Managerial Economics California College of the Arts Amy Whitaker Residency 2
Class Topics 1. Guest Speaker: Marney Morris 2. Review of Price ElasEcity and ProducEon FuncEons 3. Market Power and Structure Monopoly, Oligopoly, Duopoly – Game Theory MonopolisEc CompeEEon – Brand Power 4. Market Failure ExternaliEes, RegulaEon, Environmental Policy 5. Guest Speaker: John Bodt
Interac2ve Design is Self Explanatory If a design is good, a user will immediately know how to use it. To make a design self explanatory there are three simple rules: 01. Present a minimal amount of informaEon. 02. Arrange the informaEon so there is an obvious starEng point. 03. Build each "next step" on the logic of the step before. When designing for screens, here a couple of addiEonal Eps: Reduce your variables so the choice on the next screen is obvious. For example, when you use the same font, same size font, same color font, and line all the text up, any text that is diﬀerent (bold, diﬀerent color, or diﬀerent locaEon) is easily disEnguished. Register everything. When things shiY from screen to screen they are distracEng.
Monopolis2c Compe22on CompeEEon on brand or other forms of market segmenta2on You Are The determinaEon has to do with Here. whether there are subsEtutes – perfect, imperfect, improvised or otherwise
Strategy of MonopolisEc CompeEEon • Non-‐price compeEEon • Inﬂuence over demand via adverEsing, branding • Increase switching costs • Bolster number of complements • Extended service agreements, frequent upgrades • Network externaliEes • Technical standards (Blue Ray v. HD DVD)
Example: Maple Bacon Donuts Say Dynamo increases the price from $3 to $4.50 for maple bacon donut. They were selling 100 a day. Now they sell 75. What is the PED? Revenue? If $2 per donut and $75 overhead, what is their proﬁt?
Perfect vs. Imperfect CompeEEon • Eﬃciency vs. Power • In perfect compeEEon, ﬁrms are powerless – They do not set price. They can only respond. • Economists believe perfect compeEEon creates eﬃciency which allocates resources eﬀecEvely – “allocaEve eﬃciency.
Perfect CompeEEon • Inﬁnite Buyers/Inﬁnite Sellers – Inﬁnite consumers with the willingness and ability to buy the product at a certain price, Inﬁnite producers with the willingness and ability to supply the product at a certain price. • Zero Entry/Exit Barriers – It is relaEvely easy for a business to enter or exit in a perfectly compeEEve market. • Perfect Factor Mobility -‐ In the long run factors of producEon are perfectly mobile allowing free long term adjustments to changing market condiEons. • Perfect Informa2on -‐ Prices and quality of products are assumed to be known to all consumers and producers. • Zero Transac2on Costs -‐ Buyers and sellers incur no costs in making an exchange [Perfect mobility]. • Proﬁt Maximiza2on -‐ Firms aim to sell where marginal costs meet marginal revenue, where they generate the most proﬁt. • Homogeneous Products – The characterisEcs of any given market good or service do not vary across suppliers. • Constant Returns to Scale -‐ Constant returns to scale insure that there are suﬃcient ﬁrms in the industry.
monopoly • Single seller • High barriers to entry • Price-‐maker not price-‐taker • No subsEtutes (pure monopoly), or power in proporEon to availability of subsEtutes • If more subsEtute products are available, demand elasEcity will be greater and mark-‐up will be lower
Monopsony vs. Monopoly (one buyer, many sellers vs. one seller, many buyers) WalMart, Gates Founda2on, Warren Buﬀeg. . .
Demand Curves (market power means being able to set price) P P Q Q The market overall Facing the individual ﬁrm
Monopolists are the whole market • Firm demand curve = industry demand curve • For compeEEve ﬁrm: MR = MC = P because P is “taken.” • If you tried to raise price, you would lose all sales. • For monopolist, MR ≠ P; rather... • MR is always less than P so long as demand curve is downward sloping
What this looks like P (Price) D (Demand) Q MR (QuanEty)
Marginal Revenue for Monopolists Example: Perfect compeEEon: price = $5 MR = $5 no ma_er what Monopoly: To sell more units, you have to lower price: At price of $5, you sell 20. TR = 100. At price of $4, you sell 30. TR = 120. MR = Change in total revenue divided by change in output = (120-‐100)/(20-‐30) = 20/10 = 2
Bushels of Fish – p. 199 Marginal Revenue < Price for monopolist for every sale aYer the theoreEcal ﬁrst
Schiller, p. 200 monopolist always seek to produce so that MR = MC
Takeaways • The decision of how much to produce is as criEcal for monopolists as compeEEve ﬁrms but in a diﬀerent way • Over-‐producEon raises costs above the point where MR = MC, and proﬁts would not be maximized • Even monopolists can’t charge the highest possible rate if they want to be proﬁt-‐ maximizing
oligopolies Behave like a monopoly but made up of individual actors, so they face problems of coordinaEon and game theory Examples: oil cartel (OPEC), airlines, eyeglasses pre-‐Warby Parker
Group of eyeglasses ﬁrms domina2ng the industry
cargo surcharge collusion 21 airlines arEﬁcially inﬂated passenger and cargo fuel surcharges between 2000 and 2006 to make up for lost proﬁts. In July 2005, LuYhansa told the JusEce Department about airlines conspiring to set cargo surcharges. By ValenEnes Day 2006, FBI agents and their counterparts in Europe made the invesEgaEon public by raiding airline oﬃces. AYer those raids, BriEsh-‐based Virgin AtlanEc came forward about its role in a similar scheme to set fuel surcharges for passengers.
