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SES 1
I. BEHIND THE DEMAND CURVE
From now on we will assume that:
1. All goods have utility
Utility: value or satisfaction from consumption.
Marginal utility (MU): the change in utility from consuming an additional unit.
2. There is no saving
Consumers spend all income (ignore future consumption for now).
3. Marginal utility diminishes with every unit
Diminishing marginal utility: each additional unit of a good adds less to utility than the
previous unit.
The budget constraint
- A budget constraint requires that the cost of a consumer’s consumption bundle be no
more than the consumer’s total income
- A consumer’s consumption possibilities is the set of all consumption bundles that can
be consumed given the consumer’s income and prevailing prices.
- A consumer’s budget line shows the consumption bundles available to a consumer
who spends all of his or her income
Spending the marginal euro
- The marginal utility per euro spent on a good or service is the additional utility from
spending one more euro on that good or service.
- Marginal analysis solves “how much” decisions by setting the marginal benefit of
some activity equal to its marginal cost.
- The right answer for marginal decisions involving consumption is that the marginal
utility per dollar spent on each good must be the same at the optimal consumption
bundle.
- In consumption decisions, unlike production decisions, there’s a budget constraint
which must be accounted for when doing marginal analysis.
- The optimal consumption rule says that when a consumer maximizes utility, the
marginal utility per dollar spent must be the same for all goods and services in the
consumption bundle:
From Utility to the Demand Curve
- The main reason for studying consumer behavior is to go behind the market demand
curve. Specifically, to understand how the downward slope of the market demand curve is
explained by the utility‐maximizing behavior of individual consumers.
- Using the previous graph, think about how the demand of potatoes changes for sequential
increases in P P
The Substitution Effect
The substitution effect (of a change in the price of a good): the change in the quantity
consumed of that good as the consumer substitutes the good that has become relatively
cheaper for the good that has become relatively more expensive.
The Income Effect
The income effect (of a change in the price of a good):
The change in the quantity consumed of a good that results from a change in the
consumer’s purchasing power due to the change in the price of the good.
Normal goods : Increase in price causes consumers’ purchasing power to drop and
reduces consumption (and vice versa).
Inferior goods : Increase in price causes consumers’ purchasing power to drop and
increases consumption (and vice versa)
In this chapter you should have learned...
How consumers choose to spend their income on goods and services
Why consumers make choices by maximizing utility , a measure of satisfaction from
consumption
Why the principle of diminishing marginal utility applies to the consumption of most
goods and services
How to use marginal analysis to find the optimal consumption bundle
What income and substitution effect s are.
SES 2
II. BEHING THE SUPPLY CURVE
The Production Function
A production function is the relationship between the quantity of inputs a firm uses and the
quantity of output it produces.
A fixed input is an input whose quantity is fixed for a period and cannot be varied.
A variable input is an input whose quantity the firm can vary at any time.
Inputs and Output
Marginal Cost
As in the case of marginal product, marginal cost is equal to “rise” (the increase in total
cost) divided by “run” (the increase in the quantity of output).
Why Is the Marginal Cost Curve Upward Sloping?
Because there are diminishing returns to inputs in this example. As output increases, the
marginal product of the variable input declines.
This implies that more and more of the variable input must be used to produce each
additional unit of output as the amount of output already produced rises.
And since each unit of the variable input must be paid for, the cost per additional unit of
output also rises.
Average Cost
Average total cost (often referred to simply as average cost) = total cost divided by quantity
of output produced.
ATC =
Total Cost
Q of output
Average Cost
Average fixed cost is the fixed cost per unit of output. AFC = FC / Q = (Fixed Cost) / (Quantity
of Output)
Average variable cost is the variable cost per unit of output.
AVC = VC / Q = (Variable Cost) / (Quantity of Output)
Active Learning: Practice
If TFC = total fixed cost, TVC = total variable cost, TC = total cost,
Average fixed cost = TFC/Q.
Average variable cost = TVC/Q.
Average total cost = TC/Q.
