Econ exam 3

To see if a merger hurts consumers,

figure out if it helps rival firms.

which of the following is a variable cost a. labor wages b. rent c. taxes d. dividends

labor wages

free entry continues until

price = average cost of the marginal supplier

Monopoly produces output

where MR = MC

The monopoly maximizes profit by:

(1) Finding where MR = MC to determine its optimal output, Qm (2) Comparing that output to the demand curve to determine its price, Pm (3) Profits are just (P − ATC )xQ

how does a shift from pricing with market power to perfect competition change outcome?

A. Market Power: set quantity by producing until marginal revenue = marginal cost, then set price by looking up to the demand curve B. Perfect Competition: keep producing until price = marginal cost, which occurs when the demand curve cuts the marginal cost curve lesson 1: the market power price exceeds the competitive lesson 2: the market power quantity is less than the competitive quantity lesson 3: a firm with market power earns a healthy profit margin (equal to the market power price - average cost) lesson 4: these profits mean that a business with market power can survive, even if it has inefficiently high costs

free entry continues until price equals average cost

A. in the short run, firms can earn profits when price exceeds average cost B. profits attract new entrants, pushing the firm's demand curve to the left and making the curve more elastic C. entry and exit continues until profits are zero D. in this long run equilibrium, price equals average total cost

accounting profit

Accounting profit is total revenue less out-of- pocket financial costs. These out-of-pocket financial costs are called explicit costs. Accounting profit = Total revenue - Explicit costs

average cost curve

Average cost and average variable costs will tend together because fixed costs tend to zero Marginal cost has to cross average variable cost and average cost from below at the respective minimums

Setting prices to maximize profit involves a trade-off:

It is a trade-off between selling a large quantity of items versus making more money on each item. Use your firm demand curve and the marginal revenue curve to evaluate this trade-off. Firm demand curve: Summarizes the quantity that buyers demand from an individual firm as it changes its price. Market demand is the quantity demanded across all firms. Firm demand is the quantity demand from your firm. Individual demand is the quantity demanded by a single buyer. Your market power shapes your firm's demand curve.

Supply-Side Strategies: Develop Unique Cost Advantages.

Learning by doing means that experience yields efficiency gains. The benefits of mass production can keep small firms from being competitive entrants. Research and development can create cost advantages. Relationships with suppliers can get you cheaper inputs. Access to key inputs can freeze out your competitors.

long run

Long run: The horizon over which you or your rivals may expand or contract production capacity and new rivals may enter the market or existing firms may exit. (all costs are variable) Long-run analysis is useful for planning purposes, such as planning how much to invest in new plant and equipment for a business expansion. (factory size would be fixed in short run, but change in long run)

Marginal revenue =

MR = P − ∆P × Q

the problem with market power

Market power distorts market forces, leading to worse outcomes. - For instance, life-saving drugs can be expensive. - Pharmaceutical companies need patents, which give them the incentives to spend billions of dollars to invent new drugs. Sellers exploit their market power.

Market structure & market power

Market structure is important because it shapes your market power. Market power is the extent to which a seller can charge a higher price without losing many sales to competing businesses.

Why the price gap?

No cost: printing costs are <$1 for both books Timing: hardcover is released six months earlier

example of output and discount effect graphically

P= 10 - Q Total revenue is maximized at Q = 5, P = 5 where TR = 25 In order to sell one more unit, the firm must lower the price from $5 to $4 This generates an additional $4 of revenue (MR = 4). [output effect] However there's a tradeoff, the previous five units must be sold for $1 less: this generates -$1*5 of revenue (-$5). [discount effect] Overall we get: $25 +$4 - $5 = $24 is the total revenue for Q = 6, P = 4. MR (going from 5th unit to 6th unit) is: P - Delta P x Q MR = 4 - 1(5) = -1 So we went from TR = 25 at Q = 5 to TR = 24 at Q = 6 Better formula for MR: (Change in TR / Change in Q) MR = dTR/dQ

Regulatory Strategies: Government Policy (1 of 2)

Patents give you the right to be the only producer. Regulations make it difficult for new businesses to enter your market. Compulsory licenses can limit competition. Lobbying can create new regulatory barriers.

