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Chapter Six: The Firm and its Environment

Foundations of the Theory of the Firm: The Law of Demand. The Law of Demand - The quantity of a well-defined good or service that people are willing and able to purchase during a particular period of time decreases as the price of that good or service increases everything else held constant.The La

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Chapter Six: The Firm and its Environment

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    1. Chapter Six: The Firm and its Environment The Theory of the Firm Summarized Introduction to Industrial Organization Perfect Competition Monopoly Monopolistic Competition Oligopoly Profit Maximization Across Time

    2. Foundations of the Theory of the Firm: The Law of Demand The Law of Demand - The quantity of a well-defined good or service that people are willing and able to purchase during a particular period of time decreases as the price of that good or service increases everything else held constant. The Law of Demand gives us the relationship between price and quantity. Via the concept of elasticity, we have the relationship between total revenue and quantity. From total revenue we move to marginal revenue. Key idea: For the firm to increase output it must lower its price. Not only will marginal revenue also fall as output is increased, marginal revenue will also be less than the price the firm charges.

    3. The Mathematics of Demand P = a bQ Understand how elasticity varies along a linear demand curve. TR = aQ bQ2 Understand the connection between elasticity and total revenue. MR = a 2bQ Understand Why!!! Understand the connection between elasticity and marginal revenue. When Total Revenue is maximized, marginal revenue is zero. Total Revenue is maximized when marginal revenue is zero. WHY??? When Marginal Revenue is positive, Total Revenue is rising. When Marginal Revenue is negative, Total Revenue is falling. When Marginal Revenue is zero, Total Revenue is neither rising or falling, therefore it is maximized. Revenue Maximization is NOT the Objective of the Firm!!!

    4. Foundations of the Theory of the Firm: The Law of Diminishing Returns The Law of Diminishing Returns As a variable input increases, holding all else constant, the rate of increase in output will eventually diminish. The Law of Diminishing Returns underlies the relationship between total (as well as average and marginal) product and labor. The short run production functions give use the short run total cost, average cost, and marginal cost function. Remember, the law of diminishing returns is a short-run concept. Key Idea: As the firm increases

    5. The Mathematics of Cost When MC = AC, Average Cost is Minimized. If Marginal Cost is less than Average Cost, Average Cost will be declining. If Marginal Cost is greater than Average Cost, Average Cost will be increasing. Average Cost minimization is where the firm is most efficient. Average Cost Minimization is NOT the Objective of the Firm!!!

    6. Profit Maximization Profit = Total Revenue Total Cost Marginal Profit = MR MC Profit is maximized when marginal profit equals zero. WHY? When marginal profit is positive (MR>MC), profit is rising. When marginal profit is negative (MR<MC), profit is falling. When marginal profit is zero (MR=MC), profit is not rising or falling, it is maximized.

    8. MR = MC Can firms estimate demand and cost functions? Yes Do all firms estimate demand and cost functions? No Why do we need to know MR = MC if we do not have access to the demand and cost functions?

    9. Industrial Organization Industrial Organization The Study of the Structure of Firms and Markets and of Their Interactions. OUTLINE Perfect Competition Monopoly Monopsony Monopolistic Competition Oligopoly

    10. Perfect Competition & Monopoly Definitions Perfect Competition A market structure characterized by a large number of buyers and sellers of an identical product. Monopoly A market structure characterized by a single seller of a highly differentiated (unique) product.

    11. Price Taker vs. Price Maker Price Taker Buyers and sellers whose individual transactions are so small that they do not affect market prices. Price Maker Buyers and sellers whose large transactions affect market prices. NOTE: Being a price maker does not mean you can charge any price you like.

    12. Factors that Determine the Level of Competition Product differentiation (real or perceived differences in the quality of goods and services). Size of the market relative to MES. Barriers to entry and mobility. Barriers to entry any advantage for industry incumbents over new arrivals. Barriers to mobility any advantage for leading firms over small non-leading rivals. Barriers to exit Any limit on asset redeployment from one line of business or industry to another. Monopsony (a market with one buyer) power.

    13. Perfect Competition Characteristics Large number of buyers and sellers. Product homogeneity. Free entry and exit. Perfect dissemination of information.

    14. Perfect Competition Short Run vs. Long Run In the short-run economic profit (or loss) is possible. In the long-run, competitive pressures will cause the typical firm to earn zero economic profits. NOTE: UNDERSTAND THE MATHEMATICS OF PERFECT COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.

    15. Monopoly Characteristics A single seller. Unique product. Blockaded entry and exit. Imperfect dissemination of information. NOTE 1: Monopoly power can exist without these conditions being exactly met. NOTE 2: UNDERSTAND THE MATHEMATICS OF MONOPOLY IN THE SHORT-RUN AND THE LONG-RUN.

    16. Monopsony If the market for labor is competitive, then the firm simply pays the market wage to each additional worker hired. For a monopsonist to hire an additional worker the firm must pay both the added worker, and all other employees, a higher wage rate. Hence the marginal expense of a new workers exceeds the wage paid the additional employee. A monopsonist will stop hiring workers when the marginal expense of the last worker equals the last workers MRP. The wage paid will correspond to labor supply at that level of employment.

    17. The Baseball Players Market The union is a monopolist: The sole seller of baseball talent. Major League Baseball is a monopsony: The sole buyer of baseball talent. Countervailing power buyer market power that offsets seller market power. How will wages be determined? Via bargaining. BE ABLE TO ILLUSTRATE THIS STORY.

    18. Monopolistic Competition and Oligopoly Monopolistic Competition A market structure characterized by a large number of sellers of differentiated products. Oligopoly A market structure characterized by few sellers and interdependent price/output decisions.

    19. Monopolistic Competition Characteristics Large number of buyers and sellers. Product heterogeneity. Free entry and exit. Perfect dissemination of information.

    20. Monopolistic Competition Short Run vs. Long Run In the short-run economic profit (or loss) is possible. In the long-run, competitive pressures will cause the typical firm to earn zero economic profits.

    21. More on Monopolistic Competition Although economic profit is zero (P=ATC), price is still greater than marginal cost. Product differentiation results in a downward sloping demand curve. Consequently, price exceeds marginal revenue. WHY? To profit maximize MR = MC, therefore price exceeds marginal cost.

    22. Even More on Monopolistic Competition If P = ATC and P > MC, then ATC > MC. What does this mean? A firm in monopolistic competition does not produce at capacity (i.e. it is not as efficient as perfect competition). Is this a social cost? Is product differentiation worth inefficient production? NOTE: UNDERSTAND THE MATHEMATICS OF MONOPOLISTIC COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.

    23. Oligopoly Characteristics Few sellers Homogenous or unique product. Barriers to entry and exit. Imperfect dissemination. Key: Price and output decisions are interdependent.

    24. MR = MC, Again Imagine an oligopolist who is currently charging a price less than (or greater than) profit maximization. If the firm raises (or lowers) its price, how will other firms in the market respond? When other firms respond, the price that maximizes profit will change. WHY? Consequently an oligopolist cannot determine a profit maximizing price unless she or he can predict accurately the responses of her/his competitors.

    25. Oligopoly Model: The Kinked Demand Curve Model Premise of the model: Firms follow a price decrease, but do not follow a price increase. Hence the elasticity of demand will differ depending upon the decision the firm makes. Implication: Firms have an incentive not to change price, even if costs change. Be able to explain why costs can change but profit maximizing output and price would the not in the kinked demand curve model. Note: We can model an oligopoly model if we assume how firms will respond to price changes.

    26. Bertrand Duopoly Assumptions: Two Firm Identical Products Constant MC (to simplify presentation) Perfect Information Zero Transaction Costs Equilibrium in the model: P = MC Lessons from the Bertrand Duopoly: Product differentiation matters Firms do not wish to compete on price.

    27. Sustaining Economic Profit In a competitive environment economic profit will be competed to zero. For economic profit to be sustained, a firm needs to establish a barrier to entry. Product differentiation Technological difference

    28. Game Theory Game Theory - a mathematical technique used to analyze the behavior of decision makers. the study of behavior in situations in which each partys payoff directly depends on what another party does. Example: Two firms are determining how much to advertise. The elements of the game: The players: Firm 1, Firm 2 The strategies: High advertising, low advertising

    29. Prisoners Dilemma The payoffs: Are as follows (payoffs read 1,2) Firm 2 High Low High 40,40 100, 10 Firm 1 Low 10, 100 60,60 Solving games Equilibrium: no pressure for any participant to change his/hers action Dominant strategy equilibrium: In this game, the dominant strategy for firm 1 and firm 2 is high. So the outcome of the game is 40,40. This illustrates the prisoners dilemma: Games in which the equilibrium of the game is not the outcome the players would choose if they could perfectly cooperate.

    30. Future Value and Present Value: One Time Period Future Value = PV(1 + interest rate) If you have $10,000 and the interest rate is 8%, what is the future value? Present Value = FV/(1 + interest rate) If you will have $10,000 and the interest rate is 8%, what do you have currently?

    31. Future Value and Present Value: Multiple Time Periods If you have multiple time periods, the calculation is a bit different. Future Value = PV(1 + interest rate)time If you have$10,000 and the interest rate is 8%, what is the future value in 10 years? Present Value = FV/(1 + interest rate)time If you will have $10,000 in 10 years and the interest rate is 8%, what is the present value?

    32. Profit Maximization, Again Firms should not profit maximize strictly with respect to the current time period. Firms should seek to profit maximize over multiple time periods. Expected Value Maximization Optimization of profits in light of uncertainty and the time value of money Value of the Firm The present value of the firms expected net cash flows.

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