CH-10-12 Externalities: When the Price Is Not Right – Modern Principles: Microeconomics : Chapter Notes

This Document Contains Chapters 10 to 12 Chapter 10 Externalities: When the Price Is Not Right Learning Objectives After completing this chapter, students should: > know that if the market price doesn’t account for external costs or benefits, then the efficient quantity will not be traded. > know that there are theoretically four ways to internalize the costs of externalities: private solutions, command and control regulations, taxes and subsidies, and tradable allowances. > understand the Coase theorem, which explains that the source of an externality problem is too few markets and that if markets for the externality can be established, the efficient solution can be reached at the lowest cost. Chapter Outline External Costs, External Benefits, and Efficiency External Costs External Benefits Private Solutions to Externality Problems Government Solutions to Externality Problems Command and Control Tradable Allowances Tradable Allowances in Practice Comparing Tradable Allowances and Pigouvian Taxes—Advanced Material Takeaway Chapter Narrative This chapter discusses externalities by examining the evolution of diseases in response to antibiotics, vaccinations, and pollution. The famous fable of the bees is also discussed. The chapter begins by describing how President Calvin Coolidge’s son died of a staphylococcal infection he contracted because of a blister. Penicillin was discovered a few years later and has been a successful drug for treating staph infections. However, the staphylococcus bacteria have evolved and are now resistant to penicillin, and some variants are resistant to almost all antibiotics. This evolution occurs because when an antibiotic is taken, the drug kills the weakest bacteria, and only the stronger bacteria remain. Without competition for resources, these stronger bacteria multiply, and after many generations the evolved bacteria are strong enough to resist the antibiotics. Because bacteria move among people, when one person takes an antibiotic, it exposes other people to more evolved and resistant bacteria. Exposing others to these bacteria is an external cost of using an antibiotic. When antibiotics are consumed, the private cost (the cost borne by the consumer) is less than the social cost (the cost to everyone). Because of the external cost (the costs borne by people other than the consumer), too many antibiotics are consumed, and harmful bacteria evolve too quickly. The market price doesn’t account for the cost of faster bacterial evolution. Antibiotic resistance is a problem of both evolution and economics. The economics are driving the evolution to occur too quickly. The first five minutes of the MRU video An Introduction to Externalities provides a general introduction to externalities using the example of antibiotic-resistant bacteria. External Costs, External Benefits, and Efficiency The total social surplus in the economy equals the consumer surplus plus the producer surplus plus the surplus or costs of everyone else. The efficient quantity traded is the quantity that maximizes the social surplus. When there are no externalities, the social surplus is simply the producer surplus plus the consumer surplus, and the efficient quantity is the same as was found in Chapter 4. External Costs Figure 10.2 in the text illustrates the deadweight loss from overproduction when externalities raise the social cost above the marginal cost to suppliers. Whenever the social cost curve is above the demand curve, the market equilibrium quantity of the good is greater than the efficient quantity of the good. This is because efficiency requires that both private costs (those paid by the producers) and external costs (those paid by people other than the consumer or producer) maximize total social surplus. In the case of Figure 10.2 the private costs are those costs paid for the creation of the antibiotic and the external costs come in the form of stronger forms of bacteria more resistant to the antibiotics. Since these external costs are not part of the market price, the market does not consider them and there is too much consumption of antibiotics. To resolve this, we need the consumers and producers (that is to say, the market) to internalize these external costs and treat them as they would private costs. One way to do this is to recall that the graph in Figure 10.2 resembles the same graph that represents a tax on producers (see Figure 6.1). If we can impose a tax equal to the external cost of using antibiotics, then the market would internalize these costs via the tax and we would reduce the amount of antibiotic use to the efficient level. These types of taxes are called Pigouvian taxes. Potential Pitfall: This is beyond what is covered in the text, but now might be a good time to point out to your students that while computing social cost versus private marginal cost is simple on a graph, it is not so simple in the real world. When buyers and sellers interact, their actions allow us to observe values they place on items. If the externalities are not traded, no such observable signal exists. While we might think that antibiotic prescriptions have a negative externality, it is impossible to precisely value the externality because it has no market. It’s important to caution students about this, as it is all too easy for them to believe that taxes or other policies easily “solve” externalities. Figure 10.2 When external costs are significant, output is too high The last 7 minutes of the MRU video An Introduction to Externalities discusses the implications of external costs (using Figure 10.2) and how a Pigouvian tax can be used to correct such an externality. External Benefits Just like external costs, an external benefit affects people other than the producers or consumers in a market. The text uses the example of vaccines as a good with an external benefit. When