# Lesson 3-2 Profit Maximization

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1 Lesson 3-2 rofit Maximization E: What is a Market Graph? 13-3 (4) Standard 3b: Students will explain the 5 dimensions of market structure and identify how perfect competition, monopoly, monopolistic competition, and oligopoly are characterized by the 5 dimensions of market structure. Standard 3c: Students will determine the profit maximizing quantity of output a firm should produce and the price at which the product should be sold given numerical, graphical, or tabular information. Essential uestions: (a) What is a market graph? (b) How do I read a market graph? (c) What does the market graph for erfect Competition look like? (d) What does the market graph for Monopoly look like? (e) What does the market graph for Monopolistic Competition look like? (f) What does the market graph for ligopoly look like? (g) How do I Identify the rofit Maximizing uantity of utput? (h) What quantity should I produce & what price should I charge in order to maximize profit? erfect Competition Monopoly Monopolistic Competition ligopoly E: What is a Market Graph? E: How o I Read a Market Graph? Curve is the amount of added revenue that a business earns if it produces and sells one more unit. Curve is the amount of added cost that a business pays if it produces and sells one more unit. emand Curve emand is the relationship between price and quantity demanded by buyers for the product. Curve is the total cost per unit to produce the product. Curve is the variable cost per unit to produce the product. Each of these five variables (,, rice,, and ) describes the business at a particular level of output (i.e., at a specific uantity). Choose a uantity along the x-axis and then follow that line vertically to see where it intersects each of the curves. At the point of intersection, move left over to the level on the y-axis. That -value is the value of that variable at the chosen uantity. Continue following the chosen uantity vertically to get the values of the other 4 variables. Sometimes, two or more variables will have the same value.

2 E: How o I Read a Market Graph? Identify the values of,, rice,, and at the following levels of output: When = 5: = = rice= = = When = 7: = = rice= = = E: How o I Read a Market Graph? Identify the values of,, rice,, and at the following levels of output: When = 5: = 42 = 19 rice= 57 = 27 = 15 When = 7: = 28 = 28 rice= 50 = 26 = 18 E: What oes the Market Graph for erfect Competition Look Like? E: What oes the Market Graph for erfect Competition Look Like? Let s start with the one graph that is different. o you see a demand curve here? No. But actually, there is a demand curve here it is identical to the curve. First, the market price ( e ) is determined by the overall market Supply and emand. The resulting price is the Market rice for all sellers. S Market Because sellers in perfect competition are price takers, they do not get to increase or decrease the price, so they do not have a downward sloping demand curve. e The demand curve is perfectly elastic (i.e., horizontal, remember?) and equal to, so it is under the curve that you see. Since each seller is a pricetaker, the price is the same no matter the quantity sold. Market Let s see why

3 E: What oes the Market Graph for erfect Competition Look Like? E: What oes the Market Graph for erfect Competition Look Like? A demand curve that has the same rice at every level of output (uantity) is horizontal (perfectly elasticity). emand = rice S Market S Market Marginal Revenue is the increase in TR when you sell one more unit of something. Well, if the price is the same at every level of quantity demanded, then TR will always increase by the amount of the price. So, = rice. S Market = e = emand = rice Even if market forces change the price, all sellers will still be price-takers and the demand curve will still be horizontal. Market = If emand = rice, and = rice, then emand =. Market E: What oes the Market Graph for Monopoly Look Like? E: What oes the Market Graph for Monopoly Look Like? Unlike erfect Competition, Monopoly has a downward sloping demand curve and a separate curve. This has to do with the fact that a Monopoly is a price setter. Higher A monopoly is a price-setter, meaning that it can set the price of its product at any level. f course, if the price is set higher, fewer units will be sold. If the price is set lower, more units will be sold. This negative relationship indicates a downward sloping demand curve. In this case, demand is less elastic, so it is more vertical than the demand curve in erfect Competition. So, what s with the separate curve? Lower Let s look at that Lower Higher

