EEP100 - Lecture 9

Uploaded by calcommunitycontent on 07.10.2009

So congratulations for handing in your homework. The good news is it's only 5
points of your grade. No, the good news is that it's done. The bad news is that now
Diana and Fei have to grade it. Let me go through some logistical stuff and
then we'll get on to more lecture stuff. First of all, any out standing questions?
Like, oh, please explain the economic recovery package to me? Nothing? Anything
out there right now? Yes. [Do you have another blog called the Great
Recession Conspiracy or something like that?]
The Great Recession Conspiracy is a book written by the friend of mine and he made
me the coauthor. And I said, "Alright, fine." So he runs that blog. I actually have
literally never looked at that blog. But if you enjoy it, then go for it. Because I've
been doing a lot of political economy, I've been paying attention to that particular
macroeconomy aspect; the idea of Henry Paulsen calling his buddy at Goldman
Sachs and asking what? We don't know. We have the idea that they
have a conversation, so this is all about the bailout and Wall Street and Main Street,
and all that. So if Henry Paulsen, who I think was the head of Goldman, goes in to
work for the government, and the government has a package that happens to benefit
Goldman a little bit better than Merrill Lynch or Lehman Brothers, which is
bankrupt now. Then is that because Goldman Sachs is actually a firm better deserving
of that outcome because they're just more clever than everybody else, or is
it because Henry Paulsen is their friend? So the conspiracy theories about Wall Street
revolve around the interactions of friendships and personalities and the typical
back channel connection between politics and economics.
There's actually a book; you can buy it for $4.95, I've read through it; I agree with
80% of it, and I'm a co-author of it, but I didn't write it. So that's that blog. Enjoy
it, and if you have questions about it, go ahead
and bring it up. And remember when I said (earlier in the class) that there's a
difference between the natural state (where politics and economics interact with each
other). Remember that? I said who's from a developing country or something like
that? That's what's going on here. The idea thatÉthat's what could be going on here.
The idea that political connections will get you economic policies that benefit
you. And the money that you get from that connection will make your political connection
work. That's the idea of lobbyists or the pharmaceutical
companies spending money on lobbying. They send lobbyists to WashingtonÉthe
farmers doing it with ethanol programs (actually not even the farmersÉmidland
and then Cargill)Éso that political economy cycle which we're seeing
all the time, and then in this country, and of course around the world, it may be playing
a very large role in the wall street bailout. Or it might not have any role at
all, and we're just paranoid. So I personally think that there's a lot more
politics involved with the economic bailout than maybe there was with the conspiracy
around 9/11, but it's not obvious, that's the problem. I'm reading all of these
confessional articles coming out right now from ex-bush administrators. I just read
this thing about one of Bush's old speechwriters talking about how he had no
clue that about the package he was presenting to the country.
So his idea was buy low, sell high. And everybody was like no, no Paulsen wants to
buy high and sell low. So the president went out and made a speech, but he didn't
know what he was talking about. Well, he did know what he was talking about, but
it didn't match what was going on. So this kind of stuff will come out. And this is the
good thing about a democracy (better than other places).
In the same issueÉI was reading about the Russians, and the Chechnya war...(this is
a little off topic but not that much off topic)Éand if there was one really strange
thing about how Putin got into powerÉPutinÉno one had heard of this guy in 1999.
And suddenly he's just a leader in this war against the terrorist Chechnyans who'd
just blown up a whole bunch of apartment buildings. But that, in my mind, was a
complete inside job. That was the KGB. And they blew up their own citizens in order
to switch the power over to the guy who was going to lead the war against the
Chechnyans. He declares victory, suddenly he's popular, and he becomes president.
Has anybody ever seen Wag the Dog? No, yes? I had to look and see. Wag the
Dog is about a president who is embattled over some problem. I think in the
movie he was having an affair with an intern, right? And he starts a war in another
country, and the thing is that this movie, I believe, came out before the Monica
Lewinski thing came out. And the Monica Lewinski thing came out, and then Clinton
has the Kosovo Serbian bombing campaign. It's almost like the White House
said, "Wow, that's a good movie, maybe I should have an affair with this intern, and
then there's going to be a media uproar, and then I'll go attack Kosovo." It was just
unbelievably Russian, right? Or it's a pattern that just gets repeated
over and over again, right? So that's the politics side of things. So Putin is now the
most powerful man in Russia, obviously. And it came from this war of liberation and
freedom to fight the Chechnyans, and the Chechnyans were like, "Hey, it wasn't
us." They were essentially the scapegoats, the same way that the Vietnam War was turned
up by what? There's some notion that FDR knew about Pearl Harbor happeningÉthere's
all kinds of stuff going on. Anyway, that's politics and this is economics.
And they interact a lot. So that's why I think this is actually on topic.
That was a question. Other questions? [Do prices tend to increase or decrease during
a depression or a recession?] That's a good question. What happens with
demand in a recession? [It goes down?]
Right. SoÉand let's just sayÉthis is the economy (this is Q, right? All of the
economyÉ). This is the demand before the recession, and then demand shifts in.
This is a macro thing. I'm a micro economist. There's this IS/LM stuff and the
velocity of money. But let's just try and be stupid about it for a second. The
question is: do prices go up or down? If we have, essentially, a perfectly competitive
supply in a market, then prices would tend to be level by definition, right? If we
have an increasing supply curve, then prices will go down as the quantity of goods
demanded falls as the demand curve shifts in. So prices are going to either stay the
same or they could rise. Because remember, if you have an increasing returns to
scale technology, you've got this kind of marginal cost curve.
Usually the prices will fall. I'm not going to sit there and make a large argument for
the counterfactual. But for an individual firm, they might be able to sell as many
units as they used to, so their cost per unit might go higher, right? This is a real
problem with water, right? People use less water, and the fixed costs of water are so
big that they actually have to raise the price per unit of water even though people
are using less. That's an accounting problem. But in the macro sense, my general
impression is that the prices are going to fall. Same thing, just assuming your
perfectly elastic supply curve, which is not typical.
[Given that situation, wouldn't that cause the Y to shift in too because they would
expect consumers to consume less, so the prices might riseÉ?]
Yeah, so this is the dynamics question, right? You're a company. If you're Starbucks,
do you say, "Oh there's a depression outside. Well, whatever, a latte is still $4.50." or
do they say, "We better fire somebody because we're not going to have enough
volume." Or "we're going to have the Go-Go value coffee special, which is only half a
cup for 2/3 of the price." So that kind of adjustment in the market is what will be
happening. And then we're talking about demand shifts, supply shifts, and
expectations of a demand shift. The demand will shift, and that will be accurate or
not, right? Because the Starbucks man might think, "Oh I think it will shift in like
thatÑfarther than anticipated, right?" This might happen in the house market. They're
like "Holy cow, demand is really shifting in." or maybe they overestimated.
And this has to do with business cycles, right? So the idea that you have change in
GDP, and basically business cycles are just like this. And what is this? Recession.
Or, more importantly, this is a recession, right? Growth is negative. And then, wow,
look, our economy is likeÉas a wholeÉif you think of this as being positive growthÉit's
decreasing at a decreasing rate, and then it starts increasing, and then it goes
positive. If you go from -5% to -3% GDP, you're actually
doing better, right? The economy is getting better. And then you go to 0% or 1%.
So this is why, in China, when their economy slowed down to 9 from 11%, all the
way down to 7%, it was a huge disaster. 7% economic growth is awesome anywhere
else in the world, but relative to what the Chinese economy (or the people
in the Chinese economy) were used to, that 7% was essentially a depression for them
(or a recession). [Doesn't that shift cause a change in inflation?]
Well inflation isÉI'm a Milton Friedman fanÉso this is actually just Real GDP. Real.
That mean's adjusted for prices. [And what does it look like if you don't adjust
it for prices?] It's usually accentuated. And it depends because
the fall in prices reflects all kinds of stuff. Real economic activity will be going
up and down. The money supply can have a big impact on that, right? And when
the Fed put the interest rate down to 0%, what else can you do to pump up demand?
And they have this thing called quantitative easing, which is just pumping
lot's of money into the economy, so money is cheap, and so whatever you have it's
likeÉoh I better spend it. Or, the alternative is, if I have $10 today, and I
have 0% inflation, what's it worth tomorrow? What's it worth tomorrow? $10, right?
What if I have 10% inflation? It's 10 divided by 1+i. it's worth less. And
it's worth less tomorrow, so maybe I should spend it today, right? So idea, sometimes,
is that if inflation is happening, you should spend your money right now.
And in the worst cases of hyperinflation, Zimbabwe just went through several
million percent inflation. People get paid with wages 2 or 3 times a day. They
would go out, buy bread, go back to work. Because the prices were changing so fast.
[In a hyperinflation like that, don't you just go back to bartering?]
Yeah. Money's worth nothing. And I've been in places were money was the toilet
paper. Where the toilet paper was more expensive than the actual money. So it's
cheaper to use your money as toilet paper, ironically. But those watermarks are
really tough. So any other questions I have no idea how
to answer right? [So what do you then in a situation of hyperinflation?]
What do you do with hyperinflation? Traditionally the solution is to impose some
kind of gold standard or currency board. Basically, throw away your money and
start it again. In Zimbabwe I don't know if they're trying
actively or not. But in the most famous example, that I remember of an economist actually
having a positive impact on this question was when Jeffrey Sachs was the advisor
to the Bolivian government during the hyperinflation in the 1980s. And they
had a problem, they had inflation. And I think they put together a currency board,
so they linked the money to a firm currency like the dollar. And then the government
couldn't inflate the currency anymore. And the people said, "Oh, I guess
my money will be worth the same tomorrow as it is today. Maybe I can hold
on to it."
