Economcs 21 Bentz X02 Topic2

8/4/2019 Economcs 21 Bentz X02 Topic2

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 21

Andreas Bentz page 1

Dartmouth College, Department of Economics: Economics 21, SummerDartmouth College, Department of Economics: Economics 21, SummerDartmouth College, Department of Economics: Economics 21, Summer020202

Topic 2: Theory of the FirmTopic 2: Theory of the Firm

Economics 21, Summer 2002Andreas Bentz

Based Primarily on Varian, Ch. 18-25

2

The SetupThe Setup

A firm produces output y, which it can sell for price p(y)

p(y) is the inverse market demand function

from quantities of inputs (factors): x1, x2,

input cost (per unit): w1, w2,

How can this firm produce? technology

How shouldthis firm produce? cost minimization

How much should this firm produce? profit maximization


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TechnologyTechnology

Production

4

Intro: ProductionIntro: Production

In our problem, the firms productiontechnology is given;

and: the technology is independent of themarket form (market structure):

in particular it has nothing to do with competition orfirm behavior.


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5

Production FunctionProduction Function

Aproduction function tells you how muchoutput (at most) you can get from givenquantities of inputs (factors).

Example (Cobb-Douglas): f(x1, x2) = x1a x2

b.

Here: x10.5 x2

0.5.

6

ShortShort--Run Production FunctionRun Production Function

In the short run, not all inputs can be varied: at leastone input is fixed. Suppose input 2 is fixed at x2 = x2: y = f(x1, x2)

We can still vary output by varying input 1. This is theshort-run production function.


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7

Marginal ProductMarginal Product

Suppose input 2 is held constant: how does outputchange as we change input 1? The marginal productof input 1 is the partial derivative of the

production function with respect to input 1.

Example: Holding x2 constant at x2 = 2, how does u change aswe change x1 by a little, i.e. what is the slope of the blue line?

8

Marginal Product, contdMarginal Product, contd

Formally, the marginal product of input 1 of theproduction function f(x1, x2) is:

That is, at which rate does output increase asthis firm uses more of input 1?

1

21211

0x1

x

)x,x(f)x,xx(flimMP

1 +

=

1

21

x

)x,x(f

=


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9

Buzz Group: Marginal ProductBuzz Group: Marginal Product

What is the marginal product of input 1 of theCobb-Douglas production function

f(x1, x2) = x10.5 x2

0.5?

Does the marginal product increase ordecrease as the firm uses more of input 1?

Answer:

MP1 = 0.5 x1-0.5 x2

0.5.

This decreases as x1 increases, because its slope

is negative: MP1 / x1 = -0.25 x1-1.5 x20.5.

10

IsoquantsIsoquants

Definition: An isoquantis the locus of all inputcombinations that yield the same level of output.


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11

Technical Rate of SubstitutionTechnical Rate of Substitution

The technical rate of substitution is the slopeof an isoquant at a point.

That is, holding total output constant(remaining on the same isoquant), at what ratecan we exchange input 2 for input 1?

12

TRS, contdTRS, contd

0

dx

))x(x,x(df

1

121 =

c))x(x,x(f 121

1

12

2

21

1

21

1

121

dx

)x(dx

x

)x,x(f

x

)x,x(f

dx

))x(x,x(df

+

=

Along an isoquant, output is constant:

Since this is an identity, we can differentiate both sideswith respect to x1 to get:

What is df(x1, x2(x1)) / dx1?

First, there is a direct effect: f(x1, x2) / x1. Then, there is also an indirect effect, through x2:

f(x1, x2(x1)) / x2 dx2(x1) / dx1 (chain rule).


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13

TRS, contdTRS, contd

So we know that

But we wanted to keep output constant, so

So we have:

which we can rearrange as:

2

1

MP

MP=x

)x,x(f

x

)x,x(f

1

12

dx

)x(dx

2

21

1

21

=

1

12

2

21

1

21

1

121

dx

)x(dx

x

)x,x(f

x

)x,x(f

dx

))x(x,x(df

+

=

0dx

))x(x,x(df

1

121 =

0dx

)x(dx

x

)x,x(f

x

)x,x(f

1

12

2

21

1

21 =

+

14

Buzz Group: TRSBuzz Group: TRS

What is the technical rate of substitution (slopeof the isoquant) for the Cobb-Douglasproduction function

f(x1, x2) = x10.5 x2

0.5

at the point x1

= x2

= 2?

at the point x1 = 4, x2 = 1 ?

