1 00:00:00,000 --> 00:00:01,916 [SQUEAKING] 2 00:00:01,916 --> 00:00:04,790 [RUSTLING] 3 00:00:04,790 --> 00:00:11,940 [CLICKING] 4 00:00:11,940 --> 00:00:14,230 JONATHAN GRUBER: Why don't we get started. 5 00:00:14,230 --> 00:00:16,410 We're going to start by finishing up 6 00:00:16,410 --> 00:00:18,150 our lecture on costs, with a concept I 7 00:00:18,150 --> 00:00:20,070 didn't get to cover last time. 8 00:00:20,070 --> 00:00:22,590 Then we'll move on to talking about competition. 9 00:00:22,590 --> 00:00:25,350 So I want to start by talking about one concept on costs 10 00:00:25,350 --> 00:00:27,150 we didn't get the cover last time, 11 00:00:27,150 --> 00:00:30,630 which is fixed versus sunk costs. 12 00:00:30,630 --> 00:00:33,180 And sunk costs are an important term in economics, 13 00:00:33,180 --> 00:00:37,010 so I want to make sure people understand what they are. 14 00:00:37,010 --> 00:00:43,920 Sunk costs are essentially costs that cannot be changed, 15 00:00:43,920 --> 00:00:47,980 no matter what action you take from this date forward. 16 00:00:47,980 --> 00:00:51,580 So in some sense, some costs are long-run fixed costs. 17 00:00:51,580 --> 00:00:53,820 I know we said in the long run, nothing's fixed. 18 00:00:53,820 --> 00:00:57,870 But a sunk cost is the idea of an investment that once made, 19 00:00:57,870 --> 00:00:59,165 can never, ever be changed. 20 00:01:01,920 --> 00:01:04,510 So the thing is, if we think about it in the short run, 21 00:01:04,510 --> 00:01:06,560 let's imagine you're a doctor. 22 00:01:06,560 --> 00:01:08,750 In the short run, your variable costs 23 00:01:08,750 --> 00:01:11,810 are how many hours you work, or the nurses you employ, 24 00:01:11,810 --> 00:01:14,300 or the physician assistants you employ. 25 00:01:14,300 --> 00:01:16,430 In the long run, your fixed costs 26 00:01:16,430 --> 00:01:18,060 or how big your office is. 27 00:01:18,060 --> 00:01:21,950 You can get a bigger office or smaller office. 28 00:01:21,950 --> 00:01:24,917 But your sunk cost is having gone to med school. 29 00:01:24,917 --> 00:01:26,750 You can ever undo having gone to med school. 30 00:01:26,750 --> 00:01:28,550 Having paid that cost, it is sunk. 31 00:01:28,550 --> 00:01:29,660 It is gone. 32 00:01:29,660 --> 00:01:30,620 You're never going to-- 33 00:01:30,620 --> 00:01:32,030 you could go to more med school. 34 00:01:32,030 --> 00:01:33,572 You could take supplementary classes, 35 00:01:33,572 --> 00:01:35,767 but you can never undo having gone to med school. 36 00:01:35,767 --> 00:01:38,100 So that's the sense in which some things are sunk costs. 37 00:01:38,100 --> 00:01:40,550 They're investments that are made that can never, 38 00:01:40,550 --> 00:01:43,760 essentially, be undone. 39 00:01:43,760 --> 00:01:46,430 And essentially, we can think of these as long-run fixed costs, 40 00:01:46,430 --> 00:01:48,680 which I know is really confusing, because the long run 41 00:01:48,680 --> 00:01:50,540 is when costs aren't fixed. 42 00:01:50,540 --> 00:01:53,480 But that's essentially what they amount to. 43 00:01:53,480 --> 00:01:57,170 Now, sunk costs turn out to have a very important place 44 00:01:57,170 --> 00:02:01,430 in economic lore, because the thing about sunk costs 45 00:02:01,430 --> 00:02:04,560 is it's hard to think about them. 46 00:02:04,560 --> 00:02:07,800 It's hard to remember the rule that sunk costs are always 47 00:02:07,800 --> 00:02:09,210 sunk. 48 00:02:09,210 --> 00:02:11,670 So let me give you one example-- it's in one of my videos 49 00:02:11,670 --> 00:02:14,550 for the 1401X videos that supplement this course. 50 00:02:14,550 --> 00:02:16,080 But if you've seen it, I apologize. 51 00:02:16,080 --> 00:02:19,170 We'll go through it again, which is literally a case where 52 00:02:19,170 --> 00:02:22,380 I got this wrong two years ago. 53 00:02:22,380 --> 00:02:25,740 So about two and a half years ago, 54 00:02:25,740 --> 00:02:27,570 I made the decision that I take my wife 55 00:02:27,570 --> 00:02:30,000 to go see the band Journey. 56 00:02:30,000 --> 00:02:32,430 So I went and I bought tickets, and the tickets 57 00:02:32,430 --> 00:02:35,130 were $240 for the pair-- 58 00:02:35,130 --> 00:02:38,460 pretty good tickets at a big stadium, $240 for the pair. 59 00:02:38,460 --> 00:02:40,065 Then about a month before the show, 60 00:02:40,065 --> 00:02:41,940 I was looking, and realized I didn't actually 61 00:02:41,940 --> 00:02:43,710 like Journey that much. 62 00:02:43,710 --> 00:02:45,398 I like-- I love a couple of their songs. 63 00:02:45,398 --> 00:02:46,440 I looked at the set list. 64 00:02:46,440 --> 00:02:48,910 I'm like, I don't really like that many of their songs. 65 00:02:48,910 --> 00:02:50,640 There's a couple I love, but I don't want to sit there. 66 00:02:50,640 --> 00:02:51,810 It's a couple hours to get there. 67 00:02:51,810 --> 00:02:53,268 I don't want to sit there all night 68 00:02:53,268 --> 00:02:54,360 for two songs that I like. 69 00:02:54,360 --> 00:02:56,110 I want to sell them. 70 00:02:56,110 --> 00:02:57,890 So you can sell tickets through StubHub 71 00:02:57,890 --> 00:03:00,023 or other secondary mechanisms, but you 72 00:03:00,023 --> 00:03:01,940 have to decide what price you're going to ask. 73 00:03:01,940 --> 00:03:05,000 And I said, I gotta at least make back my $240. 74 00:03:05,000 --> 00:03:06,680 That's my goal. 75 00:03:06,680 --> 00:03:08,240 And then I realized I was thinking 76 00:03:08,240 --> 00:03:10,420 about it completely wrong. 77 00:03:10,420 --> 00:03:12,920 I didn't realize immediately, but I was [INAUDIBLE] about it 78 00:03:12,920 --> 00:03:14,840 completely wrong-- 79 00:03:14,840 --> 00:03:18,990 that the $240 was already gone. 80 00:03:18,990 --> 00:03:22,080 The fact I spent $240, given that I'd already spent it, 81 00:03:22,080 --> 00:03:24,560 is irrelevant. 82 00:03:24,560 --> 00:03:26,390 How should I think about it? 83 00:03:26,390 --> 00:03:29,510 I should only ask how much am I still 84 00:03:29,510 --> 00:03:31,648 willing to pay to see Journey? 85 00:03:31,648 --> 00:03:34,190 And as long as someone else is willing to pay more than that, 86 00:03:34,190 --> 00:03:36,080 I should sell them my tickets. 87 00:03:36,080 --> 00:03:38,000 And if they're not, I should go. 88 00:03:38,000 --> 00:03:40,700 So let's say, for example, I decided, 89 00:03:40,700 --> 00:03:44,040 I'd still pay $100 for my wife and I to go see Journey. 90 00:03:44,040 --> 00:03:46,540 Then I should say, as long as the tickets sell for more than 91 00:03:46,540 --> 00:03:50,920 $100, I'll sell them, but if it's less than $100, I won't. 92 00:03:50,920 --> 00:03:54,230 And the fact I paid $240 is irrelevant-- 93 00:03:54,230 --> 00:03:55,460 that's gone. 94 00:03:55,460 --> 00:03:57,560 That is a sunk cost. 95 00:03:57,560 --> 00:04:00,898 So a common [INAUDIBLE] is the sunk cost fallacy-- 96 00:04:00,898 --> 00:04:02,440 the notion we pay attention to things 97 00:04:02,440 --> 00:04:03,580 that don't matter anymore. 98 00:04:03,580 --> 00:04:05,960 Having spent that money was irrelevant. 99 00:04:05,960 --> 00:04:09,040 All that mattered was the decision looking forward, 100 00:04:09,040 --> 00:04:12,430 which was, do I want to go or do I want to sell the tickets? 101 00:04:12,430 --> 00:04:14,418 And that decision simply depends on how much 102 00:04:14,418 --> 00:04:15,460 I was willing to pay now. 103 00:04:18,019 --> 00:04:19,160 Now that's confusing. 104 00:04:19,160 --> 00:04:20,373 I've explained this. 105 00:04:20,373 --> 00:04:22,040 If you guys get it, you're a rare breed. 106 00:04:22,040 --> 00:04:24,570 I've tried this story on many people, and they're, like, no, 107 00:04:24,570 --> 00:04:26,195 of course it matters how much you paid. 108 00:04:26,195 --> 00:04:28,165 It doesn't. 109 00:04:28,165 --> 00:04:29,790 AUDIENCE: Does this kind of [INAUDIBLE] 110 00:04:29,790 --> 00:04:31,020 apply to the housing market crash, 111 00:04:31,020 --> 00:04:33,290 and homeowners are trying to sell their houses for way more 112 00:04:33,290 --> 00:04:34,920 than they're worth, because they're trying to get 113 00:04:34,920 --> 00:04:35,720 some of their money back? 114 00:04:35,720 --> 00:04:37,928 JONATHAN GRUBER: The sunk cost fallacy finds its name 115 00:04:37,928 --> 00:04:39,990 very much in the housing market. 116 00:04:39,990 --> 00:04:42,780 Many homeowners set as a benchmark 117 00:04:42,780 --> 00:04:44,377 what they paid for their house. 118 00:04:44,377 --> 00:04:46,710 They'll say, I don't want to sell less than what I paid. 119 00:04:46,710 --> 00:04:47,610 That's silly. 120 00:04:47,610 --> 00:04:49,050 Doesn't matter what you paid. 121 00:04:49,050 --> 00:04:51,688 What matters is how much you can sell it for and whether or not 122 00:04:51,688 --> 00:04:52,980 you want to sell at that price. 123 00:04:52,980 --> 00:04:54,490 And what you paid is irrelevant. 124 00:04:54,490 --> 00:04:57,335 Now, it might matter because there are borrowing constraints 125 00:04:57,335 --> 00:04:57,960 we'll get into. 126 00:04:57,960 --> 00:04:59,710 You might have a mortgage you have to pay back, 127 00:04:59,710 --> 00:05:01,168 and you can't afford to pay it back 128 00:05:01,168 --> 00:05:02,803 unless you sell for a certain price. 129 00:05:02,803 --> 00:05:04,220 But aside from that, let's imagine 130 00:05:04,220 --> 00:05:05,678 you just bought your house outright 131 00:05:05,678 --> 00:05:07,680 without a mortgage for $1 million. 132 00:05:07,680 --> 00:05:09,180 Then that's irrelevant. 133 00:05:09,180 --> 00:05:11,040 Whether you sell your house for $900,000 134 00:05:11,040 --> 00:05:13,740 just depends on whether it's worth $900,000 for you 135 00:05:13,740 --> 00:05:14,820 to stay there or not. 136 00:05:14,820 --> 00:05:16,672 The million you paid is irrelevant, 137 00:05:16,672 --> 00:05:18,880 except if you have a mortgage and you've borrowed it. 138 00:05:18,880 --> 00:05:21,330 That can make it complicated. 