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Tutorial 4
Firms in competitive market
•
•
Because a competitive firm is a price taker, its
revenue is proportional to the amount of output
it produces. The price of the good equals both
the firm’s average revenue and its marginal
revenue.
To maximize profit, a firm chooses a quantity of
output such that marginal revenue equals
marginal cost. Because marginal revenue for a
competitive firm equals the market price, the
firm chooses quantity so that price equals
marginal cost.
Firms in competitive market
•
In the short run when a firm cannot
recover its fixed costs, the firm will
choose to shut down temporarily if the
price of the good is less than average
variable cost. In the long run, when the
firm can recover both fixed and variable
costs, it will choose to exit if the price is
less than average total cost.
Firms in competitive market
• Polly’s Ping Pong Balls is a firm that
operates in a competitive market. The ping
pong balls sell for $3 per package. Fill in
the following table and discuss the profitmaximizing level of output:
Firms in competitive market
Output Price
Total
Revenue
Total
Cost
0
$3
$1.50
1
3
2.00
2
3
3.00
3
3
4.50
4
3
6.50
5
3
9.00
6
3
12.00
7
3
15.50
8
3
19.50
9
3
24.00
Profit
Marginal
Revenue
Marginal
Cost
Firms in competitive market
Output Price
Total
Revenue
Total
Cost
Profit
Marginal
Revenue
Marginal
Cost
----
----
0
$3
$0.00
$1.50
$-1.50
1
3
3.00
2.00
1.00
$3
$0.50
2
3
6.00
3.00
3.00
3
1.00
3
3
9.00
4.50
4.50
3
1.50
4
3
12.00
6.50
5.50
3
2.00
5
3
15.00
9.00
6.00
3
2.50
6
3
18.00
12.00
6.00
3
3.00
7
3
21.00
15.50
5.50
3
3.50
8
3
24.00
19.50
4.50
3
4.00
9
3
27.00
24.00
3.00
3
4.50
Firms in competitive market
• “As a recent graduate of this college you have landed a job in
production management for Universal Clones, Inc. You are
responsible for the entire company on weekends.”
• “Your costs are shown below.”
Quantity
Average Total Cost
500
200
501
201
• Your current level of production is 500 units. All 500 units have been
ordered by your regular customers.
• “The phone rings. It’s a new customer who wants to buy one unit of
your product. This means you would have to increase production to
501 units. Your new customer offers you $450 to produce the extra
unit.”
• a. Should you accept this offer?
• b. What is the net change in the firm’s profit?
Firms in competitive market
• Most students will answer “yes.” Selling something for
$450 when the average cost of production is $201
seems like good business. They are wrong.
• The relevant comparison is marginal cost to marginal
revenue. Marginal cost can be easily calculated as the
change in total costs.
Quantity
Average Total Cost Total Cost = Q  ATC
500
200
100,000
501
201
100,701
• $100,701 – $100,000 = $701
• Marginal cost in this example is $701. This is much
higher than the marginal revenue of $450. The offer
should not be accepted. It would result in a $251 loss.
GDP-Key Points
•
•
Because every transaction has a buyer
and a seller, the total expenditure in the
economy must equal the total income in
the economy.
Gross domestic product (GDP) is the
market value of all final goods and
services produced within a country in a
given period of time.
GDP-Key Points
•
GDP is divided among four components of
expenditure: consumption, investment, government
purchases, and net exports.
–
–
–
–
Consumption includes spending on goods and services by
households, with the exception of purchases of new housing.
Investment includes spending on new equipment and
structures, including households’ purchases of new housing.
Government purchases include spending on goods and
services by local, state, and federal governments.
Net exports equal the value of goods and services produced
domestically and sold abroad (exports) minus the value of
goods and services produced abroad and sold domestically
(imports).
GDP-Key Points
•
•
•
Nominal GDP uses current prices to
value the economy’s production of goods
and services.
Real GDP uses constant base-year
prices to value the economy’s production
of goods and services.
The GDP deflator―calculated from the
ratio of nominal to real GDP―measures
the level of prices in the economy.
GDP
What components of GDP (if any) would each
of the following transactions affect?
a.
b.
c.
d.
e.
f.
A family buys a new refrigerator.
Marut buys a new house.
Honda sells a civic from its inventory.
You buy a pizza.
Government repaves Paholyothin road.
Your parents buy a bottle of French wine.
g. Toyota expands its factory in Thailand.
GDP
a. Consumption increases because a refrigerator is a good
purchased by a household.
b. Investment increases because a house is an investment good.
c. Consumption increases because a car is a good purchased by
a household, but investment decreases because the car in
Honda’s inventory had been counted as an investment good
until it was sold.
d. Consumption increases because pizza is a good purchased
by a household.
e. Government purchases increase because the government
spent money to provide a good to the public.
f. Consumption increases because the bottle is a good
purchased by a household, but net exports decrease because
the bottle was imported.
g. Investment increases because new structures and equipment
were built.
GDP
Wonderland produces two goods: footballs and basketballs. Below is a table showing prices
and quantities of output for three years:
Year
Year 1
Year 2
Year 3
Price of Footballs
Quantity of Footballs Price of Basketballs Quantity of Basketballs
$10
12
14
Nominal GDP in Year 1 =
Nominal GDP in Year 2 =
Nominal GDP in Year 3 =
Using Year 1 as the Base Year:
Real GDP in Year 1 =
Real GDP in Year 2 =
Real GDP in Year 3 =
GDP deflator for Year 1 =
GDP deflator for Year 2 =
GDP deflator for Year 3 =
120
200
180
$12
15
18
200
300
275
GDP
Year
Year 1
Year 2
Year 3
Price of Footballs
$10
12
14
Quantity of Footballs Price of Basketballs Quantity of Basketballs
120
200
180
$12
15
18
Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600
Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900
Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470
Using Year 1 as the Base Year:
Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600
Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600
Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100
(Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.)
GDP deflator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100
GDP deflator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21
GDP deflator for Year 3 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47
200
300
275
CPI-Key Points
•
The consumer price index (CPI) shows
the cost of a basket of goods and
services relative to the cost of the same
basket in the base year. The index is
used to measure the overall level of
prices in the economy. The percentage
change in the consumer price index
measures the inflation rate.
CPI-Key Points
• The CPI is an imperfect measure of the
cost of living for three reasons.
– First, it does not take into account consumers’
ability to substitute toward goods that become
relatively cheaper over time.
– Second, it does not take into account
increases in the purchasing power of the
dollar due to the introduction of new goods.
– Third, it is distorted by unmeasured changes
in the quality of goods and services.
CPI-Key Points
•
Like the CPI, the GDP deflator also measures
the overall level of prices in the economy.
Although the two price indexes usually move
together, there are important differences.
–
–
The GDP deflator differs from the CPI because it
includes goods and services produced rather than
goods and services consumed. As a result,
imported goods affect the consumer price index but
not the GDP deflator.
In addition, while the consumer price index uses a
fixed basket of goods, the GDP deflator
automatically changes the group of goods and
services over time as the composition of GDP
changes.
CPI-Key Points
•
•
Dollar figures from different points in time do
not represent a valid comparison of purchasing
power. To compare a dollar figure from the
past to a dollar figure today, the older figure
should be inflated using a price index.
Various laws and private contracts use price
indexes to correct for the effects of inflation.
The tax laws, however, are only partially
indexed for inflation.
CPI-Key Points
• A correction for inflation is especially important
when looking at data on interest rates. The
nominal interest rate is the interest rate usually
reported; it is the rate at which the number of
dollars in a savings account increases over time.
By contrast, the real interest rate takes into
account changes in the value of the dollar over
time. The real interest rate equals the nominal
interest rate minus the rate of inflation.
CPI
• Which do you think has a greater effect on
the CPI: a 10% increase in the price of
chicken or a 10% increase in the price of
caviar?
• If the price of a navy submarine rises, is
the CPI or the GDP deflator affected
more?
CPI
• A 10% increase in the price of chicken has a
greater effect on the consumer price index than
a 10% increase in the price of caviar because
chicken is a bigger part of the average
consumer's market basket.
• If the price of a Navy submarine rises, there is
no effect on the consumer price index, because
Navy submarines are not consumer goods. But
the GDP price index is affected, because Navy
submarines are included in GDP as a part of
government purchases.
CPI
• Suppose that the residents of Proteinland spend
all of their incomes on ham, chicken, and beef.
In 2006, they buy 50 kg of ham for $150, 35 kg
of chicken for $140, and 100 kg of beef for $500.
In 2007, they buy 35 kg of ham for $140, 50 kg
of chicken for 200, and 100 kg of beef for $600.
a. Calculate the price of each meat in each year
b. Using 2006 as the base year, calculate the CPI
for each year.
c. What is the inflation rate for 2007?
CPI
• a. Find the price of each good in each year:
Year
Ham
Chicken
Roast
Beef
2006
$3
$4
$5
2007
$4
$4
$6
CPI
• b. If 2006 is the base year, the market basket
used to compute the CPI is 50 pounds of ham,
35 pounds of chicken, and 100 pounds of roast
beef. We must now calculate the cost of the
market basket in each year:
2006: (50 x $3) + (35 x $4) + (100 x $5) = $790
2007: (50 x $4) + (35 x $4) + (100 x $6) = $940
• Then, using 2006 as the base year, we can
compute the CPI in each year:
2006: $790/$790 x 100 = 100
2007: $940/$790 x 100 = 119
CPI
• c. We can use the CPI to compute the
inflation rate for 2007:
(119 − 100)/100 x 100% = 19%