Summary Microeconomics by Perloff

This summary of Microeconomics by Perloff is written in 2013-2014.

Chapter A: The supply-and-demand model

Microeconomics is the study of how individuals and firms make themselves as well as off as possible in a world of scarcity and the consequences of those individual decisions for markets and the entire economy. It studies the allocation of scarce resources, often called the price theory, to show the important role of prices. Economists make use of models, which describe the relationship between two or more economic variables. Economic theories are the development and the using of models to test hypotheses, predictions about cause and effect. Within theories there is a distinction between positive statements, a testable hypothesis about cause and effect, and normative statements, a conclusion as to whether something is good or bad. Important in economics is the interaction between supply and demand.

Demand

Potential consumers’ buying behaviour is influenced by the next determinants of demand:

• Price of the good
• Consumers’ tastes
• Information or misinformation about the good or the use of it
• Prices of other goods; substitutes (product that is similar, like apples and pears) or complements (good that needs to be consumed at the same time, like toothpaste and a toothbrush)
• Income
• Government rules and regulations, like sales taxes or government-imposed limits
• Other factors, like friends and the time of the year

Quantity demanded: the amount of goods that a costumer is willing to buy at a certain price, holding all other factors constant. This can be displayed in a demand curve; a curve that shows the relationship between demand and price, holding all other factors constant.

Law of demand: consumers demand more of a good when its price is lower and less when its price gets higher; the demand curve slopes downward.

Changes in quantity demanded as a response to pricing, holding all other factors constant, are movements along the demand curve. A change in one of the other factors will cause a shift of the entire demand curve.

The demand function of a product, appears in such a form:

Q= D(p,pa,pb,Y)

Which means that the quantity demanded varies with the price of the product, the price of the two substitutes a and b, and the income of the consumer. This can be rewritten as a specific function, taken for example the demand function of pork:

Q = 171−20p + 20p_b + 3p_c + 2Y

• where Q is the quantity of pork demanded
•  p is the price of pork (dollars per kg)
•  p_bis the price of beef (dollars per kg)
•  p_c is the price of chicken (dollars per kg)
•  Y is the income of consumers (thousand dollars)

When using the next values p_b = 4, p_c = 3.33 and Y = 12.5

The function can be rewritten as:

            Q = 171−20p + (20 x 4) + (3 x 3.33) + (2 x 12.5)

                                               Q = 286−20p

The slope of a demand curve can be calculated by: ∆p/∆Q, which in case of a demand curve is always negative, because the higher the price of a product, the less of that product will be demanded by the customer. The total market demand is obtained by summing all consumers’ demand curves. So when having the two customer demand curves:

Q1= -2p + 3 and Q2= -3p + 1, than the total market demand would be: Qtot= -5p + 4

See fig.1 in the attachment

Supply

On the other side of the market mechanism, there is the quantity that firms are willing to supply at any given price. This is mainly determined by:

• Price of the goods
• Costs
• Government rules and regulation

Quantity supplied: the amount of goods that firms want to sell at any given price, holding all other factors constant. This is being displayed in a supply curve. Although most of those curves have an upward slope as the higher the price, the more firms are willing to supply, there is no particular slope for the supply curve as it can be upward sloping, downward, vertical and horizontal.

The same as for the demand curve, shifts in prices causes movements along the supply curve, whereas changes in costs or government regulations will shift the entire supply curve. Another factor that would change the supply curve would be a quota; a limit on the quantity of the import of a foreign-produced good, set by the government. This forbids foreign firms to supply quantities that are higher than the quota.

See fig.2 in the attachment

Market equilibrium

Market equilibrium: a situation in the market where all traders are able to buy and sell as much as they want. This is being obtained when supply is equal to demand: Qs=Qd. With solving this equation, the equilibrium price can be found. When substituting this equilibrium price in one of the formula’s, the corresponding equilibrium quantity can be found. For example:

• Demand: Q^d= 286 − 20p
• Supply: Q^s = 88 + 40p
• Equilibrium:
  • Q^d = Q^s
  • 286 − 20p = 88 + 40p
  • 60p = 198
  •  P = €3.30
  •  Q = 286 – 20(3.3) = 220

See fig.3 in the attachment

When the market is at a disequilibrium, there will be an excess demand (at P < Pequilibrium) or an excess supply (at P > Pequilibrium). In this situation, an invisible hand directs people to coordinate their activities, so the price will change back to the market equilibrium. This equilibrium only changes when a shock occurs that either shifts the demand or supply curve. See fig.4 in the attachment

Take the example above to see the working of this invisible hand. When the supply increases (possibly as a result from new firms entering the market), the supply curve shifts to the right. The old equilibrium was set at P = 5, Q = 10, but now for P = 5, the supply increased to Q = 14. This means an excess supply of 4. At a market, when the supply of good is higher than the demand for it, the value of the good decreases, which will bring the price of it eventually to P = 3, which will decrease demand to Q = 12.

Possible shifts of the demand and supply curves:

See fig.5 in the attachment

• Demand curve to the right; D1 to D3
  • This indicates an increase in the total demand, as a possible result of an increase of total income, taste for the good, population or increase in the price of a substitute.
• Demand curve to the left; D1 to D2
  • A decrease in the total demand, possibly resulted from an increase of the price of a complementary good or decrease of popularity of the good.
• Supply curve to the right; S1 to S2
  • This indicates an increase in the total supply of a good, as a possible result from an increase in productivity or number of firms in the market.
• Supply curve to the left; S1 to S3
  • A decrease in the total supply of a good, possibly resulted from an increase in the price of an input, an increase of the price of a substitute in production or an increase of the expected future price of the product.

Interventions that affect the market equilibrium

The government can affect the market equilibrium in many ways:

• Quotas: a ban on foreign supplies can cause the equilibrium price to go up, see page 51 (page 31 and 32 for the fifth ed) for a graphic example.
• Price ceilings: the government sets a price p, which will be the maximum price for all those goods. Setting a price ceiling protects the customer against high prices at the market. This price ceiling would be irrelevant when set above the equilibrium price. Where this ceiling is lower than the equilibrium price, shortages will arise as a result of a persistent excess demand. This shortage can be calculated as followed:
  • Qd= -2p + 14       
  • Qs= 3p + 4          
  • Equilibrium: -2p + 14 = 3p + 4, peq= 2, Qeq= 10
  • Because of a price ceiling, the maximum price allowed: p = 1
  • When entering this price into both formula’s, Qd = 12 and Qs = 8
  • The shortage resulting from this price ceiling will be 12-8=4
  • See page 53 (page 34 in the fifth ed) for a graphic example of a price ceiling
• Price floors: setting a minimum price for a good to protect the supplier for prices that are too low to be profitable. Price floors are irrelevant when being set beneath the equilibrium price, but when being set higher it will cause surplus as a result of a persistent excess supply. This surplus can be calculated in the same manner as being done above. One of the most important examples of a price floor is a minimum wage in the labour market. The ironic thing about this law though, is that it is designed to help workers by raising their wages, but it also brings along an excess supply of labour which eventually results in unemployment. See page 53 (page 38 in the fifth ed) for a graphic example of a price floor.

As you have learned above, the supply-and-demand model can help us to understand and predict the reality in many markets. This model is only applicable in markets in which:

• Everyone is a price taker. No one should be able to affect the market price by themselves. Large numbers of firms, achieved through an easy entrance to the market, are necessary to ensure that firms become price takers. 
• Firms sell identical products. So one firm’s goods will not be preferred above another firm’s goods.
• Everyone has full information about the price and quality of goods.
• Costs of trading are low.

Above characteristics are characteristics of a perfectly competitive market.

In contrast you have a monopoly: there is only one seller of a good of service, the seller is a price setter. In an oligopoly firms are also price setters, because there are only a small number of firms in the market, where they sell differentiated products. In such markets where there are price setters, the market price is usually higher than the one predicted by the supply-and-demand model. Another market where the market price will be different from the one set by the supply-and-demand-model, is a market where the costs for trading are high. These are the so-called transaction costs; the costs of finding a trading partner and making the trade for a good of service, beyond the price paid for that good of service. These costs could include costs for advertising or transportation, and may raise the market price.

Chapter B: Elasticity and sale taxes

The shape of a supply and demand curve determines how much a shock affects the equilibrium price and quantity. See page 66 (page 45 in the fifth ed) for a graphic example of the differences in responses to a shock. This is not only through graphs, but it is also possible to calculate the sensitivity of quantity demanded/supplied to price through price elasticity: the percentage change in a variable in response to a given percentage change in another variable.

Price elasticity of demand

Price elasticity of demand (represented by ε): the percentage change in the quantity demanded in response to a percentage change in the price.

ε = percentage change in quantity demanded / percentage change in price

ε = (∆Q/Q) / (∆p/p)

• ∆Q is the change in quantity demanded
• ∆Q/Q is the percentage change in quantity demanded
• ∆p is the change in price
• ∆p/p is the percentage change in price

The formula could be rewritten as:

ε = (∆Q/∆p) x (p/Q)

For a linear demand curve, with the function Qd = a – bp, the elasticity can be calculated by:

ε = - b (p/Q)

As (∆Q/∆p) is the same as the slope of the curve, b.

The price elasticity of demand is always negative because of the law of demand; less quantity is demanded when the price rises. 

There are different types of values for elasticity:

• ε = 0, perfectly inelastic demand
• 0 > ε > -1, inelastic demand
• ε = -1, unit elastic
• -∞ < ε < -1 elastic demand
• ε = -∞, perfectly elastic demand

The elasticity of demand varies along most demand curves:

• With a down-ward sloping linear demand curve the elasticity of the demand is a more negative number the higher the price is. The demand curve is perfectly inelastic (ε = 0) where the demand curve hits the horizontal axis and it is perfectly elastic (ε = -∞) where it hits the vertical axis. Unitary elasticity (ε = -1) can be found at the midpoint of the demand curve. See page 69 (page 49 in the fifth ed) for the corresponding graph.
• With a demand curve that is horizontal at p*, shows that people are willing to buy at any price ≤ p*. When the price gets higher than p*, the demand immediately falls to zero, so the demand is perfectly elastic.
• A vertical demand curve is perfectly inelastic everywhere; when the price goes up, quantity demanded will not change. This curve is applicable for essential goods, which are goods for what people will pay anything to get.

