1 00:00:00,040 --> 00:00:02,460 The following content is provided under a Creative 2 00:00:02,460 --> 00:00:03,870 Commons license. 3 00:00:03,870 --> 00:00:06,910 Your support will help MIT OpenCourseWare continue to 4 00:00:06,910 --> 00:00:10,560 offer high quality educational resources for free. 5 00:00:10,560 --> 00:00:13,460 To make a donation or view additional materials from 6 00:00:13,460 --> 00:00:16,180 hundreds of MIT courses, visit mitopencourseware@ocw.mit.edu. 7 00:00:24,850 --> 00:00:25,260 PROFESSOR: All right. 8 00:00:25,260 --> 00:00:26,900 Let's get started. 9 00:00:26,900 --> 00:00:30,520 Today we are going to talk about competition. 10 00:00:33,480 --> 00:00:37,490 Just, once again, I want you guys to try to have in mind a 11 00:00:37,490 --> 00:00:39,450 flowchart of where the course is all going. 12 00:00:39,450 --> 00:00:40,800 Where does this fit in? 13 00:00:40,800 --> 00:00:46,350 We talked last time about how firms decide on the cost 14 00:00:46,350 --> 00:00:49,200 minimizing way to produce a given level of output through 15 00:00:49,200 --> 00:00:52,530 the tangency of the isoquant and the isocost. And we talked 16 00:00:52,530 --> 00:00:56,600 about how if we were consumers, we'd be done then. 17 00:00:56,600 --> 00:00:58,300 Consumers just find the tangency and indifference 18 00:00:58,300 --> 00:01:00,000 curve in the budget constraint, and they're done. 19 00:01:00,000 --> 00:01:00,950 But firms aren't done. 20 00:01:00,950 --> 00:01:03,720 Because the level of output, unlike the budget which is 21 00:01:03,720 --> 00:01:06,390 given to you as a consumer, the level of output is not 22 00:01:06,390 --> 00:01:07,140 given to the firm. 23 00:01:07,140 --> 00:01:08,670 They get to choose it. 24 00:01:08,670 --> 00:01:12,000 So with firms, we have to go one step further. 25 00:01:12,000 --> 00:01:13,790 We actually have to choose the level of 26 00:01:13,790 --> 00:01:14,790 output that we produce. 27 00:01:14,790 --> 00:01:17,420 We don't just choose the way to produce it but actually how 28 00:01:17,420 --> 00:01:18,690 much to produce. 29 00:01:18,690 --> 00:01:20,830 So, for consumers, it would be sort of like consumers 30 00:01:20,830 --> 00:01:23,900 choosing what their budget constraint is. 31 00:01:23,900 --> 00:01:27,730 And the way we do that is we bring in-- since we now have a 32 00:01:27,730 --> 00:01:30,640 third variable, which is how much to produce-- 33 00:01:30,640 --> 00:01:32,670 we have to bring in a third equation. 34 00:01:32,670 --> 00:01:35,930 And that equation we bring in is essentially the market. 35 00:01:35,930 --> 00:01:40,090 Essentially, we say the market imposes conditions on the firm 36 00:01:40,090 --> 00:01:43,340 which helps them figure out how much to produce. 37 00:01:43,340 --> 00:01:44,950 So we take all the stuff we did before. 38 00:01:44,950 --> 00:01:46,770 We then take that and put that in a market. 39 00:01:46,770 --> 00:01:49,500 And the market interacts with the firm. 40 00:01:49,500 --> 00:01:51,250 And from that market setting, the firm 41 00:01:51,250 --> 00:01:53,680 derives how much to produce. 42 00:01:53,680 --> 00:01:56,230 So, basically, the level of production for a given firm, 43 00:01:56,230 --> 00:01:59,760 little q, will be derived from how firms behave in different 44 00:01:59,760 --> 00:02:01,530 market settings. 45 00:02:01,530 --> 00:02:04,870 And the market setting we're going to start with today is 46 00:02:04,870 --> 00:02:08,800 the classic starting point for economics which is the market 47 00:02:08,800 --> 00:02:10,075 setting of perfect competition. 48 00:02:16,274 --> 00:02:18,750 We're going to start talking about perfectly competitive 49 00:02:18,750 --> 00:02:23,510 markets, a benchmark of perfect competition. 50 00:02:23,510 --> 00:02:26,550 With perfect competition, this is basically a case where many 51 00:02:26,550 --> 00:02:30,400 firms are selling goods to many consumers. 52 00:02:30,400 --> 00:02:32,890 We're then going to, in the next few lectures, talk about 53 00:02:32,890 --> 00:02:35,790 more realistic alternatives like monopoly which is not a 54 00:02:35,790 --> 00:02:37,930 game but rather a market structure. 55 00:02:37,930 --> 00:02:39,980 It is basically a case where one firm 56 00:02:39,980 --> 00:02:42,180 sells to many consumers. 57 00:02:42,180 --> 00:02:46,080 Or oligopoly, my favorite word in all of economics, not 58 00:02:46,080 --> 00:02:47,005 because I like the topic so much, I 59 00:02:47,005 --> 00:02:48,730 think it's a cool word. 60 00:02:48,730 --> 00:02:52,130 This is when several firms sell to a large market, which 61 00:02:52,130 --> 00:02:54,120 is probably the most realistic setting of all. 62 00:02:54,120 --> 00:02:55,800 And we're going to come to talk about those. 63 00:02:55,800 --> 00:02:57,510 But, today, we're going to start with our benchmark of 64 00:02:57,510 --> 00:02:59,160 perfect competition. 65 00:02:59,160 --> 00:03:00,410 Now, what is perfect competition? 66 00:03:03,500 --> 00:03:05,830 I can give you a technical definition. 67 00:03:05,830 --> 00:03:09,330 Technically, perfect competition exists whenever 68 00:03:09,330 --> 00:03:16,240 firms are price takers on both the output and input markets. 69 00:03:16,240 --> 00:03:21,040 They're price takers on both the output and input markets. 70 00:03:21,040 --> 00:03:23,080 So perfectly competitive firms are price takers. 71 00:03:23,080 --> 00:03:28,300 That is no action that they take can affect either the 72 00:03:28,300 --> 00:03:32,260 price at which they sell their goods or the price that they 73 00:03:32,260 --> 00:03:35,060 pay for their inputs. 74 00:03:35,060 --> 00:03:36,150 They're price takers. 75 00:03:36,150 --> 00:03:37,110 They're not price makers. 76 00:03:37,110 --> 00:03:40,080 No action they take affects either the price at which they 77 00:03:40,080 --> 00:03:40,710 sell their good. 78 00:03:40,710 --> 00:03:43,810 No action the individual firm takes affects either the price 79 00:03:43,810 --> 00:03:45,880 at which they sell their goods or the price they pay for 80 00:03:45,880 --> 00:03:48,130 their inputs. 81 00:03:48,130 --> 00:03:50,570 Well, when will this be true? 82 00:03:50,570 --> 00:03:52,430 Go back to lecture one. 83 00:03:52,430 --> 00:03:56,280 Technically this would be true if a firm faced perfectly 84 00:03:56,280 --> 00:04:06,730 elastic demand for their goods, and if they had 85 00:04:06,730 --> 00:04:12,440 perfectly elastic supply of inputs. 86 00:04:12,440 --> 00:04:15,400 Under those conditions, firms will be perfectly competitive 87 00:04:15,400 --> 00:04:18,709 if they face perfectly elastic demand for their goods and 88 00:04:18,709 --> 00:04:21,399 perfectly elastic supply of inputs. 89 00:04:21,399 --> 00:04:22,230 OK. 90 00:04:22,230 --> 00:04:25,810 So let's focus on the first of those which is perfectly 91 00:04:25,810 --> 00:04:26,710 elastic demand. 92 00:04:26,710 --> 00:04:29,270 Let's take a look at Figure 10-1. 93 00:04:29,270 --> 00:04:31,160 These should be little q's by the way. 94 00:04:31,160 --> 00:04:31,860 This isn't a market. 95 00:04:31,860 --> 00:04:32,930 This is a firm. 96 00:04:32,930 --> 00:04:34,380 These should be little q's. 97 00:04:34,380 --> 00:04:40,350 So, basically, what you have here is that you have a firm 98 00:04:40,350 --> 00:04:41,815 facing a perfectly elastic demand. 99 00:04:46,080 --> 00:04:51,690 What that means is the firm's quantity is pegged by their 100 00:04:51,690 --> 00:04:52,500 supply curve. 101 00:04:52,500 --> 00:04:54,860 Or, in other words, the point is the firm cannot change the 102 00:04:54,860 --> 00:05:00,456 price one iota from that level P. So, in other words, if this 103 00:05:00,456 --> 00:05:04,000 is a supply shift, say the price of the firm's inputs go 104 00:05:04,000 --> 00:05:06,520 up, the firm doesn't get to charge any 105 00:05:06,520 --> 00:05:07,680 more for their goods. 106 00:05:07,680 --> 00:05:09,860 They just sell fewer goods. 107 00:05:09,860 --> 00:05:13,438 So the supply shift from S1 to S2, the firm is going to be-- 108 00:05:13,438 --> 00:05:16,080 it should be little q1 to little q2. 109 00:05:16,080 --> 00:05:17,540 They're going to reduce the quantity they sell, but they 110 00:05:17,540 --> 00:05:18,720 cannot change the price. 111 00:05:18,720 --> 00:05:20,550 They face perfectly elastic demand. 112 00:05:23,180 --> 00:05:27,150 So when does this make sense as a description of the world? 113 00:05:27,150 --> 00:05:29,170 Well, it makes sense as a description of the world under 114 00:05:29,170 --> 00:05:30,680 four conditions. 115 00:05:30,680 --> 00:05:33,360 So there's four conditions under which perfect 116 00:05:33,360 --> 00:05:39,210 competition will exist. 117 00:05:39,210 --> 00:05:43,060 The first condition is identical products. 118 00:05:49,400 --> 00:05:54,135 In a perfectly competitive market, when the firms in that 119 00:05:54,135 --> 00:05:56,860 market sell identical products, now let's be clear. 120 00:05:56,860 --> 00:05:58,200 They don't have to literally be identical. 121 00:05:58,200 --> 00:06:00,860 They have to be perceived by consumers as identical. 122 00:06:00,860 --> 00:06:02,280 So when I say identical products, they don't have to 123 00:06:02,280 --> 00:06:03,100 literally be identical. 124 00:06:03,100 --> 00:06:07,360 But consumers have to consider them identical for purposes of 125 00:06:07,360 --> 00:06:10,710 their demand across firms. 126 00:06:10,710 --> 00:06:13,804 So firms have to sell identical products for there 127 00:06:13,804 --> 00:06:14,580 to be perfect competition. 128 00:06:14,580 --> 00:06:17,610 Because if products aren't identical, then firms will be 129 00:06:17,610 --> 00:06:19,790 able to charge different prices from each other because 130 00:06:19,790 --> 00:06:22,190 they have something different to sell. 131 00:06:22,190 --> 00:06:24,300 So firms need to be identical. 