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Principles of Economics. Session 6. Topics To Be Covered. Market Structure Characteristics of Perfectly Competitive Market Profit Maximization for a Competitive Firm Zero-Profit Point and Shut-Down Point Short-Run Supply Curve Long-Run Supply Curve Producer Surplus Pricing Information.

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topics to be covered
Topics To Be Covered
  • Market Structure
  • Characteristics of Perfectly Competitive Market
  • Profit Maximization for a Competitive Firm
  • Zero-Profit Point and Shut-Down Point
  • Short-Run Supply Curve
  • Long-Run Supply Curve
  • Producer Surplus
  • Pricing Information
market structure
Market Structure
  • Perfect Competition
  • Monopoly
  • Oligopoly
  • Monopolistic Competition
characteristics of perfectly competitive market
Characteristics of Perfectly Competitive Market
  • Many buyers and sellers
  • Product homogeneity
  • Free entry and exit
  • Price taking
product homogeneity
Product Homogeneity
  • The products of all firms are perfect substitutes.
  • Examples: Agricultural products, oil, copper, iron, lumber
free entry and exit
Free Entry and Exit
  • Buyers can easily switch from one supplier to another.
  • Suppliers can easily enter or exit a market.
price taking
Price Taking
  • The individual firm sells a very small share of the total market output and, therefore, cannot influence market price.
  • The individual consumer buys too small a share of industry output to have any impact on market price.
  • Buyers and sellers in competitive markets are said to be price takers, for they must accept the price determined by the market.
price elasticity of demand
Price Elasticity of Demand
  • Individual producer sells all units for $4 regardless of the producer’s level of output, so price under $4 is irrational. If the producer tries to raise price, sales are zero.
  • The price elasticity of demand for products of a single firm is

E=∞

revenue of a perfectly competitive firm
Revenue of a Perfectly Competitive Firm

Total revenue for a firm is the selling price times the quantity sold.

TR=P×Q

revenue of a perfectly competitive firm1
Revenue of a Perfectly Competitive Firm

Average revenue tells us how much a firm receives for the typical unit sold.

revenue of a perfectly competitive firm2
Revenue of a Perfectly Competitive Firm

Marginal revenue is the change in total revenue from an additional unit sold.

demand price ar and mr
Demand, Price, AR, and MR

P

Firm

$4

d=P=AR=MR

Q

profit maximization for the perfectly competitive firm

Profit Maximization for the Perfectly Competitive Firm

The goal of a competitive firm is to maximize profit.

This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

profit maximization for the perfectly competitive firm2
Profit Maximization for the Perfectly Competitive Firm
  • When MR > MC,Q increasewill increase profit
  • When MR < MC, Qdecrease will increase profit
  • When MR = MC,economic profit is maximized
profit maximization for the perfectly competitive firm3

TR

Slope of TR = MR

Profit Maximization for the Perfectly Competitive Firm

Revenue

($s per year)

0

Output (units per year)

profit maximization for the perfectly competitive firm4

TC

Slope of TC = MC

Profit Maximization for the Perfectly Competitive Firm

Cost

$ (per year)

0

Output (units per year)

profit maximization for the perfectly competitive firm5

TC

TR

A

B

q1

Profit

MR=MC

Profit Maximization for the Perfectly Competitive Firm

Cost,

Revenue,

Profit

($s per year)

0

Output (units per year)

profit maximization for the perfectly competitive firm6

TC

TR

A

B

q2

q3

Profit

Profit Maximization for the Perfectly Competitive Firm

Cost,

Revenue,

Profit

($s per year)

Profits are maximized when MC = MR.

