char lee econ

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Today

I. A recap of the last two lecturesII. Inefficiencies in monopolyIII. Price discriminationIV. Regulation and alternativesV. Imperfect competition introducedVI. Monopolistic competition introducedVII. Pricing and output decisions in

monopolistic competitionVIII. Review questions

Homework Answers

Calculate the missing values in the following table

Number of Ice Cream cones Consumed

Total Utility Marginal Utility

1 6 6

2 5

3 15 4

4 3

5 20

11

18

2

Homework Answers

5 When Jeff’s mom offers him a second scoop of her homemade mashed potatoes at the family dinner table and Jeff’s marginal utility of that second scoop equals zero, how will he respond to his mom?He will refuse the second scoop, as he has reached his satiation point. He gets no more satisfaction out of eating the second scoop of mashed potatoes, and will thus decline.

Homework Answers

Jamie’s favorite food is pizza. Jamie eats pizza several times a week, but Jamie also eats chicken, fish, hamburgers and vegetables. Explain why Jamie does not eat pizza only.The more pizza Jamie eats, the lower his marginal utility (additional satisfaction) will be from eating more pizza. As marginal utility continues to decrease, at some point, the marginal utility per dollar for some other food will become greater than the marginal utility per dollar of pizza, at which point Jamie will start consuming other foods.

# books Marginal Utility of books

# Ice cream

Marginal utility of ice cream

# Workouts

Marginal utility of workouts

1 12 1 24 1 30

2 11 2 21 2 25

3 10 3 18 3 20

4 9 4 15 4 15

5 8 5 12 5 10

6 7 6 9 6 5

Celina has $12 to spend. Books cost $1, Ice cream costs $3, and workouts cost $10. How much of each good will she consume?

Write two equations where the first equation states the accounting profit and the second equation states economic profit. Why do economists define profit differently than accountants?Accounting profit = Total Revenue – Explicit costsEconomic profit = Accounting profit – implicit opportunity costsEconomists include implicit costs in our calculation of profit, whereas accountants ignore these costs.

What is the difference between the long run and the short run? In which of these is there a fixed input? What is the fixed input? Which one of these is identified with the planning horizon?

In the short run, capital is fixed, in the long run both capital and labor are variable. We associate the long run with the planning horizon

State the definition of marginal product. How does this differ from the definition of average product? Which term does the law of diminishing returns refer to?Marginal product is the additional output we get from adding one more unit of laborAverage product is the average amount of product each unit of input is responsible for producingMarginal product is affected by the law of diminishing returns

Today



A Recap

Let’s quickly go over what we’ve talked about the last two lectures 1. Pricing and output in perfect

competition 2. Pricing and output in monopolies

Perfect competition

Very many buyers and sellersStandardized product (no differentiation)Market entry and exit very easyFirms are price takersSo how do they decide what level of output to produce at?

Q MR=P=AR TC AC MC M0 - 100 - - -

1 110 155.7 155.70 55.7 54.30

2 110 205.6 102.80 49.9 60.10

3 110 253.9 84.63 48.3 61.70

4 110 304.8 76.20 50.9 59.10

5 110 362.5 72.50 57.7 52.30

6 110 431.2 71.87 68.7 41.30

7 110 515.1 73.59 83.9 26.10

8 110 618.4 77.30 103.3 6.70

9 110 745.3 82.81 126.9 -16.90

10 110 900.0 90.00 154.7 -44.70

11 110 1,086.7 98.79 186.7 -76.70

12 110 1,309.6 109.13 222.9 -112.90

The MR - MC approach

A firm that wants to maximize its profit (or minimize its loss) should produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit. In short, MR=MC.

For the perfectly competitive firm, the MR=MC rule may be restated as P=MC. This is because P=MR in perfectly

competitive markets.

