Microeconomics & Markets

Frederieke Dijkhuizen

Microeconomics

Chapter 1. The fundamentals of managerial economics Manager: a person who directs resources to achieve a stated goal. Economics: the science of making decisions in the presence of scarce resources. Managerial economics: the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Economic profits: the difference between total revenue and total opportunity cost. Opportunity cost: the explicit cost of a resource plus the implicit cost of giving up its best alternative use.

The five forces framework -­‐
Entry

-­‐
Power
of input suppliers: industry profits tend to be lower when suppliers have the power to negotiate favourable terms for their inputs.

-­‐
Power
of buyers: industry profits tend to be lower when consumers have the power to negotiate.

-­‐
Substitutes
and complements -­‐
Industry
rivalry: rivalry tends to be less intense in concentrated industries (with few firms).

Within a firm, incentives affect how resources are used and how hard workers work.

Rivalry within markets -­‐
Consumer-­‐producer
rivalry:

-­‐
Consumer-­‐consumer
rivalry -­‐
Producer-­‐producer
rivalry -­‐
Government
and the market

Time value of money !"
Present
value = ! !!!

i = ratio of interest or the opportunity cost of funds. n = number of years !

Present value of a stream =

!"!
!!! !

!!!

Net present value: the present value of the income stream generated by a project minus the current cost of the project.

1+ !

Marginal benefit: the change in total benefits arising from a change in the managerial control variable Q. Marginal cost: the change in total costs arising from a change in the managerial control variable Q. Marginal net benefits (MNB) = −

Incremental values: the additional revenues that stem from a yes-­‐or-­‐no decision. Incremental costs: the additional costs that stem from a yes-­‐or-­‐no decision.

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Microeconomics & Markets

Frederieke Dijkhuizen

Chapter 2. Market forces: demand and supply Demand

Market demand curve: a curve indication the total quantity of a good all consumers are willing and able to purchase at each possible price, holding the prices or related goods, income, advertising, and other variables constant.

Demand shifters: variables other than the price of a good that influence demand are known as demand shifters. -­‐
Income
» shift depends on the type of good -­‐
Prices
of related goods » shift depends on the type of related goods -­‐
Advertising
and consumer tastes -­‐
Population
» population growth causes a shift to right -­‐
Consumer
expectations

Change in quantity demanded: changes in the price of a good lead to a change in the quantity demanded of that good. This corresponds to a movement along a given demand curve.

Change in demand: changes in variables other than the price of a good, such as income or the price of another good, lead to a change in demand. This corresponds to a shift of the entire demand curve. Normal good: a good for which an increase (decrease) in income leads to an increase (decrease) in the demand for that good. Inferior good: a good for which an increase in income leads to a decrease in the demand for that good. Substitutes: goods for which an increase in the price of one good leads to an increase in the demand for the other good. Complements: goods for which an increase in the price of one good leads to a decrease in the demand for the other good.

Demand function: a function that describes how much of a good will be purchased at alternative prices of that good and related goods, alternative income levels, and alternative values of other variables affecting demand.

Linear demand function: a representation of the demand function in which the demand for a given good is a linear function of prices, income levels, and other variables influencing demand.

= − With a ≥ 0 and b > 0 Consumer surplus: the value consumers get from a good but do not have to pay for.

Supply

Market supply curve: a curve indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant.

Change in quantity supplied: changes in the price of a good lead to a change in the quantity supplied of that good. This corresponds to a movement along a given supply curve. Change in supply: changes in variables other than the price of a good, such as input prices or technological advances, lead to a change in supply. This corresponds to a shift of the entire supply curve.

There is an increase in supply when suppliers supply more for the same price. Supply shifters: -­‐
Input
prices » rise in input prices causes a shift to left -­‐
Technology
or government regulations -­‐
Number
of firms » more firms, shift to the right -­‐
Substitutes
in production -­‐
Taxes

-­‐
Producer
expectations Supply function: a function that describes how much of a god will be produced at alternative prices of that good, alternative input prices, and alternative values of other variables affecting supply. Linear supply function: a representation of the supply function in which the supply of a given good is a linear function of prices and other variables affecting supply.

= + With d > 0 Producer surplus: the amount producers receive in excess of the amount necessary to induce them to produce the good.

!!!
Equilibrium:

!!!

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Microeconomics & Markets

Frederieke Dijkhuizen

Price restrictions Price ceiling: the maximum legal price that can be charged in a market.