And inflation fell fromÉI think it was a hundred plus percent per year down to more
like 8% per year. And if you don't know it already, this is the micro of development
economics. Inflation hurts who? The rich or the poor? You get a choice. Rich?
Poor? It hurts everybody, but it hurts the poor
more. Because the rich can just put their money into dollars. Or they have real property.
And the poorÉwhatever money they have is worth nothing. If you have nothing
you lose nothing, that's right, but it depends also on like, if you're getting paid
wages versus you're buying things. Are your wages rising faster than what you're
buying? These are difficult questions for poverty.
[What about in terms of debt versus savings? People can save money that's worth
nothing tomorrow, but they can get their debt loweredÉ]
Right, yeah, so debtors and creditors are different from rich and poor. Because if
you're a creditor, and you're a rich person then you have those loans out there. You
don't have it in your national currency. You have it in hard currencies. So then
you're insulated. I lived in Croatia for a while. You paid your
rent in Deutsch Marks. You didn't pay your rent in the local currency. Deutsch Marks.
Because they didn't trust the local currency. People salaries were set in Deutsch
Marks, even though they had a local currency. So Americans are not used to this
idea, because we have this thing called the dollar, and everybody likes dollars around
the world. And the Australian dollar is not the same as the American dollar.
[And then some places, they'll trick you. They'll go out and say that the price is 10.
And you pay 10 Turkish Liras, but they'll take 10 dollars or 10 Euros or 10 Lira.]
Oh yeah. If you put more money on the table, they will take it off the table. I met
someone, and she's like, "Oh, yeah, I'm American; I go to Canada to pay American
dollars." It's 1:1, right? I mean the Canadian dollar got stronger than the American
dollar very briefly, but you're just throwing your money away. So, whatever, make
people happy. Any other questions? I didn't know that there was a handout that
contained the word Hessian on it. And it had a lot of math? That has been struck from
the record. Forget everything you ever saw. I don't even know what a Hessian
is. It has something to do with the Prussians or something like that. I have no
idea what this meansÉ Okay so on the blog: some people have failed
repeatedly to follow my instructions. Do not send an attachment that is a word document.
If your attachment is on the e- mail, it should be .txt (that means text)
I asked for text, I didn't ask for a word document. I will send it write back to you.
If it's after the deadline, you will get zero points if I don't get to it. And I'm
not going to be monitoring my computer at like 11:59 on October 1st. So do not send
a word document. Okay? And have a bottom line. I don't care how ridiculous it
is. Bottom line: ______. You don't have that? I send it right back. And that's all
the vetting I am doing. So someone asked me, "Oh, will you read it and make sure it's
good economics?" No. It's going to go on the web, and then everybody gets to criticize
it. So if you're worried about your economics, talk to your roommates (if they
know economics). [So we can also copy it into the e-mail?]
Absolutely. I just want words. I don't want this word crap formatting. Due October
1st. Homework 2 is going to be on all this producer
stuff. It's due October 8th, which means that we have to get our act together
to make another homework. It'll be similar problems, in a way, to these problems.
But these ones were consumer, that'll be producer. It's due on the 8th. The midterm
is on the 15th. So that material will be showing up on the midterm, okay? And because
of the lag between grading and handing back, we're probably going to be handing
out the answer key. So you guys will have time to check your answers. Or I'll
do a tutorial onÉif it's the 8thÉI'll try to
do a tutorial on the answer key so you could have a good idea.
I am writing the midterm. The midterm will look a little bit like the homework and a
lot more like this crap I put on the board. So people that are worried about Hessians
on the midterm, it's not going to happen. Any other outstanding questions before I
get to variable cost, marginal cost, and all that stuff?
[Did you write the homework?] No. It was very beautifully typed and formatted,
which is my favorite. Typography language. Any other questions? I looked at
it ahead of time to make sure that it was okay. Just stuff you should know.
So last lecture I screwed up on this discussion of the optimal point for a firm's
production, in terms of where it was most profitable. And we're going to spend a lot
of time today on this word, which means what? [Profit]
Profit. So we're going to spend a lot of time on profit today, and this should help
clarify what I made a mistake in. So I think the mistake was something along the
lines of quantity, average variable cost, marginal cost. Or average cost. So we were
looking at the average cost curve (and the average cost is the fixed cost plus the
variable cost). That's your accounting identity. This is just
a stylized average cost curve. We use it to show that as the average fixed costsÉand
we basically assume that average variable cost is rising, average fixed cost
is falling. If you combine, you get this kind of bowl shape. Does that derivation make sense?
It's a stylized shape of this curve. Obviously, the actual shapes of these curves
for an actual firm will be different. But we just want to start with the idea that the
cost of the item is falling as you amortize these fixed costs across quantity. And then
they're risingÉalthough this part is falling, this part is rising. Because it's
just reflecting our usual assumptionÉrising marginal costs.
