Chapter 11

Marginal Cost

• Marginal Cost is the extra cost per additional unit of output.
• Marginal Cost is below AC and AVC when they are falling and above AC and AVC when they are rising.

Marginal Revenue

• Marginal Revenue is the extra revenue per additional unit of output.

Profit Maximization

• To maximize profits a firm must produce up to the point where MR = MC.

If MC > MR, the additional cost exceeds the additional revenue per additional unit of output. In this case the firm should cut back on production.

• If MC < MR, the firm should increase its output.

Short-run Supply

• Firms maximize profits by equating MC & MR.

Long-run Supply

• In the long-run all costs are variable and therefore AVC = AC
• The long-run supply curve for the firm is equal to the MC curve as long as price is above the minimum AC.
• The market supply curve is the sum of the individual supply curves.

Pure Competition

• Pure Competition exists when we have :
  • a large number of buyers and sellers
  • a homogenous product
  • free entry and exit
  • perfect information
• In which industries do we have pure competition ?
  • automobile production
  • farming
  • fast food restaurants_

Market Power

• Market Power exists if firms can control prices.
• In pure competition firms lack market power. They are price takers NOT price makers.
• Advertising is not worthwhile under pure competition. Firms can sell all they can produce at the existing price.

Invisible Hand

• Under Pure Competition
  • You know only a few of the many producers.
  • You don't consider these producers to be competitors. They are friends.
  • You are not reluctant to share information.
  • There are no trade secrets.
  • Prices are the key information you need to make decisions.
  • You are concerned about technology but you do not invest heavily in research.
  • You operate in an environment of anonymous rivalry.

Revenue & Demand

• Average Revenue = Total Revenue per unit sold.
• Marginal Revenue is the additional revenue resulting from an additional unit sold.

Total Revenue

If the firm is a price taker, its total revenue curve is a straight line with a slope equal to the market price.

TR = P Q = 25 Q

Loss Minimization

The marginal conditions for profit maximization are the same as those for loss minimization. i.e. Equate MC & MR

Firm Demand

A representative competitive firm is a price taker. It can sell all it can produce at the market price. Thus, it's demand curve is horizontal

• If AR = P is constant, MR is also constant and equal to Price.

Market Changes

• Suppose that demand increases and the market price increases.
• What happens in the short-run ?
  • Firms will increase use of variable inputs and increase output.
  • They will temporarily earn a profit.
  • AC will increase.

Cost Changes

• Suppose that average costs increase, ceteris paribus. What happens in the short-run?
  • Firms continue to equate MC to MR
  • Production will decline.
  • Firms will lose money.

Long-run Changes

• Suppose market demand increases. What happens as we move to the long-run position?
  • firms earn profits as prices go up
  • the profits induce entry
  • prices move back to minimum AC
  • In the long-run, we have more firms in the industry.

Supply Changes

As the market supply increases, the market price goes down. This reduces the MR of the competitive firm. As a result, they make less profit.

Long-run Equilibrium

• If nothing changed over time, competitive firms would eventually move to the lowest point on their LRAC curves.
• But things do change:
  • Market demands change
  • Technology changes
• Thus, long-run equilibrium is something firms keep moving toward, but seldom reach.

Efficiency

• Ideally, we would like markets to provide the conditions necessary for efficiency.
• Economists judge market structures by how close they come to meeting this ideal -- in theory.

Allocative Efficiency

Allocative efficiency exists when no resources are wasted. In this case, no one can be made better off without making someone worse off. (Pareto Optimality) This requires:

• Producer Efficiency
• Consumer Efficiency
• Exchange Efficiency

Producer Efficiency

Producer efficiency exists when the economy is producing at a point on its production possibility frontier (PPF). To achieve this, firms must be:

• Technologically Efficient
  • Getting the most output from inputs.
• Economically Efficient
  • Getting the most output per dollar spent on inputs.

MPX / MPY = PX / PY

Consumer Efficiency

Consumer efficiency occurs when consumers can not make themselves better off by reallocating their budgets. i.e. The consumer is maximizing utility subject to the budget constraint when:

MUA / MUB = PA / PB

Exchange Efficiency

Exchange efficiency exists when the price at which a transaction takes place equals both the marginal social cost (MSC) and the marginal social benefit (MSB).

• This condition is met under perfect competition only if there are no external costs or external benefits.

External Costs

• External costs are costs not borne by the producer. They are paid in some form by someone else.
  • Factory style hog production
  • Chemical firms polluting rivers
• External benefits are benefits received by people other than the buyers of the good.
  • You enjoy the fine roads of Colorado but don't pay the cost.
  • You enjoy seeing Christmas lights someone else purchased.

Social Costs

• Marginal social cost is the cost of producing an additional unit of output, including external costs.

MSC = MC + MEC

• Marginal social benefit is the benefit from an additional unit of consumption, including any external benefits.

MSB = P + MEB

MSC & MSB

• We have allocative efficiency when MSC equals MSB.

Benefits of Competition

• The benefits of pure competition are:

P = ACmin

• Firms produce and sell at the lowest possible price.

P = MC

• Resources are used in a way that reflects consumers preferences_. Consumers receive the maximum possible satisfaction.

We have allocative efficiency if there are no external costs or benefits.

Competition Problems

• Some criticisms of pure competition include :
  • Lack of research
    • There is no incentive to do research. Nor are there profits to fund such research.
  • Lack of product variety
    • Part of your enjoyment of purchasing things comes from variety. This is missing under pure competition.