Full economic price: the dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.

If there is a price ceiling, consumers can pay the maximum price of Pc, even though they are willing to pay more (Pf).

Pf – Pc = nonpecuniary price = price consumers are willing to pay by waiting in line. Pf = full economic price = Pc + (Pf – Pc) Pc = dollar price

Price floor: the minimum legal price that can be charged in a market.

Gains of trade 1. Find equilibrium price and quantity. 2. Calculate consumer surplus:

a. Intersection demand function with Y-­‐axis – equilibrium price b. Answer x equilibrium quantity c. Answer / 2 3. Calculate producer surplus: a. Equilibrium price – intersection supply function with Y-­‐axis b. Answer x equilibrium quantity c. Answer / 2 4. Answer = 2c + 3c

Chapter 3. Quantitative demand analysis The elasticity concept Elasticity: a measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable.

If variable G depends on S in G = f(S): %∆ ∆

!,! =
=
=

%∆
∆

∆!
= the slope of the functional relation between G and S. ∆!

Important aspects of elasticity: -­‐
Is
the elasticity positive or negative? -­‐
Is
the absolute value of the elasticity greater than 1 or smaller than 1? Greater than 1: the numerator is larger than the denominator in the elasticity formula, a small percentage change in S leads to a big change in G. Less than 1: the numerator is smaller than the denominator in the elasticity formula » small changes.

Own price elasticity of demand Own price elasticity: a measure of the responsiveness of the quantity demanded of a good to a change in the price of that good; the percentage change in quantity demanded divided by the percentage change in the price of the good. !
!
%∆!
!
!
!",!" =
=

%∆!
!
!

Important aspects: -­‐
The
own price elasticity of demand is a negative number due to the law of demand.

-­‐
!",!"
> 1: elastic demand -­‐
!",!"
< 1: inelastic demand -­‐
!",!" = 1: unitary elastic demand

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Microeconomics & Markets

Frederieke Dijkhuizen

Elasticity and total revenue The absolute value of the own price elasticity gets larger as the price increases, the own price elasticity of demand varies along a linear demand curve.

When the absolute value of the own price elasticity is less than 1, an increase in price

increases TR. If demand is elastic, an increase in price will lead to a decrease in TR.

This is called

The price-­‐quantity combination that maximizes TR gives an own price elasticity of -­‐1.

the TR test.

Perfectly elastic demand: demand is perfectly elastic if the own price elasticity is infinite in absolute value. In this case the demand curve is horizontal. Perfectly inelastic demand: demand is perfectly inelastic if the own price elasticity is zero. In this case the demand curve is vertical.

Factors affecting the own price elasticity -­‐
Available
subsitutes: the more substitutes, the more elastic a good is. The demand for broadly defined commodities tends to be more inelastic than the demand for specific commodities (e.i. food and beef).

-­‐
Time:
demand tends to be more inelastic in the short term than in the long term.

-­‐
Expenditure
share: goods that comprise a relatively small share of consumers’ budgets tend to be more inelastic than goods for which consumers spend a sizable portion of their incomes.

Marginal revenue and the own price elasticity of demand For a linear demand curve, the MR schedule lies exactly halfway between the demand curve and the vertical axis.

The MR is less than the price charged for the good because the company has to lower its price to induce more customers to purchase the good. When the firm charges the same price for each unit sold, this lower price is received not only on the last unit sold, but on all the units. When at a price of $5 one unit is sold, and at a price of $4 two units are sold, the MR is 8 – 5 = $3.

1+ =

Cross-­‐price elasticity Cross-­‐price elasticity: a measure of the responsiveness of the demand for a good to changes in the price of a related good; the percentage change in the quantity demanded of one good divided by the percentage change in the price of a related good.

!
!
%∆!
! !
!",!" =
=

%∆!
! !

If X and Y are substitutes: !",!" > 0. If X and Y are complements: !",!" < 0.

If a company sells two products, the impact of a small percentage change in the price of product X on the TR of the firm is: ∆ = ! 1 + !",!" + ! !",!" %∆!

Income elasticity Income elasticity: a measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income.

!
!
%∆!
!

!",! =
=

%∆ !

Obtaining elasticities from demand functions Elasticities for linear demand functions: !
! = ! + ! ! + ! ! + ! + ! Own price elasticity: !",!" = !
Cross-­‐price
elasticity: !",!" = !
Income
elasticity: !",! = !

!
!!

!!