Marginal Cost, Average Cost, Marginal Cost, Average Cost, and Average Variable Cost and Average Variable Cost CurvesCurves

Dol

lars

QuantityQuantity

Marginal CostMarginal Cost

Average CostAverage Cost

Average Variable Average Variable CostCost

Price = MR = DPrice = MR = D

Q*

Total Profit

Profit = TR – TC = (P – AC) x Q

Monopoly

There’s only one firm in the industryThe firm is the industryMarket entry impossible or illegalFirm is a price setter/makerBut if a firm wants to sell more of a unit, it must lower pricesThis will result in lower marginal revenues as quantity sold increases

Assume demand is a straight line, for example:Qd = 101 – P

Qd Price Total Revenue Marginal Revenue

12345678910

100 100 10099 198 9898 294 96

97 388 9496 480 9295 570 9094 658 8893 744 8692 828 8491 910 82

You can see marginal revenue decreases as we increase quantity

P Q TR MR AC TC MC 180 0 0 - - 100 - -

100.0

170 1 170 170 155.7 155.7 55.7 14.30

160 2 320 150 102.8 205.6 49.9 114.40

150 3 450 130 84.63 253.9 48.3 196.10

140 4 560 110 76.2 304.8 50.9 255.20

130 5 650 90 72.5 362.5 57.7 287.50

120 6 720 70 71.87 431.2 68.7 288.80

110 7 770 50 73.59 515.1 83.9 254.90

100 8 800 30 77.3 618.4 103.3 181.60

90 9 810 10 82.81 745.3 126.9 64.70

80 10 800 -10 90 900.0 154.7 -100

70 11 770 -30 98.79 1,086.7

186.7 -316.7

60 12 720 -50 109.13

1,309.6

222.9 -589.6

Pricing and Output in Monopoly Markets

Monopolies are also going to want to produce up until the point where marginal costs start to exceed marginal revenuesMonopolies are going to produce at a level where MR=MCThe exact same rule as perfect competitionEven though monopolies have the power to set prices, the are still limited by a downward sloping demand curve, and increasing marginal costs of production

Monopoly Output and Monopoly Output and PricePrice

Monopoly price

Monopolyoutput

Dol

lars

Quantity

Marginal Cost

Marginal Revenue

Demand

#1 the monopolist sets output to equate marginal revenue and marginal cost

#2 The monopolist charges as much as the market willbear for that output.

Profit, Breakeven, or LossProfit, Breakeven, or Loss

Price

Profit maximizing output

Dol

lars

QuantityMarginal Revenue

Marginal Cost

Demand

Average Cost

Number of unit

Profit per unit

Profit

Monopoly Breakeven, or Monopoly Breakeven, or LossLoss

Marginal cost

Average cost

Demand

Marginal revenue

Price

Profit-maximizing output

Quantity

Demand

Quantity

Marginal revenue

Marginal cost

Average cost

Loss-minimizing quantity

Price

Maximum profit is zero profit

Average cost exceeds price

Loss per unit Number

of units

Today



Efficiency and Price Discrimination

Monopoly is allocatively inefficient because the quantity that equates marginal cost and marginal revenue falls short of the quantity that equates marginal cost and demand The profit maximizing quantity is less than

the efficient quantity The area of deadweight loss shows the

benefits consumers would have received from the additional output minus the cost the firm would have incurred to produce it

SupplySupply

DemandDemandCompetitive

OutputQuantity

Maximum social surplus

Efficiency in perfect competition

The Inefficiency of The Inefficiency of MonopolyMonopoly

Monopoly Price

Monopoly Output

Dol

lars

Quantity

Marginal Cost

Demand = marginal benefit

Efficient Output

Average cost

Efficiency forgone:the deadweight lossfrom monopoly.

•

Marginal revenue

Today



The Inefficiency of Monopoly

It may be possible for monopolies to eliminate these inefficienciesThis would come through the practice of price discriminationPrice discrimination is when a firm has the ability to charge different customers or different customer segments different pricesIf the monopolist knows each individual’s demand, he can charge each the highest price they would be willing to pay, thus producing at a more efficient level

