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Market

In an economic sense, a market is a system by which buyers and sellers bargain for the price of a product, settle the price and transact their business—buy and sell a product.Personal contact between the buyers and sellers is not necessary. In some cases, e.g., forward sale and purchase, even immediate transfer of ownership of goods is not necessary. Market does not necessarily mean a place. The market for acommodity may be local, regional, national or international. What makes a market is a set of buyers, a set of sellers and a commodity. While buyers are willing to buy and sellers are willing to sell, and there is a price for the commodity.

The Four Types of Market Structure

Copyright © 2004 South-Western

• Tap water

• Cable TV

Monopoly

• Novels

• Movies

Monopolistic

Competition

• Tennis balls

• Crude oil

Oligopoly

Number of Firms?

Perfect

• Wheat

• Milk

Competition

Type of Products?

Identical

products

Differentiated

products

One

firm

Few

firms

Many

firms

Market Structure

• Market structure – identifies how a market is made up in terms of:– The number of firms in the industry

– The nature of the product produced

– The degree of monopoly power each firm has

– The degree to which the firm can influence price

– Profit levels

– Firms’ behaviour – pricing strategies, non-price competition, output levels

– The extent of barriers to entry

– The impact on efficiency

Market Structure

More competitive (fewer imperfections)

Perfect Competition

Pure Monopoly

Market Structure

Less competitive (greater degree of imperfection)

Perfect Competition

Pure Monopoly

Market StructurePerfect

Competition

Pure Monopoly

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree of monopoly power exercised by the firm.

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Game theory is the study of how people behave in strategic situations.

• Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Because the number of firms in an oligopolistic market is small, each firm must act strategically.

• Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners’ Dilemma

• The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.

• Often people (firms) fail to cooperate with one another even when cooperation would make them better off.


• The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Figure 2 The Prisoners’ Dilemma

Copyright©2003 Southwestern/Thomson Learning

Bonnie’ s Decision

Confess

Confess

Bonnie gets 8 years

Clyde gets 8 years

Bonnie gets 20 years

Clyde goes free

Bonnie goes free

Clyde gets 20 years

gets 1 yearBonnie

Clyde gets 1 year

Remain Silent

Remain

Silent

Clyde’s

Decision


• The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.


• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

Figure 3 An Oligopoly Game


Iraq’s Decision

High

Production

High Production

Iraq gets $40 billion

Iran gets $40 billion







Low Production

Low

Production

Iran’s

Decision

Oligopolies as a Prisoners’ Dilemma

• Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

Figure 4 An Arms-Race Game


Decision of the United States (U.S.)

Arm

Arm

U.S. at risk

USSR at risk

U.S. at risk and weak

USSR safe and powerful

U.S. safe and powerful

USSR at risk and weak

U.S. safe

USSR safe

Disarm

Disarm

Decision

of the

Soviet Union

(USSR)

Figure 5 An Advertising Game


Marlboro’ s Decision

Advertise

Advertise

Marlboro gets $3

billion profit

Camel gets $3

billion profit

Camel gets $5

billion profit

Marlboro gets $2

billion profit

Camel gets $2

billion profit

Marlboro gets $5

billion profit

Camel gets $4

billion profit

Marlboro gets $4

billion profit

Don’t Advertise

Don’t

Advertise

Camel’s

Decision

Figure 6 A Common-Resource Game


Exxon’s Decision

Drill Two

Wells

Drill Two Wells

Exxon gets $4

million profit

Texaco gets $4

million profit

Texaco gets $6

million profit

Exxon gets $3

million profit

Texaco gets $3

million profit

Exxon gets $6

million profit

Texaco gets $5

million profit

Exxon gets $5

million profit

Drill One Well

Drill One

Well

Texaco’s

Decision

Why People Sometimes Cooperate

• Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

Figure 7 Jack and Jill Oligopoly Game


Jack’s Decision

Sell 40

Gallons

Sell 40 Gallons

Jack gets

$1,600 profit

Jill gets

$1,600 profit

Jill gets

$2,000 profit

Jack gets

$1,500 profit

Jill gets

$1,500 profit

Jack gets

$2,000 profit

Jill gets

$1,800 profit

Jack gets

$1,800 profit

Sell 30 Gallons

Sell 30

Gallons

Jill’s

Decision

PUBLIC POLICY TOWARD OLIGOPOLIES

• Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too lowand prices that are too high.

Restraint of Trade and the Antitrust Laws

• Antitrust laws make it illegal to restrain trade or attempt to monopolize a market.