!!
!!

!!

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Microeconomics & Markets

Frederieke Dijkhuizen

Chapter 4. The theory of individual behaviour Consumer behaviour Consumer opportunities: the possible goods and services consumers can afford to consume. Consumer preferences: the determination of which goods will be consumed.

Basic properties of preferences:

-­‐
Completeness:
by assuming that preferences are complete, we assume the customer is capable of expressing a preference for, or indifference among, all different bundles of products.

-­‐
More
is better: if bundle A has at least as much of every good as bundle B and more of some good, bundle A is preferred to bundle B. If more is better, the consumer views the products under consideration as “goods” instead of “bads”.

Indifference curve: a curve that defines the combinations of two goods that give a consumer the same level of satisfaction. All points on the indifference curve are equal. The shape of the curve depends on the preferences of the customer. One important way to summarize information about a consumer’s preferences is in terms of the marginal rate of substitution (MRS): the rate at which a consumer is willing to substitute one good for another good and still remain the same level of satisfaction.

-­‐
Diminishing
marginal rate of substitution: as a consumer obtains more of good X, the amount of good Y he or she is willing to give up to obtain another unit of X decreases.

-­‐
Transitivity:
the assumption of transitive preferences, together with the more-­‐is-­‐better assumption, implies that indifference curves do not intersect one another. It also eliminates the possibility that the consumer is caught in a perpetual cycle in which he or she never makes a choice.

-­‐
When
dealing with more than one indifference curve, curves farther from the origin imply higher levels of satisfaction than curves closer to the origin.

Constraints The budget constraint M = consumer’s income Budget set: the bundles of goods a consumer can afford. !
!
Budget line: the bundles of goods that exhaust a consumer’s income » ! + ! = or = − ! A consumer can afford a maximum quantity of X of =

!
!!

!!

!!

Market rate of substitution: the rate at which one good may be traded for another in the market; slope of the ! budget line = − ! !!

!

Horizontal intercept of the budget line:

!!

Changes in income If income increases and prices are unchanged, the slope of the budget line is unaffected, but both the vertical and the horizontal intercepts of the budget line increases.

Changes in prices A decrease of the price of product X changes the slope of the budget line; it becomes flatter. This changes the horizontal intercept, but not the vertical intercept of the budget line.

Consumer equilibrium Consumer equilibrium: the equilibrium consumption bundle is the affordable bundle that yields the greatest satisfaction to the consumer. This is the bundle that is farthest away from the origin and lies on the budget line. At the equilibrium consumption bundle, the slope of the indifference curve is equal to the slope of the budget line. Recalling that the absolute value of the slope of the indifference curve is called MRS and the slope of the !
!
budget line is given by – ! , we see that at a point of consumer equilibrium MRS = !

!!

!!

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Microeconomics & Markets

Frederieke Dijkhuizen

Comparative statics Price changes and consumer behaviour Precisely where the new equilibrium point lies along the new budget line after a price change depends on consumer preferences.

If X and Y are substitutes, a decrease in the price of X would lead to a point where Y is consumed less than before. If X and Y are complements, a reduction in the price of X would lead the consumer to move to a point where more of Y is consumed than before.

Changes in prices affect the market rate at which a consumer can substitute among various goods. The primary advantage of indifference curve analysis is that is allows a manager to see how price changes affect the mix of goods that consumers purchase in equilibrium.

Income changes and consumer behaviour As in the case of a price change, the exact location of the new equilibrium point will depend on consumer preferences.

Good X is a normal good if an increase in income leads to an increase in the consumption of good X.

Good X is an inferior good if an increase in income leads to a decrease in the consumption of good X.

Substitution and income effects If the price of a good increases two things happen: 1. Since the budget set gets smaller due to the price increase, the consumer will be worse off after the price increase. A lower real income will be achieved, as a lower indifference curve is all that can be reached after the price increase. 2. The increase in the price of good X leads to a budget line with a steeper slope, reflecting a higher market rate of substitution between the two goods.

Substitution effect: the movement along a given indifference curve that results from a change in the relative prices of goods, holding real income constant.

Income effect: the movement from one indifference curve to another that results from the change in real income caused by a price change. This happens because the price change causes a new budget line.

The total effect of a price increase thus is composed of substitution and income effects. The substitution effect reflects a movement along an indifference curve, thus isolating the effect of a relative price change in consumption.

The income effect results from a parallel shift in the budget line; thus, it isolates the effect of reduced real income on consumption. See page 140 and 141.

