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Exam 3 notes


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Exam 3 notes

  1. 1. CHAPTER 22 - PRICE TAKERS AND THE COMPETITIVE PROCESSLast chapter looked at production costs. In next two chapters, we look at the interaction of prices,profits and production for two groups of firms:PRICE TAKERS - Firms that must take/accept the market price, no control over setting price.Markets where:1. Homogeneous, identical products: coffee, sugar, steel, oil, gold, beef, milk, corn, wheat, soybeans,eggs, etc.2. Many small firms whose output is small relative to the market: e.g. wheat farms.3. Sellers/producers can sell all output at the market price, but cannot sell at a price above marketprice. No pricing decision.4. No barriers to entering the market/industry. Easy to get into the business, easy to get out.PRICE SEARCHERS (next chapter, CH 23) -1. Downward sloping demand curve.2. Products are not identical.3. Firms may or may not be small relative to the market.4. Firm faces a pricing decision, know that if it raises (lowers) prices, it will sell less (more).Examples: Nike, GM, Coke, Disney, Mars, etc.Most firms are price searchers. Why study price-takers?1. Many industries are price-taker markets: agriculture, energy and utilities, commodities, currency,credit markets, etc.2. Price taker markets are also known as "perfectly competitive markets" or markets with "pure orperfect competition" and they help us understand competition in the economy, e.g. competitive marketsand competitive behavior. Price-searcher markets can be just as competitive as price-taker markets,they are not necessarily "less pure" than price-taker markets.Perfectly competitive markets: large numbers of small firms producing an identical, homogeneousproduct. "No brand names/no advertising" e.g. wheat farms. No barriers to entry or exit: easy to get in,easy to get out.Barriers to entry: obstacles to entering and competing in a market/industry. Occupational licensurefor example (lawyers, doctors, accountants, barbers, plumbers, etc.).See page 486, Exhibit 1. Market prices are determined by market forces in the overall, world marketfor corn, soybeans, wheat, beef, etc. (Panel b) The individual firm/farm then faces a horizontal demandcurve (panel a). If the price of wheat is $5/bu., the wheat farmer can sell his/her entire crop at $5/bu.,but would find no buyers at $5.01/bu. There would be no reason to accept $4.99/bu., so the farmer is a"price taker" at $5/bu., and his/her output decision cannot influence the market price because their 1MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  2. 2. output is so small relative to the overall market.OUTPUT IN THE SRFirms output decision is based on comparing Benefits (additional or marginal revenue, MR) vs. Costsof additional or marginal units of output (MC).MR = Δ Total Revenue / Δ Output = ΔTR/ ΔQ (where Δ = change)Due to the Law of Diminishing Marginal Returns, MC will eventually rise, and so will ATC. In theSR, profit-maximizing Price-Taker will expand output as long as MR > MC, and will stop whenMR=MC. Beyond that level of output, MC > MR and firm would lose money on those units.RULE: PRODUCE ADDITIONAL UNITS UNTIL MR = MC, TO MAX PROFITS (OR MINLOSSES).See page 487, Exhibit 2. Demand (d) = P = MR. If market price is $5/bu., thats the firms Price, andalso is the firms MR, since each additional bushel generates $5 in revenue. Firm would continueproducing to Output level "q" to maximize profits.TR($) = (P x q) = 0PBq = Rectangle area for Total Revenue.Remember that: ATC = TC / q, therefore TC = ATC x q (or TC = C x q). (TC = Average cost (C) perunit ($) x the number of units (q)).TC = C x q = OCAq = Rectangle area for Total Cost.TR ($) - TC($) = Profits ($) = Rectangle area CPBAEntrepreneur probably doesnt actually make decisions based on considering MR and MC curves, ATCcurves, etc., but follows this process intuitively. To Max Profits, you want to sell output where thePrice > Costs of Production, you dont want to sell units where the Cost > Price. Without formalunderstanding of economics, the entrepreneur follows economic principles - "organized commonsense." Music example.PROFIT MAX - EXAMPLE, see page 489, Exhibit 3.At 1-10 units of output, and when Q >= 20, profits are negative, in both cases P < ATC and TR < TC.Between 11-19 units, profits are positive, TR > TC. Profits are maximized when Q = 15, which iswhen MR = MC approx. When Q > 15, MC > MR of $5, and profits fall. See graphs page 490,Exhibit 4. 2MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  3. 