one person is vaccinated against flu, the private benefit is that that person is less likely to catch the flu. The external benefit is that because that person is less likely to catch the flu, he or she is less likely to pass the flu on to others. This second benefit isn’t accounted for when most people decide whether to get flu shots. But the costs of flu shots—time, money, fever, and ache—are private costs that do influence their decisions. If there is an external benefit to flu shots and all the costs are private, then the 36,000 people who die of the flu in the United States each year are socially inefficient, because too few flu shots are consumed. Figure 10.3 in the text illustrates such a situation. Because the social marginal benefit is greater than the private marginal benefit, too little is consumed. If a Pigouvian subsidy equal to the difference between the private and social benefit (also called the external benefit) could be calculated and applied, then the efficient quantity could be reached. The MRU video External Benefits discusses the implications of external benefits (using Figure 10.3 in the text) and how a Pigouvian subsidy can be used to correct such an externality. Private Solutions to Externality Problems Nobel Prize–winning economist James Meade claimed the market for honey was inefficient because as bees make honey, they also pollinate fruits and vegetables, providing an external benefit to farmers. Meade assumed that because the pollination was an external benefit, too little honey was being produced. Meade was wrong! Figure 10.3 When external benefits are significant, market output is too low Bees do pollinate for farmers, but beekeepers are paid for this service. Beekeepers across the United States rent out around half a billion bees to farmers each year. Farmers pay the beekeepers for this service, so the external benefit is internalized. Beekeepers have an incentive to expand honey production to take account of the benefit that they provide to fruit and vegetable production because they are paid for the service. In fact, beekeepers are paid differently for pollinating different crops. Pollination of almonds tends to degrade the taste of honey, so beekeepers charge about $75 per colony of bees for almond production, but only $25 per colony when the bees are pollinating apples. The fable of the bees illustrates an important point: Even with externalities, the market equilibrium can be efficient if there is systematic trading in the externalities. To have systematic trading in externalities, the transactions’ costs must be low and property rights clearly defined. In the case of bees, the property rights over farms and bees are clearly defined, and because farms are large and bees don’t fly far, beekeepers need to negotiate with only one farmer for any colony of bees, so the transaction costs are low. This leads us to the Coase theorem: If transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even with externalities. This leads to a direct implication for improving efficiency in the presence of externalities. If you can make a new market by clearly defining property rights or lowering transaction costs, then efficiency can improve. Teaching Tip: If you’re teaching business students, now could be a good time to illustrate how understanding externalities and transaction costs can lead to profits. In a market economy, today’s inefficiencies are tomorrow’s profit opportunities. If businessmen can identify an inefficient externality and come up with a way to internalize it, they can make a profit. One such example is the tendency for many apple orchards that are open to the public to sell not only apple-related goods but also honey. The orchards have purchased their own bee hives and profit via the honey that is produced. One example is that when a neighbor keeps his house freshly painted and in good condition, it confers an external benefit on the homeowners around him. One way in which developers have internalized this benefit is by forming homeowners’ associations that either charge a fee to provide maintenance for all homeowners in the association or punish homeowners who don’t maintain their homes. Ask your students for more examples. The MRU video The Coase Theorem discusses the “fable of the bees” and explains how the Coase theorem can be used as a solution to externalities. Government Solutions to Externality Problems Governments can try to solve externality problems three ways: with taxes and subsidies, with command and control, or with tradable allowances. The text considers how these methods apply to acid rain. Acid rain damages the environment, corrodes metal and stone, and constitutes a health hazard. Acid rain occurs when sulfur dioxide and nitrogen dioxide are released into the atmosphere; the production of electricity significantly contributes to the release of both gases. Command and Control Compared to all other policies governments use to deal with externalities, command and control regulations leave producers and consumers the least flexibility to make decisions for themselves. Command and control requires the government to know more about the least costly way to reduce the externality than any of the other policy options, because it leaves people with the least flexibility. Because electricity generation contributes to acid rain, one solution the government often favors to deal with acid rain is to mandate appliances that will consume less electricity. In 2007, the U.S. Department of Energy mandated that all clothes washers had to use 21% less energy. Unfortunately, Consumer Reports found that this requirement caused inexpensive washers to do a poor job and that consumers would have to spend around $900 on machines to get clothes as clean as they could before. The same savings in total electricity use could have been obtained more cheaply. To illustrate to the students why and how it could have been done more cheaply, suppose, as the text does, that the use of more energy-efficient washing machines would have decreased total energy consumption by 1%. Ask the students how they think consumers would have responded if a tax large enough to decrease electricity consumption by 1% had been imposed. Would everyone have run out and bought $900 washers? How else would people have coped? If they instead would have turned off more lights or used less heat and air conditioning, that indicates that those ways of consuming less electricity are less costly than what command and control dictated. This highlights one problem with command and control: Higher prices send signals to people to economize. People respond by giving up their lowest-valued uses of a given product. Unless the government’s command and control mandate exactly matches how each and every person would respond, command and control isn’t the least costly way to correct the externality. Put another way, for the same cost as command and control, more of the externality could have been corrected. The textbook makes a case that command and control can be useful if the best approach to correct an externality problem is known and if success requires very strong compliance. For example, the World Health Organization’s program against smallpox was a successful command and control program. The MRU video Command and Control Solutions discusses the implications of command and control solutions to externalities and provides a comparison to economic solutions (using Pigouvian taxes and subsidies). Tradable Allowances Requiring all factories to reduce pollutants by a certain quantity is another form of command and control regulation. The government did this in the 1970s, when it limited the maximum rate of sulfur dioxide emissions from generators of electricity. However, not all firms can reduce or limit emissions at the same cost. Tradable allowances are a method for ensuring that the lowest-cost pollution is eliminated. Teaching Tip: If you have time, this is an interesting point to tell the story of the Clean Air Act and the use of tradable allowances by the EPA. It is also a great chance to highlight several economic principles at once. The first attempt to limit sulfur dioxide was a command and control policy that attempted to accommodate the idea that different firms face different costs to limit emissions (one of the general criticisms of command and control policy). The law did this by exempting older power plants from the limits. The response from power companies was to either put off building new power plants or to close newer plants and reopen older ones they had already shut down. This resulted in an actual increase in total sulfur dioxide emissions. The response was the implementation of the tradable permits system. Tradable allowances give each firm the right to emit a certain amount of pollution and then allow firms to trade these rights to each other. If one firm can eliminate 1 ton of pollution for $1,000 and another firm can eliminate an equivalent ton for only $300, there is potential for gains from trade. The first firm could pay the second anywhere between $300 and $1,000 for the right to pollute, and the second firm would reduce its emissions. Profits for both firms would increase, and in the process pollution would be eliminated at a lower cost. Teaching Tip: Some students with environmentalist leanings might feel uncomfortable with firms trading “rights to pollute.” You should emphasize to them that if firms are allowed to trade, not only can the firms increase profits but a society can afford to eliminate more pollution because the cost of eliminating it has fallen. You can also point to the next section of the text. The MRU video Trading Pollution explains how tradeable pollution permits can succeed at lowering pollution at lower costs while increasing profits by firms that pollute. Tradable Allowances in Practice A tradable allowance system was set up by the Clean Air Act of 1990. The EPA distributed allowances giving firms the right to emit 1 ton of sulfur dioxide. Firms can trade the allowances with each other or bank them for future use. Since the implementation of this allowance system, sulfur dioxide emissions have fallen 35% even though electricity generation has increased. The Clean Air Act defined the property rights in pollution and reduced transaction costs by distributing the allowances, monitoring emissions, and setting up a database that tracks ownership. One benefit of tradable permits is that citizens, as well as factories, can own them. An environmentalist who believes that the permits allow for too much pollution is free to buy the right to pollute from a firm and then not exercise the right. Potential Pitfall: After learning about tradable allowances, many students will conclude that they are superior to command and control regulations. Tradable permits, however, are not without problems. Although tradable permits can reduce emissions at lowest cost, there is still the problem of how many permits to issue. Whether using command and control or tradable permits, the government must know the size of the externality to set an appropriate quantity of pollution. But without market prices for the (uncapped) externality, this information is not available. There will likely be inefficiency associated with the use of tradable permits, command and control, or taxes. Teaching Tip: The most obvious and controversial application of a tradable permit system is implementing a worldwide system for carbon dioxide emissions to combat global warming. This might be a good topic to use as a class discussion. Try to get the class to distinguish between the issues: whether (and by how much) emissions should be limited and how best to limit emissions if it is desirable to do so. Teaching Tip: You can also find several online games which walk students through the costs and benefits of each of the systems discussed in this chapter. If the class is small