Essentials of Economics

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Essentials of Economics

• Business 502

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Profit Maximization 1

• Assumptions
• Price is given -- determined by the market.
• The businessperson has control only over the
  quantity produced.
• (Baumol and Blinder skip over this).
• Therefore, the objective is to adjust output to
  give max profits under those assumptions

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Profit Maximization 2
p MC
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Adjustment

• Suppose that price is less than Marginal cost.
  Then cutting output by one unit will cut cost
  more than it will cut revenues, increasing
  profits.
• Suppose that price is greater than Marginal cost.
  Then adding one more unit of output will increase
  revenues more than costs, increasing profits.

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Another Equimarginal Principle

• The marginal cost curve is the supply curve.
• (We will see that this is true whenever quantity
  supplied is positive).
• An industry can be defined as a group of all
  firms that sell a particular, differentiated
  product.
• For a group of firms in a particular industry,
  the supply curve is the horizontal sum of their
  supply curves, which is the industrys marginal
  cost curve.
• Here is the qualification

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Supply Curve

• Implication The supply curve for an individual
  firm is the firms marginal cost curve (if it
  produces any output at all).

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The Shut-Down Point 1

• As long as the firm produces something, it will
  maximize its profits by producing "on the
  marginal cost curve." But it might produce
  nothing at all.
• When will the firm shut down?
• The answer goes a bit against common sense. The
  firm will shut down if it cannot cover its
  variable costs.
• So long as it can cover the variable costs, it
  will continue to produce.
• As long as it can pay the variable costs and
  still have something to apply toward the fixed
  costs, it is better off continuing to produce.

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The Shut-Down Point 2

• This is an application of the opportunity cost
  principle. Just because fixed costs are fixed,
  they are not opportunity costs in the short run
  -- so they are not relevant to the decision to
  shut down.
• It is important not to confuse shut-down with
  bankruptcy. They are two different things. If a
  company cannot pay its interest and debt payments
  (usually fixed costs), then it is bankrupt. But
  that doesn't mean it will shut down. Bankrupt
  firms are often reorganized under new ownership,
  and continue to produce -- just because they can
  cover their variable costs, and so the new owners
  do better to continue producing than to shut
  down.

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Firm Supply

• We can now refine the definition of the firms
  supply curve
• The supply curve is the marginal cost curve above
  the average variable cost curve.
• This application may illustrate the importance of
  the cost curve analysis last week.

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Monopoly

• In economics we define a monopoly is a firm that
  is the only seller of a product with no close
  substitutes.
• Whenever a firm has some power to influence its
  price, we say that it has monopoly power.
• However, many firms that are by no means
  monopolies have some influence over their prices.
  
• (Baumol and Blinder focus on this case.)

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Monopoly Demand
The demand curve for the monopoly is the demand
curve for the industry -- since the monopoly
controls the output of the entire industry -- and
the industry demand curve is downward sloping,
That means the monopoly can push the price up by
limiting output. If the monopoly cuts back on its
output, it can move up the industry demand curve
to a higher price. In general, a firm with
influence over its price will have a downward
sloping demand curve, even if it is not the
industry demand curve.
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Monopoly Pricing

• Because it has no competition, a monopoly can
  control its selling price (within the limits of
  demand).
• We will assume that the monopoly charges only one
  price -- no price discrimination.
• What price? To answer this question we need two
  concepts
• Marginal revenue
• Marginal cost
• We proceed to marginal revenue.

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Marginal Revenue
Revenue, R price times quantity sold.
We can interpret marginal revenue as
(approximately) the increase in total revenue as
a result of selling one more unit of output.
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Marginal Revenue Example
Suppose output increases from 10000 to 11000 and
revenue increases from 754286 to 714286. Then
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Marginal Revenue and Demand
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Example 1

• Simplifying assumptions
• The industry demand curve is linear.
• Cost is the sum of a fixed overhead cost and a
  variable or unit cost proportional to output,
  i.e.
• CabQ20,00040Q
• (per day)

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Example 2

• CabQ20,00040Q
• Implies

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Example 3
Marginal Cost
Clearly the monopolist will price above marginal
cost. By how much?
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Example 4
Clearly, the monopoly can increase its profits by
reducing output and pushing the price up. But how
far? If the price were to go up to 100, sales and
profits would be zero. The key to answering this
question is to balance Marginal Cost and
Marginal Revenue.
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Adjustment

• Suppose that Marginal Revenue is less than
  Marginal cost. Then cutting output by one unit
  will cut cost more than it will cut revenues,
  increasing profits.
• Suppose that Marginal Revenue is greater than
  Marginal cost. Then adding one more unit of
  output will increase revenues more than costs,
  increasing profits.

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Maximum Profits 1
Unit cost
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Maximum Profits 2
We see that a price of 70 and an output of 10,500
just balances the advantages of cutting output
against the disadvantages. This is where Marginal
Revenue (not price) equals the Marginal Cost.
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Monopoly is Inefficient 1

• The red triangle is a loss of consumers surplus
  with no offsetting benefit.