Applications of indifference curve analysis Choices by consumers -­‐
Buy
one, get one free If a consumer buys one good and gets one for free, the price of that good is zero between 1 and 2 goods. This implies that the budget line is horizontal between 1 and 2 units, since the slope is zero.

See page 142.

-­‐

Cash gifts, in-­‐kind gifts and gift certificates In-­‐kind gifts: When a consumer gets a present, he or she moves to a higher indifference curve, but not in the same way as when he would have had got the money in cash. When receiving one good X, the new equilibrium point moves to the right to the new value of X.

Cash gifts: Would the consumer have received the same value in cash, the same budget line would appear when receiving the gift, but the equilibrium point would lay at the old Y value + value of the cash. This would bring more satisfaction, unless the in-­‐kind gift is exactly what the consumer would have bought personally.

Gift certificates: When a consumer receives a gift certificate, which can only be used at store X, the income increases with a value for X goods, but the new income does not increase the possibility to buy Y goods. This brings a kinked budget line. The effect of gift certificates on consumer behaviour depends. If X is a normal good, the consumer will probably spend more on both good X and Y.

See page 144.

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Microeconomics & Markets

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Choices by workers and managers -­‐
A
simplified model of income-­‐leisure choice When dealing with an indifference curve with income on the Y-­‐axis and leisure on the X-­‐axis, the vertical intercept is the pay per hour x 24 hours. The horizontal intercept are the hours possibly spend on leisure, which is 24.

-­‐
The
decisions of managers Baumol has argued that many managers derive satisfaction from the underlying output and profits of their firms. When drawing an indifference curve, we use the curve of the firm’s profits.

Managers that value both output (X) and profit (Y), will have indifference curves like we have seen before. Note that the equilibrium point does not have to be the profit maximum. Managers that solely value output have vertical indifference curves and managers that solely value profit have horizontal indifference curves. See page 148.

The relationship between indifference curve analysis and demand curves Individual demand The consumer’s demand curve for good X indicates that, holding other things constant, when the price of good 0
1
!
X
is !! , the consumer will purchase X units of X; when the price of good X is ! , the consumer will purchase X units of X.

Market demand The market demand curve is the horizontal summation of individual demand curves and indicates the total quantity all consumers in the market would purchase at each possible price.

Chapter 5. The production process and costs The production function Production function: a function that defines the maximum amount of output that can be produced with a given set of inputs.

Short-­‐run versus long-­‐run decisions Capital is fixed in the long run, labour is variable. The short run is defined as the time frame in which there are fixed factors of production.

Fixed and variable factors of production: fixed factors are the inputs the manager cannot adjust in the short run. Variable factors are the inputs a manager can adjust to alter production.

Measures of productivity -­‐
Total
product: the maximum level of output that can be produced with a given amount of inputs.

-­‐
Average
product: a measure of the output produced per unit of input.

-­‐
Marginal
product: the change in total output attributable to the last unit of an input.

Increasing marginal returns: range of input usage over which marginal product increases.

Decreasing (diminishing) marginal returns: range of input usage over which marginal product declines.

Negative marginal returns: range of input usage over which marginal product is negative.

The role of the manager in the production process -­‐
Produce
on the production function The production function describes the maximum possible output that can be produced with given inputs. This means that workers must be putting forth maximal effort.

-­‐
Use
the right level of inputs Value marginal product: the value of the output produced by the last unit of an input.

! = ! Profit-­‐maximizing input usage: to maximize profits, a manager should use inputs at levels at which the marginal benefit equals the marginal cost. More specifically, when the cost of each additional unit of labour is w, the manager should continue to employ labour up to the point where ! = in the range of diminishing marginal product.

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Microeconomics & Markets

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Algebraic forms of production functions Linear production function: a production function that assumes a perfect linear relationship between all inputs and total output.

Leontief production function: a production function that assumes that inputs are used in fixed proportions. This is also called a fixed-­‐proportions production function.

Cobb-­‐Douglas production function: a production function that assumes some degree of substitutability among inputs. The relationship between output and input is not linear.

Algebraic measures of productivity If the production function is linear and given by = , = + !"

! = =

Cobb-­‐Douglas production function: = , = ! ! ! = ! !!! ! = !!! !

