Efficiency Revisited

At the conclusion of the topic of perfect competition, the concept of efficiency was introduced. Recall that there are three definitions of efficiency:

1. Productive or technical efficiency

2. Allocative efficiency

3. Dynamic efficiency

Recall also, that the perfectly competitive model illustrates both productive and allocative efficiency --- something that is very significant for the firm and also society because it means that 1) production is occurring at its lowest possible per unit cost, and 2) the additional cost of production exactly matches the additional value placed on the goods and services consumed. In other words, society gains the most consumer and producer surplus than in any other type of market structure resulting in a model that has an appropriate name --- perfect competition!

When considering the other three market structures, we find that the conditions for productive and allocative efficiency do NOT hold, both in the short run and in the long run.

However, there is one more definition of efficiency to consider --- dynamic efficiency.

More to follow.

Oligopoly --- Mutual Interdependence

Do firms base their decision-making on the expectations of what their competitors might do? If so, then these firms are mutually interdependent, another assumption in the oligopolistic model.

Unlike all the other market structures studied up to this point (perfect competition, monopoly, etc.) there are several models of firm behavior in oligopoly in which the appropriate model *depends* on the amount of mutual interdependence.

For example, consider a line measuring "no interdependence" to "considerable interdependence" in an industry. If firms act independently of each other, then the potential models of oligopoly would be either 1) a profit-maximization model where MR = MC, or 2) a revenue-maximization model where MR = 0.

If firms make decisions completely interdependently, then the potential models would be 1) a price leadership model of tacit collusion, or 2) a cartel model of express or explicit collusion.

If the interdependence is somewhere in the middle, then the potential models would be 1) the kinked demand curve, 2) game theory, 3) contestable market theory, or 4) Nash Equilibrium (named after the main character of the movie "A Beautiful Mind" --- John Nash).

Note: Christian --- It's difficult to know right now what your professor's going to focus on, so I won't elaborate yet on any of these models. Hopefully though, he'll talk about game theory and the kinked demand curve, and leave the other models for another semester of microeconomic theory. Love you, mom

Oligopoly --- Concentration Ratio

One of the characteristics of this model is that of a "high" concentration ratio defined as the percentage market share belonging to the top 4 (top 8, top 20, or top 50) firms in the industry. For example, the CR4 measures the market share of the largest 4 firms in their respective industry, the CR8 measures the market share of the largest 8 firms, and so on .......

The term "high" CR4 is relative (as is the term "few" which measures the number of firms in the industry). In fact, whether an industry is considered "oligopolistic" or not, depends on the combination of two concepts interacting together --- the number of firms in the industry as well as the industry's concentration ratio.

Hypothetically, suppose there are 7 firms in the Chewing Gum Industry (listed in alphabetical order) where the percentage market share of each firm is as follows:

Firm A = 40%
Firm B = 5%
Firm C = 20%
Firm D = 6%
Firm E = 25%
Firm F = 2%
Firm G = 2%

Find the CR4. Find the CR8.

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As mentioned above, the interaction of the number of firms in the industry together with the industry's CR4 will determine what type of market structure an industry is part of. Consider the following data published by the U.S. Census Bureau in their Annual Survey of Manufacturers (2007 data):

Industy; number of firms; CR4

Data to follow.

[An aside: Concentration in an industry is also measured by the Herfandahl-Hirshmann Index.]

Oligopoly --- Characteristics of ...

The prefix "oli" means "few" in Greek --- that should help you remember the characteristics of the oligopolistic market structure. There are some topics that haven't appeared here yet, but only because I'm still working on them.

Characteristics of Oligopoly
1. "Few" firms
2. "High" concentration ratio
3. Similar or different products
4. Medium to high barriers to entry
5. Mutual interdependence

More to follow.

Monopolistic Competition --- Characteristics of ...

First, do not get "monopoly" confused with "monopolistic competition", as so many people do. The word "competition" implies that the model of monopolistic competition is similar to perfect competition (i.e., competition means there are many sellers); however, the term "monopolistic" also implies that it has some monopoly tendencies, as we will soon see**.

If we think of our line again, measuring "no competition" on one side with "considerable competition" on the other, then monopolistic competition would be closer to perfect competition on that line.

Characteristics of Monopolistic Competition
1. many firms
2. produces a differentiated product
3. few barriers to entry or exit
4. downward-sloping demand curve (like monopoly, but more elastic)

**Since each firm produces a slightly different product from that of their competitors, this model gets the title of "monopolistic competition".

In the real world, this model will describe the behavior of most firms in the economy. Some examples of the types of firms that would be considered monopolistically competitive are:
restaurants
pet stores
lots of retail-type stores
gas stations
banks (think small banks)
law firms
direct-selling consultants
think of mostly small businesses --- sole proprietorships, partnerships, etc.

Monopoly --- Other Models (Natural Monopoly)

A "natural" monopoly is characterized by a decreasing long run average cost curve. Simply put, this means that it will cost less per unit as production is increased, so encouraging competition is this industy is not beneficial to the firm, to consumers, or society.

Monopoly --- Short and Long-run Equilibrium

In this model, the short run = the long run. More to follow.

Monopoly --- Downward-sloping Demand Curve

Recall that in perfect competition, the demand curve in the industy is downward-sloping, but for the firm(s), the demand curve is horizontal. Do you remember why?

In any case, since the monopolist is the only firm in the industry, the firm's demand curve = the industry's demand curve and that demand curve is downward-sloping.

It's important to understand that the MR curve will lie below the demand curve and is also downward-sloping. To show the value of MR, complete the following hypothetical example:

Suppose P = $10, 9, 8, 7, 6, 5, 4
and Q = 2, 4, 6, 8, 10, 12, 14

Find TR. Find MR. Is it true that P > MR?

Monopoly --- Characteristics of ...

If you were to compare perfect competition to monopoly, say, on a line measuring "no competition" on one side to "considerable competition" on the other, then monopoly would be at one end and perfect competition would be at the other end. The two market structures are almost polar opposites.

First, let's consider some characteristics of the monopoly model.

Characteristics of Monopoly
1. one firm (one seller)
2. produces a unique product for which no close substitute exists
3. extremely high barriers to entry
4. downward-sloping demand curve (price-maker)

Charcteristic #3 (extremely high barriers) deserves a further comment. More to follow.

Efficiency

There are three types of efficiency discussed in microeconomics:

1. Productive or technical efficiency

2. Allocative efficiency

3. Dynamic efficiency

I won't define these terms as you can just look them up in your text, but remember that long-run equilibrium in the perfectly competitive model results in both productive and allocative efficiency, something that is really quite significant in microeconomics! In the next chapter, we'll get further into the "debate" as to whether dynamic efficiency is of greater important to society than the first two types.

Perfect Competition --- Long Run Equilibrium

Think of the following as a market adjustment process .......

If economic profit > 0 then firms enter the industry, supply increases, market price falls, so economic profit disappears ...

If economic profit < 0 then firms exit the industry, supply decreases, market price rises, so economic profit increases ... Therefore, only when economic profit = 0 will firms no longer enter or exit the industry and this is ultimately referred to as long-run equilibrium.

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Remember, there are two equilibrium conditions in the long-run.

1. To maximize profit, set MR = MC!
2. P = AC (i.e., TR = TC) so that economic profit = 0


One of the most significant results of the perfectly competitive model is that in the long run, price ends up equal to AC at it's minimum point. This is a very, very, very important result that occurs only in perfect competition!

What does P = minimum AC imply for the firm? for the industry?

Perfect Competition --- Short Run Equilibrium

The one and only characteristic of short run equilibrium is as follows:

To maximize profit, set MR = MC!

[Note: Since P = MR in the perfectly competitive model (due to the horizontal demand curve), then the profit-maximizing condition for perfect competition is also P = MC.]

Why?

There's a very simple mathematical explanation that I'm not willing to share in a "public" forum. Christian, I'll chat with you at home about this concept, and the accompanying graphs. Love you, mom

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Be sure you also understand that any of the three situations (below) will also be true when the firm is maximizing profit in the short run.

