ECON 201: Principles of Microconomics I (Micro)

Text: Bradley R. Schiller, The Economy Today

Lecture Notes Dr. Shawkat Hammoudeh

Chapter 1. Economics: the Core Issues

Economics is the study of how people use scarce resources in an attempt to satisfy their unlimited wants. Resources are inputs used to produce goods and services. They are also called factors of production.

Factors of Production:
There are four basic factors of production Land: Includes the ground and natural resources such as crude oil, water and minerals. Labor: Includes skilled and unskilled labor. Both the quantity and the quality of human resources are included in the labor factor (e.g., skilled, unskilled etc). Capital: Final goods produced to be used as inputs in further production. It includes machines, equipment, buildings. Example: residents of a fishing village in southern Thailand braided huge fishing nets to catch more fish. The fishing nets are regarded as capital. Entrepreneurship: This factor of production is related to how well a given quantity of resources can be used in production. Entrepreneur is the person who sees the opportunity of new or better products and brings together the resources needed for producing them. The entrepreneur is an organizer and a risk taker.

Payments to Resources (returns to factors of production): Land is paid rent Labor is paid wages Capital is paid interest or the rental price of capital. Entrepreneur is rewarded profit.

Unlimited Wants

Production of goods and services

Scarce Resources

Land Labor Capital Entrepreneur

Choic Limits to Output es 2

Since resources are insufficient to satisfy all desired uses, then there is scarcity, which is the core problem. Scarcity: The imbalance between our desires and available resources. Then economic scarcity forces us to make economic choices. The most cited example is the choice between more defense spending (guns) or more spending on civilian goods and services (butter). (in 1986 the defense budget / total output was 6%, and this share dropped to 3% in 2001). This decline in defense spending share is refereed to as the peace dividend. An increase in national defense would imply more sacrifices of civilian goods and services. This is the Guns Vs Butter dilemma that all nations face.

Opportunity cost:
Every time scarce resources are used in one way we must give up the opportunity to use them in other ways. To produce more weapons, you must sacrifice the opportunity of producing more civilian goods. The sacrificed or foregone civilian goods represent the opportunity cost of producing more weapons. The opportunity cost of producing more of good X is the most desired goods or services foregone in order to transfer resources to this good. Production Possibilities: The limit on resources implies limits to total output that can be produced. This means that if production of good X is increased then production of good Y must be decreased because resources would be transferred from Y to X. Suppose we have two goods: Shoes (S) and TVs (T). Suppose the limit on labor = 10 workers each day, given the available technology. Suppose it takes 2 workers to produce one shoe a day. The maximum amount of shoes that can be produced with the 10 workers = 5 shoes and zero TVs. Suppose the production of TV is assumed as in the third column of Table: 1: 1 Table 1.1 Production Possibilities Schedule (Columns 2 &3) Combinations Shoes TVs A B C D E F 5 4 3 2 1 0 0 2.0 3.0 3.8 4.5 5.0 TV increase -+2.0 TVs +1.0 +0.8 +0.7 + 0.5

(This column or production of TV is assumed this way) The two columns of shoes and TVs (2&3) represent the possible output combinations of shoes and TVs that can be produced a day from 10 workers and the given technology. If these combinations (A, B, ----, F) are connected then they yield the production possibilities curve (PPC) or frontier.

Fig 1.1: Production Possibilities curve

At the beginning (point B), the opportunity cost of increasing TVs by two is the foregone opportunity of producing one shoe (one pair), which is the sacrificed one shoe. At this point the opportunity cost of increasing TV by one is 1/ 2 of a shoe. Next (point C), the opportunity of increasing TVs by one extra unit is the sacrificed one shoe and so on as shown in the table below In this case the PPC illustrates two essential principles. Scarce resources or output tradeoff (limits to output) Opportunity cost (sacrifice in production of the other good)

Increasing Opportunity Cost: The shape of the PPC is related to the direction of change in opportunity cost. Shoes 54 decrease 43 32 21 1-0 TVs 02 increase 23 3 3.8 3.8 4.5 4.5 5 Foregone Shoes (S) 1 1 1 1 1 Increase in TV Output (T) +2 +1 +0.8 +0.7 +0.5 Opportunity cost of producing one extra TV: (S / T) = shoes shoe 1 shoe 1/0.8 = 1.25 shoes 1/0.7 = 1.43 shoes 1/0.5 = 2 shoes

(sacrifice is numerator and increase is denominator) The opportunity cost of producing one more TV is increasing. Graphically, this is represented by the concave (bowed out) curve of the PPC. 4

The reason for the increase in opportunity cost is that the transferred resources from one good to another may not have the suitable skills or are the right match for the new production. What would the shape of the PPC be if the opportunity cost is constant? Increasing opportunity cost? All output combinations on the PPC such as point P are attainable and efficient; although they are not equally desirable. Efficiency means getting the maximum output from the available resources.

Inefficiency: This is represented by points inside the PPC such as point Y. $

P X

TV Point X which lies outside the PPC is unattainable, given our resources and technology. Point Y is inefficient because we are not getting the maximum output from the given resources and technology.

Economic Growth(%):
This growth is a result of increases in resources and / or improvement in technology. An increase in economic growth would shift the PPC outward, making a point like X, unattainable in the previous graph, attainable.

S PPC2

PPC1

TV Fig. 1.5: Growth: Increasing Production Possibilities

Basic Decisions
There are millions of efficient points along a PPC, and each one represents a specific mix of output. The country can choose only one point (the most desirable) at any time period. In the famous example on Guns vs. Butter, this point determines how many guns, and how much butter are produced. But the PPC does not tell us which output mix is the best or most desirable. It is just a menu of available choices. Its up to the country to pick up the output mix. Guns

N. Korea (16.3%) in 2002 Saudi Arabia (12%) China (4%) USA (3.4%) Butter There are three decisions the country must make:

What to Produce? That is, the country should pick only one point on the PPC. This determines the output mix, more guns or butter? How to produce? Should we generate electricity from oil, coal, nuclear power, solar power? Here someone should make a decision about which production methods to use. This is a question of not just efficiency but of social values as well. For whom to produce? Who is going to get the output produced? How should the goods and services an economy produces be distributed? (income distribution)

For whom America produces? (2002) Income Quintile 2002 income Highest Fifth Above $87,000 fourth Fifth $ 54,000 $87,000 Third fifth $34,000 - $54,00 Fourth fifth $18,000 - $34000 Lowest Fifth $0 - 18,000 Average Income Share of Total income $147,000 49.8% $69,400 23.4% $44,000 $26,000 $10,000 14.8% 8.7% 3.4%

Index of Economic Freedom Ranks countries answers to the above three questions: What to Produce? How to Produce? and For Whom to Produce? The 2004 Index ranks 155 countries in terms of ten freedom measures such as their market reliance on taxes, regulations, free trade, property rights etc. It favors economies that depend more on market signals than on government directives. Hong Kong is ranked # 1 in economic freedom in terms of low tax rates, free trade policies, minimal govt regulations and property rights, and United States is # 10 in 2004). The 2009 Index of Economic Freedom ranks 179 countries. Hong Kong is still # 1 (score 90) and The U.S. is # 6 (score 87.3). North Korea is # 179 (score 2). See this link: http://www.heritage.org/Index/Ranking.aspx However, we should keep in mind that this index represents some ideological view and is not the Bible or the Koran.

CHAPTER 3: Supply and Demand

Market Participants:
There are four participants in a market: consumers, business firms, government and the international sector. There are two types of markets: the factors of production markets and the product markets.

Goods and services demanded

Product markets

International participants Goods and services supplied

Consumers Factors of production supplied International participants

Governments

Business Firms

Factors of production demanded Factor markets

A market includes buyers and sellers and it exists whenever any exchange takes place. The buyers are on the demand side of the market, and the sellers are on the supply side of the market.

DEMAND: Let us focus first on a single consumer or a buyer.

Individual Demand:
Tom is willing and able to pay for a tutor in web-design.

Tom is willing to buy 1 hour of tutoring per semester if he must pay $50 an hour. If the price drops to $45/hr, Tom would be able and willing to buy 2 hours per semester. Thus, Tom would purchase more tutoring services if the price per hour drops. Demand is an expression of consumer buying intention, of willingness to buy not a statement of actual purchases. The demand curve is a summary of buying intentions. Common feature of demand is that it has a downward slope(QD/P < 0) PCurrent QD PCurrent QD This inverse relationship between the current price and quantity is called the law of demand. Graphically, this is a movement along the demand curve. In the graph above, if the price drops from say $50 to $30 the quantity demanded increases from 1 to 7 tutoring hours. Compaq used this law to increase computer sales in 2001. In the holiday season people snapped a Compaq Presario computer priced at $1099 for $699.

Other Determinants of Market Demand:

The simple demand schedule or curve has only one determinant which is the current price. Other determinants of the standard demand include: Tastes (desire) Income (purchasing power) Price of related goods Expectations of future income, price and taste Number of buyers in the market.

 Related goods: Include substitute goods (consumed instead of, say, tutoring in web design), complementary goods (consumed with tutoring in web design). If the price of a substitute (e.g.,: Math tutoring and Scuba diving) for webdesign tutoring falls, the entire demand for web-design falls (or shifts down). This is because other goods or services have become cheaper and they can be substituted for web design tutoring. Then the entire demand for web design tutoring shifts down. If the price of a complement (books, software etc) to web design increases, then the entire demand for web design declines. If the expected future price (Pe) for web-design, expected future income or expected taste increases the entire demand increases. If the number of buyers increases, the market demand which is an aggregate of individual demands in the market will increase. Ceteris Paribus Assumption: The simple demand schedule or curve, which depends only on the current price and quantity, has a big assumption. This assumption is called ceteris paribus. It means nothing else other than the current price changed. It is used to isolate the effects of the other determinants on demand when the current price changes.

