Principles of Microeconomics Module 5.1. Understanding Profit

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1 Principles of Microeconomics Module 5.1 Understanding Profit 180

2 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs 181

3 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs 182

4 Economic Costs Economic Costs for producers include explicit and implicit costs - Explicit Costs: Financial costs - Implicit Costs: Opportunity costs Example: Caroline can use $300,000 of her savings to start her firm which is in a savings account paying 5% interest. OR Caroline borrow $200,000 from a bank at the same interest rate and used $100,000 from her savings. Which should she do? 183

5 Economic Costs Economic Costs for producers include explicit and implicit costs - Explicit Costs: Financial costs - Implicit Costs: Opportunity costs Example: Caroline can use $300,000 of her savings to start her firm which is in a savings account paying 5% interest. (OR) Caroline borrow $200,000 from a bank at the same interest rate and used $100,000 from her savings. Which should she do? 184

6 Example of Economic Costs Choice A: Caroline s cost to start her business: Explicit Cost = $300,000 Implicit Cost = ($300,000 X 5%) = $15,000 Total Economic Cost = $315,000 Total Accounting Cost = $300,000 Choice B: Caroline s cost to start her business: Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) = $310,000 Implicit Cost = ($100,000 X 5%) = $5,000 Total Economic Cost = $315,000 Total Accounting Cost = $310,

7 Example of Economic Costs Choice A: Caroline s cost to start her business: Explicit Cost = $300,000 Implicit Cost = ($300,000 X 5%) = $15,000 Total Economic Cost = $315,000 Total Accounting Cost = $300,000 Choice B: Caroline s cost to start her business: Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) = $310,000 Implicit Cost = ($100,000 X 5%) = $5,000 Total Economic Cost = $315,000 Total Accounting Cost = $310,

8 Key Equations Total Revenue (TR) = Price x Quantity Marginal Revenue = Change in TR/ Change in Q Marginal Cost= Change in TC/ Change in Q Marginal Revenue captures the change in a firm s revenue from one additional unit produced Marginal Cost captures the change in a firm s cost from one additional unit produced 187

9 Key Equations Total Revenue (TR) = Price x Quantity Marginal Revenue = Change in TR/ Change in Q Marginal Cost= Change in TC/ Change in Q Marginal Revenue captures the change in a firm s revenue from one additional unit produced Marginal Cost captures the change in a firm s cost from one additional unit produced 188

10 Profit Maximizing Point of Production Firms will maximize their profits by producing at the point where MR = MC If MR > MC: Increase profits by producing more If MR < MC: Increase profits by producing less 189

11 Profit Maximizing Point of Production Where MR = MC tells us that the additional revenue generated from the last unit produced is equal to the additional cost of producing it The firm cannot increase their profits by producing any more or any less than at the point where MR = MC, in other words marginal profit = 0 190

12 Profit Maximizing Point of Production Where MR = MC tells us that the additional revenue generated from the last unit produced is equal to the additional cost of producing it The firm cannot increase their profits by producing any more or any less than at the point where MR = MC, in other words marginal profit = 0 191

13 Key Takeaways All firms are profit maximizing Point of maximizing profits is where MR = MC for all firms Where MR = MC, profit is at its highest and the firm cannot produce any more or less to increase profit further 192

14 Principles of Microeconomics Module 5.2 Perfect Competition 193

15 Perfectly Competitive Markets Key Characteristics: Many buyers and sellers Goods are identical Firms can freely enter and exit the market No single firm can exert price control in the market. All firms are price takers. To maximize revenue can only change quantity! 194

16 Profit Maximizing Point of Production Firms will maximize their profits by producing at the point where MR = MC If MR > MC: Increase profits by producing more If MR < MC: Increase profits by producing less NOTE: Marginal Revenue is constant and equal to price ONLY under perfect competition. 195

17 Perfect Competition Consider Firm A which sells ping pong balls. The following table describes their revenues and costs: Output Price Total Total Revenue Cost 0 $3 $0.00 $ $3 $3.00 $ $3 $6.00 $ $3 $9.00 $ $3 $12.00 $ $3 $15.00 $ $3 $18.00 $ $3 $21.00 $ $3 $24.00 $ $3 $27.00 $ Profit Marginal Revenue Marginal Cost - How many ping pong balls should Firm A produce to maximize its profits? - What do you observe about MR and MC at this point? 196