1. economic profit > 0
2. economic profit < 0
3. economic profit = 0
What's the significance of knowing the amount of economic profit?
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Answer: The existence of economic profit (whether it's positive, negative, or zero) has such a dynamic effect on an industry and thus, an economy. The value of economic profit signals either entry, exit, or long-run equilibrium. For a continued explanation of the market adjustment process resulting in long-run equilibrium, please see the next topic. Something to consider at this point in the course: Exactly what does economic profit = 0 mean for the firm, and the industy? Be specific in your answer. [An aside: Christian, We'll talk about the short-run "shut-down rule" at home instead of online. Love you, mom]

Perfect Competition --- Profit-Maximizing Output Level

In the previous topic, we showed that P = MR = D = $5 and is constant at every level of Q; thus, the demand curve is horizontal.

[Note: What's the shape (slope) of TR? You need to know this as well.]

Christian,
We'll put all these graphs on the scanner soon. Until then, just visualize the following in your mind. -- Love, mom

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The fundamental rule of profit-maximization is probably the most important function you'll learn this semester! It applies to all four market structures. Let's prove it's validity here.


Questions first:

1. Draw the MR curve and the TR curve on two different graphs.

2. What is the slope of TR called?

3. What is the definition of (economic) profit?

4. What is the slope of TC called?

5. Describe its shape.

6. Draw the TC curve on the same graph as the TR curve.

7. What do you notice?


More to follow.

Perfect Competition --- Horizontal Demand Curve

And why not a downward-sloping demand curve?

Consider the characteristic of price-taking behavior. This means the price of the product produced is determined in the industry, not by each individual firm. Because perfectly competitive firms have no market power whatsoever, they take price as a given --- thus, the demand curve is horizontal at the going market price.

Recall from the elasticity chapter that P x Q = TR.

Assume the following:
Q = 1, 2, 3, 4, 5, 6, 7
P = $5 (& stays contant due to the horizontal demand curve)

Find TR.
Find MR.

Answers to follow.

Perfect Competition --- Characteristics of ...

Without doubt, this is probably the most important chapter in your text! Everything you've learned so far (demand/supply, elasticity, production/cost functions, short run/long run., etc.) will come up again in this chapter.

Let's begin.

Perfect Competition is the first of four market structures studied in microeconomics. These four market structures are:

Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly

You'll need to remember a few characteristics of each market structure in terms of how many firms exist in the industries, what type of product is produced, shape of the demand curves facing the firms, etc.

Characteristics of Perfect Competition
1. many, many, many firms
2. firms produce an identical product
3. no barriers to entry and exit into the market
4. firms are price-takers (this implies a horizontal demand curve)
5. perfect information

It's true that the model of perfect competition is simply an ideal by which to compare all other market structures (i.e., imperfect competition) and most likely does not really exist in the real world; however, this model is very useful as a "benchmark" as you will soon see.

Examples of Perfect Competition
It's always useful to think of examples associated with each market structure as you study them. In fact, there's a very useful table on page 157 of your text. Although perfect competition is an "ideal" market structure that doesn't really exist, firms that come fairly close to the perfectly competitive model could be the stock market, some firms agricultural, ebay, etc.

Theory of the Firm --- Economies/Diseconomies of Scale

Absolutely one of my favorite (long run) micro topics because this concept is so relevant, not just in this course, but also in the real world!

Some terms to start off with .......

Economies of Scale = Increasing Returns to Scale
Diseconomies of Scale = Decreasing Returns to Scale

There's also Constant Returns to Scale --- a very important assumption in Economics, in general.

Something to note is that "The Law of Diminishing Marginal Returns" is a short run, not a long run concept, and doesn't apply to the topic of Economies/Diseconomies of Scale.

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Let's assume that a firm doubles its inputs. Instead of L = 1 and K = 1, let's suppose that L = 2 and K = 2. [Note that since all inputs are now "variable", this is a long run, not a short run, situation!]

When inputs (L and K) double, one of three things will potentially happen to output:

Output more than doubles (Q > 2) then AC will fall .... called Economies of Scale
Output less than doubles (Q < 2) then AC will rise ... called Diseconomies of Scale
Output exactly doubles (Q = 2) then AC is constant ... called Constant Returns to Scale

To confirm what happens to AC, first determine why TC rises when inputs double. Remember that AC = TC/Q.

Check the graph on page 107 of your text for a picture of what's explained above.

Practice Questions .......

Fill in the blanks below.

