Directed reading in Industrial Organization

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Chapter 2: Basic Microeconomic Tools

Basic Microeconomics

Chapter 2: Basic Microeconomic Tools

Efficiency and Market Performance

Contrast two polar cases
perfect competition
monopoly
What is efficiency?
no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off
example: given an initial distribution of food aid will trade between recipients improve efficiency?

Chapter 2: Basic Microeconomic Tools

Profit Maximization: the Basics

Focus on profit maximizing behavior of firms
Take as given the market demand curve

Equation:

P = A - BQ

linear

demand

Importance of:
time
short-run vs. long-run
willingness to pay

Maximum willingness

to pay

$/unit

Quantity

A/B

Demand

Constant

slope

At price P1 a consumer

will buy quantity Q1

Chapter 2: Basic Microeconomic Tools

Perfect Competition

Firms and consumers are price-takers
Firm can sell as much as it likes at the ruling market price
do not need many firms
do need the idea that firms believe that their actions will not affect the market price
Therefore, marginal revenue equals price
To maximize profit a firm of any type must equate marginal revenue with marginal cost
So in perfect competition price equals marginal cost

Chapter 2: Basic Microeconomic Tools

The First Order Condition: MR = MC

Profit is p(q) = R(q) - C(q)
Profit maximization: dp/dq = 0
This implies dR(q)/dq - dC(q)/dq = 0
But dR(q)/dq = marginal revenue
dC(q)/dq = marginal cost
So profit maximization implies MR = MC

Chapter 2: Basic Microeconomic Tools

Perfect competition: an illustration

$/unit

Quantity

$/unit

Quantity

(b) The Industry

(a) The Firm

With market demand D1

and market supply S1

equilibrium price is PC

and quantity is QC

With market price PC

the firm maximizes

profit by setting

MR (= PC) = MC and

producing quantity qc

Now assume that

demand

increases to

With market demand D2

and market supply S1

equilibrium price is P1

and quantity is Q1

Existing firms maximize

profits by increasing

output to q1

Excess profits induce

new firms to enter

the market

The supply curve moves to the right

Price falls

Entry continues while profits exist

Long-run equilibrium is restored

at price PC and supply curve S2

Q´C

Chapter 2: Basic Microeconomic Tools

Perfect competition: additional points

Derivation of the short-run supply curve
this is the horizontal summation of the individual firms’ marginal cost curves

Example 1: Three firms

Firm 1: MC = 4q + 8

Firm 2: MC = 2q + 8

Firm 3: MC = 6q + 8

Invert these

Aggregate: Q= q1+q2+q3

= 11MC/12 - 22/3

MC = 12Q/11 + 8

Firm 1: q = MC/4 - 2

Firm 2: q = MC/2 - 4

Firm 3: q = MC/6 - 4/3

Firm 1

Firm 3

Firm 2

q1+q2+q3

$/unit

Quantity

Chapter 2: Basic Microeconomic Tools

Example 2: Eighty firms

Each firm: MC = 4q + 8

Invert these

Each firm: q = MC/4 - 2

Aggregate: Q= 80q

= 20MC - 160

MC = Q/20 + 8

Firm i

$/unit

Quantity

Definition of normal profit
not the same as zero profit
implies that a firm is making the market return on the assets employed in the business

Aggregate

Perfect Competition: Additional Points 2

Chapter 2: Basic Microeconomic Tools

Monopoly

The only firm in the market
market demand is the firm’s demand
output decisions affect market clearing price

$/unit

Quantity

Demand

Loss of revenue from the

reduction in price of units

currently being sold (L)

Gain in revenue from the sale

of additional units (G)

Marginal revenue from a

change in price is the

net addition to revenue

generated by the price

change = G - L

At price P1

consumers

buy quantity

At price P2

consumers

buy quantity

Chapter 2: Basic Microeconomic Tools

Monopoly 2

Derivation of the monopolist’s marginal revenue

Demand: P = A - B.Q

Total Revenue: TR = P.Q = A.Q - B.Q2

Marginal Revenue: MR = dTR/dQ

 MR = A - 2B.Q

With linear demand the marginal

revenue curve is also linear with the same price intercept

but twice the slope of the demand curve

$/unit

Quantity

Demand

Chapter 2: Basic Microeconomic Tools

Monopoly and Profit Maximization

The monopolist maximizes profit by equating marginal revenue with marginal cost
This is a two-stage process

$/unit

Quantity

Demand

Stage 1: Choose output where MR = MC

This gives output QM

Stage 2: Identify the market clearing price

This gives price PM

MR is less than price

Price is greater than MC: loss of

efficiency

Price is greater than average cost

ACM

Positive economic profit

Long-run equilibrium: no entry

Output by the

monopolist is less

than the perfectly

competitive

output QC

Profit

Chapter 2: Basic Microeconomic Tools

Profit today versus profit tomorrow

Money today is not the same as money tomorrow
need way to convert tomorrow’s money into today’s
important since firms make decisions over time
is it better to make profit now or invest for future profit?
how should investment in durable assets be judged?
sacrificing profit today imposes a cost
is this cost justified?
Financial market techniques can be applied
the concept of discounting and present value

Chapter 2: Basic Microeconomic Tools

The concept of discounting

Take a simple example:
you have $1,000
this can be deposited in the bank at 5% per annum interest
or it can be loaned to a start-up company for one year
how much will the start-up have to contract to repay?
$1,000 x (1 + 5/100) = $1,000 x 1.05 = $1,050

More generally:
you have a sum of money Y
can generate an interest rate r per annum (in the example r = 0.05)
so it will grow to Y(1 + r) in one year
but then Y today trades for Y(1 + r) in one year’s time

