Midterm 2 Flashcards
law of supply
firms are willing to produce and sell a greater quantity of a good when the price of the good is HIGHER
Industrial organization
the study of how firms decisions about prices and quantities depend on the market conditions they face
-a firms COSTS are a key determinant of its production and pricing decisions
total revenue, cost and profit
Total revenue - the amt. the firm receives for the sale of its output (Q*P)
Total cost - the amt. the firm pays to buy inputs
profit - firm’s total revenue minus its total cost
Explicit costs
input costs that require an outlay of money by the firm (ingredients, materials, workers wages)
—accountants measure explicit - money that flows into and out of firms…but ignore implicit costs
Implicit costs
Input costs that do not require an outlay of money by the firm
—cookie store owner is also comp. programmer and could earn $100 per hour…for every hour she works in cookie factory she gives up $100 in income (opp. cost)
—economists study how firms make production and pricing decisions (study both explicit and implicit - even though can’t see implicit costs…it affects the decisions they make
Implicit costs pt. 2
Total cost = sum of explicit and implicit costs
imp. implicit cost is opportunity cost of financial capital that has been invested in the business
- –used $300,000 of savings to buy factory…if had left in the bank would have made 5% interest a year in interest income = IMPLICIT COST (accountants would ignore, but economists count the 15,000 as an implicit cost she gives up0
if instead had used $100,000 savings and borrowed $200,000 from bank at interest rate of 5%…accountants will measure the $10,000 of interest paid on bank loan each year as a cost bc money flows out of the firm
—but economists look at opp. cost of owning business as the 15,000 = (interest on bank loan - explicit cost of 10,000 plus the forgone interest on savings (implicit of $5000)
Economic profit vs. accounting profit
economic profit - total revenue minus total cost (including both explicit and implicit costs)
accounting revenue - total revenue minus EXPLICIT costs (usually larger than economic profit)
- –from economic standpoint - in order to be profitable total revenue must EXCEED all opp.costs, both explicit and implicit
- -when firms economic losses (negative economic profit) - business owners are failing to earn enough revenue to cover all costs of production
production function
the relationship btw quantity of inputs (workers) used to make a good and quantity of output (cookies) of that good - input on horizontal and output on vertical (look at costs in the short run - assume factory size fixed)
- -production function is positive slope that gets flatter as hire more workers (bc diminishing marginal product)
- -first picture
total cost curve
shows relationship btwn quantity of output produced (horizontal) and total cost of production) - gets steeper as quantity of output increases bc of diminishing marginal product)
–2nd picture
marginal product
the increase in output that arises from an additional unit of input (when # of workers foes from 1 to 2, cookie production increases from 50 to 90 - marginal product of 2nd worker is 40 cookies)
diminishing marginal product
property whereby the marginal product of an input declines as the quantity of the input increases (marginal product from 1-2 workers (40 cookies) is less than that from 2-3 workers (30 cookies))
—kitchen gets more crowded and have to share the equipment and materials (as hire more, each contributes fewer cookies)
SLOPE OF PRODUCTION FUNCTION
MEASURES MARGINAL PRODUCT
—most important relationship is btw quantity produced and total cost
OPPOSITE: Total cost curve gets steeper as amt. produced rises, where production function gets flatter as production rises
- –many workers = crowded - each additional worker adds less to production - reflects diminishing marginal product (so production function is flat)
- -when kitchen is crowded, producing an additional cookie requires a lot of additional labor and costly - the quantity produced is large, total-cost curve is steep
fixed and variable costs
fixed - do not vary with quantity of output produced
variable - change as firm alters quantity of output produced (ingredients, workers’ salaries)
–total cost is sum of fixed and variable costs
average total cost
total cost divided by quantity of output (cost of typical unit produced)
—tells as cost of typical unit, but not how much total cost will change as alters production levels
ATC = TC/Q
average fixed and variable cost
AFC - fixed cost divided by quantity of output
AVC - variable cost divided by quantity of output
Marginal cost
marginal cost - the increase in total cost that arises from an extra unit of production
—MC = CHANGE TC/ CHANGE Q
–IMP!!! ATC tells us cost of a typical unit of output if total cost is divided evenly over all units. Marginal cost tells us the increase in total cost that arises from producing an additional unit (use both when making decisions of how much to supply)
Average total cost and marginal cost curves
quantity on x and costs on y (costs MC, ATC, AVC, AFC
- MARGINAL COST RISES AS QUANTITY OF OUTPUT INCREASES
- —bc of diminishing marginal product (with small quantity = marginal product of extra worker is large and marginal cost of extra cup of coffee is small - but with large Q = many workers and marginal product is low but marginal cost of extra cup is large) - ATC CURVE IS U SHAPED
- –ATC = AVC + AFC
- –AFC always DECLINES as output RISES bc FC is spread over large number of units
- –VC usually RISES as output INCREASES bc diminishing marginal product
- -ATC reflects changed in AFC and AVC
- –efficient scale - Q of output that minimizes ATC - if produce less than amt. ATC is higher and bc FC is spread over so few units - if produce more, ATC is higher bc marginal product of inputs has diminished - MARGINAL-COST CURVE CROSSES ATC CURVE AT THE MINIMUM OF ATC
- –whenever marginal cost is less than ATC, ATC is falling (and when MC is > ATC, ATC is rising)
- –ex. like grades - ATC = grade point average, MC = grade in next course - if grade in next course is lower than grade pt. ave., ave. will fall
- -MC crosses ATC at minimum ATC - bc low levels of output, MC is below ATC, so ATC is falling - but after curves cross, MC rises above ATC
ATC MC AVF AFC curves
4th picture!!
–at low levels of output, firm experiences increasing MC and MC curve falls - eventually exp. diminishing marginal product and MC curve starts to rise
–doesn’t always simply fall with first new worker - usually see increasing marginal product for a while before diminishing marginal product
short run and long run ATC
Many decisions (factory size) are fixed in short run but variable in long run
–picture 5
long run have much flatter U shape (firms are more flexible in the long run)
-shape of long run ATC shows info. about production processes that a firm has available for manufacturing a good (by size of firm)
Economies of scale, diseconomies and constant returns to scale
economist of scale - property whereby long-run ATC falls as Q of output increases - usually bc high production levels allow specialization among workers (assembly line)
diseconomies of scale - property whereby long-run average total cost rises as Q of output increases
–arise bc coordination problems (less effective)
constant returns to scale - long run ATC does not vary with levels of output
Competitive market basic info.
