ECON 332 - Industrial Economics

Lecture 2: Microeconomics Review

Kadir Has University
SPRING, 2024

1
Basic Microeconomics

2
 Market Demand 1/2

p q=f(p) direct
p=g(q) inverse
D

• Willingness to pay for a given quantity

• Purchased quantity for a given p

3
 Market Demand 2/2

Depends on
• Income (Engel law)
– Normal goods
– Inferior goods
• Price
– Decreasing
– Except for Giffen goods
• Price of other goods
– Substitutes
– Complements

4
 Price Elasticity of Demand 1/3

Elasticity
Dq
q Dq p
e = =
Dp Dp q
p

Dq
= % change of q
q
Dp
= % change of p
p

5
 Price Elasticity of Demand 2/3

e=1 If p increases by 10%, q reduces by 10%

e<1 Increasing price increases revenue (p*q)

e > 1 Increasing p reduces revenue

6
 Price Elasticity of Demand 3/3

Dq1
q Dq p
e1,2 = 1 = 1 2
Dp2 Dp2 q1
p2

e1,2 > 0  substitute goods

e1,2 < 0  complement goods

• Useful to define markets we will see

7
 Firm’s Demand

• How much of my product I can sell given my price

• If I am the only firm, it is also the market demand
• If not, it also depends on others:
– How many competitors
– Their products
– Their prices
• Negatively sloped in general if firms has market power
• If no market power, it is just flat becuase I cannot affect the
price I get even if change the quantity I sell

8
 Profit Maximization (the basics)
• Focus on profit maximizing behavior of firms
• Take as given the market demand curve

$/unit Maximum willingness

to pay
Equation: A
Constant
P = A - BQ
P1 slope
linear
demand
Demand

• Importance of:
Q1 A/B Quantity
– short-run vs. long-run
– willingness to pay
At price P1 a consumer
will buy quantity Q1

9
 Simple Market Structures
• Perfect Competition
• Monopoly

10
 Perfect Competition
• Firms and consumers are price-takers
• Firm can sell as much as it likes at the ruling market price
– do not need many firms
– do need the idea that firms believe that their actions will not affect
the market price
• Therefore, marginal revenue equals price (MR=p)
• To maximize profit a firm of any type must equate marginal
revenue with marginal cost (MR=c)
• So in perfect competition price equals marginal cost
(MR=MC=p)

11
 The First Order Condition: MR = MC
• Profit is p(q) = R(q) - C(q)
• Profit maximization: dp/dq = 0
• This implies dR(q)/dq - dC(q)/dq = 0
• But dR(q)/dq = marginal revenue
dC(q)/dq = marginal cost
• So profit maximization implies MR = MC
• Why?
• What is MR here with perfect competition?

12
 Perfect competition: an illustration
(a) The Firm (b) The Industry

• The supply curve moves to the right

• Price falls Now assume that
With market price PC demand
$/unit $/unitprofits exist
• Entry continues while
the firm maximizes increases to
profit by setting • MC
Long-run equilibrium is restored D2
MR (= PC) = MC and at price PC and supply curve S2 S1
D1
producing quantity qc AC

P1 P1 S2
Excess profits induce
PC new firms to enter
PC
the market
D2

qc q1 Quantity QC Q1 Q´C Quantity

13
 Monopoly 1/2
• The only firm in the market
– market demand is the firm’s demand
– output decisions affect market clearing price

At price P1 Marginal revenue from a

consumers change in price is the
$/unit Loss of revenue from the net addition to revenue
buy quantity
reduction in price of units generated by the price
Q1 currently being sold (L) change = G - L
P1
L Gain in revenue from the sale
P2 of additional units (G)
At price P2
consumers G
buy quantity Demand
Q2 Q1 Q2 Quantity

14
 Monopoly 2/2
• Derivation of the monopolist’s marginal revenue

Demand: P = A - B.Q $/unit

Total Revenue: TR = P.Q = A.Q - B.Q2 A
Marginal Revenue: MR = dTR/dQ
MR = A - 2B.Q

With linear demand the marginal

Demand
revenue curve is also linear with
the same price intercept
but twice the slope of the demand Quantity
curve MR

15
 Monopoly and Profit Maximization
• The monopolist maximizes profit by equating marginal
revenue with marginal cost
• This is a two-stage process

Stage 1: Choose output where MR = MC

$/unit This gives output QM
Output by the Stage 2: Identify the market clearing price
monopolist is less
MC This gives price PM
than the perfectly
competitive
MR is less than price
PM output
ACQC
Price is greater than MC
Profit Loss of efficiency
Price is greater than average cost
ACM Demand
MR Positive economic profit
Long-run equilibrium: no entry
QM QC Quantity
16
 Efficiency and Market Performance
• We want to measure efficiency in markets: how well
scarce resources are used
• Contrast two polar cases
– perfect competition
– monopoly
• What is efficiency?
– no reallocation of the available resources makes one economic
agent better off without making some other economic agent worse
off
– example: given an initial distribution of food aid will trade
between recipients improve efficiency?

