Download elastic when - Personal.psu.edu

Managerial Economics
Dr. Timothy Simin
2011
Tim.Simin@mccombs.utexas.edu
Outline
Day 1
1. Introductions
– Who am I?
– Syllabus
– Who are you?
2. Helicopter Tour of Economics
– Overview of Micro
– Overview of Macro
– Other economics we won’t have time for
3. Micro Economics
– This morning
– This afternoon – CASES!
– Tomorrow
Tim.Simin@mccombs.utexas.edu
2
Introduction
Who am I?
Tim Simin
– Born in Detroit BUT raised in Dallas, TX
– 1992: Graduated Summa Cum Laude from UTD with BS in
Economics and Finance
– 1992 – 1994 : Division of Monetary Affairs at the Federal Reserve
Board of Governors in Washington, D.C.
– 1995 – 2000: Ph.D. in Finance from the University of Washington
– 2000 – Today: Assoc. professor of Finance, Smeal College of
Business, Penn State
– Course taught
– Research
Tim.Simin@mccombs.utexas.edu
3
Introductions
Syllabus
1. Download it (for now) at http://timsimin.net/UT/
2. Schedule
3. Please contact me via email about scheduling, homework,
or other problems
Tim.Simin@mccombs.utexas.edu
4
Introductions
Who are you?
Write down on regular sized piece of paper:
– Name
– Current Job, i.e. company and position
 Be specific please
– Expertise
– Economic background
 Senior Economist
 Some undergrad economics
 Took home economics in high school
 I abhor economics
– Anything else you want me to know about you
 Nickname, etc.
Tim.Simin@mccombs.utexas.edu
5
Helicopter Tour
What is economics?
1. Wikipedia:
– Economics is the social science that analyzes the production,
distribution, and consumption of goods and services
2. Most economics based on the idea that agents are rational
3. Most economics can be summed up by saying, “People
respond to incentives” - Landsberg
4. A “positive” rather than “normative” science
– Not a science of what is right or wrong, only what the outcome will
be given some action
– May be morally offensive
Tim.Simin@mccombs.utexas.edu
6
Helicopter Tour
What Microeconomics?
Microeconomics covers:
– Price determination via quantities supplied and demanded
 Laws of demand
– Opportunity costs and sunk costs
– Theory of the firm
 Monopolies, Oligopolies, and perfect competition
 Cost benefit analysis/profit maximization
– Theory of the consumer
 Utility functions, budget constraints, utility maximization
– Specialization, efficiency, comparative advantage
– Examples
Tim.Simin@mccombs.utexas.edu
7
Helicopter Tour
What is Macroeconomics?
Macroeconomics covers:
– Fiscal policy

http://www.wtfnoway.com/ and http://www.usdebtclock.org/
– Monetary policy
– National Income Accounting
 GNP, GDP
– Interest rate determination
– Exchange rate determination
– Business Cycles
– Inflation
Tim.Simin@mccombs.utexas.edu
8
Helicopter Tour
What Else is in economics?
1. Game theory
– Models of strategic interaction between agents
 Prisoner’s dilemma
2. Finance
– The economics of how companies choose and finance projects
– The economics of how financial asset prices are determined
3. Law and Economics
– Coase theorems
4. Behavioral Economics
– People are NOT rational but behave according to documented
psychological biases
Tim.Simin@mccombs.utexas.edu
9
Game Theory
The game of dilemmas
1.
Consider a non-cooperative duopoly trying to figure out what price to charge
for a homogeneous good. Both firms can pick between just two prices, a high
price, $10 or a low price, $6
2.
If firm 1 charges the high price and firm 2 also charges a high price their
profits will be $1000.
3.
If firm 1 charges a high price and firm 2 charges a low price then firm two
will get more business and the profits of firm 1 will be $0 and firm 2 will
make $1500.
4.
Now if both firms charge the low price then each firm will only make $300.
5.
Let’s look at a picture of these assumptions.
Tim.Simin@mccombs.utexas.edu
10
Game Theory
The game of dilemmas
Firm A
High price = $10
1.
High Price = $10
Firm B
2.
Profit for A = $1000
Profit for B = $1000
3.
Low Price = $6
Low price = $6
Profit for A = $1500
Profit for B = $0
4.
Profit for A = $0
Profit for B = $1500
Profit for A = $300
Profit for B = $300
1. What price will the each firm end up paying?
2. Is that rational?
3. Is it efficient?
Tim.Simin@mccombs.utexas.edu
11
Introduction
Some definitions
1. Models
– A filter for reality
– Don’t attack assumptions only how well it fits reality
2. Opportunity cost:
– Value of the next best alternative
– Sum of explicit and implicit costs
3. Positive vs. Normative analysis:
– Positive analysis = scientific or objective
– Normative analysis = moral or value judgment
Tim.Simin@mccombs.utexas.edu
12
Introduction
Some definitions
1. Rationality:
– What is rational behavior?
– “Most of economics can be summarized in four words: ‘People
respond to incentives.’ The rest is commentary.” - Landsberg
– This assumption brings up many questions of seemingly
“irrational” behavior
 Why do people vote?
 Why do people buy insurance when they rent a car even
though their car insurance or credit card already provides
them coverage?
 Why do people buy actively managed mutual funds?
Tim.Simin@mccombs.utexas.edu
13
Demand
Types of demand
1. Demand (Qd)
– Amount of a good consumers are willing to buy at a given price
and over a given period of time
– Not how much a consumer wants or desires a good
2. Two types of demand functions
– Generalized demand

