Price exam 3

Barriers of Entry

A barrier to entry is something that prevents firms from entering a market where incumbent firms are earning economic profits. Examples include economies of scale, government policy, exclusive control over an input, brand loyalty, consumer lock-in (something that makes it costly for consumers to change suppliers), network effects, entry costs.

Market Power

A firm has market power if it can choose the price at which it sells its product without losing all of its sales.

Long-run profit maximization for a firm with market power

A firm with market power maximizes profits in the long run by setting LMC equal to MR.

Short-run profit maximization for a firm with market power

A firm with market power maximizes profits in the short run by setting SMC equal to MR. The firm is better off producing as long as P AVC, otherwise the firm should shut down.

Profit maximizing input usage for a firm with market power

A firm with market power should choose its input levels so that the price of the input equals the product of the input's marginal product and the firm's marginal revenue. For example, in the case of labor, a profit maximizing firm with market power should choose labor so that , where w is the wage.

Market Definition

A market definition identifies the producers and products/services that compete in a particular geographic area. A market is defined along two dimensions: the product (which products can be considered substitutes for one another?) and geography (how large do we have to set the geographic boundary of a market in order to include all firms that are competing with one another and all buyers of the product?).

Numerical Measures of Market Power

A numerical measure of market power can give us some idea if a firm has market power. Examples of numerical measures of market power include the elasticity of demand (relatively inelastic demand suggest market power), the Lerner Index (the inverse of the absolute value of the elasticity of demand, 1/|E|), and the cross-price elasticity of demand (the percent change in quantity demanded due to a one percent change in the price of a related good).

Monopoly

A single firm selling a product for which there are no close substitutes. There are barriers to entry preventing other firms from entering the market. A monopoly may or may not earn economic profits in the short and long runs.

Monopolistic Competition

A situation in which there are many firms producing differentiated products (the products being sold are different but can be substituted for one another to a limited degree), and there are no barriers to entry or exit from the market. Firms may earn economic profits or losses in the short-run, free entry guarantees that economic profits for all firms will be zero in the long run.

Constant-cost industry

An industry where price is constant in the long run, i.e., the supply curve is perfectly elastic (flat). In a constant cost industry, the supply curve for each input is perfectly elastic (flat). As firms enter or exit the industry in the long run, the demand curve for each input shifts (outward if firms enter the market and inward if firms leave the market), but since the supply curve of each input is flat, the price of inputs does not change. Since the price of inputs does not change, production costs in the industry are unaffected. Since production costs are unaffected, each firm's LAC curve is unchanged. Since price equals the minimum of LAC in long-run competitive equilibrium, and each firm's LAC curve remains the same regardless of how many firms are in the market, price does not change as firms enter or exit the market in the long-run. Since price is always the same in the long-run regardless of the number of firms in the industry, the long-run supply curve for a constant cost industry is perfectly elastic (flat).

Increasing-cost industry

An industry where the long run the supply curve slopes upward. In an increasing-cost industry, the supply curve for each input used by firms in the industry is less than perfectly elastic (slopes upward). As firms enter the industry, the demand curve for each input shifts outward, and the price of each input goes up. Since the price of inputs goes up, each firm in the industry has higher long-run average costs (LAC). Since price equals the minimum of LAC in long-run competitive equilibrium, a greater number of firms means a higher price. Therefore as firms come into the market, quantity produced goes up, but price goes up as well: the supply curve slopes upward.

Economic rent

Any payment to an input or factor used in production over and above the minimum payment needed to keep the factor in production at its current level. For example, if it would cost $1,000 to use 100 units of labor, but those 100 units of labor are being paid $2,000, labor is earning $1,000 in economic rent.

Producer Surplus in the Short Run

For a single perfectly competitive firm, short-run producer surplus is given by TR - TVC, the area above the firm's short-run supply curve and below price. For the market as as a whole, short-run producer surplus is the area above the market short-run supply curve and below price (or the sum of TR - TVC for all firms in the market).

