TA Session 1

B ela Szabadi
April 11, 2014
Review of previous courses
1 Demand
Demand is characterized by a demand function q = D(p).
For example, q = 100 10p. This function is generally non-increasing in p. In this course we will take the aggre-
gate demand as given, and for simplicity will mostly use linear demand functions.
We will often nd it convenient to use the inverse demand p = p(q) = D
1
(q), at what price are the con-
sumers willing to buy q units of product. Demand, willingness to pay and marginal social benet are basically
the same concepts here.
1.1 Consumer Surplus
Consumer surplus is a measure of the consumers benet from participating in the market. The consumer surplus
is dened as the area between the demand curve and the price.
2 Supply
The supply function may be given directly q = S(p), e.g. q = 20 +5p or indirectly by the cost function, for example
c = q
2
, and a description of the market in which the rm is operating. A monopolist will behave differently than
a competitive rm even if they have the same production function.
2.1 Individual Supply
This function describes the optimal behavior of a single rm, i.e., what the optimal level of production is, given
the price.
2.2 Aggregate Supply
This function describes the entire supply side of the market, i.e. what will be the level of production in the market
at a given price level after all rms re-optimize their production, new rms join the market, rms close down,.....
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3 The Cost Functions
Total Cost This function c = C(q) describes the entire cost of production. In many cases this function will have a
xed part and a variable part (e.g. c = 100 + 50q). These parts are often referred to as the xed cost, which
the rm pays whatever its production level is; and the variable cost which depends on the production level.
Average Cost This function describes the average cost of producing one unit of good AC(q) =
C(q)
q
. In the exam-
ple given above average cost is AC =
100
q
+ 50.
Marginal Cost This function describes the costs of producing the last unit of good produced. Or in other words
this is the derivative of the cost function: MC(q) =
dC(q)
dq
. In the example above the marginal cost is constant
and equal to 50.
In a competitive equilibrium the marginal cost will equal the market price.
Revenue R(q) = p(q) q, note that under perfect competition the rmdoes not control the price, while a monopoly
can actually x it.
Marginal Revenue The increase in revenue generated by selling an additional unit of good. MR(q) =
dR(q)
dq
=
dp(q)
dq
q + p(q)
Producer Surplus Measure of the producers benet from participating. Equals the area between the price and
the marginal cost curve.
Remember that economic agents generally make their decisions according to the marginal costs and not the
average cost.
Also note that if we have a linear production technology with no xed cost (as we will often have in this course)
the marginal cost will equal the average one. However, this is true ONLY in this specic case.
4 Competitive Equilibrium
In a CE all economic agents (rms and consumers) take the market price as given. In this case we are interested in
nding the price the clears the market. i.e. a price for which supply equals demand. Technically this is easy and
consists of nding the intersection(s) of the demand and supply curves.
5 Monopoly
In a monopolistic market there is only one rm which has all the market power. It sets either the price or the
quantity in order to maximize its own prot.
The monopoly price is the solution to
max
p
D(p) p C(D(p)).
The solution to this problem is identical to that of choosing the optimal output
max
q
q p(q) C(q)
This will not be true in oligopolistic settings.
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6 Exercises
Exercise 1
In the Beer industry there are eight identical breweries. Each brewery has a production cost of C(q) = 1 +q
2
. The
demand for beer is Q = 20 p where Q =
8
i=1
q
i
.
Calculate the price and quantity in competitive equilibrium, the consumer surplus, producer surplus and DWL.
Solution
First, compute the supply function at the rm level:
from p = MC = 2q
i
we get S
i
(p) =
1
2
p.
the aggregate supply is S(p) =
8
i=1
S
i
(p) = 8
1
2
p = 4p
competitive equilibrium:
demand=supply: 20 p = 4p
5p = 20 p=4
using the demand function, Q = 20 p = 16
an individual rms supply: q
i
= Q/8 = 2
consumer surplus equals the area between the demand function and the price:
CS =
(20p)Q
2
=
16
2
2
= 128
producer surplus is the area between the price and the supply function:
PS =
pQ
2
=
1416
2
= 32
since the marginal social benet and the marginal social cost are the same in competitive equilibrium, welfare
is maximized and there is no DWL.