0

Output (units per year)

q1

the marginal principle
The Marginal Principle
  • The marginal principle is the fundamental notion that people will maximize their income or profits when the marginal costs and marginal benefits of their actions are equal.
  • A profit-maximizing firm will set its output at that level where marginal cost equals price (MC=P).
firms making profits

Costs

and

Revenue

Profit

P

P = AR = MR

QMAX

Firms Making Profits

MC

ATC

AVC

0

Quantity

firms incurring losses

Costs

and

Revenue

Loss

P

P = AR = MR

QMAX

Firms Incurring Losses

MC

ATC

AVC

0

Quantity

zero profit point

Costs

and

Revenue

Zero-Profit Point

P

P = AR = MR

QMAX

Zero-Profit Point

MC

ATC

AVC

0

Quantity

zero profit point1
Zero-Profit Point
  • Total cost includes all the opportunity costs of the firm.
  • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.
  • Although the economic profit is zero, the firm has realized its normal profit.
shut down point

Costs

and

Revenue

P

P = AR = MR

QMAX

Shut-Down Point

MC

ATC

AVC

Shut-Down Point

0

Quantity

shut down point1
Shut-Down Point

When AVC<P <ATC, why does the firm continue production?

shutdown vs exit
Shutdown vs. Exit
  • A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.
  • Exit refers to a long-run decision to leave the market.
shutdown vs exit1

Shutdown vs. Exit

The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down.

Sunk costs are costs that have already been committed and cannot be recovered.

summary of production decisions
Summary of Production Decisions
  • Profit is maximized when MC = MR
  • If P > ATC the firm is making profits.
  • If AVC < P < ATC the firm should produce at a loss.
  • If P < AVC < ATC the firm should shut-down.
the firm s short run supply curve

Costs

and

Revenue

The Firm’s Short-Run Supply Curve

The portion of MC above AVC is the competitive firm’s short-run supply curve.

MC

ATC

AVC

0

Quantity

production and supply curve

Firm’s short-run supply curve.

If P > ATC,

keep producing

at a profit.

If P > AVC,

keep producing

in the short run.

If P < AVC,

shut down.

Production and Supply Curve

Costs

ATC

AVC

0

Quantity

the response of a firm to a change in product price
The Response of a Firm to a Change in Product Price

When the price of a firm’s product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.

industry supply in the short run

S

MC1

MC2

MC3

P2

P1

15

21

Industry Supply in the Short Run

The short-run

industry supply curve

is the horizontal

summation of the supply

curves of the firms.

$ per

unit

Quantity

0

2

4

5

7

8

10

output in the long run

Costs

and

Revenue

Output in the Long Run

In the long run all costs are variable

MC

ATC=AVC

0

Quantity

the firm s long run decision to exit or enter a market
The Firm’s Long-Run Decision to Exit or Enter a Market

In the long-run, the firm exits if the revenue it would get from producing is less than its total cost.

Exit if TR < TC

Exit if TR/Q < TC/Q

Exit if P < ATC

the firm s long run decision to exit or enter a market1
The Firm’s Long-Run Decision to Exit or Enter a Market

A firm will enter the industry if such an action would be profitable.

Enter if TR > TC

Enter if TR/Q > TC/Q

Enter if P > ATC

the firm s short run vs long run supply curves
The Firm’s Short-Run vs. Long-Run Supply Curves
  • Short-Run Supply Curve
    • The portion of its marginal cost curve that lies above average variable cost.
  • Long-Run Supply Curve
    • The marginal cost curve above the minimum point of its average total cost curve.
long run profit of the competitive firm

Profit

ATC

Q

Long-Run Profit of the Competitive Firm

Price

MC

ATC

P

P = AR = MR

0

Quantity

Profit-maximizing quantity

long run loss of the competitive firm

ATC

Loss

Long-Run Loss of the Competitive Firm

Price

MC

ATC

P

P = AR = MR

0

Quantity

Q

Loss-minimizing quantity

the long run market supply with entry and exit
The Long Run: Market Supply with Entry and Exit
  • Firms will enter or exit the market until profit is driven to zero.
  • In the long run, price equals the minimum of average total cost.
  • The long-run market supply curve is horizontal at this price if the input prices remains constant, but it will be upward sloping if the input prices rises.
long run competitive equilibrium

S1

LMC

P1

LAC

S2

$30

P2

D

Q1

Q2

Long-Run Competitive Equilibrium

Profit attracts firms, and supply increases until profit = 0

$ per

unit of

output

$ per

unit of

output

Firm

Industry

$40

q2

Output

Output

long run supply in a constant cost industry

Economic profits attract new firms.