– Sherman Antitrust Act of 1890

– Clayton Act of 1914

Controversies over Antitrust Policy

• Antitrust policies sometimes may not allow business practices that have potentially positive effects:

– Resale price maintenance

– Predatory pricing

– Tying

Controversies over Antitrust Policy

• Resale Price Maintenance (or fair trade) – occurs when suppliers (like wholesalers) require

retailers to charge a specific amount

• Predatory Pricing– occurs when a large firm begins to cut the price of its

product(s) with the intent of driving its competitor(s) out of the market

• Tying– when a firm offers two (or more) of its products

together at a single price, rather than separately

Summary

• Oligopolists maximize their total profits by forming a cartel and acting like a monopolist.

• If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome.

Summary

• The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual self-interest.

• The logic of the prisoners’ dilemma applies in many situations, including oligopolies.

Summary

• Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.

Market Structure

• Monopoly:– High barriers to entry

– Firm controls price OR output/supply

– Abnormal profits in long run

– Possibility of price discrimination

– Consumer choice limited

– Prices in excess of MC

• While a competitive firm is a price taker, a monopoly firm is a price maker.

• A firm is considered a monopoly if . . .

– it is the sole seller of its product.

– its product does not have close substitutes.

WHY MONOPOLIES ARISE

• The fundamental cause of monopoly is barriers to entry.

WHY MONOPOLIES ARISE

• Barriers to entry have three sources:

– Ownership of a key resource.

– The government gives a single firm the exclusive right to produce some good.

– Costs of production make a single producer more efficient than a large number of producers.

Monopoly Resources

• Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.

Government-Created Monopolies

• Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets.

Government-Created Monopolies

• Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.

Natural Monopolies

• An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

Natural Monopolies

• A natural monopoly arises when there are economies of scale over the relevant range of output.

Figure 1 Economies of Scale as a Cause of Monopoly


Quantity of Output

Average

total

cost

0

Cost

HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS

• Monopoly versus Competition– Monopoly

• Is the sole producer

• Faces a downward-sloping demand curve

• Is a price maker

• Reduces price to increase sales

– Competitive Firm• Is one of many producers

• Faces a horizontal demand curve

• Is a price taker

• Sells as much or as little at same price

Figure 2 Demand Curves for Competitive and Monopoly Firms


Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

0

Price

Quantity of Output0

Price

Demand

A Monopoly’s Revenue

• A Monopoly’s Marginal Revenue

– A monopolist’s marginal revenue is always less than the price of its good.

• The demand curve is downward sloping.

• When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.

A Monopoly’s Revenue

• A Monopoly’s Marginal Revenue

– When a monopoly increases the amount it sells, it has two effects on total revenue (P Q).

• The output effect—more output is sold, so Q is higher.

• The price effect—price falls, so P is lower.

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly


Quantity of Water

Price

$11

10

9

8

7

6

5

4

3

2

1

0

–1

–2

–3

–4

Demand

(average

revenue)

Marginal

revenue

1 2 3 4 5 6 7 8

Profit Maximization

• A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

• It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Figure 4 Profit Maximization for a Monopoly


QuantityQ Q0

Costs and

Revenue

Demand

Average total cost

Marginal revenue

Marginal

cost

Monopoly

price

QMAX

B

1. The intersection of the

marginal-revenue curve

and the marginal-cost

curve determines the

profit-maximizing

quantity . . .

A

2. . . . and then the demand

curve shows the price

consistent with this quantity.

Profit Maximization

• Comparing Monopoly and Competition

– For a competitive firm, price equals marginal cost.

P = MR = MC

– For a monopoly firm, price exceeds marginal cost.

P > MR = MC

A Monopoly’s Profit

• Profit equals total revenue minus total costs.

– Profit = TR - TC

– Profit = (TR/Q - TC/Q) Q

– Profit = (P - ATC) Q

Figure 5 The Monopolist’s Profit


Monopoly

profit

Average

total

cost

Quantity

Monopoly

price

QMAX0

Costs and

Revenue

Demand

Marginal cost

Marginal revenue

Average total cost

B

C

E

D

A Monopolist’s Profit

• The monopolist will receive economic profits as long as price is greater than average total cost.

Figure 6 The Market for Drugs


Quantity0

Costs and

Revenue

DemandMarginal

revenue

Price

during

patent life

Monopoly

quantity

Price after

patent

expires

Marginal

cost

Competitive

quantity

THE WELFARE COST OF MONOPOLY

• In contrast to a competitive firm, the monopoly charges a price above the marginal cost.

