1. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Markets When Firms are Price Takers

2. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Conditions for a Market of Price Takers All firms produce an identical product. A large number of firms are in the market. Each firm supplies only a small portion of the total supplied to the market. No barriers to entry or exit exist.

3. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Output Price Firm Output Price Market Price Taker’s Demand Curve Market forces (supply & demand) determine price. Price takers have no control over the price that they may charge in the market. If such a firm was to charge a price above that established by the market, consumers would simply buy elsewhere. So, the price taker’s demand will be perfectly elastic. Only at the market price will there be any demand. P Market demand Market supply Firm’s demand P Firms must take the market price

4. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Output in the Short Run

5. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Marginal Revenue = (MR) change in total revenue change in output Marginal Revenue Marginal Revenue is the change in total revenue divided by the change in output. In a price taker market, marginal revenue (MR) = market price, because all units are sold at the same price (market price).

6. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. In the short run, the price taker will expand output until marginal revenue (MR = price) is just equal to marginal cost (MC). When P > MC then the firm can make more on the next unit sold than it costs to increase output for that unit. In order for the firm to maximize its profits it increases output until MC = P. This will maximize the firm’s profits (rectangle PBAC). d (P = MR) q Price Output ATC MC When P < MC then the firm made less on the last unit sold than it cost for that unit. In order for the firm to maximize its profits it decreases output until MC = P. Profit A C P B increase q P > MC decrease q P < MC Profit Maximization when the Firm is a Price Taker P = MC

7. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Average and/or marginal product 108 6 42 25 50 100 1214 16 18 20 Output 75 At low levels of output TC > TR and, hence, profits are negative. An alternative way of viewing the firm’s profit maximization problem focuses on total revenue (TR) and total cost (TC). TR TC Total Revenue (TR) Output Total Cost (TC) Profit (TR - TC) 0 2 8 10 12 14 15 16 18 20 0 10 40 50 25.00 33.75 48.00 50.25 - 25.00 - 23.75 60 70 75 80 90 100 53.25 59.25 64.00 70.00 85.50 108.00...... - 8.00 - 0.25 6.75 10.75 11.00 10.00 4.50 - 8.00 Total Revenue / Total Cost Approach...... Profits occur where TR > TC Losses occur where TC > TR Profits maximized where difference is largest After some point, TR may exceed TC. Profits are largest where this difference is maximized.

8. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. MC 0 2 8 10 12 14 15 16 18 20 ---- 5 5 5 $ 3.95 $ 1.50 $ 1.00 - 25.00 - 23.75 1 3 7 9 5 5 5 5 5 5 5 $ 1.75 $ 3.50 $ 4.75 $ 6.00 $ 8.25 $ 13.00 - 8.00 -.25 6.75 10.75 11.00 10.00 4.50 - 8.00 MR............ Marginal Revenue (MR) Output Marginal Cost (MC) Profit (TR - TC) Price and cost per Unit 108 6 42 1214 16 18 20 Output Marginal Revenue / Marginal Cost Approach At low output levels MR > MC. After some point, additional units cost more than the MR realized from selling them. Profit is maximized where P = MR = MC. Profit Maximum p = MR = MC

9. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The firm operates at an output level where P = MC, but here ATC > MC resulting in a loss. A firm experiencing losses but covering average variable costs will operate in the short-run. The magnitude of the firm’s short-run losses is equal to the size of the rectangle CABP 1 d (P = MR) q ATC MC A C P1P1 AVC P2P2 A firm will shutdown in the short-run whenever price falls below average variable cost (P 2 ). A firm will shutdown in the long-run whenever price falls below average total cost. Price Output Operating with Short-Run Losses B P = MC Loss P1P1

10. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Output Adjustments in the Long Run

11. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The two conditions necessary for long-run equilibrium in a price-taker market are depicted here. Given the price established in the market, firms in the industry must earn zero economic profit (the “normal market rate of return”). The quantity supplied and the quantity demanded must be equal in the market, as shown below at P 1 with output Q 1. Output Price Firm P1P1 q1q1 MC ATC d1d1 Long-run Equilibrium Output Price Market P1P1 D S sr Q1Q1

12. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Output Price Output Price Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D 1 to D 2 … market price increases to P 2 … Market Firm P1P1 P1P1 q1q1 Q1Q1 D1D1 S1S1 MC ATC d1d1 Adjusting to Expansion in Demand shifting the firm’s demand curve upward. At the higher price, firms expand output to q 2 and earn short-run profits. Economic profits will draw competitors into the industry, shifting the market supply curve from S 1 to S 2. P2P2 d2d2 q2q2 D2D2 S2S2 Q2Q2 P2P2

13. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Output Price Output Price After the increase in market supply, a new equilibrium is established at the original market price P 1 and a larger rate of output (Q 3 ). As the market price returns to P 1, the demand curve facing the firm returns to its original level. In the long-run, economic profits are driven down to zero. Note the long-run market supply curve is flat (S lr ). Adjusting to Expansion in Demand Market Firm P 1 P 1 q 1 Q1Q1 D1D1 S1S1 MC ATC d1d1 P2P2 d2d2 q2q2 D2D2 S2S2 Q2Q2 P2P2 S lr Q3Q3 d1d1

14. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Case of Monopoly

15. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Monopoly Monopoly is a market with: high entry barriers, and, a single seller of a well-defined product for which there are no good substitutes. Only a few markets exist with a single seller but it is worth studying. understanding monopoly theory also helps us understand markets with only a few sellers.

16. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price and Output Under Monopoly As there is only one producer of a good or service in a market with a monopolist, the market demand curve is the monopolist’s demand curve. In order to maximize its profits, a monopolist will expand its output until marginal revenue just equals marginal cost. The monopolist will charge the price along the demand curve consistent with that level of output.

17. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Quantity/time d P MR q MC ATC C B A with price determined by the height of the demand curve at that level of output, P. Price and Output Under Monopoly The monopolist will reduce price and expand output as long as MR > MC. MR > MC MR < MC The monopolist will raise price and reduce output when ever MR < MC. Output level q will result … At q the average total cost per unit for that scale of output is C. As P > C (price > ATC) the firm is making economic profits equal to the area PABC. Economic profits

18. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. 0 ---- Total revenue = (1)*(2) (3) Price (per unit) (2) Output (per day) (1) 1 $25.00 2 3 4 5 6 7 8 9 10 ----- $50.00 Total costs (per day) (4) Profit = (3) - (4) (5) Marginal cost (6) Marginal revenue (7) $24.00 $23.00 $22.00 $21.00 $19.75 $18.50 $17.25 $16.00 $14.75 $25.00 $48.00 $69.00 $88.00 $105.00 $118.50 $129.50 $138.00 $144.00 $147.50 $60.00 $69.00 $77.00 $84.00 $90.50 $96.75 $102.75 $108.50 $114.75 $121.25 -$35.00 -$21.00 -$8.00 $4.00 $14.50 $21.75 $26.75 $29.50 $29.25 $26.25 -$50.00 ---- $10.00$25.00 $9.00$23.00 $8.00$21.00 $7.00$19.00 $6.50$17.00 $6.25$13.50 $6.00$11.00 $5.75$8.50 $6.25$6.00 $6.50$3.50 ---- < < < < < < < < Maximum profits A monopolist will reduce price and expand output as long as MR > MC. Price and Output Under Monopoly As the monopolist reduces price and expands output, profits increase … until the point where MC > MR. Here an output of 8 a day will maximize profits.

19. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Profits Under Monopoly High entry barriers protect monopolists from competitive pressures. Monopolists can earn long-run profits. However even a monopolist will not always be able to earn profit. When ATC is always above the demand curve, the monopolist will be unable to cover costs (unable to earn a profit).

20. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. A monopolist will set output equal to q, where MR = MC When a Monopolist Incurs Losses d P MR q MC ATC C A B Price Quantity/time Short-run losses Note that at this level of output, the price that the monopolist charges does not cover the average total cost of producing the output ( P < C ). Whenever the ATC curve lies always above the demand curve, the monopolist will incur short-run losses. In this diagram the firm is making economic losses equal to the shaded area, CABP.

21. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Characteristics of Oligopoly

22. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Characteristics of Oligopoly A few characteristics of oligopoly: small number of rival firms interdependence among firms substantial economies of scale significant barriers to entry products may be identical or differentiated

23. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price and Output in the Case of Oligopoly

24. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price and Output Under Oligopoly No general theory exists for price and output under oligopoly. If the firms operated independently, they would drive down the price to the per unit cost of production. If the firms colluded perfectly, the price would rise to the monopoly price. The outcome is usually between these two extremes.

25. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price D MR PMPM QCQC PCPC QMQM LRATC Price and Output Under Oligopoly If oligopolists compete with one another, price cutting drives price down to P C, and expands total output to Q C. In contrast, perfect cooperation among firms leads to a higher price P M and a smaller market output of Q M. Due to the difficulty to perfectly collude, when firms try to coordinate their activity, price is typically between P C and P M and output between Q M and Q C. Quantity/time Profits to oligopoly with perfect collusion.

26. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Incentive to Collude Oligopolists have a strong incentive to collude and raise their prices. However, each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve. This conflict makes collusive agreements difficult to maintain.

27. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Quantity/time Price IndustryFirm DiDi MR i PfPf qfqf PiPi QiQi MC dfdf MR f MC PiPi Gaining from Cheating Using industry demand D i and marginal revenue MR i, oligopolists maximize their joint profit where MR i = MC – at output Q i and price P i. Demand facing each firm d f (where no other firms cheat) would be much more elastic than industry demand D i. The firm maximizes its profit where MR f = MC by expanding output to q f and lowering its price to P f from P i. Individual firms have an incentive to cheat by cutting price to expand output Quantity/time

28. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Obstacles to Collusion As the number of firms in an oligopolistic market increases, the likelihood of effective collusion declines. When it is difficult to detect cheating (secret price cuts), effective collusion is less likely. Low entry barriers also make effective collusion less likely because profit attracts additional rivals. Unstable demand conditions lead to honest differences among firms about the size of shares and price that maximizes total profit. Rigorous enforcement of antitrust law makes collusion potentially more costly.

29. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. D P0P0 MR Q0Q0 LRATC MC P1P1 P2P2 Q1Q1 Q2Q2 Regulation of a Monopolist Price Quantity/time An unregulated monopolist with the cost structure here produces where MR = MC (Q 0 ) and charge price P 0. From an efficiency viewpoint, this output is too small and the price is too high. Why is this? If a regulatory agency forced the monopolist to reduce its price to P 1 (average cost pricing) the monopolist expands output to Q 1. Ideally, we would like output to be expanded to Q 2 where P = MC (marginal cost pricing), but regulatory bodies do not usually attempt to keep prices as low as P 2. Can you explain why? Average cost pricing Marginal cost pricing

30. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Problems with Government Intervention Problems with price regulation: Lack of information – do regulators know the cost structures behind the firm’s real ATC? Cost shifting – with P = ATC, do monopolists have much incentive to keep costs low? Special interest influence – will monopolists have an incentive to influence the decisions of regulatory bodies? Problem with government production: Less incentive to minimize costs and adopt new technologies. Fewer incentives to satisfy customers, improve quality, and introduce new products. Political considerations may influence decision making of firm.

31. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Monopolistic Competition Competitive Price-Searcher Markets

32. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Competitive Price-Searcher Markets Firms in price-searcher markets with low entry barriers face a downward sloping demand curve. Firms are free to set price, but face strong competitive pressure. Competition exists from existing firms and potential rivals An alternative term for such markets is monopolistic competition.

33. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Product Differentiation Price-searchers produce differentiated products – products that differ in design, dependability, location, ease of purchase, etc. Rival firms produce similar products (good substitutes) and therefore each firm confronts a highly elastic demand curve.

34. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price and Output A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost. Price will be lowered and output expanded until MR = MC The price charged by a price searcher will be greater than its marginal cost.

35. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price d MR MC ATC Price and Output: Short Run Profit Quantity/time q P C Economic Profits A price searcher maximizes profits by producing where MR = MC, at output level q … and charges a price P along the demand curve for that output level. At q the average total cost is C. Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q ) What impact will economic profits have if this is a typical firm?

36. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Profits and Losses in the Long Run If firms are making economic profits, then rival firms will be attracted to the market. The entry of new firms will expand supply and lower price. The demand curve of each will shift inward until the economic profits are eliminated. Economic losses will cause price searchers to exit from the market. Demand for the remaining firms’ output will rise until the losses have been eliminated, ending the incentive to exit. Competitive price searchers can make either profits or losses in the short run, but only zero economic profit in the long run.

37. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Because entry and exit are free, competition will eventually drive prices down to the level of ATC. Quantity/time q P d MR MC ATC Price and Output: Long Run When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored. The price searcher establishes its output level where MC = MR. At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present. C = P

38. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Quantity/Time Price Taker Price Searcher Price Quantity/Time d MC ATC d MR MC ATC P2P2 q2q2 P1P1 q1q1 Below, we show the long-run equilibrium for both price taker & price searcher markets with low entry barriers. For both, P = ATC and there are no economic profits. As the price-searcher faces a downward-sloping demand curve, its profit-maximizing price exceeds MC. In contrast with the price-taker market, price-searcher output is too small to minimize ATC in long-run equilibrium. Comparing Price Searchers & Takers

39. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Quantity/Time Price Taker Price Searcher Price Quantity/Time d Price MC ATC d MC ATC P2P2 P1P1 Price Comparing Price Searchers & Takers MR q2q2 q1q1 Even though the two markets have the same cost structure, the price in the price-searcher’s market is higher than that in the price-taker’s market ( P 2 > P 1 ). Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation).

40. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Allocative Efficiency Allocative efficiency is achieved when the most desired goods are produced at the lowest possible cost. Criticism of traditional theory of competitive price-searcher markets: price > marginal cost at the profit maximizing output level per-unit cost may not be minimized excessive advertising is encouraged

41. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Allocative Efficiency Recently economists have been more positive about competitive price-searcher markets. Consumers may value a wider variety of styles and quality (product differentiation). Advertising often reduces search time and provides valuable information. Price searchers have an incentive to innovate and operate efficiently.

42. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. A Special Case: Price Discrimination

43. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Discrimination Price discrimination: When a seller charges different consumers different prices for the same good or service. Price discrimination can only occur when a price searcher is able to: identify groups of customers with different elasticities of demand prevent customers re-trading the product.

44. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Discrimination Sellers may gain from price discrimination by charging: higher prices to groups of customers with more inelastic demand lower prices to groups of customers with more elastic demand Price discrimination generally leads to more output and additional gains from trade.

45. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Economics of Price Discrimination If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats. Price Quantity/time Single price $400 $200 $300 $100 $500 $600 $700 MC D 100 MR Net operating revenue ($300*100) = $30,000 Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100. This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000.

46. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Price Quantity/time Single price $400 $200 $300 $100 $500 $600 $700 MC D 100 MR Net operating revenue ($300*100) = $30,000 The Economics of Price Discrimination By charging higher prices to consumers with less elastic demand and lower prices to those with more elastic demand it will increase net operating revenue. If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000. Price Quantity/time Price Discrim. $400 $200 $300 $100 $500 $600 $700 MC D Net operating revenue from business travelers ($500*60) = $30,000 Net operating revenue from all others ($200*60) = $12,000 60120

47. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1. Is price discrimination harmful to the economy? How does price discrimination affect the total amount of gains from exchange? Explain. Why do colleges often charge students different prices, based on their family income? 2. What is the primary requirement for a market to be competitive? Is competition necessary for markets to work well? How does competition influence the following: (a) the cost efficiency of producers (b) the quality of products (c) new product discovery and development

48. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3. Which of the following is a necessary condition for long run equilibrium in both competitive price searcher and competitive price taker markets? a. Price must equal marginal cost (MC). b. The typical firm in the market must be earning zero economic profit. c. All of the firms in the market must be charging the same price. 4. “If a movie theater is going to increase its revenues by charging students a lower price than other customers, the demand of students must be more elastic than the demand of other customers.” Is this statement true?

49. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 5. Which of the following indicates that a firm operating in the highly competitive retail sector is providing goods and services that consumers value highly relative to their cost? a. The firm is making losses and its sales are declining. b. The wages earned by the employees of the firm are low. c. The firm is highly profitable and its sales have grown rapidly.