Shifts in Market Demand:

If any of the so-called other determinants of demand changes then the entire demand curve will shift up or down. Suppose Toms income increases by $1,000 after he won the lottery. This means his entire demand schedule will shift up if income increases (for a normal good). QD (hours / semester) Price Initial Demand ($/hour) (in hours) $50 1 45 2 40 3 35 5 30 7 25 9 20 12 New Demand (in hours) 8 9 10 12 14 16 19

A B C D E F G

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The increase in income shifted market demand to the right; which is an increase in demand. This increase or the right shift in demand can also happen if: Taste increases. The prices of the substitutes for the web design increase If the prices of complements decrease. Movements vs Shifts: A movement along the demand curve is a change in the quantity demanded in response to changes in the current price (slope). A shift in the demand curve is a shift in the entire demand curve in response to changes in other determinants of demand. Market Demand: Market demand is the sum of individual demands. It is the total quantity of a good or service consumers are willing to purchase at different prices in a given period. Suppose there are three consumers in the market. The market demand is the sum of the three quantities purchased by these consumers at each possible price. Price ($) 50 45 40 30 30 25 20 15 Quantity Demanded by: Tom George Lisa (hours) (hours) (hours) 1 4 0 2 6 0 3 8 0 5 11 0 7 14 1 9 18 3 12 22 5 15 26 6 Market Demand 5 8 11 16 22 30 39 47

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SUPPLY: This is the other side of the market and it deals with producers or sellers of, say, the webdesign services. Market Supply: the total quantities (QS) of a good that sellers are willing and able to sell at alternative prices (P) in a given time period, ceteris paribus. The relationship is positive. Or QS/P > 0. Slope is positive. PCurrent QS, ceteris paribus. (That is, if current price goes down producers supply less) PCurrent QS This means that slope of the market supply is positive. In other words, there is a law of supply that parallels the law of demand. This law says that larger quantities will be offered for sale at higher prices and vise versa. Other Determinants of Market Supply: These determinants change the entire supply curve: Technology: Improvement in technology enables sellers or producers to supply the good or service easier and quicker. Then the market supply curve increases. Costs of factors of production: If labor, capital or materials cost of production decreases the supply curve increases and shifts to the right because of increased profitability. Prices of related goods: If other jobs or business offer better prices than webdesign, sellers of web-design will offer less web design services. The entire supply curve for web-design services decreases. Taxes: An increase in taxes decreases the supply curve which shifts to the left. Expectation of a price change: The supply curve may increase or decrease if the price is expected to increase in the future. It depends on storability of the good. Storable: (e.g., Oil) an expected increase in price of oil decreases the supply curve because oil is storable and extraction can be reduced. Non-Storable: (e.g., Milk) an expected increase in price, increases the supply curve. Here the producers can increase output easily and they want to maintain market share. This is the standard case. Number of individual suppliers: The market supply is also an aggregate supply in the sense that it is the sum of individual quantities supplied at each price during a given time period, Ceteris Paribus. If this number increases then the aggregate will increase, which means an increase in the aggregate supply. Suppose there are three individual suppliers: Ann, Bob and Cory.

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(Prices in the first column should be multiplied by 10 to be consistent with the previous table. So $5.00 should be $50 and son on)

Shifts in the Market Supply (again): Graphs

Changes in the other determinants (other than the current price) of the market supply shifts the entire supply curve. A decrease in any of the costs of production (labor, capital and materials factor costs) or taxes, or an improvement in technology, or an increase in the number of individual suppliers will shift the market supply curve to the right (an increase in supply). If the good is non storable (milk), an increase in the expected future price will also shift the supply curve to the right (an increase in supply P S1 S2 (Non Storable)

QS If the good is storable (oil), an increase in the expected future price will shift the supply curve to the left (a decrease in supply. See below)

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P S2 S1 Storable

QS Thus, the impact of change in Pex on supply depends on goods storability.

Market Equilibrium
Market equilibrium occurs at the intersection of market supply and demand (QS = QD) Fig. 3.6: Equilibrium price and quantity

shortage = 47 (Prices should be multiplied by 10 to be consistent)) If QS > QD , there is a market surplus= QS- QD If QS < QD , there is a market shortage =QD - QS If QS = QD , there is a market equilibrium = QD- DS = 0

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(Equilibrium price Pe = $20 and equilibrium Qe = 39 units) Changes in Equilibrium (within Supply/Demand framework): If there is a change in one of the other determinants of supply or demand, there will be a change in market equilibrium. Suppose there is an increase in taste, or income, or prices of substitutes or expected price. Then the market demand will shift up, leading to a new intersection or equilibrium with the given supply. Fig 3.7: Changes in Equilibrium

Both equilibrium quantity and price increase.

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MARKET (DIS)EQUILIBRIUM
There are two types of market dis-equilibrium (shortage or surplus): Price controls (shortages) and Price floors (surpluses). Price Control or Ceiling: Governments intervention prevents the market price from moving up to clear the market and achieve equilibrium. Thus PC < Pe ; where PC is the ceiling price. Pc < Pe. Sometimes business impose price ceilings

Pe PC

Shortage

QSC Qe QDC

(Figure : Price ceiling) Price controls such as rent controls lead to shortages because the controlled price is too low. Total shortages = QCD QCS. If these are apartments, then the total shortage can be divided into two parts: Qe- QCS = # of existing apartments that are taken out of the market. QCD Qe = # of new apartments that are sought by new renters. Shortages will need a rationing mechanism. (1) First come , first served; (2) Californias government and gasoline rationing in 1979; (3) sports team and preferred customers with season tickets at times of playoffs. For more information on ceilings see:
http://daphne.palomar.edu/llee/101Chapter08.pdf

How Do Businesses Deal with Losses Created by Price Ceilings?

Price ceilings provide a gain for buyers and a loss for sellers. Sellers would like to avoid the loss if they can.

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1. One way to do so is called a black market. In this case, the sellers illegally raise the price and hope to get away with it. So, for example, tickets to popular events are sold by scalpers at high prices. (In California, ticket scalping is not illegal if it is not conducted at the place the event takes place.) While there are many other examples, black markets are not smart; it is just too easy to be caught. It is also not smart because of the existence of gray markets. 2. A gray market is a way of getting around the price ceiling without actually doing anything illegal. There are two forms of gray market. (a) One form of gray market involves charging for goods or services that were formerly provided free. If the rent cannot be raised on the apartment, there is nothing preventing the landlord from charging for the parking space, charging for use of the elevator, charging for gardening and cleaning services, forcing the tenants to pay for electricity and water, and so forth. In New York, a rent-controlled apartment near Central Park might rent for $300 to $400 per month; in a free market, the rent would probably be $2,000 per month. To get in, one needs the key. This has been known to cost $1,000. This is not a refundable deposit; this is a charge to have the key. It is obviously worth it to be able to rent the apartment for $300 to $400 per month. A Berkeley apartment owner converted his apartment into a church. To be able to live there, one had to pay church dues of $1,200 per year in addition to the rent. Gasoline stations would commonly charge for washing the windows, checking the tires, and so forth. The price of oil used in oil changes would be raised. (Those having oil changes at the station were favored in access to gasoline during the years of the price ceiling. In these years, Americans had the cleanest

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engines in history.) Some gas station owners ran the line to the gasoline pump through the car wash. One San Diego station forced people to have a $7 car wash to get to the gasoline pump. ($7 in these years is the equivalent of about $20 today.). This practice was later declared illegal. (b) The second form of gray market is to provide less service for the same price. Numerical Example on Price Ceilings : (Rent control and shortages) QD = 100 5P (where P is expressed in $100 but we ignore the zeros) QS = 50 + 5P (where number of apartments is in 10,000 an zeros will be ignored). a. Calculate market equilibrium QD = QS 100 5Pe = 50 + 5 Pe 100 - 50 = 5Pe + 5Pe Pe = 50/10 Pe = $5 (one hundred which is ignored) is the equilibrium price. Plug = $5 into any of the two equations. Then Qe = 50 + 5*($5) = 75 apartments is equilibrium quantity. b. Assume ceiling PC = $1 (one hundred) as set by the govt. Calculate the total shortage. QCD = 100 - 5PC = 100 5*($1) = 95 apartments QCS = 50 + 5PC = 50 + 5*($1) = 55 apartments Total shortage = QCD QCS = 95 55 = 40 apartments. Price Floor or Support: The government sets the price floor (Pf ) above the equilibrium price to support farmers income. Price support leads to surplus, which is usually purchased by the government. Thus, Pf > Pe Because the intervention price (Pf) is set too high, there is a surplus of this agricultural commodity.

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Sometimes manufactures imposes floors on the prices of goods sold at retailers such as bookstores, music stores and so on. For more information, see : http://daphne.palomar.edu/llee/101Chapter08.pdf
http://en.wikipedia.org/wiki/Price_floor

P D
Surplus

Pf Pe

QDf Qe QSf

Total Surplus = QfS - QfD For the price to stay at Pf the government must purchase the surplus.

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Cost of purchasing the surplus is illustrated in the Figure above (A Price Floor). The cost of purchasing the surplus = (amount of surplus)*(price floor). Example: Suppose price floor for corn is $4/bushel). Equilibrium price is #3/bushel Quantity supplied at the price floor is 100 bushels, while the quantity demanded is 75 bushels. Calculate the cost of purchasing the surplus. Cost of purchasing the surplus = Price floor*(QS-QD) = $4*(100 -75) =$100 million.

How Do Businesses Solve the Surplus Problem?

There were many ways to solve the problem of surpluses. 1. Occasionally, a store simply broke the manufacturer's policy. The store lowered the price to get rid of the surplus. The manufacturer had threatened that the store would be prohibited from selling the manufacturer's product; the store either believed that the manufacturer would not carry-out the threat or did not care. For example, Crown Books began lowering the prices of its books and a company called Discount Records began lowering the prices of phonograph records. 2. More likely, stores would try to get around the price floor without actually violating. (a) One common solution was to provide more service for the same money. Stereo stores could add free CDs or other free accessories. Washing machine stores used to virtually give away the dryer. Gas stations gave away glasses, knives, and Blue Chip Stamps. (b) A second solution was to simply absorb the surplus. Your textbook producers would have a surplus of textbooks. At the end of each edition, the books would be returned to the publisher and the

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paper was recycled. (c) A third solution was to change the name of the product in order to reduce the price. Surplus gasoline was sold to independent dealers who would sell it as Thrifty, 7-11, or Discount Gas at a lower price. Surplus liquor was bottled with a different label and sold as Slim Price, or Yellow Wrap at a lower price. Surplus washing machines and refrigerators were sold, for example, to Sears and marketed as Kenmore at a lower price. When automobiles were fairtraded, the dealers could not lower the price; however, they would give a trade-in value that was much greater than the trade-in car was actually worth. The main point here is that, even if someone interferes with the market process, there are powerful forces to return to equilibrium

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Chapter (20) 5 in the split: The Demand for Goods

DEMAND CURVE One of the determinants of demand is taste or desire. We measure desires by the pleasure, satisfaction or utility obtained from a good or a service. The more we desire a good or the more utility we obtain from it, the more we are willing to pay for it. Total Utility Vs Marginal Utility Total Utility (TU): measures the satisfaction derived from the entire consumption of a product. This could be the total utility from drinking three cups of cappuccino. Total utility usually increases with additional amounts of a good consumed. Then TU(3 cups) > TU(2 Cups). That is, total utility of consuming 3 cups is greater than total utility of consuming two cups and so on. Marginal Utility (MU): The utility derived from the last or an additional unit is called marginal utility.

Marginal Utility = total Utility / quantity MU = TU / Q Example: Cups 0 1 2 3 TU 0 50 80 100 MU= TU / Q (50-0)/(1-0) = 50 (80-50)/(2-1) =30 20

In this example, the utility derived from each additional cup/unit of cappuccino consumed decreases as more units of a good are consumed. This is a universal phenomenon and applies to many goods. Economists have fashioned a law around it, and called the law of diminishing marginal utility. It states that each successive unit of a good consumed yields less additional or marginal utility.

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Example: Eating Popcorn (boxes) at the Movies: Boxes 0 1 2 3 4 5 6 TU 0 30 50 60 65 65 62 MU= TU / Q 30 20 10 5 0 -3

20 units of satisfaction under MU is the number of units of satisfaction derived from consuming the 2nd boxt, 10 from the 3rd box and so on. From Box 1 to 4, MU is positive and TU is increasing, at Box 5, MU = 0 and TU is flat. Finally at Box 6, MU is negative and TU is decreasing.