(this is the same isoquant)


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Firm Decisions andFirm Decisions andMarket StructureMarket Structure

What to do, when.

16

Intro: Tools for Firm DecisionsIntro: Tools for Firm Decisions

How should firms make choices (aboutproduction, input purchases, etc.)?

These tools (unlike production technology)depend on market structure:

e.g. does the firm operate in a competitive market,or is it a monopolist?

For instance, we assume that the firmoperates in a market, so that there are pricesfor inputs and output.


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Firm Decisions IFirm Decisions I

Profit Maximization

18

Profit MaximizationProfit Maximization

Firms maximize profits (revenue - cost).

Why?

Shareholders are interested in the value of theirshares.

Shares reflect the present value of the firm, that isthe present discounted value of all future profits.

Shareholders therefore will want management tomaximize profits.

(Is this really true? Can shareholders controlmanagement sufficiently? See topic 5.)


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19

Short Run Profit MaximizationShort Run Profit Maximization

A (competitive) firms profit maximizationproblem is:

maxx1 p f(x1, x2) - (w1 x1 + w2 x2).

The necessary (first order) condition is:

p f(x1, x2)/x1 - w1 = 0, or: p MP1 = w1

The value of the marginal product of thevariable input has to be equal to that inputs

price.

20

Long Run Profit MaximizationLong Run Profit Maximization

A (competitive) firms profit maximizationproblem is:

maxx1,x2 p f(x1, x2) - (w1 x1 + w2 x2).

The necessary (first order) conditions are:

(i) p f(x1, x2)/x1 - w1 = 0, or: p MP1 = w1 (ii) p f(x1, x2)/x2 - w2 = 0, or:

p MP2 = w2

The value of the marginal product of eachinput has to be equal to the inputs price.


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Firm Decisions IIFirm Decisions II

Cost Minimization

22

Cost MinimizationCost Minimization

How should a firm produce?

Given that the firm wishes to produce a certainlevel of output, with what combination of inputsshould it produce that output?

The firm should use inputs so as to minimize cost.

This fits a delegation story.

That is, the firm solves:

y)x,x(f:.t.s

xwxwmin

21

2211x,x 21

=

+


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23

Cost Min., GraphicallyCost Min., Graphically

A firms cost c is: c = w1 x1 + w2 x2

where x1, x2 are inputs at prices w1, w2

rearrange: x2 = c / w2 - (w1 / w2) x1 This is the equation for the isocost line

corresponding to cost level c.

Definition: An isocost line is the locus of inputcombinations that have the same cost.

24

Cost Min., Graphically, contdCost Min., Graphically, contd

Isocost lines: x2 = c / w2 - (w1 / w2) x1


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25

Cost Min., Graphically, contdCost Min., Graphically, contd

Firms choose to produce a given level ofoutput (on a given isoquant) using the leastcost combination of inputs (they minimizecost).

Firms choose to locate on the lowest isocost line,subject to the constraint of producing a given levelof output.

Implication: TRS = - MP1 / MP2 = - w1 / w2

26

Cost Min., CalculusCost Min., Calculus

Write down the Lagrangean:

Write down the necessary (first-order) conditions:

Then solve for x1 and x2. Without a specific functional form for f(, ) we cannot solve for

x1 and x2. But the necessary conditions are still informative.

( )y)x,x(fxwxwL 212211 +=

0y)x,x(f 21 =

0x )x,x(fw 2212 =

0x

)x,x(fw

1

211

=

y)x,x(f:or 21 =

x )x,x(fw:or 2212

=

x

)x,x(fw:or

1

211

=


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27

Cost Min., Calculus, contdCost Min., Calculus, contd

Necessary conditions:

Divide (i) by (ii) to obtain the familiar:2

212

1

211

x

)x,x(fw:)ii(

x

)x,x(fw:)i(

=

=

2

1

2

21

1

21

2

1

MP

MP

x

)x,x(f

x

)x,x(f

w

w =

=

28

Buzz Group: Cost MinimizationBuzz Group: Cost Minimization

Find the firms cost minimizing choices ofinputs 1 and 2, when it produces with thefollowing (Cobb-Douglas) production function:

f(x1, x2) = x1a x2

b.

Given that the firm chooses inputs in a cost-minimizing way, what is its (minimum) cost forany level of output?


