ECON Ch 12,15,5 Flashcards
Price takers
Since there are many buyers and sellers and all firms sell identical products, firms in a perfectly competitive market are price takers– they are unable to affect the market price because they are tiny relative to the market and sell exactly the same product as everyone else.
Perfectly competitive markets
Many buyers and sellers
All firms sell identical products
There are no barriers to firms entering the market
Homogenous product
Firms are small – can’t influence the price!!!
Demand curve for perfectly competitive firm
Horizontal!
Whether you sell 6000 or 15000 wheat bushels, still the same price per bushel
Too small to affect the market price!
This price is determined by the overall intersection of market supply and market demand.
Marginal revenue
The change in total revenue from selling one more unit of a product
In competitive markets, how are price and marginal revenue related?
P = MR in a perfectly competitive market because the price of the next good sold will be equal to the price of the last good sold.
Profit
Total revenue - total cost
= P*Q - ATC * Q
= Q (P-ATC)
Profit maximizing point of a competitive firm
Table of marginal cost and marginal revenue
Produce up until MC = MR
or the last point where MC is still < MR
Profit maximizing decision is when MR = MC
But, in competitive markets, P = MR
so it is when Price = MC
- The profit maximizing level of output is where the difference between total revenue and total cost is greatest, and
- The profit maximizing level of output is also where MR = MC
These are true for every firm!
For perfectly competitive firms, since P = MR, - The profit maximizing level of output is also where P = MC
Illustrating profit on the graph
Since we get profit = (P-ATC) * Q, this is a rectangle with height (P-ATC) and length Q
Perfectly competitive firm maximizes profit when P= MR=MC, so when the MC curve intersects the demand curve. Get this quantity. Then look at where this quantity intersects the ATC curve. Subtract the MC and ATC values and multiply by the quantity to get the profit.
How to show/calculate loss or break even on a graph for perfectly competitive firm
Loss is negative profit.
Profit = Q* (P-ATC). Quantity can’t be negative, so it’s only at a loss when (P-ATC) < 0
P<ATC
If the price curve is never above the ATC curve, can’t make a profit. So the optimal point is still when MC=MR=P though.
Takes the smallest loss–> when the demand=MR=P curve intersects the MC curve. That’s the quantity. Multiple the quantity by the vertical distance at that quantity from the MR curve to the ATC curve.
Price and ATC relationship to tell if a firm makes profit or loss
If P> ATC, profit
P=ATC, break even
P<ATC, loss
Deciding whether to produce or shut down in the short run
In the short run, firms in perfectly competitive markets at a loss cannot raise price because price taker.
2 options:
1. Continue to produce
2. Stop production by shutting down temporarily
But, if a firm shuts down, still needs to pay fixed costs, but this is a sunk cost, so shouldn’t be taken into consideration.
Decide whether to just take the L with the fixed costs or produce and incur some variable costs, but obtain some revenue too.
Should only stop producing if:
Total revenue < variable cost
P* Q < VC (divide each side by Q)
P < AVC
So, if AVC > Price, shut down
If price >= AVC, then produce until MC=MR = price for perfectly competitive firms.
This means the marginal cost curve gives us they relationship between P and Q–> firms supply curve.
Competitive firm short run supply curve
Produces output at MR=MC
Since price = MR, firm produces where P=MC
So, supplies output according to its MC curve–> MC curve is the supply curve for the individual firm.
But, if the price is too low, below the minimum point of the AVC, shuts down.
Long run entry for perfectly competitive markets
Zero economic profit in the long run because:
If you are making profit, with free entry, new firms will be attracted. This increases supply (supply curve shifts right, causing lower price and greater quantity) This causes market EQ price to fall. Eq price falls until individuals make no economic profit. So, Price = ATC = MC at this point.
Long run exit for perfectly competitive firms
If the profit is negative, in the long run, firms exit. Supply curve shifts left, causes less supply and increased prices. Firms continue to leave until the price returns to the break even price of D=MR=P=MC=ATC
Long run competitive equilibrium
The situation in which the entry and exit of firms has resulted in the typical firm breaking even.
If firms are making an economic profit, additional firms enter the market, driving price down to break even level
If firms are making an economic loss, existing firms exit the market, driving the price up to the break even level
Expect the price to be driven down to the minimum point on the ATC curve.
Long run supply curve for perfectly competitive market
A curve that shows the relationship in the long run between market price and the quantity supplied
In the long run, the market supply and demand is equal at the price of the minimum of the ATC
So, long run supply curve is horizontal. Long run price is compeltelt determined by forces of supply. Number of suppliers adjusts to meet demand, at the lowest possible price.
Situation 1:
Increase in demand temporarily increases price and allows for profit, but this attracts new firms, increases supply, drives down price and eliminates profit. This supply is horizontal line with the original
Situation 2:
Decrease in demand temporarily decrease the price and causes firms to suffer losses which leads to some firms exiting, decreasing supply, driving up the price, eliminating economic losses, and having parallel supply to original. Horiztonal supplt curve!
Productive efficiency
Situation in which a good or service is produced at the lowest possible cost
Allocative efficiency
A state of the economy in which production represents consumer pref.