Isoquants In the presence of multiple variables of production, various combinations of inputs enable the manager to produce the same level of output. The basic tool for understanding how alternative inputs can be used to produce output is an isoquant. Isoquant: defines the combinations of inputs that yield the same level of output. Points that lay on the same isoquant produce the same level of output. Isoquants farther from the origin are associated with higher levels of output.

Marginal rate of technical substitution (MRTS): the rate at which a producer can substitute between two inputs and maintain the same level of output. This is the slope of the isoquant. !
!" =

!
Linear
production functions have linear isoquants, Leontief production functions have L shaped isoquants. For the Leontief production function there is no MRTS, because there is no substitution among inputs along an isoquant.

The law of diminishing marginal rate of technical substitution: a property of a production function stating that as less of one input is used, increasing amounts of another input must be employed to produce the same level of output.

Isocosts Isocost line: a line that represents the combinations of inputs that will cost the producer the same amount of !
!
money. Along an isocost line, K is a linear function of L with a vertical intercept of and a slope of – !
!

= −

Changes in input prices affect the position of the isocost line. An increase in the price of labour makes the isocost curve steeper, while an increase in the price of capital makes it flatter.

Cost minimization Cost minimization: producing output at the lowest possible cost. At the cost-­‐minimizing input mix, the slope of the isoquant is equal to the slope of the isocost line. Recalling that the absolute value of the slope of the ! isoquant reflects the MRTS and that the slope of the isocost line is given by – , we see that at the cost-­‐
! = =

!"

!

!

minimizing input mix !" = !
See
page 180.

Optimal input substitution To minimize the cost of producing a given level of output, the firm should use less of an input and more of other inputs when that input’s price rises.

See page 182 and 183.

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Microeconomics & Markets

Frederieke Dijkhuizen

The cost function For given input prices, different isoquants will entail different production costs, even allowing for optimal substitution between capital and labour. Each isoquant corresponds to a different level of output, and the isocost line tangent to higher isoquants will imply higher costs of production.

Short-­‐run costs Total cost: sum of fixed and variable costs. Fixed costs: costs that do not change with changes in output; include the costs of fixed inputs used in production. Variable costs: costs that change with changes in output; include the costs of inputs that vary with output.

Short-­‐run cost function: a function that defines the minimum possible cost of producing each output level when variable factors are employed in the cost-­‐minimizing fashion.

Average and marginal costs Average fixed cost: fixed costs divided by the number of units of output.

Average variable cost: variable costs divided by the number of units of output.

∆!

Marginal (incremental) cost: the cost of producing an additional unit of output »

∆!

Relations among costs The marginal cost curve intersects the ATC and AVC curves at their minimum points. This implies that when marginal cost is below an average cost curve, average cost is declining, and when marginal cost is above average cost, average cost is rising.

The ATC and ANC curves get closer together as output increases.

Fixed and sunk costs Sunk cost: a cost that is forever lost after it has been paid. Sunk costs are the amount of fixed costs that cannot be recouped.

Algebraic forms of cost functions Cubic cost function: costs are a cubic function of output; provides a reasonable approximation to virtually any cost function » = + + ! + ! a, b and c are constants and f represents fixed costs.

Long-­‐run costs In the long run all costs are variable. Long-­‐run average cost curve: a curve that defines the minimum average cost of producing alternative levels of output, allowing for optimal selection of both fixed and variable factors of production. The LRAC is the lower envelope of all the short-­‐run average cost curves.

See page 192 and 193.

Economies of scale Economies of scale: exist when long-­‐run average costs decline as output is increased. After a point, further increases in output lead to an increase in average costs » diseconomies of scale: exist when long-­‐run average costs rise as output is increased.

Constant returns of scale: exist when long-­‐run average costs remain constant as output is increased.

A reminder: economic costs versus accounting costs Accounting costs are the costs most often associated with the costs of producing. It are the cost that appear on the income statements of firms.

By choosing to produce one good, producers give up the opportunity for producing some other good. Thus, the costs of production include not only the accounting costs but also the opportunities forgone by producing a given product.

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Microeconomics & Markets

Frederieke Dijkhuizen

Multiple-­‐output cost functions We will assume that the cost function for a multiproduct firm is given by ! , ! . Multiproduct cost function: a function that defines the cost of producing given levels of two or more types of outputs assuming all inputs are used efficiently.

Economies of scope Economies of scope: when the total cost of producing two types of outputs together is less than the total cost of producing each type of output separately.

Cost complementarity Cost complementarity: when the marginal cost of producing one type of output decreases when the output of another good is increased »

∆!"! !! ,!!
∆!!

