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Market Structure:Combining Costs and Revenues

Concepts you will be expected to be familiar with:1. Profit maximization2. Producer surplus3. Market power4. Competitive supply

- elasticity- individual supply to market supply

6. Short run equilibrium -- equating supply and demand7. Long run competitive supply8. Who bears the burden of a marginal cost increase?



1. Profit = Total Revenue - Total Cost

• Profits are maximized when we adjustoutput so that the marginal increase inrevenue is just offset by the marginal

increase in costs.

• Mathematically:

d(Profit)/dQ = d(TR)/dQ - d(TC)/dQ = 0.



Marginal Revenue, Marginal Cost and ProfitMaximization

We can then rewrite this as:

d(TR)/dQ = d(TC)/dQ• Recall: Marginal Revenue is the additional revenue the firm

generates

by increasing output by one more unit:MR = d(TR)/dQ.

• Marginal Cost is the additional expense the firm incurs byincreasing output by one more unit:

MC = d(TC)/dQ.• So we can rewrite our profit-maximization formula as:

MR = MC

By setting these equal, we can then identify the profitmaximizing quantity which, after entered into the demandequation gives us the profit maximizing price.



Graphically

MR

D

MC$

Q

P*

Q*



What is the blueshaded region called?

MR

D

MC$

Q

P*

Q*



2. Producer Surplus

Just as we defined consumer surplus as thedifference between what a consumer actuallypays for a good and the value of the good to

the consumer, we can define producer surplusas:Producer surplus: the difference between the

price received for a good and the marginalcost of producing that unit



Graphically

MR

D

MC$

Q

P*

Q*

This shaded areais the ProducerSurplus



Consumer Surplus and ProducerSurplus

Consumer surplus represents the gains to tradefrom the consumers’ perspectives.

Why?Producer surplus represents the gains to trade

from the producer’s perspective given theyare producing any at all .

Why?What does the sum of producer surplus and

consumer surplus equal?



Producer Surplus

Since producer surplus is the price minus themarginal cost of producing each unit, could aproducer have positive producer surplus but

still be losing money?



3. Social cost of market power

We can use the concepts of producer surplusand consumer surplus to determine the socialcost associated with market power.

Market power is when a single producer faces adownward sloping demand curve.

A firm has market power when the firm knowsthat by changing its output, it can change theprice it receives.



Social cost of market power

MR

D

MC

$

Q

P*

Q*

What are the maximum possible gains from trade?




MR

D

MC

$

Q

P*

Q*

maximum possible total surplus wherethe blue region is consumer surplusand the green region is producer

surplus

P c

Qc




MR

D

MC

$

Q

P*

Q*

Of the maximum possible gains, note thatwe lose both red triangles as a result of thefact that the producer has market power.The bottom (darker) triangle is a loss ofproducer’s surplus and the top triangle is aloss of consumers’ surplus. We call thissocial loss Dead-weight lo ss .

P c




MR

D

MC

$

Q

P*

Q*

The producer, though it loses some surplus(relative to the surplus maximizingsolution) gains on net because of a transferfrom consumers to producers equal to theblue shaded region.

P c




MR

D

MC

$

Q

P*

Q*

In sum, as a result of market power, theproducer loses the lower, dark redshaded triangle, and the consumers losethe upper red shaded triangle. Sincethere is no compensating gain for eitherof these losses, these represent thesocial loss. Producers gain the bluerectangle but consumers lose it.

Therefore the rectangle is not a socialloss it is a transfer.

P c



4. Accounting profits vs. economic profits

• Suppose a farmer in Iowa owns the best land forgrowing corn, and as such can grow corn at a lowercost than anyone else. Since he gets the same pricefor corn as every other farmer, can he reap profits

even in the LR?• Yes, he will earn LR accounting profits. This is prettystraightforward to see.

• No, he will not earn LR economic profits. Why?Because he faces an opportunity cost on using this

very fertile land. The fertility of the land will bereflected in its market value, and by using the landhe faces a very high opportunity cost.



5. Competitive supply

Define a competitive industry as one in which allfirms have the following characteristics:

• they produce a perfectly homogeneous

product, like wheat;• each firm is so small in relation to the industry

that its production decisions have no effect onthe market price (they are price takers); and

• in the long run there is “free” entry and exitby new and incumbent firms alike.



What happens to price when Jim grows 10,000bushels of corn, up from 8,000 last year?