So the first thing I want you to know isÉif we assume that this is the marginal cost
curve, the relationship between the marginal cost curve and the average variable
cost curve is something like this. You just take an arbitrary point, and we take the
average of this MC one, Q one. MC one (that's the marginal cost there) the marginal
cost here and halfway in betweenÉand this average variable cost curve is going to
be tracing that average. So the average variable cost at this point is going to be
equal (just dividing that in half). So average variable cost is rising. Average variable
cost is rising, variable cost is rising more slowly than marginal cost.
So how does that relate to this curve here? Now this is obviously the minimum of
average cost. And this is what we often do (we economists in our stylized versions
of the way that costs work). We have that going through there because marginal
cost is rising. It's always above average variable cost. This is the most important
point for you to concentrate on. Or to remember. That the marginal cost curve
passes through the minimum of the average cost curve.
And what's going on at that point, is thatÉnotice that the average costs are falling
and then they're rising. Marginal cost is below average cost, so it's falling, it's
falling. Remember marginal cost is the cost of each
additional unit. When marginal cost per unit is above the average cost curve, then
it's pulling those costs up. Think ofÉthe marginal cost is pulling upÉthis is always
continuing to exert an upward force on average variable cost. If this was the shape
of the marginal cost curve, then the average variable cost curve will go like this
and then it will level out also. No, it would slowly go tangent to here.
So these curves and the relations are very hard to get the first time you see them.
Hopefully this is not the first time. If it is, you're just going to see them more and
more. Keep in mind that the marginal costÉthis is the cost of producing this unit
here. The marginal cost of Q one and the average variable cost is that particular
small cost plus all of the other small costs that were on the way. So that's just the
average. If you have to put in the number, go ahead. This is four, this is zero, so this
is two. [You know the intersection up there? Can we
see that on the bottom graph?] Umm, good question. That point actually depends
on the calculus because I think it's going to be the point where the increase in
average variable cost is identical to the decrease in the average fixed costs.
[So it's not when those two cross?] It is not when these two cross. This is not
important, as far is that's concerned. In fact, that's not important, period. Neither
is this. [I don't understand why the average variable
cost is rising, and not a straight lineÉ] Because in this particular example, marginal
cost is rising. If marginal cost is flatÉ Variable cost, marginal cost. That's marginal
cost. What's variable cost? Same, right? And what's average variable cost? Same.
So if marginal cost is rising, then they both start off with 0, but take this
is an example. This is the marginal cost (let's say it starts at 5) the average variable cost
of that point is not 5, that's the marginal cost. The average at 5 is rise over runÉhere's
the way to look at itÉ This is the area under the marginal cost curve,
this is the total variable cost. Essentially, we want to push this area over
there until we fill it in and get a flat line, and that would end up being the same volume,
the same total variable cost, and that is how we would get this average variable
cost curve. The average variable cost at this point, times the quantity, is also that
volume. This is actually a useful way of seeing things.
But remember that average cost is taken across all your units, and marginal is just
for the last unit. Marginal. On the margin. The last one.
Now, let's look at this and how it relates to question last time that I was getting
right, and that I was saying wrong. The right partÉ
So let's use this bowl up here (average cost, marginal cost). And the question is
where is it most profitable for that firm to produce? Well, let's say that this is price.
Is this company a price take or a price maker? Price taker right? Because as quantity
changesÉ This axis as MC, AC, and Price on it. So the
price taker, this line representsÉwhat's the other name for price on this line, in
terms of profit maximization? Marginal revenue. Marginal Revenue=Marginal Cost where?
Marginal Revenue=Marginal Cost at points A. They cross. That's a nice,
easy one. So the firm is going to choose to produce Q1. Now that is not at the minimum
point of the average cost curve. That's what I made a mistake on last time.
Either I said it, I implied it, or I talked about it. It's not true. A profit maximizing
firm will make a decision on how much to produce based on the relationship between
marginal cost and marginal revenue. Now what's clear is that this is an area between
the minimal point and the actual decision. Average cost has risen, but that
doesn't matter. What matters is the relationship between marginal cost and marginal
revenue. At that point Q1, the marginal revenue is P, the marginal cost is
P. To the right of that, producing more, let's say here. Let's say you produce this
much here. You have a marginal cost of producing it as far larger than marginal revenue.
That is making a loss. You do not want to do that as a firm. You do not produce
that far. You stop at this point Q*. [You know the curve for Q1, is that where
the curve for average cost is the lowest?] No it is not. Q1 is an arbitrary point with
respect to average cost. Arbitrary. [Why wouldn't it be more efficient to produce
when the average cost is the lowest?] Because the average cost reflects all the
costs of all the units you have produced so far. Now remember there was this question
of whereÉI think this is where it startedÉthis is where it was getting confusingÉwe
had this average cost curve, and we have a price line here. What's the profits
at this point? Zero, right? Because average costs and price are equal. I mean
itsÉtotal revenue minus total cost is equal to profit. I'm going to call that P times
Q (I'm going to call that P2) minus AC, Q2. And that's essentially the same number, so
that's equal to zero. Now should I produce right here? That's where the average
costs of all the units so far is minimized. So this is why I gave this example
here. The profit here is zero because you're looking at areas in this thing. The
area under the total revenue curve and the area under the average cost curve is the same.
