Lesson 3-2 Profit Maximization

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1 Lesson 3-2 Profit Maximization 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 Questions: (a) What is a market graph? (b) How do I read a market graph? (c) What does the market graph for Perfect 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 Oligopoly look like? (g) How do I Identify the Profit Maximizing Quantity of Output? (h) What quantity should I produce & what price should I charge in order to maximize profit?

2 EQ: What is a Market Graph? $ $ 13-3 (4) Perfect Competition Monopoly Monopolistic Competition Oligopoly

3 EQ: What is a Market Graph? $ MR Curve MR is the amount of added revenue that a business earns if it produces and sells one more unit. MC Curve MC is the amount of added cost that a business pays if it produces and sells one more unit. Demand Curve Demand is the relationship between price and quantity demanded by buyers for the product. ATC Curve ATC is the total cost per unit to produce the product. AVC Curve AVC is the variable cost per unit to produce the product.

4 EQ: How Do I Read a Market Graph? $ Each of these five variables (MR, MC, Price, ATC, and AVC) describes the business at a particular level of output (i.e., at a specific Quantity). Choose a Quantity 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 Quantity. Continue following the chosen Quantity vertically to get the values of the other 4 variables. Sometimes, two or more variables will have the same value. Q

5 EQ: How Do I Read a Market Graph? Identify the $ values of MR, MC, Price, ATC, and AVC at the following levels of output: When Q = 5: MR= MC= Price= ATC= AVC= When Q = 7: MR= MC= Price= ATC= AVC=

6 EQ: How Do I Read a Market Graph? Identify the $ values of MR, MC, Price, ATC, and AVC at the following levels of output: When Q = 5: MR= $42 MC= $19 Price= $57 ATC= $27 AVC= $15 When Q = 7: MR= $28 MC= $28 Price= $50 ATC= $26 AVC= $18

7 EQ: What Does the Market Graph for Perfect Competition Look Like? $ Let s start with the one graph that is different. Do you see a demand curve here? No. But actually, there is a demand curve here it is identical to the MR curve. 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. The demand curve is perfectly elastic (i.e., horizontal, remember?) and equal to MR, so it is under the MR curve that you see. Let s see why

8 EQ: What Does the Market Graph for Perfect Competition Look Like? $ First, the market price (P e ) is determined by the overall market Supply and Demand. The resulting price is the Market Price for all sellers. S Market P e P Since each seller is a pricetaker, the price is the same no matter the quantity sold. D Market O Q

9 $ EQ: What Does the Market Graph for Perfect Competition Look Like? A demand curve that has the same Price at every level of output (Quantity) is horizontal (perfectly elasticity). Demand = Price S Market S Market P P D = P D = P Demand = Price Even if market forces change the price, all sellers will still be price-takers and the demand curve will still be horizontal. D Market O Q

10 EQ: What Does the Market Graph for Perfect Competition Look Like? $ Marginal Revenue is the increase in TR when you sell one more unit of something. S Market 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, MR = Price. P e D = P If Demand = Price, and MR = Price, then Demand = MR. D Market O Q

11 EQ: What Does the Market Graph for Monopoly Look Like? $ Unlike Perfect Competition, Monopoly has a downward sloping demand curve and a separate MR curve. This has to do with the fact that a Monopoly is a price setter. In this case, demand is less elastic, so it is more vertical than the demand curve in Perfect Competition. So, what s with the separate MR curve? Let s look at that

12 EQ: What Does the Market Graph for Monopoly Look Like? $ PHigher A monopoly is a price-setter, meaning that it can set the price of its product at any level. Of 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. PLower D O QLower QHigher Q

13 EQ: What Does the Market Graph for When a firm faces a downward sloping demand curve, unlike perfect competition: Price Demand Monopoly Look Like? Demand Marginal Revenue Instead, since there is a new price for every different output quantity, the MR curve is steeper and inside the demand curve.

14 EQ: What Does the Market Graph for Monopoly Look Like? $ Note that the slope of the MR curve is steeper than that of the Demand curve and that the MR curve is inside the Demand curve. D O MR Q

15 EQ: What Does the Market Graph for Monopoly Look Like? For example, let s consider the following demand schedule for a monopoly:

16 EQ: What Does the Market Graph for Monopoly Look Like? If you don t understand how these numbers were calculated, see this figure:

17 $ EQ: What Does the Market Graph for Monopoly Look Like? $9 $7 $7 $5 $4 $3 As you can see, the MR curve diverges from the Demand curve here, as quantities increase and prices decrease. This is because decreased prices times increased quantities (P x Q) result in marginal revenues that are less than price. $1 O -$ Q MR D -$3

18 EQ: What Does the Market Graph for Monopolistic Competition Look Like? $ 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 Perfect 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.