$

Quantity(Millions of

Bushels)

Market Demand

100 200 300 400 500 600 700 800 900

4.00



Jim’s Demand (Calculated from the market demand)

Quantity(Thousandsof Bushels)

$

4.00 Jim’s Demand



Jim’s Marginal Revenue (Calculated from the market demand)

Quantity(Thousandsof Bushels)

$

4.00 Jim’s Demand

8 10

Total Revenue= 8000*$4

= $32,000

TR =$40K



For a competitive firm, MR isthe same as Price

What is the effect of an increase in output on earlier unitswhen a firm faces a downward sloping demand curve?Following our earlier results, this means the firm operating in

a perfectly competitive environment will price such that:P=MC

The rule that always applies is still:

MR=MC



Competitive Firm Profit Maximization

At this quantity, totalrevenues areqi*x P*

TR

TC

Profits

ACMC

Total costs areqi* x AC (qi*)Profits areqi*(P* - AC (qi*))

qi

P

P*=MR

qi*



Individual Firm Decisions

P1=MR1

Suppose the marketprice is P 1 What quantity willthis firm choose toproduce?Now suppose themarket price is P 2

What quantity willthis firm choose toproduce?

P2=MR2

Now suppose themarket price is P 3 …

P3=MR3

q1q2 q3

AC

AVC

MC

q

P



Now What?

Now suppose marketprice P* => how muchshould you produce?

q

P

ACAVC

MC

P*=MR

q*

At least you are

covering yourvariable costs (andremember sincethis is short run,fixed costs will beincurred anyhow).



The Shut-down Decision

What happens if themarket price is P*?At MR = P* = MC, the

price is below AVC =>produce q* or nothing?

q

P

ACAVC

MC

P*=MR

q*

You would havesaved this much ifyou stayed in bedthat day.



Short-run Firm Level Supply

The individual firm’s

supply curve in the

short run is MC aboveMin AVC!

q

P

ACAVC

MCFirmSupply

For P < MinAVC, thesupply curve is at Q=0

(the firm shuts down)



Short-Run Operating Decision

May accept lower prices in the short run due to:Economies of scopeNetwork and/or learning economiesContractual obligationsGovernment regulationLarge shut-down and start-up costs (e.g. steel mills)Etc.

Rule of thumb:

Stay open if P >= AVC (even if P < ATC)Shut down if P < AVC



What happens to the firm’s AVC’s andMC’s when one of its variable inputs

increases in price?Decreases in price?



In general, what sorts of things move the firm along Itssupply curve and what sorts of things shift the firm’s

supply curve?

• An increase in wage rates will . . . .•

A decrease in materials costs will . . . .• An increase in fixed costs will . . . (in the

short run)•

An increase in the price of the productwill . . .• And so forth ...



The firm’s supply curve might look something like this ...

qs = 10 + 2.5P

How do we find the market supply?In the short run, we simply aggregate across all firms.

Individual supply to marketsupply



So if there are ten firms eachwith a supply curve that looks

like:

Then the market supply curve willbe:

qs = 10 + 2.5P

Qs = 100 + 25P



Elasticity of Supply ...•

We define the elasticity of supply as thepercentage change in quantity supplied inresponse to a one percent change in price:

Es = (% Q)/(% P)= ( Q/Q)/( P/P)= (P/Q)( Q/ P) 0

• So the formula looks identical, except that weare looking at supply rather than demandresponses. And all of the intuition remains asbefore.



Quantity

$

Supply

6. Short run equilibrium

Demand

P*

Q*





Quantity

$

Supply

Alternately, suppose P < P* ...

Demand

P*

Q*

P

? ?



“Equilibrium” What is likely to happen when the quantity of output

does not equal the quantity determined by Supply =Demand?

Equilibrium holds when no one has the incentive todeviate from that output once it is reached.

An equilibrium is stable if there are forces that movemarket participants toward the equilibrium whenthe market is not at the equilibrium.



The market mechanism: using prices toallocate resources

• The equilibrium price is often referred to asthe “market -clearing” price.

• Supply and demand may not always be in

equilibrium, and some markets may not clearas fast as others when conditions changesuddenly.

• The assertion here is that there is a tendency for markets to clear over time.



Other mechanisms that allocate resources

• Consider a restaurateur finds that her establishmenthas long lines waiting to eat. The reason? Possiblythat she underestimated demand. She might thenconsider raising her prices.

• Our hypothetical restaurateur may reduce portion sizeor the quality of ingredients; or she may cram in moretables (thereby reducing sq. ft. per diner). etc.

• This can still be explained using the same analysis. It isthe quality controlled price that we are considering. Tolower the quality is to raise the quality controlled price.