18 Perfect Competition Output Price Total Revenue Total Cost Profit Marginal Revenue Marginal Cost 0 $3 $0.00 $ 1.50 ($1.50) 1 $3 $3.00 $ 2.00 $ $ $3 $6.00 $ 3.00 $ $ $3 $9.00 $ 4.50 $ $ $3 $12.00 $ 6.50 $ $ $3 $15.00 $ 9.50 $ $ $3 $18.00 $ $ $ $3 $21.00 $ $ $ $3 $24.00 $ $ $ $3 $27.00 $ $ $

19 Perfect Competition What if the price increases to $4? Output Price Total Revenue Total Cost Profit 0 $4 $0.00 $ $4 $4.00 $ $4 $8.00 $ $4 $12.00 $ $4 $16.00 $ $4 $20.00 $ $4 $24.00 $ $4 $28.00 $ $4 $32.00 $ $4 $36.00 $ Marginal Revenue Marginal Cost 198

20 Perfect Competition What if the price increases to $4? Output Price Total Revenue Total Cost Profit Marginal Revenue Marginal Cost 0 $4 $0.00 $ 1.50 ($1.50) 1 $4 $4.00 $ 2.00 $ $ $4 $8.00 $ 3.00 $ $ $4 $12.00 $ 4.50 $ $ $4 $16.00 $ 6.50 $ $ $4 $20.00 $ 9.50 $ $ $4 $24.00 $ $ $ $4 $28.00 $ $ $ $4 $32.00 $ $ $ $4 $36.00 $ $ $ 4.00 New Price à New Marginal Revenue New optimal point of production 199

21 Graphing Production Decisions Firm A is a price taker If observe price change increase to $4 will respond by producing more New MR à New point where MR = MC New profit max point of production 200

22 Firm s Short Run Decisions In the short firm must decide if it should produce or temporarily shutdown Temporary shutdown Exit from market Firm is suspending production temporarily Must still pay fixed costs No longer pays variable costs, no longer receives revenue SHUTDOWN WHEN: Total Revenue < Variable Cost TR = P X Q AVC = VC X Q Shutdown: P < AVC 201

23 Firm s Short Run Supply Curve P (Cost) MC P (Cost) Short Run Supply Curve ATC AVC AVC Quantity Quantity Because, in the short run, a firm will produce only if P AVC, the firm's short run supply curve will be its MC above AVC If: P AVC P < AVC The Firm Will: Produce output level where MR = MC Shut down and produce zero output 202

24 Firm s Long Run Decisions Firm must decide: Enter a market? Continue producing? Exit a market? When enter a market TR > 0; TC > 0 Will enter if TR > TC à P > ATC When exit a market TR = 0; TC = 0 Will exit if TR < TC à P < ATC 203

25 Firm s Long Run Supply Curve Because, in the long run, a firm will remain in a market only if P ATC, the firm's long-run supply curve will be its MC above ATC If: P > ATC P = ATC P < ATC The Firm Will: Enter because economic profits are earned Not enter or exit because economic profits are zero Exit because economic losses are incurred 204

26 Firm s Long Run Supply Curve P (Cost) MC P (Cost) Long Run Supply Curve ATC ATC AVC AVC Quantity Quantity Because, in the long run, a firm will remain in a market only if P ATC, the firm's long-run supply curve will be its MC above ATC If: P > ATC P = ATC P < ATC The Firm Will: Enter because economic profits are earned Not enter or exit because economic profits are zero Exit because economic losses are incurred 205

27 Measuring Profit or Loss Profit = TR TC TR = P x Q TC = ATC x Q Profit = (P ATC) x Q P (Cost) MC P (Cost) MC P ATC PROFIT ATC MR ATC P LOSS ATC MR Quantity Quantity 206

28 Long Run Equilibrium Zero Economic Profits MR = MC P = ATC P (Cost) MC ATC P= ATC MR Quantity 207

29 Impact of Shift in Demand Increase in Demand à Increase in Price MR increases In the short run: movement along the supply curve (MC) because new price = new MR SHORT RUN PRODUCTION P (Cost) MC P (Cost) S ATC P.2 MR.2 P.2 PROFIT P.1 MR.1 P.1 D.2 Q.1 Q.2 Quantity Q.1 Q.2 D.1 Quantity 208

30 Impact of Shift in Demand Increase in Price à MR increases à Profits in Short Run In the long run: New Firms enter to take advantage of positive profits Shift in the supply curve because change in number of sellers LONG RUN PRODUCTION P (Cost) MC P (Cost) S.1 S.2 ATC P.2 MR.2 P.2 P.1 MR.1 P.1 D.2 Q.1 Q.2 Quantity Q.1 Q.2 D.1 Q.3 Quantity 209

31 Key Takeaways Perfectly competitive firms are price takers to change their profit max point of production they can only change quantity Face short run and long run decisions on production Short run profit/loss depends on prices and ATC Firms will operate in the long run with zero economic profits because of the free entry and exit of firms 210

32 Principles of Microeconomics Module 5.3 Monopoly 211

33 Fundamental Causes of Monopoly Barriers to Entry cause Monopoly Power Resource Restrictions: Monopoly has sole ownership of a key resource in production Gov t created Monopolies Monopoly is granted exclusive rights to produce or sell a good Natural Monopolies One firm can provide the good at a lower cost than two or more firms 212

34 Pricing and Production Decisions A monopoly firm has complete price control because they are the sole provider of the good Considered a Price Maker Monopoly firm still faces a downward sloping demand curve To sell more = must lower the price Price: determined by firm Quantity: determined by demand 213

35 Understanding Monopoly Consider the market for diamonds where DeBeers has a monopoly. It is deciding how much to sell and at what price. Price Quantity TR TC MR MC , , , , , , , , , , ,000 Where will it gain positive revenue? What price should it set and where should it produce to maximize profits? What will be the size of its profits at this point? 214

36 Understanding Monopoly Consider the market for diamonds where DeBeers has a monopoly. It is deciding how much to sell and at what price. Price Quantity TR TC MR MC , , , , , , , , , , , Anywhere below $2000 $1400 $130,

37 Understanding Monopoly Monopoly can set the price anywhere below $2000 and gain positive revenue Optimal point of production? Need to consider profit maximization MR = MC If MR > MC: Increase profits by increasing Qs If MR < MC: Increase profits by decreasing Qs 216

38 Understanding Monopoly Price (Cost) MC MC ATC MR D Quantity 217

39 Profits for a Monopoly Profits = TR TC = (P x Q) (ATC x Q) = Q (P ATC) Profits = 300 ( ) ATC = 290,000 / 300 =

40 Understanding Quick Check For a profit-maximizing monopoly that charges the same price to all consumers, what is the relationship between price (P), marginal revenue (MR), and marginal cost (MC)? a) P = MR and MR = MC. b) P > MR and MR = MC. c) P = MR and MR > MC. d) P > MR and MR > MC. 219

41 Understanding Quick Check For a profit-maximizing monopoly that charges the same price to all consumers, what is the relationship between price (P), marginal revenue (MR), and marginal cost (MC)? a) P = MR and MR = MC. b) P > MR and MR = MC. c) P = MR and MR > MC. d) P > MR and MR > MC. 220

42 Welfare Costs of a Monopoly Since monopolies set prices and quantities at MR = MC and MR P the monopoly outcome is socially inefficient. Total surplus would be maximized at P = D = MC D = MC à Socially Efficient Outcome MR = MC à Profit Max Outcome 221

43 Difference between Monopoly Outcome and Socially Efficient Outcome à Deadweight loss 222

44 Ways to Regulate Monopoly Power Increase competition with Antitrust Laws Regulate natural monopolies to bring price as close to socially efficient point as possible Public Ownership à Government takes over Do nothing: Cost to regulation > Benefit of regulating 223

45 Key Takeaways Monopolies are the least competitive market structure but they still depend on demand to set prices and profit maximizing quantities There are social costs to monopoly power, including deadweight loss There are many harmless and harmful examples of monopoly power in the world today. 224

46 Principles of Microeconomics Module 5.4 Oligopoly and Game Theory 225

47 Oligopoly Markets Few sellers Selling an identical good Because few sellers, the production choices of one firm will affect the outcomes of all other firms in the market Firms must act strategically because profits now depend on: How much it produces How much all other firms produce Tension between cooperation and self-interest 226

48 Oligopoly and Game Theory Oligopoly: best outcome is to cooperate and act as a monopoly Produce small quantity of output at P > MC Yields highest profits! Incentive to act in own self-interest Each cares only about their own profits If one cheats: even higher profits! To reach the monopoly outcome each firm relies on the other (interdependent) Collude to set prices or quantities produced to reach the point of highest possible profits Cartels: groups of firms that act together and collude 227

49 Understanding Oligopoly Jack and Jill own the only water well in town. Each can bring in water to town to sell it but they need to agree on how much to bring in. Assume MC = 0. Quantity Price Total Revenue