3. LOSSES and GOING OUT OF BUSINESSFirm should always produce where MR = MC, to either MAX profits or MIN loss. Profits/lossinvolves comparing ATC v P. What if firm is producing where MR = MC, but P < ATC, so that firm islosing money? See page 491, Exhibit 5, what to do? Three options for firm losing money:1. Continue to operate in SR, and lose money.2. Shut down temporarily.3. Shut down permanently (go out of business).If the situation is permanent (P < ATC), firm should go out of business, since there is no possibility thatthe firm will ever make money. If the firm expects that eventually P > ATC, then they have to decidewhether to operate in SR or shut down in SR. That decision is based on comparing P v AVC (averagevariable cost). Can the firm at least cover its average variable costs? If the firm can cover its variablecosts (P > AVC or TR > VC), then it makes sense to operate in SR, since it can make some money(profits) to cover FC (fixed costs). If P < AVC (TR < VC), then the firm is better off shutting down inthe SR, since it will lose more money by operating than by shutting down temporarily.Example: restaurant near GM plant. Fixed costs are $1000/month (rent, etc.) or $250/week andvariable costs are $500/week (labor, food, electricity, etc.). UAW goes on strike, business dropsdramatically from $1000/wk down to ???. Should the restaurant operate during the strike orshutdown? Depends on Total Revenue vs. VC of $500. If they can generate at $600 in sales, then theyshould stay open, since $600 > $500. They would then make $100 contribution towards FC of$250/week). The Loss = - $150/week (TR - TC = $600 - $750) ($500 VC + $250 FC = $750 TC).The firm would lose more money (-$250) by shutting down versus staying open (loss = -$150).But if the firm can only generate $400/week in sales, then it should shut down since $400 < $500, itcant even cover its variable costs. It will lose even more money by operating (-$350) than by notoperating (-$250).In fact, several restaurants, bars, sandwich shops near GM plants in Flint did shut down during thestrike in June and July 1998.If they never expected TR > $3000 per month ($1000 FC + $2000 VC), then they should shut downpermanently. They can avoid FC by shutting down.OUTPUT IN THE LONG RUN (LR)In the LR, firm can make major changes (expansion or contraction) in output. New firms can enter,existing firms can exit.Price taker market in LR equilibrium (p. 494, Exhibit 7):1. Qd = Qs = Market Price2. Economic profits = 0. (P = ATC and TR = TC) 3MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  4. 4. Why? Positive Economic Profits attract entry (P > ATC and TR > TC). Positive economic profitsmeans that firms in the industry are earning abnormally high risk-adjusted returns, which will attractentry. Existing firms will increase production and new firms will enter, so Supply increases, P fallsback to ATC.Negative economic profits, P < ATC. Firms will exit industry and/or contract production, Supply falls,Upward pressure on Price. P rises to ATC, normal profits are restored. "Rate-of-return Equalization Principle." Highly profitable industries attract entry, competitionincreases, leading to normal, risk-adjusted returns in LR. In unprofitable industries, firms exit, there isless competition, and normal profitability is restored in LR.INCREASE IN MARKET DEMAND, see page 495, Exhibit 8.Demand increases from D1 to D2 in the market (panel b), from d1 to d2 for a price-taking firm (panel a),market price rises from P1 to P2 in both markets. Firm initially make economic profits, since P2 >ATC. Profits attract entry from new firms and existing firms expands output to take advantage of highprofits. Market Supply shifts from S1 to S2 (panel b) as new firms enter the industry and existing firmsincrease output. Market price eventually returns from P2 to P1. Short run profits are eliminated.DECREASE IN DEMAND, see page 496, Exhibit 9.Market Demand falls from D1 to D2 (panel b), from d1 to d2 for price-taker firm (panel a), and marketprice falls from P1 to P2. Price is now < ATC, firms lose money. Firms cut back on production, andsome firms go out of business. Supply shifts back from S1 to S2, and Price goes back up to P1 from P2.Short run losses are eliminated.See p. 496, coffee market as an example of price-taker industry.LR SUPPLYLong-run Market Supply curve shows the minimum price at which firms will supply output, givenenough time to adjust to market conditions. Shows the cost of production as the entire industrys outputchanges. Three possibilities:1. Constant-cost industries. Input prices, resource prices, factor prices remain constant at output isexpanded or contracted. LR Supply curve would be horizontal, perfectly elastic. In both cases onpages 495 and 496 the LR supply curve was perfectly elastic, indicating a constant-cost industry.Example: industry where the resources used are very small relative to the entire supply/demand forthese resources. Match industry - the demand for wood in the match industry is small relative to theentire market for wood, so that if the output of matches doubled, there would not be any upwardpressure on prices for wood. If the output of matches fell significantly, there would likewise be noeffect on the market price of wood. 4MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  5. 5. 2. Increasing-cost industries. More realistic for many industries. As industry expands output, thedemand for inputs/resources/raw materials/labor increases, which puts upward pressure on resourceprices as prices for materials and labor get bid up. Rising prices for resources means that the industryfaces increasing-costs as output/supply increases, resulting in an upward sloping market supply curve.Example: Demand for new houses rises, due to population increases, low interest rates, rising income,changes in tax laws, etc. More homes are built, but resources for houses have to be bid away fromother uses for wood, labor, supplies, etc. The cost of supplying housing will eventually rise.See page 498, Exhibit 10. D1 to D2 for market demand (panel b), d1 to d2 for price-taker firm (panel a),price goes from P1 to P2. P is initially > ATC, Supply increases from S1 to S2. New long-runequilibrium is established. Market Supply curve in LR (Slr) is now upward sloping, reflectingincreasing costs of production in the industry.3. Decreasing cost industry. Industry where input costs decline as output expands. Not as common asincreasing cost industries. Could happen if expanded production lowers component prices, e.g.electronic industry. Market Supply curve would slope downward.SUPPLY ELASTICITY and TIMESee page 499, Exhibit 11. Suppose market P rises from P1 to P2. Firms in the industry will expandoutput from Q1 to Q2 initially. Over time, firms will gradually adjust to higher price, by expandingoutput gradually to Q3, Q4, Q5. Why not expand right away? Might be too costly, "cost penalty" forimmediate increases in output. Might take time to find new sources of inputs/raw material, bestsources of capital (credit card vs. bank loan), new employees (vs. overtime), etc. Supply curve is moreelastic over time, as firms can adjust to higher levels of output.PROFITS and LOSSESThe role of economic profits is clearly illustrated in the Price-Taker model.1. Free entry (or low barriers to entry) serves consumers, protects them from producers, and ensureslow or competitive prices. Example: taxi cabs in D.C. versus NYC.2. Profits and losses communicate signals to producers from consumers, about how well they are doingat pleasing consumers, creating value for consumers. Profits are rewards to successful producers forcreating value, losses are penalties to firms that are unsuccessful at pleasing consumers. Profit/losssystem is a very effective disciplining system, rewarding success, efficiency, value, service in themarket and penalizing inefficiency, poor service, low value in the market. Successful firms arerewarded with profits, and they attract resources to expand. Unsuccessful firms face the discipline ofthe market, they are forced to operate more efficiently, serve customers more effectively, create moreconsumer value, or they will be forced out of business. 5MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  6. 6. 3. Market system of Economic Profits and Losses produces a continual reallocation of scarce resources,away from unsuccessful, inefficient firms, towards successful, efficient firms. Success = pleasingconsumers. "Consumer sovereignty." " Incentives matter." Important role of the entrepreneur.Example: Videotape rental market. Market with low barriers to entry. In 1982, market was justdeveloping, there were only 5000 stores in US, prices were $5/day. Profits were very high in thevideotape rental market, attracting entry, increasing supply to 25,000 stores in 1990. Prices came downto $1-2/day, due to intense competition. Producers responded to the consumer preferences, profitsattracted resources to an expanding industry. Consumers were served by the producers. Profits in theLR were restored to normal level. Some firms left the industry, because it was so highly competitive.PRICE TAKERS, COMPETITION AND PROSPERITY1. Price-taker firms have no control over price, they have to take the market price. However, they cancontrol their costs, so there is a strong incentive to reduce costs of production, and invest in cost-savingtechnology, to operate more efficiently. Eggs - physical product has not changed over time, but costsof production have been reduced by 80% over time, due to intense competition.2. Firms face the competitive pressure of the market - forces them to be serve consumers, operate atmaximum efficiency - or they go out of business. Invisible hand - Adam Smith. See quote page 502.Main point: "Competition breeds competence."See "Outstanding Economist" on p. 501, Nobel prize economist Hayek - "spontaneous order" and "thefatal conceit." 6MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  7. 