Lecture 8

Dynamics: Cobweb Model

Consumer Theory
Consumers optimize their well being
subject to a budget constraint
Enjoyment from consumption
referred to as utility

Good 1:
Number of
Units
Purchased

Total Value

$18

$30

$36

$4

$8

$12

Good 2:
Number of
Units
Purchased

Total value

Price of good 1= $12 , price of good 2 = $3

Good 1:
Number of
Units
Purchased

Total Value

$18

$30

$36

$4

$8

$12

Good 2:
Number of
Units
Purchased

Total value

Price of good 1= $12 , price of good 2 = $3

Income = $18

Good 1: Number of
Units Purchased

Total Value

18

30

36

Marginal value

18

12

Marginal value per

dollar

1.5

0.5

Good 2: Number of
Units Purchased

Total value

12

Marginal value

Marginal value per

dollar

1.33

1.33

1.33

Price of good 1= $12 , price of good 2 = $3, Income = $18

Good 1: Number of
Units Purchased

Total Value

18

30

36

Marginal value

18

12

Marginal value per

dollar

1.5

0.5

Good 2: Number of
Units Purchased

Total value

12

Marginal value

Marginal value per

dollar

.8

.8

.8

Price of good 1= $12 , price of good 2 = $5, Income = $18

Budget Set
Set of goods and services you can
buy with the money you have
available to you

 Price of coke = $1 per unit, price of

snickers =$2 per unit
snickers
1 unit of coke, 2 units of snickers
2.5

coke
List some other combinations

How do you decide what to choose?

You rank all the combinations and choose your best one.

snickers

2.5

3 units coke, 1 unit snickers

coke

Now suppose prices change

Price of coke = $1 per unit, price of snickers =$1
per unit

snickers

2 unit of coke, 3 units of snickers

coke
List some other combinations

You rank all the combinations and choose your best one.

snickers
5
2 units of coke, 3 units of snickers

coke

Individual Demand for

snickers
Demand curve for snickers

Price of
snickers
2
1

Quantity of
snickers

Notes for individual demand

Income constant
Price of other goods constant
Tastes constant

Demand curve
Price Rs.
Willingness to pay
Rs. 30
Rs. 15

10

Quantity of
Cake per week

Market Demand: Horizontal Summation

Marginal Cost
The cost of producing one more unit of good or
service

Decreasing marginal returns

Marginal Product: The additional
units of a good or service that can be
produced with an additional unit of
input ( e.g. labour)
Principle of decreasing marginal
returns
The marginal product of an input
decreases as additional units of the
input are employed

Output

Labour units Total Cost

10

10

2.5

25

15

4.5

45

20

Price of labor = Rs. 10

Marginal
Cost

Marginal cost curve

Rs. 30

Rs.
15:Market
price
20

Quantity of
Cake per week

 If the market price is Rs. 15 how

much should producer produce?
Marginal
cost in Rs.

1
51
0
1

Quantity produced

 What if the price changes if the

producer produces more?
We assume price remains constant
firm is a price taker
Marginal cost curve is the supply
curve of the individual firm in a
perfectly competitive market

Price taker demand curve

S
30
D

QD = 625 25P
QS = 175 + 15P
P = 45
Q = 400
100 firms, 4 units each
Suppose 1 firm increases output to 5(25%
increase)
QS = 176 + 15P
P = 44.9
1000 firms?

