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Mba1014 perfect competition 180513
 

Mba1014 perfect competition 180513

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Perfect Competition

Perfect Competition

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    Mba1014 perfect competition 180513 Mba1014 perfect competition 180513 Presentation Transcript

    • Go Global !Go Global !Managerial Economics :Managerial Economics :Perfect CompetitionPerfect CompetitionByStephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management,Visiting Professor, College of Management,Shenzhen UniversityShenzhen UniversityMay 2013May 2013
    • AgendaAgenda1.1. Market TypesMarket Types2.2. Profit MaximisationProfit Maximisation3.3. Market EfficiencyMarket Efficiency
    • Learning ObjectivesLearning ObjectivesTo understand the four market typesTo understand the four market typesTo compare the degree of priceTo compare the degree of pricecompetition among the four marketcompetition among the four markettypestypesTo explain why the P=MC rule leadsTo explain why the P=MC rule leadsfirms to the optimal level of productionfirms to the optimal level of productionTo explain how the MR=MC rule helps aTo explain how the MR=MC rule helps amonopoly to determine its optimummonopoly to determine its optimumTo explain the relationship between theTo explain the relationship between theMR=MC rule and the P=MC ruleMR=MC rule and the P=MC ruleTo describe what happens in the longTo describe what happens in the longrunrun
    • 11Market TypesMarket Types
    • OverviewOverviewCompetition and market typesCompetition and market typesPricing and output decisionsPricing and output decisionsin perfect competitionin perfect competitionImplications for managerialImplications for managerialdecisionsdecisions
    • Market StructureMarket StructureCharacteristicCharacteristicPerfectPerfectCompetitionCompetitionMonopolisticMonopolisticCompetitionCompetition OligopolyOligopoly MonopolyMonopolyNumber of firmsNumber of firmscompetingcompetingLarge numberLarge number Large numberLarge number Small numberSmall number Single firmSingle firmNature of theNature of theproductproductUndifferentiatedUndifferentiated DifferentiatedDifferentiatedUndifferentiatedUndifferentiatedor differentiatedor differentiatedUniqueUniqueEntryEntry No barriersNo barriers Few barriersFew barriers Many barriersMany barriers BlockedBlockedInformationInformationavailabilityavailabilityCompleteComplete Relatively goodRelatively good AsymmetricAsymmetric AsymmetricAsymmetricFirm’s controlFirm’s controlover priceover priceNoneNone SomeSome SomeSome SubstantialSubstantial
    • Market type 1: Perfect competitionMarket type 1: Perfect competitionNo market powerNo market powerlarge number of relativelylarge number of relativelysmall buyers and sellerssmall buyers and sellersstandardized productstandardized productvery easy market entry andvery easy market entry andexitexitNon-price competition notNon-price competition notpossiblepossible
    • 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 governmentsubject to governmentregulationregulationone firm, firm is the industryone firm, firm is the industryunique product or no closeunique product or no closesubstitutessubstitutesmarket entry and exit difficult ormarket entry and exit difficult orlegally impossiblelegally impossibleNon-price competition notNon-price competition notnecessarynecessaryMarket type 2: MonopolyMarket type 2: Monopoly
    • Four market typesFour market typesExamplesExamples: Monopoly: MonopolypharmaceuticalspharmaceuticalsMicrosoftMicrosoftgas station on edge ofgas station on edge ofdesertdesert
    • Market power based on productMarket power based on productdifferentiationdifferentiationlarge number of small firms actinglarge number of small firms actingindependentlyindependentlydifferentiated productdifferentiated productmarket entry and exit relativelymarket entry and exit relativelyeasyeasyNon-price competition veryNon-price competition veryimportantimportantMarket type 3:Market type 3: MonopolisticMonopolisticCompetitionCompetition
    • Four market typesFour market typesExamplesExamples: Monopolistic Competition: Monopolistic Competitionboutiquesboutiquesrestaurantsrestaurantsrepair shopsrepair shops
    • Product differentiationProduct differentiationand/or the firm’sand/or the firm’sdominance of the marketdominance of the market small number of large mutuallysmall number of large mutuallyinterdependent firmsinterdependent firms differentiated or standardizeddifferentiated or standardizedproductproduct market entry and exit difficultmarket entry and exit difficult Non-price competition importantNon-price competition importantMarket type 4: OligopolyMarket type 4: Oligopoly
    • Four market typesFour market typesExamplesExamples: oligopoly: oligopolyoil refiningoil refiningprocessed foodsprocessed foodsairlinesairlinesinternet accessinternet access
    • Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.15Four market types
    • 22Profit MaximisationProfit Maximisation
    • Perfectly Competitive MarketsPerfectly Competitive MarketsPRICE TAKINGPRICE TAKINGBecauseBecause each individual firm sells a sufficiently smalleach individual firm sells a sufficiently smallproportion of total market output, its decisions have noproportion of total market output, its decisions have noimpact on market price.impact on market price.Price takerPrice taker Firm that has no influence over market price and thusFirm that has no influence over market price and thustakes the price as given.takes the price as given.PRODUCT HOMOGENEITYPRODUCT HOMOGENEITYWhenWhen the products of all of the firms in a market are perfectlythe products of all of the firms in a market are perfectlysubstitutable with one another—that is,substitutable with one another—that is, when they arewhen they arehomogeneoushomogeneous—no firm can raise the price of its product—no firm can raise the price of its productabove the price of other firms without losing most or all of itsabove the price of other firms without losing most or all of itsbusiness. In contrast, when products are heterogeneous, eachbusiness. In contrast, when products are heterogeneous, eachfirm has the opportunity to raise its price above that of itsfirm has the opportunity to raise its price above that of itscompetitors without losing all of its sales.competitors without losing all of its sales.The assumption of product homogeneity is important becauseThe assumption of product homogeneity is important becauseit ensures that there is a single market price, consistent withit ensures that there is a single market price, consistent withsupply-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 specialCondition under which there are no specialcosts 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 thatMany markets are highly competitive in the sense thatfirms face highly elastic demand curves and relativelyfirms face highly elastic demand curves and relativelyeasy entry and exit. But there is no simple rule of thumbeasy entry and exit. But there is no simple rule of thumbto describe whether a market is close to being perfectlyto describe whether a market is close to being perfectlycompetitive. Because firms can implicitly or explicitlycompetitive. Because firms can implicitly or explicitlycollude in setting pricescollude in setting prices, the presence of many firms, the presence of many firmsis not sufficient for an industry to approximate perfectis not sufficient for an industry to approximate perfectcompetition. Conversely, the presence of only a few firmscompetition. Conversely, the presence of only a few firmsin 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 fromone supplier to another, and suppliers can easily enter orone supplier to another, and suppliers can easily enter orexit a market.exit a market.
    • Profit MaximisationProfit MaximisationDo Firms Maximise Profit?The assumption ofThe assumption of profit maximisationprofit maximisation isisfrequently used in microeconomics because itfrequently used in microeconomics because itpredicts business behaviour reasonablypredicts business behaviour reasonablyaccurately and avoids unnecessary analyticalaccurately and avoids unnecessary analyticalcomplications.complications.ForFor smaller firms managed by their owners,smaller firms managed by their owners,profitprofit is likely to dominate almost all decisions.is likely to dominate almost all decisions.In larger firms, however, managers who makeIn larger firms, however, managers who makeday-to-day decisions usually have little contactday-to-day decisions usually have little contactwith the owners.with the owners.Firms that do not come close to maximisingFirms that do not come close to maximisingprofit are not likely to survive. The firms that doprofit are not likely to survive. The firms that dosurvive make long-run profit maximisation one ofsurvive make long-run profit maximisation one oftheir highest priorities.their highest priorities.
    • While owners of condominiums must join with fellow condo ownersWhile owners of condominiums must join with fellow condo ownersto manage common, they can make their own decisions as to how toto manage common, they can make their own decisions as to how tomanage their individual units. In contrast, co-ops share joint liabilitymanage their individual units. In contrast, co-ops share joint liabilityon any outstanding mortgage on the co-op building and are subjecton any outstanding mortgage on the co-op building and are subjectto more complex governance rules.to more complex governance rules.Nationwide, condos are far more common than co-ops, outnumberingNationwide, condos are far more common than co-ops, outnumberingthem by a factor of nearly 10 to 1. In this regard, New York City isthem by a factor of nearly 10 to 1. In this regard, New York City isvery different from the rest of the nation—co-ops are more popular,very different from the rest of the nation—co-ops are more popular,and outnumber condos by a factor of about 4 to 1.and outnumber condos by a factor of about 4 to 1.Many building restrictions in New York have long disappeared, andMany building restrictions in New York have long disappeared, andyet the conversion of apartments from co-ops to condos has beenyet the conversion of apartments from co-ops to condos has beenrelatively slow. The typical condominium apartment is worth aboutrelatively slow. The typical condominium apartment is worth about15.5 percent more15.5 percent more than a equivalent apartment held in thethan a equivalent apartment held in theform of a co-op. Clearly, holding an apartment in the form of a co-opform of a co-op. Clearly, holding an apartment in the form of a co-opis 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 forgoIt appears that in New York, many owners have been willing to forgosubstantial amounts of money in order tosubstantial amounts of money in order to achieve non-achieve non-monetary benefits.monetary benefits.CONDOMINIUMS VERSUS COOPERATIVES INCONDOMINIUMS VERSUS COOPERATIVES INNEW 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 increaseChange in revenue resulting from a one-unit increasein output.in output.A firm chooses outputA firm chooses output qq*, so*, sothat profit, the differencethat profit, the difference ABABbetween revenuebetween revenue RR and costand cost CC,,is maximized.is maximized.At that output, marginalAt that output, marginalrevenue (the slope of therevenue (the slope of therevenue curve) is equal torevenue curve) is equal tomarginal cost (the slope of themarginal cost (the slope of thecost curve).cost curve).Δπ/ΔΔπ/Δqq == ΔΔRR//ΔΔqq −− ΔΔC/C/ΔΔqq = 0= 0MR(MR(qq) = MC() = MC(qq))PROFIT MAXIMIZATONPROFIT MAXIMIZATONIN THE SHORT RUNIN THE SHORT RUN
    • Demand and Marginal Revenue for aDemand and Marginal Revenue for aCompetitive FirmCompetitive FirmA competitive firm supplies only a small portion of the total output of allA competitive firm supplies only a small portion of the total output of allthe firms in an industry. Therefore, the firm takes the market price of thethe firms in an industry. Therefore, the firm takes the market price of theproduct as given, choosing its output on the assumption that the priceproduct as given, choosing its output on the assumption that the pricewill be unaffected by the output choice. In (a) the demand curve facingwill be unaffected by the output choice. In (a) the demand curve facingthe firm is perfectly elastic,the firm is perfectly elastic, even though the market demand curve ineven though the market demand 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 curveThe demand curve dd facing an individual firm in afacing an individual firm in acompetitive market is both its average revenue curvecompetitive market is both its average revenue curveand its marginal revenue curve. Along this demandand its marginal revenue curve. Along this demandcurve, marginal revenue, average revenue, and pricecurve, marginal revenue, average revenue, and priceare all equal.are all equal.Profit Maximization by a Competitive FirmProfit Maximization by a Competitive FirmMC(MC(q) =q) = MRMR = P= PBecause each firm in a competitive industry sells only aBecause each firm in a competitive industry sells only asmall fraction of the entire industry output,small fraction of the entire industry output, how muchhow muchoutput the firm decides to sell will have no effect on theoutput the firm decides to sell will have no effect on themarket 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 anindividual competitive firm is given by a horizontal line.individual competitive firm is given by a horizontal line.A perfectly competitive firm should choose itsA perfectly competitive firm should choose itsoutput so thatoutput so that marginal cost equals pricemarginal cost equals price::
    • Short-Run Profit Maximisation by a Competitive FirmShort-Run Profit Maximisation by a Competitive FirmA COMPETITIVEA COMPETITIVEFIRM MAKING AFIRM MAKING APOSITIVE PROFITPOSITIVE PROFITIn the short run, theIn the short run, thecompetitive firmcompetitive firmmaximises its profit bymaximises its profit bychoosing an outputchoosing an output q*q* atatwhich its marginal costwhich its marginal costMC is equal to the priceMC is equal to the pricePP (or marginal revenue(or marginal revenueMR) of its product.MR) of its product.The profit of the firm isThe profit of the firm ismeasured by themeasured by therectanglerectangle ABCDABCD..Any change in output,Any change in output,whether lower atwhether lower at qq11 ororhigher athigher at qq22, will lead to, will lead tolower profit.lower profit.Output Rule: If a firm is producingOutput Rule: If a firm is producingany output, it should produce at theany output, it should produce at thelevel at which marginal revenuelevel at which marginal revenueequals marginal cost.equals marginal cost.Choosing Output in the Short RunChoosing Output in the Short Run
    • Model of Perfect CompetitionModel of Perfect CompetitionAA large numberlarge number of firms inof firms inthe marketthe marketAnAn undifferentiated productundifferentiated productEase of entry into the marketEase of entry into the marketoror no barriers to entryno barriers to entryComplete informationComplete informationavailable to all marketavailable to all marketparticipantsparticipants
    • Model of the Industry andModel of the Industry andthe Firmthe FirmSDQPQEPEMCATCD = P = MRQ*PQ
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Basic business decision: entering aBasic business decision: entering amarket using the following questions:market using the following questions:how much should wehow much should we produceproduce??if we produce such an amount, howif we produce such an amount, howmuchmuch profitprofit will we earn?will we earn?if a loss rather than a profit isif a loss rather than a profit isincurred, will it be worthwhile toincurred, will it be worthwhile tocontinue in this market in the longcontinue in this market in the longrun (in hopes that we will eventuallyrun (in hopes that we will eventuallyearn a profit) or should weearn a profit) or should we exit?exit?
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Key assumptions of the perfectlyKey assumptions of the perfectlycompetitive market:competitive market: the firm is athe firm is a price takerprice taker the firm makes the distinction betweenthe firm makes the distinction betweenthe short run and the long runthe short run and the long run the firm’s objective is tothe firm’s objective is to maximize itsmaximize itsprofitprofit (or minimize loss) in the short(or minimize loss) in the shortrunrun the firm includes itsthe firm includes its opportunity costopportunity costof operating in a particular market asof operating in a particular market aspart of its total cost of productionpart of its total cost of production
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competitionPerfectly elastic demandPerfectly elastic demandcurvecurve:: consumers are willingconsumers are willingto buy as much as the firm isto buy as much as the firm iswilling to sell at the goingwilling to sell at the goingmarket pricemarket price firm receives the samefirm receives the samemarginal revenue from the salemarginal revenue from the saleof each additional unit ofof each additional unit ofproduct;product; equal to the priceequal to the priceof the productof the product no limit to the totalno limit to the totalrevenuerevenue that the firm canthat the firm cangain in a perfectly competitivegain in a perfectly competitivemarketmarket
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Total revenue/Total costTotal revenue/Total costapproach:approach: compare the total revenue and totalcompare the total revenue and totalcost schedules and find thecost schedules and find the level oflevel ofoutputoutput that either maximizes the firm’sthat either maximizes the firm’sprofits or minimizes its lossprofits or minimizes its loss
    • Profit Maximizing Level ofProfit Maximizing Level ofOutputOutput Profit is theProfit is thedifference betweendifference betweentotal revenue andtotal revenue andtotal cost:total cost:π =π = TRTR -- TCTCwherewhereπ = profitπ = profitTR =TR = total revenuetotal revenueTC =TC = total costtotal cost To maximize profits,To maximize profits,a firm shoulda firm shouldproduce the level ofproduce the level ofoutput whereoutput wheremarginal revenuemarginal revenueequals marginal cost.equals marginal cost.MR = MCMR = MCwherewhereMR =MR = ΔTR / ΔQΔTR / ΔQMC =MC = ΔTC / ΔQΔTC / ΔQ
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Marginal revenue/Marginal costMarginal revenue/Marginal costapproachapproach produce a level of output at which theproduce a level of output at which theadditional revenue received from the lastadditional revenue received from the lastunit is equal to the additional cost ofunit is equal to the additional cost ofproducing that unit (ie.producing that unit (ie. MR=MCMR=MC))Note: for the perfectly competitive firm, theNote: for the perfectly competitive firm, theMR=MC rule may be restated asMR=MC rule may be restated as P=MCP=MCbecause P=MR in perfectly competitivebecause P=MR in perfectly competitivemarketmarket
    • Marginal RevenueMarginal RevenueThe marginalThe marginalrevenue curve for therevenue curve for theperfectly competitiveperfectly competitivefirm is horizontalfirm is horizontalbecause the firm canbecause the firm cansell all units ofsell all units ofoutput at the marketoutput at the marketprice thereforeprice therefore pricepriceequals marginalequals marginalrevenuerevenue for thefor theperfectly competitiveperfectly competitivefirm.firm.$QP = MR
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competitionCase A:Case A: EconomicEconomicprofitprofitThe point whereThe point whereP=MR=MCP=MR=MC is theis theoptimal outputoptimal output(Q*)(Q*) profit = TR – TCprofit = TR – TC= (P - AC)= (P - AC) xx Q*Q*
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Case B:Case B: EconomicEconomiclosslossThe firm incurs a loss.The firm incurs a loss.At optimum output,At optimum output,price is below ACprice is below AC however, sincehowever, sinceP>AVCP>AVC, the firm is, the firm isbetter off producingbetter off producingin the short run,in the short run,because it will stillbecause it will stillincur fixed costsincur fixed costsgreater than the lossgreater than the loss
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competitionContribution margin:Contribution margin:the amount by whichthe amount by whichtotal revenuetotal revenueexceeds totalexceeds totalvariable costvariable costCM = TR – TVCCM = TR – TVC if CM > 0, the firmif CM > 0, the firmshould continue toshould continue toproduce in the shortproduce in the shortrun in order to defrayrun in order to defraysome of the fixedsome of the fixedcostcost
    • Calculation of ProfitCalculation of Profitππ == TRTR -- TCTCπ = (π = (PP)()(QQ) - () - (ATCATC)()(QQ))π = (π = (PP -- ATCATC)()(QQ),),thereforethereforeIfIf P >P > ATC,ATC, π > 0π > 0IfIf P <P < ATC,ATC, π < 0π < 0IfIf PP == ATC,ATC, π = 0π = 0
    • Shutdown Point for aShutdown Point for aPerfectly Competitive FirmPerfectly Competitive FirmThe price, whichThe price, whichequals a firm’sequals a firm’sminimumminimumaverage variableaverage variablecostcost, below which, below whichit is more profitableit is more profitablefor the perfectlyfor the perfectlycompetitive firm tocompetitive firm toshut down than toshut down than tocontinue tocontinue toproduce.produce.MCATCAVCPsd
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competitionShutdown point:Shutdown point: the lowest price atthe lowest price atwhich the firm would still producewhich the firm would still produceAt the shutdown point, the price isAt the shutdown point, the price isequal to the minimum point on the AVCequal to the minimum point on the AVCP=min(AVC)P=min(AVC)If the price falls below the shutdownIf the price falls below the shutdownpoint, revenues fail to cover the fixedpoint, revenues fail to cover the fixedcosts and the variable costs. The firmcosts and the variable costs. The firmwould be better off if it shut down andwould be better off if it shut down andjust paid its fixed costsjust paid its fixed costs
    • When Should the Firm Shut Down?When Should the Firm Shut Down?A COMPETITIVEA COMPETITIVEFIRM INCURRINGFIRM INCURRINGLOSSESLOSSESA competitive firmA competitive firmshould shut down ifshould shut down ifprice is below AVC.price is below AVC.The firm mayThe firm mayproduce in the shortproduce in the shortrun if price isrun if price isgreater thangreater thanaverage variableaverage variablecost.cost.
    • THE SHORT-RUN OUTPUT OF ANTHE SHORT-RUN OUTPUT OF ANALUMINUM SMELTING PLANTALUMINUM SMELTING PLANTTHE SHORT-RUN OUTPUT DECISION OF ANALUMINUM SMELTING PLANTHow should the manager determine the plant’sHow should the manager determine the plant’sprofit maximizing output? Recall that the smeltingprofit maximizing output? Recall that the smeltingplant’s short-run marginal cost of productionplant’s short-run marginal cost of productiondepends on whether it is running two or threedepends on whether it is running two or threeshifts per day.shifts per day.In the short run, the plant shouldIn the short run, the plant shouldproduce 600 tons per day if priceproduce 600 tons per day if priceis above $1140 per ton but lessis above $1140 per ton but lessthan $1300 per ton.than $1300 per ton.If price is greater than $1300 perIf price is greater than $1300 perton, it should run an overtime shiftton, it should run an overtime shiftand 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 inbut it should probably stay inbusiness because the price maybusiness because the price mayrise in the future.rise in the future.
    • The application of the rule that marginal revenue should equal marginal costThe application of the rule that marginal revenue should equal marginal costdepends 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 costaverage variable costshould 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 MANAGERSCurrent outputCurrent output 100 units per day, 80 of which are produced during the regular shift100 units per day, 80 of which are produced during the regular shiftand 20 of which are produced during overtimeand 20 of which are produced during overtimeMaterials costMaterials cost $8 per unit for all output$8 per unit for all outputLabor 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 shiftFor the first 80 units of output, average variable cost andFor the first 80 units of output, average variable cost andmarginal cost are both equal to $38 per unit. When outputmarginal cost are both equal to $38 per unit. When outputincreases to 100 units, marginal cost is higher than averageincreases to 100 units, marginal cost is higher than averagevariable cost, so a manager who relies on average variable costvariable cost, so a manager who relies on average variable costwill produce too much.will produce too much.2.2.Also, a single item on a firm’s accounting ledger may have twoAlso, a single item on a firm’s accounting ledger may have twocomponents, only one of which involvescomponents, only one of which involves marginal costmarginal cost..3.3.Finally, allFinally, all opportunity costsopportunity costs should be included in determiningshould be included in determiningmarginal cost.marginal cost.These three guidelines can help a manager to measure marginalThese three guidelines can help a manager to measure marginalcost correctly. Failure to do so can cause production to be toocost correctly. Failure to do so can cause production to be toohigh or too low and thereby reduce profit.high or too low and thereby reduce profit.
    • Supply Curve for theSupply Curve for thePerfectly Competitive FirmPerfectly Competitive FirmThe portion of aThe portion of afirm’s marginal costfirm’s marginal costcurve that liescurve that liesabove the minimumabove the minimumaverage variableaverage variablecost.cost.$QSRATCSRAVCSRS =MC
    • The Competitive Firm’s Short-runThe Competitive Firm’s Short-runSupply CurveSupply CurveTHE SHORT-RUNTHE SHORT-RUNSUPPLY CURVE FOR ASUPPLY CURVE FOR ACOMPETITIVE FIRMCOMPETITIVE FIRMThe firm’s supply curve isThe firm’s supply curve is the portion of the marginalthe portion of the marginalcost curve for which marginal cost is greater thancost curve for which marginal cost is greater thanaverage variable cost.average variable cost.In the short run, the firmIn the short run, the firmchooses its output sochooses its output sothat marginal cost MC isthat marginal cost MC isequal to price as longequal to price as longas the firm covers itsas the firm covers itsaverage variable cost.average variable cost.The short-run supplyThe short-run supplycurve is given by thecurve is given by thecrosshatched portion ofcrosshatched portion ofthe marginal cost curve.the marginal cost curve.
    • THE RESPONSE OF ATHE RESPONSE OF AFIRM TO A CHANGE INFIRM TO A CHANGE ININPUT PRICEINPUT PRICEWhen the marginalWhen the marginalcost of productioncost of productionfor a firm increasesfor a firm increases(from MC(from MC11 to MCto MC22),),the level of outputthe level of outputthat maximizesthat maximizesprofit falls (fromprofit falls (from qq11toto qq22).).The Firm’s Response to an Input PriceThe Firm’s Response to an Input PriceChangeChange
    • THE SHORT-RUNTHE SHORT-RUNPRODUCTION OFPRODUCTION OFPETROLEUM PRODUCTSPETROLEUM PRODUCTSTHE SHORT-RUN P RODUCTION OFTHE SHORT-RUN P RODUCTION OFPETROLEUM PRODUCTSPETROLEUM PRODUCTSAlthough plenty of crude oil is available,Although plenty of crude oil is available,the amount that you refine depends on thethe amount that you refine depends on thecapacity of the refinery and the cost ofcapacity of the refinery and the cost ofproduction.production.As the refinery shifts fromAs the refinery shifts fromone processing unit toone processing unit toanother, the marginal costanother, the marginal costof producing petroleumof producing petroleumproducts from crude oilproducts from crude oilincreases sharply at severalincreases sharply at severallevels of output.levels of output.As a result, the output levelAs a result, the output levelcan be insensitive to somecan be insensitive to somechanges in price but verychanges in price but verysensitive to others.sensitive to others.
    • The Short-Run Market Supply CurveThe Short-Run Market Supply CurveINDUSTRY SUPPLY ININDUSTRY SUPPLY INTHE SHORT RUNTHE SHORT RUNThe short-run industryThe short-run industrysupply curve is thesupply curve is thesummation of the supplysummation of the supplycurves of the individualcurves of the individualfirms.firms.Because the third firm has aBecause the third firm has alower average variable costlower average variable costcurve than the first twocurve than the first twofirms, the market supplyfirms, the market supplycurvecurve SS begins at pricebegins at price PP11and follows the marginaland follows the marginalcost curve of the third firmcost curve of the third firmMCMC33 until price equalsuntil price equals PP22,,when there is a kink.when there is a kink.ForFor PP22 and all prices aboveand all prices aboveit, the industry quantityit, the industry quantitysupplied is the sum of thesupplied is the sum of thequantities supplied by eachquantities supplied by eachof the three firms.of the three firms.Elasticity of Market SupplyElasticity of Market SupplyEEss == ((ΔΔQQ//QQ)/()/(ΔΔPP//PP))
    • THE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPERCosts of mining, smelting, and refining copper differCosts of mining, smelting, and refining copper differbecause of differences in labour and transportation costsbecause of differences in labour and transportation costsand because of differences in the copper content of theand because of differences in the copper content of theore.ore.TABLE 1TABLE 1 THE WORLD COPPER INDUSTRY (2010)THE WORLD COPPER INDUSTRY (2010)COUNTRYCOUNTRYANNUAL PRODUCTIONANNUAL PRODUCTION(THOUSAND METRIC(THOUSAND METRICTONS)TONS)MARGINAL COSTMARGINAL COST(DOLLARS PER(DOLLARS PERPOUND)POUND)AustraliaAustralia 900900 2.302.30CanadaCanada 480480 2.602.60ChileChile 5,5205,520 1.601.60IndonesiaIndonesia 840840 1.801.80PeruPeru 12851285 1.701.70PolandPoland 430430 2.402.40RussiaRussia 750750 1.301.30USUS 11201120 1.701.70ZambiaZambia 770770 1.501.50
    • THE SHORT-RUN WORLDTHE SHORT-RUN WORLDSUPPLY OF COPPERSUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPERThe world supply curve is obtained by summing each nation’sThe world supply curve is obtained by summing each nation’ssupply curve horizontally. The elasticity of supply depends on thesupply curve horizontally. The elasticity of supply depends on theprice of copper. At relatively low prices, the curve is quite elasticprice of copper. At relatively low prices, the curve is quite elasticbecause small price increases lead to large increases in the quantitybecause small price increases lead to large increases in the quantityof copper supplied. At higher prices—say, above $2.40 per pound—of copper supplied. At higher prices—say, above $2.40 per pound—the curve becomes more inelastic because, at those prices, mostthe curve becomes more inelastic because, at those prices, mostproducers would be operating close to or at capacity.producers would be operating close to or at capacity.The supply curve for worldThe supply curve for worldcopper is obtained bycopper is obtained bysumming the marginal costsumming the marginal costcurves for each of the majorcurves for each of the majorcopper-producing countries.copper-producing countries.The supply curve slopesThe supply curve slopesupward because the marginalupward because the marginalcost of production rangescost of production rangesfrom a low of 65 cents infrom a low of 65 cents inRussia to a high of $1.30 inRussia to a high of $1.30 inCanada.Canada.
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition In theIn the lonlong run, the price in theg run, the price in thecompetitive market will settle at thecompetitive market will settle at thepoint where firms earn apoint where firms earn a normalnormalprofitprofit economic profiteconomic profit invites entry of new firmsinvites entry of new firms shifts the supply curve to the rightshifts the supply curve to the right puts downward pressure on price andputs downward pressure on price andreduces profitsreduces profits economic losseconomic loss causes exit of firmscauses exit of firms  shiftsshiftsthe supply curve to the leftthe supply curve to the left  puts upwardputs upwardpressure on price and increases profitspressure on price and increases profits
    • Pricing and output decisionsPricing and output decisionsin perfect competitionin perfect competition Observations in perfectlyObservations in perfectlycompetitive markets:competitive markets: the earlier the firm enters a market, the betterthe earlier the firm enters a market, the betterits chances ofits chances of earningearning above-normal profitabove-normal profit as new firms enter the market, firms must findas new firms enter the market, firms must findways to produce at theways to produce at the lowest possible costlowest possible cost,,or at least at cost levels below those of theiror at least at cost levels below those of theircompetitorscompetitors firms that find themselves unable to compete onfirms that find themselves unable to compete onthe basis of cost might want to try competing onthe basis of cost might want to try competing onthe basis ofthe basis of product differentiationproduct differentiation insteadinstead
    • Implications of perfectImplications of perfectcompetition for decision makingcompetition for decision making Perfectly competitive marketPerfectly competitive market most important lesson is that it ismost important lesson is that it isextremely difficult to make moneyextremely difficult to make money must be asmust be as cost efficientcost efficient as possibleas possible it might pay for a firm to move into ait might pay for a firm to move into amarketmarket before othersbefore others start to enterstart to enter
    • Global applicationGlobal application ExampleExample: Bluefin tuna: Bluefin tuna sushi restaurants operate insushi restaurants operate inmonopolistic competitionmonopolistic competition bluefin tuna pricebluefin tuna pricedetermined by perfectdetermined by perfectcompetitioncompetition low profit marginlow profit margin
    • 33Market EfficiencyMarket Efficiency
    • Long-Run Adjustment inLong-Run Adjustment inPerfectly Competitive IndustryPerfectly Competitive IndustryAn increase in industry demand willAn increase in industry demand willresult in aresult in a positive economic profitpositive economic profit for afor aperfectly competitive firm.perfectly competitive firm.However, this profit will be competedHowever, this profit will be competedaway by theaway by the entry of other firmsentry of other firms into theinto themarket in the long run.market in the long run.TheThe zero economic profitzero economic profit point or thepoint or thepoint where price equals average totalpoint where price equals average totalcost is the equilibrium point for thecost is the equilibrium point for theperfectly competitive firmperfectly competitive firm..
    • Long-Run Adjustment in PerfectlyLong-Run Adjustment in PerfectlyCompetitive Industry - GraphicalCompetitive Industry - GraphicalD1D2S1S2PE1PE2QE1 QE3QE2MCATCD1=P1=MR1D2=P2=MR2Q1 Q2P PQ Q
    • Long-Run Adjustment in PerfectLong-Run Adjustment in PerfectCompetition: The Optimal ScaleCompetition: The Optimal Scaleof Productionof ProductionIn the long run, the perfectlyIn the long run, the perfectlycompetitive firm has tocompetitive firm has tochoose the optimal scale ofchoose the optimal scale ofoperation. This decision,operation. This decision,combined with entry and exit,combined with entry and exit,will forcewill force price to equal long-price to equal long-run average costrun average cost..
    • Long-Run Adjustment in PerfectLong-Run Adjustment in PerfectCompetition: The Optimal ScaleCompetition: The Optimal Scaleof Production - Graphicalof Production - Graphical$QSMC1SMC2SATC1SATC2LRACP1=MR1P2=MR2Q1Q2
    • Long-Run Profit MaximisationLong-Run Profit MaximisationOUTPUT CHOICEOUTPUT CHOICEIN THE LONG RUNIN THE LONG RUNThe firm maximises itsThe firm maximises itsprofit by choosing theprofit by choosing theoutput at which priceoutput at which priceequals long-runequals long-runmarginal cost LMC.marginal cost LMC.In the diagram, the firmIn the diagram, the firmincreases its profit fromincreases its profit fromABCDABCD toto EFGDEFGD bybyincreasing its output inincreasing its output inthe long run.the long run.The long-run output of a profit-maximizingThe long-run output of a profit-maximizingcompetitive firm is the point at which long-runcompetitive firm is the point at which long-runmarginal 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 EquilibriumACCOUNTING PROFIT AND ECONOMIC PROFITACCOUNTING PROFIT AND ECONOMIC PROFITπ =π = R − wL − rKR − wL − rKZERO ECONOMIC PROFITA firm is earning a normal return on its investment—i.e., it is doingA firm is earning a normal return on its investment—i.e., it is doingas well as it could by investing its money elsewhere.as well as it could by investing its money elsewhere.ENTRY AND EXITENTRY AND EXITIn a market with entry and exit, a firm entersIn a market with entry and exit, a firm enterswhen it can earn a positive long-run profitwhen it can earn a positive long-run profitand exits when it faces the prospect of aand exits when it faces the prospect of along-run loss.long-run loss.
    • Long-run competitive equilibriumLong-run competitive equilibriumAll firms in an industry are maximising profit, no firm has anAll firms in an industry are maximising profit, no firm has anincentive to enter or exit, and price is such thatincentive to enter or exit, and price is such that quantity suppliedquantity suppliedequals quantity demanded.equals quantity demanded.When a firm earns zero economic profit, it has no incentiveWhen a firm earns zero economic profit, it has no incentiveto 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 threeA long-run competitive equilibrium occurs when threeconditions hold:conditions hold:1.1.All firms in the industry areAll firms in the industry are maximising profit.maximising profit.2.2. No firm has an incentive either to enter or exitNo firm has an incentive either to enter or exitthe industry because all firms arethe industry because all firms are earning zeroearning zeroeconomic profit.economic profit.3.3. The price of the product is such that theThe price of the product is such that thequantity supplied by the industry isquantity supplied by the industry is equalequal to theto thequantity demanded by consumers.quantity demanded by consumers.
    • LONG-RUN COMPETITIVELONG-RUN COMPETITIVEEQUILIBRIUMEQUILIBRIUMInitially the long-run equilibriumInitially the long-run equilibriumprice of a product is $40 per unit,price of a product is $40 per unit,shown in (b) as the intersection ofshown in (b) as the intersection ofdemand curvedemand curve DD and supply curveand supply curveSS11..In (a) we see that firms earnIn (a) we see that firms earnpositive profits because long-runpositive profits because long-runaverage cost reaches a minimumaverage cost reaches a minimumof $30 (atof $30 (at qq22).).Positive profit encourages entry ofPositive profit encourages entry ofnew firms and causes a shift tonew firms and causes a shift tothe right in the supply curve tothe right in the supply curve to SS22,,as shown in (b).as shown in (b).The long-run equilibrium occurs atThe long-run equilibrium occurs ata price of $30, as shown in (a),a price of $30, as shown in (a),where each firm earns zero profitwhere each firm earns zero profitand there is no incentive to enterand there is no incentive to enteror exit the industry.or exit the industry.
    • FIRMS HAVING IDENTICAL COSTSFIRMS HAVING IDENTICAL COSTSTo see why all the conditions for long-run equilibrium mustTo see why all the conditions for long-run equilibrium musthold, assume that all firms have identical costs.hold, assume that all firms have identical costs.Now consider what happens if too many firms enter theNow consider what happens if too many firms enter theindustry in response to an opportunity for profit. The industryindustry in response to an opportunity for profit. The industrysupply 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 isOnly when there is no incentive to exit or entno incentive to exit or enter can aer can amarket 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 identicalNow suppose that all firms in the industry do not have identicalcost curves. Perhaps one firm has a patent that lets it produce atcost curves. Perhaps one firm has a patent that lets it produce ata lower average cost than all the others. In that case, it isa lower average cost than all the others. In that case, it isconsistent with long-run equilibrium for that firm to earn aconsistent with long-run equilibrium for that firm to earn agreatergreater accountingaccounting profit and to enjoy a higher producer surplusprofit and to enjoy a higher producer surplusthan other firms.than other firms.If the patent is profitable, other firms in the industry will pay toIf the patent is profitable, other firms in the industry will pay touse it. The increased value of the patent thus represents anuse it. The increased value of the patent thus represents anopportunity cost to the firm that holds it. It could sell the rights toopportunity cost to the firm that holds it. It could sell the rights tothe patent rather than use it. If all firms are equally efficientthe patent rather than use it. If all firms are equally efficientotherwise, theotherwise, the economiceconomic profit of the firm falls to zeroprofit of the firm falls to zero..
    • THE OPPORTUNITY COST OF LANDTHE OPPORTUNITY COST OF LANDThere are other instances in which firms earning positiveThere are other instances in which firms earning positiveaccounting profit may be earning zero economic profit.accounting profit may be earning zero economic profit.Suppose, for example, that a clothing store happens to beSuppose, for example, that a clothing store happens to belocated near a large shopping centre. The additional flow oflocated near a large shopping centre. The additional flow ofcustomers can substantially increase the store’s accountingcustomers can substantially increase the store’s accountingprofit because the cost of the land is based on its historicalprofit because the cost of the land is based on its historicalcost. When the opportunity cost of land is included, thecost. When the opportunity cost of land is included, theprofitability of the clothing store is no higher than that of itsprofitability of the clothing store is no higher than that of itscompetitors.competitors.Economic RentIn 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 forAmount that firms are willing to pay foran input less the minimum amountan input less the minimum amountnecessary to obtain it.necessary to obtain it.In the long run, in a competitive market,In the long run, in a competitive market, the producerthe producersurplus that a firm earns on the output that it sellssurplus that a firm earns on the output that it sellsconsists of the economic rent that it enjoys from all itsconsists of the economic rent that it enjoys from all itsscarce 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 thatIn (a), a baseball team in a moderate-sized city sells enough tickets so thatprice ($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 teamIn (b), the demand is greater, so a $10 price can be charged. The teamincreases sales to the point at which the average cost of production plus theincreases sales to the point at which the average cost of production plus theaverage 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 intoWhen the opportunity cost associated with owning the franchise is taken intoaccount, 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 CurveConstant-Cost IndustryConstant-Cost IndustryIndustry whose long-run supply curve is horizontal.Industry whose long-run supply curve is horizontal.In (b), the long-run supplyIn (b), the long-run supplycurve in a constant-costcurve in a constant-costindustry is a horizontal lineindustry is a horizontal lineSSLL. When demand increases,. When demand increases,initially causing a price rise,initially causing a price rise,the firm initially increases itsthe firm initially increases itsoutput fromoutput from qq11 toto qq22, as, asshown in (a).shown in (a).But the entry of new firmsBut the entry of new firmscauses a shift to the right incauses a shift to the right inindustry supply.industry supply.Because input prices areBecause input prices areunaffected by the increasedunaffected by the increasedoutput of the industry, entryoutput of the industry, entryoccurs until the original priceoccurs until the original priceThe long-run supply curve for aThe long-run supply curve for aconstant-cost industry is, therefore, aconstant-cost industry is, therefore, ahorizontal line at a price that is equalhorizontal line at a price that is equalto theto the long-run minimum average costlong-run minimum average costof production.of production.LONG-RUN SUPPLY IN ALONG-RUN SUPPLY IN ACONSTANT COSTCONSTANT COSTINDUSTRYINDUSTRY
    • The Industry’s Long-Run Supply CurveThe Industry’s Long-Run Supply CurveIncreasing-Cost IndustryIncreasing-Cost IndustryIndustry whose long-run supply curve is upward sloping.Industry whose long-run supply curve is upward sloping.LONG-RUN SUPPLY IN ANLONG-RUN SUPPLY IN ANINCREASING COSTINCREASING COSTINDUSTRYINDUSTRYIn (b), the long-run supply curveIn (b), the long-run supply curvein an increasing-cost industry isin an increasing-cost industry isan upward-sloping curvean upward-sloping curve SSLL..When demand increases, initiallyWhen demand increases, initiallycausing a price rise, the firmscausing a price rise, the firmsincrease their output fromincrease their output from qq11 totoqq22 in (a).in (a).In that case, the entry of newIn that case, the entry of newfirms causes a shift to the rightfirms causes a shift to the rightin supply fromin supply from SS11 toto SS22..Because input prices increase asBecause input prices increase asa result, the new long-runa result, the new long-runequilibrium occurs at a higherequilibrium occurs at a higherprice than the initial equilibrium.price than the initial equilibrium.In an increasing-cost industry, theIn an increasing-cost industry, thelong-run industry supply curve islong-run industry supply curve isupward 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 theWe saw that the supply of coffee is extremely elastic in thelong run. The reason is that land for growing coffee is widelylong run. The reason is that land for growing coffee is widelyavailable and the costs of planting and caring for treesavailable and the costs of planting and caring for treesremains constant as the volume grows. Thus, coffee is aremains constant as the volume grows. Thus, coffee is aconstant-cost industry.constant-cost industry.The oil industry is an increasing cost industry because thereThe oil industry is an increasing cost industry because thereis a limited availability of easily accessible, large-volume oilis a limited availability of easily accessible, large-volume oilfields.fields.Finally, a decreasing-cost industry. In the automobileFinally, a decreasing-cost industry. In the automobileindustry, certainindustry, certain cost advantages arise because inputs can becost advantages arise because inputs can beacquired more cheaply as the volume of production increasesacquired more cheaply as the volume of production increases..CONSTANT-, INCREASING-, AND DECREASING-COSTCONSTANT-, INCREASING-, AND DECREASING-COSTINDUSTRIES: 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 sameThe long-run elasticity of industry supply is defined in the sameway as the short-run elasticity: It is the percentage change inway as the short-run elasticity: It is the percentage change inoutput (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 isIn a constant-cost industry, the long-run supply curve ishorizontal, 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 largeincrease in output.)increase in output.)In an increasing-cost industry, however, the long-run supplyIn an increasing-cost industry, however, the long-run supplyelasticity will be positive but finite.elasticity will be positive but finite.Because industries can adjust and expand in the long run, weBecause industries can adjust and expand in the long run, wewould generally expect long-run elasticities of supply to bewould generally expect long-run elasticities of supply to belarger than short-run elasticities.larger than short-run elasticities.The magnitude of the elasticity will depend on the extent toThe magnitude of the elasticity will depend on the extent towhichwhich input costs increase as the marketinput costs increase as the marketexpandsexpands. For example, an industry that depends on inputs. For example, an industry that depends on inputsthat are widely available will have a more elastic long-runthat are widely available will have a more elastic long-runsupply than will an industry that uses inputs in short supply.supply than will an industry that uses inputs in short supply.
    • THE SUPPLY CURVE FORTHE SUPPLY CURVE FORNEW YORK TAXICABSNEW YORK TAXICABSTHE SUPPLY OF TAXICABS IN NEW YORKTHE SUPPLY OF TAXICABS IN NEW YORKWhile reducing taxi fares will indeed cause a reduction in theWhile reducing taxi fares will indeed cause a reduction in thequantity supplied, raising the price will not cause an increasequantity supplied, raising the price will not cause an increasein the quantity supplied. Why not? Because the number ofin the quantity supplied. Why not? Because the number ofmedallions is fixed.medallions is fixed.If there were no restriction on theIf there were no restriction on thenumber of medallions, the supplynumber of medallions, the supplycurve would be highly elastic.curve would be highly elastic.Cab drivers work hard and don’tCab drivers work hard and don’tearn much, so a drop in the priceearn much, so a drop in the pricePP (of a 5-mile ride) would lead(of a 5-mile ride) would leadmany of them to find another job.many of them to find another job.Likewise, an increase in priceLikewise, an increase in pricewould bring many new driverswould bring many new driversinto the market. But the numberinto the market. But the numberof medallions—and therefore theof medallions—and therefore thenumber of taxicabs—is limited tonumber of taxicabs—is limited to13,150, so the supply curve13,150, so the supply curvebecomes 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 eachThe city of New York limits the number of taxis by requiring eachtaxi to have a medallion (essentially a permit), and then limitingtaxi to have a medallion (essentially a permit), and then limitingthe number of medallions. In 2011 there were 13,150 medallionsthe number of medallions. In 2011 there were 13,150 medallionsin New York—roughly the same number as in 1937. Why not justin New York—roughly the same number as in 1937. Why not justissue more medallions? The reason is simple. Doing so would incurissue more medallions? The reason is simple. Doing so would incurthe wrath of the current owners of medallions. Medallions can bethe wrath of the current owners of medallions. Medallions can bebought 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 hadIn 1937, there were plenty of medallions to go around, so they hadlittle value. By 1947, the value of a medallion had increased tolittle 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 right$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 value of—because New York City won’t issue more medallions, the value ofa taxi medallion is approaching $1 million!a taxi medallion is approaching $1 million!But of course that value would drop sharply if the city startingBut of course that value would drop sharply if the city startingissuing more medallions. So the New York taxi companies thatissuing more medallions. So the New York taxi companies thatcollectively own the 13,150 available medallions have donecollectively own the 13,150 available medallions have doneeverything possible to prevent the city from issuing any more—andeverything possible to prevent the city from issuing any more—andhave succeeded in their efforts. If the city were to issue anotherhave succeeded in their efforts. If the city were to issue another7,000 medallions for a total of about 20,000, demand and supply7,000 medallions for a total of about 20,000, demand and supplywould equilibrate at a price of about $350,000 per medallion– stillwould equilibrate at a price of about $350,000 per medallion– stilla lot, but just enough to lease cabs, run a taxi business, and stilla lot, but just enough to lease cabs, run a taxi business, and stillmake a profit.make a profit.
    • WHY CAN’T I FIND A TAXI?WHY CAN’T I FIND A TAXI?TAXI MEDALLIONSTAXI MEDALLIONSIN NEW YORK CITYIN NEW YORK CITYThe demand curveThe demand curve DDshows the quantity ofshows the quantity ofmedallions demanded bymedallions demanded bytaxi companies as ataxi companies as afunction of the price of afunction of the price of amedallion.medallion.The supply curveThe supply curve SS showsshowsthe number of medallionsthe number of medallionsthat would be sold bythat would be sold bycurrent owners as acurrent owners as afunction of price.function of price.New York limits theNew York limits thequantity to 13,150, so thequantity to 13,150, so thesupply curve becomessupply curve becomesvertical and intersectsvertical and intersectsdemand at $880,000, thedemand at $880,000, themarket price of amarket price of amedallion in 2011.medallion in 2011.
    • To begin, consider the supply of owner-occupied housing inTo begin, consider the supply of owner-occupied housing insuburban or rural areas where land is not scarce. In this case, thesuburban or rural areas where land is not scarce. In this case, theprice of land does not increase substantially as the quantity ofprice of land does not increase substantially as the quantity ofhousing supplied increases. Likewise, costs associated withhousing supplied increases. Likewise, costs associated withconstruction are not likely to increase because there is a nationalconstruction are not likely to increase because there is a nationalmarket for lumber and other materials. Therefore, the long-runmarket for lumber and other materials. Therefore, the long-runelasticity 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. TheThe market for rental housing is different, however. Theconstruction of rental housing is often restricted by local zoningconstruction of rental housing is often restricted by local zoninglaws. Many communities outlaw it entirely, while others limit it tolaws. Many communities outlaw it entirely, while others limit it tocertain areas. Because urban land on which most rental housingcertain areas. Because urban land on which most rental housingis located is restricted and valuable, the long-run elasticity ofis located is restricted and valuable, the long-run elasticity ofsupply of rental housing is much lower than the elasticity ofsupply of rental housing is much lower than the elasticity ofsupply of owner-occupied housing. With urban land becomingsupply of owner-occupied housing. With urban land becomingmore valuable as housing density increases, and with the cost ofmore valuable as housing density increases, and with the cost ofconstruction soaring, increased demand causes the input costs ofconstruction soaring, increased demand causes the input costs ofrental housing to rise. In this increasing-cost case, the elasticityrental housing to rise. In this increasing-cost case, the elasticityof 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 CompetitiveExamples of CompetitiveIndustriesIndustries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 theEven at a price of zero (the effective price under thelaw), donors supply about 16,000 kidneys per year.law), donors supply about 16,000 kidneys per year.It has been estimated that 8000 more kidneysIt has been estimated that 8000 more kidneyswould 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 forma supply curve of the form QQ == aa ++ bPbP..WhenWhen PP = 0,= 0, QQ = 16,000, so= 16,000, so aa = 16,000. If= 16,000. If PP ==$20,000,$20,000, QQ = 24,000, so= 24,000, so bb = (24,000= (24,000 −−16,000)/20,000 = 0.4.16,000)/20,000 = 0.4.Thus the supply curve isThus the supply curve is SupplySupply:: QQSS= 16,000 + 0.4= 16,000 + 0.4PPNote that at a price of $20,000, the elasticity ofNote that at a price of $20,000, the elasticity ofsupply is 0.33. It is expected that at a price ofsupply 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 wouldbe 24,000 per year. Like supply, demand isbe 24,000 per year. Like supply, demand isrelatively price inelastic; a reasonable estimate forrelatively price inelastic; a reasonable estimate forthe price elasticity of demand at the $20,000 pricethe price elasticity of demand at the $20,000 priceis −0.33. This implies the following linear demandis −0.33. This implies the following linear demandcurve:curve: DemandDemand:: QQDD= 32,000= 32,000 −− 0.40.4PP
    • THE MARKET FOR KIDNEYS AND THE EFFECT OF THETHE MARKET FOR KIDNEYS AND THE EFFECT OF THENATIONAL ORGAN TRANSPLANTATION ACTNATIONAL ORGAN TRANSPLANTATION ACTTHE MARKET FOR HUMAN KIDNEYSTHE MARKET FOR HUMAN KIDNEYSEconomics, the dismal science, showsEconomics, the dismal science, showsus that human organs have economicus that human organs have economicvalue that cannot be ignored, andvalue that cannot be ignored, andprohibiting their sale imposes aprohibiting their sale imposes a costcoston society that must be weighedon society that must be weighedagainst the benefits.against the benefits.The market-clearing price isThe market-clearing price is$20,000; at this price, about$20,000; at this price, about24,000 kidneys per year would24,000 kidneys per year wouldbe supplied.be supplied.The law effectively makes theThe law effectively makes theprice zero. About 16,000price zero. About 16,000kidneys per year are stillkidneys per year are stilldonated; this constraineddonated; this constrainedsupply is shown as S’.supply is shown as S’.The loss to suppliers is givenThe loss to suppliers is givenby rectangle A and triangle C.by rectangle A and triangle C.If consumers received kidneysIf consumers received kidneysat no cost, their gain would beat no cost, their gain would begiven by rectangle A lessgiven by rectangle A lesstriangle B.triangle B.
    • EFFECT OF AIRLINEEFFECT OF AIRLINEREGULATION BY THEREGULATION BY THECIVIL AERONAUTICSCIVIL AERONAUTICSBOARDBOARDAIRLINE REGULATIONAIRLINE REGULATIONAirline deregulation in 1981 led to major changes in theAirline deregulation in 1981 led to major changes in theindustry. Some airlines merged or went out of business asindustry. Some airlines merged or went out of business asnew ones entered. Although prices fell considerably (tonew ones entered. Although prices fell considerably (tothe benefit of consumers), profits overall did not fallthe benefit of consumers), profits overall did not fallmuch.much.At priceAt price PPminmin, airlines would like to, airlines would like tosupplysupply QQ22, well above the quantity, well above the quantityQQ11 that consumers will buy.that consumers will buy.Here they supplyHere they supply QQ33. Trapezoid. Trapezoid DDis the cost of unsold output.is the cost of unsold output.Airline profits may have beenAirline profits may have beenlower as a result of regulationlower as a result of regulationbecause trianglebecause triangle CC and trapezoidand trapezoidDD can together exceed rectanglecan together exceed rectangleAA. In addition, consumers lose. In addition, consumers lose AA
    • 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 ofreal cost index which removes the effects ofchanging fuel costs.changing fuel costs.TABLE 2TABLE 2 AIRLINE INDUSTRY DATAAIRLINE INDUSTRY DATA19751975 1980 1990 2000 2010Number of U.S. carriersNumber of U.S. carriers 36 63 70 94 63Passenger Load Factor (%)Passenger Load Factor (%) 54.0 58.0 62.4 72.1 82.1Passenger-Mile Rate (constant 1995 dollars)Passenger-Mile Rate (constant 1995 dollars) 0.218 0.210 0.149 0.118 0.094Real Cost Index (1995 = 100)Real Cost Index (1995 = 100) 101 145 119 89 148Real Fuel Cost Index (1995 = 100)Real Fuel Cost Index (1995 = 100) 249 300 163 125 342Real Cost Index w/o Fuel Cost IncreasesReal Cost Index w/o Fuel Cost Increases(1995 = 100)(1995 = 100)71 87 104 85 76
    • THE SUGAR QUOTATHE SUGAR QUOTAIn recent years, the world price of sugar has been between 10In recent years, the world price of sugar has been between 10and 28 cents per pound, while the U.S. price has been 30 toand 28 cents per pound, while the U.S. price has been 30 to40 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 towhich would virtually be put out of business if it had tocompete with low-cost foreign producers. This policy hascompete with low-cost foreign producers. This policy hasbeen 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 poundsU.S.consumption:22.8 billion poundsU.S. price: 36 cents per poundWorld price 24 cents per poundU.S. supplyU.S. supply:: QQSS == −− 7.95 + 0.667.95 + 0.66PPU.S. demandU.S. demand:: QQDD = 29.73= 29.73 −− 0.190.19PPAt the 24-cent world price, U.S. production would have been onlyAt the 24-cent world price, U.S. production would have been onlyabout 7.9 billion pounds and U.S. consumption about 25.2 billionabout 7.9 billion pounds and U.S. consumption about 25.2 billionpounds, of which 25.2 − 7.9 = 17.3 billion pounds would have beenpounds, of which 25.2 − 7.9 = 17.3 billion pounds would have beenimported. But fortunately for U.S. producers, imports were limited toimported. But fortunately for U.S. producers, imports were limited toonly 6.9 billion pounds.only 6.9 billion pounds.
    • THE SUGAR QUOTATHE SUGAR QUOTASUGAR QUOTA IN 2010SUGAR QUOTA IN 2010At the world price of 24 centsAt the world price of 24 centsper pound, about 25.2 billionper pound, about 25.2 billionpounds of sugar would havepounds of sugar would havebeen consumed of which allbeen consumed of which allbut 7.9 billion pounds wouldbut 7.9 billion pounds wouldhave been imported.have been imported.Restricting imports to 6.9Restricting imports to 6.9billion pounds caused thebillion pounds caused theU.S. price to go up by 12U.S. price to go up by 12cents.cents. The cost to consumers,The cost to consumers,AA ++ BB ++ CC ++ DD, was about, was about$2.9 billion.$2.9 billion.The gain to domesticThe gain to domesticproducers was trapezoidproducers was trapezoid AA,,about $1.4 billion.about $1.4 billion. RectangleRectangleDD, $836 million, was a gain to, $836 million, was a gain tothose foreign producers whothose foreign producers whoobtained quota allotments.obtained quota allotments.TrianglesTriangles BB andand CC representrepresentthe deadweight loss of aboutthe deadweight loss of about$614 million.$614 million.
    • ConclusionConclusion“…“…Every individual endeavours toEvery individual endeavours toemploy his capital … only (for) hisemploy his capital … only (for) hisown security, … only his gain… led byown security, … only his gain… led byan invisible hand…”an invisible hand…”Adam Smith, The Wealth of Nations (1776)Adam Smith, The Wealth of Nations (1776)
    • Casestudy : StarbucksCasestudy : Starbucks1.1. Read and prepare theRead and prepare theCasestudy onCasestudy onSTARBUCKS forSTARBUCKS fordiscussion anddiscussion andpresentation next.presentation next.2.2. Identify and evaluateIdentify and evaluatethe challenges facingthe challenges facingSTARBUCK’s globalSTARBUCK’s globalbusiness bybusiness byconducting Externalconducting ExternalEnvironment analysisEnvironment analysis(PESTEL);and(PESTEL);andIndustry (5+1 Forces)Industry (5+1 Forces)analysis.analysis.
    • Core ReadingCore Reading• Keat, Paul G. and Young, Philip KY (2009)Managerial Economics, 6thedition, Pearson• Samuelson, William F. and Marks, Stephen G.(2010) Managerial Economics, 6thedition, JohnWiley• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)Microeconomics, 8thedition, 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, 19ththEditionEdition• 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?