132 00:06:24,300 --> 00:06:33,240 Second of all, consumers have to have full information on 133 00:06:33,240 --> 00:06:34,490 all prices. 134 00:06:39,890 --> 00:06:41,880 Well, let me write down the next two conditions, because 135 00:06:41,880 --> 00:06:42,950 they're related. 136 00:06:42,950 --> 00:06:53,255 And the third is low transaction or shopping costs. 137 00:06:56,310 --> 00:06:58,200 OK, these two are critical. 138 00:06:58,200 --> 00:07:00,630 Because the way perfect competition is going to work, 139 00:07:00,630 --> 00:07:04,770 its consumers are going to shop across firms selling 140 00:07:04,770 --> 00:07:06,300 identical goods. 141 00:07:06,300 --> 00:07:10,195 And they're going to buy from the cheapest one. 142 00:07:10,195 --> 00:07:14,430 And if there's any failure of either of these, the consumers 143 00:07:14,430 --> 00:07:16,670 might not know if you're the cheapest. And, therefore, you 144 00:07:16,670 --> 00:07:19,230 might be able to charge extra. 145 00:07:19,230 --> 00:07:23,035 So perfectly elastic demand, once again we're getting to 146 00:07:23,035 --> 00:07:25,570 the microfoundation of something we discussed in the 147 00:07:25,570 --> 00:07:26,690 second lecture. 148 00:07:26,690 --> 00:07:27,780 We discussed perfectly elastic demand. 149 00:07:27,780 --> 00:07:28,880 Now we're talking about where that comes from. 150 00:07:28,880 --> 00:07:30,440 What conditions do you need? 151 00:07:30,440 --> 00:07:33,540 Perfectly elastic demand is going to require that 152 00:07:33,540 --> 00:07:37,480 consumers know all the prices and can cautiously shop across 153 00:07:37,480 --> 00:07:39,380 all the options. 154 00:07:39,380 --> 00:07:41,410 Otherwise, firms might have some opportunity to charge 155 00:07:41,410 --> 00:07:43,890 different prices. 156 00:07:43,890 --> 00:07:45,900 And finally-- and we'll come back to why this is 157 00:07:45,900 --> 00:07:47,150 important-- 158 00:07:47,150 --> 00:07:55,580 there needs to be free entry and exit of firms. This one I 159 00:07:55,580 --> 00:07:57,210 can't really give you intuition for yet. 160 00:07:57,210 --> 00:07:58,000 Just take my word for it. 161 00:07:58,000 --> 00:07:59,450 We'll come back to why that's important. 162 00:08:04,390 --> 00:08:08,920 So, basically, what you want for an example of a perfectly 163 00:08:08,920 --> 00:08:11,960 competitive market, you want a market where producers are 164 00:08:11,960 --> 00:08:16,910 selling homogeneous goods in an easily informed, easily 165 00:08:16,910 --> 00:08:20,070 shocked arena. 166 00:08:20,070 --> 00:08:23,470 So I think the best example of a perfectly competitive market 167 00:08:23,470 --> 00:08:27,150 is those guys selling like shlocky touristy things around 168 00:08:27,150 --> 00:08:32,850 Port Authority in New York or in any large open air market. 169 00:08:32,850 --> 00:08:37,960 Basically, in that area, these guys all sell the same crap. 170 00:08:37,960 --> 00:08:39,809 You can go from one to one quite easily. 171 00:08:39,809 --> 00:08:41,440 And it's quite easy to find out what the prices are. 172 00:08:41,440 --> 00:08:44,550 That's not perfectly easy, but it's quite easy to find out 173 00:08:44,550 --> 00:08:45,440 what the prices are. 174 00:08:45,440 --> 00:08:47,980 That is a condition for a perfectly competitive market. 175 00:08:47,980 --> 00:08:50,410 It's easy to shop, because they're all in the same area. 176 00:08:50,410 --> 00:08:52,320 Prices are pretty easy to observe, and the products are 177 00:08:52,320 --> 00:08:53,880 all, basically, identical. 178 00:08:53,880 --> 00:08:55,580 There are only so many little Statues of 179 00:08:55,580 --> 00:08:57,880 Liberty you can buy. 180 00:08:57,880 --> 00:09:00,720 So, basically, that's an example of a perfectly 181 00:09:00,720 --> 00:09:01,820 competitive market. 182 00:09:01,820 --> 00:09:05,530 Now, in reality, no perfectly competitive market exists. 183 00:09:05,530 --> 00:09:08,260 There's never been a perfectly competitive market. 184 00:09:08,260 --> 00:09:12,680 But this is sort of as close as we can get. 185 00:09:15,680 --> 00:09:18,250 Questions about that? 186 00:09:18,250 --> 00:09:22,940 Now that provides a good moment to pause and talk about 187 00:09:22,940 --> 00:09:25,560 Peter Diamond who just won the Nobel Prize in Economics. 188 00:09:25,560 --> 00:09:28,915 This is my MIT economics Peter Diamond, MIT Econ Peter 189 00:09:28,915 --> 00:09:30,640 Diamond shirt. 190 00:09:30,640 --> 00:09:33,250 Peter Diamond just won the Nobel Prize in Economics. 191 00:09:33,250 --> 00:09:35,610 Peter Diamond is the greatest economic theorist of his 192 00:09:35,610 --> 00:09:39,290 generation, sort of the heir of the Paul Samuelson, Bob 193 00:09:39,290 --> 00:09:41,420 Solow generation that founded this economics department and 194 00:09:41,420 --> 00:09:42,290 made it great. 195 00:09:42,290 --> 00:09:44,360 Peter Diamond was sort of the next generation that led this 196 00:09:44,360 --> 00:09:47,320 economics department forward and kept it great. 197 00:09:47,320 --> 00:09:50,200 And Peter has made contributions throughout 198 00:09:50,200 --> 00:09:50,990 economic theory. 199 00:09:50,990 --> 00:09:52,860 He should have won the Nobel 10 times over. 200 00:09:52,860 --> 00:09:56,560 What they finally gave it to him on Monday for was for 201 00:09:56,560 --> 00:09:58,350 search theory. 202 00:09:58,350 --> 00:10:01,230 And search theory is essentially about what happens 203 00:10:01,230 --> 00:10:03,720 when markets don't work like these vendors around Port 204 00:10:03,720 --> 00:10:06,810 Authority in New York, when markets aren't perfectly 205 00:10:06,810 --> 00:10:08,730 competitive. 206 00:10:08,730 --> 00:10:12,240 Where, basically, you have markets where there is some 207 00:10:12,240 --> 00:10:16,360 mismatch and some search costs that sellers have to pay to 208 00:10:16,360 --> 00:10:18,600 find the right buyers, and buyers have to pay to find the 209 00:10:18,600 --> 00:10:21,120 right sellers. 210 00:10:21,120 --> 00:10:23,400 So the best example here, and the example of which they 211 00:10:23,400 --> 00:10:25,560 really gave him the Nobel Prize, was the labor market. 212 00:10:25,560 --> 00:10:27,630 It was about search costs in the labor market. 213 00:10:27,630 --> 00:10:30,590 And what Peter Diamond and his fellow co-winners talked about 214 00:10:30,590 --> 00:10:31,840 was about how in the labor market, 215 00:10:31,840 --> 00:10:32,860 your firms have vacancies. 216 00:10:32,860 --> 00:10:35,940 They have jobs they want to fill. 217 00:10:35,940 --> 00:10:38,080 Individuals have labor supply. 218 00:10:38,080 --> 00:10:40,060 They want to provide themselves to these jobs. 219 00:10:40,060 --> 00:10:41,040 And so there's unemployment. 220 00:10:41,040 --> 00:10:42,820 There's people out of jobs looking for jobs. 221 00:10:42,820 --> 00:10:43,760 But there's vacancies. 222 00:10:43,760 --> 00:10:44,660 There's jobs that are empty. 223 00:10:44,660 --> 00:10:46,590 And both exist at the same time. 224 00:10:46,590 --> 00:10:48,120 And how can that be? 225 00:10:48,120 --> 00:10:49,890 In a perfectly competitive market, that couldn't be. 226 00:10:49,890 --> 00:10:52,450 You couldn't have both jobs looking for people and people 227 00:10:52,450 --> 00:10:53,900 looking for jobs. 228 00:10:53,900 --> 00:10:55,960 But what Diamond wrote down, and these other theorists 229 00:10:55,960 --> 00:10:59,320 developed in their models, is basically how you get these 230 00:10:59,320 --> 00:11:00,850 frictions in the labor market. 231 00:11:00,850 --> 00:11:03,360 Where since these jobs have specific characteristics 232 00:11:03,360 --> 00:11:06,200 employers are looking for, you can't quite match the 233 00:11:06,200 --> 00:11:08,640 vacancies to the unemployed workers. 234 00:11:08,640 --> 00:11:11,300 There's a sorting process where some are easy to match. 235 00:11:11,300 --> 00:11:12,430 You can take the high school dropout and put him in 236 00:11:12,430 --> 00:11:12,900 McDonald's. 237 00:11:12,900 --> 00:11:13,980 That's easy. 238 00:11:13,980 --> 00:11:17,280 But the job which requires some computer skills, you have 239 00:11:17,280 --> 00:11:20,070 to find the right guy to take that. 240 00:11:20,070 --> 00:11:23,490 And, basically, it's these frictions that lead to what we 241 00:11:23,490 --> 00:11:26,240 call the natural rate of unemployment in our economy, 242 00:11:26,240 --> 00:11:28,920 which is the notion that no economy would ever get down to 243 00:11:28,920 --> 00:11:29,770 0 unemployment. 244 00:11:29,770 --> 00:11:31,130 That's impossible. 245 00:11:31,130 --> 00:11:32,900 And the reason is because there will always be some 246 00:11:32,900 --> 00:11:34,490 frictions and some mismatch. 247 00:11:34,490 --> 00:11:36,730 There will always be some inability of people to find 248 00:11:36,730 --> 00:11:39,580 the right people to fill their vacancies. 249 00:11:39,580 --> 00:11:41,290 Now, we don't know what the natural rate is. 250 00:11:41,290 --> 00:11:44,650 When I was in grad school, we learned that the rate was 7%. 251 00:11:44,650 --> 00:11:47,950 In the 1990s, the natural rate seemed to fall to about 4%. 252 00:11:47,950 --> 00:11:50,550 That is we got to about a 4% unemployment rate. 253 00:11:50,550 --> 00:11:53,300 Now who the heck knows what the natural rate is anymore. 254 00:11:53,300 --> 00:11:55,470 And a big debate right now among economists in macro is 255 00:11:55,470 --> 00:11:59,340 how much of our 9.6% is an increase in the natural rate, 256 00:11:59,340 --> 00:12:01,030 which is something the government can't really fix 257 00:12:01,030 --> 00:12:03,710 very well, versus short-term demand reductions, which the 258 00:12:03,710 --> 00:12:05,520 government could fix by pumping more resources into 259 00:12:05,520 --> 00:12:06,610 the economy. 