The efficiency of price discrimination

Price discrimination increases the quantity you sell Selective discounts induce additional sales

Price discrimination

Price discrimination: selling the same product at different prices Set prices close to (and just below) marginal benefit Reservation price: the maximum price a customer will pay for a product

Quantity discount:

Quantity discount: A per-unit price that is lower when you buy a larger quantity. Also, different types of customers buy different quantities (such as at Costco and Sam's Club). Bundling creates a hurdle to getting the second good at a lower price. Cable TV pricing is a bundling strategy. What are some goods that you purchase in bundles?

How should you set group prices? Set one price for all consumers Set a different price for each consumer Set prices for different groups as you would for different markets Set supply equal to demand

Set prices for different groups as you would for different markets

short run

Short run: The horizon over which the production capacity and the number and type of competitors you face cannot change. (at least one cost is fixed)

example of economic profit to make decisions

Suppose that in order to start a new business, you will have to quit your current job, which pays you $60,000 per year, and invest $100,000 in the business, instead of keeping it in the bank where it's earning 5% interest per year. Should you start this business?

Demand-Side Strategies: Create Customer Lock-In.

Switching costs lock in your customers. Switching costs are impediments that make it costly for customers to switch to buying from another business. Reputation and goodwill keep your customers loyal. Network effects mean that your product becomes more useful the more people use it.

The Rational Rule for Entry

The Rational Rule for Entry says you should enter a market if you expect to earn a positive economic profit, which occurs when price exceeds average cost.

The Rational Rule for Exit

The Rational Rule for Exit says to exit the market if you expect to earn a negative economic profit, which occurs if price is less than average cost.

discount effect

The discount effect is the revenue loss from cutting the price on all the units sold. Discount effect = ∆P × Q

output effect

The output effect is the revenue increase from selling one more unit. (market price) Output effect = P

imperfect competition

The situation of facing at least some competitors and/or selling products that differ at least a little from those of competitors.

Entrepreneurs need to overcome barriers to entry:

Use demand-side strategies to combat customer lock- in. Use supply-side strategies to overcome cost disadvantages. Use regulatory strategies to your advantage. Overcome deterrence strategies to fight the big guys

Criteria one: segment your market into groups with different demand

Use observable proxies-like being a student-that are related to each customer's reservation price The better the proxy-that is, the more closely it captures differences in reservation prices-the more successful your strategy will be Find how best to divide your market into segments with distinct patterns of demand This depends on what information you have available to you

perfect competition

markets in which: • all businesses in an industry sell an identical good, and • there are many sellers and many buyers, • each of whom is small relative to the size of the market. Sellers have no market power. (maybe a farmers market where all stands are selling the same product- you can go to the next stand and get something cheaper so you wouldn't want to price high)

monopolistic competition

markets in which: - many small businesses compete, each selling differentiated products - product differentiation is efforts by sellers to make their products different from those of their competitors - similar to perfect competition 'but without identical products' the sellers have some market power

oligopoly

markets in which: - only a handful of large sellers - sellers pay attention to both consumers and each other - the sellers have some market power (sellers realize that any difference they make will be reacted to by their rivals - commercials where they mention rival - at&t and tmobile)

monopoly

markets in which: - there is only one seller - the market demand curve is the firm's demand curve - the seller has a lot of market power

entry and exit shift your firm's demand curve

panel A: entry decreases your firm's demand when a new competitor enters... A. you'll lose customers, and this decrease in demand shifts your firm's demand curve left B. you'll lose market power, flattening your firm's demand curve panel B: exit increases your firm's demand when an existing firm exits... A. you'll gain customers, and this increase in demand shifts your firm's demand curve right B. you'll gain market power, steepening your firm's demand curve

group pricing

price discrimination by charging different prices to different groups of people. - Groups are effective if they have a relationship to the expected marginal benefit. - Group pricing involves offering different prices to groups that differ by their age, location, purchase history, or any other identifiable characteristic. Examples include the following: Books are cheaper in India than in the United States. Internet companies charge lower prices for residential rather than business service. Movie theaters offer student discounts.

proft margin

profit margin is the price less the average cost - this is a per-unit measure - remember that price is equal to average revenue profit margin = price - average cost

Marginal revenue reflects

the output effect minus the discount effect.