See page 70 (page 50 in the fifth ed) for the corresponding graphs of a horizontal and vertical demand curve.

Income elasticity (represented by ξ): the percentage change in the quantity demanded in response to a given percentage change in income. This may be calculated as:

ξ = percentage change in quantity demanded / percentage change in income

ξ = (∆Q/Q) / (∆Y/Y)

• ∆Y is the change in income
• ∆Y/Y is the percentage change in income

Here the formula can also be rewritten as:

ξ = (∆Q/∆Y) x (Y/Q)

Generally, goods that are being viewed as necessities, such as food, will have income elasticities near to zero. Luxury goods on the other hand, will generally have income elasticities greater than one.

Cross-price elasticity: the percentage change in the quantity demanded in response to a given percentage change in the price of another good. This may be calculated as:

Cpe = % change in quantity demanded / % change in price of another good

Cpe = (∆Q/Q) / (∆po/po)

Cpe = (∆Q/po) / (po/Q)

• Where o stands for another good

Complements: goods that need to be consumed at the same time. This results in a negative cross-price elasticity, as people buy less of one good when the price of the complementing good increases. This for example, would shift the demand curve for this goods to the left.

Substitutes: products that are similar, which results in a positive cross-price elasticity. When the price of substitute good A increases, people will demand more of good B.

Price elasticity of supply

Price elasticity of supply (represented by η): the percentage change in the quantity supplied in response to a given percentage change in the price.

η = percentage change in quantity supplied / percentage change in price

η = (∆Q/Q) / (∆p/p)

η = (∆Q/∆p) x (p/Q)

If the supply curve is upward sloping, (∆p/∆Q) > 0, the supply elasticity will be positive. When curving downward, the supply elasticity will be negative. For upward sloping curves:

• η = 0, perfectly inelastic supply
• 0 < η < 1, inelastic supply
• η = 1, unit elastic
• η > 1, elastic demand
• η = ∞, perfectly elastic demand

By the same reasoning as before, for a linear supply curve Q = g + hp, the supply elasticity can be calculated by η = h (p/Q). Constant supply curves are the only curves with the same elasticity at every point along the curve. This could be vertical and perfectly inelastic (for example a perishable good as fresh fruit, the seller accepts any market price as at the end of the day it becomes worthless) or horizontal and perfectly elastic (where firms supply as much as the market wants).

Long run vs short run

Long-run and long-run elasticities of supply and demand may differ from each other. Long-run demand curves will be more elastic than short-run demand curves when consumers can substitute between goods more readily in the long run. When goods can be stored easily though, short-run demand curves will be more elastic than the long-run demand curves. The long-run elasticity of supply will be greater than the one in the short-run, when producers can increase output at lower cost in the long run than in the short run.

Sale taxes

The way a sale tax affects the equilibrium price and quantity and how much the customers will be affected by it, depends on elasticities. There are two types of taxes:

• Ad valorem tax (or the sales tax): for every dollar the consumer spends, the government keeps a fraction α, which is the ad valorem tax rate.
• Unit tax (or specific tax): a specified dollar amount τ, is collected per unit of output.

The effect of a specific tax: when the government imposes a specific tax τ, the suppliers will keep only p – τ of the price p that consumers pay. This results in suppliers willing to supply less of a good, than when they would receive the full amount of money. Subsequently, the after-tax supply curve will be τ above the original supply curve for every quantity, as firms want to receive the original amount of money they would get before the taxes. See page 61 for a graphic example. The tax revenue that the government acquires, can be calculated by τ x Q.

Elasticities of supply and demand determine the effects of a tax on the equilibrium prices and quantities. When the government raises the tax from zero to τ, the change in tax is:

∆τ = τ – 0

As a reaction on this tax change, the prices that customers pay increases by:

∆p = (η / (η – ε) x ∆τ

• η is the supply elasticity at the equilibrium
• ε is the demand elasticity at the equilibrium

The more elastic the demand is for a given supply elasticity, the less the equilibrium rises when a tax is imposed. The greater the supply elasticity for a given demand elasticity, the higher the equilibrium price that consumers pay.

The incidence of a specific tax: the part of the tax that falls on the consumers, so this answers the question ‘who is hurt by the tax?’. This can be calculated by:

∆p / ∆τ = the share of the tax that falls on the consumers.

1 – (∆p / ∆τ) = the share of tax that falls on the firms.

When a demand curve slopes down-ward and the supply curve slopes upward, the incidence of the tax will be shared by customer and firm. Only when the demand or supply elasticity has extreme values, firms can pass along the full costs of the tax. With the information of how the incidence of the tax depends on the elasticities of supply and demand at the pretax equilibrium, we can determine the conditions under which firms can pass along the full tax. To start with, by dividing both sides of the equation by ∆τ, the incidence of tax that falls on consumers will change into:

∆p / ∆τ = η / (η - ε)

The incidence of tax falls mainly on consumers, when the demand curve becomes relatively inelastic (ε approaches zero) or the supply curve becomes relatively elastic (η increases).

In competitive markets, the effect of a tax on equilibrium quantities, prices, and the incidence of the tax is unaffected by whether the tax is collected from consumers or producers.

Chapter C: Consumer behavior

For information about individual decision making we need a model of individual behavior, which is based on the following premises:

• The amount of pleasure that people derive from the goods and services they consume, is determined by individual tastes or preferences.
• Consumers face limits or constraints on their choices.
• Consumers maximize their well-being or pleasure from consumption which is subjected to the constraints they face.

Bundle/market basket: the combination of goods that consumers buy.

There are three fundamental assumptions on consumer preferences:

1. Completeness: a consumer is able to rank different bundles of goods (x≿y,x≾y,or x∼y).
2. Transitivity: a consumer’s preferences over bundles is consistent (x≻y and y≻z, then x≻z).
3. More is better: more of a commodity is better than less of it (nonsatiation).

The preferences of a consumer can be graphically displayed with indifference curves in an indifference map.

Indifference curve: the set of all bundles of goods that a consumer views as being equally desirable.

Indifference map: a complete set of indifference curves that summarize a consumer’s tastes or preferences.

See fig.6 in the attachment

Indifference curve maps have four important properties:

• The bundles on the indifference curve that are further from the origin are preferred to those that are closer, so I2 is preferred to I0.
• Through every possible bundle, there is an indifference curve.
• Indifference curves cannot cross.
• Indifference curves slope downward.

Marginal rate of substitution

As can be seen from the indifference curves, a consumer is willing to make some trades between goods. The consumer for example, would be indifferent whether he/she would have bundle c, or bundle e, as they are on the same indifference curve. A customer’s willingness to trade one good for another is measured by the marginal rate of substitution (MRS), which is the maximum amount of one good a consumer will sacrifice to obtain one more unit of another good.

MRS = ∆Good 1 / ∆Good 2

The marginal rate of substitution is the slope of the indifference curve. This is likely to be negative, as the more of good 1 you have, the more you will be willing to trade for good 2. Whilst, the lesser of good 1 you have, the lesser you will be willing to trade for good 2. This makes the curve convex and it reflects a diminishing marginal rate of substitution: the marginal rate of substitution approaches zero as we move down and to the right of the along the indifference curve.

There are two extreme cases where the indifference curve is no convex:

1. Where the goods are perfect substitutes: the consumer is completely indifferent as to which to consume. The customer will be indifferent between one additional unit of one good or one additional unit of the other good. This makes the slope of this curve -1, which make straight lines.
2. Where the goods are perfect complements: the consumer is only interested in consuming only in fixed proportions. The consumer will only have good 1, when having it together with good 2. This results in an indifference curve with right angles.

See fig.7 in the attachment

Utility

Utility: the set of numerical values that reflect the relative rankings of various bundles of goods. When a consumer prefers bundle 1 to bundle 2, it means that consuming bundle 1 would give the consumer more utility than consuming bundle 2.

Utility function: shows the relationship between utility values and every possible bundle of goods. An example of a utility function could be:

Ordinal measure: a measure that tells us the relative ranking of two things but not how much more rank is than another.

Cardinal measure: a measure by which absolute comparisons between ranks may be made.

Utility is an ordinal measure, so we should only look at the relatively utility or ranking between two bundles.

Marginal utility: the extra utility that a consumer gets from consuming the last unit of a good. This is the slope of the utility function as we hold the quantity of the other good constant. Marginal utility of good 1 is:

MUgood1 = ∆U / ∆Good 1

• Where ∆U is the extra utility which is received from consuming the last unit of a good.
• And ∆ Good 1 is the extra consumption of good 1.

Earlier we saw that the marginal rate of substitution (MRS) is the slope of the indifference curve and that it is the maximum amount of one good a consumer will sacrifice to obtain one more unit of another good. Well the MRS can also be expressed in terms of marginal utilities. When a consumer trades from one bundle on an indifference curve to another by giving up some units of Good 1 to gain more of Good 2. Than the consumer gains marginal utility from the extra unit of Good 2 but loses utility from having fewer units of Good 1. The MRS can be written as:

MRS = ∆Good 2/ ∆Good 1 =  - (MUgood1 / MUgood2)

The MRS is the negative of the ratio of the marginal utility of another unit of Good1 to the marginal utility of another unit of Good 2.

Budget constraints

Another step in the individual model of behavior was that consumers maximize their well-being subject to constraints.

Budget line (or budget constraint): the bundles of goods that can be bought if the entire budget is spent on those goods at given prices.

Opportunity set: all the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint.

When a consumers spends all his/her budget, Y, on the goods 1 and 2, then:

Y = pgood1 x Good1 + pgood2 x Good2

• Where pgood1 x Good1 is the total amount being spent on Good 1 and pgood2 x Good2 is the total amount being spent on Good 2.
• This equation is the consumer’s budget constraint and shows that the expenditures on those goods use up the entire budget.