 P = MR

Producers decision

MC
Rs. 30

Quantity

 Producers maximize profit by selling

the quantity for which marginal
revenue equals marginal cost

 Long run equilibrium is attained

where MR=MC=ATC
Economic profit is zero and only
normal return is realized

Firm and market supply

price

price
ATC

Sshort run

AVC

quantity

quantity

Monopoly
Single seller that produces a good with
no close substitutes
Sources of monopoly
What could be the causes of
monopoly to exist

Barriers to entry
Legal barriers
Patents
Government granted franchises

Natural barriers
Economies of scale
Average cost of production is falling
through the relevant range of consumer
demand

Is at the opposite extreme of perfect

competition. Monopolist is a price
maker as against perfect competitor
is who price taker

Rs

Profit maximising under

monopoly

AR
MR
O

Rs

AR

MC

AR
MR
O

Qm

Rs

MC
AC

AR

AC

b
c

AR
MR
O

Qm

Case Study
The Market Value of Monopoly Profits in
the New York City Taxi Industry
NY city requires a license (medallion) to operate a
taxi. These are limited in numbers and confer a
monopoly power (I.e. ability to earn economic
profits) to owners. Value of medallion is the PV of
future streams of earnings from medallion. For
example the # of medallions in NY city have
remained at 11787 since 1937 till 1996. In 1996 it
was increased by only 400 to 12187 medallions.
The value of medallion has risen from $ 10 in
1937 to 250000 in 1999 (18% p.a.). The price of
medallion is lower in other cities (e.g. $ 90000 in
Boston, $ 25000 in Chicago) reflecting much
lower capacity in these cities.

Case Study
The Market Value of Monopoly Profits in
the New York City Taxi Industry (Contd..)
If the city authorities could give freely the
medallions then the price of medallions could fall
to zero. Alternatively the Municipality has
allowed sharp increase in the radio taxis although they are much less flexible.
As a result the profit of NY taxi operators has
come down from 32% to only about 11% in 1999.

Monopoly
Monopoly

Comparison of monopoly
with perfect competition:
(a) same industry MC curve

Rs

MC

Equilibrium of industry under perfect competition and monopoly:

with the same MC curve

P1

AR = D
MR
O

Q1

Equilibrium of industry under perfect competition and monopoly: with

the same MC curve

MC

Rs

P1
P2

AR = D
MR
O

Q1

Q2

Rs

Equilibrium of industry under perfect competition and monopoly: with

the same MC curve

MC ( = supply under

perfect competition)

P1
P2

AR = D
MR
O

Q1

Q2

Monopoly
Monopoly

Comparison of monopoly
with perfect competition:
(b) monopoly has lower MC
curve (i.e. it is experiencing economies
of scale)

Equilibrium of industry under perfect competition

Rs
and monopoly: with different MC curves

MCmonopoly

P1

AR = D
MR
O

Q1

Equilibrium of industry under perfect competition and

monopoly: with different MC curves

MC ( = supply)perfect competition

Rs

MCmonopoly
P2
P1

AR = D
MR
O

Q2

Q1

Equilibrium of industry under perfect competition and monopoly:

with different MC curves

MC ( = supply)perfect competition

Rs

MCmonopoly
P2
P1

AR = D
MR
O

Q2

Q1

Equilibrium of industry under perfect competition and monopoly:

with different MC curves

MC ( = supply)perfect competition

Rs

MCmonopoly
P2
P1
P3

AR = D
MR
O

Q2

Q1

Q3

MONOPOLY
Disadvantages of monopoly
high prices / low output: short run
high prices / low output: long run
lack of incentive to innovate
X-inefficiency

Advantages of monopoly
economies of scale
profits can be used for investment

MONOPOLY
Disadvantages of monopoly
high prices / low output: short run
high prices / low output: long run
lack of incentive to innovate
X-inefficiency

Advantages of monopoly
economies of scale
profits can be used for investment
promise of high profits encourages risk taking

Deadweight loss under

monopoly

Deadweight loss under monopoly

MC
(= S under perfect competition)

Consumer
surplus
a

Ppc
Producer
surplus

AR = D
O

Qpc

(a) Industry equilibrium under perfect competition

Deadweight loss under monopoly

MC
(= S under perfect competition)

Pm

Consumer
surplus

Ppc

Deadweight
welfare loss

Producer
surplus

AR = D

MR
O

Qpc

Qpc

(b) Industry equilibrium under monopoly