# Profit Maximization Profit = MR – MC

## Presentation on theme: "Profit Maximization Profit = MR – MC"— Presentation transcript:

A C T I V E L E A R N I N G 1 Calculating TR, AR, MR
Fill in the empty spaces of the table. Q P TR AR MR \$10 n/a 1 \$10 \$10 2 \$10 3 \$10 4 \$10 \$40 \$10 5 \$10 \$50

Profit Maximization Profit = MR – MC
(continued from earlier exercise) Q TR TC Profit MR MC Profit = MR – MC At any Q with MR > MC, increasing Q raises profit. \$0 45 33 23 15 9 \$5 \$10 1 10 10 2 20 At any Q with MR < MC, reducing Q raises profit. 10 (The table on this slide is similar to Table 2 in the textbook.) For most students, seeing the complete table all at once is too much information. So, the table is animated as follows: Initially, the only columns displayed are the ones students saw at the end of the exercise in Active Learning 1: Q, TR, and MR. Then, TC appears, followed by MC. It might be useful to remind students of the relationship between MC and TC. Then, the Profit column appears. Students should be able to see that, at each value of Q, profit equals TR minus TC. The last column to appear is the change in profit. When the table is complete, we use it to show it is profitable to increase production whenever MR > MC, such as at Q = 0, 1, or 2. it is profitable to reduce production whenever MC > MR, such as at Q = 5. 3 30 10 4 40 10 5 50 FIRMS IN COMPETITIVE MARKETS 1

A C T I V E L E A R N I N G 2 Identifying a firm’s profit
A competitive firm Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. Q Costs, P MC ATC P = \$10 MR 50 \$6 2

A C T I V E L E A R N I N G 3 Identifying a firm’s loss
A competitive firm Determine this firm’s total loss, assuming AVC < \$3. Identify the area on the graph that represents the firm’s loss. Q Costs, P MC ATC \$5 30 P = \$3 MR 3

A C T I V E L E A R N I N G 1 A monopoly’s revenue
Common Grounds is the only seller of cappuccinos in town. The table shows the market demand for cappuccinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR? Q P TR AR MR \$4.50 1 4.00 2 3.50 3 3.00 4 2.50 5 2.00 6 1.50 n.a. 4

A Monopolistic Competitor in the Long Run
Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC. MC ATC Quantity Price P = ATC markup D MC MR Q MONOPOLISTIC COMPETITION 5

EXAMPLE: Cell Phone Duopoly in Smalltown
P Q \$0 140 5 130 10 120 15 110 20 100 25 90 30 80 35 70 40 60 45 50 Smalltown has 140 residents The “good”: cell phone service with unlimited anytime minutes and free phone Smalltown’s demand schedule Two firms: T-Mobile, Verizon (duopoly: an oligopoly with two firms) Each firm’s costs: FC = \$0, MC = \$10 To understand the behavior of oligopoly, we will consider an oligopoly with just two members – a duopoly. The textbook’s example (water) is simpler, because it uses zero marginal cost (as well as zero fixed cost). This is appropriate, because students will not have the instructor’s assistance when reading the textbook. But in class, with the instructor’s guidance, a slightly more complex example is appropriate. The added complexity in this example is non-zero marginal cost. (However, fixed costs are still zero.) Students probably think cell phones are more interesting than water, so they may like this example better than the one in the textbook. To keep the example manageably simple, we assume unlimited anytime minutes & free cell phone. Without either of these assumptions, then the “product” consumers buy would not have a single well-defined price, but the price would vary based on how many minutes the customer used, or what kind of phone the customer wanted with her service plan. Regarding the zero fixed cost assumption: This merely makes the math easier. As students will recall from Chapter 13, fixed costs are sunk costs and do not affect decisions or outcomes. OLIGOPOLY 6

