B.B. Wolfe and �The Little Red Riding Good �
A CAUTIONARY TALE
Once upon a time there was a town that had no transportation system at all. ��There were no cars, trucks, busses, livestock, bikes,skateboards, golf carts, Segways…you get the picture. No means of transportation would work in the town. The only way to get around was to walk.
Which was not much fun for the townspeople.�
Then one day, the slightly evil entrepreneur extraordinaire, Ms. B.B. Wolfe, had an idea! ��If she could invent a mode of transportation that would work in the town and then invest her savings to develop and market the product, she could earn high economic profits. And if she patented her new product, NOBODY could enter the market and stop her! BWAHAHAH!! ��*Of course, she would be doing this for the good of the townspeople
So Ms. Wolfe innovated and risked her financial capital to create and sell;��The Little Red Riding Good
Ms. Wolfe (B.B.) was;��1) the single seller of a product with �2) no close substitutes and �3) her patent was a barrier to entry
SHE WAS A MONOPOLIST!!!
People LOVED the little red riding good and market demand was high. Of course, B.B. was the only seller, so the market demand was ALL hers!
Demand
Little Red Riding Good
Market and Firm
P
Q
Now B.B. had to decide what quantity to produce. And once she did that, she could figure out how high she could set her price. B.B. LOVED being a price searcher!!BWAHAHA!��Her only goal was to maximize her profits, so…
SHE WOULD SET HER Q WHERE MC = MR
She remembered that her MC curve had a swooshy shape (thanks, diminishing returns…)
$
Q
MC
Market
But where was her MR curve?!?�She knew MR = the additional revenue from selling one more
But since her demand curve was
downward-sloping, to sell one more,
she had to lower her price.
Maybe this price-searcher thing wasn’t all good
To sell one more, for example to increase quantity from Q1 to Q2,
Requires that she lower price from P1 to P2
P
Q
D
P1
P2
Q1
Q2
1 more
Lower P
*Q 2 = Q1 + 1
The good news in this case is that she would sell one more
And her revenue would increase by P2 x Q2
P
Q
D
P1
P2
Q1
Q2
1 more
But the bad news is that she would have to lower her price from P1 to P2
On ALL of her output, not just the last unit.
P
Q
D
P1
P2
Q1
Q2
Lower P
So her MR =
-
Since
= P2, we know MR < P
Which means her MR curve is below the D curve
(because the D curve is what gives us her price)
To recap and emphasize:
2) The MR curve is below the D curve because to sell an additional unit of output, a monopolist has to lower price on ALL UNITS OF THE GOOD SOLD.
Did you realize that elasticity determines the size of
&
?!
So now B.B. had her MC and MR so she could set her profit-maximizing output level where MC = MR.
$
Q
MC
Market
D
MR
Q*
Profit = TR - TC
And while she can’t choose any price she wants, she CAN charge the most the market demand will allow because she is a price searcher!
$
Q
MC
Market
D
MR
Q*
P*
TR =
P x Q
Profit = TR - TC
Adding B.B.’s ATC to the graph shows that her entrepreneurial skill pays off with economic profit since her ATC(cost per unit) is below P(revenue per unit)!!
$
Q
MC
Market
D
MR
Q*
P*
Profit = TR - TC
ATC*
*Note that the ATC is “U-shaped” and MC crosses it at the minimum
ATC*
TC = ATCxQ
Profit! =
TR - TC
And Nobody can enter
to compete away B.B.’s profits
because of her patent
Bwahahaha!!
But the townspeople, while happy to have their Little Red Riding Goods, weren’t so sure B.B. Wolfe was giving them a good deal.
$
Q
MC
Market
D
MR
Q*
P*
If the market were perfectly
competitive, the people
would have more (Qm) and
pay less (Pm). I mean, they
were glad B.B. Wolfe
reduced their walking, but
she was creating scarcity
AND making big profits!!
Qm
Pm
And B.B.’s monopoly market wasn’t yielding the efficient outcome. It didn’t give them allocative efficiency…
$
Q
MC
Market
D
MR
Q*
P*
B.B.’s P and Q aren’t
allocatively efficient like
the perfectly competitive
Market P and Q!
Her Q is lower and her P
is higher…
Qm
Pm
Allocative efficiency
P = MC
Or productive efficiency….�
$
Q
MC
Market
D
MR
Q*
P*
ATC*
ATC*
Productive efficiency
Minimum ATC
In fact, B.B. Wolfe, entrepreneur extraordinaire and profit-maximizing monopolist was creating deadweight loss by restricting Q and raising P!
$
Q
MC
Market
D
MR
Q*
P*
Qm
dwl
The townspeople seriously wondered whether the cost of giving B.B. the patent (dwl) outweighed the benefit (creation of the little red riding good).
FORTUNATELY, AS OFTEN HAPPENS, TECHNOLOGY CONTINUED ITS ADVANCE AND MARKETS FOR NEW TRANSPORTATION ALTERNATIVES DEVELOPED.
And the perhaps evil Ms. B.B. Wolfe invested
her profits from the Little Red Riding Good
in Apple and rode off into the sunset.