< 0

Chapter 8. managing in competitive, monopolistic and monopolistically competitive markets Perfect competition Perfectly competitive market: a market in which: -­‐
There
are many buyers and sellers -­‐
Each
firm produces a homogeneous product -­‐
Buyers
and sellers have perfect information -­‐
There
are no transaction costs -­‐
There
is free entry and exit

Demand at the market and firm levels In a perfectly competitive market, the demand curve for an individual firm’s product is simply the market price. The individual firm’s demand curve is perfectly elastic. Firm demand curve: the demand curve for an individual firm’s product.

Short-­‐run output decisions -­‐
Maximizing
profits Marginal revenue: the change in revenue attributable to the last unit of output; for a competitive firm, MR is the market price.

The slope of the cost curve at the profit-­‐maximizing level of output exactly equals the slope of the revenue line. Recall that the slope of the cost curve is marginal cost and the slope of the revenue line is marginal revenue. Therefore, the profit-­‐maximizing output is the output at which marginal revenue equals marginal cost.

-­‐
Minimizing
losses Short-­‐run operating losses: sometimes the price lies below the ATC function, but above the AVC function. This means that each unit sold generates more revenue than the cost per unit of the variable inputs » the firm should continue producing.

The decision to shut down: when the price is less than the ACV of production, the firm loses less by shutting down its operation; since for each unit sold, the firm would lose ∗ − -­‐
The
short-­‐run firm and industry supply curves To determine how much a perfectly competitive firm will produce at each price, we determine the output at which marginal cost equals that price. To ensure that the firm will produce a positive level of output, price must be above the average variable cost curve.

The market supply curve reveals the total quantity that will be produced in the market at each possible price. Since the amount an individual firm will produce at a given price is determined by its marginal cost curve, the horizontal sum of the MC of all firms determines how much total output will be produced at each price.

Long-­‐run decisions If firms earn short-­‐run economic profits, in the long run additional firms enter the industry. As more firms enter the industry, the industry supply curve will shift to the right. This also happens the other way around and this process will continue until all firms in the market earn zero economic profits.

The market price is equal to the marginal cost of production. If the price would be higher than the MC, society would value another unit of the product, and production would therefore be expanded.

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Price equals the minimum point on the average cost curve. This implies not only that firms are earning zero economic profits, but also that all economies of scale have been exhausted.

The fact that a firm earns zero economic profits in the long rum does not mean that accounting profits are zero; rather, zero economic profits implies that accounting profits are just high enough to offset any implicit costs of production.

Monopoly Monopoly: a market structure in which a single firm serves an entire market for a good that has no close substitutes.

Monopoly power In determining whether a market is characterized by monopoly, it is important to specify the relevant market for the product. Since there is only one producer in the market, the market demand curve is the demand curve for the monopolist’s product. In the absence of legal restrictions, the monopolist is free to charge any price for the product. The monopolist can choose a price or quantity, but not both.

Sources of monopoly power -­‐
Economies
of scale Exist whenever long-­‐run average costs decline as output increases. Diseconomies of scale: exist whenever long-­‐run average costs increase as output increases.

If the amount of goods produced would be the same, despite whether there are one or two suppliers in the market, the revenue of the supplier in the case that there is only one supplier is twice as high as if there were two suppliers. Two suppliers might gain negative profits.

-­‐
Economies
of scope Exists when the total cost of producing two products within the same firm is lower than when separate firms produce the products. Efficient production requires that a firm produce several products jointly. Economies of scope tend to encourage larger firms. To the extent that smaller firms have more difficulty obtaining funds than do larger firms, the higher cost of capital may serve as a barrier to entry.

-­‐
Cost
complementarity Exist when the marginal cost of producing one output is reduced when the output of another product is increased. Multiproduct firms that enjoy cost complementarities tend to have lower marginal costs than firms producing a single product.

-­‐
Patents
and other legal barriers In some instances, government may grant an individual or a firm a monopoly right. Another example is the potential monopoly power generated by the patent system. This gives the inventor of a new product the exclusive right to sell the product for a given period of time.

Maximizing profits -­‐
Marginal
revenue A linear demand curve is elastic at high prices and inelastic at low prices. Revenue is maximized at the output where demand is unitary elastic.

The MR is the slope of the slope of the TR curve. For a monopolist, the MR is less than the price charged for the good.

See page 292.

