microeconomics chapters 6-10

Perfectly competitive market

A market with many sellers and buyers of a homogeneous product and no barriers to entry.

Five features of a perfectly competitive market

1. There are many sellers.

2. There are many buyers.

3. The product is homogeneous.

4. There are no barriers to market entry.

5. Both buyers and sellers are price takers.

Firm-specific demand curve

A curve showing the relationship between the price charged by a specific firm and the quantity the firm can sell.

economic profit

total revenue minus economic cost.

Marginal revenue

The change in total revenue from selling one more unit of output

Break-even price

The price at which economic profit is zero; price equals average total cost (ATC).

Operate if

total revenue > variable cost

Shut down if

total revenue < variable cost

Shut-down price

The price at which the firm is indifferent between operating and shutting down; equal to the minimum average variable cost.

Sunk cost

A cost that a firm has already paid or committed to pay, so it cannot be recovered.

Short-run supply curve

A curve showing the relationship between the market price of a product and the quantity of output supplied by a firm in the short run.

Short-run market supply curve

A curve showing the relationship between the market price and quantity supplied in the short run

Long-run market supply curve

A curve showing the relationship between the market price and quantity supplied in the long run

Increasing-cost industry

An industry in which the average cost of production increases as the total output of the industry increases; the long-run supply curve is positively sloped.

Increasing input price

As the industry grows, it competes with other industries for scarce inputs, raising their price, and hence the break-even price in the industry

Less productive inputs

A small industry uses only the most productive inputs, but as it grows it will be forced to use less productive inputs.

Constant-cost industry

An industry in which the average cost of production is constant; the long-run supply curve is horizontal

Monopoly

A market in which a single firm sells a product that does not have any close substitutes.

Barrier to entry

Something that prevents firms from entering a profitable market.

Market power

The ability of a firm to affect the price of its product.

Barriers to Entry

Patent

Network externalities

Natural monopoly

Patent

The exclusive right to sell a new good for some period of time.

Network externalities

The value of a product to a consumer increases with the number of other consumers who use it.

Natural monopoly

A market in which the economies of scale in production are so large that only a single large firm can earn a profit.

Price discrimination

The practice of selling a good at different prices to different consumers.

Conditions for Price Discrimination

1. market power

2. different consumer groups

3. resale is not possible

Market power

The firm must have some control over its price.

Different consumer groups

Groups of consumers that differ in their willingness to pay for the product, along with the ability to distinguish these groups.

Resale is not possible

Otherwise a low-price consumer could resell to a high-price consumer, circumventing the price discrimination.

How to Price Discriminate

• Discounts on airline tickets

• Discount coupons for groceries and restaurant meals

• Manufacturers’ rebates for appliances

• Senior citizen or student discounts

Monopolistic competition

A market served by many firms that sell slightly different products

Entry Squeezes Profit From Three Sides

As the new firm enters the market:

1. The market price drops.

2. The quantity produced by the first firm decreases.

3. The first firm’s average cost of production increases.

The key features of monopolistic competition are:

• Many firms

• A differentiated product

• No artificial barriers to entry

Under the market structure of monopolistic competition,

firms will continue to enter the market until economic profit is zero

Product differentiation:

The process used by firms to distinguish their products from the products of competing firms

Oligopoly

A market served by a few firms.

Concentration ratio

The percentage of the market output produced by the largest firms.

The main alternative measure of concentration is

Herfindahl Hirschman Index (HHI), obtained by summing the squares of the percentage market shares of all firms in the market.

Why Do Oligopolies Exist?

1. Government barriers to entry

2. economies of scale in production

3. advertising campaigns

Government barriers to entry

the government may limit the number of firms in the market.

Economies of scale in production

similar to natural monopoly, but with smaller scale economies that are not large enough to generate a natural monopoly

Advertising campaigns

Breaking into some markets can be difficult without a very large and expensive advertising campaign

Duopoly

A market with two firms

Cartel

A group of firms that act in unison, coordinating their price and quantity decisions

Price fixing

An arrangement in which firms conspire to fix prices

Game tree

A graphical representation of the consequences of different actions in a strategic setting

Dominant strategy

An action that is the best choice for a player, no matter what the other player does

Duopolists’ dilemma

A situation in which both firms in a market would be better off if both chose the high price, but each chooses the low price

Nash equilibrium

An outcome of a game in which each player is doing the best he or she can, given the action of the other players.

