ECON 101 Exam 3

Profit Maximization Assumption

We assume that Firms attempt to maximize profits

TR = TC

firm breaks even

At low levels of output

the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small.

Nash Equilibrium

Occurs when, holding the strategies of all other players constant, no player can obtain a higher payoff by choosing a different strategy. Given what the other players are currently doing, no player can gain by altering their own strategy

Duopoly

Oligopoly with two firms

duopoly

Oligopoly with two firms

Barriers to Entry

1) Control of scarce resource or input 2) Cost advantage Large set-up costs High initial set-up costs A given quantity of output produced at a lower ATC by one large firm than by two or more smaller firms Natural monopoly Local utilities: water, gas, electricity 3) Government Created Monopoly Government License: Government grants firm exclusive right to serve given area Patents and Copyrights Patents: 20 years from date of filing Copyrights: 70 years post death

Conditions Necessary for Price Discrimination

1) Firm must have market power(Monopoly, Oligopoly; Perfectly competitive firms do not) 2) Firm must be able to identify differences in willingness to pay between consumers 3) Firm must be able to limit resale of product

two key conditions for perfect competition

1) For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. 2) An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. Homogeneous product (standardized product): Consumers regard the products of different producers as the same good.

Conditions for Cooperation

1) Repeated Interactions Over time: Tit for Tat strategy 2) Easy to monitor other firms: Good information concerning prices and output levels 3) Entry by non-colluding firms difficult: Easier to successfully collude if collectively hold high market share 4) Merge To avoid problem of cheating some firms merge into single entity Mergers may reduce costs and increase efficiency Subject to approval by Government

Antitrust Legislation

1) Restrict the formation of cartels and prohibit other collusive practices regarded as being in restraint of trade 2) Restrict mergers and acquisitions of organizations which could substantially lessen competition 3) Restrict the creation of a monopoly and abuse of monopoly power Sherman Antitrust Act (1890) Clayton Act (1914) Federal Trade Commission Act (1914) Robinson-Patman Act (1936)

Reason Monopolies Exist

A monopolist has market power. Charges a higher price than perfectly competitive outcome Produces a lower quantity than the perfectly competitive outcome Creates deadweight loss Generates economic profits for the firm In order for profits to persist in the long-run, some form of barrier to entry must be in place. Otherwise, other firms will enter

Profit Maximization In Perfectly Competitive Markets

A price-taking firm's profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price.

Two-Part Tariff

A pricing system in which the firm charges a customer a lump-sum fee for the right to buy as many units of the good as the consumer wants at a specified price Lump Sum Fee (Part One) Per-Unit Price (Part Two)

Regulation

Break-up Monopoly Anti-trust legislation Price Regulation (Price Ceiling): If set at proper amount can get rid of welfare losses Increase Competition: Grant more licenses Reduce trade barriers for foreign firms Alter patent laws Subsidize competing firms (offer tax breaks)

Marginal Revenue (MR)

Change in Total Revenue (TR) generated by selling an additional unit of output MR = ∆TR/∆Q

Two-Part Tariff

Charge customer a lump-sum fee for the right to buy the good at specified price

Multi-Market Price Discrimination

Charge different groups of customers different prices

Perfect Price Discrimination

Charge the maximum amount each consumer is willing to pay

Price Discrimination

Charging different prices to different consumers for the same good. Differences exist in consumer willingness to pay for a good. Price discrimination is profitable when consumers differ in their sensitivity to the price Key element is elasticity: It is profit-maximizing to charge a higher price to consumers who are relatively more price inelastic and charge a lower price to consumers who are more price sensitive (elastic) Charging a high price to price sensitive consumers may drive them out of the market.

Imperfect Competition

Competition among firms who have some market power Price Searchers Decisions made by each firm has an impact on the market Each firm must consider the actions of the other firms in the industry Strategic Behavior

Cooperative Imperfect Competition

Decisions made jointly Price or Quantity Setting (typically illegal) Collusion: Two or more firms acting together to set prices or quantity rather than competing

Why does a colluding Duopolist have an incentive to change production levels when a monopolist does not?