19 $ EQ: What Does the Market Graph for Oligopoly Look Like? 13-3 (21 The market graph for Oligopoly 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 Oligopoly more complicated by introducing three theories of Oligopoly behavior. Each of these three theories has a different graph. For now, let s say it looks like Monopoly.

20 EQ: How do I Identify the Profit Maximizing Quantity of Output? 14-1 (4) The profit-maximizing quantity is the point at which Marginal Revenue = Marginal Cost Remember: Marginal Cost (MC) the change in total cost that results from producing an additional unit Marginal Revenue (MR) the change in total revenue arising from the sale of an additional unit

21 EQ: How do I Identify the Profit Maximizing Quantity of Output? What if MR > MC? If MR is greater than MC, then the added revenue from selling one more unit will be greater than the added cost of producing that unit that is a profit. Producing more will result in greater profit as long as MR > MC, so keep producing! What if MR < MC? If MR is less than MC, then the added cost of producing one more unit will be greater than the added revenue from selling it that is a loss. Producing more will result in greater losses as long as MR < MC, so stop producing!

22 EQ: How do I Identify the Profit Maximizing Quantity of Output? The bottom line is that You should keep producing as long as MR > MC You should stop producing before MR < MC The point between MR > MC and MR < MC is: MR = MC The profit maximizing quantity!

23 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? The rule remains the same no matter the structure of the market. To maximize profit, produce the quantity of output (Q) where MR = MC. Important questions: What Quantity should I produce in order to maximize profit? What Price should I set in order to sell the profitmaximizing Quantity?

24 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? How much should this firm produce in order to maximize profit? What price should be charged?

25 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? How much should this firm produce in order to maximize profit? What price should be charged? Q = 4 & P = $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.

26 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? How much should this firm produce in order to maximize profit? What price should be charged?

27 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? How much should this firm produce in order to maximize profit? What price should be charged? Q = 9 & P = $18

28 EQ: What Quantity Should I Produce & What Price Should I Charge in order to Maximize Profit? 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 MR = MC. This will be the place where the MR curve and the MC curve intersect. On this graph, the MR curve intersects the MC curve where Q = 7. If you follow Q = 7 up to the demand curve, you can see the Price = $50.

29 Lesson 3-3 Profit, Loss, & the Shut Down Decision 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 Questions: (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 Perfect Competition? (f) What is Zero Economic Profit?

30 EQ: How Do I Identify if a Firm is Generating Profit 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 MR, MC, and Demand 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 ATC and AVC curves come in.

31 EQ: How Do I Identify if a Firm is Generating Profit 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 MR = MC 2. Identify the price where Qprofitmax intersects Demand 3. Identify ATC where Qprofitmax intersects the ATC curve 4. Difference between Price and ATC is the profit/loss

32 EQ: How Do I Identify if a Firm is Generating Profit or Loss Given a Market Graph? $ P 4. The difference between Price and ATC is the profit or the loss (in this case, profit). 2. Identify price where profit maximizing quantity intersects with Demand curve. MC ATC ATC Profit 3. Identify ATC (cost per unit) where profit maximizing quantity intersects with ATC curve. AVC D 1. Identify quantity where MR = MC MR O Qprofitmax Q

33 EQ: How Do I Identify if a Firm is Generating Profit or Loss Given a Market Graph? $ 3. Identify ATC (cost per unit) where profit maximizing quantity intersects with ATC curve. 2. Identify price where profit maximizing quantity intersects with Demand curve. ATC MC ATC P Loss AVC 4. The difference between Price and ATC is the profit or the loss (in this case, loss). 1. Identify quantity where MR = MC D MR O Qlossmin Q

34 EQ: What Conditions Show that a Firm is Profitable? AVC is the Variable Cost per unit at any given quantity. ATC is the Total Cost per unit at any given quantity. Price is the Total Revenue per unit. Consider that: Profit = Total Revenue Total Cost ProfitPer Unit = Price ATC So Price must be > ATC in order to profit.

35 EQ: What Conditions Show that a There are three possibilities for a seller in a market (look at the y-axis values): Price > ATC > AVC Price > AVC but Price < ATC Price < AVC < ATC Firm is Profitable?

36 EQ: What Conditions Show that a There are three possibilities for a seller in a market (look at the y-axis values): Price > ATC > AVC (Figure A) This is the only economically profitable situation for a seller in a market. Quantity is determined at the point where MR = MC Where Quantity intersects with the ATC curve is the ATC of production (Total Cost per unit) Profit is the box below Price and above ATC Price > AVC but Price < ATC Price < AVC < ATC Firm is Profitable?

