Notes 12 05 2010 13 19 00 Chapter 12 Perfect competition arises When firm s minimum efficient scale is small relative to market demand so there is room for many firms in the industry When each firm is perceived to produce a good or service that has no unique characteristics so consumers don t care which firm they buy from In order to maximize economic profit the perfectly competitive firm must decide How to produce at minimum cost What quantity to produce Whether to enter or exit a market At shutdown point AVC is at its minimum MC curve crosses AVC curve Firm is indifferent between producing and shutting down Incurs a loss equal to TFC from either action Firms enter market Market supply increases Market price falls Firms make zero economic profit in long run Firms exit market Market supply decreases Market price rises until firms make zero economic profit Permanent increase in demand Economic profit induces entry o Increases short run supply o Shifts short run market supply curve rightward As market supply increases price falls and market quantity continues to With falling price each firm decreases its output as it moves along its marginal cost curve supply curve New long run equilibrium occurs when price has fallen to equal minimum increase average total cost market Firms make zero economic profit and firms have no incentive to enter the The main difference between the initial and new long run equilibrium is the number of firms In the new equilibrium a larger number of firms produce the equilibrium quantity New Technologies Are constantly discovered that lower price Enables firms to produce at lower average cost and lower marginal cost Firm s cost curves shift downward Firms that adopt new technology make economic profit New technology firms enter old technology firms exit or adopt new technology Industry supply increases industry supply curve shifts rightward Price falls and quantity increases Eventually new long run equilibrium emerges in which all firms use the new technology price equals minimum average total cost each firm makes zero economic profit Choices Consumer s demand curve shows how best budget allocation changes as Consumers get the most value out of their resources at all points along With no external benefits market demand curve is the marginal social price of a good changes demand curves benefit curve Competitive firm s supply curve shows how the profit maximizing quantity changes as the price of a good changes Firms get the most value out of their resources at all points along supply With no external cost market supply curve is marginal social cost curve curve In competitive equilibrium Resources are used efficiently quantity demanded equals quantity supplied so marginal social benefit marginal social cost Gains from trade for consumers is measured by consumer surplus Gains from trade for producers is measured by producer surplus Total gains from trade total surplus In long run equilibrium total surplus is maximized Chapter 13 Three types of barriers to entry Natural creates Natural Monopoly Ownership Legal creates Legal Monopoly Two types of monopoly price setting strategies Single price monopoly Price discrimination If demand is elastic a fall in price brings an increase in total revenue Increase in revenue from increase in quantity sold outweighs the decrease in revenue from the lower price per unit Marginal revenue is positive As the price falls total revenue increases If demand is inelastic A fall in price brings a decrease in total revenue Rise in revenue from increase in quantity sold is outweighed by the fall in revenue from lower price per unit MR is negative As price falls total revenue decreases If demand is unit elastic Fall in price does not change total revenue Rise in revenue from increase in quantity sold equals fall in revenue from lower price per unit MR 0 which means total revenue is maximized Rent seekers pursue their goals in two main ways Buy a monopoly transfers rent to creator of monopoly Create a monopoly uses resources in political activity To be able to price discriminate a monopoly must Identify and separate different buyer types Sell a product that cannot be resold A monopoly can discriminate Among units of a good ex Quantity discounts Among groups of buyers ex Advance purchase on airline tickets The more perfectly a monopoly can price discriminate the closer its output is to the competitive output P MC and the more efficient is the outcome This outcome differs from outcome of perfect competitions The monopoly captures the entire consumer surplus that leads to inefficiency The increase in economic profit attracts even more rent seeking activity Two theories about how regulation works are Social interest theory Capture theory How can the firm cover its costs and at the same time obey the marginal cost pricing rule Where possible a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing Natural monopoly might charge a one time fee to cover its fixed costs and then charge a price equal to marginal cost Average cost pricing rule Government might pay a subsidy equal to the monopoly s loss Regulators use one of two practical rules Rate of return regulation Price cap regulation Chapter 14 The presence of a large number of firms in the market implies Each firm has only a small market share and therefore has limited market power to influence the price of its product Each firm is sensitive to the average market price but no firm pays attention to the actions of others So no one firm s actions directly affect the actions of others Collusion or conspiring to fix prices is impossible Product differentiation enables firms to compete in three areas Quality design reliability and service Price Marketing Excess capacity Markup Two key differences between monopolistic competition and perfect competition Downward sloping demand curve in monopolistic competition because Firms produce less than the efficient scale Firms operate with positive markup Perfectly elastic demand curve for firms in perfect competition because No excess capacity No markup Is Monopolistic Competition efficient Price marginal social benefit Marginal cost marginal social cost Price exceeds marginal cost so marginal social benefit exceeds marginal social cost In long run produces less than efficient quantity Advertising expenditures affect the firm s profit in two ways Increase costs Change demand Chapter 15 Definitions
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