Price Agreement • 19 execuEves have been charged with wrongdoing – four have gone to prison • 21 airlines have paid more than $1.7 billion in ﬁnes in one of the largest criminal anEtrust invesEgaEons in U.S. history. • The court cases reveal a complex web of schemes between mostly internaEonal carriers willing to ﬁx fees in lockstep with compeEtors for ﬂights to and from the United States. • Convicted airlines include BriEsh Airways, Korean Air, and Air France-‐ KLM. No major U.S. carriers have been charged. • The price-‐ﬁxing unraveled largely because two airlines decided to come clean and turn in their co-‐ conspirators.
Some basic characterisEcs of games 1. Simultaneous v. Sequen2al Whether it is played sequen*ally (one player chooses, then the other like Ec-‐tac-‐toe or chess) or simultaneously (both choose at the same Eme like two magazines choosing newspaper headlines). The Prisoner’s Dilemma is a simultaneous game because they are quesEoned at the same Eme. Simultaneous games tend to be modelled in tables, sequenEal games in trees (see later). 2. Backward Induc2on Look forward, reason back. In a simultaneous game, this means to imagine your way into your rival’s shoes, see what their best strategy is and assume they will be doing the same to you (ad inﬁnitum), and reason back to what to do accordingly. In a sequenEal game, it means follow your move through a few steps and if you would fail on step three or four of forty, then don’t undertake step one. (In chess, if you see a checkmate ﬁve moves away, you don’t move your pawn out on move 1.)
3. Dominant Strategy Whether there is one way to behave that always works best, or a dominated strategy in which case it is always the worst outcome—or neither. The way to ﬁgure out whether you have a dominant strategy is mentally to picture a row of the table and to superimpose it on the other rows. If it is always higher for every box, it is dominant. 4. Credibility and Commitment: Threats and Promises Many games – eg, nuclear disarmament, poliEcs, parenthood – rest on the credibility of threats and promises. An incenEve has to be believable, and a threat has to be plausible and in proporEon to the oﬀense. Commitment, as in the game of chicken (cars driving head on) is a form of threat or promise. 5. Repeat or Single Game? Be more ﬁerce in a single game and more cooperaEve in a repeated game. 6. Predictability It is always strategically be_er to be unpredictable, as in a sport like football.
Expected Value “a good decision can have a bad outcome” If I play poker with Bob and Anne, these three things could happen: • A 50% chance of making $20 • A 30% chance of losing $20 • A 20% chance of breaking even Expected value = the probability x the value of the outcome What is the expected value of each outcome? 50% chance of $20 = .5 x $20 = +$10 30% chance of $20 = .3 x -‐$20 = -‐$6 20% chance of zero = .2 x $0 = 0
Expected Value Example 2: I am going to teach a class and charge $30. • If I get great a_endance, 100 people will come. ($30 x 100 people = $3,000) • If I get poor a_endance, 20 people will come. ($30 x 20 people = $600) At 50/50 odds, that is $1500 + $300 = $1800 At 20/80 odds, that is $600 + 480 = $1080
Nash Equilibrium each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy unilaterally
Cournot Companies compete on the amount of output they will produce, which they decide on independently of each other and at the same Eme Firm treats the output level of its compe&tors as ﬁxed and decides how much it should produce. Cournot Equilibrium: each ﬁrms output maximizes its proﬁts given the output of the other ﬁrms
Demand Curve in Oligopoly • Li_le consensus among economists on oligopoly price theory • Kinked demand curve is a fudge: really economists’ way of saying “we don’t know how rivals are going to respond to an oligopolist’s change in price, so here are the major opEons” • If rivals match price reduc*ons but not increases, kink results • Unmatched price decrease leads to increased sales and market share at lower prices: unlikely outcome • Unmatched price increase leads to reduced sales at higher price • Matched price decrease leads to growth in total quan*ty demanded, but revenue falls • Pricing behavior cannot be precisely formulated for oligopoly, because it is highly dependent upon assumpEons used
Review cartels, pricing leadership, and predatory pricing
AnEtrust, regulaEon, natural monopoly No compeEEve pressure can create ineﬃciency
Natural Monopoly Industry like a uElity or the post oﬃce that is so vast only one ﬁrm can support the ﬁxed cost structure
Government RegulaEon of Natural Monopolies 1. Regulate price • P = MC: consistent with opportunity cost • because MC is always less than ATC, would cause a loss on every unit produced 2. Provide Subsidy: • P = MC + subsidy 3. Regulate Proﬁt: • P=ATC • Doesn’t regulate cost 4. Regulate output: • Require minimum level of output • Doesn’t specify quality
Market Power • Consumer segmentaEon and discriminatory pricing • Divide the market according to willingness to pay, and charge diﬀerent prices
Barriers to Entry patents; monopoly franchises; exclusive suppliers (control of key inputs) or outlets; predatory liEgaEon (large ﬁrms have resources to liEgate); acquisiEon of compeEtors; scale economies, brand (to an extent)
Some Determinants of Market Power • ReputaEon (for toughness toward new entrants) • Long-‐term contracts with key suppliers (that make entry hard) • Licenses/patents • Learning curve eﬀects (ﬁrst mover advantage) • Brand advantage (strong for “experience goods”) • High exit costs (deters risk of entry)
Tests of Market Power • Number of producer ﬁrms • Size of each ﬁrm • Barriers to entry • Availability of subsEtute goods In essence, is the market contestable?
Red Flags for AnEtrust • Patents • CompeEtors must establish alternate means of producing or license process from patent holder • Supply & DistribuEon Control • Control distribuEon outlets • Also: control essenEal supplies, resources • Mergers and acquisiEons
MicrosoY’s anEtrust defense: That prices hadn’t increased, as they would have under expected monopoly condiEons of restricEng supply Also, that signiﬁcant anEtrust acEon would sEﬂe innovaEon The reality is that prices didn’t need to be super high, only for MR = MC Court found that MicrosoY had behaved illegally to maintain its monopoly posiEon and to take advantage of the fact that suppliers and consumers had limited alternaEves given network eﬀects, etc.
Cross elasEcity as measure Cross elasEciEes help answer quesEon of market deﬁniEon: • % change in QuanEty demanded of X divided by % change in price of Y. Analysis of cross-‐elasEcity shows the strength of subsEtuEon • If cross-‐elasEciEes are strongly posiEve – if increase in price of product being examined causes signiﬁcant increase in quanEty demanded of another product = eﬀecEve subsEtutes
ConcentraEon Measures of Monopoly 1. ConcentraEon RaEo – market share of top 4 ﬁrms >60% is considered oligopoly 2. Herﬁndahl-‐Hirschman Index – sum of squares of all the market concentraEons – if merger creates an HHI > 1800: DOJ will challenge – if merger creates an HHI between 1000 – 1800: DOJ will challenge if merger if likely to increase HHI by 100 points or more
Public Good • ConsumpEon by one person does not interfere with consumpEon by another – Private good: donut – Public good: water, air • Free-‐rider problem • The market tends to overproduce private goods and underproduce public ones
ExternaliEes • Costs or beneﬁts of producEon that are borne by a third party – Costs that don’t get added or subtracted + beekeeper who lives next to a ﬂower grower -‐ polluEon, excessive noise, environmental damage • PosiEve externaliEes tend to get subsumed into business models, negaEve externaliEes are oYen regulated
Examples of ExternaliEes • Costs of PolluEon • EsEmaEng the cost of environmental damage • Tangible or speciﬁc costs can be calculated by: • Diminished life expectancies • Lost work days • Direct medical costs • ProducEvity losses • Cost of replacing, restoring, remediaEng environmental damage
Remedies? • Regulate (producEon or purchase) • ShiY to consumers (consumer tax) • Assign Property Rights (Coase Theorem)
Coase Theorem A resource alloca*on can be eﬃcient as long as contrac*ng costs are suﬃciently low and property rights are assigned clearly, enforced well, and exchanged readily. • Ronald Coase, 1960 • The free market is more powerful in producing eﬃcient outcomes than previously thought • Pricing in externaliEes lets people trade them. Even if the price isn’t set right the ﬁrst Eme, the market will correct it.