enough, it might also be an interesting way to highlight the differences. One can be found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=432985 The MRU video A Deeper Look at Tradeable Allowances provides a more detailed look at tradeable allowances and provides a comparison to Pigouvian taxes as a solution for externalities. The possibility of using these methods to fight global climate change is discussed at the end of the video. Comparing Tradable Allowances and Pigouvian Taxes—Advanced Material A tax on an externality should be set so that the private cost plus the tax equals the social cost of an activity. If the tax is set at this level, the market participants will trade to achieve the efficient quantity. Issuers attempt to set the number of tradable allowances at the efficient quantity and then let market participants trade them to reach the efficient price. The equilibrium price and quantity are the same in either case. In practice, the difficulty with either approach is that the government doesn’t know what the efficient quantity or price is. The main difference between taxes and tradable allowances is political. With a tax, firms must pay to make the externality. With allowances, they are often given the initial permits without paying and must only pay if they want to buy more permits from someone else (which allows the selling firm to gain a profit). Firms get a big benefit from allowances compared to taxes. However, permits could also be sold to firms instead of given away to produce government revenue similar to that of a tax. Takeaway Students should understand that prices send signals but that if there are externalities, the market price signals may not lead buyers and sellers to efficient outcomes. They should also understand that markets cope with this problem by establishing markets for the externalities themselves. When transaction costs are low and property rights well-defined, markets can reach efficient outcomes even in the presence of externalities. Students should understand how taxes or subsidies can, in theory, correct the price signals so that they reflect the value of externalities and markets reach efficient outcomes. However, they should also understand the difficulty of knowing what size the tax or subsidy should be. Students should also understand the difference between command and control regulations, tradable allowances, and taxes and subsidies. In- and Out-of-Class Activities Many economics students are interested in business applications of what they have learned. Here’s something you can use for an in-class discussion or give students to work on outside the classroom. When businesses find ways to internalize externalities, they can make more money. Try asking the students why shopping malls charge a low price per square foot to department stores like Sears, a medium price to stores like Levi’s, and a high price per square foot to jewelry stores and food vendors. Large department stores generate a lot of foot traffic. People come to the mall to go to these big stores, but then they walk by other stores and occasionally buy things there as well. The foot traffic a department store generates is a positive externality for the other firms. The food vendors and smaller stores generate a much smaller positive externality, but they benefit a great deal from the foot traffic the other stores generate. Mall owners make money by offering low rental prices to stores that generate a lot of foot traffic because they are then able to charge higher rental prices to the other occupants who benefit. The low price that department stores pay means that they benefit from causing the externality. Malls have effectively internalized the benefit of much of the spillover foot traffic that stores attract. What role did transactions costs have in moving stores out of downtowns and into malls across the United States? Store owners could have negotiated with all downtown neighbors to pay them for the positive externality. But transactions costs were often lower in suburbs when a single owner put together a large tract of real estate. Now large store owners only had to negotiate with one mall owner to get the benefit of the externality they generate for all the nearby stores. If the students could figure out this problem, ask them for some other examples of externalities being internalized and how someone has profited from this internalization. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: External Costs, External Benefits, and Efficiency An Introduction to Externalities External Costs, External Benefits, and Efficiency External Benefits Government Solutions to Externality Problems Command and Control Solutions Private Solutions to Externality Problems The Coase Theorem Tradeable Allowances Trading Pollution Tradeable Allowances in Practice A Deeper Look at Tradeable Allowances Chapter 11 Costs and Profit Maximization Under Competition Learning Objectives After completing this chapter, students should: > understand why a competitive firm maximizes profits when price equals marginal cost and be able to illustrate it graphically. > understand that firms enter an industry when profits are positive and be able to illustrate entry and exit graphically. > understand that most long-run average cost curves are U-shaped because at first average cost falls as fixed costs are spread over more units but then rises again as variable costs increase. > be able to illustrate a long-run industry supply curve by summing short-run supply curves in increasing, constant, and decreasing cost industries. Chapter Outline What Price to Set? Maximizing Profits Ignore Sunk Costs and Ignore Fixed Costs in the Short Run Don’t Ignore Opportunity Costs What Quantity to Produce? Profits and the Average Cost Curve Entry, Exit, and Shutdown Decisions The Short-Run Shutdown Decision Entry, Exit, and Industry Supply Curves Increasing Cost Industries Constant Cost Industries A Special Case: The Decreasing Cost Industry Industry Supply Curves: Summary Takeaway Chapter Narrative This chapter covers firms’ and industries’ costs to derive short- and long-run supply curves in competitive markets. It focuses on three key decisions firms must make: what price to set, what quantity to produce, and when to enter or exit an industry. The chapter also highlights factors that firms should and should not ignore in making these decisions. The chapter begins with the example of small stripper oil wells that produce only 10 barrels a day as an example of a firm whose output will not have a noticeable impact on market price. Other industries—hotels and domain name registries—are considered later in the chapter. Teaching Tip: As with most texts, cost curves can be a confusing topic for students. You should assume that simply reading the textbook hasn’t given them a strong understanding and that it may take multiple illustrations from you before they understand why the curves are shaped as they are. It’s important not to let the large number of curves get in the way of understanding the big picture of profit maximization. What Price to Set? There are over 400,000 stripper oil wells in the United States today, each producing 10 barrels of oil or fewer per day. World oil production is approximately 82 million barrels a day. At what price should the owner of a stripper well sell the oil? Oil from one place in the world is pretty close to a perfect substitute for oil from other places. If an individual oil well owner asked for more than the going rate, consumers would switch to buy from other producers. Because individual owners produce such a tiny share of total oil production, they can sell all of the oil they have at the market price without pushing the market price down. So it doesn’t make any sense for them to sell for less than the market price. In this situation it is easy to figure out what price to sell at. They can’t sell for more than the market price, but they can sell all they want at the market price, so to maximize profits, an owner sells the oil for the going market price. This result applies whenever the demand for an individual firm’s product is perfectly elastic at the going market price. This occurs when there are perfect substitutes for the individual firm’s product and the individual firm produces a small fraction of total industry output. The textbook mentions that gold, wheat, paper, steel, lumber, cotton, sugar, vinyl, milk, trucking, glass, and Internet domain name registration approximately satisfy this condition. Also, because firms can enter in the long run to compete, long-run demand for any given firm’s product is also more elastic and may approximate this assumption. When the following conditions hold, a firm will not have much influence over choosing the price of its product: > The product being sold is similar across sellers. > There are many buyers and sellers, each small relative to the total market, and/or many potential sellers. The MRU video Introduction to the Competitive Firm provides a nice opening to this chapter. It explains the characteristics of a competitive firm and illustrates the implications using Figure 11.1 in the text. Maximizing Profit This section provides some important definitions and explains some important principles that set the stage for the discussion of profit-maximization in this chapter. Ignore Sunk Costs and Ignore Fixed Costs in the Short Run This section emphasizes that any cost that cannot be changed should be ignored in the profit maximization decision. One type of cost that cannot be changed is a sunk cost. A sunk cost is a cost that has already been incurred and cannot be recovered. The example discussed in the text is the price paid for a movie ticket. If the movie turns out to be awful, should you sit through it just because you bought the ticket? The answer is no, since the ticket purchase is a sunk cost. Just walk out and find something better to do with your time. Another type of cost that cannot be changed is a firm’s fixed cost. A fixed cost is any cost that does not vary with the quantity of output produced. In other words, the firm is committed to pay the fixed cost regardless of how much output it produces, even if it shuts down completely and produces nothing. The period of time during which the firm is committed to pay the fixed cost is called the short run. Since fixed costs do not vary with output in the short run, they cannot be changed and therefore should be ignored in the short run. Don’t Ignore Opportunity Costs Here the textbook makes the distinction between explicit costs—those that entail monetary outlays—and implicit costs—those that do not. Interest is given as an example of a cost that is sometimes implicit and sometimes explicit. If Alex borrows $200,000 to drill an oil well in his backyard, the 5% interest he pays is explicit: He actually has to make a monetary payment to the bank. If Tyler pays $200,000 out of pocket to drill the well, his interest cost is implicit, because he gives up the opportunity to invest that money elsewhere and earn interest on it. The interest cost of the loan will be on Alex’s books, but the forgone interest of the $200,000 cash will not show up on Tyler’s books. Therefore, the two wells will have different levels of accounting profit: total revenue minus explicit costs. However, economists consider both implicit and explicit costs, so as long as the interest rate at which Tyler could have invested is equal to the interest rate that Alex pays to borrow, the wells will have identical levels of economic profit. What Quantity to Produce? The firm wants to produce the quantity that maximizes profit. Profit is defined as total revenue minus total cost. Total revenue is pretty straightforward, at least at this point, since there is one market price: TR = P × Q. Total cost is a little more complicated, because there are so many ways to categorize and discuss costs. For