260 00:12:06,610 --> 00:12:09,300 And all that is informed, theoretically, by the work 261 00:12:09,300 --> 00:12:10,360 that Peter Diamond did. 262 00:12:10,360 --> 00:12:14,070 Now, I hope what I just described sounded pretty 263 00:12:14,070 --> 00:12:15,940 obvious to you. 264 00:12:15,940 --> 00:12:19,460 And that's good, because that's what great theory does. 265 00:12:19,460 --> 00:12:22,720 Great theory ex-post sounds obvious. 266 00:12:22,720 --> 00:12:25,440 It's just ex-ante, before Peter Diamond did this, people 267 00:12:25,440 --> 00:12:26,150 always said, well, we have these 268 00:12:26,150 --> 00:12:27,150 perfectly competitive markets. 269 00:12:27,150 --> 00:12:28,260 This is how they should function. 270 00:12:28,260 --> 00:12:30,130 And he's the guy who really taught us how real markets 271 00:12:30,130 --> 00:12:31,370 should function like this. 272 00:12:31,370 --> 00:12:34,350 And that's why he gets to go to Stockholm. 273 00:12:34,350 --> 00:12:37,450 So that's very exciting for our economics department, very 274 00:12:37,450 --> 00:12:38,770 exciting for the profession. 275 00:12:38,770 --> 00:12:43,670 And it's just a great moment, really, in taking economics-- 276 00:12:43,670 --> 00:12:45,540 I saw it described very well in one article-- 277 00:12:48,480 --> 00:12:50,690 these last few Nobel Prizes are the beginning of 278 00:12:50,690 --> 00:12:52,770 recognizing that economics is not what we teach in this 279 00:12:52,770 --> 00:12:54,460 course anymore. 280 00:12:54,460 --> 00:12:57,230 You need what we teach in this course to go on in economics. 281 00:12:57,230 --> 00:13:00,020 But probably the first couple dozen Nobel Prizes were for 282 00:13:00,020 --> 00:13:01,670 about what we teach in this course. 283 00:13:01,670 --> 00:13:03,440 And the last few have been about what you teach in the 284 00:13:03,440 --> 00:13:04,650 subsequent courses. 285 00:13:04,650 --> 00:13:07,110 And that's a real evolution of Freakonomics, to understand 286 00:13:07,110 --> 00:13:09,630 that we need to mature as a science and move beyond the 287 00:13:09,630 --> 00:13:13,820 basics that you learn in 14.01 and move beyond 288 00:13:13,820 --> 00:13:14,560 to these other things. 289 00:13:14,560 --> 00:13:15,630 So we're giving you the basics here. 290 00:13:15,630 --> 00:13:19,140 But the excitement happens elsewhere. 291 00:13:19,140 --> 00:13:21,090 So it's a very exciting time for our department and for the 292 00:13:21,090 --> 00:13:22,560 profession as a whole. 293 00:13:22,560 --> 00:13:27,500 Now with that little diatribe aside, let's go back. 294 00:13:27,500 --> 00:13:28,180 So we have these. 295 00:13:28,180 --> 00:13:31,450 So now, having said all that, forget it. 296 00:13:31,450 --> 00:13:33,620 Forget Peter Diamond existed. 297 00:13:33,620 --> 00:13:35,340 We're now going back to perfect competition. 298 00:13:35,340 --> 00:13:37,340 And, once again, as I said in the first lecture-- 299 00:13:37,340 --> 00:13:39,000 and Peter would be the first guy to say it, this is how he 300 00:13:39,000 --> 00:13:40,620 taught me to do economic theory-- you've got to make 301 00:13:40,620 --> 00:13:42,940 simplifying assumptions if you want to get anywhere. 302 00:13:42,940 --> 00:13:44,540 So we're going to make a simplifying assumption of 303 00:13:44,540 --> 00:13:45,640 perfect competition. 304 00:13:45,640 --> 00:13:46,860 We'll weaken that as we go along. 305 00:13:46,860 --> 00:13:49,820 But, for now, imagine it's perfect competition. 306 00:13:49,820 --> 00:13:53,000 And we have the situation of perfectly competitive firms. 307 00:13:53,000 --> 00:13:54,745 Now a very important distinction to draw-- and 308 00:13:54,745 --> 00:13:56,410 that's why it's important to remember that these are little 309 00:13:56,410 --> 00:13:57,890 q's not big Q's-- 310 00:13:57,890 --> 00:14:04,770 is the distinction between firm demand and market demand, 311 00:14:04,770 --> 00:14:05,890 firm versus market. 312 00:14:05,890 --> 00:14:07,895 And this is something which is confusing. 313 00:14:07,895 --> 00:14:09,230 It confuses me at times. 314 00:14:09,230 --> 00:14:10,320 I may even get it wrong at times. 315 00:14:10,320 --> 00:14:11,570 I'll need you to correct me. 316 00:14:13,770 --> 00:14:17,850 Even if a given firm faces perfectly elastic demand, it 317 00:14:17,850 --> 00:14:19,740 doesn't necessarily mean that market demand 318 00:14:19,740 --> 00:14:21,890 is perfectly elastic. 319 00:14:21,890 --> 00:14:26,350 That is the overall demand for little, fake Statues of 320 00:14:26,350 --> 00:14:32,730 Liberty around Port Authority in New York is 321 00:14:32,730 --> 00:14:35,300 not perfectly elastic. 322 00:14:35,300 --> 00:14:36,910 As the price goes up, fewer people will buy them. 323 00:14:36,910 --> 00:14:38,490 As the prices goes down, more people will buy them. 324 00:14:38,490 --> 00:14:40,425 But for any given vendor selling them, it 325 00:14:40,425 --> 00:14:41,670 is perfectly elastic. 326 00:14:41,670 --> 00:14:42,750 Because there's always someplace next 327 00:14:42,750 --> 00:14:43,880 door you can go. 328 00:14:43,880 --> 00:14:47,220 So it's very important to distinguish between the demand 329 00:14:47,220 --> 00:14:50,530 facing the firm being perfectly elastic and the 330 00:14:50,530 --> 00:14:53,070 demand facing the market not being perfectly elastic. 331 00:14:53,070 --> 00:14:54,680 And the way to think about this is to think about the 332 00:14:54,680 --> 00:14:56,370 concept of residual demand. 333 00:15:01,370 --> 00:15:05,260 We have a demand function for market D of p. 334 00:15:05,260 --> 00:15:11,460 We have a demand function for a market which is that as the 335 00:15:11,460 --> 00:15:14,970 price goes up demand goes down. 336 00:15:14,970 --> 00:15:19,000 Now the demand function for a given firm, we'll call the 337 00:15:19,000 --> 00:15:23,420 residual demand D super r of p, is equal to what? 338 00:15:23,420 --> 00:15:31,150 It's equal to the demand for the market minus the supply 339 00:15:31,150 --> 00:15:35,730 that all other firms in the market provide, S super 0 of 340 00:15:35,730 --> 00:15:38,970 p, the supply that all other firms in the market provide. 341 00:15:38,970 --> 00:15:41,870 So the demand for my product as a firm 342 00:15:41,870 --> 00:15:45,450 is my residual demand. 343 00:15:45,450 --> 00:15:49,810 It's the market demand minus what other firms supply. 344 00:15:49,810 --> 00:15:54,070 Well, if you differentiate this with respect to price, 345 00:15:54,070 --> 00:16:04,620 you'll see that dDr/dp equals dD/dp minus dS0/dp. 346 00:16:13,080 --> 00:16:15,190 This first one is the market demand curve. 347 00:16:15,190 --> 00:16:17,040 We know that's a negative number, because demand curves 348 00:16:17,040 --> 00:16:17,640 slope down. 349 00:16:17,640 --> 00:16:19,440 We're not assuming Giffen goods. 350 00:16:19,440 --> 00:16:21,670 We know that's a negative number. 351 00:16:21,670 --> 00:16:24,240 But this is a positive number. 352 00:16:24,240 --> 00:16:25,930 Supply curves slope up. 353 00:16:25,930 --> 00:16:28,450 The amount that other firms in the market will supply as the 354 00:16:28,450 --> 00:16:30,080 prices goes up is positive. 355 00:16:30,080 --> 00:16:31,520 Supply curves slope up. 356 00:16:31,520 --> 00:16:33,330 So this is a negative number. 357 00:16:33,330 --> 00:16:36,270 But this is a positive number which means, by definition, 358 00:16:36,270 --> 00:16:39,840 this is a very negative number. 359 00:16:39,840 --> 00:16:42,465 The firm's residual demand responds more to price than 360 00:16:42,465 --> 00:16:44,510 the market's demand does. 361 00:16:44,510 --> 00:16:46,580 Because the firm's residual demand is after all the supply 362 00:16:46,580 --> 00:16:48,830 of other firms. 363 00:16:48,830 --> 00:16:52,730 So we can rewrite this in terms of elasticities. 364 00:16:52,730 --> 00:16:56,470 So let's assume, for a second, that all firms are identical. 365 00:16:56,470 --> 00:16:58,100 Assume, for one second, that we're in a market where all 366 00:16:58,100 --> 00:17:02,700 firms are identical, that little q equals big Q over N. 367 00:17:02,700 --> 00:17:06,089 Assume that all firms are identical. 368 00:17:06,089 --> 00:17:10,140 And so, therefore, the amount produced by other firms, Q 369 00:17:10,140 --> 00:17:15,609 super 0 is (n - 1) x q. 370 00:17:15,609 --> 00:17:20,230 So, basically, the amount that's produced by other firms 371 00:17:20,230 --> 00:17:21,920 is (n - 1) x q. 372 00:17:21,920 --> 00:17:27,099 So the last is demand facing a given firm, epsilon sub i is n 373 00:17:27,099 --> 00:17:31,280 times the elasticity of demand for the entire market minus (n 374 00:17:31,280 --> 00:17:35,310 - 1) times the elasticity of supply for the market. 375 00:17:35,310 --> 00:17:38,300 So, for example, let's say you've got a market with 100 376 00:17:38,300 --> 00:17:40,632 firms in it. 377 00:17:40,632 --> 00:17:43,860 It's a big market but not outrageously big. 378 00:17:43,860 --> 00:17:46,180 We have plenty of markets with more firms than that. 379 00:17:46,180 --> 00:17:48,430 And let's say that the elasticity of demand for this 380 00:17:48,430 --> 00:17:50,580 market equals minus 1. 381 00:17:50,580 --> 00:17:54,560 So it's in between elastic and inelastic, not a crazy number. 382 00:17:54,560 --> 00:17:57,970 And the elasticity of supply is 1. 383 00:17:57,970 --> 00:18:00,320 Let's just say that's the example. 384 00:18:00,320 --> 00:18:05,540 Then what you get is that for a given firm, if you used this 385 00:18:05,540 --> 00:18:08,620 formula, the elasticity of demand facing a given 386 00:18:08,620 --> 00:18:11,350 firm is minus 199. 387 00:18:11,350 --> 00:18:13,910 It's a huge negative number. 388 00:18:13,910 --> 00:18:19,470 So even though the market demand is modestly elastic, 389 00:18:19,470 --> 00:18:22,330 minus 1-- it's elastic but not crazy-- 390 00:18:22,330 --> 00:18:24,890 the demand facing the given firm is crazy elastic. 