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Price and Quantity: MU is a measure of how much we desire particular goods (our taste). The more we desire a good, the greater MU of each additional unit consumed of that good. In this case we are willing to pay more for it. But since MU is diminishing as additional units of the good is consumed, the consumers are willing to pay progressively less for additional quantities of the product, given that income, tastes, prices of other goods are held constant (Ceteris Paribus). This is the law of demand. Law of Demand: the quantity of a good demanded increases as its price falls during a given time period, Ceteris Paribus. Demand Curve: A curve that describes the quantities the consumer is willing and able to buy at alternative prices in a given time period, Ceteris Paribus.

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Figure 5.3 Price Elasticity (% / %): This elasticity measures by how much the quantity demanded would fall if the price were raised or vice versa. Suppose the price increases by 10%, would the quantity change by more or less than 10%? The elasticity answers this question. Price elasticity of demand: Elasticity = %Q / %P = {(Q2 Q1 )/Average Q)} / {(P2 P1)/Average P)} where Average Q = (Q1+Q2 )/ 2 , Average P = (P2+P1) / 2 Example: (calculate the midpoint price elasticity of demand) P $9 (P1 ) 7 (P2 ) QD 15 Units Q1 25 Q2 25

EPD = (Q2 - Q1) / (Q1 + Q2) = (Q2 - Q1) / average Q (P2 - P1) / (P1 + P2) (P2 - P1) / average P EPD = (25 - 15)/ (15 + 25) (7 - 9) / (7 + 9)

= -2 (if the price increases by 10% percent, then the quantity decreases by 20%). The price elasticity of demand is expressed as a positive number for convenience (not compare negative numbers) but it is always negative. Types of Elasticities: We use the absolute value of the elasticity (coefficient of Elasticity) If EDP > 1 in absolute value (e.g., -1.5, -2.3, -3.4etc) then the demand is price elastic (the consumer is responsive to the price change). If EDP < 1 in absolute value (e.g., -0.33, -0.50, -0.76 etc) then the demand is price inelastic (the consumer is not very sensitive to the price change). If EDP = 1 in absolute value then the demand is price unitary elastic (%Q = %P in absolute value).

Fig. 20.3: Elasticity Estimates (remember: the demand elasticity is always negative)
There are positive elasticties which mean coefficient of price elasticity of demand.

Example: Price elasticity of demand for the airline industry is -2.4 (p-elastic). How much will the quantity drop %Q if the price increases on average by 10% (i.e., %P = 10%)? 26

Elasticity = EDP = %Q / %P = %Q / +10% = -2.4.

Then %Q =elasticity* %P= -2.4* %P = -2.4* 10%= -24%.

Demand for Popcorn: Price (Per Ounce) A $0.50 B 0.45 C 0.40 D 0.35 E 0.30 F 0.25 G 0.20

Quantity Demanded (Ounces Per Show) 1 2 4 6 9 12 16

Example: Let the price drop from $0.50 to $0.45 and quantity increases from 1 to 2 ounces. P1 = $0.50 Q1 = 1 ounces P2 = $0.45 Q2 = 2 ounces Average P = (0.5 + 0.45)/2 = $ 0.475 Average Q = 1.5 units Calculate: EDP = (Q2 Q1)/[( Q1 + Q2)/2] / (P2 P1)/[( P1 + P2)/2] In this definition, the two 2s cancel out. Then EDP = [(2 -1) / *(1+2)] / [(0.45 0.50) / *(0.50 + 0.45)] or EDP = (1/1.5) / (-0.05/0.475)

EDP = -0.6667 / 0.1053 = -6.331 (Price-elastic)

Next, suppose %P = +10%. Then solve for %Q by using the calculated elasticity: %Q = EDP * %P

Then %Q = -6.331*10% = -63.31% (quantity drops by more than 63 percent).

The consumer is highly responsive or sensitive to the change in the price. Extremes of Elasticities If EDP = , then the demand is perfectly price elastic. The demand curve would be a horizontal line. If P1 increases to P2 then quantity can decrease to zero. Or if price decreases, quantity can increase to infinity.

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If EDP = 0 (that is, %Q / %P = 0/%P), then the demand is perfectly price inelastic. The demand curve would be a vertical line and the consumer is not at all responsive to the change in price. An example of this case is the demand for heart transplants. Demand for illegal drugs is almost perfectly inelastic.

Example: Domestic Rise in Youth Smoking (highly inelastic)

Youth Smoking

1971

1991

1992

1997

1998

Years

Major explanation for the rise in youth smoking in 1990s was a sharp drop in cigarette prices in the 1990, caused by a price war between the tobacco companies.

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The two researchers Gruber and Zinman found that young people are relatively more sensitive to the price of cigarettes (EDP = 0.7 for youth vs. 0.4 for adults). This means that for every 10% drop in price, youth smoking rose by almost 7%, a much stronger price sensitivity for youth smokers then for adult smokers.

Determinants of Price Elasticity of Demand Why consumers are more sensitive, in terms of changing quantity demanded, to the same percentage change in price of airlines travel than to changes in price of gasoline. We must look at the determinants of the price elasticity demand. Four determinants are particularly important. Necessities Vs. Luxuries: Necessities are goods to which we have a strong taste to have (e.g.; tooth paste, shaving cream, salt etc). Demand for necessities is relatively price inelastic. Luxuries: are the goods we like to have, but can get by without them. Ex: vacation travel, new cars. The demand for luxuries is relatively price elastic. Availability of substitutes: The greater the availability of substitutes for a certain good, the more price elastic is the demand (compare Pepsi and gasoline).

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Relative price of a good to consumer income: The greater the ratio (price/income), the more elastic the demand is. The ratio is high for vacation travel and for new cars but low for salt.

Price Elasticity & Total Revenue Total revenue of a seller = Price*quantity sold. TR = P * Q (an ambiguous effect on total revenue because D has a negative slope). If price increases, total quantity sold decreases because the demand has a negative slope. What will happen to the demand curve? Will revenues increase or decrease? The change in total revenue depends on the EDP. P ($/Pack) 1 2 3 4 5 6 7 QD (Packs ) 100 90 70 50 25 10 6 TR=P* Q ($) 100 180 210 200 125 60 42 EDP Low (inelastic = -0.16) Low (inelastic = -0.63) High (elastic = -1.17) High (elastic) High (elastic) High (elastic) P and TR P and TR P and TR P and TR P and TR P and TR P and TR

Changing Values of Elasticity along demand Curve: Recall, EDP = (Q/P) * P/Q . The first part of the elasticity is the slope of demand with respect to the quantity. The second part is the location of a point along demand curve. In this case, elasticity can change along the curve if location changes.

Price Elasticity of Demand along a Linear Demand Curve.

The demand is unitary elastic around the middle of the demand line. It is elastic for prices higher than the middle price, and inelastic for prices below the middle.

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Effect on TR if Demand is Elastic(E>1) Inelastic(E<1) Unitary Elastic(E=1)

Price increase TR Decreases TR Increase TR Unchanged

Price reduction TR Increases Decrease Unchanged

Other Elasticities: The price elasticity of demand changes not only when the price changes along the demand curve but also when there is a shift in demand. Income Elasticities of Demand: Suppose there is an increase in income. Given the same price, the demand curve shifts out to the right as a result of the income increase.

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EID = %QD / %I = (Q/Average quantity) / (I/Average income) = (Q2 Q1) / [( Q1 + Q2)/2] / (I2 I1) / [( I1 + I2)/2] Example: Suppose income increases and the price stays constant at $0.25 a unit. Calculate the income elasticity of demand. I $11 0 $12 0 QD 12 ounces 16

EID ={(16-12) / [* (12+16)]} / {(120-110) / [*(110+120)]} EID = (4/14) / (10/115) = 0.286/0.087

EID = 3.2 (income elastic)

An increase in income does not always shift the demand curve out or to the right. If the good is normal, an increase in income shifts demand out. In this case, EID>0 or demand is income elastic (example: designer clothes). This means if income increases quantity demanded also increases. If the good is inferior (EID < 0), demand shifts to the left. Inferior goods include discount clothes, used books, used cars, cheap beer, and generic brands.

Cross Price Elasticity of demand

Demand and quantity demanded for good X can also change when prices of related goods Y or Z change. There are two related goods: substitutes and complements. The Case of Substitutes: Coke and Pepsi The cross Elasticity of demand for coke when the price of Pepsi changes is:

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Ep(Pepsi)Q(Coke) = (QCoke /Average quantity of coke) / (PPepsi /Average price of Pepsi) >0 This means if the price of Pepsi increases, the quantity demanded of coke also increases because the entire demand for Coke below shifts from R to F. The cross price elasticity of demand for substitutes is positive. Or in general, EpyQx = (Qx/average Qx)/(Py/average Py) > 0 (substitutes).

If the cross price elasticity of demand is negative the two goods are complements.

EQ(tea)P(sugar) = (%Qtea / %Psugar) < 0

Demand for teas below shifts to the right from F to R if price of sugar increases with no change in price of tea.

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Choosing Among Products

Consumer choice and Optimal consumption

Our analysis of demand has focused on the decision to buy a single product at different prices. But consumer behavior is multi dimensional and involves buying more than one product. The basic objective is still the same: to maximize satisfaction or utility from our income. The consumer choice that maximizes utility out of income builds on the theory of marginal utility and the law of demand. Rational consumer behavior requires that we compare the anticipated utility of buying each product with its price.

Suppose we have two goods: Coke, whose price is PCoke and marginal utility is MUCoke; and video game with price PV and marginal utility MUV. Then we must compare MU and the price for each purchase. MUCoke / PCoke with MUV / PV
In this case we are comparing units of utility per dollar for coke with units of utility per dollar for video games. If (MUCoke / PCoke) > (MUV / PV) (anticipated MU per dollar for coke > anticipated MU per dollar for video game) then the coke should be bought before the video game. This continues until

MUCoke / PCoke = MUV / PV

You should also check that Pcoke*Qcoke + Pv*Qv = I (must spend all income).

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Example: Two goods: coke and video game Suppose PCoke = $0.50 and PV = $0.25 and Income = $3.00

Q 0 1 2 3 4 5 6

TUCoke 0 15 23 25 25 22 12

MUCoke 0 15 8 2 0 -3 -10

MUCoke / PCoke 0 15/$0.5 = 30 (#3) 16 (#6) 4 (#8) 0 -6 -20

TUV 0 10 19 26 31 34 35

MUV 0 10 9 7 5 3 1

MUV / PV 0 10/$.25= 40 (#1) = 36 (#2) = 28 (#4) = 20 (#5) = 12 (#7) = 4 (#9)

(Note: The yellow table is reproduced in the table below it but with more details) The consumer choice or optimal consumption that maximizes utility requires that:

MUCoke / PCoke = MUV / PV

4=4

(coke, video) = (3, 6) = consumer equilibrium

Check if this consumer choice (Coke =3, V=6) is affordable.

