core micro 111 ac unit7

7/23/2019 Core Micro 111 Ac Unit7

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The Firms and its

CustomersAli Cheema

Department of Economics

Lahore University of ManagementSciences


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Structure

1. Stylized facts and decision makingframework of the rm

2. Cost function Cost advantages of large-scale production

3. Price-setting and output determination sopro!t and demand curves

Marginal revenue and marginal cost curves

. !ains from trade" surpluses and #argaining

power "ole of elasticity of demand

$. Price setting" competition and market power

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S%&'()*+ ,C%S + +*C(S(/0(! ,0*/

Firms and customers

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Large !rms is #here the action is$

4Seeding large rms critical challenge forde4eloping economies 56sieh and /lken 527188


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%hy large !rms&

'#ners of !rms ma(e more money if theycan attain large si)e

nvestors get higher returns from o#ningstoc( in large !rms

Employees in large !rms are also paid more

e discuss why later

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Model price and output decisionsmade *y !rms under+

Cost conditions that favor large !rms

Capitalism #here survival for pro!ts isdominant strategy

Typical rules of ,mar(et institutions #here Firms ma(es .uantity and price decisions

Then individual customers decide #hether to*uy

Firm has to set one price for all consumers

Assumptions correspond to reality ote perfect competition is not starting

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Decision ma(ing frame#or( / !rmsuccess

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Decision frame#or(

0rices 10ile it high and sell it cheap2 motto of 3ac(

Cohen founder of TESC'+4lo# price and highvolume 5pro!t per unit *et#een 6-64789

E:ploit price premium for di;erentiatedproducts ala Apple 5pro!t per unit *et#een 89

%hich strategy depends on Demand it faces i4e4 #illingness to pay ofpotential consumers

Cost of production

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C/S% ,:C%(/

Firms and customers

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Cost function

Assume Costs vary #ith level of production

Small !rm produces specialty carscalled ?eautiful Cars or 1?-cars2

For this *usiness #hat are the

components of costs&

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Components of costs

0remises e.uipped #ith machinery eithero#ned or rented 5!:ed costs9

"a# material and components 5varia*le

costs9 %ages and salaries 5some !:ed costs9

'pportunity cost of capital to induce

shareholders to invest in !rms assets %hat shareholder received if they investedelse#here is opportunity cost of capital 5recallfrom unit @9

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Cost curve

Total cost curve 5TCC9 sho#s that Total costs depend on the .uantity of cars B

produced per day

TCC in upper panel of Figure 46 %e can #or( out average cost 5AC9 of a car

from TCC and ho# it changes #ith B Depicted *y average cost curve 5ACC9 in lo#er

panelAC at any point is slope of line oining origin to

the relevant point

;C < %C=> < C5>8=>?---------------518

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TCC and ACC

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Economies of scale and advantagesof large-scale production

Cost ad4antages Large !rms a*le to purchase input at lo#er costs *ecause

have *argaining po#er in negotiations #ith suppliers

%echnological ad4antages

Large-scale production uses fe#er inputs per unit of output Economies of scale may result from speciali)ation or for

engineering reasons 5see end of chapter Einstein9

ncreasing returns #here dou*ling every input more thandou*les output

,iAed costs "esult in cost per unit falling as !rm produces more output For e:ample "/D mar(eting e:penses lo**ying

+emand-side economies of scale or network eBects

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Diseconomies of scale

+il#ert law of rm hierarchy

Supervising production #or(ers re.uires more thanproportional increase in the input of supervisors

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19

Number ofworkers

10 100 1000 10000

Management tiers

1 2 3 4

Workers 101 102 103 104

Directu!er"isors

0 101 102 103

Manageria##a$er 1

0 0 101 102

Manageria##a$er 2

0 0 0 101

%wner 1 1 1 1


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Falling AC

Evidence suggests that producing large-amounts creates economies of scalereduces costs and increases demand

5sieh and 'l(en 3E0 >5@9 GH


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Marginal Costs

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Marginal Costs

MC is cost of producing one more car Corresponds to slope of cost function

Fi:ed costs have no impact on marginal

cost

MCC is up#ard sloping in this e:ample

?-cars has increasing marginal costs of carproduction

t is rising MC that causes AC to increase

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Marginal Costs

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Marginal Costs

f #e (no# that cost #ill rise *yJHGGG to produce an e:tra 7 cars#hat #ill *e the MC&

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Marginal Costs

f #e (no# that cost #ill rise *yJHGGG to produce an e:tra 7 cars#hat #ill *e the MC&

