Market Structures and Economic Profit Determination

Learning Objectives and Administrative Notices

• At the conclusion of this class, students will be able to:

  • Explain and demonstrate through graphical representations the concepts of positive economic profit, negative economic profit, and zero economic profit.

  • Understand and define the concept of a fair return.

  • Identify and explain which types of profits are accessible to firms in the short-run compared to those available in the long-run.

• Administrative Reminders:

  • The 2nd term test is scheduled for Thursday 7 May.

  • Students must consult their timetables for their specific room assignment and must report to the correct room.

  • Format and instructions for this test are identical to Test 1 and are available on Learn.

• Thought for the day: "The best car safety device is a rear-view mirror with a police car in it."

Famous Economists: Millicent Fawcett (1847 – 1929)

• Millicent Fawcett was a prominent political activist and writer who advocated strongly for women’s rights and suffrage (voting rights).

• Early Influences:

  • She became interested in radical liberal politics during her teens after attending lectures by John Stuart Mill.

  • John Stuart Mill introduced her to Henry Fawcett, who was a Member of Parliament (M.P.) and a professor of economics at Cambridge.

• Major Works and Academic Achievements:

  • Her most famous publication is her 1870 book, Political Economy for Beginners.

  • This book was highly successful, setting a record as a principles textbook for students by running through $10$ editions over a span of $41$ years.

  • The success was notable because she presented economic theory in a "thoroughly Ricardian vein," even as that perspective was declining in Great Britain following the Marginalist Revolution.

  • In 1872, she published a collection on economic topics in collaboration with Henry Fawcett.

• Educational and Political Legacy:

  • She was a vigorous promoter of education for women and helped establish Newnham College for women at Cambridge in 1871.

  • Her daughter, Philippa Fawcett, achieved the distinction of being the first woman to top the Mathematical Tripos at Cambridge in 1890, though she was technically denied the official title of 'Senior Wrangler'.

  • Following her husband's early death, Millicent shifted her focus more toward political activities, including a 1901 appointment to inquire into conditions in British concentration camps during the Boer War.

  • She was knighted (received a damehood) in 1925.

Market Structure Taxonomy

• Market types exist on a spectrum ranging from "Lots of competition" to "No competition":

  • PC: Perfect Competition

  • MC: Monopolistic Competition

  • OL: Oligopoly

  • Du: Duopoly

  • NM: Natural Monopoly

  • M: Monopoly

• Characteristics of "Price Takers" (Competitive end of the spectrum):

  • Includes "More firms."

  • Associated with "Lower prices."

  • Results in "More efficient markets."

  • Produces a "Greater quantity."

• Characteristics of "Price Makers" (Monopolistic end of the spectrum):

  • Includes "Fewer firms."

  • Associated with "Higher prices."

  • Results in "Less efficient markets."

  • Produces a "Smaller quantity."

• Note: The graphical placement of these market types is for illustrative purposes and is not strictly to scale.

Finding the Profit Maximizing Output

• The determination of profit-maximizing output is illustrated through two side-by-side graphs representing the Market and the Individual Firm.

• Market Graph:

  • The vertical axis represents Price ($P$) and the horizontal axis represents Quantity ($Q$).

  • The intersection of the Supply curve and Demand curve determines the equilibrium price ($P_e$) and equilibrium quantity ($Q_e$).

• Firm Graph:

  • The vertical axis represents costs and revenue, while the horizontal axis represents quantity ($q$).

  • For a price-taking firm (Perfect Competition), the price is a horizontal line: $P_e = AR = MR$ (Average Revenue equals Marginal Revenue).

  • The Profit Maximizing Output ($q^*$) occurs where the Marginal Cost ($MC$) curve intersects the Marginal Revenue ($MR$) line.

  • Analysis of production levels:

    • At $q_1$ (where q < q^*), further production increases profit.

    • At $q_2$ (where q > q^*), production is beyond the optimal point.

Graphical Analysis of Economic Profit States

• Zero Economic Profit:

  • Defined as a state of "fair return."

  • Graphically, the Average Cost ($AC$) curve is tangent to the price line ($P_e = AR = MR$) at its minimum point.

  • At $q^*$, the price is exactly equal to the average cost ($P = AC$).

• Positive Economic Profit:

  • Occurs when Average Revenue ($AR$) is greater than Average Cost ($AC$) at the profit-maximizing quantity ($q^*$).

  • The $AC$ curve lies below the $P_e$ line at point $q^*$ (at the mark denoted by * in the firm diagram).

  • Calculation formula: $\text{Profit} = (AR - AC) \times q^*$

• Negative Economic Profit:

  • Occurs when Average Revenue ($AR$) is less than Average Cost ($AC$) at the profit-maximizing quantity ($q^*$).

  • The $AC$ curve lies above the $P_e = AR = MR$ line at point $q^*$.

  • Calculation formula: $\text{Profit} = (AR - AC) \times q^*$ (resulting in a negative value/loss).

Numerical Application: Perfect Competition and Revenue Analysis

• Assumptions for the model:

  • Fixed Costs = $\$100$

  • Cost per unit of Labour ($L$) = $\$40$

  • Selling Price ($P$) for the firm = $\$0.80$

• Data Table (Production and Revenue):

  • $L=0$: $TP=0$, $TR=0$

  • $L=1$: $TP=80$, $MC=0.5$, $P=0.8$, $TR=64$

  • $L=2$: $TP=220$, $MC=0.29$, $P=0.8$, $TR=176$, $AR=0.8$

  • $L=3$: $TP=270$, $MC=0.8$, $P=0.8$, $TR=216$, $AR=0.8$

  • $L=4$: $TP=300$, $MC=1.33$, $P=0.8$, $TR=240$, $AR=0.8$

  • $L=5$: $TP=315$, $MC=2.67$, $P=0.8$, $TR=252$, $AR=0.8$

• Key Definitions and Derived Calculations:

  • $TR$ = Total Revenue.

  • Average Revenue ($AR$) at $3$ workers: $\frac{TR}{TP} = \frac{216}{270} = 0.8$

  • Marginal Revenue ($MR$) from $2$ to $3$ workers: Calculated as $\frac{\Delta TR}{\Delta TP}$. For a price taker in perfect competition, $MR = P = AR$, which remains constant at $0.8$.