how do you maximize profit in perfectly comp. society? - by producing Q where marginal revenue = marginal cost
- –benefit of shutting down is saving VC - will not save FC (bc still pay rent)
- -if P > AVC, then firm produces Q where P = MC
- -As long as you can cover VC want to keep producing - anything over VC is helping overcome the loss coming from FC
Competitive market
each buyer and seller is small compared to the size of the market, therefore has little ability to influence market prices (Each buyer and seller is a price taker - meaning they must accept the price the market determines)
Perfectly competitive if
- Many buyers and sellers in the market
- Goods offered by various sellers are largely the same
- Firms can freely enter or exit the market (not a necessary condition but usually happens)
- –But when there is free entry and exit in a comp. market, it is a powerful force shaping the long-run equilibrium
Market power - if a firm can influence the market price of the good it sells (water company)
revenue of a competitive firm
Tries to maximize revenue (total revenue minus total cost) - (TR = P x Q)
—Price does not depend on the quantity produced - Total revenue is proportional to the amount of output
Total Revenue = P x Q
average and marginal revenue in comp. market
Average Revenue = TR / Q sold (total revenue divided by total output)
—Tells us how much revenue firm receives for typical unit sold - (IMP!!) for all types of firms (not only competitive) average revenue equals the price of the good
Marginal revenue = (Change in TR) / (Change in Q)
- –The change in total revenue from the sale of each additional unit of output
- –Total revenue is P x Q and P is FIXED for competitive firms - when Q rises by 1 unit, total revenue rises by P dollars
IMP!! for competitive firms marginal revenue equals the price of the good
Example of profit maximization for comp. market (picture 6 - gallons of milk)
Can look and see it is maximized when produces either 4 or 5 gallons (profit)
- –Can find profit-maximizing quantity by comparing marginal revenue and marginal cost from each unit produces
- –(IMP!!) As long as marginal revenue exceeds marginal cost, increasing the quantity produced raises profits
Marginal cost = (Change in Total Cost / (change in quantity)
Change in profit = (marginal revenue) - (marginal cost)
Revenue and Marginal revenue are CONSTANT in COMPETITIVE firms - bc price is same
One of ten principles of economics - “rational people think at the margin
MC curve in comp. market (picture 7)
firm MAXIMIZES profit by producing Q where MC = MR (or PRICE bc P = MR in comp. market)
- —Marginal cost curve is upward sloping (bc variable costs same per unit)
- —Average-total-cost curve is U shaped
- —Marginal cost curve crosses average-total-cost curve at the MINIMUM of average total cost
- —MARKET PRICE IS HORIZONTAL LINE IN COMPETITIVE MARKET BC CONSTANT PRICE
Already know the price - trying to find the profit-maximizing quantity
—For a competitive firm, price equals both the firm’s average revenue and its marginal revenue
Learn 3 things from this analysis (key to rational decision making by profit-maximizing firm)
1. If marginal revenue is greater than marginal cost, the firm should increase its output 2. If marginal cost is greater than marginal revenue, the firm should decrease its output 3. At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal
IMP!!! In competitive markets, the marginal revenue is equal to price - so to find the profit-maximizing quantity - look at intersection of price and Marginal cost curve
IMP!!! Because the firm’s marginal cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve
Temporary shut down in comp. market
Shutdown - short-run decision not to produce during a specific period of time bc of current market conditions (Still will pay fixed costs)
—If shuts down, loses all revenue from sales, but also saves the variable costs - still will lose money but loses more staying open
Firm shuts down if REVENUE THAT IT WOULD EARN FROM PRODUCING is less than its variable cost of production
Shut down if TR < VC or (TR/Q < VC/Q)
Left side can just be P bc TR=Q x P - and right side is AVC (Average variable cost)
Shut down if P < AVC
Exit (long run decision in comp. market)
Exit - long-run decision to leave the market (can’t avoid fixed costs in short run but can in long run)
—For comp. markets - produce the Q where MC = P, but if P is < AVC, firm is better off shutting down temporarily
◦ A comp. firm’s short-run supply curve is the portion of its marginal-cost curve that lies above the AVC
(graph = picture 8)
sunk cost
cost that has already been committed and cannot be recovered - ignore them when making decisions bc nothing can be done
—Fixed costs are SUNK in the short run, firm should ignore them when deciding how much to produce
—Short-run supply curve is part of marginal-cost curve above the AVC, and size of fixed costs don’t matter for supply decision
—Look at the value and see If it exceeds the opportunity cost (sunk cost) - lost $10 ticket for $15 movie don’t want to pay $20, but the $15 is worth more than the $10 you lost
Golf courses, restaurants at lunch time - when decided when to open and temporarily close down - look if the revenue made will exceed variable costs (bc fixed costs are irrelevant, will pay regardless)
long run decisions to exit or enter a market (graph #9) in comp. market
—Exits if the revenue it would get from producing is less that its TOTAL COST (Bc loses revenue but also saves VC and FC in long run)
Exit if TR < TC
◦ TR/Q < TC/Q —> Exit if P < ATC
• Enter if P > ATC (Exact opposite for entering)
A firm’s long run supply curve is the portion of its marginal-cost curve that lies above average TOTAL COST
profit in comp. market
Profit = TR - TC
• Rewrite —> Profit = (TR/Q - TC/Q) x Q
◦ TR/Q is average revenue, which is = to price, and TC/Q is average total cost
PROFIT = (P-ATC) x Q
profit max. Q is where MC and MR (or P) cross - the area above that point too ATC is a loss - the area below that point to ATC is profit (picture 9)
short run supply curve in comp. market
The short run: market supply with a fixed number of firms (bc short run = diff. to enter and exit)
- –Choose Q where MX = P —> as long as P > AVC, each firm’s marginal cost curve is its supply curve
- –Market supply curve found by adding quantity of output from each firm - sum
- –Same curve but quantity is much larger - but same bc firms are all equal
long run: market supply with entry and exit (comp. market)
Decision to enter/exit depend on incentives facing owners of existing firms and entrepreneurs who could start new firms
- –Firms already in market are profitable = new firms have incentive to enter - expand # of firms, increase Q supplied and decrease price and profits
- –If firms are making losses - then some existing firms will exit market - exit will reduce number of firms, decrease Q supplied, increase prices and profits
- –At the end of entry and exit process, firms that remain in the market must be making zero economic profit
Zero economic profit when Price = ATC - process of entry and exit ends only when price and average total cost are driven to equality
- –Free entry and exit force price to equal average total cost
- –Marginal cost and ATC are equal, ONLY when the firm is operating at the minimum of average total cost (also equal to Price)
efficient scale in long run equilibrium of comp. market
Called the efficient scale - in the long run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale ◦ Shows long run - price P = MC so firm is maximizing profit - P also = ATC, so profit is 0
- –New firms have no incentive to enter and existing firms have no incentive to exit
- –Enter and exit until profit is driven to 0 - then process stops - long-run market supply curve is horizontal at this price
- –At this point, only ONE price consistent with zero profit - minimum of ATC
- –Any price above would generate profit, leading to entry and increase in Total quantity supplied
- –Any price below would generate losses, leading to exit and decrease in quantity supplied
- –Eventually number of firms in market adjusts so price = minimum ATC, and there are enough firms to satisfy demand at this price
why comp. stay open at zero profit?
Profit = TR - TC —> total cost includes all opportunity costs to firm and business owners (including time and money)
- –In zero profit equilibrium, firm’s revenue must compensate owners for these opportunity costs
- –Remember at zero-profit equilibrium…economic profit is zero, but accounting profit is positive
shift in demand in short run and long run of comp. market (picture 11 I think!! the one with 6 pictures)
At zero profit, Price = the MINIMUM of Average total cost
A. Equilibrium - each firm makes zero profit and price equals minimum average total cost
B. Short run demand rises. Equilibrium moves from A to B and price rises and Quantity sold rises = profit - encourages new firms to enter the market - price now exceeds ATC, so each firm makes profit - shifts supply curve to the right\
—Bc each firm’s supply curve reflects its marginal cost curve - how much each firm increases production is determined by its marginal-cost curve
C. New long-run equilibrium - Price returned to P1, but quantity sold increased to Q3. Profits again zero and price is back to minimum of ATC, but market has more firms to satisfy the greater demand - each firm is once again producing at its efficient scale, but bc more firms, Q is higher
long run supply curve in comp. market
—Entry and exit can cause the long-run market supply curve to be perfectly elastic
—Large number of potential entrants - each faces the same costs
◦ As a result, long-run market supply curve is horizontal at the minimum of average total cost
◦ When D increases, long-run result is an increase in number of firms and in total quantity supply - NO change in price
2 reasons long-run market supply curve might slope upward
1. Some resources used in production may be available only in limited quantities (Farm - anyone can choose to buy land and start farm, but quantity of land is limited - as more ppl become farmers, price of farmland increases and raises the costs of all farmers in the market) - increase D, Cost, Q Supplied, and Price - result is a long-run market supply curve that is upward sloping, even with free entry 2. Firms may have different costs - (painters - anyone can enter market, but not everyone has same costs - some work faster than others, some use their time diff.) - to increase quantity of painting services supplied, entrants must be encouraged o enter market - new entrants have higher costs, so price must rise to make entry profitable for them - result is long-run market supply curve that slopes upward
- -If firms have diff. costs, some firms earn profit even in the long run - in this case, market price reflects average total cost of the marginal firm (firm that would exit the market if price were any lower) - this firm earns zero profit, but firms with lower costs earn positive profit
- –Thus a higher price may be necessary to induce a larger quantity supplied - in this case the long-run supply curve is upward-sloping, not horizontal
- –However, basic truth - because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than short-run - more horizontal
conclusion of comp. market
—When you buy a good from a firm in a competitive market, you can be assured that the price you pay is close to the cost of production
—Competitive and profit-maximizing firms - price = marginal cost of making that good
—If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production
—Price of a good equals both the firm’s average revenue and its marginal revenue
—Maximize profit - firm chooses a quantity of output so marginal revenue = marginal cost, therefore chooses one that price = marginal cost (bc in comp. market price = marginal rev.)
◦ Thus firm’s marginal-cost curve is its supply curve
—Profit diff. over time - short run - increase in demand raises prices and leads to profits, and decrease in D lowers prices and leads to losses - in long run, number of firms adjusts to drive market back to the zero-profit equilibrium
In the competitive market - demand curve is perfectly elastic, so is horizontal - meaning it is the same as the price, marginal revenue and average revenue graphs
Graphing question with marginal cost, price and quantity - in order to produce a positive output, need to choose quantity where price = marginal cost (where the price and MC curve would intersect is your quantity)
◦ Then have to decide if it will produce at all - firm’s decision in the short run depends on whether it can earn enough revenue to cover its variable cost (price line must but above the AVC line
monopoly - intro.