4 E: What oes the Market Graph for Monopoly Look Like? When a firm faces a downward sloping demand curve, unlike perfect competition: rice emand emand Marginal Revenue Instead, since there is a new price for every different output quantity, the curve is steeper and inside the demand curve. E: What oes the Market Graph for Monopoly Look Like? Note that the slope of the curve is steeper than that of the emand curve and that the curve is inside the emand curve. E: What oes the Market Graph for Monopoly Look Like? E: What oes the Market Graph for Monopoly Look Like? For example, let s consider the following demand schedule for a monopoly: If you don t understand how these numbers were calculated, see this figure:

5 E: What oes the Market Graph for Monopoly Look Like? E: What oes the Market Graph for Monopolistic Competition Look Like? As you can see, the curve diverges from the emand curve here, as quantities increase and prices decrease. This is because decreased prices times increased quantities ( x ) result in marginal revenues that are less than price The market graph for Monopolistic Competition looks a lot like the market graph for Monopoly. That is because Monopolistic Competitors are price setters. Also, in the short-run, Monopolistic Competition acts a lot like a Monopoly (i.e., Monopolistic ). In the long-run, Monopolistic Competition acts more like erfect Competition (i.e., Competition ). For now, Monopolistic Competition looks just like Monopoly, except that Monopolistic Competition will have a demand curve that is not quite as steep because there are competitors; and some consumers are sensitive to price increases. E: What oes the Market Graph for ligopoly Look Like? 13-3 (21 The market graph for ligopoly looks a lot like the market graph for Monopoly. This is because firms in oligopoly markets are price setters. Also, oligopolies are often such tight-knit communities that they can behave as huge monopolies that are made up by all the firms. This is the easy graph. Later, we will make ligopoly more complicated by introducing three theories of ligopoly behavior. Each of these three theories has a different graph. For now, let s say it looks like Monopoly. E: How do I Identify the rofit Maximizing uantity of utput? 14-1 (4) The profit-maximizing quantity is the point at which Marginal Revenue = Marginal Cost Remember: Marginal Cost () the change in total cost that results from producing an additional unit Marginal Revenue () the change in total revenue arising from the sale of an additional unit

6 E: How do I Identify the rofit Maximizing uantity of utput? What if >? If is greater than, then the added revenue from selling one more unit will be greater than the added cost of producing that unit that is a profit. roducing more will result in greater profit as long as >, so keep producing! What if <? If is less than, then the added cost of producing one more unit will be greater than the added revenue from selling it that is a loss. roducing more will result in greater losses as long as <, so stop producing! E: How do I Identify the rofit Maximizing uantity of utput? The bottom line is that You should keep producing as long as > You should stop producing before < The point between > and < is: = The profit maximizing quantity! E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? The rule remains the same no matter the structure of the market. To maximize profit, produce the quantity of output () where =. Important questions: What uantity should I produce in order to maximize profit? What rice should I set in order to sell the profitmaximizing uantity? E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? How much should this firm produce in order to maximize profit? What price should be charged?

7 E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? How much should this firm produce in order to maximize profit? What price should be charged? = 4 & = 7 Notice that we did not say whether it is a perfect competitor, a monopoly, a monopolistic competitor, or an oligopoly firm? That s because it doesn t matter (but it s not perf comp). The profit max rule is the same. How much should this firm produce in order to maximize profit? What price should be charged? E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? E: What uantity Should I roduce & What rice Should I Charge in order to Maximize rofit? You can also identify the profit maximizing quantity of output and price by viewing a market graph. Remember, you are looking for the place where =. This will be the place where the curve and the curve intersect. How much should this firm produce in order to maximize profit? What price should be charged? = 9 & = 18 n this graph, the curve intersects the curve where = 7. If you follow = 7 up to the demand curve, you can see the rice = 50.