7. Long run competitive supply

• Recall what distinguishes short run from long run.• Recall that one of the defining characteristics of a

competitive industry was “free” entry and “free” exit. •

So ... what sorts of things might happen in the longrun in industries where firms are incurring losses?What about in industries where firms are reapinglarge profits?

•

Is supply more or less elastic in the long run than inthe short run?



Competition in the long run

• In the long run, all inputs are variable.

• To qualify as a competitive industry, there

must be no legal restrictions or specialcosts attending entry or exit. In otherwords, “free” entry and exit.

• Firms move to their long run cost curves.



Long run competitive equilibrium’s threeconditions:

1) All firms in the industry must bemaximizing profit.

2) No firm has an incentive either to enter orto exit the industry.

3) The price of the product is such that the

quantity supplied by the industry is equalto the quantity demanded by consumers.



Long run competitive equilibrium

• Profit-maximizing firms• No incentive for entry or exit• supply = demand

ATC

MC

P

q

$

Qty.

P

Q

Demand

Supply

$

Q



Note the effect on social welfare

ATC

MC

P

q

$

Qty.

P

Q

Demand

Supply

$

Q



The industry’s long run supply curve • We cannot derive the LR supply curve for the

industry using horizontal summation. Why not?Because in the LR firms will enter and exit. Wedon’t know which firms’ supplies to add.

•

In the long run, we need to take into accountproduction technologies and input prices.Current supply curves may not be relevant.

The industry’s long run supply curve:




Let’s suppose that an industry is in LR competitiveequilibrium initially:

Here we have firms acting as price takers; we seethem earning zero economic profits; and we seeno incentive either to enter or exit the industry.

ATCMC

P

q

$

Qty.

P

Q

Demand

Supply

$

Q





But now suppose there is an unanticipated increase indemand:

Now we are out of equilibrium. The typical firm follows itsSR MC curve and increases output to q’, and earns SRprofits. How do we get back to LR equilibrium?

ATCMC

P

q

$

Qty.

P

Q

NewDemand

Supply

$

Qq’




The industry s long run supply curve:

Answer: New firms (in the long run) enter the industry, and they shiftthe supply curve to the right.

For us to get back to LR equilibrium, supply must shift until firms areearning zero economic profit again and there are no incentives toenter/exit.

At what point will this occur? Well ... it depends upon the cost of theinputs used to make this product.

In a constant-cost industry, the higher output can be produced withoutan increase in the per unit price. This requires that the inputs usedto make this product do not increase in price as the demand forthem increases (e.g., if the primary input is unskilled labor, and themarket wage of such unskilled laborers is unaffected by the higheroutput.)

The LR supply curve of a constant-cost industry is a horizontal line at aprice equal to LR minimum ATC.



In an i i g ti d t the prices of



ATCMC

P

q

$

Qty.

P

Q

NewDemand

S1

$

Qq’

In an inc reas ing-co s t indu s t ry , the prices ofsome inputs increase as industry outputrises. The input could be the skill ofmanagement at reducing costs.

S2



Wh l th



When can we apply thecompetitive model?

•

It is never completely accurate. But there are manyindustries for which it is a good approximation:agriculture, commodities (excepting oil, diamonds,and a few others), financial markets.

•

Many services (e.g., haircuts) also fit the model.• Many “intermediate goods” may also qualify. • But what about other goods, say “fast food”, where

the good is not perfectly homogeneous; where

firms are not, strictly speaking, price takers; andwhere trademarks and patents throw up barriers?



Returns in LR Competition

• In a perfectly competitive market, pricereflects production costs -- including anyopportunity costs that may arise -- and inthe LR, at least, firms earn zero economicprofits.

• Note that though firms do not reapsupernormal gains, the owners of the super-productive inputs may earn handsomereturns.



What does price reflect?• Price does not represent any inherent value of

a good -- it only represents the market’svaluation of the good or service given marketconditions .

For example: Consider what would happen toprices if all teenagers were suddenly givenmore wealth.

Is the new pricing system and resultingdistribution of productive resources better orworse than the previous distribution?



Does this apply? Almonds(U.S. Farmers Feel Almond Joy, Chicago Tribune)

How would we represent this:“Besides being championed by trendy diets, almonds have benefited from

increasing awareness of their health attributes”

What would we expect the result to be in the short run?“Almonds did something you never see in farming – production is going up

and so are prices”

And in the long run?“Almonds are so hot that California farmers are ripping up apricot orchards

and vineyards to plant almond trees. . . Investors in China are reportedlytesting ground for Almond production.”



