P1 Sep Oct 2012 Timothy Van Zandt Prices & Markets Session R1 Midterm Review. 3. An exercise on (a) medium run and (b) long run

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1 Page 1 1 Midterm review 1. Some sample quiz questions 2. Some ideas on elasticity of demand 3. An exercise on (a) medium run and (b) long run 2 Sample quiz question Which of the following hold (in equilibrium) for an individual firm in the model of perfect competition? a. Its marginal revenue is less than the market price. b. It never earns an economic profit. c. Its marginal cost equals its marginal revenue.

2 Page 2 3 Sample quiz question Which statements about the inefficiency of the decisions of a firm with market power are true, in the models we have studied? a. The firm has no incentive to reduce its cost of production. b. The firm will produce too much in order to take over market share. c. The firm may forgo projects that have positive net social value. 4 Midterm review Some sample quiz questions Some ideas on elasticity of demand 3. An exercise on (a) medium run and (b) long run

3 Page 3 5 Scenario From Exercise on Demand and Elasticity Product category: Passenger jets. Dominated by two firms: Airbus (A) and Boeing (B). (For simplicity, imagine that each firm produces one kind of jet, and these two jets make up the entire product category.) Hypothetical demand functions: A = 60 3P A + 2P B B = 60 3P B + 2P A 6 Find Airbus elasticity at P A = 24 when Boeing s price is P B = 30 : And when P B = 24?

4 Page 4 7 Illustrate graphically Graph Airbus demand curve when P B = 24 and when P B = 30 : P i i 8 Market demand Market demand: How does aggregate demand for the entire product category respond when the prices of all products in the category go up? Aggregation problem: Need to define aggregate output A = 60 3P A + 2P B B = 60 3P B + 2P A a price index Our numerical example is easy. We can just add the two quantities: = A + B For a price index, we use the average price: P = P A + P B 2

5 Page 5 9 Aggregation: Calculation Aggregate demand as a function of the average price P? A = 60 3P A + 2P B B = 60 3P B + 2P A A + B = (60 3P A + 2P B ) + (60 3P B + 2P A ) }{{} = 1 P A P B ( ) PA + P B = }{{} P = 1 2P 10 Summary: Market demand versus Airbus demand MARKET DEMAND = 1 2P AIRBUS DEMAND (If P B = 24 ) A = 108 3P A P 60 P i i (From slide 18) (From slides 15 & 16)

6 Page 6 11 Comparing the elasticities Calculate the elasticity of the market demand curve at P = 24 : From = 1 2P,chokepriceis P = 60 : = E = = = 0.67 It is much lower than the elasticity of Airbus demand curve at P A = 24,given P B = 24.Intuition? 12 Broader idea This illustrates a broader idea brought up in Session 3: The more we aggregate across products, the less elastic is demand. For example: demand for computer monitors less elastic than demand for LCD monitors less elastic than demand for Acer LCD monitors less elastic than demand for the Acer AL widescreen monitor

7 Page 7 13 Midterm review Some sample quiz questions Some ideas on elasticity of demand An exercise on (a) medium run and (b) long run 14 Falafel vendors on the beach of Lebanon E C Beach D F J I A G H K B

8 Page 8 15 An illustration of these ideas for perfect competition 1. For individual firm: Supply decision, when in market, depends only on marginal cost. Fixed cost drives exit/entry decision. 2. But at level of the market (equilibrium) Fixed costs exit/entry decisions market prices 16 How we do this For case of identical firms (free entry) Study adjustments following a shift in demand: 1 Long run given initial demand curve. 2 Medium run after shift in demand. 3 Long run after shift in demand. (We did this in Session 6 for an increase in fixed cost.)

9 Page 9 17 A falafel vendor on the beach of Lebanon Typical cost structure: Lira (100s) MC 12 8 AC Assume free entry Draw approx. aggregate supply curve and show equilibrium. Lira (100s) 28 Demand: = P

10 Page So find equilibrium (a) i (b) P (c) (d) N How we do this For case of identical firms (free entry) Study adjustments following a shift in demand: 1 Long run given initial demand curve. 2 Medium run after shift in demand. 3 Long run after shift in demand.

11 Page But then demand fluctuates How does long-run equilibrium change? Lira (100s) So find (long-run) equilibria (a) i (b) P (c) (d) N

12 Page How we do this For case of identical firms (free entry) Study adjustments following a shift in demand: 1 Long run given initial demand curve. 2 Medium run after shift in demand. 3 Long run after shift in demand. 24 But suppose entry and exit take time Think of long run as after exit/entry; medium run is before exit/entry. What are medium-run supply decisions and equilibrium??

13 Page Of an individual vendor? What is medium-run supply? Lira (100s) MC 12 8 AC Of the entire market? What is medium-run supply? Lira (100s)