• From the standpoint of consumers, this high price makes monopoly undesirable.

• However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

Figure 7 The Efficient Level of Output


Quantity0

Price

Demand

(value to buyers)

Marginal cost

Value to buyers

is greater than

cost to seller.

Value to buyers

is less than

cost to seller.

Cost

to

monopolist

Cost

to

monopolist

Value

to

buyers

Value

to

buyers

Efficient

quantity

The Deadweight Loss

• Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.

– This wedge causes the quantity sold to fall short of the social optimum.

Figure 8 The Inefficiency of Monopoly


Quantity0

Price

Deadweight

loss

Demand

Marginal

revenue

Marginal cost

Efficient

quantity

Monopoly

price

Monopoly

quantity

The Deadweight Loss

• The Inefficiency of Monopoly

– The monopolist produces less than the socially efficient quantity of output.

The Deadweight Loss

• The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax.

• The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

PUBLIC POLICY TOWARD MONOPOLIES

• Government responds to the problem of monopoly in one of four ways.

– Making monopolized industries more competitive.

– Regulating the behavior of monopolies.

– Turning some private monopolies into public enterprises.

– Doing nothing at all.

Increasing Competition with Antitrust Laws

• Antitrust laws are a collection of statutes aimed at curbing monopoly power.

• Antitrust laws give government various ways to promote competition.

– They allow government to prevent mergers.

– They allow government to break up companies.

– They prevent companies from performing activities that make markets less competitive.

Increasing Competition with Antitrust Laws

• Two Important Antitrust Laws

– Sherman Antitrust Act (1890)

• Reduced the market power of the large and powerful “trusts” of that time period.

– Clayton Act (1914)

• Strengthened the government’s powers and authorized private lawsuits.

Regulation

• Government may regulate the prices that the monopoly charges.

– The allocation of resources will be efficient if price is set to equal marginal cost.

Figure 9 Marginal-Cost Pricing for a Natural Monopoly


Loss

Quantity0

Price

Demand

Average total cost

Regulated

price Marginal cost

Average total

cost

Regulation

• In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

Public Ownership

• Rather than regulating a natural monopolythat is run by a private firm, the government can run the monopoly itself (e.g. in the United States, the government runs the Postal Service).

Doing Nothing

• Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

PRICE DISCRIMINATION

• Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.


• Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

• Perfect Price Discrimination– Perfect price discrimination refers to the situation

when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.


• Two important effects of price discrimination:

– It can increase the monopolist’s profits.

– It can reduce deadweight loss.

Figure 10 Welfare with and without Price Discrimination


Profit

(a) Monopolist with Single Price

Price

0 Quantity

Deadweight

loss

DemandMarginal

revenue

Consumer

surplus

Quantity sold

Monopoly

price

Marginal cost

Figure 10 Welfare with and without Price Discrimination


Profit

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Demand

Marginal cost

Quantity sold


• Examples of Price Discrimination

– Movie tickets

– Airline prices

– Discount coupons

– Financial aid

– Quantity discounts

CONCLUSION: THE PREVALENCE OF MONOPOLY

• How prevalent are the problems of monopolies?

– Monopolies are common.

– Most firms have some control over their prices because of differentiated products.

– Firms with substantial monopoly power are rare.

– Few goods are truly unique.

Summary

• A monopoly is a firm that is the sole seller in its market.

• It faces a downward-sloping demand curve for its product.

• A monopoly’s marginal revenue is always below the price of its good.

Summary

• Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal.

• Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.

Summary

• A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus.

• A monopoly causes deadweight losses similar to the deadweight losses caused by taxes.

Summary

• Policymakers can respond to the inefficiencies of monopoly behavior with antitrust laws, regulation of prices, or by turning the monopoly into a government-run enterprise.

• If the market failure is deemed small, policymakers may decide to do nothing at all.

Summary

• Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay.

• Price discrimination can raise economic welfare and lessen deadweight losses.