8 Lesson 3-3 rofit, Loss, & the Shut own ecision Standard 3d: Students will identify whether a firm is experiencing positive economic profit, zero economic profit, or economic loss and assess whether the firm should continue doing business or shut down given numerical, graphical, or tabular information. Essential uestions: (a) How can I identify if a firm is generating profit or loss given a market graph? (b) What conditions show that a firm is profitable? (c) When should a firm generating a loss continue doing business? (d) When should a firm shut down operations? (e) How do the profit, loss, & shut down situations look in erfect Competition? (f) What is Zero Economic rofit? E: How o I Identify if a Firm is Generating rofit or Loss Given a Market Graph? 14-2 (4) Market graphs are useful for identifying whether a firm is profiting or losing money. You have seen that the,, and emand curves are useful for identifying the profit maximizing quantity and price. The last piece of the puzzle is to determine whether you are actually maximizing profit or minimizing loss. This is where the and curves come in. E: How o I Identify if a Firm is Generating rofit or Loss Given a Market Graph? To determine whether a firm is operating at a profit or a loss by viewing a market graph, do the following: 1. Identify quantity where = 2. Identify the price where profitmax intersects emand 3. Identify where profitmax intersects the curve 4. ifference between rice and is the profit/loss E: How o I Identify if a Firm is Generating rofit or Loss Given a Market Graph? 4. The difference between rice and is the profit or the loss (in this case, profit). rofit 3. Identify (cost per unit) where profit maximizing quantity intersects with curve. 1. Identify quantity where = 2. Identify price where profit maximizing quantity intersects with emand curve. profitmax

9 E: How o I Identify if a Firm is Generating rofit or Loss Given a Market Graph? E: What Conditions Show that a Firm is rofitable? 4. The difference between rice and is the profit or the loss (in this case, loss). Loss 3. Identify (cost per unit) where profit maximizing quantity intersects with curve. 1. Identify quantity where = 2. Identify price where profit maximizing quantity intersects with emand curve. is the Variable Cost per unit at any given quantity. is the Total Cost per unit at any given quantity. rice is the Total Revenue per unit. Consider that: rofit = Total Revenue Total Cost rofiter Unit = rice So rice must be > in order to profit. lossmin E: What Conditions Show that a Firm is rofitable? There are three possibilities for a seller in a market (look at the y-axis values): rice > > rice > but rice < rice < < E: What Conditions Show that a Firm is rofitable? There are three possibilities for a seller in a market (look at the y-axis values): rice > > (Figure A) This is the only economically profitable situation for a seller in a market. uantity is determined at the point where = Where uantity intersects with the curve is the of production (Total Cost per unit) rofit is the box below rice and above rice > but rice < rice < <

10 E: What Conditions Show that a Firm is rofitable? E: When Should a Firm Generating a Loss Continue oing Business? There are three possibilities for a seller in a market (look at the y-axis values): rofit rice > > rice > but rice < (Figure B) This situation will end up in a loss. However, the seller should still produce because he will limit his losses. At least variable costs are covered and some portion of fixed cost is recovered. Shutting down would result in a greater loss because no portion of fixed cost would be recouped. rice < < profitmax E: When Should a Firm Generating a Loss Continue oing Business? Loss ortion of Fixed Costs Recovered lossmin E: When Should a Firm Shut own perations? There are three possibilities for a seller in a market (look at the y-axis values): rice > > rice > but rice < rice < < (Figure C) This situation is a shut-down situation. The seller should not produce any output until conditions change. By shutting down, the seller limits losses to fixed costs. Even if the seller produces the loss minimizing quantity at =, the losses would be greater than the fixed cost losses from shutting down.

11 E: When Should a Firm Shut own perations? E: When Should a Firm Shut own perations? Loss ue to Fixed Costs Losses would be limited to this area if the firm SHUTS WN Additional Loss ue to Variable Costs At the = uantity, this is the Variable Cost per unit. As you can see, is greater than price and, subsequently, will make losses greater with each unit produced and sold. It is time to shut down. Additional losses if the firm ES NT SHUT WN lossmin lossmin E: How o the rofit, Loss, & Shut own Situations Look in erfect Competition? Since the demand curve in erfect Competition is the same as the curve and the rice, it looks a little different. However, the dynamics are identical. Here are examples of rofit, Loss, and Shut own in erfect Competition. E: How o the rofit, Loss, & Shut own Situations Look in erfect Competition? rofit = = Loss = = profitmax lossmin