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29

Buzz Group: Cost Min., contdBuzz Group: Cost Min., contd

30


multiply (i) by x1 and (ii) by x2 to get:

now put these into (i):

yxx:)iii(

xbxw:)ii(

xaxw:)i(

b2

a1

1b2

a12

b2

1a11

=

=

=

b2

a122 xbxxw:)ii( =

b2

a111 xaxxw:)i( =

byxw:or 22 =

ayxw:or 11 =

a11

b2

1bababa1

b

2

1a

1

1 wwybaw:or,w

yb

w

yaaw

++

=

=

2

2wybx:or =

1

1w

yax:or =

ba

ba1

ba

b

2ba

a

1ba

b

ba

a

ywwba +

+++

+

=


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31


Putting into the expressions for x1 and x2:2

2

1

1

w

ybx

wyax

=

=ba

ba1

ba

b

2ba

a

1ba

b

ba

a

ywwba +

+++

+

=

ba

1

ba

a

2ba

a

1ba

a

ba

a

2 ywwbax++

+++

=

ba

1

ba

b

2ba

b

1ba

b

ba

b

1 ywwbax+++

+

+=

32


these are the input demands:

so this firms cost (when it uses the cost minimizing

quantities of inputs) is:

ba

1

ba

a

2ba

a

1ba

a

ba

a

2

ba

1

ba

b

2ba

b

1ba

b

ba

b

1

ywwbax

ywwbax

++

+++

++++

+

=

=

ba

1

ba

b

2ba

a

1ba

a

ba

a

ba

b

ba

b

ywwbaba)y(c +++++

+

+

+=

ba

1

ba

a

2ba

a

1ba

a

ba

a

2ba

1

ba

b

2ba

b

1ba

b

ba

b

1 ywwbawywwbaw)y(c++

+++

+++

+

+ +=

2211 xwxw)y(c +=


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33

(Long Run) Total Cost(Long Run) Total Cost

Out of the firms cost minimization problem comes its(long run) total cost function: The long run total cost function tells you what the cost of

producing different output level is, given that you use inputs inthe best possible (cost minimizing) way.

34

LMC, LACLMC, LAC

(Long run) marginal costis the ratio at which costincreases with output:

(Long run) average costis the per-unit productioncost:

y

c c(y)

y

LAC

LMC

LAC

LMC

dy

)y(dc)y(LMC =

y

)y(c)y(LAC =


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35

Buzz Group: LMC, LACBuzz Group: LMC, LAC

Derive LMC and LAC for the long run total costfunction:

ba

1

ba

b

2ba

a

1ba

a

ba

a

ba

b

ba

b

ywwbaba)y(c +++++

+

+

+=

Answer:

36

Long Run and Short Run CostLong Run and Short Run Cost

The long run total cost function tells you what the costof producing different output level is, given that youuse inputs in the best possible (cost minimizing) way. This implies that you can vary all inputs: in the long run, all

inputs can be varied. Production function f(x1, x2).

Long run cost: c(y)

In the short run, not all inputs are variable: some (atleast one) inputs are fixed. Remember: short run production function f(x1, x2).

Short run cost: cs(y, x2)


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37

LL--R and SR and S--R Cost, contdR Cost, contd

x2

c(y)

cs(y, x2)

In the short run, not all factors are variable. Suppose x2 is fixed at x2.

How does short run cost compare to long run cost?

38


For every level of output y,

there is an optimal level of input 2, x2(y)

(and an optimal level of input 1, x1(y).)

So: the long run cost for output level y, c(y) isjust the same as:

short run cost if the fixed input is fixed at theoptimal level x2(y), that is at the level of that inputthat would be optimal for that level of output y.

That is:

c(y) cs(y, x2(y)).


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39


In the diagram on slide 37, the optimal level ofinput 2 for an output level of y3 would havebeen x2.

Therefore, when in the short run input 2 was fixedat x2, the short run cost function for output y3 wasthe same as the long run cost function for output y3.

But for all other output levels, the short run costwas higher than the long run cost, because input 2was fixed at the wrong level.

40

(Short Run) Marginal Cost(Short Run) Marginal Cost

The short run total cost function is: cs(y, x2).