(PCoke* Coke) + (PV * V) = I

($0.5*3) + ($0.25*6) = $3.00

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Chapter 6 (21): Costs of Production

The Production Function
Resources are used in producing goods and services. These resources are called factors of production. The basic factors include land, labor and capital. The costs of production are measured as the costs of those resources. To asses these costs, we should know that given an amount of the resources, what is the best way of producing a product? Or thats the maximum amount attainable from a given quantity of resources? The answer to these questions is reflected in the production function. Thus this function defines a relation between maximum amount of output for given amount of inputs, holding technology constant. In this case, the production function represents maximum technical efficiency. Varying Input Levels: Table 21.1 reports a production function for the Tight Jeans Corporation. The output is pairs of jeans per day, and the inputs include workers (labor) per day and sewing machines (capital) per day. If both labor and capital change freely without any amount is fixed, we are in a planning period and the production function is in the long term. Table 21.1: Production Function Schedule for Producing Pairs of Jeans

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Both capital and labor are essential inputs for production. If sewing machines are zero, then output is zero regardless of how many workers are used. Additionally, the output (pairs of jeans) is zero regardless of how many sewing machines we rent. If we use one worker per day and one machine per day the maximum attainable output from this particular input combination is 15 pairs of jeans. If we employ two workers and rent two machines per day, the total output is 46 pairs of jeans per day. Short-Run Production Function: In the short-run, there are constraints on increasing certain inputs, particularly, capital. In other words, there are constraints on capacity of facilities. In Table 21.2 the capacity constraint is fixing the number of machines and moving row-wise. If sewing machines = 1, then increasing labor will give us a short-run production function associated with one machine, and so on. Fig. 21.1: Short-run Production Function

Along this short run production function, total output increases as input (workers) increases until the 7th worker where output is flat. For workers = 8, total output declines. Fig. 22.2: Marginal Physical Product:

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Marginal Productivity
Marginal productivity of labor is a movement along short-run production function. Suppose the number of machines is fixed at one. Then the first worker adds 15 jeans to total output per day. If we add a second worker, this worker increases total output by 19 jeans per day. This increase in productivity of the second worker is because of specialization among the two workers. There is no difference in quality between the workers. Thus, it does not mean that the first worker is lazy and the second worker is more hard-working. If you reverse the order, you get the same productivity. This productivity is called marginal physical product (MPP). MPPL = Total output / Workers. For the 1st worker, MPPL= (15-0)/(1-0)=15 pairs.

There is a diminishing MPPL starting with the 3rd worker. This happened because of facility constraint. There is a downtime when there are three workers or more with one machine. This phenomenon of diminishing marginal product for labor (MPPL) happens to many production processes in the short run when there is a facility or a short run

38

constraint. Then economists fashioned the law of diminishing returns to the single variable input (labor) around it. This law is a short-run concept because capital is fixed.

Resource costs
The production function reports the maximum output attainable from a given amount of resources. It does not tell us how much the firm wants to produce. In order to determine the most desirable output (that output that maximizes profit), the firm needs to know the economic cost or the resource cost of production. In Table 21.1, the resource cost of producing jeans includes the physical amounts of labor, denim, machines and land. We translate output data into related input (cost) data. For example, if we use one worker a day to produce 15 pairs of jeans at point b then the labor (resource) cost of producing one pair of jeans for the first worker is L/ Q = (1-0)/ (15-0) = 1 /15 jeans = 0.067 labor units per one pair of jeans Marginal Resource Cost (MRC= Total resource cost / output) How do input or resource costs change when output increases per one additional unit? In Fig 21.3a, at point c, total output increases by 19 pairs when we hire an additional worker. Then whats the implied labor (resource) cost of producing one additional pair of jeans when those additional 19 pairs produced by the second worker? = L/ Q = (2-1)/ (34-15) = 1 / 19 labor units per one additional per of jeans = 0.053 is the labor cost of that extra output (point 1/c in Fig 21.3b). Marginal resource cost (MC) is the additional costs of resources ( in input units) from a change in output by an extra unit. In general, for marginal resource cost MC of resources = Total resource cost / output. Suppose labor is the only variable input. Then the marginal resource cost of the additional jeans is = (1 additional worker / 19 additional pairs) = 0.053 workers day per pair (point c). Marginal labor costs of jeans production declines when the 2nd worker is employed. Fig. 21.3: Fall MPP and Rising Marginal Cost

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Diminishing marginal physical product implies increasing the labor cost of consecutive workers. That is, the diminishing marginal productivity implies rising cost of each additional worker which is called marginal cost (MC) Summary of marginal resource cost MC = Total cost / Output MC of the added one paper of jeans associated with the 1st worker = Cost of 1st worker / output = 1 / 15 = 0.06 worker day per one pair. MC of the added jeans associated with the 2nd worker = Cost of 1 additional worker / output = 1 / 19 = 0.053 worker day per one pair. MC of the added jeans associated with the 3rd worker = 1 / 10 = 0.1 worker day This is point 1/d in fig 21.3 MC of the added jeans associated with the 4th worker = 1 / 4 = 0.25 of a worker day. It should be obvious that if there is a diminishing physical marginal product then there is an increasing marginal cost. It means that at a certain worker level, each additional pair of jeans becomes more expensive because it uses more labor than the one before it.

Dollar Costs
In calculating the dollar costs, we add up the market ($) values of all the resources we use in production. In producing jeans we assumed to use a factory, sewing machines, operators (workers) and bolts of (denim) jeans. These resources can be classified into two types:

Fixed resources: The factory and sewing machines (do not change with output) Variable resources: Operators and bolts of jeans (change with output).
The cost of fixed resources is called fixed costs (do not vary with output) The cost of variable resources is called variable costs (vary with output) Total cost is the sum of fixed costs and variable costs.

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Example: (Table 21.2) suppose to produce 15 jeans per day the total cost includes: Cost of factory rent $100 per day (Fixed cost) Cost of one sewing machine rent $20 per day (Fixed cost) Cost of one operator $80 per day (Variable cost) Cost of 1.5 bolts of denim (1.5 * $30 a bolt) $45 (Variable cost) Total cost of producing 15 jeans per day = $245.
(Footnote: One bolt of denim can make 10 jeans and costs $30). The fixed cost (FC) to produce the 15 jeans is $120 per day and the variable cost (VC) is $125 per day. Then the total cost (TC) is $245. What will happen to FC and VC if we produce more than 15 pairs of jeans? FC does not change but VC will increase. In the short run, total cost (TC) increases because variable cost (VC) increases as a result of increases in output. Fixed cost (FC) does not change with output. Other examples of FC are costs of a copy machine (not including ink and electricity), a school bus (not including gasoline) In short run, there is an upper limit on production of jeans, which is the capacity of the factors. Once output reaches 51 jeans a day, adding more workers will make total cost rise rapidly without any noticeable increases in output. Thus, there is no upper limit on total cost of production. However there is a lower limit on total cost which is the fixed cost.

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Fixed, Variable and Total Costs in the short run Output Q (pairs) 0 pairs 10 pairs 15 20 30 40 50 51 (max capacity) 47 Fixed Cost FC ($) $120 $120 120 120 120 120 120 120 120 Variable Cost VC($) $0 $85 125 150 240 ?= 470 -120 =350 ? = 670 -120 = 550 753- 120 =633 Total Cost TC ($) $120=FC $205 245 (example above) 270 360 470 670 753 (no limit)

Notice that TC + FC when output is zero. Then VC can be derived by subtracting FC from TC. Note that TC = FC + FC or VC = TC -FC

Average Costs in the short run

These are costs per unit. Average fixed cost (AFC) AFC = Fixed cost / Total output Fixed cost (FC) does not change with the level of total output. But the average fixed cost (AFC) means dividing the fixed cost over more output units, which reduces the fixed cost per unit. Examples, maintenance cost, property taxetc AFC declines all the way as output increases. Average variable cost (AVC) AVC = Variable cost / Total output

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AVC declines initially then it increases as output increases. The rise in AVC is due to diminishing returns in production which happens because of facility constraints. This happens at point k where output is 20 units in the figure below. Average total cost (ATC) ATC = Total cost / Total output or ATC = AFC + AVC. ATC is Ushaped because of the battle between the declining AFC and the declining and rising AVC. Initially, both AFC and AVC decline, so does the ATC. Still the decline in AFC dominates the rise in AVC, so ATC declines. Then later the rise in AVC dominates the small decline in AFC, and ATC rises. AVERAGE COSTS IN THE SHORT_RUN Output (Q) 0 Pairs 10 15 20 30 40 50 51 Fixed Cost (FC) $120 120 120 120 120 120 120 120 AFC = FC/Q $120/0 120/10=12 120/15=8 120/20= 6 120/30=4 120/4 = 3 Variable Cost (VC) $0 $85 125 150 240 350 AVC = VC/Q $0/0 $85/10= 8.5 125/15=8.33 150/20= 7.5=min AVC 240/30= 8.0 8.75 Total cost ATC = TC/Q (TC) $120=FC 120/0 205 245 270 360 470 670 753 205/10=20.50 245/15=16.33 270/20=13.50 360/30=12.00 11.75 =min ATC 13.40 ?

120/50 = 2.4 ? = TC- FC 550/50=11.00 120/51=2.35 753-120=633 ? = VC/Q

FC does not change with output but its AFC declines all the way. VC increases with output, but AVC goes down for a while reaching a minimum at $7.5 per pair then it goes up and thus is U-shaped because the initial decline has to do with increase in productivity due to specialization and then the later increase in AVC has to do with downtime. ATC is also U-shaped. It reaches it minimum at $11.75 per pair

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AVC reaches its minimum at an output level less than that corresponding to the min ATC. Marginal Cost This is the cost of additional increases in the amounts of resources as output increases by one extra unit. There are a marginal resource cost and a marginal dollar cost. We can move from the marginal resource cost to the marginal dollar cost by multiplying the amounts of the resources by their corresponding prices. Marginal resource cost:

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Recall an increase in output of jeans from 15 pairs to 16 pairs (an additional pair) requires an increase in labor cost by 1 / 19 = 0.053 workers day and an increase in denim cost by 1 / 10 = 0.1 bolt of one denim ( recall one bolt produces 10 pairs of jeans). There is no change in fixed cost. Resources used per an additional pair 0.053 (worker/ day) 0.1 bolt of denim Market value of MC resources $80 / worker a day 0.053*80 = $4.24 $30 / bolt 0.1*30 = $3.00

Marginal dollar cost in the short-run: MC = change in total cost / change in total output. Or MC = VC/Q you get the same marginal cost in the short run because FC will cancel out.

Output 0 P Q R S 10 15 20 30

TC $12 0 205 245 270 360

TC/Q = MC $85 /10 =$8.5 40 / 5 = $8.0 25 / 5 = $5.0 90 / 10 = $9.0

Output 0 10 15 20 30

VC
$0 $85 125 150 240

MC = VC/Q $8.5 = $85 /10 $8.0 = 40 / 5 $5.0 = 25 / 5 $9.0 = 90 /10

Marginal cost decreases then starts rising. It crosses AVC and ATC at their respective minimums.

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Economic Vs Accounting Costs

The distinction between economic costs and accounting costs is one between resource cost and dollar cost. Dollar cost refers to actual dollar payments and thus are accounting costs, while resource costs reflect the economic costs to the society whether it has cash payments or not. Part of economic cost is imputed and the other part is actual payments. In this case economic costs include accounting costs. Examples of costs without cash payments include: self-employed labor, self owned capital.

Accounting cost = explicit dollar costs Economic cost = explicit dollar costs + implicit costs. Economic cost = Accounting cost + implicit costs
Implicit costs are the costs of the self-employed labor, self-owned capital etc.

