Mba1014 perfect competition 180513

Go Global !Go Global !Managerial Economics :Managerial Economics :Perfect CompetitionPerfect Competition

By

Stephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management, Visiting Professor, College of Management,

Shenzhen UniversityShenzhen UniversityMay 2013May 2013

AgendaAgenda

1.1. Market TypesMarket Types

2.2. Profit MaximisationProfit Maximisation

3.3. Market EfficiencyMarket Efficiency

Learning ObjectivesLearning Objectives

To understand the four market typesTo understand the four market types

To compare the degree of price To compare the degree of price competition among the four market competition among the four market typestypes

To explain why the P=MC rule leads To explain why the P=MC rule leads firms to the optimal level of productionfirms to the optimal level of production

To explain how the MR=MC rule helps a To explain how the MR=MC rule helps a monopoly to determine its optimummonopoly to determine its optimum

To explain the relationship between To explain the relationship between the MR=MC rule and the P=MC rulethe MR=MC rule and the P=MC rule

To describe what happens in the long To describe what happens in the long runrun

11Market TypesMarket Types

OverviewOverview

Competition and market Competition and market typestypes

Pricing and output decisions Pricing and output decisions in perfect competitionin perfect competition

Implications for managerial Implications for managerial decisionsdecisions

Market StructureMarket Structure

CharacteristicCharacteristic

PerfectPerfect

CompetitionCompetition

MonopolisticMonopolistic

CompetitionCompetition OligopolyOligopoly MonopolyMonopoly

Number of firms Number of firms competingcompeting Large numberLarge number Large numberLarge number Small numberSmall number Single firmSingle firm

Nature of the Nature of the productproduct UndifferentiatedUndifferentiated DifferentiatedDifferentiated Undifferentiated Undifferentiated

or differentiatedor differentiated UniqueUnique

EntryEntry No barriersNo barriers Few barriersFew barriers Many barriersMany barriers BlockedBlocked

Information Information availabilityavailability CompleteComplete Relatively goodRelatively good AsymmetricAsymmetric AsymmetricAsymmetric

Firm’s control Firm’s control over priceover price NoneNone SomeSome SomeSome SubstantialSubstantial

Market type 1: Perfect competitionMarket type 1: Perfect competition

No market powerNo market powerlarge number of relatively small large number of relatively small buyers and sellersbuyers and sellers

standardized productstandardized productvery easy market entry and exitvery easy market entry and exitNon-price competition not Non-price competition not possiblepossible

Four market typesFour market types

ExamplesExamples: Perfect Competition: Perfect Competition

agricultural productsagricultural products

financial instrumentsfinancial instruments

precious metalsprecious metals

petroleumpetroleum

Absolute market power, Absolute market power, subject to government subject to government regulationregulationone firm, firm is the industryone firm, firm is the industryunique product or no close unique product or no close substitutessubstitutesmarket entry and exit difficult or market entry and exit difficult or legally impossiblelegally impossibleNon-price competition not Non-price competition not necessarynecessary

Market type 2: MonopolyMarket type 2: Monopoly


ExamplesExamples: Monopoly: Monopoly

pharmaceuticalspharmaceuticals

MicrosoftMicrosoft

gas station on edge of gas station on edge of desertdesert

Market power based on product Market power based on product

differentiation differentiation large number of small firms acting large number of small firms acting

independentlyindependentlydifferentiated productdifferentiated productmarket entry and exit relatively market entry and exit relatively

easyeasyNon-price competition very Non-price competition very

importantimportant

Market type 3: Market type 3: MonopolisticMonopolistic CompetitionCompetition


ExamplesExamples: Monopolistic Competition: Monopolistic Competition

boutiquesboutiques

restaurantsrestaurants

repair shopsrepair shops

Product differentiation Product differentiation and/or the firm’s and/or the firm’s dominance of the marketdominance of the market

small number of large mutually small number of large mutually interdependent firmsinterdependent firms

differentiated or standardized differentiated or standardized productproduct

market entry and exit difficultmarket entry and exit difficult Non-price competition importantNon-price competition important

Market type 4: OligopolyMarket type 4: Oligopoly

Four market typesFour market typesExamplesExamples: oligopoly: oligopoly

oil refiningoil refining

processed foodsprocessed foods

airlinesairlines

internet accessinternet access

Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.15

Four market types

22Profit MaximisationProfit Maximisation

Perfectly Competitive MarketsPerfectly Competitive MarketsPRICE TAKINGPRICE TAKINGBecause Because each individual firm sells a sufficiently small each individual firm sells a sufficiently small proportion of total market output, its decisions have no proportion of total market output, its decisions have no impact on market price.impact on market price.

Price takerPrice taker Firm that has no influence over market price and thus Firm that has no influence over market price and thus takes the price as given.takes the price as given.

PRODUCT HOMOGENEITYPRODUCT HOMOGENEITYWhenWhen the products of all of the firms in a market are the products of all of the firms in a market are perfectly substitutable with one another—that is, perfectly substitutable with one another—that is, when they when they areare homogeneous homogeneous—no firm can raise the price of its product —no firm can raise the price of its product above the price of other firms without losing most or all of its above the price of other firms without losing most or all of its business. In contrast, when products are heterogeneous, business. In contrast, when products are heterogeneous, each firm has the opportunity to raise its price above that of each firm has the opportunity to raise its price above that of its competitors without losing all of its sales.its competitors without losing all of its sales.The assumption of product homogeneity is important because The assumption of product homogeneity is important because it ensures that there is a single market price, consistent with it ensures that there is a single market price, consistent with supply-demand analysis.supply-demand analysis.

FREE ENTRY AND EXITFREE ENTRY AND EXITFree entry (or exit) Free entry (or exit) Condition under which there are no special Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry.costs that make it difficult for a firm to enter (or exit) an industry.

When Is a Market Highly Competitive?Many markets are highly competitive in the sense that Many markets are highly competitive in the sense that firms face highly elastic demand curves and relatively firms face highly elastic demand curves and relatively easy entry and exit. But there is no simple rule of thumb easy entry and exit. But there is no simple rule of thumb to describe whether a market is close to being perfectly to describe whether a market is close to being perfectly competitive. Because firms can implicitly or explicitly competitive. Because firms can implicitly or explicitly

collude in setting pricescollude in setting prices, the presence of many firms , the presence of many firms is not sufficient for an industry to approximate perfect is not sufficient for an industry to approximate perfect competition. Conversely, the presence of only a few firms competition. Conversely, the presence of only a few firms in a market does not rule out competitive behaviour.in a market does not rule out competitive behaviour.

With free entry and exitWith free entry and exit, buyers can easily switch from , buyers can easily switch from one supplier to another, and suppliers can easily enter or one supplier to another, and suppliers can easily enter or exit a market.exit a market.

Profit MaximisationProfit MaximisationDo Firms Maximise Profit?

The assumption of The assumption of profit maximisation profit maximisation is is frequently used in microeconomics because it frequently used in microeconomics because it predicts business behaviour reasonably predicts business behaviour reasonably accurately and avoids unnecessary analytical accurately and avoids unnecessary analytical complications. complications.

For For smaller firms managed by their owners, smaller firms managed by their owners, profit profit is likely to dominate almost all decisions. is likely to dominate almost all decisions. In larger firms, however, managers who make In larger firms, however, managers who make day-to-day decisions usually have little contact day-to-day decisions usually have little contact with the owners.with the owners.

Firms that do not come close to maximising Firms that do not come close to maximising profit are not likely to survive. The firms that do profit are not likely to survive. The firms that do survive make long-run profit maximisation one survive make long-run profit maximisation one of their highest priorities.of their highest priorities.

While owners of condominiums must join with fellow condo owners While owners of condominiums must join with fellow condo owners to manage common, they can make their own decisions as to how to to manage common, they can make their own decisions as to how to manage their individual units. In contrast, co-ops share joint liability manage their individual units. In contrast, co-ops share joint liability on any outstanding mortgage on the co-op building and are subject on any outstanding mortgage on the co-op building and are subject to more complex governance rules.to more complex governance rules.

Nationwide, condos are far more common than co-ops, Nationwide, condos are far more common than co-ops, outnumbering them by a factor of nearly 10 to 1. In this regard, New outnumbering them by a factor of nearly 10 to 1. In this regard, New York City is very different from the rest of the nation—co-ops are York City is very different from the rest of the nation—co-ops are more popular, and outnumber condos by a factor of about 4 to 1.more popular, and outnumber condos by a factor of about 4 to 1.

Many building restrictions in New York have long disappeared, and Many building restrictions in New York have long disappeared, and yet the conversion of apartments from co-ops to condos has been yet the conversion of apartments from co-ops to condos has been relatively slow. The typical condominium apartment is worth about relatively slow. The typical condominium apartment is worth about

15.5 percent more 15.5 percent more than a equivalent apartment held in the than a equivalent apartment held in the form of a co-op. Clearly, holding an apartment in the form of a co-op form of a co-op. Clearly, holding an apartment in the form of a co-op is not the best way to maximize the apartment’s value.is not the best way to maximize the apartment’s value.

It appears that in New York, many owners have been willing to forgo It appears that in New York, many owners have been willing to forgo

substantial amounts of money in order to substantial amounts of money in order to achieve non-achieve non-monetary benefits.monetary benefits.

CONDOMINIUMS VERSUS COOPERATIVES IN CONDOMINIUMS VERSUS COOPERATIVES IN NEW YORK CITYNEW YORK CITY

Marginal Revenue, Marginal Cost,Marginal Revenue, Marginal Cost,and Profit Maximisationand Profit MaximisationProfit : Profit : Difference between total revenue and total cost.Difference between total revenue and total cost.

π(π(q) = R(q) − C(q)q) = R(q) − C(q)

Marginal revenue : Marginal revenue : Change in revenue resulting from a one-unit increase Change in revenue resulting from a one-unit increase in output.in output.

A firm chooses output A firm chooses output qq*, so *, so that profit, the difference that profit, the difference ABAB between revenue between revenue RR and cost and cost CC, , is maximized. is maximized.

At that output, marginal At that output, marginal revenue (the slope of the revenue (the slope of the revenue curve) is equal to revenue curve) is equal to marginal cost (the slope of the marginal cost (the slope of the cost curve).cost curve).Δπ/ΔΔπ/Δqq = = ΔΔRR//ΔΔqq − − ΔΔC/C/ΔΔqq = 0 = 0

MR(MR(qq) = MC() = MC(qq))

PROFIT MAXIMIZATON PROFIT MAXIMIZATON IN THE SHORT RUNIN THE SHORT RUN

Demand and Marginal Revenue for a Demand and Marginal Revenue for a Competitive FirmCompetitive Firm

A competitive firm supplies only a small portion of the total output of all A competitive firm supplies only a small portion of the total output of all the firms in an industry. Therefore, the firm takes the market price of the the firms in an industry. Therefore, the firm takes the market price of the product as given, choosing its output on the assumption that the price product as given, choosing its output on the assumption that the price will be unaffected by the output choice. In (a) the demand curve facing will be unaffected by the output choice. In (a) the demand curve facing the firm is perfectly elastic, the firm is perfectly elastic, even though the market demand even though the market demand curve in curve in (b) (b) is downward sloping.is downward sloping.

DEMAND CURVE FACED BY A COMPETITIVE FIRMDEMAND CURVE FACED BY A COMPETITIVE FIRM

The demand curve The demand curve d d facing an individual firm in a facing an individual firm in a competitive market is both its average revenue curve competitive market is both its average revenue curve and its marginal revenue curve. Along this demand and its marginal revenue curve. Along this demand curve, marginal revenue, average revenue, and price curve, marginal revenue, average revenue, and price are all equal.are all equal.

Profit Maximization by a Competitive FirmProfit Maximization by a Competitive Firm

MC(MC(q) = q) = MRMR = P = P

Because each firm in a competitive industry sells only a Because each firm in a competitive industry sells only a small fraction of the entire industry output, small fraction of the entire industry output, how much how much output the firm decides to sell will have no effect on the output the firm decides to sell will have no effect on the market price of the product.market price of the product.Because it is a price takerBecause it is a price taker, the demand curve d facing an , the demand curve d facing an individual competitive firm is given by a horizontal line.individual competitive firm is given by a horizontal line.

A perfectly competitive firm should choose its A perfectly competitive firm should choose its output so that output so that marginal cost equals pricemarginal cost equals price::

Short-Run Profit Maximisation by a Competitive FirmShort-Run Profit Maximisation by a Competitive FirmA COMPETITIVE A COMPETITIVE FIRM MAKING A FIRM MAKING A POSITIVE PROFITPOSITIVE PROFIT

In the short run, the In the short run, the competitive firm competitive firm maximises its profit by maximises its profit by choosing an output choosing an output q* q* at at which its marginal cost which its marginal cost MC is equal to the price MC is equal to the price PP (or marginal revenue (or marginal revenue MR) of its product. MR) of its product. The profit of the firm is The profit of the firm is measured by the measured by the rectangle rectangle ABCDABCD. . Any change in output, Any change in output, whether lower at whether lower at qq11 or or

higher at higher at qq22, will lead to , will lead to

lower profit.lower profit.

Output Rule: If a firm is producing Output Rule: If a firm is producing any output, it should produce at the any output, it should produce at the level at which marginal revenue level at which marginal revenue equals marginal cost.equals marginal cost.

Choosing Output in the Short RunChoosing Output in the Short Run

Model of Perfect CompetitionModel of Perfect Competition

A A large number large number of firms in of firms in the marketthe market

An An undifferentiated productundifferentiated productEase of entry into the market Ease of entry into the market

or or no barriers to entryno barriers to entryComplete informationComplete information

available to all market available to all market participantsparticipants

Model of the Industry and Model of the Industry and the Firmthe Firm

S

D

Q

P

QE

PE

MC

ATC

D = P = MR

Q*

P

Q

Pricing and output decisionsPricing and output decisions in perfect competition in perfect competition

Basic business decision: entering a Basic business decision: entering a market using the following questions:market using the following questions:

how much should we how much should we produceproduce??if we produce such an amount, how if we produce such an amount, how

much much profitprofit will we earn? will we earn?if a loss rather than a profit is if a loss rather than a profit is

incurred, will it be worthwhile to incurred, will it be worthwhile to continue in this market in the long continue in this market in the long run (in hopes that we will eventually run (in hopes that we will eventually earn a profit) or should we earn a profit) or should we exit?exit?


Key assumptions of the perfectly Key assumptions of the perfectly competitive market:competitive market:

the firm is a the firm is a price takerprice taker the firm makes the distinction between the firm makes the distinction between

the short run and the long runthe short run and the long run the firm’s objective is to the firm’s objective is to maximize its maximize its

profitprofit (or minimize loss) in the short (or minimize loss) in the short runrun

the firm includes its the firm includes its opportunity cost opportunity cost of operating in a particular market as of operating in a particular market as part of its total cost of productionpart of its total cost of production


Perfectly elastic demand Perfectly elastic demand curvecurve: : consumers are willing consumers are willing to buy as much as the firm is to buy as much as the firm is willing to sell at the going willing to sell at the going market pricemarket price

firm receives the same firm receives the same marginal revenue from the sale marginal revenue from the sale of each additional unit of of each additional unit of

product; product; equal to the price equal to the price of the productof the product

no limit to the total no limit to the total revenue revenue that the firm can that the firm can gain in a perfectly competitive gain in a perfectly competitive marketmarket


Total revenue/Total cost Total revenue/Total cost approach:approach:

compare the total revenue and total compare the total revenue and total cost schedules and find the cost schedules and find the level of level of outputoutput that either maximizes the that either maximizes the firm’s profits or minimizes its lossfirm’s profits or minimizes its loss

Profit Maximizing Level of Profit Maximizing Level of OutputOutput

Profit is the Profit is the difference between difference between total revenue and total revenue and total cost:total cost:

π = π = TR TR - - TCTCwherewhere

π = profitπ = profit

TR =TR = total revenue total revenue

TC =TC = total cost total cost

To maximize profits, To maximize profits, a firm should a firm should produce the level of produce the level of output where output where marginal revenue marginal revenue equals marginal cost.equals marginal cost.

MR = MCMR = MCwherewhere

MR = MR = ΔTR / ΔQΔTR / ΔQ

MC = MC = ΔTC / ΔQΔTC / ΔQ


Marginal revenue/Marginal cost Marginal revenue/Marginal cost approachapproach

produce a level of output at which the produce a level of output at which the additional revenue received from the last additional revenue received from the last unit is equal to the additional cost of unit is equal to the additional cost of

producing that unit (ie. producing that unit (ie. MR=MCMR=MC))

Note: for the perfectly competitive firm, the Note: for the perfectly competitive firm, the

MR=MC rule may be restated as MR=MC rule may be restated as P=MCP=MC because P=MR in perfectly competitive because P=MR in perfectly competitive marketmarket

Marginal RevenueMarginal RevenueThe marginal The marginal

revenue curve for revenue curve for the perfectly the perfectly competitive firm is competitive firm is horizontal because horizontal because the firm can sell all the firm can sell all units of output at units of output at the market price the market price therefore therefore price price equals marginal equals marginal revenuerevenue for the for the perfectly competitive perfectly competitive firm.firm.

$

Q

P = MR


Case A: Case A: Economic Economic profitprofit

The point where The point where P=MR=MCP=MR=MC is the is the optimal output (Q*)optimal output (Q*)

profit = TR – TCprofit = TR – TC

= (P - AC) = (P - AC) xx Q*Q*


Case B: Case B: Economic Economic lossloss

The firm incurs a loss. The firm incurs a loss. At optimum output, At optimum output,

price is below ACprice is below AC however, sincehowever, since

P>AVCP>AVC, the firm is , the firm is better off producing better off producing in the short run, in the short run, because it will still because it will still incur fixed costs incur fixed costs greater than the lossgreater than the loss


Contribution margin: Contribution margin: the amount by which the amount by which total revenue total revenue exceeds total exceeds total variable costvariable cost

CM = TR – TVCCM = TR – TVC if CM > 0, the firm if CM > 0, the firm

should continue to should continue to produce in the short produce in the short run in order to defray run in order to defray some of the fixed some of the fixed costcost

Calculation of ProfitCalculation of Profit

ππ = = TR TR - - TCTC

π = (π = (PP)()(QQ) - () - (ATCATC)()(QQ))

π = (π = (P P - - ATCATC)()(QQ), ), thereforethereforeIf If P >P > ATC, ATC, π > 0π > 0

If If P <P < ATC, ATC, π < 0π < 0

If If P P = = ATC, ATC, π = 0π = 0

Shutdown Point for a Shutdown Point for a Perfectly Competitive FirmPerfectly Competitive Firm

The price, which The price, which equals a firm’s equals a firm’s minimum minimum average variable average variable costcost, below which , below which it is more profitable it is more profitable for the perfectly for the perfectly competitive firm to competitive firm to shut down than to shut down than to continue to continue to produce.produce.

MC ATC

AVC

Psd


Shutdown point: Shutdown point: the lowest price at the lowest price at which the firm would still producewhich the firm would still produce

At the shutdown point, the price is At the shutdown point, the price is equal to the minimum point on the AVCequal to the minimum point on the AVC

P=min(AVC)P=min(AVC) If the price falls below the shutdown If the price falls below the shutdown

point, revenues fail to cover the fixed point, revenues fail to cover the fixed costs and the variable costs. The firm costs and the variable costs. The firm would be better off if it shut down and would be better off if it shut down and just paid its fixed costsjust paid its fixed costs

When Should the Firm Shut When Should the Firm Shut Down?Down?

A COMPETITIVE A COMPETITIVE FIRM INCURRING FIRM INCURRING LOSSESLOSSES

A competitive firm A competitive firm should shut down if should shut down if price is below AVC.price is below AVC.

The firm may The firm may produce in the short produce in the short run if price is run if price is greater than greater than average variable average variable cost.cost.

THE SHORT-RUN OUTPUT OF AN THE SHORT-RUN OUTPUT OF AN ALUMINUM SMELTING PLANTALUMINUM SMELTING PLANT

THE SHORT-RUN OUTPUT DECISION OF AN ALUMINUM SMELTING PLANTHow should the manager determine the plant’s How should the manager determine the plant’s profit maximizing output? Recall that the smelting profit maximizing output? Recall that the smelting plant’s short-run marginal cost of production plant’s short-run marginal cost of production depends on whether it is running two or three depends on whether it is running two or three shifts per day.shifts per day.

In the short run, the plant should In the short run, the plant should produce 600 tons per day if price produce 600 tons per day if price is above $1140 per ton but less is above $1140 per ton but less than $1300 per ton. than $1300 per ton.

If price is greater than $1300 per If price is greater than $1300 per ton, it should run an overtime shift ton, it should run an overtime shift and produce 900 tons per day. and produce 900 tons per day.

If price drops below $1140 per ton, If price drops below $1140 per ton, the firm should stop producing, the firm should stop producing, but it should probably stay in but it should probably stay in business because the price may business because the price may rise in the future.rise in the future.

The application of the rule that marginal revenue should equal marginal cost The application of the rule that marginal revenue should equal marginal cost depends on a manager’s ability to estimate marginal cost. depends on a manager’s ability to estimate marginal cost.

1.1.First, except under limited circumstances, First, except under limited circumstances, average variable cost average variable cost should not be used as a substitute for marginal costshould not be used as a substitute for marginal cost..

SOME COST CONSIDERATIONS FOR MANAGERSSOME COST CONSIDERATIONS FOR MANAGERS

Current outputCurrent output 100 units per day, 80 of which are produced during the regular shift 100 units per day, 80 of which are produced during the regular shift and 20 of which are produced during overtimeand 20 of which are produced during overtime

Materials costMaterials cost $8 per unit for all output$8 per unit for all output

Labor costLabor cost $30 per unit for the regular shift; $50 per unit for the overtime shift$30 per unit for the regular shift; $50 per unit for the overtime shift

For the first 80 units of output, average variable cost and For the first 80 units of output, average variable cost and marginal cost are both equal to $38 per unit. When output marginal cost are both equal to $38 per unit. When output increases to 100 units, marginal cost is higher than average increases to 100 units, marginal cost is higher than average variable cost, so a manager who relies on average variable cost variable cost, so a manager who relies on average variable cost will produce too much.will produce too much.

2.2.Also, a single item on a firm’s accounting ledger may have two Also, a single item on a firm’s accounting ledger may have two components, only one of which involves components, only one of which involves marginal costmarginal cost..3.3.Finally, all Finally, all opportunity costs opportunity costs should be included in determining should be included in determining marginal cost. marginal cost. These three guidelines can help a manager to measure marginal These three guidelines can help a manager to measure marginal cost correctly. Failure to do so can cause production to be too cost correctly. Failure to do so can cause production to be too high or too low and thereby reduce profit.high or too low and thereby reduce profit.

Supply Curve for the Supply Curve for the Perfectly Competitive FirmPerfectly Competitive Firm

The portion of a The portion of a firm’s marginal cost firm’s marginal cost curve that lies curve that lies above the minimum above the minimum average variable average variable cost.cost.

$

Q

SRATC

SRAVC

SRS =MC

The Competitive Firm’s Short-run The Competitive Firm’s Short-run Supply CurveSupply Curve

THE SHORT-RUN THE SHORT-RUN SUPPLY CURVE FOR A SUPPLY CURVE FOR A COMPETITIVE FIRMCOMPETITIVE FIRM

The firm’s supply curve is The firm’s supply curve is the portion of the marginal the portion of the marginal cost curve for which marginal cost is greater than cost curve for which marginal cost is greater than average variable cost.average variable cost.

In the short run, the firm In the short run, the firm chooses its output so chooses its output so that marginal cost MC is that marginal cost MC is equal to price as long equal to price as long as the firm covers its as the firm covers its average variable cost. average variable cost.

The short-run supply The short-run supply curve is given by the curve is given by the crosshatched portion of crosshatched portion of the marginal cost curve.the marginal cost curve.

THE RESPONSE OF A THE RESPONSE OF A FIRM TO A CHANGE IN FIRM TO A CHANGE IN INPUT PRICEINPUT PRICE

When the marginal When the marginal cost of production cost of production for a firm increases for a firm increases (from MC(from MC11 to MC to MC22),),

the level of output the level of output that maximizes that maximizes profit falls (from profit falls (from qq11

to to qq22).).

The Firm’s Response to an Input Price The Firm’s Response to an Input Price ChangeChange

THE SHORT-RUN THE SHORT-RUN PRODUCTION OF PRODUCTION OF PETROLEUM PRODUCTSPETROLEUM PRODUCTS

THE SHORT-RUN P RODUCTION OFTHE SHORT-RUN P RODUCTION OFPETROLEUM PRODUCTSPETROLEUM PRODUCTS

Although plenty of crude oil is available, Although plenty of crude oil is available, the amount that you refine depends on the amount that you refine depends on the capacity of the refinery and the cost of the capacity of the refinery and the cost of production.production.

As the refinery shifts from As the refinery shifts from one processing unit to one processing unit to another, the marginal cost another, the marginal cost of producing petroleum of producing petroleum products from crude oil products from crude oil increases sharply at several increases sharply at several

levels of output. levels of output. As a result, the output level As a result, the output level can be insensitive to some can be insensitive to some changes in price but very changes in price but very sensitive to others.sensitive to others.

The Short-Run Market Supply CurveThe Short-Run Market Supply CurveINDUSTRY SUPPLY IN INDUSTRY SUPPLY IN THE SHORT RUNTHE SHORT RUN

The short-run industry The short-run industry supply curve is the supply curve is the summation of the supply summation of the supply curves of the individual curves of the individual firms.firms.

Because the third firm has a Because the third firm has a lower average variable cost lower average variable cost curve than the first two curve than the first two firms, the market supply firms, the market supply curve curve SS begins at price begins at price PP11

and follows the marginal and follows the marginal cost curve of the third firm cost curve of the third firm MCMC33 until price equals until price equals PP22, ,

when there is a kink. when there is a kink.

For For PP22 and all prices above and all prices above

it, the industry quantity it, the industry quantity supplied is the sum of the supplied is the sum of the quantities supplied by each quantities supplied by each of the three firms.of the three firms.

Elasticity of Market SupplyElasticity of Market Supply

EEss = = ((ΔΔQQ//QQ)/()/(ΔΔPP//PP))

THE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPERCosts of mining, smelting, and refining copper differ Costs of mining, smelting, and refining copper differ because of differences in labour and transportation costs because of differences in labour and transportation costs and because of differences in the copper content of the and because of differences in the copper content of the ore.ore.

TABLE 1 TABLE 1 THE WORLD COPPER INDUSTRY (2010)THE WORLD COPPER INDUSTRY (2010)

COUNTRYCOUNTRYANNUAL PRODUCTION ANNUAL PRODUCTION (THOUSAND METRIC (THOUSAND METRIC

TONS)TONS)

MARGINAL COST MARGINAL COST (DOLLARS PER (DOLLARS PER

POUND)POUND)

AustraliaAustralia 900900 2.302.30

CanadaCanada 480480 2.602.60

ChileChile 5,5205,520 1.601.60

IndonesiaIndonesia 840840 1.801.80

PeruPeru 12851285 1.701.70

PolandPoland 430430 2.402.40

RussiaRussia 750750 1.301.30

USUS 11201120 1.701.70

ZambiaZambia 770770 1.501.50

THE SHORT-RUN WORLD THE SHORT-RUN WORLD SUPPLY OF COPPERSUPPLY OF COPPER

THE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPERThe world supply curve is obtained by summing each nation’s The world supply curve is obtained by summing each nation’s supply curve horizontally. The elasticity of supply depends on the supply curve horizontally. The elasticity of supply depends on the price of copper. At relatively low prices, the curve is quite elastic price of copper. At relatively low prices, the curve is quite elastic because small price increases lead to large increases in the because small price increases lead to large increases in the quantity of copper supplied. At higher prices—say, above $2.40 per quantity of copper supplied. At higher prices—say, above $2.40 per pound—the curve becomes more inelastic because, at those prices, pound—the curve becomes more inelastic because, at those prices, most producers would be operating close to or at capacity.most producers would be operating close to or at capacity.

The supply curve for world The supply curve for world copper is obtained by copper is obtained by summing the marginal cost summing the marginal cost curves for each of the major curves for each of the major copper-producing countries. copper-producing countries.

The supply curve slopes The supply curve slopes upward because the marginal upward because the marginal cost of production ranges cost of production ranges from a low of 65 cents in from a low of 65 cents in Russia to a high of $1.30 in Russia to a high of $1.30 in Canada.Canada.


In the In the lonlong run, the price in the g run, the price in the competitive market will settle at the competitive market will settle at the point where firms earn a point where firms earn a normal normal profitprofit

economic profit economic profit invites entry of new firms invites entry of new firms shifts the supply curve to the right shifts the supply curve to the right puts downward pressure on price and puts downward pressure on price and reduces profitsreduces profits

economic loss economic loss causes exit of firms causes exit of firms shifts shifts the supply curve to the left the supply curve to the left puts upward puts upward pressure on price and increases profitspressure on price and increases profits


Observations in perfectly Observations in perfectly competitive markets:competitive markets:

the earlier the firm enters a market, the better the earlier the firm enters a market, the better its chances of its chances of earning earning above-normal profitabove-normal profit

as new firms enter the market, firms must find as new firms enter the market, firms must find ways to produce at the ways to produce at the lowest possible costlowest possible cost, , or at least at cost levels below those of their or at least at cost levels below those of their competitorscompetitors

firms that find themselves unable to compete on firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of cost might want to try competing on the basis of the basis of product differentiationproduct differentiation instead instead

Implications of perfect Implications of perfect competition for decision makingcompetition for decision making

Perfectly competitive marketPerfectly competitive market

most important lesson is that it is most important lesson is that it is extremely difficult to make moneyextremely difficult to make money

must be as must be as cost efficient cost efficient as possibleas possible

it might pay for a firm to move into a it might pay for a firm to move into a market market before others before others start to enterstart to enter

Global applicationGlobal application

ExampleExample: Bluefin tuna: Bluefin tuna

sushi restaurants operate in sushi restaurants operate in monopolistic competitionmonopolistic competition

bluefin tuna price bluefin tuna price determined by perfect determined by perfect competitioncompetition

low profit marginlow profit margin

33Market EfficiencyMarket Efficiency

Long-Run Adjustment in Long-Run Adjustment in Perfectly Competitive IndustryPerfectly Competitive Industry

An increase in industry demand will An increase in industry demand will result in a result in a positive economic profitpositive economic profit for a for a perfectly competitive firm. perfectly competitive firm.

However, this profit will be competed However, this profit will be competed away by the away by the entry of other firms entry of other firms into into the market in the long run. the market in the long run.

The The zero economic profit zero economic profit point or the point or the point where price equals average total point where price equals average total cost is the equilibrium point for the cost is the equilibrium point for the perfectly competitive firmperfectly competitive firm..

Long-Run Adjustment in Perfectly Long-Run Adjustment in Perfectly Competitive Industry - GraphicalCompetitive Industry - Graphical

D1

D2

S1

S2

PE1

PE2

QE1 QE3QE2

MCATC

D1=P1=MR1

D2=P2=MR2

Q1 Q2

P P

Q Q

Long-Run Adjustment in Perfect Long-Run Adjustment in Perfect Competition: The Optimal Scale Competition: The Optimal Scale of Productionof Production

In the long run, the perfectly In the long run, the perfectly competitive firm has to competitive firm has to choose the optimal scale of choose the optimal scale of operation. This decision, operation. This decision, combined with entry and exit, combined with entry and exit, will force will force price to equal long-price to equal long-run average costrun average cost..

Long-Run Adjustment in Perfect Long-Run Adjustment in Perfect Competition: The Optimal Scale Competition: The Optimal Scale of Production - Graphicalof Production - Graphical

$

Q

SMC1

SMC2

SATC1

SATC2

LRACP1=MR1

P2=MR2

Q1Q2

Long-Run Profit MaximisationLong-Run Profit MaximisationOUTPUT CHOICE OUTPUT CHOICE IN THE LONG RUNIN THE LONG RUN

The firm maximises its The firm maximises its profit by choosing the profit by choosing the output at which price output at which price equals long-run equals long-run marginal cost LMC. marginal cost LMC.

In the diagram, the firm In the diagram, the firm increases its profit from increases its profit from ABCDABCD to to EFGDEFGD by by increasing its output in increasing its output in the long run.the long run.

The long-run output of a profit-maximizing The long-run output of a profit-maximizing competitive firm is the point at which long-run competitive firm is the point at which long-run marginal cost equals the price.marginal cost equals the price.

Choosing Output in the Long RunChoosing Output in the Long Run

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

ACCOUNTING PROFIT AND ECONOMIC PROFITACCOUNTING PROFIT AND ECONOMIC PROFIT

π = π = R − wL − rKR − wL − rKZERO ECONOMIC PROFITA firm is earning a normal return on its investment—i.e., it is doing A firm is earning a normal return on its investment—i.e., it is doing as well as it could by investing its money elsewhere.as well as it could by investing its money elsewhere.

ENTRY AND EXITENTRY AND EXIT

In a market with entry and exit, a firm enters In a market with entry and exit, a firm enters when it can earn a positive long-run profit when it can earn a positive long-run profit and exits when it faces the prospect of a and exits when it faces the prospect of a long-run loss.long-run loss.

Long-run competitive equilibrium Long-run competitive equilibrium All firms in an industry are maximising profit, no firm has an All firms in an industry are maximising profit, no firm has an incentive to enter or exit, and price is such that incentive to enter or exit, and price is such that quantity supplied quantity supplied equals quantity demanded.equals quantity demanded.

When a firm earns zero economic profit, it has no incentive When a firm earns zero economic profit, it has no incentive to exit the industry.to exit the industry.Likewise, other firms have no special incentive to enter. Likewise, other firms have no special incentive to enter. A long-run competitive equilibrium occurs when three A long-run competitive equilibrium occurs when three conditions hold:conditions hold:

1.1.All firms in the industry are All firms in the industry are maximising profit.maximising profit.

2. 2. No firm has an incentive either to enter or exit No firm has an incentive either to enter or exit the industry because all firms are the industry because all firms are earning zero earning zero economic profit.economic profit.

3. 3. The price of the product is such that the The price of the product is such that the quantity supplied by the industry is quantity supplied by the industry is equalequal to the to the quantity demanded by consumers.quantity demanded by consumers.

LONG-RUN COMPETITIVE LONG-RUN COMPETITIVE EQUILIBRIUMEQUILIBRIUM

Initially the long-run equilibrium Initially the long-run equilibrium price of a product is $40 per unit, price of a product is $40 per unit, shown in (b) as the intersection of shown in (b) as the intersection of demand curve demand curve DD and supply curve and supply curve SS11. .

In (a) we see that firms earn In (a) we see that firms earn positive profits because long-run positive profits because long-run average cost reaches a minimum average cost reaches a minimum of $30 (at of $30 (at qq22). ).

Positive profit encourages entry of Positive profit encourages entry of new firms and causes a shift to new firms and causes a shift to the right in the supply curve to the right in the supply curve to SS22, ,

as shown in (b). as shown in (b).

The long-run equilibrium occurs at The long-run equilibrium occurs at a price of $30, as shown in (a), a price of $30, as shown in (a), where each firm earns zero profit where each firm earns zero profit and there is no incentive to enter and there is no incentive to enter or exit the industry.or exit the industry.

FIRMS HAVING IDENTICAL COSTSFIRMS HAVING IDENTICAL COSTSTo see why all the conditions for long-run equilibrium must To see why all the conditions for long-run equilibrium must hold, assume that all firms have identical costs. hold, assume that all firms have identical costs.

Now consider what happens if too many firms enter the Now consider what happens if too many firms enter the industry in response to an opportunity for profit. The industry industry in response to an opportunity for profit. The industry supply curve will shift further to the right, and price will fall.supply curve will shift further to the right, and price will fall.

Only when there is Only when there is no incentive to exit or entno incentive to exit or enter can a er can a market be in long-run equilibrium.market be in long-run equilibrium.

FIRMS HAVING DIFFERENT COSTSFIRMS HAVING DIFFERENT COSTSNow suppose that all firms in the industry do not have identical Now suppose that all firms in the industry do not have identical cost curves. Perhaps one firm has a patent that lets it produce at cost curves. Perhaps one firm has a patent that lets it produce at a lower average cost than all the others. In that case, it is a lower average cost than all the others. In that case, it is consistent with long-run equilibrium for that firm to earn a consistent with long-run equilibrium for that firm to earn a greater greater accountingaccounting profit and to enjoy a higher producer surplus profit and to enjoy a higher producer surplus than other firms.than other firms.

If the patent is profitable, other firms in the industry will pay to If the patent is profitable, other firms in the industry will pay to use it. The increased value of the patent thus represents an use it. The increased value of the patent thus represents an opportunity cost to the firm that holds it. It could sell the rights opportunity cost to the firm that holds it. It could sell the rights to the patent rather than use it. If all firms are equally efficient to the patent rather than use it. If all firms are equally efficient otherwise, the otherwise, the economiceconomic profit of the firm falls to zero profit of the firm falls to zero..

THE OPPORTUNITY COST OF LANDTHE OPPORTUNITY COST OF LANDThere are other instances in which firms earning positive There are other instances in which firms earning positive accounting profit may be earning zero economic profit. accounting profit may be earning zero economic profit.

Suppose, for example, that a clothing store happens to be Suppose, for example, that a clothing store happens to be located near a large shopping centre. The additional flow of located near a large shopping centre. The additional flow of customers can substantially increase the store’s accounting customers can substantially increase the store’s accounting profit because the cost of the land is based on its historical profit because the cost of the land is based on its historical cost. When the opportunity cost of land is included, the cost. When the opportunity cost of land is included, the profitability of the clothing store is no higher than that of its profitability of the clothing store is no higher than that of its competitors.competitors.

Economic Rent

In competitive markets, in both the short and the long run, In competitive markets, in both the short and the long run, economic rent is often positive even though profit is zero.economic rent is often positive even though profit is zero.

Amount that firms are willing to pay for Amount that firms are willing to pay for an input less the minimum amount an input less the minimum amount necessary to obtain it.necessary to obtain it.

In the long run, in a competitive market, In the long run, in a competitive market, the producer the producer surplus that a firm earns on the output that it sells surplus that a firm earns on the output that it sells consists of the economic rent that it enjoys from all its consists of the economic rent that it enjoys from all its scarce inputs.scarce inputs.

Producer Surplus in the Long RunProducer Surplus in the Long Run

FIRMS EARN ZERO PROFIT IN LONG-RUN EQUILIBRIUMFIRMS EARN ZERO PROFIT IN LONG-RUN EQUILIBRIUMIn long-run equilibrium, all firms earn zero economic profit.In long-run equilibrium, all firms earn zero economic profit.

In (a), a baseball team in a moderate-sized city sells enough tickets so that In (a), a baseball team in a moderate-sized city sells enough tickets so that price ($7) is equal to marginal and average cost.price ($7) is equal to marginal and average cost.

In (b), the demand is greater, so a $10 price can be charged. The team In (b), the demand is greater, so a $10 price can be charged. The team increases sales to the point at which the average cost of production plus the increases sales to the point at which the average cost of production plus the average economic rent is equal to the ticket price. average economic rent is equal to the ticket price.

When the opportunity cost associated with owning the franchise is taken into When the opportunity cost associated with owning the franchise is taken into account, the team earns zero economic profit. account, the team earns zero economic profit.

The Industry’s Long-Run Supply CurveThe Industry’s Long-Run Supply Curve

Constant-Cost IndustryConstant-Cost Industry Industry whose long-run supply curve is horizontal.Industry whose long-run supply curve is horizontal.

In (b), the long-run supply In (b), the long-run supply curve in a constant-cost curve in a constant-cost industry is a horizontal line industry is a horizontal line SSLL. When demand increases, . When demand increases,

initially causing a price rise, initially causing a price rise, the firm initially increases its the firm initially increases its output from output from qq11 to to qq22, as , as

shown in (a). shown in (a).

But the entry of new firms But the entry of new firms causes a shift to the right in causes a shift to the right in industry supply. industry supply.

Because input prices are Because input prices are unaffected by the increased unaffected by the increased output of the industry, entry output of the industry, entry occurs until the original price occurs until the original price is obtained (at point is obtained (at point BB in (b)). in (b)).

The long-run supply curve for a The long-run supply curve for a constant-cost industry is, therefore, a constant-cost industry is, therefore, a horizontal line at a price that is equal horizontal line at a price that is equal to the to the long-run minimum average cost long-run minimum average cost of production.of production.

LONG-RUN SUPPLY IN A LONG-RUN SUPPLY IN A CONSTANT COST CONSTANT COST INDUSTRYINDUSTRY

The Industry’s Long-Run Supply CurveThe Industry’s Long-Run Supply CurveIncreasing-Cost IndustryIncreasing-Cost Industry

Industry whose long-run supply curve is upward sloping.Industry whose long-run supply curve is upward sloping.LONG-RUN SUPPLY IN AN LONG-RUN SUPPLY IN AN INCREASING COST INCREASING COST INDUSTRYINDUSTRY

In (b), the long-run supply curve In (b), the long-run supply curve in an increasing-cost industry is in an increasing-cost industry is an upward-sloping curve an upward-sloping curve SSLL. .

When demand increases, initially When demand increases, initially causing a price rise, the firms causing a price rise, the firms increase their output from increase their output from qq11 to to

qq22 in (a). in (a).

In that case, the entry of new In that case, the entry of new firms causes a shift to the right firms causes a shift to the right in supply from in supply from SS11 to to SS22. .

Because input prices increase as Because input prices increase as a result, the new long-run a result, the new long-run equilibrium occurs at a higher equilibrium occurs at a higher price than the initial equilibrium.price than the initial equilibrium.

In an increasing-cost industry, the In an increasing-cost industry, the long-run industry supply curve is long-run industry supply curve is

upward slopingupward sloping..

Decreasing-Cost IndustryDecreasing-Cost IndustryIndustry whose long-run supply curve is downward sloping.Industry whose long-run supply curve is downward sloping.

You have been introduced to industries that have constant, You have been introduced to industries that have constant, increasing, and decreasing long-run costs.increasing, and decreasing long-run costs.

We saw that the supply of coffee is extremely elastic in the We saw that the supply of coffee is extremely elastic in the long run. The reason is that land for growing coffee is widely long run. The reason is that land for growing coffee is widely available and the costs of planting and caring for trees available and the costs of planting and caring for trees remains constant as the volume grows. Thus, coffee is a remains constant as the volume grows. Thus, coffee is a constant-cost industry.constant-cost industry.

The oil industry is an increasing cost industry because there The oil industry is an increasing cost industry because there is a limited availability of easily accessible, large-volume oil is a limited availability of easily accessible, large-volume oil fields.fields.

Finally, a decreasing-cost industry. In the automobile Finally, a decreasing-cost industry. In the automobile industry, certain industry, certain cost advantages arise because inputs can be cost advantages arise because inputs can be acquired more cheaply as the volume of production acquired more cheaply as the volume of production increasesincreases..

CONSTANT-, INCREASING-, AND DECREASING-COST CONSTANT-, INCREASING-, AND DECREASING-COST INDUSTRIES: COFFEE, OIL, AND AUTOMOBILESINDUSTRIES: COFFEE, OIL, AND AUTOMOBILES

Long-Run Elasticity of SupplyLong-Run Elasticity of SupplyThe long-run elasticity of industry supply is defined in the same The long-run elasticity of industry supply is defined in the same way as the short-run elasticity: It is the percentage change in way as the short-run elasticity: It is the percentage change in output (output (QQ//QQ) that results from a percentage change in price ) that results from a percentage change in price ((PP//PP). ).

In a constant-cost industry, the long-run supply curve is In a constant-cost industry, the long-run supply curve is horizontal, and the long-run supply elasticity is infinitely large. horizontal, and the long-run supply elasticity is infinitely large. (A small increase in price will induce an extremely large (A small increase in price will induce an extremely large increase in output.) increase in output.) In an increasing-cost industry, however, the long-run supply In an increasing-cost industry, however, the long-run supply elasticity will be positive but finite. elasticity will be positive but finite.

Because industries can adjust and expand in the long run, we Because industries can adjust and expand in the long run, we would generally expect long-run elasticities of supply to be would generally expect long-run elasticities of supply to be larger than short-run elasticities.larger than short-run elasticities.

The magnitude of the elasticity will depend on the extent to The magnitude of the elasticity will depend on the extent to

which which input costs increase as the market input costs increase as the market expandsexpands. For example, an industry that depends on inputs . For example, an industry that depends on inputs that are widely available will have a more elastic long-run that are widely available will have a more elastic long-run supply than will an industry that uses inputs in short supply.supply than will an industry that uses inputs in short supply.

THE SUPPLY CURVE FOR THE SUPPLY CURVE FOR NEW YORK TAXICABSNEW YORK TAXICABS

THE SUPPLY OF TAXICABS IN NEW YORKTHE SUPPLY OF TAXICABS IN NEW YORKWhile reducing taxi fares will indeed cause a reduction in the While reducing taxi fares will indeed cause a reduction in the quantity supplied, raising the price will not cause an increase quantity supplied, raising the price will not cause an increase in the quantity supplied. Why not? Because the number of in the quantity supplied. Why not? Because the number of medallions is fixed.medallions is fixed.

If there were no restriction on the If there were no restriction on the number of medallions, the supply number of medallions, the supply curve would be highly elastic. curve would be highly elastic. Cab drivers work hard and don’t Cab drivers work hard and don’t earn much, so a drop in the price earn much, so a drop in the price PP (of a 5-mile ride) would lead (of a 5-mile ride) would lead many of them to find another job. many of them to find another job. Likewise, an increase in price Likewise, an increase in price would bring many new drivers would bring many new drivers into the market. But the number into the market. But the number of medallions—and therefore the of medallions—and therefore the number of taxicabs—is limited to number of taxicabs—is limited to 13,150, so the supply curve 13,150, so the supply curve becomes vertical at this quantity.becomes vertical at this quantity.

WHY CAN’T I FIND A TAXI?WHY CAN’T I FIND A TAXI?The city of New York limits the number of taxis by requiring each The city of New York limits the number of taxis by requiring each taxi to have a medallion (essentially a permit), and then limiting taxi to have a medallion (essentially a permit), and then limiting the number of medallions. In 2011 there were 13,150 medallions the number of medallions. In 2011 there were 13,150 medallions in New York—roughly the same number as in 1937. Why not just in New York—roughly the same number as in 1937. Why not just issue more medallions? The reason is simple. Doing so would incur issue more medallions? The reason is simple. Doing so would incur the wrath of the current owners of medallions. Medallions can be the wrath of the current owners of medallions. Medallions can be bought and sold by the companies that own them. bought and sold by the companies that own them.

In 1937, there were plenty of medallions to go around, so they In 1937, there were plenty of medallions to go around, so they had little value. By 1947, the value of a medallion had increased had little value. By 1947, the value of a medallion had increased to $2,500, by 1980 to $55,000, and by 2011 to $880,000. That’s to $2,500, by 1980 to $55,000, and by 2011 to $880,000. That’s right—because New York City won’t issue more medallions, the right—because New York City won’t issue more medallions, the value of a taxi medallion is approaching $1 million! value of a taxi medallion is approaching $1 million!

But of course that value would drop sharply if the city starting But of course that value would drop sharply if the city starting issuing more medallions. So the New York taxi companies that issuing more medallions. So the New York taxi companies that collectively own the 13,150 available medallions have done collectively own the 13,150 available medallions have done everything possible to prevent the city from issuing any more—everything possible to prevent the city from issuing any more—and have succeeded in their efforts. If the city were to issue and have succeeded in their efforts. If the city were to issue another 7,000 medallions for a total of about 20,000, demand and another 7,000 medallions for a total of about 20,000, demand and supply would equilibrate at a price of about $350,000 per supply would equilibrate at a price of about $350,000 per medallion– still a lot, but just enough to lease cabs, run a taxi medallion– still a lot, but just enough to lease cabs, run a taxi business, and still make a profit.business, and still make a profit.

WHY CAN’T I FIND A TAXI?WHY CAN’T I FIND A TAXI?TAXI MEDALLIONS TAXI MEDALLIONS IN NEW YORK CITYIN NEW YORK CITY

The demand curve The demand curve DD shows the quantity of shows the quantity of medallions demanded by medallions demanded by taxi companies as a taxi companies as a function of the price of a function of the price of a medallion. medallion.

The supply curve The supply curve SS shows shows the number of medallions the number of medallions that would be sold by that would be sold by current owners as a current owners as a function of price. function of price.

New York limits the New York limits the quantity to 13,150, so the quantity to 13,150, so the supply curve becomes supply curve becomes vertical and intersects vertical and intersects demand at $880,000, the demand at $880,000, the market price of a market price of a medallion in 2011.medallion in 2011.

To begin, consider the supply of owner-occupied housing in To begin, consider the supply of owner-occupied housing in suburban or rural areas where land is not scarce. In this case, suburban or rural areas where land is not scarce. In this case, the price of land does not increase substantially as the quantity the price of land does not increase substantially as the quantity ofofhousing supplied increases. Likewise, costs associated with housing supplied increases. Likewise, costs associated with construction are not likely to increase because there is a national construction are not likely to increase because there is a national market for lumber and other materials. Therefore, the long-run market for lumber and other materials. Therefore, the long-run elasticity of the housing supply is likely to be very large, elasticity of the housing supply is likely to be very large, approximating that of a constant-cost industry.approximating that of a constant-cost industry.

The market for rental housing is different, however. The The market for rental housing is different, however. The construction of rental housing is often restricted by local zoning construction of rental housing is often restricted by local zoning laws. Many communities outlaw it entirely, while others limit it to laws. Many communities outlaw it entirely, while others limit it to certain areas. Because urban land on which most rental housing certain areas. Because urban land on which most rental housing is located is restricted and valuable, the long-run elasticity of is located is restricted and valuable, the long-run elasticity of supply of rental housing is much lower than the elasticity of supply of rental housing is much lower than the elasticity of supply of owner-occupied housing. With urban land becoming supply of owner-occupied housing. With urban land becoming more valuable as housing density increases, and with the cost of more valuable as housing density increases, and with the cost of construction soaring, increased demand causes the input costs of construction soaring, increased demand causes the input costs of rental housing to rise. In this increasing-cost case, the elasticity rental housing to rise. In this increasing-cost case, the elasticity of supply can be much less than 1.of supply can be much less than 1.

THE LONG-RUN SUPPLY OF HOUSINGTHE LONG-RUN SUPPLY OF HOUSING

Examples of Competitive Examples of Competitive IndustriesIndustries

AgricultureAgriculture

Boiler ChickensBoiler Chickens

Red-MeatRed-Meat

MilkMilk

TruckingTrucking

THE MARKET FOR HUMAN KIDNEYSTHE MARKET FOR HUMAN KIDNEYSEven at a price of zero (the effective price under Even at a price of zero (the effective price under the law), donors supply about 16,000 kidneys per the law), donors supply about 16,000 kidneys per year. It has been estimated that 8000 more kidneys year. It has been estimated that 8000 more kidneys would be supplied if the price were $20,000.would be supplied if the price were $20,000.We can fit a linear supply curve to this data—i.e.,We can fit a linear supply curve to this data—i.e.,a supply curve of the form a supply curve of the form Q Q = = a a + + bPbP. . When When P P = 0, = 0, Q Q = 16,000, so = 16,000, so a a = 16,000. If = 16,000. If P P = = $20,000, $20,000, Q Q = 24,000, so = 24,000, so b b = (24,000 = (24,000 16,000)/20,000 = 0.4.16,000)/20,000 = 0.4.Thus the supply curve is Thus the supply curve is SupplySupply: : QQSS = 16,000 + 0.4= 16,000 + 0.4PPNote that at a price of $20,000, the elasticity of Note that at a price of $20,000, the elasticity of supply is 0.33. It is expected that at a price of supply is 0.33. It is expected that at a price of $20,000, the number of kidneys demanded would $20,000, the number of kidneys demanded would be 24,000 per year. Like supply, demand is be 24,000 per year. Like supply, demand is relatively price inelastic; a reasonable estimate for relatively price inelastic; a reasonable estimate for the price elasticity of demand at the $20,000 price the price elasticity of demand at the $20,000 price is −0.33. This implies the following linear demand is −0.33. This implies the following linear demand curve: curve: DemandDemand: : QQDD = 32,000 = 32,000 0.4 0.4PP

THE MARKET FOR KIDNEYS AND THE EFFECT OF THE THE MARKET FOR KIDNEYS AND THE EFFECT OF THE NATIONAL ORGAN TRANSPLANTATION ACTNATIONAL ORGAN TRANSPLANTATION ACT

THE MARKET FOR HUMAN KIDNEYSTHE MARKET FOR HUMAN KIDNEYS

Economics, the dismal science, shows Economics, the dismal science, shows us that human organs have economic us that human organs have economic value that cannot be ignored, and value that cannot be ignored, and prohibiting their sale imposes a prohibiting their sale imposes a cost cost on society that must be weighed on society that must be weighed against the benefits.against the benefits.

The market-clearing price is The market-clearing price is $20,000; at this price, about $20,000; at this price, about 24,000 kidneys per year would 24,000 kidneys per year would be supplied. be supplied.

The law effectively makes the The law effectively makes the price zero. About 16,000 price zero. About 16,000 kidneys per year are still kidneys per year are still donated; this constrained donated; this constrained supply is shown as S’.supply is shown as S’.

The loss to suppliers is given The loss to suppliers is given by rectangle A and triangle C. by rectangle A and triangle C.

If consumers received kidneys If consumers received kidneys at no cost, their gain would be at no cost, their gain would be given by rectangle A less given by rectangle A less triangle B.triangle B.

EFFECT OF AIRLINE EFFECT OF AIRLINE REGULATION BY THE REGULATION BY THE CIVIL AERONAUTICS CIVIL AERONAUTICS BOARDBOARD

AIRLINE REGULATIONAIRLINE REGULATIONAirline deregulation in 1981 led to major changes in the Airline deregulation in 1981 led to major changes in the industry. Some airlines merged or went out of business as industry. Some airlines merged or went out of business as new ones entered. Although prices fell considerably (to new ones entered. Although prices fell considerably (to the benefit of consumers), profits overall did not fall the benefit of consumers), profits overall did not fall much.much.

At price At price PPminmin, airlines would like to , airlines would like to

supply supply QQ22, well above the quantity , well above the quantity

QQ11 that consumers will buy. that consumers will buy.

Here they supply Here they supply QQ33. Trapezoid . Trapezoid DD

is the cost of unsold output.is the cost of unsold output.

Airline profits may have been Airline profits may have been lower as a result of regulation lower as a result of regulation because triangle because triangle CC and trapezoid and trapezoid DD can together exceed rectangle can together exceed rectangle AA. In addition, consumers lose . In addition, consumers lose AA + + BB..

AIRLINE REGULATIONAIRLINE REGULATIONBecause airlines have no control over oil prices, Because airlines have no control over oil prices, it is more informative to examine a “corrected” it is more informative to examine a “corrected” real cost index which removes the effects of real cost index which removes the effects of changing fuel costs.changing fuel costs.

TABLE 2TABLE 2 AIRLINE INDUSTRY DATAAIRLINE INDUSTRY DATA

19751975 1980 1990 2000 2010

Number of U.S. carriersNumber of U.S. carriers 36 63 70 94 63

Passenger Load Factor (%)Passenger Load Factor (%) 54.0 58.0 62.4 72.1 82.1

Passenger-Mile Rate (constant 1995 dollars)Passenger-Mile Rate (constant 1995 dollars) 0.218 0.210 0.149 0.118 0.094

Real Cost Index (1995 = 100)Real Cost Index (1995 = 100) 101 145 119 89 148

Real Fuel Cost Index (1995 = 100)Real Fuel Cost Index (1995 = 100) 249 300 163 125 342

Real Cost Index w/o Fuel Cost Increases (1995 Real Cost Index w/o Fuel Cost Increases (1995 = 100)= 100)

71 87 104 85 76

THE SUGAR QUOTATHE SUGAR QUOTAIn recent years, the world price of sugar has been between 10 In recent years, the world price of sugar has been between 10 and 28 cents per pound, while the U.S. price has been 30 to and 28 cents per pound, while the U.S. price has been 30 to 40 cents per pound. Why? 40 cents per pound. Why? By restricting imports, the U.S. By restricting imports, the U.S. government protects the $4 billion domestic sugar industry, government protects the $4 billion domestic sugar industry, which would virtually be put out of business if it had to which would virtually be put out of business if it had to compete with low-cost foreign producers. This policy has compete with low-cost foreign producers. This policy has been good for U.S. sugar producers, but bad for consumers.been good for U.S. sugar producers, but bad for consumers.

U.S. production: 15.9 billion pounds

U.S. consumption: 22.8 billion pounds

U.S. price: 36 cents per pound

World price 24 cents per pound

U.S. supplyU.S. supply: : QQSS = = 7.95 + 0.66 7.95 + 0.66PP

U.S. demandU.S. demand: : QQDD = 29.73 = 29.73 0.19 0.19PP

At the 24-cent world price, U.S. production would have been only At the 24-cent world price, U.S. production would have been only about 7.9 billion pounds and U.S. consumption about 25.2 billion about 7.9 billion pounds and U.S. consumption about 25.2 billion pounds, of which 25.2 − 7.9 = 17.3 billion pounds would have been pounds, of which 25.2 − 7.9 = 17.3 billion pounds would have been imported. But fortunately for U.S. producers, imports were limited to imported. But fortunately for U.S. producers, imports were limited to only 6.9 billion pounds.only 6.9 billion pounds.

THE SUGAR QUOTATHE SUGAR QUOTASUGAR QUOTA IN 2010SUGAR QUOTA IN 2010

At the world price of 24 cents At the world price of 24 cents per pound, about 25.2 billion per pound, about 25.2 billion pounds of sugar would have pounds of sugar would have been consumed of which all been consumed of which all but 7.9 billion pounds would but 7.9 billion pounds would have been imported. have been imported. Restricting imports to 6.9 Restricting imports to 6.9 billion pounds caused the billion pounds caused the U.S. price to go up by 12 U.S. price to go up by 12 cents. cents. The cost to The cost to consumers, consumers, A A + + B B + + C C + + DD, , was about $2.9 billion.was about $2.9 billion.The gain to domestic The gain to domestic producers was trapezoid producers was trapezoid AA, , about $1.4 billion. about $1.4 billion. Rectangle Rectangle DD, $836 million, was a gain to , $836 million, was a gain to those foreign producers who those foreign producers who obtained quota allotments. obtained quota allotments. Triangles Triangles B B and and C C represent represent the deadweight loss of about the deadweight loss of about $614 million.$614 million.

ConclusionConclusion

“…“…Every individual Every individual endeavours to employ his endeavours to employ his capital … only (for) his own capital … only (for) his own security, … only his gain… led security, … only his gain… led by an invisible hand…” by an invisible hand…” Adam Smith, The Wealth of Nations (1776)Adam Smith, The Wealth of Nations (1776)

Casestudy : StarbucksCasestudy : Starbucks

1.1. Read and prepare the Read and prepare the Casestudy on Casestudy on STARBUCKS for STARBUCKS for discussion and discussion and presentation next. presentation next.

2.2. Identify and evaluate Identify and evaluate the challenges facing the challenges facing STARBUCK’s global STARBUCK’s global business by business by conducting External conducting External Environment analysis Environment analysis (PESTEL);and (PESTEL);and Industry (5+1 Forces) Industry (5+1 Forces) analysis.analysis.

Core ReadingCore Reading

• Keat, Paul G. and Young, Philip KY (2009) Managerial Economics, 6th edition, Pearson

• Samuelson, William F. and Marks, Stephen G.(2010) Managerial Economics, 6th edition, John Wiley

• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013) Microeconomics, 8th edition, Pearson

• Samuelson, P.A. and Nordhaus, W. D. Samuelson, P.A. and Nordhaus, W. D. (2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth EditionEdition

• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy – “Competitive Strategy – Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors” Free PressFree Press

Questions?Questions?

Mba1014 perfect competition 180513

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