MC K J


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ACC and MCC

At values of B #here

ACMC AC curve slopes do#n#ards

ACMC AC curve slopes up#ards

AC K MC AC at minimum point and t#ocurves cross

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ACC and MCC

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P(C* S*%%(! %/0(0()* P/,(%S

Firms and customers

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Conte:t

?-cars is a small !rm sellingdi;erentiated products ts cars have uni.ue features of design

and performance These features di;erentiate its products

from others in the mar(et

hat implications does thisconteAt ha4e for the demand cur4efacing D-Cars@

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Do#n#ard sloping demand curve

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Demand curve

For any product demand curve relationship sho#s ho#much consumers *uy at each possi*le priceLaw of Demand

Use simple model #here num*er of consumers on :-

a:isAssume each consumer *uys H car

Allo#s us to see the num*er of consumers #ith di;erentlevels of #illingness to pay 5%T09

Slopes do#n#ardAs price rises .uantity demanded falls

%hen availa*ility is lo# it can *e sold at a high price

Nives feasi*le sets of com*inations *et#een price and.uantity

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sopro!t curve

?-cars #ill set price to ful!ll #hicho*ective&

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sopro!t curve

0ro!t ma:imi)ation

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sopro!t curve

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sopro!t curve

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sopro!t curve

%e can use this e.uation to construct isopro!tcurves

sopro!t curves are li(e indi;erence curves Nive com*inations of price and .uantity that give same

pro!t From e.uation you can see that the shape of the

isopro!t curve depends on the shape of ACCAs more output is sold the same pro!t is earned *y

charging a lo#er price

sopro!t curves nearer to the origin correspond to lo#erlevels of pro!t

At same .uantity a higher isopro!t curve corresponds tohigher pro!ts

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sopro!t curve

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sopro!t curve

The lowest cur4e shows )ero-economic pro!t Sho#s com*ination of price-.uantity that

give )ero economic pro!t appens #here price is ust e.ual to AC at

each .uantity

%hen B is lo# it needs to charge a price to

*rea( even

%hen B


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Slope of the isopro!t curve

f at point N output increased *y Hunit #hat #ould you need to do tohold pro!ts constant&

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To understand this thin( a*out #hatthe additional pro!t #ill *e if H morecar 5B K=9 is sold at point N #here B K> and 0MC&

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To understand this thin( a*out #hat theadditional pro!t #ill *e if H more car 5BK=9 is sold at point N #here B K>

and 0MC& %ould earn 50-MC9 on the =thcar

To hold pro!t constant this additionalpro!t #ill have to *e o;set *y a fall inrevenue of 50-MC9 on the other >thcarsOou can do this *y reducing 0 K 50-MC9PB

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Features Slope do#n#ard #hen 0MC

Slope up#ard #hen 0 MC

%here isopro!t curves are hori)ontal 0K MC or MC passes through lo#estpoint on curve

,igure out why@

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Setting prices to ma:imi)e pro!ts

The *est choice of price and .uantityis one #hich ma:imi)es pro!ts The feasi*le choices must lie on or

*elo# the demand curve 0ro!t ma:imi)ing choice must satisfy

tangency condition i4e4 slopes of

demand and isopro!t curves must *ee.ual 5point E9

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0ro!t Ma:imi)ation and Tangency

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Tangency

Tangency has to *e satis!ed *ecauseoptimal com*ination *alances t#otrade-o;s

The trade-o; you are constrained tomakeor the rate at #hich the demandcurveallo#s you to 1transform2 .uantityinto price

The trade-o; you are willing to make*et#een 0 and B to ma:imi)e pro!tsdepicted *y isoproft curve

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Tangency

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P/,(% 0(0()%(/E0 + 0C

Firms and customers

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Di;erent method to !ndma:imi)ing point

This method does not use isopro!tcurves This is the method used in standard

te:t*oo(s

Uses marginal revenue and costscurves

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Calculating marginal revenue

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Calculating marginal revenue

%hen e:tra unit is sold revenuechanges for t#o reasonsAn e:tra car is sold at the ne# price

?ut as the price is lo#er there is a lossof J>G per car on the other G cars

Marginal revenue is the com*inationof these t#o changes

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Features of marginal revenue curve

Usually 5not al#ays9 a do#n#ard sloping line

%hen 0 is high B is lo# M" is high Nain from selling one more car is much greater

than the total loss on the small num*er of othercars

As #e move do#n the demand curve 0 falls So gain on e:tra car sold *ecomes smaller