Many different things affect quantity demanded
– Ordinary demand

Only price affects Qd. Price is the most important factor
Tim.Simin@mccombs.utexas.edu
14
Demand
Determinants of demand
Qd = f(P, M, Pr, T, Pe, N)
•
•
P = own price: (inverse relation to Qd)
M = income


•
Normal goods: Qd up as Income up and visa versa
Inferior goods: Qd down as Income up and visa versa
Pr = price of related goods:


Substitutes have a direct price/quantity relation
Complements have an inverse relation
•
•
•
T = tastes (direct)
Pe = expectation of future price (direct)
N = changes in population - the plague (direct)
•
Other factors affecting demand



Availability of credit (direct)
Level of advertising: production costs (direct)
Disposable income: after tax and benefits (direct)
Tim.Simin@mccombs.utexas.edu
15
Demand
Generalized vs. Ordinary
1. Linear generalized demand
Qd = a + bP + cM + dPr + eT + fPe + gN
2. Linear ordinary demand
Q = a - bP
3. In both cases:
– a is the intercept - the reservation price
– b is the partial derivative with respect to P - measures how Q
changes with a one unit change in P, etc
Tim.Simin@mccombs.utexas.edu
16
Demand
Linear generalized demand function
1. Suppose we know all the parameters and variable values
except price, then the generalized demand collapses into
the ordinary demand function.
Q = 1 - 10P + 2M - 1Pr + 3T + 0Pe + 2N
Q = 1 - 10P + 2(2) - 1(5) + 3(3) + 2(1)
Q = 1 - 10P + 4 - 5 + 9 + 2
Q = 11 - 10P
Q = f(p) [holding everything but price constant]
2. Changes in P cause movement along the line; all others
shift the line
Tim.Simin@mccombs.utexas.edu
17
Demand
The First Law of Demand
1. First Law of Demand:
– The price of a good is inversely related to the quantity demanded
ceteris paribus. Normally, as the price of a good increases the
quantity demanded decreases.
2. Difference between “demand” and “quantity demanded”
– Demand refers to the whole curve.
– Quantity demanded refers to points (movements) along the curve.
3.
Incentives - a justification for the First Law of Demand
– Example: Do seat belt and helmet laws reduce the number of
injuries that occur while driving?
Tim.Simin@mccombs.utexas.edu
18
Supply
Determinants of supply
Qs = g(P, Pi, Pr, T, Pe, F)
– P = own price (direct relation to Qs)
– Pi = price of inputs (inverse)
– Pr = prices of goods related in production (inverse for substitutes
and direct for complements)
– T = level of technology (direct)
– Pe = expectations of producers as to future price (inverse)
– F= the number of firms producing the good (direct)
Tim.Simin@mccombs.utexas.edu
19
Market Equilibrium
Equilibrium, excess supply, excess demand
1. Market equilibrium: consumers can buy and suppliers
can sell all they want
Qs = Qd
2.
When a price is set above the equilibrium price then there
is an excess supply (surplus).
Qs > Qd  Qs - Qd > 0
3. When a price is set below the equilibrium price then there
is an excess demand (shortage).
Qs < Qd  Qs - Qd < 0
Tim.Simin@mccombs.utexas.edu
20
Market Equilibrium
Equilibrium, excess supply, excess demand
Excess supply of 1 unit
Price
$2.00
1.75
1.50
1.25
1.00
.75
.50
.25
0
Excess demand of 2 units
Supply
Price
1 unit
Demand
Price
$2.00
1.75
1.50
1.25
1.00
.75
.50
.25
0
1 2 3 4 5 6 7 8 9 10
Supply
Price
two units
Demand
1 2 3 4 5 6 7 8 9 10
Quantity
Quantity
1. Can either of these situations last?
2. What happens in each case?
Tim.Simin@mccombs.utexas.edu
21
Surplus
Consumer and Supplier
Price
$10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
Price
Demand
1 2 3 4 5 6 7 8 9 10
Quantity
Supply
$10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
Price
1.00
Price
1 2 3 4 5 6 7 8 9 10
Quantity
Tim.Simin@mccombs.utexas.edu
22
Surplus
Consumer and Supplier
Price
Price
Supply
Supply
Price
X
Y
Z
Price
Price ceiling
Demand
Quantity
Demand
Quantity
Tim.Simin@mccombs.utexas.edu
23
Elasticity, TR, and MR
Elasticity
1. Elasticity: How much quantity demanded changes when
price changes.
2. Three kinds of elasticity
– Price elasticity (Ed): response of Qd to changes in “own price”.
 Ed = (% change in Qd) / (% change in P)
– Cross-price elasticity of demand (CPE): Response in Qd of A when
price of B changes
 CPE = % change in QA / % change in PB
– Income elasticity of demand (IE): Response Qd to income changes
 IE = % change in Qd / % change in M
Tim.Simin@mccombs.utexas.edu
24
Elasticity, TR, and MR
Price elasticity
1. Price elasticity: response of quantity demanded of a
product to changes in its “own price”.
(Q2  Q1)
Qd
* 100
Qd P
Qd P
Q1
Qd