—Are price makers - have market power
—Comp. firms take market price of its output and chooses the quantity it will supply so that price equals marginal cost - monopoly charges a price to exceed marginal cost
—The outcome in a market with monopoly is often not in the best interest of society
Monopoly - firm that is the sole seller of a product without any close substitutes
—Main cause of monopoly is barriers to entry - remains only seller in market bc other firms cannot enter and compete with it
Barriers to entry - 2 sources
- Monopoly resources - Key resource required for production is owned by a single firm
◦ Not as common - bc huge world and many resources - can find substitutes - Gov. regulation - gov. gives a single firm the exclusive right to produce a good or service
a. Patent (medical drugs) and copyright laws (makes author a monopolist in selling her novel) - encourage research and author’s to write more books (bc high price) - The production process - a single firm can produce output at a lower cost than a larger number of firms
◦ Natural monopoly - a single firm can supply a good or service to an entire market at a lower cost than could 2 or more firms
◦ Arises when there are economies of scale over the relevant range of output
◦ Ex. Water - too many fixed costs to have more than one firm build buildings and pipes to provide water - lowest ATC if a single firm serves the market
◦ Club good - excludable but not RIC (uncongested toll bridge)
• Depends on market size - when pop. Is small, one bridge can satisfy and is natural monopoly - but when market expands, natural monopoly can evolve into a more competitive market (Require 2 or more bridges)
monopoly vs. competition (picture!! of two graphs)
Main difference is that monopoly can control its price - consider the demand curve of each type of market
- –Competitive firm faces a horizontal demand curve bc a comp. firm can sell as much or as little as it wants at a horizontal, constant price - bc comp. firm sells product with many perfect substitutes (all other firms in market), demand curve that any one firm faces is perfectly elastic (horizontal)
- –Bc monopoly is sole producer, its demand curve is the market demand curve - slope downward - if raises price, consumers buy less - or if it reduces the quantity of output it produces and sells, the price of its output increases (provides a constraint on a monopoly’s ability to profit from its market power)
- –Can’t sell at whatever price it wants bc of the market demand curve
monopoly’s revenue
TR = Q x P
Average Revenue = TR/Q of output (AR always equals the PRICE of a good - in comp. and monopoly)
Marginal revenue = (change in TR) / (change in Q) - amt. of revenue a firm receives for each additional unit of output
A monopoly’s marginal revenue is LESS THAN the price of its good - (bc monopoly faces a downward-sloping demand curve) - to inc. amt. sold, monopoly firm must decrease the price it charges to all customers
when monopoly increases amt. it sells, has 2 effects on total revenue (P x Q)
- The output effect - more output sold, so Q is higher, which increases TR
- The price effect - price falls, so P is lower, which tends to decrease TR
- —As a result, marginal revenue is less than its price (for monopoly only)
demand curve in monopoly
Because price = average revenue, demand curve is also the average-revenue curve (PICTURE)
—These 2 curves always start at the same point on the vertical axis bc the marginal revenue of the first unit sold equals the price of the good - but marginal revenue of all units after the first is less than the price of the good -thus marginal revenue is below the demand curve
Marginal revenue can become negative when price effect on revenue is greater than the output effect - means when firm produces an extra unit of output, price falls by enough to cause the firm’s total revenue to decline, even though selling more units
- –Maximum of total revenue occurs at the peak of the graph - the peak corresponds to the point on the marginal revenue curve at which marginal revenue is = 0
- ——–Bc marginal revenue is defines as the change in total revenue from producing one more unit, the marginal revenue curve corresponds to the slop of the total revenue curve at a given point
- ———When marginal revenue is positive, total revenue has not yet maximized and must be increasing (bc producing an additional unit increases TR)
- ——When it is negative, producing that last unit actually lowers total revenue
- —–At its peak, total revenue is neither rising nor falling, therefore its slope is = to 0
Question I missed about MR
“comparing your total revenue graph to your marginal revenue graph, you can see that total revenue is MAXIMIZED at the output at which MARGINAL REVENUE is = to 0
profit maximization in monopolies
Monopoly maximizes profit by choosing Q at which Marginal Revenue = Marginal cost,
—-Then uses the Demand curve AT that quantity to determine the PRICE
—-If was producing at Q1, cost is less than revenue so firm increases profit by inc. Q
—-But if Q2, cost is greater than revenue - save money by reducing Q
—-A monopolies profit-maximizing quantity of output is determined by the intersection of the marginal -revenue curve and the marginal-cost curve
• Same in comp. firms - choose Profit MAX when MC = MR, but diff. is in comp. firms MR = PRICE, but in Monopoly MR < P
• FOR COMP. FIRM: P = MR = MC
• FOR MONOPOLY: P > MR = MC (looks at demand curve to find price, bc shows how much customers are willing to pay at that profit maximizing Q)
Key diff. btwn comp. and monopoly is: in comp. market, price = Marginal cost…in monopoly, price > marginal cost
monopoly’s profit (PICTURE)
Profit = TR-TC
- –(rewrite) Profit = (TR/Q - TC/Q) x Q
- –TR/Q is average revenue which = PRICE (AVERAGE REVENUE = PRICE)
- –And TC/Q = Average total cost
PROFIT = (P - ATC) x Q
Area of the box is the profit - HEIGHT (BC) is PRICE - AVERAGE TOTAL COST = Profit per unit sold
- –Measure price in monopoly market using market demand curve and firm’s cost curves
- —Monopoly does not have a supply curve - when monopolist chooses the Q to supply, that decision (along with the demand curve) determines the price
- –Whereas comp. firms are price takers, determine what amount to produce at a given price - monopolists are price makers - comp. market, firm’s decisions can be analyzed without knowing the demand curve…not true in monopoly
Graph with patented goods
With patented goods, such as drugs - the product will originally have a high monopoly price - when patent runs out and new firms enter market, becomes competitive and price is driven down from the monopoly price to marginal cost
the welfare cost of monopolies
Monopolies are expensive to consumers, but high price makes them profitable to seller’s - do the benefits to firm owners exceed the costs imposed on consumer…making it desirable to society as a whole?
Total surplus - the sum of consumer surplus and producer surplus (measure economic well-being of society - welfare economics (Ch. 7)
—-Consumer surplus - price consumer is willing to pay minus the amt. actually pay
—Producer surplus - amt. producers receive for a good minus production costs
• In comp. market - invisible hand naturally leads total surplus to be as large as possible
deadweight loss (picture!)
Monopoly run by someone who cares about both profits and benefits received by customers - wants to Maximize TOTAL SURPLUS (CS + PS) OR (value of the good to consumers minus the costs incurred by producer)
—-Demand curve represents value of good to consumers (willingness to pay)
◦ Marginal cost curve = costs of the monopolist
◦ Socially efficient quantity is where demand curve and marginal-cost curve intersect
• Below this quantity, value of extra unit to consumers exceeds cost to provide (increase output to raise total surplus)
• Above this, cost of producing exceeds value to consumers (decrease output to raise total surplus)
Efficient by charging price at intersection of demand and marginal-cost
—-In comp. firm, charge price = to marginal cost - price give consumers accurate signal about cost of producing the good
how to evaluate efficiency of monopoly (picture!!)
Evaluate efficiency of monopoly by comparing level of output firm chooses to level of output social planner would choose
- –Monopolists choose where Marginal revenue and marginal cost intersects
- —Social planner chooses were demand and marginal cost curves intersect
Bc. Monopoly charges above marginal cost, not all consumers who value the good at more than its cost buy it - thus Q output is below socially efficient level
• Deadweight loss - area btwn demand curve (reflects value to consumers) and marginal cost curve (reflects costs of monopoly producer)
▪ Deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax - monopolist is like a private tax collector
▪ Tax places a wedge btwn consumers willingness to pay (represented by demand curve) and producers cost (Represented by supply curve)
▪ Monopoly places wedge bc exerts its market power by charging price above marginal cost
• However not bad for total surplus (and society) - transfer of more money from consumers to producers - same size pie of total surplus…but producers slice gets bigger and consumers is smaller (in monopoly)
• Monopoly profit is NOT a social problem
▪ The problem stems from deadweight loss - an inefficiently in low quantity
price discrimination in monopoly
Price discrimination - the business practice of selling the same good at diff. prices to diff. customers (don’t charge same price to all customers)
—Price discrimination is not possible when a good is sold in competitive market
◦ To discriminate, must have some market power
Story about selling books to consumers ($30 each to 100,000 people or $5 to 500,000 people - profit is higher with $30, even though deadweight loss arises to 400,000 ppl - then realizes the $30 ppl in Australia and $5 in US - charges diff. to max. profit
- –In price discrimination - monopolist charges each customer a price closer to her willingness to pay than is possible with a single price - need to be able to separate
- –Forces can prevent firms from price discriminating
arbitrage
process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference (ex. If Australian’s bought the book from US and sold within Australia)
price discrimination and economic welfare (PICTURE)
Price discrimination can RAISE economic welfare - eliminates the deadweight loss (bc will sell it to all people at their willing to pay price
◦ This increase in welfare shoes as a higher producer surplus than consumer surplus
Perfect price discrimination - monopolist knows exactly each customer’s willingness to pay and can charge each a diff. price - charge exactly their willingness to pay, and monopolist gets the entire surplus in every transaction
Monopolistic competition (Class notes)
Main key is differentiation (Water)
LOOK UP THE DIFFERENCES BTWN THE MARKETS CHART IN HIS SLIDES!!! - EXPLAINS IT ALL
—–Why is ATC curve U-shaped? — bc average fixed costs are spread out at first so it is spread amongst more Q of products - but as Q increases AVC increases and can’t be spread out and the ATC curves upward again
—Make most revenue at the MINIMUM of the AVERAGE TOTAL COST CURVE
If demand curve is below ATC curve = A LOSS
Book business - seem monopolistic - bc each book is unique and are price makers - price exceeds marginal cost
◦ But also seems competitive - bc SO many authors and books - thousands of competing products to choose from
◦ Bc are monopolistic competition companies
Btwn monopoly and perfect competition
◦ Price in perfectly competitive market always equals the marginal cost of production - in long run, entry and exit drive economic profit to 0, so price equals average TC
◦ Monopoly firms use market power to keep prices above marginal cost, leading to positive economic profit for firm and deadweight loss for society
advertising (Class notes)
most useful with differentiated products (monopolistic competition) - 10-20% of methods
- –Experts argue that firms advertise to manipulate people’s tastes - psychological rather than informative - advertising impedes competition
- –Those who defend it say informed buyers can more easily find and exploit price differences - provides necessary information
- —Eyeglasses were MORE expensive in states that PROHIBITED advertising than in states that did not restrict it
Look up the summary’s at the end of each chapter!!! - explain the main points and differences in the markets
imperfect competition
Typical firm has competition and market power, but not as great as monopoly - most industries fall btwn perfect competition and monopoly - called imperfect competition
—2 types: oligopoly and monopolistic competition
oligopoly - basic notes
- one type of imperfectly competitive market - with only a few sellers, each offering a product that is similar or identical to products offered by other sellers in the market
Concentration ratio - percentage of total output in market supplied by 4 largest firms - economists use to measure a market’s domination by a small # of firms
- –In US, most industries have a four-firm concentration ratio under 50%, but in some industries the biggest firms play dominant role
- –Highly concentrated industries - major household appliances, tires, light bulbs, soda, wireless telecomm. (oligopolies)
- –Few sellers - makes comp. less likely and strategic interactions among firms important
monopolistic comp. basic notes
- imperfectly competitive market - many firms selling products that are similar but not identical - each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers
- –Many sellers - each is small compared to the market
- –Product differentiation - slightly diff. from other firms - rather than price taker, each firm faces downward-sloping demand curve
- –Free entry and exit - without restriction - number of firms in market adjusts until economic profits are driven to zero
PICTURE EXPLAINS DIFFERENCES
Monopolistic comp. in short run (picture)
- –Bc each product is diff. than others - faces downward-sloping demand curve (contrast - perfectly competitive firm faces a horizontal demand curve at the market price)
- –Follows monopoly rule for profit max - choose to produce Q where Marginal Revenue = MC, then use demand curve to find price to sell that Q
- –When price > ATC = profit, when price < ATC = loss
Chooses price and Q like monopoly - in short run, they are similar in structure
long run equilibrium of monopolistic comp.
- –Do not last long, bc when firms make profits - incentive for new firms to enter market - entry increases number of products and reduces demand for each firm already in market
- –Profit = entry increases = demand for existing firms decrease = profit decrease
- –Loss = firms exit market - customers have fewer products to choose from - increases demand for staying firms = shifts D curve to right for those who stay - as D rises Profit increases
- –This process of entry and exit continues until firms are making exactly zero profit
QUIZ: What is true about BOTH monopolistic comp. and monopoly in long run?
firms are not price takers and price is above marginal cost (NOT price = ATC in long run OR firms earn 0 profit in long run - true for monopolistic comp. but not for BOTH monopoly - true for perfectly competitive)
• When firms rec. negative profit - means there are more shops in industry relative to long-run equilibrium - firms exit and causes Demand curve to shift to the RIGHT
monopolistic comp. long run graph
Long run equilibrium - price = ATC, and each firm earns zero profit
Profit per unit sold = price - ATC, max profit is zero if two curves touch each other without crossing - (this occurs at same Q where MR intersects with MC)
—-BC Q where MR = MC is profit maximizing Q - and max profit is zero in long run
Two characterists describe long run equilibrium in monopolistic comp. market
1. Like monopoly, Price > MC - bc profit maximization requires MR = MC, and bc downward sloping demand curve makes MR < price 2. Like comp. Market, price = ATC - conclusion arises bc free entry and exit drive economic profit to zero - --Shows how diff. than monopoly - bc monopoly is sol seller, can earn positive economic profit in long run too - but bc free entry and exit, profit driven to zero
monopolistic comp. vs. perfect competition
Can notice 2 differences
1. Perf. Comp. firm produces at efficient scale, where ATC is minimized - but monopolistic comp. firm produces < efficient scale - ---Entry and exit drives mon. comp. market to where D and ATC met - but this Q of output is < quantity that minimizes average total cost - ---EFFICIENT SCALE - the Q that minimizes ATC (at the minimum of the U shaped curve) - in long run perf. Comp. firms produce at this Q, but mon. comp. firms produce below it - -------Firms have EXCESS CAPACITY in mon. comp. - firm could increase Q it produces and lower ATC, but forgoes opp. Bc would need to cut price to sell additional output - more profitable to have excess capacity in mon. comp.
- Price = MC in perfect comp., but price is > MC in monopolistic comp.
- —Zero-profit condition ensures price = ATC, but not that price = MC, mon. comp. have downward slope, so for Price to = ATC, P must be > MC
- —In perfectly comp., doesn’t matter if one more customer comes bc P is same regardless - but monopolistic comp. firms want bc P > MC, so profit inc. by one more unit sold
Monopolistic comp. and welfare of society
Perfectly comp. markets lead to efficient outcomes, but monopoly leads to deadweight losses
• One source of inefficiency in mon. comp. market is markup of price over MC - bc some value good at more than MC but < price, won’t buy it = deadweight loss of monopoly price
◦ But bc mon. comp. firms make zero profits…require to lower price to MC would cause losses - to keep firms in business, gov. would have to help cover losses - rather than raise taxes to subsidize, policy makers decide better to live with inefficiency of monopolistic pricing
Also inefficient bc number of firms may not be “ideal” - too much or too little entry - entry of firm has two possible effects that are external to the firm
externalities in monopolistic comp.
- Product-variety externality - bc consumers get some consumer surplus from intro. Of new product = entry of new firm brings positive externality on consumers
- —Arises bc new firms offer products that differ from those of existing firms - Business-stealing externality - bc other firms lose customers and profits when faced with new competitor, entry of new firm imposes negative externality on existing firms
- —Occurs bc firms post price above MC, and eager to sell additional units
Can have both positive or negative externalities in mon. comp. market
- –Neither of these externalities exist in perfect comp. bc identical goods and P = MC
- –In mon. comp. invisible hand does not ensure total surplus is maximized - but subtle inefficiencies
(IMP!!) Mon. comp. is socially inefficient bc too many or too few firms in market - presence of business stealing externality implies there is too much entry of new firms in market
Advertising
In mon. comp. - firms sell differentiated products and charge above MC = each firm has inventive to advertise to attract more buyers to its product
Amt. of advertising varies btwn products - firms with HIGHLY diff. goods (over-counter drugs, perfumes, soft drinks, razor blades, cereal, dog food) spend about 10-20% of their revenue on advertising
◦ Firms selling industrial products (drill, satellites) spend little on advertising
◦ Firms that sell homogenous products (wheat, salt, sugar, oil) spend nothing
◦ For economy as a whole, about 2% of total firm revenue is spent on advertising
CRITIQUE on advertising
—Argue firms advertise to manipulate people’s tastes - psychological not informational
—-Does not tell about price or quality - rather to show if have product gain popularity/happiness
—Commercial creates a desire that otherwise might not exist
—Argue advertising impedes competition (convince products are more diff. than they truly are) - inc. perception of product differentiation and foster brand loyalty
• Makes buyers less concerned with price diff. and Demand for curve less elastic - when firm faces less elastic D curve, can increase profits by charging over MC
markets to allocate resources efficiently
DEFENSE of advertising
- –Provide information to customers - prices, new products, locations
- –Consumers can make better choices about what to buy - enhances markets to allocate resources efficiently
- –Fosters competition - allows customers to be more informed about all firms in market - more easily take advantage of price differences - thus each firm has less market power
- –Allows firms to enter more easily bc gives entrants means to attract customers
Restricted “unprofessional” advertising in fields such a lawyers, doctors, and pharmacists
advertising as a signal of quality
• Even though advertising conveys little information according to critics, does show quality - willingness of firm to spend large amt. of money on advertising is signal to consumers about quality of product being offered
• Bc quality is good, if try will keep buying - advertise bc they just need people to try and then get hooked!! - bad quality, won’t spend money on advertising, when people will only try once then never want to try again…spends money trying to come up with better product
• Willingness to spend money on advertising shows consumers that product is good quality
• But if advertising cost was cheap - both would use it to market…bc both good and bad cereals are advertised…consumers in the long run would learn to ignore cheap advertising
• Important info. With advertising is not its content but its existence and expense
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brand names
In markets, 2 types of firms - one sells products with widely recognized brand names - others sell generic substitutes
—Most often firm with brand name spends much more on advertising and charges higher price
Critics
—Brand names cause consumers to perceive differences that don’t really exist - generic is essentially same products, but consumers willing to pay more for brand bc advertising
Defenders
—Useful way for consumers to ensure goods they buy are high quality (consistent anywhere you find it) - brand names provide info. About quality - second, give firms incentive to maintain high quality bc firms have financial stake in maintaining the reputation of their brand names (reputation)
inefficiencies of monopolistic comp. market
- –Have deadweight loss of monopoly caused by markup of price over marginal cost
- –Number of firms (variety of products) can be too large or too small
- –Ability of policymakers to correct these inefficiencies is limited
Oligopoly
Market structure with only a few sellers who offer similar or identical products - as a result, actions of any one sellers in market have large impact on profits of others - interdependent in a way that comp. firms are not
Game theory - study of how people behave in strategic situations - consider how others might respond to the action she takes
- –Bc oligopolistic markets have only small number of firms…each must act strategically
- –Each firm must consider how its decision might affect the production decisions of other firms in the market
- –Oligopolies are best off when cooperate and act like monopolist: produce small quantity of output and charge price above MC
- –Qualities: mutual interdependence, difficult entry, market control by a few large firms
duopoly
Duopoly (oligopoly with only two members) - simplest type - Jack and Jill pumping water
- –Perfectly comp. - drive price to = MC, MC is zero to pump water so equilibrium price is zero - equilibrium Q is 120 gallons
- –Monopoly - profit is maximized at 60 gallons and price $60 a gallon - profit maximize would choose this - price exceed MC - result is inefficient bc Q of water produced and consumed falls short of socially efficient level of 120 gallons
- –Duopolists
1. COLLUSION - an agreement among firms in market about quantities to produce or prices to charge - CARTEL (group of firms acting in unison) - once cartel is formed, market is similar to monopoly and can apply analysis from ch. 15 (sell 60 at $60 per gallon, price > MC , outcome is socially inefficient) - cartel agrees on total level of production and amt. produced by each member
equilibrium for oligopolys
- Want to form cartels, but diff. bc argue over how to divide profit - also antitrust laws prohibit explicit agreements among oligopolists
- If each sell 30 for $60, make $1800 - but one knows that he can sell 40 for $50 and make $2000 - so does the other - will each sell 40 making total sales 80 and drop price to $40 – produce more than monopoly quantity, but charge lower price and earn less profit than monopoly profit - bc self interested
