Chapter 2: Basic Microeconomic Tools 1

Basic Microeconomic Tools
Chapter 2: Basic Microeconomic Tools
Efficiency and Market Performance

Contrast two polar cases
perfect competition monopoly
What is efficiency?
no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off example: given an initial distribution of food aid will trade between recipients improve efficiency?
Focus on profit maximizing behavior of firms Take as given the market demand curve
$/unit
Equation: P = A - B.Q linear demand Importance of:

time short-run vs. long-run willingness to pay
Maximum willingness to pay Constant slope
A P1
Demand Q1 A/B Quantity
At price P1 a consumer will buy quantity Q1

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Perfect Competition
Firms and consumers are price-takers Firm can sell as much as it likes at the ruling market price
do not need many firms do need the idea that firms believe that their actions will not affect the market price
Therefore, marginal revenue equals price To maximize profit a firm of any type must equate marginal revenue with marginal cost So in perfect competition price equals marginal cost
MR = MC
Profit is p(q) = R(q) - C(q) Profit maximization: dp/dq = 0 This implies dR(q)/dq - dC(q)/dq = 0 But dR(q)/dq = marginal revenue dC(q)/dq = marginal cost So profit maximization implies MR = MC
Perfect competition: an illustration

With market price PC $/unit the firm maximizes profit by setting MR (= PC) = MC and producing quantity qc
P1 PC With market demand D2 The supply curve moves to the right With market demand and market supplyD S1 (a) The Firm (b) The Industry 1 Price falls and market supply S1P1 equilibrium price is equilibrium price is is Q P1 $/unit and quantity C Entry continues while profits exist and quantity is QCthat Now assume Existing Long-run equilibrium is restored MC firms maximize demand at price Pby supply curve S2 profits increasing C and S1 to increases D1 output AC to q1 D2 P1 Excess profits induce PC new firms to enter the market S2
D2
qc q1
Quantity
QC
Q1 QC
Quantity
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Perfect competition: additional points

Derivation of the short-run supply curve
this is the horizontal summation of the individual firms marginal cost curves
$/unit Example 1: Three firms Firm 3 Firm 1 Firm 2 q1+q2+q3
Firm 1: q MC = MC/4 = 4q + -8 2
Firm 2: q MC = MC/2 = 2q + -8 4 Firm 3: q MC = MC/6 = 6q + -8 4/3 Invert these 8 Aggregate: Q= q1+q2+q3 = 11MC/12 - 22/3 MC = 12Q/11 + 8
Quantity
7
Example 2: Eighty firms Each firm: q MC = MC/4 = 4q + -8 2 Invert these Aggregate: Q= 80q = 20MC - 160 MC = Q/20 + 8
$/unit
Firm i
Aggregate 8
Quantity
Definition of normal profit

not the same as zero profit implies that a firm is making the market return on the assets employed in the business
Chapter 2: Basic Microeconomic Tools 8
Monopoly
The only firm in the market
At price P1 consumers buy quantity Q1
market demand is the firms demand output decisions affect market clearing price
$/unit Marginal revenue from a change in price is the Loss of revenue from the net addition to revenue reduction in price of units generated by the price currently being sold (L) change = G - L Gain in revenue from the sale of additional units (G)
P1
P2
At price P2 consumers buy quantity Q2
G
Q1 Q2
Demand Quantity
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Monopoly (cont.)
Derivation of the monopolists marginal revenue
Demand: P = A - B.Q Total Revenue: TR = P.Q = A.Q - B.Q2 Marginal Revenue: MR = dTR/dQ MR = A - 2B.Q $/unit A
With linear demand the marginal revenue curve is also linear with the same price intercept but twice the slope of the demand curve
Demand Quantity
MR
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Monopoly and Profit Maximization

