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ECO 1003 Handouts for Chapters 15-16-17 Chapter 15 Patent Trolls and Seed Monopolies • imperfectly competitive industry An industry in which single firms have some control over the price of their output. • market power An imperfectly competitive firm’s ability to raise price without losing all of the quantity demanded for its product. • Imperfect competition does not mean that no competition exists in the market. • In some imperfectly competitive markets competition occurs in more arenas than in perfectly competitive markets. • Firms can differentiate their products, advertise, improve quality, market aggressively, cut prices, and so forth. Chapter 15 Patent Trolls and Seed Monopolies DEFINING INDUSTRY BOUNDARIES • The ease with which consumers can substitute for a product limits the extent to which a monopolist can exercise market power. • The more broadly a market is defined, the more difficult it becomes to find substitutes. • pure monopoly An industry with a single firm that produces a product for which there are no close substitutes and in which significant barriers to entry prevent other firms from entering the industry to compete for profits. Chapter 15 Patent Trolls and Seed Monopolies BARRIERS TO ENTRY • barrier to entry Something that prevents new firms from entering and competing in imperfectly competitive industries. • Government franchise A monopoly by virtue of government directive. • Patent A barrier to entry that grants exclusive use of the patented product or process to the inventor. • Economies of Scale and Other Cost Advantages • Ownership of a Scarce Factor of Production Chapter 15 Patent Trolls and Seed Monopolies PRICE: THE FOURTH DECISION VARIABLE • Regardless of the source of market power, output price is not taken as given by the firm. Instead: • Price is a decision variable for imperfectly competitive firms. • Firms with market power must decide not only (1) how much to produce, (2) how to produce it, (3) how much to demand in each input market (4) what price to charge for their output. Chapter 15 Patent Trolls and Seed Monopolies • To analyze monopoly behavior, we make two assumptions: (1) that entry to the market is blocked, and (2) that firms act to maximize profits. Chapter 15 Patent Trolls and Seed Monopolies DEMAND IN MONOPOLY MARKETS The Demand Curve Facing a Perfectly Competitive Firm Is Perfectly Elastic; In a Monopoly, the Market Demand Curve Is the Demand Curve Facing the Firm With one firm in a monopoly market, there is no distinction between the firm and the industry. In a monopoly, the firm is the industry. The market demand curve is the demand curve facing the firm, and the total quantity supplied in the market is what the firm decides to produce. Chapter 15 Patent Trolls and Seed Monopolies • By knowing the demand curve it faces, the firm must simultaneously choose both the quantity of output to supply and the price of that output. • Once the firm chooses a price, the market determines how much will be sold. • The monopoly chooses the point on the market demand curve where it wants to be. Chapter 15 Patent Trolls and Seed Monopolies Marginal Revenue and Market Demand Marginal Revenue Facing a Monopolist (1) QUANTITY 0 1 2 3 4 5 6 7 8 9 10 (2) PRICE (3) TOTAL REVENUE $11 10 9 8 7 6 5 4 3 2 1 0 $10 18 24 28 30 30 28 24 18 10 (4) MARGINAL REVENUE $10 8 6 4 2 0 2 4 6 8 For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output to sell it. Chapter 15 Patent Trolls and Seed Monopolies • A profit-maximizing monopolist will continue to produce output as long as MR exceeds MC. • Because the market demand curve is the demand curve for a monopoly, a monopolistic firm faces a downward-sloping demand curve. • The monopolist must lower the price it charges to raise output and sell it. • Selling the additional output will raise revenue, but this increase is offset somewhat by the lower price charged for all unit sold. • Therefore, the increase in revenue from increasing output by one (MR) is less than the price. Chapter 15 Patent Trolls and Seed Monopolies Marginal Revenue and Total Revenue A monopoly’s marginal revenue curve shows the change in total revenue that results as a firm moves along the segment of the demand curve that lies directly above it. Chapter 15 Patent Trolls and Seed Monopolies • At zero units →TR=0 • To begin selling, the firm must lower the product price (MR>0, TR begins to increase) • To sell more, the firm must lower its price more and more • Output between 0 and Q* → firm moves down on its demand curve from A to B: MR>0, TR continues to increase • Q rising pushing TR (PxQ) up and P falling pushing TR down • Up to point B → the effect of increasing Q dominates the effect of falling P: TR rises, MR>0 • Point B toward C → lowering P to sell more Q, but above Q* : MR<0, TR starts to fall • Beyond Q* → the effect of cutting P on TR is larger than the effect of increasing Q: TR falls • At C → TR=0 because P=0 Chapter 15 Patent Trolls and Seed Monopolies The Monopolist’s Profit-Maximizing Price and Output Price and Output Choice for a Profit-Maximizing Monopolist Chapter 15 Patent Trolls and Seed Monopolies • All firms, including