Marginal costis the rate at which short run cost

increases as output is increased. So:

y

)x,y(c)y(MC 2s

=

y

cscs(y, x2)

y

MC

MC


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41

(Short Run) Marginal Cost, contd(Short Run) Marginal Cost, contd

There is a close connection between long runmarginal cost and (short run) marginal cost:

Remember that: c(y) cs(y, x2(y)).

y

cscs(y, x2*)

y

MC

MCc(y)

LMC

y* y*

42

(Short Run) Marginal Cost, contd(Short Run) Marginal Cost, contd

Remember that: c(y) cs(y, x2(y)). Differentiate both sides with respect to y to obtain:

dy

)y(dx

x

)x,y(c 2

2

2s

+

y

)x,y(c 2s

dy

)y(dc =

LMC = MC + stuff

We want to know what LMC is at the output level y* forwhich x2* is just the right level of input 2:

cs(y*, x2*) / x2 = 0 when x2 is chosen optimally (i.e. such thatit minimizes cost), so at that point:

y

*)x*,y(c

dy

*)y(dc 2s

=


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43

Short Run Total and Variable CostShort Run Total and Variable Cost

Since in the short run some inputs are fixed,we can split up short run total cost cs(y, x2) into

fixed cost (the cost coming from the fixed input),that is: F = w2x2, and

variable cost (the cost that comes from the inputthat can be varied in the short run), that is: cv(y).

Even when producing nothing (y = 0), in theshort run there is a cost, F (the fixed cost).

That is why the short run total cost function doesnot start at the origin:

44

SS--R Total and Var. Cost, contdR Total and Var. Cost, contd

cs(0, x2) = F Even when no output is

produced, in the short runthere is a cost: the fixedcost.

The variable costis the

part of short run costthat varies with output,that is, it is cs(y, x2) - F. Variable cost is just short

run total cost less thefixed cost.

y

cscs(y, x2)

c(y)

y*

FC

cv(y)


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45

SS--R Average CostR Average Cost

Average Fixed Cost: AFC = F / y

Average Variable Cost: AVC = cv(y) / y

Average Total Cost ATC = cs(y, x2) / y, or:

cs(y, x2) = cv(y) + F

cs(y, x2)/y = cv(y)/y + F/y

ATC = AVC + AFCy

c

AFC

AVC

ATC

MC

Marginal Cost intersects AVC and ATC at theirminimum points.

46

Buzz Group: CostBuzz Group: Cost

If the short run total cost curve is:

cs(y, 2) = 5 y2 + 20

What is Average Total Cost?

ATC(y) =

What is Fixed Cost?

F =

What is Variable Cost?

VC(y) =

What is Average Variable Cost?

AVC(y) =

What is Marginal Cost?

MC(y) =


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47

Short Run Average Total CostShort Run Average Total Cost

Remember that: c(y*) cs(y*, x2*), and c(y) cs(y, x2).

So we have the following relationship between (shortrun) average total cost and (long run) average cost: AC(y*) = c(y*) / y* = cs(y*, x2*) / y* = ATC(y*)

AC(y) = c(y) / y cs(y, x2) / y = ATC(y)

That is: Short run ATC is always above long run AC ...

and the two are equal at the output level where short run cost= long run cost (which is also the output level at whichmarginal costs are equal).

48

SS--R Average Total Cost, contdR Average Total Cost, contd

Short run ATC is always above long run AC ...

and the two are equal at the output level whereshort run cost = long run cost


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49

SS--R Average Total Cost, contdR Average Total Cost, contd

and there is one ATC cost curve for each level of

the fixed input: The (long run) average cost curve is the lower envelope of the

(short run) average total cost curves.

50

Short Run and Long Run CostShort Run and Long Run Cost

and long run average cost equals short run averagetotal cost at the output level where long run marginalcost equals short run marginal cost.


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51

Returns to Scale:Returns to Scale: ConstConst. Returns. Returns


Firm Decisions IIIFirm Decisions III

Profit Maximization again


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53

SupplySupply

A firm aims to supply the quantity of output thatmaximizes its profit: maxy revenue - cost

for each perfectly competitive firm: competitive firms are price takers: they face a horizontal

demand curve:

maxy p y - cs(y, x2)

for a monopolist: a monopolist faces the (inverse) market demand curve p(y):

maxy

p(y) y - cs(y, x

2)


Firm Decisions:Firm Decisions:Competitive FirmsCompetitive Firms

ex pluribus unum


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55

Supply: Competitive FirmSupply: Competitive Firm

A perfectly competitive firms problem is to: maxy p y - cs(y, x2)

The necessary (first-order) condition for maximizationis:

p - cs(y, x2)/y = 0

cs(y, x2)/y = p MC(y) = p

(but only when its better to produce in the short run than toshut down, that is when:

p y - cs(y, x2) > - F

p y - VC(y) - F > - F

p > VC(y)/y, or: p > AVC(y).)

