1 Teaching about Market Structures Felix B. Kwan, Ph.D. Professor of Econ/Finance, Maryville University AP Econ Conference - FRB St. Louis June 17-19, 2015
2 Profits Foundational Concepts Some basic terms/concepts that students often misinterpret, thereby making them unable to understand the topics of market structures Profits vs Revenues (vs sales, income, earnings) Price Price vs Cost (vs revenue who pays?) Quantity simplify: quantity produced = quantity sold (no inventories)
3 Economic vs. Accounting Profit Profit = TR TC Profit = (P AC) x Q economic profit = revenue economic costs accounting profit = revenue explicit costs accounting costs include only explicit costs (or expenses), not implicit costs; accounting profs teach profits = revenues expenses
4 Economic vs. Accounting Profit economic cost = explicit cost + implicit cost normal profit: minimum acceptable amount of accounting profit for a firm; this is part of economic cost. economic profit = profit over & above normal profit (hence, also called abnormal, pure, or extraordinary profit)
5 Economic vs. Accounting Profit If a firm is incurring economic losses (negative economic profits), the owners are receiving less income than could be received if their resources were employed in an alternative use. In the long run, we'd expect to see firms leave the industry when this occurs. Economic (extraordinary or abnormal) profits will attract other firms to enter the industry, unless there are barriers to entry
6 Accounting vs. Economic Costs & Profits Economic profit Economic (Opportunity) Costs Implicit costs (including a normal profit) Explicit costs Total Revenue Accounting profit Accounting costs (explicit costs only) LO2
7 Economic Profits π = 0 What It Means If economic profits equal zero, then: owners receive an income (accounting profits) equal to their opportunity costs (what they could get in their next-best alternative); no incentive for firms to either enter or leave the industry; accounting profit of existing firms = normal profit.
8 Maximum Profits Two Basic Perspectives * MR = MC Approach (emphasized in AP) * TR TC Approach (more intuitive; a concept that most students already understand, and is thus a good anchor we teachers can use, to promote learning)
9 Profits: The (TR minus TC) Approach At any given output level, we know: how much revenue the firm will earn the firm s total cost of production Loss Negative profit: when total cost > total revenue In the total revenue total cost approach, the firm calculates Profit = TR TC at each output level, then selects the output level where profit is greatest (if positive, or smallest if negative) 9
10 Profit Maximization (when TR > TC over some range) Profit = gap (distance) between TR and TC Dollars $3,500 3,000 2,500 2,000 1,500 Profit at 3 Units Profit at 5 Units Profit at 7 Units TC TR 1, Output Questions: Why does TC not start at zero (the origin)? Why does TR do so?
11 Loss Minimization (when TR < TC over all Q levels) When does it makes sense to continue operating at a loss (because TR<TC)? When does it make sense to just shut down?
12 Loss Minimization (when TR < TC over all Q levels) Dollars TFC Q* Output basic point: compare TR against TVC, or AR (i.e., P) against AVC
13 Total Revenue & Cost, and Maximum Profit (or Minimum Loss) Cost, Revenue, Profit $ (per year) TC A TR Comparing TR and TC Why is profit negative when output is 0, or low? What is the importance of q0? Will there always be a q0? 0 B q 0 q * π (q) Output (units per year)
14 MR = MC Perspective marginal revenue (MR) -- the additional revenue resulting from the production/sale of an additional unit of output marginal cost (MC) -- the additional cost resulting from the production/sale of an additional unit of output
15 Remember: TR, TC, MR & MC and Profit Maximization MR is the slope of the tangent to TR MC is the slope of the tangent to TC Question: Cost, Revenue, Profit $ (per year) B A TC TR Why does profit shrink if production goes above, or below, q*? 0 q 0 q * π (q) Output (units per year)
16 MR > MC If marginal revenue exceeds marginal cost, the production of an additional unit of output adds more to revenue than to costs so what happens to profit? In this case, a firm adds to its profits if it increases its level of production so Q
17 MR < MC If marginal cost exceeds marginal revenue, the production of an extra unit of output costs more than the additional revenue generated by the sale of this extra unit. Does this mean that profits are negative? In this case, firms can increase their profits by reducing its production level so Q
18 MR = MC A profit-maximizing firm will produce more output when MR > MC, and less output when MR < MC The firm's profits are maximized (or losses minimized) at the level of output at which MR = MC. Questions: Does MR > MC mean positive profits? Does MR = MC mean breaking even?
