources of market power: Patents Government regulations other than patents Economies of scale Exclusive access to an important input Technological innovation We look at these later 64 Market Power

65 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: 65 How a Firm Uses Market Power to Maximize Profit

66 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: 66 How a Firm Uses Market Power to Maximize Profit Lets show this.

67 MR < P Price Quantity $ Demand MR Revenue loss = $2 x 2 = $4 At P = 16: TR = $16 x 2 = $32 At P = 14: TR = $14 x 3 = $42 Marginal Revenue equals: Revenue loss = - $4 + Revenue gain = $14 x 1 = $14 MR = $14 -$4 = $10 Revenue gain MR = $10 67

68 Short-Cut for Finding MR MR begins at same point on the vertical axis. MR has twice the slope 68 Price Quantity a P = a – bQ MR = a – 2bQ MRDemand a/ba/2b Lets look at some examples.

69 Short-Cut for Finding MR Short-cut for finding MR 69 Price a a Quantity Q Demand MR The value of Q where MR= 0 is one half of that where P = 0.

70 How a Firm Uses Market Power to Maximize Profit Quantity (millions of pills) Price ($/pill) MR Demand AC MC Profit maximizing output = 80 Profit maximizing price = $12.50 Profit per pill = $10.00 Total profit = $10 x 80 = $800 m 80 $ Profit // 70

71 The Elasticity of Demand and the Monopoly Markup The two effects can make the elasticity of demand for pharmaceuticals more inelastic: The you cant take it with you effect People with serious illnesses are relatively insensitive to the price of life saving medicine. The other peoples money effect If third parties are paying for the medicine, people are less sensitive to price. 71 Lets see how this effects the monopoly markup.

72 The Elasticity of Demand and the Monopoly Markup 72 Price Quantity Demand MR Demand MC Relatively inelastic demand big markup Relatively elastic demand small markup QIQI PIPI QEQE PEPE Large markup Small markup

73 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?

74 The Cost of Monopoly: Deadweight Loss Compared to competition monopolies reduce total surplus (CS+ PS) This implies a deadweight loss. Lets use a model of a constant cost industry to show this. 74

75 Because the profit maximizing monopolist will produce where: And because P > MR: Result: deadweight loss (inefficiency) 75 How a Firm Uses Market Power to Maximize Profit To show this we will use the monopoly model.

76 The Cost of Monopoly: Deadweight Loss 76 PP MonopolyCompetition Q C = Optimal quantity PCPC Monopolist gets this Supply MR Demand MC = AC PMPM QCQC CS QMQM Profit Consumers get this DWL No one gets this (deadweight loss) QQ Consumers get this P > MC P = MC

77 The Cost of Monopoly: Deadweight Loss 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. 77

78 The Costs of Monopoly: Corruption and Inefficiency In Indonesia Tommy Suharto, the presidents son, was given the clove monopoly. He bought the entire Lamborghini company with his monopoly profits. 78 Many monopolies are born of government corruption

79 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 79

80 The Benefits of Monopoly: Incentives for Research and Development Drug prices are lower in India and Canada India does not offer strong patent protection. Canadas 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. 80

81 The Benefits of Monopoly: Incentives for Research and Development What the U.S. government opened up the pharmaceutical industry to competition? 81 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.

82 The Benefits of Monopoly: Incentives for Research and Development 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 82

83 The Benefits of Monopoly: Incentives for Research and Development 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. 83

84 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. Whats the downside? Higher taxes – they also create DWL Difficulty in determining the right price Possible corruption 84

85 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. 85 Lets use a model to learn the economics of natural monopoly.

86 Natural Monopoly 86 P Quantity MR Demand Competitive price PCPC Average costs for small firms AC MC QCQC Competitive quantity QMQM PMPM Monopoly quantity Monopoly price Optimal quantity It is possible for PM < PC If economies of scale are large enough

87 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 firms profit is less than the normal level. P = AC, is a compromise Profits are normal There is a deadweight loss. Lets go to our model to take a closer look.

88 Price Control and Natural Monopoly 88 P Quantity MR Demand Competitive price PCPC Average costs for small firms AC MC QCQC Competitive quantity QMQM PMPM Monopoly quantity Monopoly price Optimal quantity If the government sets: P = MC Firm loses money Loss if P = MC

89 Price Control and Natural Monopoly 89 P Quantity MR Demand Competitive price PCPC Average costs for small firms AC MC QCQC Competitive quantity QMQM PMPM Monopoly quantity Monopoly price Optimal quantity If the government sets: P = AC Profit = normal Results in DWL P = AC

90 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. 90

91 Californias Perfect Storm California deregulated wholesale electricity prices in 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. 91

92 Other Sources of Monopoly Power Barriers to entry – factors that increase the cost to new firms of entering an industry. 92

93 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?

94 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. 94

95 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. 95

96 Second Edition End of Chapter 13


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