391 00:18:28,080 --> 00:18:31,800 So, basically, the point is that even if a market does not 392 00:18:31,800 --> 00:18:35,270 have super elastic demand, a given firm can face very 393 00:18:35,270 --> 00:18:36,360 elastic demand. 394 00:18:36,360 --> 00:18:39,610 And that's what can lead to perfect competition. 395 00:18:39,610 --> 00:18:41,510 It's very important to keep those distinct. 396 00:18:41,510 --> 00:18:43,430 When we talk about demand, think about demand at the firm 397 00:18:43,430 --> 00:18:46,620 level versus demand at the market level. 398 00:18:46,620 --> 00:18:50,590 Demand at the market level, that's about substitutability 399 00:18:50,590 --> 00:18:52,300 with other goods and the things we've talked about 400 00:18:52,300 --> 00:18:53,670 deriving demand curves. 401 00:18:53,670 --> 00:18:56,070 When we derive demand curves, we're not 402 00:18:56,070 --> 00:18:57,400 deriving firm demand curves. 403 00:18:57,400 --> 00:18:59,840 We're deriving market demand curves. 404 00:18:59,840 --> 00:19:02,570 And so the demand curve was a function of elasticities and 405 00:19:02,570 --> 00:19:07,150 substitutability across goods. 406 00:19:07,150 --> 00:19:09,640 The firm demand curve is a function of all that but also 407 00:19:09,640 --> 00:19:11,620 how many firms are in the market. 408 00:19:11,620 --> 00:19:13,220 If there are a lot of firms in the market, it's going to be 409 00:19:13,220 --> 00:19:17,650 very elastic in a perfectly competitive market. 410 00:19:17,650 --> 00:19:19,250 Questions about that? 411 00:19:19,250 --> 00:19:21,130 It's an important distinction to keep in mind. 412 00:19:21,130 --> 00:19:25,350 Now, with that as background, let's now come to profit 413 00:19:25,350 --> 00:19:27,580 maximization which is what this is all about. 414 00:19:27,580 --> 00:19:33,220 Remember I said we assume that every decision consumers make 415 00:19:33,220 --> 00:19:36,160 is driven by utility maximization. 416 00:19:36,160 --> 00:19:39,680 Every decision producers make is driven by profit 417 00:19:39,680 --> 00:19:40,970 maximization. 418 00:19:40,970 --> 00:19:45,730 So let's talk about profit maximization in the short run. 419 00:19:49,780 --> 00:19:54,200 How do firms maximize profits in the short run? 420 00:19:54,200 --> 00:19:56,290 Now, the first question we have to 421 00:19:56,290 --> 00:20:00,040 ask is what is profits? 422 00:20:00,040 --> 00:20:03,060 Well, that seems pretty straightforward. 423 00:20:03,060 --> 00:20:04,760 I defined those already. 424 00:20:04,760 --> 00:20:08,440 I said, the profits were equal to revenue minus costs. 425 00:20:10,990 --> 00:20:14,740 Profits are equal to revenue minus costs. 426 00:20:14,740 --> 00:20:17,740 Well, the trick is that there's two different types of 427 00:20:17,740 --> 00:20:20,100 people who measure costs. 428 00:20:20,100 --> 00:20:20,970 Revenue is revenue. 429 00:20:20,970 --> 00:20:22,220 It's just, basically, the money you make. 430 00:20:22,220 --> 00:20:24,070 And anybody can measure that. 431 00:20:24,070 --> 00:20:27,310 But there's two different ways of measuring costs. 432 00:20:27,310 --> 00:20:36,110 There's accounting costs, and there's economic costs. 433 00:20:36,110 --> 00:20:39,910 And these are different concepts. 434 00:20:39,910 --> 00:20:48,880 Accounting costs are cash flow costs what you actually pay. 435 00:20:48,880 --> 00:20:51,700 So your accounting costs are what you actually pay. 436 00:20:51,700 --> 00:20:53,790 So if you buy something for x dollars, that's your 437 00:20:53,790 --> 00:20:56,710 accounting costs. 438 00:20:56,710 --> 00:21:04,390 The economic costs are about opportunity costs, which is 439 00:21:04,390 --> 00:21:08,090 not about what you lay out in cash, but what you could have 440 00:21:08,090 --> 00:21:11,030 done with that cash. 441 00:21:11,030 --> 00:21:13,140 It's not just about what you lay out, but what you could 442 00:21:13,140 --> 00:21:15,980 have done with that cash. 443 00:21:15,980 --> 00:21:18,370 So to give you an example, let's 444 00:21:18,370 --> 00:21:19,870 just do a simple example. 445 00:21:19,870 --> 00:21:23,630 Imagine that you graduate. 446 00:21:23,630 --> 00:21:24,330 You're going to graduate. 447 00:21:24,330 --> 00:21:24,720 I don't mean that. 448 00:21:24,720 --> 00:21:25,750 You're going to graduate. 449 00:21:25,750 --> 00:21:29,886 Imagine that after you graduate, you decide you're 450 00:21:29,886 --> 00:21:32,620 going to start a website design firm on the side. 451 00:21:32,620 --> 00:21:34,530 You're going to do this while you decide what to do with the 452 00:21:34,530 --> 00:21:35,095 rest your life. 453 00:21:35,095 --> 00:21:35,858 You're trying to figure out where to go to 454 00:21:35,858 --> 00:21:36,340 grad school or whatever. 455 00:21:36,340 --> 00:21:37,720 You'll start a website design firm. 456 00:21:37,720 --> 00:21:39,490 That seems easy. 457 00:21:39,490 --> 00:21:42,010 Basically, how does the website design firm work? 458 00:21:42,010 --> 00:21:45,120 Basically, you work full-time, and you hire some slave 459 00:21:45,120 --> 00:21:46,450 programmer who works for you. 460 00:21:46,450 --> 00:21:48,480 He does all of the grunt work. 461 00:21:48,480 --> 00:21:51,680 And let's say that you have to pay him $40,000 a year. 462 00:21:51,680 --> 00:21:53,510 So it's going to be you working full-time plus some 463 00:21:53,510 --> 00:21:59,050 slave programmer you're going to pay $40,000 a year. 464 00:21:59,050 --> 00:22:02,960 And let's say that you have a computer that's like six 465 00:22:02,960 --> 00:22:04,000 months old, a year old. 466 00:22:04,000 --> 00:22:04,900 It's still in pretty good shape. 467 00:22:04,900 --> 00:22:06,520 It's not brand new, but it's still in pretty good shape. 468 00:22:06,520 --> 00:22:08,450 And you just let the slave programmer use that. 469 00:22:08,450 --> 00:22:10,590 So you don't have to buy a new one. 470 00:22:10,590 --> 00:22:12,716 So you've got the programmer, you're paying him $40,000. 471 00:22:12,716 --> 00:22:14,900 You're letting him use your computer. 472 00:22:14,900 --> 00:22:16,750 You buy some new computer you're working on. 473 00:22:16,750 --> 00:22:18,660 So you do your work, and he does work. 474 00:22:18,660 --> 00:22:19,760 You put it together. 475 00:22:19,760 --> 00:22:22,250 At the end of the year, you tally up all the receipts 476 00:22:22,250 --> 00:22:23,500 you've had from your website design, 477 00:22:23,500 --> 00:22:26,820 and you've made $60,000. 478 00:22:26,820 --> 00:22:29,310 So you sit back and say, well, that's pretty good. 479 00:22:29,310 --> 00:22:30,660 I put in $40,000. 480 00:22:30,660 --> 00:22:32,130 I paid $40,000. 481 00:22:32,130 --> 00:22:33,360 I brought home $60,000. 482 00:22:33,360 --> 00:22:35,690 That's $20,000 in profit. 483 00:22:35,690 --> 00:22:37,430 That's not a bad profit. 484 00:22:37,430 --> 00:22:42,800 If we think about profit margins, we'll often think 485 00:22:42,800 --> 00:22:44,690 about profit relative to revenue. 486 00:22:44,690 --> 00:22:47,800 Well that's $20,000 of profit on $60,000 of revenue. 487 00:22:47,800 --> 00:22:49,520 It's a 33% profit margin. 488 00:22:49,520 --> 00:22:51,995 Most companies would kill for that. 489 00:22:51,995 --> 00:22:53,230 So you say, that's not bad. 490 00:22:53,230 --> 00:22:55,740 I made a 33% profit margin. 491 00:22:55,740 --> 00:22:59,080 But what opportunity costs did this calculation miss? 492 00:22:59,080 --> 00:23:00,380 So if you were an accountant, you'd stop there. 493 00:23:00,380 --> 00:23:02,330 That's why accountants don't make as much as economists. 494 00:23:02,330 --> 00:23:03,710 Because we're better. 495 00:23:03,710 --> 00:23:05,320 If you're an accountant, you'd stop there. 496 00:23:05,320 --> 00:23:07,280 But if you were an economist, what do you recognize? 497 00:23:07,280 --> 00:23:08,690 What did this calculation miss? 498 00:23:08,690 --> 00:23:11,820 What opportunity costs were involved in running this firm 499 00:23:11,820 --> 00:23:14,840 that the cash flow calculation didn't capture? 500 00:23:14,840 --> 00:23:15,400 Yeah? 501 00:23:15,400 --> 00:23:17,835 AUDIENCE: If you plot your grunt worker and your 502 00:23:17,835 --> 00:23:20,339 computer, you might have been able to do more work, because 503 00:23:20,339 --> 00:23:21,589 the computer might be more efficient. 504 00:23:24,190 --> 00:23:25,230 PROFESSOR: Yeah. 505 00:23:25,230 --> 00:23:25,410 OK. 506 00:23:25,410 --> 00:23:26,590 That's sort of a different issue. 507 00:23:26,590 --> 00:23:28,090 That's sort of about the fact that you might not have 508 00:23:28,090 --> 00:23:30,090 produced as efficiently as possible. 509 00:23:30,090 --> 00:23:32,510 I'm not asking that question. 510 00:23:32,510 --> 00:23:35,960 I'm asking, given the numbers I gave you, why did I misstate 511 00:23:35,960 --> 00:23:37,620 your economic profit? 512 00:23:37,620 --> 00:23:39,096 Yeah, in the back. 513 00:23:39,096 --> 00:23:39,792 AUDIENCE: You could have gotten another 514 00:23:39,792 --> 00:23:41,400 job that paid more. 515 00:23:41,400 --> 00:23:42,970 PROFESSOR: I could have gotten another job that paid more. 516 00:23:42,970 --> 00:23:43,740 Here's another thing about it. 517 00:23:43,740 --> 00:23:44,860 I just spent an entire freaking 518 00:23:44,860 --> 00:23:47,580 year, and I made $20,000. 519 00:23:47,580 --> 00:23:48,910 You're hoping you do better than that with an MIT degree. 520 00:23:48,910 --> 00:23:50,400 At least your parents are hoping you do better than that 521 00:23:50,400 --> 00:23:52,260 with an MIT degree. 522 00:23:52,260 --> 00:23:55,890 So, basically, the first source of opportunity cost 523 00:23:55,890 --> 00:24:00,950 that this has missed is the value of your time. 524 00:24:00,950 --> 00:24:04,250 That doesn't show up as an accounting cost. But it's a 525 00:24:04,250 --> 00:24:06,200 real opportunity cost, because you could 526 00:24:06,200 --> 00:24:09,150 have had another job. 527 00:24:09,150 --> 00:24:11,780 So let's say you could have gone out and 528 00:24:11,780 --> 00:24:14,770 made $60,000 a year. 529 00:24:14,770 --> 00:24:15,940 You could have easily found a job making 530 00:24:15,940 --> 00:24:19,170 $60,000 as an MIT graduate. 