Average Total Cost Curve
Increasing output has two opposing effects on average total cost:
The spreading effect : The larger the output, the more output over which fixed cost is spread ,
leading to lower average fixed cost.
The diminishing returns effect : The larger the output, the more variable input required to
produce additional units , which leads to higher average variable cost.
Putting the Four Cost Curves Together
Note that:
- marginal cost is upward sloping because of diminishing returns.
- Average variable cost also is upward sloping but is flatter than the marginal cost
curve.
- Average fixed cost is downward sloping because of the spreading effect.
- The marginal cost curve intersects the average total cost curve from below, crossing it
at its lowest point.
Active Learning: Practice
At high levels of output the spreading effect is:
a) stronger than the diminishing returns effect.
b) weaker than the diminishing returns effect.
Short‐Run versus Long‐Run Costs
All inputs are variable in the long run. This means that in the long run, fixed cost (like factory
size) may also vary.
The firm will choose its fixed cost in the long run based on the level of output it expects to
produce.
There is a trade‐off between higher fixed cost and lower variable cost for any given output
level and vice versa.
The Long‐Run Average Total Cost Curve
The long‐run average total cost curve shows the relationship between output and average
total cost when fixed cost has been chosen to minimize average total cost for each level of
output.
(We assume the firm has chosen the cheapest plant size for each output level.)
Returns to Scale
There are increasing returns to scale (economies of scale) when long‐run average
total cost declines as output increases.
There are decreasing returns to scale (diseconomies of scale ) when long‐run average
total cost increases as output increases.
There are constant returns to scale when long‐run average total cost is constant as
output increases.
Take a look ....
In this chapter you should have learned...
The relationship between inputs and output is a producer’s production function
Marginal revenue and the optimal output rule:
Marginal revenue : change in total revenue generated by an additional unit of output.
MR = ∆ TR / ∆ Q
For price-taking firms, MR is simply the good’s market price.
Optimal output rule: profit is maximized by producing the quantity of output at which the
marginal revenue of last unit produced is equal to its marginal cost.
Explaining the optimal output rule
Why is profit maximized where MR = MC?
Each tme the firm produces another unit, there are extra costs and extra revenues.
If producing another unit adds more to revenue than cost, profit will increase.
Because if MR > MC, producing more will add to profit.
Since MR = P for competitive firms, the profit-maximizing rule is: choose the quantity of
output where P = MC.
Costs and production in the Short Run
As long as increasing production by one unit created more MR than MC, it makes sense to do
it.
The short Run and the long run
In the short run, plant size is fixed.
We focus here on short-run profit maximization at a given plant size.
The price taking firm’s profit maximizing quantity of output
What is marginal revenue and marginal cost aren’t exactly equal?
What do you do if there is no output level at which marginal revenue equals marginal cost?
In that case, you produce the largest quantity for which marginal revenue exceeds marginal
costs.
WHEN IS PRODUCTION PROFITABLE?
Recall we are using economic profit, chich included implicit costs. It is normal for a firm’s
economic profit to be zero.
If TR>TC, the firm is profitable
If TR=TC, the firm breaks even
If TR<TC, the firm incurs a loss
Profitability and the market price
If the price is just high enough to cover ATC and if it chooses the Q where MR = Mc, the firm
will break even.
Calculating total costs and profit:
Profit= TR – TC = (TR/Q – TC/Q) * Q
Profit = (P – ATC) *Q
Break-even price of a price-taking firm is the market price at which it earns zero profit.
Losses don’t mean immediate shutdown.
Remember, fixed costs must be pad whether or not the firm produces in the short run.
Firms will choose to produce (event at a loss) if they can cover their variable and some of
their fixed costs.
Shutdown price = minimum average variable cost.
The short-run individual supply curve
A firm will produce at every price above minimum ATC where price intersects the Mc curve
but will stop producing in the short run if the market price falls below the shutdown price so
the MC curve (above shut-down price) s the firm’s supply curve.
SUMMARY:
In the short run, a firm will produce if P > shutdown price (min AVC).
A firm will not produce if P < min AVC
If P > break-even (min ATC), firms are profitable. This profit attracts new entrants.
