Economics: Own-Price Elasticity of Demand, Consumer Surplus, and Market Equilibrium - Prof, Study notes of Microeconomics

Download Economics: Own-Price Elasticity of Demand, Consumer Surplus, and Market Equilibrium - Prof and more Study notes Microeconomics in PDF only on Docsity! Professor C.L. Ballard Fall Semester, 2011 ECONOMICS 201 KEY CONCEPTS FROM THE MIDDLE PART OF THE COURSE I. Elasticity A. The own-price elasticity of demand is our measure of the responsiveness of quantity demanded for a good to changes in the current price of the good. An analogous measure is used for the elasticity of supply. The own- price elasticity of demand is defined as the proportionate change in quantity demanded, divided by the proportionate change in price. We get the same results if we define the own-price elasticity of demand as the percentage change in quantity demanded, divided by the percentage change in price. In this course, our convention is to drop the minus sign, so that the demand elasticity is positive when the Law of Demand is obeyed. Another convention is to use the average, or midpoint, of the beginning and ending prices as our measure of the reference level of price, and to use the average or midpoint quantity demanded as our measure of the reference level of quantity demanded. B. A vertical demand curve is perfectly inelastic, and has elasticity of zero. A horizontal demand curve is perfectly elastic, and has elasticity of infinity. Along a downward-sloping, straight-line demand curve, the elasticity decreases as we go down from left to right. C. In an elastic portion of a demand curve, the elasticity exceeds one. If demand is elastic, total revenue for the sellers will grow as price falls. This is because, when the price falls and demand is elastic, the increase in quantity demanded is sufficiently large that it will outweigh the price decrease. Similarly, if demand is elastic, total revenue will fall when price rises. D. In an inelastic portion of a demand curve, the elasticity is less than one. If demand is inelastic, total revenue for the sellers will fall as price falls. This is because, when the price falls and demand is inelastic, the increase in quantity demanded is relatively small, and is not large enough to outweigh the price decrease. Similarly, if demand is inelastic, total revenue will increase when price increases. E. When demand is unit elastic, the elasticity is exactly one, and sales revenue will not change when price changes. This is because, when the elasticity is one, the percentage change in price is exactly equal to the percentage change in quantity demanded. Thus, any change in price is exactly offset by a change in quantity demanded, and the total revenue will remain unchanged. F. All else equal, demand tends to be more elastic (i.e., the own-price elasticity of demand tends to be larger) if it is easy to substitute away from a good when its price changes. Also, all else equal, demand tends to be more elastic if consumers are given a longer period of time in which to adjust to changes in price. Finally, all else equal, demand tends to be more elastic if the item is a relatively large share of the consumer’s expenditure. G. The income elasticity of demand measures the responsiveness of demand to changes in the incomes of consumers. Whereas the own-price elasticity of demand refers to movements along an existing demand curve, the income elasticity of demand refers to shifts in the demand curve caused by changes in income. The income elasticity is the percentage change in demand, divided by the percentage change in income. The income elasticity is positive for normal goods and negative for inferior goods. H. The cross-price elasticity of demand measures the responsiveness of demand for one good to changes in the 1 price of some other good. Whereas the own-price elasticity of demand refers to movements along an existing demand curve, the cross-price elasticity of demand refers to shifts in the demand curve caused by changes in the prices of other goods. The cross-price elasticity is the percentage change in demand for one good, divided by the percentage change in the price of another good. The cross-price elasticity is negative for complements and positive for substitutes. When the cross-price elasticity of demand is zero, we say that the two goods are “independent in demand”. I. The (own-price) elasticity of supply is the percentage change in quantity supplied, divided by the percentage change in the price. When the Law of Supply is obeyed, the supply elasticity will be a positive number. However, the Law of Supply is not always obeyed. In the case of something that cannot be reproduced (e.g., Leonardo’s painting “Mona Lisa”), the supply curve is vertical. In this case, the supply elasticity is zero, and we say that supply is perfectly inelastic. If the supply curve is horizontal, supply is perfect elastic. For many goods, the supply elasticity will be larger for a longer time period. In other words, as we give suppliers more time to adjust, they may be able to respond more to a change in price. II. Consumer Behavior I A. We define marginal utility as the additional utility derived from consuming one more unit of any good. When utility is measured in dollars of willingness to pay, marginal utility is the extra amount of money that the individual is willing to pay, in order to consume one additional unit. We assume that consumers have diminishing marginal utility, which means that their marginal utility will decrease when their consumption of a good increases. B. We assume that the individual consumer is too small to affect the market price. Therefore, the individual consumer takes the market price as given. The consumer will maximize satisfaction by choosing the quantity at which marginal utility is equal to price for every