That's why it's zero profits. But when you're talking aboutÉso you were making
a profitÉand now you have your marginal costs.
Given the marginal costs are increasing, the decision to produce will always be after.
With one exception. It will always be at this point or to the right of this point. And
what I mean by that a perfectly competitive market place, where you have a lot
of firms, they're going to compete away profits so that the price falls, and they're just
making an economic profit of zero. This is perfect competition. And in the long run.
I'm going to talk more about that. In the long run, firms will keep entering
the market. If the price is over here, if the
price is higher, at this point here, is the firm making a profit or not? Yes, it is making
a profit. At this point Q2, marginal revenue and marginal cost are equal, so that's the
profit maximizing decision, but the price here, times the quantity, which is the box
here, and the cost is taken off of the average cost curve. The cost is either going to
be this cost here (so it's all the way over and all the way down, so it's a rectangle,
under that box) or it's going to be the sum of all the marginal revenues under the
marginal revenue curve. The thing that's obvious here is that the difference
between this and this is greater than zero. So this entire box here is profits for the
firm at that point. If there are profits, then another firm says, "OO, maybe I should
enter the market." So another firm enters the market, and another
firm enters the market, and another firm enters the market price will fall, and
another firm enters the market. As firms enter the market, price will fall because
the supply curve is shifting out. As firms enter the market, the supply curve is shifting
out, price is falling. And as prices fall, you can see that that profit is getting squeezed.
And it will get squeezed all the way down to zero. If there's negative profits,
the firms start to leave the industry. They go somewhere else. That's a discussion where
long run profitability goes. Long run profits in a perfectly competitive market
are what? Zero. And the fact is, we're almost never in a negatively
competitive market and we're almost never in the long run. We're stuck.
It's interesting. Is that clearer? Are there more questions?
[So in your error last time, where you did not make the marginal cost curve go to the
minimum of the average cost curveÉ] I forgot to do that. I forgot to say at the
time the firm was going to produce the difference between average cost and price
was the greatest. They won't produce there. They're going to produce where marginal
revenue and marginal cost are equal. I should be just shot for that because
we say that all the time. I should have a tattoo. So this is a point that's interesting
almost all the time. It's trivially interesting. It only really matters in this
long run perfect competition context. When that point actually gets used, right?
Until then, all we know is that the marginal cost curve passes through the minimum
of average cost. It's not necessarily by construction, it makes sense
from an economic decision perspective. [So what would be the optimal Q then?]
Under MR2 or MR1? Where would it be? [Where Marginal Revenue = Marginal Cost]
Yeah, that's always going to be the optimal point. And I'll show you the math in a
second. It's kind of cool when you see it explained more. Yeah.
[So it doesn't really matter with the average cost. All we have to observe is that the
average cost is falling and rising...the inflection point?]
Yeah that's the inflection point. So the inflection point shows up because we know
the average cost curve is always falling. And we assume that average variable cost is
always rising. Because of the marginal cost curve. So the combination of falling and
rising is that you're going to have an inflection point somewhere, right? It turns out
to be an accounting identity that the marginal cost curve will pass through the
minimum. And that's helpful in terms of doing analysis. Because if I say, "where's
the equilibrium point in a long run competitive market?" You'll say, "there."
You don't even have to do any math, calculus nothing. It's just right there. But at
that point you have to say, marginal cost = marginal revenue. What about the other
optimal point? Marginal cost = marginal revenue. But the marginal revenue might
be moving around. The marginal cost curve is static in this. But the marginal
revenue is moving around because of that price entry because that's falling and
rising. [So where MR2 and AC intersect, that's noÉ]
No, because the production decision with MR2 is what Q?
What Q would the company produce given MR2? Marginal revenue = marginal cost, but where?
Q2. That point here is like whatever. It's out
there. This point determines this quantity. The fact that this point and that point exist
doesn't have any impact on the decision of the firm.
[But if we weren't in a profit maximizing society or a profit-maximizing firm, and we
just wanted to produce as much output as possible instead of breaking even, then we
would produce at that point there. So if we were socialistÉthat's where we wouldÉ]
That's the theory, in fact, of regulated utilities. The theory is that they'll be breaking
even. It turns out that it's very hard to manage that. Like if you're only breaking
even, then do you care about cost increasing? Because you could just raise your
price. There's all kinds of interesting dynamics. But from a social welfare
perspective, and I'll get to that in a second about prices.
Any other stuff about this VC/AC stuff? So let me segue into more on profits. I'm
going to give you a couple of examples. I'm going to four here, and then I'll go back
to three. I want to give this example because it'll make things more concrete with profit
decision. So profit, we'll define as total revenue minus total cost. Now if we have a
perfectly competitive firmÉwhen we have a perfectly competitive firm, do we have
an impact on the price and the market. Price is exogenous, right?