The short-run industry supply curve
The short-run industry supply curve: how the Q supplied by an industry depends on the
market price (given a fixed number of producers).
A higher price means more firms are willing to supply.
The long-run market equilibrium
New firms enter as long as there us economics profit (P>min ATC). A market is in long-run
equilibrium when the quantity supplied equals the quantity demanded, given that sufficient
time has elapsed for entry into and exit from the industry to occur.
The effect of an increase in demand: now and later
The LRS shows how the quantity supplied responds to the price (once producers have had
time to enter or exit the industry).
The meaning of monopoly
Monopolist: A firm that is the only producer of a good with no close substitutes.
(an industry controlled by a monopolist is known as a monopoly)
Market power: the ability of a firm to raise prices.
What a monopolist does
A monopolist reduces the quantity supplied to QM and moves up the demand curve from C to
M, raising the price to PM.
Why do monopolist exist?
How do they get away with this and protect their profit from new firms?
Profit will not persist in the long run unless there is a barrier to entry.
Barriers to entry
Barriers to entry are essential for monopolies. They generate profit for the monopolist in the
short run and long-run.
This can take the form of:
- Control of natural resources or inputs.
- Increasing returns to scale
- Technological superiority
- Network externality
- Government-made barriers, including patents and copyrights. 1. Control of a scare resource or input
If De Beers owned nearly all of the diamond mines in the world, it would have a monopoly in
diamond production.
2. Increasing returns to scale
A natural monopoly exists when increasing returns to scale (economies of scale) provide a
large cost advantage to a single firm.
A given quantity of output is produced more cheaply by one large firm than by two or more
smaller firms.
3. Technological Superiority
A firm that maintains a consistent technological advantage over potential competitors can
establish itself as a monopolist.
4. Network externality
Network externality: the value of a good or service to an individual increasing as more
others use the same good or service.
5. Government-made barrier
A patent gives an inventor a temporary monopoly in the use or scale of an invention.
A copyright gives the creator of a literary or artistic work sole rights to profit from that work.
How a monopolist maximizes profit
Competitive firms cannot choose price. Monopolist can.
All firms face the same rule: profit is maximized at the Q where MR = MC.
So what does MR look like?
MR = ∆^ TR^ /^ ∆^ Q
MR is below the demand curve…
An increase in production by a monopolist has two opposing effects on revenue:
- A quantity effect : one more unit is sold, increasing total revenue by the prce at which
the unit is sold.
- A price effect : to sell the last unit, the monopolist must cut the market price on all
units sold. This decreases total revenue.
Profit maximization for a monopoly
Profit maximization consists if two steps:
- Choosing a quantity rule: choose Q where MR = MC
- Choosing a price choose the highest price you can get away with, which is the
highest price consumers will pay for that quantity.
Rule: Once you’ve picked your quantity, follow the graph to the demand curve, which shows
you how much consumers will pay.
Some firms practice price discrimination: they charge different prices to different consumers
for the same good.
Price discrimination and profit maximization
Recall the profit-maximizing rule for firms with monopoly power:
- Produce the Q at which MR = MC
- Based on that Q charge as much as the market will bear (found by the position of the
demand curve).
But what is you sell to more than one market, each with its own demand curve?
Under perfect price discrimination, the firm captures all consumer surplus as profit.
Price discrimination
- There is no deadweight loss, because all mutually beneficial transactions are exploited.
- There is zero consumer surplus: the entire surplus is captured by the monopolist in the
form of profit.
Perfect price discrimination
Common techniques for price discrimination:
- Advance purchase restrictions
- Volume discounts
- Two-part tariffs
The Lerner Index
(profit maximisation condition)
Ses 5:
V. OLIGOPOLY
The meaning of oligopoly, and why it occurs
Why oligopolists have an incentive to act in ways that reduce their combined profit, and why
they can benefit from collusion
How our understanding of oligopoly can be enhanced by using game theory, especially the
concept of the prisoners’ dilemma
How repeated interactions among oligopolists can help them achieve tacit collusion
How oligopoly works in practice, under the legal constraints of antitrust policy
Oligopoly and monopolistic competition
An oligopoly is a market that is dominated by a small number of firms.