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Economic Cost versus Accounting Cost

Accountants: Take a retrospective view of a firms finances Their purpose is to evaluate past performance Equate cost with actual expenses and depreciation expenses Depreciation expenses are calculated according to tax rules Economists: Take a forward-looking view of the firms finances. Purpose to evaluate future profitability Equate costs with opportunity costs because the firm rearranges resources to minimize cost and increase expected profitability. The cost = actual expenses + opportunity costs of own time, money, materials and buildings. Depreciation expenses = actual wear or tear. Example : Owner/manager of a pizza restaurant in his/her own building Accounting costs Owners/managers salary = 0 Own building rent = 0 Workers wages > 0 Cheese > 0 Flour > 0 Other expenses > 0 Total accounting cost Economic costs Owners / managers salary = opportunity cost > 0 Own building rent = opportunity cost > 0 Workers wages > 0 Cheese > 0 Flour > 0 other expenses > 0 < Total economic cost

Total economic Cost = Explicit $ cost + Implicit cost Explicit $ cost = accounting cost (out of pocket expenses). Implicit cost = forgone own salary + forgone interest on own money + forgone own rent In this case, the implicit cost is the sum of opportunity costs.

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Long Run Cost The long run is a planning period during which the firm attempts to figure out the future demand for its product. Capacity or size is not fixed in the long-run. Once a firm chooses a fixed size, then there is a fixed capital, and hence there is a fixed cost and the firm is operating in the short-run. Suppose the firm is considering three sizes: Small Size with shortrun ATC = ATC1 Mid Size with short run ATC = ATC2 Large Size with short run ATC = ATC3

If the anticipated demand is between 0 and point a, the firm should consider building a small plant (size 1) because this is the size that gives the lowest possible cost per unit. If the demand is between a and b it should consider the medium size with ATC2. If the demand is expected to exceed b, then the firm should build the large size. In the long-run the firm should consider building sizes with lowest possible cost per unit. The long run ATC is the three solid portions of the three short run ATCs. Since the firm can build any size, then it is faced by infinitely many sizes with infinitely many short run ATCs. These ATCs can smooth out the long run ATC, which includes only one point on each short run ATC. This point corresponds to the minimum ATC. A Cost Summary MC equals AVC when the latter is at its minimum. MC also equals ATC when the latter is at its minimum.

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MC

ATC AVC

Min ATC

Min AVC MC goes through min AVC and min ATC.

Output

Scale Economies
Scale economies include three types: economies of scale; no economies of scale (constant returns to scale) and diseconomies of scale. This concept summarizes the relationship between changes in output and changes in costs, and it is characterized by the shape of the long-run ATC (LATC). Suppose the desired output is a relatively large one such as level QM in the graph below. This output level can be produced using several small plants or one large one. Let ATCS represent the ATC for a typical small plant and ATCL be the ATC for the large plant. How would the choice of plant size or scale affect costs? This has to do with scale economies.

Case1: Economies of Scale

Suppose in this case the minimum ATC decreases as the plant size or scale increases as shown in( Fig 21.8(b) middle graph).

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If the producer builds several small sized plants, the typical minimum ATC is min ATCS at point c, and if it builds the large size plant the min ATC is min ATCL at point m2. In

this case as the plant size increases, min ATC decreases. Min ATCS > Min ATCL
This implies that a producer who wants to minimize costs should build a large plant rather than several small ones. In this case, economies of scale exist. This type of scale economies is characterized by declining long run average cost. Centralization of operations has a cost advantage in this case. Specialization also has a cost advantage.

Case 2: No Economies of Scale or Constant Returns to Scale. In this case plant size
does not affect min ATC (Fig. 21 a). That is, the min ATCS at point c for any of the small-sized plants equals the min ATCL at m2 for the large plant. For this case there is no economic advantage to centralization of manufacturing operations by building a large plant. This is the case of no economies of scale or constant returns to scale. Thus: Min ATCS = Min ATCL

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ATCS

ATCL

Min ATCS = Min ATCL

Output QM FIG 21.a or 10 (a): Constant returns to scale (or no economies of scale) This is the case of no economies of scale or Constant returns to scale. This type of scale economies is characterized by constant long run ATC LATC

LATC

Output (constant returns to scale)

Case 3:Diseconomies of scale

Suppose that Min ATCL > Min ATCS That is, as the scale or size increases the minimum ATC increases. That is, as the size becomes large, the firm becomes large too.

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This is diseconomies of scale (Fig. 21.c or 10 c)

ATCL
Min ATCL Min ATCS

ATCS

Output QM Diseconomies of scale (Fig. 21.10 C) In terms of long run ATC (LATC), the cost per unit increases as output decreases. Description of Diseconomies of Scale in terms of the long-run ATC curve:

LATC

LATC

Output (diseconomies of scale) Example: Determine the type of scale economies? 52

Output 10 Units 12 15

Total Cost $20 24 30

LAT C 2 ? ?

where LATC is the long-run average total cost. Solution of the above example: To determine the type of scale economies, calculate first the long-run average cost (LATC = Total Cost/Output) Output Total Cost LATC 10 Units $20 20/10=2 12 24 24/12=2 15 30 30/15=2 [LATC= (total cost /output) is constant, suggesting no economies of scale or constant returns to scale]

Global Competitiveness The US productivity is high relative to that of other countries because it depends on the quantity and quality of the other resources used in the production process. US workers work with vast quantities of capital and the state of art technology. They also have more education than other workers. Their high wages reflect their greater productivity. Those two factors (productivity and wages) should be taken into account in measuring international competitiveness of a country. A measure of international competitiveness that uses both of these factors is called the unit labor cost. Unit labor cost = wage rate/MPPL where MPPL is the marginal physical product of labor OR MARGINAL PRODUCTIVITY. Suppose MPPL of a US worker is 6 units of output per hour and the wage rate is $12 an hour, then the unit labor cost would be Unit labor cost = $12/6 = $ 2 per unit of output. Relatively lower unit labor cost means greater global competitiveness.

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http://krugman.blogs.nytimes.com/2010/02/06/spains-problemillustrated/

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CHAPTER 7 (22): The Competitive Firm

The Profit Motive:
The basic incentive for producing goods and services is profit. Profit = total revenue total costs. Other motives may include worrying about social status or recognition. Profit may encourage producers to produce the goods desired by the consumers and provide it at reasonable prices. Profit may encourage producers to damage the environment and produce inferior goods. The typical consumer in the US believes that 35 cents of every sales dollar goes to the product. In reality, average profit is 5 cents per sales dollar. Whats the profit margin for Service Corp International (SCI)? What type of company is SCI? 12 cents per one dollar of sales!

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Economic Vs Accounting Cost:

We use economic (resource) and accounting ($) costs to distinguish between accounting profit and economic profit. To economists, total costs are economic costs which include the explicit costs and the implicit non dollar costs. The implicit costs are the opportunity costs of using self-owned labor, land and money.

Accounting costs = explicit dollar costs or $ costs Economic costs = explicit dollar costs + implicit costs = resource costs Economic Profits
As mentioned above, people have different views of total costs. To accountants, total cost is explicit dollar payments. This is known as accounting cost. Thus,

Accounting profit = total revenue explicit costs = total revenue accounting costs Economic profit = total revenue - explicit dollar cost - implicit costs

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= accounting profit - implicit costs.

Suppose TR =$100, explicit cost is $60 million, implicit cost is $40 million. How much are accounting and economic profits?

Thus if, implicit cost is included and is high, a positive accounting profit may turn into a negative economic profit. Table 22.1: Economic cost and computation of economic profit Suppose an owner/ manager has a drug store. In this drug store, the owner works 10hrs/day, seven days a week for a total of 300 hrs/ month at $10 an hour. Then the opportunity cost of working for him-self (monthly labor implicit cost or labor opportunity cost) is $3,000 a month. He has on his shelf an inventory of drugs that he bought with his own money. The drugs on the shelf are worth $120,000. If he invests this money at 10% a year then the annual opportunity cost of sacrificing return on own capital (yearly capital implicit cost) is 10% * 120,000 = $12,000 (yearly return on capital). The sacrificed monthly return on self-owned capital is $12,000/12= $1,000 a month. Total implicit cost = labor implicit cost + capital implicit cost = $3,000 + $1,000 = $4,000 per month. Suppose the following monthly explicit costs: the cost of merchandise sold = $17,000. This is an explicit cost. the wages and salaries = $2,500. This is an explicit cost. the rent and utilities =$800. This is an explicit cost. the taxes = $700. This is an explicit cost. Than total accounting or explicit cost equals =17,000+2,500+800+700=$21,000.

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Market Structure
The size of a companys profit depends on the market structure in which it operates A market structure is the number and relative size of individual firms in an industry.

Market Power and Market Structure

Monopoly One Producer

Duopoly Two Producers

Oligopoly Few producers Homogeneous Product

Monopolistic Competition

Perfect Competition

Many producers with

Many Producers. homogeneous Free entry/exit

Or Differentiated Product Equilibrium Conditions:

Differentiated products

MR = MC P=equation

MR = MC P=equation

MR = MC P=eq

MR = MC P=eq

P = MC P=constant

58

If the market structure is monopoly, then the firm is producing the entire supply of the product and its product dose not have a close substitute. This is an extreme case. At the other extreme is the case of perfect competition which is a market in which no buyer or seller has market power because each is very small. Prices are constant. In the US, there are 20 million businesses which fall between monopoly and perfect competition.

The Nature of Perfect Competition

A perfectly competitive industry has several characteristics: Many small firms Identical or homogenous products (e.g. agricultural products). Very low barriers of entry (whether financial, legal or technological) to new firms in a certain industry. Small Firms: The individual firm is very small relative to the market and it cannot influence the market price. Thus in this case, the individual firm takes the prices as set by the market. Thus, the implication of smallness is that the perfectly competitive firm is a price taker and

the price facing each firm is a constant.

The Production Decisions under Perfect Competition Output and Resources: Since the price facing the perfectly competitive firm is constant, the implication is that the firm has the option of only determining the output level that maximizes profit.

Profit = Total revenue Total cost = TR TC where

_ _ TR = P*quantity sold = P*q. _ and the price P in this case is constant and q is variable.

Thus, the firm should select the quantity sold (q*) in order to maximize profit. The total revenue curve (TR = P*q) is a straight line because the price is a constant and q is variable (this is like Y = aX then graph for Y is a straight line starting from the origin).

59

TR = Price*Quantity is a straight line because Price is a constant. Slope of total revenue under perfect competition is the price (slope =MR=TR/q = P). Low Entry Barriers: Basically there are no technological, legal and capital barriers to entry under perfect competition. Thus entry which takes place when profit is positive is free. Entry shrinks profit because supply curve shifts to the right and P decreases, decreasing TR.

Market demand curve Vs. Firm demand curve:

Under perfect competition, the firm is a price-taker. It cannot influence price regardless of the level of its output. Thus the individual firms demand is a straight (horizontal) line.

On the other hand, collective action of all the firms in a specific market can influence the price. Thus, the market demand is negatively sloped. 60

Output and Costs:

The perfectly competitive firm in the short run has fixed costs and variable costs. The typical total cost curve under perfect competition is an inverted S curve (cubic eq.).