139 00:05:21,330 --> 00:05:23,340 So basically, sunk costs are sunk. 140 00:05:23,340 --> 00:05:27,510 Now, I ended up selling the tickets for $220, so I did OK. 141 00:05:27,510 --> 00:05:29,400 But if I thought about it incorrectly, 142 00:05:29,400 --> 00:05:30,850 I would've said that's a bummer. 143 00:05:30,850 --> 00:05:31,415 I lost $20. 144 00:05:31,415 --> 00:05:33,040 And in the big picture, it is a bummer. 145 00:05:33,040 --> 00:05:35,550 I never should have bought them in the first place. 146 00:05:35,550 --> 00:05:37,982 But having made that decision to buy them, 147 00:05:37,982 --> 00:05:40,440 the fact I was only willing to pay about $100 at that point 148 00:05:40,440 --> 00:05:45,060 to go and sold for $220 meant I did well, not badly. 149 00:05:45,060 --> 00:05:46,978 Questions about that? 150 00:05:46,978 --> 00:05:48,020 It's a confusing example. 151 00:05:48,020 --> 00:05:49,580 None of your friends understand this. 152 00:05:49,580 --> 00:05:51,420 You could totally mess with your friends' minds 153 00:05:51,420 --> 00:05:52,545 by explaining this to them. 154 00:05:52,545 --> 00:05:53,109 Yeah. 155 00:05:53,109 --> 00:05:58,100 AUDIENCE: [INAUDIBLE] more I might make [INAUDIBLE] 156 00:05:58,100 --> 00:06:02,200 JONATHAN GRUBER: What I mean is, think of them-- 157 00:06:02,200 --> 00:06:04,030 I have a set of Journey tickets. 158 00:06:04,030 --> 00:06:05,060 I have a choice-- 159 00:06:05,060 --> 00:06:06,670 I can sell them or go. 160 00:06:06,670 --> 00:06:08,380 So the only question is, how much is it 161 00:06:08,380 --> 00:06:11,190 worth to me to go to Journey? 162 00:06:11,190 --> 00:06:13,682 I decided it was worth $100 to go to Journey. 163 00:06:13,682 --> 00:06:15,390 So I simply put them on StubHub, and said 164 00:06:15,390 --> 00:06:17,730 if they sell for more than $100, I won't go. 165 00:06:17,730 --> 00:06:19,620 If they sell for less than $100, I'll go. 166 00:06:19,620 --> 00:06:22,630 The fact that I paid $240 is irrelevant. 167 00:06:22,630 --> 00:06:23,320 Yeah. 168 00:06:23,320 --> 00:06:26,060 AUDIENCE: So, basically you've lost [INAUDIBLE].. 169 00:06:26,060 --> 00:06:27,467 You've lost overall you've-- 170 00:06:27,467 --> 00:06:28,300 [INTERPOSING VOICES] 171 00:06:28,300 --> 00:06:29,270 JONATHAN GRUBER: I lost $20. 172 00:06:29,270 --> 00:06:31,080 AUDIENCE: --by making the mistake of buying them. 173 00:06:31,080 --> 00:06:33,455 JONATHAN GRUBER: Yeah, ex ante, there was a mistake made. 174 00:06:33,455 --> 00:06:37,100 But having made the mistake, that's irrelevant. 175 00:06:37,100 --> 00:06:40,010 So that's an important concept to keep in mind, is sunk cost. 176 00:06:40,010 --> 00:06:43,220 Let's go on now and move on to the next topic, which 177 00:06:43,220 --> 00:06:45,440 is the focus of the next two lectures, 178 00:06:45,440 --> 00:06:48,230 which is perfect competition. 179 00:06:54,830 --> 00:06:57,830 Perfect competition. 180 00:06:57,830 --> 00:07:02,560 Now, stepping back, as we highlighted, 181 00:07:02,560 --> 00:07:05,050 a lot of what we did for producer theory 182 00:07:05,050 --> 00:07:08,210 is the same as what we did for consumer theory. 183 00:07:08,210 --> 00:07:11,030 We have isoquants and isocosts instead of indifference curves 184 00:07:11,030 --> 00:07:13,390 and budget constraints, but the same damn exercise, 185 00:07:13,390 --> 00:07:15,520 same math, same graphics. 186 00:07:15,520 --> 00:07:20,230 The difference was we have a series of tangencies 187 00:07:20,230 --> 00:07:22,330 between the isocosts and isoquants, 188 00:07:22,330 --> 00:07:25,150 and we didn't know which one was the right one to choose. 189 00:07:25,150 --> 00:07:27,490 With consumer theory, we pin that down by the fact 190 00:07:27,490 --> 00:07:29,470 our parents gave us a certain amount of money. 191 00:07:29,470 --> 00:07:31,897 For producer theory, there was nothing pinning down q. 192 00:07:31,897 --> 00:07:33,730 There's nothing pinning down our total costs 193 00:07:33,730 --> 00:07:36,010 we can afford to spend. 194 00:07:36,010 --> 00:07:38,890 What pins that down is an additional constraint 195 00:07:38,890 --> 00:07:43,485 we bring into the system, which is the market. 196 00:07:43,485 --> 00:07:46,110 So now, we're going to take that next step of actually deciding 197 00:07:46,110 --> 00:07:47,700 what a firm produces. 198 00:07:47,700 --> 00:07:50,010 What a firm produces partly comes from all the math 199 00:07:50,010 --> 00:07:52,120 we do before developing the cost curve. 200 00:07:52,120 --> 00:07:55,350 But it also comes from the fact that firm exists in a market. 201 00:07:55,350 --> 00:07:57,300 And we focused on the cost side. 202 00:07:57,300 --> 00:07:59,048 Now, we turn to the revenue side. 203 00:07:59,048 --> 00:08:00,840 The markets can determine what the firm can 204 00:08:00,840 --> 00:08:03,750 make from selling that good, and that's and that's 205 00:08:03,750 --> 00:08:06,180 going to pin down how much they produce. 206 00:08:06,180 --> 00:08:09,390 Now, we're getting set of three different market settings. 207 00:08:09,390 --> 00:08:11,910 Today, we'll talk about perfect competition, which 208 00:08:11,910 --> 00:08:14,790 is the market with many, many firms competing 209 00:08:14,790 --> 00:08:16,680 to sell a homogeneous good. 210 00:08:16,680 --> 00:08:19,440 I'll talk about it more precisely later. 211 00:08:19,440 --> 00:08:21,210 Then, we're going to talk-- 212 00:08:21,210 --> 00:08:22,667 that's one extreme. 213 00:08:22,667 --> 00:08:24,750 That's the extreme of markets that economists sort 214 00:08:24,750 --> 00:08:27,450 of dream about is a perfectly competitive market. 215 00:08:27,450 --> 00:08:29,900 The other extreme is monopoly, where 216 00:08:29,900 --> 00:08:34,515 there's one firm, only one firm that sells the good. 217 00:08:34,515 --> 00:08:36,390 And then in between, we have my favorite word 218 00:08:36,390 --> 00:08:39,280 in economics-- oligopoly, which is when there's 219 00:08:39,280 --> 00:08:42,190 several firms competing to sell a good, not as many as perfect 220 00:08:42,190 --> 00:08:44,140 competition, but more than one. 221 00:08:44,140 --> 00:08:46,070 That turns out to be super complicated. 222 00:08:46,070 --> 00:08:48,070 So what we do is we start with the two extremes, 223 00:08:48,070 --> 00:08:50,020 develop a set of intuitions and rules, 224 00:08:50,020 --> 00:08:52,420 and then we sort of hand-wave a bit around oligopoly. 225 00:08:52,420 --> 00:08:54,045 And that's where I introduce the notion 226 00:08:54,045 --> 00:08:55,850 of game theory, which we'll talk about some 227 00:08:55,850 --> 00:08:58,085 in a couple of lectures. 228 00:08:58,085 --> 00:08:59,710 So today, we're going to start with one 229 00:08:59,710 --> 00:09:02,350 extreme-- perfect competition. 230 00:09:02,350 --> 00:09:05,300 What is perfect competition? 231 00:09:05,300 --> 00:09:07,370 Basically, the technical definition 232 00:09:07,370 --> 00:09:09,440 of a perfectly competitive market 233 00:09:09,440 --> 00:09:15,510 is where producers are price takers. 234 00:09:15,510 --> 00:09:17,040 A perfectly competitive market is 235 00:09:17,040 --> 00:09:19,230 one where a producer doesn't have 236 00:09:19,230 --> 00:09:22,770 any influence over the price that they sell their good at. 237 00:09:22,770 --> 00:09:24,910 They are price takers. 238 00:09:24,910 --> 00:09:28,020 So I can't actually, as one-producer market, 239 00:09:28,020 --> 00:09:31,290 can't actually affect the market price. 240 00:09:31,290 --> 00:09:34,680 The market price is given to me. 241 00:09:34,680 --> 00:09:36,630 When will this be true? 242 00:09:36,630 --> 00:09:43,150 This will be true when the demand for a firm's output 243 00:09:43,150 --> 00:09:49,800 is perfectly elastic, when the demand for a given firm's 244 00:09:49,800 --> 00:09:52,350 output-- little q, not the market elasticity, 245 00:09:52,350 --> 00:09:56,760 but the firm elasticity-- when you have 246 00:09:56,760 --> 00:10:00,248 an infinitely elastic little q. 247 00:10:00,248 --> 00:10:01,540 So let's think about that case. 248 00:10:01,540 --> 00:10:04,560 Let's turn to the first figure. 249 00:10:04,560 --> 00:10:05,908 So we have little q2 and-- 250 00:10:05,908 --> 00:10:08,450 so we basically have little q, because it's the firm's output 251 00:10:08,450 --> 00:10:09,810 on the x-axis. 252 00:10:09,810 --> 00:10:12,500 The y-axis is the market price. 253 00:10:12,500 --> 00:10:14,690 The firm faces a perfectly elastic demand curve. 254 00:10:14,690 --> 00:10:19,190 That means that they can't change the market price that's 255 00:10:19,190 --> 00:10:20,090 charged. 256 00:10:20,090 --> 00:10:21,450 So what does that mean? 257 00:10:21,450 --> 00:10:25,280 That means that no matter what their cost function 258 00:10:25,280 --> 00:10:29,120 is, whether their supply curve 1 or supply curve 2, 259 00:10:29,120 --> 00:10:31,610 they always sell at price p. 260 00:10:31,610 --> 00:10:34,700 So shifts in the cost function-- that is shifts in the supply 261 00:10:34,700 --> 00:10:35,510 curve-- 262 00:10:35,510 --> 00:10:40,810 only affect how much you sell, not the price you get. 263 00:10:40,810 --> 00:10:46,140 That would be true in a perfectly competitive market. 264 00:10:46,140 --> 00:10:50,970 So what conditions make a perfectly competitive market? 265 00:10:50,970 --> 00:10:55,080 There's basically three conditions. 266 00:10:55,080 --> 00:10:57,515 The first is identical products. 267 00:11:01,058 --> 00:11:02,850 A market will only be perfectly competitive 268 00:11:02,850 --> 00:11:05,828 if all the firms are selling at least what consumers perceive 269 00:11:05,828 --> 00:11:06,870 to be identical products. 270 00:11:06,870 --> 00:11:09,210 They don't have to be technologically identical. 271 00:11:09,210 --> 00:11:10,920 But from a consumer's perspective, 272 00:11:10,920 --> 00:11:14,360 they have to be viewed as identical. 273 00:11:14,360 --> 00:11:20,730 The second condition is there's full information about prices. 274 00:11:24,500 --> 00:11:28,330 That is, consumers know what every firm is charging. 