Studying oligopoly behavior…
… is complicated because it’s not a single firm considering its costs and pricing in a vacuum
(like perfectly competitive firms and monopolies).
The profits of a large firm depend heavily on the actions taken by other large firms.
The prevalence of oligopoly
Imperfect competition: no one firm has a monopoly, but producers can affect market prices.
Measuring Oligopoly
To get a better picture of market structure, economists often use the Herfindahl-Hirschman
index, or HHI.
The HHI for an industry is the sum of the squares of each firm’s share of market sales.
For example, if there are three firms with 60%, 25%, and 15% market share each:
A payoff Matrix
The prisoners’ dilemma
When each firm has an incentive to cheat but both are worse off it both cheat, the situation is
known as a prisoner’s dilemma.
The game based on two premises:
- Each player has an incentive to choose an action that benefits itself as the other
player’s expense.
- When both players act in this way, both are worse off than if they had acted
cooperatively.
A dominant strategy : a strategy that is a player’s best action regardless of the action taken
by the other player. Depending on the payoffs, a player may or may not have a dominant
strategy.
Nash equilibrium (also known as noncooperative equilibrium ): the result when each
player in a game chooses the action that maximizes his or her payoff given the actions of
other players, ignoring the effects of his or her action on the payoffs received by those other
players.
Overcoming the Prisoners’ Dilemma
Repeated interaction and tacit collusion
Players who don’t take their interdependence into account arrive at a Nash, or noncooperative,
equilibrium.
But if a game is played repeatedly, players may engage in strategic behavior, sacrificing
short‐run profit to influence future behavior.
Tit for tat: a strategy of playing cooperatively at first, then doing whatever the other player did
in the previous period.
The meaning of monopolistic competition
Why oligopolists and monopolistically competitive firms differentiate their products
How prices and profits are determined in monopolistic competition in the short run and the
long run
Why monopolistic competition poses a trade‐off between lower prices and greater product
diversity.
The economic significance of advertising and brand names
Monopolistic Competition
Monopolistic competition is a market structure that’s a little like monopoly and a little like
perfect competition. Specifically:
many competitors
products similar but not identical
free entry into and exit from the industry in the long run
Product differentiation
Product differentiation plays a crucial role in monopolistic competition.
Tacit collusion is almost impossible when there are many producers.
Product differentiation is the only way these firms can acquire some market power.
There are three important forms of product differentiation:
Differentiation by style or type sedans vs. SUVs
Differentiation by location
dry cleaner near home vs. cheaper dry cleaner far
away
Differentiation by quality
ordinary ($) vs. gourmet chocolate ($$$)
There are two important features of industries with differentiated products.
Competition among sellers : Entry by more producers reduces the quantity each existing
producer sells.
Value in diversity: Consumers gain from the increased diversity of products.
Adjustments to long run equilibrium
New entrants mean fewer customers for the original firms: Demand and MR shift left.
(economic) profits fall to zero: firms break even and new entry stops.
Short-run losses
New exists mean more customers for remaining firms: demand and MR shifts rights.
(Economic) profits fall to zero: firms break even exits stop.
Zero profit in the long run
If firms are earning economic profits, new firms will want to enter the industry.
This will reduce the demand curve facing each individual producer.
In the long run, each supplier will earn normal profits, and price will equal ATC.
Is monopolistic competition inefficient?
Firms in a monopolistically competitive industry have excess capacity: they produce less than
the output at which average total cost is minimized.
Price > MC, so some mutually beneficial trades are unexploited.
The economics of advertising
Oligopolies and monopolistically competitive firms advertise.
Advertising good is good, they are different types of advertising
Types of advertising
Advertising as part of the product:
Even if no information is given, does “banding” make the product more enjoyable?
Tasters enjoy the cola more if it’s labeled “Coke”…
“INFORMATIVE” advertising
- Price, quality and available information
Advertising as signaling if they are spending so much $$$ on advertising for this product,
they must expect it to be profitable and around a long time. Must be good.