Eventually, total cost escalates due to the law of diminishing returns. The concave part in TC curve signifies that at first total cost rises slowly or MC is declining and the convex part implies that the cost increases rapidly later or MC is rising. Concave part in total cost curve corresponds to convex production part in short run production function and vice versa. Concave means the variable increases at a decreasing rate, while convex means the variable increases at an increasing rate. Marginal Cost:

Recall, MC = TC / Q = Total Cost / Output

Profit Maximization There are two approaches for profit maximization: The total approach and the marginal approach. Total Approach: This approach pictures a profit or a loss as the difference between TR and TC curves. To determine the maximum profit in the case of profit, look for the maximum difference (Vertical distance) between TR and TC. In the case of loss, look for the minimum loss or minimum difference between TC and TR.

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At the beginning the firm experiences losses then it moves to economic profit, and then back to losses. The output that maximizes the profit difference between TR and TC, it is around point h.

Price (1) $13 $13 $13 $13 $13 $13

Output (q) (2) 0 1 2 3 =q* or 4 5

Total Revenue (TR) (3) =1*2 $0 13 26 39 52 65

Total Cost (TC) (4) $10 = FC 15 22 31 44 61

Profit or loss (5) = (3) (4) $-10 loss -2 loss +4 profit 8 Max 8 Max 4

The output q* that maximizes the profit difference between TR and TC, is 3 or 4 units.

The marginal approach.

This approach compares the addition to TR with the addition to TC as output increases by an extra unit each time. If the addition to TR exceeds the addition to TC, then the firm should produce the extra unit (i.e., increase output). If the case is reversed, then the firm should reduce output by an extra unit (i.e., reduce output). But if

Addition to TR = Addition to TC

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Then the firm reached the maximum profit or the minimum loss and it should stop. This is the equilibrium profit-maximizing output level. Note that Addition to TR = TR / Q and addition to TC = TC / Q when output changes

by one extra unit. Then equilibrium or profit-maximizing output is realized when: TR / Q = TC / Q (this is the 1st profit maximization rule).
Marginal Revenue = TR / Q = TC / Q = Marginal Cost Before we apply this rule, let us look at the relation between Price and Marginal Revenue, and also calculate marginal cost.

Then under perfect competition P =MR. So the rule becomes P = MC

According to the marginal approach, profit is maximized when Q* = 4 baskets because

63

MR = MC (1st profit maximization rule) $13 = $13 since MR = Price under perfect competition, then the 1st profit maximization rule can be rewritten as P = MC $ 13 = $13 which implies that Q* = 4 Sometimes we do not have equality between P and MC. Then in this case q* is determined according to this rule P > MC P < MC and q* is in between those two inequalities. Example: Find profit-maximizing output q* (Check both rules). HERE P MC. Price (1) $13 $13 $13 $13 $13 $13 Output (q) (2) 0 1 2 3 =q* or 4 5 MC $7 (P>MC) $10 (P>MC) $12 (P>MC) $17 (P< MC) $30 TR= P*q 0 $13 $26 $39 $52 $65 TC Profit or loss= TR- TC $10 =FC 0-$15 = - $10 (loss) 17 27 39 56 85 -4 -1 loss 0 =normal profit -4 loss -$20 loss

Case 1: Positive Economic Profit:

64

E P ATC* AVC Profit A B

ATC AVC

D-curve

Min AVC MC

O q* Output One Firms Profit Maximization under Perfect Competition Total Revenue = P*q* = O P E q* Total Cost = ATC*q* = O ATC A q* (total) Profit = TR TC = ATC P E A Variable cost = AVC B Q* 0 Fixed cost = AVC ATC A B Profit per unit = = P ATC = E A Profit per unit is also called the markup on cost per unit. If profit per unit (P-ATC) is multiplied by the quantity produced (q*) then the result is (total) profit. (P-ATC)*q* = P*q* q**ATC = TR TC = total profit Comparison on the total approach and the Marginal Approach Profit under the total approach is a vertical distance while in the marginal approach it is a rectangle. In the vertical approach at the vertical distance slope of total revenue=slope of total cost or MR = MC as in the marginal approach.

65

The Shutdown Decision (in the short-run)

This is illustrated in terms of the second profit maximization rule.

The second profit maximization rule: The shutdown rule.

The first profit maximization rule (P = MC) gives either the maximum profit or the minimum loss. If the firm is producing at a loss, the firm profit maximization rule does not specify whether the firm should produce or shut down. The firm can produce while realizing a loss in the short-run. However, it should compare the loss with the fixed cost. If loss < fixed cost, the firm should not shut down (it should produce, q*>0) If loss > fixed cost, the firm should shutdown (it should not produce, q*= 0) The shutdown rule can also be cast in terms of the price (P) and the average variable cost (AVC) by eyeballing without mentioning the fixed cost and the loss.

If P > min AVC (then loss < fixed cost), then the perfectly competitive firm should produce (q*> 0) in the short run. If P < min AVC (then loss > fixed cost), then the perfectly competitive firm should shutdown (q* = 0) in the short run.

Case 2: Loss/no shutdown: Example: P= $5, q* = 5 units, FC = $60, ATC = $15 and loss = $50. Since this firm is making a loss, should it shut down? Loss=$5*5 - $15*5 = $50 < FC (no shutdown).

66

MC Price costs ATC* Loss P AVC* E B Min AVC D-curve A ATC AVC

q*

Output

Loss with no Shutdown: Price is above Min AVC (or loss < FC) TC = O ATC* A q* TR = O P E q* Loss = [P ATC* A E ] FC = AFC*q* = [AVC* ATC* A B] which is greater than the loss (no shutdown: loss < FC). Also, compare P with min AVC*??? By eyeballing, price P is above AVC*.

67

Case 3: Loss with Shutdown: Price costs ATC* Loss A MC ATC AVC

AVC* P

B E

Min AVC

D-curve

q*

Output

Loss with Shutdown: Price is below the Min AVC at Point B TC = O ATC* A q* TR = O P E q* Loss = [P ATC* A E ] > FC = [AVC* ATC* A B] Since the loss exceeds FC, the firm is better off to just accept to pay the fixed cost and shutdown in the short run (q* = 0).

68

Determinants of Supply (in the short run)

Since FC is fixed in the short run, production decisions are dominated by marginal costs. Thus, the quantity supplied will be affected by all the forces that alter MC. Thus, the determinants of a perfectly competitive firms MC or supply in the short-run include: Prices of factor inputs or production costs (labor wage, capital rental price,

etc.) Technology (productivity) Expectation (perception of the future price) Taxes and subsidies (affects disposable profits)

These determinants shift the supply curve because they shift the MC curve.

Derivation of short-run supply curve under perfect competition: Use the first rule only (no shutdown) if there is a positive profit. Use the two rules if there is a loss. The first profit maximization rule says:
MC = P (or marginal profit = P - MC = zero). This rule is sufficient if the firm is making a profit. Thus, under perfect competition MC (=P) is the lowest or minimum price a firm will accept to supply a given quantity of output. In this sense, the MC curve is the supply curve for the perfectly competitive firm in the short run. Each time the price changes it will intersect MC at a new point, and a new output q* will be chosen. In this case the positive relation between MC and output is really a relation between P and output. Therefore, the supply curve traces the MC curve. To derive the supply curve we need to use the two rules if there is a loss.

From the 2nd profit maximization (shutdown) rule:

The firm shuts down or q* = 0 if P < min AVC (or loss > FC). Then the lowest point on the MC curve is the one associated with the shutdown corresponds to min AVC. The other points on the supply curve are associated with P being greater than min AVC. Thus, the supply curve is the MC above the min AVC curve.

69

Supply Curve is MC curve above min AVC

MC AVC

Min AVC

70

Chapter 8 (23): Competitive Markets

The Market Supply Curve We know that individual firms supply curve under perfect competition in the short run is the MC curve above the min AVC. How about the market or industry supply curve under perfect competition? It is the sum of the individual firms supply curves above their min AVC curves. Suppose we have 3 farmers: A, B and C.

For each price, determine where the price P equals MC for each farmer. Then add up horizontally the output levels for all farmers. This makes one point on the market supply. Repeat this process for each price. Then connect the aggregate output points. This will make up the market supply. Market Entry Since entry barriers are low, if positive economic profit exists in the market then new firms will enter the market. This will shift the market supply curve to the right and in the Market supply/demand framework the market price will drop. The end result is that the individual firms profit will shrink. This process of market entry will continue until economic profit becomes zero (or normal economic profit pays all opportunity costs) in the long run under perfect competition. In this case, Normal econ profit = total revenue explicit cost - implicit cost = 0 Or under zero or normal economic, accounting profit = implicit cost (owners/managers just make their own opportunity costs) no more no less. But if there is positive economic profit then those owners/managers make more than their opportunity costs. Positive econ profit does not exist in the long-run under perfect competition. Must be zero.

71

After entry, the supply-curve in the market graph shifts to the right, thus creating the new equilibrium E2. As a result, the price drops from P1 to P2 and the positive econ profit shrinks in the typical firms graph to the purple rectangle.

Entry will continue as long as economic profit is positive. It stops when it becomes zero (normal econ profit). In this case, the price line will touch the ATC at its minimum (point m in the individual firms graph). Since now we have Min ATC = P (multiply both sides by q) then ATC * q = P*q or TC = TR or zero econ profit. Or profit = TR TC = 0 (normal economic profit in the long run under perfect competition).

72

Industry D

Firm

ATC

Min ATC

Q*

q*

Long run equilibrium conditions under perfect competition: 1. MC = P. 2. P = min ATC (zero or normal economic profit)

73

Chapter 9 (24): Monopoly

Market Power
Market power is the ability of the producer to alter the price of the product and have P > MC. In chapter (8) 23 for perfect competition, there are 2000 catfish producers. Under perfect competition, the product is homogenous. No individual catfish producer has the ability to alter price of catfish. The demand for this producer is a horizontal line. This means the perfectly competitive producer is a price taker. The price is set by the market which can alter the price and the firm is a price-taker.

If the perfectly competitive firm increases the price it would lose all its customers. Only the firms collectively can change output and consequently the price. Downward sloping demand curve: If the firm has market power, then it can alter the price of its product without losing all its customers because some customers will continue to buy. In this case, firms with market power confront a downward sloping demand curve for their own output.

74

Price

d-curve

quantity Figure: demand curve for firms with market power

Monopoly
The entire output in the market can be produced by a single firm. In this case, the firm is a monopoly. So the monopolistic firm is the market. Therefore, the demand curve facing the monopolist is identical to the market demand curve for the product, and thus has a downward slope.

Price

$5 3

Demand curve for a monopoly 0 4 6 Q

Figure: Demand curve for monopoly

75

Price, Marginal Revenue and Marginal cost

Marginal revenue is the contribution of the additional unit of output to the total revenue. MR = TR / Output = (TR2 - TR1)/(Q2 - Q1). If the demand curve is downward sloping then the contribution of each additional unit and all the previous units decline as output increases.

Conclusion: Price is not constant and MR is lower than the price under monopoly.

MR < P and P is not a constant under monopoly. Example: If P = 10 -2 Q then MR = 10 2*2Q (has twice the slope). Graph P equation and MR equation.