Price times Qi, the amount of quantity chosen, minus a function of C-Qi, is still the
profit equation. If we want to find maximum profit with respect to the amount of Qi
that we choose, we take the derivative. We find P minus C prime. We take a
derivative. This is the derivative. We set it equal to zero. And then we solve. We
find that P is equal to C. or marginal revenue is equal to marginal cost (C prime).
So this should be fairly straightforward. All we're doing is we're setting up pretty
straightforward stuff. Price times quantity, how much revenue do I have, cost, and
the assumption you make about cost is C prime is what? Is marginal cost rising or
falling? Rising. We're just going to assume that. And that's howÉwe assume that
it's greater than zero. All the math geeks out thereÉit's risingÉC is greater than
zero. C prime is greater than equal to zero. C double prime is also greater than or
equal to zero. It's increasing at an increasing rate. So that's just true. That's a true
assumption. We're assuming that. Later on I'll get to the examples of falling
marginal costs. Just because that's a significant industry. Now, next to that, let's
look at the (this perfectly competitive firm)É A monopolist. Does a monopolist have an impact
on the prices? Yes, good. So profit is equal to total revenue minus total cost.
I'm just going to put an m here for monopolist. P, which is a function of Qm,
PQm-CQm. What have I changed here on that one compared to perfectly competitive?
Price is a function of quantity, right? This price is no longer exogenous, the price is
endogenous, right? Price is determined inside of the equation. So the profit making
firm is going to setÉit's going to take a derivativeÉQm so we get P*Q + P-C'Q. So
this is the additional component that get's added to this.
I'll get to an example that will make this really clear, but this is what's going on
with the basic math. So we set that equal to zero.
And now we've gotÉP'Q plus P equals C prime.
[How did you get P for theÉ] This thing here? That's the chain rule.
[Is it the chain rule or the product rule] The Product rule. Here's the thing. So if
the marginal cost here is _, and over here, what's price going to be? Price is _, right?
Marginal cost is _. Just for example. Then price is equal to marginal cost, right?
Price is falling. So here, I'd say that's _.
Price is going to be (this is a positive number). Is price is going to be higher or
lower? Lower, right? The firm, by producing in the market, is actually
lowering the price. And I'm going to give you a graphic example so you could
see it. But every time the firm a firm puts another unit in the market, the price
is falling. That's because the firm is affecting price, right? By meeting demand
the price is dropping. And let's look at an example of that to make this abundantly clear.
Over here, let's just say, for both of these firms, C(Q)=Q squared. C prime is equal to
what? 2Q. Just taking a derivative right? So that looks like this, this looks like that.
Cost is increasing at an increasing rate, and marginal cost is just linear. And this
is just and example. Marginal cost can be curved,
as long as it's going up. That's all I care about. So, with our perfectly competitive
firm here, let's say that we're going to have price, and we're going to have marginal
cost, and they're going to pass each other. But we know thatÉlet's just make this
P=1. So price is equal to one. It's a price taker, price can be anywhere I want.
Price can be one, two, four, five, doesn't matter. _. Price is equal to one, what's the
quantity produced? 1=2Q. Q= 1/2. Right? That is it.
Total revenue equals what? P times Q. Total cost equals what? What's the cost function
of this firm? Q squared. So profit of the firm is _. Is that equal
to area A or area B? Area A. The area above the marginal cost curve and below the price
curve. What's that also called in our econ one language? Producer surplus, right?
And I'm doing this because I want to compare this outcome. I want to compare this
outcome to the situation facing a monopoly. And remember that the vast majority of
the world is an oligopoly. It's in between these two, right? But these extreme cases
are meant to teach you what's going on. Oh, to give you intuition: so the thing that
drove me crazy when I went to grad school was when the professor said, "Oh, use
your intuition." Intuition in economics is not the stuff you
were born with. Like, I like sweet food, or I want to sleep on Saturday mornings. Intuition
is what you learn in economics. So I'm trying to teach you the intuition. So
this example is about that. So we have a monopolist. We have a demand
function, which depends on the quantity of the market. Now there's different
ways of thinking about this. The easiest way to think about this is that this
is one firm out of many, many, many firms. This firm is only one firm. I'm going
to change this Q and make it only 1 Q for the market, or the monopoly. I'm going to
change the scale, sorry. Qm, P, 1, and 1.
[When you're talking about I, do you mean that graph there?]
This is I, this is M. [Is that the graph for the monopolist?]
No, this is all perfectly competitive. Everybody got that? One column, perfectly
competitive. Next column, monopolist. I'm trying to compare them side by side.
So the total revenue of the firm, the monopolists, is this equation here. And I've got
a functional form here. That makes life easily. Let's rewrite the total revenue equation.
P is a function of Q. That's the price times Qm. Right? I'm assuming, I'm asserting that
this is the demand curve. That was general now, and this is a specific example.
So if I take a derivative of this, I get that. What is that? You can think about it.
This is the total revenue function. What is this? Marginal revenue function. Ok?