Market Structure

• Advantages and disadvantages of monopoly:• Advantages:

– May be appropriate if natural monopoly– Encourages R&D– Encourages innovation– Development of some products not likely without some

guarantee of monopoly in production– Economies of scale can be gained – consumer may benefit

Market Structure

• Disadvantages:

– Exploitation of consumer – higher prices

– Potential for supply to be limited - less choice

– Potential for inefficiency –

X-inefficiency – complacency over controls on costs

Market Structure

Kinked Demand CurvePrice

Quantity

D = elastic

D = Inelastic

£5

100

Kinked D Curve

Monopolistic or Imperfect Competition• In each case there are many firms

in the industry

• Each can try to differentiate its product in some way

• Entry and exit to the industry is relatively free

• Consumers and producers do not have perfect knowledge of the market – the market may indeed be relatively localised. Can you imagine trying to search out the details, prices, reliability, quality of service, etc for every plumber in the UK in the event of an emergency??

Oligopoly

• Competition between the few– May be a large number of firms in the industry but the

industry is dominated by a small number of very large producers

• Concentration Ratio – the proportion of total market sales (share) held by the top 3,4,5, etc firms:– A 4 firm concentration ratio of 75% means the top 4 firms

account for 75% of all the sales in the industry

Oligopoly

• Example:

• Music sales –The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this ‘independents’ group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers.

Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

http://www.ifpi.org/site-content/press/20030909.html



Oligopoly

• Features of an oligopolistic market structure:– Price may be relatively stable across the industry –

kinked demand curve?

– Potential for collusion

– Behaviour of firms affected by what they believe their rivals might do – interdependence of firms

– Goods could be homogenous or highly differentiated

– Branding and brand loyalty may be a potent source of competitive advantage

– Non-price competition may be prevalent

– Game theory can be used to explain some behaviour

– AC curve may be saucer shaped – minimum efficient scale could occur over large range of output

– High barriers to entry

Oligopoly

The kinked demand curve - an explanation for price stability?Price

Quantity

D = elastic

D = Inelastic

£5

100

Kinked D Curve

The principle of the kinked demand

curve rests on the principle

that:

a. If a firm raises its price, its

rivals will not follow suit

b. If a firm lowers its price, its

rivals will all do the same

Assume the firm is charging a price of

£5 and producing an output of 100.

If it chose to raise price above £5, its

rivals would not follow suit and the firm

effectively faces an elastic demand

curve for its product (consumers would

buy from the cheaper rivals). The %

change in demand would be greater

than the % change in price and TR

would fall.

Total Revenue A

Total Revenue B

If the firm seeks to lower its price to

gain a competitive advantage, its rivals

will follow suit. Any gains it makes will

quickly be lost and the % change in

demand will be smaller than the %

reduction in price – total revenue

would again fall as the firm now faces

a relatively inelastic demand curve.

Total Revenue B

Total Revenue A

The firm therefore, effectively faces

a ‘kinked demand curve’ forcing it to

maintain a stable or rigid pricing

structure. Oligopolistic firms may

overcome this by engaging in non-

price competition.

Duopoly

• Market structure where the industry is dominated by two large producers– Collusion may be a possible feature

– Price leadership by the larger of the two firms may exist – the smaller firm follows the price lead of the larger one

– Highly interdependent

– High barriers to entry

– Cournot Model – French economist – analysed duopoly –suggested long run equilibrium would see equal market share and normal profit made

– In reality, local duopolies may exist

Monopoly

• Pure monopoly – where only one producer exists in the industry

• In reality, rarely exists – always some form of substitute available!

• Monopoly exists, therefore,where one firm dominates the market

• Firms may be investigated for examples of monopoly power when market share exceeds 25%

• Use term ‘monopoly power’ with care!

Monopoly

• Monopoly power – refers to cases where firms influence the market in some way through their behaviour –determined by the degree of concentration in the industry– Influencing prices

– Influencing output

– Erecting barriers to entry

– Pricing strategies to prevent or stifle competition

– May not pursue profit maximisation – encourages unwanted entrants to the market

– Sometimes seen as a case of market failure

Monopoly

• Origins of monopoly:

– Through growth of the firm

– Through amalgamation, merger or takeover

– Through acquiring patent or license

– Through legal means – Royal charter, nationalisation, wholly owned plc

Monopoly

• Summary of characteristics of firms exercising monopoly power:

– Price – could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible.

