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Midterm review ➥ 1. Some sample quiz questions 2. Some ideas on elasticity of demand 3. An exercise on (a) medium run and (b) long run Session R1 • Midterm Review Slide 1 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Sample quiz question Which of the following hold (in equilibrium) for an individual firm in the model of perfect competition? a. Its marginal revenue is less than the market price. b. It never earns an economic profit. c. Its marginal cost equals its marginal revenue. Session R1 • Midterm Review Slide 2 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Sample quiz question Which statements about the inefficiency of the decisions of a firm with market power are true, in the models we have studied? a. The firm has no incentive to reduce its cost of production. b. The firm will produce too much in order to take over market share. c. The firm may forgo projects that have positive net social value. Session R1 • Midterm Review Slide 3 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Midterm review ✓ 1. Some sample quiz questions ➥ 2. Some ideas on elasticity of demand 3. An exercise on (a) medium run and (b) long run Session R1 • Midterm Review Slide 4 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

From “Exercise on Scenario Demand and Elasticity” Product category: Passenger jets. Dominated by two firms: Airbus (A) and Boeing (B). (For simplicity, imagine that each firm produces one kind of jet, and these two jets make up the entire product category.) Hypothetical demand functions: Q A = 60 − 3 P A + 2 P B Q B = 60 − 3 P B + 2 P A Session R1 • Midterm Review Slide 5 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Find Airbus’ elasticity at P A = 24 … when Boeing’s price is P B = 30 : And when P B = 24 ? Session R1 • Midterm Review Slide 6 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Illustrate graphically Graph Airbus’ demand curve when P B = 24 and when P B = 30 : P i 40 30 20 10 30 60 90 120 Q i Session R1 • Midterm Review Slide 7 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market demand Market demand: How does aggregate demand for the entire product category respond when the prices of all products in the category go up? Aggregation problem: Need to define … Q A = 60 − 3 P A + 2 P B Q B = 60 − 3 P B + 2 P A • aggregate output • a price index Our numerical example is easy. We can just add the two quantities: Q = Q A + Q B For a price index, we use the average price: P = P A + P B 2 Session R1 • Midterm Review Slide 8 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Aggregation: Calculation Aggregate demand Q as a function of the average price P ? Q A = 60 − 3 P A + 2 P B Q B = 60 − 3 P B + 2 P A Q A + Q B = (60 − 3 P A + 2 P B ) + (60 − 3 P B + 2 P A ) = 120 − P A − P B � P A + P B � = 120 − 2 ⇒ Q = 120 − 2 P 2 � �� � � �� � Q P Session R1 • Midterm Review Slide 9 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Summary: Market demand versus Airbus’ demand MARKET DEMAND AIRBUS’ DEMAND (If P B = 24 ) Q = 120 − 2 P Q A = 108 − 3 P A P P i 60 60 50 50 40 40 30 30 20 20 10 10 30 60 90 120 30 60 90 120 Q Q i Session R1 • Midterm Review Slide 10 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Comparing the elasticities Calculate the elasticity of the market demand curve at P = 24 : From Q = 120 − 2 P , choke price is ¯ P = 60 : 60 − 24 = 24 24 E = 36 = 0.67 = ⇒ It is much lower than the elasticity of Airbus’ demand curve at P A = 24 , given P B = 24 . Intuition? Session R1 • Midterm Review Slide 11 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Broader idea This illustrates a broader idea brought up in Session 3: The more we aggregate across products, the less elastic is demand. For example: demand for computer monitors less elastic than demand for LCD monitors less elastic than demand for Acer LCD monitors less elastic than demand for the Acer AL1916 19” widescreen monitor Session R1 • Midterm Review Slide 12 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Midterm review ✓ 1. Some sample quiz questions ✓ 2. Some ideas on elasticity of demand 3. An exercise on (a) medium run and (b) long run ➥ Session R1 • Midterm Review Slide 13 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Falafel vendors on the beach of Lebanon E h c a e C B D F J I A G H K B Session R1 • Midterm Review Slide 14 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

An illustration of these ideas … for perfect competition 1. For individual firm: • Supply decision, when in market, depends only on marginal cost. • Fixed cost drives exit/entry decision. 2. But at level of the market (equilibrium) Fixed costs ⇒ exit/entry decisions ⇒ market prices Session R1 • Midterm Review Slide 15 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

How we do this For case of identical firms (free entry) … Study adjustments following a shift in demand: Long run given initial demand curve. 1 Medium run after shift in demand. 2 Long run after shift in demand. 3 (We did this in Session 6 for an increase in fixed cost.) Session R1 • Midterm Review Slide 16 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

A falafel vendor on the beach of Lebanon Typical cost structure: Lira (100s) 28 24 20 MC 16 12 AC 8 4 100 200 300 Q Session R1 • Midterm Review Slide 17 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Assume free entry Draw approx. aggregate supply curve and show equilibrium. Lira (100s) Demand: Q = 3000 − 100 P 28 24 20 16 12 8 4 1000 2000 3000 Q Session R1 • Midterm Review Slide 18 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

So find equilibrium … (a) Q ∗ i (b) P ∗ (c) Q ∗ (d) N ∗ Session R1 • Midterm Review Slide 19 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

How we do this For case of identical firms (free entry) … Study adjustments following a shift in demand: ✓ Long run given initial demand curve. 1 Medium run after shift in demand. 2 Long run after shift in demand. ➥ 3 Session R1 • Midterm Review Slide 20 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

But then demand fluctuates How does long-run equilibrium change? Lira (100s) 28 24 20 16 12 8 4 1000 2000 3000 Q Session R1 • Midterm Review Slide 21 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

So find (long-run) equilibria … (a) Q ∗ i (b) P ∗ (c) Q ∗ (d) N ∗ Session R1 • Midterm Review Slide 22 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

How we do this For case of identical firms (free entry) … Study adjustments following a shift in demand: ✓ Long run given initial demand curve. 1 ➥ Medium run after shift in demand. 2 Long run after shift in demand. ✓ 3 Session R1 • Midterm Review Slide 23 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

But suppose entry and exit take time … Think of long run as after exit/entry; medium run is before exit/entry. What are medium-run supply decisions and equilibrium?? Session R1 • Midterm Review Slide 24 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

What is Of an individual vendor? medium-run supply? Lira (100s) 28 24 20 MC 16 12 AC 8 4 100 200 300 Q Session R1 • Midterm Review Slide 25 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

What is Of the entire market? medium-run supply? Lira (100s) 28 24 20 16 12 8 4 1000 2000 3000 Q Session R1 • Midterm Review Slide 26 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets