Market
In an economic sense, a market is a system by which buyers
and sellers bargain for the price of a product, settle the price
and transact their business—buy and sell a product.
Personal contact between the buyers and sellers is not
necessary. In some cases, e.g., forward sale and purchase,
even immediate transfer of ownership of goods is not
necessary.
Market does not necessarily mean a place. The market for a
commodity may be local, regional, national or international.
What makes a market is a set of buyers, a set of sellers and a
commodity. While buyers are willing to buy and sellers are
willing to sell, and there is a price for the commodity.
The Four Types of Market Structure
Number of Firms?
Many
firms
Type of Products?
One
firm
Monopoly
• Tap water
• Cable TV
Few
firms
Oligopoly
• Tennis balls
• Crude oil
Differentiated
products
Monopolistic
Competition
• Novels
• Movies
Identical
products
Perfect
Competition
• Wheat
• Milk
Copyright © 2004 South-Western
Market Structure
• Market structure – identifies how a market
is made up in terms of:
–
–
–
–
–
–
The number of firms in the industry
The nature of the product produced
The degree of monopoly power each firm has
The degree to which the firm can influence price
Profit levels
Firms’ behaviour – pricing strategies, non-price competition, output
levels
– The extent of barriers to entry
– The impact on efficiency
Market Structure
Perfect
Competition
Pure
Monopoly
More competitive (fewer imperfections)
Market Structure
Perfect
Competition
Pure
Monopoly
Less competitive (greater degree
of imperfection)
Market Structure
Pure
Monopoly
Perfect
Competition
Monopolistic Competition
Oligopoly
Duopoly Monopoly
The further right on the scale, the greater the degree
of monopoly power exercised by the firm.
GAME THEORY AND THE ECONOMICS
OF COOPERATION
• Game theory is the study of how people
behave in strategic situations.
• Strategic decisions are those in which each
person, in deciding what actions to take, must
consider how others might respond to that
action.
GAME THEORY AND THE ECONOMICS
OF COOPERATION
• Because the number of firms in an
oligopolistic market is small, each firm must
act strategically.
• Each firm knows that its profit depends not
only on how much it produces but also on
how much the other firms produce.
The Prisoners’ Dilemma
• The prisoners’ dilemma provides insight into
the difficulty in maintaining cooperation.
• Often people (firms) fail to cooperate with
one another even when cooperation would
make them better off.
The Prisoners’ Dilemma
• The prisoners’ dilemma is a particular “game”
between two captured prisoners that
illustrates why cooperation is difficult to
maintain even when it is mutually beneficial.
Figure 2 The Prisoners’ Dilemma
Bonnie’ s Decision
Confess
Bonnie gets 8 years
Remain Silent
Bonnie gets 20 years
Confess
Clyde gets 8 years
Clyde’s
Decision
Bonnie goes free
Clyde goes free
Bonnie gets 1 year
Remain
Silent
Clyde gets 20 years
Clyde gets 1 year
Copyright©2003 Southwestern/Thomson Learning
The Prisoners’ Dilemma
• The dominant strategy is the best strategy for
a player to follow regardless of the strategies
chosen by the other players.
The Prisoners’ Dilemma
• Cooperation is difficult to maintain, because
cooperation is not in the best interest of the
individual player.
Figure 3 An Oligopoly Game
Iraq’s Decision
High Production
Iraq gets $40 billion
Low Production
Iraq gets $30 billion
High
Production
Iran’s
Decision
Iran gets $40 billion
Iraq gets $60 billion
Iran gets $60 billion
Iraq gets $50 billion
Low
Production
Iran gets $30 billion
Iran gets $50 billion
Copyright©2003 Southwestern/Thomson Learning
Oligopolies as a Prisoners’ Dilemma
• Self-interest makes it difficult for the oligopoly
to maintain a cooperative outcome with low
production, high prices, and monopoly profits.
Figure 4 An Arms-Race Game
Decision of the United States (U.S.)
Arm
Disarm
U.S. at risk
U.S. at risk and weak
Arm
Decision
of the
Soviet Union
(USSR)
USSR at risk
USSR safe and powerful
U.S. safe and powerful
U.S. safe
Disarm
USSR at risk and weak
USSR safe
Copyright©2003 Southwestern/Thomson Learning
Figure 5 An Advertising Game
Marlboro’ s Decision
Advertise
Marlboro gets $3
billion profit
Don’t Advertise
Marlboro gets $2
billion profit
Advertise
Camel’s
Decision
Don’t
Advertise
Camel gets $3
billion profit
Marlboro gets $5
billion profit
Camel gets $2
billion profit
Camel gets $5
billion profit
Marlboro gets $4
billion profit
Camel gets $4
billion profit
Copyright©2003 Southwestern/Thomson Learning
Figure 6 A Common-Resource Game
Exxon’s Decision
Drill Two Wells
Drill Two
Wells
Exxon gets $4
million profit
Texaco gets $4
million profit
Texaco’s
Decision
Exxon gets $6
million profit
Drill One
Well
Texaco gets $3
million profit
Drill One Well
Exxon gets $3
million profit
Texaco gets $6
million profit
Exxon gets $5
million profit
Texaco gets $5
million profit
Copyright©2003 Southwestern/Thomson Learning
Why People Sometimes Cooperate
• Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a onetime gain.
Figure 7 Jack and Jill Oligopoly Game
Jack’s Decision
Sell 40 Gallons
Jack gets
$1,600 profit
Sell 40
Gallons
Jill’s
Decision
Sell 30
Gallons
Sell 30 Gallons
Jill gets
$1,600 profit
Jack gets
$1,500 profit
Jill gets
$2,000 profit
Jack gets
$2,000 profit
Jill gets
$1,500 profit
Jack gets
$1,800 profit
Jill gets
$1,800 profit
Copyright©2003 Southwestern/Thomson Learning
PUBLIC POLICY TOWARD OLIGOPOLIES
• Cooperation among oligopolists is undesirable
from the standpoint of society as a whole
because it leads to production that is too low
and prices that are too high.
Restraint of Trade and the Antitrust Laws
• Antitrust laws make it illegal to restrain trade
or attempt to monopolize a market.
– Sherman Antitrust Act of 1890
– Clayton Act of 1914
Controversies over Antitrust Policy
• Antitrust policies sometimes may not allow
business practices that have potentially
positive effects:
– Resale price maintenance
– Predatory pricing
– Tying
Controversies over Antitrust Policy
• Resale Price Maintenance (or fair trade)
– occurs when suppliers (like wholesalers) require
retailers to charge a specific amount
• Predatory Pricing
– occurs when a large firm begins to cut the price of its
product(s) with the intent of driving its competitor(s)
out of the market
• Tying
– when a firm offers two (or more) of its products
together at a single price, rather than separately
Summary
• Oligopolists maximize their total profits by
forming a cartel and acting like a monopolist.
• If oligopolists make decisions about
production levels individually, the result is a
greater quantity and a lower price than under
the monopoly outcome.
Summary
• The prisoners’ dilemma shows that selfinterest can prevent people from maintaining
cooperation, even when cooperation is in
their mutual self-interest.
• The logic of the prisoners’ dilemma applies in
many situations, including oligopolies.
Summary
• Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that
reduces competition.
Market Structure
• Monopoly:
– High barriers to entry
– Firm controls price OR output/supply
– Abnormal profits in long run
– Possibility of price discrimination
– Consumer choice limited
– Prices in excess of MC
• While a competitive firm is a price taker, a
monopoly firm is a price maker.
• A firm is considered a monopoly if . . .
– it is the sole seller of its product.
– its product does not have close substitutes.
WHY MONOPOLIES ARISE
• The fundamental cause of monopoly is
barriers to entry.
WHY MONOPOLIES ARISE
• Barriers to entry have three sources:
– Ownership of a key resource.
– The government gives a single firm the exclusive
right to produce some good.
– Costs of production make a single producer more
efficient than a large number of producers.
Monopoly Resources
• Although exclusive ownership of a key
resource is a potential source of monopoly, in
practice monopolies rarely arise for this
reason.
Government-Created Monopolies
• Governments may restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
Government-Created Monopolies
• Patent and copyright laws are two important
examples of how government creates a
monopoly to serve the public interest.
Natural Monopolies
• An industry is a natural monopoly when a
single firm can supply a good or service to an
entire market at a smaller cost than could two
or more firms.
Natural Monopolies
• A natural monopoly arises when there are
economies of scale over the relevant range of
output.
Figure 1 Economies of Scale as a Cause of Monopoly
Cost
Average
total
cost
0
Quantity of Output
Copyright © 2004 South-Western
HOW MONOPOLIES MAKE PRODUCTION AND
PRICING DECISIONS
• Monopoly versus Competition
– Monopoly
•
•
•
•
Is the sole producer
Faces a downward-sloping demand curve
Is a price maker
Reduces price to increase sales
– Competitive Firm
•
•
•
•
Is one of many producers
Faces a horizontal demand curve
Is a price taker
Sells as much or as little at same price
Figure 2 Demand Curves for Competitive and Monopoly Firms
(a) A Competitive Firm’s Demand Curve
Price
(b) A Monopolist’s Demand Curve
Price
Demand
Demand
0
Quantity of Output
0
Quantity of Output
Copyright © 2004 South-Western
A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
– A monopolist’s marginal revenue is always less
than the price of its good.
• The demand curve is downward sloping.
• When a monopoly drops the price to sell one more
unit, the revenue received from previously sold units
also decreases.
A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
– When a monopoly increases the amount it sells, it
has two effects on total revenue (P  Q).
• The output effect—more output is sold, so Q is higher.
• The price effect—price falls, so P is lower.
Figure 3 Demand and Marginal-Revenue Curves for a Monopoly
Price
$11
10
9
8
7
6
5
4
3
2
1
0
–1
–2
–3
–4
Demand
(average
revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity of Water
Copyright © 2004 South-Western
Profit Maximization
• A monopoly maximizes profit by producing
the quantity at which marginal revenue equals
marginal cost.
• It then uses the demand curve to find the
price that will induce consumers to buy that
quantity.
Figure 4 Profit Maximization for a Monopoly
Costs and
Revenue
2. . . . and then the demand
curve shows the price
consistent with this quantity.
B
Monopoly
price
1. The intersection of the
marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .
Average total cost
A
Demand
Marginal
cost
Marginal revenue
0
Q
QMAX
Q
Quantity
Copyright © 2004 South-Western
Profit Maximization
• Comparing Monopoly and Competition
– For a competitive firm, price equals marginal cost.
P = MR = MC
– For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopoly’s Profit
• Profit equals total revenue minus total costs.
– Profit = TR - TC
– Profit = (TR/Q - TC/Q)  Q
– Profit = (P - ATC)  Q
Figure 5 The Monopolist’s Profit
Costs and
Revenue
Marginal cost
Monopoly E
price
B
Monopoly
profit
Average
total D
cost
Average total cost
C
Demand
Marginal revenue
0
QMAX
Quantity
Copyright © 2004 South-Western
A Monopolist’s Profit
• The monopolist will receive economic profits
as long as price is greater than average total
cost.
Figure 6 The Market for Drugs
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
Marginal
cost
Marginal
revenue
0
Monopoly
quantity
Competitive
quantity
Demand
Quantity
Copyright © 2004 South-Western
THE WELFARE COST OF MONOPOLY
• In contrast to a competitive firm, the
monopoly charges a price above the marginal
cost.
• From the standpoint of consumers, this high
price makes monopoly undesirable.
• However, from the standpoint of the owners
of the firm, the high price makes monopoly
very desirable.
Figure 7 The Efficient Level of Output
Price
Marginal cost
Value
to
buyers
Cost
to
monopolist
Value
to
buyers
Cost
to
monopolist
Demand
(value to buyers)
Quantity
0
Value to buyers
is greater than
cost to seller.
Value to buyers
is less than
cost to seller.
Efficient
quantity
Copyright © 2004 South-Western
The Deadweight Loss
• Because a monopoly sets its price above
marginal cost, it places a wedge between the
consumer’s willingness to pay and the
producer’s cost.
– This wedge causes the quantity sold to fall short of
the social optimum.
Figure 8 The Inefficiency of Monopoly
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
0
Monopoly Efficient
quantity quantity
Demand
Quantity
Copyright © 2004 South-Western
The Deadweight Loss
• The Inefficiency of Monopoly
– The monopolist produces less than the socially
efficient quantity of output.
The Deadweight Loss
• The deadweight loss caused by a monopoly is
similar to the deadweight loss caused by a tax.
• The difference between the two cases is that
the government gets the revenue from a tax,
whereas a private firm gets the monopoly
profit.
PUBLIC POLICY TOWARD MONOPOLIES
• Government responds to the problem of
monopoly in one of four ways.
– Making monopolized industries more competitive.
– Regulating the behavior of monopolies.
– Turning some private monopolies into public
enterprises.
– Doing nothing at all.
Increasing Competition with Antitrust Laws
• Antitrust laws are a collection of statutes
aimed at curbing monopoly power.
• Antitrust laws give government various ways
to promote competition.
– They allow government to prevent mergers.
– They allow government to break up companies.
– They prevent companies from performing
activities that make markets less competitive.
Increasing Competition with Antitrust Laws
• Two Important Antitrust Laws
– Sherman Antitrust Act (1890)
• Reduced the market power of the large and powerful
“trusts” of that time period.
– Clayton Act (1914)
• Strengthened the government’s powers and authorized
private lawsuits.
Regulation
• Government may regulate the prices that the
monopoly charges.
– The allocation of resources will be efficient if price
is set to equal marginal cost.
Figure 9 Marginal-Cost Pricing for a Natural Monopoly
Price
Average total
cost
Regulated
price
Loss
Average total cost
Marginal cost
Demand
0
Quantity
Copyright © 2004 South-Western
Regulation
• In practice, regulators will allow monopolists
to keep some of the benefits from lower costs
in the form of higher profit, a practice that
requires some departure from marginal-cost
pricing.
Public Ownership
• Rather than regulating a natural monopoly
that is run by a private firm, the government
can run the monopoly itself (e.g. in the United
States, the government runs the Postal
Service).
Doing Nothing
• Government can do nothing at all if the
market failure is deemed small compared to
the imperfections of public policies.
PRICE DISCRIMINATION
• Price discrimination is the business practice of
selling the same good at different prices to
different customers, even though the costs for
producing for the two customers are the
same.
PRICE DISCRIMINATION
• Price discrimination is not possible when a
good is sold in a competitive market since
there are many firms all selling at the market
price. In order to price discriminate, the firm
must have some market power.
• Perfect Price Discrimination
– Perfect price discrimination refers to the situation
when the monopolist knows exactly the
willingness to pay of each customer and can
charge each customer a different price.
PRICE DISCRIMINATION
• Two important effects of price discrimination:
– It can increase the monopolist’s profits.
– It can reduce deadweight loss.
Figure 10 Welfare with and without Price Discrimination
(a) Monopolist with Single Price
Price
Consumer
surplus
Deadweight
loss
Monopoly
price
Profit
Marginal cost
Marginal
revenue
0
Quantity sold
Demand
Quantity
Copyright © 2004 South-Western
Figure 10 Welfare with and without Price Discrimination
(b) Monopolist with Perfect Price Discrimination
Price
Profit
Marginal cost
Demand
0
Quantity sold
Quantity
Copyright © 2004 South-Western
PRICE DISCRIMINATION
• Examples of Price Discrimination
– Movie tickets
– Airline prices
– Discount coupons
– Financial aid
– Quantity discounts
CONCLUSION: THE PREVALENCE OF
MONOPOLY
• How prevalent are the problems of
monopolies?
– Monopolies are common.
– Most firms have some control over their prices
because of differentiated products.
– Firms with substantial monopoly power are rare.
– Few goods are truly unique.
Summary
• A monopoly is a firm that is the sole seller in
its market.
• It faces a downward-sloping demand curve for
its product.
• A monopoly’s marginal revenue is always
below the price of its good.
Summary
• Like a competitive firm, a monopoly
maximizes profit by producing the quantity at
which marginal cost and marginal revenue are
equal.
• Unlike a competitive firm, its price exceeds its
marginal revenue, so its price exceeds
marginal cost.
Summary
• A monopolist’s profit-maximizing level of
output is below the level that maximizes the
sum of consumer and producer surplus.
• A monopoly causes deadweight losses similar
to the deadweight losses caused by taxes.
Summary
• Policymakers can respond to the inefficiencies
of monopoly behavior with antitrust laws,
regulation of prices, or by turning the
monopoly into a government-run enterprise.
• If the market failure is deemed small,
policymakers may decide to do nothing at all.
Summary
• Monopolists can raise their profits by charging
different prices to different buyers based on
their willingness to pay.
• Price discrimination can raise economic
welfare and lessen deadweight losses.
Market Structure
• Advantages and disadvantages of monopoly:
• Advantages:
–
–
–
–
May be appropriate if natural monopoly
Encourages R&D
Encourages innovation
Development of some products not likely without some
guarantee of monopoly in production
– Economies of scale can be gained – consumer may benefit
Market Structure
• Disadvantages:
– Exploitation of consumer – higher prices
– Potential for supply to be limited - less choice
– Potential for inefficiency –
X-inefficiency – complacency
controls on costs
over
Market Structure
Price
Kinked Demand Curve
£5
Kinked D Curve
D = elastic
D = Inelastic
100
Quantity
Monopolistic or Imperfect Competition
• In each case there are many firms
in the industry
• Each can try to differentiate its product
in some way
• Entry and exit to the industry is relatively free
• Consumers and producers do not have perfect knowledge of
the market – the market may indeed be relatively localised.
Can you imagine trying to search out the details, prices,
reliability, quality of service, etc for every plumber in the UK in
the event of an emergency??
Oligopoly
• Competition between the few
– May be a large number of firms in the industry but the
industry is dominated
by a small number of very large producers
• Concentration Ratio – the proportion of total market
sales (share) held by the top 3,4,5, etc firms:
– A 4 firm concentration ratio of 75% means the top 4 firms
account for 75% of all
the sales in the industry
Oligopoly
• Example:
• Music sales –
The music industry has
a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
Oligopoly
• Features of an oligopolistic market structure:
– Price may be relatively stable across the industry –
kinked demand curve?
– Potential for collusion
– Behaviour of firms affected by what they believe their rivals
might do – interdependence of firms
– Goods could be homogenous or highly differentiated
– Branding and brand loyalty may be a potent source of competitive advantage
– Non-price competition may be prevalent
– Game theory can be used to explain some behaviour
– AC curve may be saucer shaped – minimum efficient scale
could occur over large range of output
– High barriers to entry
Oligopoly
Price
The kinked demand curve - an explanation for price stability?
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Kinked D Curve
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D = elastic
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100
Quantity
Duopoly
• Market structure where the industry is dominated
by two large producers
– Collusion may be a possible feature
– Price leadership by the larger of the two firms may exist – the
smaller firm follows the price lead
of the larger one
– Highly interdependent
– High barriers to entry
– Cournot Model – French economist – analysed duopoly –
suggested long run equilibrium would see equal market share and
normal profit made
– In reality, local duopolies may exist
Monopoly
• Pure monopoly – where only
one producer exists in the industry
• In reality, rarely exists – always
some form of substitute available!
• Monopoly exists, therefore,
where one firm dominates the market
• Firms may be investigated for examples of
monopoly power when market share exceeds
25%
• Use term ‘monopoly power’ with care!
Monopoly
• Monopoly power – refers to cases where firms influence
the market in some way through their behaviour –
determined by the degree
of concentration in the industry
–
–
–
–
–
Influencing prices
Influencing output
Erecting barriers to entry
Pricing strategies to prevent or stifle competition
May not pursue profit maximisation – encourages unwanted
entrants to the market
– Sometimes seen as a case of market failure
Monopoly
• Origins of monopoly:
– Through growth of the firm
– Through amalgamation, merger
or takeover
– Through acquiring patent or license
– Through legal means – Royal charter,
nationalisation, wholly owned plc
Monopoly
• Summary of characteristics of firms exercising
monopoly power:
– Price – could be deemed too high, may be set to destroy
competition (destroyer or predatory pricing), price
discrimination possible.
– Efficiency – could be inefficient due to lack of competition
(X- inefficiency) or…
• could be higher due to availability of high profits
Monopoly
• Innovation - could be high because
of the promise of high profits, Possibly encourages
high investment in research and development (R&D)
• Collusion – possible to maintain monopoly power of
key firms
in industry
• High levels of branding, advertising
and non-price competition
Monopoly
• Problems with models – a reminder:
– Often difficult to distinguish between a monopoly
and an oligopoly – both may exhibit behaviour
that reflects monopoly power
– Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
– Degree of contestability of the market may influence behaviour
– Monopolies not always ‘bad’ – may be desirable
in some cases but may need strong regulation
– Monopolies do not have to be big – could exist locally
Monopoly
Costs / Revenue
MC
£7.00
AC
Monopoly
Profit
This(D)
AR
Given
isthe
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abnormal
Output assumed
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(note caution
market
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here – not all
monopolists may aim
for profit maximisation!)
£3.00
MR
Q1
AR
Output / Sales
Monopoly
Welfare
implications of
monopolies
Costs / Revenue
MC
£7
AC
Loss of consumer
surplus
£3
AR
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Q2
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competitive
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compared
environments.
to a monopoly.
Q1
Output / Sales
Monopoly
Welfare
implications of
monopolies
Costs / Revenue
MC
£7
AC
Gain in producer
surplus
The monopolist will benefit
be
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by a loss
producer
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showntobythe
thegrey
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shaded
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£3
AR
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Q2
Q1
Output / Sales
Monopoly
Welfare
implications of
monopolies
Costs / Revenue
MC
£7
AC
The value of the grey shaded
triangle represents the total
welfare loss to society –
sometimes referred to as
the ‘deadweight welfare loss’.
£3
AR
MR
Q2
Q1
Output / Sales
Contestable Markets
• Theory developed by William J. Baumol,
John Panzar and Robert Willig (1982)
• Helped to fill important gaps in market
structure theory
• Perfectly contestable market – the
pure form – not common in reality but a
benchmark to explain firms’ behaviours
Contestable Markets
• Key characteristics:
– Firms’ behaviour influenced by the threat
of new entrants to the industry
– No barriers to entry or exit
– No sunk costs
– Firms may deliberately limit profits made
to discourage new entrants – entry limit pricing
– Firms may attempt to erect artificial barriers to entry –
e.g…
Contestable Markets
• Over capacity – provides the
opportunity to flood the market
and drive down price in the event
of a threat of entry
• Aggressive marketing and branding
strategies to ‘tighten’ up the market
• Potential for predatory
or destroyer pricing
• Find ways of reducing costs and
increasing efficiency to gain competitive
advantage
Contestable Markets
• ‘Hit and Run’ tactics – enter the
industry, take the profit and get
out quickly (possible because of
the freedom of entry and exit)
• Cream-skimming – identifying
parts of the market that are high
in value added and exploiting
those markets
Contestable Markets
• Examples of markets exhibiting
contestability characteristics:
– Financial services
– Airlines – especially flights
on domestic routes
– Computer industry – ISPs, software,
web development
– Energy supplies
– The postal service?
The Goal Of Profit Maximization
• To analyze decision making at the firm, let’s start with a very
basic question
– What is the firm trying to maximize?
• A firm’s owners will usually want the firm to earn as much
profit as possible
• We will view the firm as a single economic decision maker
whose goal is to maximize its owners’ profit
• Why?
– Managers who deviate from profit-maximizing for too long are
typically replaced either by
• Current owners or
• Other firms who acquire the underperforming firm and then replace
management team with their own
– Many managers are well trained in tools of profit-maximization
Understanding Profit: Two Definitions of
Profit
• Profit is defined as the firm’s sales revenue minus its
costs of production
• If we deduct only costs recognized by accountants,
we get one definition of profit
– Accounting profit = Total revenue – Accounting costs
• A broader conception of costs (opportunity costs)
leads to a second definition of profit
– Economic profit = Total revenue – All costs of production
– Or Total revenue – (Explicit costs + Implicit costs)
Why Are There Profits?
• Economists view profit as a payment for two
necessary contributions
• Risk-taking
– Someone—the owner—had to be willing to take
the initiative to set up the business
• This individual assumed the risk that business might fail
and the initial investment be lost
– Innovation
• In almost any business you will find that some sort of
innovation was needed to get things started
The Firm’s Constraints: The Demand
Constraint
• Demand curve facing firm is a profit constraint
– Curve that indicates for different prices, quantity of output
customers will purchase from a particular firm
• Can flip demand relationship around
– Once firm has selected an output level, it has also
determined the maximum price it can charge
• Leads to an alternative definition
– Shows maximum price firm can charge to sell any given
amount of output
Total Revenue
• The total inflow of receipts from selling a
given amount of output
• Each time the firm chooses a level of output, it
also determines its total revenue
– Why?
• Because once we know the level of output, we also
know the highest price the firm can charge
• Total revenue—which is the number of units
of output times the price per unit—follows
automatically
The Cost Constraint
• Every firm struggles to reduce costs, but there is a
limit to how low costs can go
– These limits impose a second constraint on the firm
• The firm uses its production function, and the prices
it must pay for its inputs, to determine the least cost
method of producing any given output level
• For any level of output the firm might want to
produce
– It must pay the cost of the “least cost method” of
production
The Total Revenue And Total Cost Approach
• At any given output level, we know
– How much revenue the firm will earn
– Its cost of production
• Loss
– A negative profit—when total cost exceeds total revenue
• In the total revenue and total cost approach, the firm
calculates Profit = TR – TC at each output level
– Selects output level where profit is greatest
The Marginal Revenue and Marginal Cost
Approach
• Marginal revenue
–Change in total revenue from
producing one more unit of output
• MR = ΔTR / ΔQ
• Tells us how much revenue rises per
unit increase in output
The Marginal Revenue and Marginal Cost
Approach
• Important things to notice about marginal revenue
– When MR is positive, an increase in output causes total revenue to rise
– Each time output increases, MR is smaller than the price the firm charges
at the new output level
• When a firm faces a downward sloping demand curve, each
increase in output causes
– Revenue gain
• From selling additional output at the new price
– Revenue loss
• From having to lower the price on all previous units of output
– Marginal revenue is therefore less than the price of the last unit of output
Using MR and MC to Maximize Profits
• Marginal revenue and marginal cost can be used to
find the profit-maximizing output level
– Logic behind MC and MR approach
• An increase in output will always raise profit as long as marginal
revenue is greater than marginal cost (MR > MC)
– Converse of this statement is also true
• An increase in output will lower profit whenever marginal revenue
is less than marginal cost (MR < MC)
– Guideline firm should use to find its profit-maximizing level
of output
• Firm should increase output whenever MR > MC, and decrease
output when MR < MC
Figure 2(a): Profit Maximization
Dollars
$3,500
TC
3,000
2,500
Profit at 5
Units
2,000
Profit at 3
Units
1,500
1,000
TR
DTR from producing 2nd unit
500
Total Fixed
Cost
Profit at 7
Units
DTR from producing 1st unit
0
1
2
3
4
5
6
7
8
9
10
Output
Figure 2(b): Profit Maximization
Dollars
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
4
5
6
7
profit falls
8
Output
MR
The MR and MC Approach Using Graphs
• Figure 2 also illustrates the MR and MC approach to
maximizing profits
• Can summarize MC and MR approach
– To maximize profits the firm should produce level of
output closest to point where MC = MR
• Level of output at which the MC and MR curves intersect
• This rule is very useful—allows us to look at a
diagram of MC and MR curves and immediately
identify profit-maximizing output level
An Important Proviso
• Important exception to this rule
– Sometimes MC and MR curves cross at two
different points
– In this case, profit-maximizing output level
is the one at which MC curve crosses MR
curve from below
What About Average Costs?
• Different types of average cost (ATC, AVC, and AFC) are
irrelevant to earning the greatest possible level of profit
– Common error—sometimes made even by business managers—is to
use average cost in place of marginal cost in making decisions
• Problems with this approach
– ATC includes many costs that are fixed in short-run—including cost of all fixed
inputs such as factory and equipment and design staff
– ATC changes as output increases
• Correct approach is to use the marginal cost and to consider
increases in output one unit at a time
– Average cost doesn’t help at all; it only confuses the issue
• Average cost should not be used in place of marginal cost as a
basis for decisions
Dealing With Losses: The Short Run and
the Shutdown Rule
• You might think that a loss-making firm should always shut down its
operation in the short run
– However, it makes sense for some unprofitable firms to continue operating
• The question is
– Should this firm produce at Q* and suffer a loss?
• The answer is yes—if the firm would lose even more if it stopped producing and
shut down its operation
• If, by staying open, a firm can earn more than enough revenue to cover its
operating costs, then it is making an operating profit (TR > TVC)
– Should not shut down because operating profit can be used to help pay fixed
costs
– But if the firm cannot even cover its operating costs when it stays open, it
should shut down
Dealing With Losses: The Short-Run and
the Shutdown Rule
• Guideline—called the shutdown rule—for a lossmaking firm
– Let Q* be output level at which MR = MC
– Then in the short-run
• If TR > Q* firm should keep producing
• If TR < Q* firm should shut down
• If TR = Q* firm should be indifferent between shutting down and
producing
• The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in shortrun
Figure 4(a): Loss Minimization
Dollars
TFC
Q*
Output
Figure 4(b): Loss Minimization
Dollars
MC
Q*
MR
Output
Figure 5: Shut Down
Dollars
TC
TVC
Loss at Q*
TFC
TR
TFC
Q*
Output
The Long Run: The Exit Decision
• We only use term shut down when referring
to short-run
• If a firm stops production in the long-run it is
termed an exit
• A firm should exit the industry in long- run
– When—at its best possible output level—it has
any loss at all
Using The Theory: Getting It Wrong—The
Failure of Franklin National Bank
• In the mid-1970’s, Franklin National Bank—one of
the largest banks in the United States—went
bankrupt
• In mid-1974, John Sadlik, Franklin’s CFO, asked his
staff to compute average cost to bank of a dollar in
loanable funds
– Determined to be 7¢
– At the time, all banks—including Franklin—were charging
interest rates of 9 to 9.5% to their best customers
– Ordered his loan officers to approve any loan that could be
made to a reputable borrower at 8% interest
Using The Theory: Getting It Wrong—The
Failure of Franklin National Bank
• Where did Franklin get the additional funds it was
lending out?
– Were borrowed not at 7%, the average cost of funds, but
at 9 to 11%, the cost of borrowing in the federal funds
market
• Not surprisingly, these loans—which never should
have been made—caused Franklin’s profits to
decrease
– Within a year the bank had lost hundreds of millions of
dollars
– This, together with other management errors, caused bank
to fail
Using The Theory: Getting It Right—The
Success of Continental Airlines
• Continental Airlines was doing something that
seemed like a horrible mistake
– Yet Continental’s profits—already higher than industry
average—continued to grow
• A serious mistake was being made by the other
airlines, not Continental
– Using average cost instead of marginal cost to make
decisions
• Continental’s management, led by its vice-president
of operations, had decided to try marginal approach
to profit
Macroeconomics
•
Macroeconomics is the study of the
economy as a whole.
 Its
goal is to explain the economic changes
that affect many households, firms, and
markets at once.
Macroeconomics
•
Macroeconomics answers questions like
the following:
 Why
is average income high in some countries and
low in others?
 Why do prices rise rapidly in some time periods
while they are more stable in others?
 Why do production and employment expand in
some years and contract in others?
The Economy’s
Income and Expenditure
When judging whether the economy is
doing well or poorly, it is natural to look
at the total income that everyone in the
economy is earning.
What is National Income?
• National income measures the total value of
goods and services produced within the economy
over a period of time
• National Income can be calculated in three main
ways
• 1. The sum of factor incomes earned in
production
• 2. Aggregate demand for goods and services
• 3. The sum of value added from each productive
sector of the economy
Why is national income important?
• Measuring the level and rate of growth of
national income (Y) is important to economists
when they are considering:
– Economic growth and where a country is in the
business cycle
– Changes to average living standards of the
population
– Looking at the distribution of national income (i.e.
measuring income and wealth inequalities)
The Economy’s
Income and Expenditure
•
For an economy as a whole, income must
equal expenditure because:
Every
transaction has a buyer and a seller.
Every dollar of spending by some buyer is
a dollar of income for some seller.
Gross Domestic Product
•
•
Gross domestic product (GDP) is a
measure of the income and
expenditures of an economy.
It is the total market value of all final
goods and services produced within a
country in a given period of time.
The Circular-Flow Diagram
The equality of income and
expenditure can be illustrated
with the circular-flow diagram.
The Circular-Flow Diagram
Revenue
Goods &
Services sold
Market for
Goods
and Services
Firms
Spending
Goods &
Services bought
Households
Inputs for
production
Wages, rent, and
profit
Market for
Factors
of Production
Labor, land, and
capital
Income
The Measurement of GDP
GDP is the market value of all
final goods and services
produced within a country in a
given period of time.
The Measurement of GDP
•
•
•
Output is valued at market prices.
It records only the value of final goods, not
intermediate goods (the value is counted only
once).
It includes both tangible goods (food, clothing,
cars) and intangible services (haircuts,
housecleaning, doctor visits).
The Measurement of GDP
•
•
It includes goods and services currently
produced, not transactions involving goods
produced in the past.
It measures the value of production within
the geographic confines of a country.
The Measurement of GDP
•
It measures the value of production that
takes place within a specific interval of
time, usually a year or a quarter (three
months).
What Is Counted in GDP?
GDP includes all items
produced in the economy
and sold legally in markets.
What Is Not Counted in GDP?
•
•
GDP excludes most items that are
produced and consumed at home and
that never enter the marketplace.
It excludes items produced and sold
illicitly, such as illegal drugs.
Other Measures of Income
•
•
•
•
•
Gross National Product (GNP)
Net National Product (NNP)
National Income
Personal Income
Disposable Personal Income
Gross National Product
•
•
Gross national product (GNP) is the total
income earned by a nation’s permanent
residents (called nationals).
It differs from GDP by including income that
our citizens earn abroad and excluding
income that foreigners earn here.
Net National Product (NNP)
•
•
Net National Product (NNP) is the total
income of the nation’s residents (GNP)
minus losses from depreciation.
Depreciation is the wear and tear on the
economy’s stock of equipment and
structures.
National Income
•
•
National Income is the total income earned
by a nation’s residents in the production of
goods and services.
It differs from NNP by excluding indirect
business taxes (such as sales taxes) and
including business subsidies.
Personal Income
•
•
•
Personal income is the income that households
and noncorporate businesses receive.
Unlike national income, it excludes retained
earnings, which is income that corporations
have earned but have not paid out to their
owners.
In addition, it includes household’s interest
income and government transfers.
Disposable Personal Income
•
•
Disposable personal income is the income
that household and noncorporate
businesses have left after satisfying all their
obligations to the government.
It equals personal income minus personal
taxes and certain nontax payments.
The Components of GDP
GDP (Y ) is the sum of the following:




Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)
Y = C + I + G + NX
The Components of GDP
•
Consumption (C):
 The
spending by households on goods and
services, with the exception of purchases of
new housing.
•
Investment (I):
 The
spending on capital equipment,
inventories, and structures, including new
housing.
The Components of GDP
•
Government Purchases (G):
 The
spending on goods and services by local,
state, and federal governments.
 Does not include transfer payments because
they are not made in exchange for currently
produced goods or services.
•
Net Exports (NX):
 Exports
minus imports.
GDP and Its Components (1998)
Total
(in billions of dollars)
Per Person
(in dollars)
% of Total
Gross domestic product, Y
$8,511
$31,522
100 percent
Consumption, C
5,808
21,511
68
Investment, I
1,367
5,063
16
Government purchases, G
1,487
5,507
18
Net exports, NX
-151
-559
-2
GDP and Its Components (1998)
GDP and Its Components (1998)
Consumption
68 %
GDP and Its Components (1998)
Investment
16%
Consumption
68 %
GDP and Its Components (1998)
Investment
16%
Consumption
68 %
Government
Purchases
18%
GDP and Its Components (1998)
Government Purchases
Investment
Net Exports
18%
16%
-2 %
Consumption
68 %
Real versus Nominal GDP
•
•
Nominal GDP values the production of
goods and services at current prices.
Real GDP values the production of goods
and services at constant prices.
Real versus Nominal GDP
An accurate view of the economy
requires adjusting nominal to real
GDP by using the GDP deflator.
GDP Deflator
•
•
The GDP deflator measures the current
level of prices relative to the level of prices
in the base year.
It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than a
rise in the quantities produced.
GDP Deflator
The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
Converting Nominal GDP to Real GDP
Nominal GDP is converted to real GDP
as follows:
(Nominal GDP20xx )
Real GDP20xx =
X 100
(GDP deflator20xx )
Real and Nominal GDP
Year
Price of
Hot dogs
Quantity of
Hot dogs
Price of
Hamburgers
Quantity of
Hamburgers
2001
$1
100
$2
50
2002
$2
150
$3
100
2003
$3
200
$4
150
Real and Nominal GDP
Calculating Nominal GDP:
2001
($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002
($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600
2003
($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200
Real and Nominal GDP
Calculating Real GDP (base year 2001):
2001
($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002
($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
2003
($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500
Real and Nominal GDP
Calculating the GDP Deflator:
2001
($200/$200) x 100 = 100
2002
($600/$350) x 100 = 171
2003
($1200/$500) x 100 = 240
Real GDP in the United States
Billions of 1992
Dollars
(Periods of falling real GDP)
8,000
7,000
6,000
5,000
4,000
3,000
1970
1975
1980
1985
1990
1995
2000
GDP and Economic
Well-Being
•
•
GDP is the best single measure of the
economic well-being of a society.
GDP per person tells us the income and
expenditure of the average person in the
economy.
GDP and Economic
Well-Being
•
•
Higher GDP per person indicates a higher
standard of living.
GDP is not a perfect measure of the
happiness or quality of life, however.
GDP and Economic
Well-Being
•
Some things that contribute to well-being are
not included in GDP.
 The
value of leisure.
 The value of a clean environment.
 The value of almost all activity that takes place
outside of markets, such as the value of the time
parents spend with their children and the value of
volunteer work.
GDP, Life Expectancy, and Literacy
Country
Real GDP per
Person (1997)
Life
Expectancy
United States
$29,010
77 years
99%
Japan
24,070
80
99
Germany
21,260
77
99
Mexico
8,370
72
90
Brazil
6,480
67
84
Russia
4,370
67
99
Indonesia
3,490
65
85
China
3,130
70
83
India
1,670
63
53
Pakistan
1,560
64
41
Bangladesh
1,050
58
39
920
50
59
Nigeria
Adult
Literacy
Summary
•
•
Because every transaction has a buyer and a
seller, the total expenditure in the economy
must equal the total income in the economy.
Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of these
goods and services.
Summary
•
•
GDP is the market value of all final goods
and services produced within a country in a
given period of time.
GDP is divided among four components of
expenditure: consumption, investment,
government purchases, and net exports.
Summary
•
•
Nominal GDP uses current prices to value
the economy’s production. Real GDP uses
constant base-year prices to value the
economy’s production of goods and
services.
The GDP deflator--calculated from the ratio
of nominal to real GDP--measures the level
of prices in the economy.
Summary
•
•
GDP is a good measure of economic wellbeing because people prefer higher to
lower incomes.
It is not a perfect measure of well-being
because some things, such as leisure time
and a clean environment, aren’t measured
by GDP.
Graphical
Review
The Circular-Flow Diagram
Revenue
Goods &
Services sold
Market for
Goods
and Services
Firms
Spending
Goods &
Services bought
Households
Inputs for
production
Wages, rent, and
profit
Market for
Factors
of Production
Labor, land, and
capital
Income
GDP and Its Components (1998)
Government Purchases
Investment
Net Exports
18%
16%
-2 %
Consumption
68 %