Nash equilibrium
Nash equilibrium
situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen - (if one acts in their own self-interest, the other will too for both to be equal and max profits)
- —Ex. Either both sell 30 gallons for high price, one sells 40 and other 30 (1st gets more), other way around and 2nd gets more, or both sell 40 (get equally high, but not as high as if both agreed and didn’t go after greedy option)
- –Once they reach Nash equilibrium, neither has an incentive to make a diff. decision
- –Illustrates tension btwn cooperation and self-interest
- –Would be better off cooperation and reaching monopoly outcome…yet bc each pursue their own self-interest, don’t reach mon. outcome and fail to maximize their joint profit - each is tempted to raise production and capture larger share of market = in process total production rises and price falls
- –But do not reach competitive outcome - stop producing before the point where price = MC
(IMP!!!) When firms in oligopoly individually choose production to max profit, they produce a Q of output greater than level produced in monopoly and less than level produced in perfect competition - oligopoly price is less than monopoly price but > than comp. price (which equals MC)
How size of oligopoly affects market outcome (output effect and price effect)
More sellers than 2 - try to form cartel to max total joint profit by producing monopoly quantity and monopoly price - need to agree on amt. for each and enforce agreement - reaching and enforcing agreement is diff. as size of group increases
2 effects when deciding how much to produce (without cartel)
1. Output effect - bc. Price is above MC, selling one more gallon of water at going price will raise profit
—-If output effect is greater than price effect, will increase production
2. Price effect - raising production will increase total amt. sold, which will lower the price of water and lower profit on all other gallons sold
—If price effect > output effect will not raise production (Reduce)
• The larger the number of sellers, less each seller is concerned about her own impact on the market price - as number increases, magnitude of price effect falls - when too large, price effect disappears altogether = price decision of one firm no longer affects market price - large oligopoly becomes more like a group of competitive firms (comp. firm considers ONLY output effect when deciding how much to produce - price taker so price effect is absent)
(IMP!!) As number of sellers in oligopoly grows larger, looks more like comp. market - price approaches MC and Q produced approaches socially efficient level
—With international trade - 6 members in car industry - free trade inc. number of
producers and inc. competition keeps prices closer to MC
QUIZ QUESTION ABOUT OLIGOPOLY
Based on the fact that both parties increased production from initial cartel quantity, you know that the output effect was smaller than the price effect on quantity = FALSE (bc when output effect is greater than price effect you inc. production Q)
Prisoner’s dilemma
Oligopolists would like to reach monopoly outcome - but requires cooperation - diff. to establish and maintain
Prisoners’ dilemma - a particular “game” btwn 2 captured prisoners that illustrates why cooperation is diff. to maintain even when it is mutually beneficial (fail to cooperate even when cooperation would make BOTH better off)
—-2 prisoners captured by police - police has enough evidence to convict both of the minor crime and each spend a year in jail - police also suspect both committed bank robbery together, but lack evidence to convict of the major crime - take them into separate rooms and offer same deal (lock you up for 1 year, if you confess you get immunity and go free while partner gets 20 years in jail, but if both confess you each get 8 years) - only care about individual - but their sentence depends on strategy he or she chooses and strategy chosen by partner
- –In ex. If Clyde confesses, best strategy is to also confess. If Clyde doesn’t confess, best strategy is also to confess - so Bonnie is always better of confessing
- –DOMINANT STRATEGY - a strategy that is best for a player in a game regardless of the strategies chosen by other players (in this case confessing - spends less time in jail if she confesses, regardless of whether Clyde confesses or remains silent)
- –Both choose dominant strategy and both serve 8 years = NASH EQUILIBRIUM - if both had remained silent, would have been better off…but bc pursue his or her own interests, 2 together reach an outcome that is worse for each of them
Oligopolies as a prisoner’s dilemma
- –Jack thinks regardless of Jill’s decision, he is better of producing at a higher level and disregarding their agreement - producing 40 is dominant strategy - both choose that dominant strategy and result is an inferior outcome with lose profits for each of them
- –Prisoners’ dilemma explains why oligopolies have trouble maintaining monopoly profits - monopoly outcome is jointly rational, but each has an incentive to cheat - self-interest makes it difficult to maintain cooperation
- –Similar to oligopoly of oil production in Middle East - formed a cartel called OPEC - OPEC members want to maintain a mutually beneficial high price for oil…but each is tempted to inc. production and get larger share of the profit - they freq. agree to reduce production but then cheat on their agreements
- –Although this lack of cooperation has reduced profits of oil-producing nations, it has benefited consumers around the world
- –Other examples of prisoners’ dilemma (self-interest prevents cooperation and leads to inferior outcome for parties involved)
Arms races - WWII - US and Soviet Union - military power - each country wants to live in a world safe from weapons, but choosing to arm is dominant strategy
—US and Soviet Union tried to reach cartel to agree over amt. of arms each country should be allowed - feared other would cheat - self-interest drives participants towards noncooperative outcome - worse for both parties
Common resources
—Oil - companies do not use efficiently - each could drill more wells and get more profit - if both drill a second well, split the oil and share profit
prisoner’s dilemma and welfare of society
- –Shoes cooperation would make both players in game better off, but is difficult to maintain
- –In some cases, noncooperative equilibrium is bad for society and players (arms race or common resources)
- –But in oligopolist situation, lack of cooperation is good for society - monopoly outcome is good for firms but bad for consumers - more comp. outcome maximizes total surplus - fail to cooperate and Q is closer to optimal level
Cooperation not impossible - if game played MANY times (not just once) easier to maintain and enforce bc can set penalties for cheating - care about future profit enough to forgo on-time gain
—-In game of repeated prisoners’ dilemma, 2 players more likely to reach cooperative outcome
Tournament
—-Tit-for-tat strategy - player should start by cooperation and then do whatever the other player did last time (player cooperates until other player defects, defects until other play cooperates again)
Quiz vocab
Collusion - the event that occurs when agents in a game form an agreement about which strategies to implement
Nash equilibrium - set of strategies (one for each player) in which each player’s strategy is the best option for that player, given the chosen strategy of the player’s opponents
Dominant strategy - a player’s best choice, regardless of his or her opponents strategy
Payoff matrix - a visual representation of a game showing all possible strategies for each player and all potential outcomes and payoffs
Prisoners’ Dilemma - case in which individually rational behavior leads to a jointly inefficient outcome
Do the Nash equilibrium quiz practices before the midterm again
public policies toward oligopolies
—-Cooperation is undesirable to society as a whole bc it leads to production that is too low and prices that are too high - to move allocation of resources closer to social optimum, policymakers try to induce firms in oligopoly to compete rather than cooperate
Restrain of trade and antitrust laws
- —Sherman Antitrust Act of 1980 - illegalized every contract or conspiracy in restraint of trade of commerce among several states or foreign nations - those who attempt to monopolize or conspire with groups to monopolize trade will be guilty and fined not exceeding 50,000, or imprisonment by one year or both
- —Clayton Act of 1914 - further strengthened the antitrust laws - if person could prove she was damaged by illegal arrangement to restrain trade, person could sue and recover 3 times the damages she sustained (encouraged private lawsuits against oligopolies)
- —These laws prevent mergers that would lead to excessive market power in any single form and to prevent oligopolists from acting together in ways that would make their markets less competitive
controversies over antitrust policies
Most agree that price-fixing agreements among competing firms should be illegal, yet antitrust laws have been used to condemn some business practices whose effects are not obvious
–resale price maintenance, predatory pricing, tying
Resale price maintenance
sell to retail stores for $50 and require the retailers to charge customers $75 - prevents retailers from competing on price
- –Defenders - argue it is not aimed at reducing competition - also want its retailers to provide customers a pleasant showroom and knowledgeable sales force - without resale price maintenance, customers would use one store’s service to learn then buy at cheaper discount retailer with poor service
- –Free ride to service provided by other retailers, leading to less service - helps solve free rider problem
- –Shows: business practices that appear to reduce competition may in fact have legitimate purposes
predatory pricing
firms with market power use that power to raise prices above competitive level
—Argue not that effective bc in order to make a difference have to drop price below cost - argue it isn’t a profitable business strategy
tying
tying two products together (theater offers 2 movie films together at a single price)
—-Issue with Microsoft trying to integrate its Internet browser into its Windows operating system - gov. claimed Microsoft was tying 2 products together to expand its market power - 1999 concluded the Microsoft had great monopoly power and it had illegally abused that power - 2000 ordered Microsoft be broken into 2 companies: one that sold operating system and one that sold applications software
oligopoly conclusion
- –Oligopolies want to act like monopolies, but self-interest drives them towards competition - where they end up on spectrum depends on number of firms and how cooperative firms are
- –Prisoners’ dilemma shows why oligopolies fail to maintain cooperation, even when in best interest
- –regulate behavior of oligopolies through antitrust laws
measuring a nation’s income
Gross domestic product (GDP) - Total income of everyone in economy - thought to be the single best measure of a society’s economic well-being
- —Inflation/deflation - rate at which average prices are rising or falling
- –Unemployment - the percentage of labor force that is out of word
- –Retail sales - total spending at stores
- –Trade deficit - imbalance of trade btwn US and rest of world
All above are macroeconomic - tell us about entire economy, rather than particular household, firm or market - study of economy as a whole
• Goal of macro is to explain the economic changes that affect many households, firms and markets simultaneously
• Look at: why average income high in some countries and low in others? Why do prices sometimes rise rapidly while other times stable? Why do production and employment expand in some years and contract in others? What can gov. do to promote rapid growth in incomes, low inflation and stable employment?
Microeconomics - the study of how households and firms make decisions and how they interact in markets
• Closely linked bc economy as a whole is a collection of households and firms - so supply and demand are central to both macro and micro
gross domestic product
—To judge if economy is doing well - look at total income everyone in economy is earning
• GROSS DOMESTIC PRODUCT (GDP) - measures 2 things at once:
1. Total income of everyone in economy
2. Total expenditure on the economy’s output of goods and services
—Can measure bc are the SAME - for economy as a whole…income must = expenditure (bc always has a buyer and seller - every dollar spent is income to someone else) - transactions contribute equally to economy
GDP = the total amount spent by households in the market for goods and services - it also equals the total wages, rent and profit paid by firms in markets for factors of production
—-Compute in 2 ways: by adding up total expenditure of households or by adding up total income (Wages, rent, profit) paid by firms = SAME AMOUNT
circular flow diagram
- –describes transactions btwn households and firms
- –When households buy goods and services from firms, these expenditures flow through markets for goods and services
- –When firms use money from sales to pay wages, rent, and firm owners’ profit - this income flows through markets for factors of production
- –Study question one about diagram in the QUIZ before midterm
- –Labor is not a flow from firm to household - (firm) Cho performs labor to company (firm) - but the wages is a flow from firm to household
measurement of GDP
market value of all final goods and services produced within a country in a given period of time (simple definition but complications can arise)
- GDP - “is market value”
Meaning it adds together diff. kinds of products into a single measure of the value of economic activity - using market prices (which measure the amt. ppl are willing to pay for goods) - if price of an apple is 2x price of an orange, then an apple contributes twice as much to GDP as an orange
- GDP “of all”
—All products market value
—-Also al housing services - rental housing (=tenant’s expenditure and landlord’s income) - but when people own homes and do not pay rent, calc. GDP by estimating rental value (based on assumption that owner is renting house to herself - homeowners expenditure and income)
—GDP excludes items produced and sold illegally - als0 products produced and consumed at home (bc never enter market)
◦ Vegetables bought at store are GDP, Vegetables grown in home garden are not
◦ Pay neighbor to mow lawn, but if married and he mows…doesn’t count
- GDP “Final”
—International paper makes paper, Hallmark uses to make a card - paper is an immediate good and the card is a final good - GDP is only FINAL GOODS
—Bc value of intermediate goods is already included in price of final - if counted would be double counting
—-Exception = if intermediate good is added to firm’s inventory of goods for use or sale at a later date - adds to inventory = GDP - when later used or sold, reductions in inventory subtract from GDP
• Ex. From quiz - if produce wood in Oregon and sell to construction company to produce a new house - it is an immediate good and does NOT count
- GDP “goods and services”
Tangible goods (food, clothes, cars) and intangible services (haircuts, housecleaning, doctor)
- GDP “produced”
Currently produced - not include transactions involving items produced in the past
- –Ford produces and sells new car, value of car is included in GDP
- –BUT when one person sells used car to another, value NOT included in GDP
- GDP “within a country”
- –Within country - when Canadian citizen works temporarily in US - her production is part of US GDP
- –BUT when American citizen owns factory in Haiti, production of factory NOT included in GDP (in Haiti’s GDP)
- –“within the US” - NOT “By US citizens” or “US. Owned companies”
- –So a US company produced a convertible at a plant in Germany - then imports the convertible to the US - DOES NOT COUNT
- GDP “In a given period of time”
—Usually a year or a quarter (3 months) - measures income and expenditure during that interval
—When reports GDP for a quarter - usually represents “At an annual rate” - meaning figure for quarterly GDP is multiplied by 4
—Also reports after it has been modified by seasonal adjustment - if unadjusted…shows that economy produces more goods and services during some times of the year (Dec. holiday shopping) - gov. statisticians adjust quarterly data to take out seasonal cycle
This definition focused on GDP as total expenditure in the economy - but IMPORTANT TO REMEMBER than every dollar spent becomes a dollar of income to seller
—Apply this definition AND add up total income in the economy
—Should be the same # despite method - if different…statistical discrepancy (calculations)
5 important measures for measuring income for GDP
1. Gross national product (GNP)
- Gross national product (GNP) - Total income earned by nation’s permanent residents (nationals)
- –DOES include income citizens earned abroad and excludes income that foreigners earn here
- –Canadian’s work in US is part of US GDP but NOT part of US GNP
- –However, most domestic residents are responsible, so GDP and GNP are close
- Net National product (NNP)
- total income of a nation’s residents (GNP-losses from depreciation)
◦ Depreciation - wear and tear of economy’s stock of equipment and structures (trucks rusting, old computer models becoming obsolete)
◦ Depreciation also called “consumption of fixed capital”
- National income
- total income earned by nation’s residents in production of goods and services (almost identical to NNP)
◦ Differ from NNP because of problems in statistical discrepancy
- Personal income
- income households and noncorporate businesses receive
◦ Unlike national income, it excludes retained earnings - income that corporations have earned but have not paid out to their owners
◦ Also subtracts indirect business taxes (sales tax), corporate income taxes, contributions to social insurance (mostly social security taxes)
◦ Also includes interest income that households receive from holdings of gov. debt and income households receive from gov. transfer programs (Welfare and social security)
- Disposable personal income
- income that households and noncorporate businesses have left after satisfying all obligations to gov.
◦ = personal income - personal taxes and nontax payments (such as traffic tickets)
Differ but can be read similarly - when GDP grows, these measures of income usually grow rapidly, when GDP falls, these other measures also fall
components of GDP
GDP = Y (Divided into 4 components) - (C: Consumption, I: investment, G: gov. purchases, NX: net exports)
Y = C + I + G + NX
◦ Equation is an identity - equation that must be true bc of how variables in equation are designed
GDP - 1. Consumption C
spending by households on goods and services, with exception of purchases of new housing
◦ Includes durable goods (cars and appliances), nondurable goods (good and clothing)
◦ Services - intangible (haircuts and medical care) - household spending on education also included
GDP - 2. Investment I
purchase of goods (capital goods) that will be used in the future to produce more goods and services - (sum of the purchases of business capital, residential capital, and inventories)
◦ Business structures (factory or office), equipment (worker’s computer), intellectual property products (software that runs the computer)
◦ Residential capital - includes landlord’s apartment building and homeowner’s personal residence
• Purchase of a new house is one type of household spending categorized as investment and NOT consumption
◦ Inventories - apple buys computer and adds to inventory NOT selling - “purchased” computer and is investment spending - if later sells computer out of inventory, inventory investment will be negative and offset the initial positive expenditure
◦ Aim of GDP is to measure value of economy’s production, and goods added to inventory are part of that period’s production
◦ This investment means - purchases of goods that will be used to produce other goods and services in the future
• Movement about whether or not to include prostitution and illegal drugs in GDP (started in France who said they will NOT) - diff. to compare bc are legal in some countries and therefore included in their own GDP
GDP - 3. Government purchases G
spending on goods and services by local, state and federal gov.