Differences in size of Price Effect

Non-Cooperative Imperfect Competition

Each firm makes decisions about output and price without consulting each other Choices impact each other

Equilibrium

Each player attempts to maximize their individual payoffs

(T/F) An increase in fixed cost lowers the profit-maximizing quantity of output produced in the short-run.

False. Changes in fixed cost do not affect marginal cost and so do not change the profit maximizing quantity of output produced (P = MC). Changes in fixed cost do, however, change the amount of profit earned and the firms break-even price. The higher fixed cost, the higher the firm's break-even price and lower its profit.

Quantity Discrimination

Firm charges a different price for large quantities than for small quantities

Quantity Discrimination

Firm charges a different price for large quantities than for small quantities of a good All customers who buy a given quantity pay the same price Takes advantage of downward sloping demand curves Consumers willing to pay a lower price for successive units

Multi Market Price Discrimination

Firm charges different groups different prices according to willingness to pay for the group Most common type of Price Discrimination Identify different groups of customers Charge each group a different price Essentially act a single price monopolist within each group Won't know individual willingness to pay, but have some idea about willingness to pay for groups Need to identify which group individual belongs How to identify which group an individual belongs to Observable Characteristics Age, location (country) Get Consumers to "self-select" themselves into different groups Our behavior places us into different groups Coupons Airline tickets

Perfect Price Discrimination

Firm charges each customer exactly what they are willing to pay (maximum each is willing to pay) Price = Marginal Value If able to do so, the Marginal Revenue curve becomes the Demand Curve Will continue to sell the good as long as Price exceeds the Marginal Cost of producing an additional unit Stop producing when: Price = Marginal Cost Perfectly Price Discriminating Monopolist results in an efficient outcome Net Benefits to Society are Maximized No Deadweight Loss All benefits go to Producer Consumer surplus is zero Efficient, not equitable

Monopolist is the market

Firm faces downward sloping, market demand curve If the monopolist alters their quantity produced, the market price will change As a result: Marginal revenue will not equal price Has important implications for which price they charge and how many units they sell.

cartel

Firms acting together as if a monopoly

price searcher

Firms that have at least some influence on market price Face downward sloping demand curve Monopoly, Oligopoly

Marginal Revenue Curve

For a Monopolist, at any given quantity, marginal revenue will be less than price due to Price Effect The Marginal Revenue Curve then will be lower than the Demand curve at any given quantity produced If Demand Curve is Linear, then Marginal Revenue Curve will be linear Marginal Revenue Curve will intersect horizontal axis exactly halfway between the origin and where the Demand Curve intersects the horizontal axis. Accident? No! Elasticity!

Justice Department Classifications

HHI below 1,500: Unconcentrated Market Strongly competitive HHI between 1,500 and 2,500: Moderately Concentrated Market HHI above 2,500: Highly Concentrated Market

Herfindahl-Hirschman Index

Herfindahl-Hirschman Index (HHI) Measure of market concentration Used by the Justice Department when evaluating potential mergers Calculating the HHI for an industry: Square each firm's share of market sales Add together the squared market shares for all firms in the industry. Takes into account the relative size distribution of the firms in the market Gives proportionately greater weight to larger market shares

Oligopoly: Collusion Vs Competition

Imperfect competition Oligopolists face competition Competition is limited; barriers to entry still exist May either compete (non-cooperative) or collude (cooperative) If attempt to collude: Will collectively want to act like a monopoly If firms collude, they want to collectively produce the monopoly outcome

Monopolist Profit Maximizing Condition

In order to maximize profits, a firm should continue to produce as long as the additional revenue from an additional unit of output is greater than the additional cost from an additional unit of output. Keep producing as long as MR > MC Profits are maximized by producing the quantity at which the marginal cost of the last unit produced is equal to its marginal revenue. Stop producing where MR = MC