How do I draw that? This is 1-m, this is 1-2m. How convenient. This is demand, this
is marginal revenue. What's the intersect down here?
When price is 0, what's quantity, _. Right on. Just as a matter of technique, if you
ever see, and you will, in this class, a demand curve, the marginal revenue curve is
twice as steep. Pure math. If it's linear, linear, linear. Let's use the same cost curve
(same marginal cost curve). Where's that firm going to produce in terms of things
that are on that graph there? [Where MR intersects with MC?]
Yes, where marginal revenue and marginal cost are the same. Marginal cost equals
marginal revenue. So they're going to produce this much quantity.
What's the price at that quantity? It's on the demand curve. You just go up from
this intersection to the demand curve and you plug it in. What is the number here?
Q. Did we figure this out yet? What the quantity
is yet? Okay hold on. So let's do that. This is marginal revenue,
right? And the marginal cost curveÉdid we specify the cost curve? Here. Here's the
marginal cost curve, can somebody solve for that and tell me what Qm is going to be?
_. Price is therefore going to be what? _. This
demand curve is 1-Qm. 1-Qm is _ 1- 1/4 = _.
Now what I want you to take away from this are two things:
One: The monopolists will not choose to produce where the marginal cost curve
crosses the demand function. They will produce less. Over here, the perfect
competitor will choose to produce where marginal cost crosses the demand
function. The fact that this is equal to one and this is equal to _ is irrelevant. It's
a simple mathematical example. But the perfect
competitor would produce as long as marginal revenue is greater than marginal
cost. Profit maximizing firm (which is still the same as a perfect competitor) will
produce where marginal revenue equals marginal cost.
It's the same decision, but the curve that maters for a perfect competitor is the
demand curve, which is basically that price, The curve that matters for a monopolist
is the marginal revenue curve. That is a big, big difference, right? Marginal revenue.
And this is the thing. We'll get to price discrimination. The monopolist can charge,
can reduce quantity to here and charge this price. Just choke back supply and
produce it so that it produces so the price up here, or produce so the price is here.
Or it can produce so the price is here. The monopolist gets to choose how much to
produce. The monopolist will choose to produce where the profit is maximized.
Which is where marginal revenue and marginal cost are equal. But the reason that
it's not more profitable to produce so the price is higher is why?
What's the intuition. So the surplus here, I get this area here as profits if I choose
to produce here. If I lower my price a little
bit, everybody pays the same price. This is very important. Price discrimination [is]
different. We'll talk about this a little bit
more about that. Cell phones, cable bills, DVD renting, car insurance, razor blades,
all those things are ideas of price discrimination. This is a much more simple
example. Everybody pays the same price. If I lower my price a little bit, says the
monopolist. Oo look, that's bad because I lose some revenue up here. But it's good
because I get this whole other bit here. You lower the price, you sell more quantity.
You lower the price, you sell more quantity. You lower the price, you sell more
quantity. And after a while, you can keep lowering the price, and sell more quantity,
but the effect will reverse. This is the key point. If you go down here "Oh look
I'm selling a lot more!" but the area of this rectangle here is maximized at the optimal
point. The area is maximized. The profits are maximized. So the graphical way
of looking at it is area. The calculus way of looking at it is, every time I lower
my price a little bit my quantity increases. How does that affect my total revenue versus
my total cost? And I'll draw a picture of that in a second.
And the algebra and the area are showing the exact same process. If I lower my price
I can sell more. If I lower too far, I'm selling more, but now I'm making less of a
profit. And that's completely driven by the idea that marginal cost is increasing.
Just for example, you've got a monopolist they're facing a downward sloping demand curve.
Marginal revenue curve is here. And the marginal cost for this firm is zero.
How much does the firm produce? At what point, what quantity? What odes the monopolist
choose to do when marginal cost is zero?
MR = MC. Where does MR=MC? [Zero]
Marginal cost is zero. Where does marginal revenue equal zero? On the axis. What
part of the axis? I got one and two. Which point? One. Marginal revenue curve
crosses the marginal cost curve right here. Bang, there's my price. It happens to be
_ because of this 1 minus 2 construction. So this for the monopolist is the optimal
point of production. And all of this is profit to the monopolist.
Consumer surplus is that area A above that line. Typical scenario. What's happening
with so-called deadweight loss? Social cost? Are they greater than zero or equal to
zero in this construction? Deadweight loss is equal to zero. It's equal to area C,
right? The marginal cost is zero, I could produce
all the way out here to point 2 couldn't I? Cost is zero, so that's fine. And I'm lowering
the price, and lowering the price, and lowering the price, says the monopolist. My
profits are falling but social welfare is increasing until, when you get down to price
zero, A+B+C is equal to profits? Yes or no? No. Is that the consumer surplus? Yes.
Is that the social surplus? Yes. Consumer surplus + producer surplus = social
surplus. When you're a regulator looking at this situation,
you're like, "Hey there's a monopolist here. What we want to do is push
their output from one to two, so that they produce more so that society is better
off." Unfortunately this monopolist doesn't want that. Monopolist pushes back,
right? I want profit. So that's that tension between one and two. And it's also
called the tension between bargaining and efficiency in some circles.