12 E: How o the rofit, Loss, & Shut own Situations Look in erfect Competition? E: How o the rofit, Loss, & Shut own Situations Look in erfect Competition? Loss ue to Fixed Costs Additional Loss ue to Variable Costs = = Losses would be limited to this area if the firm SHUTS WN Additional losses if the firm ES NT SHUT WN = = lossmin lossmin E: What is Zero Economic rofit? 14-2 (21 Lesson 3-4 Market Structures in the Short Run & Long Run = Sometimes, is neither less than nor greater than rice, it is equal to rice. In these cases, there is neither a profit nor a loss. We call this zero economic profit. We will see this when we discuss market structures in the long run and the short run. profitmax Standard 3e: Students will distinguish between the short-term and long-term economic returns received by firms in each of the four basic market structures. Essential uestions: (a) Which dimensions of market structure affect a change in market structure profitability in the long run? (b) How is erfect Competition different in the long run? (c) How is Monopolistic Competition different in the long run? (d) Why is there no change in the long run for Monopoly and ligopoly?

13 E: Which imensions of Market Structure Affect a Change in rofitability in the Long Run? 14-3 (4) Structure imensions Relevant to Long-Run: Barriers to Entry/Exit rofits & Losses rofits in a market draw new competitors because they want a piece of the pie. Losses discourage new competitors, but drive away those with losses because they can t sustain losses in the long run. Entry & Exit If competitors can enter/exit a market easily, they will if there are profits to be earned or losses to avoid. Markets with high barriers to entry and exit usually do not look much different in the long run because firms can t get in or leave. E: Which imensions of Market Structure Affect a Change in rofitability in the Long Run? Structure imensions Relevant to Long-Run: Information Symmetry erfect Information erfect Information when all sellers know everyone s business, they know when there are profits. If everyone knows that other sellers are profiting, they will try to enter the market. Imperfect Information It s harder to know whether firms are earning profit when information is secret, so new competitors may not know that they could earn profit. Imperfect Information erfect Competition Monopolistic Competition ligopoly Monopoly E: How is erfect Competition ifferent in the Long Run? E: How is erfect Competition ifferent in the Long Run? erfect Competition in the Short Run erfect Competition in the Short Run This is a perfect competitor earning profit in the short run. This is a perfect competitor realizing a loss in the short run. rofit = = Loss = = profitmax lossmin

14 E: How is erfect Competition ifferent in the Long Run? In the long run: Economic profit and economic losses are eliminated. Because of (a) no barriers to entry or exit and (b) perfect information: The existence of economic profits will draw new entrants into the market. As new firms enter, increased supply will drive the price down until all economic profits are deteriorated. The existence of economic losses will spur some to exit the market. As firms exit, decreased supply will drive the price up until all economic losses are gone. E: How is erfect Competition ifferent in the Long Run? erfect Competition in the Long Run profitmax rofit ( > ) 0 rofit (=) Loss ( < ) E: How is erfect Competition ifferent in the Long Run? erfect Competition in the Long Run E: How is Monopolistic Competition ifferent in the Long Run? Monopolistic Competition in the Short Run This is a Monopolistic competitor earning profit in the short run. In the long-run, = =. The result is no economic profit and no economic loss (but there is accounting profit). rofit = = = profitmax profitmax

15 E: How is Monopolistic Competition ifferent in the Long Run? Loss Monopolistic Competition in the Short Run This is a Monopolistic competitor realizing a loss in the short run. lossmin E: How is Monopolistic Competition ifferent in the Long Run? Just like perfect competition, in the long run: Economic profit and economic losses are eliminated because of low barriers to entry or exit. When there are profits, competitors enter the market (with close substitutes), drawing buyers away from sellers and shifting demand curves to the left, decreasing prices to match. When there are losses, competitors exit the market, moving buyers to existing sellers and shifting their demand curves to the right, increasing the price to match. E: How is Monopolistic Competition ifferent in the Long Run? Monopolistic Competition in the Long Run E: How is Monopolistic Competition ifferent in the Long Run? Monopolistic Competition in the Long Run > In the long-run, rice =. The result is no economic profit and no economic loss (but there is accounting profit). = = < profitmax profitmax