50 Oligopoly Outcome If cooperate: reach monopoly outcome P = 60; Q = 60; Profit = 3600 Jack Profits à P = 60, Q = 30, Profit = 1800 Jill Profits à P = 60, Q = 30, Profit = 1800 If one cheats: can gain more! P = 50, Q = 70, Profit = 3500 Cheater à P = 50, Q = 40, Profit = 2000 Cooperator à P = 50, Q = 30, Profit =

51 Oligopoly Outcome If both cheat: lower profits but oligopoly outcome P = 40, Q = 80, Profits = 3200 Jack Profits: P = 40, Q = 40, Profits = 1600 Jill Profits: P = 40, Q = 40, Profits = 1600 Oligopoly Outcome: Both cheat! Act in own self-interest Fail to cooperate 230

52 Nash Equilibrium Agents that interact with one another will choose their optimal strategy given the strategies that all other agents have chosen à One firm s optimal strategy takes into account all other firms choices à Nash Equilibrium: Both Cheat Can t do any better regardless of what the other person does 231

53 Oligopoly Outcome & Nash Equilibrium Oligopoly Outcome = N N + 1 x Competitive Outcome N = Number of firms Note: As the number of firms grows the oligopoly outcome reaches competitive equilibrium Larger number of firms each becomes less concerned about how they impact all other firms More incentive to act in their own self-interest 232

54 Oligopoly Outcome & Game Theory JILL JACK CHEAT COOPERATE CHEAT Jack Profits: $1600 Jack Profits: $1500 Jill Profits: $1600 Jill Profits: $2000 COOPERATE Jack Profits: $2000 Jack Profits: $1800 Jill Profits: $1500 Jill Profits: $1800 If cooperate, collectively gain highest profits but individually irrational because potential to make even more by cheating! Regardless of what the other person does best to cheat! - Avoid lower profits ($1500) - Potential for even higher profits ($2000) 233

55 Oligopoly Outcomes When there are only a few firms in a market each firm acts strategically Game theory guides the strategies that firms choose Will act in their own self-interest despite the potential to gain when cooperate Cooperation is possible in repetitive games when the rules don t change 234

56 Principles of Microeconomics Module 5.5 Monopolistic Competition

57 Monopolistic Competition Monopolistically Competitive Markets: Have many buyers and sellers Sell similar but differentiated products Free entry and exit in the market Firms: Have some price control In short run: experience economic profits + act as monopoly In long run: zero economic profits + act as perfect competition

58 In the short run Market outcome looks similar to monopoly Profit Max Point: MR = MC Price > MR = MC If P > ATC POSITIVE ECONOMIC PROFITS Possible in Short Run Determines quantity based on MR = MC Determines price based on demand

59 In the long run Market outcome similar to perfectly competitive markets Reason: FREE ENTRY/EXIT Firms in the long run operate at: P > MC Due to firm facing a downward sloping demand curve P = ATC Due to free entry and exit into the market

60 Long Run when P > ATC If P > ATC: Short run positive profits Overtime: more firms enter to take advantage of profits Increase variety of goods as more firms enter Decrease in demand for each firm s differentiated good Decrease in price for firms until P = ATC Zero Economic Profits In long run Adjust until P = ATC in Long run

61 Long Run when P > ATC Price (Cost) MC MC Price S ATC MR D Quantity D Quantity 240

62 Long Run when P > ATC Price (Cost) MC MC Price S S.2 ATC MR MR.2 D.2 D Quantity As new firms enter à supply in the market goes up But for each individual firm à demand goes down No change in costs à adjustment until P= ATC D Quantity 241

63 Long Run when P < ATC If P < ATC: Short run negative profits Loss! Overtime: firms exit market to avoid losses Decrease variety of goods as more firms exit Increase in demand for each firm s differentiated good Increase in price for firms that stay in market until P = ATC Zero Economic Profits In long run Adjust until P = ATC in Long run

64 Long Run when P < ATC Price (Cost) MC MC ATC Price S MR D Quantity D Quantity 243

65 Long Run when P < ATC Price (Cost) MC MC ATC Price S.2 S MR.2 MR D.2 D Quantity As firms exità supply in the market goes down But for each individual firm à demand goes up No change in costs à adjustment until P= ATC D Quantity 244

66 Welfare and Monopolistic Competition Because P > MC à some costs to society as with monopoly outcome Regulation of these firms would be very difficult à too many firms to regulate Two externalities arise from M.C. outcome: Product-variety externality Business-stealing externality

67 Key Takeaways Monopolistically Competitive firms act as both monopolies (in SR) and perfectly competitive firms (in LR) Have some excess capacity and mark up because have some price control Advertising only works when there are similar but differentiated products only in M.C. markets

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