BUSINESS
A. I. Practice Problems
1. Chapter 8: 1, 3, 7-13, 16, 20
II. SUBSTANCE
A. Incidence of taxation: Reduce Quantity Transacted
1. Motivation: $0.05 tax increase is shared between buyer and seller; doesnt
matter who is taxed; who is burdened?
Buyer pays $0.03 more (slightly more price inelastic)
Seller receives $0.02 less
Examples:
Sales tax: collected from buyer
Gas station: pay price on gas pump; collected from seller; built into the
price you see
2. Tools:
a. Elasticity: Magnitude of response to tax
b. Economic surplus: Total net benefit to society of engaging in market
exchange
In absence of government, ES = CS + PS
i. Consumer surplus: net benefit of buyers for engaging in market
exchange
ii. Producer surplus: net benefit of sellers for engaging in market
exchange
Surplus = Benefit Cost; Rational if Surplus is > or = to zero
C.S. = Reservation Price Actual Price
P.S. = Actual Price Reservation Price
Q* is the only facor in E.S. (Price is irrelevant)
Price irrelevant because every dollar spent is another earned;
cancels out
Increase Demand
C.S.
P.S.
E.S.
Increase P*
Bad
Good
IRRELEVANT
Increase Q*
Good
Good
Good (Increases)
Ambiguous
Increase
Increase
iii. Government revenue: taxes
G.R. = Net benefit to government
ES = CS + PS + GR
Tax creates 2 different P*s: The price the buyer pays is not the
same as the price the seller receives
Tax Amount = Price paid by Buyer Price of Seller
G.R. = Tax Amount*Q
iv. Deadweight loss: Net loss of E.S. as a result of tax
Welfare
Burden of Tax: Lost consumer/producer surplus
Area under curve; see graph
Function of 3 variables
DL = f[size of tax(+); ES (+); ED(+)]
Loss to buyer/consumer is less than or equal to gain by
government
Change is the same or lower without the tax
High tax on inelastic goods; will not get a big change in Q*
% of Tax paid by Buyer = [ES/ ES + ED]*100
% of Tax paid by Seller= [ED/ ES + ED]*100
Tax: Increase buyer price, buy less; sellers sell less
3. Examples
1) ES=2.5; ED= 1.5; Excise Tax = $1.00
Buyer pays (5/8ths) 62.5%; Seller pays (3/8ths) 37.5%
Buyer bears bigger burden because more INELASTIC in demand
2) If both 50%, the elasticities are equal
3) EBAY no shipping
Reservation Price = $50 (DOES NOT CHANGE)
Winning bid = $50
Price of Buyer = $50
Price of Seller = $50
EBAY seller pays $10 shipping
Winning bid = $50
Price of Buyer = $50
Price of Seller = $40 (-$10 to UPS)
EBAY buyer pays $10 shipping
Winning bid = $40 (+$10 to UPS)
Price of Buyer = $50
Price of Seller = $40 (Seller holds burden)
a. Who bears the burden of a tax? SIDE WHICH IS RELATIVELY
MORE INELASTIC WILL BEAR LARGER BURDEN OF TAX
b. How is economic surplus affected?
A. Theory of the Firm: The Basics
1. Profit = Total Revenue Total Cost
a. Definitions
i. Total Revenue (TR): $ coming into business from selling
goods/services; benefit from selling
T.R. = Price*Quantity
ii. Marginal Revenue (MR): Change in Total Revenue from selling
one more unit of good/service
M.R. = TR/ Q
iii. Total Cost (TC)
. Explicit: accounting; $ out of pocket
Ex. Rent for stand, ingredients, etc.
