OUTLINE -- CHAPTER 9
Producer Decisions: Benefits (Pure Competition)
[Class Handout: Three Rules and Four Models (.doc) (.htm)]

I. Benefit-Cost Analysis and Producer Decisions

A. Decision: How Many to Produce:
B. Goal: Maximize Profits
C. Benefit Cost Analysis:

all where: MB > MC
up to where: MB=MC
but never where: MB<MC

II. The Product Market

A. Circular Flow Model
B. Four Product Market Models

1. Competitive Market (Ch. 9)

2. Monopoly (Ch. 10)

3. Monopolistic Competition (Ch. 11)

4. Oligopoly (Ch. 11)

C. General Outline for Each Model

1. Characteristics and Examples
2. Nature of the Demand Curve
3. Short Run Equilibrium (Profit Max.)
4. Long Run Equilibrium and Efficiency
5. Other Issues

III. Pure Competition.

A. Definition

A market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no nonprice competition; a market characterized by a very large number of buyers and sellers. 

B. Characteristics of Competitive Markets

1. NUMBER OF FIRMS: very large numbers

2. TYPE OF PRODUCT: standardized product

3. CONTROL OVER PRICE: "price takers"

A seller (or buyer) of a product or resource who is unable to affect the price at which a product or resource sells by changing the amount it sells (or buys).

4. EASE OF ENTRY: free entry

5. NONPRICE COMPETITION: none

C. Examples / Relevance

1. applying benefit cost analysis
2. competitive markets used as the "standard" of efficiency
3. agriculture

D. Demand and Competitive Markets

1. demand faced by the firm is perfectly elastic
2. market demand is downsloping

IV. Short Run Profit Maximization: Benefit-Cost Analysis Approach

A. Benefit-Cost Analysis

1. definition

the selection of ALL possible alternatives where the marginal benefits are greater than the marginal cost

select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

2. marginal costs = MC (ch. 8)
3. What are the MBs of selling one more unit of output?

marginal benefits =marginal revenue (MR)

a) total revenue (TR = P x Q)
b) MR = TR / Q

B. Profit Maximization -- Applying Benefit-Cost Analysis

1. step 1: find best quantity (where MR = MC)
2. step 2: are AR > AVC? If yes, then produce this quantity
3. calculate profits

a) profits = TR - TC
b) check to see if profits are maximized

C. Three Cases -- using BOTH cost schedules and graphs

1. profit maximizing case

a) step 1: find quantity where MR = MC

b) step 2: are AR > AVC? If yes, then produce this quantity

c) calculate profits

d) textbook graph, graph

 

2. loss minimizing case

a) step : find quantity where MR = MC
b) step 2: are AR > AVC? If yes, then produce this quantity
c) calculate profits
d) check to see if losses are minimized
e) why not close down?
f) graph

3. shutdown case

a) step 1: find quantity where MR = MC
b) step 2: are AR > AVC? If yes, then produce this quantity
c) calculate profits/check
d) graph

4. Quick Review Quiz / Quick Review Quiz

 

D. Marginal Cost and the Short Run Supply Curve

• A supply curve which shows the quantity of a product a firm in a purely competitive industry will offer to sell at various prices in the short run;
• the portion of the firm’s short-run marginal cost curve which lies above its average variable cost curve.

  graph

  

V. Profit Maximization: total cost minus total revenue approach

A. Short Run
B. Graphs

VI. Profit Maximization in the Long Run

A. Assumptions

B. LR Equilibrium: competitive markets

1. "After all long-run adjustments are completed, product price will be exactly equal to, and production will occur at, each firm's point of minimum average total cost"
2. zero profit (normal profit) model

C. Why?

1. entry of firms eliminates profits (graph)

 

 

From the Textbook:

IF DEMAND INCREASES, PRICE WILL INCREASE NEW FIRMS WILL ENTER AND PRICE WILL FALL BACK TO WHERE IT WAS	PROFITS WILL RETURN TO NORMAL (ZERO)

2. exodus of firms eliminates losses (graph)

 

From the Textbook:

IF DEMAND DECREASES, PRICE WILL DECREASE FIRMS WILL GO OUT OF BUSINESS AND PRICE WILL RISE BACK TO WHERE IT WAS	PROFITS WILL RETURN TO NORMAL (ZERO)

D. Pure competition: Long-run equilibrium graph

F. Long Run Supply Curve

A schedule or curve showing the prices at which a purely competitive industry will make various quantities of the product available in the long run.