275 00:11:28,330 --> 00:11:31,210 So I go to market, and I know what every firm is charging. 276 00:11:31,210 --> 00:11:34,750 I have full information. 277 00:11:34,750 --> 00:11:45,480 And the third condition is that there's low transaction costs, 278 00:11:45,480 --> 00:11:49,100 or what you might call "search costs," 279 00:11:49,100 --> 00:11:53,180 that it's very costless for me to search across opportunities. 280 00:11:53,180 --> 00:11:55,580 It's very costly for me to care-- 281 00:11:55,580 --> 00:11:57,763 everybody's price is perfectly posted, 282 00:11:57,763 --> 00:11:59,930 and it's very costless for me to search across them. 283 00:11:59,930 --> 00:12:01,680 Sort of two and three are kind of related. 284 00:12:05,160 --> 00:12:08,577 So this is obviously never true, much 285 00:12:08,577 --> 00:12:10,410 like many of our assumptions are never true. 286 00:12:10,410 --> 00:12:15,290 But it's a useful benchmark for thinking about a lot of what 287 00:12:15,290 --> 00:12:16,500 we're going to think about. 288 00:12:16,500 --> 00:12:20,140 So you want to think about markets like this-- 289 00:12:20,140 --> 00:12:23,930 so for example, the classic case you might think of is eBay. 290 00:12:23,930 --> 00:12:27,590 If you go on eBay and you search-- 291 00:12:27,590 --> 00:12:32,550 I just bought a pair of 72-inch red shoelaces. 292 00:12:32,550 --> 00:12:34,550 There's 72-inch red shoelace or [INAUDIBLE] 293 00:12:34,550 --> 00:12:37,700 It turns out not quite-- some are flat, some are oval. 294 00:12:37,700 --> 00:12:39,920 But within oval 72-inch red shoelaces, 295 00:12:39,920 --> 00:12:41,570 there's literally no variation. 296 00:12:41,570 --> 00:12:43,210 They're 72-inch, red shoelaces. 297 00:12:43,210 --> 00:12:45,650 Now, they could be of different quality, 298 00:12:45,650 --> 00:12:47,160 and that might be unobservable. 299 00:12:47,160 --> 00:12:51,140 That's why it's not perfect, but it's pretty close to identical. 300 00:12:51,140 --> 00:12:54,293 I go on eBay, and all the prices are listed there. 301 00:12:54,293 --> 00:12:55,960 So I have full information on my prices, 302 00:12:55,960 --> 00:12:58,670 and they're easy to compare. 303 00:12:58,670 --> 00:13:01,480 Now, it's not perfect because, a, there 304 00:13:01,480 --> 00:13:03,820 could be unobserved quality differences. 305 00:13:03,820 --> 00:13:06,200 Some shoelaces may be made by cheaper manufacturers. 306 00:13:06,200 --> 00:13:09,190 Others are easier to break or fray. 307 00:13:09,190 --> 00:13:11,980 And the second reason is that I might not have full information 308 00:13:11,980 --> 00:13:14,840 about prices, because at least in the old days-- 309 00:13:14,840 --> 00:13:16,600 eBay's changed this-- 310 00:13:16,600 --> 00:13:20,290 they can price compare on the non-shipping cost price. 311 00:13:20,290 --> 00:13:21,350 Now eBay's fixed this. 312 00:13:21,350 --> 00:13:23,812 You get the price including shipping costs. 313 00:13:23,812 --> 00:13:25,270 So in the old days, you could shop, 314 00:13:25,270 --> 00:13:26,140 and think you had the cheapest deal, 315 00:13:26,140 --> 00:13:28,900 but it turned out when you add shipping costs, it wasn't. 316 00:13:28,900 --> 00:13:31,520 So even eBay, which is sort of the economist's dream platform, 317 00:13:31,520 --> 00:13:33,140 doesn't quite meet these conditions, 318 00:13:33,140 --> 00:13:35,830 but it's about as close as you can come. 319 00:13:35,830 --> 00:13:38,410 Now, the other example I like to point to 320 00:13:38,410 --> 00:13:44,640 is like buying little knickknacks in a tourist area. 321 00:13:44,640 --> 00:13:48,000 That basically, if you've ever gone to a tourist area 322 00:13:48,000 --> 00:13:50,820 and tried to buy a little knickknack like a replica 323 00:13:50,820 --> 00:13:53,250 of the Eiffel Tower around the Eiffel Tower, 324 00:13:53,250 --> 00:13:56,580 there's a bunch of guys with blankets, out selling them. 325 00:13:56,580 --> 00:13:59,580 And it's pretty easy to get see they're all the same replicas. 326 00:13:59,580 --> 00:14:01,288 And it's pretty easy to ask the guy, what 327 00:14:01,288 --> 00:14:04,308 do you want for your Eiffel tower replica? 328 00:14:04,308 --> 00:14:05,350 So that's another market. 329 00:14:05,350 --> 00:14:08,600 Now, I taught this as a casual example. 330 00:14:08,600 --> 00:14:12,640 Someone watched this video from when I did this four years ago, 331 00:14:12,640 --> 00:14:15,130 and went to the Eiffel Tower-- 332 00:14:15,130 --> 00:14:16,630 some guy in France-- 333 00:14:16,630 --> 00:14:19,570 and actually did the exercise of marching from blanket 334 00:14:19,570 --> 00:14:20,890 to blanket. 335 00:14:20,890 --> 00:14:24,505 And he found that when you got further from the Eiffel Tower, 336 00:14:24,505 --> 00:14:26,380 they're more expensive, because there weren't 337 00:14:26,380 --> 00:14:27,833 many people selling them. 338 00:14:27,833 --> 00:14:30,250 But once you got close to the Eiffel Tower, all these guys 339 00:14:30,250 --> 00:14:31,600 selling them, he found that everyone 340 00:14:31,600 --> 00:14:32,350 charged the identical price. 341 00:14:32,350 --> 00:14:34,808 And he sent me a little package of 24 little Eiffel towers. 342 00:14:34,808 --> 00:14:37,600 It was really cute. 343 00:14:37,600 --> 00:14:41,840 So that was sort of this exercise in reality. 344 00:14:41,840 --> 00:14:44,490 Now, the important thing to remember, though, 345 00:14:44,490 --> 00:14:47,700 is this is a perfectly elastic, firm demand. 346 00:14:47,700 --> 00:14:51,080 So I want to talk for a second about demand 347 00:14:51,080 --> 00:14:54,200 for a firm's good versus demand for a market's good, so 348 00:14:54,200 --> 00:14:55,550 firm versus market demand. 349 00:15:01,840 --> 00:15:05,080 These are two different things. 350 00:15:05,080 --> 00:15:07,450 And the way to think about this, think about the concept 351 00:15:07,450 --> 00:15:11,310 of residual demand. 352 00:15:11,310 --> 00:15:13,560 So you could think about the demand 353 00:15:13,560 --> 00:15:16,230 for a market, demand function for a market, 354 00:15:16,230 --> 00:15:18,325 as being some Q of p. 355 00:15:18,325 --> 00:15:19,950 That's a demand function of the market. 356 00:15:19,950 --> 00:15:21,408 That's this demand curve we've been 357 00:15:21,408 --> 00:15:23,070 looking at since lecture one. 358 00:15:23,070 --> 00:15:28,200 It's a downward-sloping function of the price. 359 00:15:28,200 --> 00:15:34,120 And we can then think of any given firm, little q's demand, 360 00:15:34,120 --> 00:15:44,340 q of p, as equal to big Q of p minus S0 of p, where S0 of p 361 00:15:44,340 --> 00:15:46,245 we call "residual demand." 362 00:15:49,040 --> 00:15:51,340 S super 0 of p is residual demand. 363 00:15:51,340 --> 00:15:53,970 It's what everyone else is supplying. 364 00:15:53,970 --> 00:15:55,552 So the demand to my firm-- 365 00:15:55,552 --> 00:15:57,010 once again, under these conditions, 366 00:15:57,010 --> 00:15:59,730 perfectly competitive market-- 367 00:15:59,730 --> 00:16:03,780 the demand to my firm is simply the total market demand minus 368 00:16:03,780 --> 00:16:05,055 what everyone else is selling. 369 00:16:05,055 --> 00:16:06,930 So if I'm going to set up my little tchotchke 370 00:16:06,930 --> 00:16:11,130 blanket by the Eiffel Tower, my demand 371 00:16:11,130 --> 00:16:14,160 is going to be the total demand for little Eiffel towers minus 372 00:16:14,160 --> 00:16:18,230 what everyone else is selling at on their blanket. 373 00:16:18,230 --> 00:16:23,510 The key point is, even with fairly inelastic, big Q, 374 00:16:23,510 --> 00:16:25,910 you can get really elastic little q. 375 00:16:25,910 --> 00:16:27,330 So let's do an example. 376 00:16:27,330 --> 00:16:29,570 Let's first differentiate this. 377 00:16:29,570 --> 00:16:34,560 If you do dq dp, what do you get? 378 00:16:34,560 --> 00:16:41,120 You get d big Q dp minus d S0 dp. 379 00:16:44,810 --> 00:16:47,330 Now, the first term is negative, because demand is downward 380 00:16:47,330 --> 00:16:49,100 sloping. 381 00:16:49,100 --> 00:16:52,430 This term is positive, dS0 dp. 382 00:16:52,430 --> 00:16:54,290 The higher the price, the more suppliers 383 00:16:54,290 --> 00:16:56,660 are going to be in the market. 384 00:16:56,660 --> 00:16:58,250 So it's a positive minus a negative. 385 00:16:58,250 --> 00:17:01,310 So already, we see d little q dp is 386 00:17:01,310 --> 00:17:04,339 going to be bigger in absolute value than d big Q dp, 387 00:17:04,339 --> 00:17:08,310 because dS0 dp is positive, and you're subtracting it. 388 00:17:08,310 --> 00:17:11,579 But we can actually go further if we 389 00:17:11,579 --> 00:17:13,579 assume firms are identical. 390 00:17:13,579 --> 00:17:15,270 Let's assume firms are identical, 391 00:17:15,270 --> 00:17:18,839 so that little q equals big Q over N. Assume 392 00:17:18,839 --> 00:17:20,190 there's N identical firms. 393 00:17:24,960 --> 00:17:32,010 And what that means is that S0 equals 394 00:17:32,010 --> 00:17:35,770 N minus 1 times little q. 395 00:17:35,770 --> 00:17:38,230 The supply of everyone else is the number of firms 396 00:17:38,230 --> 00:17:40,390 in the market-- that's an N, big N-- 397 00:17:40,390 --> 00:17:42,220 number of firms in the market minus 1, 398 00:17:42,220 --> 00:17:44,080 because that's your firm, minus little q, 399 00:17:44,080 --> 00:17:47,290 because you're all identical. 400 00:17:47,290 --> 00:17:49,800 Then we can rewrite this-- you can do the math at home-- we 401 00:17:49,800 --> 00:17:53,290 can rewrite this equation as-- under these conditions, 402 00:17:53,290 --> 00:17:57,030 we can rewrite this as the elasticity of demand 403 00:17:57,030 --> 00:18:02,460 facing firm i is equal to the number of firms 404 00:18:02,460 --> 00:18:08,440 times the market elasticity minus N 405 00:18:08,440 --> 00:18:13,040 minus 1 times the market supply elasticity. 406 00:18:13,040 --> 00:18:17,260 Nu is the market supply elasticity. 