(P2  P1)
P
P Qd
P Qd
* 100
P1
P
– Always negative for downward sloping demand and always quoted
in absolute value
– Smaller absolute values of Ed = less consumer response to a price
change
– Use “coefficient of elasticity” to predict effects of price changes.
Tim.Simin@mccombs.utexas.edu
25
Elasticity, TR, and MR
Price elasticity
Price
1. Demand is:
– elastic when |Ed| > 1
– inelastic when |Ed| <1
– unitary elastic when |Ed| = 1
Ed>1
$1.00
.90
.80
.70
.60
.50
.40
.30
.20
.10
Ed =1
Ed<1
1 2 3 4 5 6 7 8 9 10
Quantity
2. As price goes from $1 to $0.90,
– 10% decrease price,
– Qd goes up 100% increase.
3. As price goes from $0.20 to $0.10
– 50% decrease in price
– Qd goes up 11.11% increase.
Price
$1.00
.90
.80
.70
.60
.50
.40
.30
.20
.10
Price effect
Quantity effect
Price effect
Quantity effect
1 2 3 4 5 6 7 8 9 10
Quantity
Tim.Simin@mccombs.utexas.edu
26
Elasticity, TR, and MR
Price elasticity
1. Who Cares?
P
– Managers! elasticity shows effect of
price change on Total Revenue.
Demand
TR = P * Q
– Raise price TR will go up due to a
price effect, but falls due to a
quantity effect.
Elasticity
Responsiveness
Ed
elastic
|%Q| > |%P| TR falls if P up
|Ed| > 1
unitary
|%Q| = |%P| No change in TR
|Ed| = 1
inelastic
|%Q| < |%P| TR up if P up
|Ed| < 1
TR
Q
Total
Revenue
Q
Tim.Simin@mccombs.utexas.edu
27
Elasticity, TR, and MR
Marginal revenue
1. MR = addition to TR from selling one more unit of output
– (the change in total revenue) / (the change in quantity)
2. Let’s derive MR
– Demand
P = a – bQ
– Total Revenue
TR = P * Q = (a - bQ) * Q = aQ - bQ2
– Marginal Revenue
MR =
TR
 a  2bQ
Q
– MR is just a line. It is the same line as demand with twice the slope!
Tim.Simin@mccombs.utexas.edu
28
Elasticity, TR, and MR
Marginal revenue
Example:
– Let demand be P = 5 - (1/10)Q
– First: Find TR = P * Q = (5 - (1/10)Q) * Q = 5Q - (1/10)Q2
– Next: find MR = 5 - 2*(1/10)Q
P and MR
6
5
4
3
2
1
0
Demand
MR
0 10 20 30 40 50 60
Q
Tim.Simin@mccombs.utexas.edu
29
Elasticity, TR, and MR
Relating all three
1. How are TR, MR, and elasticity related?
Elasticity
Responsiveness
MR
Ed
elastic
|%Q| > |%P| TR falls if P up
MR > 0
|Ed| > 1
unitary
|%Q| = |%P| No change in TR
MR = 0
|Ed| = 1
inelastic
|%Q| < |%P| TR up if P up
MR < 0
|Ed| < 1
P
Ed > 1
Ed < 1
MR
TR
Demand
Q
TR
Tim.Simin@mccombs.utexas.edu
Q
30
Optimization
Concepts and terms
1. Objective function: function to maximize or minimize.
– Managers maximize profits or sales or minimize costs
– Consumers maximize utility or satisfaction
2. Choice variables: variables that when changed affect
value of objective
– If objective is profit, then a choice variable is quantity.
– If objective is cost, then a choice variable is expenditures.
– If objective is utility, then a choice variable is amount of a good
3. Unconstrained and constrained maximization
4. Why is marginal analysis so important?
Tim.Simin@mccombs.utexas.edu
31
Optimization
Example I
Cost/benefit analysis
level of activity total benefit total cost net benefit marginal benefit marginal cost
0
$0
$0
$0
1
16
2
14
16
2
2
30
6
24
14
4
3
40
11
29
10
5
4
48
20
28
8
9
5
54
30
24
6
10
Tim.Simin@mccombs.utexas.edu
32
Optimization
Example II
1. Economists define profit as total revenue less total costs
p = TR - TC
2.