16 E: Why is There No Change in the Long Run for Monopoly & ligopoly? In the long run Monopoly looks the same as it does the short run. That is, there is no difference between the short run and the long run for Monopoly. Why? Monopoly has extremely high barriers to entry/exit: New competitors cannot enter the market, increase supply, and drive down the price to erode profits. Monopolies cannot exit the market when experiencing losses. Monopolies are very secretive: Even if there was a way to enter the market, only the monopoly would know about it, and they would likely keep it secret. E: Why is There No Change in the Long Run for Monopoly & ligopoly? 14-3 (17 In the long run, ligopoly looks very similar to what it looks like in the short run. Why? Like Monopolies, ligopolies have high barriers to entry/exit: New competitors have difficulty entering the market and eroding profits. ligopolies can, however, exit the market when experiencing losses, though they will probably merge with a competitor. Like Monopolies, ligopolies are also very secretive: The group of firms in the market guard their market as a group to keep new firms from learning the secrets to success. Lesson 3-5 Theories of ligopoly Behavior Standard 3f: Students will distinguish among three theories of oligopoly behavior and their characteristics. Essential uestions: (a) What is the Mindset of oligopoly firms? (b) What are the three theories of oligopoly behavior? (c) What is Kinked emand Curve Theory? (d) Why is there a gap in the curve in Kinked C Theory? (e) What is Unkinked emand Curve Theory? (f) What is Cartel Theory? ligopoly 15-1 (4) ligopoly is a market structure with the following characteristics: Many Buyers and Few Sellers Some market power (price-setter) High or many barriers to entry or exit roduct can be either homogeneous or heterogeneous Imperfect Information

17 E: What is the Mindset of ligopoly Firms? Because there are few competitors in an oligopoly market, each firm is very familiar with the other firms in the industry and exhibit certain degrees of rivalry. They watch one another very closely and often mimic one another s behaviors, especially in terms of product features/pricing/promotion. Though they mimic one another, they also know that it is important to be seen as different, so they rely strongly on brand loyalty and identifying themselves as different from competitors. E: What are the 3 Theories of ligopoly Behavior? Economists have identified 3 theories that explain how oligopoly firms make decisions: Kinked emand Curve Theory Unkinked emand Curve Theory Cartel Theory E: What is Kinked emand Curve Theory? Kinked emand Curve Theory Because oligopoly firms mimic one another, if one firm lowers its price, the others will match those price cuts. However, kinked demand curve theory assumes that price increases will NT be copied. If one player increases its price, buyers will move to a different player and market share will increase for that player simply because it did not increase its price. E: What is Kinked emand Curve Theory? Kinked emand Curve Theory The result is a kinked demand curve with the kink at the current market price: Below the kink, decreases in price result in normal increases in quantity demanded. Above the kink, increases in price result in substantial decreases in quantity demanded.

18 E: What is Kinked emand Curve Theory? E: Why is There a Gap in the Curve in Kinked emand Curve Theory? Kinked emand Curve Theory The kink in the demand curve also affects the marginal revenue curve: Below the kink, the curve is steeper. Above the kink, the curve is more horizontal. The kink in the demand curve also creates a vertical gap in the curve at the quantity demanded at the point of the kink in the demand curve Vertical gap in at emand curve & curve for lower portion of kinked demand curve. emand curve & curve for upper portion of kinked demand curve. Additionally, you can also see that instead of the curve kinking at the level of output, there is actually a huge vertical gap in the curve. verlap both demand curves and you can see that the kink in the demand curve takes place at the price. E: Why is There a Gap in the Curve in Kinked emand Curve Theory? E: What is Kinked emand Curve Theory? Usually, the curve will past through the gap in the curve, indicating the proper level of production and the price. Kinked emand Curve Theory This theory makes oligopoly appear very similar to perfect competition since there is little freedom to set a higher price. After all, notice that above the kink, the demand curve goes almost horizontal and the marginal revenue curve is very close to the demand curve.