19 Profit Maximization Dollars MC profit rises Questions: Why does MR decline as Q increases? And why does MC rise? profit falls Output MR
21 Pure Competition Characteristics Individual firm is a price taker -- why? -- how do you reconcile the flat D curve with the downward-sloping D curve? -- implications for TR and for MR So, if D is flat, then why does S retain its upward slope?
22 Perfect Competition: Short-Run Equilibrium
23 Maximum PROFITS: MR = MC Approach; Profit = (P AC) x Q Why is MR flat? Do you see the TR rectangle? the TC rectangle? the two ways of viewing the profit rectangle?
24 Maximum PROFITS: TR TC Approach; Profit = gap between TR & TC Why is TR a straight line? Is it always a straight line? What is the importance of the slope of TR? What would be the consequence if TR became much flatter? What causes this to occur? Total revenue and total cost Total Revenue Break-Even Point (Normal Profit) Total Cost Maximum Economic Profits
25 Perfect Competition: Long-Run Equilibrium Questions: How does the industry reach this long-run situation, from its short-run equilibrium (shown a few slides back)? How does this picture translate into the TR-TC view in the preceding slide?
26 Pure Monopoly * CHARACTERISTICS * BARRIERS to ENTRY: -- Economies of Scale The Natural Monopoly Case Minimum Efficient Scale -- Legal Barriers to Entry Patents Licenses -- Ownership or Control of Essential Resources -- Pricing and Other Strategic Barriers to Entry * The monopolist faces the industry demand
27 Maximum Profits: TR-TC Approach Profits = gap between TR & TC * Questions: How much is the firm s fixed costs? Why is TR not a straight line anymore? When will a monopolist be UNABLE to earn positive profits or, is that possible?
28 Maximum Profits: MR = MC Approach Profits = (P AC) x Q
29 INEFFICIENCY OF PURE MONOPOLY P An industry in pure competition sells where supply and demand are equal. S = MC P m P c At MR=MC A monopolist will sell less units at a higher price than in competition. Q m Q c MR D Q
30 Check your understanding (alternative goals in monopoly):
32 Monopolistic Competition * In what ways is this similar to pure competition? * In what ways is this similar to monopoly?
33 Bases of Differentiation Three Categories 1) Product Attributes exploiting the actual product, including its availability 2) Firm-Customer Relationships exploiting relationships with customers (e.g., customization, reputation) 3) Firm Linkages exploiting relationships within the firm and/or relationships with other firms (e.g., complements, customer services)
34 Maximum Profits in Monopolistic Competition: MR = MC MC ATC P 1 Price and Costs AC 1 Short-Run Economic Profits D MR Q 1 Quantity
35 MONOPOLISTIC COMPETITION Long-Run Equilibrium Question: How is this attained? Normal Profit Only MC ATC P 3 = AC 3 Price and Costs MR D Q 3 Quantity
36 MONOPOLISTIC COMPETITION Long-Run Equilibrium Not Productively Efficient Q not at minimum ATC Excess Capacity Not Allocatively Efficient Price MC Zero Economic Profit In what ways are these results similar to competition? to monopoly?
37 OLIGOPOLY * Characteristics * Alternative Models
39 Profit Maximization For all firms, at ALL TIMES, regardless of the market structure they re in, the profit maximizing solution is: MR = MC Copyright Houghton Mifflin Company. All rights reserved.
40 Profit Maximization the Price Taker vs. Price Maker ( monopoly power = the ability to set one s own price) Copyright Houghton Mifflin Company. All rights reserved.
41 Profit Maximization Do firms maximize profits? Possibility of other objectives Revenue maximization Dividends for stockholders Short-run vs long-run profits Sales volume (greater economic, political, etc. influence) Social/ environmental concerns Co-ops (focus on other stakeholders, esp. workers)
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