Define TR as we did above
TR = P * Q; where P = a – bQ
so TR = P * Q = (a - bQ) * Q = aQ - bQ2
3. Define costs as something simple like an input
TC = w*Q
4.
Then our profit function becomes
p = TR – TC = aQ - bQ2 - wQ
Tim.Simin@mccombs.utexas.edu
33
Optimization
Example II (cont)
1. We want Q that to produce to get maximum profit
– To do this take the derivative of the profit function with respect to
Q and set the first derivative equal to zero.
p
 a  2bQ  w  0
Q
– NOTE: MR = MC  a - 2bQ = w
2. Now just solve out for Q
Q* = (a - w)/2b = profit maximizing level of output.
THIS IS ALWAYS THE CASE: MB = MC IS OPTIMUM CHOICE!!!
Tim.Simin@mccombs.utexas.edu
34
Consumer behavior
Some definitions
1. Rational behavior:
– Consistent with behavior postulates and preference axioms
2. Behavior Postulates:
– Statement without proof – usually obvious or well known
3. Preference axioms:
– How people deal with ranking preferences
4. Utility:
– Ranking of preferences or a measure of happiness. More
preferred goods or bundles of goods have a higher utility
5. Utility Maximization:
– Trying to get most preferred bundle of goods they can afford
Tim.Simin@mccombs.utexas.edu
35
Consumer behavior
Indifference Curves (IC’s)
1. Lets define some variables.
–
–
–
–
–
–
x1 = some number of hamburger’s
x2 = some number of CD’s
p1 = the price of a hamburger
p2 = the price of a CD
x2=CDs
M = income
6
(x1,x2) = A consumption bundle
5
2. Graph consumption bundles
– A=(5,2), five burgers and two CDs
– B=(2,1), two burgers and one CD
4
3
2
1
0
A
B
0 1 2 3 4 5 6
x1=hamburgers
Tim.Simin@mccombs.utexas.edu
36
Consumer behavior
Indifference Curves (cont)
1. Indifference Curves (I.C.’s): lines connecting bundles
that we prefer by the same amount
2. Properties of Indifference Curves:
–
–
–
–
–
Visual representation of utility
Higher the IC, higher the level of utility
I.C.’s almost always convex to the origin
x2=CDs
I.C.’s never intersect
6
I.C.’s are infinite in number
5
4
3
2
1
0
C
IC 2
A
B
IC 1
0 1 2 3 4 5 6
x1=hamburgers
Tim.Simin@mccombs.utexas.edu
37
Consumer behavior
Indifference Curves (cont)
1. Why do I.C.’s usually have that shape?
Satiation point
Utility
x2
U=5
U=3
U=5
U=3
U=2
U=1
x2
U=2
U=1
x1
x1
Tim.Simin@mccombs.utexas.edu
38
Consumer behavior
Indifference Curves (cont)
1. What about perfect substitutes/compliments?
x2=red
x2=right
6
5
4
3
2
1
0
B
A
indifference curve
0 1 2 3 4 5 6
x1=blue
6
5
4
3
2
1
0
B
indifference curve
A
0 1 2 3 4 5 6
x1=left
Tim.Simin@mccombs.utexas.edu
39
Consumer behavior
Budget lines
1. Goal of consumers
– Spend income to obtain the greatest possible satisfaction
– Limited means or income
2. Budget Constraint
– Income = price of burger’s * quantity of burger’s + price of CD’s
* quantity of CD’s
x2
– M = p1x1 + p2x2
3. Rearrange and graph
M
p1
x2=
x1
p2 p2
4. Work out example
M/p2
p2/p1
M/p1
Budget line
x1
Tim.Simin@mccombs.utexas.edu
40
Utility Maximization
Putting it all together
1. Consumer is faced with two combinations of cds and
burgers, bundle A and bundle B
– Which can she afford?
– Which will she pick?
x2=CDs
– Can we do this in excel?
6
5
4
3
2
1
0
IC 1
IC 2
B
A
0 1 2 3 4 5 6
x1=hamburgers
Tim.Simin@mccombs.utexas.edu
41
Production Theory
Costs and Product
1. Production Theory:
– How firms deal with inputs in production and costs of inputs
– Notes:
 Short run vs. Long run
 Assume firm produces a product rather than a service
2. The Producer’s Problem:
– Producers want to be efficient
 maximize output subject to costs of production OR
 minimize costs subject to an output level.
– Two kinds of efficiency
 technical efficiency
 economic efficiency
Tim.Simin@mccombs.utexas.edu
42
Production Theory
Costs and Product (cont)
1. Production:
– Creation of goods and services from inputs or resources
– Production function:
 Schedule (table or equation) of max output produced from
specified set of inputs and technology
 Assuming producers are technically efficient (not wasteful)
 Really dealing with economic efficiency
2. Two views of the producer problem:
– Find optimal level of output given a cost function
 Solve the profit max problem
– Find the most efficient means of producing a given level of output
 Constrained minimization problem with production function
being the objective function and an output the constraint
Tim.Simin@mccombs.utexas.edu
43
Production Theory
Total Product
1. Total Product: fancy name for output (Q)
Q = f(I1, I2, I3, ...)
–
–
–
–
Land
labor (L)
capital (K)
entrepreneurial ability
2. There are two different types of inputs
– Fixed inputs
 These can be changed only in the long run
– Variable inputs
3. Restrict ourselves to L and K for simplicity
Tim.Simin@mccombs.utexas.edu
44
Production Theory
Total Product (cont)
4. The general production function will be Q = f(L,K)
– Specific forms of typical production functions
Multiplicative:
Cubic:
Cobb-Douglas:
Additive:
Q=LK
Q=aK3L3+bK2L2
Q=KL
Q=wL+rK
5. Three aspects of short run production
–
–
–
Total product:
Average product
Marginal product
TP = Q=f(L,K)
AP = Q/L
MP = Q/L
6. Fix K to examine short-run production
Tim.Simin@mccombs.utexas.edu
45
Production Theory
Example
1. Cubic production: Q=aK3L3+bK2L2
– Let a = -.1 and b = 3.
2. See excel sheet
3. Note shapes of curves
– TP increases and then falls back down right around 10 people.
– AP is maximized at 44.8, somewhere between 7 and 8 people.
– MP (the additional output coming from adding one more worker),
actually goes negative at the 11th worker.
– MP = 0 when TP is maximized. Why?
4. Why do the curves have these shapes?
– Law of diminishing marginal product: As variable input
increases, ceteris paribus, a point will be reached where mp falls
Tim.Simin@mccombs.utexas.edu
46
Using TP, AP, MP
What can we do with this stuff
1. Assume the following production function: Q=2L.3K.7
– Make a short run decision about how many people to hire to
produce 20 units. Fix our capital input at 8.
– In the long run, we can increase our capital input to 12. How
many people will we need working for us to produce 20 units?
– What does AP do for us?
 Not much really. It is just the average amount of output per
worker, given a particular K.
– What does MP do for us?
 How much more output we get for one more unit of input.
 Back to our original scenario with k=8. What is MP?
 Is the Law of diminishing marginal product at work here?
Tim.Simin@mccombs.utexas.edu
47
Costs
A rose by any other name…
1. Opportunity costs: The value of the next best alternative
– Consist of two different parts