-­‐
-­‐

-­‐

The output decision The absence of a supply curve A monopolist determines how much to produce based on MR, which is less than price. Consequently, there is no way to express how a monopolist’s quantity choice would change for different given prices, so there is no supply curve for a monopolist.

Multiplant decisions Profit maximization implies that the two-­‐plant monopolist should produce output in each plant such that the marginal cost of producing in each plant equals the marginal revenue of total output.

Implications of entry barriers Monopoly profits, if they exist, will continue over time so long as the firm maintains its monopoly power.

See page 302:

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Since the price of a monopoly good exceeds MC, the monopolist produces less output than is socially desirable. In effect, society would be willing to pay more for one more unit of output than it would cost to produce the unit. But, the monopolist refuses this because it would reduce the firm’s profit, since profit max is at MC=MR. thus, the monopolist produces less output and charges a higher price than would a perfectly competitive industry. Deadweight loss of monopoly: the consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost.

Monopolistic competition Monopolistically competitive market: a market in which: 1. There are many buyers and sellers 2. Each firm produces a differentiated product 3. There is free entry and exit.

Conditions for monopolistic competition -­‐
There
are many buyers and sellers -­‐
Each
firm produces a differentiated product -­‐
There
is free entry and exit.

Profit maximization The determination of the profit-­‐maximizing price and output under monopolistic competition is the same as for a firm operation under monopoly. Maximum profit » MR = MC. The demand and marginal revenue curves used to determine the monopolistically competitive firm’s profit-­‐ maximizing output and price are based not on the market demand for the product but on the demand for the individual firm’s product.

Long-­‐run equilibrium If firms earn short-­‐run economic profits, in the long run additional firms enter the industry. As more firms enter the industry, the industry supply curve will shift to the right. This also happens the other way around and this process will continue until all firms in the market earn zero economic profits.

As additional firms enter the market, some consumers who were buying the firm’s product will begin to consume one of the new firms’ products. Thus, one would expect the existing firms to lose a share of the market when new firms enter.

As in the case of monopoly, the price of a good exceeds MC, monopolistic competitive firms produce less output than is socially desirable. The monopolistic competitive firm refuse this because it would reduce the firm’s profit.

Note that the price of output exceeds the minimum point on the AC curve, which implies that firms do not take full advantage of economies of scale in production. There are too many firms in the industry to enable any individual firm to take full advantage of economies of scale in production, or this is the cost to society of having product variety.

Implications of product differentiation The demand for a firm’s product is less elastic when consumers view other firms’ products as poor substitutes for it. The less elastic the demand for a firm’s product, the greater the potential for earning profits.

Firms in monopolistically competitive industries employ two strategies to persuade consumers that their products are better than those offered by competitors: -­‐
They
spend considerable amounts on advertising campaigns. Very typically, these campaigns involve comparative advertising: a form of advertising where a firm attempts to increase the demand for its brand by differentiating its product from competing brands.

Brand equity: the additional value added to a product because of its brand.

-­‐
Firms
in monopolistically competitive industries frequently introduce new products into the market to further differentiate their products from other firms.

Niche marketing: a marketing strategy where goods and services are tailored to meet the needs of a particular segment of the market.

Green marketing: a form of niche marketing where firms target products toward consumers who are concerned about environmental issues.

Brand myopic: a manager or company that rests on a brand’s past laurels instead of focusing on emerging industry trends or changes in consumer preferences.

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Microeconomics & Markets

Frederieke Dijkhuizen

Chapter 11. Pricing strategies for firms with market power Basic pricing strategies Review of the basic rule of profit maximization Firms with market power face a downward-­‐sloping demand for their products.

A simple pricing rule for monopoly and monopolistic competition Even small firms can obtain some information about demand and costs from publicly available information. The key is to recall the relationship between the elasticity of demand for a firm’s product and MR.

1 + ! =

!
EF
= own-­‐price elasticity of demand for the firm’s product.

!
Profit-­‐maximizing
price: = ! !!!!

A manager should note two important things about this pricing rule: -­‐
The
more elastic the demand for the firm’s product, the lower the profit-­‐maximizing markup.

-­‐
The
higher the MC, the higher the profit-­‐maximizing price. A thing that you should keep in mind when applying the markup formula is that the elasticity of demand may change when you alter the price of a good, depending on the demand function.

A simple pricing rule for Cournot oligopoly Not covered in earlier chapters.