Price DiscriminationPrice DiscriminationPrice DiscriminationPrice Discrimination

1 2 3 4 5 6 7 8 9 10

$19$18

$17 $16

$15 $14

$13$12

$11$10 •

Marginal cost

Demand = Marginal benefit= Marginal revenue

$

Quantity

The arrows are prices, which differ from customer to customer

Efficient and profit-maximizing output

Price Discrimination

Another example of price discrimination is multi-part pricingMulti-part pricing depends upon the amount consumedThe monopolist sets the price high for the first units consumed, since those are the hardest to do without. The price for additional units could be lowerMulti-pare pricing causes marginal revenue to fall somewhere between the extremes of the monopolist with a single price and one able to practice perfect price discrimination

Today



Antitrust and Regulation

Antitrust law is a body of public policies designed to limit the abuse of market power, and is enforced by the justice departmentThe antitrust laws neither make monopoly illegal nor apply to monopolyAntitrust laws are intended to curb abuses of market power, of which monopolists have the most

Examples of Antitrust Legislation

Sherman Act (1890)Sherman Act (1890)

Federal Trade Commission Act (1914)Federal Trade Commission Act (1914)

Clayton Act (1914)Clayton Act (1914)

Robinson-Patman Act (1936)Robinson-Patman Act (1936)

Celler-Kefauver Antimerger Act (1950)Celler-Kefauver Antimerger Act (1950)

Antitrust PolicyAntitrust PolicyAntitrust PolicyAntitrust Policy

Exclusive dealing:

A firm prohibits its distributors from selling competitors’ products.

A firm assigns a geographic area to a distributor and prohibits other distributors from operating in that territory.A firm prices a product below the marginal cost of producing it to drive rivals out of business.

A firm charges different customers different prices for the same product.

Exclusive territories:

Predatory pricing:

Price discrimination:

GLOSSARY OF TERMS

Antitrust PolicyAntitrust PolicyAntitrust PolicyAntitrust Policy

A firm prohibits rivals from purchasing/using scarce resources (called essential facilities) that are needed to stay in business.

Refusals to deal:

Resale price maintenance:

Tie-in sales:

A manufacturer sets a minimum retail price for its product.

A firm conditions the purchase of one product upon the purchase of another.

GLOSSARY OF TERMS

Antitrust Law and the Antitrust Law and the CourtCourt American American

Tobacco (1911)Tobacco (1911) Standard Oil Standard Oil

(1911)(1911) U.S. Steel U.S. Steel

(1920)(1920) Paramount Paramount

Pictures (1948)Pictures (1948) Dupont (The Dupont (The

cellophane cellophane case) (1956)case) (1956)

Von’s Grocery Von’s Grocery (1956)(1956)

IBM (1982)IBM (1982) Microsoft 1 Microsoft 1

(1994)(1994) Microsoft 2 Microsoft 2

(1998)(1998) The compact The compact

disk case (2003)disk case (2003)

Firms that violate the antitrust laws are sometimes broken into pieces.Firms that violate the antitrust laws are sometimes broken into pieces.

The courts pay careful consideration to The courts pay careful consideration to the question of the scope of the market.the question of the scope of the market.Mergers are a focus of attention in Mergers are a focus of attention in antitrust law and enforcement.antitrust law and enforcement.Antitrust policy allows mergers to be Antitrust policy allows mergers to be blocked by the government.blocked by the government.Mergers, of whatever type, are allowed Mergers, of whatever type, are allowed when, in the opinion or the government, when, in the opinion or the government, two conditions are met:two conditions are met:

The market is not concentrated after the The market is not concentrated after the merger.merger.Entry of new competitors into the market is Entry of new competitors into the market is possible.possible.

Antitrust Law and the Antitrust Law and the CourtCourtAntitrust Law and the Antitrust Law and the CourtCourt

The Herfindahl-Hirschman The Herfindahl-Hirschman IndexIndex

The method used by the government to The method used by the government to measure concentration in merger cases measure concentration in merger cases is called the is called the Herfindahl-Hirschman index Herfindahl-Hirschman index (HHI).(HHI).The HHI is the sum of the squared The HHI is the sum of the squared market shares of all the firms in the market shares of all the firms in the market.market. For an infinite number of firms in an industry, For an infinite number of firms in an industry,

the value of the HHI will be as small as zero. the value of the HHI will be as small as zero. This value would apply to a purely This value would apply to a purely competitive industry.competitive industry.