– Efficiency – could be inefficient due to lack of competition (X- inefficiency) or…

• could be higher due to availability of high profits

Monopoly

• Innovation - could be high because of the promise of high profits, Possibly encourages high investment in research and development (R&D)

• Collusion – possible to maintain monopoly power of key firms in industry

• High levels of branding, advertising and non-price competition

Monopoly

• Problems with models – a reminder:– Often difficult to distinguish between a monopoly

and an oligopoly – both may exhibit behaviour that reflects monopoly power

– Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation

– Degree of contestability of the market may influence behaviour

– Monopolies not always ‘bad’ – may be desirable in some cases but may need strong regulation

– Monopolies do not have to be big – could exist locally

MonopolyCosts / Revenue

Output / Sales

AC

MC

ARMR

AR (D) curve for a monopolist

likely to be relatively price

inelastic. Output assumed to

be at profit maximising output

(note caution here – not all

monopolists may aim

for profit maximisation!)

Q1

£7.00

£3.00

Monopoly Profit

Given the barriers to entry,

the monopolist will be able to

exploit abnormal profits in the

long run as entry to the

market is restricted.

This is both the short run and

long run equilibrium position

for a monopoly


Output / Sales

AC

MC

ARMR

Welfare implications of monopolies

A look back at the diagram for

perfect competition will reveal

that in equilibrium, price will be

equal to the MC of production.

We can look therefore at a

comparison of the differences

between price and output in a

competitive situation compared

to a monopoly.

Q1

£3

The price in a competitive

market would be £3 with

output levels at Q1.

Q2

£7The monopoly price would be

£7 per unit with output levels

lower at Q2.

On the face of it, consumers

face higher prices and less

choice in monopoly conditions

compared to more competitive

environments.

Loss of consumersurplus

The higher price and lower

output means that consumer

surplus is reduced, indicated by

the grey shaded area.


Output / Sales

AC

MC

ARMR


Q1

£3

Q2

£7The monopolist will be

affected by a loss of producer

surplus shown by the grey

triangle but……..

The monopolist will benefit

from additional producer

surplus equal to the grey

shaded rectangle.Gain in producer surplus


Output / Sales

AC

MC

ARMR


Q1

£3

Q2

£7

The value of the grey shaded

triangle represents the total

welfare loss to society –

sometimes referred to as

the ‘deadweight welfare loss’.

Contestable Markets

• Theory developed by William J. Baumol, John Panzar and Robert Willig (1982)

• Helped to fill important gaps in market structure theory

• Perfectly contestable market – the pure form – not common in reality but a benchmark to explain firms’ behaviours

Contestable Markets

• Key characteristics:– Firms’ behaviour influenced by the threat

of new entrants to the industry

– No barriers to entry or exit

– No sunk costs

– Firms may deliberately limit profits made to discourage new entrants – entry limit pricing

– Firms may attempt to erect artificial barriers to entry –e.g…

Contestable Markets• Over capacity – provides the

opportunity to flood the market and drive down price in the event of a threat of entry

• Aggressive marketing and brandingstrategies to ‘tighten’ up the market

• Potential for predatory or destroyer pricing

• Find ways of reducing costs and increasing efficiency to gain competitive advantage

Contestable Markets

• ‘Hit and Run’ tactics – enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit)

• Cream-skimming – identifying parts of the market that are high in value added and exploiting those markets

Contestable Markets

• Examples of markets exhibiting contestability characteristics:–Financial services

–Airlines – especially flights on domestic routes

–Computer industry – ISPs, software, web development

–Energy supplies

–The postal service?

The Goal Of Profit Maximization

• To analyze decision making at the firm, let’s start with a very basic question– What is the firm trying to maximize?

• A firm’s owners will usually want the firm to earn as much profit as possible

• We will view the firm as a single economic decision maker whose goal is to maximize its owners’ profit

• Why?– Managers who deviate from profit-maximizing for too long are

typically replaced either by• Current owners or • Other firms who acquire the underperforming firm and then replace

management team with their own

– Many managers are well trained in tools of profit-maximization

Understanding Profit: Two Definitions of Profit

• Profit is defined as the firm’s sales revenue minus its costs of production

• If we deduct only costs recognized by accountants, we get one definition of profit– Accounting profit = Total revenue – Accounting costs

• A broader conception of costs (opportunity costs) leads to a second definition of profit– Economic profit = Total revenue – All costs of production

– Or Total revenue – (Explicit costs + Implicit costs)

Why Are There Profits?

• Economists view profit as a payment for two necessary contributions

• Risk-taking– Someone—the owner—had to be willing to take

the initiative to set up the business• This individual assumed the risk that business might fail

and the initial investment be lost

– Innovation• In almost any business you will find that some sort of

innovation was needed to get things started

The Firm’s Constraints: The Demand Constraint

• Demand curve facing firm is a profit constraint

– Curve that indicates for different prices, quantity of output customers will purchase from a particular firm

• Can flip demand relationship around

– Once firm has selected an output level, it has also determined the maximum price it can charge

• Leads to an alternative definition

– Shows maximum price firm can charge to sell any given amount of output

Total Revenue

• The total inflow of receipts from selling a given amount of output

• Each time the firm chooses a level of output, it also determines its total revenue– Why?

• Because once we know the level of output, we also know the highest price the firm can charge

• Total revenue—which is the number of units of output times the price per unit—follows automatically

The Cost Constraint

• Every firm struggles to reduce costs, but there is a limit to how low costs can go– These limits impose a second constraint on the firm

• The firm uses its production function, and the prices it must pay for its inputs, to determine the least cost method of producing any given output level

• For any level of output the firm might want to produce– It must pay the cost of the “least cost method” of

production

The Total Revenue And Total Cost Approach

• At any given output level, we know

– How much revenue the firm will earn

– Its cost of production

• Loss

– A negative profit—when total cost exceeds total revenue

• In the total revenue and total cost approach, the firm calculates Profit = TR – TC at each output level

– Selects output level where profit is greatest

The Marginal Revenue and Marginal Cost Approach

• Marginal revenue–Change in total revenue from

producing one more unit of output• MR = ΔTR / ΔQ

• Tells us how much revenue rises per unit increase in output

The Marginal Revenue and Marginal Cost Approach

• Important things to notice about marginal revenue– When MR is positive, an increase in output causes total revenue to rise

– Each time output increases, MR is smaller than the price the firm charges at the new output level

• When a firm faces a downward sloping demand curve, each increase in output causes – Revenue gain

• From selling additional output at the new price

– Revenue loss

• From having to lower the price on all previous units of output

– Marginal revenue is therefore less than the price of the last unit of output

Using MR and MC to Maximize Profits

• Marginal revenue and marginal cost can be used to find the profit-maximizing output level– Logic behind MC and MR approach

• An increase in output will always raise profit as long as marginal revenue is greater than marginal cost (MR > MC)

– Converse of this statement is also true• An increase in output will lower profit whenever marginal revenue

is less than marginal cost (MR < MC)

– Guideline firm should use to find its profit-maximizing level of output

• Firm should increase output whenever MR > MC, and decrease output when MR < MC

Figure 2(a): Profit Maximization

Total Fixed Cost

TC

TR

DTR from producing 2nd unit

DTR from producing 1st unit

Profit at 3 Units

Profit at 5 Units

$3,500

3,000

2,500

2,000

1,500

1,000

500

Output

Dollars

1 210 3 4 5 6 7 8 9 10

Profit at 7 Units

Figure 2(b): Profit Maximization

profit rises profit falls

MC

MR

0

600

500

400

300

200

100

–100

–200

Output

Dollars

1 2 3 4 5 6 7 8

The MR and MC Approach Using Graphs

• Figure 2 also illustrates the MR and MC approach to maximizing profits

• Can summarize MC and MR approach

– To maximize profits the firm should produce level of output closest to point where MC = MR

• Level of output at which the MC and MR curves intersect

• This rule is very useful—allows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level

An Important Proviso

• Important exception to this rule

– Sometimes MC and MR curves cross at two different points

– In this case, profit-maximizing output level is the one at which MC curve crosses MR curve from below

What About Average Costs?

• Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit– Common error—sometimes made even by business managers—is to

use average cost in place of marginal cost in making decisions

• Problems with this approach

– ATC includes many costs that are fixed in short-run—including cost of all fixed inputs such as factory and equipment and design staff

– ATC changes as output increases

• Correct approach is to use the marginal cost and to consider increases in output one unit at a time– Average cost doesn’t help at all; it only confuses the issue

• Average cost should not be used in place of marginal cost as a basis for decisions

Dealing With Losses: The Short Run and the Shutdown Rule

• You might think that a loss-making firm should always shut down its operation in the short run

– However, it makes sense for some unprofitable firms to continue operating

• The question is

– Should this firm produce at Q* and suffer a loss?