To decide how much a consumer can buy from Good 1, the budget constraint has to be solved for Good 1, which would be the quantity being bought from Good 1. This would result in an equation like: Good1 = ….

See fig.8 in the attachment

Marginal rate of transformation (MRT): the slope of the budget line, which is the trade-off the market imposes on the consumer in terms of the amount of one good the consumer must give up to obtain more of the other good.

MRT = ∆Good2 / ∆Good1 = - (pgood1 / pgood2)

Two possible changes in the budget constraint:

1. A change in price, for example the price of Good 1 doubles, where the price of Good 2 remains unchanged. This changes the slope of the budget line, as this would double as well.
2. A change in income, for example the income doubles. This results in a shift of the entire budget line.

See fig.9 in the attachment

Optimal bundle

The optimal bundle of a consumer lies on an indifference curve that touches the budget constraint at only one point, without crossing the line. This point is called the consumer’s optimum and when consuming this bundle, the consumer has no incentive to change its behavior by substation one good for another. There are two ways that this outcome can be reached:

• Interior solution: here the optimal bundle has positive quantities of both goods and is situated on the budget line other than at one end or the other.
• Corner solution: here the optimal bundle is at one end or the other of the budget line, so it is at a corner with one of the axes.

See fig.10 in the attachemnt

To calculate this consumer’s optimum, the budget constraint and the indifference curve need to have the same slope at point e where they thought, so they need to be tangent. To translate this in a formula:

MRS = - (MUgood1 / MUgood2) = - (pgood1 / pgood2) = MRT

Or:

(MUgood1 / pgood1) =  (MUgood2 / pgood2)

Chapter D: Applications of the consumer theory

A consumer chooses an optimal bundle of goods by picking the point on the highest indifference curve that touches the budget line. After a price change, the budget constraint of the consumer shifts, so the consumer has to choose a new bundle. By varying the price of a good there will be various indifferences curves and budget constraints. The line that goes through all those equilibrium bundles is called the price-consumption curve. When this is sloped upwards, the consumer’s consumption of good 1 and 2 increases when the price of good 1 falls. With this information from the price-consumption curve we can draw the consumer’s demand curve for good 1. See page 135 (page 113 in the fifth ed).

The same as when the price of one of the goods increases, the rise in income will also affect the budget constraint of the consumer: this will shift the budget constraint outward which increases the customer’s opportunities. There are three ways of looking at the relationship between income and the quantity demanded:

• With the touching indifference curves and budget constraints. Through all the equilibrium bundles that arise here, an income-consumption curve can be formed.
• With looking at the demand curves that will derive from the one above, showing the relationship between the price and the demand of a good.
• Engel curve: shows the relationship between the quantity demanded of a single good and income, holding prices constant.

See page 141 (page 116 in the fifth ed) for the corresponding graphs.

Income elasticities

Income elasticities can be used to summarize the shape of the Engel curve, the shape of the income-consumption curve, or the movement of the demand curves when income increases. We already defined income elasticity as:

ξ = percentage change in quantity demanded / percentage change in income

ξ = (∆Q/Q) / (∆Y/Y)

• ∆Y is the change in income
• ∆Y/Y is the percentage change in income

The formula can also be rewritten as:

ξ = (∆Q/∆Y) x (Y/Q)

• Normal good: when income rises, as much or more is demanded of this good. A good is a normal good when ξ ≥ 0.
• Inferior good: when income rises, the demand for this good decreases. A good is an inferior good when ξ < 0.

A good may be normal at some income levels and inferior to others.

Price changes

The increase of a price has two effects on an individual’s demand:

• Substitution effect: the change in quantity of a good that a consumer demands when the good’s price changes, holding other prices and the consumer’s utility constant.
• Income effect: the change in the quantity of a good a consumer demands because of a change in income, holding prices constant.

The total effect from a price change, is the sum of the substitution and income effects:

Total effect = SE + IE

For normal goods, both the SE and the IE go upwards when the prices goes upwards:

Price↓ → SE↑ + IE↑, so Total effect ↑

To see the total effect from a price change on a normal good in a graph, see page 123.

When a good is inferior the income effect goes in opposite direction from the substitution effect. Within this there are two options:

• Price ↓ + SE > IE → SE ↑ + IE ↓, so total effect is that the quantity demanded ↑
• Price ↓ + SE < IE → SE↑ + IE ↓, so total effect is that the quantity demanded↓
  • This is called a giffen good: a decrease in its price causes the quantity demanded to decrease also.

Chapter E: Production functions

Firm: an organization that converts inputs such as labor, materials, energy, and capital into outputs, the goods and services that it sells.

There are three legal forms of for-profit firms:

• Sole proprietorship: owned by a single individual, who is personally liable for the debts of the firm with all its personal wealth.
• Partnerships: a jointly owned by two or more people business, operating under a partnership agreement. With the leaving of one of the partners, this agreement ends and for continuing the operations, a new partnership agreement must be written. Here there is also personal liability, where even the assets of partners who might not be responsible for the failure, will be held liable.
• Corporations: firms owned by shareholders through stocks. Those shareholders elect a board of directors that will run the firm. Those will hire managers for the short-term decisions and long-term plans. Instead of being personally liable, corporations have limited liability. This means that the personal assets of the owners cannot be taken to pay the corporation’s bankruptcy.

Profit (Π) = R – C

• Where R is the firm’s revenue, which is p x q (price times the quantity).
• And C are the costs that the firm faces, due to labor, materials, and other inputs.

A competitive firm is likely to be driven out of competition when it doesn’t maximize profits. To obtain this, firms need to have an efficient production or technological efficiency, which is a situation in which the current level of output cannot be produced with fewer inputs, giving existing knowledge about technology and the organization of production. Efficient production is needed to be maximizing profits, so this is a necessary condition for profit maximizing. Though, efficient production is to a sufficient condition for ensuring maximizing profits, as there are also other factors which are important.

There are three broad categories of inputs:

• Capital (K): inputs that are long-lived, such as land, buildings, and equipment.
• Labor (L): services of humans, provided by managers, skilled workers, and less-skilled workers.
• Materials (M): processed products and raw goods.

Production function: a function that shows the relationship between the quantities of inputs used and the maximum quantity of output that can be produced, given current knowledge about technology and organization. A production function for a firm that only uses capital (K) and labor (L) is:

q = f (L,K)

• Where q units of output are produced by using L units of labor and K units of capital.

Short run: planning period where at least one of the production factors is fixed, and others are variable.

Fixed input: a factor of production that cannot be varied practically in the short run.

Variable input: a factor of production whose quantity can be changed readily by the firm during the relevant time period.

Long run: a long-enough period, where all the inputs are variable, and L and K are substitutable.

Short run production

In the short run, it is being assumed that capital is a fixed input and labor a variable. This means that output can be increased by only increasing labor. So the short run production function looks like this:

q = f(L,)

• Where is the fixed number of units of capital.

Marginal product of labor: the change in total output, ∆q, resulting from using an extra unit of labor, ∆L, holding all other factors constant.

MPL = ∆q/∆L

Average product of labor: the ratio of output, q, to the number of workers, L, used to produce that output.

APL = q / L

Total product of labor: the amount of output that can be produced by a given amount of labor.

In most production processes, the average product of labor first rises, as it helps to have more workers working on one good. Similarly, with having more workers, everyone can specialize at a special activity, which will make output increase more than labor. Eventually, however, the average product of labor will fall down, as at a certain point workers may be in each other’s way, and they might have to wait for using certain tools or whatsoever.

Relationships of the product curves:

• The average product of labor slopes upward where the marginal product is above it, and downwards when the marginal product is below.

This is because when a worker adds more output than the average product of the initial workers, the worker raises the average.

• The average product of labor reaches a peak, where marginal product of labor and the average product of labor cross.
• The average product of labor can be determined through using the total product of labor curve. Here the average product of labor for L workers equals the slope of a straight line from the origin to a point on the total product of labor curve for L workers.
• The slope of the total product curve at a given point equals the marginal product of labor.

See fig.11 in the attachment

The relationships of the product curves are being displayed here. In point a, in graph b), you can see that the law of diminishing marginal returns sets in.

The law of diminishing marginal returns: when a firm keeps increasing an input, holding all other inputs and technology constant, the corresponding increase in output will become smaller eventually. So the marginal product of that input will diminish eventually.

Long run production

In contrast to the short run production, are all inputs in the long run production variable. A firm can substitute one input for another while continuing to produce the same level of output. Typically a firm can produce in four ways, some of which require more labor than others. Those four combinations can be shown within the family of isoquants.

Isoquant: a curve that shows the efficient combinations of labor and capital that can produce a single level of output. It shows the flexibility that a firm has in producing a given level of output. When a production function is q = f(L,), then the equation for an isoquant, where output is held constant at  :

  = f(L,K)

See fig.12 in the attachment

A sketch of a family of isoquants, as you can see, they have the same shape as indifference curves. See page 187 (page 165 fifth ed), for a graphical example of what happens when capital is constant within the isoquant function.

Isoquants have the same characteristics as indifference curves, only isoquants hold quantity constant, whereas indifference curves hold utility constant. The other characteristics of isoquants, mostly results from firms’ producing efficiently:

• The farther an isoquant is from the origin, the greater the level of output.
• Isoquants do not cross; otherwise there is no efficient production.
• Isoquants slope downward. If it would slope upward, the firm could produce the same level of output with relatively few inputs or relatively many inputs, this last would be inefficient. So, because isoquants only show efficient production, an upward-sloping isoquant is impossible.

Possible shapes of isoquants:

• When the inputs are perfect substitutes, each isoquant is a straight line and can be written by: q = x + y
• When the inputs cannot be substituted at all. This production function is called a fixed-proportion function. An output cannot be produced when having only one of the inputs. These isoquants are right angles.
• Normal isoquants lay between the extreme cases of straight lines and the right angles. The ability to substitute one input for another varies along the curve.