7. Chapter 23 - COMPETITIVE PRICE-SEARCHER MARKETS WITH LOW ENTRY BARRIERSFirms who are Price-takers just take the market price - there is no pricing decision, no advertising, nomarketing, etc. They can adjust their output (expand/contract) and they can try to reduce costs ofproduction, but they have NO pricing decision (corn farmer).We now look at Competitive Price-Searcher Markets, where:1) firms face a downward sloping demand curve for their product or service, and2) there is easy entry and exit . With low entry barriers, the "smell of profits" will attract competition.Price-searching firms face a more complex set of decisions - see opening quote on p. 490. Firms neverreally directly observe demand curves, so they have to engage in a process of trial-and-error to searchfor the price that maximizes profits. Since markets are continually changing, the price searchingprocess is continual and ongoing, e.g. airlines, long distance, computers, online services, etc.Firms are now selling differentiated products with brand names and have pricing decisions - how tomarket, advertising, bundling (computer + printer), specials, discounts, promotions, rebates, coupons,quantity discounts, senior citizen discounts, price discrimination, etc.However, there are usually many close substitutes so these price-searcher markets are highlycompetitive - fast food, cell phones, airlines, computers, athletic shoes, etc. A price-searching firm canraise its prices and NOT lose all its customers, unlike a price-taker. However, because there are lots ofclose substitutes, the demand curve facing an individual price-search firm will be highly ELASTIC.The firm faces stiff competition from two sources:1) all existing firms in the industry and2) potential rivals or competitors who will enter the industry if profits are high, e.g. coffee shops,online services. "The smell of profits."Firms can set price, but then market forces determine how much is actually sold at a given price. Firmsattempt to find the Price-Quantity combinations that MAX PROFITS.Firms also can control more than just Price, they can control other non-Price factors that affectconsumer value: Quality, location, service, advertising, convenience, bonuses (frequent flier miles), etc.Main Point: price-searching firms face a complex set of decisions, compared to price-taker.PRICE AND OUTPUTHow does a price-searcher decide on the Price-Output combination that MAX PROFITS?A firm faces a trade-off when changing its price. If price is lowered, more units are sold, but at a lowerprice for ALL units. If price is raised, fewer units are sold, but at a higher price for ALL units. SeeExhibit 1, page 508. Firm lowers price from P1 to P2 and output expands from q1 to q2. There are twoeffects: 7MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  8. 8. 1. (P2 - P1) x q1 = Loss of Total Revenue from selling the original units (q1) at a new lower price (P2),since the new price (P2) applies to both new customers and old customers.2. (q2 - q1) x P2 = Gain in Total Revenue from attracting more customers (q2 - q1) times the new Price(P2).Because of these conflicting forces on TR, the marginal revenue (MR) will always be less than Price,and the MR curve will always be below the Demand curve, see Exhibit 1.PROFIT MAX RULE: Expand output as long as MR > MC. See Exhibit 2, page 509. At all units upto q, MR > MC, which increases profits. Beyond q, MC > MR, which will reduce profits. Firm shouldproduce q units to Max Profits (Min losses).General Procedure:1. MR = MC determines profit maximizing (loss minimizing) level of output (q or Q*).2. Based on Profit Max output level (q or Q*), we can determine the profit-maximizing price (P*) fromthe Demand curve (d).3. Based on P*, we can determine profits (losses) by comparing P* vs. ATC.Exhibit 2: TR = 0PAq and TC = 0CBq. Since TR - TC = PROFITS, the brown shaded area representsEconomic Profits.The positive Economic Profits of the firm will now attract competition into the market since barriers toentry are low - competitors will expand output and new firms will enter the industry. Eventually, otherfirms will take away some the original firms business and the demand curve will shift back until thefirm will just cover its costs of production and P = ATC as on Exhibit 3, page 510. Economic Profitswill be zero (TR = TC; and P = ATC) and there will be no more pressure to enter the industry.In the long run, the economic conditions of a representative competitive price-searching firm areillustrated in Exhibit 3. P = ATC, firms are covering all costs of production (including opp costs ofcapital, etc.), economic profits are zero, firms are earning a positive, risk-adjusted normal rate of return.In the SR, price-searching firms can either make economic profits or economic losses. Economicprofits attract entry and drive prices down to ATC. Economic losses cause competitors to leave theindustry, surviving firms can eventually raise prices to cover ATC, economic profits will return to zero.LR = Zero Economic Profits = Risk-adjusted Normal Rate of Return = Rate-of- Return EqualizationPrinciple.BUSINESS FAILUREThe profit-loss system imposes strict discipline on firms. Firms that suffer economic losses musteventually fail and go out of business. Business failures, although painful for workers who lose theirjobs, and investors and creditors who lose money, play an important role for the economy as a whole.Business failures free up and release valuable and scarce resources (labor, land, capital, credit, real 8MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  9. 