◦ Includes salaries of gov. workers and expenditures on public works
◦ Also called “gov. consumption expenditure and gross investment”
◦ When gov. pays salary of arm general or schoolteacher, included
• BUT when gov. pays social security benefit to elder or unemployment insurance benefit to laid off worker = transfer payments bc not make in exchange for a currently produces good or service
▪ Transfer payments alter household income, but not reflect economy’s production - macro economics say they are like negative taxes
▪ Bc GDP intends to measure income and expenditure, transfer payments are NOT counted in gov. purchases
GDP - 4. Net exports NX
the foreign purchases of domestically produced goods minus the domestic purchases of foreign goods
◦ = exports - imports
◦ If domestic firm sells to another country = increases net exports
◦ Net refers to imports being subtracted from exports - subtract bc the import (Car from Sweden of $40,000 is counted as in increase in consumption)
• Increases consumption by $40,000 but decreases net exports by $40,000
◦ Net exports include goods and services produced abroad (with a minus sign) bc these goods and services are included in consumption, investment, and gov. purchases (With a plus sign)
• SO, when household, firm or gov. buys from abroad, purchase reduces net exports but also raises either C, I or G so does NOT affect GDP
things GDP does NOT include or measure properly
The costs of air and water pollution, the quality of goods available to consumers, the value of babysitting services when the babysitter is paid in cash and transaction is NOT reported to the gov., the variety of goods available to consumers, selling of illegal drugs from South America, costs of overfishing and overly intensive uses of resources
GDP measuring truths
GDP measures total spending of goods and services in all markets in the economy
• If total spending rises from one year to next, 2 things true:
1. Economy is producing a larger output of goods and services
2. Goods and services are being sold at higher prices
• Economists want to measure total quantity of goods and services economy is producing that is NOT affected by changes in prices of those goods/services
Real GDP
• answers question: “what would be the value of goods and services produced this year if we valued these goods and services at prices that prevailed in some specific year in the past?”
◦ Evaluates current production using prices that are fixed at past levels - shows how economy’s overall production of goods and services changes over time
Nominal GDP
• To compute total spending in this example, multiply Q by price - total expenditure would be sum of hot dogs and hamburgers
◦ = nominal GDP (production of goods and services valued at current prices)
◦ In example, total spending rises from $200 to $600 to $1,200 each year - part of the increase is due to increase in Q and part is due to increase in P
Real GDP vs. Nominal GDP
• Use real GDP (production of goods and services valued at a CONSTANT price) - to measure amt. produced not affected by changed in price - choose a base year (2016) for price then add quantities btwn years
• Nominal GDP uses current prices to place a value on the economy’s production of goods and services - real GDP uses constant base year prices to place a value on the economy’s production of goods and services - real GDP not affected by price change, so changes in real GDP reflect ONLY changes in amts. Being produced
◦ So REAL GDP is a measure of economy’s production of goods and services
◦ Role of GDP is to measure how well the overall economy is performing
◦ Real GDP is a better gauge of economic well-being than nominal (bc reflects economy’s ability to satisfy people’s needs and desires)
◦ When economists talk about growth in economy - measure growth as percentage change in real GDP from one period to another
GDP deflator
Measure of the price level calculated as the ratio of nominal GDP to real GDP X 100
GDP DEFLATOR = (Nominal GDP / Real GDP) x 100
- –This measures the current level of prices relative to the level of prices in the base year
- —Ex. Q changes over time but Price stays same - means nominal and real GDP rise at same rate so GDF deflator is CONSTANT
- —Or P increases but Q stays the same - nominal GDP rises but real stays same, so GDP deflator INCREASES
- —(IMP!!)GDP Deflator reflects what’s happening to prices, not Q
- —Deflator is always 100 in the base year (bc constant and not changing yet bc time hasn’t passed)
Inflation - economy’s overall price level is rising
- —Inflation rate - percentage change in some measure of price level from one period to the next - using GDP Deflator, inflation rate is found
- —Inflation rate in year 2 = ((GDP deflator in year 2) - (GDP deflator in year 1) / (GDP deflator in year 1) all x 100
- —Inflation rate is 71 percent - in 2018, GDP deflator rose from 171 to 240 = 240 (100 x (240-171/171) = 40% = inflation rate is 40 percent
GDP facts
- Real GDP grows over time - the output of goods and services produced in the US has grown about 3% each year
- GDP growth is not steady - upward climb of GDP is interrupted by periods which GDP declines, called recessions
—-Much of macroeconomics aims to explain long run growth and short-run fluctuations in real GDP
GDP measures economy’s total output - labor productivity measures output per unit of labor input - if GDP is measured incorrectly, so is productivity
Is GDP a good measure of economic well-being??
- —GDP per person tells us the income and expenditure of the average person in the economy
- —Argue “GDP measures everything, in short, except that which makes life worthwhile and it can tell us everything about America except why we are proud that we are Americans” - doesn’t measure education quality, health, joy, beauty of poetry, strength of marriages, intelligence of public debates, integrity, courage, wisdom, or devotion to country
- —Does not tell but it can help improve - does not measure health, but nations with large GDP can afford better healthcare, better educational systems - GDP does not measure those things directly but it does measure our ability to obtain many of the inputs for a worthwhile life
- —Also does not include leisure - GDP excludes almost all activity that takes place outside markets
- —One approach is to enhance GDP with other objective factors (inequality, leisure and life expectancy)
- —One way to gauge usefulness of GDP as a measure economic well-being is to examine international data (can compare other countries GDP with their standard of living and look for a correlation)
Production and Growth intro
—People in richer countries have better nutrition, safer housing, better healthcare and longer life expectancy - also more automobiles, telephones, computers
—In US, standard of living changes - GDP increased per person by 2% per year
—GDP measures total income and total expenditure on economy’s output of goods/services
◦ Real GDP is good gauge of economic prosperity and growth of real GDP is good gauge of economic progress
—-Look at international GDP - then productivity (amt. of goods/services produced for each hour of worker’s time) - SEE THAT NATION’S STANDARD OF LIVING IS DETERMINED BY THE PRODUCTIVITY OF ITS WORKERS - consider link btwn productivity and nation’s economic policies
Productivity
Productivity - explains why living standards vary so much around the world
—-Daniel Defoe - novel: Robinson Crusoe - if Crusoe good at catching fish, growing food, making clothes = lives well - if bad he lives poorly - he consumers what he produces and his living standard is tied to his productivity - productivity is key determinant
—John D. Rockefeller richest man in history - but lived without planes, air conditioning, washing machine, cell phone - who is better off?
• Standard price indexes - used to compare sums of money from diff. points in time - fail to fully reflect the introduction of new good in the economy - result = inflation is overestimation - also rate of real economic growth is underestimated
• Productivity - the quantity of goods and services produced from each unit of labor input
◦ GDP shows that economy’s income is the economy’s output - in order to enjoy a high standard of living, it must produce a large quantity of goods and services
◦ Ten principles of economics: country’s standard of living depends on its ability to produce goods and services
How productivity is determined
4 determinants of productivity = physical capital, human capital, natural resources, tech. knowledge
- Physical capital (productivity)
- Physical capital per worker - the stock of equipment and structures that are used to produce goods and services (or just capital)
◦ More productive if they have tools to work with (more tools = quicker and more accurate output)
◦ Inputs used to produce goods and services = factors of production (labor, capital) - important feature of capital is that it is a PRODUCED factor of production (capital is an input into the production process that in the past was an output from the production process
- Human capital (productivity)
- Human capital per worker - the knowledge and skills that workers acquire through education, training and experience
◦ Includes skills from childhood programs, elementary, high school, college, on the job training
◦ Human capital raises nation’s ability to produce goods and services - like physical capital, human capital is a produced factor of production
◦ Producing human capital requires inputs in the form of teachers, libraries and student time
◦ Students can be viewed as “workers” with imp. Job of producing capital that will be used in future production
- Natural resources (productivity)
- Natural resources per worker - inputs into the production of goods and services that are provided by nature, such as land, rivers and mineral deposits
◦ Two forms:- Renewable resources - forest (when one tree is cut down, seed can be planted and harvested in the future)
- Nonrenewable resources - oil (oil is produced by nature over millions of years, limited supply) - once depleted, impossible to create more
◦ Important to inc. standard of living but not necessary for highly productive economy (Japan has few natural resources but is one of the richest countries in the world - international trade makes success possible)
- Technological knowledge (productivity)
- Technological knowledge - society’s understanding of the best ways to produce goods and services
◦ Many forms:- Common knowledge: after one person uses it, everyone becomes aware of it (Henry Ford assembly line)
- Proprietary - it is known only by the company that discovers it (Coca-Cola is only one who knows secret recipe)
• Often proprietary for only a short time - new drugs have patent, temporary right - when patent expires, other companies have opportunity
◦ Diff. than Human capital - tech. knowledge refers to society’s understanding about how world works - human capital refers to resources expended in transmitting this understanding to the labor force
• Tech. knowledge is quality of society’s textbooks and human capital is amt. of time the population has devoted to reading them
The production function
Describes the relationship btwn the quantity of inputs used in production and the quantity of output from production
Y = AF(L, K, H, N)…..Y: quantity of output, L: Q of labor, K: Q of physical capital, H: Q of human capital, N: W of natural resources –> F() is function that shows how inputs are combined to produce output - A: variable that reflects the available production technology (as tech. improves, A rises and economy produces more output from any given combination of inputs)
◦ Many production functions have property called constant returns to scale - means doubling all inputs causes the amt. of output to double as well
◦ Written as: xY = AF(xL, xK, xH, xN) (For any positive number x)
• If x=2, doubling right side means doubling output on left side
◦ X= 1/L —–> Y/L = AF(1,K/L, H/L, N/L) - Y/L is output per worker (measure of productivity)
• Shows that labor productivity depends on physical capital per worker (K/L), human capital per worker (H/L) and natural resources per worker (N/L) - productivity also depends on the state of tech. shown by A
Quiz productivity - which would lead to an increase in productivity?
