## Evaluating Different Market StructuresDecember 13, 2012

Posted by tomflesher in Micro, Teaching.
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Market structures, like perfect competition, monopoly, and Cournot competition have different implications for the consumer and the firm. Measuring the differences can be very informative, but first we have to understand how to do it.

Measuring the firm’s welfare is fairly simple. Most of the time we’re thinking about firms, what we’re thinking about will be their profit. A business’s profit function is always of the form

Profit = Total Revenue – Total Costs

Total revenue is the total money a firm takes in. In a simple one-good market, this is just the number of goods sold (the quantity) times the amount charged for each good (the price). Marginal revenue represents how much extra money will be taken in for producing another unit. Total costs need to take into account two pieces: the fixed cost, which represents things the firm cannot avoid paying in the short term (like rent and bills that are already due) and the variable cost, which is the cost of producing each unit. If a firm has a constant variable cost then the cost of producing the third item is the same as the cost of producing the 1000th; in other words, constant variable costs imply a constant marginal cost as well. If marginal cost is falling, then there’s efficiency in producing more goods; if it’s rising, then each unit is more expensive than the last. The marginal cost is the derivative of the variable cost, but it can also be figured out by looking at the change in cost from one unit to the next.

Measuring the consumer’s welfare is a bit more difficult. We need to take all of the goods sold and meausre how much more people were willing to pay than they actually did. To do that we’ll need a consumer demand function, which represents the marginal buyer’s willingness to pay (that is, what the price would have to be to get one more person to buy the good). Let’s say the market demand is governed by the function

QD = 250 – 2P

That is, at a price of $0, 250 people will line up to buy the good. At a price of$125, no one wants the good (QD = 0). In between, quantity demanded is positive. We’ll also need to know what price is actually charged. Let’s try it with a few different prices, but we’ll always use the following format1:

Consumer Surplus = (1/2)*(pmax – pactual)*QD

where pmax is the price where 0 units would be sold and QD is the quantity demanded at the actual price. In our example, that’s 125.

Let’s say that we set a price of $125. Then, no goods are demanded, and anything times 0 is 0. What about$120? At that price, the quantity demanded is (250 – 240) or 10; the price difference is (125 – 120) or 5; half of 5*10 is 25, so that’s the consumer surplus. That means that the people who bought those 10 units were willing to pay $25 more, in total, than they actually had to pay.2 Finally, at a price of$50, 100 units are demanded; the total consumer surplus is (1/2)(75)(100) or 1875.

Whenever the number of firms goes up, the price decreases, and quantity increases. When quantity increases or when price decreases, all else equal, consumer surplus will go up; consequently, more firms in competition are better for the consumer.

Note:
1 Does this remind you of the formula for the area of a triangle? Yes. Yes it does.
2 If you add up each person’s willingness to pay and subtract 120 from each, you’ll underestimate this slightly. That’s because it ignores the slope between points, meaning that there’s a bit of in-between willingness to pay necessary to make the curve a bit smoother. Breaking this up into 100 buyers instead of 10 would lead to a closer approximation, and 1000 instead of 100 even closer. This is known mathematically as taking limits.

## Duopoly and Cournot EquilibriumDecember 12, 2012

Posted by tomflesher in Micro, Teaching.
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A few days ago, we discussed perfectly competitive markets; yesterday, we talked about monopolistic markets. Now, let’s expand into a case in between – a duopolistic, or two-seller, market. This is usually called a Cournot problem, after the economist who invented it.

We’ll maintain the assumption of identical goods, so that consumers won’t be loyal to one company or the other. We’ll also assume that each company has the same costs, so we’re looking at identical firms as well. Finally, assume that there are a lot of buyers, so the firms face a market demand of, let’s say, QD(P) = 500 – 2P, so P = 250 – QD(P)/2. Since the firms are producing the same goods, then QS(P) = q1(P) + q2(P).

Neither firm knows what the other is doing, but each firm knows the other is identical to it, and each firm knows the other knows this. Even though neither firm knows what’s going on behind the scenes, they’ll assume that a firm facing the same costs and revenues is rational and will optimize its own profit, sothey can make good, educated guesses about what the other firm will do. Each firm will determine the other firm’s likely course of action and compute its own best response. (That’s the one that maximizes its profit.)

Now, let’s take a look at what the firms’ profit functions will look like.

Recall that Total Profit = Total Revenue – Total Cost, and that Marginal Profit = Marginal Revenue – Marginal Cost. Companies will choose quantity to optimize their profit, so they’ll continue producing until their expected Marginal Profit is 0, and then produce no more. Firm 1’s total revenue is Pxq1 – revenue is always price times quantity. Keeping in mind that price is a function of quantity, we can rewrite this as (250 – QD(P)/2)xq1. Since QD(P) = q1 + q2, this is the same as writing (250 – (1/2)(q1 + q2))q1. Then, we need to come up with a total cost function. Let’s say it’s 25 + q12, where 25 is a fixed cost (representing, say, rent for the factory) and q12 is the variable cost of producing each good. Then, Firm 1’s profit function is:

Profit1 = (250 – (1/2)(q1 + q2))q1 – 25 – q12

or

Profit1 = (250 – q1 /2 – q2/2)q1 – 25 – q12

or

Profit1 = 250q1 – q12/2 – q1q2/2 – 25 – q12

The marginal profit is the change in the total profit function if Firm 1 produces one more unit; in this case it’s easier to just use the calculus concept of taking a derivative, which yields

Marginal Profit1 = 250 – q1 – q2/2 – 2q1 = 250 – 3q1 – q2/2

Since the firms are identical, though, firm 1 knows that firm 2 is doing the same optimization! So, q1 = q2, and we can substitute it in.

