ECON 251 Module 12: Entry, Exit, and Long-run Profitability Price Discrimination

Accounting profits

total revenue firm receives minus total costs

Economic profits

firm’s revenue, minus explicit financial costs and implicit opportunity costs, accounting profits are greater than economic profits

Short run

horizon over which production capacity and number and type of competitors you face cannot change; number and type of competitors is fixed

Long run

horizon over which you or your rivals may expand or contract your production capacity, and new rivals may enter or existing rivals may exit; new rivals may enter and expand market, existing rivals may leave

Cost benefit principles

enter market if benefits exceed costs, enter if accounting profits are greater than implicit opportunity costs and economic profits are greater than 0

If entry and exit are free, long run price will equal

average cost

If price>average total cost

economic profit>0, new firms enter, price falls

If price<average total cost

economic profit<0, existing firms exit, price falls

Free entry in perfect competition

increases market supply, in long run the P=MC and MC=ATC (lowest ATC means cheapest cost of production and cost efficiency)

Long run of perfect competition

MR(Q) = MC(Q), P=MC (allocatively efficient, no DWL), P=ATC (normal econ profit), Q at min ATC (productively efficient)

Monopolistic competition

entering firms capture some of incumbent firms market share (decreases demand for each firm, market stealing externality), gives consumers more options (makes demand more elastic, product variety externality)

Monopolistic competition long run

P>MC because D>MR (not allocatively efficient), ATC not at minimum (not cost effective)

As new firms enter

each firm’s demand decreases and becomes more elastic

Importance of barriers to entry

long run profitability depends on them

Barriers to entry

obstacles that make it difficult for new firms to enter a market, not naturally occurring defenses

Entrepreneur

build barriers to entry to maximize firm profit, enhance market power, wants higher prices and profits

Policymaker

eliminate barriers to entry to maximize economic surplus, enhance competition, requires free entry

Four strengths to create barriers to entry

demand-side strategies (create customer lock-in), supply-side strategies (develop unique cost advantages), regulation (mobilize the government to prevent entry), deterrence strategies (scare away potential entrants with credible threats)

What can firms do to try to maintain positive economic profits?

block other firms or successfully differentiate

What does advertising do?

shifts demand curve right and makes curve steeper

Price discrimination

selling the same good at different prices, decreases inefficiency; examples being movie theaters, college tuition, coupons, bulk discounts, shopper card discounts, “sliding scales”

Properly price discriminate

change higher prices to high marginal benefit folks, expand market with selective discounts

First degree (perfect price discrimination)

most power, able to charge each buyer their entire willingness to pay, no DWL, no consumer surplus

Second degree pricing discrimination (non-linear pricing)

different pricing for different quantities

Third degree pricing discrimination (group pricing)

seller or customer sorts themselves into pricing groups

Three conditions needed for price discrimination

operate in imperfectly competitive market, have ability to sort customers, prevent resale

Ways to sort customers

group discounts (targeted at groups with lower willingness to pay, qualify for discounts based on verifiable characteristics, characteristics must be hard to change)

Problem with price discrimination

who gets a discount (target proxy related to marginal benefit), everyone wants to pay the lower price (group discounts and hurdle method)

Hurdle method

offer lower prices only to buyers who are willing to overcome some hurdle