37 EQ: What Conditions Show that a Firm is Profitable? $ MC ATC P Profit AVC ATC D MR O Qprofitmax Q

38 EQ: When Should a Firm Generating a Loss Continue Doing Business? There are three possibilities for a seller in a market (look at the y-axis values): Price > ATC > AVC Price > AVC but Price < ATC (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. Price < AVC < ATC

39 $ EQ: When Should a Firm Generating a Loss Continue Doing Business? ATC MC ATC P AVC Loss Portion of Fixed Costs Recovered AVC D MR O Qlossmin Q

40 EQ: When Should a Firm Shut There are three possibilities for a seller in a market (look at the y-axis values): Price > ATC > AVC Down Operations? Price > AVC but Price < ATC Price < AVC < ATC (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 MR = MC, the losses would be greater than the fixed cost losses from shutting down.

41 $ ATC EQ: When Should a Firm Shut Loss Due to Fixed Costs Down Operations? MC AVC ATC AVC P Additional Loss Due to Variable Costs At the MR = MC Quantity, this is the Variable Cost per unit. As you can see, AVC is greater than price and, subsequently, will make losses greater with each unit produced and sold. It is time to shut down. O Qlossmin MR D Q

42 $ ATC AVC P EQ: When Should a Firm Shut Losses would be limited to this area if the firm SHUTS DOWN Additional losses if the firm DOES NOT SHUT DOWN Down Operations? MC AVC ATC O Qlossmin MR D Q

43 EQ: How Do the Profit, Loss, & Shut Down Situations Look in Perfect Competition? $ Since the demand curve in Perfect Competition is the same as the MR curve and the Price, it looks a little different. However, the dynamics are identical. Here are examples of Profit, Loss, and Shut Down in Perfect Competition. MC ATC AVC P ATC Profit D = P = MR O Qprofitmax Q

44 EQ: How Do the Profit, Loss, & Shut Down Situations Look in Perfect Competition? $ MC ATC AVC ATC P Loss D = P = MR O Qlossmin Q

45 EQ: How Do the Profit, Loss, & Shut Down Situations Look in Perfect Competition? $ MC ATC AVC ATC Loss Due to Fixed Costs AVC P Additional Loss Due to Variable Costs D = P = MR O Qlossmin Q

46 EQ: How Do the Profit, Loss, & Shut Down Situations Look in Perfect Competition? $ MC ATC AVC ATC AVC P Losses would be limited to this area if the firm SHUTS DOWN Additional losses if the firm DOES NOT SHUT DOWN D = P = MR O Qlossmin Q

47 EQ: What is Zero Economic Profit? $ 14-2 (21 MC ATC P = ATC Sometimes, ATC is neither less than nor greater than Price, it is equal to Price. 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. MR AVC D O Qprofitmax Q

48 Lesson 3-4 Market Structures in the Short Run & Long Run 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 Questions: (a) Which dimensions of market structure affect a change in market structure profitability in the long run? (b) How is Perfect 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 Oligopoly?

49 EQ: Which Dimensions of Market Structure Affect a Change in Profitability in the Long Run? 14-3 (4) Structure Dimensions Relevant to Long-Run: Barriers to Entry/Exit Profits & Losses Profits 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.

50 EQ: Which Dimensions of Market Structure Affect a Change in Profitability in the Long Run? Structure Dimensions Relevant to Long-Run: Information Symmetry Perfect 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. Perfect Information Imperfect Information Perfect Competition Monopolistic Competition Oligopoly Monopoly

51 $ EQ: How is Perfect Competition Different in the Long Run? Perfect Competition in the Short Run P ATC This is a perfect competitor earning profit in the short run. Profit MC ATC AVC D = P = MR O Qprofitmax Q

52 $ EQ: How is Perfect Competition Different in the Long Run? Perfect Competition in the Short Run This is a perfect competitor realizing a loss in the short run. MC ATC AVC ATC P Loss D = P = MR O Qlossmin Q

53 EQ: How is Perfect Competition Different 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.

54 EQ: How is Perfect Competition Different in the Long Run? $ Perfect Competition in the Long Run MC ATC MR Profit (P > ATC) MR 0 Profit (P=ATC) MR Loss (P < ATC) O Qprofitmax Q

55 $ EQ: How is Perfect Competition Different in the Long Run? Perfect Competition in the Long Run MC In the long-run, MC = MR = ATC. ATC The result is no economic profit and no economic loss (but there is accounting profit). P = ATC D = P = MR O Qprofitmax Q

56 $ EQ: How is Monopolistic Competition Different in the Long Run? Monopolistic Competition in the Short Run This is a Monopolistic competitor earning profit in the short run. MC ATC P Profit AVC ATC D MR O Qprofitmax Q

57 $ EQ: How is Monopolistic Competition Different in the Long Run? Monopolistic Competition in the Short Run This is a Monopolistic competitor realizing a loss in the short run. MC ATC ATC P Loss AVC D MR O Qlossmin Q

58 EQ: How is Monopolistic Competition Different 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 ATC. 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 ATC.

59 $ EQ: How is Monopolistic Competition Different in the Long Run? Monopolistic Competition in the Long Run MC ATC P>ATC P = ATC P<ATC AVC D MR O Qprofitmax Q

60 $ EQ: How is Monopolistic Competition Different in the Long Run? Monopolistic Competition in the Long Run In the long-run, Price = ATC. The result is no economic profit and no economic loss (but there is accounting profit). MC ATC P = ATC AVC D MR O Qprofitmax Q

61 EQ: Why is There No Change in the Long Run for Monopoly & Oligopoly? 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.

62 EQ: Why is There No Change in the Long Run for Monopoly & Oligopoly? 14-3 (17 In the long run, Oligopoly looks very similar to what it looks like in the short run. Why? Like Monopolies, Oligopolies have high barriers to entry/exit: New competitors have difficulty entering the market and eroding profits. Oligopolies can, however, exit the market when experiencing losses, though they will probably merge with a competitor. Like Monopolies, Oligopolies 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.

63 Lesson 3-5 Theories of Oligopoly Behavior Standard 3f: Students will distinguish among three theories of oligopoly behavior and their characteristics. Essential Questions: (a) What is the Mindset of oligopoly firms? (b) What are the three theories of oligopoly behavior? (c) What is Kinked Demand Curve Theory? (d) Why is there a gap in the MR curve in Kinked DC Theory? (e) What is Unkinked Demand Curve Theory? (f) What is Cartel Theory?

64 Oligopoly 15-1 (4) Oligopoly 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 Product can be either homogeneous or heterogeneous Imperfect Information

65 EQ: What is the Mindset of Oligopoly 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.

66 EQ: What are the 3 Theories of Oligopoly Behavior? Economists have identified 3 theories that explain how oligopoly firms make decisions: Kinked Demand Curve Theory Unkinked Demand Curve Theory Cartel Theory

67 EQ: What is Kinked Demand Curve Theory? Kinked Demand 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 NOT 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.

68 EQ: What is Kinked Demand Curve Theory? Kinked Demand 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. P

69 EQ: What is Kinked Demand Curve Theory? Kinked Demand Curve Theory The kink in the demand curve also affects the marginal revenue curve: Below the kink, the MR curve is steeper. Above the kink, the MR curve is more horizontal. The kink in the demand curve also creates a vertical gap in the MR curve at the quantity demanded at the point of the kink in the demand curve P Vertical gap in MR at QD

70 EQ: Why is There a Gap in the MR Curve in Kinked Demand Curve Theory? Demand curve & MR curve for lower portion of kinked demand curve. P Demand curve & MR curve for upper portion of kinked demand curve. MR D P D MR Overlap both demand curves and you can see that the kink in the demand curve takes place at the price. Additionally, you can also see that instead of the MR curve kinking at the level of output, there is actually a huge vertical gap in the MR curve. P D MR MR

71 EQ: Why is There a Gap in the MR Curve in Kinked Demand Curve Theory? MC P D MR MR Usually, the MC curve will past through the gap in the MR curve, indicating the proper level of production and the price.

72 EQ: What is Kinked Demand Curve Theory? Kinked Demand 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.

73 EQ: What is Unkinked Demand Curve Theory? Un-Kinked Demand 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.

74 EQ: What is Unkinked Demand Curve Theory? Un-Kinked Demand Curve Theory Like Monopolistic Competition, the demand curve in Unkinked Demand Curve Theory is very elastic. It has a downward slope, but it is not very steep. D

75 EQ: 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.

76 EQ: What is Cartel Theory? Cartel Theory Problems 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.

77 EQ: What is Cartel Theory? 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.

78 Lesson 3-6 Economic Efficiency & Government Price 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 Questions: (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 Does Government Intervention in Markets Affect Economic Efficiency?

79 EQ: What is Economic Efficiency? 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 (4)

80 EQ: What are Consumer s Surplus & Producer 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. Producer 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. $ Pe 0 Consumer s Surplus Producer s Surplus Price the buyer is willing to pay. Price actually received. Price the seller is willing to accept. Price actually paid. Qe S Consumer s Surplus + Producer s Surplus = Total Benefit to Society Maximizing the Total Benefit to Society = Economic Efficiency D Q

81 EQ: What are Consumer s Surplus & Producer s Surplus? 1. The first person willing and able to buy is willing and able to pay a very high price; but since one price is set for all buyers, the first buyer is getting a lot of additional benefit. 2. One of the last buyers to come into the market is willing and able to pay a lower price that is much closer to the actual price; so this buyer is not getting as much additional benefit as the first person willing and able to buy. $ Pe Willing & Able to pay a Higher Price Consumer s Surplus Willing & Able to pay a Lower Price The actual price that everyone pays. 3. Consumer s Surplus is equal to the sum of all of the additional benefit that every buyer gets from paying less than they are willing and able to pay. S 4. In an efficient market, it is equal to the area of the triangle created by the Y-axis, the equilibrium price line, and the demand curve. D 0 Qe Q

82 EQ: What are Consumer s Surplus & Producer s Surplus? 1. The first unit the seller sells, he is willing to sell for a lower price; but since one price is set for all units sold, the seller is getting a lot of additional benefit for the first unit sold. 2. The seller is willing to sell one of the last units sold for a price that is much closer to the actual price; so the seller is not getting as much additional benefit for later units sold compared to earlier units sold. $ Pe 3. Producer s Surplus is equal to the sum of all of the additional benefit that the seller receives for every unit sold from receiving more than he is willing to receive. 4. In an efficient market, it is equal to the area of the triangle created by the Y-axis, the equilibrium price line, and the supply curve. Producer s Surplus Willing to accept a Price that is higher than prior units sold. The actual price that the seller receives. S 0 Willing to accept a Lower Price Qe D Q

83 EQ: What is a Deadweight Loss? $ (Economic Efficiency) S Monopoly Price Consumer s Surplus Pe Producer s Surplus Deadweight Loss D 0 Q ProfitMax Qe Q

84 EQ: What is a Deadweight Loss? $ (Economic Efficiency) S Pe Consumer s Surplus Deadweight Loss Price Limit Producer s Surplus D 0 Q LossMin Qe Q

85 EQ: What is a Deadweight 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).

86 EQ: How Economically Efficient are each of the 4 Basic Market Structures? Perfect Competition Perfect competition is the only economically efficient market structure, because it is the only market where Price is equal to Marginal Cost. Monopoly Monopolistic Competition Oligopoly

87 EQ: How Economically Efficient are each of the 4 Basic Market Structures? Perfect Competition Monopoly Monopoly is an economically inefficient market structure because it produces a quantity and sets a price where Price > 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 Oligopoly Deadweight Loss

88 EQ: How Economically Efficient are each of the 4 Basic Market Structures? Perfect Competition Monopoly Monopolistic Competition Monopolistic competition also introduces a deadweight loss by setting Price > MC. The inefficiency is not as severe as that introduced by monopoly, but it is economically inefficient nonetheless. Oligopoly Deadweight Loss

89 EQ: How Economically Efficient are each of the 4 Basic Market Structures? Perfect Competition Monopoly Monopolistic Competition Oligopoly Oligopoly also introduces a deadweight loss by setting Price > MC. The inefficiency is not as severe as that introduced by monopoly, but it is economically inefficient nonetheless. Deadweight Loss

90 EQ: How Does Government Intervention in Markets Affect Economic Efficiency? 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, Oligopolies, 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) (15)

91 EQ: How Does 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: Price 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.)

92 EQ: How Does Government Intervention in Markets Affect Economic Efficiency? Sometimes, the government imposes price controls: Price 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 Price controls shave down the consumer and producer surplus triangles the result is economic inefficiency.

93 EQ: How Does Government Intervention in Markets Affect Economic Efficiency? $ S Price Floor Pe Price Ceiling Consumer s Surplus Consumer s Surplus with Price Ceiling Producer s Surplus with Price Floor Producer s Surplus Loss in efficiency due to price controls Surplus Shortage 0 Qe D Q

94 EQ: How Does Government Intervention in Markets Affect Economic Efficiency? Though a price ceiling can introduce an economic inefficiency and a shortage in a market, it can also increase economic efficiency if used appropriately. Price Deadweight Loss The Deadweight Loss has been reduced significantly. MC Price Ceiling MC

95 EQ: How Does Government Intervention in Markets Affect Economic Efficiency? Price floors, unfortunately, cannot increase economic efficiency because sellers tend to want higher prices anyway. Price floors mainly just benefit inefficient suppliers and help keep them in business. Price floors can actually make efficient markets less efficient by robbing buyers of consumer s surplus.

96 EQ: How Does 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.

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

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