Tutorial 4

Firms in competitive market

• Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue.

• To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost.

Firms in competitive market

• In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.

Firms in competitive market

• Polly’s Ping Pong Balls is a firm that operates in a competitive market. The ping pong balls sell for $3 per package. Fill in the following table and discuss the profit-maximizing level of output:

Firms in competitive marketOutpu

tPric

eTotal

Revenue

Total Cost

Profit Marginal

Revenue

Marginal Cost

0 $3 $1.50

1 3 2.00

2 3 3.00

3 3 4.50

4 3 6.50

5 3 9.00

6 3 12.00

7 3 15.50

8 3 19.50

9 3 24.00

Firms in competitive marketOutpu

tPric

eTotal

Revenue

Total Cost

Profit Marginal

Revenue

Marginal Cost

0 $3 $0.00 $1.50 $-1.50

---- ----

1 3 3.00 2.00 1.00 $3 $0.50

2 3 6.00 3.00 3.00 3 1.00

3 3 9.00 4.50 4.50 3 1.50

4 3 12.00 6.50 5.50 3 2.00

5 3 15.00 9.00 6.00 3 2.50

6 3 18.00 12.00 6.00 3 3.00

7 3 21.00 15.50 5.50 3 3.50

8 3 24.00 19.50 4.50 3 4.00

9 3 27.00 24.00 3.00 3 4.50

Firms in competitive market• “As a recent graduate of this college you have landed a job in

production management for Universal Clones, Inc. You are responsible for the entire company on weekends.”

• “Your costs are shown below.”Quantity Average Total Cost500 200501 201

• Your current level of production is 500 units. All 500 units have been ordered by your regular customers.

• “The phone rings. It’s a new customer who wants to buy one unit of your product. This means you would have to increase production to 501 units. Your new customer offers you $450 to produce the extra unit.”

• a. Should you accept this offer?• b. What is the net change in the firm’s profit?

Firms in competitive market• Most students will answer “yes.” Selling something for

$450 when the average cost of production is $201 seems like good business. They are wrong.

• The relevant comparison is marginal cost to marginal revenue. Marginal cost can be easily calculated as the change in total costs.

Quantity Average Total Cost Total Cost = Q ATC

500 200 100,000 501 201 100,701• $100,701 – $100,000 = $701• Marginal cost in this example is $701. This is much

higher than the marginal revenue of $450. The offer should not be accepted. It would result in a $251 loss.

GDP-Key Points

• Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.

• Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time.

GDP-Key Points

• GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

– Consumption includes spending on goods and services by households, with the exception of purchases of new housing.

– Investment includes spending on new equipment and structures, including households’ purchases of new housing.

– Government purchases include spending on goods and services by local, state, and federal governments.

– Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports).

GDP-Key Points

• Nominal GDP uses current prices to value the economy’s production of goods and services.

• Real GDP uses constant base-year prices to value the economy’s production of goods and services.

• The GDP deflator―calculated from the ratio of nominal to real GDP―measures the level of prices in the economy.

GDPWhat components of GDP (if any) would each

of the following transactions affect?a. A family buys a new refrigerator.

b. Marut buys a new house.

c. Honda sells a civic from its inventory.

d. You buy a pizza.

e. Government repaves Paholyothin road.

f. Your parents buy a bottle of French wine.

g. Toyota expands its factory in Thailand.

GDPa. Consumption increases because a refrigerator is a good

purchased by a household.b. Investment increases because a house is an investment good.c. Consumption increases because a car is a good purchased by

a household, but investment decreases because the car in Honda’s inventory had been counted as an investment good until it was sold.

d. Consumption increases because pizza is a good purchased by a household.

e. Government purchases increase because the government spent money to provide a good to the public.

f. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported.

g. Investment increases because new structures and equipment were built.

GDPWonderland produces two goods: footballs and basketballs. Below is a table showing prices and

quantities of output for three years:

Year Price of Footballs Quantity of Footballs Price of Basketballs Quantity of Basketballs

Year 1 $10 120 $12 200Year 2 12 200 15 300Year 3 14 180 18 275

Nominal GDP in Year 1 = Nominal GDP in Year 2 = Nominal GDP in Year 3 =

Using Year 1 as the Base Year:Real GDP in Year 1 = Real GDP in Year 2 = Real GDP in Year 3 =

GDP deflator for Year 1 = GDP deflator for Year 2 = GDP deflator for Year 3 =

GDPYear Price of Footballs Quantity of Footballs Price of Basketballs Quantity of

BasketballsYear 1 $10 120 $12 200Year 2 12 200 15 300Year 3 14 180 18 275

Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470

Using Year 1 as the Base Year:Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100(Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.)

GDP deflator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100GDP deflator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21GDP deflator for Year 3 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47

CPI-Key Points

• The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.

CPI-Key Points

• The CPI is an imperfect measure of the cost of living for three reasons. – First, it does not take into account consumers’

ability to substitute toward goods that become relatively cheaper over time.

– Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods.

– Third, it is distorted by unmeasured changes in the quality of goods and services.

CPI-Key Points

• Like the CPI, the GDP deflator also measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences.

– The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator.

– In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

CPI-Key Points

• Dollar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.

• Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.

CPI-Key Points

• A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

CPI

• Which do you think has a greater effect on the CPI: a 10% increase in the price of chicken or a 10% increase in the price of caviar?

• If the price of a navy submarine rises, is the CPI or the GDP deflator affected more?

CPI

• A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket.

• If the price of a Navy submarine rises, there is no effect on the consumer price index, because Navy submarines are not consumer goods. But the GDP price index is affected, because Navy submarines are included in GDP as a part of government purchases.

CPI• Suppose that the residents of Proteinland spend

all of their incomes on ham, chicken, and beef. In 2006, they buy 50 kg of ham for $150, 35 kg of chicken for $140, and 100 kg of beef for $500. In 2007, they buy 35 kg of ham for $140, 50 kg of chicken for 200, and 100 kg of beef for $600.

a. Calculate the price of each meat in each year

b. Using 2006 as the base year, calculate the CPI for each year.

c. What is the inflation rate for 2007?

CPI

• a. Find the price of each good in each year:

Year Ham Chicken Roast Beef

2006 $3 $4 $5

2007 $4 $4 $6

CPI

• b. If 2006 is the base year, the market basket used to compute the CPI is 50 pounds of ham, 35 pounds of chicken, and 100 pounds of roast beef. We must now calculate the cost of the market basket in each year:2006: (50 x $3) + (35 x $4) + (100 x $5) = $7902007: (50 x $4) + (35 x $4) + (100 x $6) = $940

• Then, using 2006 as the base year, we can compute the CPI in each year:2006: $790/$790 x 100 = 1002007: $940/$790 x 100 = 119

CPI

• c. We can use the CPI to compute the inflation rate for 2007:

(119 − 100)/100 x 100% = 19%