Eco 12

Things to Know for the Final

Firm Decision-Making

• Know (from Topic 6, really) how to calculate marginal and average cost from total cost.
  
  
• Given a demand curve, be able to calculate total revenue and marginal revenue.
  
  
• Know some of the basic properties of the marginal revenue curve: Downward-sloping, below the demand curve, and steeper.
  
  
• Cost-benefit analysis: Internal vs. external benefits; total benefit, total net benefit, and marginal net benefit; the relationship between marginal net benefit and the maximum total net benefit; the requirements of concavity and the circumstances when it fails (lumpiness, multiple equilibria, and path dependency).
  
  
• Profit maximization: The definitions of total and marginal profit; the relationship between marginal profit and profit maximization; the motivations of various types of firms to maximize or not maximize profits; the MR=MC criterion.


• Private and social cost: Know the difference between private and social cost; what positive and negative externalities are; how to calculate the benefit-maximizing quantity when there are externalities.

Competition

• Recall: A Pareto efficient allocation of resources is one where it's impossible to redistribute goods to make someone better off without making someone else worse off. Note that this definition does not take equality into account.
• If a product is sold in a market with a uniform price, then at the margin, people will only purchase a good if it's worth to them what they pay for it, that is, when the price of the good equals every person's marginal benefit from using it.
• The goal of cost-benefit analysis is to maximize total net benefit.  This implies setting output where marginal benefit is equal to marginal cost.  If price equals marginal benefit, then this implies that price equals marginal cost.
  
• The tie-in to Pareto efficiency: If price were above marginal cost, some benevolent (non-profit-maximizing) person could make everyone better off by producing the good, selling it at the same price, and distributing the profit to everyone. Thus maximizing net benefit is the same as achieving Pareto efficiency.
• Elasticity: Know how to calculate elasticity given two points on a demand curve; the determinants of elasticity (luxury/necessity, percent of income spent, availability of close substitutes); and the relationship between elasticity and monopoly pricing (price is higher and therefore output less efficient when demand is less elastic).

• Features: A single seller, no close substitutes, and barriers to entry. Bases of barriers to entry: Legal restrictions, patents, control of a scarce resource, deliberate barriers, large sunk costs, technical superiority, and natural monopoly.
• Firm demand is industry demand; industry demand is downward sloping, so MR < P. Firms will maximize profits by setting output such that MR=MC, but price will be above MC, from the demand curve at that level of output. Profit is given by (P-AC)xOutput.
• Effects of monopoly: Prices are higher than the Pareto efficient price; output is lower than efficient output; this implies society's resources are under-allocated to producing the good.
  

• Sherman Anti-Trust Act passed in 1890. Prohibits "all contracts, combinations, and conspiracies in restraint of trade" (section 1) and any action to "monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations."
  
• In 1914, Congress passed the Clayton Act. Makes illegal: Price discrimination in restraint of trade; exclusive contracts (preventing buyers from buying from competitors); and stock purchases if they reduce competition.
  
• FTC Act (also 1914) was created to investigate "unfair" and "predatory" practices. Ineffective at first.
  
• Robinson-Patman Act (1936): Protects independent sellers from large distributors.
• Predatory pricing: Sell a product at a loss to drive firms out of a market and make profits later.
• Current problem: Monopolies are often global, but governments are national.  How to coordinate anti-trust behavior?
  

• Features: Many buyers and sellers; free entry and exit; perfect information; heterogeneous products.  Like monopoly, except for free entry and exit and number of buyers and sellers.  Tends to describe retail and small business.
  
• Firms will set MC=MR but MR does not equal price. In the short run, monopolistic competitors behave exactly like monopolists.  In the long run, because there are no barriers to entry, firms will enter until there are zero profits, i.e., AC=P. The excess capacity theorem says that monopolistic competitors will produce at an inefficiently low scale and charge inefficiently high prices.  However, there may be excess variety -- that is, there may be more brands available than what would exist if each firm was producing at a larger scale.

Perfect Competition

• A special case of monopolistic competition in which firms are indistinguishable to consumers and there is zero cost of switching vendors.  Thus, firms are price takers: They take their price from a market consensus, and all of their demand will disappear if they sell a penny above the market price.  Perfect competition is considered rare, but stock exchanges and some agricultural markets may approximate it.
• A result of price-taking is that firms' marginal revenue is exactly equal to their price (MR=P).  This implies that if firms are maximizing profits (setting MR=MC), then perfect competitors set output where P=MC, in both the short and long run.  This implies a Pareto efficient level of output.
• In the long run, like other monopolistic competitors, perfect competitors have their profits eaten away by competition, so that price equals average cost (P=AC).
• This implies that, in the long run, all of the following are equal for perfect competitors: P, MC, AC, MR.
• Note in particular MC=AC, which implies that average cost is at a minimum.  Thus, in the long run, perfect competition results in a level of output where firms are producing at the lowest possible cost to society.
  