17
 Efficiency and Surplus
• Can we reallocate resources to make some individuals
better off without making others worse off?
• Need a measure of well-being

– consumer surplus: difference between the maximum amount a

consumer is willing to pay for a unit of a good and the amount
actually paid for that unit
– aggregate consumer surplus is the sum over all units consumed and
all consumers

– producer surplus: difference between the amount a producer

receives from the sale of a unit and the amount that unit costs to
produce
– aggregate producer surplus is the sum over all units produced and
all producers

– total surplus: consumer surplus + producer surplus

18
 Efficiency and surplus: Illustration 1/2

$/unit
The demand curve measures the
Competitive
willingness to pay for each unit
Consumer surplus is the area Supply
between the demand curve and the
equilibrium price
Consumer
The supply curve measures the Equilibrium occurs
surplus
marginal cost of each unit PC where supply equals
Producer surplus is the area Producer demand: price PC
between the supply curve and the surplus quantity QC
equilibrium price
Demand
Aggregate surplus is the sum of
consumer surplus and producer surplus
The competitive equilibrium is QC Quantity
efficient

19
 Efficiency and Surplus Illustration 2/2

Assume that a greater quantity QG $/unit

is traded The net effect is a Competitive
Price falls to PG reduction in total Supply
surplus

Producer surplus is now a positive

part and a negative part

PC
Consumer surplus increases
PG
Part of this is a transfer from
producers
Part offsets the negative producer Demand
surplus

QC QG Quantity

20
 Deadweight loss of Monopoly 1/2

Assume that the industry is $/unit

monopolized
The monopolist sets MR = MC to Competitive
give output QM Supply
This is the deadweight
The market clearing price is PM loss of monopoly

PM
Consumer surplus is given by this
area
And producer surplus is given by PC
this area

The monopolist produces less Demand

surplus than the competitive
industry. There are mutually
beneficial trades that do not take QM QC MR Quantity
place: between QM and QC

21
 Deadweight loss of Monopoly 2/2
• Why can the monopolist not appropriate the deadweight
loss?
– Strange! There are “consumers” ready to pay a price higher than
marginal costs, but the monopolist does not want to sell
– Increasing output requires a reduction in price
– this assumes that the same price is charged to everyone.
• The monopolist creates surplus
– some goes to consumers
– some appears as profit
• The monopolist bases her decisions purely on the surplus
she gets, not on consumer surplus
• The monopolist undersupplies relative to the competitive
outcome
• The primary problem: the monopolist is large relative to
the market

22
 A Non-Surplus Approach 1/2
• Take a simple example
• Monopolist owns two units of a valuable good
• There are 50,000 potential buyers
• Reservation prices:

Number of Buyers Reservation Price

First 200 $50,000
Next 40,000 $30,000
Last 9,800 $10,000
Both units will be sold at $50,000; no deadweight loss
Why not? Monopolist is small relative to the market.

23
 A Non-Surplus Approach 2/2
• Monopolist has 200 units
• Reservation prices:

Number of Buyers Reservation Price

First 100 $50,000
Next 40,000 $15,000
Last 9,900 $10,000
Now there is a loss of efficiency and so a deadweight loss.

24
 Question 1
• Suppose that the total cost of producing pizzas for the typical
firm in a local town is given by: C(q) = 2q + 2q2.
– a. Show that the competitive supply behavior of the typical
pizza firm is described by: q = P/4 – 1/2
– b. If there are 100 firms in the industry, each acting as a
perfect competitor, show that the market supply curve is, in
inverse form, given by: P = 2 + Q/25.

25
 Question 2
• Let the market demand for widgets be described by Q = 1000 −
50P. Suppose further that widgets can be produced at a constant
average and marginal cost of $10 per unit. Calculate the market
output and price under perfect competition and under
monopoly.

26
 Question 3
• Suppose that the inverse demand for clothes hangers is given
by: P = 3 − Q/16,000. Suppose further that the marginal cost of
producing hangers is constant at $1.
– a. What is the equilibrium price and quantity of hangers if
the market is competitive?
– b. What is the equilibrium price and quantity of hangers if
the market is monopolized?
– c. What is the deadweight or welfare loss of monopoly in
this market?

27