56

Supply: Competitive Firm, contdSupply: Competitive Firm, contd

A competitive firms supply curve is its marginal costcurve above AVC.


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57

Buzz Group: Competitive FirmBuzz Group: Competitive Firm

If the short run total cost curve is:cs(y, 2) = 5 y

2 + 20

What is the firms profit? At what output is itmaximized?

(y) = p y - (5 y2 + 20)

(y) = p - 10 y

profit maximum: (y) = 0, or: p = 10 y, or: y = p/10

If the firm produces that output, what is its(maximum) profit?

p (p/10) - (5 (p/10)2 + 20) = p2/20 - 20

58

Supply: Competitive Firm, contdSupply: Competitive Firm, contd

In competitive markets, there is free entry into, andexit from, the market. If firms in this market make positive profits, there is an

incentive for other firms to enter the market

which lowers price

and erodes profits.

When is there no opportunity for firms to make positiveprofits (i.e. when will entry no longer occur)?

When (y) = p y - cs(y, x2) = 0, and no other choice of x2 cangive you lower cost.

That is, when p = cs(y, x2) / y ATC(y), and you are operatingon the lowest possible ATC curve.

That is, when you are operating at the lowest point on LAC.


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59

LongLong--Run Competitive EquilibriumRun Competitive Equilibrium

In long-run equilibrium, all profit has been eliminatedthrough entry into the market: each firm in this industry produces at the lowest point of its

long-run average cost curve.

y

p

yf

p

D

S

market firm

LAC

LMC

yf*

S

p* = MR

MC

ATC


Firm Decisions:Firm Decisions:MonopolyMonopoly

The best of all monopoly profits is aquiet life.

-- John Hicks Annual Survey of Economic Theory: TheTheory of Monopoly Econometrica 1935


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61

Supply: MonopolistSupply: Monopolist

A monopolists problem is to: maxy p(y) y - cs(y, x2)

The necessary (first-order) condition formaximization is:

dp(y)/dy y + p(y) - cs(y, x2)/y = 0

cs(y, x2)/y = p(y) [1 + dp(y)/dy y/p(y)]

MC(y) = p(y) [1 + 1/] MR(y)

Mark-up pricing:

p(y) = [1/(1+1/)] MC(y)

62

Supply: Monopolist, contdSupply: Monopolist, contd

Example:

linear (inverse) demand p(y) = a - by

(y) = (a - by) y - cs(y, x2) = ay - by2 - cs(y, x2) ay - by2 is revenue

(y) = a - 2by - cs(y, x2)/y a - 2by is marginal revenue

profit maximum: a - 2by = MC(y)


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63

Supply: Monopolist, contdSupply: Monopolist, contd

Linear demand p(y) = a - by, so MR(y) = a - 2by


Market Structure IMarket Structure I

Monopoly Behavior:Price Discrimination and

Two-Part Tariffs


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65

Price DiscriminationPrice Discrimination

First-degree (perfect) price discrimination: different prices for different units of output, and

different prices for different consumers.

Second-degree price discrimination (non-linearpricing):

different prices for different units of output, and

same prices for similar customers.

Third-degree price discrimination:

same prices for different units of output, but

different prices for different customers.

66

FirstFirst--Degree Price DiscriminationDegree Price Discrimination

The perfectly discriminating monopolist knows eachconsumers demand curve.

The monopolist prices each unit of output at eachconsumers marginal willingness to pay.


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67

FirstFirst--Degree Price Disc., contdDegree Price Disc., contd

Perfectly discriminating monopolist would like to sell: to consumer A: x1 at price A + A; to consumer B: x2 at B + B

All consumer surplus is extracted by the monopolist.

First-degree price discrimination is efficient. But: informationally demanding.

68

FirstFirst--Degree Price Disc., contdDegree Price Disc., contd

What limits first-degree price discrimination:

unobservable preferences: informationally demanding;

competition (or the threat of entry): instead, the monopolist may try to limit entry (more on

entry deterrence in Topic 7); arbitrage (resale):

Example: Suppose my marginal willingness to pay is low(i.e. I pay a low price for the quantity I buy). Since myconsumer surplus is zero, there are gains from trade if Isell to you (your willingness to pay is high);

administrative costs.