407 00:18:17,260 --> 00:18:20,440 eta is the market demand elasticity. 408 00:18:20,440 --> 00:18:23,380 eta i is the firm demand elasticity. 409 00:18:23,380 --> 00:18:25,588 So the firm demand elasticity is equal to N-- 410 00:18:25,588 --> 00:18:27,380 I keep mixing my little n's and my big N's. 411 00:18:27,380 --> 00:18:28,660 It's all the same thing. 412 00:18:28,660 --> 00:18:34,120 N times e-- so firm demand elasticity 413 00:18:34,120 --> 00:18:36,300 is equal to number of firms times market demand 414 00:18:36,300 --> 00:18:41,580 elasticity minus number of firms minus 1 times the market 415 00:18:41,580 --> 00:18:43,238 supply elasticity. 416 00:18:43,238 --> 00:18:44,280 We know this is positive. 417 00:18:44,280 --> 00:18:46,490 Supply curves slope up. 418 00:18:46,490 --> 00:18:49,000 We know this is negative. 419 00:18:49,000 --> 00:18:52,770 So we know it's a negative number. 420 00:18:52,770 --> 00:18:54,150 What's good about this formula is 421 00:18:54,150 --> 00:18:57,500 it gives us examples showing how much bigger firm elasticity can 422 00:18:57,500 --> 00:18:58,750 be than the market elasticity. 423 00:18:58,750 --> 00:19:01,860 So for example, suppose, as a simple example, 424 00:19:01,860 --> 00:19:03,930 suppose N equals 100 suppose it's 425 00:19:03,930 --> 00:19:06,060 100 people selling Eiffel towers on their blankets 426 00:19:06,060 --> 00:19:09,090 around the Eiffel Tower. 427 00:19:09,090 --> 00:19:13,275 And suppose that the market elasticity is minus 1-- 428 00:19:13,275 --> 00:19:15,600 that is, it's an elastically demanded good. 429 00:19:15,600 --> 00:19:17,100 It's not super elastically demanded. 430 00:19:17,100 --> 00:19:20,160 Basically, we call that an elastically demanded good, 431 00:19:20,160 --> 00:19:22,110 minus 1. 432 00:19:22,110 --> 00:19:25,170 So it's sort of a 45-degree line demand curve, a 45-degree line 433 00:19:25,170 --> 00:19:26,700 demand curve sloping down. 434 00:19:26,700 --> 00:19:30,810 And let's also imagine that the elasticity of supply is 1. 435 00:19:30,810 --> 00:19:34,870 That's a 45-degree line, upward-sloping supply curve. 436 00:19:34,870 --> 00:19:36,730 These are pretty standard assumptions. 437 00:19:36,730 --> 00:19:39,960 It's what I drew in lecture 1, a 45-degree demand 438 00:19:39,960 --> 00:19:43,830 curve, a 45-degree supply curve, with 100 firms. 439 00:19:43,830 --> 00:19:48,420 That gives you that the firm specific elasticity 440 00:19:48,420 --> 00:19:52,470 is minus 199. 441 00:19:52,470 --> 00:19:53,745 That is virtually flat. 442 00:19:56,680 --> 00:19:58,600 That is approximately negative infinity, 443 00:19:58,600 --> 00:20:02,040 as far as these things go. 444 00:20:02,040 --> 00:20:05,910 So basically, even with just a regular-looking, 445 00:20:05,910 --> 00:20:08,070 downward-sloping demand curve, if it's 446 00:20:08,070 --> 00:20:09,670 100 firms of independent marketing, 447 00:20:09,670 --> 00:20:12,430 you get a virtually flat firm specific demand curve. 448 00:20:12,430 --> 00:20:15,920 So it's not crazy that firms in a really competitive market 449 00:20:15,920 --> 00:20:18,933 would face essentially perfectly elastic demand. 450 00:20:18,933 --> 00:20:20,600 And that's the key thing that's going on 451 00:20:20,600 --> 00:20:22,280 in a perfectly competitive market, 452 00:20:22,280 --> 00:20:25,160 is firms themselves-- not the market demand, the market 453 00:20:25,160 --> 00:20:28,940 demand can be sensible-- but firms themselves face virtually 454 00:20:28,940 --> 00:20:30,350 perfectly elastic demand. 455 00:20:30,350 --> 00:20:32,780 If you're all selling little Eiffel towers next 456 00:20:32,780 --> 00:20:35,930 to each other, then if you try to raise your price by one 457 00:20:35,930 --> 00:20:38,025 euro, you're gone. 458 00:20:38,025 --> 00:20:38,900 No one buys from you. 459 00:20:38,900 --> 00:20:41,240 If you lower it by one euro, everyone buys from you. 460 00:20:41,240 --> 00:20:44,165 That sort of makes sense. 461 00:20:44,165 --> 00:20:45,040 Questions about that? 462 00:20:45,040 --> 00:20:46,060 Yeah. 463 00:20:46,060 --> 00:20:47,435 AUDIENCE: What was the difference 464 00:20:47,435 --> 00:20:49,080 between big Q and little q? 465 00:20:49,080 --> 00:20:52,495 JONATHAN GRUBER: Little q is the firm and big Q is the market-- 466 00:20:52,495 --> 00:20:53,620 very important to remember. 467 00:20:53,620 --> 00:20:54,382 Always remember. 468 00:20:54,382 --> 00:20:55,840 That's a middle of the night thing. 469 00:20:55,840 --> 00:20:57,757 When I wake you up in the middle of the night, 470 00:20:57,757 --> 00:20:59,375 you have to know that one. 471 00:20:59,375 --> 00:21:00,250 Little q is the firm. 472 00:21:00,250 --> 00:21:02,787 Big Q is the market. 473 00:21:02,787 --> 00:21:04,370 Now, I'm not guaranteeing I always get 474 00:21:04,370 --> 00:21:05,937 that right on the board. 475 00:21:05,937 --> 00:21:08,270 But I am guaranteeing if I get it wrong, one of you guys 476 00:21:08,270 --> 00:21:10,860 will correct me. 477 00:21:10,860 --> 00:21:12,300 So armed with this-- 478 00:21:12,300 --> 00:21:14,550 any other question about this? 479 00:21:14,550 --> 00:21:22,620 Armed with this, we now turn to how firms maximize profits, 480 00:21:22,620 --> 00:21:24,600 short-run profit maximization. 481 00:21:24,600 --> 00:21:27,510 This is what we've been heading for. 482 00:21:27,510 --> 00:21:30,690 With consumers, our goal was to model how 483 00:21:30,690 --> 00:21:32,700 they maximize their utility. 484 00:21:32,700 --> 00:21:38,430 With firms, our goal is to model how they maximize profit. 485 00:21:38,430 --> 00:21:42,130 Now, what is the key thing in the short run? 486 00:21:42,130 --> 00:21:43,900 The fact is that short run means we're 487 00:21:43,900 --> 00:21:45,525 going to make-- we talk about short run 488 00:21:45,525 --> 00:21:47,380 being capital is fixed, but there's 489 00:21:47,380 --> 00:21:50,650 one other assumption we're going to make about the short run. 490 00:21:50,650 --> 00:21:56,730 We're going to assume no firm entry or exit. 491 00:21:56,730 --> 00:22:00,010 It's sort of a complement of capital being fixed. 492 00:22:00,010 --> 00:22:01,630 Firms are you're in. 493 00:22:01,630 --> 00:22:04,800 You make your capital investment and you're in. 494 00:22:04,800 --> 00:22:08,480 You could stop producing, but you still already made 495 00:22:08,480 --> 00:22:09,680 your capital investment. 496 00:22:09,680 --> 00:22:11,180 Or in other words, in the short run, 497 00:22:11,180 --> 00:22:14,210 capital is a sunk cost in the short run. 498 00:22:14,210 --> 00:22:15,910 You're in. 499 00:22:15,910 --> 00:22:18,352 And once the market starts, no one new is coming in. 500 00:22:18,352 --> 00:22:19,810 So you sort of roll in this market. 501 00:22:19,810 --> 00:22:21,102 People have announced to begin. 502 00:22:21,102 --> 00:22:23,270 They've set up their blankets. 503 00:22:23,270 --> 00:22:25,160 No one else has come to set up a blanket 504 00:22:25,160 --> 00:22:27,368 and no one's rolling up their blanket and going home. 505 00:22:29,920 --> 00:22:37,350 So now, let's ask first question-- what is profit? 506 00:22:37,350 --> 00:22:40,290 Well, that seems sort of easy. 507 00:22:40,290 --> 00:22:44,825 Profit, as I wrote down earlier, is just revenue minus costs. 508 00:22:44,825 --> 00:22:47,200 And if you're taking one of those goddamn boring counting 509 00:22:47,200 --> 00:22:50,070 courses in course 15, that's where you'd stop. 510 00:22:50,070 --> 00:22:51,100 But you're not. 511 00:22:51,100 --> 00:22:54,330 You're take an interesting course 14 course instead, 512 00:22:54,330 --> 00:22:56,320 where we tell you that while this 513 00:22:56,320 --> 00:23:00,490 may be the correct definition of accounting profits, 514 00:23:00,490 --> 00:23:03,850 accountants simply say, you add up the revenues 515 00:23:03,850 --> 00:23:09,040 you make minus the costs you incur, and that's the profit. 516 00:23:09,040 --> 00:23:11,230 But economists say, wait a second-- 517 00:23:11,230 --> 00:23:14,860 that's not right, because we also 518 00:23:14,860 --> 00:23:20,970 have to account for opportunity costs, as well as cash costs. 519 00:23:20,970 --> 00:23:23,430 Let's do a simple example. 520 00:23:23,430 --> 00:23:25,670 Let's say you're going to start a website design 521 00:23:25,670 --> 00:23:27,380 firm when you graduate. 522 00:23:27,380 --> 00:23:28,790 And all the firm's going to be is 523 00:23:28,790 --> 00:23:31,570 you, some slave programmer you're 524 00:23:31,570 --> 00:23:33,965 going to hire for $40,000, and the computer 525 00:23:33,965 --> 00:23:34,840 they're going to use. 526 00:23:39,860 --> 00:23:41,480 And moreover, let's say you already 527 00:23:41,480 --> 00:23:42,860 have a computer sitting around. 528 00:23:42,860 --> 00:23:43,735 That's your computer. 529 00:23:43,735 --> 00:23:45,450 It's in pretty good shape. 530 00:23:45,450 --> 00:23:50,120 So you could just have the slave work on that computer. 531 00:23:50,120 --> 00:23:51,690 And you can just basically say, look, 532 00:23:51,690 --> 00:23:53,390 I'll pay this guy $40,000. 533 00:23:53,390 --> 00:23:55,970 I'll think up all the ideas and supervise them. 534 00:23:55,970 --> 00:23:58,220 And then that's the way the firm's going to work. 535 00:23:58,220 --> 00:24:00,920 Let's say you do that, and at the end of the first year, 536 00:24:00,920 --> 00:24:05,250 you have sales of $60,000. 537 00:24:05,250 --> 00:24:09,690 Then your accounting profits are the $60,000 538 00:24:09,690 --> 00:24:13,260 that you earned minus the $40,000 you paid your employee. 539 00:24:13,260 --> 00:24:16,920 So you've made a $20,000 accounting profit. 540 00:24:16,920 --> 00:24:18,640 Why does that make no sense. 541 00:24:18,640 --> 00:24:20,820 In fact, why are economic profits, 542 00:24:20,820 --> 00:24:23,070 the true profits from this enterprise once you account 543 00:24:23,070 --> 00:24:26,050 for opportunity cost negative. 