MICROECONOMICS FINAL

Some economists emphasize that it is misleading to compare the cost curves of a monopoly and a competitive industry at a single point in time because:

A monopoly's costs may be lower than those of a competitive industry in the long run.

Why is P = MC in perfect competition?

Because under perfect competition P = MR so P = MR MR = MC P = MC

Monopolistic Competition

-Many firms -Differentiated product -Easy entry/exit -Price makers (MR=MC) -Imperfect Information -Downward slope D -Yes Short Run profits, No Long Run

Perfect Competition

-Many small firms -Homogenous (identical) products -No barriers to entry/exit -Price takers (P=MC) -Perfect knowledge of market -Perfectly elastic Demand curve -Yes Short Run Profits, No Long Run

Monopoly

-One Firm -Unique product/no subsitute -Almost impossible entry/exit -Price makers (MR=MC) -Imperfect Info -Downward slope D -Yes Short Run Profits, Yes Long Run

A Monopolistically Competitive Firm in the Long Run

1. In the long run, profit attracts entry, which shifts the firm's demand curve leftward. 2. Entry continues until P=ATC at the best output level, and economic profit is zero. 3. The typical firm produces where its new MR crosses MC

What is the relationship between market price and the total revenue curve in a perfectly competitive market?

As market price increases, the slope of the total revenue curve becomes steeper.

Sources of Monopoly:

Barriers to Entry and Cost Advantages

Marginal revenue, average revenue, and price are all equal for a monopolist. true or false?

False

Why is the perfectly competitive firm a price taker?

Firm's market is to small to change price (which is determined by market demand & supply)

The long-run supply curve is upward sloping in a(n)

increasing-cost industry

A dominant strategy is one that

is best for a player, regardless of what strategy other players follow

At the long-run equilibrium output level, a monopolistically competitive firm's average total cost curve

is tangent to (just touches but does not cross) the demand curve

Price stickiness (or sticky prices)

is the resistance of market price(s) to change quickly despite changes in the broad economy that suggest a different price is optimal. ..

In the short run, the horizontal sum of all of the marginal cost curves (above minimum average variable cost) of individual firms in a competitive market defines the

market supply curve

Which of the following is a possible regulation strategy for a natural monopoly?

Requiring the monopolist to set a price equal to the average total cost of a good

Why can't the perfectly competitive firm earn economic profit in the long run?

Short run: make profits/loss IF profit, new firms will enter the market (no barriers), then market supply curve shifts right, then market price falls until = to ATC (zero economic profit) THEN firms will break even and firms will stop entering the market IF losses, firms losing money, will exit the market. Market supply curve shifts left, price rises until = to ATC

Suppose that for a monopolist, MR = MC = $10 and P = $15 at the profit-maximizing level of output. At this level of output, the firm

will shut down if AVC > $15

Why is oligopolistic behavior difficult to analyze?

•Decisions made by a firm depends on how its rivals react •Because there are many ways a rival might respond, analysis complicated •Hard to draw unambiguous conclusions about resource allocation

The Kinked Demand Curve Model (2)

•Explains price stickiness in some oligopoly industries • •Two demand curves based on how a firm expects its rivals to respond to a price change •If Firm X cuts its price, expects rivals to also cut their price If Firm X raises its price, expects rivals to keep their prices the same

Natural monopoly

•Industry in which advantages of large-scale production make it possible for one firm to produce all output at a lower average cost than a number of small firms • •What matter is size of the firm relative to the market

How is this different than perfect competition?

•Like a monopoly, the monopolistically competitive firm produces a lower output and charges a higher price than the perfectly competitive firm

Cartels

▶A group of sellers of a product who have joined together to control its production, sales, and price ▶The firms jointly acts as a monopoly ▶OPEC ▶Hard to organize and enforce agreements

Ignoring Interdependence

▶Assume a firm maximizes profits, assuming that its decisions will not affect its rivals' decisions

Strategic Interaction

▶Since firms operate in the same market, decisions are interdependent ▶If one firm decides to cut its price, needs to consider how a rival will respond ▶Tactics, strategies, moves, and countermoves matter

Tacit Collusion and Price Leadership

▶Tacit collusion involves indirect ways of communicating with one another ▶Under price leadership, one firm sets the price and the other firms follow ▶Leader may be largest firm or role may rotate ▶Avoids possible price war

Total Profit=

T R - T C

When the oil-producing countries of the Middle East meet to set prices and output levels, this is an example of

explicit collusion

Tacit collusion occurs where

firms choose actions that are likely to minimize a response from another firm, e.g. avoiding the opportunity to price cut an opposition because it would cause the opposition to retaliate. Put another way, two firms agree to play a certain strategy without explicitly saying so.