example, costs can be fixed or variable. Some costs entail outlays of money, while others do not. Finally, in addition to total costs, economists often discuss average costs and marginal costs. Total cost has two components: fixed costs, which do not vary with output, and variable costs, which do. In other words, TC = FC + VC. In the example from the textbook, the fixed cost of oil production is the interest on the loan that was used to drill the oil well. Because fixed costs do not vary with output, they must be paid whether output is produced or not. Therefore, if any cost is associated with not producing (producing zero units), then it must be a fixed cost. The variable costs in the textbook’s example are the costs of running the oil pump: electricity, maintenance, barrels, trucking, and so on. These costs rise as output rises. An easy way to find the quantity that maximizes profit is to look at the marginal revenue and marginal cost rather than total revenue and total costs. The general rule for all firms is to maximize profit the firm should keep producing as long as marginal revenue is greater than marginal cost, including the quantity where marginal revenue equals marginal cost. Since these firms are so small compared to the world market, their production doesn’t affect the world market price, so their marginal revenue equals price. It may be helpful to define a few new terms for students at this point: > Marginal revenue (MR) is the change in total revenue from selling an additional unit. For a competitive firm, marginal revenue equals price. > Marginal cost (MC) is the change in total cost from producing an additional unit. Teaching Tip: Students are going to get a lot of definitions of the various costs and revenues during the lecture on this chapter. It would be useful to mark off an area on the side of your blackboard where you can write each definition as you introduce it so you can refer to them later in your lecture. It would be helpful to use a table and illustrate how a competitive firm, like a stripper oil well, maximizes profit, as is done in Figure 11.2 in the text. Two important results that should be emphasized in this discussion are the following: (1) For a firm operating in a competitive market, its marginal revenue will always equal the market price, that is MR = P. (2) For a competitive firm, the profit-maximizing quantity occurs where P = MC. Teaching Tip: Students often wonder why the last unit, where marginal revenue equals marginal cost, should be produced. Try describing it as drops of oil in the barrel: At the last drop of oil in the last barrel, marginal revenue equals marginal cost, but some profit is made on the previous drops, and it is important to fill the barrel. Explain to your students that situations like these arise in part because we do not use calculus in principles courses, but that with calculus the explanation is a little clearer. Many students will be happy not to have to use calculus. You can also use the “no harm, no foul” rule and explain that since the firm does not lose profits, then why not. A third way to show this is to draw a simple supply and demand graph and show that between the second to last and the last unit, there is some surplus generated with its production and trade. The MRU video Maximizing Profit Under Competition explains the key terms introduced in the section along with a detailed discussion of the firm’s profit maximization decision. The video ends with the graphical depiction of profit maximization shown in Figure 11.2 in the text. Profits and the Average Cost Curve To teach how to compute average cost, it is useful to begin by constructing a table like the one in Figure 11.4 in the text. Once you remind students that average cost is total cost divided by quantity, you can begin filling in the average cost column. It might be useful to have the students complete the column themselves. At this point you can draw a graph based on the table illustrating the average and marginal cost curves. Total profit can be computed as total revenue minus total cost or as the average profit per unit multiplied by quantity. To measure profit the second way we compute it as follows: "Profit"=(P-AC)×Q Now you can easily illustrate this profit with the table and graph you just constructed to compute average cost. Begin by going to the table and computing a profit column. Explain that at a quantity of zero, there is no revenue, but fixed costs still have to be paid, so profit is −30.Then, for each line, compute the difference between P and AC multiplied by the quantity to calculate profit. Maximum profit is achieved at a quantity of 8 units. Figure 11.2 Profit is maximized by producing until MR = MC Use the graph to remind the students that this is precisely the rule they learned before: Produce up to the point where MC = P. Point that out on the graph, and then you can show them how to calculate the profits graphically by measuring the distance between P and AC at a quantity of 8 and finding the area of the rectangle. Now would be a good time to illustrate a few other points to the students. > Profit is positive whenever price is greater than average cost. > Profit is negative (that is, a loss occurs) whenever price is less than average cost. > Profit is zero when price equals marginal cost, which equals average cost. Students also need to know that the MC curve will always intersect the AC curve at the minimum point on the AC curve. The reason is simple: Figure 11.4 Profit = (P – AC) × Q > Whenever the marginal cost is less than average, it must pull the average down. > Whenever the marginal cost is higher than average, it must pull the average up. Teaching Tip: Students all have firsthand experience with this in terms of their grades. Try asking them what happens to their average in the class if they have an average grade of 75 and their next exam (marginal exam) is below 75. If their next grade is an 80, what happens to