• The answer is yes—if the firm would lose even more if it stopped producing and shut down its operation

• If, by staying open, a firm can earn more than enough revenue to cover its operating costs, then it is making an operating profit (TR > TVC)

– Should not shut down because operating profit can be used to help pay fixed costs

– But if the firm cannot even cover its operating costs when it stays open, it should shut down

Dealing With Losses: The Short-Run and the Shutdown Rule

• Guideline—called the shutdown rule—for a loss-making firm– Let Q* be output level at which MR = MC

– Then in the short-run• If TR > Q* firm should keep producing

• If TR < Q* firm should shut down

• If TR = Q* firm should be indifferent between shutting down and producing

• The shutdown rule is a powerful predictor of firms’ decisions to stay open or cease production in short-run

Figure 4(a): Loss Minimization

Q*

Dollars

Output

TFC

Figure 4(b): Loss Minimization

MC

MRQ*

Dollars

Output

Figure 5: Shut Down

Q*

TC

TR

TVC

TFC

TFC

Loss at Q*

Dollars

Output

The Long Run: The Exit Decision

• We only use term shut down when referring to short-run

• If a firm stops production in the long-run it is termed an exit

• A firm should exit the industry in long- run

– When—at its best possible output level—it has any loss at all

Using The Theory: Getting It Wrong—The Failure of Franklin National Bank

• In the mid-1970’s, Franklin National Bank—one of the largest banks in the United States—went bankrupt

• In mid-1974, John Sadlik, Franklin’s CFO, asked his staff to compute average cost to bank of a dollar in loanable funds– Determined to be 7¢

– At the time, all banks—including Franklin—were charging interest rates of 9 to 9.5% to their best customers

– Ordered his loan officers to approve any loan that could be made to a reputable borrower at 8% interest

Using The Theory: Getting It Wrong—The Failure of Franklin National Bank

• Where did Franklin get the additional funds it was lending out?– Were borrowed not at 7%, the average cost of funds, but

at 9 to 11%, the cost of borrowing in the federal funds market

• Not surprisingly, these loans—which never should have been made—caused Franklin’s profits to decrease– Within a year the bank had lost hundreds of millions of

dollars– This, together with other management errors, caused bank

to fail

Using The Theory: Getting It Right—The Success of Continental Airlines

• Continental Airlines was doing something that seemed like a horrible mistake– Yet Continental’s profits—already higher than industry

average—continued to grow

• A serious mistake was being made by the other airlines, not Continental– Using average cost instead of marginal cost to make

decisions

• Continental’s management, led by its vice-president of operations, had decided to try marginal approach to profit

Macroeconomics

• Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes

that affect many households, firms, and markets at once.

Macroeconomics

• Macroeconomics answers questions like the following:Why is average income high in some countries and

low in others?

Why do prices rise rapidly in some time periods while they are more stable in others?

Why do production and employment expand in some years and contract in others?

The Economy’s Income and Expenditure

When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

What is National Income?

• National income measures the total value of goods and services produced within the economy over a period of time

• National Income can be calculated in three main ways

• 1. The sum of factor incomes earned in production

• 2. Aggregate demand for goods and services• 3. The sum of value added from each productive

sector of the economy

Why is national income important?• Measuring the level and rate of growth of

national income (Y) is important to economists when they are considering:

– Economic growth and where a country is in the business cycle

– Changes to average living standards of the population

– Looking at the distribution of national income (i.e. measuring income and wealth inequalities)

The Economy’s Income and Expenditure

• For an economy as a whole, income must equal expenditure because:

Every transaction has a buyer and a seller.

Every dollar of spending by some buyer is a dollar of income for some seller.

• Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

• It is the total market value of all final goods and services produced within a country in a given period of time.

Gross Domestic Product

The Circular-Flow Diagram

The equality of income and expenditure can be illustrated with the circular-flow diagram.


FirmsHouseholds

Market for

Factors

of Production

Market for

Goods

and Services

SpendingRevenue

Wages, rent, and profit

Income

Goods & Services sold

Goods & Services bought

Labor, land, and capital

Inputs for production

The Measurement of GDP

GDP is the market value of all final goods and services

produced within a country in a given period of time.


• Output is valued at market prices.

• It records only the value of final goods, not intermediate goods (the value is counted only once).

• It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).


• It includes goods and services currently produced, not transactions involving goods produced in the past.

• It measures the value of production within the geographic confines of a country.

• It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).


What Is Counted in GDP?

GDP includes all items produced in the economy and sold legally in markets.

What Is Not Counted in GDP?

• GDP excludes most items that are produced and consumed at home and that never enter the marketplace.

• It excludes items produced and sold illicitly, such as illegal drugs.

Other Measures of Income

• Gross National Product (GNP)

• Net National Product (NNP)

• National Income

• Personal Income

• Disposable Personal Income

Gross National Product

• Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals).