monopolies, raise output as long as marginal revenue is greater than marginal cost. • Any positive difference between marginal revenue and marginal cost can be thought of as marginal profit. • The profit-maximizing level of output for a monopolist is the one at which marginal revenue equals marginal cost: MR = MC. The Absence of a Supply Curve in Monopoly • A monopoly firm has no supply curve that is independent of the demand curve for its product. • A monopolist sets both price and quantity, and the amount of output that it supplies depends on both its marginal cost curve and the demand curve that it faces. Chapter 15 Patent Trolls and Seed Monopolies Monopoly in the Long and Short Run Price and Output Choice for a Monopolist Suffering Losses in the Short Run If a firm can reduce its losses by operating in the short run, it will do so. Chapter 15 Patent Trolls and Seed Monopolies • Perfectly competitive markets: Long run and short run • Short run → fixed factor of production, no entry and exit (MC increase with Q) • Long run → free entry and exit, LR equilibrium where industry profits equal to zero • Monopoly: • Short run → limited with fixed factor of production (diminishing returns to factors of production) • Long run → if monopoly earning positive profits, nothing will happen (entry blocked) • Monopoly will operate at the most efficient scale of production (no change in LR) Chapter 15 Patent Trolls and Seed Monopolies PERFECT COMPETITION AND MONOPOLY COMPARED A Perfectly Competitive Industry in Long-run Equilibrium Chapter 15 Patent Trolls and Seed Monopolies Comparison of Monopoly and Perfectly Competitive Outcomes for a Firm with Constant Returns to Scale Relative to a perfectly competitive industry, a monopolist restricts output, charges higher prices, and earns positive profits. Chapter 15 Patent Trolls and Seed Monopolies COLLUSION AND MONOPOLY COMPARED • collusion The act of working with other producers in an effort to limit competition and increase joint profits. • The outcome would be exactly the same as the outcome of a monopoly in the industry. Chapter 15 Patent Trolls and Seed Monopolies INEFFICIENCY AND CONSUMER LOSS Welfare Loss from Monopoly Monopoly leads to an inefficient mix of output. Chapter 17 Coffee, Tea, or Tuition-Free? • price discrimination Charging different prices to different buyers. • perfect price discrimination Occurs when a firm charges the maximum amount that buyers are willing to pay for each unit. Chapter 17 Coffee, Tea, or Tuition-Free? Price Discrimination Chapter 16 Contracts, Combinations, and Conspiracies Perfect Competition • perfect competition An industry structure in which there are many firms, each small relative to the industry, producing virtually identical products and in which no firm is large enough to have any control over prices. In perfectly competitive industries, new competitors can freely enter and exit the market. • homogeneous products Undifferentiated products; products that are identical to, or indistinguishable from, one another. Chapter 16 Contracts, Combinations, and Conspiracies THE PRODUCTION PROCESS: THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS Demand Facing a Single Firm in a Perfectly Competitive Market Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN VERSUS LONG-RUN DECISIONS • short run The period of time for which two conditions hold: The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry. • long run That period of time for which there are no fixed factors of production: Firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry. Chapter 16 Contracts, Combinations, and Conspiracies TOTAL REVENUE (TR)&MARGINAL REVENUE (MR) • total revenue (TR) The total amount that a firm takes in from the sale of its product: the price per unit times the quantity of output the firm decides to produce (P x q). total revenue price x quantity TR P x q • marginal revenue (MR) The additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, P = MR. Chapter 16 Contracts, Combinations, and Conspiracies OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION COMPARING COSTS AND REVENUES TO MAXIMIZE PROFIT The Profit-Maximizing Level of Output The Profit-Maximizing Level of Output for a Perfectly Competitive Firm Chapter 16 Contracts, Combinations, and Conspiracies • As long as marginal revenue is greater than marginal cost, even though the difference between the two is getting smaller, added output means added profit. • Whenever marginal revenue exceeds marginal cost, the revenue gained by increasing output by one unit per period exceeds the cost incurred by doing so. • The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost—the level of output at which P* = MC. • The profit-maximizing output level for all firms is the output level where MR = MC. Chapter 16 Contracts, Combinations, and Conspiracies Profit Analysis for a Simple Firm: A Numerical Example (1) (2) (3) (4) (5) q TFC TVC MC P = MR (6) TR (P x q) $ $ $ 0 $ 15 0 (7) TC (TFC + TVC) $ 10 (8) PROFIT (TR TC) 0 $ 10 $ -10 1 10 10 10 15 15 20 -5 2 10 15 5 15 30 25 5 3 10 20 5 15 45 30 15 4 10 30 10 15 60 40 20 5 10 50 20 15 75 60 15 6 10 80 30 15 90 90 0 Chapter 16 Contracts, Combinations, and Conspiracies OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION THE SHORT-RUN SUPPLY CURVE Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm The marginal cost curve of a competitive firm is the firm’s short-run supply curve. Chapter 16 Contracts, Combinations, and Conspiracies • We begin our discussion of the long run by looking at firms in three short-run circumstances: • firms earning economic profits, • firms suffering economic losses but continuing to operate to reduce or minimize those losses, and • firms that decide to shut down and bear losses just equal to fixed costs. Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS breaking even The situation in which a firm is earning exactly a normal rate of return. MAXIMIZING PROFITS Example: The Blue Velvet Car Wash Blue Velvet Car Wash Weekly Costs TOTAL VARIABLE COSTS (TVC) (800 WASHES) TOTAL FIXED COSTS (TFC) 1. Normal return to investors 2. Other fixed costs (maintenance contract, insurance, etc.) $ 1,000 1,000 $ 2,000 1. Labor 2. Materials TOTAL COSTS (TC = TFC + TVC) $ 3,600 $ 1,000 600 Total revenue (TR) at P = $5 (800 x $5) $ 4,000 $ 1,600 Profit (TR TC) $ 400 Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Graphic Presentation Firm Earning Positive Profits in the Short Run Chapter 16 Contracts, Combinations, and Conspiracies MINIMIZING LOSSES • operating profit (or loss) or net operating revenue Total revenue minus total variable cost (TR TVC). • If revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating. • If revenues are smaller than variable costs, the firm suffers operating losses that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down. Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited A Firm Will Operate If Total Revenue Covers Total Variable Cost CASE 1: SHUT DOWN Total Revenue (q = 0) CASE 2: OPERATE AT PRICE = $3 $ 0 Total Revenue ($3 x 800) Fixed costs Variable costs Total costs $ 2,000 + 0 $ 2,000 Fixed costs Variable costs Total costs Profit/loss (TR TC) $ 2,000 Operating profit/loss (TR TVC) Total profit/loss (TR TC) $ 2,400 $ 2,000 + 1,600 $ 3,600 $ 800 $ 1,200 Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Graphic Presentation Firm Suffering Losses but Showing an Operating Profit in the Short Run Chapter 16 Contracts, Combinations, and Conspiracies • Remember that average total cost is equal to average fixed cost plus average variable cost. This means that at every level of output, average fixed cost is the difference between average total and average variable cost: ATC = AFC + AVC or AFC = ATC AVC = $4.10 $3.10 = $1.00 • As long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down. Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Shutting Down to Minimize Loss A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost CASE 1: SHUT DOWN Total Revenue (q = 0) CASE 2: OPERATE AT PRICE = $1.50 $ 0 Total revenue ($1.50 x 800) $ 1,200 Fixed costs Variable costs Total costs $ 2,000 + 0 $ 2,000 Fixed costs Variable costs Total costs $ 2,000 + 1,600 $ 3,600 Profit/loss (TR TC): $ 2,000 Operating profit/loss (TR TVC) Total profit/loss (TR TC) $ 400 $ 2,400 Chapter 16 Contracts, Combinations, and Conspiracies • Any time that price (average revenue) is below the minimum point on the average variable cost curve, total revenue will be less than total variable cost, and operating profit will be negative—that is, there will be a loss on operation. • In other words, when price is below all points on the average variable cost curve, the firm will suffer operating losses at any possible output level the firm could choose. • When this is the case, the firm will stop producing and bear losses equal to fixed costs. • This is why the bottom of the average variable cost curve is called the shut-down point. • At all prices above it, the marginal cost curve shows the profitmaximizing level of output. • At all prices below it, optimal short-run output is zero. Chapter 16 Contracts, Combinations, and Conspiracies • shut-down point The lowest point on the average variable cost curve. When price falls below the minimum point on AVC, total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs. • The short-run supply curve of a competitive firm is that portion of its marginal cost curve that lies above its average variable cost curve Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Short-Run Supply Curve of a Perfectly Competitive Firm Chapter 16 Contracts, Combinations, and Conspiracies SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS THE SHORT-RUN INDUSTRY SUPPLY CURVE short-run industry supply curve The sum of the marginal cost curves (above AVC) of all the firms in an industry. The Industry Supply Curve in the Short Run Is the Horizontal Sum of the Marginal Cost Curves (above AVC) of All the Firms in an Industry Chapter 16 Contracts, Combinations, and Conspiracies Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run SHORT-RUN CONDITION Profits Losses TR > TC 1. With operating profit (TR TVC) 2. With operating losses (TR < TVC) SHORT-RUN DECISION LONG-RUN DECISION P = MC: operate Expand: new firms enter P = MC: operate Contract: firms exit (losses < fixed costs) Shut down: losses = fixed costs Contract: firms exit