?ut loss on other cars is no# very *ig

As a result M" falls and eventually *ecomesnegative

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0ro!t Ma:imi)ation

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0ro!t Ma:mi)ation

0ro!t ma:imi)ing point is #here M" KMC "emem*er 0ro!t K T" Q TC

The marginal pro!t K M" Q MC

f M" MC the !rm could increase pro!t *y

raising B or marginal pro!t is positive

M"MC marginal pro!t is negative and*etter to lo#er B

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!(S ,/0 %+*" S:P':S*S+ D!((! P/*

Firms and customers

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Nains from trade

%e analy)e the outcome of economicinteractions *et#een consumers and !rms interms of E;iciency

Fairness

The institutional conditions of interaction are Firm decides ho# many items to produce and

sets a price

The individual consumers decided #hether to *uy

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Nains from trade and surpluses

n interaction *et#een !rm and its consumerspotential gains for *oth as long as Firm is a*le to manufacture a car at a cost less than the

value of the car to a consumer

"ecall demand curve sho#s %T0 for each potentialconsumerA consumers #hose %T0 0 gains a surplus

51consumers surplus29

MC sho#s #hat it costs to ma(e each additional car f MC 0 !rm gains a surplus 51producers surplus29

The sum of the t#o surpluses e.uals total surplus "ecall this is called 1gains from trade2

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Nains from trade and surpluses

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Nains from Trade and Surpluses

n Figure 4H@ Shaded area a*ove 0R gives consumers surplus

Shaded area *elo# 0R is producers surplus

%e see from relative si)e of t#o areas that inthis mar(et !rm o*tains greater share ofsurplus

Division of gains determined *y *argaining po#er n this case !rm has more po#er *ecause only

seller hence consumers have little po#er

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Nains from Trade and Surpluses

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0areto e;iciency

s allocation of cars in this mar(et0areto E;icient&

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0areto e;iciency

o *ecause Consumers not *eing a*le to *uy a car at the

prevailing price

Even though #ould *e #illing to pay morethan it #ould cost the !rm to produce the car

This o;ers the possi*ility of adding to totalsurplus

n this case #e say that 1potential gainsfrom trade have not *een e:hausted2 at E

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0areto e;iciency

%here #ould #e get 0aretoe;iciency&

'r #here #ould total surplus *ema:imi)ed&

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0areto e;iciency and D%L

%here MC crosses demand curve o further potential gains from trade

f any more cars #ere produced they #ould costmore than any of the remaining consumers #ould

pay

Total surplus or pie to *e shared *et#een!rms and its consumers highest at F Consumer surplus also ma:imi)ed at F

Loss of potential surplus (no#n as D%L Triangular area *et#een B K@ demand curve

and MCC

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Dead#eight loss

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Dead#eight loss

So #hy is total surplus not *eingma:imi)ed&

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Dead#eight loss

?ecause producers surplus is lo#erat F than at E

Firm on a lo#er isopro!t curve at F

The reason is that in order to sellmore then !rm has to drop the price

on all previous units

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*'S%(C(%& /, +*0+

Firms and customers

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Elasticity of demand

%e (no# !rms pro!t ma:imi)ing decisiondemands on slope of demand curve "emem*er ma:imi)ation condition re.uires

e.uality of slopes of demand and isopro!t curves

That is decision depends on ho# much consumersdemand for a good #ill change if the price changes

0rice elasticity of demand measures theresponsiveness of a consumer to a price

change De!ned as percentage change in demand that

#ould occur in response to a H8 increase in price

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Elasticity of demand

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Elasticity and slope of demand


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Elasticity and slope of demandcurve

0rice elasticity of demand related to slope ofdemand curve f DD curve Iat 5.uantity changes a lot in response

to a small change in price9 elasticity is high

f DD steep 5.uantity less responsive to price orneed *ig change in price to sell additional .uantity9elasticity lo#

?ut t#o not the same

Elasticity changes as #e move along demand curve Slope does not

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E:ample

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Elasticity and the demand curve

As #e move do#n demand curvesame change in 0 and B correspondto a

igher percentage change in 0 Lo#er percentage change in B

So elasticity falls

%e say demand is Elastic if elasticity H

nelastic if elasticity H

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Elasticity and the demand curve

M" G #hen demand is highlyelastic *ecause

Firm can increase B #ithout lo#ering 0much

f demand inelastic M" H *ecause Firm cannot increase B #ithout a *ig

drop in 0

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Elasticity and !rms decision

Firm #ill never produce in theinelastic portion of demand curve

%hy&

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Elasticity and !rms decision

Firm #ill never produce in theinelastic portion of demand curve

*ecause M" H

?y decreasing B it could increase 0 *y

much more and hence raise revenueand also decrease costs

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Elasticity and pro!t margin

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f demand is very elastic !rms 5Iatcurve9 pro!t ma:imi)ing point not far*elo# 0areto e;icient .uantity