their average? The same applies to marginal and average cost. Profits are maximized when P = MC. So as prices rise, firms expand production along their marginal cost curve. As prices decrease, firms decrease production along their marginal cost curve. The first 7 minutes of the MRU video Maximizing Profit and the Average Cost Curve explains the definitions of the average costs and illustrates the average cost curves. The profit maximization decision is illustrated using Figure 11.4 in the text. Entry, Exit, and Shutdown Decisions Firms are profitable when P > AC and incur losses when P AC and exit an industry when P Above AC, so that the firm is earning profits > Below AC but above AVC, so that the firm can cover its variable costs and should remain open in the short run while trying to exit > Below AC and below AVC, so that the firm cannot even cover its variable costs and should shut down immediately The three ranges can be illustrated graphically as shown in Figure 11.6 in the text. Figure 11.6 The Firm’s Entry, Exit, and Shutdown Decisions The simple rule of entering an industry when P > AC and exiting when P understand how the competitive process leads to the minimization of total industry production costs. > understand that the elimination principle means that above-normal profits are eliminated by entry and losses are eliminated by exit and that for a firm to continually earn above-normal profits, it must constantly innovate. > understand how, with no central commander, a competitive market organizes production so that total output is produced at minimum costs and that entry and exit decisions naturally tend to balance production across industries so that consumer welfare is maximized. > be able to explain the conditions necessary for markets to have desirable properties. Chapter Outline Invisible Hand Property 1: The Minimization of Total Industry Costs of Production Invisible Hand Property 2: The Balance of Industries Creative Destruction The Invisible Hand Works with Competitive Markets Takeaway Chapter Narrative This chapter combines Chapter 7’s big picture view of how prices lead to incentives to efficiently allocate resources with Chapter 11’s closer look at how firms maximize profit by entering industries whose price is greater than average cost, leaving industries whose price is below average cost, and producing where price equals marginal cost. Big Idea Two from the first chapter (the metaphor of the invisible hand) is also a central feature of this chapter, showing how the actions of firms, responding to price incentives, yield some desirable outcomes that the firms neither intended nor designed. Invisible Hand Property 1: The Minimization of Total Industry Costs of Production In a competitive industry, all firms face the same market price. Each firm maximizes profits when it produces up to the point where price equals marginal cost. This leads all firms in a competitive industry to produce at a level where they all have the same marginal cost of production even if they have different marginal cost curves. The text starts the discussion by considering two farms owned by the same farmer. Figure 12.2 shows one farm with a steeper marginal cost curve than the other to illustrate how the farmer will allocate production across the two farms to maximize profits. Figure 12.2 To Minimize the Total Costs of Production Across Two Farms Choose Output to Make Marginal Costs Equal Starting with a quantity of 200 bushels produced at farm 2 and no production at farm 1, shifting production from farm 2 to farm 1 reduces total costs of production. This can be seen by comparing the decrease in costs from cutting production at farm 2 (shaded area A) to the increase in costs from increasing production at farm 1 (shaded area B). Shifting production in this way will continue to cut costs until the two shaded areas are the same size, which occurs only when farm 1’s marginal costs increase to equal farm 2’s marginal costs. The result is that total production costs are minimized when marginal cost at the two firms are equal; that is, when MC1 = MC2. A single person who owns both of these farms will allocate production to minimize these total costs. Amazingly, a competitive market achieves exactly the same outcome, because each farm faces the same market price. You may want to draw a horizontal market price line across both panels in the graph and illustrate that the profit-maximizing condition for each farm leads them to minimize total production costs for any given quantity. More generally, the condition required for cost minimization in a competitive market with N firms is given by P = MC1 = MC2 = … = MCN This leads to two important implications. First, a competitive market chooses the ideal minimization of costs that a central planner (with no private agenda and full information) would choose. Since the central planner typically never has full information about all of the firms’ individual MC curves, they would not know how to achieve this outcome. The ideal outcome, however, can be approached better by allowing decentralized competition than by central planning. Second, it implies that allowing free trade also helps to minimize total costs of production because free trade tends to equalize prices across geographic regions. The MRU video Minimization of Total Industry Costs of Production illustrates Invisible Hand Property 1 using Figure 12.2 in the text. Invisible Hand Property 2: The Balance of Industries A competitive market ensures that any given quantity of a good will tend to be produced at the lowest cost. Entry and exit decisions in a competitive market also tend to ensure that the right quantity is produced. It is helpful to tell a story of two industries to illustrate why we want entry and exit decisions made in markets. The text chooses the computer industry and the auto industry. Both use capital and labor. Capital and labor are scarce, and we want to ensure that we produce the most value we can with them. Total revenue in an industry measures the value produced by the industry, and total cost measures the value of the inputs that the industry used up to make its products. Profit is a signal that the limited labor and capital are being used productively. High profits signal that outputs of high value are being made from inputs of relatively low value. Losses signal the value of the output is lower than the value of the inputs being utilized. If one industry is more profitable than another, it is a signal that more of our limited labor and capital should move into that industry from the other. Invisible Hand Property 2 further shows that the entry and exit decisions not only work to eliminate profit, but they also ensure that labor and capital move to balance production optimally across industries, making best use of limited resources. The first half of the MRU video The Balance of Industries and Creative Destruction explains Invisible Hand Property 2. Creative Destruction The text refers to the elimination principle whereby above-normal profits are eliminated by entry and below-normal profits are eliminated by exit. The elimination principle implies that in a competitive economy there is a tendency toward a uniform rate of profit at the normal level. However, in a dynamic economy, change is constant, and some industries will always be expanding and some contracting. As a result, although we never completely solve the economic problem, we are always tending toward an increase in consumer welfare. Because the elimination principle tends to weed out above-normal profits, entrepreneurs must constantly innovate to earn profits above the normal rate. Joseph Schumpeter referred to this type of competition as creative destruction. He argued that rather than the traditional textbook description of competition depicted in this chapter, competition that spurs entrepreneurs to create a new commodity, new technology, new sources of supply, or new types of organizations was the most important in a market economy. When entrepreneurs stand still, they fall behind and are eliminated, but when they innovate, they can leap ahead of the competition and earn profits in the process. The second half of the MRU video The Balance of Industries and Creative Destruction explains creative destruction. The Invisible Hand Works with Competitive Markets It is important, after discussing the desirable properties of the invisible hand, to recall the conditions under which competitive markets will deliver these results. Prices must send the correct signals. In the presence of externalities (Chapter 10), this may not be the case. Likewise, in the case of imperfectly competitive industries (such as monopolies and oligopolies, covered in later chapters), not enough capital and labor will move into these industries. This is because the firms in these industries earn above-normal profits, which ought to inspire entry, but the firms are protected from entry by competitors. Output in these industries will be too low. Finally, in the case of public goods or commons, self-interest and social interest may be misaligned. Achieving the desirable properties of the invisible hand requires the right institutions. Takeaway The students should understand how the elimination principle drives entry and exit decisions and how competition, when it works well, leads to two invisible hand theorems: Even without central direction, a free and competitive market will achieve P = MC1 = MC2 =  MCN so that total costs of production are minimized. Entry and exit decisions not only tend to eliminate profits and losses, they ensure that there is a tendency toward a uniform rate of profit among all industries, which is required to balance production across industries and make best use of limited resources. In- and Out-of-Class Activities Students often do not appreciate how powerful creative destruction is in the marketplace. They may assume that today’s big firms have always been the leading businesses and always will be. By using the Fortune 500 list of the top corporations in the United States, you can illustrate how entrepreneurs fall behind when they stand still, but when they innovate, they can leap ahead of the competition. You can easily access the top 500 for every year since 1955 online at http://money.cnn.com/magazines/fortune/fortune500_archive/full/1955/index.html. Of the top 10 firms in 1955, only 3 (General Motors, General Electric, and Exxon) remained in the top 10 in 2005. You can use this database to give the students any number of assignments that will illustrate how creative destruction is always leading to some firms contracting and new ones expanding. Here are a few suggested assignments, but feel free to use your own: > Ask the students to construct a table with the top 10 firms for every 10 years to see how quickly firms fall from the top. > Have them figure out how many of the original top 500 remain in the top 500 today. > Have them investigate what happened to each of the top 10 firms listed in 1955. > Have them investigate the history of today’s top 10 firms. How long ago were they founded? When did they first make the top 500? How quickly did they rise through the top 500 rankings year by year? If you want to have them investigate all of these questions and possibly others, you could break up the assignment and give different groups of students different questions and then have them all share their findings the next class period. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: Invisible Hand Property 1: The Minimization of Total Industry Costs of Production Minimization of Total Industry Costs of Production Invisible Hand Property 2: The Balance of Industries The Balance of Industries and Creative Destruction (first half of video) Creative Destruction The Balance of Industries and Creative Destruction (second half of video) Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766