ECON 6021 Nov 2004 Price Taking Price Setting

ECON 6021 (Nov 2004) Price Taking, Price Setting, and Competitive Market

This lecture will introduce: n n Profit maximization Price Taking Firm – Supply curve – Application: multi-plant firm n Price Setting Firm – Price-cost margin – Price discrimination n Competitive Market – Efficiency of Competitive Market

Marginal Analysis n Firm’s objective – to maximize profit π=TR-TC n If MR > MC, the extra revenue from selling one more unit exceeds the extra cost. n If MR < MC, the extra revenue from selling one more unit is less than the extra cost. n If MR = MC economic profit is maximized.

Profit Maximization n π is maximized if – MR = MC and MR cuts MC from above – So long as it is worthwhile producing n This holds for whatever market structure such as – Perfect competition (price taking firm) – Monopoly (price setting firm)

Total revenue & total cost (dollars per day) Price Taking Firm TR 300 225 Economic profit = TR - TC 183 100 Economic loss 0 4 9 12 Quantity (sweaters per day)

Marginal revenue & marginal cost (dollars per day) Profit-Maximizing Output for a Price Taking Firm 30 25 Profitmaximization point MC D=AR=MR 20 10 8 9 10 Quantity (sweaters per day)

Total revenue & total cost (dollars per day) Total Revenue, Total Cost, and Economic Profit for a Price Setting Firm 300 225 183 100 0 4 9 12 Quantity (sweaters per day)

Price and cost (dollars per hour) A Price Setting Firm’s Profit Maximizing Output MC 20 14 10 D MR 0 1 2 3 4 5 Quantity (haircuts per hour)

Price Taking Firm

Characteristics of Perfect Competition – Many firms, each selling an identical product – Many buyers – No restrictions on entry into the industry – Firms in the industry have no advantage over potential new entrants – Firms and buyers are well informed about prices of the products of each firm in the industry n As a result of these characteristics, perfect competitors are price takers. n Price takers -- firms that cannot influence the market price

Marginal revenue & marginal cost (dollars per day) A Firm’s Supply Curve MC curve = Supply curve 31 MR 2 25 MR 1 AVC s 17 MR 0 7 9 10 Quantity (sweaters per day)

Marginal revenue & marginal cost (dollars per day) A Firm’s Supply Curve S 31 25 s 17 7 9 10 Quantity (sweaters per day)

Application: Multi-plant firm n n Suppose a perfectly competitive firm has two plants producing identical goods with marginal cost functions MC 1(Q 1) and MC 2(Q 2). It is straightforward to show that it show produce Q 1 and Q 2 in the two plant so that MC 1(Q 1) = MC 2(Q 2) = P where P is market price.

Price Setting Firm

Price Setting Firm and How Monopoly Arises n n The simplest form of price setting firm is monopoly A monopoly is an industry that produces a good or service – for which no close substitute exists and – in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Barriers to Entry n Key input owned by a firm – De. Beers, a South African firm that controls more than 80 percent of the world’s supply of natural diamonds. n But most monopolies arise from two other types of barrier: legal barriers and natural barriers

Barriers to Entry n Legal Barriers to Entry – In a legal monopoly competition and entry is restricted by the granting of a public franchise, government license, patent, or copyright. – E. g. Microsoft is the only firm that is allowed to produce Window 98, etc. HK Town gas. China light n Natural Barriers to Entry – A natural monopoly results from a situation in which one firm can supply the entire market at a lower price than two or more firms can. – Example: Electric utility – A market used to be thought as a natural monopoly may turn out to be no longer the case as technology progresses

Price (cents per kilowatt-hour) Natural Monopoly 15 10 5 ATC D 0 1 2 3 4 Quantity (millions of kilowatt-hours)

Monopoly Price. Setting Strategies n n Price discrimination is the practice of selling different units of a good or service for different prices. A single-price monopoly is a firm that must sell each unit of its output for the same price.

Single-Price Monopoly n n n The firm’s demand curve is the market demand curve. Marginal revenue is not the same as the market price. There is no supply curve for a monopoly.

Price and Output Decision n n The competitive firm is a price taker, whereas the monopoly influences its price. For the monopoly, price exceeds marginal revenue, thus price exceeds marginal cost. Profit is maximized where MC = MR Monopolists can earn economic profits--firms cannot enter due to barriers to entry.

Price and cost (dollars per hour) A Monopoly’s Output and Price MC 20 Profit = $12 ($4 x 3 units) 14 10 ATC Economic profit $12 D MR 0 1 2 3 4 5 Quantity (haircuts per hour)

An example: Linear Demand Q = 100 – 2 P; AC=MC=10 n n n Inverse demand: P = 50 – Q/2 TR = P*Q = (50 – Q/2) Q = 50 Q – Q 2/2 MR = 50 – Q – Remark: if P = A – BQ, then MR = A – 2 BQ n n MR = MC → 50 – Q = 10 → Q = 40 Substituting Q = 40 into inverse demand, P = 50 – 40/2 = 30

Optimal output, profit margin, and profit P AR = P(Q) =50 – Q 2/2 30 Profit = profit margin X Q* = (P* - AC) Q* MC = AC 10 MR = 50 – Q 2 40 Q

Price-cost Margin and Elasticity

Price-cost market and n n n Equating MC with MR, we have The more elastic the demand, the smaller the price-cost margin Price-cost margin, a. k. a. price-cost markup, or Lerner Index of market power (1934).

