Managerial Economics: Perfect Competition Profit Maximization

Go Global !Go Global !
Managerial Economics :Managerial Economics :
Perfect CompetitionPerfect Competition
By
Stephen OngStephen Ong
Visiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City University
Visiting Professor, College of Management,Visiting Professor, College of Management,
Shenzhen UniversityShenzhen University
May 2013May 2013

AgendaAgenda
1.1. Market TypesMarket Types
2.2. Profit MaximisationProfit Maximisation
3.3. Market EfficiencyMarket Efficiency

Learning ObjectivesLearning Objectives
To understand the four market typesTo understand the four market types
To compare the degree of priceTo compare the degree of price
competition among the four marketcompetition among the four market
typestypes
To explain why the P=MC rule leadsTo explain why the P=MC rule leads
firms to the optimal level of productionfirms to the optimal level of production
To explain how the MR=MC rule helps aTo explain how the MR=MC rule helps a
monopoly to determine its optimummonopoly to determine its optimum
To explain the relationship between theTo explain the relationship between the
MR=MC rule and the P=MC ruleMR=MC rule and the P=MC rule
To describe what happens in the longTo describe what happens in the long
runrun

OverviewOverview
Competition and market typesCompetition and market types
Pricing and output decisionsPricing and output decisions
in perfect competitionin perfect competition
Implications for managerialImplications for managerial
decisionsdecisions

Market StructureMarket Structure
CharacteristicCharacteristic
PerfectPerfect
CompetitionCompetition
MonopolisticMonopolistic
CompetitionCompetition OligopolyOligopoly MonopolyMonopoly
Number of firmsNumber of firms
competingcompeting
Large numberLarge number Large numberLarge number Small numberSmall number Single firmSingle firm
Nature of theNature of the
productproduct
UndifferentiatedUndifferentiated DifferentiatedDifferentiated
UndifferentiatedUndifferentiated
or differentiatedor differentiated
UniqueUnique
EntryEntry No barriersNo barriers Few barriersFew barriers Many barriersMany barriers BlockedBlocked
InformationInformation
availabilityavailability
CompleteComplete Relatively goodRelatively good AsymmetricAsymmetric AsymmetricAsymmetric
Firm’s controlFirm’s control
over priceover price
NoneNone SomeSome SomeSome SubstantialSubstantial

Market type 1: Perfect competitionMarket type 1: Perfect competition
No market powerNo market power
large number of relativelylarge number of relatively
small buyers and sellerssmall buyers and sellers
standardized productstandardized product
very easy market entry andvery easy market entry and
exitexit
Non-price competition notNon-price competition not
possiblepossible

Four market typesFour market types
ExamplesExamples: Perfect Competition: Perfect Competition
agricultural productsagricultural products
financial instrumentsfinancial instruments
precious metalsprecious metals
petroleumpetroleum

Absolute market power,Absolute market power,
subject to governmentsubject to government
regulationregulation
one firm, firm is the industryone firm, firm is the industry
unique product or no closeunique product or no close
substitutessubstitutes
market entry and exit difficult ormarket entry and exit difficult or
legally impossiblelegally impossible
Non-price competition notNon-price competition not
necessarynecessary
Market type 2: MonopolyMarket type 2: Monopoly

ExamplesExamples: Monopoly: Monopoly
pharmaceuticalspharmaceuticals
MicrosoftMicrosoft
gas station on edge ofgas station on edge of
desertdesert

Market power based on productMarket power based on product
differentiationdifferentiation
large number of small firms actinglarge number of small firms acting
independentlyindependently
differentiated productdifferentiated product
market entry and exit relativelymarket entry and exit relatively
easyeasy
Non-price competition veryNon-price competition very
importantimportant
Market type 3:Market type 3: MonopolisticMonopolistic
CompetitionCompetition

ExamplesExamples: Monopolistic Competition: Monopolistic Competition
boutiquesboutiques
restaurantsrestaurants
repair shopsrepair shops

Product differentiationProduct differentiation
and/or the firm’sand/or the firm’s
dominance of the marketdominance of the market
 small number of large mutuallysmall number of large mutually
interdependent firmsinterdependent firms
 differentiated or standardizeddifferentiated or standardized
productproduct
 market entry and exit difficultmarket entry and exit difficult
 Non-price competition importantNon-price competition important
Market type 4: OligopolyMarket type 4: Oligopoly

ExamplesExamples: oligopoly: oligopoly
oil refiningoil refining
processed foodsprocessed foods
airlinesairlines
internet accessinternet access

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

22
Profit MaximisationProfit Maximisation

Perfectly Competitive MarketsPerfectly Competitive Markets
PRICE TAKINGPRICE TAKING
BecauseBecause each individual firm sells a sufficiently smalleach individual firm sells a sufficiently small
proportion of total market output, its decisions have noproportion of total market output, its decisions have no
impact on market price.impact on market price.
Price takerPrice taker Firm that has no influence over market price and thusFirm that has no influence over market price and thus
takes the price as given.takes the price as given.
PRODUCT HOMOGENEITYPRODUCT HOMOGENEITY
WhenWhen the products of all of the firms in a market are perfectlythe products of all of the firms in a market are perfectly
substitutable with one another—that is,substitutable with one another—that is, when they arewhen they are
homogeneoushomogeneous—no firm can raise the price of its product—no firm can raise the price of its product
above the price of other firms without losing most or all of itsabove the price of other firms without losing most or all of its
business. In contrast, when products are heterogeneous, eachbusiness. In contrast, when products are heterogeneous, each
firm has the opportunity to raise its price above that of itsfirm has the opportunity to raise its price above that of its
competitors 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 because
it ensures that there is a single market price, consistent withit ensures that there is a single market price, consistent with
supply-demand analysis.supply-demand analysis.

FREE ENTRY AND EXITFREE ENTRY AND EXIT
Free entry (or exit)Free entry (or exit) Condition under which there are no specialCondition under which there are no special
costs that make it difficult for a firm to enter (or exit) an industry.costs that make it difficult for a firm to enter (or exit) an industry.
When Is a Market Highly Competitive?
Many markets are highly competitive in the sense thatMany markets are highly competitive in the sense that
firms face highly elastic demand curves and relativelyfirms face highly elastic demand curves and relatively
easy entry and exit. But there is no simple rule of thumbeasy entry and exit. But there is no simple rule of thumb
to describe whether a market is close to being perfectlyto describe whether a market is close to being perfectly
competitive. Because firms can implicitly or explicitlycompetitive. Because firms can implicitly or explicitly
collude in setting pricescollude in setting prices, the presence of many firms, the presence of many firms
is not sufficient for an industry to approximate perfectis not sufficient for an industry to approximate perfect
competition. Conversely, the presence of only a few firmscompetition. Conversely, the presence of only a few firms
in a market does not rule out competitive behaviour.in a market does not rule out competitive behaviour.
With free entry and exitWith free entry and exit, buyers can easily switch from, buyers can easily switch from
one supplier to another, and suppliers can easily enter orone supplier to another, and suppliers can easily enter or
exit a market.exit a market.

Profit MaximisationProfit Maximisation
Do Firms Maximise Profit?
The assumption ofThe assumption of profit maximisationprofit maximisation isis
frequently used in microeconomics because itfrequently used in microeconomics because it
predicts business behaviour reasonablypredicts business behaviour reasonably
accurately and avoids unnecessary analyticalaccurately and avoids unnecessary analytical
complications.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 make
day-to-day decisions usually have little contactday-to-day decisions usually have little contact
with the owners.with the owners.
Firms that do not come close to maximisingFirms that do not come close to maximising
profit are not likely to survive. The firms that doprofit are not likely to survive. The firms that do
survive make long-run profit maximisation one ofsurvive make long-run profit maximisation one of
their highest priorities.their highest priorities.

While owners of condominiums must join with fellow condo ownersWhile owners of condominiums must join with fellow condo owners
to manage common, they can make their own decisions as to how toto manage common, they can make their own decisions as to how to
manage their individual units. In contrast, co-ops share joint liabilitymanage their individual units. In contrast, co-ops share joint liability
on any outstanding mortgage on the co-op building and are subjecton any outstanding mortgage on the co-op building and are subject
to more complex governance rules.to more complex governance rules.
Nationwide, condos are far more common than co-ops, outnumberingNationwide, condos are far more common than co-ops, outnumbering
them 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 is
very 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, and
yet the conversion of apartments from co-ops to condos has beenyet the conversion of apartments from co-ops to condos has been
relatively slow. The typical condominium apartment is worth aboutrelatively slow. The typical condominium apartment is worth about
15.5 percent more15.5 percent more than a equivalent apartment held in thethan a equivalent apartment held in the
form 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-op
is not the best way to maximize the apartment’s value.is not the best way to maximize the apartment’s value.
It appears that in New York, many owners have been willing to forgoIt appears that in New York, many owners have been willing to forgo
substantial 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 IN
NEW YORK CITYNEW YORK CITY

Marginal Revenue, Marginal Cost,Marginal Revenue, Marginal Cost,
and Profit Maximisationand Profit Maximisation
Profit :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 increase
in output.in output.
A firm chooses outputA firm chooses output qq*, so*, so
that profit, the differencethat profit, the difference ABAB
between revenuebetween revenue RR and costand cost CC,,
is maximized.is maximized.
At that output, marginalAt that output, marginal
revenue (the slope of therevenue (the slope of the
revenue curve) is equal torevenue curve) is equal to
marginal cost (the slope of themarginal cost (the slope of the
cost curve).cost curve).Δπ/ΔΔπ/Δqq == ΔΔRR//ΔΔqq −− ΔΔC/C/ΔΔqq = 0= 0
MR(MR(qq) = MC() = MC(qq))
PROFIT MAXIMIZATONPROFIT MAXIMIZATON
IN THE SHORT RUNIN THE SHORT RUN

Demand and Marginal Revenue for aDemand and Marginal Revenue for a
Competitive FirmCompetitive Firm
A 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 all
the 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 the
product as given, choosing its output on the assumption that the priceproduct as given, choosing its output on the assumption that the price
will be unaffected by the output choice. In (a) the demand curve facingwill be unaffected by the output choice. In (a) the demand curve facing
the firm is perfectly elastic,the firm is perfectly elastic, even though the market demand 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 a
competitive market is both its average revenue curvecompetitive market is both its average revenue curve
and its marginal revenue curve. Along this demandand its marginal revenue curve. Along this demand
curve, marginal revenue, average revenue, and pricecurve, marginal revenue, average revenue, and price
are all equal.are all equal.
Profit Maximization by a Competitive FirmProfit Maximization by a Competitive Firm
MC(MC(q) =q) = MRMR = P= P
Because each firm in a competitive industry sells only aBecause each firm in a competitive industry sells only a
small fraction of the entire industry output,small fraction of the entire industry output, how muchhow much
output the firm decides to sell will have no effect on theoutput the firm decides to sell will have no effect on the
market price of the product.market price of the product.
Because it is a price takerBecause it is a price taker, the demand curve d facing an, the demand curve d facing an
individual competitive firm is given by a horizontal line.individual competitive firm is given by a horizontal line.
A perfectly competitive firm should choose itsA perfectly competitive firm should choose its
output 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 Firm
A COMPETITIVEA COMPETITIVE
FIRM MAKING AFIRM MAKING A
POSITIVE PROFITPOSITIVE PROFIT
In the short run, theIn the short run, the
competitive firmcompetitive firm
maximises its profit bymaximises its profit by
choosing an outputchoosing an output q*q* atat
which its marginal costwhich its marginal cost
MC is equal to the priceMC is equal to the price
PP (or marginal revenue(or marginal revenue
MR) of its product.MR) of its product.
The profit of the firm isThe profit of the firm is
measured by themeasured by the
rectanglerectangle ABCDABCD..
Any change in output,Any change in output,
whether lower atwhether lower at qq11 oror
higher athigher at qq22, will lead to, will lead to
lower profit.lower profit.
Output Rule: If a firm is producingOutput Rule: If a firm is producing
any output, it should produce at theany output, it should produce at the
level at which marginal revenuelevel at which marginal revenue
equals marginal cost.equals marginal cost.
Choosing Output in the Short RunChoosing Output in the Short Run

Model of Perfect CompetitionModel of Perfect Competition
AA large numberlarge number of firms inof firms in
the marketthe market
AnAn undifferentiated productundifferentiated product
Ease of entry into the marketEase of entry into the market
oror no barriers to entryno barriers to entry
Complete informationComplete information
available to all marketavailable to all market
participantsparticipants

Model of the Industry andModel of the Industry and
the Firmthe Firm
S
D
Q
P
QE
PE
MC
ATC
D = P = MR
Q*
P
Q

 Basic business decision: entering aBasic business decision: entering a
market 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, how
muchmuch profitprofit will we earn?will we earn?
if a loss rather than a profit isif a loss rather than a profit is
incurred, will it be worthwhile toincurred, will it be worthwhile to
continue in this market in the longcontinue in this market in the long
run (in hopes that we will eventuallyrun (in hopes that we will eventually
earn a profit) or should weearn a profit) or should we exit?exit?

 Key assumptions of the perfectlyKey assumptions of the perfectly
competitive market:competitive market:
 the firm is athe firm is a price takerprice taker
 the firm makes the distinction betweenthe firm makes the distinction between
the 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 its
profitprofit (or minimize loss) in the short(or minimize loss) in the short
runrun
 the firm includes itsthe firm includes its opportunity costopportunity cost
of operating in a particular market asof operating in a particular market as
part of its total cost of productionpart of its total cost of production

Perfectly elastic demandPerfectly elastic demand
curvecurve:: consumers are willingconsumers are willing
to buy as much as the firm isto buy as much as the firm is
willing to sell at the goingwilling to sell at the going
market pricemarket price
 firm receives the samefirm receives the same
marginal revenue from the salemarginal revenue from the sale
of each additional unit ofof each additional unit of
product;product; equal to the priceequal to the price
of the productof the product
 no limit to the totalno limit to the total
revenuerevenue that the firm canthat the firm can
gain in a perfectly competitivegain in a perfectly competitive
marketmarket

 Total revenue/Total costTotal revenue/Total cost
approach:approach:
 compare the total revenue and totalcompare the total revenue and total
cost schedules and find thecost schedules and find the level oflevel of
outputoutput that either maximizes the firm’sthat either maximizes the firm’s
profits or minimizes its lossprofits or minimizes its loss

Profit Maximizing Level ofProfit Maximizing Level of
OutputOutput
 Profit is theProfit is the
difference betweendifference between
total revenue andtotal revenue and
total cost:total cost:
π =π = TRTR -- TCTC
wherewhere
π = profitπ = profit
TR =TR = total revenuetotal revenue
TC =TC = total costtotal cost
 To maximize profits,To maximize profits,
a firm shoulda firm should
produce the level ofproduce the level of
output whereoutput where
marginal revenuemarginal revenue
equals marginal cost.equals marginal cost.
MR = MCMR = MC
wherewhere
MR =MR = ΔTR / ΔQΔTR / ΔQ
MC =MC = ΔTC / ΔQΔTC / ΔQ

 Marginal revenue/Marginal costMarginal revenue/Marginal cost
approachapproach
 produce a level of output at which theproduce a level of output at which the
additional revenue received from the lastadditional revenue received from the last
unit is equal to the additional cost ofunit is equal to the additional cost of
producing that unit (ie.producing that unit (ie. MR=MCMR=MC))
Note: for the perfectly competitive firm, theNote: for the perfectly competitive firm, the
MR=MC rule may be restated asMR=MC rule may be restated as P=MCP=MC
because P=MR in perfectly competitivebecause P=MR in perfectly competitive
marketmarket

Marginal RevenueMarginal Revenue
The marginalThe marginal
revenue curve for therevenue curve for the
perfectly competitiveperfectly competitive
firm is horizontalfirm is horizontal
because the firm canbecause the firm can
sell all units ofsell all units of
output at the marketoutput at the market
price thereforeprice therefore priceprice
equals marginalequals marginal
revenuerevenue for thefor the
perfectly competitiveperfectly competitive
firm.firm.
$
Q
P = MR

Case A:Case A: EconomicEconomic
profitprofit
The point whereThe point where
P=MR=MCP=MR=MC is theis the
optimal outputoptimal output
(Q*)(Q*)
 profit = TR – TCprofit = TR – TC
= (P - AC)= (P - AC) xx Q*Q*

 Case B:Case B: EconomicEconomic
lossloss
The firm incurs a loss.The firm incurs a loss.
At optimum output,At optimum output,
price is below ACprice is below AC
 however, sincehowever, since
P>AVCP>AVC, the firm is, the firm is
better off producingbetter off producing
in the short run,in the short run,
because it will stillbecause it will still
incur fixed costsincur fixed costs
greater than the lossgreater than the loss

Contribution margin:Contribution margin:
the amount by whichthe amount by which
total revenuetotal revenue
exceeds totalexceeds total
variable costvariable cost
CM = TR – TVCCM = TR – TVC
 if CM > 0, the firmif CM > 0, the firm
should continue toshould continue to
produce in the shortproduce in the short
run in order to defrayrun in order to defray
some of the fixedsome of the fixed
costcost

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 a
Perfectly Competitive FirmPerfectly Competitive Firm
The price, whichThe price, which
equals a firm’sequals a firm’s
minimumminimum
average variableaverage variable
costcost, below which, below which
it is more profitableit is more profitable
for the perfectlyfor the perfectly
competitive firm tocompetitive firm to
shut down than toshut down than to
continue tocontinue to
produce.produce.
MC
ATC
AVC
Psd

Shutdown point:Shutdown point: the lowest price atthe lowest price at
which the firm would still producewhich the firm would still produce
At the shutdown point, the price isAt the shutdown point, the price is
equal to the minimum point on the AVCequal to the minimum point on the AVC
P=min(AVC)P=min(AVC)
If the price falls below the shutdownIf the price falls below the shutdown
point, revenues fail to cover the fixedpoint, revenues fail to cover the fixed
costs and the variable costs. The firmcosts and the variable costs. The firm
would be better off if it shut down andwould be better off if it shut down and
just paid its fixed costsjust paid its fixed costs

When Should the Firm Shut Down?When Should the Firm Shut Down?
A COMPETITIVEA COMPETITIVE
FIRM INCURRINGFIRM INCURRING
LOSSESLOSSES
A competitive firmA competitive firm
should shut down ifshould shut down if
price is below AVC.price is below AVC.
The firm mayThe firm may
produce in the shortproduce in the short
run if price isrun if price is
greater thangreater than
cost.cost.

THE SHORT-RUN OUTPUT OF ANTHE SHORT-RUN OUTPUT OF AN
ALUMINUM SMELTING PLANTALUMINUM SMELTING PLANT
THE SHORT-RUN OUTPUT DECISION OF AN
ALUMINUM SMELTING PLANT
How should the manager determine the plant’sHow should the manager determine the plant’s
profit maximizing output? Recall that the smeltingprofit maximizing output? Recall that the smelting
plant’s short-run marginal cost of productionplant’s short-run marginal cost of production
depends on whether it is running two or threedepends on whether it is running two or three
shifts per day.shifts per day.
In the short run, the plant shouldIn the short run, the plant should
produce 600 tons per day if priceproduce 600 tons per day if price
is above $1140 per ton but lessis above $1140 per ton but less
than $1300 per ton.than $1300 per ton.
If price is greater than $1300 perIf price is greater than $1300 per
ton, it should run an overtime shiftton, it should run an overtime shift
and produce 900 tons per day.and produce 900 tons per day.
If price drops below $1140 per ton,If price drops below $1140 per ton,
the firm should stop producing,the firm should stop producing,
but it should probably stay inbut it should probably stay in
business because the price maybusiness because the price may
rise 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 cost
depends on a manager’s ability to estimate marginal cost.depends on a manager’s ability to estimate marginal cost.
1.1.First, except under limited circumstances,First, except under limited circumstances, average variable costaverage variable cost
should not be used as a substitute for marginal costshould not be used as a substitute for marginal cost..
SOME COST CONSIDERATIONS FOR MANAGERSSOME COST CONSIDERATIONS FOR MANAGERS
Current outputCurrent output 100 units per day, 80 of which are produced during the regular shift100 units per day, 80 of which are produced during the regular shift
and 20 of which are produced during overtimeand 20 of which are produced during overtime
Materials costMaterials cost $8 per unit for all output$8 per unit for all output
Labor costLabor cost $30 per unit for the regular shift; $50 per unit for the overtime shift$30 per unit for the regular shift; $50 per unit for the overtime shift
For the first 80 units of output, average variable cost andFor the first 80 units of output, average variable cost and
marginal cost are both equal to $38 per unit. When outputmarginal cost are both equal to $38 per unit. When output
increases to 100 units, marginal cost is higher than averageincreases to 100 units, marginal cost is higher than average
variable cost, so a manager who relies on average variable costvariable cost, so a manager who relies on average variable cost
will produce too much.will produce too much.
2.2.Also, a single item on a firm’s accounting ledger may have twoAlso, a single item on a firm’s accounting ledger may have two
components, 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 determining
marginal cost.marginal cost.
These three guidelines can help a manager to measure marginalThese three guidelines can help a manager to measure marginal
cost correctly. Failure to do so can cause production to be toocost correctly. Failure to do so can cause production to be too
high or too low and thereby reduce profit.high or too low and thereby reduce profit.

Supply Curve for theSupply Curve for the
Perfectly Competitive FirmPerfectly Competitive Firm
The portion of aThe portion of a
firm’s marginal costfirm’s marginal cost
curve that liescurve that lies
above the minimumabove the minimum
cost.cost.
$
Q
SRATC
SRAVC
SRS =MC

The Competitive Firm’s Short-runThe Competitive Firm’s Short-run
Supply CurveSupply Curve
THE SHORT-RUNTHE SHORT-RUN
SUPPLY CURVE FOR ASUPPLY CURVE FOR A
COMPETITIVE FIRMCOMPETITIVE FIRM
The firm’s supply curve isThe firm’s supply curve is the portion of the marginalthe portion of the marginal
cost curve for which marginal cost is greater thancost curve for which marginal cost is greater than
average variable cost.average variable cost.
In the short run, the firmIn the short run, the firm
chooses its output sochooses its output so
that marginal cost MC isthat marginal cost MC is
equal to price as longequal to price as long
as the firm covers itsas the firm covers its
average variable cost.average variable cost.
The short-run supplyThe short-run supply
curve is given by thecurve is given by the
crosshatched portion ofcrosshatched portion of
the marginal cost curve.the marginal cost curve.

THE RESPONSE OF ATHE RESPONSE OF A
FIRM TO A CHANGE INFIRM TO A CHANGE IN
INPUT PRICEINPUT PRICE
When the marginalWhen the marginal
cost of productioncost of production
for a firm increasesfor a firm increases
(from MC(from MC11 to MCto MC22),),
the level of outputthe level of output
that maximizesthat maximizes
profit falls (fromprofit falls (from qq11
toto qq22).).
The Firm’s Response to an Input PriceThe Firm’s Response to an Input Price
ChangeChange

THE SHORT-RUNTHE SHORT-RUN
PRODUCTION OFPRODUCTION OF
PETROLEUM PRODUCTSPETROLEUM PRODUCTS
THE SHORT-RUN P RODUCTION OFTHE SHORT-RUN P RODUCTION OF
PETROLEUM PRODUCTSPETROLEUM PRODUCTS
Although 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 the
capacity of the refinery and the cost ofcapacity of the refinery and the cost of
production.production.
As the refinery shifts fromAs the refinery shifts from
one processing unit toone processing unit to
another, the marginal costanother, the marginal cost
of producing petroleumof producing petroleum
products from crude oilproducts from crude oil
increases sharply at severalincreases sharply at several
levels of output.levels of output.
As a result, the output levelAs a result, the output level
can be insensitive to somecan be insensitive to some
changes in price but verychanges in price but very
sensitive to others.sensitive to others.

The Short-Run Market Supply CurveThe Short-Run Market Supply Curve
INDUSTRY SUPPLY ININDUSTRY SUPPLY IN
THE SHORT RUNTHE SHORT RUN
The short-run industryThe short-run industry
supply curve is thesupply curve is the
summation of the supplysummation of the supply
curves of the individualcurves of the individual
firms.firms.
Because the third firm has aBecause the third firm has a
lower average variable costlower average variable cost
curve than the first twocurve than the first two
firms, the market supplyfirms, the market supply
curvecurve SS begins at pricebegins at price PP11
and follows the marginaland follows the marginal
cost curve of the third firmcost curve of the third firm
MCMC33 until price equalsuntil price equals PP22,,
when there is a kink.when there is a kink.
ForFor PP22 and all prices aboveand all prices above
it, the industry quantityit, the industry quantity
supplied is the sum of thesupplied is the sum of the
quantities supplied by eachquantities supplied by each
of the three firms.of the three firms.
Elasticity of Market SupplyElasticity of Market Supply
EEss == ((ΔΔQQ//QQ)/()/(ΔΔPP//PP))

THE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPER
Costs of mining, smelting, and refining copper differCosts of mining, smelting, and refining copper differ
because of differences in labour and transportation costsbecause of differences in labour and transportation costs
and because of differences in the copper content of theand because of differences in the copper content of the
ore.ore.
TABLE 1TABLE 1 THE WORLD COPPER INDUSTRY (2010)THE WORLD COPPER INDUSTRY (2010)
COUNTRYCOUNTRY
ANNUAL PRODUCTIONANNUAL PRODUCTION
(THOUSAND METRIC(THOUSAND METRIC
TONS)TONS)
MARGINAL COSTMARGINAL COST
(DOLLARS PER(DOLLARS PER
POUND)POUND)
AustraliaAustralia 900900 2.302.30
CanadaCanada 480480 2.602.60
ChileChile 5,5205,520 1.601.60
IndonesiaIndonesia 840840 1.801.80
PeruPeru 12851285 1.701.70
PolandPoland 430430 2.402.40
RussiaRussia 750750 1.301.30
USUS 11201120 1.701.70
ZambiaZambia 770770 1.501.50

THE SHORT-RUN WORLDTHE SHORT-RUN WORLD
SUPPLY OF COPPERSUPPLY OF COPPER
THE SHORT-RUN WORLD SUPPLY OF COPPERTHE SHORT-RUN WORLD SUPPLY OF COPPER
The world supply curve is obtained by summing each nation’sThe world supply curve is obtained by summing each nation’s
supply curve horizontally. The elasticity of supply depends on thesupply curve horizontally. The elasticity of supply depends on the
price of copper. At relatively low prices, the curve is quite elasticprice of copper. At relatively low prices, the curve is quite elastic
because small price increases lead to large increases in the quantitybecause small price increases lead to large increases in the quantity
of 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, most
producers 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 world
copper is obtained bycopper is obtained by
summing the marginal costsumming the marginal cost
curves for each of the majorcurves for each of the major
copper-producing countries.copper-producing countries.
The supply curve slopesThe supply curve slopes
upward because the marginalupward because the marginal
cost of production rangescost of production ranges
from a low of 65 cents infrom a low of 65 cents in
Russia to a high of $1.30 inRussia to a high of $1.30 in
Canada.Canada.

 In theIn the lonlong run, the price in theg run, the price in the
competitive market will settle at thecompetitive market will settle at the
point where firms earn apoint where firms earn a normalnormal
profitprofit
 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 and
reduces profitsreduces profits
 economic losseconomic loss causes exit of firmscauses exit of firms  shiftsshifts
the supply curve to the leftthe supply curve to the left  puts upwardputs upward
pressure on price and increases profitspressure on price and increases profits

 Observations in perfectlyObservations in perfectly
competitive markets:competitive markets:
 the earlier the firm enters a market, the betterthe earlier the firm enters a market, the better
its 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 find
ways 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 their
competitorscompetitors
 firms that find themselves unable to compete onfirms that find themselves unable to compete on
the basis of cost might want to try competing onthe basis of cost might want to try competing on
the basis ofthe basis of product differentiationproduct differentiation insteadinstead

Implications of perfectImplications of perfect
competition for decision makingcompetition for decision making
 Perfectly competitive marketPerfectly competitive market
 most important lesson is that it ismost important lesson is that it is
extremely 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 a
marketmarket before othersbefore others start to enterstart to enter

Global applicationGlobal application
 ExampleExample: Bluefin tuna: Bluefin tuna
 sushi restaurants operate insushi restaurants operate in
monopolistic competitionmonopolistic competition
 bluefin tuna pricebluefin tuna price
determined by perfectdetermined by perfect
competitioncompetition
 low profit marginlow profit margin

33
Market EfficiencyMarket Efficiency

Long-Run Adjustment inLong-Run Adjustment in
Perfectly Competitive IndustryPerfectly Competitive Industry
An increase in industry demand willAn increase in industry demand will
result in aresult in a positive economic profitpositive economic profit for afor a
perfectly competitive firm.perfectly competitive firm.
However, this profit will be competedHowever, this profit will be competed
away by theaway by the entry of other firmsentry of other firms into theinto the
market in the long run.market in the long run.
TheThe zero economic profitzero economic profit point or thepoint or the
point where price equals average totalpoint where price equals average total
cost is the equilibrium point for thecost is the equilibrium point for the
perfectly competitive firmperfectly competitive firm..

Long-Run Adjustment in PerfectlyLong-Run Adjustment in Perfectly
Competitive Industry - GraphicalCompetitive Industry - Graphical
D1
D2
S1
S2
PE1
PE2
QE1 QE3QE2
MC
ATC
D1=P1=MR1
D2=P2=MR2
Q1 Q2
P P
Q Q

Long-Run Adjustment in PerfectLong-Run Adjustment in Perfect
Competition: The Optimal ScaleCompetition: The Optimal Scale
of Productionof Production
In the long run, the perfectlyIn the long run, the perfectly
competitive firm has tocompetitive firm has to
choose the optimal scale ofchoose the optimal scale of
operation. 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 Perfect
Competition: The Optimal ScaleCompetition: The Optimal Scale
of Production - Graphicalof Production - Graphical
$
Q
SMC1
SMC2
SATC1
SATC2
LRACP1=MR1
P2=MR2
Q1
Q2

Long-Run Profit MaximisationLong-Run Profit Maximisation
OUTPUT CHOICEOUTPUT CHOICE
IN THE LONG RUNIN THE LONG RUN
The firm maximises itsThe firm maximises its
profit by choosing theprofit by choosing the
output at which priceoutput at which price
equals long-runequals long-run
marginal cost LMC.marginal cost LMC.
In the diagram, the firmIn the diagram, the firm
increases its profit fromincreases its profit from
ABCDABCD toto EFGDEFGD byby
increasing its output inincreasing its output in
the long run.the long run.
The long-run output of a profit-maximizingThe long-run output of a profit-maximizing
competitive firm is the point at which long-runcompetitive firm is the point at which long-run
marginal cost equals the price.marginal cost equals the price.
Choosing Output in the Long RunChoosing Output in the Long Run

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium
ACCOUNTING PROFIT AND ECONOMIC PROFITACCOUNTING PROFIT AND ECONOMIC PROFIT
π =π = R − wL − rKR − wL − rK
ZERO ECONOMIC PROFIT
A 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 doing
as well as it could by investing its money elsewhere.as well as it could by investing its money elsewhere.
ENTRY AND EXITENTRY AND EXIT
In a market with entry and exit, a firm entersIn a market with entry and exit, a firm enters
when it can earn a positive long-run profitwhen it can earn a positive long-run profit
and exits when it faces the prospect of aand exits when it faces the prospect of a
long-run loss.long-run loss.

Long-run competitive equilibriumLong-run competitive equilibrium
All firms in an industry are maximising profit, no firm has anAll firms in an industry are maximising profit, no firm has an
incentive to enter or exit, and price is such thatincentive to enter or exit, and price is such that quantity suppliedquantity supplied
equals 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 incentive
to exit the industry.to exit the industry.
Likewise, other firms have no special incentive to enter.Likewise, other firms have no special incentive to enter.
A long-run competitive equilibrium occurs when threeA long-run competitive equilibrium occurs when three
conditions 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 exit
the industry because all firms arethe industry because all firms are earning zeroearning zero
economic profit.economic profit.
3.3. The price of the product is such that theThe price of the product is such that the
quantity supplied by the industry isquantity supplied by the industry is equalequal to theto the
quantity demanded by consumers.quantity demanded by consumers.

LONG-RUN COMPETITIVELONG-RUN COMPETITIVE
EQUILIBRIUMEQUILIBRIUM
Initially the long-run equilibriumInitially the long-run equilibrium
price of a product is $40 per unit,price of a product is $40 per unit,
shown in (b) as the intersection ofshown in (b) as the intersection of
demand curvedemand curve DD and supply curveand supply curve
SS11..
In (a) we see that firms earnIn (a) we see that firms earn
positive profits because long-runpositive profits because long-run
average cost reaches a minimumaverage cost reaches a minimum
of $30 (atof $30 (at qq22).).
Positive profit encourages entry ofPositive profit encourages entry of
new firms and causes a shift tonew firms and causes a shift to
the 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 at
a 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 profit
and there is no incentive to enterand there is no incentive to enter
or exit the industry.or exit the industry.

FIRMS HAVING IDENTICAL COSTSFIRMS HAVING IDENTICAL COSTS
To see why all the conditions for long-run equilibrium mustTo see why all the conditions for long-run equilibrium must
hold, assume that all firms have identical costs.hold, assume that all firms have identical costs.
Now consider what happens if too many firms enter theNow consider what happens if too many firms enter the
industry in response to an opportunity for profit. The industryindustry in response to an opportunity for profit. The industry
supply curve will shift further to the right, and price will fall.supply curve will shift further to the right, and price will fall.
Only when there isOnly when there is no incentive to exit or entno incentive to exit or enter can aer can a
market be in long-run equilibrium.market be in long-run equilibrium.
FIRMS HAVING DIFFERENT COSTSFIRMS HAVING DIFFERENT COSTS
Now suppose that all firms in the industry do not have identicalNow suppose that all firms in the industry do not have identical
cost curves. Perhaps one firm has a patent that lets it produce atcost curves. Perhaps one firm has a patent that lets it produce at
a lower average cost than all the others. In that case, it isa lower average cost than all the others. In that case, it is
consistent with long-run equilibrium for that firm to earn aconsistent with long-run equilibrium for that firm to earn a
greatergreater accountingaccounting profit and to enjoy a higher producer surplusprofit and to enjoy a higher producer surplus
than other firms.than other firms.
If the patent is profitable, other firms in the industry will pay toIf the patent is profitable, other firms in the industry will pay to
use it. The increased value of the patent thus represents anuse it. The increased value of the patent thus represents an
opportunity 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 to
the patent rather than use it. If all firms are equally efficientthe patent rather than use it. If all firms are equally efficient
otherwise, theotherwise, the economiceconomic profit of the firm falls to zeroprofit of the firm falls to zero..

THE OPPORTUNITY COST OF LANDTHE OPPORTUNITY COST OF LAND
There are other instances in which firms earning positiveThere are other instances in which firms earning positive
accounting profit may be earning zero economic profit.accounting profit may be earning zero economic profit.
Suppose, for example, that a clothing store happens to beSuppose, for example, that a clothing store happens to be
located near a large shopping centre. The additional flow oflocated near a large shopping centre. The additional flow of
customers can substantially increase the store’s accountingcustomers can substantially increase the store’s accounting
profit because the cost of the land is based on its historicalprofit because the cost of the land is based on its historical
cost. When the opportunity cost of land is included, thecost. When the opportunity cost of land is included, the
profitability of the clothing store is no higher than that of itsprofitability of the clothing store is no higher than that of its
competitors.competitors.
Economic Rent
In competitive markets, in both the short and the long run,In competitive markets, in both the short and the long run,
economic rent is often positive even though profit is zero.economic rent is often positive even though profit is zero.
Amount that firms are willing to pay forAmount that firms are willing to pay for
an input less the minimum amountan input less the minimum amount
necessary to obtain it.necessary to obtain it.
In the long run, in a competitive market,In the long run, in a competitive market, the producerthe producer
surplus that a firm earns on the output that it sellssurplus that a firm earns on the output that it sells
consists of the economic rent that it enjoys from all itsconsists of the economic rent that it enjoys from all its
scarce inputs.
Producer Surplus in the Long RunProducer Surplus in the Long Run

FIRMS EARN ZERO PROFIT IN LONG-RUN EQUILIBRIUMFIRMS EARN ZERO PROFIT IN LONG-RUN EQUILIBRIUM
In 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 that
price ($7) is equal to marginal and average cost.price ($7) is equal to marginal and average cost.
In (b), the demand is greater, so a $10 price can be charged. The teamIn (b), the demand is greater, so a $10 price can be charged. The team
increases sales to the point at which the average cost of production plus theincreases sales to the point at which the average cost of production plus the
average economic rent is equal to the ticket price.average economic rent is equal to the ticket price.
When the opportunity cost associated with owning the franchise is taken intoWhen the opportunity cost associated with owning the franchise is taken into
account, the team earns zero economic profit.account, the team earns zero economic profit.

The Industry’s Long-Run Supply CurveThe Industry’s Long-Run Supply Curve
Constant-Cost IndustryConstant-Cost Industry
Industry whose long-run supply curve is horizontal.Industry whose long-run supply curve is horizontal.
In (b), the long-run supplyIn (b), the long-run supply
curve in a constant-costcurve in a constant-cost
industry is a horizontal lineindustry is a horizontal line
SSLL. When demand increases,. When demand increases,
initially causing a price rise,initially causing a price rise,
the firm initially increases itsthe firm initially increases its
output fromoutput from qq11 toto qq22, as, as
shown in (a).shown in (a).
But the entry of new firmsBut the entry of new firms
causes a shift to the right incauses a shift to the right in
industry supply.industry supply.
Because input prices areBecause input prices are
unaffected by the increasedunaffected by the increased
output of the industry, entryoutput of the industry, entry
occurs until the original priceoccurs until the original price
The long-run supply curve for aThe long-run supply curve for a
constant-cost industry is, therefore, aconstant-cost industry is, therefore, a
horizontal line at a price that is equalhorizontal line at a price that is equal
to theto the long-run minimum average costlong-run minimum average cost
of production.of production.
LONG-RUN SUPPLY IN ALONG-RUN SUPPLY IN A
CONSTANT COSTCONSTANT COST
INDUSTRYINDUSTRY

The Industry’s Long-Run Supply CurveThe Industry’s Long-Run Supply Curve
Increasing-Cost IndustryIncreasing-Cost Industry
Industry whose long-run supply curve is upward sloping.Industry whose long-run supply curve is upward sloping.
LONG-RUN SUPPLY IN ANLONG-RUN SUPPLY IN AN
INCREASING COSTINCREASING COST
INDUSTRYINDUSTRY
In (b), the long-run supply curveIn (b), the long-run supply curve
in an increasing-cost industry isin an increasing-cost industry is
an upward-sloping curvean upward-sloping curve SSLL..
When demand increases, initiallyWhen demand increases, initially
causing a price rise, the firmscausing a price rise, the firms
increase their output fromincrease their output from qq11 toto
qq22 in (a).in (a).
In that case, the entry of newIn that case, the entry of new
firms causes a shift to the rightfirms causes a shift to the right
in supply fromin supply from SS11 toto SS22..
Because input prices increase asBecause input prices increase as
a result, the new long-runa result, the new long-run
equilibrium occurs at a higherequilibrium occurs at a higher
price than the initial equilibrium.price than the initial equilibrium.
In an increasing-cost industry, theIn an increasing-cost industry, the
long-run industry supply curve islong-run industry supply curve is
upward slopingupward sloping..

Decreasing-Cost IndustryDecreasing-Cost Industry
Industry 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 the
long run. The reason is that land for growing coffee is widelylong run. The reason is that land for growing coffee is widely
available and the costs of planting and caring for treesavailable and the costs of planting and caring for trees
remains constant as the volume grows. Thus, coffee is aremains constant as the volume grows. Thus, coffee is a
constant-cost industry.constant-cost industry.
The oil industry is an increasing cost industry because thereThe oil industry is an increasing cost industry because there
is a limited availability of easily accessible, large-volume oilis a limited availability of easily accessible, large-volume oil
fields.fields.
Finally, a decreasing-cost industry. In the automobileFinally, a decreasing-cost industry. In the automobile
industry, certainindustry, certain cost advantages arise because inputs can becost advantages arise because inputs can be
acquired more cheaply as the volume of production increasesacquired more cheaply as the volume of production increases..
CONSTANT-, INCREASING-, AND DECREASING-COSTCONSTANT-, INCREASING-, AND DECREASING-COST
INDUSTRIES: COFFEE, OIL, AND AUTOMOBILESINDUSTRIES: COFFEE, OIL, AND AUTOMOBILES

Long-Run Elasticity of SupplyLong-Run Elasticity of Supply
The long-run elasticity of industry supply is defined in the sameThe long-run elasticity of industry supply is defined in the same
way as the short-run elasticity: It is the percentage change inway as the short-run elasticity: It is the percentage change in
output (output (QQ//QQ) that results from a percentage change in price) that results from a percentage change in price
((PP//PP).).
In a constant-cost industry, the long-run supply curve isIn a constant-cost industry, the long-run supply curve is
horizontal, and the long-run supply elasticity is infinitely large.horizontal, and the long-run supply elasticity is infinitely large.
(A small increase in price will induce an extremely large(A small increase in price will induce an extremely large
increase in output.)increase in output.)
In an increasing-cost industry, however, the long-run supplyIn an increasing-cost industry, however, the long-run supply
elasticity will be positive but finite.elasticity will be positive but finite.
Because industries can adjust and expand in the long run, weBecause industries can adjust and expand in the long run, we
would generally expect long-run elasticities of supply to bewould generally expect long-run elasticities of supply to be
larger than short-run elasticities.larger than short-run elasticities.
The magnitude of the elasticity will depend on the extent toThe magnitude of the elasticity will depend on the extent to
whichwhich input costs increase as the marketinput costs increase as the market
expandsexpands. For example, an industry that depends on inputs. For example, an industry that depends on inputs
that are widely available will have a more elastic long-runthat are widely available will have a more elastic long-run
supply than will an industry that uses inputs in short supply.supply than will an industry that uses inputs in short supply.

THE SUPPLY CURVE FORTHE SUPPLY CURVE FOR
NEW YORK TAXICABSNEW YORK TAXICABS
THE SUPPLY OF TAXICABS IN NEW YORKTHE SUPPLY OF TAXICABS IN NEW YORK
While reducing taxi fares will indeed cause a reduction in theWhile reducing taxi fares will indeed cause a reduction in the
quantity supplied, raising the price will not cause an increasequantity supplied, raising the price will not cause an increase
in the quantity supplied. Why not? Because the number ofin the quantity supplied. Why not? Because the number of
medallions is fixed.medallions is fixed.
If there were no restriction on theIf there were no restriction on the
number of medallions, the supplynumber of medallions, the supply
curve would be highly elastic.curve would be highly elastic.
Cab drivers work hard and don’tCab drivers work hard and don’t
earn much, so a drop in the priceearn much, so a drop in the price
PP (of a 5-mile ride) would lead(of a 5-mile ride) would lead
many of them to find another job.many of them to find another job.
Likewise, an increase in priceLikewise, an increase in price
would bring many new driverswould bring many new drivers
into the market. But the numberinto the market. But the number
of medallions—and therefore theof medallions—and therefore the
number of taxicabs—is limited tonumber of taxicabs—is limited to
13,150, so the supply curve13,150, so the supply curve
becomes vertical at this quantity.becomes vertical at this quantity.

WHY CAN’T I FIND A TAXI?WHY CAN’T I FIND A TAXI?
The city of New York limits the number of taxis by requiring eachThe city of New York limits the number of taxis by requiring each
taxi to have a medallion (essentially a permit), and then limitingtaxi to have a medallion (essentially a permit), and then limiting
the number of medallions. In 2011 there were 13,150 medallionsthe number of medallions. In 2011 there were 13,150 medallions
in New York—roughly the same number as in 1937. Why not justin New York—roughly the same number as in 1937. Why not just
issue more medallions? The reason is simple. Doing so would incurissue more medallions? The reason is simple. Doing so would incur
the wrath of the current owners of medallions. Medallions can bethe wrath of the current owners of medallions. Medallions can be
bought and sold by the companies that own them.bought and sold by the companies that own them.
In 1937, there were plenty of medallions to go around, so they hadIn 1937, there were plenty of medallions to go around, so they had
little 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 of
a 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 starting
issuing more medallions. So the New York taxi companies thatissuing more medallions. So the New York taxi companies that
collectively own the 13,150 available medallions have donecollectively own the 13,150 available medallions have done
everything possible to prevent the city from issuing any more—andeverything possible to prevent the city from issuing any more—and
have succeeded in their efforts. If the city were to issue anotherhave succeeded in their efforts. If the city were to issue another
7,000 medallions for a total of about 20,000, demand and supply7,000 medallions for a total of about 20,000, demand and supply
would equilibrate at a price of about $350,000 per medallion– stillwould equilibrate at a price of about $350,000 per medallion– still
a 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 still
make a profit.make a profit.

WHY CAN’T I FIND A TAXI?WHY CAN’T I FIND A TAXI?
TAXI MEDALLIONSTAXI MEDALLIONS
IN NEW YORK CITYIN NEW YORK CITY
The demand curveThe demand curve DD
shows the quantity ofshows the quantity of
medallions demanded bymedallions demanded by
taxi companies as ataxi companies as a
function of the price of afunction of the price of a
medallion.medallion.
The supply curveThe supply curve SS showsshows
the number of medallionsthe number of medallions
that would be sold bythat would be sold by
current owners as acurrent owners as a
function of price.function of price.
New York limits theNew York limits the
quantity to 13,150, so thequantity to 13,150, so the
supply curve becomessupply curve becomes
vertical and intersectsvertical and intersects
demand at $880,000, thedemand at $880,000, the
market price of amarket price of a
medallion in 2011.medallion in 2011.

To begin, consider the supply of owner-occupied housing inTo begin, consider the supply of owner-occupied housing in
suburban or rural areas where land is not scarce. In this case, thesuburban or rural areas where land is not scarce. In this case, the
price of land does not increase substantially as the quantity ofprice of land does not increase substantially as the quantity of
housing supplied increases. Likewise, costs associated withhousing supplied increases. Likewise, costs associated with
construction are not likely to increase because there is a nationalconstruction are not likely to increase because there is a national
market for lumber and other materials. Therefore, the long-runmarket for lumber and other materials. Therefore, the long-run
elasticity of the housing supply is likely to be very large,elasticity of the housing supply is likely to be very large,
approximating that of a constant-cost industry.approximating that of a constant-cost industry.
The market for rental housing is different, however. TheThe market for rental housing is different, however. The
construction of rental housing is often restricted by local zoningconstruction of rental housing is often restricted by local zoning
laws. Many communities outlaw it entirely, while others limit it tolaws. Many communities outlaw it entirely, while others limit it to
certain areas. Because urban land on which most rental housingcertain areas. Because urban land on which most rental housing
is located is restricted and valuable, the long-run elasticity ofis located is restricted and valuable, the long-run elasticity of
supply of rental housing is much lower than the elasticity ofsupply of rental housing is much lower than the elasticity of
supply of owner-occupied housing. With urban land becomingsupply of owner-occupied housing. With urban land becoming
more valuable as housing density increases, and with the cost ofmore valuable as housing density increases, and with the cost of
construction soaring, increased demand causes the input costs ofconstruction soaring, increased demand causes the input costs of
rental housing to rise. In this increasing-cost case, the elasticityrental housing to rise. In this increasing-cost case, the elasticity
of supply can be much less than 1.of supply can be much less than 1.
THE LONG-RUN SUPPLY OF HOUSINGTHE LONG-RUN SUPPLY OF HOUSING

Examples of CompetitiveExamples of Competitive
IndustriesIndustries
AgricultureAgriculture
Boiler ChickensBoiler Chickens
Red-MeatRed-Meat
MilkMilk
TruckingTrucking

THE MARKET FOR HUMAN KIDNEYSTHE MARKET FOR HUMAN KIDNEYS
Even at a price of zero (the effective price under theEven at a price of zero (the effective price under the
law), 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 kidneys
would be supplied if the price were $20,000.would be supplied if the price were $20,000.
We can fit a linear supply curve to this data—i.e.,We can fit a linear supply curve to this data—i.e.,
a supply curve of the 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 + 0.4PP
Note that at a price of $20,000, the elasticity ofNote that at a price of $20,000, the elasticity of
supply 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 would
be 24,000 per year. Like supply, demand isbe 24,000 per year. Like supply, demand is
relatively price inelastic; a reasonable estimate forrelatively price inelastic; a reasonable estimate for
the price elasticity of demand at the $20,000 pricethe price elasticity of demand at the $20,000 price
is −0.33. This implies the following linear demandis −0.33. This implies the following linear demand
curve: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 THE
NATIONAL ORGAN TRANSPLANTATION ACTNATIONAL ORGAN TRANSPLANTATION ACT
THE MARKET FOR HUMAN KIDNEYSTHE MARKET FOR HUMAN KIDNEYS
Economics, the dismal science, showsEconomics, the dismal science, shows
us that human organs have economicus that human organs have economic
value that cannot be ignored, andvalue that cannot be ignored, and
prohibiting their sale imposes aprohibiting their sale imposes a costcost
on society that must be weighedon society that must be weighed
against 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, about
24,000 kidneys per year would24,000 kidneys per year would
be supplied.be supplied.
The law effectively makes theThe law effectively makes the
price zero. About 16,000price zero. About 16,000
kidneys per year are stillkidneys per year are still
donated; this constraineddonated; this constrained
supply is shown as S’.supply is shown as S’.
The loss to suppliers is givenThe loss to suppliers is given
by rectangle A and triangle C.by rectangle A and triangle C.
If consumers received kidneysIf consumers received kidneys
at no cost, their gain would beat no cost, their gain would be
given by rectangle A lessgiven by rectangle A less
triangle B.triangle B.

EFFECT OF AIRLINEEFFECT OF AIRLINE
REGULATION BY THEREGULATION BY THE
CIVIL AERONAUTICSCIVIL AERONAUTICS
BOARDBOARD
AIRLINE REGULATIONAIRLINE REGULATION
Airline deregulation in 1981 led to major changes in theAirline deregulation in 1981 led to major changes in the
industry. Some airlines merged or went out of business asindustry. Some airlines merged or went out of business as
new ones entered. Although prices fell considerably (tonew ones entered. Although prices fell considerably (to
the benefit of consumers), profits overall did not fallthe benefit of consumers), profits overall did not fall
much.much.
At priceAt price PPminmin, airlines would like to, airlines would like to
supplysupply QQ22, well above the quantity, well above the quantity
QQ11 that consumers will buy.that consumers will buy.
Here they supplyHere they supply QQ33. Trapezoid. Trapezoid DD
is the cost of unsold output.is the cost of unsold output.
Airline profits may have beenAirline profits may have been
lower as a result of regulationlower as a result of regulation
because trianglebecause triangle CC and trapezoidand trapezoid
DD can together exceed rectanglecan together exceed rectangle
AA. In addition, consumers lose. In addition, consumers lose AA

AIRLINE REGULATIONAIRLINE REGULATION
Because 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 of
changing fuel costs.changing fuel costs.
TABLE 2TABLE 2 AIRLINE INDUSTRY DATAAIRLINE INDUSTRY DATA
19751975 1980 1990 2000 2010
Number of U.S. carriersNumber of U.S. carriers 36 63 70 94 63
Passenger Load Factor (%)Passenger Load Factor (%) 54.0 58.0 62.4 72.1 82.1
Passenger-Mile Rate (constant 1995 dollars)Passenger-Mile Rate (constant 1995 dollars) 0.218 0.210 0.149 0.118 0.094
Real Cost Index (1995 = 100)Real Cost Index (1995 = 100) 101 145 119 89 148
Real Fuel Cost Index (1995 = 100)Real Fuel Cost Index (1995 = 100) 249 300 163 125 342
Real Cost Index w/o Fuel Cost IncreasesReal Cost Index w/o Fuel Cost Increases
(1995 = 100)(1995 = 100)
71 87 104 85 76

THE SUGAR QUOTATHE SUGAR QUOTA
In recent years, the world price of sugar has been between 10In recent years, the world price of sugar has been between 10
and 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 to
40 cents per pound. Why?40 cents per pound. Why? By restricting imports, the U.S.By restricting imports, the U.S.
government protects the $4 billion domestic sugar industry,government protects the $4 billion domestic sugar industry,
which would virtually be put out of business if it had towhich would virtually be put out of business if it had to
compete with low-cost foreign producers. This policy hascompete with low-cost foreign producers. This policy has
been good for U.S. sugar producers, but bad for consumers.been good for U.S. sugar producers, but bad for consumers.
U.S. production: 15.9 billion pounds
U.S.
consumption:
22.8 billion pounds
U.S. price: 36 cents per pound
World price 24 cents per pound
U.S. supplyU.S. supply:: QQSS == −− 7.95 + 0.667.95 + 0.66PP
U.S. demandU.S. demand:: QQDD = 29.73= 29.73 −− 0.190.19PP
At the 24-cent world price, U.S. production would have been onlyAt the 24-cent world price, U.S. production would have been only
about 7.9 billion pounds and U.S. consumption about 25.2 billionabout 7.9 billion pounds and U.S. consumption about 25.2 billion
pounds, of which 25.2 − 7.9 = 17.3 billion pounds would have beenpounds, of which 25.2 − 7.9 = 17.3 billion pounds would have been
imported. But fortunately for U.S. producers, imports were limited toimported. But fortunately for U.S. producers, imports were limited to
only 6.9 billion pounds.only 6.9 billion pounds.

THE SUGAR QUOTATHE SUGAR QUOTASUGAR QUOTA IN 2010SUGAR QUOTA IN 2010
At the world price of 24 centsAt the world price of 24 cents
per pound, about 25.2 billionper pound, about 25.2 billion
pounds of sugar would havepounds of sugar would have
been consumed of which allbeen consumed of which all
but 7.9 billion pounds wouldbut 7.9 billion pounds would
have been imported.have been imported.
Restricting imports to 6.9Restricting imports to 6.9
billion pounds caused thebillion pounds caused the
U.S. price to go up by 12U.S. price to go up by 12
cents.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 domestic
producers was trapezoidproducers was trapezoid AA,,
about $1.4 billion.about $1.4 billion. RectangleRectangle
DD, $836 million, was a gain to, $836 million, was a gain to
those foreign producers whothose foreign producers who
obtained quota allotments.obtained quota allotments.
TrianglesTriangles BB andand CC representrepresent
the deadweight loss of aboutthe deadweight loss of about
$614 million.$614 million.

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

Casestudy : StarbucksCasestudy : Starbucks
1.1. Read and prepare theRead and prepare the
Casestudy onCasestudy on
STARBUCKS forSTARBUCKS for
discussion anddiscussion and
presentation next.presentation next.
2.2. Identify and evaluateIdentify and evaluate
the challenges facingthe challenges facing
STARBUCK’s globalSTARBUCK’s global
business bybusiness by
conducting Externalconducting External
Environment analysisEnvironment analysis
(PESTEL);and(PESTEL);and
Industry (5+1 Forces)Industry (5+1 Forces)
analysis.analysis.

Core ReadingCore Reading
• Keat, Paul G. and Young, Philip KY (2009)
Managerial Economics, 6th
edition, Pearson
• Samuelson, William F. and Marks, Stephen G.
(2010) Managerial Economics, 6th
edition, John
Wiley
• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)
Microeconomics, 8th
edition, Pearson
• Samuelson, P.A. and Nordhaus, W. D.Samuelson, P.A. and Nordhaus, W. D.
(2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth
EditionEdition
• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy –“Competitive Strategy –
Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors”
Free PressFree Press

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