Low-price guarantee

A promise to match a lower price of a competitor

Some Repeated Game Strategies

1. duopoly pricing strategy

2. A grim-trigger strategy

3. A tit-for-tat strategy

Duopoly pricing strategy

Simply choose the duopoly price for the lifetime of the firm. This is not very profitable, but avoids being underpriced

Grim-trigger strategy

A strategy where a firm responds to underpricing by choosing a price so low that each firm makes zero economic profit.

Tit-for-tat strategy

A strategy where one firm chooses whatever price the other firm chose in the preceding period.

Price leadership

A system under which one firm in an oligopoly takes the lead in setting prices

Limit pricing

The strategy of reducing the price to deter entry

Limit price

The price that is just low enough to deter entry

Contestable market

A market with low entry and exit costs

Trust

An arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees

Merger

A process in which two or more firms combine their operations

Regulating Business Practices

Tie-in sales

Cooperative agreements to limit advertising

predatory pricing

Tie-in sales

A business practice under which a business requires a consumer of one product to purchase another product

Predatory pricing

A firm sells a product at a price below its production cost to drive a rival out of business and then increases the price

Imperfect information

Either buyers or sellers do not know enough about the product to make informed decisions

External benefits

The benefits of a product are not confined to the person who pays for it

External costs

The cost of producing a product is not confined to the person who sells it

Asymmetric information

A situation in which one side of the market—either buyers or sellers—has better information than the other

Mixed market

A market in which goods of different qualities are sold for the same price.

Adverse-selection problem

A situation in which the uninformed side of the market must choose from an undesirable or adverse selection of goods.

Thin market

A market in which some high-quality goods are sold but fewer than would be sold in a market with perfect information

Experience rating

A situation in which insurance companies charge different prices for medical insurance to different firms depending on the past medical bills of a firm’s employees

Moral hazard

A situation in which one side of an economic relationship takes undesirable or costly actions that the other side of the relationship cannot observe

External benefit

A benefit from a good experienced by someone other than the person who buys the good

Public good

A good that is available for everyone to consume, regardless of who pays and who doesn’t; a good that is nonrival in consumption and nonexcludable

Free rider

A person who gets the benefit from a good but does not pay for it

Private good

A good that is consumed by a single person or household; a good that is rival in consumption and excludable

Private cost of production

The production cost borne by a producer, which typically includes the costs of labor, capital, and materials

External cost of production

A cost incurred by someone other than the producer

Social cost of production

Private cost plus external cost

Pollution tax

A tax or charge equal to the external cost per unit of pollution

Command-and-control policies

specify maximum amounts of pollution and mandate particular pollution reduction technologies

Economists discourage command-and-control approaches

• Requiring the same technology for all firms is unlikely to be efficient when firms differ in their production technology.

• Even worse, there is no incentive to improve beyond the mandated technology.

Marketable pollution permits (pollution allowances).

A system under which the government picks a target pollution level for a particular area, issues just enough pollution permits to meet the pollution target, and allows firms to buy and sell the permits; also known as a cap-and-trade system.

voluntary exchange

exchange between two people makes both people better off

Marginal product of labor

The change in output from one additional unit of labor.

Marginal-revenue product of labor (MRP)

The extra revenue generated from one additional unit of labor; MRP is equal to the price of output times the marginal product of labor.

Short-run demand curve for labor

A curve showing the relationship between the wage and the quantity of labor demanded over the short run, when the firm cannot change its production facility.

Long-run demand curve for labor

A curve showing the relationship between the wage and the quantity of labor demanded over the long run, when the number of firms in the market can change and firms can modify their production facilities

The long-run demand curve for labor slopes downward for two reasons:

1. The output effect: when wages are higher, the price of output will be higher; less output will be demanded, and hence fewer workers also.

2. The input-substitution effect: when wages are higher, firms can substitute toward other inputs.

Output effect

The change in the quantity of labor demanded resulting from a change in the quantity of output produced

Input-substitution effect

The change in the quantity of labor demanded resulting from an increase in the price of labor relative to the price of other inputs

Substitution effect for leisure demand

The change in leisure time resulting from a change in the wage (the price of leisure) relative to the price of other goods

Income effect for leisure demand

The change in leisure time resulting from a change in real income caused by a change in the wage

Market supply curve for labor

A curve showing the relationship between the wage and the quantity of labor supplied

Learning effect

The increase in a person’s wage resulting from the learning of skills required for certain occupations

Signaling effect

The information about a person’s work skills conveyed by completing college.

Labor union

A group of workers organized to increase job security, improve working conditions, and increase wages and fringe benefits

Featherbedding

Work rules that increase the amount of labor required to produce a given quantity of output; may actually decrease the demand for labor

Means-tested program

A program that restricts eligibility to people or households with less than a specified maximum wealth or income