Chapter Six: The Firm and its Environment

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Chapter SixThe Firm and its Environment

• The Theory of the Firm Summarized
• Introduction to Industrial Organization
• Perfect Competition
• Monopoly
• Monopolistic Competition
• Oligopoly
• Profit Maximization Across Time

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Foundations of the Theory of the FirmThe Law of
Demand

• The Law of Demand - The quantity of a
  well-defined good or service that people are
  willing and able to purchase during a particular
  period of time decreases as the price of that
  good or service increases everything else held
  constant.
• The Law of Demand gives us the relationship
  between price and quantity.
• Via the concept of elasticity, we have the
  relationship between total revenue and quantity.
• From total revenue we move to marginal revenue.
• Key idea For the firm to increase output it must
  lower its price. Not only will marginal revenue
  also fall as output is increased, marginal
  revenue will also be less than the price the firm
  charges.

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The Mathematics of Demand

• P a bQ
• Understand how elasticity varies along a linear
  demand curve.
• TR aQ bQ2
• Understand the connection between elasticity and
  total revenue.
• MR a 2bQ Understand Why!!!
• Understand the connection between elasticity and
  marginal revenue.
• When Total Revenue is maximized, marginal revenue
  is zero.
• Total Revenue is maximized when marginal revenue
  is zero. WHY???
• When Marginal Revenue is positive, Total Revenue
  is rising.
• When Marginal Revenue is negative, Total Revenue
  is falling.
• When Marginal Revenue is zero, Total Revenue is
  neither rising or falling, therefore it is
  maximized.
• Revenue Maximization is NOT the Objective of the
  Firm!!!

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Foundations of the Theory of the FirmThe Law of
Diminishing Returns

• The Law of Diminishing Returns As a variable
  input increases, holding all else constant, the
  rate of increase in output will eventually
  diminish.
• The Law of Diminishing Returns underlies the
  relationship between total (as well as average
  and marginal) product and labor.
• The short run production functions give use the
  short run total cost, average cost, and marginal
  cost function.
• Remember, the law of diminishing returns is a
  short-run concept.
• Key Idea As the firm increases

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The Mathematics of Cost

• When MC AC, Average Cost is Minimized.
• If Marginal Cost is less than Average Cost,
  Average Cost will be declining.
• If Marginal Cost is greater than Average Cost,
  Average Cost will be increasing.
• Average Cost minimization is where the firm is
  most efficient.
• Average Cost Minimization is NOT the Objective of
  the Firm!!!

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Profit Maximization

• Profit Total Revenue Total Cost
• Marginal Profit MR MC
• Profit is maximized when marginal profit equals
  zero. WHY?
• When marginal profit is positive (MRMC), profit
  is rising.
• When marginal profit is negative (MRis falling.
• When marginal profit is zero (MRMC), profit is
  not rising or falling, it is maximized.

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The Law of Demand
Law of Diminishing Returns

• Total Cost and Output
• Marginal Cost and Average Cost
• AVERAGE COST
• MINIMIZING LEVEL OF
• OUTPUT

• Price and Output
• via Own-Price Elasticity
• Total Revenue and Output
• Marginal Revenue and Output
• REVENUE MAXIMIZING LEVEL
• OF OUTPUT

Profit Total Revenue Total Cost Marginal
Profit Marginal Revenue Marginal Cost PROFIT
MAXIMIZING LEVEL OF OUTPUT
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MR MC

• Can firms estimate demand and cost functions?
  Yes
• Do all firms estimate demand and cost functions?
  No
• Why do we need to know MR MC if we do not have
  access to the demand and cost functions?

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Industrial Organization

• Industrial Organization The Study of the
  Structure of Firms and Markets and of Their
  Interactions.
• OUTLINE
• Perfect Competition
• Monopoly
• Monopsony
• Monopolistic Competition
• Oligopoly

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Perfect Competition MonopolyDefinitions

• Perfect Competition A market structure
  characterized by a large number of buyers and
  sellers of an identical product.
• Monopoly A market structure characterized by a
  single seller of a highly differentiated (unique)
  product.

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Price Taker vs. Price Maker

• Price Taker Buyers and sellers whose individual
  transactions are so small that they do not affect
  market prices.
• Price Maker Buyers and sellers whose large
  transactions affect market prices.
• NOTE Being a price maker does not mean you can
  charge any price you like.

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Factors that Determine the Level of Competition

• Product differentiation (real or perceived
  differences in the quality of goods and
  services).
• Size of the market relative to MES.
• Barriers to entry and mobility.
• Barriers to entry any advantage for industry
  incumbents over new arrivals.
• Barriers to mobility any advantage for leading
  firms over small non-leading rivals.
• Barriers to exit Any limit on asset
  redeployment from one line of business or
  industry to another.
• Monopsony (a market with one buyer) power.

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Perfect CompetitionCharacteristics

• Large number of buyers and sellers.
• Product homogeneity.
• Free entry and exit.
• Perfect dissemination of information.

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Perfect CompetitionShort Run vs. Long Run

• In the short-run economic profit (or loss) is
  possible.
• In the long-run, competitive pressures will cause
  the typical firm to earn zero economic profits.
• NOTE UNDERSTAND THE MATHEMATICS OF PERFECT
  COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.

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MonopolyCharacteristics

• A single seller.
• Unique product.
• Blockaded entry and exit.
• Imperfect dissemination of information.
• NOTE 1 Monopoly power can exist without these
  conditions being exactly met.
• NOTE 2 UNDERSTAND THE MATHEMATICS OF MONOPOLY
  IN THE SHORT-RUN AND THE LONG-RUN.

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Monopsony

• If the market for labor is competitive, then the
  firm simply pays the market wage to each
  additional worker hired.
• For a monopsonist to hire an additional worker
  the firm must pay both the added worker, and all
  other employees, a higher wage rate. Hence the
  marginal expense of a new workers exceeds the
  wage paid the additional employee.
• A monopsonist will stop hiring workers when the
  marginal expense of the last worker equals the
  last workers MRP.
• The wage paid will correspond to labor supply at
  that level of employment.

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The Baseball Players Market

• The union is a monopolist The sole seller of
  baseball talent.
• Major League Baseball is a monopsony The sole
  buyer of baseball talent.
• Countervailing power buyer market power that
  offsets seller market power.
• How will wages be determined? Via bargaining.
• BE ABLE TO ILLUSTRATE THIS STORY.

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Monopolistic Competition and Oligopoly

• Monopolistic Competition A market structure
  characterized by a large number of sellers of
  differentiated products.
• Oligopoly A market structure characterized by
  few sellers and interdependent price/output
  decisions.

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Monopolistic CompetitionCharacteristics

• Large number of buyers and sellers.
• Product heterogeneity.
• Free entry and exit.
• Perfect dissemination of information.

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Monopolistic CompetitionShort Run vs. Long Run

• In the short-run economic profit (or loss) is
  possible.
• In the long-run, competitive pressures will cause
  the typical firm to earn zero economic profits.

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More on Monopolistic Competition

• Although economic profit is zero (PATC), price
  is still greater than marginal cost.
• Product differentiation results in a downward
  sloping demand curve.
• Consequently, price exceeds marginal revenue.
  WHY?
• To profit maximize MR MC, therefore price
  exceeds marginal cost.

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Even More on Monopolistic Competition

• If P ATC and P MC, then ATC MC. What does
  this mean? A firm in monopolistic competition
  does not produce at capacity (i.e. it is not as
  efficient as perfect competition).
• Is this a social cost? Is product differentiation
  worth inefficient production?
• NOTE UNDERSTAND THE MATHEMATICS OF MONOPOLISTIC
  COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.

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OligopolyCharacteristics

• Few sellers
• Homogenous or unique product.
• Barriers to entry and exit.
• Imperfect dissemination.
• Key Price and output decisions are
  interdependent.

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MR MC, Again

• Imagine an oligopolist who is currently charging
  a price less than (or greater than) profit
  maximization.
• If the firm raises (or lowers) its price, how
  will other firms in the market respond?
• When other firms respond, the price that
  maximizes profit will change. WHY?
• Consequently an oligopolist cannot determine a
  profit maximizing price unless she or he can
  predict accurately the responses of her/his
  competitors.

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Oligopoly Model The Kinked Demand Curve Model

• Premise of the model Firms follow a price
  decrease, but do not follow a price increase.
• Hence the elasticity of demand will differ
  depending upon the decision the firm makes.
• Implication Firms have an incentive not to
  change price, even if costs change. Be able to
  explain why costs can change but profit
  maximizing output and price would the not in the
  kinked demand curve model.
• Note We can model an oligopoly model if we
  assume how firms will respond to price changes.

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Bertrand Duopoly

• Assumptions
• Two Firm
• Identical Products
• Constant MC (to simplify presentation)
• Perfect Information
• Zero Transaction Costs
• Equilibrium in the model P MC
• Lessons from the Bertrand Duopoly
• Product differentiation matters
• Firms do not wish to compete on price.

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Sustaining Economic Profit

• In a competitive environment economic profit will
  be competed to zero.
• For economic profit to be sustained, a firm needs
  to establish a barrier to entry.
• Product differentiation
• Technological difference

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Game Theory

• Game Theory - a mathematical technique used to
  analyze the behavior of decision makers.
• the study of behavior in situations in which each
  partys payoff directly depends on what another
  party does.
• Example Two firms are determining how much to
  advertise.
• The elements of the game
• The players Firm 1, Firm 2
• The strategies High advertising, low advertising

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Prisoners Dilemma

• The payoffs Are as follows (payoffs read 1,2)
• Firm 2
• High Low
• High 40,40 100, 10
• Firm 1
• Low 10, 100 60,60
• Solving games
• Equilibrium no pressure for any participant to
  change his/hers action
• Dominant strategy equilibrium In this game, the
  dominant strategy for firm 1 and firm 2 is high.
  So the outcome of the game is 40,40.
• This illustrates the prisoners dilemma Games in
  which the equilibrium of the game is not the
  outcome the players would choose if they could
  perfectly cooperate.

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Future Value and Present ValueOne Time Period

• Future Value PV(1 interest rate)
• If you have 10,000 and the interest rate is 8,
  what is the future value?
• Present Value FV/(1 interest rate)
• If you will have 10,000 and the interest rate is
  8, what do you have currently?

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Future Value and Present ValueMultiple Time
Periods

• If you have multiple time periods, the
  calculation is a bit different.
• Future Value PV(1 interest rate)time
• If you have10,000 and the interest rate is 8,
  what is the future value in 10 years?
• Present Value FV/(1 interest rate)time
• If you will have 10,000 in 10 years and the
  interest rate is 8, what is the present value?

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Profit Maximization, Again

• Firms should not profit maximize strictly with
  respect to the current time period.
• Firms should seek to profit maximize over
  multiple time periods.
• Expected Value Maximization Optimization of
  profits in light of uncertainty and the time
  value of money
• Value of the Firm The present value of the
  firms expected net cash flows.