Long-run competitive equilibrium under monopolistic competition

Free entry and exit of firms guarantees zero profits in the long run. Therefore in the long run, price must be equal to long-run average cost at the profit maximizing quantity for all firms in a monopolistically competitive market. Price can only be equal to long-run average cost at the profit maximizing quantity if long-run average cost is tangent to the demand curve.

The Cross-price elasticity of demand

If the related good is a possible substitute, a small cross-price elasticity of demand would indicate possible market power, because it would show that demand for the good does not change very much in response to changes in the price of substitutes.

Long-run producer surplus in a perfectly competitive industry

In a perfectly competitive market, producer surplus in the long run is given by the area above the supply curve and below price; this is the same definition used in the short run. For producer surplus to be greater than zero, the long-run supply curve must slope upward (the industry must be an increasing-cost industry). However, since profits are zero in a perfectly competitive market in long-run equilibrium, producer surplus cannot be earned by firms in the industry. Instead, in the long run, all producer surplus in a perfectly competitive industry is paid to inputs as economic rent.

Long-run competitive equilibrium in a perfectly competitive market:

In long-run equilibrium in a perfectly competitive market, free entry and exit of firms guarantees that economic profits are zero for all firms. Since profits are zero, price in the long-run must be equal to the minimum of long-run average cost (LAC).

LIFO

LIFO is a characteristic of a good market definition. It indicates that there are few sales into the market from sellers outside the market.

LOFI

LOFI is a characteristic of a good market definition. It indicates that there are few purchases from sellers inside the market by buyers outside the market.

Marginal Revenue

Marginal revenue is the increase in revenue caused by one unit increase in output. Each point on the marginal revenue curve tells you how much was added to revenue by each additional unit of production. For example, if the marginal revenue curve has a value of 10 when quantity produced is 20, then the 20th unit of output added 10 to total revenue. For a perfectly competitive firm, the demand curve and the marginal revenue curve are one and the same. For a firm with market power, the marginal revenue curve slopes downward and is always steeper than the demand curve, ensuring that marginal revenue is less than price. Marginal revenue is less than price for a firm with market power because in order to increase sales by one unit, a firm must sell the marginal unit (the last unit) at a lower price than all previous units (the inframarginal units), and must also cut the price on all inframarginal units. Thus the marginal revenue of the last unit sold is equal to the revenue earned on the last unit (the price of the unit) minus the lost revenue from cutting the price for all inframarginal units.

Long-run market supply curve for a perfectly competitive market

The long-run market supply curve for a perfectly competitive market shows how price and quantity in the market change as firms enter and exit the market. Each quantity on the supply curve is equal to the quantity supplied by a single firm, multiplied by the number of firms in the market.

Short Run Competitive Equilibrium in a Perfectly Competitive Market

The market is in short-run equilibrium if all firms are maximizing profits. Profit is maximized in the short run if MR = SMC. For a perfectly competitive firm, MR = P, so profit is maximized for a perfectly competitive firm if P = SMC. The firm produces if P AVC and shuts down in the short-run if P < AVC.

Short-run supply curve for a single perfectly competitive firm

The portion of the firm's SMC curve that is above its shutdown price. The short-run supply curve shows the quantity the firm is willing to supply at each price.

Short-run market supply curve for a perfectly competitive market

The short-run market supply curve shows the quantity that will be supplied by all firms in the market at each price; recall that in the short run, the number of firms in the market is fixed. This curve is created by adding up the quantities produced at each price by all firms in the market. You can calculate these quantities by finding how much a single firm produces at each price and multiplying the quantities by the number of firms in the market.

Perfect Competition

a market in which all firms are price takers and produce an identical product, i.e., all firms have zero market power and face a perfectly elastic (flat) demand curve. There are no barriers to entry or exit of firms. Firms may or may not earn economic profits in the short run. Free entry and exit guarantees that all firms earn zero economic profits in the long run, although it is possible that firms earn economic profits in the short run.

Profit maximizing input usage

in order to maximize profits, a perfectly competitive firm must choose its input amount so that the marginal revenue product of each input is equal to the price of each input.

Marginal revenue product

price of the product sold by the firm, multiplied by the marginal product of the input.