0ro!t margin is small ?ut small changes in price have *ig impact

on sales

And cut *ac(s in .uantity #ill *ring

modest gains in price So pro!t ma:imi)ing strategy to increase

.uantity

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El i i d ! i


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f demand inelastic !rms 5steep curve9 pro!tma:imi)ing point far from 0areto e;icient.uantity 0ro!t margin is large

?ut small changes in price small impact on salesAnd cut *ac(s in .uantity #ill *ring large gains in

price

Firm has po#er to raise price #ithout losing manyconsumers

So pro!t ma:imi)ing strategy to lo#er .uantity

Firms #ill e:ploit this strategy igh une:ploited gains from trade

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El i i d ! i


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%hat causes the demand curve to *eelastic&

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El ti it d !t i


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f !rms produce similar productstheir a*ility to charge a

di;erentiated price is restricted

%hy&

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El ti it d !t i


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f !rms produce similar productstheir a*ility to charge a

di;erentiated price is restricted ?ecause raising price #ould cause

consumers to s#itch to others

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Si f h ( h * !


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Si)e of the mar(up chosen *y !rm

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Si f th ( h * !


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Si)e of the mar(up chosen *y !rm

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P(C* S*%%(!" C/0P*%(%(/+ 0*% P/*

Firms and customers

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Di;erentiated goods elasticity and


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Di;erentiated goods elasticity andpro!t margin

Analysis of !rms pricing decisionsapplica*le to any case of imperfectsu*stitutes Cournot 5H>GH-9 similar analysis using *ottled

#ater e:ample "eferred to this as 1monopoly2 case

From previous section Firm producing di;erentiated good sets 0 MC

"esulting allocation 0areto ine;icient D%L

0ro!t margin 50-MC9 depends on demandelasticity

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%hy do some !rms face more elasticdemand than others&

To ans#er this .uestion #e need tothin( a*out decisions made *y

consumers

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Mar(ets #ith di;erentiated productsreIect di;erences in the preferencesof consumers

n such mar(ets consumers %T0 fora model ts characteristics

Characteristics and prices of similartypes of cars sold *y other !rms

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g ypro!t margin

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g ypro!t margin

< cars similar in main characteristic*ut #e*site compares them on 7

other features Many di;er *et#een them

Ma(ing goods imperfect su*stitues

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g ypro!t margin

%hen consumers a*le to choose *et#eenseveral .uite similar cars

Demand for each of these cars .uite elastic

More similar models are to each other moreresponsive consumer #ill *e to price di;erences

n these cases !rms #ill set lo# price and havelo# margins

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g ypro!t margin

n contrast if cars very speciali)ed 0roducer faces little competition

Demand inelastic

0rice #ell a*ove MC #ith high margins#ithout losing consumers

*arn FrentsG i.e. economic protso4er and a#o4e cost of production

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g ypro!t margin

Firm has mar(et po#er if it faces littlecompetition from other !rms Fe# !rms produce close su*stitutes from o#n

*rand

n these case elasticity of demand lo#

Firm #ill have su;icient *argaining po#erin its relationship #ith its customers to sethigh price #ithout losing customers

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0ro*lem of mar(et po#er


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0olicyma(ers concerns #ith mar(etpo#er *ecause Firms can set high prices and ma(e high

pro!ts at e:pense of consumers

0otential consumers lost *oth *ecause fe#consumers *uy

And *ecause those *uying pay high price

And overall D%L 5surplus lost to society9 0articular cause of concern is #hen fe#

!rms in mar(et and may form cartel

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0olicy to limit mar(et po#er and

prevent cartels (no#n ascompetition policy or antitrust

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atural monopoly


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atural monopoly

Competition policy not solution in all cases Domestic utilities such as #ater have high

!:ed costs of providing supply net#or(

irrespective of demand conditions ?ecause of increasing returns to scaleAverage and marginal cost falling over large

range

f single !rm can supply #hole mar(et atlo#er average cost than t#o !rms ndustry said to *e a natural monopoly

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atural monopoly


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atural monopoly

ere policyma(ers may choose toregulate !rms activities *y limiting

!rms discretion over pricesAim to reduce D%L

Alternative pu*lic o#nership

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"egulating the price of natural


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MC

AC

AR

MR

$/Q

Setting the price at Pr

giving profits as large as

possible without going outof business

Pr

PC

If the price were regulate to be Pc,

the firm would lose moneyand go out of business. an!t cover

average costs

Pm

"nregulated, the monopolistwould produce Q

mand

charge Pm.

g g pmonopoly

core micro 111 ac unit7

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