Competition and Efficiency n Efficiency is achieved when all the gains from trade have been realized (social welfare is maximized).

Price Monopoly and Competition Compared PA Single-price monopoly restricts output, raises price MC PM Equilibrium in competitive industry PC MR 0 QM QC D Quantity

Price Inefficiency of Monopoly PA Consumer surplus Monopoly MC PM Deadweight loss PC Monopoly’s gain MR 0 QM QC D Quantity

Gains from Monopoly n Economies of Scale and Scope – Lowers average total cost and a greater range of goods produced n Incentives to Innovate – The attempt to apply new knowledge in the production process and obtain a patent

Price Discrimination n Arcadia Publisher is planning to publish a book. – loyalty to the author is fixed at $2 M – production cost=$0 per copy – two groups of buyers • 100 K group 1 readers--each willing to pay up to $30 • 400 K group 2 readers--each willing to pay up to $5 n n n If p= $30, only group 1 readers will buy the book. Arcadia obtains $30 x 100 K =$3 M (gross of loyalty) If p= $5, both groups of readers will buy the book. Arcadia obtains $5 x 500 K=$2. 5 M (gross of loyalty) Hence, charging $30 is better.

Price Discrimination n n Now suppose Arcadia knows that all group 1 readers are in HK and group 2 readers are in Chile. Then it can charges a fee of $30 for a book sold in HK and $5 for a book sold in Chile. Price discrimination leads to – greater profits – greater social welfare!!

Determination of differentiated prices under constant marginal cost

More generally, the problem is n Optimal output for the two markets are given by n. Equalization of marginal cost and marginal revenue in each segment

Evidence of Geographic Price Discrimination n Parallel imports--unauthorized flows of genuine products across countries that compete with authorized distribution channels (ranging from deluxe cars to cheap beer) n It is often thought that parallel imports of HK made movie and music products back into HK market adversely affects the very survival of HK movie and music industry.

Price Discrimination: How to separate different customers n n n Coupons--those people who have lower time cost will collect and use coupons to get a discount; they are likely to have lower maximum willingness to pay as well (Sincere VIP card works similarly) In 1999, CTI charged different fees for its registered IDD users--37 cents/min to US for smart users who made a double registration; $2. 9 /min for not-so-smart users who did not (c. w. HKTC’s 001 and 0060). Educational edition--software companies charge a substantial lower price to teachers and students for their software

Price Discrimination: How to separate different customers n n Hardcover vs paperback--readers of lower maximum willingness to pay are more patient; hence publishing a paperback later attract these buyers without affecting sale to hardcover buyers (compared w. seasonal sales in department stores)--production differentiation in general Different prices for different geographic locations – golf clubs are much more expensive in HK than in the US (HK$4. 5 K vs US$250) – tennis ball--HK’s price is two or three times that in the US

Competitive Markets

Market Equilibrium is defined as the price at which the quantity demanded equals the quantity supplied (so markets clear) n – n n n While all five conditions for perfect competition are (obviously) never fully satisfied, the model is still useful as frame of reference. When a market is out of equilibrium, market forces push the price towards equilibrium Excess supply (a. k. a. , surplus) -- This triggers a price decrease Excess demand (a. k. a. , shortage) --This triggers a price increase

Price ($ per ton-mile) Market Equilibrium (cont. ) a surplus when market price = 22 22 b 20 equilibrium c 0 supply demand 8 10 11 Quantity (Million ton-miles a year)

Invisible Hand n n n Social welfare (SW) = net gains from production and trade In the absence of tax, SW = buyer surplus + seller surplus In the presence of tax, SW = buyer surplus + seller surplus + tax revenue An outcome is efficient if the SW cannot be further increased. [taxation cannot increase SW, to be shown shortly] Perfect competition is efficient, in which – marginal benefit = price – marginal cost = price – single price in market

Price Ceiling Upper limit that sellers can lawfully charge and buyers can lawfully pay n rent control n regulated price for electricity

Price Floor Lower limit that sellers can charge and buyers can pay n minimum wage n agricultural price supports

Minimum Wage: Equilibrium Wage ($ per hour) Net inc. in seller surplus = fdge -ghb Net inc. in buyer surplus = - (fdge +egb) Net inc. in SW = - (ghb + egb) a 4. 20 4. 00 f d excess supply e g b equilibrium h c 0 supply demand 8 10 11 Quantity (Billion worker-hours a week)

Minimum Wage: Losses n n deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur price elasticities of demand supply

Can tax improve SW? Price ($ per ticket) Net Net 804 f 800 d 794 j 0 inc. in in $10 e g supply b h 900 buyer surplus = -(fdge + egb) seller surplus = -(djhg + ghb) tax revenue = fdge + djhg SW = -(egh + ghb) demand 920 Quantity (Thousand tickets a year)

Tax: Does it matter whom the tax is imposed upon: sellers or buyers? n If an excise tax of $10 is levied on sellers, the sellers will be willing to supply the same quantity as before only when the price is increased by $10. [upper shifting of supply, demand unmoved] n If an excise tax of $10 is levied directly on buyers, the buyers will buy the same quantity as before only when the price charged by sellers is reduced by $10. [downward shifting of demand, supply unmoved. ] n The outcomes under the two scenarios are the same