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Monopoly is Inefficient 2

• After monopolization, the net benefits from
  widget production have two components the profit
  rectangle plus the upper (green) consumers'
  surplus triangle.
• But the opportunity cost of monopolization is the
  consumers' surplus the consumers would have
  enjoyed if they had continued to buy at 40 --
  the sum of the three areas.
• Thus, the benefits of monopolization are less
  than the costs, and the difference -- the excess
  cost -- is measured by the area of the (red)
  triangle to the right.

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A More Complex Example
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Interim Conclusion on Monopoly

• Within limits, a monopoly can increase its
  profits by cutting its output.
• The limit is MRMC
• A simplifying assumption here is that the
  monopoly charges the same price for every unit.
• This is the rationale for antitrust laws.
• But we are ignoring another important monopoly
  effect price discrimination.

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Price and Revenue for a Firm

• In economics we define a monopoly as a firm
  that is the only seller of a product with no
  close substitutes.
• Whenever a firm has some power to influence its
  price, we say that it has monopoly power.
• However, many firms that are by no means
  monopolies have some influence over their prices.

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Back to Elasticity
Any firm that can influence its price by
restricting its output has to take its Marginal
Revenue into account. There is a useful
relationship between MR and elasticity. It is
called the Lerner rule, after socialist economist
Abba Lerner.
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Markup
Thus we can derive the profit-maximizing markup
as (Youll have to trust me on this -- it
takes a bit of calculus to fill in the details.)
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Example 1
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Working Problem Continued
Tentative commitments from various stadiums and
statistical analysis lead to the estimated demand
relation we just saw What is their elasticity?
How will their sales influence their revenues?
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Example 2
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Example 3
To maximize profits, MRMC and MC 6
Recall,
We have
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Example 4

• So their price should be 3618 per bumbershoot.
  
• At that price, the demand curve tells us they
  will sell 10,895 umbrellas
• For total revenue of 196,110
• Cost is 93,370
• Profit is 100,740.

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Another Example

• Heres another example.
• Cost depends on output and a capacity limit.
• The elasticity of demand is constant at 2.
• Lets apply the MR/MC/elasticity approach to find
  the profit maximum.

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Cost
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Elasticity and MR

• Remember --

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Demand
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Cost and Revenue
Looks like and
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Exact Computation
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Supply Curve

• We see that a firm with pricing power does not,
  strictly, have a supply curve.
• Rather there is a single quantity supplied and
  price -- a supply point.
• However -- provided we know that the elasticity
  of demand is constant, we can define something a
  little like a supply curve, using the Lerner
  rule.

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Markup Rule
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Further Application of Consumers Surplus Concepts

• Concepts of consumers surplus -- and similar
  concepts of producers surplus -- can be applied
  to estimate the losses from unwise government
  policy. Marginal cost will also play a role.
• One of my favorite examples (I have mentioned it
  before) is farm subsidies.
• Here is a more detailed treatment, building on an
  editorial report by the Economist magazine in
  2005.

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Farm Subsidies

• A subsidy is a payment from the government to a
  private sector agent, without quid pro quo.
• Payments to farmers in proportion to their
  production are one example.
• As the Economist points out, these have been
  controversial because they interfere with
  international trade.

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Are Subsidies a Problem?

• They seem to be politically popular.
• The Economist reports some opinions on both
  sides.
• No doubt, there are some cases in which subsidies
  can be good things.
• However, when we dig deeper, the case for farm
  subsidies in particular seems very weak.

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The Economics of Subsidy
Source Farnham, Economics for Managers
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Remember the Reasoning
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With a Subsidy
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With a Subsidy
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Effect on LDC
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In Addition

• Funds must be raised (via taxes) to pay for the
  subsidy (or the interest on the deficit it
  generates).
• Taxes have their own net loss triangle, the
  excess burden.
• Still more resources are wasted in the political
  competition for subsidies rent seeking
  behavior.
• In all, the case against subsidies as
  misallocation of resources is a strong one.

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Not the Whole Story

• Of course, supply-and-demand isnt the whole
  story.
• Distributional issues can outweigh resource
  allocation
• Environmental problems and imperfect competition
  may influence the allocation of resources away
  from the efficient market equilibrium.

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However --

• Distribution -- subsidies seem to favor (richer)
  developed country farmers and city folks over
  (poorer) LDC rural people.
• There is no evidence that subsidies improve
  environmental outcomes or monopoly power.
• Therefore -- it seems right that subsidies should
  be eliminated.

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Overall Conclusion

• A more detailed study of the form and basis of
  the determinants of demand and supply gives us
• Tools that can help us understand changes in the
  economy, such as the decline of agriculture
• Tools that can help us measure the impacts of
  some of those changes, such as introduction of
  new goods or government subsidies,
• Tools that can help us to focus on the
  profit-maximizing price decision for a realistic
  business firm.