Ch.8 1. Managers can operate in accordance with a complex set of objectives and under various constraints. However, we can assume that firms act as if they are maximizing long-run profit. 2. Many markets may approximate perfect competition in that one or more firms act as if they face a nearly horizontal demand curve. In general, the number of firms in an industry is not always a good indicator of the extent to which that industry is competitive. 3. Because a firm in a competitive market accounts for a small share of total industry output, it makes its output choice under the assumption that its production decision will have no effect on the price of the product. In this case, the demand curve and the marginal revenue curve are identical. 4. In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost. Price must, however, be greater than or equal to the firm’s minimum average variable cost of production. 5. The short-run market supply curve is the horizontal summation of the supply curves of the firms in an industry. It can be characterized by the elasticity of supply: the percentage change in quantity supplied in response to a percentage change in price. 6. The producer surplus for a firm is the difference between its revenue and the minimum cost that would be necessary to produce the profit-maximizing output. In both the short run and the long run, producer surplus is the area under the horizontal price line and above the marginal cost of production. 7. Economic rent is the payment for a scarce factor of production less the minimum amount necessary to hire that factor. In the long run in a competitive market, producer surplus is equal to the economic rent generated by all scarce factors of production. 8. In the long run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost. 9. A long-run competitive equilibrium occurs under these conditions: (a) when firms maximize profit; (b) when all firms earn zero economic profit, so that there is no incentive to enter or exit the industry; and (c) when the quantity of the product demanded is equal to the quantity supplied. 10. The long-run supply curve for a firm is horizontal when the industry is a constant-cost industry in which the increased demand for inputs to production (associated with an increased demand for the product) has no effect on the market price of the inputs. But the longrun supply curve for a firm is upward sloping in an increasing-cost industry, where the increased demand for inputs causes the market price of some or all inputs to rise. Ch.9 1. Simple models of supply and demand can be used to analyze a wide variety of government policies, including price controls, minimum prices, price support programs, production quotas or incentive programs to limit output, import tariffs and quotas, and taxes and subsidies. 2. In each case, consumer and producer surplus are used to evaluate the gains and losses to consumers and producers. Applying the methodology to natural gas price controls, airline regulation, price supports for wheat, and the sugar quota shows that these gains and losses can be quite large. 3. When government imposes a tax or subsidy, price usually does not rise or fall by the full amount of the tax or subsidy. Also, the incidence of a tax or subsidy is usually split between producers and consumers. The fraction that each group ends up paying or receiving depends on the relative elasticities of supply and demand. 4. Government intervention generally leads to a deadweight loss; even if consumer surplus and producer surplus are weighted equally, there will be a net loss from government policies that shifts surplus from one group to the other. In some cases, this deadweight loss Ch.10 1. Market power is the ability of sellers or buyers to affect the price of a good. 2. Market power comes in two forms. When sellers charge a price that is above marginal cost, we say that they have monopoly power, which we measure by the extent to which price exceeds marginal cost. When buyers can obtain a price below their marginal value of the good, we say they have monopsony power, which we measure by the extent to which marginal value exceeds price. 3. Monopoly power is determined in part by the number of firms competing in a market. If there is only one firm—a pure monopoly—monopoly power depends entirely on the elasticity of market demand. The less elastic the demand, the more monopoly power the firm will have. When there are several firms, monopoly power also depends on how the firms interact. The more aggressively they compete, the less monopoly power each firm will have. 4. Monopsony power is determined in part by the number of buyers in a market. If there is only one buyer— a pure monopsony—monopsony power depends on the elasticity of market supply. The less elastic the supply, the more monopsony power the buyer will have. When there are several buyers, monopsony power also depends on how aggressively they compete for supplies. 5. Market power can impose costs on society. Because monopoly and monopsony power both cause production to fall below the competitive level, there is a deadweight loss of consumer and producer surplus. There can be additional social costs from rent seeking. 6. Sometimes, scale economies make pure monopoly desirable. But the government will still want to regulate price to maximize social welfare. 7. More generally, we rely on the antitrust laws to prevent firms from obtaining excessive market power. Ch.11 FIGURE 11.1 CAPTURING CONSUMER SURPLUS If a firm can charge only one price for all its customers, that price will be P* and the quantity produced will be Q*. Ideally, the firm would like to charge a higher price to consumers willing to pay more than P*, thereby capturing some of the consumer surplus under region A of the demand curve. The firm would also like to sell to consumers willing to pay prices lower than P*, but only if doing so does not entail lowering the price to other consumers. In that way, the firm could also capture some of the surplus under region B of the demand curve Price discrimination can take three broad forms, which we call first-, second-, and third-degree price discrimination. We will examine them in turn. First-Degree Price Discrimination Ideally, a firm would like to charge a different price to each of its customers. If it could, it would charge each customer the maximum price that the customer is willing to pay for each unit bought. We call this maximum price the customer’s reservation price. The practice of charging each customer his or her reservation price is called perfect first-degree price discrimination.1 Let’s see how it affects the firm’s profit. First, we need to know the profit that the firm earns when it charges only the single price P* in Figure 11.2. To find out, we can add the profit on each incremental unit produced and sold, up to the total quantity Q*. This incremental profit is the marginal revenue less the marginal cost for each unit. In Figure 11.2, this marginal revenue is highest and marginal cost lowest for the first unit. For each additional unit, marginal revenue falls and marginal cost rises. Thus the firm produces the total output Q*, at which point marginal revenue and marginal cost are equal. If we add up the profits on each incremental unit produced, we obtain the firm’s variable profit; the firm’s profit, ignoring its fixed costs. In Figure 11.2, variable profit is given by the yellow-shaded area between the marginal revenue and marginal cost curves.2 Consumer surplus, which is the area between the average revenue curve and the price P* that customers pay, is outlined as a black triangle. FIGURE 11.2 ADDITIONAL PROFIT FROM PERFECT FIRST-DEGREE PRICE DISCRIMINATION Because the firm charges each consumer her reservation price, it is profitable to expand output to Q**. When only a single price, P*, is charged, the firm’s variable profit is the area between the marginal revenue and marginal cost curves. With perfect price discrimination, this profit expands to the area between the demand curve and the marginal cost curve. PERFECT PRICE DISCRIMINATION What happens if the firm can perfectly price discriminate? Because each consumer is charged exactly what he or she is willing to pay, the marginal revenue curve is no longer relevant to the firm’s output decision. Instead, the incremental revenue earned from each additional unit sold is simply the price paid for that unit; it is therefore given by the demand curve. Since price discrimination does not affect the firm’s cost structure, the cost of each additional unit is again given by the firm’s marginal cost curve. Therefore, the additional profit from producing and selling an incremental unit is now the difference between demand and marginal cost. As long as demand exceeds marginal cost, the firm can increase its profit by expanding production. It will do so until it produces a total output Q**. At Q**, demand is equal to marginal cost, and producing any more reduces profit. Variable profit is now given by the area between the demand and marginal cost curves.3 Observe from Figure 11.2 how the firm’s profit has increased. (The additional profit resulting from price discrimination is shown by the purple-shaded area.) Note also that because every customer is being charged the maximum amount that he or she is willing to pay, all consumer surplus has been captured by the firm. IMPERFECT PRICE DISCRIMINATION In practice, perfect first-degree price discrimination is almost never possible. First, it is usually impractical to charge each and every customer a different price (unless there are only a few customers). Second, a firm usually does not know the reservation price of each customer. Even if it could ask how much each customer would be willing to pay, it probably would not receive honest answers. After all, it is in the customers’ interest to claim that they would pay very little. Sometimes, however, firms can discriminate imperfectly by charging a few different prices based on estimates of customers’ reservation prices. This practice is often used by professionals, such as doctors, lawyers, accountants, or architects, who know their clients reasonably well. In such cases, the client’s willingness to pay can be assessed and fees set accordingly. For example, a doctor may offer a reduced fee to a low-income patient whose willingness to pay or insurance coverage is low, but charge higher fees to upper-income or betterinsured patients. And an accountant, having just completed a client’s tax returns, is in an excellent position to estimate how much the client is willing to pay for the service. Another example is a car salesperson, who typically works with a 15-percent profit margin. The salesperson can give part of this margin away to the customer by making a “deal,” or can insist that the customer pay the full sticker price. A good salesperson knows how to size up customers: A customer who is likely to look elsewhere for a car is given a large discount (from the salesperson’s point of view, a small profit is better than no sale and no profit), but the customer in a hurry is offered little or no discount. In other words, a successful car salesperson knows how to price discriminate! Still another example is college and university tuition. Colleges don’t charge different tuition rates to different students in the same degree programs. Instead, they offer financial aid, in the form of scholarships or subsidized loans, which reduces the net tuition that the student must pay. By requiring those who seek aid to disclose information about family income and wealth, colleges can link the amount of aid to ability (and hence willingness) to pay. Thus students who are financially well off pay more for their education, while students who are less well off pay less. Figure 11.3 illustrates imperfect first-degree price discrimination. If only a single price were charged, it would be P4 * . Instead, six different prices are charged, the lowest of which, P6 , is set at about the point where marginal cost intersects the demand curve. Note that those customers who would not have been willing to pay a price of P4 * or greater are actually better off in this situation—they are now in the market and may be enjoying at least some consumer surplus. In fact, if price. Ch.12 In many industries, the products are differentiated. For one reason or another, consumers view each firm’s brand as different from other brands. Crest toothpaste, for example, is perceived to be different from Colgate, Aim, and other toothpastes. The difference is partly flavor, partly consistency, and partly reputation—the consumer’s image (correct or incorrect) of the relative decay-preventing efficacy of Crest. As a result, some consumers (but not all) will pay more for Crest. Because Procter & Gamble is the sole producer of Crest, it has monopoly power. But its monopoly power is limited because consumers can easily substitute other brands if the price of Crest rises. Although consumers who prefer Crest will pay more for it, most of them will not pay much more. The typical Crest user might pay 25 or 50 cents a tube more, but probably not one or two dollars more. For most consumers, toothpaste is toothpaste, and the differences among brands are small. Therefore, the demand curve for Crest toothpaste, though downward sloping, is fairly elastic. (A reasonable estimate of the elasticity of demand for Crest is −5.) Because of its limited monopoly power, Procter & Gamble will charge a price that is higher, but not much higher, than marginal cost. The situation is similar for Tide detergent or Scott paper towels. The Makings of Monopolistic Competition A monopolistically competitive market has two key characteristics: 1. Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes. In other words, the crossprice elasticities of demand are large but not infinite. 2. There is free entry and exit: It is relatively easy for new firms to enter the market with their own brands and for existing firms to leave if their products become unprofitable. To see why free entry is an important requirement, let’s compare the markets for toothpaste and automobiles. The toothpaste market is monopolistically competitive, but the automobile market is better characterized as an oligopoly. It is relatively easy for other firms to introduce new brands of toothpaste, and this limits the profitability of producing Crest or Colgate. If the profits were large, other firms would spend the necessary money (for development, production, advertising, and promotion) to introduce new brands of their own, which would reduce the market shares and profitability of Crest and Colgate. The automobile market is also characterized by product differentiation. However, the large-scale economies involved in production make entry by new firms difficult. Thus, until the mid-1970s, when Japanese producers became important competitors, the three major U.S. automakers had the market largely to themselves. There are many other examples of monopolistic competition besides toothpaste. Soap, shampoo, deodorants, shaving cream, cold remedies, and many other items found in a drugstore are sold in monopolistically competitive markets. The markets for many sporting goods are likewise monopolistically competitive. So is most retail trade, because goods are sold in many different stores that compete with one another by differentiating their services according to location, availability and expertise of salespeople, credit terms, etc. Entry is relatively easy, so if profits are high in a neighborhood because there are only a few stores, new stores will enter. Equilibrium in the Short Run and the Long Run As with monopoly, in monopolistic competition firms face downward-sloping demand curves. Therefore, they have some monopoly power. But this does not mean that monopolistically competitive firms are likely to earn large profits. Monopolistic competition is also similar to perfect competition: Because there is free entry, the potential to earn profits will attract new firms with competing brands, driving economic profits down to zero. To make this clear, let’s examine the equilibrium price and output level for a monopolistically competitive firm in the short and long run. Figure 12.1(a) shows the short-run equilibrium. Because the firm’s product differs from its competitors’, its demand curve DSR is downward sloping. (This is the firm’s demand curve, not the market demand curve, which is more steeply sloped.) The profitmaximizing quantity QSR is found at the intersection of the marginal revenue and marginal cost curves. Because the corresponding price PSR exceeds average cost, the firm earns a profit, as shown by the shaded rectangle in the figure. In the long run, this profit will induce entry by other firms. As they introduce competing brands, our firm will lose market share and sales; its demand curve will shift down, as in Figure 12.1(b). (In the long run, the average and marginal cost curves may also shift. We have assumed for simplicity that costs do not change.) The long-run demand curve DLR will be just tangent to the firm’s average cost curve. Here, profit maximization implies the quantity QLR and the price PLR. It also implies zero profit because price is equal to average cost. Our firm still has monopoly power: Its long-run demand curve is downward sloping because its particular brand is still unique. But the entry and competition of other firms have driven its profit to zero. More generally, firms may have different costs, and some brands will be more distinctive than others. In this case, firms may charge slightly different prices, and some will earn small profits. Monopolistic Competition and Economic Efficiency Perfectly competitive markets are desirable because they are economically efficient: As long as there are no externalities and nothing impedes the workings of the market, the total surplus of consumers and producers is as large as possible. Monopolistic competition is similar to competition in some respects, but is it an efficient market structure? To answer this question, let’s compare the long-run equilibrium of a monopolistically competitive industry to the long-run equilibrium of a perfectly competitive industry. Figure 12.2 shows that there are two sources of inefficiency in a monopolistically competitive industry: 1. Unlike perfect competition, with monopolistic competition the equilibrium price exceeds marginal cost. This means that the value to consumers of additional units of output exceeds the cost of producing those units. If output were expanded to the point where the demand curve intersects the marginal cost curve, total surplus could be increased by an amount equal to the yellow-shaded area in Figure 12.2(b). This should not be surprising. We saw in Chapter 10 that monopoly power creates a deadweight loss, and monopoly power exists in monopolistically competitive markets. 2. Note in Figure 12.2(b) that for the monopolistically competitive firm, output is below that which minimizes average cost. Entry of new firms drives profits to zero in both perfectly competitive and monopolistically competitive markets. In a perfectly competitive market, each firm faces a horizontal demand curve, so the zero-profit point occurs at minimum average cost, as Figure 12.2(a) shows. In a monopolistically competitive market, however, the demand curve is downward sloping, so the zero-profit point is to the left of minimum average cost. Excess capacity is inefficient because average cost would be lower with fewer firms. These inefficiencies make consumers worse off. Is monopolistic competition then a socially undesirable market structure that should be regulated? The answer—for two reasons—is probably no: 1. In most monopolistically competitive markets, monopoly power is small. Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has much monopoly power. Any resulting deadweight. FIGURE 12.1 A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN Because the firm is the only producer of its brand, it faces a downward-sloping demand curve. Price exceeds marginal cost and the firm has monopoly power. In the short run, described in part (a), price also exceeds average cost, and the firm earns profits shown by the yellow-shaded rectangle. In the long run, these profits attract new firms with competing brands. The firm’s market share falls, and its demand curve shifts downward. In long-run equilibrium, described in part (b), price equals average cost, so the firm earns zero profit even though it has monopoly power.