Long-run supply curve

S1

S2

MC

AC

C

P2

P2

A

B

SL

P1

P1

D1

D2

q1

q2

Q1

Q2

Long-Run Supply in aConstant-Cost Industry

$ per

unit of

output

$ per

unit of

output

Output

Output

long run supply in an increasing cost industry

Due to the increase in input prices, long-run equilibrium occurs at a higher price.

S1

S2

SMC1

LAC2

SMC2

SL

P2

LAC1

P2

P3

B

P3

A

P1

P1

D1

D1

q1

q2

Q1

Q2

Q3

Long-Run Supply in anIncreasing-Cost Industry

$ per

unit of

output

$ per

unit of

output

Output

Output

the long run market supply with entry and exit1
The Long Run: Market Supply with Entry and Exit
  • At the end of the process of entry and exit, firms that remain must be making zero economic profit.
  • The process of entry & exit ends only when price and average total cost are driven to equality.
  • Long-run equilibrium must have firms operating at their efficient scale.
firms stay in business with zero profit
Firms Stay in Business with Zero Profit
  • Profit equals total revenue minus total cost.
  • Total cost includes all the opportunity costs of the firm.
  • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.
producer surplus

Costs

and

Revenue

Producer Surplus

P

P = AR = MR

QMAX

Producer Surplus

MC

ATC

0

Quantity

producer surplus in an exporting country

Price

of Steel

Price after trade

World

price

Price before trade

Exports

Domestic

quantity demanded

Domestic

quantity supplied

Producer Surplus in an Exporting Country

Domestic

supply

Domestic

demand

0

Quantity

of Steel

producer surplus in an exporting country1

Price

of Steel

Producer Surplus in an Exporting Country

Domestic

supply

A

Exports

Price after trade

World

price

D

B

Price before trade

C

Domestic

demand

0

Quantity

of Steel

producer surplus in an exporting country2

Price

of Steel

Consumer surplus

before trade

A

B

C

Producer surplus

before trade

Producer Surplus in an Exporting Country

Domestic

supply

Price after trade

World

price

Price before trade

Domestic

demand

0

Quantity

of Steel

producer surplus in an exporting country3

Price

of Steel

Consumer surplus

after trade

A

Exports

D

B

C

Producer surplus

after trade

Producer Surplus in an Exporting Country

Domestic

supply

Price after trade

World

price

Price before trade

Domestic

demand

0

Quantity

of Steel

producer surplus in an importing country

Price

of Steel

Price before trade

World Price

Price after trade

Imports

Domestic

quantity

demanded

Domestic

quantity

supplied

Producer Surplus in an Importing Country

Domestic

supply

Domestic demand

0

Quantity

of Steel

producer surplus in an importing country1

Price

of Steel

Producer Surplus in an Importing Country

Domestic

supply

A

Price before trade

B

D

World Price

Price after trade

C

Imports

Domestic demand

0

Quantity

of Steel

producer surplus in an importing country2

Price

of Steel

Consumer surplus

before trade

A

B

C

Producer surplus

before trade

Producer Surplus in an Importing Country

Domestic

supply

Price before trade

World Price

Price after trade

Domestic demand

0

Quantity

of Steel

producer surplus in an importing country3

Price

of Steel

Consumer surplus

after trade

A

B

D

C

Imports

Producer surplus

after trade

Producer Surplus in an Importing Country

Domestic

supply

Price before trade

World Price

Price after trade

Domestic demand

0

Quantity

of Steel

producer surplus and tax

Price buyers pay

Size of tax

Tax Revenue (T x Q)