See fig.13 in the attachement

Substituting inputs

The slope of an isoquant tells something about the ability of a firm to substitute inputs, whilst holding output constant. This slope is called the marginal rate of technical substitution:

MRTS = change in capital / change in labor = ∆K / ∆L

The MRTS is the number of extra units of one input needed to replace one unit of another input that enables a firm to keep the amount of output it produces constant. This is always negative, as isoquants slope downward.

Diminishing marginal rates of technical substitution: the decline in the MRTS (in absolute value) along an isoquant as the firm increases labor. The more labor that a firm has, the harder it is to replace the remaining capital with labor. This makes the MRTS fall as the isoquant becomes flatter. In special cases, where inputs remain perfect substitutes, the isoquants are straight lines, so there is no diminishing of the MRTS, as neither of the inputs becomes more valuable in the production process.

MRTS can also be calculated in another way:

MRTS = - MPL / MPK = ∆K / ∆L

• Where MPL is the marginal product of labor (∆q / ∆L)
• MPK is the marginal product of capital (∆q / ∆K)

Scale

After determining the effects of increasing one input whilst holding the other constant (which shifted us from one isoquant to another) or decreasing the other input by an offsetting amount (which causes a movement along an isoquant), we are now turning to the increasing of all inputs proportionately.

Scale: a firm’s size in the long run.

Constant returns to scale, CRS: property of a production function whereby when all inputs are increased by a certain percentage, output increases by that same percentage. So:

f (2L, 2K) = 2f (L, K)

Increasing returns to scale, IRS: property of a production function whereby output rises more than in proportion to an equal increase in all inputs.

f (2L, 2K) > 2f (L,K)

This could be a result of greater specialization of labor or capital.

Decreasing returns to scale, DRS: property of a production function whereby output increases less than in proportion to an equal percentage increase in all inputs.

f (2L, 2K) < 2f (L,K)

This could be caused by the fact that the difficulty of organizing, coordinating, and integrating activities might increase with firm size.

Technical productivity

What a firm produces in comparison to companies that produce the same depends on its technical productivity and the technical and managerial innovations it makes. All firms will try to produces as efficiently as possible to optimize profits, but firms may not be equally productive, because some firms can produce more than another with a given amount of inputs.

The relative productivity of a firm can be measured by expressing the firm’s actual output, q, as a percentage of the output that the most productive firm in the industry could have produced, q*, from the same amount of inputs. 100q/q* is the relative productivity measure given in percentages.

Technical progress: an advance in knowledge that allows more output to be produced with the same level of inputs. This could be a better management or organization of the production process.

Neutral technical change: a technical change in which the firm can produce more output using the same ratio of inputs.

Non-neutral technical change: innovations that alter the proportion in which inputs are used.

Chapter F: Cost functions

Technologically efficiency: being able to produce the desired level of output with the least amount of inputs.

Economically efficiency: being able to minimize the cost of producing a certain amount of output.

Economic/ opportunity costs: the value of the best alternative use of a resource.

Durable good: a product that is usable for years. For example capital.

Two problems arise in measuring the cost of capital:

• The allocation of the initial purchase cost over time. When having bought a good, a firm’s bookkeeper may expense or amortize the costs over its life.
• What to do when the value of capital changes over time. For maximizing profits, a firm has to properly measure the costs of a piece of capital

Sunk cost: an expenditure that cannot be recovered.

Costs in the short-run

Let’s first start with naming all basic concepts:

• F (fixed cost): production expense that does not vary with output, costs that cannot be adjusted in the short run, such as land, large machines, and other capital goods. The fixed cost for a capital good that is being owned by a firm, is the opportunity cost of not renting it to someone else.
• VC (variable cost): production expense that varies with the quantity of output produced.
• C (total cost): the sum of a firm’s variable and fixed costs:
  • C = VC + F

• MC (marginal cost): the amount by which a firm’s cost changes if the firm produced one more unit of output:
  • MC = ∆C / ∆q
• AFC (average fixed costs): F / q
• AVC (average variable costs): VC / q
• AC (average costs): C / q, and also:
  • AVC = AFC + AVC

Then let’s look at it with the help of a graph, see page 213 (page 188 for the fifth ed):

• F is a horizontal line, as it does not vary with output.
• VC curve is zero at zero units of output, and it rises with output.
• TC curve is the vertical sum of the VC curve and the F cost curve.
• AFC curve falls as output increases, it comes close to zero when output is large, as then the fixed cost is spread over many units.
• AC curve is again the vertical sum of the AFC curve and the AVC curve.
• Where the MC curve is below the AC, the AC curve declines with output. Where it is above the AC, the AC curve will rise with output.
• MC curve always crosses the AC curve in its minimum point.

The shape of a firm’s cost curve is determined by its production function. It shows the amount of inputs that is needed to produce a certain level of output. In the short run, when a firm produces output with capital and labor, and capital is fixed (because of being in the short run), the firm’s variable cost is the cost of labor:

VC = wL

Where

• VC are the variable costs
• w is the wage per hour
• L are the number of hours of labor

As the capital is fixed in the short run, the only way to increase output, is to use more labor. When labor is increased enough, the firm will reach the point of diminishing marginal return to labor, which means that each extra worker increase output by a smaller amount. This information will be used for determining the shapes of the next curves:

• The shape of the VC curve: this is determined by the production function ,when all input prices are constant. As labor increases, the total product of labor curve increases less than proportion, this diminishing rate of return flattens the total product of labor curve at higher levels. So the diminishing marginal returns in the production function cause the variable cost to rise more than in proportion as output increases. See page 215 (page 190 for the fifth ed) for a graphical example of a variable cost curve.
• The shape of the MC curve: to recall, MC = ∆C / ∆q. In the short run capital is fixed, so to increase production extra labor has to be used. These extra labor costs, cost the firm w per unit. As a result:
  • MC = ∆VC / ∆q = w (∆L / ∆q)

To calculate the extra labor that is needed, we need to divide 1 by MPL (the amount of extra output produced by one extra unit of labor. So the extra labor that is needed to produce one more unit of output is (∆L / ∆q), is the same as 1 / MPL . Thus the firm’s marginal cost is:

MC = w / MPL

• The shape of the AC curve: the diminishing marginal returns to labor, determine the shape of the AVC curve, which determines the shape of the AC curve. Reminder: AVC = VC / q. When the only variable input is labor, the variable cost will be wL, then the average variable cost is:
  • AVC = VC / q = wL / q
  • This could also be written as AVC = w / APL , as the average product of labor (APL) is q/L.

The AC curve is the vertical sum of the AVC curve and the AFC curve. At high output levels, the AVC and the AFC curve don’t differ that much anymore. So as the AVC curve is U-shaped, the AC curve will be U-shaped as well.

Short summary of the short-run costs:

• The costs associated with inputs that cannot be adjusted are fixed in the short run, while the costs from the inputs that can be adjusted are variable.
• The shapes of the variable costs (VC) and the cost (C) curves are determined by the production function, given that the input prices are constant.
• Because of diminishing marginal returns to a variable input, the variable cost (VC) and the cost (C) curve become relatively steep as output increases. So the AC, AVC, MC rise with output.
• The relationships between marginals and averages make the AC and the AVC fall when MC is below them, and rise when MC is above them, so the MC cuts both curves at their minimum points.
• So to find the minimum AC:
  • Put MC = AC and solve for q
  • Or find the first derivative of AC and put that equal to zero, AC’ = 0

Costs in the long-run

In the long run, the costs of production are as low as possible, because the firm adjusts its inputs so. Even in the long run fixed cost may incur, but these are avoidable rather than sunk (past costs that already been incurred and cannot be recovered) as it would be in the short run. Eventually in the long run, we get C = VC. So in the long run we only have C, VC and MC.

Input choices

A firm can use different technologically efficient combinations of inputs, which are summarized by an isoquant, as we have been examining before. From those technological combinations, a firm also wants an economically efficient combination of inputs, which is the bundle with the lowest cost of production.

Isocost line: all the combinations of inputs that require the same total expenditure. This total expenditure can be summed up in such a formula:

C = wL + rK

Where

• C is the total cost
• w is the labor cost, the wage per hour
• L is the hours of labor services
• r is the rental rate per hour, so the capital costs
• K is the rented hours of machine services

Along an isocost line, cost is fixed at a particular level , so the above formula should be rewritten:

 = wL + rK

To calculate the amount of capital that the firm can buy, we can again rewrite the equation:

K = (/ r ) – (w / r)L

Characteristics of the isocost line:

4. The isocost line intersects the capital axis (Y-axis) where the firm is using only K, so L=0. This is at / r The isocost line intersects the labor axis (X-axis) where the firm is using only L, so at /w.
5. Isocosts that are farther from the origin have higher costs than those that are closer to the origin.
6. The slope of each isocost line is the same. The slope of an isocost line, ∆K/∆L is equal to –w/r.

The combination of cost and product information

The lowest-cost way to produce a certain level of output, can be found by combining the information about cost, in the isocost line, with the combination about efficient production, displayed in an isoquant. There are three equivalent ways to minimize costs:

3. Lowest-isocost rule: choose the bundle of inputs where the lowest isocost line touches the isoquant.
4. Tangency rule: choose the bundle of inputs where the isoquant is tangent to the isocost line. The slope of an isoquant is the marginal rate of substitution (MRTS). The slope of the isocost is –w/r. So for minimizing costs:
   1. MRTS = -w/r, is the same as:
   2. MPL / MPK = w/r, is the same as:
   3. MPL / w = MPK / r
5. Last-dollar rule: choose the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other input.

All three ways, use the same formula, so always for minimizing costs:

MRTS = - MPL / MPK = - w/r

Or

MPL / w = MPK / r

Expansion path: the cost-minimizing combination of labour and capital for each output level. Here you see how the expansion path consists of the points where the isoquants and isocost lines are tangent:

See fig.14 in the attachment

See also page 228 (page 206 for the fifth ed) how you compose such an expansion path.

