Competition and the Invisible Hand PDF

CH 12 Competition and the Invisible Hand All Firms in a perfectly industry face the same market price as they are price takers - To maximize profits each firm adjusts its output until P = MC - P= MC1 = MC2 = … MCn Competitive markets ensure that the right amount of a good is produc...

CH 12 Competition and the Invisible Hand All Firms in a perfectly industry face the same market price as they are price takers - To maximize profits each firm adjusts its output until P = MC - P= MC1 = MC2 = … MCn Competitive markets ensure that the right amount of a good is produced Entrepreneurs seek profit and avoid losses Profit is a signal that labor and capital are being used productively, satisfy our unlimited wants Profit-Seeking aligns with the social incentive to move labor and capital out of low-value industries and into high-value industries. Resources flow from low-value industries to high-value industries - If price is greater than average cost, prices are above normal, causing capital and labor to enter the industry - As firms enter, supply rises, price decreases, profits decrease - If P is less than average costs, prices are below normal, causing capital and labor to exit the industry - As firms exit, supply goes down, price increases, and profits increase. The profit rate in all competitive industries tends toward the same level. Marginal Cost = J curve Average Cost = Smile Curve Elimination Principle: Above-normal profits are eliminated by entry, and below-normal profits are eliminated by exit. Resources move toward an increase in the value of production Entrepreneurs move resources from unprofitable to profitable industries Implication of the elimination principle - Above-normal profits are temporary - To earn above-normal profits, entreneapurs must innovate. The invisible hand will not work if… - Prices do not accurately signal costs and benefits - There is no optimal balance between industries  Markets are not competitive. - Monopolies and oligopolies produce less than ideal amount - Firms make above-normal profits, and entry is limited. Commodities are public goods - Self-Interest does not align with social interest. Monopoly: A firm with Market Power Market Power: Power to raise prices above marginal costs without fear that other firms will enter the market. Patent: Gives exclusive rights to make, use or sell the product. Marginal Revenue: change in total revenue after selling an additional unit Marginal Costs= change in total costs after selling an additional unit. To maximize profits, firms produce at the level of output where: Marginal Costs = Marginal Revenue A firm with market power (monopoly) must lower its price to sell an additional unit. It faces a downward-sloping demand curve. The additional revenue per unit is less than the current price. Elasticity of Demand and Monopoly Markup - Two effects make demand for pharmaceuticals inelastic - The “you can't take it with you” effect: People with serious illnesses are relatively insensitive to the price of life-saving drugs. - The “other people’s money” effect: If third parties are paying for the medicine, people are less sensitive to price. - The more inelastic the demand curve, the more a monopolist will raise the price above the marginal curve. Monopolies charge a higher price and produce less. If monopolies want to ACTUALLY sell, they must sell lower, but they can charge anything. Many monopolies are the result of government corruption. Monopolies are especially harmful if they control a good that is used to produce other goods. The result is a greater deadweight loss, and the “pie” shrinks. It Costs one billion to develop a new drug. Patents are one way of rewarding research and development. Creates an incentive to make the drug Economies of Scale: The advantage of large-scale production that reduce average cost as quantity increases Natural Monopoly: When a single firm can supply the entire market at a lower cost than two or more firms. Monopolies can arise naturally when economies of scale allow a single firm to produce at lower cost than many small firms. Utilities such as water, natural gas, and cable television are often natural monopolies. If Economies of scale are large enough, prices can be lower under a natural monopoly than under competition. Barriers to Entry: Factors that increase the cost to new firms of entering an industry. Ownership of an input that is difficult to duplicate. Network Effects make a product or service more valuable the more users there are. Facebook has a few competitions because everybody wants to use the site. There are only a few credit card companies. - Customers want cards that are widely accepted - Firms want to accept card that are widely used. Innovation can lead to products that other firms cant immediately duplicate Involves a trade-off - Iphones are priced higher than if there were stronger competitors - But Apple would have less incentive to innovate if it didn't expect monopoly profits. Monopolies: - Charge a higher price than competitive firms (Price Makers). - Reduce total surplus, create deadweight loss (IMPORTANT) - Use market power to earn above-normal profits - The markup of price over marginal cost is larger the more inelastic the demand. CH 14 Price Discrimination: Selling the same product at different prices to different customers. Price Discrimination is common: Movie Theaters often charge seniors less. Businesses often pay more for software than students do.  