The Behaviour of Firms PDF

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Topic 4 - The Behaviour of Firms lecture notes...

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The Behaviour of Firms

The firm’s objective  A key assumption we will make in our study of firms’ behaviour is: The goal of the firm is to maximise profits  Profit is the firm’s economic rent. It is the firm’s total revenue minus its total cost (including opportunity costs) Market power:  Market power is the ability of the seller (or sometimes the buyer) to have an influence over market prices  How do firms get market power? 1. By selling a differentiated product (a product that is different from the products being sold by their competitors) 2. Through barriers to entry, that prevent other firms from entering the market and competing  In the most extreme case, the firm with market power is a monopoly – the only seller of a product that has no close substitutes Product differentiation and branding  A firm might can gain some degree of market power by differentiating their product  If products are undifferentiated (homogeneous), then they are perfect substitutes (recall from Topic 2)  The indifference curves are straight lines (usually with MRS = -1)  Consumers will buy from whichever seller is selling at the lowest price  A differentiated product leads to indifference curves that are curved  The lowest-price seller will no longer get all of the market  Firms can differentiate their product through branding (which makes the product seem different in the eyes of consumers) Barriers to entry  A firm can also gain market power when there are barriers to entry that stop other firms from competing effectively with them  Barriers to entry can be created when:  A key resource is owned by the firm

 e.g. DeBeers (diamonds)  The government gives the firm an exclusive right to produce and/or sell some good or service, or where being a seller requires certification  e.g. Prescription medicines (patented), occupational licenses (dentists, doctors, etc.)  Economies of scale make a single producer much more efficient than a large number of smaller producers  e.g. Transpower (electricity transmission), railways, water supply, etc.  If the firm is a first mover in a market with network externalities, this may create a barrier to entry  e.g. Facebook, Twitter, but also VHS, etc.  A special case of network externalities exists in two-sided markets (or platform markets)  In a two-sided market a firm brings together two sides (e.g. buyer and seller), both of whom benefit by the existence of the platform, and both of whom may (or may not) have to pay to have access to the platform  e.g. TradeMe, Kickstarter, but also credit cards, malls, trade shows, etc. The pricing game  A firm’s decision about pricing is part of a sequential game with its customers  However, the game is too complex for us to represent simply with a tree diagram  The pricing game proceeds like this:  The firm sets the price; then  The customers each decide how much of the good (if any) they want to buy  When there is a sequential game, we can solve for the Nash equilibrium using backward induction  We work out what the second player (the customers) will do, and from that we can work out what the first player (the firm) should do

Consumers and the demand curve  We looked at the constrained optimisation model for the consumer (the consumer choice model)  Consumers decide how much of each good to buy, and this depends on their preferences (shown by their indifference curves), the price of each good, and the consumers’ income

 Firms are choosing the price in the first step of the pricing game, but in order to know the ‘best’ price to set, they need to know what quantity the consumers will buy for each price the firm could set  For this, we need the demand curve The demand curve  Demand describes the relationship between the quantity of a good or service that a consumer chooses to buy and the price of the good  The demand curve shows the quantity demanded by the consumer at each price, ceteris paribus (the demand curve holds constant everything other than the good’s price and quantity)  The demand curve also shows what the consumer would be willing to pay for each quantity of the good Consumer choice, individual and market demand  A consumer’s individual demand curve can be derived from the consumer choice model  Because, using the consumer choice model, we can show the effect of a change in price on the quantity of Good X demanded by a consumer  By transferring the prices and quantities of Good X onto a graph, we can then construct the demand curve for Good X for the consumer  The firm’s market demand curve can then be obtained by adding up the quantities demanded by each consumer The firm’s total and average revenue  The firm’s total revenue is equal to:

TR=P ×Q  If the firm is selling at a single price, then the demand curve shows the average revenue of the firm:

AR=

TR P ×Q = =P Q Q

Marginal revenue  The firm’s total revenue and average revenue are not relevant to the firm’s pricing decision  The firm is not trying to maximise total revenue, it is trying to maximise profits  To maximise profits, first we need to find the firm’s marginal revenue  Marginal revenue is the additional revenue generated by selling one additional unit of the product Total revenue and marginal revenue

 Total revenue has a peak (a maximum)  The peak of total revenue is at the quantity where marginal revenue is exactly equal to zero  Marginal revenue decreases more quickly than average revenue (the price)  In fact, the marginal revenue curve for the firm with market power has the same intercept and exactly twice the slope of the average revenue (demand) curve  We can show why using a little bit of calculus

Average cost and marginal cost  The firm’s total cost is equal to:

TC=AC × Q  Where AC is the firm’s average cost per unit sold  Marginal cost is the additional cost of producing and/or selling one additional unit of the product The constant cost firm  Each unit of output costs a constant amount  In this case:

MC = AC  This is represented on a diagram by the marginal costs of the firm being a horizontal line at the level of average cost (all units cost the same average cost to produce)

The profit-maximising price: Maximising revenue does not maximise profits  The profit-maximising price for the firm occurs where:

MR = MC  If the firm sets the price a little higher, consumers will be willing to buy a slightly lower quantity  But at that quantity MR will be greater than MC, and they could increase profits by lowering the price and selling more  If the firm sets the price a little lower, consumers will be willing to buy a slightly higher quantity  But at that quantity MR will be less than MC, and they could increase profits by increasing the price and selling a bit less (but at a higher price)

 The highest iso-profit curve will touch the demand curve at exactly he same quantity where marginal revenue is equal to marginal cost

Consumer surplus  The consumer surplus is a measure of the economic rent that consumers earn by participating in the market  It is calculated as the difference between the buyers’ willingness to pay and the amount the buyers actually pay (the price)  This is the amount of net benefit that the buyers receive by participating in the market  Since the buyers’ willingness to pay is shown by the demand curve, the consumer surplus is the area bounded by the demand curve, the quantity traded, and the price Producer surplus  The producer surplus is a measure of the economic rent that producers earn by participating in the market  It is calculated as the difference between the amount the seller receives (the price) and the sellers’ cost  This is also the amount of economic profit (excluding fixed costs) that the sellers receive by participating in the market  Since the sellers’ costs are shown by the marginal cost curve, the producer surplus is the area bounded by the marginal cost curve, the quantity traded, and the price Total welfare  Total welfare (or total surplus) is the sum of consumer surplus and producer surplus, i.e. the net benefit of the market to buyers plus the profits from the market for sellers  Total welfare is maximised at the price and quantity where the demand curve meets the marginal cost curve The deadweight loss of a firm with market power  The point that maximises total welfare is where demand meets marginal cost. However, a firm with market power will choose the price that ensures that the marginal revenue is equal to marginal cost if it wants to maximise profits  The firm with market power will choose a price that is too high to maximise total welfare, and the quantity that is traded will be too low  The resulting loss of total welfare is called a deadweight loss Calculating the size of welfare areas

 The welfare areas (consumer surplus, producer surplus, total welfare, deadweight loss) have all been triangles, rectangles, or combinations of triangles and rectangles  To calculate the value of these welfare areas, we simply need to calculate the areas of triangles or rectangles  The area of a rectangle is equal to:

Area=Base × Height  The area of a triangle is equal to:

1 Area= × Base × Height 2...