The shape of the long-run cost curve determines the shapes of the AC and MC curves. This long-run cost curve rises less rapidly than output at output levels below q* and more rapidly at higher output levels. As a consequence, the MC and the AC curves are u-shaped. The MC curve crosses the AC curve at its minimum at q*. See page 230 (page 207 for the fifth ed).

Economies of scale: property of a cost function whereby the AC of production falls as output increases. 

Diseconomies of scale: property of a cost function whereby the AC of production rises when output increases.

On the basis of how many units it produces, a firm chooses a plant size and other investments so as to minimize its long run costs. The plant and equipment will be fixed in the short run, so long-run decisions determine short-run costs, which will always be at least as high as the long-run costs. A firm will choose a plant size that minimizes its cost of production, so the one with the lowest AC for each possible outcome.

The long-AC curve is the solid version of all the short-run curves, where it includes one point of each possible short-run AC curve.

The costs in the long run are lower that short-run costs, as the firm has more flexibility in the long run. With comparing the short-run and the long-run expansion path (that correspond with the short-run and long-run cost curves), we can show the advantage of this flexibility. A long-run expansion path is upward sloping, as the producer will increase its output by using more inputs. The short-run expansion path on the other hand, is horizontal at the fixed level of output, as in the short run a firm cannot vary its capital. So its output will be increased by increasing the amount of labour. Here you can compare the LREP, long-run expansion path, with the SREP, short-run expansion path:

See fig 15 in the attachment

Chapter G : Competition

Market structure: the ease with which firms can enter and leave the market, the number of firms in the market, and the ability of firms to differentiate their products from those of their rivals. Now we will focus on the competitive market structure, where the many firms produce identical products and entering and exiting the market is easy. All firms are price taker, as they only have a small share of the total market output and its output is the same as other firms.

So firms are price takers when:

• All firms in the market sell identical products according to the consumers
• The market is free to enter and exit
• The price that is being charged by firms, is known by buyers and sellers
• Transaction costs are low (there are the costs that arise from finding a trading partner and making a trade for a good or service, other than the price that is paid)

Those are the characteristics of a perfect competitive market.

Homogeneous or undifferentiated products: products that are all seen as perfect substitutes and no firm can sell its product if it charges more than the others, as consumers are not willing to pay a premium for what is in their eyes the same product, this results in a horizontal demand curve for the firm. For example, different brands of apples.

Heterogeneous or differentiated products: when consumers prefer one product to those of the product of another firm, so one firm can charge more than the other firm, this results in a firm’s demand curve with a downward slope. For example, different brands of cars.

The demand curve of an individual firm is called the residual demand curve, which shows the market demand that is not met by other sellers at any given price. The firm only sells to the people that not have been purchasing from another firm yet. So the residual demand function is:

Dr(p) = D (p) – S0(p)

Where

• Dr(p) is the residual quantity demanded
• D (p) is the market function
• S0(p) is the supply curve of other firms

When the prices are so high that D (p) < S0(p), the residual quantity demanded will be zero.

As you can see in the next figure, (see fig 16 in the attachment)

The residual demand curve (on the left) is much flatter that the market demand curve (on the right). This results in the elasticity of the residual demand curve being much higher than the market elasticity. When there are n identical firms in the market, the elasticity of demand, εi, facing firm i is:

εi = nε- (n – 1) ηo

Where

3. ε is the market elasticity of demand
4. η0 is the elasticity of supply of each of the other firms (normally a positive number)
5. n – 1 is the number of other firms

The demand elasticity’s that will be an outcome of the above formula, can be high numbers, so to assume that such a firm in a competitive model faces an infinite price elasticity is not strange.

Perfectly competitive markets are important because:

• Many markets can be described as such, so the competitive supply-and-demand model can be used in many cases
• A perfectly competitive market has many desirable properties; economists find this model the ideal against which real-world markets are compared.

Further on, perfectly competitive markets will be named as competitive markets.

Maximizing profits

A firms profit is:

Π = R – C

Where

• Π is the profit, when this is negative, the firm makes a loss
• R are the firm’s revenues
• C are the firm’s costs

Economic costs: include both explicit (the firm’s out-of-the-pocket expenditures on inputs such as wages, so direct payments) and implicit costs (costs of resources that the firm’s owner makes available for production, without direct cash outlays).

Economic profit: revenue – economic costs.

Business profit: based on only explicit costs, often larger than economic profit.

From this point on, when mentioning the term profit, economic profit is meant, except when specially referring to business profit.

When a firm wants to maximize its profit, it needs to answer:

• What output level, q*, maximizes its profit or minimizes the loss? (output decision)
• Is it more profitable to produce q*, or to shut down? (shutdown decision)

There are three rules to choose how much output to produce, output rules:

• The firm sets its output where its profit is maximized. The peak of the profit curve has to be found. The slope of this curve is the firm’s marginal profit (the change in profit a firm gets from selling one more unit of output = ∆Π/∆q) .
• A firm sets its output where its marginal profit is zero.
  • Marginal profit (q) = MR (q) – Mc (q)
  • MR is marginal revenue, the change in revenue that a firm gets from selling one more unit of output.
• A firm sets its output where its marginal revenue equals its marginal cost:
  • MR (q) = MC (q)

So profit is maximized for MR (q) = MC (q).

For the shutdown decision, there are two rules:

• The firm shuts down only if it can reduce its loss by doing so. In the short run, a firm faces variable costs, which will be eliminated by shutting down, and sunk fixed costs, which cannot be eliminated by shutting down. Therefore, sunk fixed costs are irrelevant to the shutdown decision. In the short term, it pays for the firm to shut down only if its revenue is less that its avoidable costs, as only they are relevant. In the long term though, all costs are avoidable, so then it should shut down when it faces any losses at all.
• So, the firm shuts down only if its revenue is less than its avoidable cost.

Short run competition

We will now start with examining the profit-maximizing behavior of competitive firms in the short run. This will also contain an output and a shutdown decision.

The short-run output decision

We already know that profit is maximized where marginal profit is zero, so where MC = MR. The revenue of a competitive firm, R=pq, because of its horizontal demand curve. By the increase of q, the marginal revenue is p, so MC = p. As you can see in the figure on page 259 (page 234 for the fifth ed), the profit is maximized where MC = MR = p. You can also see here, how you can draw the rectangle that displays the maximized profit.

The short-run shutdown decision

A firm would gain by shutting down when pq < VC (which means that the profit pq, is lower than the variable costs). This condition can be rewritten as: p < AVC (is average variable costs). Concluding we could say, that a firm should shut down, when the market price is less than the minimum of its short-run average variable cost curve.

The short-run supply curve is the same as the firm’s marginal cost curve, only at the points above the minimum average costs. This is, because the firm would shut down when producing below the minimum average cost curve. See page 264 (page 240 for the fifth ed) what happens to the supply curve when there is an increase in cost of materials.

The short-run market supply curve is the horizontal sum of the supply curves of all individual firms in the market.

With identical firms: the more identical firms producing at a given price, the flatter (more elastic) the short-run market supply curve at that price will be.

With firms that differ: the more firms differ in costs, the steeper the market supply curve will be at low prices.

The short-run competitive equilibrium can be found by combining the short-run market supply curve and the market demand curve.

Long run competition

Competitive firms can in the long run, vary the inputs that where fixed in the short run. This makes the long-run firm and market supply different from the short-run ones. Then, the firm’s profit-maximizing decisions are easier in the long run than in the short run:

• Long-run output decision: the quantity that maximizes its profits using the same rules as in the short run will be chosen. So where the long-run marginal profit is zero and where MR = MC in the long run.
• Long-run shutdown decision: the firm will shut down when its revenue is less than its avoidable or variable costs. So in the long run, the firm will shut down when it will make an economic loss by operating.

A firm’s long-run supply curve may differ from its short-run supply curve, as the firm is now free to choose its capital in the long run. It’s its long-run marginal cost curve above the minimum of its long-run average cost curve, as all costs are variable in the long run. In the next graph you can see the differences in short and long run curves.

See fig.17 in the attachment

The long-run market supply curve is the horizontal sum of the supply curves of all individual firms in both the short and the long run. In contrast to the short run (where the number of firms in the market is fixed), firms can enter of leave the market in the long run. So before we can add all supply curves, we first need to determine how many firms are in the market at each possible market price.

Role of entry and exit

How many firms there are in a market, is determined by the entry and exit of the firms. In the long run, this is determined by firms based on the long-run profit they can make. Where in the short run it is difficult for firms to enter a new market because of barriers and high costs, in the long run those costs are often lower and the profits from entering are higher. On the other hand, firms might also react faster to losses than potential profits, so the ease of exiting a market is also quite high.

Firms continue to leave the market until the next firm considers leaving, the marginal firm, is again earning zero long-run profit. So in a market with free entry and exit:

• A firm enters the market if it can make a long-run profit, Π > 0
• A firm exits the market to avoid a long-run loss, Π < 0

The shape of the long-run market supply curve

• With identical firms and free entry. Here the long-run market supply curve is horizontal, an unlimited number of firms have identical costs, and input prices are constant. This holds only when there is free entry and exit.
• When entry is limited. Now the market supply curve slopes upward, because the only way for this limited number of firms to get more output, is to produce more. So here the long-run market supply curve is the sum of all the firms upward-sloping marginal cost curves above minimum average cost.
• When firms differ. Here again the long-run market supply curve is upward sloping, because firms with relatively low minimum long-run average costs, are willing to enter the market at lower prices than others. The upward slope is a result of the differences in costs across firms.
• When input prices vary with output. In an increasing-cost market and a constant-cost market firms produce at minimum average cost in the long run. The difference is that the minimum average cost rises as market output increase in an increasing-cost market, whereas minimum average cost is constant in a constant-cost market. Therefore, the long-run supply curve is upward sloping in an increasing-cost market and flat in a constant-cost market. Logically, in a decreasing-cost market, the long-run supply curve will be downward sloping.
• With trade. The supply curve of a country that imports goods, is the horizontal sum of its domestic industry’s supply curve and the import supply curve. Therefore, the import supply curve needs to be examined. The country’s import supply function is its residual supply curve (the quantity that the market supplies that is not consumed by other demanders at any given price), Sr(p), which is the quantity supplied to this country at price p.
  • Sr(p) = S(p) – D0(p) (where S(p) is the world supply and D0(p) is other demand elsewhere in the world)
  • The elasticity of this residual supply ηr = η/Θ – ( (1- Θ)/Θ) ε0
  • Where η is the market supply elasticity, ε0 is the demand elasticity, and Θ=Qr/Q is the importing country’s share of the world’s output.