Chapter 2: Basic Microeconomic Tools

Put this another way:
assume an interest rate of 5% per annum
the start-up contracts to pay me $1,050 in one year’s time
how much do I have to pay for that contract today?
Answer: $1,000 since this would grow to $1,050 in one year
so in these circumstances $1,050 in one year is worth $1,000 today
the current price of the contract is $1,050/1.05 = $1,000
the present value of $1,050 in one year’s time at 5% is $1,000
More generally
the present value of Z in one year at interest rate r is Z/(1 + r)
The discount factor is defined as R = 1/(1 + r)
The present value of Z in one year is then RZ

Concept of Discounting 2

Chapter 2: Basic Microeconomic Tools

What if the loan is for two years?
How much must start-up promise to repay in two years’ time?
$1,000 grows to $1,050 in one year
the $1,050 grows to $1,102.50 in a further year
so the contract is for $1,102.50
note: $1,102.50 = $1,000 x 1.05 x 1.05 = $1,000 x 1.052
More generally
a loan of Y for 2 years at interest rate r grows to Y(1 + r)2 = Y/R2
Y today grows to Y/R2 in 2 years
a loan of Y for t years at interest rate r grows to Y(1 + r)t = Y/Rt
Y today grows to Y/Rt in t years
Put another way
the present value of Z received in 2 years’ time is R2Z
the present value of Z received in t years’ time is RtZ

Concept of Discounting 3

Chapter 2: Basic Microeconomic Tools

Now consider how to evaluate an investment project
generates Z1 net revenue at the end of year 1
Z2 net revenue at the end of year 2
Z3 net revenue at the end of year 3 and so on for T years
What are the net revenues worth today?
Present value of Z1 is RZ1
Present value of Z2 is R2Z2
Present value of Z3 is R3Z3 ...
Present value of ZT is RTZT
so the present value of these revenue streams is:
PV = RZ1 + R2Z2 + R3Z3 + … + RTZT

Concept of Discounting 4

Chapter 2: Basic Microeconomic Tools

Two special cases can be considered

Case 1: The net revenues in each period are identical

Z1 = Z2 = Z3 = … = ZT = Z

Then the present value is:

PV =

(1 - R)

(R - RT+1)

Case 2: These net revenues are constant and perpetual

Then the present value is:

PV = Z

(1 - R)

= Z/r

Concept of Discounting 5

Chapter 2: Basic Microeconomic Tools

Present value and profit maximization

Present value is directly relevant to profit maximization
For a project to go ahead the rule is
the present value of future income must at least cover the present value of the expenses in establishing the project
The appropriate concept of profit is profit over the lifetime of the project
The application of present value techniques selects the appropriate investment projects that a firm should undertake to maximize its value

Chapter 2: Basic Microeconomic Tools

Efficiency and Surplus

Can we reallocate resources to make some individuals better off without making others worse off?
Need a measure of well-being
consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit
aggregate consumer surplus is the sum over all units consumed and all consumers

Chapter 2: Basic Microeconomic Tools

Efficiency and Surplus 2

producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce
aggregate producer surplus is the sum over all units produced and all producers
total surplus = consumer surplus + producer surplus

Chapter 2: Basic Microeconomic Tools

Quantity

$/unit

Demand

Competitive Supply

The demand curve measures the willingness to pay for each unit

Consumer surplus is the area between the demand curve and the equilibrium price

Consumer surplus

The supply curve measures the marginal cost of each unit

Producer surplus is the area between the supply curve and the equilibrium price

Producer surplus

Aggregate surplus is the sum of consumer surplus and producer surplus

Equilibrium occurs

where supply equals

demand: price PC

quantity QC

Efficiency and surplus: illustration

The competitive equilibrium is efficient

Chapter 2: Basic Microeconomic Tools

Efficiency and Surplus Illustration 2

Quantity

Demand

Competitive Supply

$/unit

Assume that a greater quantity QG is traded

Price falls to PG

Producer surplus is now a positive part

and a negative part

Consumer surplus increases

Part of this is a transfer from producers

Part offsets the negative producer surplus

The net effect is a reduction in total surplus

Chapter 2: Basic Microeconomic Tools

Deadweight loss of Monopoly

Demand

Competitive Supply

$/unit

Quantity

Assume that the industry is monopolized

The monopolist sets MR = MC to give output QM

The market clearing price is PM

Consumer surplus is given by this area

And producer surplus is given by this area

The monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between QM and QC

This is the deadweight

loss of monopoly

Chapter 2: Basic Microeconomic Tools

Deadweight loss of Monopoly 2

Why can the monopolist not appropriate the deadweight loss?
Increasing output requires a reduction in price
this assumes that the same price is charged to everyone.
The monopolist creates surplus
some goes to consumers
some appears as profit
The monopolist bases her decisions purely on the surplus she gets, not on consumer surplus
The monopolist undersupplies relative to the competitive outcome
The primary problem: the monopolist is large relative to the market

Chapter 2: Basic Microeconomic Tools

Last 9,800 $10,000

Next 40,000 $30,000

A Non-Surplus Approach

Take a simple example
Monopolist owns two units of a valuable good
There are 50,000 potential buyers
Reservation prices:

First 200 $50,000

Number of Buyers Reservation Price

Both units will be sold at $50,000; no deadweight loss

Monopolist is small relative to the market.

Why not?

Chapter 2: Basic Microeconomic Tools

Non-Surplus Approach 2

Monopolist has 200 units
Reservation prices:

Last 9,900 $10,000

Next 40,000 $15,000

First 100 $50,000

Number of Buyers Reservation Price

Now there is a loss of efficiency and so a deadweight loss no matter what the monopolist does.

Chapter 2: Basic Microeconomic Tools

Directed reading in Industrial Organization

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