Demand curve - using Game Results How much customers will buy at a given price Downward sloping - more demand at lower prices

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1 31 October Bige Kahraman Class Notes First half of course (Michaelmas) is Microeconomics, second half (Hilary) is Macroeconomics Focusing on profit maximization & price formation Looking at industry level dynamics Assessment: 30% Industry Report - due 9 Dec 20% Exam - taken 9 Jan 50% Coursework Assignments - due 13 Mar Alusaf Hillside Project Supply curve - see Excel/Word docs How much outputs producers will supply at a given price Upward sloping - more supply as price goes up Can become (nearly) vertical at the industrial capacity At higher prices, more firms willing to produce Produce if price >= cost Excess industry capacity drives prices down to variable costs In the long run, new entry can hold prices down Trading game Demand curve - using Game Results How much customers will buy at a given price Downward sloping - more demand at lower prices Elasticity How sensitive supply or demand is to prices Elasticity = % change in demand / % change in price Inelastic: elasticity < 1; quantity demanded doesn t move much on price E.g. gasoline Elastic: elasticity > 1; quantity moves a lot when price changes More inelastic demand curve is associated with market power Example: Apple creating eco-system, not just devices More inelastic supply curve indicates diseconomies of scale Example: Hedge funds become more difficult to manage as they grow Equilibrium Price Where supply and demand curves intersect

2 31 October Bige Kahraman In Trading Game, 63 shares demanded at $45 What if supply exceeds demand? Price is above equilibrium What if demand exceeds supply? Price is below equilibrium Market wants to be at equilibrium, not traders What about shifts? In Demand: Quantity supplied increases higher prices, more quantity Shift could be from movements in complementary products, wealth effect, etc. In Supply: Quantity demanded increases lower prices, more quantity Shift could be from new technology, lowered barriers to entry, etc. The Invisible Hand Mechanism for achieving equilibrium Market adapts quickly to changes in demand and supply Pursuit of self-interest leads to socially efficient outcome Gains from trade at equilibrium Surpluses from trading at equilibrium will be equal for buyers and sellers in the aggregate Equilibrium price maximizes the total gains from trade Allocative efficiency (or inefficiency) buyer/consumer surplus People willing to buy at higher prices than equilibrium seller/producer surplus People willing to sell at lower prices than equilibrium Works out to profits Price Ceiling Example Loses producer and consumer surplus in area between price ceiling and equilibrium Quantity demanded will be > quantity supplied

3 Cost Functions & Profit Maximization Total Cost Function Fixed Costs (FC) Do not vary with output level Examples: rent, administrative costs, etc. Main reason Average Costs AC(Q) usually fall at first Variable Costs (VC) Increase as output increases Include materials, direct labor, etc. Average VC is a useful proxy for MC (marginal cost) Average & Marginal Costs Average cost shows how per-unit costs vary with output level AC(Q) = TC(Q)/Q Marginal cost shows how total costs increase with output Equal to slope of total cost function Additional cost of each additional unit produced: MC(Q) = TC(Q+1) - TC(Q) (Dis)economies of Scales Constant returns to scale: MC = AC Economies of scale: AC falls as output rises Due to fixed costs - spread over more units Increased productivity due to extensive specialization and experience Increased bargaining power with suppliers Diseconomies of scale: AC increase as output rises Firms become less efficient as they grow More layers of bureaucracy Difficult to coordinate multiple projects Slower in making decisions Typically firms first experience economies of scale, then diseconomies of scale Economic vs. Accounting Costs Economic costs include opportunity costs of all resources used Usually value of the best alternative choice Economic profit = Revenue - Economic Cost Zero Economic Profit does not equal Zero Accounting profit A zero economic profit = positive accounting profit

4 Profit Maximization Trade off between price & quantity Optimal decision: Marginal Revenue (MR(Q)) = Marginal Cost (MC(Q)) Marginal Revenue MR(Q) = TR(Q+1) - TR(Q), where TR(Q) = p(q) x Q If MR(Q) < MC(Q) additional unit is too costly to produce If MR(Q) > MC(Q) additional unit is profitable, should produce more Rules for Profit Maximization: Market Structures Marginal Output Rule: produce until MR(Q) = MC(Q) Shutdown Rule: shut down operations if TR(Q) < TC(Q) What if there are Sunk Costs? Sunk costs can t be recovered If sunk costs are unavoidable, firms should choose optimal time based on expected future profits Firms should ignore sunk costs when optimizing, need to be forward looking Sunk cost fallacy : firms don t always ignore sunk costs, make suboptimal decisions Perfect Competition Assumes: infinitely small, equally efficient firms Homogenous products, consumers care only about price Consumers are rational Unrestricted entry and exit of firms Reasonable proxy for: Agriculture, metals, financial markets All firms take, accept the market price - price takers MR(Q) = market price, flat firm demand curve Each new unit sold at market price Profits maximized where MC(Q) = P Long Run Equilibrium p = AC(Q) Price = AC = MC firms earn normal profit (zero economic profit) Produce at lowest AC productive efficiency

5 Monopoly Welfare Economics Perfectly competitive markets maximize total surplus - Allocative efficiency Perfectly competitive markets allocate demand to lowest cost sellers - Productive efficiency Market share approach Strong definition: 100% market share Many utilities Some patented products Weak definition: significant market share, no close competitor Microsoft Windows Intel in microprocessors Measure of market concentration Herfindahl Index = S S Si is market share of firm i - firm sales / total market sales Higher Herfindahl index more concentration H < 0.01 is highly competitive H < 0.15 is unconcentrated H < 0.25 is moderately concentrated H > 0.25 is highly concentrated Monopolist is a price maker Market power is the ability to charge above marginal cost MC(Q) = MR(Q) P will be higher than perfect competition, lower Q p MC 1, e is price elasticity of demand p = e What gives rise to monopolies? Barriers to entry Structural Economies of scale Large initial fixed costs Patents, high switching costs Strategic Strategic commitments Reputation Types of Monopoly Natural - economies of scale Government-created: exclusive sales rights Demand-driven: customer loyalty Deterrence to Entry Destroyer pricing: hold below AC for a period of time