Zero profit in the long run

Although firms may make profits or losses in the short run, they earn zero economic profit in the long run. If necessary, the prices of scarce inputs adjust to ensure that competitive firms make zero long-run profit. Because profit-maximizing firms just break even in the long run, firms that do not try to maximize profits will lose money. Competitive firms must maximize profits to survive. 

Chapter H: Welfare in the competitive model

The term welfare is being used by economists to refer to the well-being of various groups like consumers and producers. To see the benefits or harm that consumers receive from shocks that affect the equilibrium price and quantity, we need a way to measure consumer’s welfare. The most widely used method for this is, to measure consumer’s welfare in terms of dollars.

The consumer

Consumer welfare: the benefit a consumer gets from consuming a certain good, minus what the consumer paid to buy the good.

Marginal willingness to pay: the maximum amount that a consumer would spend for an extra unit. This equals the marginal value that the consumer places on the last unit of output.

Consumer surplus (CS): the monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs.

Here you can see these concepts in a graph of a demand curve:

See fig.18 in the attachment

• The consumer surplus is the area under the demand curve and above the market price up to the quantity that the consumer buys.
• The expenditure is the price x quantity.
• The marginal willingness to pay is the height of the demand curve.

When the equilibrium price on a market rises, consumer surplus will be reduced. This can best be shown in a graph:

See fig. 19 in the attachment

First at P2 the consumer surplus was the triangle P2, A, D. Then, after a price increase from P2 to P1, the new consumer surplus triangle is P1, P, D. The fall in consumer surplus can be calculated now, as this is the figure P1, P, A, P2.

Normally, when the price increases, consumer surplus falls more the greater the initial revenues spent on the good, and the less elastic the demand curve. The less elastic a demand curve is, the less consumers are willing to give up the good, which means that consumers do not cut their consumption much as the prices increases, which results in greater consumer surplus losses. See page 303 (page 276 for the fifth ed) for a graphical example of differences in consumer surplus losses for different elasticities.

The producer

Producer surplus (PS): the difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good.

For determining the producer surplus, we use the market’s (or in some cases, when calculating it for one individual producer, the firm’s) supply curve:

See fig 20 in the attachement

Graphically, the total producer’s surplus is the area above the supply curve and beneath the market price up to the quantity produced. This equals the revenue minus variable costs, so:

• PS = R – VC
  • Where Ps is the producer surplus
  • R is revenue, is the square p x q
  • VC are the variable costs

Then, profit (Π), is revenue minus total costs (C), which equals variable costs plus fixed costs:

• Π = R – C = R – (VC + F)

So the difference between producer surplus and profit are the fixed costs. In the long run, it often occurs that F = 0, then producer surplus equals profit.

Calculating the effect of a change in price is being done in the same way as for consumer surplus. Graphically:

See fig.20 in the attachment

Originally, at P1, the producer surplus consists of the triangle P1, C, D. Then, when the price falls from P1 to P2, the new producer surplus becomes the triangle P2, B, D. You see here a fall in producer surplus of the area P1, C, B, P2. When having the numbers of the prices and quantities, this loss in producer surplus can be calculated.

The society

The commonly used measure of the welfare of society, W, is:

W = CS + PS

With using this equation, there is a value judgement being made that the well-being of producers and consumers are equally important. Maximizing this measure of welfare is not being agreed by everyone, as different groups find consumers’ or producers’ well-being of bigger importance. Competitive markets do maximize this measure of welfare, so when the produced output is lower or higher than the competitive level, welfare will decrease.

Deadweight loss (DWL): the net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium. This results because consumers value extra output by more than the marginal cost of producing it.

The DWL is the opportunity cost of giving up some of this good to buy more of another good. A DWL will occur when:

• Producing less than the competitive output. As you can see in the next graph,

 See fig.22 in the attachment

consumer surplus at Q1, the competitive output, is equal to A + B + C. The producer surplus equals D + E. So total welfare, W = A + B + C + D + E. Subsequently, when producing at a smaller output, Q2, the total welfare comes to, W = A + B + D. This producing at a smaller output, results in a DWL of C + E, which indicates the loss in welfare.

• Producing more than the competitive output. As you can see in the graph below,

See fig. 23 in the attachment

The consumer surplus is the area A and producer surplus equals area C + F, so W = A + C + F. At a higher output, namely Q2, the consumer surplus now equals A + C + D + E, the producer surplus equals F – B – D – E, so the W = A + C + F – B. Because the producers lose more than the consumers gain, the DWL is B.

Market failure: inefficient production or consumption, often a result of a price exceeding marginal cost.

This welfare model is created for being able to predict the impact of government policies and other events. Government actions move us from an unconstrained competitive equilibrium to a new, constrained competitive equilibrium, and they all lower welfare. There are two types of government actions:

• Restricting the number of firms: limiting the number of firms, will shift the supply curve to the left, which raise the equilibrium price and lowers its quantity. Consumers are being harmed by this. See page 313 (page 286 for fifth ed) for an example of what happens to welfare when there is a restriction imposed on number of firms. This causes a deadweight loss.
• Raising entry and exit costs: this is an indirect way of restricting the number of firms.
  • Entry barriers: an explicit restriction or a cost that applies only to potential new firms.
  • Exit barriers: barriers that make it difficult for a firm to exit by going out of business. Exit barriers can keep the number of firms in a market relatively high in the short run, and in the long run they may limit the number of firms in a market. Exit barriers may raise prices, lower consumer surplus and reduce welfare.

The most common government policies creating a wedge between supply and demand are:

• Sales taxes: they cause the price consumers pay to rise, which results in a loss of consumer surplus, a fall in the price that the firms receive, so also a loss in producer surplus. We should include tax revenue in the definition of welfare, as we are assuming that the government does something useful with it. So:
  • W = CS + PS + T, and change in welfare is ∆W = ∆CS + ∆PS + ∆T.

With the next graph the effects of a sales tax can be shown:

See fig.24 in the attachment

Before the tax, the consumer surplus is A + B + C, the producer surplus D + E + F, tax revenue (T = tQ) is 0, so welfare, W = A + B + C + D + E + F. When the tax is imposed, it creates a shift of the supply curve, which makes the equilibrium price to rise to P2. The new consumer surplus now equals A, producer surplus equals only area F (as the price they eventually receive is now P3), tax revenue T = B + D (which is Q times the tax), so the total welfare, W = A + B + D + F. In the end, the DWL resulted from this tax equals C + E.

• Price floor: this entails the minimum price, which is the lowest price a consumer can legally pay for the good. See fig 25 in the attachment

With the help of this graph, we can show the effects of a price floor. Before the price floor, so at P* Q*, the consumer surplus is A + B, the producer surplus equals D + G, government expense (-X) is 0, so the welfare, W = A + B + D + G.

Then, after imposing the price floor, so at Q1 and P1, consumer surplus becomes A + B + D + E, producer surplus B + C + D + G, government expenses – ( B + C + D + E + F), and total welfare, W = A + B + D + G – F, which means a DWL of F. This DWL reflects two distortions in this market:

• Excess production: more output is produced then consumed, so the excess output is either stored, destroyed, or shipped abroad.
• Inefficiency in consumption: the price that the consumers are willing to pay at given quantity, is higher than the marginal cost of producing.

• Price ceiling: this entails the highest price that a firm can legally charge. When this ceiling is being set below the competitive price, consumers will demand more than the equilibrium quantity and firms will supply less than that. This will make the producer surplus to fall, as firms will receive a lower price and sell fewer units.

See fig.26 in the attachment

With the help of this graph, the effects of a price ceiling can be shown. Before the price ceiling, so at the equilibrium Q1, P1, the consumer surplus consisted of area A + B + C, the producer surplus of area D + E + F, so the total welfare, W = A + B + C + D + E+ F. After the imposing of the price ceiling at P2, the new consumer surplus is the area A + B + D, the new producer surplus the area F, and the new welfare, W = A + B + D + F. Which means there is a DWL of C + E.

Policies for international trade

The government of an importing country can use the next import policies:

• Allowing free trade, so no import restrictions for the country.
• Banning all imports, which means a quota of zero, which means no imports at all.
• Setting a positive quota, which means that the number of imports will be limited to the number of the quota.
• Setting a tariff, this is a tax only on imported goods.

Now we can compare welfare under free trade versus a ban on imports, free trade versus a tariff, and free trade versus a quota.

1. Comparing free trade with a ban on imports

A ban on imports eliminates free trade. Preventing this imports into the domestic markets raises the prices. We can show the results of this in the next graph:

See fig.27 in the attachment

In this graph you can see the world price, this is the supply line being used when there is free trade. The quantity imported at this price is Q3 – Q2. In the situation of free trade, with price P2 set on the world price, the consumer surplus equals A + B +C, the producer surplus D, so total welfare, W = A + B + C + D. With banning all imports, the new supply line will be set at the domestic supply, so the price will be P1, quantity set at Q1 and imports set on 0. Here the consumer surplus is A, producer surplus is B + D, so total welfare, W = A + B + D. This means that there is a DWL of C. As can be seen is that the ban helps producers, as their surplus increases, but it harms consumers as they have a decreasing consumer surplus because of the increase in price.

2. Comparing free trade with a tariff

Two types of tariffs:

• Specific tariff, T dollars per unit.
• Ad valorem tariff, α percent of the sales price.