For market prices that are below the shut-down point of every firm in the market, the short-run market supply curve

follows the vertical axis

This difference in values between money today and money in the future is _____ when the rate of interest is higher

greater

Firms will demand the quantity of borrowed funds that makes the marginal revenue product of the investment financed by the funds ________ to the interest payment charged for borrowing

just equal

A sum of money received at a future date is worth ____ than the same sum of money received today.

less

If average cost rises as a firm increases its output level,

marginal cost is greater than average cost

For the firm in monopolistically competitive

marginal revenue is less than the product's price

total money profit

price - cost

A monopolist earns a profit whenever

price exceeds average total cost

In the short run, a monopoly should shut down whenever

price is less than average variable cost everywhere

For a monopoly, profit per unit of output is

price minus average total cost

If there is an increase in market demand in a perfectly competitive market, then in the short run

profits will rise

If a monopolistically competitive firm raises its price

quantity demanded declines, but not to zero

In the long run, monopolies

will not incur economic losses

What is an Oligopoly?

•A market dominated by a few sellers •Several large enough relative to the total market to be able to influence the market price •Firms produce identical or differentiated products: steel plate versus breakfast cereal •Some oligopolies may also include large number small firms •Firms seek to create unique products: features, location, appeal

Pure monopoly

•An industry in which there is only one supplier •Sells a product for which there are no close substitutes •Entry is very difficult or impossible

How does the firm determine price and output?

•Behaves like a monopoly •Find output where MR = MC •Set price off the demand curve •Compare P to AC to determine profits or losses • •One difference: demand curve is flatter or more elastic •There are many substitutes

How is monopolistic competition similar to or different than perfect competition?

•Characteristics the same except for differentiated products •Demand curve facing a monopolistic competitive firm downward sloping •The firm can increase price and not lose all its customers •Can think of the firm as a tiny monopoly •In long run, free entry will drive economic profits to zero

The Kinked Demand Curve Model (1)

•Explains price stickiness in some oligopoly industries •Two demand curves based on how a firm expects its rivals to respond to a price change •If Firm X cuts its price, expects rivals to also cut their price If Firm X raises its price, expects rivals to keep their prices the same

Is there anything beneficial about monopoly?

•May lead to more innovation •Monopoly protected from rivals ▶Captures benefits from any cost-saving methods and new products it can invent ▶Strong motivation to invest in research •Natural monopolies •Lower costs than perfectly competitive firm •Economies of large-scale production

TOWARDS LONG RUNG EQUILIBRIUM Since the firm makes a profit (P > AC), what happens?

•New firms enter •Each firm's demand curve will decrease and become more elastic •New firms enter until economic profit = 0

Characteristics of Monopolistic Competition

•Numerous participant •Many buyers and sellers, all of whom are small relative to the market •Freedom of exit and entry •Incomplete information •Heterogeneous or differentiated products Each seller's product differs at least somewhat from every other seller's produc

Price discrimination

•Sale of a product at different prices to different customers when there are no differences in the costs of supplying these customers. •Customers charged the same price even if it costs more to supply one customer than another •Examples of price discrimination •Mail, airline seats, movie tickets, university tuition

Do pure monopolies exist?

•Telephone companies and US Post Office in the past •How about Microsoft in operating system market

Profit maximizing rule for price discrimination

•The firm wants to set prices such that •MR from group A = MR from group B •MRA = MRB •What about costs? •MRA = MRB = MC •For each group, maximize profits by producing where MR = MC •Then get price off the demand curve

Two Different Models

•The kinked demand curve •Game Theory

Excess capacity theorem

•Under monopolistic competition in the long run •The firm will tend to produce an output lower than that which minimizes its unit costs •The level of output at minimum average cost is the firm's optimal capacity •Therefore, the monopolistically competitive firm produces with wasted capacity

As a general rule (PRICE DISCRIMINATION)

•With discriminatory prices, profits are normally higher than when the firm charges nondiscriminatory (uniform) prices •Firm can divide customers into separate groups •Charges each group the price that maximizes its profits from those customers

If a perfectly competitive firm faces a price below its average total cost but above the shutdown point, it should stay open. True or False

True

Under price leadership

all firms follow price changes initiated by the leader

In the long run, entry and exit in a perfectly competitive market will drive the price to the point where the marginal cost curve intersects the _________.

average total cost curve at its minimum

The entry of new firms into a perfectly competitive market in the long run is most likely the result of

continued above-normal profit, combined with the absence of barriers to entry

Fixed Cost (Sunk Cost)

cost a firm has already paid or has agreed to pay some time in the future

Which of the following formulas represents total profit for a perfectly competitive firm?

Q × (P - ATC)

Discounting

Converting future value into its present value (PV)

Consider the market for a fictional product called juppers. If total surplus under a competitive environment is $100, but under a monopoly consumer surplus is $20 and producer surplus is $60, what is the value of the deadweight loss caused by this monopoly?

$20 Deadweight loss caused by a monopoly market structure is equal to the loss of total surplus resulting from the good being sold by a monopolist rather than in a competitive market. Therefore, it is equal to $100 - $20 - $60 = $20.