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69

TwoTwo--Part TariffPart Tariff

The monopolist couldachieve the same outcomeby charging a two-part tariff: charge a one-off fee of A

(consumer surplus), and

charge each unit bought atmarginal cost.

The consumer will then buyx1 units (i.e. up to whereprice = willingness to pay),

and all consumer surplus isextracted.

As before, this isefficient, but

informationallydemanding.

70

TwoTwo--Part Tariff: ExamplesPart Tariff: Examples

How does economic theory (the theory of two-part tariffs) explain features of the real world?

Amusement parks:

admission fee + marginal cost per ride.

Telephone line: connection charge + marginal cost per call.

Xerox photocopiers:

rental fee + marginal cost per copy.


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71

SecondSecond--Degree Price Disc.Degree Price Disc.

Suppose a monopolist cannot observe eachcustomers marginal willingness to pay.

But: she can observe the quantity demanded bycustomers.

She could sell different price-quantity packages,aimed at customers with different marginalwillingness to pay: customers will self-selectintobuying the package designed for them.

An example of an asymmetric informationproblem (more in Topic 5).

72

ThirdThird--Degree Price DiscriminationDegree Price Discrimination

The monopolist charges different prices todifferent customers (i.e. in different elasticitymarkets).

Examples: private/business telephony, studentdiscounts, business/economy class air travel,

(The monopolist must be able to observe acustomers demand elasticity.)

Marginal cost equals marginal revenue in eachmarket. (Monopoly pricing in each market.)

(argument by contradiction)


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73

ThirdThird--Degree Price Disc., contdDegree Price Disc., contd

Suppose there are two markets, with (inverse)demand curves p1(y1) and p2(y2). The monopolistsproblem is to: maxy1,y2 y1 p1(y1) + y2 p2(y2) - c(y1 + y2)

The necessary (first order) conditions for this are: (i) y1 dp1(y1)/dy1 + p1(y1) - c(y1 + y2) = 0

(ii) y2 dp2(y2)/dy2 + p2(y2) - c(y1 + y2) = 0

Rewrite (i): (and analogously for (ii)) c(y1 + y2) = p1(y1) [1 + (y1/p1(y1)) dp1(y1)/dy1], or:

p1(y1) = c(y1 + y2) / [1 + (1/)] The more elastic demand in a market, the lower price

in that market and vice versa.

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ThirdThird--Degree Price Disc., contdDegree Price Disc., contd

Example: Low elasticity market: demand D1 (e.g. private telephony)

High elasticity market: demand D2 (e.g. business telephony)

Price where marginal cost = marginal revenue

Price is high in the low elasticity market, and low in thehigh elasticity market.

MC


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ThirdThird--Degree Price Disc.: WelfareDegree Price Disc.: Welfare

The welfare effects of third-degree price discrimination(compared with standard monopoly pricing) areambiguous:

Two inefficiencies: Output is too low:

The monopolist charges the monopoly price in each market.(She restricts output below the efficient level.)

Misallocation of goods:

Goods are allocated to the wrong individuals.

Example: I value a theater ticket at $20, you value it at $10. You

get a student discount (ticket for $8) and buy the ticket. I have topay the normal price ($28) so I dont buy the ticket. But myvaluation is higher than yours!

And a welfare improvement over monopoly: ...

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ThirdThird--Degree Price Disc.: WelfareDegree Price Disc.: Welfare

If the monopolist were not allowed to (third-degree)price-discriminate, she might only sell in one market: Pricing uniformly in both markets may be less profitable than

selling in only one market.

In this example, the monopolist would only sell in market 1:profit in market 1 is greater than profit in market 2

MC


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Market Structure IIMarket Structure II

Monopolistic Competition:Differentiated Products and the

Hotelling Model

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Product DifferentiationProduct Differentiation

Monopolistic Competition: every firm faces adownward-sloping demand curve (i.e. hassome degree of monopoly power).

In an industry with non-homogeneousproducts, how do firms choose their productscharacteristics?

Example: cars, economics courses,

Imagine one product characteristic that can bechosen continuously: e.g. location of two ice-cream vendors along a beachfront.


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Product Differentiation: LocationProduct Differentiation: Location

Hotellings principle of minimum differentiation: bothice-cream vendors locate in the middle of the beach.

This is not welfare maximizing (the location choice in the left-hand panel in the diagram is).

More examples: political parties, radio stations, ...

Economcs 21 Bentz X02 Topic2

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