Laws to ensure competition thrives

- Anti-collusion laws prevent businesses from agreeing not to compete. - Collusion: An agreement to limit competition. - Merger laws prevent competing businesses from combining to consolidate market power. -Some laws thwart abuses of market power: monopolizing versus being a monopoly. - International trade fosters competition. *Price fixing is absolutely illegal

Increasing competition can yield better outcomes

- Competition leads to lower prices and a higher quantity. - Market power leads businesses to produce a lower quantity and sell at a higher price — the underproduction problem. - Higher prices are a problem for customers but a benefit for sellers. - Smaller quantity is not best for society. - Patents provide an incentive to engage in research.

good decisions focus on marginal revenue

- Marginal revenue is the addition to total revenue you get from selling one more unit. - Calculate marginal revenue as the change in total revenue from selling one more unit. - Marginal revenue lies below the demand curve and declines faster.

Five key insights into imperfect competition

- Market power allows you to pursue independent pricing strategies. - Having more competitors leads to less market power. - Successful product differentiation gives you more market power. - Imperfect competition among buyers gives them bargaining-power. - Your best choice depends on the actions that other businesses make.

Which of the following is an example of group pricing? The local cafe charges $3.50 for a cup of cappuccino A ham and cheese sandwich is $3.99 at the school cafeteria A hairdresser charges more for women's haircuts than for men's All of the above are examples of group pricing

A hairdresser charges more for women's haircuts than for men's

What is the relationship among marginal cost, marginal revenue, average cost, and price in a market with imperfect competition and free entry in the long run? A. Marginal cost = Marginal revenue < Price = Average Cost B. Marginal cost = Marginal revenue = Price = Average cost C. Marginal cost = Average cost < Price = Marginal revenue D. Marginal cost = Marginal revenue = Average cost < Price

A. Marginal cost = Marginal revenue < Price = Average Cost

Which of the following is an example of the hurdle method? Jane uses coupons when shopping for groceries at her local supermarket Pete waits until black friday to purchase a video game console When buying a new car, fred haggles for a discount at the car dealership All of the above

All of the above

average cost

Average cost: Cost per unit, calculated as your firm's total costs (including fixed and variable costs) divided by the quantity produced. average cost = (total costs/ quantity) = (fixed costs/ quantity) + (variable costs / quantity) Fixed costs do not change with output like rent of a bakery, your rent is invariant to the number of pastries you make, downsloping Variable costs are the ingredients for the bakery (like eggs, flour) → is a function of quantity, will be increasing in output, upward sloping

average revenue

Average revenue: Revenue per unit, calculated as total revenue divided by the quantity supplied. Average revenue is equal to the price if you charge everyone the same price. TR = (PQ)/Q = P Average revenue = Total revenue/quantity= price

Suppose you run a coffee stand. Your fixed costs are $10,000 for the equipment. Your variable costs are $1 per cup of coffee. You expect to sell 20,000 cups of coffee this year at a price of $3 per cup. What is your profit margin per cup of coffee? A. $2 per cup B. $1.50 per cup C. $0.50 per cup D. -$3 per cup (operating at a loss)

B. $1.50 per cup - correct answer (turn into average variable cost: 10,000/20,000 = 0.5+1 → 3-1.5 = 1.5)

A competitive merger creates a more fearsome competitor.

Bad for rivals Could be good for consumers

Firms' ongoing profitability depend on barriers to entry.

Barriers to entry are obstacles that make it difficult for new firms to enter.

Criteria three: base group discounts on difficult to change characteristics

Base group discounts on characteristics that are not only verifiable but also difficult to change This avoids the possibility that customers will switch into a different group in order to get a lower price Examples: student discounts, senior citizen discounts, regional discounts Can you come up with other examples

Entry Deterrence Strategies: Convince Your Rivals That You'll Crush Them.

Build excess capacity so that your rivals expect fierce competition. Financial resources signal that you can survive a costly fight. Brand proliferation can ensure there are no profitable niches for a rival to exploit. Your reputation for fighting can be helpful, too.