EXAMPLE: Cell Phone Duopoly in Smalltown
50 45 60 40 70 35 80 30 90 25 100 20 110 15 120 10 130 5 140 \$0 Q P 2,250 2,400 2,450 2,000 1,650 1,200 650 \$0 Revenue 500 600 700 800 900 1,000 1,100 1,200 1,300 \$1,400 Cost 1,750 1,800 1,600 1,350 1,000 550 –650 –1,400 Profit Competitive outcome: P = MC = \$10 Q = 120 Profit = \$0 Monopoly outcome: P = \$40 Q = 60 Profit = \$1,800 Before considering possible duopoly outcomes, we first review the competitive and monopoly outcomes. Competitive outcome: P = MC = \$10 (remember, we are assuming MC is constant at \$10/unit). At P = \$10, market demand equals 120 units, which the two firms split. Economic profit is zero, as we learned in the chapter “Firms in Competitive Markets.” Monopoly outcome: A single firm would produce the quantity where economic profit is maximized. In this example, Q = 60. The firm would set P = \$40, from the demand curve. It is true, in fact, that MR=MC at Q=60, even though the table does not provide sufficient detail to see this. But if a student asks about this, here is a response that might satisfy the student: We can estimate MR at Q=60 as follows: Increase output from 50 to 70, dR = \$200, dQ=20, MR = dR/dQ = \$200/20 = \$10. OLIGOPOLY 7

A C T I V E L E A R N I N G 1 Collusion vs. self-interest
A C T I V E L E A R N I N G Collusion vs. self-interest P Q \$0 140 5 130 10 120 15 110 20 100 25 90 30 80 35 70 40 60 45 50 Duopoly outcome with collusion: Each firm agrees to produce Q = 30, earns profit = \$900. If T-Mobile reneges on the agreement and produces Q = 40, what happens to the market price? T-Mobile’s profits? Is it in T-Mobile’s interest to renege on the agreement? If both firms renege and produce Q = 40, determine each firm’s profits. 8

A C T I V E L E A R N I N G 2 The oligopoly equilibrium
A C T I V E L E A R N I N G The oligopoly equilibrium P Q \$0 140 5 130 10 120 15 110 20 100 25 90 30 80 35 70 40 60 45 50 If each firm produces Q = 40, market quantity = 80 P = \$30 each firm’s profit = \$800 Is it in T-Mobile’s interest to increase its output further, to Q = 50? Is it in Verizon’s interest to increase its output to Q = 50? 9

Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players. Nash equilibrium: both confess Bonnie’s decision Confess Remain silent Bonnie gets 8 years Bonnie gets 20 years Confess Clyde gets 8 years Clyde goes free Clyde’s decision This slide is animated carefully as follows: 1) If Clyde confesses, then Bonnie gets 8 years if she confesses or 20 years if she does not. 2) If Clyde remains silent, Bonnie goes free if she confesses or gets 1 year if she does not. At this point, it may be worth mentioning that Bonnie’s best move is to confess, regardless of Clyde’s decision – hence, “confess” is Bonnie’s dominant strategy. 3) If Bonnie confesses, Clyde gets 8 years if he confesses or 20 years if he does not. 4) If Bonnie remains silent, Clyde goes free if he confesses or gets 1 year if he does not. Regardless of Bonnie’s decision, Clyde’s best move is to confess. Both players have a dominant strategy of confessing. Bonnie goes free Bonnie gets 1 year Remain silent Clyde gets 20 years Clyde gets 1 year OLIGOPOLY 10

T-Mobile & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement, produce Q = 40. T-Mobile Q = 30 Q = 40 T-Mobile’s profit = \$900 T-Mobile’s profit = \$1000 Q = 30 Verizon’s profit = \$900 Verizon’s profit = \$750 Verizon T-Mobile’s profit = \$750 T-Mobile’s profit = \$800 Q = 40 Verizon’s profit = \$1000 Verizon’s profit = \$800 OLIGOPOLY 11

A C T I V E L E A R N I N G 3 Answers
A C T I V E L E A R N I N G Answers Nash equilibrium: both firms cut fares American Airlines Cut fares Don’t cut fares \$400 million \$200 million Cut fares United Airlines \$400 million \$800 million \$800 million \$600 million Don’t cut fares \$200 million \$600 million 12