Explicit costs: Out of pocket expense or monetary expense.

Implicit costs: Forgone return had the owners used their
resources in the next best use.
– These are both real costs!
2. Example: Consider two companies exactly the same in
every way except one rents the building and the other
owns the building it operates in. Are their costs different?
Tim.Simin@mccombs.utexas.edu
48
Costs
Total, fixed, and variable
1. Short Run Costs:
– Total costs = Fixed costs + Variable costs
TC = FC + VC
– Fixed costs: must be paid whether we produce or not (I.E. Rent,
Debt payments)
– Variable costs: Costs which change with level of output (I.E. Cost
of inputs, Wages)
 Can break down these costs too.
• Average fixed costs = FC/Q
• Average variable costs = VC/Q
– Short Run Marginal Costs = TC/Q = the derivative of TC
 SMC is additional cost for next unit of output
 In the short run fixed costs are constant so = (VC/Q)
Tim.Simin@mccombs.utexas.edu
49
Costs
What do the short run cost curves look like
$
$
SMC
TC
ATC
AVC
Quantity
Quantity
Tim.Simin@mccombs.utexas.edu
50
Costs
Relation to production
1. Define TC = VC + FC
2. Assuming capital is a fixed
cost so TC = wL + rK
$
SMC
AVC
– w is the wage rate
– r is the cost of capital
3. In short run:
– AVC = w/AP
– SMC = w/MP
Q
AP,
MP
4. When MP is decreasing,
MC is increasing
MP
AP
L
Tim.Simin@mccombs.utexas.edu
51
Returns to Scale
Changing the amount of Q
1. What might happen if production is scaled up?
f(cL,cK)=zQ
– Increasing returns to scale: z > c
– Constant returns to scale: z = c
– Decreasing returns to scale: if z < c
2. Internal Economies of scale: Size matters!
– Labor, Investment and capital
– Procurement, R&D
– Diversification, By-products, Promotion, Distribution
3. Internal diseconomies of scale:
– Management: One word, bureaucracy
– Labor: One word, unions
Tim.Simin@mccombs.utexas.edu
52
Profit
A clarification
1. Profit = p = TR - TC.
2. Total Costs = opportunity (implicit + explicit) costs
3. Define two different kinds of profit
– Economic profit:
p = TR - TC = TR - explicit costs - normal profits
– Normal profits = implicit part of opportunity costs
4. Economic profit equals zero if total revenue after explicit
costs is equal to the implicit costs or normal profits
p = 0 when (TR - explicit costs) = normal profits
– A zero economic profit does not equal zero accounting profit
– Means all factors of production are paid their opportunity costs
Tim.Simin@mccombs.utexas.edu
53
Theory of the Firm
The Perfectly Competitive Model of a Firm
1. Perfect Competition:
–
–
–
–
Large number of small firms.
Homogeneous products (Perfect substitutes)
No single firm can affect the price - firms are price takers
Each firm can sell all the output it produces at the current market
price - the demand curve is perfectly elastic
– Entry and exit are unrestricted
– All firms have perfect information of the production and market
for this product
– Managers are profit maximizers
Tim.Simin@mccombs.utexas.edu
54
Perfectly Competitive Market
Homogeneous goods
1. More substitutes = more elastic
2. Demand curve faced by any one firm is perfectly elastic
P
P
Market
Individual Firm
S
Price = MR = D
D
Quantity
Quantity
Tim.Simin@mccombs.utexas.edu
55
Perfectly Competitive Firm
Graphical model
1. Three scenarios
– If price=demand > ATC, firm earns economic profits
– If ATC > price > AVC, firm operates at loss
– If price < AVC, firm shuts down
2. Work through examples
$\unit
12
10
9
8
7
6
5
SMC
ATC
AVC
P1
P2
P3
100 200 300 400 500 600 700 800
Quantity
Tim.Simin@mccombs.utexas.edu
56
Perfectly Competitive Firm
Managerial decisions
1. Because producers are price takers managers really have
two big picture decisions
– Does the company produce or shut down?
 Compare the AVC to the Price
– If the company produces, how much do they produce?
 To find profit maximizing output set MC = MR
2. Where is the supply curve?
$
SMC
P’’ = MR = D
3. What’s different in long run?
ATC
AVC
4. Do the example.
P’ = MR = D
P = MR = D
Breakeven point
Shutdown point
Quantity
Tim.Simin@mccombs.utexas.edu
57
Market Power
Monopolies
1. Market power: change price without losing all sales
2. Monopolies: produces a good with no close substitute and
exists in a market with high barriers to entry
–
Barriers to entry
 Economies of Scale
 Barriers created by government:
•
•
•
•