531 00:24:19,170 --> 00:24:23,330 Well, then that's a cost of running this website. 532 00:24:23,330 --> 00:24:25,690 By spending the year setting this up, you forgo-- 533 00:24:29,730 --> 00:24:31,920 I don't know what the past tense of forgo is-- 534 00:24:31,920 --> 00:24:33,350 forgoed? 535 00:24:33,350 --> 00:24:36,640 $60,000 in income you could've earned. 536 00:24:36,640 --> 00:24:39,330 You've forgone $60,000 you could have earned. 537 00:24:39,330 --> 00:24:40,980 That's a real cost. It's not an accounting cost. It didn't 538 00:24:40,980 --> 00:24:42,350 show up on anybody's books. 539 00:24:42,350 --> 00:24:45,650 But it's an opportunity cost. What else? 540 00:24:45,650 --> 00:24:46,334 Yeah. 541 00:24:46,334 --> 00:24:48,886 AUDIENCE: Also the $40,000 that you gave the program, you 542 00:24:48,886 --> 00:24:49,582 could have invested it somewhere else. 543 00:24:49,582 --> 00:24:51,438 And it could be growing. 544 00:24:51,438 --> 00:24:53,720 PROFESSOR: You could have invested the $40,000. 545 00:24:53,720 --> 00:24:55,810 You gave him the $40,000. 546 00:24:55,810 --> 00:24:56,400 You paid it. 547 00:24:56,400 --> 00:24:56,750 It's gone. 548 00:24:56,750 --> 00:24:58,600 If you put it in the bank, you could've earned interest on 549 00:24:58,600 --> 00:24:59,580 that money. 550 00:24:59,580 --> 00:25:01,550 That's an opportunity cost. And we'll come back and talk 551 00:25:01,550 --> 00:25:03,100 about capital markets and interest later. 552 00:25:03,100 --> 00:25:04,630 But that's opportunity cost. What else? 553 00:25:04,630 --> 00:25:05,190 There's one more. 554 00:25:05,190 --> 00:25:06,560 AUDIENCE: You could have sold the computer. 555 00:25:06,560 --> 00:25:07,660 PROFESSOR: I could have sold the computer. 556 00:25:07,660 --> 00:25:08,980 I gave it to him, and he used it for free. 557 00:25:08,980 --> 00:25:11,980 But if I could have sold that for $1,000, that's an 558 00:25:11,980 --> 00:25:13,780 opportunity cost as well. 559 00:25:13,780 --> 00:25:16,680 So, in fact, if I could have worked for $60,000. 560 00:25:16,680 --> 00:25:20,520 On the $40,000, I could have made $2,000 of interest. And I 561 00:25:20,520 --> 00:25:21,890 could have sold the computer for $1,000. 562 00:25:21,890 --> 00:25:27,170 Then, actually, my opportunity costs were $63,000 plus the 563 00:25:27,170 --> 00:25:28,820 $40,000 I paid the guy. 564 00:25:28,820 --> 00:25:31,880 So, actually, the entire cost of the operation was $103,000. 565 00:25:31,880 --> 00:25:34,780 So I actually lost more than $40,000 running my little 566 00:25:34,780 --> 00:25:36,870 website business. 567 00:25:36,870 --> 00:25:40,070 So opportunity costs represent the fact that you could have 568 00:25:40,070 --> 00:25:41,820 done other things with your resources. 569 00:25:41,820 --> 00:25:43,450 It's not just the fact that your cash flow 570 00:25:43,450 --> 00:25:44,680 said positive $20,000. 571 00:25:44,680 --> 00:25:48,330 Your economic flow said minus $43,000. 572 00:25:48,330 --> 00:25:50,770 Because while you're plus $20,000, you were minus 573 00:25:50,770 --> 00:25:52,360 $60,000 that you could have earned. 574 00:25:52,360 --> 00:25:53,380 Now you're down to minus $40,000. 575 00:25:53,380 --> 00:25:54,830 You're minus $2,000 that you could have earned in interest 576 00:25:54,830 --> 00:25:56,350 on the money you paid the programmer. 577 00:25:56,350 --> 00:25:57,740 Now you're down to minus $42,000. 578 00:25:57,740 --> 00:25:59,465 And you're down another minus $1,000 you could have made by 579 00:25:59,465 --> 00:26:00,890 selling that computer. 580 00:26:00,890 --> 00:26:02,730 So you're at minus $43,000. 581 00:26:02,730 --> 00:26:04,190 So you actually lost money. 582 00:26:04,190 --> 00:26:07,770 So when we talk about profit, we want to think about 583 00:26:07,770 --> 00:26:09,680 economic profit, not accounting profit. 584 00:26:09,680 --> 00:26:12,850 Now, I'm not going to make that distinction much now. 585 00:26:12,850 --> 00:26:15,230 But I want you to keep that in mind as you go out and think 586 00:26:15,230 --> 00:26:16,740 about starting your business or think about whether firms 587 00:26:16,740 --> 00:26:19,710 are profitable, remember we use an economic concept which 588 00:26:19,710 --> 00:26:22,640 accounts for opportunity cost, not just an accounting concept 589 00:26:22,640 --> 00:26:25,740 which follows the dollars. 590 00:26:25,740 --> 00:26:27,660 Question about that? 591 00:26:27,660 --> 00:26:27,940 OK. 592 00:26:27,940 --> 00:26:32,090 Now, armed with this, we now say, OK, how does a firm 593 00:26:32,090 --> 00:26:33,660 maximize profits? 594 00:26:33,660 --> 00:26:34,680 Well, that's easy. 595 00:26:34,680 --> 00:26:38,450 We say that profits is a function of quantity produced. 596 00:26:38,450 --> 00:26:40,960 Revenues is a function of quantity produced minus cost 597 00:26:40,960 --> 00:26:42,420 as a function of quantity produced. 598 00:26:42,420 --> 00:26:44,260 Remember, what was our goal when we laid out the start of 599 00:26:44,260 --> 00:26:45,070 this lecture? 600 00:26:45,070 --> 00:26:48,790 It was to figure out what little q a firm chooses. 601 00:26:48,790 --> 00:26:52,640 Well, what little q a firm chooses is dictated by 602 00:26:52,640 --> 00:26:53,950 maximizing this equation. 603 00:26:53,950 --> 00:27:02,140 So a firm will choose little q such that dR/dq equals dC/dq. 604 00:27:02,140 --> 00:27:04,550 That's the profit maximizing equation. 605 00:27:04,550 --> 00:27:08,680 A firm will choose its quantity such that dR/dq 606 00:27:08,680 --> 00:27:15,490 equals dC/dq or, to put it in economic terms, where marginal 607 00:27:15,490 --> 00:27:18,190 revenue equals marginal costs. 608 00:27:18,190 --> 00:27:22,110 The firm will choose to produce a quantity q where its 609 00:27:22,110 --> 00:27:26,200 marginal revenue, which is the revenue made from selling the 610 00:27:26,200 --> 00:27:29,160 next unit, equals it's marginal cost, which is the 611 00:27:29,160 --> 00:27:33,860 cost incurred by making the next unit. 612 00:27:33,860 --> 00:27:38,100 Well, in a competitive market, we know what dR/dq is. 613 00:27:38,100 --> 00:27:40,360 Because remember in a competitive market, dR/dq is 614 00:27:40,360 --> 00:27:42,380 given to the firm by the market. 615 00:27:42,380 --> 00:27:45,590 In a competitive market, dR/dq, or marginal revenue, 616 00:27:45,590 --> 00:27:47,520 equals the price. 617 00:27:47,520 --> 00:27:48,610 The price is given to the firm. 618 00:27:48,610 --> 00:27:50,600 It comes from God in the competitive market. 619 00:27:50,600 --> 00:27:51,820 We'll talk later about where it comes from. 620 00:27:51,820 --> 00:27:53,890 But, for now, let's consider it God. 621 00:27:53,890 --> 00:27:55,610 They're price takers. 622 00:27:55,610 --> 00:27:58,410 They just get some price handed to them. 623 00:27:58,410 --> 00:28:00,950 So in a competitive market, we know what marginal revenue is, 624 00:28:00,950 --> 00:28:01,850 it is price. 625 00:28:01,850 --> 00:28:05,740 So what this says is that in a competitive market, the profit 626 00:28:05,740 --> 00:28:10,190 maximizing equation is price equals marginal cost. Memorize 627 00:28:10,190 --> 00:28:12,800 it, put it under your pillow. 628 00:28:12,800 --> 00:28:15,970 In a competitive market, price equals marginal cost is the 629 00:28:15,970 --> 00:28:17,840 profit maximizing condition. 630 00:28:17,840 --> 00:28:20,370 You will produce until the marginal cost of producing the 631 00:28:20,370 --> 00:28:23,350 next unit is equal to the price you can sell that unit 632 00:28:23,350 --> 00:28:24,600 for in the market. 633 00:28:26,990 --> 00:28:29,960 So, to see that further, let's look at an example. 634 00:28:29,960 --> 00:28:37,390 Let's go to the next figure, Figure 10-2a. 635 00:28:37,390 --> 00:28:39,260 For the next few examples, I'm going to use a 636 00:28:39,260 --> 00:28:41,070 particular cost function. 637 00:28:41,070 --> 00:28:45,440 The cost function I'm going to use to make this all concrete 638 00:28:45,440 --> 00:28:54,320 is C equals 10 plus 0.5q squared. 639 00:28:56,970 --> 00:28:59,470 That's the cost function I'm going to use. 640 00:28:59,470 --> 00:29:03,040 So armed with that cost function, let's say the price 641 00:29:03,040 --> 00:29:07,310 in the market is 6. 642 00:29:07,310 --> 00:29:09,010 Let's say the price in the market 6. 643 00:29:09,010 --> 00:29:10,650 I just pulled that out of my hat. 644 00:29:10,650 --> 00:29:11,640 It's a market for whatever. 645 00:29:11,640 --> 00:29:14,340 We're just doing an example. 646 00:29:14,340 --> 00:29:18,340 Now, what we have on this graph, we have a cost curve 647 00:29:18,340 --> 00:29:19,790 and a revenue curve. 648 00:29:19,790 --> 00:29:22,010 The cost curve literally graphs that function. 649 00:29:22,010 --> 00:29:26,290 So, in other words, if you produce two units, then your 650 00:29:26,290 --> 00:29:30,440 cost is 10 plus half of 2 squared or 12. 651 00:29:30,440 --> 00:29:34,060 If you produce 2 units, your costs are 12, and so on. 652 00:29:34,060 --> 00:29:36,570 You've got this cost curve. 653 00:29:36,570 --> 00:29:38,190 You've also got a revenue curve. 654 00:29:38,190 --> 00:29:40,860 Well, the revenue curve is just 6 times the number of 655 00:29:40,860 --> 00:29:41,360 units produced. 656 00:29:41,360 --> 00:29:42,930 Because the price per unit is 6. 657 00:29:42,930 --> 00:29:47,150 So it's just a straight line with a slope of 6. 658 00:29:47,150 --> 00:29:51,090 So each unit you produce, you make 6. 659 00:29:51,090 --> 00:29:59,800 Now, what you'll see here is that for this cost curve, 660 00:29:59,800 --> 00:30:01,290 what's marginal cost? 661 00:30:01,290 --> 00:30:03,970 Well, if we differentiate this, we see that marginal 662 00:30:03,970 --> 00:30:06,380 cost equals q. 663 00:30:06,380 --> 00:30:07,880 I made this an easy example. 