. Implicit: $ not flowing into pocket because chosen to do
something else instead; Accounting Profit from doing the
next best thing
Economic Cost = Explicit + Implicit
iv. Marginal Cost (MC): Change in total cost from producing one
more unit of good or service
M.C. = TC/ Qoutput
b. Accounting Profit = TR Explicit Cost
c. Economic Profit = TR Explicit Implicit
Accounting Profit is ALWAYS > Economic Profit by the amt. of Implicit Cost
d. Maximizing rule FOR EVERY FIRM:
Produce Q of output where MR=MC
1) MR > MC (Profit is Positive)
Produce more
2) MR = MC (Zero Profit)
Equilibrium, no change in behavior
3) MR < MC (Profit is Negative)
Produce less
e. Normal Profit: When Economic Profit = 0
Equilibrium condition: No change in behavior
Therefore, Accounting Profit is Positive
E.P. = 0 = TR Explicit Implicit
A.P. = TR Explicit
Implicit = TR Explicit (A.P. from next best thing)
f. Examples (On Moodle: Danielle)
Explicit Costs: $108,000
Implicit Costs: $28,000 + $1,400 (interest) = $29,400
Expected Revenue per year: $125,000
Accounting Profit = $125,000 - $108,000 = +17,000/yr
Economic Profit = $125,000 - $108,000 - $29,400
= -$12,400/yr
2. Costs
a. Total (TC) = Fixed Costs + Variable Costs
b. Fixed (FC): Doesnt change with respect to amt. of output
Ex. Rent
c. Variable (VC): f[Q] (+) positively related
d. Marginal (MC): = TC/ Qoutput= VC/ Qoutput
Because only Variable Cost changes
Fixed Cost overhead; does not determine maximizing profits
e. Average
i. Total (ATC) = AFC + AVC = TC/Q
ii. Fixed (AFC) = FC/Q
iii. Variable (AVC) = VC/Q
f. Average/Marginal cost relationship
Marginal > Average: Average going up
Marginal < Average: Average going down
Marginal = Average: Average stays same
g. Graph
Minimum Point: MC = ATC; Slope = 0
3. Time
a. Short run
i. Definition: FC > 0
b. Long run
i. Definition: FC = 0; All cost is variable cost
Ex. Rent Lease expires (Renew? Move?)
Option is long run decision
B. Perfect competition
1. Market structure
a. Many small buyers and sellers
Small in size relative to entire market
Ex. Gas in EBR: Purchase small amt. of gas; Small part of market
does not affect market price; If seller disappeared it would not affect
market
b. Homogeneous good
Sell exactly same good; Sell perfect substitutes
Prices move identical; Buyers care more about price
Demand is perfectly elastic (horizontal line on graph)
D = P = MR (all the same)
MR = TR/ Q = Price*1 more unit
Maximizing Rule: Q* where MR=MC(=P)
c. Perfect information: Know much theyre charging and sellers know
what their competition is selling (know what price to charge)
Firm in perfect competition is PRICE TAKER; No control over price
d. No barriers to entry/exit: In long run Economic Profit = 0
2. Firm behavior in the short run: How much to produce?
Economic Profit = TR TC
TC = ATC*Q or ATC = TC/Q
= P*Q ATC*Q
= Q(P-ATC)
a. Case 1: P > ATC
i. Equilibrium quantity: Q* > 0
ii. Profit: > 0
b. Case 2: P = ATC
i. Equilibrium quantity: Q* > 0
ii. Profit = 0
Positive Accounting Profit = Implicit Cost (next best option)
c. Case 3: ATC > P AVC
i. Equilibrium quantity: Q* >0
ii. Profit < 0
Operating at loss; Loss minimizing decision
Continue to produce in order to minimize losses
Profit > or = -Fixed Costs
d. Case 4: P < AVC
i. Equilibrium quantity: Q* = 0
ii. Profit < 0
Shut down immediately
e. Conclusions (in short run)
Profit = TR TC = TR Fixed Costs Variable Costs
If Q*=0, then = TR 0 and VC =0
Result is Profit = -Fixed Costs
If shut down, firm will be losing
Case 3 and 4 have choice to have Q* = 0 or Q* > 0
Case 3: Where Q* > 0
Profit = (P AVC AFC)*Q
P AVC can be > or = 0
Therefore, Profit is > or = -Fixed Cost
Case 3: Where Q* = 0
Profit = TR VC FC
Profit = 0 0 FC
Therefore, Profit is = -Fixed Cost
*Case 3 will continue to produce in order to minimize losses
Case 4: Where Q* > 0
Profit = (P AVC AFC)*Q
3. Graphically (see graph)
Perfect Competition: entry continues until P* in long run = ATC
4. Firm behavior in the long run: How much to produce?
a. Case 1: P > ATC
i. Entry: Supply Increases
ii. Change in lR Profit = 0 (transform to Case 2)
b. Case 2: P = ATC
i. Entry/Exit: Neither; No incentive to change
ii. Simultaneously existing in short and long run
Change in output/profit = 0
c. Case 3: ATC > P AVC (see graph)
i. Exit: Supply Decrease; Price Increase
ii. Loss gets smaller until P* in long run = ATC in long run
Adjustment process over time until Profit = 0
Operating at loss; Loss minimizing decision
B. Monopoly
1. Market structure
Profit Maximizing rule: MC = MR however MR does not equal Demand
Profit = (P-ATC)*Q
So Price will always be > MR = MC
Because they can & it is profitable; mark up price
a. One seller
i. Implications: No distinction between firm and market
Price Maker Firm = Market; Set quantity and price
b. Good with no close substitutes
i. Implications: The monopolist determines price
Demand is Price Inelastic
c. High barriers to entry
i. Causes: copy rights, patens, legal reasons, natural reasons,
exclusive contracts, high fixed costs typically
Ex. Entergy (distributing, etc.)
ii. Implications: Can hold on in long run
2. Firm behavior in the short run (see graph)
a. How much to produce? Q* where MC=MR
b. What price to charge? On demand curve (not = to MR)
c. Profit?