Total loss =

(TVC + TFC) - TR

Duopoly

-An oligopoly market with only two sellers

Situations duopolists might face

-Both players have dominant strategies -Only one player has a dominant strategy -Neither player has a dominant strategy

Oligopoly

-Few firms -Differentiated product -Difficult entry/exit to market -Price Makers (MR=MC) -Imperfect Info -Downward Slope/kinked D -Yes Short Run Profits, Yes Long Run

A Shopping List of Oligopoly Models:

1.Ignoring Interdependence 2.Strategic Interaction 3.Cartels 4.Tacit Collusion and Price Leadership

Barriers to entry

1.Legal restrictions •Monopoly granted by federal, state or local governments •USPS, cable television providers, sports franchises 2.Patent •Privilege granted to an inventor, that for a specified period of time prohibits anyone else from producing or using that invention without permission 3.Control of a scarce resource or input •ALCOA, DeBeers 4.Deliberately erected barriers •Costly lawsuits against new rivals, excessive advertising expenditure 5.Large sunk costs •Cost is sunk if it cannot be recouped for a considerable period of time, if at all •Asset specific investments 6.Technical superiority •IBM, Microsoft, Google 7.Economies of scale •Average costs decrease as output expands

Differences between monopoly and perfect competition

1.Monopoly restricts output to raise price both in the short and long run 2.Monopoly profits persist •Consequence of barriers to entry 3.Monopoly leads to inefficient resource allocation •Under perfect competition: MU = P = MR = MC •Under a monopoly: MU = P > MR = MC ▶So MU > MC •Can measure cost of inefficiency by looking at consumer and producer surplus 3.Monopoly leads to inefficient resource allocation continued •Total surplus is less under a monopoly •Deadweight loss (efficiency loss) of monopoly ▶Lost producer and consumer surplus that occurs when a monopolist produces less than the efficient quantity of a product

Demand Curves in Perfect Competition

Individual Firm: Perfectly elastic (straight horizontal line) D = AR = P = MR Market as a Whole: downward sloping D = AR = P

Which concept is best illustrated by the "prisoner's dilemma"?

Interdependence

Should the firm stay open or shut down?

It will be sensible to operate at a loss if the firm loses even more money by shutting down.

It will open if:

Losses < TFC •(TVC + TFC) - TR < TFC •(TVC+ TFC) - TR - TFC + TR < TFC - TFC + TR •TVC < TR •Dividing this equation by quantity: AVC < AR (P)

It will close if:

Losses > TFC •(TVC + T FC) - TR > TFC •(TVC + T FC) - TR - TFC + TR > TFC - TFC + TR •TVC > TR •Dividing this equation by quantity: AVC > AR (P)

A firm can maximize profits in the short run by producing output where

MC = MR and the MC curve crosses the MR curve from below (as long as P>AVC)

A monopolist that does not price discriminate will set the output level where

MR = MC

Why is P = MR?

MR = ∆TR/∆Q = P×∆Q/∆Q+Q×∆P/∆Q MR = P×1+Q× 0 = P [∆P= 0, since P does not change]

Which of the following expressions equals profit per unit of output?

P - ATC

TR =

P X Q

Economic Profits =

P greater than AC

Firm should open if

P is greater than AVCmin

Firm should close if

P is less than AVCmin

Economic Losses=

P less than AC

Short-run Equilibrium Conditions:

P* = MC (to find profit-maximizing output) P* ⋛ AC (to find whether the firm makes profits, losses or breaks even) P* is not necessarily equal to the ACmin

Long-run Equilibrium Conditions:

P* = MC = ATCmin= LRATCmin Three Important Prices: The Break-even Price: P = ATCmin The Shut-down Price: P = AVCmin The Exiting Price in LR: P = LRATCmin

Long-Run Equilibrium Condition

P= AC

Firm is indifferent if

P=AVCmin

Discount Rate:

The interest rate used in computing present value (PV)

What is the relationship between marginal revenue and market price in a perfectly competitive market?

The marginal revenue will always be equal to the market price in a perfectly competitive market.

What is the shutdown point?

The price below which a firm lacks enough revenue to cover variable costs

The Present Value (PV) of Future Dollars →

The value, in today's money, of a sum of money to be received or paid in the future •PV= Y/[(1+r)]^n

What is the expected result in an industry with prohibitively large fixed costs, but low marginal costs thereafter?

There will be a natural monopoly. When economies of scale are large such that marginal cost is low once fixed costs are in place, a natural monopoly will arise.

Finding the profit maximizing price and output for a monopolist:

Unlike a perfectly competitive firm, a monopolist is a price maker •A monopolist faces a downward-sloping demand curve: P = AR •The marginal revenue curve lies below demand curve: MR < AR •To maximize profits, the monopolist will produce and output level were . . . •MC = MR •Then set price off the demand curve •To find the monopolist's profit, compare the price to average costs

Where is the monopoly supply curve located?

there is no monopoly supply curve

total revenue is maximized when marginal revenue is equal

to zero: MR=0

If a firm shuts down its production facility, it will still pay its sunk cost. Therefore, it will remain open if its

total loss is less than the sunk cost

total economic profit

total revenue - ( explicit costs + implicit costs)

The fact that a single-price monopolist must lower its price to sell more output explains why price exceeds marginal revenue true or false

true