Marginal Profit1 = 250 – 3q1 – q1/2 = 250 – 5q1/2

This is 0 where 250 = 5q1/2, or where q1 = 100. Firm 2 will also produce 100 units. Total supplied quantity is then 200, and total price will be 200. We can figure out each firm’s profit simply by plugging in these numbers:

Total Revenue = Pxq12 = 200×100 = 20,000

Total cost = 25 + q12 = 25 + 100×100 = 25 + 10,000 = 10,025

Total Profit = 9,075

This was a bit heavier on the mathematics than some of the other problems we’ve talked about, but all that math is just getting to one big idea: it’s rational to produce when you expect your marginal benefit to be at least as much as your marginal cost.

## Equilibrium in MacroeconomicsApril 22, 2011

Posted by tomflesher in Macro, Teaching.
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One of the things macroeconomists focus on quite a bit is calculating equilibrium conditions, or equilibria. Sometimes these account for random shocks or long-term growth – these have names like Dynamic stochastic general equilibrium and they’re outside the scope of this blog, which has so far focused on introductory-level material. We’re going to develop an idea of what an equilibrium is supposed to be and show how to figure out an equilibrium in a simple, open macroeconomy.

Equilibrium has a connotation of balance. The idea is that two (or more) things need to be balanced for some definition of balance that makes sense in the discussion. In economics, we generally think of equilibrium as representing a point where everything that’s produced is consumed. In a market for an individual good, that means we need to find a point where enough of those goods are produced so that everyone who wants to buy a good can do so.

That’s not very exact, though – it’s very rare that we see a goods market where everyone who wants the good can get it. There has to be some sort of incentive for the item to be produced, and generally that isn’t the satisfaction of seeing people using your trinket. (Sometimes it is – for example, the satisfaction of producing this blog and the fact that it forces me to think clearly are incentives for me to produce.) In general, that incentive is a price for the good – by producing, you get the opportunity to sell the good and get some money in exchange. That also provides a mechanism by which people self-select whether or not they participate in the market – at a certain price, people are willing to buy if they value the product at least that much. If the price is too high, they might still want the item, but they aren’t willing to pay for it so they’re no worse off.

How does that generalize to a macroeconomy, where we’re concerned about lots of goods and lots of prices? Well, it can be difficult to do so. That’s part of what makes grad macro so difficult. We, however, are going to make a couple of simplifying assumptions.

First of all, think back to the idea of the GDP Factory, where everyone works. Instead of producing individual goods, imagine that everyone just produces Stuff. The Stuff goes out on the market and is sold for money, the money is used to pay workers, and the workers go back to work and produce more Stuff. So, we can think of all goods as being part of the larger concept of production. So, everything we produce is supplied to the market. Remember that the supply equation is $Y^S = A \times f(K,H,N,L)$

where $Y^S$ is Stuff supplied, A is technological knowledge, K is capital, H is human capital, N is natural resources, and L is labor.

Then, remember that all the Stuff we produce has to be bought, stored in inventory, or exported, so our demand equation is $Y^D = C + I + G + NX$

where $Y^D$ is Stuff demanded, C is consumption, I is investment, G is government spending, and NX is Stuff exported less Stuff imported.

In order to find an equilibrium, we need to make another pair of assumptions:

• The more you can sell for, the more you want to produce.
• The more goods cost, the less you’ll want to buy.1

Since we’re simplifying away from individual goods, instead of a price, think about the price level of the economy as a whole (which we’ll abbreviate as PL). Also since we’re not thinking too much about individual goods, we don’t have to worry too much about changes in relative prices. (We can talk about those a little bit later.) So, basically, we’re looking at things statically – we don’t need to figure out what happens if coffee’s price goes up more than tea, for example.

The price level determines, on average, how much Stuff sells for. As the price level increases, we’ll produce more. As the price level decreases, we’ll buy less. There’s just one more condition we need to allow an equilibrium:

• At 0 production, we need an incentive to produce more. So, at 0 production, demand is greater than 0 and supply is 0 by definition. At infinite production, demand is less than infinite.

So, these conditions say 2 things: At a low level of production, demand outstrips supply. As the price level increases, we produce more and demand less. These conditions guarantee that there’s a price level at which we’ll want to supply exactly as much as we want to demand – a little bit lower in price and more will be demanded than produced, and a little bit higher and more will be produced than demanded. So, at that price level, $Y^D = Y^S$

Supply equals demand.

Equilibrium.

1Mathematically, $\frac{\partial Y^D}{\partial PL} > 0$ $\frac{\partial Y^S}{\partial PL} < 0$