19 E: What is Unkinked emand Curve Theory? Un-Kinked emand Curve Theory Like kinked demand curve theory, this theory assumes that price cuts will be copied by competitors. However, unlike kinked demand curve theory, this theory assumes that price increases will also be copied by competitors in oligopoly. This theory makes oligopoly appear very similar to monopolistic competition, but with higher barriers to entry and fewer sellers. E: What is Unkinked emand Curve Theory? Un-Kinked emand Curve Theory Like Monopolistic Competition, the demand curve in Unkinked emand Curve Theory is very elastic. It has a downward slope, but it is not very steep. E: What is Cartel Theory? Cartel Theory A cartel is an organization of firms within an industry that cooperates in making production and pricing decisions together. Cartels act as a single organization in making production and pricing decisions, much like a monopoly. This usually means that output is lower, price is higher, and profits will be higher for the whole industry. E: What is Cartel Theory? Cartel Theory roblems with Cartels: Non-Cartel Competition Since cartel members earn monopoly-level profits, the industry will attract new entrants that can overcome barriers to entry and not be subject to the cartels agreements Cheating Cartel Members: Even though cartels behave as monopolies, they are still different firms with separate goals and desires for profits. Restricting production results in a higher price. Since the price is higher, cartel members are tempted to cheat by increasing production to earn higher profits.

20 E: What is Cartel Theory? Lesson 3-6 Cartel Theory 15-1 (17) Like Monopoly, the demand curve in Cartel Theory is very inelastic. It has a downward slope and is very steep. Basically, the cartel behaves as a single organization making decisions as one supplier. That is, the cartel acts like a monopoly. Economic Efficiency & Government rice Controls Standard 3g: Students will assess the economic efficiency of each of the four basic market structures and identify solutions for dealing with market inefficiency. Standard 3h: Students will assess the effects of government price controls on economic efficiency and on other market dynamics. Essential uestions: (a) What is economic efficiency? (b) What are consumer s surplus & producer s surplus? (c) What is a deadweight loss? (d) How economically efficient are each of the 4 basic market structures? (e) How oes Government Intervention in Markets Affect Economic Efficiency? E: What is Economic Efficiency? 15-2 (4) Economic efficiency is a concept concerned with getting the most benefit as possible from every resource in society (every tree, every person, every tool, etc.). It does not care who gets the benefit and how much they each get, but refers to the sum of all benefits received by all sellers and consumers. Sometimes, consumers can get more benefit (called consumer s surplus ) by taking away benefit for sellers. Sometimes, sellers can get more benefit (called producer s surplus ) by taking away benefit from consumers. When sellers or consumers take extra benefit from one another, it usually results in some wasted benefit. This wasted benefit is called deadweight loss. E: What are Consumer s Surplus & roducer s Surplus? Consumer s Surplus is: - the difference between the price actually paid and the price that a buyer is willing to pay. - the area directly underneath the demand curve but above the price. roducer s Surplus is: - the difference between the price actually received and the price that a seller is willing to accept. - the area directly above the supply curve but below the price. e 0 Consumer s Surplus roducer s Surplus rice the buyer is willing to pay. rice actually received. rice the seller is willing to accept. rice actually paid. e S Consumer s Surplus + roducer s Surplus = Total Benefit to Society Maximizing the Total Benefit to Society = Economic Efficiency

22 E: What is a eadweight Loss? In both cases of economic inefficiency, the problem is that marginal benefit to society is not equal to marginal cost to society. The marginal benefit that society gets from an economic exchange is the utility received by the buyer, indicated by the price paid. The marginal cost that society pays to create the benefit is the marginal cost of the resources used, which is indicated by the marginal cost of production. So, economic efficiency is maximized where the marginal benefit to consumers (price) is equal to the marginal cost (the firm s marginal cost). E: How Economically Efficient are each of the 4 Basic Market Structures? erfect Competition erfect competition is the only economically efficient market structure, because it is the only market where rice is equal to Marginal Cost. Monopoly Monopolistic Competition ligopoly E: How Economically Efficient are each of the 4 Basic Market Structures? erfect Competition Monopoly Monopoly is an economically inefficient market structure because it produces a quantity and sets a price where rice > Marginal Cost. This transfers some consumer s surplus from buyers and provides the monopoly with more producer s surplus, introducing a deadweight loss. Monopolistic Competition ligopoly eadweight Loss E: How Economically Efficient are each of the 4 Basic Market Structures? erfect Competition Monopoly Monopolistic Competition Monopolistic competition also introduces a deadweight loss by setting rice >. The inefficiency is not as severe as that introduced by monopoly, but it is economically inefficient nonetheless. ligopoly eadweight Loss

23 E: How Economically Efficient are each of the 4 Basic Market Structures? erfect Competition Monopoly Monopolistic Competition ligopoly ligopoly also introduces a deadweight loss by setting rice >. The inefficiency is not as severe as that introduced by monopoly, but it is economically inefficient nonetheless. eadweight Loss E: How oes Government Intervention in Markets Affect Economic Efficiency? 15-2 (15) Because market structures that are not perfectly competitive wind up being less economically efficient, governments often take measures to impose efficiency on those markets. Monopolies, ligopolies, and Monopolistic Competitors tend to set their prices higher than Marginal Cost, so by forcing these companies to set lower prices, governments can make these markets more economically efficient. This is called a price ceiling (a maximum price allowable within a market). E: How oes Government Intervention in Markets Affect Economic Efficiency? 15-3 (4) We ve seen how firms decide on the price they will charge to maximize profit, but Sometimes, the government imposes price controls: rice Ceiling a maximum legal price Intended to benefit consumers/buyers Create shortages: suppliers make less than people want Result in illegal sales at prices above the ceiling (people bid up the price on the side because there is a shortage) Encourages non-price rationing (long lines, lottery, favoritism, etc.) E: How oes Government Intervention in Markets Affect Economic Efficiency? Sometimes, the government imposes price controls: rice Floor a minimum legal price Intended to protect producers/sellers Create surpluses: suppliers make more than people want Government purchasing surpluses to maintain price floor rice controls shave down the consumer and producer surplus triangles the result is economic inefficiency.

24 E: How oes Government Intervention in Markets Affect Economic Efficiency? E: How oes Government Intervention in Markets Affect Economic Efficiency? rice Floor e rice Ceiling Consumer s Surplus Consumer s Surplus with rice Ceiling roducer s Surplus with rice Floor roducer s Surplus Loss in efficiency due to price controls Surplus Shortage S Though a price ceiling can introduce an economic inefficiency and a shortage in a market, it can also increase economic efficiency if used appropriately. rice eadweight Loss rice Ceiling The eadweight Loss has been reduced significantly. 0 e E: How oes Government Intervention in Markets Affect Economic Efficiency? rice floors, unfortunately, cannot increase economic efficiency because sellers tend to want higher prices anyway. rice floors mainly just benefit inefficient suppliers and help keep them in business. rice floors can actually make efficient markets less efficient by robbing buyers of consumer s surplus. E: How oes Government Intervention in Markets Affect Economic Efficiency? Because more competitive markets tend to be more economically efficient, the U.S. government likes competition and has created laws to encourage competition: Anti-Trust Laws: Legislation prohibiting monopolies. Legislation prohibiting businesses from gaining and holding monopoly-like power. Anti-Trust laws tend to increase economic efficiency by making markets more competitive.

25 E: How oes Government Intervention in Markets Affect Economic Efficiency? 15-3 (10) erfect Competition is the most economically efficient market structure. There is nothing the government can do to make a perfectly competitive market more efficient. rice ceilings will make perfect competition less efficient. rice floors will make perfect competition less efficient. Unfortunately, perfect competition doesn t really exist in its purest form.

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