76

Profit Maximization under Monopoly: Two Decisions

Therefore, the first profit maximization rule is expressed as

MR =MC Q* P*
This rule will determine producers equilibrium output q* and the price P*. Q A B C D E 1 2 3 Q*=4 5 Price $13 12 11 P*=10 9 TR $13 24 33 $40 ? MR= TR/ Q $11 > 9 > 7 = 5 < TC $16 21 27 34 44 MC= TC/ Q $5 6 7 10 $6=$40-$34 Profit= TR-TC

MR = MC
$7 = $7 Then Q* = 4 baskets and P* = $10 Max profit = TR TC = $40 $34 = $6 or (another way): = (Profit per unit)*Q* =(P* ATC*)*Q*= P* TC*/Q*)*Q*= (P* 34/4) *Q* = ($10 - $34/4)*4 = ($10 - $8.5)*4 = 1.5*4 = $6 where 8.5 = TC/Q=ATC.

Profit maximization under monopoly TR = O P A q* = P*Q =$10*4 = $40 TC = O ATC* B q* = ATC*Q= $8.5*4 = $34 Profit = P A B ATC* = $40- $ 34 = $6

77

Market Power at Work

Assume a mythical Universal Electronics has a patent on producing microprocessors and thus constituting a monopoly. In this case, there is a legal barrier to entry (PATENT). Assume for illustration purposes that this monopolist produces from plants which are identical to the typical firm under perfect competition (this is not usually the case because monopoly has larger sizes to generate economies of scale). Suppose the demand facing the monopoly plant and the perfectly competitive firm is the same. Example: Figure (24.4) or (9.4) (Panel b: the market). The intersection of market supply and demand determines the market equilibrium at point X for the competitive industry (D = S). The market equilibrium price is $1,000 per computer and market equilibrium quantity is 24,000 computers.

Q*PC = 600 units, P*PC =$1,000 and ATC PC = $700. Market Q*PC = 24,00 units Q*M = 475 units, P*M =$1,100 and ATC M = $630.All these numbers are assumed. The perfectly competitive price per computer is $1000 and the competitive industry produces 24,000 computers. In Panel (a) (the firms competitive equilibrium) the typical competitive firms equilibrium (P=MC) is at point C and this firm produces 600 computers. All this information is assumed. For monopoly, in Panel (a) the monopoly equilibrium (MR = MC) is at point M. The monopoly price is at point W ($1,100 per computer) on the demand curve. The monopoly output for the typical plant is 475 computers. 78

Conclusions: The monopolist restricts output and charges a higher price than the perfectly competitive firm. P*M > P*PC ($1,100 > $1,000) Q*M < Q*PC ( 475 units < 600 units) In this case, monopoly aims at realizing a higher profit than perfect competition. Question: 1. how many firms are in the perfectly competitive market? (Market output / Firms output) = 24,000 / 600 = 40 firms (not high enough for perfect competition) Question 2. Does the monopolist prefer an elastic or inelastic demand? Elastic because if demand is inelastic then MR is negative. Here is the relationship between MR and price elasticity of demand: MR = P* [(1+EDp)/ EDp]. What would MR be if EDp = -1? -1/2? -2?

Reduced Output
Question 3. Why does monopoly restrict output in comparison to perfect competition? The typical monopoly plant cannot produce 600 computers like the typical perfectly competitive firm because at this output level, MR (at point B) is less than MC (at point C) which means a loss for the typical monopoly plant. Thus this plant must reduce output to 475 computers because at this level MR = MC (at point M).

Monopoly Profit
Compare the monopoly plants profit with perfect competition firms profit. Monopoly Plants total profit = TRM - TCM = [P*M *Q*M] [Q*M * ATC*M] = [$1,100 * 475] [475 * $630] = $223,250 where $630 is the assumed monopoly plants ATC at point K and 475 is the equilibrium output. We can calculate this monopoly plants total profit using the profit per unit method. Monopoly Plants Total profit = profit per unit * quantity =(P*M - ATC*M) * Q*M = ($1,100 - $630) * 475 = $223,250

79

Figure 24.6 (or 9.6): Competitive profit vs. monopoly profit for the entire company (not just for one plant)

Competitive Profit
It is the area defined by [T, $1000, X, U] which is smaller than the profit purple area for monopoly. Competitive Firms short-run total profit = (P*PC ATC*PC) * Q*PC = ($1,000 - $700) * 600 = $180,000 The competitive firms long-run profit is zero (i.e., P = min ATC or TR = TC) because of free entry (exit) which drives positive profit (loss) to normal economic profit.

Barriers to Entry
The presence of positive economic profit whether under monopoly or perfect competition would entice other firms to enter the market. Under perfect competition in the long run high profits and low barriers to entry lure newcomers to this market, and this entry would bring about an enormous expansion of output and a steep decline in the price. In Figure 9.6 the longrun equilibrium price for a competitive industry is at point V which corresponds to where:

P = MC = min ATC (normal or zero economic profit in the long-run)

Profit per unit = P - ATC= 0. Output qc is much lower in the L/R than in the S/R after entry.

Under monopoly, our company Universal Electronics is assumed to have an exclusive patent on microprocessor chips. This is a legal and a very high barrier to entry. In this case, this monopolist can prevent a surge in output and this can keep the prices so high.

Example of monopoly in live concert industry:

80

Clear Channel Entertainment and Ticket Master have controls on the live concerts. The cost of a ticket for example to a Godsmacks concert that was held in Verizon wireless amphitheater (Irvine, CA) in the summer 2001 was $16.5. The monopolist added a 116% market convenience fee, facility fee, handing fee and a parking fee to the cost of the ticket, boosting the price to $ 35.60 a ticket.

81

Chapter 25 (10): Oligopoly

Market Structure
There are two basic determinants of a market structure: 1. The number of firms in a products market. 2. The relative size of firms in this market (market concentration). Monopoly and perfect competition are two types of market structure. The higher the number of the firm and smaller the relative size of the individual firm, the closer the market is to perfect competition and vice versa. Monopoly has one firm with one product. Between those two market structures, there are many degrees of market power. To sort these degrees out, we classify firms into five market structures: perfect competition, monopolistic competition, oligopoly, duopoly and monopoly. If we exclude perfect competition, we call the other four structures imperfectly competitive. Under imperfect competition, the firm in a particular market has some degree of market power over prices because of its differentiated product or its size relative to the overall market (or both). Oligopoly is a market structure that yields a market power primarily because there are a few firms controlling most of the output in the market. These firms could produce homogenous product (example: the steel industry) or heterogeneous product (the airline industry). In the long distance telephone service market, there are 800 firms supply this service. But three of them (AT&T-MCI and Sprint merged) account for 74% of all calls. Determinants of Market Power There are four determinants of market power: 1. Number of firms in the market. 2. Size of each firm in the market. 3. Barriers of entry. 4. Availability of substitute goods or product differentiation. 5. Production costs and technolog. Quantitative Measure of Market Power: Although there are four determinants of market power, one quantitative measure is usually sufficient to gauge market power. The standard measure is the concentration ratio. Concentration Ratio: C4 This measure relates the size of few individual firms to the size of the overall market. It tells the share of the largest few (usually four) firms relative to the total market. 0= <C4 = (S1 +S2 + S3 +S4)/ Total industry sales = (S1 +S2 + S3 +S4)/ ST =<1.

82

where S1 is sales of the first largest firm in dollars, S2 sales of the second largest etc and ST is the total sales of all firms in the industry. If C4 is close to zero it means that there are many small sellers in the market and the market structure is close to perfect competition. If it is close 1, then ..? Example 1: Suppose the industry has six firms and the sale of the firms from the largest to the smallest are: $40, $30, $20,10, $5 and $5. Then C4 = (40+30+20+10)/110=100/110 = 91%. where ST = $110. Example 2: suppose there are six firms and their sizes in dollars are: $25, $25, $20, $15, $10 and $5. Here total sales ST = $100 C4 = (25+25+20+15)/100 = 85/100??? As indicated above, C4 is given by C4 = (S1 + S2 + S3 + S4)/ST which can be expressed in terms in terms of market shares: C4 = (S1/ST) + (S2/ST) + (S3/ST) + (S4/ST) or 0 < C4 = w1 + w2 + w3 + w4 1 where wi (i = 1,2,3,4) are the four firms market shares. If C4 is close to zero it indicates there are many sellers, giving rise to much competition (see wood containers and pallets in Table). If it is close to one, it implies little competition, see motor vehicles industry and breweries.

83

84

Table 25.3 (or 10.3) (Market Power in US product markets) gives the concentration of the market share accounted for by the largest four or less firms in a particular market. In the baby food market and in the infant breakfast market, four firms or less in the each of these markets control about 100% of the market. In the laser eye surgery two firms control 100% of the market.

85

APPENDIX

Measure of Industry concentration

There are two measures of share concentration: C4 and HHI.

86

The HerfindahlHirschman index (HHI) This is the second quantitative measure of market concentration and this measure is used in courts. Let firm is share of total industry output denoted by

wi = Si / ST
HHI is defined as the squared market shares of all firms in an industry.

HHI = [ {(w1)2 + (w2)2 + .. +(wn)2 }*10,000]

The multiplication by 10,000 is to eliminate the need for decimals, squaring the shares means giving higher weights to higher shares in the index. 0 < HHI 10,000 If HHI = 10,000 it means there is a single firm in the industry and w1 = 1. A value close to zero means very small firms in the industry. The government cutoff point is for concentration is 1,800. In this case the industry is considered highly concentrated and the Justice Department may challenge or block a horizontal merger if increases the HHI by more than 100 points. However, the Justice department permits the merger in industries that have high HHI if there is evidence of significant foreign competition, an emerging new technology, increased efficiency or when one of the firms has financial problems. Industries with HHI below 1,000 are generally considered unconcentrated by the Justice Department and mergers are usually allowed. If HHI is between 1,000 and 1,800 the Justice Department relies on other factors such as economies of scale. Demonstration 7-2 Suppose an industry has three firms. The largest firms sales are $30 and the remaining two have sales of $10 each. Calculate both the HHI and the four-firm concentration ratio.

HHI = [ {(w1)2 + (w2)2 + (w3)2 }*10,000]

HHI = 10,000*[(30/50)2 + (10/50)2 + (10/50)2 ] = 4,400 Would the government challenge any potential merger in this industry? Yes? Why? 4,400 > 1,800.

87

The four-firm concentration ratio is: C4 = (S1 + S2 + S3 + S4)/ST C4 = (30+10+10)/50 = 1, because the three firms account for all industry sales. Oligopoly Behavior: Assume that the initial condition in the fictitious computer market is that there are three firms in this market: Universal Electronics, World Computers and International Semiconductor. Producer Universal World International Total Output (Computers per month) 8,000 6,500 5,500 20,000 Market share (%) 40.0 32.5 27.5 100.00

Assume that the initial price is $1,000 per computer. The consumers are willing to buy only 20,000 computers. This is the market demand at this price.

The Battle for Market Share

88

Universal electronics can increase it market share by, say, 1,000 computers to increase its sales from 8,000 to 9,000 computers. If total market sales stay at 20,000 computers per month, then the other two firms will face a possible reduction in their market shares. Universal can sell the 1,000 increase at either the existing price ($1,000 a computer) or by reducing the existing price, say, to $900 per computer. Case1: Universal Electronics is selling at existing price. In the face of increase in production by Universal, the two other firms (World and International) can defend their market shares by following two strategies: At the existing price, they may step up their marketing efforts to differentiate their products (product differentiation strategy, i.e., nonprice competition strategy). They may cut prices on their computers (price competition strategy). Product differentiation strategy may maintain the two firms market shares but cutting prices may bring them more customers and could increase their market shares. Universal will respond to cutting prices by lowering its own price to $900 per computer. This means that the three companies become more competitive and there will be a downward slide along the market demand. Now the initial situation has changed (see Figure 10.2 or 20.2).