Tariffs are almost the same as taxes, only tariffs are applied to only the imported goods, whereas taxes are being applied to all goods. The results of a tariff being imposed, can again be shown with a graph:

See fig.28 in the attachment

Before the imposing of the tariff, the consumer surplus equals A + B + C + D + E, the producer surplus F, the tariff revenues equal 0, so the welfare, W = A + B + C + D + E + F. In this situation, import equals Q4 – Q1. Now a tariff of T is being imposed which causes the price P1, to rise to P1 + T, this gives a new supply line. In this situation the consumer surplus now equals A, the producer surplus B + F, and the tariff revenues are D (which are the number of imported goods, Q3 – Q2 times the tariff T), which makes the total welfare to equal W = A + B + D + F. This shows a DWL of C + E. As can be seen, a tariff protects domestic producers from foreign competition. The larger the tariff, the less is being imported, the higher the price is that the domestic firms can charge. So for domestic firms their producer surplus will increase with a tariff. For consumers, their surplus will decrease as prices have gone up. Because not all imports are being banned by a tariff, the welfare loss is smaller than when all the imports are banned.

Within the deadweight loss of the above situation, two components can be interpreted:

• C is the loss from producing more outputs per day domestically, instead of importing it.
• E is a consumption distortion loss from the domestic consumers’ buying too little of the product, because of the rise in price. So it is the difference between the value at world prices and the value the domestic consumers place on the extra products being produced per day.

3. Comparing free trade with a quota

 The effect of a tariff is almost the same as the effect of a positive quota. When the government limits imports to Q_, this will be binding as imports are higher under free trade. The equilibrium price with a quota will be at where the quantity demanded minus the quantity supplied by domestic producers, will equal Q_.

Let’s use a graph to show the effects of a quota:

Fig 29 in the attachment

When we would state that Q3 – Q2 would equal the quota, Q_, we can see that the new equilibrium price with a quota would be P2. Here again, equally to the tariff mentioned before, the gain to producers equals area B, and the loss to consumers equals area C + E. Only the difference between a tariff and a quota, is that with the quota the government does not receive any revenue (unless selling import licenses), so area D may go to foreign exporters. So with a quota, the DWL results in area C + D + E.

Rent seeking: efforts and expenditures of firms or individuals to influence a government to adapt a policy that favours them, so which will give them a gain in surplus. By using resources, rent seeking makes the welfare loss beyond the deadweight loss worse, caused by the policy itself. When being in a perfect competition, government policies frequently lower welfare.

Chapter I: Monopolies

Monopoly: the only supplier of a good for which there is no close substitute.

Patent: an exclusive right to sell that lasts for a limited period of time.

As we already knew, all firms maximize their profits at MR = MC, so by setting marginal revenue equal to marginal costs. We also know that MC is the derivative of TC.

Marginal revenue: the change in revenue as a result of selling one more unit.

MR = ∆R / ∆q

• Where ∆R is change in revenue, (revenue = p x q)
• ∆q is change in output

The marginal revenue of a monopoly is different from the one of a competitive firm, as the monopoly has a downward-sloping demand curve, whilst the competitive firm has a horizontal one as it’s a price taker. As a result, the marginal revenue for a competitive firm equals the market price. Here you can see the difference between the competitive firm and a monopoly: See fig.30 in the attachment

For the competitive firm the initial revenue equals area A (which is pxq), the revenue of producing one more unit is area A + B, so the marginal revenue equals area B, which equals p. The monopoly has an initial revenue of area A + C (p1xq), the revenue of producing one more unit equals area A + B (which is the new q x p2, as price lowers with the increase of demand), so marginal revenue now equals area B – C, which is p2 – C. As you can see, it is the downward sloping demand curve of the monopoly, which makes its marginal revenue to be less than its price.

This fact makes its marginal revenue curve to lie below the monopoly’s demand curve. The marginal revenue curve has twice the slope of a demand curve, so it touches the horizontal axis, the Q-axis, at half the quantity as the demand curve does. Where the marginal revenue equals zero, so where it cuts the horizontal axis, the elasticity of the demand is ε= -1. In the next graph, you can see how the marginal revenue curve is being derived from the demand curve of a monopoly:

See fig.31 in the attachement

This can also be written down in a formula:

MR = p + (∆p / ∆Q)Q

The slope of the demand curve is ∆p / ∆Q, and the slope of the MR curve is ∆MR / ∆Q, which will always be twice the slope of the demand curve. The MR always depends on the demand curve’s shape and its height. As the shape of this curve is being determined by the elasticity at a certain point, MR equals the price times a term involving the elasticity of demand:

MR = p (1 + (1/ε))

This shows that MR is closer the price when demand becomes more elastic, and that even at Q=0, MR = p.

For maximizing profits, a firm will operate at the point where MR=MC, but now, unlike a competitive firm, a monopoly can adjust its price, so it will be a choice of setting its price or its quantity to maximize profits. We will now use the two step analysis for the monopoly to determine the output level that maximizes profits:

See fig.32 in the attachment

ing this graph, we can see that the output where profits will be maximized, will be where MR=MC, so that will occur at q1. The corresponding profit will be the rectangle (p1 – p2)x q1, as the revenue per unit equals the price minus the total cost per unit, which equals the ATC at the given q. The revenue-maximizing quantity is the quantity where MR=0, this is at a higher q than the profit-maximizing point. The linear demand curve is more elastic at smaller quantities, so the monopoly profit is maximized in the elastic portion of the demand curve. This also means that a monopoly never operates in the inelastic portion of its demand curve.

1. Shutdown decision.

Shutting down is to avoid making a loss in the long run if the monopoly-optimal price is below its average costs. In the graph you can see that p1 is above the ATC at p2, so the firm will choose to produce.

The profit-maximizing quantity can also be found mathematically:

• MC is the first derivative of TC
• MR is the first derivative of R
• AC is TC/Q

MC = MR, from this equation the profit-maximizing quantity can be found. Then for the second step, the shutdown decision, all you have to do is to check whether the price at this profit-maximizing quantity (so q filled in, in the demand curve), is higher than the ATC at this quantity (q filled in, in the ATC curve).

Shifting the demand curve, differences between competitive firm and a monopoly

A monopoly’s output decision is determined by the shapes of its MC curve and its demand curve. As a competitive firm has a supply curve, the monopoly does not. Shifting the demand curve of a monopoly has total different effects than when the demand curve of a competitive firm is shifted:

See fig.33 in the attachment

As you can see in the graph of competition, a shift of the demand curve from D1 to D2, will cause the profit-maximizing quantity to shift from q1 to q2, accompanied by a shift from p1 to p2.

In the case of a monopoly, the same shift in the demand curve from D1 to D2, will not affect the quantity to shift. Only the price will shift from p1 to p2, but the profit-maximizing quantity will stay the same.

A monopoly’s power in the market

Market power: the ability of a firm to charge a price above marginal cost and earn a positive profit.

As we already derived before, we can use the next equation for profit-maximizing:

MR = p (1 + (1/ε)) = MC

Rearranging terms:

p / MC = 1 / (1 + (1/ε))

This equation says that the ratio of the price to marginal cost depends only on the elasticity of demand at the profit-maximizing quantity. Not all monopolies can set high prices, as some monopolies might face a horizontal, perfectly elastic demand curve just as competitive firms. In this case, raising the price would only result in the loss of sales. The more elastic a demand curve is, the less a monopoly can raise its prices without losing sales. This is because a high elasticity indicates the presence of many substitutes.

Lerner index: the ratio of the difference between price and marginal cost to price (p – MC)/p.

This Lerner index is another way to show how elasticity of demand has an effect on a monopoly’s price relative to its marginal costs. For a competitive firm, this measure is zero as it cannot raise its price above marginal cost. The larger the Lerner index, the greater the difference between price and marginal cost, and the greater the ability of the monopoly to set price above marginal cost. For maximizing profits the Lerner index can be expressed in terms of elasticity of demand:

(p – MC) / p = (-1 / ε)

The demand curve of a firm becomes more elastic when:

• Better substitutes for the firm’s product are to be introduced.
• More firms enter the market selling the same product.
• Firms that provide the same product locate closer to this firm.

Monopolies and welfare

As we already know, welfare, W is the sum of CS and PS. A competition maximizes welfare as price here equals marginal cost. As a monopoly sets its price above marginal cost, it causes consumers to buy less of the good than the competitive level, so a DWL occurs. These differences of welfare in competitive market and with a monopoly can be shown here:

See fig.34 in the attachment

In the case of a competition, the firm would produce at q2 and p2, because this is where the MC curve cuts the supply curve (for a competitive market the marginal cost curve). Here the CS is area A + B + C, PS equals D + E, and so welfare, W = A + B + C + D + E. In the case of a monopoly, there will be produced at quantity q1 and price p1 because here MC = MR for the monopoly. Now the CS equals A, the PS equals B + D and so the total welfare, W = A + B + D. This means that now there is a DWL of area C + E.  The DWL when having a monopoly is a result of producing less than the competitive output.

Ad valorem versus specific taxes

Governments use Ad valorem taxes (paying a % of the price as a tax per unit of output) more often than Specific taxes (the monopoly paying the government τ dollars per unit sold). The reason for this is that Ad valorem taxes will give the government more tax revenue than Specific taxes would do. This can be seen with the graph on page 395 (page 367 for fifth ed). With imposing an Ad valorem tax, the output will be reduced with the same amount as the Specific tax does, but the Ad valorem tax raises more revenue, as can be seen in the graph. Both taxes harm consumers by the same amount, as they both raise the price and reduce quantity purchased.

Creating monopolies

Monopolies will arise from cost advantages or through government actions. Let us first look at the cost advantage that can result in a monopoly. The cost advantages that a firm has over its rivals could be:

• The firm controlling an essential facility: This is a scarce resource that a rival needs to survive.
• The firm can use a superior technology or has a better way of organizing production, which results in having lower costs.

Natural monopoly: situation in which one firm can produce the total output of the market at lower costs than several firms could. When a firm has economies of scale at all levels of output, its average cost curve falls as output increases. When all potential firms in the market have this same strictly declining average cost curve, this market had a natural monopoly.

Governments can also create monopolies by preventing competing firms from entering a market. This can be achieved in two ways:

• Barriers to entry. A monopoly can here be obtained by the government (1) making it difficult for new firms to obtain a license to operate, (2) by granting a firm the rights to be a monopoly, or (3) by auctioning the rights to be a monopoly.
• Patents. These are exclusive rights granted to an inventor to sell a new and useful product, process, substance or design for a fixed period of time.

Reducing market power

Some governments want to reduce the market power of a monopoly; this can be done through regulating the monopolies or destroying them by breaking them up into smaller firms. The first method that is often used by governments is placing a ceiling on the price that a monopoly charges.

Optimal price regulation is a regulation that eliminates the deadweight loss of a monopoly by placing a price ceiling. This regulation would give the same outcome as would occur if this market would be competitive, where welfare is maximized.

See page 409 (page 377 fifth ed) for an example of optimal price regulation, and how this affects the welfare and creates deadweight loss.

Network externality: the situation where one person’s demand for a good depends on the consumption of the good by others. When a good has a positive externality, its value to consumers grows as the number of units sold increases.

Critical mass of users: the amount of adopters needed for others wanting to join.

Direct size effect: when a consumer gets a direct benefit from a larger output.

Behavioural economics: the explanations of consumer’s behaviour that depends on beliefs or tastes.

Bandwagon effect: the situation in which a person places greater value on a good as more and more other people possess it.

Snob effect: the situation in which a person places greater value on a good as fewer and fewer other people possess it.

Chapter J: Prices and discrimination

Nonuniform pricing: charging consumers different prices for the same product or charging a single customer a price that depends on the number of units the consumer buys.

A monopoly that uses nonuniform pricing can earn a higher profit than when setting a single price because now it can capture some or all of the consumer surplus and deadweight loss that results when the monopoly sets a single price. This deadweight loss namely, arises because of the loss in sale to customers who value the good less than the high price that is being set by the monopoly. By raising the high price to customers who value the good the highest and lowering the price to its other customers, the monopoly will make additional sales, which changes the deadweight loss into profits. From all several types of nonuniform pricing, we will focus on the most common form: price discrimination.

Price discrimination: practice in which a firm charges consumers different prices for the same good. 

Firms always face a trade-off between charging consumers who really want the good as much as they are willing to pay and charging a low enough price that the firm doesn’t lose sales to less enthusiastic consumers. A price-discriminating firms avoids this trade off, and earns a higher profit than with uniform pricing for two reasons:

• Some or all of the consumers’ surplus of the consumers who are willing to pay more than the uniform price will be captured when charging the highest possible price.
• There will also be some units now sold to consumers who were not willing to pay as much as the uniform price.

For a firm to price discriminate successfully, the next conditions must be met:

• A firm needs to have market power to be able to charge above the competitive price.
• Consumers must differ in their demand elasticity, so in their sensivity to price, and the firm must be able to identify this.
• A firm must be able to prevent or limit resales to higher-price-paying consumers by consumers who were able to buy at the lower price. Normally the resale for most services are difficult or even impossible. A firm could prevent resales by vertically integrating, which is participating in more than one successive stage of the production and distribution chain for a good or service. Government tariffs make resales also difficult, as they make it expensive to buy goods in a low-price country and reselling them in a high-price country.

There are three main types of price discrimination:

1. Perfect price discrimination (first-degree price discrimination): situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it, so prices differ across customers and a given customer may pay more for some units than others.
2. Quantity discrimination (second-degree price discrimination): situation in which a firm charges a different price for large quantities than for small quantities but all customers who buy a given quantity pay the same price.
3. Multimarket price discrimination (third-degree price discrimination): a situation in which a firm charges different groups of customers different prices but charges a given customer the same price for every unit of output sold.

Perfect price discrimination

Reservation price: the maximum amount a person would be willing to pay for a unit of output. If a firm with market power knows these prices exactly and charges these reservation prices, a firm is perfectly price discriminating.

A perfectly price discriminating monopoly’s marginal revenue is the same as its price, so it equals its demand curve. Profits are being maximized at MR = p = MC. This equilibrium is efficient and it maximizes total welfare (W = CS + PS). This means that a perfectly price discriminating monopoly as more in common with a competitive equilibrium than with a single-price-monopoly equilibrium. In the next graph we will compare those two types:

See fig 35 in the attachment

We will look at the welfare of three types of markets:

• Competition: within a competition, price would equal marginal costs, so would be set at p1, quantity at q1. CS would equal A + B + C, PS would equal 0, so welfare, W = A + B + C. No DWL would occur, as being in perfect competition.
• Single price: here the quantity would be set where MR = MC, so at q2 and p2. Here CS would be A, PS would equal B, total welfare, W = A + B. This results in a DWL of area C.
• Perfect price discrimination: here the CS would equal 0, as the highest prices are to be charged. The maximum that a consumer is willing to pay, he or she will pay for the good. PS then equals the area A + B + C, total welfare, W = A + B + C, so as you can see, no deadweight loss occurs.

The perfect price discrimination equilibrium is more efficient than the single-price equilibrium, as more output is produced. The single-price equilibrium though, takes less of the consumer’s surplus, but also adds less to the producer’s surplus.

Quantity discrimination

Most of the time it is difficult to determine which consumers have the highest reservation prices.

Well-known though, is that most consumers are willing to pay more for the first units than for subsequent units. As the typical consumer’s demand curve is downward sloping, the firm can price discriminate by letting the price that each consumer pays, vary with the number of units the consumer buys. It is important to see though, that not all quantity discounts are a price discrimination, as they can also reflect a reduction in a firm’s average costs with large-quantity sales (like having a bigger soft drink).

Block-pricing schedules: there are used by many utilities, and they represent charging one price for the first few units (a block) of usage and a different price for the subsequent blocks. Declining-block and increasing-block pricing are both possible. The more block prices a monopoly can set, the more the monopoly will come to a perfect price competition. As deadweight loss results from the price being set above marginal costs which results in a sale of fewer units. The more block prices there will be set by the monopoly, the lower the last price will be and the closer it will be to marginal cost. Here you can see this in a graph:

See fig.36 in the attachement

Again, we are looking at two types of markets:

• Quantity discrimination. First you see q1, which represents the first block, then you see q2 which represents the second block. The length of both are the same. The CS here equals the area’s A + C, as the charged price for the first block is p1, and the charged price for the second block is p2. PS then equals B. So total welfare, W = A + B + C, and DWL is D.
• Single-price monopoly. Here the price and quantity are set where MR = MC, so q3 and p3. The CS that results from this is area E, PS equals F, so total welfare, W = E + F, which thus results in a DWL of area G.

As you can see in the graph, area G is bigger than area D, so with quantity discrimination the deadweight loss is getting smaller and smaller, and closer to a perfect competition where there is no deadweight loss at all.

Multimarket price discrimination

As a firm does not always know the reservation price for each customer, but it might know which groups of customers are likely to have higher reservation prices. Therefore a firm can use multimarket price discrimination, for which it divides potential customers into two or more groups and set a different price for each group. Again, to succeed in this discrimination type, a firm must have market power, be able to identify groups with different demands, and prevent resales. A multimarket-price-discriminating monopoly with a constant marginal cost, maximizes its profit by maximizing the profit for both groups separately. This is being achieved by setting MR equal to the common MC. Because the monopoly equates the MR for each group to its MC, m, the MR of both countries are equal:

MRa = m = MRb

Then, each MR is a function of the corresponding price and the price elasticity of demand, as we saw before:

MRa = pa (1 + 1 / εa)

• Where εa equals the price elasticity of the demand of group A.

This could also be written down equally for group B, so at the end rewriting the equations we find that:

MRa = pa (1 + 1 / εa) = m = pb (1 + 1 / εb) = MRb

• Where m equals MC for both countries.

Rearranging the above equation, we see that the ratio of prices in the two countries depends only on the demand elasticities in those countries:

Pb / Pa = (1 + 1 / εa) / (1 + 1 / εb)

Here we can see a graph of multimarket-price discrimination:

See fig.37 in the attachment

In this graph you can see the two groups where the multimarket is divided into. Both groups face the same MC line, m, and both groups maximize profits where m equals their MR curve. In group A the price is being set lower than the price at market B.    

There are two methods for dividing customers into groups:

• Dividing customers based on observable characteristics of consumers that the firm believes are associated with unusually high or low price elasticities. For example differentiating on age or country.
• Dividing customers based on their actions, this allows the customers to self-select the group to which they belong. They could be selected on their willingness to spend time to buy.

As multimarket price discrimination causes inefficient production and consumption, the welfare under multimarket price discrimination is lower that under competition of perfect price discrimination. Welfare might be the same, higher or lower that an single-price monopoly though.

Let’s first compare a multimarket price discrimination with a competition. With a competition (and perfect price discrimination) there is more output produced and consumer surplus will be greater. The multimarket price discrimination transfers some of the consumer surplus to the monopoly as additional profit. The rest of the consumer surplus will be deadweight loss, due to the multimarket-price-discrimination pricings above marginal costs, which results in reduced production from the optimal competitive level.

Then we will compare the multimarket price discrimination with the single-price monopoly. Here, both types will set their price above marginal cost, so both produce less than the competitive output. When starting the multimarket price discrimination, output might rise as the groups that did not wanted to buy at the single price, may now buy.

In the more groups the multimarket price discrimination divides the market, so the closer it comes to perfectly discrimination, the higher the output becomes, so the less production inefficiency there will be. Welfare is likely to be lower with discrimination (unless a multimarket-price-discriminating monopoly sells a significant higher output than it would sell at the single-price) because of consumption inefficiency and time wasted shopping. These two inefficiencies would not occur when charging all consumers the same price.

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