544 00:24:26,050 --> 00:24:28,570 What do the accountants miss that economists get? 545 00:24:28,570 --> 00:24:29,195 Yeah. 546 00:24:29,195 --> 00:24:30,820 AUDIENCE: [INAUDIBLE] something better. 547 00:24:30,820 --> 00:24:33,400 JONATHAN GRUBER: The opportunity cost of your time. 548 00:24:33,400 --> 00:24:34,870 You just spent a year doing this. 549 00:24:34,870 --> 00:24:36,970 You could have been off making a zillion dollars, 550 00:24:36,970 --> 00:24:39,370 like you guys all will. 551 00:24:39,370 --> 00:24:44,005 So we missed the opportunity cost of your time. 552 00:24:44,005 --> 00:24:45,880 Let's say you could have graduated and gotten 553 00:24:45,880 --> 00:24:49,200 a job at $80,000 a year. 554 00:24:49,200 --> 00:24:51,725 Well then, actually, the cost of the year 555 00:24:51,725 --> 00:24:53,730 is not just the $40,000 you paid the programmer. 556 00:24:53,730 --> 00:24:57,240 It's the $80,000 that you forgoed by working 557 00:24:57,240 --> 00:25:00,180 that year on your company. 558 00:25:00,180 --> 00:25:00,680 What else? 559 00:25:00,680 --> 00:25:02,780 What's the other opportunity cost? 560 00:25:02,780 --> 00:25:05,450 Much smaller, but still relevant. 561 00:25:05,450 --> 00:25:07,576 What could you've done with the computer? 562 00:25:07,576 --> 00:25:09,340 AUDIENCE: [INAUDIBLE] 563 00:25:09,340 --> 00:25:11,340 JONATHAN GRUBER: Well, you could have done what? 564 00:25:11,340 --> 00:25:12,480 AUDIENCE: You could have sold it. 565 00:25:12,480 --> 00:25:14,880 JONATHAN GRUBER: You could have sold the computer, right. 566 00:25:14,880 --> 00:25:16,690 Now, used computers aren't worth that much, 567 00:25:16,690 --> 00:25:19,470 but let's say you could have gotten a grand for it. 568 00:25:19,470 --> 00:25:21,810 Well, that's an opportunity cost. 569 00:25:21,810 --> 00:25:24,923 If you would just gone on and used your-- 570 00:25:24,923 --> 00:25:26,340 now, you might get all the utility 571 00:25:26,340 --> 00:25:27,210 from the computer, whatever. 572 00:25:27,210 --> 00:25:28,000 Let's put that aside. 573 00:25:28,000 --> 00:25:28,890 But you just gave it to this guy. 574 00:25:28,890 --> 00:25:30,810 You never touched it, literally got rid of it. 575 00:25:30,810 --> 00:25:33,813 It was like you didn't have the computer that year. 576 00:25:33,813 --> 00:25:34,980 Then you could have sold it. 577 00:25:34,980 --> 00:25:37,890 Let's say you could have sold it for another $1,000. 578 00:25:37,890 --> 00:25:41,220 So now, you've paid him $40,000. 579 00:25:41,220 --> 00:25:44,310 You've given up $80,000 of earnings and $1,000 580 00:25:44,310 --> 00:25:49,590 on the computer, so your true costs are actually $121,000. 581 00:25:49,590 --> 00:25:52,020 So actually, you haven't made $20,000. 582 00:25:52,020 --> 00:25:55,460 You've lost $61,000. 583 00:25:55,460 --> 00:25:57,980 And that's why we don't care about accounting profits. 584 00:25:57,980 --> 00:26:00,620 We care about economic profits, the difference 585 00:26:00,620 --> 00:26:03,740 being economic profits account for opportunity costs-- 586 00:26:06,450 --> 00:26:07,670 very important to remember. 587 00:26:07,670 --> 00:26:09,080 Yeah. 588 00:26:09,080 --> 00:26:11,870 AUDIENCE: The profits, economic profits 589 00:26:11,870 --> 00:26:14,450 will be higher than financial profit or typically 590 00:26:14,450 --> 00:26:15,710 [INAUDIBLE]? 591 00:26:15,710 --> 00:26:17,510 JONATHAN GRUBER: It all depends on-- 592 00:26:17,510 --> 00:26:19,260 it depends on there's no way to assign it. 593 00:26:21,940 --> 00:26:23,313 yeah. 594 00:26:23,313 --> 00:26:25,230 AUDIENCE: You've been talking about sunk costs 595 00:26:25,230 --> 00:26:27,500 and opportunity costs. 596 00:26:27,500 --> 00:26:30,110 Is it like [INAUDIBLE] economics to consider time 597 00:26:30,110 --> 00:26:33,050 to be a sunk cost, like if you spend 598 00:26:33,050 --> 00:26:35,030 a lot of time on something? 599 00:26:35,030 --> 00:26:37,430 JONATHAN GRUBER: Well, no, it's not. 600 00:26:37,430 --> 00:26:39,680 I mean, in some sense, a sunk-- 601 00:26:39,680 --> 00:26:42,240 basically, sunk costs is sort of an irreversible fixed cost. 602 00:26:42,240 --> 00:26:44,115 If you spend time on it, yeah, in that sense, 603 00:26:44,115 --> 00:26:45,770 from today's perspective, it's sunk. 604 00:26:45,770 --> 00:26:48,200 But the point is, the more important concept 605 00:26:48,200 --> 00:26:51,740 is that time is money, that if you spent your time running 606 00:26:51,740 --> 00:26:54,470 this business, that's time you could've 607 00:26:54,470 --> 00:26:56,450 spent doing something else. 608 00:26:56,450 --> 00:26:58,220 Now, one thing we'll come to in a couple 609 00:26:58,220 --> 00:26:59,870 lectures, you might say, well, hey, 610 00:26:59,870 --> 00:27:02,260 I would've taken the year off and screwed around. 611 00:27:02,260 --> 00:27:04,233 So in fact, there was no $80,000 cost. 612 00:27:04,233 --> 00:27:05,900 What if instead of running this company, 613 00:27:05,900 --> 00:27:08,317 the only thing I want to do in my life is run the company. 614 00:27:08,317 --> 00:27:10,850 My second choice is watching TV. 615 00:27:10,850 --> 00:27:12,350 So then there's no opportunity cost. 616 00:27:12,350 --> 00:27:13,290 That's wrong. 617 00:27:13,290 --> 00:27:15,040 And we'll teach you why in a few lectures. 618 00:27:15,040 --> 00:27:16,580 I don't want you to tell me why now. 619 00:27:16,580 --> 00:27:18,230 I want you to think about why, even if you would have 620 00:27:18,230 --> 00:27:19,220 spent the year watching TV. 621 00:27:19,220 --> 00:27:19,720 No, I don't. 622 00:27:19,720 --> 00:27:20,360 I said, no. 623 00:27:20,360 --> 00:27:21,945 Put your hand down. 624 00:27:21,945 --> 00:27:22,820 AUDIENCE: [INAUDIBLE] 625 00:27:22,820 --> 00:27:24,410 JONATHAN GRUBER: I knew you're going to try. 626 00:27:24,410 --> 00:27:26,490 I love, I love that willingness in this class 627 00:27:26,490 --> 00:27:27,030 to answer questions. 628 00:27:27,030 --> 00:27:28,520 This one I want you to just think about, 629 00:27:28,520 --> 00:27:30,978 because we're going to come back to this in a few lectures. 630 00:27:30,978 --> 00:27:34,025 Now, let's go on and talk about maximizing profits. 631 00:27:39,800 --> 00:27:43,670 Maximizing profits-- now that we defined what profits are, 632 00:27:43,670 --> 00:27:45,920 how do you maximize them? 633 00:27:45,920 --> 00:27:48,020 We know how to maximize a function. 634 00:27:48,020 --> 00:27:54,073 If pi equals R minus C, then the maximum d pi dq-- 635 00:27:54,073 --> 00:27:55,240 you can't control the price. 636 00:27:55,240 --> 00:27:57,650 All you can control is how much you produce. 637 00:27:57,650 --> 00:28:00,890 Your only control variable is q, little q. 638 00:28:00,890 --> 00:28:08,670 So d pi dq equals dR d little q minus dC d little q. 639 00:28:08,670 --> 00:28:09,957 Know what dC d little q is. 640 00:28:09,957 --> 00:28:11,040 We defined that last time. 641 00:28:11,040 --> 00:28:13,660 What's that? 642 00:28:13,660 --> 00:28:16,790 What do we call that, the change in costs with respect 643 00:28:16,790 --> 00:28:18,720 to an increment in quantity? 644 00:28:18,720 --> 00:28:19,720 AUDIENCE: Marginal cost. 645 00:28:19,720 --> 00:28:21,012 JONATHAN GRUBER: Marginal cost. 646 00:28:21,012 --> 00:28:23,960 So we know this is the marginal cost, 647 00:28:23,960 --> 00:28:29,690 but for a competitive firm, what is marginal revenue? 648 00:28:29,690 --> 00:28:31,490 So that's marginal revenue, the amount you 649 00:28:31,490 --> 00:28:33,860 work on the next unit you sell. 650 00:28:33,860 --> 00:28:38,830 For a competitive firm, what is their marginal revenue? 651 00:28:38,830 --> 00:28:40,193 What is the amount? 652 00:28:40,193 --> 00:28:40,860 AUDIENCE: Price. 653 00:28:40,860 --> 00:28:42,818 JONATHAN GRUBER: Price, which is given to them, 654 00:28:42,818 --> 00:28:45,720 because they're a price taker. 655 00:28:45,720 --> 00:28:48,178 Firms, they don't have to think about a complicated concept 656 00:28:48,178 --> 00:28:48,678 here. 657 00:28:48,678 --> 00:28:50,530 This is all complicated, with tons of math. 658 00:28:50,530 --> 00:28:52,570 I hated that last lecture, all the math. 659 00:28:52,570 --> 00:28:53,200 This is hard. 660 00:28:53,200 --> 00:28:54,470 This is easy. 661 00:28:54,470 --> 00:28:56,750 It's price. 662 00:28:56,750 --> 00:28:59,000 You're given-- if you're a price taker, 663 00:28:59,000 --> 00:29:00,913 you're given a price by the market. 664 00:29:00,913 --> 00:29:03,080 So marginal revenue for a perfectly competitive firm 665 00:29:03,080 --> 00:29:05,190 is just price. 666 00:29:05,190 --> 00:29:14,060 So you maximize profits when price equals marginal cost is 667 00:29:14,060 --> 00:29:16,300 the profit maximizing point. 668 00:29:16,300 --> 00:29:20,560 Profits are maximized when price equals marginal cost. 669 00:29:20,560 --> 00:29:23,530 That is, you want to produce until what 670 00:29:23,530 --> 00:29:26,410 you get from the next unit equals what you 671 00:29:26,410 --> 00:29:29,440 spend to make the next unit. 672 00:29:29,440 --> 00:29:30,140 Yeah. 673 00:29:30,140 --> 00:29:31,530 AUDIENCE: What if you make-- 674 00:29:31,530 --> 00:29:33,650 what if you move it to cost a bit less 675 00:29:33,650 --> 00:29:36,740 and you sell it for below the market. 676 00:29:36,740 --> 00:29:38,630 JONATHAN GRUBER: Let's go to an example. 677 00:29:38,630 --> 00:29:42,160 So let's go to figure 7.2. 678 00:29:42,160 --> 00:29:46,940 Here we have the cost function that we derived last time. 679 00:29:46,940 --> 00:29:50,610 C of q equals 10 plus 5q squared. 680 00:29:50,610 --> 00:29:54,160 You remember that from last time. 681 00:29:54,160 --> 00:29:56,100 And then we have a revenue function, 682 00:29:56,100 --> 00:29:59,417 and I assume the price per unit-- 683 00:29:59,417 --> 00:30:00,917 we have a revenue function where I'm 684 00:30:00,917 --> 00:30:02,890 going to assume the price per unit is 30. 685 00:30:02,890 --> 00:30:04,970 For our example, I'm going to assume P equals 30. 