Input barriers:
•
•

Licenses: Doctors, Lawyers, Dentists
Patents: Not a guarantee of market power.
Regional franchises: Electricity, Cable television
Regulation: FTC, FDA, FCC, etc.
Control of raw materials: ALCOA
Capital markets
Brand loyalty
Tim.Simin@mccombs.utexas.edu
58
Monopoly
Graphical model
1. Monopoly has no competition so the demand curve it
faces is the market demand curve
2. What does the MR curve look like?
$
SMC
3. Put demand, MR together with costs
ATC
P
AVC
4. Where does monopolist produce?
– Where MC = MR
5. So what price is he going to charge?
MR
Q
– Monopolists are price searchers NOT price takers
D
Quantity
 They DO NOT charge any price they want
– Run line from the intersection of MC and MR up to demand
Tim.Simin@mccombs.utexas.edu
59
Monopoly
Price searching
1. Where will the Monopolist operate?
P
– Remember our table and graph
Demand
elastic
|%Q| > |%P| TR falls if P up
unitary
|%Q| = |%P| No change in TR |Ed| = 1 TR
inelastic |%Q| < |%P| TR up if P up
|Ed| > 1
|Ed| < 1
Q
Total
Revenue
Q
Tim.Simin@mccombs.utexas.edu
60
Monopoly
Three market situations: Shutdown
1. When the price falls below AVC the firm will shut down
– Just like competitive case
2. Intuition:
Price/unit > VC/unit
firm can’t cover any costs
$
SMC
ATC
AVC
P
MR
Q
D
Quantity
Tim.Simin@mccombs.utexas.edu
61
Monopoly
Three market situations: Operating at a loss
1. When the price falls below ATC but above AVC the firm
will operate at a loss
$
SMC
– Just like competitive case
2. Intuition:
P
FC/unit > Price/unit > VC/unit
If firm shuts down it loses FC so
better to operate at a loss
ATC
MR
Q
AVC
D
Quantity
Tim.Simin@mccombs.utexas.edu
62
Monopoly
Three market situations: Profit
1. When the price falls below AVC the firm will shut down
2. Intuition:
$
SMC
Breakeven
Price/unit > (VC + FC)/unit
3. Can a monopolist really
charge any price it wants?
ATC
P
– Since we are in the elastic
portion of the demand curve
Shutdown
then a price increase will cause
Q
TR to go down
AVC
MR
D
Quantity
Tim.Simin@mccombs.utexas.edu
63
Monopoly
Are Monopolies bad?
1. When the price falls below AVC the firm will shut down
– Just like competitive case
Price
Supply
MC for
Monopoly
Price
Monopoly Price
Competative
Price
Demand
Quantity
Competative
Price
MR
Demand
Quantity
Tim.Simin@mccombs.utexas.edu
64
Monopoly
Price discrimination
1. Can a monopolist capture B and C too?
– First degree price discrimination

Everyone pays their valuation

Auctions
– Second degree

Quantity discount
– Third degree

MC for
Monopoly
Price
C
Monopoly Price
A
B
Competative
Price
Group discounts
MR
Q
Demand
Quantity
Tim.Simin@mccombs.utexas.edu
65