Q = 10
TC = _____
TFC = 10
TVC = _____
AC = _____
AFC = 1
AVC = 5
MC = _____
explicit cost = _____
implicit cost = 20

Answers to follow.

Theory of the Firm --- Relationship of MC and AC

All the cost functions studied in this chapter are related to each other, but there's a special significance placed on the relationship between MC and AC in microeconomics. Simply put, if:

MC > AC, then AC will fall
MC < AC, then AC will rise
MC = AC, then AC will remain constant

Christian --- I'll let you in on an easy way to remember this concept when I see you. -- mom

Theory of the Firm --- Short Run and Long Run

Short Run (definition) --- A period of time "short enough" where at least one input is fixed.

Long Run (definition) --- A period of time "long enough" where all inputs are variable.

Theory of the Firm --- Cost Functions

Start working on the different types of cost and how they're related to each other.

TC
TFC
TVC
AC
AFC
AVC
MC
explicit cost
implicit cost
sunk cost
economic cost
accounting cost
etc.

More to follow.

Theory of the Firm --- Production Functions

Now things start to get really fun!

This chapter analyzes production functions and cost functions from both short and long run perspectives. The concepts in the beginning of chapter 7 mirror what was covered in the previous chapter with respect to TU, MU (i.e., slope), optimal purchase rules, the Law of Diminishing Marginal Utility, consumer surplus, etc.. The difference is that *now* we are studying SUPPLY instead of DEMAND.

Consider a simple, short run model:

"Simple" because there are only two inputs (capital and labor) where capital is a fixed input and labor is a variable input. (Be sure you understand exactly what the term "capital" means in economics because it's different than what it means in finance.) The short run is assumed since at least one of your inputs is fixed.

A production function simply means that output = f(inputs), or output = f(labor, capital).

Much more to follow!

Consumer Demand Theory --- Consumer Surplus

Consumer surplus measures the difference between:

MU --- what a consumer values a good or service to be, and what they would be willing to spend to obtain that good or service
P --- the actual price of that good or service

Looked at on a graph, consumer surplus is the area below the demand curve and above the market price.

Consumer Demand Theory --- Utility Maximization

To make things a little more realistic, suppose there are two goods, and a budget constraint as given by the following numbers ......

Energy Drinks
Q = 1, 2, 3, 4, 5, 6, 7
TU = $12, 22, 30, 36, 40, 42, 42
Find MU.

Bubble Gum
Q = 1, 2, 3, 4, 5, 6, 7
MU = $6, 5, 4, 3, 2, 1, 0
Find TU.

Suppose your income = $11 and you intend to spend it all, the price of Energy Drinks = $2 and the price of Bubble Gum Packs = $0.50

To maximize your utility, how many Energy Drinks and Bubble Gum Packs will you purchase? (Hint: It's helpful to find the MU/P for each good first.)

Follow the approach in the text to answer this question. There may be more than one way to arrive at the correct answer.

More to follow.

Consumer Demand Theory --- Optimal Purchase

Utility represents how much you are willing to pay.
Price represents how much you must pay.

Using the same numbers for TU and MU, suppose the price of Vitamin Water equals $1.49 each. How many will you purchase?

Answer: Two

Consumer Demand Theory --- TU & MU

TU = Total Utility
MU = Marginal Utility

Suppose the following numbers represent how much happiness or TU (stated by how much money you are willing to trade) you derive from increasing quantities of Vitamin Water (consumed at one time):

Vitamin Water
Q = 1, 2, 3, 4
TU = $2.00, 3.50, 4.50, 4.50

Find MU.

Answer: MU = $2.00, 1.50, 1.00, 0.00

Consumer Demand Theory --- Utility

This topic (Consumer Demand Theory) represents the start of microeconomics.

Remember the assumption that ---- "consumers act to maximize utility subject to their budget constraints". Consumer choices about what to consume are really just cost/benefit decisions!

utility (benefit)
budget constraint (cost)

In your text, the author talks about trying to verbalize how much a restaurant meal was enjoyed (see page 83). He points out that it doesn't make sense to say the meal "deserves a rating of 86 on the Consumer Satisfaction Index".

But you *can* describe and measure how much you appreciate and value something by stating how much money you'd be willing to trade for it ......