Airlines set different prices according to characteristics that are correlated with willingness to pay. Price Controls - Laws, these laws make it illegal to move above a max price ( price ceilings) or below a minimum price (price floors) - Interfere with market signals - Setup by the government. - Delink some markets and link others in ways that are counterproductive. Price Ceiling: A price control that is a maximum price controlled by law. Price Ceilings create: - Shortages - Reduce Quality - Wasteful lines and other search costs. - A loss of gains. Shortages - When price ceiling is below market price, Qd is greater than Qs, which leads to a shortage - The shortage is measured by the difference between Qd and Qs at the controlled price. - Shortages in one market create breakdowns and shortages in other markets. - In a economy with many prices controls, shortages are more likely to appear at anytime Reduce Quality - At below equilibrium price, sellers find there is an excess of demand - Sellers can evade the law by cutting quality rather than raising price. - Another way quality can fail is with reductions in service. Wasteful Lines - At the below equilibrium price, demanders are willing to pay more. - The price controls make a higher price illegal. - Other ways to pay, include bribes and waiting in line (value of time (opportunity cost) ) - Bribe goes to the supplier, creating a deadweight loss. - Deadweight loss: the reduction in surplus caused by a market distortion or inefficiency. - At the controlled price, landlords have more renters than apartments so they can discriminate - Controlled price = Below equilibrium price. - Misallocation of Resources - When prices are controlled, resources do not flow to their highest use. - Ex: A cold winter increases the demand for heating oil. - The demands of heating oil are prevented from bidding up the price of oil. - There's no signal and no incentive to ship oil to where it is needed most. - Apartments are not allocated to the renters who value them the most. - People with a high willingness to pay can't buy as much housing as they want. - Low willingness to pay consume more housing than they would purchase at market rate. Rent Control: A price ceiling on rental housing. - Usually begins with a rent freeze, prohibiting landlords from raising rents. - As overall rents rise, controlled rents fall below market equilibrium rent. - The short-run supply curve for apartments is inelastic - Landlords have few options other than to absorb lower prices - The shortage grows over time because fewer apartment units are built, old units are turned into condos, units are torn down to make way for other uses. - Shortages caused by rent controls become more severe over time. - Rent controls reduce housing quality, due to because maintenance costs rise and owners respond by cutting costs/quality. - When rent controls are strong, buildings are turned into slums then eventually abandoned. - In the 1990’s, many American cities have eliminated or erased rent controls as it lowers quality, discrimination, bribes and shortages. - Some changed policy to rent regulation - Rent controls help the poor. Price Floors - Minimum price allowed by law - Most notable example is minimum wage - Minimum wage above the market price creates a surplus of labor. - A surplus of labor is called unemployment Wasteful increase in Quality/ Misallocation of Resources - U.S airlines were regulated from 1938 to 1978 - Unregulated fares were at half prices of similar length regulated flights. - The regulated prices were above the airline's willingness to sell.  - Airlines couldn't drop prices to compete for customers. - Entry of new firms into the airline industry was also regulated. - Restrictions on entry misallocated resources because low-cost airlines were kept out of the industry. Price floors create: Surpluses, loss of gains from trade, wasteful increases in quality and misallocation of resources. CH9 (IMPORTANT) International Trade: trade across national borders Basic principles of trade still apply: 1. Trade makes people better off 2. Increases productivity through specialization and division of knowledge. 3. Increases productivity through comparative advantage. Tariffs: Tax on imports Tariff leads to less consumer surplus. Producer surplus benefit, Government gets revenue and deadweight loss happens. Protectionism: Economic policy of restricting trade through quotas, tariffs, or other regulations that burden foreign producers but not domestic producers. Quota: Restriction on the quantity of goods that can be imported. Effects of Tariff: - Domestic suppliers respond to the higher price by increasing price ( Benefits) - Domestic consumers respond to the higher price by buying less ( Does not benefit). - Imports decrease - Government revenue = tariff x Quantity of Imports 3. Trade and National Security (Arguments against International Trade) - Protectionism may be justified if a good is vital for national security - Domestic vaccine industry  - This creates an incentive for every domestic producer to claim their product is vital for national security. CH 10 - For some products, some of the costs or benefits fall on bystanders - External costs are called negative externalities - External benefits are called positive externalities - When