Subsidizing research and development into new weaving technologies - encouraging saving by allowing workers to set aside a portion of their earnings in tax-free retirement accounts
Economic growth and public policy
what can the gov. do to increase productivity?
—9 things
- saving and investment (inc. productivity)
Bc capital is a produced factor of production, a society can change the amt. of capital it has - One way is to invest more current resources in the production of capital
• Tradeoff - scarce resources - devote more resources to produce capital means fewer resources to produce goods and services for current consumption (to invest more in capital, must consume less and save more of its current income)
• Gov. can encourage saving and investment to encourage growth in long run
- Diminishing returns and the catch-up effect (inc. productivity)
If nation saves more, fewer resources needed to make consumption goods and more available to make capital goods - result = capital stock increases, leading to rising productivity and more rapid growth in GDP - how long does growth last?
Diminishing returns - property whereby the benefit from an extra unit of an input declines as the quantity of the input increases
• Means when workers already have a large Q of capital to use in production…giving them an additional unit of capital increases their productivity only slightly
• Gets flatter bc of diminishing returns to capital - bc of this, an increase in saving rate leads to higher growth only for a while - benefits get smaller over time
• (IMP!!!)In long run, the higher saving rate leads to a higher level of productivity and income but not to a higher growth in these variables - but takes a while…inc. saving rate can lead to a substantially higher growth for a period of decades
Catch-up effect - property whereby countries that start off poor tend to grow more rapidly than countries that start off rich
• Small amounts of capital investment can substantially raise these workers productivity - poor countries ten to grow faster than rich countries
• Some time, US and South Korea shared similar share of GDP - but US experience mediocre growth of about 2% and Korea experienced spectacular growth of more than 6% - shows the catch-up effect
- Investment from abroad (IP)
Policies aimed at increasing a country’s saving rate can increase investment and therefore long-term economic growth - other way besides saving by domestic residents is investment by foreigners
- Foreign direct investment - a capital investment that is owned and operated by a foreign entity (Ford building a car factory in Mexico)
- Foreign portfolio investment - an investment that is financed with foreign money but operated by domestic residents (an American buying a share of stock in a Mexican corporation
—-In both cases - Americans provide the resources necessary to increase the stock of capital in Mexico - American saving is being used to finance Mexican investment - invest bc expect to earn a return on their investment
◦ Investment from abroad does not have the same effect on all measures of economic prosperity
• GDP is income earned within a country by both residents and nonresidents
• GNP gross national product is income earned by residents of a country both at home and abroad
• When Ford opens its car factory in Mexico, some of the income accrues to people who do not lives in Mexico - as a result - foreign investment in Mexico raises income of Mexicans (measured by GNP) by less than it raises the production in Mexico (GDP)
• Much of income goes back to foreign owners…but investment does increase economy’s stock of capital, leading to higher productivity and higher wages
▪ Also teaches poor countries new tech. used in richer countries
▪ Often to invest abroad - requires removing restrictions gov. have imposed on foreign ownership of domestic capital
- Education (IP)
Education - investment in human capital - is at least as important as investment in physical capital for a country’s long-run economic success
• In US, each year of schooling has raised a person’s wage by an average of about 10%
• Investment in human capital, like investment in Physical capital, has opp. Cost - when students are in school, they forgo wages they could have earned as members of labor force
• Argue human capital conveys positive externalities (one person’s actions effect well being of bystander) - if educated, generate new ideas that benefit everyone as a whole
• Brain drain - one problem facing poor countries - the emigration of many of the most highly educated workers to rich countries, where these workers can enjoy a higher standard of living - those who study abroad may not return home and reduce poor country’s human capital even further
- Health and nutrition (IP)
- Human capital also refers to an investment in people: expenditures that lead to a healthier population - healthier workers are more productive
- Height is an indicator of productivity - if eat more, population gets taller (In Korea, caloric intake increased and average male height rose by 2 inches) - see that taller workers tend to earn more (bc wages reflect productivity)
- Protecting property rights and political stability (IP)
The division of production among many firms allows economy’s factors of production to be used as effectively as possible - economy must coordinate transactions - achieve through market prices (market prices are instrument by which invisible hand brings supply and demand into balance)
Property rights - the ability of people to exercise authority over the resources they own (courts serve an important role in market economy bc they enforce property rights - discourage theft - ensure buyers and sellers live up to their contracts)
◦ In poor countries, fraud and theft go unpunished and gov. fails to protect - corruption impedes the coordinating power of markets - discourages domestic saving and investment from abroad
◦ One threat to property rights is political instability - doubt about respect and protection of property in future - threat of revolution
• Economic prosperity depends in part on political prosperity - country with efficient court system, honest gov. officials and stable constitution have higher economic standard than those with poor court system, corrupt officials, and freq. revolutions
- Free trade (IP)
- INWARD-oriented policies - policies attempt to inc. productivity and living standards within the country by avoiding interaction with the rest of the world
• Domestic firms support the infant-industry argument - claim they need protection from foreign competition to thrive and grow - leads gov. to impose tariffs and trade restrictions - OUTWARD-orientated policies - integrate countries into world economy - most economists believe poor countries are better off pursuing this course
◦ International trade = tech. - through trade exp. Same economic growth from a major tech. advance
- Research and development (IP)
- Primary reason living standards are higher today than a century ago is tech. knowledge
- Knowledge is a public good: once one person discovers an idea, the idea enters society’s pool of knowledge and others can freely use it - gov. has a role in encouraging research and development of new tech.
- Encourage through the patent system - when create new innovative product, can apply for a patent - exclusive property right to invention - public good becomes private good - enhances incentive for research
- Population growth (IP)
Population growth increases the size of the labor force - but also means more people to consumer those goods and services
• Stretching natural resources
◦ Thomas Robert Malthus - argues inc. pop. Will cont. strain society’s ability to provide for itself - mankind doomed to live in poverty - but in reality, as pop. Increased so did economy…bc tech. increased
• Diluting the capital stock
◦ Argue high pop. Reduces GDP per worker bc rapid growth in number of workers forces capital stock to be spread more thinly - each worker has less capital - leads to lower productivity (human capital - harder in schools)
◦ Many poor countries are experiencing rapid pop. Growth
• Promoting tech. progress
◦ Rapid pop. Growth may depress economic prosperity by reducing the amt. of capital each worker has, but it may also have benefits
• Engine of tech. progress and economic prosperity - more people = more scientists, inventors, engineers to contribute to tech. advance
• Large pop. Is a prerequisite for tech. advance
Conclusion productivity
Conclusion: the importance of long-run growth
• “a country’s standard of living depends on its ability to produce goods and services” - increase nation’s productive ability by encouraging rapid accumulation of factors of production and ensuring these factors are employed as effectively as possible
QUIZ - which of the following policies are consistent with the goal of increasing productivity and growth in developing countries?
Protecting property rights and enforce contracts (NOT pursuing inward-oriented policies, imposing restrictions on foreign ownership of domestic capital, increasing taxes on income from savings)
QUIZ - Which are possible outcomes of rapid population growth?
A reduction in human capital per worker, a reduction in capital per worker, an increase in tech. knowledge (all of the above)
when MC is < ATC
ATC is falling
when MC > ATC - ATC is rising
so if ATC is 25 and MC is 15 and increase production by 1 unit…ATC will decrease