Does it apply when it is not a commodity?

Indoor Waterparks• Indoor water parks began in Wisconsin in the 1990’s

• Indoor water parks in 2000: 18

• Indoor water parks today: 79

• Opened in Sandusky in 2001 – Violates PC no entry cost: Development and construction costs

~$40M, but . . . – There will be at least 5 by the end of 2005

• The Dells region, 60 miles north of Madison, went from one resort to 18in a decade.



Number of Water Parks in Mid-West

2002 2003 2004

Wisconsin 25 28 32

Minnesota 10 14 15

Michigan 2 3 5

North Dakota 3 3 3

South Dakota 2 2 3

Montana 1 2 2Ohio 1 1 2

StateNumber of Indoor Waterparks

Source: JLC Hospitality Consulting



Indoor Waterparks opening in 2005

Why might we observe this relationship between



Why might we observe this relationship betweenprice and occupied room nights?

Trends On The Supply In Wisconsin Dells Based On Seasonal Data

y = 0.0001x + 6.9658R2 = 0.9373

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

0 200000 400000 600000 800000 1000000 1200000

Occupied Room Nights

A v e r a g e

R o o m

P r i c e

( $

Hotels With Indoor Water ParksHotels With Swimming PoolsLinear (Hotels With Indoor Water Parks)Linear (Hotels With Swimming Pools)

These Points Do Not Follow ThePrice/Occupied Room Nights Trend.Probably The Hotels With No Indoor WaterParks do not want to reduce the price furtherdue to variable costs.

China Looks Beyond U S Farmers



China Looks Beyond U.S. FarmersTo Satiate Its Growing Soybean Appetite

WSJ Aug 21, 2006 Rising prosperity is outstripping (China)’s ability to meet demand internally for

certain basic commodities. . . To grow more soybeans, Chinese farmers wouldhave to buy more land or convert land used for other crops. With land priceshigh and the amount of arable land limited, the cost of expanding domesticproduction is often too expensive. Chinese farmers can't easily convertexisting crops to soybean production because of climate and weather

conditions. As a result, China is importing soybeans from countries wherethey are less-expensive to produce.U.S. soybean shipments to China had a value of $2.3 billion last year, more than

double the 2001 total . . . According to the U.S. Agriculture Department, U.S.exports to China during the 2005-06 U.S. soybean marketing year will fall to9.5 million metric tons from 11.8 million metric tons a year earlier.

Just as U.S. farmers did earlier this decade, South American farmers have stepped

up soybean production and exports. This year, South America will increaseproduction to 102 million metric tons, up 42% from 2001. South Americansoybean exports should reach 39 million metric tons this year, up 50% from2001.



And Bagels“For Bagel Chains…” (Wall Street Journal, Dec 30, 1997)

“Bagels are booming in popularity…There is just one problem:No one seems to be making much money selling them…‘There’s immense competition. It’s growing way too fast,’said Bora Sila, an investment banker…Einstein/Noah Bagel

Corp., the nation’s largest chain of bagel shops in terms ofoutlets…expects to incur a substantial loss for the periodbecause of a restructuring of its franchising system…Early inthe industry’s evolution, chains like Bruegger’s piled upsuccesses in part because they caught would-becompetitors unaware…*T+oday all manner of vendors, fromAllied Domecq PLC’s Dunkin’ Donuts to Starbucks Corp.,have bagels on their menus. Even supermarkets’ in -storebakeries turn out batches of bagels daily… ‘There are fewbarriers to entry,’ said Mr. Sila.”





Key Points

6. The short run supply curve in a competitive market:• is the horizontal sum of the individual firm supply curves (MCs).• Is shifted by anything that changes variable costs• Is not affected by changes in fixed costs

7. Since MR=P for an individual firm in a perfectly competitive market,P=MC is the profit maximizing solution.

8. The three conditions for a perfectly competitive market are:1. Output is homogeneous2. There are a large number of producers (so each one is a price taker)3. Entry and exit is free in the long run



Key Points9. A long run equilibrium exists when:

1. All firms are maximizing profits2. The quantity demanded equals the quantity supplied3. There is no incentive to enter or exit

10. In a perfectly competitive market:• total surplus is maximized• Economic profits can be positive in the short run• Economic profits are zero in the long run

11. In a constant cost industry the long run supply curve is flat; in an increasingcost industry the long run supply curve is upward sloping.

12. Economic profits are the difference between revenues and all opportunitycosts.

13. While few if any markets are “perfectly” competitive, the model does aremarkably good job of describing many industries

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