Exercise 2
The aggregate demand in an industry is given by p = 100
Q
100
.
In the market there are 100 rms of type A with a cost function c
A
(q
A
) = q
2
A
, and 200 type B rms with a cost
function c
B
(q
B
) = k +q
2
B
if q
B
> 0 and zero otherwise.
a) Will all active rms produce the same amount?
b) What is the highest k for which all rms will be active?
c) Assume k=900. How many rms of each type will be active? What are their prots?
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Solution
a) The only difference between two types of rms is the k quasi-xed cost that rms of type B incur when pro-
ducing. If k is too high, type B rms wont produce. In every case, the marginal costs of the rms that are in the
market (type A or type A and B) are the same (2q). This means that every active rm solves the same optimality
condition and sets the same output quantity.
b) Idea: compute the prots when all the rms are active and nd the highest k that leads to nonnegative prots
for rms of type B. For all k values higher than this, type B rms will not produce at all.
individual rms supply function: p = MC = 2q S
i
(p) =
1
2
p
aggregate supply if all rms are active: S(p) = 100 S
A
(p) + 200 S
B
(p) = 150p
nd competitive equilibrium: demand=supply:
100
Q
100
= Q/150
this leads to Q = 6000 and p = 40
the individual rms supply is q = q
A
= q
B
= 6000/300 = 20
prot of a type A rm:
A
= 40 20 20
2
= 400
prot of a type B rm:
A
= 40 20 k 20
2
= 400 k
this is nonnegative as long as k 400
c) Since 900 is higher than the value found in b), only type A rms will be active.
the aggregate supply is S(p) = 100 S
A
(p) = 50p
competitive equilibrium: 100
Q
100
=
Q
50
this implies Q = 3333.33, p = 66.67 and q
A
= 33.33
the prot of a rm is
A
= 66.67 33.33 33.33
2
= 1111.11.
Exercise 3
The demand for bread in a small, isolated town could be characterized by:
Q = 60 p
The technology for producing bread is
C(q) = 50 +
q
2
2
a) Draw and calculate the AC and MC.
b) Calculate the competitive equilibrium of the bread market if C(q) represents the technology at the industry
level.
c) Calculate the monopolistic price and the dead weight loss if the technology is owned by a single bakery.
d) Assume any number of rms may use this baking technology and there is free entry. Compute the price of
bread in the long-run equilibrium and nd the number of active rms.
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Solution
a) AC(q) = C(q)/q = 50/q +q/2 and MC(q) =
dC(q)
dq
= q.
b) Since MC(Q) = Q, the industrys supply function is S(p) = p.
use this and the demand function to nd p: 60 p = p p = 30
from the supply relationship, Q = p = 30.
c) Use MR = MC
TR(q) = (60 q)q
MR(q) =
dTR(q)
dq
= 60 2q
MR = MC: 60 2q = q which implies q = 20
the price is p = 60 q = 40
we need to show that the rm is indeed active (obtains a positive prot): = 40 20 50
20
2
2
= 550 > 0
since the monopoly produces less than the efcient quantity (where D and MC intersect each other), there
is DWL
DWL is the area of the triangle dened by the supply curve, the demand curve and the vertical line at
q = 20. DWL =
2010
2
= 100.
d) Since there is free entry, all rms in the market operate with zero prot
this means that they operate at the minimum of their AC curve: p = min
q
AC(q)
nd the minimum:
dAC(q)
dq
=
50
q
2
+ 1/2 = 0 q
2
= 100 q = 10.
from here price is p = min
q
AC(q) = AC(10) = 10.
the demand curve determines the aggregate equilibrium quantity: Q = 60 10 = 50
this has to be supplied by 50/10 = 5 rms.
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