Strategies that yield even greater profits Extracting surplus from consumers This is appropriate for firms in industries with monopolistic, monopolistically competitive or oligopoly structures.

-­‐
Price
discrimination Sometimes firms can earn higher profits by charging different prices for the same product.

First-­‐degree price discrimination: charge each consumer the maximum price he or she is willing to pay for each unit of the good. By adopting this strategy, a firm extracts all surplus from consumers and thus earn the highest possible profits. Disadvantage: very difficult to implement.

Second-­‐degree price discrimination: posting a discrete schedule of declining prices for different ranges of quantities.

Third-­‐degree price discrimination: firms can profit by charging different groups of consumers different prices for the same product.

-­‐
Two-­‐part
pricing Two-­‐part pricing: pricing strategy in which consumers are charged a fixed fee for the right to purchase a good, plus a per-­‐unit charge for each unit purchased.

Like first-­‐degree price discrimination, two-­‐part pricing allows a firm to extract all consumer surplus from consumers. If the MC is low, the optimal per-­‐unit fee will be low as well. With two-­‐part pricing, all profit are derived from the fixed fee. Setting the per-­‐unit fee equal to marginal cost ensures that the surplus is as large as possible, thus allowing the largest fixed fee consistent with maximizing profits.

Two-­‐part pricing allows a firm to earn higher profits than it would earn by simply charging a price for each unit sold. Unlike price discrimination, two-­‐part pricing does not require that consumer have different elasticities of demand for the firm’s product.

See page 423.

-­‐

Block pricing Block pricing: pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-­‐or-­‐none decision to purchase.

If a consumer buys two separate goods for in total 6 dollar and receives a consumer surplus of 24, the total value of buying the good is 30. As long as the price of the package of the two units is not greater than 30 dollar, the consumer will find it in her or his interest to buy the package. By doing this, the firm earns the total value of the would-­‐be consumer surplus when the goods would be sold separate. Notice that block pricing can enhance profits even in situations where consumers have identical demands for a firm’s product.

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Microeconomics & Markets

-­‐

Frederieke Dijkhuizen

Commodity bundling Commodity bundling: the practice of bundling several different products together and selling them at a single “bundle price”.

Consumer Willing to pay for computer Willing to pay for monitor 1 $2000 $200 2 $1500 $300

If a firm wants to sell to both two computers and two monitors, the max price for a computer would be $1500 and for a monitor $200. This would bring the firm $3400 profits. When bundling the computer and the monitor, the firm is able to set a price of $1800, since consumer one is willing to pay 2000 + 200 = 2200 for the bundle and consumer two 1500 + 300 = 1800. The company would then earn $3600 profit.

Notice than commodity bundling can enhance profits even when the manager cannot distinguish among the amounts different consumers are willing to pay for the firm’s products. If the manager did know precisely how much each consumer was willing to pay for each product, the firm could earn even higher profits by engaging in price discrimination.

Pricing strategies for special cost and demand structures -­‐
Peak-­‐load
pricing Peak-­‐load pricing: pricing strategy in which higher prices are charged during peak hours than during off-­‐peak hours.

In general, where there are two types of demand, a firm will maximize profits by charging different prices to the different groups of demanders. A firm should charge two different prices, so that MR equals MC at both times.

-­‐
Cross-­‐subsidies

Cross-­‐subsidy: pricing strategy in which profits gained from the sale of one product are used to subsidize sales of a related product. Firms engage in cross-­‐subsidization because complementaries in demand and costs make doing so profitable. They enjoy economies of scope and cost complementarities in making these two products jointly. -­‐
Transfer
pricing Transfer pricing: pricing strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division.

In a setting with multiple managers (both upstream and downstream), optimal transfer pricing is an important issue. This is the internal price at which an upstream division should sell inputs to the firm’s downstream should sell inputs to the firm’s downstream division.

If managers are told to maximize the profit of their own divions, double marginalization occurs and the result is less than optimal overall firm profits. The overall profits of the firm are maximized when the upstream division produces goods such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd). ! = ! − ! = ! Notice that it costs the firm MCu to produce another unit of the input. This input can be converted into another unit of output and sold to generate additional revenues of MRd in the final product market only after the downstream division expends an additional MCd to convert the input into the final output. Thus, the actual marginal benefit to the firm of producing another unit of the input is NMRd. setting this equal to the MC of producing the input maximizes overall firm profits.

See page 432.

Pricing strategies in markets with intense price competition Needed information not covered in the other chapters

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