we evaluate markets with externalities, we look at the social surplus. - Externalities- Costs or benefits that fall on bystanders - External Cost- Cost paid by people other than consumer or producer. - Private Cost- A cost paid by the consumer or the producer - Social Cost- Cost to everyone; private cost plus external cost. - Social Surplus- Consumer surplus, producer surplus, and everyone else surplus combined. - A market equilibrium maximizes consumer surplus plus producer surplus - A market with externalities does not maximize social surplus. - External Benefit- Benefit received to others that are not the producer or consumer. - Vaccines benefit the person who is vaccinated, but they also create an external benefit - People who have been vaccinated are less likely to spread the disease - Person getting the shot bears all the cost: time, money, fever and aches - But the person being vaccinated doesn't receive all the benefits. - As a result, fewer people get flu shots than is efficient. Tradable Allowances - Under the clean air act of 1990, the EPA distributes pollution allowances to generations of electricity. - Congress sets the total amount of allowances - The EPA monitors emissions so firms can't pollute beyond their allowances - Firms can trade or bank allowances for future use. - Program has been successful, as emissions have been reduced, air quality improved, illness have been reduced and electricity generation has increase Every producer must answer these questions  - What price to set - What quantity to produce - When to enter and exit the industry In a competitive market, producers are “price takers”, they dont choose price, they accept the amount in market price. - The firm can sell all its output at a Market price - A firm can’t sell any output at a lower price. - The firm’s demand is perfectly elastic at market price An industry is competitive when firms dont have much influence over the price of their product. This is a reasonable assumption when: - The product being sold is similar across sellers - Many buyers and sellers, each small relative to the total market - There are many potential sellers Demand is more elastic in the long run, due to more time and there are more substitutes. Long Run: The time after all exit or entry has occurred. Short Run: The time period before exit or entry can occur. General principle of rational choice: Ignore what you can’t change. Focus on what you can change. A sunk cost is a cost that cant be recovered. Since you can't change a sunk cost, it should be ignored. Fixed Cost: Costs that do not change with output - Can’t be changed by short-run choice; should be ignored in the short run - Can be changed in the long run; should be focused. Variable Cost: Cost that change with output Explicit Cost: A cost that requires money outlay Implicit Cost: Cost that does not require an outlay of money; opportunity cost. Maximizing profit requires taking into account both explicit costs and implicit costs Accountants typically don’t consider all opportunity costs, so accounting profits are usually more than economic profits. Accounting profit: Total revenue - Explicit Cost  Economic Profit: Total revenue- total costs minus both implicit and explicit costs. Profit is total revenue minus total costs Total revenue is price x quantity Total cost is the cost of producing a given quantity of output. - Fixed Costs: do not vary with the level of output - Variable Costs: do vary with output Total Revenue: Price times quantity sold Total Cost: Cost of producing a given quantity of output Maximizing profit means maximizing the difference between total revenue and total costs. Method 1: Calculator total revenue and total costs, and look for the quantity that maximizes the difference.’ Method 2: Compare the increase in revenue from selling an additional unit, with the increase in costs from selling an additional unit. To maximize profit: - Keep producing so long as Marginal Revenue > Marginal Costs - The last unit that the firm produces should be the one where - Marginal Revenue = Marginal Costs Marginal Revenue= Change in total revenue from selling an additional unit. For a firm in a competitive industry, MR= PRICE MR= change in Total Revenue / Change in quantity Marginal Costs: Change in total costs from selling an additional unit. To maximize profit in a competitive industry, increase output until P= MC Change in total cost / change in quantity As the prices changes, so does the profit-maximizing quantity If price increases, the firm will expand production Firm will continue to expand until it is once again maximizing profit, where P = MC Average Cost of Production: Cost per unit, or the total cost of producing Q units divided by the quantity amount. A firm can maximize profits and still have a low profile or even losses. It can be useful to show profits in a diagram To do this, we need average costs We can then calculate probability. Profit = (P - AC) x Q  AC= Total Costs divided by number of units. Any price below the minimum of AC will result, we will have losses. Firms seek profits, so in the long run: - Firms will enter the industry when price is greater than average costs - Firms will exit when prices is less than average costs - When P = AC, profits are zero and there is no incentive to enter or exit - Zero profits means that price is just enough to pay labor and capital their opportunity costs