Introduction to Economics

Egor Sidorov

1. Revenue and profit

2. Perfect competition

3. Imperfect competition

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Rational producer

─ Producer aims at achieving an efficient level of production with given inputs (and sales) in order to maximize his profit.

─ Further examples of firms’ objectives: ─ Market share─ Survive in the long run─ Good reputation for management─ Stakeholder interests

─ However, profit is an important factor of firm’s competitiveness

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Revenue

─ Total revenue (TR) – income that a company receives from the sale of goods and services.

─ Average revenue (AR) – income per unit of product.─ Marginal revenue (MR) – is the extra income

generated by selling one more unit of production.

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AR = TR / Q MR = TR / Q

TR = P*Q

Profit

─ Profit is the difference between revenue and the costs of bringing products to market:

─ Accounting profit = TR – explicit costs─ Economic profit = accounting profit – implicit costs─ If the economic profit is equal to zero, the firm is still

getting the so-called “normal profit” which is the minimum required by entrepreneur to stay in business and not to think of changing the job.

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Z = TR - TC

1. Revenue and profit

2. Perfect competition

3. Imperfect competition

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Ideal market model: 5 traits of perfect competition (1)

─ Numerous small producers and consumers: none of them is capable of influencing the price.─ If any of them increases the price, consumers

will easily switch to the substitute.

─ Homogenic product: product parameters are alike.

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=The agriculture market is very close to perfect competition. However, it is not totally the same…

Ideal market model: 5 traits of perfect competition (2)

─ No entrance or exit barriers: neither producers nor consumers have problems with entering or leaving the market. If the firm stops generating profit, the entrepreneur would easily leave.

─ Independent market agents: neither firms nor customers can agree on common behavior strategy and therefore influence the price.

─ Perfect information: firms and consumers have a perfect overview of prices and other market conditions and therefore act rationally.

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Ideal market model: perfect competition

─ In perfect competition conditions the invisible hand of market does work; source allocation is efficient and the economy is on its production possibility frontier.

─ Price is independent from the firm’s actions: the firm is capable of selling all its stock without influencing the price; demand is perfectly elastic.

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Perfect competition: Price takers

─ Market supply and demand determine the price; single firms are too small to influence prices.

─ The demand curve of the firm is perfectly elastic.

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Q

P

Q

P The firms are price takers

Industry Single firm

D

D

S

P = AR = MR

In perfect competition the price, average revenue and marginal revenue are constant.

Perfect competition: profit maximizing─ Since the price is exogenous,

producers should determine the optimal production volume based on interaction between costs and price.

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21 3 54 6 Q

P, AC, MCACMC

P

TR = P*Q

TC = AC*Q

Z = TR - TC

Rule: In perfect competition the firm would maximize its profit by producing such quantity when MC are equal to price.

Max Z: MC = MR=P

Perfect competition: Relative and absolute loss

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21 3 54 6 Q

P, C

ACMC

P

21 3 54 6 Q

P, C

ACMC

P

Relative loss

Absolute loss

Perfect competition: when should the firm stop its activities in the short run?

13

21 3 54 6 Q

P, C

ACMC

P1

AVCP2

P3

A

B

C

A: At P1 the firm maximizes its profit

C: If the price is P3 the firm stops its activities, since this is how it minimizes the loss, i.e. looses only FC. If it continued production it would lose as FC as well as part of uncovered VC.

B: At P2 the profit is zero (break-even point – point where costs are equal to revenue)

(A ;B): Profit declines

(B ;C): Loss goes up. The firm, however, continues production, since this is how it minimizes its loss by covering the whole sum of VC and a part of FC. If it stopped its activities, the loss would equal to FC.

Supply curve of the firm

─ Marginal cost curve (MC) is therefore a supply curve of the firm (D) (in the part form point C and higher).

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21 3 54 6 Q

P, C

MC=S

P1

P2

P3

A

B

C

Long run view:

─ High prices mean high profits and attract additional firms. The increased competition motivates price reductions and pushes profits to zero level.

─ In the long run the firm would stop its activity at the average costs’ level (in contrast to VC as it was in the short run). If the price goes below P2 level, part of firms would leave the market which would lead to price growth and back to equilibrium level E.

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21 3 54 6 Q

P, C

MC=S

P2 EAC

P1

Supply of the firm vs. market supply

─ Market supply is the sum of individual supply curves

21

25

3 54

2015

10

5

6

30

Q

P (thous. CZK)

S1

P Škoda BMW Market

10 1 2 1+2=3

20 2 4 2+4=6S2S

1. Revenue and profit

2. Perfect competition

3. Imperfect competition

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Imperfect competition:

─ Imperfect competition exists there, where sellers have certain control over the price of their output (market power).─ This, however, doesn’t necessarily mean that the control

is absolute: its extent depends on the type of imperfect competition.

─ Main types of imperfect competition:─ monopoly, ─ oligopoly, and─ monopolistic competition.

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Monopoly:opposing perfect competition

─ It is an extreme case: one seller with the total control over industry branch.