664 00:30:07,880 --> 00:30:09,230 If you differentiate that, you'll see that 665 00:30:09,230 --> 00:30:11,130 marginal cost equals q. 666 00:30:11,130 --> 00:30:13,780 That is just differentiate this cost equation. 667 00:30:13,780 --> 00:30:15,400 Marginal cost equals q. 668 00:30:15,400 --> 00:30:22,520 So what that says is that the profit maximizing point is 669 00:30:22,520 --> 00:30:27,640 going to be to set marginal cost equal to price. 670 00:30:27,640 --> 00:30:31,640 So that says set q equal with 6. 671 00:30:31,640 --> 00:30:32,080 And you're done. 672 00:30:32,080 --> 00:30:33,460 That's how much the firm should produce. 673 00:30:36,300 --> 00:30:39,650 The firm should produce six units, because it's marginal 674 00:30:39,650 --> 00:30:41,250 cost function is q. 675 00:30:41,250 --> 00:30:43,950 It's a linear function. 676 00:30:43,950 --> 00:30:44,940 The price is six. 677 00:30:44,940 --> 00:30:47,030 That's a horizontal line. 678 00:30:47,030 --> 00:30:51,920 So they only intersect in one point where quantity equals 6. 679 00:30:51,920 --> 00:30:56,110 Now, what you notice in this graph is that this happens to 680 00:30:56,110 --> 00:30:59,400 be the point where the gap between the revenue curve and 681 00:30:59,400 --> 00:31:04,280 the cost curve is largest. These are not marginal curves. 682 00:31:04,280 --> 00:31:08,200 This is revenue and cost. But notice that at 6 that's 683 00:31:08,200 --> 00:31:11,770 exactly where the revenue curve and the cost curve have 684 00:31:11,770 --> 00:31:13,800 the largest gap between them. 685 00:31:13,800 --> 00:31:16,160 I think a more intuitive way to see this is to flip to 686 00:31:16,160 --> 00:31:18,660 Figure 10-2b. 687 00:31:18,660 --> 00:31:24,030 This shows the marginal profit that you make on 688 00:31:24,030 --> 00:31:25,510 every unit you sell. 689 00:31:25,510 --> 00:31:27,860 So, in other words, if you sell fewer than 2 units, you 690 00:31:27,860 --> 00:31:29,050 lose money. 691 00:31:29,050 --> 00:31:29,690 Why? 692 00:31:29,690 --> 00:31:36,040 Because if you sell 1 unit, your costs are 10 plus 10.5. 693 00:31:36,040 --> 00:31:38,220 If you sell 1 unit, your costs are 10.5. 694 00:31:38,220 --> 00:31:39,420 Your revenues are 6. 695 00:31:39,420 --> 00:31:40,400 You lose money. 696 00:31:40,400 --> 00:31:42,150 You lose 4.5. 697 00:31:42,150 --> 00:31:44,320 If you sell 2 units, you make 0. 698 00:31:44,320 --> 00:31:46,730 Your costs are 12, your revenues are 12. 699 00:31:46,730 --> 00:31:48,440 You make 0. 700 00:31:48,440 --> 00:31:54,120 If you sell 3 units, your costs are 14.5, 10 701 00:31:54,120 --> 00:31:56,130 plus half of 9. 702 00:31:56,130 --> 00:31:57,570 Your revenues are 18. 703 00:31:57,570 --> 00:31:59,460 So you make money. 704 00:31:59,460 --> 00:32:03,020 So each unit, you can calculate how much you're 705 00:32:03,020 --> 00:32:04,620 making on that next unit. 706 00:32:04,620 --> 00:32:06,780 On the 3rd unit, you made money. 707 00:32:06,780 --> 00:32:09,340 4th unit, you make even more money. 708 00:32:09,340 --> 00:32:10,270 5th unit, even more. 709 00:32:10,270 --> 00:32:13,230 6th unit, you make the most money you can make. 710 00:32:13,230 --> 00:32:17,290 In the 6th unit, your costs are 10 plus half of 711 00:32:17,290 --> 00:32:21,240 36, or 18, so 28. 712 00:32:21,240 --> 00:32:22,690 Your costs are 28. 713 00:32:22,690 --> 00:32:24,390 Your revenues are 36. 714 00:32:24,390 --> 00:32:27,610 So you make a profit of 8. 715 00:32:27,610 --> 00:32:29,860 You make a profit of 8 on that 6th unit. 716 00:32:32,700 --> 00:32:34,870 Think of yourself as climbing this hill. 717 00:32:34,870 --> 00:32:37,730 In economics, optimization is a hill climbing exercise. 718 00:32:37,730 --> 00:32:40,820 Think of yourself as climbing up this hill and asking 719 00:32:40,820 --> 00:32:42,460 yourself, should I make the next unit? 720 00:32:42,460 --> 00:32:43,800 Does the hill keep going up? 721 00:32:43,800 --> 00:32:44,610 Yes, it keeps going up. 722 00:32:44,610 --> 00:32:46,120 Make that next unit. 723 00:32:46,120 --> 00:32:47,090 Then you get to the top. 724 00:32:47,090 --> 00:32:49,070 And now you say, well, should I make the 7th unit? 725 00:32:49,070 --> 00:32:52,560 Well if I make a 7th unit, my costs are 10 plus 726 00:32:52,560 --> 00:32:57,550 half of 49, so 34.5. 727 00:32:57,550 --> 00:33:00,410 My revenues are 42. 728 00:33:00,410 --> 00:33:03,220 So my profits are only 7.5. 729 00:33:03,220 --> 00:33:06,810 I make less profit on that 7th unit. 730 00:33:06,810 --> 00:33:09,910 So I shouldn't make it. 731 00:33:09,910 --> 00:33:11,240 Now, you might say, wait a second. 732 00:33:14,700 --> 00:33:16,790 Why wouldn't you make it? 733 00:33:16,790 --> 00:33:18,830 You still make profits. 734 00:33:18,830 --> 00:33:21,340 Why wouldn't you go ahead and make all units all the way 735 00:33:21,340 --> 00:33:23,050 down to 10? 736 00:33:23,050 --> 00:33:25,330 You still make profits on those units. 737 00:33:25,330 --> 00:33:28,670 And the answer is because of opportunity cost. The answer 738 00:33:28,670 --> 00:33:31,260 is that yes, you make profits. 739 00:33:31,260 --> 00:33:34,850 But given where your marginal cost curve is, you could do 740 00:33:34,850 --> 00:33:38,440 better by that point going and producing other goods. 741 00:33:38,440 --> 00:33:40,220 That's why I care about accounting costs versus 742 00:33:40,220 --> 00:33:41,310 opportunity costs. 743 00:33:41,310 --> 00:33:44,050 Accounting costs says look, you're going to make money 744 00:33:44,050 --> 00:33:46,960 until you go to 10 units. 745 00:33:46,960 --> 00:33:49,460 But opportunity cost says, no. 746 00:33:49,460 --> 00:33:53,000 At that point, the opportunity cost has gotten high enough 747 00:33:53,000 --> 00:33:54,300 that you could do better devoting 748 00:33:54,300 --> 00:33:55,980 your resources elsewhere. 749 00:33:55,980 --> 00:33:58,075 And that's why you want to stop at the point where you're 750 00:33:58,075 --> 00:34:00,810 at the top of the hill, where the price equals the marginal 751 00:34:00,810 --> 00:34:04,250 cost. 752 00:34:04,250 --> 00:34:07,540 So what are the profits you make at the top of this hill? 753 00:34:07,540 --> 00:34:11,830 Well, if you go to the next diagram, we can see what the 754 00:34:11,830 --> 00:34:13,719 profits you make are. 755 00:34:13,719 --> 00:34:17,659 So this next diagram, Figure 10-3, 756 00:34:17,659 --> 00:34:19,600 illustrates this example. 757 00:34:19,600 --> 00:34:22,030 So what we have here is an example with cost curves for 758 00:34:22,030 --> 00:34:26,290 this cost function, once again, 10 plus 0.5q squared. 759 00:34:26,290 --> 00:34:30,389 Average costs is that line in the middle there. 760 00:34:30,389 --> 00:34:32,260 That's the average costs. 761 00:34:32,260 --> 00:34:35,560 You have an average variable cost that's a line, that's 762 00:34:35,560 --> 00:34:40,350 linear, an average variable cost that has a slope of one. 763 00:34:40,350 --> 00:34:42,730 You have an average fixed cost that's everywhere declining, 764 00:34:42,730 --> 00:34:44,969 because your fixed costs of 10 is everywhere declining. 765 00:34:44,969 --> 00:34:46,000 As you produce more and more, your 766 00:34:46,000 --> 00:34:47,120 fixed costs are declining. 767 00:34:47,120 --> 00:34:50,409 And, as I said, you have a marginal cost of q. 768 00:34:50,409 --> 00:34:53,389 So your marginal cost of 1 unit is 1. 769 00:34:53,389 --> 00:34:57,420 Your marginal cost of 2 units is 2, et cetera. 770 00:34:57,420 --> 00:35:01,290 So this draws out the cost curves that correspond to that 771 00:35:01,290 --> 00:35:03,200 cost function. 772 00:35:03,200 --> 00:35:05,280 You see them drawn out here. 773 00:35:05,280 --> 00:35:10,090 Now, we also, on this diagram, have a demand curve. 774 00:35:10,090 --> 00:35:12,910 The demand curve is perfectly elastic facing this firm. 775 00:35:12,910 --> 00:35:15,530 It's a perfectly competitive market. 776 00:35:15,530 --> 00:35:20,030 And that perfectly elastic demand curve is horizontal at 777 00:35:20,030 --> 00:35:23,520 price equals 6. 778 00:35:23,520 --> 00:35:25,780 So what does the firm do? 779 00:35:25,780 --> 00:35:33,720 It chooses to produce where marginal cost equals price. 780 00:35:33,720 --> 00:35:36,710 When it produces where marginal cost equals price, 781 00:35:36,710 --> 00:35:38,810 then what profits does it make? 782 00:35:48,510 --> 00:35:50,670 On each unit, it makes a difference of the profits 783 00:35:50,670 --> 00:35:53,870 between the price and average cost. Now it's an important 784 00:35:53,870 --> 00:35:54,780 distinction. 785 00:35:54,780 --> 00:35:56,090 We went over this in lecture and section. 786 00:35:56,090 --> 00:35:57,490 But let me go through it again. 787 00:35:57,490 --> 00:36:00,420 Marginal cost is the cost of the next unit. 788 00:36:00,420 --> 00:36:02,265 Average cost is the average cost of all the 789 00:36:02,265 --> 00:36:04,040 units you've made. 790 00:36:04,040 --> 00:36:08,240 So if I make 6 units, what profit do I make? 791 00:36:08,240 --> 00:36:15,740 Well, on that 6th unit, I make a profit of 1 and 792 00:36:15,740 --> 00:36:25,700 1/8 or 1 and 1/4. 793 00:36:31,925 --> 00:36:36,380 I make profits of 1 and 1/4 on that 6th unit. 794 00:36:36,380 --> 00:36:41,020 But I make those profits on all 8 units I sell. 795 00:36:41,020 --> 00:36:44,770 So what that means is, in total, I'm going to make a 796 00:36:44,770 --> 00:36:45,970 profit of 8. 797 00:36:45,970 --> 00:36:49,330 The area of this rectangle is eight. 798 00:36:49,330 --> 00:36:50,790 Here's the key. 799 00:36:50,790 --> 00:36:53,900 You cannot choose a production level that produces a bigger 800 00:36:53,900 --> 00:36:56,270 rectangle than this. 801 00:36:56,270 --> 00:36:59,970 So if you produce 7, your rectangle will be longer. 