9. estate, machinery, etc.), that then become available for use by others in the economy who can use themmore productively. Reallocation of resources away from inefficient uses to more efficient uses.Without the release of these resources, economic expansion for profitable firms and the wholeeconomy would be slower. Point: Business failures dont destroy the assets of the firm or the talents ofthe workers, they are released for use by other more profitable and successful firms. In the long run,even many of the workers are usually better off.Examples: McDonalds vs. Sandys and Henrys. Venture capitalist activity in Russia.CONTESTABLE MARKETSVery competitive price-searching markets where:1. Barriers to entry and exit are low. Easy for firms to enter/exit the industry.2. Zero economic profits in LR (P = ATC)3. Minimum cost/most efficient method of production will prevail since both high prices andhigh/inefficient production costs will attract entry.Potential competition, as well as current/existing competition, will discipline firms in contestablemarkets. Implication of this is that even an industry with one dominant firm (software industry,Microsoft) can be contestable (competitive) if the threat of competition is sufficient to discipline thedominant firm. The dominant firm has incentive to keep prices so low that no other firm cansuccessfully challenge their position. Example: Alcoa Aluminum.Policy implication: If an industry is seen as not sufficiently competitive, we should look at what can bedone to make the industry more contestable. What barriers to entry exist that can be removed orreduced? In many cases the way to make the industry more competitive is to DEREGULATE theindustry, since regulations form a barrier to entry. Deregulation (regulation) makes markets more (less)contestable, more (less) competitive.Examples:Airline IndustryTruckingOccupational Licensing - MDs , JDs Barbers, etc.Handicap AccessibleZoningCar WashShoe ShineTHE LEFT-OUT VARIABLE: ENTREPRENEURSHIPOur economic model provides a general framework for analyzing the decision making elementscommon to all firms - sole proprietorships to GM and Microsoft. What we can accurately model is thegeneral behavior that describes Profit Maximizing behavior by firms. We know that successful firmsdo something that accounts for their business success over time - Microsoft and GM engage in decision 9MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  10. 10. making that is consistent with our economic models even though Bill Gates may have never taken aneconomics class. Many successful entrepreneurs make decisions intuitively, and pure entrepreneurialbehavior can not accurately be modeled with graphs and equations. There is no way to preciselymodel complex decision making of an entrepreneur involving uncertainty, risk, discovery, innovation,creativity, etc.Entrepreneurs are at the center of economic activity in the real world, even though they are not ineconomic models. Business is part art and part science, we can model the scientific part much easierthan the part of business that is an "art."Music example. We can study and analyze Mozart or Beethoven, put their music into a formal musicalmodel of sheet music, musical notation, musical score, etc. We dont try to model the creativity behindthe music, we just respect it and appreciate it. Same thing for business. Even though we dont modelentrepreneurship, the role of entrepreneurs as "agents of economic progress" is very clear.Entrepreneurship and Economic Progress:Quote (p. 515): "The entrepreneurial discovery and development of improved products and productionprocesses is a central element of economic progress." In a dynamic, highly competitive economicsystem, the role of entrepreneurs is critical and highly important. The market economy, more than anyother economic arrangement, nurtures, promotes and supports entrepreneurial talent. Economy vs.sports example - discuss in class.See story on "Five entrepreneurs who have changed our lives," p. 516-517.PRICE-TAKER AND COMPETITIVE PRICE-SEARCHER MARKETS (See Exhibit 4, p. 519)Similarities between Price-Taker and Price-Searcher Markets:1. P = ATC, Economic profits are 0. Competition prevents positive economic profits in LR. Firmshave strong incentive to operate as efficiently as possible, try to lower ATC, to make SR profits.In both markets, an increase in demand will result in: higher prices, SR economic profits, expansion ofoutput by existing firms, and entry by new firms, increase in market supply, downward pressure onprice, price will eventually fall to ATC, all SR economic profits will be squeezed out.Differences:1. For Price-Taker market, P = MC, for Price-Searcher Market P > MC.2. For Price-Taker market, output level minimizes ATC, for Price-Taker market, output does notminimize ATC.3. Price is slightly higher in the Price-Searcher market ($1 vs. 97 cents for Price-Taker) for identicalcost conditions.Debate: Are competitive Price-Searcher markets inefficient? 10MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  11. 11. Conventional View: Prices are higher, due to costly replication, too many firms operating below thecapacity that would min ATC. Example: too many small gas stations and convenience stores locatedtoo close together, resulting in higher prices than if there were fewer, large gas stations and grocerystores spread further apart.Also, conventional view says that firms waste money trying to differentiate their products and spendingmoney on advertising, resulting in higher prices for consumers.Modern View: Even though prices might be slightly higher, consumers receive benefits from price-searcher behavior. Advertising is costly, but consumers value the information transmitted byadvertising, it reduces search time, gives valuable information about new products and new firms, etc.Consumers also benefit from differentiated, brand-name products even though prices are higher -consumers value designer clothing even though prices are higher. Consumers value unique productsthat may reflect their personality.Example: vehicles. Consumers value a wide selection of vehicles even though prices are higher than ifwe all were willing to accept a standardized vehicle in one color with a standard set of options, etc.Consumers also value the convenience of having many gas stations, convenience stores, fast foodrestaurants, etc even if prices are slightly higher, compared to the alternative: fewer stores, morecongested, located further apart.And if consumers dont value higher priced differentiated brand name products that are heavilyadvertised, they can always buy low priced, generic products.SPECIAL PRICE-SEARCHER CASE: PRICE DISCRIMINATIONSo far, we have always assumed that there is a single price (P) and that all consumers pay the sameprice - the Market Price (P). Price discrimination is where a firm charges different customers differentprices for the same product or service.Examples: airfares, coupons, senior citizen discounts, tuition, car sales, weekend specials at hotels orski resorts, telephone service for business vs. residential, etc.Price Discrimination involves:1. Identifying and separating two or more groups with different elasticities of demand. Charge a higherprice to the group with the more INELASTIC demand, a lower price to the group with more ELASTICdemand.2. Preventing resale from the Elastic group (low price) to the Inelastic group (high price).3. Controlling resentment, so that the Inelastic group doesnt resent paying higher prices. (not in book)Example: Exhibit 5, p. 521, Airline fares. Panel a, shows a uniform, single price of $400 per ticket,and output of 100 passengers, for TR = $40,000. That is the Profit Max level of output, where MR =MC. MC is fixed at $100/person, so those costs are $10,000 (100 passengers x $100), operating profitsare $40,000 - $10,000 = $30,000. 11MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  12. 12. Panel b - airline now has two prices, $500 for travelers with Inelastic demand, mostly businesstravelers, or those who have to travel at the last minute, etc. Fares are reduced to $300 for travelerswith Elastic demand - tourists, students, vacationers, etc. To get the low price, you must makereservations far in advance, have flexible travel dates, fly during off-peak hours, stay over a weekend,etc.Result: 60 people fly for business, pay $500 and 60 people fly for leisure pay $300. Total Revenue isnow: (60 x $500) + (60 x $300) = $48,000. Costs are: 120 x $100 = $12,000, leaving $36,000 inoperating profits.Bottom Line: Using price discrimination (two prices instead of one price), the airline raises TR by$8,000 and operating profits by $6,000. This example illustrates the general principle that pricediscrimination can increase profits. Also, the more price discrimination the firm uses, the higher thepotential profits. Going from one price to two prices raised profits, going from two prices to three couldraise profits even higher, and then why not try 4 prices, 5 prices, 6 prices, etc. Airlines are masters ofprice discrimination.Also, in this case, output increased, from 100 passengers to 120 passengers, volume of trade (air travel)increased. This increase in trade can increase the overall gains from trade, increases welfare. And insome cases, price discrimination might allow trade/production to take place where none wouldotherwise occur. Example: small town in Montana may only be able to attract a physician if they canprice discriminate, charge higher prices to higher income patients.Price discrimination is so common, is it really a "special" case?COMPETITION INCREASES PROSPERITY (from the 9th edition):1. Competition forces producers to operate efficiently and cater to consumers, weeds out the inefficient,reward the firms who are successful at pleasing consumers. What makes McDonalds, Wal-Mart, GMsuccessful? Competition. If they try to raise prices, offer poor service, low quality products, consumerswill to Burger King, Target or Toyota.2. Competition provides strong incentives to operate efficiently and to constantly innovate, either toimprove production, raise quality, develop new products. Think of all the money spent on research anddevelopment, firms are in a constant process of innovation, trying to develop and make new products -microwave ovens, fax machines, cell phones, CD players, VCRs, bypass surgery, etc. The role of theentrepreneur is to engage in the discovery process, finding new products that create value forconsumers. Entrepreneurs must face the market test - "reality check" imposed by consumers.3. Competition also forces firms to discover the most efficient type and size of business organizationthat creates value for consumers. Market economy does not impose a certain size on producers, firmscan operate as sole proprietorships or huge conglomerates with thousands of employees - GM, Coca-Cola, etc. Efficient organizations will be rewarded and inefficient ones will be penalized. If a firm istoo large or too small, and unit costs are high, the firm will be penalized with losses. Part of the 12MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  13. 13. competitive market process is searching for the most efficient form of business organization that willresult in the lowest ATC/unit.Examples: Assembly line production, JIT Inventory, Modular assembly, Downsizing, Restructuring,Internal vs External production, etc.Summary: Competition harnesses personal self-interest and promotes a higher standard of living.Rival firms struggle for the dollar votes of consumers. Continual market referendum on consumerpreferences. Market economy as a "virtual voting booth."Chapter 24 - PRICE-SEARCHER MARKETS WITH HIGH ENTRY BARRIERS 13MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  14. 14. So far we have assumed that price-taker and price-searcher markets are competitive, due to low barriersto entry (and exit). We now look at industries where the barriers to entry/exit are high.WHY ARE BARRIERS TO ENTRY SOMETIMES HIGH?1. Economies of scale. If ATC is declining over the entire range of output that consumers are willingto buy, a single firm may dominate the industry. The cost advantage may protect the firm fromcompetition, including potential rivals. The barrier to entry is the cost advantage that a single, verylarge firm may have. Example: ALCOA, dominated the aluminum industry for years.2. Government Licensing. Legal barriers are the oldest and most effective way to get protection fromcompetition, coercive monopoly. Using the power of the government to eliminate, reducecompetition. Examples: post office, utilities, cable TV, radio/TV stations, Dept of Motor Vehicles, etc.Occupational licensing or business licensing - limits entry/competition. Examples: Physicians, lawyers,hair stylists, taxicabs, accountants, etc. Advantage: ensures minimum standards. Disadvantages: raisescosts, reduces competition, puts in place barriers to enter the profession. Who generally asks forincreased regulation - industry or consumers? Example: CPAs - new 150 credit hour requirement.("When buying and selling are controlled by legislation, the first things to be bought and sold arelegislators."--P.J. ORourke)3. Patents, other intellectual property rights. Examples?? Most countries have copyright laws togrant legal protection to inventors, authors, songwriters, etc. Patents give owners an exclusive legalright to be protected from competition for 17 years in U.S. Advantages: stimulates research,development of new products, fosters innovation, creative discovery process. Without legal protectionfor intellectual property, there would less innovation, fewer new products, etc. Disadvantage: pricesare higher during the patent period, owner has a temporary monopoly.4. Control over an Essential Resource. Firm has exclusive control over a natural resource, usuallyonly temporarily, due to substitutes, discoveries, etc. Examples: 1) Aluminum before WWII. 2)Diamonds are only found in a few places on the planet, mostly South Africa. One company dominatesthe diamond market, De Beers.THE CASE OF MONOPOLYMonopoly literally means "single seller." In economic terms, a monopoly is a market where there:1) is a single seller of a good for which there are no good substitutes, and2) are high barriers to entry.However, "no good substitutes" and "high barriers" are somewhat vague.For example, barriers to enter the auto industry might be considered high, because you would need tooperate at a huge scale to be competitive, and the large amount of financial capital necessary might be abarrier to entry. However, capital markets are efficient, there are thousands of global investors, so ifthere was a profitable opportunity, capital could be raised to compete against GM. Also, there aresubstitutes for everything, so there are very few situations where no good substitutes exist. 14MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  15. 15. Monopoly is always a matter of degree. For example, US Post Office is the single provider of firstclass mail, and it is a protected, coercive monopoly with a legal protection from competition.However, there are good substitutes for first class mail, such as ????PRICE AND OUTPUT UNDER MONOPOLYSuppose you have a patent on a new invention, so you are legally protected from competition for 17years. You face the cost curves on page 530, Exhibit 1. You are the only seller, so the market demandcurve is also the demand curve the firm (patent holder) faces.The general rule is exactly the same as before for price-searchers and price-takers:1. Expand output as long as MR > MC. Stop producing when MR = MC, at Q* (profit max outputlevel).2. That level of output (Q*) will determine the market price (P*), from the demand curve.3. Comparing P* vs. ATC will determine the profit per unit, and total profits.See page 530, Exhibit 2, for a numerical example of a monopoly. Firm would expand as long as MR(Column 7) > MC (Column 6). At Q=8, MR > MC ($8.50 > $5.75). At Q = 9, MC > MR ($6.25 >$6). Firms profit would be slightly higher at Q = 8 than Q = 9 ($29.50>$29.25). PROFIT MAX: Q* =8 and P* = $17.25.Important Points for Monopoly:1. Firm can sustain LR positive Economic Profits since P > ATC will not attract direct competition fora monopolist, at least during the 17 year period of a monopoly. Patent protection insulates the firmfrom direct competition.2. Even monopolists cannot get away with charging whatever price it wants, it still faces a downwardsloping demand curve. Remember, firms want to maximize profits, NOT price. If the monopoly onpage 530 tried to raise Price (P*) from $17.25 to $18.50, demand would FALL from 8 to 7 units perday, and profits would FALL from $29.50/day to $26.75.3. Even though the patent holder has a monopoly, it doesnt mean that a profit is guaranteed. There arethousands of patented products that are never produced because the demand-cost conditions are notfavorable, see Exhibit 3, page 531. P < ATC, monopolist firm suffers economic losses, and will shutdown, or never operate in the first place. (Note: If conditions on p. 531 are permanent, firm shouldshut down, or not operate in the first place. If temporary, it should continue production in SR if P >AVC. If P < AVC, firm should shut down in SR.)As before with the price-taker and price-searcher, the monopolist never actually observes demandcurve and cost curves. Like other price searchers, the monopolist has a strong incentive to find theprofit maximizing price and output, and the firm will act as if MR and MC had been used indetermining the profit-maximizing P* and Q*. The actual business owner of a patent will act more on 15MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  16. 16. intuition, trial-and-error, discovery process, "seat-of- the-pants" approach, but his/her decision makingprocess will be consistent with economic theory.OLIGOPOLYMonopoly = single seller. Oligopoly = several large, dominant firms/sellers compose the entireindustry. Examples: automobiles, steel, cigarettes, aircraft, pianos, TV (before cable - ABC, CBS,NBC), computers, retail office supplies (Office Depot, Staples and Office Max), retail discount stores(Wal-Mart, K-Mart and Target).Oligopolistic markets are characterized by:1. Small number of very large, dominant rival firms where sellers produce either identical(gasoline) or differentiated products (cars).2. Interdependence among firms. "Strategic interdependence." Since there are only 3 or 4 firms inthe entire industry, the reactions of rivals play an important role in strategic decisions. For example, ifGM is thinking of a price increase (reduction), it has to think of how Ford will react. Oligopolisticfirms are more inter-related than firms in other industries.3. Economies of scale, large scale production results in only a few, very large firms. Example: autoindustry, page 516. The entire market demand is 6m cars per year at P*. To be competitive, a singlecar company has to produce at least 1m cars per years. In this case, the entire industry can maybe onlysupport 3 cost-efficient firms, no more than 5-6 firms.4. High entry barriers. Economies of scale are usually the entry barrier that limits competition inologopolistic markets. In the auto industry, it is difficult to start out small, and gradually grow to theoptimal size, you would have to start at the optimal size immediately. It would be very difficult tocompete with GM producing 1000 cars per year, you would have to produce 1m cars/year to becompetitive. Dominos Pizza was able to start small, and eventually grow large and compete withMcDonalds, but no U.S. startup firm has been able to challenge the position of GM, Ford and Chryslerfor 50 years. Fast food would be more contestable, automobile industry has very high barriers to entry.PRICE AND OUTPUT FOR OLIGOPOLYFirm considers not only how customers will react to a change in price or quality, but how rivals willreact to price increase/decrease. Page 534, Exhibit 5: If firms act competitively, Price will get drivendown to LRATC, economic profits = 0, and Output is Qc and Price is Pc. If the market price istemporarily above Pc, then P > LRATC, firms are making econ profits. Firms will have an incentive tocut price to Pc, attract customers from rivals, leading to additional price-cutting, reducing price backdown to Pc. Therefore, when competition prevails, Price = LRATC in a competitive oligopolisitcmarket. Oligopoly doesnt necessarily mean anti-competitive behavior, market can be competitive(Target vs. Wal-Mart, or GM vs. FMC). 16MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  17. 17. