ECON 351

1
ECON 351

• Week 09
• The Firm in Competition
• (Chapter 8, 9)

2
Demand Facing the Firm
P
P
P
P
D1
D3
D4
D2
Q
Q
Q
Q
?Increasing degrees of Competition ? ?
Increasing degrees of Market Power ?
3
Alternative Economic Models
P
P
P
P
D1
D3
D4
D2
Q
Q
Q
Q
Monopoly
Oligopoly
Monopolistic Competition
Perfect Competition (Price Taker)
?Increasing degrees of Competition ? ?
Increasing degrees of Market Power ?
4
Alternative Market Structures

• The Most Competitive Case
• The Price Taker Firm

5
Assumptions for a Price Taker

• Large number of buyers sellers
• Homogeneous products
• Low information costs to buyers sellers
• Low costs of entry and exit of firms

6
Market and Firm Demand
P
P
Firm
Market
D
S
Pe
Pe
D
S
D
Q/T
Qe
Q/T
7
Price Taker Firm
P
MC
Price Marginal Revenue
Pe
D MR
Profit Maximizing Rate of output
Qe
Q/T
8
Total Revenue Pe x Qe
P
MC
Pe
D
Total Revenue
Qe
Q/T
9
Total Cost AC x Q
P
MC
AC
Pe
D
AC at Qe
Total Cost
Qe
Q/T
10
Profit TR - TC
P
MC
AC
Pe
D
Q
Q/T
11
Profits occur if (PMC) gt AC
P
MC
AC
Pe
D MR
Qe
Q/T
12
Market Response to Profits
P
D
So
S
Pe
P
D
So
Qx/T
Qe
Q
13
Price Taker Firm Zero Profits
P
MC
ATC
D
Pe
D MR
Qe
Q/T
14
Price Taker Firm Loss
P
ATC
MC
Loss
Pe
D MR
Qe
Q/T
15
Price Taker Firm Loss Shutdown?
ATC
P
MC
AVC
Loss
Pe
D MR
Stay in Business SR
TVC
Qe
Q/T
16
Price Taker Firm Loss Shutdown?
ATC
P
MC
AVC
Loss
Pe
D MR
ShutDown in SR
TVC
Q/T
Qe
17
Market Response to Losses
P
D
S
So
P
Po
D
S
Qx/T
Q
Qo
18
Price Taker Firm Zero Profits
P
MC
ATC
Pe
D MR
Po
D
Qe
Q/T
19
Price Taker Firm Short Run Supply
ATC
P
MC
Short-Run Supply
AVC
Pe
D MR
ShutDown in SR
TVC
Q/T
Qe
20
Pork Swine Flu

• Association ?Demand ?(? Price Falls)
• Industry lobbies ? Name to H1N1 virus
• China prohibits imports from US ?Demand
• Existing firms make losses (1/6 of industry)
• Firms leave industry ? (? Supply) ??Price

21
Implications of Price-Taker Industry

• Demand for the firm is horizontal at the market
  price
• Efficiency Price equals marginal cost of
  production
• Competition drives price to equal Average cost
• Economic profits only exist in the short-run.

22
Long-Run Industry Equilibrium
P
P
Firm
Market
MC
D
S
ATC
Pe
Pe
D
S
D
Q/T
Qe
Qe
Q/T
23
ECON 351

• Using the Competitive Model
• Chapter 09

24
Market Interaction
P x
10 9 8 7 6 5 4 3
2 1
Demand
Supply
Pe
Exchange Value
Dx
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
25
Allocation Efficiency Price allocates the goods
to highest valued users
Market Demand determines Price. Each buyer
responds to price by buying till Marginal Value
equals price. No reallocation can generate
greater value.
Market
A
B
C
P
Demand
Supply
P
P
P
D
D
D
Pe
Pe
Qa
Qb
Qe
Qc
Q/T
Marginal Value A Marginal Value B
Marginal Value C Market Price
26
Production Efficiency Price coordinates the
efficient use or resources
Market Supply is the sum of the industry output
at alternative prices. Each firm produces up to
the quantity where Price Marginal Cost. No
reallocation of resources will produce at a lower
opportunity cost.
Market
Firm 2
Firm 1
Firm 3
P
Demand
P
P
P
Supply
S2
Pe
S1
Pe
S3
Qe
Q/T
Q1
Q2
Q3
Market Price Marginal Cost Firm 1
Marginal Cost Firm 2 Marginal Cost Firm 3
27
Market is Efficient since at Qe the Marginal
Value Marginal cost
P x
10 9 8 7 6 5 4 3
2 1
Demand
Supply
Pe
Dx
Marginal Cost
Marginal Value
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
28
Demand Marginal Value
MVx
Consumer Surplus Value (MV Price)
10 9 8 7 6 5 4 3
2 1
Pe
Exchange Value
MVx Dx
1 2 3 4 5 6 7 8 9 10
Qtyx / T
Qe
29
Supply Reflects Marginal Cost
P x
10 9 8 7 6 5 4 3
2 1
The height reflects the marginal cost of
producing an additional unit.
Pe
Producer Surplus Value Price Marginal Cost
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
30
Market Gains from Trade
P x
10 9 8 7 6 5 4 3
2 1
Demand
C.S V.
Supply
Pe
P.S.V.
Dx
Sx
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
31
Market Efficiency Reduced Output
P x
10 9 8 7 6 5 4 3
2 1
Demand
Supply
Efficiency Loss
Pe
Dx
Sx
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
32
Market EfficiencyIncreased Output
P x
10 9 8 7 6 5 4 3
2 1
Demand
Supply
Efficiency Loss
Pe
Dx
Sx
Qtyx /T
1 2 3 4 5 6 7 8 9 10
11 12
Qe
33
Market Outcome is Efficient

• Marginal Value (MV) of last unit produced
  Marginal Cost of production (MC)
• Producing less ? Efficiency loss
• Producing more ? Efficiency Loss

34
Periods of Analysis

• Long-Run All inputs are variable (prospective)
• Short-Run Some inputs fixed, some variable
• Market Period All inputs Fixed ? Output Fixed (
  vertical supply)

35
Market Analysis

• The Market for Rental apartments
• Analyze an increase in demand
• Analyze price effects in the market period
• Analyze supply and price effects in the long-run

36
Rent
Supply
LR new Supply
D0
New LR Equilibrium
2000
1600
1400
D1
Units/Month
1000
1500
37
Rent
Supply
D0
Price Ceiling
1400
D1
Short
Units/Month
1000
1500
38
Implications Price Ceiling below Equilibrium

• Increased Transaction Costs to Buyers Sellers
• Increase in Non-Market rationing Discrimination
• Decrease in Quality
• Decrease in Supply

39
THE EFFICIENCY OF A COMPETITIVE MARKET
The Market for Human Kidneys
Figure 9.6
Supply QS 16,000 0.4P Demand QD
32,000?0.4P
The Market for Kidneys and the Effect of the
National Organ Transplantation Act
The market-clearing price is 20,000 at this
price, about 24,000 kidneys per year would be
supplied. The law effectively makes the price
zero. About 16,000 kidneys per year are still
donated this constrained supply is shown as
S. The loss to suppliers is given by rectangle A
and triangle C. If consumers received kidneys at
no cost, their gain would be given by rectangle A
less triangle B.
40
THE EFFICIENCY OF A COMPETITIVE MARKET
The Market for Human Kidneys
Supply QS 16,000 0.4P Demand QD
32,000?0.4P
Figure 9.6
The Market for Kidneys and the Effect of the
National Organ Transplantation Act (continued)
In practice, kidneys are often rationed on the
basis of willingness to pay, and many recipients
pay most or all of the 40,000 price that clears
the market when supply is constrained.
Rectangles A and D measure the total value of
kidneys when supply is constrained.
41
Price Floor above Equilibrium

• How does the labor Market work?
• What happens when you place the Minimum Wage
  above Equilibrium wage ?

42
Unskilled Labor Market
Wage
Supply of Labor
Demand
Min. Wage
Wage E
Surplus Unemployment
Qty/T
Qd
QE
Qs
43
The Minimum Wage A Price Floor
Wage
D
S
Minimum Wage
Pe
D
Qd
Qs
Qe
Qty / T
44
Implications of Price Floor above Equilibrium

• Increase in transaction costs
• Increase in non-market rationing (discrimination)
• Increase in quality (not demand driven)
• Increase in supply
• Wealth transfer from unemployed to employed

45
MINIMUM PRICES
Airline Regulation
Figure 9.9
Effect of Airline Regulation by the Civil
Aeronautics Board
At price Pmin, airlines would like to supply Q2,
well above the quantity Q1 that consumers will
buy. Here they supply Q3. Trapezoid D is the
cost of unsold output. Airline profits may have
been lower as a result of regulation because
triangle C and trapezoid D can together exceed
rectangle A. In addition, consumers lose A B.
46
PRICE SUPPORTS AND PRODUCTION QUOTAS
? Price Support Price set by government above
free-market level and maintained by governmental
purchases of excess supply.
Figure 9.10
Price Supports
To maintain a price Ps above the market-clearing
price P0, the government buys a quantity Qg. The
gain to producers is A B D. The loss to
consumers is A B. The cost to the government
is the speckled rectangle, the area of which is
Ps(Q2 - Q1).
Total change in welfare ?CS ?PS - Cost to
Govt. D - (Q2 - Q1)Ps
47
Taxes Price Effects
48
Sales Tax on Buyers
Sx
Price x
Pb
Pe
Tax Revenue
Ps
Dx
Dx
Qty x /T
Qe
Qt
49
Tax on Sellers
Sx
Price x
Sx
Pb
Pe
Tax Revenue
Ps
Dx
Qty x /T
Qe
Qt
50
Who bares the burden of a tax?

• The distribution of the tax burden is identical
  for either a sales tax on buyers or an excise tax
  on sellers.
• When the price to buyers including the tax rises,
  consumers lose consumer surplus
• When the price to sellers after the tax falls,
  sellers lose previous revenue.

51
Tax Burden Inelastic Demand
Price x
Pb
Sx
Pe
Tax
Ps
Dx
Qty x /T
Qe
Qt
52
Tax Burden Inelastic Supply
Sx
Price x
Pb
Pe
Tax
Ps
Dx
Qty x /T
Qe
Qt
53
Tax Burden Fixed Supply
Price x
Sx
900
Tax 100
800
Lost Revenue
Tax 100
700
Dx
Qe
Qd
Qty x /T
54
Tax Burden Relative Elasticity

• The burden of a tax (either sales or excise)
  depends on the relative elasticity of demand and
  supply.
• If demand is more inelastic then supply ? Buyers
  bare a larger portion of the burden.
• Is supply is more inelastic than demand, sellers
  bare a larger portion of the burden.

55
TaxiCab Supply Restriction
Price
.70 .60 .50 .40 .30 Pe
.20 .10 .05
Efficiency Loss
Supply
Increased Revenue
D1
Do
100 200 300 400 500 600 700 800 900
1000 1100 Q x/ T
Qe
56
International Trade

• Allowing Trade leads to an Efficiency Gain
• Restrictions on Trade create an Efficiency Loss

57
International Trade
Rest of World
United States
P P1 P2 P3
P P1 P2 P3
S us
S r
St
D us
Dr
Qty US
Qty Row
Q1 Q2
Q1 Q2
58
IMPORT QUOTAS AND TARIFFS
? import quota Limit on the quantity of a good
that can be imported.
? tariff Tax on an imported good.
Figure 9.14
Import Tariff or Quota That Eliminates Imports
In a free market, the domestic price equals the
world price Pw. A total Qd is consumed, of which
Qs is supplied domestically and the rest
imported. When imports are eliminated, the price
is increased to P0. The gain to producers is
trapezoid A. The loss to consumers is A B C,
so the deadweight loss is B C.
59
IMPORT QUOTAS AND TARIFFS
Figure 9.15
Import Tariff or Quota (General Case)
When imports are reduced, the domestic price is
increased from Pw to P. This can be achieved by
a quota, or by a tariff T P - Pw. Trapezoid A
is again the gain to domestic producers. The loss
to consumers is A B C D. If a tariff is
used, the government gains D, the revenue from
the tariff. The net domestic loss is B C. If a
quota is used instead, rectangle D becomes part
of the profits of foreign producers, and the net
domestic loss is B C D.
60
IMPORT QUOTAS AND TARIFFS
The Sugar Quota
U.S. supply QS ? 7.48 0.84P U.S. demand QD
26.7 ? 0.23P
Figure 9.16
Sugar Quota in 2005
At the world price of 12 cents per pound, about
23.9 billion pounds of sugar would have been
consumed in the United States in 2005, of which
all but 2.6 billion pounds would have been
imported. Restricting imports to 5.3 billion
pounds caused the U.S. price to go up by 15 cents.
61
IMPORT QUOTAS AND TARIFFS
The Sugar Quota (Continued)
U.S. supply QS ? 7.48 0.84P U.S. demand QD
26.7 ? 0.23P
Figure 9.16
Sugar Quota in 2005 (continued)
The gain to domestic producers was trapezoid A,
about 1.3 billion. Rectangle D, 795 million,
was a gain to those foreign producers who
obtained quota allotments. Triangles B and C
represent the deadweight loss of about 1.2
billion. The cost to consumers, A B C D,
was about 3.3 billion.
62
The Sugar Import Quota
U. S.
Rest of World
S us
S T
P
P
P4
S T
S T
P3
Quota
P2
P5
P1
Dus
D r
Q1 Q2
Qus
Qus i
Qus
Qty US
Qty Row