─ Pure monopolies are rare today, before all, due to antimonopoly laws. Reasons for their existence:─ Legal barriers (patents, licences - Microsoft),

protectionist policy, high entrance barriers (ČEZ), geographic location.

─ Natural monopoly─ Is the case when the only one big firm with the

lowest AC is capable of satisfying market demand instead of many smaller firms. Exists in branches with wide returns to scale possibilities.

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Environment stimulating natural monopoly and oligopoly occurrence

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21 3 …4 1000

AC

MCD

100 200 300

AC

MCD=MR

100 200 300

AC

MC

D=MR

Perfect competition Oligopoly Natural monopoly

The branch would rather consist of smaller number of firms if significant returns to scale exist and costs are diminishing. Under these circumstances large firms can produce and sell cheaper than their smaller competitors.

Market demand Market demand Market demand

Oligopoly

─ Several (2, 5 or even 15) firms on the market given each can influence the market price. ─ Some economists assume that oligopoly is the situation

when 4 biggest firms have over 40 percent market share.

─ Returns to scale are lower than monopoly has.─ Firms compete with each other:

─ Price wars: if one reduces the price, others have to react.

─ Threat of cartel agreements.

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Monopolistic competetion

─ A lot of firms satisfying demand together .─ Each of them has a small market share.─ Product is differentiated, each producer tends to

create and hold its own segment.─ Importance of non-price competition: ads,

marketing, customer services, etc.

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…

Imperfect competition:Common traits (1)

─ Differentiated product:─ One product differs from competitive ones.

─ Significant market shares of firms: ─ The firm can influence price and quantity supplied.

─ Entrance and exit barriers: ─ Legal restrictions─ Customer loyalty─ Ads – not all products can be sold─ Existing returns to scale and diminishing costs

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Imperfect competition:Common traits(2)

─ Unfair competition: firms can agree on the common strategy – cartel agreements

─ Insufficient information─ Neither firms, nor consumers have the complete

overview of prices and market conditions; uncertainty exists.

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Imperfect competition:profit maximizing─ Producers can influence price: e.g. by limiting

production they increase the price. The price change therefore influences the revenues depending on elasticity.

─ The firm is maximizing its profit by producing the amount of goods that corresponds to equality of marginal revenue and marginal costs.

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Max Z: MC = MR !!! MC = MR < P

TR = P*Q

Revenues in imperfect competition

26

2 4

4

2

6

6

Q

P (CZK)

E<1

P Q TR AR

6 0

5 1

4 2

3 3

2 4

1 5

0 6

E>1

E=1

5

0

8

5

3

8

9

5

1

-1

-3

0-5

2 4

6

3

6

9

Q

TR (CZK)

E<1E>1

E=1

Total revenue

Demand

-

5

4

3

2

1-

2

4

2

6

6

Q

AR, MR

AR=D

MR

MR

MR curve is different from AR.

E>1

E<1

TR curve is non-linear

D

TR

Optimal production volume of a monopolist

─ Firms in imperfect competition get monopolist profits; it may last much longer than in perfect competition conditions due to entrance barriers.

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21 3 54 6 Q

P, CMCD=AR

E

MRAC

Profit

TR = P*Q TC = AC*Q

Z = TR - TC

Rule: In order to maximize profits the monopolist sets production on the level where MC=MR. This output level is lower compared to what could have been under perfect competition conditions.

Max Z: MC = MRP

???

Production volume optimization differences between perfect and imperfect competition

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21 3 54 6 Q

P, CMCD=AR

E

MRAC

ProfitP

21 3 54 6 Q

P, CMC

D=AR =MR=P E

AC

P==

Market power─ is the ability of a firm to alter the market price of a

good or service. A firm with market power can raise prices without losing all customers switching to competitors. Measuring market power:─ Concentration ratio – percentage of sales,

by 2, 4, 8 biggest firms.─ Herfindahl index – sum of squares of firms’ market shares

in percents (TRi). A better reflection of real concentration.─ HI = 10 000 monopoly,─ HI = 0 perfect competition.

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HI = Σ(TRi/TR) 2

Car sales in CZ 2008 143 600 pcs 100 %

of which Škoda 44 500 pcs 31 % HI = 312=961

Perfect and imperfect competition differences

─ Perfect competition is an ideal model. Imperfect competition is the economic reality.

─ Given the technology level, the output of imperfect competition is lower compared to perfect competition case.

─ Under imperfect competition conditions firms enjoy returns to scale and are highly motivated to generate innovations, not underestimating the role of individuals and small firms of course.

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Conclusion

Type No of firms

Product Market power Entrance barriers

Perfect competition

Monopolistic competition

Oligopoly

Monopoly

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homogenous

differentiated

differentiated

Homogenous without close substitutes

none

limited

medium

high

low

low

high

very high

many

many

few

one

Thank you for attention!

Refernces:SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha: Svoboda, 2005.

KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management. Ústí n. L.: UJEP, 2003.

MCDOUGAL LITTELL. Economics: Concept and Choices. Canada: McDougal Littell, 2008.

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