Efficiency is producing at point two. The bargaining result or monopoly or strategic
result is produced at point 1. [What do those two curves represent?]
This is the demand curve and this is the marginal revenue curve. The marginal cost
curve is just zero. It's just flat along the axis. That's just for the sake of an exampleÑ
simplicity. Any other questions? The firm is dealing with this situation right
here, lot's of little messy areas here. They're producing Qm=1/4, right? What's profits
for this firm? Profit for the monopolist is equal to P times
Q, _. And P at _ is equal to what? _ minus total cost.
Total cost function is Q squared. Total cost is Q squared, 3/16 minus 1/16 = 1/8.
Now _ versus 1/8. Completely irrelevant. I'm using numeric examples, so you guys
can understand what's going on. [Does that mean that it can happen that a
competitive firm makes more profit?] No that's exactly what I'm not saying. I am
not saying that a monopoly will make less money than a firm in a perfectly competitive
market. And here's the way to understand that. This is an example. It's
a simplification. If I wanted to do this for a
monopoly, and let's just say that there's 100 firms in the market. And each of those
firms are making a profit at _. And they have this demand function here.
Then this firm would replace 100 firms. Right? And then will choose against
aggregate demand. How much to produce. And this could be (instead of 1/8) it
could beÉ125. Right? Or 12.5 if I keep the scalesÉit doesn't matter.
The monopolist is facing the entire market. The perfect competitor is facing a tiny
segment of the market. So the number 1/8 and number 1/4: the relationship
between those two numbers is completely irrelevant. What matters is that the 1/8
is a decision facing this demand curve. Notice that I have price is equal to 1. I just
set that demand equal to 1. So I could have set that equal to 4 or 5; it doesn't matter.
I just set these up. So the lesson of this example is that the
monopolist makes a decision of how much to produce based on marginal revenue = marginal
cost. But the marginal revenue curve for the firm is a downward sloping curve.
The marginal revenue curve for the monopolists is downward sloping. The marginal
revenue curve for the perfect competitive firm is a flat line. It's that
price. Does that make sense? And that's the decision they make. Now let
me draw this a different way. That would be algebra. Let's just do a little graph
showing profits. We're still doing marginal revenue and marginal cost.
Just temporarily here, let me draw inÉ Put on a note on the side of this. Total revenue
for this firm is this line here. It's just p times q. It's just linear, right? Cost function
is like this. Total costs. This is a reminder what happened in the last lecture.
Is a firm going to produce at point A or point B? Point A, right?
Total revenue is equal to total cost. Profit is equal to zero. This is where marginal
revenue (the line, the slop of the line) is equal to marginal cost. Sorry. Where
marginal cost is equal to marginal revenue. The difference here is the greatest, and
that turns out to be Q _ here. Now for the monopoly, just to keep this idea complete,
it's going to be something like this, right? Because total revenue is going to fall off
as you produce more, because you're dropping
the price. And you want to get to the point where this line and this line are parallel.
Again, where marginal revenue and marginal cost are equal. So there's less quantity
in the marketplace. Take any firm that's perfectly competitive and make them
into a monopolist given the same demand function. Which is a very big caveat,
which is kind of crazy. But anyway, they will produce less. Monopolists always
produce less because it helps them keep the price higher.
So that's just an elaboration of what's going on with the shapes and curves and the
parallels and stuff like that. Let me quickly finish this up and look at the profit
function for this firm. The perfectly competitive firm, at a quantity of zero, the profit
of the firm is zero, right? At a quantity of _, the profit for the firm is how much?
_. Right? At a quantity of one, the profit of
the firm is what? Because I've got one times one, price times
quantity minus one squared is equal to zero, right?
So at quantity of 1, the profit is again zero. You get this kind of hump shape, or
parabola. Profit maximization? At the top. Because this is profit. The highest profit
is right there. _. For a monopoly, the situation is different,
or the same. But we have one half, and one. What's the profit for the monopoly at
1? Quantity is equal to 1, what is the price we'll get? Zero, good. Revenue is zero,
costs are 1 squared, one. Zero minus one is minus one. You're down here. That's
not good. Minus one. We've got zeroÉ At _, the firm has a price ofÉthe monopolists.
1-1/2Éthe price is _. (1/2, 1/2), - (1/2) squared. _ minus 1/4, that's zero. Now
we know that the profit maximizing quantity is _ and the profit there is 1/8.
So the monopolists again have a hump shaped profit function, but the quantities
are pushed over, right? The profit maximizing quantity is again at the top, which
of course is drawn to scale (that's 1/8). That's the top, profit maximizing quantity
is _. At _, profit is zero, right? If you think that this is a perfectly competitive
firm then they become a monopolist, they're going to choke back quantity supplied,
make more money selling less goods. We're out of time for today. See you guys
on Tuesday. Your homework should come back on Thursday.