At the other extreme the maximum value for At the other extreme the maximum value for HHI is 10,000. This value applies when there HHI is 10,000. This value applies when there is a pure monopoly in the market.is a pure monopoly in the market.

Alternatives to RegulationAlternatives to Regulation

If a monopoly is a natural monopoly If a monopoly is a natural monopoly the government will typically either the government will typically either own it or regulate it with own it or regulate it with rate-of-rate-of-return regulationreturn regulation that restrict the that restrict the monopolist from charging more than monopolist from charging more than average cost.average cost.

Rate-of-return pricing is also known Rate-of-return pricing is also known as as average cost pricing.average cost pricing.

To avoid the inefficiencies of To avoid the inefficiencies of regulation, economist recommend regulation, economist recommend alternatives like alternatives like franchise monopoly,franchise monopoly, which is a right to be the exclusive which is a right to be the exclusive provider of a service.provider of a service.

o The government has allowed The government has allowed deregulation in some industries.deregulation in some industries.

o DeregulationDeregulation is the scaling back is the scaling back of government regulation of of government regulation of industry.industry.

o The reduction of government The reduction of government ownership of industries is ownership of industries is referred to as referred to as privatization.privatization.

Alternatives to RegulationAlternatives to RegulationAlternatives to RegulationAlternatives to Regulation

Today



Last Week

We distinguished between perfect competition and monopolyPerfect competition is perfect because firms have no market powerThere’s no competition with monopolies, because there’s only one firmMonopolistic competition and oligopoly are “imperfect competition

Imperfect Competition

Monopolistic competition and oligopoly: Firms in these market have power to

set prices to a certain degree Don’t have absolute market power Mutual interdependence: interaction

among competitors when making decisions

Imperfect Competition

Monopolistic competition and oligopoly: Also have non-price competition Largely based upon differentiation Decision making going to be much

harder than with monopoly or perfect competition

Today

I. A recap of the last two lecturesII. Inefficiencies in monopolyIII. Price discriminationIV. Regulation and alternativesV. Imperfect competition introducedVI. Monopolistic competition

introducedVII. Pricing and output decisions in


Monopolistic Competition

Large number of firms in the industryMarket entry and exit is relatively easyFirms have an ability to set pricesAbility to set prices comes from ability to differentiate productNon-price competition is going to be very importantFirms can earn a long run economic profit

Monopolistic CompetitionE.g. Hairdressers There are many hairdressers in Beijing,

and they are all relatively small It’s relatively easy to open or close a

hairdressing shop (enter and exit the market)

Products of hairdressing shops are not perfect substitutes Locations different (I’m not going to go to

xicheng to cut my hair) Styles may differ Salon décor may differ Staff may differ

Other examples of monopolistic competition

Retail clothing storesRetail shoe storesGas stations (in America)Fast food restaurantsCar dealersDVD storesLegal services

Today




We assume firms in monopolistic competition will follow the MR=MC rule to maximize profitsWe will use the same graph to depict costs, revenues, and profits as we did when looking at monopoly


Q

$

D

MR

ACMC

Assume this is the marginal cost and average cost curve an individual firm engaged in monopolistic competition faces

And this is the demand curve, and resulting marginal revenue curve they face


Q

$

D

MR

ACMC

P*

Q*

The firm is going to charge a price where the quantity demanded equals an amount where MR = MC

At this price and quantity, the firm would enjoy a profit


Q

$

D

MR’

ACMC

Other firms are going to see that this firm is enjoying a profit, and will thus decide to enter the market as well

This can be reflected as a shift back in the demand curve(Which is accompanied by a shift back in the MR curve as well)

D’


Q

$

D

MR’

ACMC

Why a shift back???Think about it like this:An increase in supply of this product, means each individual firm is going to experience a decreased market shareI now face a lower demand individually, because the same amount of people are buying the product, but now from more firms than before

D’


Q

$

D

MR’

ACMC

It’s hypothesized that firms will continue to enter the market until demand shifts back so much that profits level out at a normal profit

D’

Because demand has shifted back, firms face lower levels of MR at every level of output


