Market Structure Firms are assumed to maximize economic profits
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1 Profit Maximization, Supply, Market Structures, and Resource Allocation
2 Market Structure Firms are assumed to maximize economic profits Economic Profit = Revenue – Total Opportunity Costs = Explicit and Implicit CostsCosts are dependent on technology and input pricesRevenue is dependent upon the market structure in which a firm operatesTherefore, the profit maximization decision must be analyzed by market structures
4 Quick Overview of Supply and Resource Allocation in Competitive Markets Marginal benefits from a firms perspective are marginal revenue from selling outputMarginal revenue equal the extra revenue from selling another unit of outputAssuming the firm produces (does not shutdown), the firm will maximize profit (or minimize losses) where MR=MCThe level of output will determine the costs of production (measured by ATC)Comparing price to average costs show if the firm is making profits, losses or will shutdown production
5 All the buyers in the market combined form the market demand curve and all the sellers for the market supply curveMarket demand and supply determine the price and along with firms’ costs determine economic profits (hereafter simply profits)Changes in demand and supply, cause market prices to change, and thus cause profits to rise or fallIn the short-run, existing firms in an industry change production as price changes.In the transition to the long-run, firms enter or exit an industry depending on whether profits are greater than or less than zero.In the long-run, profits are driven to zero or to the level of NORMAL profits (accounting profits that just cover all opportunity costs).
6 Resource allocation is determined by: Buyers and sellers follow their self-interestBuyers maximize utilitySeller maximize profitMarket demand reflects buyer behavior (and thus each individual buyers behavior) and market supply reflect seller behaviors (and thus individual firm behavior)Prices signal increases or decreases in quantity demand and supply and profits signal resources to enter or exit an industry causing market supply to change
7 MB = MC Long-run equilibrium occurs where: The price paid by the consumer, which is equal to the marginal benefit of another unit, is just equal to the marginal cost, which is equal to the opportunity cost of another unit to society.MB = MC
8 From the videos, Resources dedicated to farming have decreased If rents are not controlled, the supply of housing will respond to increased demand without shortagesThe same is true of gasoline and waterAlso, in class, DVDs versus VCRs
9 This is Adam Smith’s “Invisible Hand at work”. Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it...He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. Wealth of Nations, 1776)
10 Marginal Revenue and Market Structure Competitive markets – sellers are price takers so MR = Market Price, MR =PMonopoly – the seller is a price maker and faces the entire market demand curve so MR < PriceOligopoly – the seller directly competes with a few firms so MR depends on the actions of competitorsMonopolistic Competition – sellers possess some market power and can set their own prices in the short-run, so MR<P
11 Competitive Markets or Pure Competition Assumptions revisitedMany buyers and sellersEach buyer and seller is a price takerHomogenous or identical productsCompetition is based only on the pricePerfect information or knowledgeAll firms have access to the same technologyCompetition is based upon priceFirms can freely enter or exitProfits will be eliminated in the long-run
12 Revenue in Competitive Markets The market demand and supply curves determine the equilibrium price and quantity and the price that buyers will pay and sellers receiveAs with producer surplus, sellers are price takers and the price they receive is their MR. The marginal revenue and the price remain the same no matter how much output is sold.
14 Competitive Firm in the Short-run Short-run – at least one fixed factor = fixed costs. Assume the plant size is fixed.Set MR=MC to find profit maximizing level of output. Use the average cost curves to determine whether oneOperates and earn profitsOperate and breakevenOperates and make lossesShutdowns and minimize losses
17 Conditions for Profits, Breakeven, Losses and Shutdown P > ATCBreakevenP = ATCFixed Costs are sunk costs and irrelevant to decision-making. To operate you must cover variable costs!Losses but operateP > AVC but P < ATC orATC < P < AVCShutdownP > AVC
20 Short-run LossesShutdown occurs when a firm cannot cover its variable costs.If a firm operated with revenues that did not cover variable costs, it would lose more than their fixed costs.Therefore, a firm must cover its variable costs first. If it can cover them it can pay down some of the fixed costs.