The monopolist maximizes profit by equating marginal revenue with marginal cost This is a two-stage process
$/unit
Stage 1: Choose output where MR = MC
PM Profit
ACM
MR QM QC
This gives output QM Output by the monopolist isStage less 2: Identify the market clearing price MC than the perfectly This gives price PM competitive output AC QC MR is less than price Price is greater than MC: loss of efficiency Price is greater than average cost Demand Positive economic profit Long-run equilibrium: no entry
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Quantity
Profit today versus profit tomorrow

Money today is not the same as money tomorrow
need way to convert tomorrows money into todays important since firms make decisions over time
is it better to make profit now or invest for future profit? how should investment in durable assets be judged?
sacrificing profit today imposes a cost

is this cost justified?
Techniques from financial markets can be applied

the concept of discounting and present value
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The concept of discounting

Take a simple example:
you have $1,000 this can be deposited in the bank at 5% per annum interest or it can be loaned to a start-up company for one year how much will the start-up have to contract to repay? $1,000 x (1 + 5/100) = $1,000 x 1.05 = $1,050
More generally:
you have a sum of money Y can generate an interest rate r per annum (in the example r = 0.05) so it will grow to Y(1 + r) in one year
but then Y today trades for Y(1 + r) in one years time
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Put this another way:

assume an interest rate of 5% per annum the start-up contracts to pay me $1,050 in one years time how much do I have to pay for that contract today? Answer: $1,000 since this would grow to $1,050 in one year so in these circumstances $1,050 in one year is worth $1,000 today the current price of the contract is $1,050/1.05 = $1,000 the present value of $1,050 in one years time at 5% is $1,000
More generally
the present value of Z in one year at interest rate r is Z/(1 + r)
The discount factor is defined as R = 1/(1 + r) The present value of Z in one year is then R.Z
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What if the loan is for two years?

How much must start-up promise to repay in two years time? $1,000 grows to $1,050 in one year the $1,050 grows to $1,102.50 in a further year so the contract is for $1,102.50 note: $1,102.50 = $1,000 x 1.05 x 1.05 = $1,000 x 1.052
More generally
a loan of Y for 2 years at interest rate r grows to Y(1 + r)2 = Y/R2
Y today grows to Y/R2 in 2 years
a loan of Y for t years at interest rate r grows to Y(1 + r)t = Y/Rt

Y today grows to Y/Rt in t years
Put another way

the present value of Z received in 2 years time is R2Z the present value of Z received in t years time is RtZ
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Now consider how to evaluate an investment project

generates Z1 net revenue at the end of year 1 Z2 net revenue at the end of year 2 Z3 net revenue at the end of year 3 and so on for T years
What are the net revenues worth today?

Present value of Z1 is RZ1 Present value of Z2 is R2Z2 Present value of Z3 is R3Z3 ... Present value of ZT is RTZT so the present value of these revenue streams is: PV = RZ1 + R2Z2 + R3Z3 + + RTZT
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Two special cases can be considered

Case 1: The net revenues in each period are identical Z1 = Z2 = Z3 = = ZT = Z Then the present value is: PV = Z (R - RT+1) (1 - R)
Case 2: These net revenues are constant and perpetual Then the present value is: PV = Z R (1 - R) = Z/r
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Present value and profit maximization

Present value is directly relevant to profit maximization For a project to go ahead the rule is
the present value of future income must at least cover the present value of the expenses in establishing the project
The appropriate concept of profit is profit over the lifetime of the project The application of present value techniques selects the appropriate investment projects that a firm should undertake to maximize its value
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Efficiency and Surplus

Can we reallocate resources to make some individuals better off without making others worse off? Need a measure of well-being
consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit aggregate consumer surplus is the sum over all units consumed and all consumers producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce aggregate producer surplus is the sum over all units produced and all producers total surplus = consumer surplus + producer surplus
Efficiency and surplus: illustration

$/unit The demand curve measures the willingness to pay for each unit Consumer surplus is the area between the demand curve and the equilibrium price The supply curve measures the marginal cost of each unit Producer surplus is the area between the supply curve and the equilibrium price Consumer surplus Producer surplus Competitive Supply
PC
Equilibrium occurs where supply equals demand: price PC quantity QC Demand
Aggregate surplus is the sum of consumer surplus and producer surplus The competitive equilibrium is efficient
QC
Quantity
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Illustration (cont.)
Assume that a greater quantity QG is traded Price falls to PG Producer surplus is now a positive part and a negative part PC Consumer surplus increases Part of this is a transfer from producers Part offsets the negative producer surplus QC QG PG Demand $/unit The net effect is a reduction in total surplus Competitive Supply
Quantity
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Deadweight loss of Monopoly

Assume that the industry is monopolized The monopolist sets MR = MC to give output QM The market clearing price is PM Consumer surplus is given by this area And producer surplus is given by this area $/unit Competitive Supply
This is the deadweight loss of monopoly PM

PC
The monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between QM and QC
Demand
QM
QC MR
Quantity
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Deadweight loss of Monopoly (cont.)

Why can the monopolist not appropriate the deadweight loss?
Increasing output requires a reduction in price this assumes that the same price is charged to everyone.
The monopolist creates surplus

some goes to consumers some appears as profit
The monopolist bases her decisions purely on the surplus she gets, not on consumer surplus The monopolist undersupplies relative to the competitive outcome The primary problem: the monopolist is large relative to the market
A Non-Surplus Approach
Take a simple example Monopolist owns two units of a valuable good There are 50,000 potential buyers Reservation prices:
Number of Buyers Reservation Price First 200 $50,000 Next 40,000 $30,000 Last 9,800 $10,000 Both units will be sold at $50,000; no deadweight loss Why not? Monopolist is small relative to the market.
Example (cont.)
Monopolist has 200 units Reservation prices: Number of Buyers First 100 Next 40,000 Last 9,900 Reservation Price $50,000 $15,000 $10,000
Now there is a loss of efficiency and so deadweight loss no matter what the monopolist does.
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Basic Microeconomic Tools

Chapter 2: Basic Microeconomic Tools

Efficiency and Market Performance

Chapter 2: Basic Microeconomic Tools

Equation: P = A - B.Q linear demand Importance of:

Maximum willingness to pay Constant slope

Demand Q1 A/B Quantity

At price P1 a consumer will buy quantity Q1

Chapter 2: Basic Microeconomic Tools

Chapter 2: Basic Microeconomic Tools

Chapter 2: Basic Microeconomic Tools

Perfect competition: an illustration

Perfect competition: additional points

Definition of normal profit

At price P2 consumers buy quantity Q2

Chapter 2: Basic Microeconomic Tools

Chapter 2: Basic Microeconomic Tools

Monopoly and Profit Maximization

Stage 1: Choose output where MR = MC

Chapter 2: Basic Microeconomic Tools

Profit today versus profit tomorrow

sacrificing profit today imposes a cost

Techniques from financial markets can be applied

Chapter 2: Basic Microeconomic Tools

The concept of discounting

but then Y today trades for Y(1 + r) in one years time

Chapter 2: Basic Microeconomic Tools

Put this another way:

Chapter 2: Basic Microeconomic Tools

What if the loan is for two years?

a loan of Y for t years at interest rate r grows to Y(1 + r)t = Y/Rt

Put another way

Chapter 2: Basic Microeconomic Tools

Now consider how to evaluate an investment project

What are the net revenues worth today?

Chapter 2: Basic Microeconomic Tools

Two special cases can be considered

Chapter 2: Basic Microeconomic Tools

Present value and profit maximization

Chapter 2: Basic Microeconomic Tools

Efficiency and Surplus

Efficiency and surplus: illustration

Equilibrium occurs where supply equals demand: price PC quantity QC Demand

Chapter 2: Basic Microeconomic Tools

Deadweight loss of Monopoly

This is the deadweight loss of monopoly PM

Chapter 2: Basic Microeconomic Tools

Deadweight loss of Monopoly (cont.)

The monopolist creates surplus

Chapter 2: Basic Microeconomic Tools

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