802 00:36:59,970 --> 00:37:03,910 But the gap between price and average cost will be smaller. 803 00:37:03,910 --> 00:37:07,240 So your total rectangle size would fall. 804 00:37:07,240 --> 00:37:10,580 The largest rectangle is produced at a 805 00:37:10,580 --> 00:37:12,390 production level of 6. 806 00:37:12,390 --> 00:37:15,610 That's the most efficient use of your resources is when you 807 00:37:15,610 --> 00:37:18,790 produce at a point where marginal cost equals price. 808 00:37:18,790 --> 00:37:21,060 Because when you produce at marginal cost equals price, 809 00:37:21,060 --> 00:37:25,620 that causes the maximum gap between price and average 810 00:37:25,620 --> 00:37:26,020 cost. 811 00:37:26,020 --> 00:37:29,150 Flip back for a second to the first figure. 812 00:37:31,980 --> 00:37:35,380 Not the first figure, I'm sorry, 10-2. 813 00:37:35,380 --> 00:37:37,170 This relates back to 10-2. 814 00:37:37,170 --> 00:37:40,510 As I noted, the largest difference between your 815 00:37:40,510 --> 00:37:45,110 revenue and your cost curve was that 6 units. 816 00:37:45,110 --> 00:37:47,510 That's where the gap is large between revenue and cost. 817 00:37:47,510 --> 00:37:48,770 That's where you produce. 818 00:37:48,770 --> 00:37:52,510 Now we flip forward again to Figure 10-3. 819 00:37:52,510 --> 00:37:56,930 You see that corresponds to the point of the largest gap 820 00:37:56,930 --> 00:38:05,790 between price and average cost, I'm sorry, the largest 821 00:38:05,790 --> 00:38:09,260 of the points on the marginal cost curve between price and 822 00:38:09,260 --> 00:38:12,100 average cost. So if you produce on the marginal cost 823 00:38:12,100 --> 00:38:17,460 curve, if you produce 7 units, then you're going to have a 824 00:38:17,460 --> 00:38:20,500 smaller gap between price and average cost. And, therefore, 825 00:38:20,500 --> 00:38:22,100 even though you produced 1 more unit and are making 826 00:38:22,100 --> 00:38:25,830 profit on it, your total profits will fall. 827 00:38:25,830 --> 00:38:29,090 The key point is that yes, climbing back down that hill I 828 00:38:29,090 --> 00:38:30,420 still make money. 829 00:38:30,420 --> 00:38:33,670 But I make less and less money. 830 00:38:33,670 --> 00:38:36,670 And that, as a result, that rectangle is being reduced as 831 00:38:36,670 --> 00:38:38,230 I climb down that hill. 832 00:38:38,230 --> 00:38:40,920 That rectangle is maximized at the top of that hill. 833 00:38:40,920 --> 00:38:44,680 That's the point at which I make the most money. 834 00:38:44,680 --> 00:38:54,750 So that's why we say profit maximization occurs at the 835 00:38:54,750 --> 00:38:56,970 point where price equals marginal cost. Because that is 836 00:38:56,970 --> 00:39:01,360 the point of greatest gap between revenues and costs. 837 00:39:01,360 --> 00:39:02,910 Where price equals marginal cost is one of the greatest 838 00:39:02,910 --> 00:39:04,220 gaps between revenues and costs. 839 00:39:04,220 --> 00:39:06,490 That's the profit maximizing point where that rectangle is 840 00:39:06,490 --> 00:39:08,260 largest. And you can demonstrate for yourself, and 841 00:39:08,260 --> 00:39:11,030 you should, that at any other production level, that 842 00:39:11,030 --> 00:39:13,970 rectangle will be smaller. 843 00:39:13,970 --> 00:39:14,880 Questions about that? 844 00:39:14,880 --> 00:39:15,820 Yeah. 845 00:39:15,820 --> 00:39:17,856 AUDIENCE: What do you do if you have 846 00:39:17,856 --> 00:39:19,110 a linear cost function. 847 00:39:19,110 --> 00:39:21,460 So that means marginal cost is a constant. 848 00:39:21,460 --> 00:39:23,960 Then how do you determine the line? 849 00:39:23,960 --> 00:39:25,210 PROFESSOR: You don't. 850 00:39:27,310 --> 00:39:28,590 It's an indeterminacy. 851 00:39:28,590 --> 00:39:29,490 That's right. 852 00:39:29,490 --> 00:39:31,170 I'll try to avoid giving you problems like that. 853 00:39:31,170 --> 00:39:33,340 Basically you get a corner solution. 854 00:39:33,340 --> 00:39:35,890 In a perfectly competitive market, you'd get an 855 00:39:35,890 --> 00:39:36,920 indeterminate solution. 856 00:39:36,920 --> 00:39:38,460 In a nonperfectly competitive market, you will have a 857 00:39:38,460 --> 00:39:39,900 determinant solution. 858 00:39:39,900 --> 00:39:42,610 But in a perfectly competitive market with a linear marginal 859 00:39:42,610 --> 00:39:44,180 cost, you'd have an indeterminate solution. 860 00:39:44,180 --> 00:39:46,230 Either you produce 0 or infinity. 861 00:39:46,230 --> 00:39:47,700 So you'd have an indeterminate solution. 862 00:39:50,570 --> 00:39:54,230 Now, just a further drill this in, imagine, for a second, 863 00:39:54,230 --> 00:39:57,140 there was a cost shock to the firm. 864 00:39:57,140 --> 00:39:59,110 Imagine there was a cost shock to the firm. 865 00:39:59,110 --> 00:40:03,590 Imagine that there's a tax on the firm where the firm has to 866 00:40:03,590 --> 00:40:05,170 pay a tax of an amount t. 867 00:40:05,170 --> 00:40:07,590 Let's say t is $1. 868 00:40:07,590 --> 00:40:13,740 The firm has to pay a tax of $1 on every unit they produce. 869 00:40:13,740 --> 00:40:15,880 Well, what is their new cost curve? 870 00:40:15,880 --> 00:40:17,960 Somebody tell me what the new cost curve is. 871 00:40:17,960 --> 00:40:20,640 If you have a tax of $1 on every unit you produce, 872 00:40:20,640 --> 00:40:23,020 someone tell me the equation for the cost curve. 873 00:40:23,020 --> 00:40:24,440 I didn't write it down here, did I? 874 00:40:24,440 --> 00:40:24,890 No. 875 00:40:24,890 --> 00:40:27,590 OK, what's the equation for the cost curve. 876 00:40:27,590 --> 00:40:28,320 Yeah. 877 00:40:28,320 --> 00:40:32,160 AUDIENCE: Just add plus tq to the top thing. 878 00:40:32,160 --> 00:40:40,840 PROFESSOR: Exactly C equals 10 plus 0.5q squared plus tq. 879 00:40:40,840 --> 00:40:43,660 Because for every unit you produce q you pay a tax t. 880 00:40:43,660 --> 00:40:46,550 And since t is $1, it would just be plus q. 881 00:40:46,550 --> 00:40:49,140 If t is $1, it would just be plus q. 882 00:40:49,140 --> 00:40:52,760 So the cost function has now shifted. 883 00:40:52,760 --> 00:40:55,660 So what we see is that it has shifted average cost and 884 00:40:55,660 --> 00:40:59,120 marginal cost both upwards. 885 00:40:59,120 --> 00:41:02,520 Average cost has shifted upwards by that amount. 886 00:41:02,520 --> 00:41:04,870 And average cost has shifted upwards. 887 00:41:04,870 --> 00:41:07,950 And marginal cost has shifted upwards by precisely $1. 888 00:41:07,950 --> 00:41:09,590 It's just a linear shift of marginal cost. Because 889 00:41:09,590 --> 00:41:15,380 marginal cost is now q plus 1. 890 00:41:15,380 --> 00:41:19,160 If you differentiate this with respect to q assuming t is 1-- 891 00:41:19,160 --> 00:41:20,350 t is now $1-- 892 00:41:20,350 --> 00:41:22,500 if you differentiate this with respect to q, marginal 893 00:41:22,500 --> 00:41:24,320 cost is q plus 1. 894 00:41:24,320 --> 00:41:29,060 So your marginal cost curve has shifted up by $1 or by t, 895 00:41:29,060 --> 00:41:32,790 in this case, in the more general case. 896 00:41:32,790 --> 00:41:36,570 Well, what does that do to the first production decision. 897 00:41:36,570 --> 00:41:40,910 Well, now it doesn't change their maximization formula. 898 00:41:40,910 --> 00:41:43,410 They still want to set marginal cost equal to price. 899 00:41:43,410 --> 00:41:47,730 So now they say, set q plus 1 equal to price. 900 00:41:47,730 --> 00:41:49,590 Well, the price is 6. 901 00:41:49,590 --> 00:41:53,100 So it says set q equal to 5. 902 00:41:53,100 --> 00:41:58,450 Now the profit maximizing level is 5 units. 903 00:41:58,450 --> 00:42:00,600 The profit maximizing level is 5 units. 904 00:42:05,270 --> 00:42:07,450 What this is saying is because the tax increases your 905 00:42:07,450 --> 00:42:11,970 marginal cost, you are now producing less. 906 00:42:11,970 --> 00:42:14,310 And what we can see now, if we flip to Figure 10-4, we can 907 00:42:14,310 --> 00:42:16,260 see what that's done to your profits. 908 00:42:16,260 --> 00:42:24,580 Your profits have now fallen to the dotted rectangle, the 909 00:42:24,580 --> 00:42:27,750 much smaller dotted rectangle. 910 00:42:27,750 --> 00:42:29,900 Your profits used to be that entire slashed 911 00:42:29,900 --> 00:42:32,160 rectangle plus the dots. 912 00:42:32,160 --> 00:42:37,800 Now your profits are just where the price exceeds 913 00:42:37,800 --> 00:42:41,690 average cost which is just that smaller dotted rectangle. 914 00:42:41,690 --> 00:42:43,690 Your profits have fallen dramatically. 915 00:42:43,690 --> 00:42:47,140 So by imposing a tax on this firm, we've dramatically 916 00:42:47,140 --> 00:42:48,390 reduced their profits. 917 00:42:52,050 --> 00:42:56,870 Now, this is the economics behind why taxes can lower 918 00:42:56,870 --> 00:42:58,960 production. 919 00:42:58,960 --> 00:43:00,910 Now, you might say, wait a second. 920 00:43:00,910 --> 00:43:02,830 In reality, if we tax a firm, the don't have 921 00:43:02,830 --> 00:43:03,260 to lower their profits. 922 00:43:03,260 --> 00:43:06,290 They just pass it on and charge consumers higher prices 923 00:43:06,290 --> 00:43:08,550 but not in a competitive market. 924 00:43:08,550 --> 00:43:10,660 In a competitive market, they can't do that. 925 00:43:14,250 --> 00:43:15,896 If you tax a firm in a competitive market, it comes 926 00:43:15,896 --> 00:43:17,146 out of their profits. 927 00:43:19,530 --> 00:43:22,015 Because they face a perfectly elastic demand, so they can't 928 00:43:22,015 --> 00:43:23,020 raise the price. 929 00:43:23,020 --> 00:43:25,360 All they can do is just say, well, the price is the same. 930 00:43:25,360 --> 00:43:26,920 My marginal cost has gone up. 931 00:43:26,920 --> 00:43:29,870 I'm going to produce less, and I'm going to make less profit. 932 00:43:29,870 --> 00:43:31,900 And that's life. 933 00:43:31,900 --> 00:43:34,390 So a tax in a market like this is just going to lower the 934 00:43:34,390 --> 00:43:36,710 firm's profits, and it's going to lower their level of 935 00:43:36,710 --> 00:43:39,210 production from 6 to 5. 936 00:43:39,210 --> 00:43:40,882 In noncompetitive markets, different things can happen. 937 00:43:40,882 --> 00:43:42,000 We'll talk about that. 938 00:43:42,000 --> 00:43:43,320 But in a competitive market, this is what 939 00:43:43,320 --> 00:43:44,710 happens with the tax. 940 00:43:44,710 --> 00:43:48,260 You basically set the new marginal cost equal to price, 941 00:43:48,260 --> 00:43:50,940 and you get that they produce 5 units instead of 6 at a 942 00:43:50,940 --> 00:43:52,630 lower profit level. 943 00:43:52,630 --> 00:43:53,592 Yeah? 944 00:43:53,592 --> 00:43:54,772 AUDIENCE: Would that be a good cause for 945 00:43:54,772 --> 00:43:56,424 entering the market-- 946 00:43:59,750 --> 00:44:00,040 PROFESSOR: You're right. 947 00:44:00,040 --> 00:44:03,530 That's an excellent point that I should have pointed out. 948 00:44:03,530 --> 00:44:04,770 What do I mean by short run? 949 00:44:04,770 --> 00:44:07,420 What I mean by short run is remember, labor is variable. 950 00:44:07,420 --> 00:44:08,470 Capital is fixed. 951 00:44:08,470 --> 00:44:09,650 What do I mean in this context? 952 00:44:09,650 --> 00:44:11,510 Think about the short run as being the period over time 953 00:44:11,510 --> 00:44:13,035 over which firms cannot enter and exit. 954 00:44:15,980 --> 00:44:18,450 When we talk about competitive markets in the short run, we 955 00:44:18,450 --> 00:44:20,550 talked about short run being the time in 956 00:44:20,550 --> 00:44:21,780 which capital is fixed. 957 00:44:21,780 --> 00:44:23,190 Now we're going to add another condition. 958 00:44:23,190 --> 00:44:25,090 We're going to say the short run is the period of time in 959 00:44:25,090 --> 00:44:31,830 which there's no firm entry or exit. 960 00:44:31,830 --> 00:44:32,520 That's the short run. 961 00:44:32,520 --> 00:44:34,730 We'll come back and talk about what entry and exit does. 962 00:44:34,730 --> 00:44:36,510 And that's going to have some funky effects. 963 00:44:36,510 --> 00:44:38,000 We'll talk about that next time. 964 00:44:38,000 --> 00:44:39,920 But what we mean by short run here is no 965 00:44:39,920 --> 00:44:40,680 firm entry and exit. 966 00:44:40,680 --> 00:44:44,510 Whichever firms are in the market at the beginning of the 967 00:44:44,510 --> 00:44:46,040 short run people are in the market at the end of the short 968 00:44:46,040 --> 00:44:46,430 run period. 969 00:44:46,430 --> 00:44:47,315 Yeah. 970 00:44:47,315 --> 00:44:49,343 AUDIENCE: But in your conditions, you had like free 971 00:44:49,343 --> 00:44:51,250 and fluid entry and exit of firms. 972 00:44:51,250 --> 00:44:51,910 PROFESSOR: Right, exactly. 973 00:44:51,910 --> 00:44:54,810 And that's why I said, don't pay attention to that yet. 974 00:44:54,810 --> 00:44:56,190 In some sense, those are the conditions of perfect 975 00:44:56,190 --> 00:44:56,670 competition. 976 00:44:56,670 --> 00:44:58,090 I didn't say if that was short run or long run. 977 00:44:58,090 --> 00:45:00,270 Those are the full long run set of conditions. 978 00:45:00,270 --> 00:45:02,220 That's why I said we're going to ignore four for now and 979 00:45:02,220 --> 00:45:03,530 just focus on the first three. 980 00:45:03,530 --> 00:45:05,720 In the short run, only the first three are relevant. 981 00:45:05,720 --> 00:45:07,790 Because in the short run there's no firm entry or exit. 982 00:45:07,790 --> 00:45:09,670 In the long run, which we'll talk about next time, that 983 00:45:09,670 --> 00:45:12,020 fourth one will be relevant. 984 00:45:12,020 --> 00:45:12,720 Good question. 985 00:45:12,720 --> 00:45:13,320 That's a good point. 986 00:45:13,320 --> 00:45:14,830 Thank you for pointing that out. 987 00:45:14,830 --> 00:45:17,400 Other questions or comments? 988 00:45:17,400 --> 00:45:20,240 One other thing I want to cover before we stop which 989 00:45:20,240 --> 00:45:24,970 relates to the long run, is that in the long run, this is 990 00:45:24,970 --> 00:45:26,340 sort of the transition, the bridge to talking 991 00:45:26,340 --> 00:45:27,840 about the long run. 992 00:45:27,840 --> 00:45:31,570 We also have to decide, ultimately, whether or not we 993 00:45:31,570 --> 00:45:34,730 want to shut the firm down. 994 00:45:34,730 --> 00:45:36,890 So, in other words, we want to set price equal to marginal 995 00:45:36,890 --> 00:45:38,530 cost. That's one condition. 996 00:45:38,530 --> 00:45:40,710 But, actually, short run profit maximization has a 997 00:45:40,710 --> 00:45:42,040 second condition. 998 00:45:42,040 --> 00:45:44,720 Short run profit maximization has two conditions. 999 00:45:44,720 --> 00:45:48,190 The first is to set price equal to marginal cost. The 1000 00:45:48,190 --> 00:45:51,490 second condition of short run profit maximization is to 1001 00:45:51,490 --> 00:45:53,920 check whether the firm wants to shut down. 1002 00:45:56,860 --> 00:45:58,170 Why would a firm want to shut down? 1003 00:45:58,170 --> 00:46:02,080 It might want to shut down if it actually loses money by 1004 00:46:02,080 --> 00:46:03,330 continuing to produce. 1005 00:46:06,120 --> 00:46:12,540 And that's because firms may lose money but not shut down. 1006 00:46:12,540 --> 00:46:14,600 Firms may lose money but not shut down. 1007 00:46:14,600 --> 00:46:17,090 Or firms may lose so much money they shut down. 1008 00:46:17,090 --> 00:46:19,520 And we need to consider that. 1009 00:46:22,760 --> 00:46:23,700 Let's get rid of the tax. 1010 00:46:23,700 --> 00:46:26,390 Let's go back to the marginal cost with the tax. 1011 00:46:26,390 --> 00:46:28,040 Imagine the price in this market suddenly 1012 00:46:28,040 --> 00:46:30,560 fell from 6 to 3. 1013 00:46:30,560 --> 00:46:35,350 The price of the market is now $3 per unit you sell. 1014 00:46:35,350 --> 00:46:37,835 Well what would the firm's profits be? 1015 00:46:37,835 --> 00:46:42,060 Well, if the price fell to 3, the firm would choose to 1016 00:46:42,060 --> 00:46:43,790 produce 3 units. 1017 00:46:43,790 --> 00:46:46,480 You would still have this condition, marginal cost 1018 00:46:46,480 --> 00:46:46,970 equals price. 1019 00:46:46,970 --> 00:46:48,580 Price is 3, and marginal cost is q. 1020 00:46:48,580 --> 00:46:49,960 So q is 3. 1021 00:46:49,960 --> 00:46:52,650 You still produce 3 units. 1022 00:46:52,650 --> 00:46:54,970 If you produce 3 units, its costs are 10 plus 1023 00:46:54,970 --> 00:46:58,530 4.5 which is 14.5. 1024 00:46:58,530 --> 00:47:01,250 At a price of 3, it makes 9. 1025 00:47:01,250 --> 00:47:05,360 So its profits are negative 5.5. 1026 00:47:05,360 --> 00:47:08,370 It would lose money from this production. 1027 00:47:12,660 --> 00:47:14,640 Remember marginal cost equals price. 1028 00:47:14,640 --> 00:47:18,160 That doesn't vary with what the price is or anything. 1029 00:47:18,160 --> 00:47:20,680 This is a maximizing condition. 1030 00:47:20,680 --> 00:47:22,770 If a price changed, it's not like you change which equation 1031 00:47:22,770 --> 00:47:23,080 you follow. 1032 00:47:23,080 --> 00:47:24,500 You always follow this equation. 1033 00:47:24,500 --> 00:47:26,800 The efficient production level is always marginal cost equals 1034 00:47:26,800 --> 00:47:29,330 price regardless of what the price is. 1035 00:47:29,330 --> 00:47:31,800 So if the price is 3, the efficient thing to do would be 1036 00:47:31,800 --> 00:47:35,710 to produce 3 units and lose money. 1037 00:47:35,710 --> 00:47:38,610 Now, you might say, well, then that's stupid. 1038 00:47:38,610 --> 00:47:41,300 If that goes negative, wouldn't they just shut down? 1039 00:47:41,300 --> 00:47:44,070 And the answer, is in the short run, no. 1040 00:47:44,070 --> 00:47:46,530 And the reason you wouldn't shut down in the short run is 1041 00:47:46,530 --> 00:47:51,270 what I talked about last time which is about the notion of 1042 00:47:51,270 --> 00:47:53,680 sunk costs. 1043 00:47:53,680 --> 00:47:57,350 In the short run, the fixed costs that you paid 1044 00:47:57,350 --> 00:47:58,830 to produce are sunk. 1045 00:47:58,830 --> 00:48:00,560 They're unchangeable in the short run. 1046 00:48:00,560 --> 00:48:02,040 In the long run, they're changeable. 1047 00:48:02,040 --> 00:48:03,390 You can just leave. 1048 00:48:03,390 --> 00:48:06,430 But in the short run, you've invested fixed costs of 10 in 1049 00:48:06,430 --> 00:48:07,600 being in this market. 1050 00:48:07,600 --> 00:48:11,520 You've paid a fixed cost of 10 to produce in this market. 1051 00:48:11,520 --> 00:48:17,200 Given you're in this market, and you've paid 10 to produce, 1052 00:48:17,200 --> 00:48:22,010 you will not exit unless you lose more than $10. 1053 00:48:22,010 --> 00:48:27,670 You will not shut down unless you lose more than $10. 1054 00:48:27,670 --> 00:48:30,480 You will not shut down unless you're losing so much money 1055 00:48:30,480 --> 00:48:32,510 that you can't cover your fixed costs. 1056 00:48:32,510 --> 00:48:34,380 Because you've paid those fixed cost. In the short run, 1057 00:48:34,380 --> 00:48:36,280 they're sunk. 1058 00:48:36,280 --> 00:48:40,180 So unless you're actually losing more than your fixed 1059 00:48:40,180 --> 00:48:44,740 costs, you will not shut down your firm. 1060 00:48:44,740 --> 00:48:45,770 OK. 1061 00:48:45,770 --> 00:48:47,145 This is actually pretty confusing, and 1062 00:48:47,145 --> 00:48:47,680 we're out of time. 1063 00:48:47,680 --> 00:48:50,410 So what I'm going to do is we'll pick it up on Monday 1064 00:48:50,410 --> 00:48:51,870 exactly at this point. 1065 00:48:51,870 --> 00:48:53,670 And I'll go through some more of the intuition for this. 1066 00:48:53,670 --> 00:48:56,180 And that will be our segue for talking long run profit 1067 00:48:56,180 --> 00:48:58,710 maximization which we'll talk about on Monday.