commodity. In this case, the individual demand curve is given by the marginal utility curve. C. Individual demand curves are summed horizontally to get market demand curves. D. Consumer surplus is the difference between (i) the maximum amount that the consumer is willing to pay, and (ii) the amount actually paid. Graphically, this is the area under the demand curve but above the price line. If price rises (for example, because of a leftward shift in the supply curve, or because of a government price control, or an import quota, or a tariff), consumer surplus will decrease. If price falls, consumer surplus will increase. The change in consumer surplus is our dollar measure of the harm to consumers from a price increase, or the benefit to consumers from a price decrease. III. Production, Cost, and Profit Maximization A. As the level of output changes, fixed inputs remain the same. Fixed costs are the costs associated with fixed inputs. Thus, the total amount of fixed cost is constant, regardless of the level of output. In particular, the firm’s fixed costs are the same when output is zero as when any positive amount of output is produced. Variable inputs are the inputs that must be increased, in order to increase the level of output. Variable costs are the costs associated with variable inputs. The short run is a period of time that is short enough that at least one input is fixed. In the long run, all inputs are variable. B. The law of diminishing returns or the law of diminishing marginal product states that, if we increase one variable input while holding all other inputs constant, the additional increases in output will eventually get 2 business, the market supply will be decreased. As a result of the decrease in supply, the market price will rise until the firms are once again earning zero economic profits. Thus, regardless of whether we begin with positive economic profits or negative economic profits, the tendency of a perfectly competitive market is toward zero economic profit. When the firms are earning zero economic profit, P=MC=ATC, implying that average total costs are minimized. V. Monopoly A. A monopolistic market has only a single firm. (We also consider "near monopolies", in which there are more than one firm, but in which one firm has a very dominant position. Thus, Microsoft Corporation is not literally the only firm in the market for personal-computer operating systems, but Microsoft controls such a large portion of the market that it is appropriate to analyze Microsoft as if it were a monopoly.) If the firm is able to earn positive economic profits, this situation can only be sustained if there are barriers to entry. These include legal restrictions, such as patents or exclusive franchise arrangements. Cost advantages can also be a barrier to entry: If average total costs are continually decreasing, then a single firm can produce at lower average total cost than could any combination of two or more firms. In this case, we say that the industry is a natural monopoly. However, in reality, natural monopolies may be rare. B. Another characteristic of monopolistic markets is that the output cannot have close substitutes. Thus, for example, Kellogg's is the only producer of a product known as Kellogg's Corn Flakes, but many other products are fairly close substitutes for Kellogg's Corn Flakes. Thus, it wouldn't be appropriate to think of Kellogg's as a monopolist in the market for Kellogg's Corn Flakes. Instead, it is better to think of Kellogg's as one of several firms in the market for breakfast cereal. C. There are many examples of monopoly. Patents give monopoly power, which is especially important for pharmaceutical companies. (Of course, the monopoly power of a pharmaceutical company can be eroded if other companies produce drugs that are similar.) DeBeers Consolidated Mines controls most of the world's diamond market. Thus, it is a near monopoly. Most professional sports franchises have local monopolies. Electric-power utilities are often set up as local monopolies, although there is controversy about whether these companies are natural monopolies. D. Since the monopolist is the only firm in the market, it "owns" the downward-sloping market demand curve. This means that the monopolist is not a price taker. Instead, we say that the monopolist is a price maker—the firm will manipulate the price in order to increase its profits. Another way to say this is that the firm has market power. This means that the firm's marginal-revenue curve slopes downward as we move to the right. The marginal-revenue curve is below the demand curve. In the case of a downward-sloping demand curve that is a straight line, the marginal-revenue curve will be exactly twice as steep as the demand curve. E. When demand is elastic, marginal revenue is positive. When demand is inelastic, marginal revenue is negative. When demand is unit elastic, marginal revenue is zero. F. To maximize profit, the monopolist chooses the quantity at which MR = MC, and then charges the price given by the demand curve at the profit-maximizing quantity. Since MC is positive, it must be that MR is also positive at the profit-maximizing quantity. Marginal revenue is positive when demand is elastic. Therefore, 5 the profit-maximizing monopoly firm will always produce a quantity that is in the elastic region of its demand curve. G. Because of barriers to entry, the monopoly may be able to make positive economic profits for a long time. H. The price charged by a monopoly will be greater than marginal cost. In a perfectly competitive market, P=MC and P=MU, which implies that MU=MC, which is a condition for social efficiency. This will not occur in a monopolistic setting. The monopolist will usually make positive economic profits, and may not produce at minimum average total cost. Consumers