Transcript Week 6 Chapter 5 & 6: Main lecture on Revenue and Production

Chapter 5&6
Main Lecture on Revenue
and Perfect Competition
Revenue
• We have looked at Production and then
Cost so we have anaylsed our technical
capabilities and the costs of producing
output,
• on average
• and at the margin (one more unit)
• Now we have to examine what we get for an
additional unit
REVENUE
• Thus we need to defining total, average and
marginal revenue
• We start by examining revenue curves when
firms are price takers
• By this we mean that firms are small relative to
the total market and that they do not have much
influence over the price charged.
• In such a market if they raise price people will go
elsewhere…
• … and if they reduce price (even if it were
profitable) they would not be able to cope with
the resultant demand.
Revenue
• That is, they perceive the price they can
receive as constant.
• So as far as they are concerned the
demand curve is horizontal.
• That means they believe:
• They can sell as much as they want at the
going price.
– average revenue (AR)
– marginal revenue (MR)
S
AR, MR (£)
Price (£)
Deriving a firm’s AR and MR: price-taking firm
Pe
D
O
Q (millions)
(a) The market
O
Q (hundreds)
(b) The firm
S
AR, MR (£)
Price (£)
Deriving a firm’s AR and MR: price-taking firm
Pe
D
O
Q (millions)
(a) The market
O
Q (hundreds)
(b) The firm
REVENUE
• Defining total, average and marginal
revenue
• Revenue curves when firms are price
takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
Total revenue for a price-taking firm
Quantity
(units)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
Price
5
5
5
5
5
5
5
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity
(units)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
Price
5
5
5
5
5
5
5
TR
(£)
0
1000
2000
3000
4000
5000
6000
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity
(units)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
Price
5
5
5
5
5
5
5
TR
TR
(£)
0
1000
2000
3000
4000
5000
6000
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
TR
6000
TR (£)
5000
4000
3000
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity Price = AR
(units) = MR (£)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
5
5
5
5
5
5
5
TR
(£)
AR=
TR/Q
0
1000
2000
3000
4000
5000
6000
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity Price = AR
(units) = MR (£)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
5
5
5
5
5
5
5
TR
(£)
AR=
TR/Q
0
1000
2000
3000
4000
5000
6000
5
5
5
5
5
5
5
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity Price = AR
(units) = MR (£)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
5
5
5
5
5
5
5
TR
(£)
0
1000
2000
3000
4000
5000
6000
AR= MR
TR/Q
5
5
5
5
5
5
5
2000
1000
0
0
200
400
600
Quantity
800
1000
1200
Total revenue for a price-taking firm
Quantity Price = AR
(units) = MR (£)
6000
0
200
400
600
800
1000
1200
TR (£)
5000
4000
3000
5
5
5
5
5
5
5
TR
(£)
0
1000
2000
3000
4000
5000
6000
AR= MR
TR/Q
5
5
5
5
5
5
5
5
5
5
5
5
5
5
2000
1000
£5
0
0
200
400
600
Quantity
800
1000
1200
Mathematics of Revenue:
Total Revenue
Average Revenue
TR  P.Q
TR P.Q

P
Q
Q
Marginal Revenue
When P is
constant
d (TR) d ( P.Q)

P
dQ
Q
When is a firm a price taker?
• PERFECT COMPETITION
• Assumptions
– firms are price takers – treat P as constant
– freedom of entry
– identical products
– perfect knowledge
VERY Short-run equilibrium of industry and firm
under perfect competition
P
£
S
D
O
O
Q (millions)
(a) Industry
VERY Short-run equilibrium of industry and firm
under perfect competition
P
£
S
Pe
D
O
O
Q (millions)
(a) Industry
VERY Short-run equilibrium of industry and firm
under perfect competition
P
£
S
Pe
D = AR
= MR
AR
D
O
O
Q (millions)
(a) Industry
q (thousands)
(b) Firm
VERY Short-run equilibrium of industry and firm
under perfect competition
P
£
MC
S
Pe
D = AR
= MR
AR
D
O
O
Q (millions)
(a) Industry
qe
q (thousands)
(b) Firm
Very Short-run equilibrium of industry and firm
under perfect competition
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
At what level of
output should
the firm
Produce?
AC
qe
q (thousands)
(b) Firm
Produce where MR = MC
RULE ALWAYS
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
At Qe how much does profit does the firm make?
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
At Qe how much does profit does the firm make?