Figure 10.2: Rivalry for the Market Shares Threatens an Oligopoly Case 2: Universal Electronics is selling at lower price. The other two firms will retaliate by cutting their prices if Universal Electronics lowers its price to increase market share. In this case, the price slides downward along the market demand as in Fig. 10.2.

89

Accordingly, it is safe to conclude that an attempt by an oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price. The three oligopolists will end up using price reductions as weapons in the battle for market shares, the kind of behavior normally associated with competitive firms. This is why oligopolists avoid price competition and instead pursue non-price competition (e.g., advertising, product differentiation). See the In the News box Pop Culture: RC Cola Goes for the Youth market. It spent $15 million on a new advertising campaign to cast its product as the hip alternative to corporate colas. RC Cola also added new products. The Kinked Demand Curve (Price Stability) It is rational to assume that rivals do not match price increases. That is, if universal decides to increase the price of its computer, it is reasonable to assume that World and International will not match the price increase. On the other hand, it is rational to assume that rivals will match price reduction. This rational assumption produces a kinked demand curve for the oligopolist. This demand is a composite of two demand curves: the no-match demand curve (d1) and the match demand curve (d2) in Figure 10.3.

Figure 10.3: The Kinked Demand Curve confronting an Oligopolist

90

Price

D1 No Match A

$1,000

Match

D2 8,000 Kinked Demand Curve Q

Oligopoly Vs. Competition We will consider two models of oligopoly behavior: sticky price (kinked demand) model and the shared monopoly model. The Sticky Price (kinked demand) Model: In this oligopoly model prices are stable because oligopolists avoid starting price wars, which will eventually destroy their oligopoly profits. (Coke Vs Pepsi in 1977). This model is motivated by two assumptions. First, there is a common satisfaction with market shares or trust among the oligopolists. Second, there is a cost cushion which will not change the price if the cost changes within a specific gap. This gap is called the marginal revenue gap which is created by the kinked demand curve. The kinked demand curve is a composite of two demand curves: the no-match demand curve (d1) and the match demand curve (d2). Corresponding to these demand curves, there are two marginal revenue curves: MR1 which corresponds to d1 (segment SF) and MR2 (segment GH) which corresponds to d2. At the kink point there is a MR gap between MR1 and Mr2, which the MR gap FG. In this kinked demand model each firm starts down the demand curve (d1) and then switches to demand curve (d2) at the kink point A. Correspondingly, we start from point S on MR1 and slide down to point F, corresponding to our slide on d2 at point A, we slide 91

on MR2 from G down to point H. Just below the kink, there is the MR gap FG. This gap creates a cost cushion that leads to stable prices

Fig. 24.5 or 10.5: An oligopolists marginal revenue . If the MC curve passes through the MR gap, modest shifts, upward or downward, in this curve will not change the industry price or the firms output. Fig.10.6 (the cost cushion) shows the shifts in the MC1 curve to the MC2 and MC3 curves without a change in output or price ( price stability). Recall, the 1st profit maximization rule requires that MR = MC q* p*

Fig: 25.6: the Cost Cushion

92

The Shared Monopoly Model: The three oligopolists may want to coordinate decisions and act like a shared monopoly because price competition would destroy their profits. For that to happen, the three monopolists must have common view of total industry market demand, satisfaction of market share and price coordination. In this case, they maximize joint total industry profit and determine output and price like a monopoly. This is they set: Industry MR = Industry MC Q* P*. Here where industry demand = Industry supply determines the industry output Q* and also the market price P*. Note that MC is the horizontal sum of all oligopolists MCs which gives the industry or market supply. Then they use the market shares to slice Q* among themselves to determine the individual outputs.

Figure 25.4 or 10.4: profit Maximization under shared monopoly. World view: OPEC to cut output by 1 million barrels. OPEC is an example of shared monopoly. Coordination Problem Successful oligopoly will achieve monopoly-level profit if it solves the coordination problem. This may not be easy.

93

1. Price fixing (e.g: laser eye surgery inflated price by $500 per eye). Price fixing does not need agreements. It can be achieved by price leadership. Just follow the leader in price! 2. Allocation of market shares (this transforms an oligopoly into a cartel). n Game Theory The game includes: players which are the firms, strategies which are plans of actions or decisions, payoffs which are profits, and solutions. There are four types of solutions: Nash equilibrium, cheating, collusion and no Nash equilibrium. Nash equilibrium means the players have done their best and have achieved their best payoffs. The can not improve their payoffs without hurting other players. Collusion does not exist in one shot game because there is no future for the players play. It can exist in infinitely repeated games where future exists. One-shot game means that the game is played one time only. So cheating is almost certain in one-shot games because the game is over after it is played once and the cheater cannot be punished by the other player. In infinitely repeated games, the game is played infinitely many times and the cheater can be punished in this came. This gives the players incentives to collude or cooperate with each other without cheating. A player can have a dominant strategy which gives him/her the highest payoff compared to his/her other strategies, regardless of the strategies of the other player. If both players have dominant strategies that will be Nash equilibrium. If players have dominant strategies, they tend to play those strategies. In the previous example about computer, the three oligopolists are not independent in their price and output decisions. They have to take into account rivals reactions. Thus, in oligopoly there is strategic interaction among firms. In our case, there are four strategic options that could affect gross profits (the payoffs) in the industry. Suppose Universal is contemplating a price cut. It has four options as seen below:

94

The two off-diagonal cells are called the cheating solution where in one of these cells Universal cheats while the rival does not, resulting in huge gains for Universal and loss for the rival, and the opposite is true in the other cell where the rival cheats and Universal does not. In the second diagonal cell, both firms collude not to reduce the price. So this is the collusion solution in this cell which is illegal. The first diagonal cell is called Nash equilibrium because you cannot make any of the firms better off with hurting the other one. Demonstration: Advertising and Dominant Strategies Firms advertise in order to entice customers from other competing companies. Suppose there are two firms: A and B, and two strategies: to advertise or not to advertise as illustrated in Table 10-3. Table 10-3: An Advertising Game Firm B Strategy Advertise Do not Advertise The profit maximizing strategies for both firms are to advertise to cancel each other advertising out. These to-advertise strategies are dominant strategies for both 95 Advertis e $4,$4 $1,$20 Do not Advertise $20,$1 $10,$10 Firm A

firms. For each player TO ADVERTISE brings more money than the DO NOT ADVERTISE, regardless of what the strategy of the other player, because of cheating. Thus if both advertise each will make $4. Note that if both collude and agreed to Do not advertise each will make more money ($10). But collusion does not work in one-shot games. If one cheats and advertises it will make $20 and the one that did not advertise will make $1. In one-shot game, the game is over right after it is played and there is no chance for punishment. So collusion (10, 10) does not work. Here advertising brings more money. The advice is to advertise

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Chapter 11

Monopolistic Competition
Examples: fast-food, toothpaste, soap, shampoo, cold medicine, etc. Brands of toothpaste: Crest, Colgate-Sub-brand of Colgate: Shrek Bubble Fruit http://images.search.yahoo.com/search/images? _adv_prop=image&fr=ush_onnetwork_fp&va=shrek+bubble+fuit Characteristics: Monopolistic competition has three key characteristics: 1) Each firm competes by selling differentiated products. The differentiated products are highly substitutable but are not perfect substitutes like under perfect competition (i.e. the cross price elasticity of demand between the products of the firms is high but not infinite). Crest is different from Colgate, Aim, and Close-up etc. Therefore, because of differentiation there is consumer loyalty on part of some consumers. Consumers are willing to pay 25 to 50 more (but may be not a 1$). Therefore, Proctor &Gamble has some but limited monopoly power. However, some of the customers may move to the substitutes. Therefore, advertising is important under monopolistic competition. 2) The demand curve is downward sloping but is fairly price elastic. The demand elasticity for crest is 7. Thus, because of its limited monopoly power, P&G charges a price that is higher than marginal cost but not much higher. 3) There is free entry and exit. Its easier to introduce, new brands of toothpaste than to start new models of cars. The latter requires large capital and technology to realize economies of scale. The free entry and exit implies that economic profit under monopolistic competition is zero (normal). Equilibrium in the short run and the long run: Like in monopoly, firms under monopolistic competition have monopoly power and, thus, they face a downward sloping demand curve. Therefore, MR < P. The profit maximization rule is MR = MC.

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In the short run the firm can earn a positive economic profit as shown below.

MC

ATC

P* Profit $ ATC* MR = MC DSR

Q*SR

MR

Profit Maximization under Monopolistic Competition

If there is a positive profit there will be an entry into this market and prices should drop. This will shift both demand and MR curves of the individual firm down, and profit will shrink until it becomes zero as shown by the tangency between the new inverse demand P and ATC curve (see next figure).

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Effect of Entry on Monopolistically Competitive Firms Demand Like in perfect competition, because of free entry and exit firms under monopolistic competition earn zero economic profit in the L/R. The point where MR=MC should correspond to the point where the demand curve is tangent to the ATC curve to realize zero profit. The Long run The positive profit will induce entry by other firms who introduce competing brands. The incumbent firm will lose some market share and the demand curve will shift down. ATC and MC may also shift when more firms enter the market. Assume no shift in those cost curves. The DLR will shift down until it becomes tangent to the long run AC corresponding to where MR=MC. In this case the profit is zero. We have two rules for the long run under monopolistic competition:

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1. MR = MC (The 1st profit-max rule) 2. P = ATC > min ATC zero profit (because R = TC). See figure below. This
condition is different from the long run condition for perfect competition P = min ATC.

MC

AC

ACLR = P*LR

Q*LR

MRLR

DLR

Long-Run Equilibrium under Monopolistic Competition Implication of Product Differentiation: Advertising As mentioned above, monopolistically competitive firms differentiate their products in order to have some control over the price. In this case, the products are not perfect substitutes, and this makes the demand less than perfectly elastic. The implication of this is that some consumer wont switch when the prices go up within a limit, while others are willing to switch. To keep the other consumers from switching to the substitutes, firms under monopolistic competition spend a lot of money on advertising. There are two kinds of advertising under monopolistic competition. 1) Comparative Advertising: This involves campaigns designed to differentiate a given firms brand from brands sold by competing firms. Comparative advertising is common in the fastfood industry, where firms such as McDonalds attempt to simulate demand for their hamburgers by differentiating them from competing brands. This may induce

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consumers to pay a premium for a particular brand. This additional value for a brand is called brand equity. 2) Niche Marketing: Firms under monopolistic competition frequently introduce new products. The products could be totally new or new improved. Firms can also advertise a product that fills special needs in the market. This advertising strategy targets a special group of consumers. For example green marketing advertise environmentally friendly products to target the segment of the society that is concerned with the environment. The firm packages a product with materials that are recyclable. These advertising strategies can bring positive profits in the shortrun. In the longrun other firms will mimic their strategy and reduce profits to zero

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