686 00:30:08,232 --> 00:30:09,190 I've just made that up. 687 00:30:09,190 --> 00:30:11,960 Once again, that comes from God in these perfectly competitive 688 00:30:11,960 --> 00:30:12,460 firms. 689 00:30:12,460 --> 00:30:14,127 They have no idea where this comes from. 690 00:30:14,127 --> 00:30:15,220 It's just a price. 691 00:30:15,220 --> 00:30:16,300 We'll talk later where it comes from, 692 00:30:16,300 --> 00:30:17,890 but for now, it's just a given thing. 693 00:30:17,890 --> 00:30:19,510 Let's say it's 30. 694 00:30:19,510 --> 00:30:22,630 So the firm's cost function is of the form-- 695 00:30:22,630 --> 00:30:24,872 is graphed on the left-hand side here. 696 00:30:24,872 --> 00:30:26,830 The revenue function is simply a straight line, 697 00:30:26,830 --> 00:30:28,103 which is 30 times q. 698 00:30:28,103 --> 00:30:29,770 So if they sell one, revenue is 30, two, 699 00:30:29,770 --> 00:30:31,720 revenue is 60, et cetera. 700 00:30:31,720 --> 00:30:35,490 And the profits are simply the difference. 701 00:30:35,490 --> 00:30:41,140 So when we maximize, how do we maximize profits? 702 00:30:41,140 --> 00:30:44,460 Well we want to graph-- 703 00:30:44,460 --> 00:30:46,470 what we want to do is graph the profit 704 00:30:46,470 --> 00:30:49,500 for each additional unit sold. 705 00:30:49,500 --> 00:30:51,960 So for example, when you go from selling 706 00:30:51,960 --> 00:30:59,060 no units to selling one unit, at no units, your cost is what? 707 00:30:59,060 --> 00:31:02,197 If you sell no units, what's your cost? 708 00:31:02,197 --> 00:31:03,780 Somebody raise their hand and tell me. 709 00:31:03,780 --> 00:31:04,335 Yeah. 710 00:31:04,335 --> 00:31:04,720 AUDIENCE: 10. 711 00:31:04,720 --> 00:31:06,370 JONATHAN GRUBER: 10, not 0, because you 712 00:31:06,370 --> 00:31:07,655 have the fixed costs. 713 00:31:07,655 --> 00:31:08,905 Those are paid no matter what. 714 00:31:08,905 --> 00:31:10,110 Remember, those are fixed in the short run. 715 00:31:10,110 --> 00:31:10,777 We'll come back. 716 00:31:10,777 --> 00:31:11,960 This is very important. 717 00:31:11,960 --> 00:31:15,630 So if you zero, your costs are 10, your revenues are what? 718 00:31:15,630 --> 00:31:18,000 0, so your profits are negative 10. 719 00:31:18,000 --> 00:31:22,680 If you produce one unit, what's your cost? 720 00:31:22,680 --> 00:31:23,360 15. 721 00:31:23,360 --> 00:31:24,990 What's your revenues? 722 00:31:24,990 --> 00:31:25,560 30. 723 00:31:25,560 --> 00:31:26,820 So you make a profit of 15. 724 00:31:29,560 --> 00:31:32,140 If you go from one unit, now you're producing one. 725 00:31:32,140 --> 00:31:34,660 You want to know, should I produce the second unit? 726 00:31:34,660 --> 00:31:37,090 What's the marginal cost of the second unit? 727 00:31:37,090 --> 00:31:39,720 Well, we know what marginal cost is with this function. 728 00:31:39,720 --> 00:31:42,460 Marginal cost, we just differentiate this with respect 729 00:31:42,460 --> 00:31:46,640 to q and we get 10q is marginal cost. 730 00:31:46,640 --> 00:31:49,930 So we know the marginal cost of the second unit is what? 731 00:31:49,930 --> 00:31:51,632 20. 732 00:31:51,632 --> 00:31:53,340 What's the revenues from the second unit? 733 00:31:53,340 --> 00:31:54,173 Well, that's linear. 734 00:31:54,173 --> 00:31:55,530 It's 30. 735 00:31:55,530 --> 00:32:02,120 So you're still making-- you're making a profit of 10 736 00:32:02,120 --> 00:32:02,720 on that unit. 737 00:32:02,720 --> 00:32:05,340 Now, we go to the third unit. 738 00:32:05,340 --> 00:32:16,613 So right, now after two units, you are still making profit. 739 00:32:16,613 --> 00:32:17,780 Now we go to the third unit. 740 00:32:17,780 --> 00:32:19,322 It's hard, because we're discretizing 741 00:32:19,322 --> 00:32:21,910 a continuous example, but let's go to the third unit. 742 00:32:21,910 --> 00:32:25,080 The third unit, what's the cost? 743 00:32:25,080 --> 00:32:28,420 What's the marginal cost? 744 00:32:28,420 --> 00:32:29,470 30. 745 00:32:29,470 --> 00:32:31,430 What's the marginal revenue? 746 00:32:31,430 --> 00:32:32,260 30. 747 00:32:32,260 --> 00:32:36,160 So you're at the profit maximizing point. 748 00:32:36,160 --> 00:32:37,450 You have climbed the hill. 749 00:32:37,450 --> 00:32:41,860 You have maximized your profits. 750 00:32:41,860 --> 00:32:44,350 What's your total profits at that point? 751 00:32:44,350 --> 00:32:50,650 Well, your total profits is 3 times 30, which is 90, minus 10 752 00:32:50,650 --> 00:32:55,090 plus 5 times 3 squared. 753 00:32:55,090 --> 00:32:58,100 Minus 10 plus 45 is 55. 754 00:32:58,100 --> 00:33:00,780 So your total profits are 45. 755 00:33:00,780 --> 00:33:03,740 That's your maximum profits. 756 00:33:03,740 --> 00:33:05,877 That's the most you're going to earn. 757 00:33:05,877 --> 00:33:08,210 Now, coming to the question that was asked a minute ago, 758 00:33:08,210 --> 00:33:10,180 or a related version-- 759 00:33:10,180 --> 00:33:13,710 wait a second, if I sell one more unit, 760 00:33:13,710 --> 00:33:16,140 I still have positive profits. 761 00:33:16,140 --> 00:33:20,070 So my profits were 45 selling three units. 762 00:33:20,070 --> 00:33:24,450 The next unit, I'm still in the black. 763 00:33:24,450 --> 00:33:25,260 Why not sell more? 764 00:33:25,260 --> 00:33:28,030 Why not sell one more unit? 765 00:33:28,030 --> 00:33:31,805 Why not sell that fourth unit? 766 00:33:31,805 --> 00:33:32,800 Yeah. 767 00:33:32,800 --> 00:33:33,490 AUDIENCE: Because it's going to cost you more 768 00:33:33,490 --> 00:33:34,240 than it's going to give you. 769 00:33:34,240 --> 00:33:35,198 JONATHAN GRUBER: Right. 770 00:33:35,198 --> 00:33:39,030 Because we always make marginal decisions in economics. 771 00:33:39,030 --> 00:33:42,250 We always ask what's the next step I should take. 772 00:33:42,250 --> 00:33:44,940 And the next step is a losing step, 773 00:33:44,940 --> 00:33:48,450 because the fourth unit, what's your marginal cost? 774 00:33:48,450 --> 00:33:49,427 40. 775 00:33:49,427 --> 00:33:50,260 What's your revenue? 776 00:33:50,260 --> 00:33:51,330 30. 777 00:33:51,330 --> 00:33:54,000 So the fourth unit has a negative 10 profit, 778 00:33:54,000 --> 00:33:56,310 so you don't want to make it. 779 00:33:56,310 --> 00:34:01,860 So profit maximization is a hill-climbing exercise. 780 00:34:01,860 --> 00:34:04,025 I like to think of it, and I describe in my videos, 781 00:34:04,025 --> 00:34:05,400 I think of it as it's like you're 782 00:34:05,400 --> 00:34:08,060 climbing a hill blindfolded. 783 00:34:08,060 --> 00:34:12,860 All you know is whether you're stepping up or stepping down. 784 00:34:12,860 --> 00:34:16,570 And you need to figure out when you get to the peak. 785 00:34:16,570 --> 00:34:18,880 If you step up, if your next step is upward, 786 00:34:18,880 --> 00:34:20,568 you must be short of the peak. 787 00:34:20,568 --> 00:34:23,110 If your next step is downward, you must have passed the peak. 788 00:34:23,110 --> 00:34:25,693 It's just keep going till your next step leads to a flat part. 789 00:34:25,693 --> 00:34:28,060 Your next steps, right in front of the other. 790 00:34:28,060 --> 00:34:30,190 That's what profit maximization is. 791 00:34:30,190 --> 00:34:31,605 The key thing is you can-- 792 00:34:31,605 --> 00:34:32,980 the key thing about the blindfold 793 00:34:32,980 --> 00:34:34,688 is you don't need to see the big picture. 794 00:34:34,688 --> 00:34:37,810 All you need to know is, is my next step increasing my profits 795 00:34:37,810 --> 00:34:38,920 or decreasing my profits? 796 00:34:38,920 --> 00:34:40,840 If it's increasing, I'm doing it. 797 00:34:40,840 --> 00:34:42,659 If it's decreasing, I'm going backwards. 798 00:34:42,659 --> 00:34:45,159 That's all you need to know, is just think about putting one 799 00:34:45,159 --> 00:34:46,284 foot in front of the other. 800 00:34:46,284 --> 00:34:49,060 Does that next unit make me money or lose me money? 801 00:34:51,582 --> 00:34:53,540 So that is how we think of profit maximization. 802 00:34:53,540 --> 00:34:54,040 Yeah. 803 00:34:54,040 --> 00:34:56,259 AUDIENCE: So what's the next [INAUDIBLE]?? 804 00:34:56,259 --> 00:34:57,680 You just stop it or-- 805 00:34:57,680 --> 00:35:00,110 JONATHAN GRUBER: Well, that is the optimal production. 806 00:35:00,110 --> 00:35:03,020 That's pinning down how much you want to produce. 807 00:35:03,020 --> 00:35:05,150 Remember I said at the biggest lecture, 808 00:35:05,150 --> 00:35:07,520 the problem with producer theory is 809 00:35:07,520 --> 00:35:10,057 we have some set of relationships between how 810 00:35:10,057 --> 00:35:11,140 much we produce and costs. 811 00:35:11,140 --> 00:35:12,260 It doesn't tell you how much you should produce. 812 00:35:12,260 --> 00:35:13,940 This tells you how much to produce. 813 00:35:13,940 --> 00:35:17,360 You have now solved the firm's problem. 814 00:35:17,360 --> 00:35:19,880 This one extra-- this imposition of the perfect competition 815 00:35:19,880 --> 00:35:25,010 constraint has allowed us to finally solve the problem. 816 00:35:25,010 --> 00:35:26,630 We have now solved it, and we've said 817 00:35:26,630 --> 00:35:29,150 that the firm, given this cost function 818 00:35:29,150 --> 00:35:32,540 and given a price of 30, a firm should produce three units. 819 00:35:32,540 --> 00:35:34,500 Done. 820 00:35:34,500 --> 00:35:36,990 Just like before, we said, we had this many pizzas 821 00:35:36,990 --> 00:35:37,770 and cookies. 822 00:35:37,770 --> 00:35:39,540 Now we're pinning down q. 823 00:35:39,540 --> 00:35:41,170 Once we pin down q, we can, of course, 824 00:35:41,170 --> 00:35:43,845 go back and pin down l and k, because l and k are 825 00:35:43,845 --> 00:35:45,960 a function of q. 826 00:35:45,960 --> 00:35:48,000 But this is where it's one step harder. 827 00:35:48,000 --> 00:35:49,440 So this extra step we have to take 828 00:35:49,440 --> 00:35:51,450 is we have to impose the market condition 829 00:35:51,450 --> 00:35:53,720 to get to the little q we want to produce. 