Profit Maximizing Condition

In order to maximize profits, a firm should continue to produce as long as the additional revenue from an additional unit of output is greater than the additional cost from an additional unit of output. Keep producing as long as MR > MC Stop producing where MR = MC (or last unit for which MR>MC

Oligopoly

Industry with a small number of producers Barriers to entry exist, just not as strong as with monopoly

Mergers: General Standards

Justice Department Considers both post-merger level of HHI and the increase in HHI resulting from the merger 1) Small Change in Concentration Mergers involving an increase in HHI of less than 100 points. Unlikely to have adverse competitive effects and ordinarily require no further analysis 2) Mergers in Moderately Concentrated Markets (HHI: 1,500 - 2,500) Mergers that involve an increase in the HHI of more than 100 points potentially raise significant competitive concerns 3) Mergers in Highly Concentrated Markets (HHI > 2,500) Mergers in highly concentrated markets that involve an increase in HHI of between 100 to 200 points potentially raise significant concerns 4) Mergers in highly concentrated markets that involve an increase in HHI of more than 200 points will be presumed to be likely to enhance market power

Price and Quantity Effects

Key Point: In order to attract new customers, the monopolist must lower price Due to fact that the monopolist faces the downward sloping market demand curve

Monopolist's Production Decision

MR = MC At that level of output profits are maximized

Monopolists will produce while

MR > MC

oligopoly

Market structure characterized by having a small number of producers Firms have market power Face downward sloping demand curve Decisions made by each firm has an impact on the market Each firm must consider the actions of the other firms in the industry

monopoly

Market with a single supplier of a good Monopolists know their actions influence market price Take this into account when deciding how much to produce Choose price and quantity to maximize profits Constrained by the Demand Curve Face downward sloping demand curve

Welfare Effects

Monopolist charges a price higher than marginal cost and produces output at a level lower than the efficient, perfectly competitive output level. As a result, monopolies cause deadweight loss to society.

long run equilibrium

P = minimum ATC

price effect

PE = (P1 - P2)*(Q1), negative if increasing output

Monopoly Versus Perfect Competition

Perfectly Competitive Firms produce where P = MC Monopolies produce where P > MR = MC. Compared with a competitive industry, a monopolist: Produces a smaller quantity: Qm < Qc Charges a higher price: Pm > Pc Earns a profit in both short-run and long-run.

Zero Economic Profit in the Long-Run

Perfectly competitive firms earn zero economic profit in the long-run due to free entry and exit If Profits > 0, other firms will enter the market Leads to an increase in Supply Puts downward pressure on prices Price falls toward ATC and reduces profits to breakeven point If Profits < 0, firms will exit the market Leads to a decrease in Supply Puts upward pressure on prices Price rises and profits are increased When Profits = 0, no incentive for firms to enter or exit Therefore, in long-run: P = AC = MC

Total Revenue

Price * Quantity = P*Q P*Q - C(Q) The amount of income received from all units sold

Perfectly Competitive Markets in the Long-Run

Produce quantity where Price (MR) = Marginal Cost (MC) Profit maximizing condition for a perfectly competitive firm: P = MC Shutdown Decision: All costs are avoidable in the long-run Shutdown and exit the industry if Price < Average Total Cost P < ATC

Production Decision (PCM) Short Run

Produce quantity where Price (MR) = Marginal Cost (MC) Profit maximizing condition for a perfectly competitive firm: P = MC Shutdown Decision: Shutdown if Price < Average Variable Cost P < AVC Fixed inputs cannot be changed in the Short-Run

Properties of oligopolies

Profit maximization: MR = MC Ability to Set Price: Price Searcher Market Power: P > MC Entry: Limited Number of Firms: few Long run profits: >= 0 Strategy dependent on rival firms: Yes

Profitability (Short Run)

Profits: (P - ATC)*Q If P > ATC, the firm is profitable. If P = ATC, the firm breaks even. If P < ATC, the firm incurs a loss. Firm should shutdown if: P < Minimum AVC MR = P = MC

quantity effect

QE = (Q2 - Q1)*(P2), positive if increasing output

Average Revenue

Revenue per unit of output AR = TR/Q = (P*Q)/Q = P Average Revenue = Price Under Perfect Competition: AR = MR = P

Monopoly Shutdown Decision

Shutdown if: Short-Run: P < AVC Long-Run: P < ATC Monopolist can charge higher price than perfectly competitive firm

In perfect price discrimination, how large is each individual's consumer surplus? Total consumer surplus? Would this market be considered efficient?