ATC < P, Profit is positive
ATC = P, Profit is zero
ATC > P, Profit is negative
3. Firm behavior in the long run
a. Case 1: P ATC; Profit is > or = zero
Monopolist has no better option; Q*>0 continue to produce
b. Case 2: P < ATC; Profit is < zero
Q*=0; Market disappears; not enough demand for product
4. Monopolists supply curve (no supply curve)
Supply curve: Willingness/ability to sell at various prices
Point NOT curve; Supply of monopolist will not charge more or less
5. vs. Perfect Competition
Monopoly: Better for seller; higher profit; can hold onto them overtime
Patens are incentive to innovate; can only be monopolist for fixed
time
Perfect Competition: Better for consumer; more output at lower price
6. Price discrimination: Charging 2 different customers 2 different prices for
same good
a. Necessary conditions (4)
1. Firm must be price setter; Able to charge 2 or more different
prices; Not possible for perfect competition (price takers)
2. 2 different customers with different price elasticities of demand
3. Identify and separate groups
Ex. Airlines (pleasure vs. business)
Identify patterns of behavior; indications of how they travel
4. Firm must make resell of good impossible or costly
Ex. Resell desks; only sell at lowest price
b. Third Degree: by person (senior citizen discounts, coupons, etc)
c. Second-Degree: by quantity (nonlinear pricing, buy one get one free)
d. First-Degree (i.e., Perfect): by both; (haggling, negotiate with customer
on price, ex. car sales)
B. Monopolistic competition (between monopoly and perfect competition)
1. Market structure
a. Many small buyers and sellers
i. Implications: relatively small compared to market
Similar to perfect competition
b. Slightly differentiated goods
i. Causes: services different, special sauce, location, etc.
Brand (shell, exxon); differentiate in location, advertising,
quality, etc.
Ex. McDonalds (food)
ii. Implications
Similar to monopoly
c. No barriers to entry/exit
i. Implications
Similar to perfect competition
Short Run: anything possible
Long Run: Profit = 0 (similar to perfect competition)
Profit Maximizing Rule for ALL FIRMS: Q* where MR = MC
In monopolistic competition, P > MR = MC
2. Firm behavior in the short run (see graph)
a. How much to produce? Where MR = MC
b. What price to charge? P > MR = MC
Demand is relatively price elastic
Behavior like monopoly except elastic demand means price is lower
because consumers have options
c. Profit? Anything possible in short run
P > ATC
P = ATC
P < ATC
3. Firm behavior in long run (see graphs)
Demand not perfectly elastic because of peoples preferences
Less output, higher price: Consumers lose in quantity and price but
gain in diversity
Operating at higher cost (not minimizing): excess capacity being unused
because demand is not constant over time
Ex. Gas station with idle pumps: If no excess capacity, they are
losing customers because they will not wait in line
Similar to perfectly competitive market
a. Profit?
P > ATC; attract entry > drive down price, drive down profit until = 0;
Differentiate product again to try to attract more demand
P = ATC; no change
P < ATC; exit the market; not profitable
B. Oligopoly
1. Market structure
a. Few sellers, many buyers
Only handful of firms dominate the market
Ex. Production of beer exploded but only some dominate
1) Concentration ratio: 60% or greater is considered strongly
oligopolistic
(Total Sales of 4 firms/Total sales)*100
2) Implications: Take into account behavior of other large firms
Coca Cola vs. Pepsi (control 80% of market)
Cost structures & business decisions of competition; game
theory to analyze
b. Homogeneous or differentiated goods
i. Implications: (homogeneous: gold)
c. Significant barriers to entry/exit
i. Implications: Fixed cost, advertising, distribution
2. Firm behavior: Compete or cooperate? Dominating firms
a. Cartel: act together as monopolist; complete cooperation
Group of producers that explicitly work together in order to
maximize group profits
Ex. European union from steel cartel after war; achieve recovery
b. Price competition
i. Contestable markets
Forces pulling cartel apart:
1. # of firms in group
a. Increase number of firms, less likely to be successful, hard to
keep agreements
2. Homogeneous vs. different goods
a. More homogeneous, more likely to persist
b. More diverse, have preferred consumers
3. Barriers of entry
a. Increase barriers, more persistent, keep others out, stay
controlling the market
4. Cheating
a. Easy to cheat, less likely to stay together
5. Government Regulation
a. Illegal in U.S.; enforced; preventing explicit price