• It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here.

Net National Product (NNP)

• Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation.

• Depreciation is the wear and tear on the economy’s stock of equipment and structures.

National Income

• National Income is the total income earned by a nation’s residents in the production of goods and services.

• It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies.

Personal Income

• Personal income is the income that households and noncorporate businesses receive.

• Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners.

• In addition, it includes household’s interest income and government transfers.

Disposable Personal Income

• Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government.

• It equals personal income minus personal taxes and certain nontax payments.

The Components of GDP

GDP (Y ) is the sum of the following: Consumption (C)

Investment (I)

Government Purchases (G)

Net Exports (NX)

Y = C + I + G + NX


• Consumption (C):The spending by households on goods and

services, with the exception of purchases of new housing.

• Investment (I):The spending on capital equipment,

inventories, and structures, including new housing.


• Government Purchases (G):The spending on goods and services by local,

state, and federal governments.

Does not include transfer payments because they are not made in exchange for currently produced goods or services.

• Net Exports (NX):Exports minus imports.

GDP and Its Components (1998)

Total(in billions of dollars)

Per Person(in dollars) % of Total

Gross domestic product, Y $8,511 $31,522 100 percent

Consumption, C 5,808 21,511 68

Investment, I 1,367 5,063 16

Government purchases, G 1,487 5,507 18

Net exports, NX -151 -559 -2



Consumption68 %

Investment16%


Consumption68 %

Consumption68 %

Government Purchases

18%


Investment16%

Net Exports-2 %


Consumption

68 %

Investment16%

Government Purchases18%

Real versus Nominal GDP

• Nominal GDP values the production of goods and services at current prices.

• Real GDP values the production of goods and services at constant prices.

Real versus Nominal GDP

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

GDP Deflator

• The GDP deflator measures the current level of prices relative to the level of prices in the base year.

• It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

GDP Deflator

100GDP Real

GDP Nominal=deflator GDP

The GDP deflator is calculated as follows:

100X )deflator (GDP

) GDP (Nominal =GDP Real

20xx

20xx20xx

Converting Nominal GDP to Real GDP

Nominal GDP is converted to real GDPas follows:

Real and Nominal GDP

YearPrice ofHot dogs

Quantity ofHot dogs

Price of Hamburgers

Quantity ofHamburgers

2001 $1 100 $2 50

2002 $2 150 $3 100

2003 $3 200 $4 150


Calculating Nominal GDP:

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200




Calculating Real GDP (base year 2001):





Calculating the GDP Deflator:

2001 ($200/$200) x 100 = 100

2002 ($600/$350) x 100 = 171

2003 ($1200/$500) x 100 = 240

(Periods of falling real GDP)

Real GDP in the United States

1970 1975 1980 1985 1990 19953,000

4,000

5,000

6,000

7,000

Billions of 1992 Dollars

2000

8,000

GDP and Economic Well-Being

• GDP is the best single measure of the economic well-being of a society.

• GDP per person tells us the income and expenditure of the average person in the economy.


• Higher GDP per person indicates a higher standard of living.

• GDP is not a perfect measure of the happiness or quality of life, however.


• Some things that contribute to well-being are not included in GDP.

The value of leisure.

The value of a clean environment.

The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

GDP, Life Expectancy, and Literacy

Country Real GDP perPerson (1997)

LifeExpectancy

AdultLiteracy

United States $29,010 77 years 99%

Japan 24,070 80 99

Germany 21,260 77 99

Mexico 8,370 72 90

Brazil 6,480 67 84

Russia 4,370 67 99

Indonesia 3,490 65 85

China 3,130 70 83

India 1,670 63 53

Pakistan 1,560 64 41

Bangladesh 1,050 58 39

Nigeria 920 50 59

Summary

• Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.

• Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

Summary

• GDP is the market value of all final goods and services produced within a country in a given period of time.

• GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

Summary

• Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services.

• The GDP deflator--calculated from the ratio of nominal to real GDP--measures the level of prices in the economy.

Summary

• GDP is a good measure of economic well-being because people prefer higher to lower incomes.

• It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t measured by GDP.

Graphical

Review


FirmsHouseholds

Market for

Factors

of Production

Market for

Goods

and Services

SpendingRevenue

Wages, rent, and profit

Income

Goods & Services sold

Goods & Services bought

Labor, land, and capital

Inputs for production


Net Exports-2 %

Consumption

68 %

Investment16%

Government Purchases18%

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