Oligopoly

• Oligopoly is a market dominated by a few sellers, more than one of which is large enough to not be a price taker.  It is a model of big-business industries (auto, telecommunications, etc.).
  
• Main difference from all other models: Strategy matters. So firms do not have a well-defined demand curve separate from their competitors' strategies.
• Analysis of strategy can take three different forms: (1) Ignoring it and treating firm like monopolist (okay for small decisions or when firms are highly differentiated); (2) treating industries as cartels; or (3) using game theory to analyze strategy.
• Cartel: Firms make joint decisions and behave like a monopolist. Example: OPEC. Actual cartels often don't last long because each firm has an individual incentive to cheat even if it leaves all members worse off if everyone cheats. Cartels usually are considered least efficient form of market organization because they combine worst aspects of monopoly (low output, high price) without any of its redeeming qualities (economies of scale; protection from free riders). While explicit cartels are rare, more common is tacit collusion: Firms "follow the golden rule" with their competitors. One common form of tacit collusion is price leadership, where one firm (or a few firms) sets the price for an industry and other firms follow.
• Game theory addresses interactions between different players by defining possible strategies and payoffs for each combination of strategies that everyone may take. It is very general and can be used to analyze many types of social behavior (or even chess), but is especially useful with oligopoly. The most famous game is the prisoner's dilemma, which can be used to represent duopoly. Different ways to solve a game like this: (1) Maximin strategy -- maximize the minimum payoff you could get. (2) Nash equilibrium: Maximum payoff given other person?s actions. When game is repeated, other strategies may become available: (a) Tit-for-tat. Play the strategy the other person played last period. (May describe tacit collusion.) (b) Trigger strategy: Play "defect" forever as soon as other person plays defect. (May describe ways of keeping firms from entering a market. Depends on a credible threat: One that the threatener is not hurt by carrying out.)
• Cournot competition exist when two firms set quantity to maximize profits in response to each other's output.  It is solved by a Nash equilibrium, in which each firm is maximizing profits given the other firm's actions.

Supply and Demand

Market Demand

• The relationship between goods can be described by how the price of one affects consumption of the other.  Goods are substitutes if an increase in the price of one increses the quantity demanded of the other.  They are complements if a decrease in the price of one increases the quantity demanded of the other.
• Good are normal goods if the demand for them rises with income, and inferior goods if the demand for them falls as income increases.
• The following can shift a demand curve out: An increase in the price of substitutes; a fall in the price of complements; a fall in income for inferior goods; an increase in income for normal goods.
• The following can shift a demand curve in: A decrease in the price of substitutes; a rise in the price of complements; a rise in income for inferior goods; an decrease in income for normal goods.

Perfect Competition

• Each firm sets output along its marginal cost curve.  Because this curve is upward-sloping, the higher the price the higher the output.  When all firms do this together, it results in an upward-sloping industry supply curve: The higher the price, the more the industry is willing to produce.
• The industry equilibrium is the point where the quantity supplied and the quantity demanded are the same -- that is, where the supply and demand curves intersect.
• If the price is above or below the equilibrium price, market forces will cause it to gravitate toward the euquilibrium price.
• The following can cause the supply curve to shift out: Improving technology, a decrease in the price of inputs, or a decrease in the price of alternative outputs.
• If the supply curve shifts out, quantity increases and price decreases.
• The following can cause the supply curve to shift in: Worsening technology, an increase in the price of inputs, or an increase in the price of alternative outputs.
• If the supply curve shifts in, quantity decreases and price increases.
• If the demand curve shifts out, both quantity and price increase.
• If the demand curve shifts in, both quantity and price decrease.
• A price control, if it has any effect, will cause the quantity supplied to decrease.

Monopoly

• There isn't really a proper supply curve.  Recall that the monopolist sets marginal revenue equal to marginal cost, so it's the marginal revenue curve, not the demand curve that determines shifts.
• An outward shift in demand could cause an increase in quantity but a decrease in price (if demand becomes flatter) or a decrease in quantity and an increase in price (if demand becomes steeper), or an increase in both.  In other words, nearly anything can happen, though it is unlikely to have both price and quantity fall when demand shifts out.
• Also, unlike perfect competitors, monopolists don't necessarily have upward-sloping marginal cost curves.
• A price control, as long as it is not too severe, can decrease the price and increase the quantity sold.