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
At Qe how much does profit does the firm make?
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
Area =
(a) Industry
(AR-AC)*qe
AC
Qe
Q (thousands)
(b) Firm
Supernormal Profits
• What was included in total costs when we
drew the TC and AC curves?
• We included the cost of capital, labour, and
raw, materials and …………….
• An appropriate return for the entrepreneur
for his or her labour, capital invested and
risk
• So what does the yellow area represent?
• (AR – AC)*qe =
• Supernormal profit
Supernormal
Profit
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
PERFECT COMPETITION
– Produce where MR = MC
– Under perfect Competition P = MR
– So MR= P = MC
– possible supernormal profits = (AR-AC)*q
Very Short-run equilibrium of industry and firm
under perfect competition
Supernormal
Profit
P
£
MC
S
P
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
P
So supernormal profits attract more firms to the
industry.
Before S = Qe= n* qe
now S = Q1= (n+a) * qe
S
P
MC
£
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
qe
q (thousands)
(b) Firm
Before S = Qe= n* qe
now S = Q1= (n+a) * qe
So Supply curve moves out!
P
S
P
S1
MC
£
D = AR
= MR
AR
AC
D
O
Qe Q1
Q (millions)
(a) Industry
O
AC
Q
Q (thousands)
(b) Firm
Price falls
P
S
Pe
S1
MC
£
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
P
S
Pe
S1
MC
£
AR
AC
D = AR
= MR
D
O
O
Q (millions)
(a) Industry
AC
Q (thousands)
(b) Firm
.. And a new LONG RUN equilibrium is established at
Pe,Qe
P
S
P
S1
MC
£
AR
AC
Pe
D = AR
= MR
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
PERFECT COMPETITION
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away
– Since AR=AC and
– (AR-AC)*Q=0
LONG RUN Equilibrium under Perfect Competition
requires that AR=P=MR=MC=AC
P
S1
MC
£
D = AR
= MR
Pe
Pe
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
Suppose now demand falls.
What happens to supply now?
P
MC
S1
£
Pe
P0
P1
D1
O
D0
O
Q (millions)
(a) Industry
Qe
Q (thousands)
(b) Firm
AC
Suppose now demand falls.
Our same MR = MC rule applies, but there is
one more consideration
P
MC
S1
£
Pe
P0
P1
D1
O
D0
O
Q (millions)
(a) Industry
Qe
Q (thousands)
(b) Firm
AC
Our same MR = MC rule applies, but there is
one more consideration
We need to check where the AVC curve lies. Why?
P
MC
S1
AC
£
AVC
Pe
P0
P1
D1
O
D0
O
Q1 Q 0
In this case P > AVC so will continue to produce.
By doing so, cover AVC and make some
contribution to covering Fixed Costs
Our same MR = MC rule applies, but there is
one more consideration
We need to check where the AVC curve lies. Why?
P
MC
S1
£
AVC
Pe
P0
P1
D1
O
D0
O
Q1 Q 0
But overall making a (supernormal) loss
= FC – (P-AVC)
AC
What if P is below AVC?
P
MC
S1
£
AVC
Pe
P0
P1
D1
O
D0
O
AC
Qe
In this case we can’t cover variable costs, so
better to close down and only lose FC
Deriving the short-run supply curve
S
P
£
MC
a
P1
D1 = MR1
D1
O
O
Q (millions)
(a) Industry
Q1
Q (thousands)
(b) Firm
Deriving the short-run supply curve
S
P
£
MC
a
P1
b
P2
D1 = MR1
D2 = MR2
D1
D2
O
O
Q (millions)
(a) Industry
Q2
Q (thousands)
(b) Firm
Deriving the short-run supply curve
S
P
£
MC
a
P1
D1 = MR1
D2 = MR2
b
P2
c
P3
D1
D3
O
AVC
D2
O
Q (millions)
(a) Industry
D3 = MR3
Q3
Q (thousands)
(b) Firm
Deriving the short-run supply curve
S
P
£
S
a
P1
b
P2
c
P3
D1
D3
O
D1 = MR1
D2 = MR2
D3 = MR3
AVC
D2
O
Q (millions)
(a) Industry
Q (thousands)
(b) Firm
PERFECT COMPETITION
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve
What happened to Supply here in the Long Run
P
MC
S S £
1
LRS
D = AR
= MR
Pe
Pe
D
O
D1
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
Various long-run industry supply curves under perfect competition
S1
P
a
D1
O
Q
(a) Constant industry costs
Various long-run industry supply curves under perfect competition
S1
P
b
a
D1
D2
O
Q
(a) Constant industry costs
Various long-run industry supply curves under perfect competition
S1
P
S2
b
a
c
D1
D2
O
Q
(a) Constant industry costs
Various long-run industry supply curves under perfect competition
S1
P
S2
b
a
c
D1
Long-run S
D2
O
Q
(a) Constant industry costs
What if there are external economies to scale in
the Long Run?
1. Demand moves out
P
MC
S
£
D = AR
= MR
Pe
Pe
D
O
D1
O
Q (millions)
(a) Industry
AC
Qe
q (thousands)
(b) Firm
What if there are external economies to scale in
the Long Run?
2. Firm moves up MC curve. S1 = nq1
P
MC
S
D = AR
= MR
Pe
Pe
D
O
£
Q0
Q (millions)
(a) Industry
D1
O
AC
q0 q1
q (thousands)
(b) Firm
What if there are external economies to scale in
the Long Run?
P
3. Supernormal Profits – So firms join the
industry
MC
S
D = AR
= MR
Pe
Pe
D
O
£
Q0
Q (millions)
(a) Industry
D1
O
AC
q0 q1
q (thousands)
(b) Firm
4. But with External Economies of scale as S
curve moves out,
P
AC curve starts to move down
MC
S S £
1
D
O
D = AR
= MR
Pe
Pe
Q0
Q (millions)
(a) Industry
D1
O
AC
q0
q (thousands)
(b) Firm
4. So with External Economies of scale,
P
Find new equilibrium with lower AC, higher
supply and lower price
MC
S
£
AC
S1
Pe
Pe
D
O
D = AR
= MR
Q0
Q (millions)
(a) Industry
D1
O
q0
q (thousands)
(b) Firm
So if there are external economies to scale in
the Long Run?
P
MC
S S £
1
D1
D = AR
= MR
Pe
LRS
Pe
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
So if there are external economies to scale in
the Long Run?
P
MC
S S £
1
D1
D = AR
= MR
Pe
LRS
Pe
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
Various long-run industry supply curves under perfect competition
P
S1
b
a
D1
O
D2
Q
(c) Decreasing industry costs: external economies of scale
Various long-run industry supply curves under perfect competition
P
S1
S2
b
a
c
D1
O
D2
Q
(c) Decreasing industry costs: external economies of scale
Various long-run industry supply curves under perfect competition
P
S1
S2
b
a
c
Long-run S
D1
O
D2
Q
(c) Decreasing industry costs: external economies of scale
What if there are external Diseconomies to
scale in the Long Run?
P
MC
S
£
D = AR
= MR
Pe
Pe
D
O
D1
O
Q (millions)
(a) Industry
AC
Qe
q (thousands)
(b) Firm
External Diseconomies to Scale
I want you to analyse the various effects on the
market and the firm when this occurs.
Classes on week 6: Hand in Short Essay
Structure
1. Motivate: Why might this occur?
2. Anaslyse (both firm and market)
3. Evaluate
How many words?
Inframarginal Producers
• In some industries such as agriculture, new
entrants may have higher costs than existing
producers (worse land etc.)
Classes on week 7: Hand in Short Essay
Structure
1. Motivate: Why might this occur in other
industries
2. Anaslyse (both firm and market)
3. Evaluate instance and implications
How many words?
Essay Writing
• Length: Approximately 800-1000 words, or
about 3 sides of A4 paper, including
diagrams (depends on how big your
diagrams are).
• See p 32 -35 in Economics Handbook for
further advice on essay writing.
PERFECT COMPETITION
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve
• Incompatibility of INTERNAL economies of
scale with perfect competition
PERFECT COMPETITION
• Advantages of perfect competition
– P = MC
– production at minimum AC
– only normal profits in long run
– responsive to consumer wishes: consumer
sovereignty
– competition  efficiency
– no point in advertising
PERFECT COMPETITION
• (ALLEGED) Disadvantages of perfect
competition
– insufficient profits for investment
– lack of product variety
– lack of competition over product design and
specification
• Not really valid set of criticisms
PERFECT COMPETITION
• Disadvantages of perfect competition
– There are none
• Except perhaps….
– Disadvantage is that it may not be a valid
version of reality
– Recall assumptions
firms are price takers
OK
freedom
of entry and exit
iffy
identical
products
Few examples
perfect
knowledge
iffy