Q

$

D

MR’

ACMC

P*

Q*

Faced with a lower demand and marginal revenues, firms will have to charge a lower price to get a level of quantity where MR=MC

D’

At this new quantity, AC=P, meaning profits are normal


Again: In monopolistic competition, firms will also set a price so that quantity demanded will yield MR=MCIf firms are making a profit, more firms will then enter the marketThe individual firm will see this as a shift back in the demand curveNow they are faced with a lower demand curve, and lower marginal revenues at every level of output


In order to get a new quantity so that MR=MC (because MR has now shifted back) firms must lower their pricesAs they lower their prices, their economic profits start to decreaseEventually all economic profits will disappear, and firms will make normal profits in the long run


Q

$

D

MR’

ACMC

P*

Q*

D’


One could see the opposite would be true if organizations were making a loss in monopolistic competitionWe would see firms starting to leave the marketThis would be seen by individual firms as an increase in demand for the productThey could then raise prices, until all losses disappeared, and they enjoyed a normal profit

Monopolistic Competition$

Q

D

MR

ACMC

P*

Q*

Economic Loss

Monopolistic Competition$

Q

D

ACMC

P*

Q*

D’

MR’


In order for firms to continue to make economic profits, they will have to differentiate themselves, so that demand for their product increasesBut in the long run, differentiation will always be followed by imitationIt’s difficult to impossible for firms in monopolistic competition to make an economic profit in the long run


Examples of continued differentiation from your book: Indian-Chinese food: Chinese food as

it is supposed to be served in India Pakistani-Italian Food Japanese spaghetti Russian sushi


Once more: Monopolistic competition occurs when

there are many small firms and market entry and exit is relatively easy

Firms can now differentiate their product to get a competitive advantage

Like a monopoly will sell at a price so that the quantity demanded will equal an amount yielding MC = MR


They may make an economic profit, loss, or normal profit at this level of P and QIn the long run other firms will enter or exit the market, until firms are forced to adjust their price and quantity to a level where they are only making a normal profit

To Sum Up

Today we started with a brief review of pricing and output in perfect competition and monopolyWe then saw that monopoly is very inefficientIt’s going to lead to deadweight loss in the economy

To Sum Up

One way to avoid deadweight loss by monopolies might be through price discriminationMonopolies can practice perfect price discriminationThis is difficultThey can also practice multi-part pricingThis is a little easier

To Sum Up

Because monopolies are so inefficient and have the ability to charge unfairly high prices, the government in the U.S. has seen fit to regulate monopoliesThere are a number of laws called anti-trust laws which were created to limit market power of individual firmsWe looked at a number of examples where companies have had anti-trust suits filed against them

To Sum Up

One way that governments can regulate monopolistic type firms is to limit the price they can charge to the average cost of productionThis will decrease deadweight loss substantiallyWe then spoke briefly about some of these alternatives to regulation, such as deregulation and privatization

To Sum Up

We then moved on to look at the concept of monopolistic competitionMonopolistic competition is like perfect competition in that there are many firms that are smallBut in monopolistic competition firms now have the power to set pricesThis market power arises from their ability to differentiate their product

To Sum Up

We assumed that monopolistic competition firms also face downward sloping demand curves and marginal revenue curvesJust like in monopoly, firms will produce where MR = MC, as this will maximize profitsUnlike monopoly, in the long run, other firms will either enter the market or start to imitate firms that are making profitsThis means in the long run in monopolistic competition firms will generally only make normal profits as well

To Sum Up

Firms that are seeking to make above normal profits in monopolistic competition will have to A. Differentiate their product B. Keep costs to a minimum C. Continue to find new ways to

innovate, so as to stay one step ahead of the competition

Homework

Chapter 9, page 233: Questions 7, 12Chapter 10, page 265: Questions 5, 9, 10This is due one week from todayKeep up the good work with your homework, it’s helping you prepare for your exams!Now let’s look at some questions, for real this time

char lee econ

Business

equates marginal

make normal

mrmc rule

lower marginal

monopolistic

monopolistic

marginal utility

marginal cost