830 00:35:53,720 --> 00:35:56,870 And in this case, that's 3. 831 00:35:56,870 --> 00:35:59,480 Questions about that? 832 00:35:59,480 --> 00:36:01,208 Yeah. 833 00:36:01,208 --> 00:36:03,000 AUDIENCE: So you know how in the beginning, 834 00:36:03,000 --> 00:36:05,888 you said that in a perfectly competitive market, 835 00:36:05,888 --> 00:36:07,430 the producers are price [INAUDIBLE]?? 836 00:36:07,430 --> 00:36:09,920 JONATHAN GRUBER: Yeah. 837 00:36:09,920 --> 00:36:12,560 AUDIENCE: So I'm having trouble understanding 838 00:36:12,560 --> 00:36:15,010 why all of the guys who are selling Eiffel towers 839 00:36:15,010 --> 00:36:17,217 wouldn't get together and [INAUDIBLE].. 840 00:36:17,217 --> 00:36:19,550 Let's just make all of the Eiffel towers more expensive. 841 00:36:19,550 --> 00:36:20,060 JONATHAN GRUBER: Great. 842 00:36:20,060 --> 00:36:20,750 Great point. 843 00:36:20,750 --> 00:36:24,142 That's exactly-- we call that a monopoly or an oligopoly, 844 00:36:24,142 --> 00:36:25,850 depending how you want to think about it. 845 00:36:25,850 --> 00:36:28,250 They essentially could monopolize. 846 00:36:28,250 --> 00:36:30,320 And we're assuming that doesn't happen here. 847 00:36:30,320 --> 00:36:31,820 And I'll talk later about why that's 848 00:36:31,820 --> 00:36:34,220 way harder than you think. 849 00:36:34,220 --> 00:36:36,260 So we're starting-- once again, in economics, 850 00:36:36,260 --> 00:36:37,700 we always start with simplifying assumptions 851 00:36:37,700 --> 00:36:38,720 to draw general lessons. 852 00:36:38,720 --> 00:36:39,680 Then we'll make some more, and then we'll 853 00:36:39,680 --> 00:36:40,790 come back to the more complicated, 854 00:36:40,790 --> 00:36:41,780 real-world examples. 855 00:36:41,780 --> 00:36:43,430 But it turns out virtually everything 856 00:36:43,430 --> 00:36:46,600 we learn here is still going to hold. 857 00:36:46,600 --> 00:36:47,860 Yeah. 858 00:36:47,860 --> 00:36:49,470 AUDIENCE: So if-- 859 00:36:53,880 --> 00:36:55,940 JONATHAN GRUBER: We can go back to it. 860 00:36:55,940 --> 00:36:59,060 So now let's ask, how big is the firm's profit? 861 00:36:59,060 --> 00:37:02,090 How do we measure the size of the profit? 862 00:37:02,090 --> 00:37:09,230 Profit, if we think about profits per unit, 863 00:37:09,230 --> 00:37:12,680 profits equals revenue minus costs. 864 00:37:12,680 --> 00:37:16,550 So profits per unit, profits per q, 865 00:37:16,550 --> 00:37:20,840 equals revenues per q minus costs per q. 866 00:37:20,840 --> 00:37:23,300 What is this term, cost divided by quantity? 867 00:37:23,300 --> 00:37:25,390 What do we call that? 868 00:37:25,390 --> 00:37:26,860 Average costs. 869 00:37:26,860 --> 00:37:28,900 And how much do you get per unit? 870 00:37:28,900 --> 00:37:30,400 You just get the price. 871 00:37:30,400 --> 00:37:34,180 So dR dq and R over q are the same. 872 00:37:34,180 --> 00:37:35,980 In a competitive market, marginal price 873 00:37:35,980 --> 00:37:37,272 and average price are the same. 874 00:37:37,272 --> 00:37:38,660 It's the price. 875 00:37:38,660 --> 00:37:40,820 So this just says profits are equal-- 876 00:37:40,820 --> 00:37:46,140 profits for q are equal to price minus average cost. 877 00:37:46,140 --> 00:37:50,300 So your per-unit profits is price minus average cost. 878 00:37:50,300 --> 00:37:58,190 And we can see that in figure 7.3. 879 00:37:58,190 --> 00:38:02,760 Figure 7.3 shows our cost curves for this 10 plus 5q squared 880 00:38:02,760 --> 00:38:05,290 function we derived before. 881 00:38:05,290 --> 00:38:07,930 And you can see we have an average total cost 882 00:38:07,930 --> 00:38:10,630 curve, which first declines and then increases. 883 00:38:10,630 --> 00:38:12,580 We have a marginal cost curve. 884 00:38:12,580 --> 00:38:16,310 And then we have an average cost curve, average total cost 885 00:38:16,310 --> 00:38:16,810 curve. 886 00:38:16,810 --> 00:38:18,977 And then we have average variable and average fixed. 887 00:38:18,977 --> 00:38:23,020 Now, we already announced that the optimal production 888 00:38:23,020 --> 00:38:28,070 level was three, where price hit marginal cost. 889 00:38:28,070 --> 00:38:29,540 What's our profit at three? 890 00:38:29,540 --> 00:38:33,080 Our profit is the difference between that price 891 00:38:33,080 --> 00:38:35,360 and the average cost of three units 892 00:38:35,360 --> 00:38:37,860 over all the units we produce. 893 00:38:37,860 --> 00:38:41,130 So the profit is actually 30. 894 00:38:41,130 --> 00:38:43,200 So there's a discreteness problem here. 895 00:38:43,200 --> 00:38:44,430 I have to work this out. 896 00:38:44,430 --> 00:38:46,290 The problem, I said 45 before-- 897 00:38:46,290 --> 00:38:47,460 it's 45 mathematically. 898 00:38:47,460 --> 00:38:49,212 It's 30 in this because of the continuity 899 00:38:49,212 --> 00:38:50,670 problem of the sort of discreteness 900 00:38:50,670 --> 00:38:51,930 between two and three. 901 00:38:51,930 --> 00:38:54,870 So the bottom line is, in a continuous example, 902 00:38:54,870 --> 00:38:56,030 this would be the same. 903 00:38:56,030 --> 00:38:57,750 And the bottom line is the profit, 904 00:38:57,750 --> 00:39:03,150 is the difference between the price and the average cost 905 00:39:03,150 --> 00:39:06,560 times the number of units sold. 906 00:39:06,560 --> 00:39:10,850 That's going to be the bottom line profit. 907 00:39:10,850 --> 00:39:16,455 Average cost here is 10 over 3 is 3. 908 00:39:16,455 --> 00:39:18,830 Let's see, let's make sure we've got the math right here. 909 00:39:18,830 --> 00:39:22,430 Average cost is 10 plus 5q squared. 910 00:39:22,430 --> 00:39:26,600 So average cost is 10 over q plus 5q. 911 00:39:26,600 --> 00:39:36,080 q is 3, so it's 3.33 plus 15, which is 18.33. 912 00:39:36,080 --> 00:39:37,860 Yeah, no, my math was right with 45. 913 00:39:37,860 --> 00:39:41,060 This graph is wrong. 914 00:39:41,060 --> 00:39:44,570 So our average cost is 18.33. 915 00:39:44,570 --> 00:39:47,630 What's the revenue at that point? 916 00:39:47,630 --> 00:39:49,490 It's 30. 917 00:39:49,490 --> 00:39:53,880 30 minus 18.33 times 3 is 45. 918 00:39:53,880 --> 00:39:56,150 So it is 45. 919 00:39:56,150 --> 00:39:57,140 Is that right? 920 00:39:57,140 --> 00:40:00,980 30 minus 18, 12 point-- 921 00:40:00,980 --> 00:40:02,060 no, that's wrong. 922 00:40:02,060 --> 00:40:04,070 No, 30, no, I got that wrong. 923 00:40:04,070 --> 00:40:05,930 You're right. 924 00:40:05,930 --> 00:40:08,510 It's 35. 925 00:40:08,510 --> 00:40:10,220 So it all comes from the discrete-- 926 00:40:10,220 --> 00:40:12,860 it's all about the problem of a very discrete function 927 00:40:12,860 --> 00:40:14,960 versus a continuous function. 928 00:40:14,960 --> 00:40:16,475 The bottom line is this-- 929 00:40:16,475 --> 00:40:18,820 did I get right? 930 00:40:18,820 --> 00:40:23,120 Yeah, 11.67 times 3 is 35. 931 00:40:23,120 --> 00:40:28,150 So the bottom line is, we got 45 from a hill-climbing exercise 932 00:40:28,150 --> 00:40:30,518 and 35 from this graph is basically 933 00:40:30,518 --> 00:40:32,310 a discreteness problem, that in some sense, 934 00:40:32,310 --> 00:40:34,910 in this continuous function, they give you the same thing. 935 00:40:34,910 --> 00:40:36,743 The bottom line is the profit is equal 936 00:40:36,743 --> 00:40:39,160 to-- we'll be clear on this in the problem sets and exams, 937 00:40:39,160 --> 00:40:40,360 what we're looking for. 938 00:40:40,360 --> 00:40:42,360 The bottom line is the profit is the difference. 939 00:40:42,360 --> 00:40:44,800 The profit per unit is the difference 940 00:40:44,800 --> 00:40:48,040 between the average costs, and the price 941 00:40:48,040 --> 00:40:50,650 that you get for that unit. 942 00:40:50,650 --> 00:40:53,215 Now, with that in mind, let me ask you 943 00:40:53,215 --> 00:40:55,140 the following question-- 944 00:40:55,140 --> 00:41:01,200 what if I imposed a tax of $1 per unit? 945 00:41:01,200 --> 00:41:09,550 What if I imposed a tax of $10 per unit? 946 00:41:09,550 --> 00:41:12,820 What if I imposed a tax of $10 per unit? 947 00:41:12,820 --> 00:41:18,730 A $10 per unit tax, what would that do to the cost curve? 948 00:41:18,730 --> 00:41:20,980 Somebody, without looking at the handout and cheating, 949 00:41:20,980 --> 00:41:23,980 somebody tell me what's the new cost curve 950 00:41:23,980 --> 00:41:26,050 if I impose a $10 per unit tax? 951 00:41:29,830 --> 00:41:31,870 What's the new cost curve? 952 00:41:31,870 --> 00:41:33,220 What was the old cost curve? 953 00:41:33,220 --> 00:41:34,970 The old cost curve was 10 plus 5q squared. 954 00:41:34,970 --> 00:41:36,260 What's the new cost curve? 955 00:41:36,260 --> 00:41:38,313 AUDIENCE: [INAUDIBLE] 956 00:41:38,313 --> 00:41:39,730 JONATHAN GRUBER: That's the answer 957 00:41:39,730 --> 00:41:41,470 that almost everyone always gives the first time, 958 00:41:41,470 --> 00:41:42,390 but it's not right. 959 00:41:42,390 --> 00:41:44,440 AUDIENCE: [INAUDIBLE] 960 00:41:44,440 --> 00:41:47,230 JONATHAN GRUBER: 10 plus 5q squared plus 10q, 961 00:41:47,230 --> 00:41:49,910 because I said per unit I charge $10. 962 00:41:49,910 --> 00:41:52,660 If I'd said a fixed tax of $10, you would've been right. 963 00:41:52,660 --> 00:41:54,160 It would've been 20 plus 5q squared, 964 00:41:54,160 --> 00:41:57,490 but it's not, because it's a per unit tax of $10. 965 00:41:57,490 --> 00:41:58,136 Yeah. 966 00:41:58,136 --> 00:42:01,527 AUDIENCE: [INAUDIBLE] 967 00:42:01,527 --> 00:42:03,360 JONATHAN GRUBER: We'll see that in a second. 968 00:42:03,360 --> 00:42:05,890 It's just an easy way to explain it. 969 00:42:05,890 --> 00:42:06,850 So that's the new-- 970 00:42:06,850 --> 00:42:11,500 with a tax of $10 per unit, the new cost function 971 00:42:11,500 --> 00:42:15,010 is 10 plus 5q squared plus 10q. 972 00:42:15,010 --> 00:42:16,690 Oh, good, we didn't show that in 7.4. 973 00:42:16,690 --> 00:42:18,680 So what does that do? 974 00:42:18,680 --> 00:42:22,140 Well, we can go to Figure 7.4 and see that. 975 00:42:22,140 --> 00:42:27,330 Here, the marginal cost and the average cost 976 00:42:27,330 --> 00:42:29,790 have both risen by 10. 977 00:42:29,790 --> 00:42:33,720 The old marginal cost was 10q. 978 00:42:33,720 --> 00:42:36,010 Now, it's 10q plus 10. 979 00:42:36,010 --> 00:42:41,050 So marginal cost is now 10q plus 10. 980 00:42:41,050 --> 00:42:47,140 Average cost used to be 10 over q plus 5q. 981 00:42:47,140 --> 00:42:53,180 Now it's 10 over q plus 5q plus 10. 982 00:42:53,180 --> 00:42:55,370 So the bottom line is both marginal and average cost 983 00:42:55,370 --> 00:42:58,307 have shifted up by 10. 984 00:42:58,307 --> 00:42:59,140 What does that mean? 985 00:42:59,140 --> 00:43:02,430 Well, first of all, it changes optimal production. 986 00:43:02,430 --> 00:43:06,630 If marginal cost is 10q plus 10, and our optimization 987 00:43:06,630 --> 00:43:09,120 is set price equals the marginal cost, 988 00:43:09,120 --> 00:43:13,800 now we're setting 30 equals 10q plus 10. 989 00:43:13,800 --> 00:43:18,660 30 equals 10q plus 10, which says the optimal q drops to 2. 990 00:43:21,230 --> 00:43:26,030 Subtract 10 from 30, divide by 10, you get the optimal q. 991 00:43:26,030 --> 00:43:31,370 Now that falls to 2, so now, you only want to produce two units, 992 00:43:31,370 --> 00:43:33,920 because the marginal cost is higher 993 00:43:33,920 --> 00:43:35,540 but the price is the same. 994 00:43:35,540 --> 00:43:37,490 You're going to produce less. 995 00:43:37,490 --> 00:43:39,920 So now, you're only going to produce two units. 996 00:43:39,920 --> 00:43:42,080 And you could see that in the graph, 997 00:43:42,080 --> 00:43:44,967 that your marginal cost hits the price now at two units, 998 00:43:44,967 --> 00:43:46,550 rather than hitting it at three units. 999 00:43:46,550 --> 00:43:49,100 You see that in Figure 7.4. 1000 00:43:49,100 --> 00:43:51,080 Your average cost is also higher, 1001 00:43:51,080 --> 00:43:54,770 so you're going to make less profits per unit. 1002 00:43:54,770 --> 00:43:58,550 So you're producing fewer units and making 1003 00:43:58,550 --> 00:44:00,030 less profit per unit. 1004 00:44:00,030 --> 00:44:02,780 So the entire rectangle is shrunk. 1005 00:44:02,780 --> 00:44:09,085 The rectangle has shrunk. 1006 00:44:09,085 --> 00:44:10,460 Yes, the entire rectangle shrunk. 1007 00:44:10,460 --> 00:44:13,380 It shrunk because you're selling fewer units. 1008 00:44:13,380 --> 00:44:15,710 And it shrunk because you're getting 1009 00:44:15,710 --> 00:44:18,715 less surplus per-- you're getting less profit per unit. 1010 00:44:18,715 --> 00:44:23,000 Remember, profit per unit is price 1011 00:44:23,000 --> 00:44:26,760 minus average cost over quantity or price minus average cost. 1012 00:44:26,760 --> 00:44:28,670 Since average cost is higher, you're 1013 00:44:28,670 --> 00:44:29,900 getting less profit per unit. 1014 00:44:29,900 --> 00:44:33,570 You're selling fewer units at less profit per unit. 1015 00:44:33,570 --> 00:44:37,190 So that tax has significantly lowered your profit. 1016 00:44:37,190 --> 00:44:39,428 Questions about that? 1017 00:44:39,428 --> 00:44:40,470 Doesn't have to be a tax. 1018 00:44:40,470 --> 00:44:42,630 If I'd said suddenly, whatever you're producing, 1019 00:44:42,630 --> 00:44:45,090 there was a change in what it costs to produce, 1020 00:44:45,090 --> 00:44:46,710 any change in what something costs 1021 00:44:46,710 --> 00:44:51,450 to produce in the production function 1022 00:44:51,450 --> 00:44:54,040 can ultimately affect how much you sell and you profit. 1023 00:44:54,040 --> 00:44:56,760 So one excise you can show yourself at home, 1024 00:44:56,760 --> 00:45:01,622 imagine that I had said there was a fixed tax of 10. 1025 00:45:01,622 --> 00:45:04,080 Actually, let me ask you this question-- imagine I had said 1026 00:45:04,080 --> 00:45:06,862 there was a fixed tax of 10. 1027 00:45:06,862 --> 00:45:08,570 How would that have affected your profit? 1028 00:45:08,570 --> 00:45:11,860 How would that affect the amount you sell and your profit? 1029 00:45:11,860 --> 00:45:14,312 It's a fixed tax of 10, not 10 per unit. 1030 00:45:14,312 --> 00:45:16,270 How would that affect how many units you'd sell 1031 00:45:16,270 --> 00:45:17,080 and what your profit is? 1032 00:45:17,080 --> 00:45:17,690 Yeah. 1033 00:45:17,690 --> 00:45:19,310 AUDIENCE: Both [INAUDIBLE] would have less profit. 1034 00:45:19,310 --> 00:45:20,040 JONATHAN GRUBER: Exactly. 1035 00:45:20,040 --> 00:45:21,810 You'd sell-- why would you sell the same amount? 1036 00:45:21,810 --> 00:45:23,030 AUDIENCE: Wouldn't affect your MC. 1037 00:45:23,030 --> 00:45:25,490 JONATHAN GRUBER: It wouldn't affect your marginal cost. 1038 00:45:25,490 --> 00:45:27,200 Remember, profit maximization is where 1039 00:45:27,200 --> 00:45:29,270 marginal cost equals price. 1040 00:45:29,270 --> 00:45:31,980 If I have a fixed tax, that's an effective marginal cost, 1041 00:45:31,980 --> 00:45:34,147 but it does lower your profits, because you've still 1042 00:45:34,147 --> 00:45:35,560 got to pay that extra tax. 1043 00:45:35,560 --> 00:45:38,080 So here, your profits get doubly hit. 1044 00:45:38,080 --> 00:45:40,720 You sell less, and you make less per unit. 1045 00:45:40,720 --> 00:45:44,392 With a flat tax, you would sell the same amount, 1046 00:45:44,392 --> 00:45:45,600 but you'd make less per unit. 1047 00:45:45,600 --> 00:45:46,933 That's an important distinction. 1048 00:45:46,933 --> 00:45:48,630 I think I'll add that for next year. 1049 00:45:48,630 --> 00:45:51,640 Now, one other important point-- 1050 00:45:51,640 --> 00:45:54,320 the firm has one other decision to make here 1051 00:45:54,320 --> 00:45:56,730 that we haven't covered yet, which is that it has 1052 00:45:56,730 --> 00:45:59,010 to decide whether to shut down. 1053 00:45:59,010 --> 00:46:01,592 Now, remember I said there's no entry and exit. 1054 00:46:01,592 --> 00:46:04,050 That means you can't literally leave and go somewhere else, 1055 00:46:04,050 --> 00:46:06,307 but you can just walk away. 1056 00:46:06,307 --> 00:46:08,640 You can just literally say, look, I'm not in this market 1057 00:46:08,640 --> 00:46:09,520 anymore. 1058 00:46:09,520 --> 00:46:11,850 I'm not going to go set up shop somewhere else, 1059 00:46:11,850 --> 00:46:14,850 but I'm not in this market anymore. 1060 00:46:14,850 --> 00:46:18,757 So the question is, when would you do so? 1061 00:46:18,757 --> 00:46:19,840 So I'm going to get to it. 1062 00:46:19,840 --> 00:46:20,910 Hold on. 1063 00:46:20,910 --> 00:46:22,045 Is it a question or answer? 1064 00:46:22,045 --> 00:46:23,670 If it's an answer, I don't want it yet. 1065 00:46:23,670 --> 00:46:25,520 If it's a question, I'll take it. 1066 00:46:25,520 --> 00:46:29,540 So basically, suppose the price in this market fell to $10. 1067 00:46:32,650 --> 00:46:37,210 Should you continue to participate in the market? 1068 00:46:37,210 --> 00:46:41,190 Well, if the price falls to $10, what 1069 00:46:41,190 --> 00:46:43,784 is the optimal level of production? 1070 00:46:43,784 --> 00:46:44,730 AUDIENCE: [INAUDIBLE] 1071 00:46:44,730 --> 00:46:46,400 JONATHAN GRUBER: Zero. 1072 00:46:46,400 --> 00:46:51,280 So does that mean you should walk away? 1073 00:46:51,280 --> 00:46:52,480 No. 1074 00:46:52,480 --> 00:46:53,710 What are your profits? 1075 00:46:53,710 --> 00:46:58,410 If you sell zero, what are your profits? 1076 00:47:01,370 --> 00:47:02,270 Negative 10. 1077 00:47:02,270 --> 00:47:06,950 If you shut down and walk away, what are your profits? 1078 00:47:06,950 --> 00:47:08,840 Negative 15. 1079 00:47:08,840 --> 00:47:09,500 What's profits? 1080 00:47:09,500 --> 00:47:11,580 Profits is revenues minus costs. 1081 00:47:11,580 --> 00:47:12,550 Costs at zero-- 1082 00:47:20,630 --> 00:47:22,140 I'm sorry, you don't produce zero. 1083 00:47:22,140 --> 00:47:22,640 That's bad. 1084 00:47:22,640 --> 00:47:23,570 You produce one unit. 1085 00:47:23,570 --> 00:47:24,830 I got the answer wrong. 1086 00:47:24,830 --> 00:47:26,745 If price equals marginal cost-- yeah. 1087 00:47:26,745 --> 00:47:29,450 AUDIENCE: [INAUDIBLE] with the tax imposed, or are we-- 1088 00:47:29,450 --> 00:47:30,410 JONATHAN GRUBER: No, without the tax. 1089 00:47:30,410 --> 00:47:31,070 I'm sorry. 1090 00:47:31,070 --> 00:47:32,090 That's what I confused. 1091 00:47:32,090 --> 00:47:34,640 We're back to without the tax. 1092 00:47:34,640 --> 00:47:37,580 The price in the market drops to $10, 1093 00:47:37,580 --> 00:47:39,407 so you produce one unit, not zero. 1094 00:47:39,407 --> 00:47:40,490 I shouldn't listen to you. 1095 00:47:40,490 --> 00:47:42,350 I should look at my notes. 1096 00:47:42,350 --> 00:47:43,820 One unit, not zero. 1097 00:47:43,820 --> 00:47:44,990 You produce one unit. 1098 00:47:44,990 --> 00:47:53,180 At that point, what are your revenues producing one unit? 1099 00:47:53,180 --> 00:47:54,860 You get 30. 1100 00:47:59,557 --> 00:48:00,890 Yeah, this example is messed up. 1101 00:48:00,890 --> 00:48:02,515 I'm going to have to come back to this. 1102 00:48:05,900 --> 00:48:07,528 We made this-- this example is wrong. 1103 00:48:07,528 --> 00:48:09,320 I'm going to have to come back to this one. 1104 00:48:09,320 --> 00:48:14,420 So the key point with the shutdown is basically, 1105 00:48:14,420 --> 00:48:16,760 you only want to shut down if you're actually 1106 00:48:16,760 --> 00:48:19,322 going to lose more money by staying in the market 1107 00:48:19,322 --> 00:48:20,780 than you get by exiting the market. 1108 00:48:20,780 --> 00:48:21,600 So let me stop there. 1109 00:48:21,600 --> 00:48:22,280 I'll come back and fix this. 1110 00:48:22,280 --> 00:48:22,970 I made an error on this. 1111 00:48:22,970 --> 00:48:24,680 I'll come back to fix it at the beginning of the next lecture. 1112 00:48:24,680 --> 00:48:27,020 And then we'll talk about finishing up short-run profit 1113 00:48:27,020 --> 00:48:27,990 maximization. 1114 00:48:27,990 --> 00:48:30,250 So let's pause there and come back.