21 Long-run Supply and Price Determination Long-run – all factors are variable = no fixed costs and plant size can be changed, ALSO firms can enter and exitIf economic profits are positive, new firms will enter.If economic profits are negative, existing firms will exit.Long-run equilibrium:Firms must chose the plant that minimizes LRATC or they will suffer losses.Economic profits are reduced to zero.Therefore, supply is more elastic in the long-run.
25 Long-run Supply CurveConstant cost industries – horizontal or perfectly elastic supplyIncreasing cost industries – upward sloping supplySome resource may be available in limited quantities (farm land)Some resources may increase in cost or be less productive (skilled labor)Decreasing cost industries – downward sloping supplyIncreased output may stimulate increased productivity or technological change (computers)
26 Competitive Markets: Short-run and Long-run Short-run supply response to changes in demand are to increase or decrease the use of existing capacity.Long-run supply response is to build efficient plant size and increase or decrease capacity.In both the short-run and long-run, the profit maximizing behavior of firms leads to supply responses to accommodate changes in demand.In the short-run, prices act as signals and, in the long-run,prices and profits act as signals to increase or decrease output.
27 Efficiency RevisitedMaximize human satisfaction from resources = maximize total surplus = maximize consumer surplus + producer surplus.Two conditions:Produce what is most highly valued and the amount that maximizes total surplusProduce it at the least possible cost.
28 In the absence of market failures, competitive markets are efficient in both the short-run and the long-run:Supply responds to what consumers demandGoods are produced at least possible costPrice and profits are extremely important as signals for the allocation of scarce resources.Examples of when prices and profits no longer act as signal are rent controls and price supports
30 Monopoly Assumptions One seller and many buyers Barriers to Entry Implication: The seller is a price maker and the buyers are price takers.Barriers to EntryOwnership of a unique resource (Diamonds)Government granted rights for exclusive production (e.g. patents, copyrights, licenses, concessions)Economies of scale and declining long-run average costsImplication: Monopolist faces the entire market demand curve and profits can persist in the short and long-run.
31 Limits to MonopolySize of the market (Pavarotti versus Joe, uncongested bridge)Definition of market and close substitutes (ornamental versus industrial diamonds, bottled water).Potential competition
32 Production Decisions Monopolist versus competitive firm. CF is a price taker who faces a perfectly elastic demand curve MR=PM is a price maker who faces the entire market demand curve MR<PIntuitive proof – to sell another unit the monopolist must lower the price. This means lowering the price not only on the extra unit sold, but also all the other units the monopolist was selling. So MR = Price of the additional unit – the sum of the decreases in all the units previously sold ( e.g. selling 4 to sell the 5 unit the price must be lowered to $90, so the monopolist’s MR = $90 – 4X$10=$50)Tabular proof – see next table and handoutGraphical proof
33 A Monopoly’s Revenue Total Revenue P Q = TR Average Revenue TR/Q = AR = PMarginal RevenueDTR/DQ = MR
37 Profit MaximizationA monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.It then uses the demand curve to find the price that will induce consumers to buy that quantity.
38 Profit Maximization –Set MR = MC to find Q that maximizes profits.Use the market demand curve to find the P that the Q bringsFind ATC and AVC cost to determine profits, losses, or shutdown.Difference between the monopolist decision and the competitive firms decisionThe monopolist does not have a supply curve like the CF, rather they pick a single price and quantityMonopolists produce where P>MR and P>MCversus CFs who produce where P=MR and P=MC.
45 Monopoly profit is not usually a social cost but a transfer of surplus from consumer to producer. Profit can be a social cost if extra costs are incurred to maintain it, such as political lobbying, or if the lack of competition leads to costs not being minimized (X-inefficiency again!)
46 Public Policy and Monopolies Working towards P=MC Attempts to increase competition through anti-trust legislationSherman Antitrust Act of 1890Examples: Breakup of Standard Oil and turning MA Bell into Baby BellsRegulation – Natural MonopoliesP=MC doesn’t work with extensive economies of scaleRegulated forms have little incentive to minimize costsPublic OwnershipPublic utilities and the Postal ServiceHands-off Approach