will have less consumer surplus with a monopoly than they would have if the industry were perfectly competitive. The loss of consumer surplus is greater than the monopoly profit. The difference between the consumers' loss and the monopoly profit is called the deadweight loss of monopoly. The deadweight loss is the amount by which society is worse off, when an industry is organized as a monopoly instead of in a competitive fashion. I. For a monopolist, the relationship between price and quantity supplied will depend on the shape of the demand curve and the MR curve. Thus, the monopolist does not have a well-defined supply curve. VI. Price Discrimination A. Price discrimination involves charging different prices to different customers for the same good or service. Monopolies may practice price discrimination. Other firms may do so, as well, including firms in industries that are monopolistically competitive or oligopolistic. However, by definition, perfectly competitive firms may not practice price discrimination, since they have no control over price. B. One example of price discrimination is the practice by which passenger airlines charge more to a customer who does not stay over a Saturday night than to a passenger who does stay over a Saturday night. Other examples include store coupons and discounts for Senior citizens. C. Price discrimination will increase the firm's profits if it involves higher prices for customers with less elastic demand, and lower prices for customers with more elastic demand. Thus, to discriminate successfully, firms must have some mechanism for distinguishing customers with less elastic demand from customers with more elastic demand. D. Finally, price discrimination requires that it must be difficult or impossible for buyers to resell the product to other buyers. VII. Monopolistic Competition A. Monopolistically competitive markets have many sellers, each of which is small relative to the market. Monopolistically competitive markets are also characterized by free entry and exit. Thus, if we only consider these two characteristics, monopolistic competition is the same as perfect competition. B. The difference between monopolistic competition and perfect competition is that monopolistically competitive firms have some market power, because of product differentiation. Consequently, each firm faces a downward-sloping demand curve for its product. However, it is unlikely that the individual monopolistically competitive firm will have a large amount of market power. This is because the other firms in the market will 6 produce goods that are fairly close substitutes. Thus, it will not usually be possible for one firm's prices to be dramatically higher than the prices of its competitors. Although the monopolistically competitive firm will not lose all of its customers if it raises its prices, the demand for the output of the individual firm is still likely to be quite elastic. C. Some of the best examples of monopolistic competition are in retailing, where product differentiation arises because of differences in location, or quality of service. D. Because of free entry into the industry, the tendency of a monopolistically competitive market is toward zero economic profit. Thus, in this respect, monopolistic competition and perfect competition are the same: In either of these market structures, there is free entry and exit. In any industry that has free entry and exit, the tendency will be toward zero economic profit. E. Monopolistically competitive firms will not produce at minimum average total cost. This is sometimes called excess capacity. The industry will have too many small firms, relative to the level that would minimize average total cost. However, the firms will usually not produce at an ATC that is much greater than the minimum ATC. Moreover, even though the firms may be small, they provide a lot of variety, which is valuable to society. VIII. Oligopoly A. Oligopolistic industries have a small number of sellers, each of which acts strategically, because it knows that it is large enough relative to the market to have an effect on the market price. (In other words, oligopolistic firms have market power. In some cases, they have a substantial amount of market power.) B. Many of the best examples of oligopoly are in manufacturing. These include the automobile industry, the commercial-aircraft manufacturing industry, the breakfast-cereal industry, and others. C. Oligopolists sometimes try to form into cartels, but the cartels are often unstable. This is because it is in each firm's interest to try to sell more by secretly offering price reductions. D. Game theory has been used to analyze the interactions among oligopolistic firms. In an oligopolistic setting, the players in a game are the oligopoly firms. In the case of oligopoly, a game is a description of the rules faced by the firms, the strategies undertaken by the firms, and the payoffs (profits or losses) received by the firms. A payoff matrix shows the relationship between strategies and payoffs. E. A well-known game is the "Prisoners' Dilemma". This is a two-person game in which each player has a dominant strategy of cheating. In the original context, this means that there are circumstances under which both prisoners will confess to the crime. In its application to oligopoly, the outcome of the Prisoners' Dilemma game is that there are circumstances under which both firms will cheat on their cartel agreement, and the cartel will break down. IX. The Michigan Economy A. In the middle decades of the 20th century, the manufacturing sector was booming. This was very good for Michigan’s economy, which was heavily concentrated in manufacturing. However, manufacturing’s share of the economy has been decreasing for half a century. In Michigan, the percentage of the economy in 7