Exam #3 Review - Microeconomics

Perfect Competition

Four Conditions Characterizing Perfect Competition

  1. Many Buyers and Sellers: No single buyer or seller can influence the market price.

  2. Homogeneous Products: All firms sell identical products.

  3. Free Entry and Exit: No significant barriers to entering or leaving the market.

  4. Perfect Information: Buyers and sellers have full knowledge of prices and product quality.

Short-Run Profit Maximization

  • A firm maximizes profit where marginal cost (MC) = marginal revenue (MR).

  • If price (P) > average total cost (ATC), the firm earns a profit.

Short-Run Profit Maximization Using Per-Unit Curves

  • Graphically, profit is the vertical distance between price (P) and ATC at the profit-maximizing quantity.

Operating at a Loss in the Short-Run

  • A firm continues to operate if price (P) ≥ average variable cost (AVC) to cover variable costs and minimize losses.

Perfectly Competitive Firm’s Short-Run Supply Curve

  • The portion of the MC curve above AVC represents the firm’s short-run supply curve.

Output Response to a Change in Input Prices

  • Changes in input prices shift the firm’s cost curves (MC, ATC, AVC), affecting the profit-maximizing output.

Long-Run Competitive Equilibrium

  • Occurs when economic profit = 0, as firms enter or exit the market until only normal profits are earned.

Zero Economic Profit

  • In the long run, firms earn normal profit, which accounts for opportunity costs but no economic profit.

Types of Industries

  • Increasing-Cost Industry: Higher output increases input costs, raising ATC.

  • Constant-Cost Industry: Output changes do not affect input costs.

  • Decreasing-Cost Industry: Higher output lowers input costs due to economies of scale.

Monopolistic Competition

Profit Maximization

  • Similar to perfect competition in the short run, where MR = MC, but firms differentiate their products.

  • In the long run, entry erodes economic profits, and firms earn zero economic profit.

Oligopoly

Cournot Model

  • Firms decide output simultaneously, assuming the other’s output remains fixed. Equilibrium output is between monopoly and perfect competition.

Stackelberg Model

  • One firm (leader) sets output first, and other firms (followers) react, leading to strategic advantages for the leader.

Dominant Firm Model

  • A dominant firm sets the price, and smaller firms (price takers) supply the residual demand.

Cartels and Collusion

  • Firms agree to act collectively to maximize joint profits. They function as a monopoly but are inherently unstable.

Why Cartels Fail?

  • Incentive to cheat and undercut agreed-upon prices.

  • Difficulty in monitoring and enforcing agreements.

  • External competition and regulatory oversight.

Game Theory

Players, Strategies, Payoffs

  • Players: Decision-makers in the game.

  • Strategies: Actions available to each player.

  • Payoffs: Outcomes based on chosen strategies.

Determination of Equilibrium

  • Equilibrium occurs when no player can improve their payoff by unilaterally changing their strategy.

Dominant Strategy Equilibrium

  • A strategy is dominant if it provides a better outcome regardless of the opponent’s choice.

Nash Equilibrium

  • A set of strategies where each player’s strategy is the best response to the other’s strategy.

Prisoner’s Dilemma

  • A scenario where rational players choose to defect, leading to suboptimal outcomes for both.

Prisoner’s Dilemma and Cheating by Cartel Members

  • Cartel members face incentives to cheat for short-term gains, undermining the cartel’s stability.

Repeated Game Model

  • Cooperation may emerge in repeated interactions if players value future payoffs.

Monopoly

Profit Maximization

  • A monopoly maximizes profit where MR = MC but charges a price based on the demand curve.

Monopoly Price and Its Relationship to Elasticity of Demand

  • Monopolies set prices where demand is elastic to maximize revenue.

Further Implications of Monopoly Analysis

  • Inefficiency arises due to higher prices and reduced output compared to perfect competition.

Measuring Monopoly Power

  • Lerner Index: Measures pricing power as = (P − MC) / P.

Sources of Monopoly Power

  • Legal barriers (patents, licenses).

  • Control of key resources.

  • Economies of scale.

Public Policy Toward Monopoly

  • Anti-trust laws to prevent abuse of market power.

  • Regulation of natural monopolies.

Types of Price Discrimination

  1. First Degree: Charging each consumer their maximum willingness to pay.

  2. Second Degree: Prices vary based on quantity consumed or product version.

  3. Third Degree: Different prices for distinct consumer groups based on elasticities.