1. constant cost industry

An industry in which expansion or contraction will not affect resource prices and therefore production costs

Graphically, it means the entry or exit of firms does not shift the long-run ATC curves of individual firms

Occurs when the industry's demand for resources is small in relation to the total demand for those resources

 

2. increasing cost industry

An industry in which expansion through the entry of new firms increases the prices firms in the industry must pay for resources and therefore increases their production costs.

 

3. decreasing cost industry

An industry in which expansion through the entry of firms decreases the prices firms in the industry must pay for resources and therefore decreases their production costs.

VII. Pure Competition and Efficiency !!!!!!!!!!!!!!!!

A. Competitive Markets Used as Standard of Efficiency
B. Productive Efficiency

1. definition

The production of a good in the least costly way or producing at a minimum cost

2. P = minimum ATC (MC=ATC)

productive efficiency occurs when production takes place at the output at which average total cost is a minimum

3. Pure competition: Long-run equilibrium graph

C. Allocative Efficiency

1. definition

The apportionment of resources among firms and industries to obtain the production of the products most wanted by society (consumers);

2. MSB = MSC

( To review MSB, MSC and Efficiency see supply, demand, and economic efficiency from chapter 3 )

3. The allocatively efficient quantity: P = MC

Allocative efficiency is achieved at the output of each product at which its marginal cost and price or marginal benefit are equal (P = MC).

a. MSB = P
b. MSC = MC
c. Therefore: MSB = MSC where P = MC

4. Pure competition: Long-run equilibrium graph

5. allocative inefficiency

a. underallocation of resources: P > MC

b. overallocation of resources: P < MC

5. marginal cost pricing

To achieve allocative efficiency: MSB should equal MSC

If P measures MSB and MC measure MSC then to achieve allocative efficiency:
P should equal MC

EXAMPLES:

a. all you can eat / free refills

• what are the MSC to society (MC to the firm) of having one more?
• what is the price (P) to the consumer of having one more?
• does P=MC (or MSB=MSC) ?
• if not, is P>MC or is P< MC ?
• is allocative efficiency achieved? - or is there an OVER- or UNDER-allocation of resources?

b. electricity rates

• summer vs. winter
  • when is the MC higher?
  • therefore, to achieve allocative efficiency, when should the price be higher?
  • if the price is not higher what might happen?

   

• days vs. evening (making snow only at night - why?)
  • Why do they only make snow at night?
  • when is the MC lower?
  • therefore, to achieve allocative efficiency, when should the price be lower?

c. plane fares

• what is the MC of adding one more traveler to a plane that is half full?
• what is the MC of adding one more traveler to a plane is is full?

 

• Why do they charge less for "standby"?
• Is this efficient?

d. rent with utilities included

• what are the MSC to society (MC to the firm) of turning the heat up in the winter?
• what is the price (P) to the consumer of turning the heat up in the winter?
• does P=MC (or MSB=MSC) ?
• if not, is P>MC or is P< MC ?
• is allocative efficiency achieved or is there an OVER- or UNDER-allocation of resources?

e. bus fares

• when is the cost (MC) to the bus company, or the cost to society (MSC), greater?
  • at rush hour ?
  • or at noon hour ?
• when should the price be higher to achieve allocative efficiency?

f. parking meters

• when is the cost to society (MSC) of allowing one more person to park greater?
  • week days when there are few or no available parking spaces?
  • weekends when there are many available parking spaces?
• when should the price be higher to achieve allocative efficiency?
• what should the price be on weekends to be allocatively efficient assuming that there are very many empty parking spaces available?

g. garbage collection and recycling

h. tollway fares

• when is the cost to society (MSC) of allowing one more car on the tollway greater?
  • rush hour when there is a lot of traffic?
  • noon hour when there is very little traffic?
• when should the price be higher to achieve allocative efficiency?
• how does this save resources?

i. external costs anad external benefits (spillover costs and benefits) (see chapters 4 and 16)

j. other

D. Dynamic Adjustments / dynamic efficiency

 VIII. Qualifications (Shortcomings) of the Competitive Price System

A. Income Distribution Problems (Equity)
B. Market Failures: Spillovers and Public Goods
C. Productive Techniques

1. natural monopolies
2. technological progress (Dynamic Efficiency)

a. incentive
b. means

D. Range of Consumer Choice