Microeconomics 1
Schedule
Two weeks ago we introduced a cost curve
… minimum cost at which a firm can produce.
Today: How much should a firm produce?
Theory of the firm:
• Maximization of profit
Microeconomics 1
A model of extreme market competition:
Lecture 4
Perfect competition
•
•
Perfectly competitive market
Competitive supply curve
•
Supply in the short and long run
Analysis of competitive markets
• Market interventions and efficiency
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Maximal profit for a firm
Knowledge clip
Chapter 8
Profit maximization
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Profit maximization - short run
Profit maximization - short run
We always assume that firms try to maximize their profits.
Profit = Revenue - Costs
q … one firm’s output
P(q) … price of unit of output
Optimal choice of output
C(q),
R(q),
P(q)
Marginal costs (MC) are given
by slope of C(q);
- additional costs from producing
C(q)
R(q)
Revenue: R(q) = P(q)•q
C(q),
R(q),
P(q)
Slope of this line
is MR at q 1
C(q)
R(q)
one more unit of output.
C(q) … total cost
Firm maximizes profit at
output level where the
difference between revenue
and costs is greatest.
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Slope of this line
is MC at q 1
Marginal revenue (MR) given
by slope of R(q);
- additional revenue from
Profit: π(q) = R (q) - C (q)
producing one more unit of output.
q (output)
0
q*
q (output)
0
! "! !
q1
q*
! "! !
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Microeconomics 1
Profit maximization - short run
Profit maximization - short run
• The price at which the firm sells its products may
depend on the firm’s output q à P(q) … (demand for firm’s products)
(this is NOT market demand)
if MR>MC then we want to increase
output (as in q 1);
if MR<MC then we want to decrease
output (as in q 2);
if MR=MC then we reached maximal
profit! (at q *)
C(q),
R(q),
P(q)
• By selling q units of output the firm will then earn revenue
R(q) = q*P(q)
C(q)
R(q)
A
Profit P(q) = R(q) - C(q)
=> at q * the slope of the revenue curve
(at A) is the same as the slope of the
cost curve (at B).
B
is maximized where
q (output)
0
q0
q1
q*
!!$ "#
=!
!"
That is:
Û MR(q) - MC(q) = 0
q2
Û
! "! !
Profit is maximal when
Profit is maximized at the output for which MR=MC!
7
!" !!"#$ !%"#$
=
#
=!
!#
!#
!#
MR(q) = MC(q)
8
Perfectly competitive markets
What are the most competitive markets?
Three characteristics for perfect competition:
1)
Chapter 8
Perfect competition
Price taking
Each individual firm is very small
à cannot influence the market price Single firm sees a horizontal
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demand curve!
2)
Product homogeneity
Firms produce homogenous product;
à all firms in the market produce perfect substitutes.
3)
Free entry and exit
No costs or limitations that would make it difficult for a
firm to enter or exit the market.
à firms can easily enter or exit this market.
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Competitive profit maximization in short run
Maximal profit under perfect competition
Knowledge clip
Competitive firm is a price taker
Þ faces a horizontal demand curve (at the current price) P(q) = P
Þ revenues are R(q) = P•q (a linear function)
Þ MR(q) = P and AR(q) = P are both constant.
Þ Because MC = MR at the maximal profit:
Marginal cost pricing rule for a perfectly competitive firm
MC(q) = P
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Microeconomics 1
Firm supply curve in the short run
Competitive profit maximization in short run
Knowledge clip
MC
Money
units 60
50
Lost profit for
q1 < q*
40 A
C
Lost profit for
q2 > q*
P=MR (=AR)
ATC
30 B
D
AVC
At q*: MR = MC
and P > ATC
p = (P-ATC)•q
= area ABCD
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0
1 2
q0
3
4
5
q 0: MC = MR, but MC is decreasing
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7 8 9
q1 q* q2
10
q0 : AVC > P
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Output
(quantity)
q*: AVC < P
This is PR:
fig. 8.3
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Supply curve
Supply curve
p, costs
p, costs
MC
ATC
p1
p1
Produce with profit
at these prices
MC
ATC
ATC(q 1)
AVC
q1
AVC
q1
q
To analyze, consider the average variable costs AVC
and the average total costs, ATC
With price p1, rule MC=P gives quantity q1.
The average costs per unit are given by ATC(q1).
Because p1>ATC(q1), the firm is making a profit.
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Supply curve
Supply curve
p, costs
loss at q2: ATC(q2) - p2 per unit.
MC
p, costs
loss at q2: ATC(q2) - p2 per unit.
MC
ATC
ATC(q 2)
p2
q
The firm will
make a profit
for all p*
larger than
the minimum
of ATC
ATC
ATC(q 2)
AVC
Total loss
q2
q
With price p2, MC=P gives quantity q2.
p2
Total loss
AVC
q2
q
If p < min ATC then the firm always makes a loss (in the short-run).
The average costs per unit are given by ATC(q2).
It incurs a loss even if it produces no output, q=0,
because it has fixed costs (in the short-run).
Because p2<ATC(q2), the firm is making a loss.
Then, (in the short run) it chooses q* that minimizes its losses.
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Microeconomics 1
Supply curve
Supply curve
loss at q2: q2 * [ATC(q2) - p2].
p, costs
p, costs
MC
MC
ATC
The firm will
produce with a
loss for all p*
between the
minimum of AVC
and min of ATC
ATC(q 2)
AVC
p2 ProduceTotal fixed cost
with loss
q2
ATC
AVC
AVC(q 3)
p3
q
q3
q
FC(q2) = q2*AFC(q2) = q2*[ ATC(q2) - AVC(q2) ] > q2*[ ATC(q2) - p2 ],
… because p2>AVC(q2)
With price p3, MC=P gives quantity q3.
=> better produce q2 than q=0: produce with a loss to earn back
some of the fixed costs!
Because p3<AVC(q3), the firm is not even earning enough to pay
the variable costs: it will lose more than fixed costs.
The average variable costs per unit are given by AVC(q3).
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Supply curve
Supply curve
p, costs
p, costs
MC
ATC
AVC
AVC(q 3)
p3
Produce 0
q3
q
Producing q=0 would lose only the fixed costs.
=> It is better to produce nothing.
Produce with profit
MC
Produce
AVC
Produce with loss
The firm will
produce
nothing for
all p* below
the min. AVC
don’t
produce
Produce 0
q
Relationship between price and quantity produced:
Supply curve
(short-run, perfect competition)
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Competitive profit maximization in short run
From individual supply to market supply
Summary of competitive production decisions
The short-run market supply curve is
the horizontal sum of the supply curves of the firms.
– Profit is maximized at q* when MC(q*) = P
(condition: P>AVC, MC are increasing at q* à Friday lecture).
ATC
MC 1
price
S
MC 2 MC 3
– If P > ATC(q*) the firm is making profits.
– If P < ATC(q*) the firm should shut-down in the long run
P3
– If AVC(q*) < P < ATC(q*) the firm should keep producing in the
short run.
Notation:
Q … market output
q … firm output
P2
A firm should shut down in the long run if, for all outputs,
the average cost of production is above the price of the product.
P1
This is PR:
fig. 8.9
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4 5
7 8
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Quantity
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Microeconomics 1
Competitive equilibrium in the long run
Long-run competitive output
Knowledge clip
Money
units
In the long run,
a firm can
change all
inputs, and
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even its size.
Short run:
P = 40 > SAC.
Profit = ABCD.
LMC
LAC
SMC
D
SAC
A
E
C
G
F
Long run:
- plant size increased,
- output increased to q 3
- profit increased:
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At P=30:
LMC=P for q 2
P=LAC
àeconomic profit = 0
P = MR
B
EFGD > ABCD.
q1
q2
q3
.
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Output
This is PR:
fig. 8.13
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Long-run competitive equilibrium
Long-run competitive equilibrium
The supply side of an economy is in a long-run
competitive equilibrium if the following holds for all firms:
price
price
Firm
Market
1) LMC = P
(each firm maximizes profit)
S1
Positive profits lead to entry
by new firms.
At P 1 firm earns positive profit.
2) LAC = P
(each active firm earns zero economic profit)
LMC
P1
LAC
P2
P1
S2
3) Equilibrium market price
(market quantity supplied equals quantity demanded)
P2
D
q2
Q1
O utput
Q2
Economic profit attracts new firms à price drops
Supply increases until economic profit = 0
What does it mean that economic profits are zero?
O utput
This is PR:
fig. 8.14
èno alternative industry is better (think of opportunity costs)
èaccounting profits can still be positive!
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Market supply curve in the long run
Long-run market supply
Knowledge clip
The long-run market supply cannot be found by summing
individual long-run supply curves.
• Because in the long-run firms exit and enter the market.
For the analysis assume
• all firms have access to the available production technology.
• output is increased only with more inputs (no invention).
But costs of inputs may change with expansions and
contractions of the industry
• Example: wages may increase if industry expands and needs more labour
• Example: machines may be mass produced with expansion, and cheaper
We distinguish between three types of industries:
constant-cost, increasing-cost, decreasing cost
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Microeconomics 1
Long-run market supply – constant input costs
Long-run market supply – increasing input costs
Money
units
P2
Let demand ­ è Eq. price ­ P 2
Economic profits è new firms.
Supply ­ to S 2 .
If input prices ­, then incr. costs.
LAC2
SMC2
SMC1
LAC1
price
S1
S2
P3
P1
P1
B
A
D1
q2
Let demand ­ è Eq. price ­ P 2
Economic profits è new firms.
Supply ­ to S 2 . If const. costs,
market returns to LR equilibrium.
SL
MC
P2
P3
q1
Money
units
Q1
O utput
Q2 Q3
input prices ­ è MC ­ è AC ­
è min AC ­
è equilibrium at higher price.
S2
S1
AC
P2
P2
P1
P1
C
B
A
D1
SL
D1
q1
O utput
If increased demand for inputs increases their prices, then long-run supply is
upward sloping.
. icroeconom ics 6011PE0139, lecture 4
M
price
This is PR:
fig. 8.17
q2
Output
Q1
Q2
D2
Output
This is only possible if purchase of more inputs leaves their prices (=AC) unaffected.
Long-run supply is then horizontal line at price equal to the minimum AC
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This is PR:
fig. 8.16
.
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Short-run producer surplus
Short-run producer surplus
Producer surplus is
the sum of MR-MC = P-MC across all q * units
Price
Producer
Surplus
MC
Producer surplus of an individual firm
AVC
Firms earn a surplus (not profit) on all but the last unit of output:
B
P
A
Alternatively:
Producer surplus is difference
between total revenue (R) and
total variable costs (VC)
D
• Producer surplus = sum (over all units produced) of difference
between market price of good and marginal costs of production.
Surplus vs. profit:
PS = R - VC
P = R – TC = R – VC – FC
Þ P=PS-FC Þ PS=P+FC
R is P•q* or area OABq*.
C
total VC at q* is AVC(q*)•q*,
or area ODCq*.
0
q*
At q , MC = MR.
Output
This is PR:
fig. 8.11
*
. icroeconom ics 6011PE0139, lecture 4
M
Producer surplus also given by area ABCD.
• Firm’s profit = firm’s surplus - firm’s fixed costs
Notation:
Q … market output
q … firm output
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Short-run producer surplus
Producer surplus for the market
Price
S
Chapter 9
Analysis of competitive markets
Total market producer surplus
is the area between P*
and S, from 0 to Q*.
P*
Because S=MC!
Total producer
surplus
D
Q*
Output
This is PR:
fig. 8.12
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Microeconomics 1
Consumer and Producer Surplus
Consumer and Producer Surplus
Consumer surplus
• Consumers A and B gain from
buying at the market price
Consumer surplus
• Consumers A and B gain from
buying at the market price
Producer surplus
• Firms gain from selling to
consumers A and B at the
market price
Total surplus = CS + PS
• Together, consumer and
producer surplus measure the
welfare benefit of a market.
• Maximal total surplus can be
gained with the equilibrium
price of a perfectly competitive
market
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Market efficiency
Price controls
Maximal price regulation
•
The price of a good is regulated to
be no higher than P max < P 0.
With the equilibrium
price and quantity, a
competitive market
can yield maximal
possible surplus
(… som e hidden assum ptions here:
week 7)
But prices and quantity in a competitive market may not be at
the equilibrium if the market is regulated:
•
taxes (BTW, VAT, sales tax, …)
•
price controls (rent limitations, agricultural subsidy, …)
•
trade controls (import tariffs, quotas)
This is why economists promote free markets.
•
However, often there are other gains from regulation:
Supply drops to Q 1 < Q 0
•
Some beneficial trades are not
made à loss of market welfare
•
Consumers gain A and lose B in
surplus. They benefit if A>B.
•
Producers lose A and C.
•
B and C are lost.
• Deadweight loss = B+C
All these may lead to welfare losses.
•
•
In equilibrium
P0 , Q0
Example: maximal rent for regulated housing
in Amsterdam
• leads to shortage of rental apartments
– taxes support public services;
– tariffs support domestic industries and employees.
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Price controls
Price controls
Knowledge clip
Deadweight loss is the
net loss of the total surplus.
Maximal price regulation with
inelastic demand
•
If demand is sufficiently inelastic,
then surplus lost to consumers B
may be larger than their gain A.
•
In this case, both producers and
consumers lose from price control.
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Microeconomics 1
Price controls
Price controls
Excessive price
•
The producers set the price at
P 2 > P 0.
•
Demand drops to Q 3 < Q 0
•
•
Some beneficial trades are not
made à loss of market welfare
The price of a good is regulated to
be no lower than P min > P 0.
•
Demand drops to Q 3 < Q 0
•
But supply may increase to Q 2 !
•
The excessive supply Q 2-Q 3 is
unsold (revenue = 0)
•
Producers gain A but lose C and
D. The loss may be larger than
their gain.
•
Producers gain A and lose C in
surplus. They benefit if A>C.
•
Consumers lose A and B.
•
B and C are lost.
Minimal price regulation
• Deadweight loss = B+C
• Deadweight loss = B+C+D
Example: enforced pricing of airline fares in
1970s
• leads to empty planes
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Price controls
Import quotas and tariffs
Price support
•
Knowledge clip
The government buys excess
supply in order to artificially inflate
prices to P s > P 0.
•
Demand drops to Q 1 < Q 0
•
Government buys Q g=Q 2-Q 1 at
price P s
•
Producers gain A+B+D in surplus.
•
Consumers lose -A-B in surplus
• Government cost = P s(Q 2 − Q 1).
•
There may be deadweight loss if
the excess quantity is not resold.
Example: USA wheat production support
• leads to produce dumping overseas
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Import Quotas and Tariffs
Import Quotas and Tariffs
Import prohibition
Import quota = limit on the quantity of a good that can be imported.
•
Consider domestic supply and
demand (in a local market)
Tariff = tax on an imported good.
•
Assume a world price P w.
Import restriction
•
In a free market, the domestic price
would be up to P w.
•
When imports are reduced, the domestic
price is increased from P w to P*.
•
This can be achieved by a quota,
but also by by a tariff T = P* − P w.
•
Domestic producers gain A
•
consumers lose: -A-B-C-D
•
•
A total Q d would be consumed, of
which Q s is supplied domestically
and the rest imported.
If imports are eliminated, the price
would increase to P 0.
•
Domestic producers would gain A.
•
Consumers would lose –A-B-C
•
deadweight loss = B+C.
Tariff:
•
•
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government gains D, the revenue from
the tariff. The net domestic loss is
-B-C.
Quota:
foreign producers gain D,
the net domestic loss is -B-C-D
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Microeconomics 1
Taxes and subsidies
Taxes and Subsidies
Specific tax
Knowledge clip
•
Fixed amount t of money per unit sold.
•
P b is the price paid by buyers,
P s is the price that sellers receive,
P b - P s = t.
•
Traded quantity drops to Q 1 such that:
$ = $# ""! !
%
# = #! ""! !
$
"$ ! "# = !
•
Buyers lose -A-B.
•
Sellers lose -D-C.
•
The government gains A+D in revenue.
•
The deadweight loss is B+C.
Example: tax charged at the purchase
• reduces consumption and market efficiency
• but enables public services (social efficiency)
• also useful if production/consumption is polluting
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Summary
Taxes and Subsidies
Specific subsidy
•
Subsidy s is a negative tax
•
Fixed amount s of price is covered by
the government.
•
P b - P s = -s à s = P s - P b
•
Traded quantity raises to Q 1 such that:
• A firm maximizes its profit by setting output such that
marginal costs = marginal revenue.
$ = $# ""! !
%
# = #! ""! !
$
• For a competitive firm the demand for its output is horizontal
– a firm sells at a constant P
– Competitive supply follows the marginal cost curves
– In the long run equilibrium P = min LAC
Ps - Pb = s
•
Buyers and sellers gain.
•
The government loses.
•
The deadweight loss comes from the
excessive trades.
• Perfect competition between sellers can lead to efficient markets
• Market interventions in competitive markets may produce deadweight loss
Example: EU agricultural subsidies
• increases agricultural production
• costly, hurt overseas agriculture producers
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After this week…..
.... you should be able to:
• explain what price taking behavior is
• show why profit maximization in perfect competition yields marginal
cost pricing
• derive an individual firm’s supply curve in perfect competition
• depict graphically firm’s producer surplus and producer surplus in a
market
• give relationship between producer surplus and profit
• derive the long-run market supply curve for constant, increasing,
and decreasing costs
• calculate the welfare effects of price regulation, taxes, quotas, and
subsidies
End of Lecture 4
Next Week
Inefficiency of monopoly
Strategy in oligopoly
M icro-econom ics 6011PE0139, lecture 3
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