How much money would you be willing to part with for:
1. a new Subaru?
2. a flight to New York?
3. lunch at the Teatro?
4. a great pair of new boots?

This is utility --- a subjective measure of how much happiness something represents to you stated in money terms!

Price Elasticity

This concept isn't difficult, but can be extremely confusing the first time you study it. It's so surprisingly straight-forward that I don't want to give away the details about how best to approach this topic in a "public" forum. I'll email you with some tips and examples!
Love you, mom

Price Ceilings and Floors

Price floors and ceilings (i.e., government intervention in the free market!) can be set above, below, or at equilibrium, but to have any affect, price ceilings must be set at a price below equilibrium, and price floors must be set at a price above equilibrium.

Would you like to see some sample questions related to floors and ceilings?

Demand & Supply Answers

1. a decrease in supply; P* rises, Q* falls

2. an increase in demand; P* rises, Q* rises

3. a decrease in supply; P* rises, Q* falls

4. an increase in demand; P* rises, Q* rises

5. an increase in supply; P* falls, Q* rises

6. a decrease in demand; P* falls, Q* falls

Demand & Supply

A few things to remember with respect to demand & supply .....

Be sure you understand the difference between a "change in quantity demanded (supplied)" and a "change in demand (supply)". They are two very different concepts!

Know the factors that will shift the demand or supply curve --- memorize them if you have to.

Be able to determine the equilibrium values of price and quantity.

If the demand or supply curves shift, be able to determine the new equilibrium value of price and quantity.

Answer the following questions that relate to the (nonorganic) cotton market. Draw a graph for each question and show the change in either demand or supply given the scenarios below. Also, determine the change in the equilibrium price and quantity. Show this on your graphs as well.

1. Suppose workers in the cotton market receive a substantial wage increase.
2. People prefer more natural fibers such as cotton rather than synthetics.
3. The cotton crop is damaged by severe weather.
4. The price of wool, a good substitute for cotton, rises.
5. Because of pesticides, the growth of the (nonorganic) cotton crop increases dramatically.
6. There's a huge shift in production and consumption toward organic cotton clothing.

Draw nice, neat graphs. Answers to follow!

Answers to PPF questions

2. 1 unit of butter

3. 2 units of butter

4. because resources are not perfectly substitutable

5. an increase in resources or technology

Production Possibilities Frontier

Given the following options to produce two goods (guns and butter) using a fixed amount of resources and technology, and assuming full-employment:

Option A --- 0 guns, 10 butter
Option B --- 1 gun, 9 butter
Option C --- 2 guns, 7 butter
Option D --- 3 guns, 4 butter
Option E --- 4 guns, 0 butter

1. Draw the PPF.
2. State the opportunity cost of the first gun produced, in terms of butter sacrificed.
3. State the opportunity cost of the second gun produced, in terms of butter sacrificed.
4. Why is the opportunity cost of gun #2 higher than the opportunity cost of gun #1? Yes, the opportunity cost tends to increase, but why?
5. What would have to happen for the economy above to be able to produce Option F --- 4 guns and 10 butter? Be specific.

Opportunity Cost

Think of opportunity cost as the value of the next best alternative action that's been sacrificed. The cost of doing something is calculated in terms of what you can no longer accomplish, not in terms of how much money you spend! Opportunity cost (or as it's sometimes called in economics --- the true cost, or the economic cost) and money cost are two completely different concepts.

Therefore ....
If you can spend the next hour studying for an exam (Option A) or working for an hourly wage of $10 (Option B), the opportunity cost of studying for an hour equals $10, because you forego the chance to earn $10 in the same hour. This is really why it makes sense to go to school when you're young (when your earning potential is low) and not when you're older and sacrificing big bucks!


See if you can answer this question correctly:

Suppose you have $20 to spend and assume you intend to spend the entire amount. You can spend the $20 on movie tickets that cost $10 each, or you can spend the $20 on paperback books that cost $5 each, or some combination of both. What is the opportunity cost of going to see a movie?
a. the sacrifice of a second movie
b. the sacrifice of a 1st and 2nd book
c. the sacrifice of a 3rd and 4th book
d. the sacrifice of two movies
e. the sacrifice of four books

Correct answer given later!