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# Top-7 - Econ 1 and 2 ELEMENTS OF ECONOMICS 2 Foster UCSD...

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Econ 1 and 2 – ELEMENTS OF ECONOMICS 2 LECTURE NOTES Foster, UCSD 6-May-09 TOPIC 7 -- MONOPOLY A. Review of Profit Maximization Rules (from Topic 5) 1. Revenue Functions: [Fig. 1] a) Let x d = d(P) be demand for the output of an individual firm . 1) If firm charges a price P, x d = d(P) is the quantity of output that this firm will be able to sell/period. 2) P = p(x d ) is the inverse demand for the individual firm's output. If the firm wishes to sell x units per period, it must charge P = p(x). 3) The law of demand holds -- the demand curve d is downward sloping. b) Important assumption. 1) The firm holds no finished product inventory and no backlog of unfilled orders. 2) Therefore, in any period, production = supply = demand: x d = x s = x p = x. c) Total revenue. 1) Total revenue received by firm = total expenditure on the firm's product by customers: TR = TE = P x. 2) Using the inverse demand function, write total revenue function TR = R(x) = p(x) x. d) Average revenue. 1) AR = TR/x = p(x)x/x = p(x) = P. 2) That is, AR = price, and the demand curve is the AR curve ! e) Marginal revenue. 1) MR is the extra revenue firm earns by selling one extra unit of output per period. 2) In tables, MR ≈ TR/ x. 3) MR and linear demand curves. [Explain] P x TR MR \$ 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 \$0 7 12 15 16 15 12 7 0 /// \$7 5 3 1 -1 -3 -5 -7 \$/x x x TR = R(x) MR \$ Fig. 1 d = AR = p(x)

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Ec 1 and 2 MONOPOLY p. 2 f) Relationship of MR to price (AR). 1) MR < P for x > 1. [Fig. 2] Sell 1 unit at P = \$7; TR = \$7 To sell 2 units, P must fall to \$6; TR = \$12 2) Gain \$6 on sale of second unit, but lose \$1 on sale of first unit, so MR = \$6 − \$1 = \$5 < \$6 = P 2. Short-Run Profit Functions: a) Total profit -- π(x) = R(x) − C(x) = p(x)x − F − V(x). b) Average profit -- π(x)/x = R(x)/x − C(x)/x = AR − ATC = P − ATC. c) Marginal profit -- Δπ/Δx ≈ ΔR/Δx − ΔC/Δx = MR − MC. 3. Marginal Revenue = Marginal Cost Rule: [Fig. 3] a) Profit-maximizing output x*. Problem -- find x to maximize π(x) = R(x) − C(x) Solution -- MR = MC at x*. b) Explanation. If x < x*, MC < MR, and an increase in x would increase π. If x > x*, MC > MR, and a decrease in x would increase π. c) The profit rectangle. d) For perfectly competitive firms, constant going price P* ≡ MR, and rule becomes “P = MC.” 4. The Short-Run Shutdown Rule: a) A firm shuts down in the SR when it lays off all variable inputs and pro-duces x = 0. TR = VC = 0 π = −FC b) The SR shutdown rule replaces the MR = MC rule when P < AVC. [Explain] x* C(x) R(x) π (x) MC ATC d MR P* atc* Fig. 3 \$/x \$ π * Short-Run Shutdown Rule If price is less than average variable cost, a firm maximizes profit by shutting down and producing x = 0. 1 2 3 \$7 \$6 \$5 Fig. 2
Ec 1 and 2 MONOPOLY p. 3 B. Pure Monopoly 1. Market Structure and Assumptions: a) One supplier/firm selling to many small buyer/customers at a single uniform price. b) For monopoly to be meaningful, we assume: no close substitutes for the product high BE c) By implication: no seller interdependence maximum seller concentration no product differentiation d) Notes.

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