Since each customer is charged exactly their willingness to pay, there is no consumer surplus. Yet, this market would still be considered efficient. The monopolist continues to produce until marginal value equals marginal cost. Net benefits to society are maximized, but all the benefits go to the producer.

Dominant Strategy

Strategy that gives the player a higher payoff no matter what strategy the opponent is playing.

Firms should shut down long run if

TR < TC

Firms should shut down in short run if

TR < VC

Market power

The ability of a firm to raise its price above the competitive level.

Marginal Cost (MC)

The additional cost incurred by producing an additional unit of output MC = ∆TC/∆Q

If demand for a good is unit elastic

The price and quantity effects will offset Marginal revenue will be zero Marginal revenue curve crosses the horizontal axis at this point.

If demand for a good is inelastic

The price effect will dominate the quantity effect A decrease in price will decrease total revenue If total revenue is decreasing, marginal revenue must be Negative

If demand for a good is elastic

The quantity effect will dominate the price effect A decrease in price will increase total revenue If total revenue is increasing, marginal revenue must be positive As the price continues to be lowered, the good becomes less elastic and marginal revenue becomes smaller.

Profit

Total Revenue (TR) - Total Cost (TC)

Colluding Duopolist

When Price = 30, Quantity = 12 Only producing half monopoly output If expand output by 1 unit, must lower the price Sell 1 more unit at a price of $29 Lower the price by $1 on all existing customers (12) Marginal Revenue: Quantity Effect = $29 * 1 = $29 Price Effect = -$1 * 12 = -$12 Marginal Revenue: $17 More than Marginal Cost: $6 Because the colluding duopolist only produces a portion of the monopoly output, the impact of lowering prices on existing customers is much lower (Smaller Price Effect)

Monopolist

When Price = 30, Quantity = 24 If a monopolist expands output by 1 unit, must lower the price Sell 1 more unit at a price of $29 Lower the price by $1 on all existing customers (24) Marginal Revenue: Quantity Effect = $29 * 1 = $29 Price Effect = -$1 * 24 = -$24 Marginal Revenue: $5 Less than Marginal Cost: $6 Would lower profits if expand output.

price-taking consumer

a consumer whose actions have no effect on the market price of the good he or she buys

Total Cost

a function of Quantity [C(Q)] The total cost of producing a given quantity of output

price-taking producer

a producer whose actions have no effect on the market price of the good it sells

price effect

in order to sell the last unit, the monopolist must reduce the market price on all units sold. This decreases total revenue.

perfectly competitive industry

industry in which producers are price takers

perfectly competitive market

market in which all market participants are price takers

free entry and exit

new producers can easily enter into or leave that industry. There are no barriers to entry or exit in the long-run.

quantity effect

one more unit is sold, increasing total revenue by the price at which the unit is sold. If only the quantity effect existed, then Marginal Revenue = Price and the marginal revenue curve would be the same as the demand curve.

marginal revenue

price effect + quantity effect

price takers

takes market price as given, has no individual impact on market price. Face horizontal, perfectly elastic demand curve

TR < TC

the firm incurs a loss

TR > TC

the firm is profitable

market share

the fraction of the total industry output accounted for by that producer's output.

Free entry and exit ensure

the number of producers in an industry can adjust to changing market conditions. producers in an industry cannot artificially keep other firms out.

As output rises

total revenue actually falls. This reflects the fact that at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large.

long-run market equilibrium

when P = MC = ATC, given that sufficient time has elapsed for entry and exit from the industry to occur. Long run profits: (P-ATC)*Q=0