Microeconomics B: Consumption, Production, Welfare

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1 Microeconomics B: Consumption, Production, Welfare Univ. Prof. dr. Maarten Janssen University of Vienna Winter semester

2 Applied Micro Theory Microeconomics Look at decisions of economic units and how they interact in a market environment Units: household and firms (no economics of organization questions Market interaction (no strategic issues, game theory) Applied What type of micro is used to think about economic issues in the real world Course talks about applications (see literature list) Theory Theory organizes the way we think about issues. Masters curriculum cannot do without it

3 Practicalities Slides, course description on my website Combination of theory (textbook), some applications (articles) Lectures (general overview), tutorials (exercises) Try exercises, read literature Grading one midterm (35%), one final exam (45%) one homework sets handed in and be active in the tutorials by providing solutions in class (10%) write one small essay (3-4 pages) analyzing a recent issue that has been in the news from a microeconomic perspective (10%). Interaction in class

4 Normative and Descriptive Econ Economics is used in two ways: Descriptive: trying to explain, predict what has happened or will happen Normative: what should (not) happen (or what is good from some perspective) We sometimes change perspective (when convenient)

5 Monopoly One firm serves the relevant market What does a firm have to decide? - How much to produce and at which price - In IO also, other choices: Which products to produce? How to make itself visible to consumers? How much to invest in R&D? Micro studies first question only Objective: maximize profits What does a firm need to know? - Revenue (demand) side - Cost side 5

6 Monopoly The only firm in the market market demand is the firm s demand output decisions affect market clearing price /unit P 1 P 2 L Loss of revenue from the reduction in price of units currently being sold (L) Gain in revenue from the sale of additional units (G) Marginal revenue from a change in price is the net addition to revenue generated by the price change = G - L G Demand Q 1 Q 2 Quantity 6

7 Marginal Revenue Monopolist P Elastic Inelastic Marginal revenue = P + Q dq dp Total Revenue ( ) MR Demand Q Total revenue=pq Q 7

8 Cost Analysis Type of Costs Fixed cost (FC) Variable cost (VC) Marginal cost (MC) Total cost (TC) Sunk cost Opportunity cost 8

9 Two important cost curves P MC ATC Q Average total cost curves are typically first decreasing and often then increasing (when the availability of some production factors becomes a limiting factor 9

10 Profit maximisation Monopolist P Profit MC ATC P M ATC D Q M MR Q Profit π = P(Q)Q C(Q) Pricing rule Q P dq dp P(1+ ) = MC P = MC /(1 1 ) ε 10

11 Seems we do not need much to start economic analysis, although. When we think more the above does not tell very much: 1. Where is this analysis relevant? When do we know we have a monopolist? 2. Does this explain or predict what a monopolist does, or is it prescriptive (normative)? 3. And at what level: is the price setting behaviour relevant, or the maximization of profits? Should a firm maximize profits? Or should it set these prices if it maximizes profits? 4. If this is descriptively (more or less) correct, should we from a society s point of view be happy about this outcome? Presumably define a market by closeness in substitutability of the commodities involved how close is close? how homogeneous do commodities have to be? 11

12 No clear consensus What is a market? the market for automobiles should we include light trucks; pick-up SUVs? the market for soft drinks what are the competitors for Coca Cola and Pepsi? With whom do McDonalds and Burger King compete? Presumably define a market by closeness in substitutability of the commodities involved how close is close? how homogeneous do commodities have to be? 12

13 General methodology Investigate to what extent goods are substitutes for each other if one firm/product changes its price to what extent is demand for another firm/product affected? If the answer is quite a bit, then products are in one market One important measure is cross price elasticity D p i j / Di p j SSNIP test / cellophane fallacy 13

14 Example 1: printers and cartridges There are different printer brands that can be connected to your PC. Each brand has a cartridge that only fits its own design printer Is there a market for printers that includes the cartridges and their replacement? Should we define a separate market for cartridges (implying that there is a separate market for every brand and that each firm has monopoly power over consumers that have bought their brand)? 14

15 Example 2: soft drinks delivery to bars Bigger firms like Coca-Cola supply soft-drinks to bars (wholesale market). A bar wants to have different soft drinks on offer. Coca-Cola and Ice Tea are complements for the bar (not for the final consumer) Is there a market for soft drinks? But Pepsi and Coke are probably also not complements for the bar. 15

16 Firm is a complex entity Firm s behaviour results from complicated interaction between different individuals having different motives, information Economics of organization (principal-agent theory) Does this imply profit maximization would just be a lucky coincidence? If firm would not be profit maximizing, it can (or will) be taken over? In long run only those firms survive that do maximie profits? In this course, firm is profit max entity

17 Is monopoly outcome desirable? From a society s point of view, economists adopt notion of Pareto efficiency An outcome is Pareto-efficicient if there does not exist another possible outcome such that no decision maker is worse off and at least one is strictly better off. Decision-makers: the monopolist, consumers Monopolist better off if it makes more profit Consumers are better off when?

18 Demand curve is expression of consumers choices Consumers want to improve their well being: at each hypothetical price they choose how many units they want to buy (instead of buying something else) The last unit they buy improves well-being by a certain amount. If price is higher, they would not buy this unit If price is lower, they would consider buying another unit (if commodity is divisble) Price equals marginal willingness to buy for additional unit

19 Is monopoly outcome Pareto efficient? P Profit MC ATC P M ATC D Q M MR Q What if monopolist could produce one more unit and would be able to charge a different price just for that unit? Why would the monopolist not do that? 19

20 Rest of this course Consumer choices: To be able to make welfare judgments we have to have a measure of consumer well being and better understand how choices are made Also choice under uncertainty Producer choices: Cost curve is also outcome of choice made by the firm Markets bring consumer and producer choices together Prices equilibrate supply and demand Welfare economics Pareto efficiency of perfectly competitive markets All these topics are discussed balancing theory and applications

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MBA 640 Survey of Microeconomics Fall 2006, Quiz 6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) A monopoly is best defined as a firm that