Price without tax

Price sellers receive

Quantity with tax

Quantity without tax

Producer Surplus and Tax

Price

Supply

Demand

0

Quantity

the effects of a tax
The Effects of a Tax
  • A tax places a wedge between the price buyers pay and the price sellers receive.
  • Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax.
  • The size of the market for that good shrinks.
consumer surplus and tax

Price

buyers

pay

A

=

PB

B

C

Price without tax

=

P1

E

D

Price sellers receive

=

PS

F

Consumer Surplus and Tax

Tax revenue = (B+D)

Price

Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)

Supply

Deadweight Loss = (C+E)

Demand

Q2

Q1

0

Quantity

effect of tax upon welfare
Effect of Tax upon Welfare
  • The change in consumer surplus,
  • The change in producer surplus,
  • The change in tax revenue.
  • The losses to buyers and sellers exceed the revenue raised by the government.
  • This fall in total surplus is called the deadweight loss.
determinants of deadweight loss
Determinants of Deadweight Loss
  • The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.
  • That, in turn, depends on the price elasticities of supply and demand.
elasticity and producer surplus loss

1. When supply is more

elastic than demand...

Price buyers pay

Tax

2. ...the

incidence of the

tax falls more

heavily on

consumers...

Price without tax

Price sellers receive

Producer Surplus Loss

3. ...than on

producers.

Elasticity and Producer Surplus Loss

Price

S

D

0

Quantity

elasticity and producer surplus loss1

1. When demand is more

elastic than supply...

Price buyers pay

Price without tax

3. ...than on consumers.

Tax

Producer Surplus Loss

Price sellers receive

2. ...the

incidence of

the tax falls more

heavily on producers...

Elasticity and Producer Surplus Loss

Price

S

D

0

Quantity

information production costs
Information Production Costs
  • First-copy costs dominate
    • Sunk costs - not recoverable
  • Variable costs small;
  • no capacity constraints
    • Microsoft has 92% profit margins
  • Significant economies of scale
    • Marginal cost less than average cost
    • Declining average cost
implications for market structure
Implications for Market Structure
  • Cannot be "perfectly competitive"
strategy
Strategy
  • What to do
    • Differentiate your product
      • Add value to the raw information to distinguish yourself from the competition
    • Achieve cost leadership through economies of scale and scope
personalize your product
Personalize Your Product
  • Personalize product, personalize price
    • PointCast
    • Personalized ads
  • Hot words (in cents/view)
    • DejaNews: 2.0 4.0
    • Excite: 2.4 4.0
    • Infoseek: 1.3 5.0
    • Yahoo: 2.0 3.0
know your customer
Know Your Customer
  • Registration
    • Required: NY Times
    • Billing: Wall Street Journal
  • Know your consumer
    • Observe Queries
    • Observe Clickstream
logic of pricing
Logic of Pricing
  • Example: Quicken
    • 1 million for $60, 2 million for $20?
    • Demand curve (next slide)
    • Assumes only one price
      • Price discrimination gives $10 million
    • Problems
      • How do you know consumer?
      • How do you prevent arbitrage(套利)?
demand curve

$60

$40

$20

1

2

3

Quantity (Millions)

Demand Curve

Price

(Dollars)

forms of differential pricing
Forms of Differential Pricing
  • Personalized pricing
    • Sell to each user at a different price
  • Versioning
    • Offer a product line and let users choose
  • Group pricing
    • Based on group membership/identity
personalized pricing
Personalized Pricing
  • Catalog inserts
    • Market research
    • Differentiation
  • Easy on the Internet
internet
Internet
  • Virtual Vineyards
  • Auctions
  • Closeouts, promotions
group pricing
Group Pricing
  • Price sensitivity
  • Network effects, standardization
  • Lock-In
  • Sharing
price sensitivity
Price Sensitivity
  • International pricing
    • US edition textbook: $70
    • Indian edition textbook: $5
  • Problems raised by Internet
    • Localization as solution
assignment
Assignment
  • Review Chapter 8
  • Answer questions on P153
  • Preview Chapter 9