Produced until last unit provides MB=MC
Are perfectly competitive markets productively or allocatively efficient?
BOTH!
Productively because lowest cost to produce
Allocative because
1. Price represents MB
2. Perf comp firms produce until price = MC
3. Firms produce until last unit provides a MB = MC
Monopoly
A market structure consisting of a firm that is the only seller of a good or service that doesn’t have a close substitute.
1 seller.
Marginal revenue and price relationship for monopolies
Price isn’t equal to MR like it is for perf comp firms
As you produce form, the price per unit will decrease
This causes MR to decrease more than the price.
Draw the MR curve intersecting price (demand) curve at quantity of 1 and then going under the curve the rest of the way.
Monopolist maximizing profit decision
Also when MR=MC. this is the quantity.
The price is when you draw the vertical line from this quantity to intersect the demand curve.
Profit is difference between our price and the ATC curve at this quantity times the quantity.
Differences between perfectly competitive and monopolist
Many vs 1 firm
Free vs barriers to entry
For both, MR=MC for profit maximization
MR= price for competitive (no power). Power for monopolists–> MR<price
For comp, MC=P. for monopolist, MC<price
0 profit in long run vs profit because of the barriers for entry
For both, profit = (P-ATC)*Q
Inefficiency of a monopoly
Since MR is below demand, monopolies sell fewer at a higher price.
Consumer surplus is reduced to the area under the demand curve to the new price.
Producer surplus is increased to the trapezoid from the marginal cost to the new price.
Deadweight loss results. The middle triangle from the old quantity to the new quantity since the price is greater than the marginal cost, rather than equal.
Market power
The ability of a firm to charge a price greater than the marginal cost.
Perfectly competitive firms don’t have this power. Monopolists do.
Government regulation with monopolies
Anti trust laws to try to eliminate collusion (agreement among firms to charge same price or otherwise not compete) and promote competition.
Herfinadahl Index (HHI)
Created by squaring the percentage market shares of each firm and adding results.
For example, if there is one firm and has 100%, then (100)^2=10,000
If 4 firms with 30,30,20,20%, then 30^2+…=2600
If the index is greater than 2500, the market is concentrated, investigation.
Encourage mergers to lower costs not increase prices.
Externality
A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service
Like a side effect
External consequences for your private actions.
Private vs social marginal cost
Private cost is how these affect the firms
Social cost is the total cost to society of producing a good or service, including private and external. Includes something like pollution. Will be higher than private cost.
PMC, SMC are supply
Negative externality in production
Example: pollution
The SMC is higher than the PMC because of the costs to those affected by pollution.
The new efficient point is when SMC intersects the unchanged demand curve
Deadweight loss results because firms want to produce where their PMC = demand
Deadweight loss is the triangle to the right of the efficient equilibrium (where SMC and demand intersect) to the right at the quantity of the market eq
When there is a negative externality, too much of the good or service will be produced at the market equilibrium.
Difference between SMC and PMC can be solved by taxation, to remove the DWL, and restore efficiency.
Private vs social marginal benefit
Private MB is the additional benefit received by consumer, less than the SMB, the total additional benefit from consuming a good or service, both the private and any external benefit.
Example: college education
Positive externality
Positive externality with example of education
SMB demand curve above the PMB because there is an added social benefit of education.
The market eq gives too few quantity and also too low price.
Deadweight loss results in the area from the market quantity to the right until the SMB intersects the MC
economically efficient to subsidize education, reduce this DWL
When there is a positive externality, too little of the good or service produced at market EQ.
Rival and non-rival goods
Rival: my consumption decreases your consumption. One person consuming one unit of a good means no one else can consume it
Non-rival is where we can both consume it.
Excludable and non excludable goods
Excludable is if I can be excluded from consumption if I don’t pay
Non excludable is if I can get it even if I don’t pay
Rival and excludable goods
Private goods
Like an Apple or a pair of shoes.
My consumption decreases your consumption and I need to pay for it
Non-rival and excludable goods
Quasi public goods
Need to pay but we can both access
Netflix, roll road without congestion, cable tv
Nonexcluable and rival goods
Common resources
My consumption decreases your consumption but don’t have to pay.
Fish in a pond
Public pasture land
Non excludable and non rival goods
Don't need to pay and my consumption doesn't decrease your consumption Public goods National defense Court system "Free-riding"
Tragedy of the commons
Rival and non excludable goods
Ideally, we want to make people pay for their consumption, but when not possible we face this. Common resource tends to be overused.
Example is the wood from a forest. When it is overused, the SMC rises above the PMC, causing too much wood being used and a deadweight loss.
Triangle to the right of the efficient eq to the quantity of the actual eq (where SMC intersects demand)
Need to cut consumption at a level or have taxation to rise PMC to SMC to restore economic efficiency.
Public good problem
Non rival and non excludable.
Free riders–> enjoy the benefits without needing to pay.
Example is if teacher gives 2 cards to every student. If they keep a card, they get $30 to you. If you give away a card, give $1 to everyone.
Socially efficient for everyone to give the card. But, markets make people keep card.
Free ride. Think they are the only free rider, but everyone is.
Leads to inefficiency.