Criteria two: target group discounts based on verifiable characteristics

Buyers will try to come up with cunning ways to avoid paying the high price Link your group discounts to verifiable characteristics, such as your customer's age, students status, or address The characteristics that are verifiable depend on the industry you are in

Price ceilings _____ economic surplus in perfectly competitive markets and _____ economic surplus in imperfectly competitive markets. A. increase; increase B. increase; decrease C. decrease; increase D. decrease; decrease

C. decrease; increase

The price in perfect competition is _____ than the price under imperfect competition. The quantity in perfect competition is _____ than the quantity under imperfect competition. A. higher; higher B. higher; lower C. lower; higher D. lower; lower

C. lower; higher

Increasing Competition Can Lead to Better Outcomes

Competition leads to lower prices and a higher quantity. Market power leads businesses to produce a lower quantity and sell at a higher price ― the underproduction problem. Higher prices are a problem for customers but a benefit for sellers. Smaller quantity is not best for society. Patents provide an incentive to engage in research.

Recall Welfare

Consumer surplus is the difference between WTP and market price, the area below demand curve and above market price Producer surplus is the difference between market price and costs, the area below the market price and above cost curve (supply) The perfectly competitive market outcome is efficient; it maximizes total surplus

economic profit

Economic profit accounts for both explicit financial costs and implicit opportunity costs. The opportunity cost of running a business includes forgone wages and interest. Economic profit = Total revenue - Explicit costs - Implicit costs *economic profit will be less than accounting profit, can never be greater than it

Short-Run versus Long-Run Business Decisions

Economic profit is important for the long-run analysis of firm entry and exit.

Free entry and exit in the long run

Entry Decreases Demand and Your Profits. New competitors will enter profitable markets. The Rational Rule for Entry says you should enter a market if you expect to earn a positive economic profit, which occurs when price exceeds average cost. New competitors will make your market less profitable.

Natural monopoly: A market in which it is cheapest for a single business to service the market.

Examples: water, gas electricity Society's best interest: Price = Marginal cost But Price < Average cost The supplier would lose money. Suppliers can stay in business only by offering prices that are too high. Solution: The government provides goods. Set Price = Marginal cost Tax revenues pay for losses.

Exit Increases Demand and Your Profits.

Existing competitors exit unprofitable markets, which helps restore profitability. The Rational Rule for Exit says to exit the market if you expect to earn a negative economic profit, which occurs if price is less than average cost. Use the cost-benefit principle to decide whether to enter or exit. If the benefits of entering exceed the costs, then enter the market! If the costs of staying exceed the benefits, then exit the market!

Regulatory strategies: government policy (2 of 2)

Explain how patents protect a firm's profitability → give exclusive ability to produce that particular thing. Their temporary. Its useful, but doesnt completely give monopoly Who gains and who loses from patents - short run the company does, and rivals lose, customers might lose

Market power distorts market forces, leading to worse outcomes.

For instance, life-saving drugs can be expensive. Pharmaceutical companies need patents, which give them the incentives to spend billions of dollars to invent new drugs. Sellers exploit their market power.

Economic Profits Tend to Zero in the Long Run. (1 of 2)

Free entry pushes economic profits down to zero, in the long run. Free entry occurs when there are no factors making it particularly difficult or costly for a business to enter or exit an industry. Price is above average cost → finally at zero profits

Price equals average cost

Free entry pushes the price down toward average cost Free exit pushes the price up toward average cost In the long run, with free entry and exit, price equals average cost Price = average cost

Economic Profits Tend to Zero in the Long Run. (2 of 2)

Free exit ensures industries won't remain unprofitable in the long run Negative profit, firms will leave until rising costs

An anti-competitive merger reduces competition for all sellers.

Good for rivals Bad for consumers

the hurdle method

Hurdle method: Offering lower prices only to buyers who are willing to overcome some hurdle or obstacle. Key idea: Set the hurdle so that high marginal benefit customers will find it too costly. This yields self-selection. Low marginal-benefit customers leap the hurdle: Pay the low price. High marginal-benefit customers don't bother: Pay the high price. Hurdle method = group discounts

Let's reflect on the comparison to perfect competition.

In a competitive market firms set P = MC (and earn zero profit in the long run). (P= MR = MC) For the monopoly, since Pm > MR = MC we have Pm − MC > 0 The monopoly price includes 'mark-up' equal to the amount Pm − MC and this yields profits. How does the monopoly do this? It restricts output! Think back to the 'law of demand' where higher prices are associated with smaller quantities (in this case relative to the competitive outcome) * marginal cost curve acts as a supply curve

Price discrimination Increases efficiency relative to a market without price discrimination Decreases efficiency relative to a market without price discrimination Has the same level of efficiency of a market without price discrimination

Increases efficiency relative to a market without price discrimination

As firms enter a market, their firm demand curves a. Flatten b. Steepen c. Remain the same d. Can flatten, steepen, or remain the same

a. Flatten - correct answer (entry, more substitutes, demand becomes elastic)

Market Structure & Market Power Key Takeaways

- Market power is the extent to which a seller can charge a higher price without losing many sales to competing businesses. - Market structures range from perfect competition with no market power, to monopolistic competition and oligopolies with some market power, to monopolies with a lot of market power. - The shape of the firm's demand curve depends on the market structure. - Marginal revenue with market power is equal to the output effect minus the discount effect. - With market power, firms set quantity at the point at which marginal cost equals marginal revenue and then look up to the demand curve to set price. - Market power leads businesses to charge a higher price, sell a smaller quantity, earn larger profits, and survive with inefficiently high costs. - Public policy can't eliminate market power, but it can limit abuses.

Comparing the outcomes of market power and perfect competition leads us to four important lessons:

- Market power leads to higher prices. - Market power leads to inefficiently smaller quantity. - Market power yields larger economic profits. - Businesses with market power can survive even with inefficiently high costs.

Public Policy to Restrain Market Power

- More competition yields better outcomes for society as a whole. - Governments regulate markets through two sets of laws: --> laws that ensure that competition thrives. --> laws that minimize the harmful ways that businesses might exploit their market power.

sophisticated pricing key takeaways

- Price discrimination is selling the same good at different prices. - Price discrimination is feasible only if the business has market power, if it can prevent resale, and if it can target the right prices to the right customers. - To use group pricing, firms must segment the market into groups with different demands, target the group discounts based on verifiable characteristics, and base group discounts on difficult-to-change characteristics. - The hurdle method means offering lower prices only to those buyers who are willing to overcome some hurdle.

How do sellers determine their prices and quantities?

- Step 1: Keep selling until your marginal revenue equals your marginal cost. Remember that the Rational Rule for Sellers tells us to sell one more item if the marginal revenue is greater than (or equal to) marginal cost. - Step 2: Set your price on the demand curve. Not on the marginal revenue curve!

Laws That Minimize the Harm from Exercising Market Power

- The government can implement price ceilings to limit market power. - Set price = Marginal cost - Eliminates the discount effect - Eliminates the underproduction problem - Perfectly competitive markets: Price ceilings reduce economic surplus - Imperfectly competitive markets: Price ceilings increase economic surplus - Laws that link prices to costs - eliminate the incentive to produce high-quality goods. - reduce incentives for managers to keep down costs.

However a standard single price monopoly introduces inefficiency into the market

- The monopoly reduces output relative to the competitive market - So this means that there are unrealized gains to trade. - Notice-the units corresponding to the area between Qm and Qc are valued more highly by consumers than they cost to produce - We know this because the demand curve lies above costs. - This is what we previously defined as deadweight loss

market structure determines market power

- The structure with the least market power is perfect competition. - At the other extreme, monopolists have the most market power because they're the only businesses selling a unique product. - Both perfect competition and monopoly are rare. - Most businesses operate in imperfectly competitive markets. Imperfect competition: The situation of facing at least some competitors and/or selling products that differ at least a little from those of competitors.

types of market structure

- perfect competition - monopoly - oligopoly - monopolistic competition

A successful price discrimination strategy

1. Charge higher prices for some customers They'll keep buying the product You receive great profit margin on each sale This transfers consumer surplus into producer surplus, but total economic surplus is unchanged (efficiency) 2. Charge lower prices for others Offer select discounts to increase the quantity you sell Profits increase This increases the economic surplus enjoyed by both your business and your consumers

How do firms deter entry?

1. Find ways to create customer lock-in (demand-side strategies). (higher switching costs) 2. Develop unique cost advantages (supply-side strategies). (costs of selling a variety of similar products might be lower like with apple) 3. Mobilize the government to prevent entry (regulatory strategies). 4. Convince potential entrants that you'll crush them (deterrence strategies).

Comparing the outcomes of market power and perfect competition leads us to four important lessons:

1. Market power leads to higher prices. 2. Market power leads to inefficiently smaller quantity. 3. Market power yields larger economic profits. 4. Businesses with market power can survive even with inefficiently high costs.

How to segment your market

1. Segment your market into groups whose demand differs 2. Target your group discounts based on verifiable characteristics 3. Base group discounts based on difficult to change characteristics

Extra info on natural monopoly:

1. Very large fixed cost of operating in the first place 2. Very low marginal cost of serving an additional consumer 3. Requires very large volume of customers to recoup fixed cost → competition is bad...because - Inefficient duplication - Siphon off customer base

conditions for price discrimination

1. Your business has market power 2. You can prevent resale 3. You can target the right prices to the right customers

Perfect price discrimination

Perfect price discrimination: charging each customer its reservation price Achieve two profit-boosting objectives 1. Charge the highest price you possibly can on each sale Make every possible sale where there's a customer whose marginal benefit exceeds your marginal cost

setting group prices

Step 1: what quantity should you produce? Keep selling until marginal revenue (in that market segment) equals your marginal cost (marginal revenue in that market equals marginal cost and marginal revenue in all the other markets) Step 2: what price should you charge? Look up to your firm's demand curve (for that segment) to find the highest price you can set and still sell this quantity

Xavier is considering quitting his job as an editor for a major publisher to become a freelance editor. He currently earns $85,000 per year, plus an additional $15,000 worth of benefits. He estimates that as a freelancer he'll earn $140,000 per year in revenue and have $40,000 per year in financial costs. To get started, he'll need to withdraw $20,000 from his bank where it's earning 5% interest per year. - calculate accounting profit, implicit opportunity cost, economic profit, and if he should become a freelance editor

What is Xavier's accounting profit? (total revenue - explicit financial cost ) = (140,000 - 40,000 = 100,000) What is Xavier's implicit opportunity cost? (85,000 + 15,000 + 20,000 (0.05) = 101,000) What is Xavier's economic profit? (140,000 - 140,100 = -1000) Should Xavier become a freelance editor? No - -1000 economic proft

haggling is a hurdle

What's the discount? Cheaper prices. What's the hurdle? Spending hours haggling. Who won't jump over the hurdle? People who don't care a lot about price. People with a high cost of time. High willingness-to-pay customers. Who will jump over the hurdle? People who are price-sensitive. People with low incomes. Low willingness-to-pay customers. Result: Successful price discrimination. High marginal benefit customers pay a high price. Low marginal benefit customers pay a low price (after haggling for hours).

Release Time and the Hurdle Method

What's the discount? The paperback is about half the price of hard cover. What's the hurdle? The customer must wait six months for the paperback to be released. Who won't jump over the hurdle? Devoted Harry Potter fans who can't wait. High marginal benefit Who will jump over the hurdle? Less devoted fans who can wait. Low marginal benefit Result High marginal benefit customers pay a high price (for hardcover). Low marginal benefit customers pay a low price (for paperback).

Selective discounts help solve the underproduction problem

When you don't price discriminate: the discount applies to all customers When you do price discriminate: offer the right discount to the right person—and only that person—and you'll make a sale you wouldn't otherwise have made Keep offering discounts until marginal cost equals your last customer's marginal benefit, and you'll produce the efficient quantity

Price discrimination graphically

why a business charges prices to different customers for the same good A. no price discrimination: everyone pays the same price. produce where marginal revenue = marginal cost, and look up to find that price price discrimination part #1: charge higher prices to those who'll pay them - increases the profit you earn on each of these items sold - reduces consumer surplus (the gap between price and marginal benefit) by an equal amount part #2: offer selective discounts to induce new costumers to buy - increases the quantity you sell, raising profits - benefits those customers who can afford to buy your goods *Grey = single price monopoly The grey marginal revenue curve is not relevant in this example of price discrimination Everything below the steps is producer surplus Everything above the steps (super tiny) is consumer surplus No deadweight loss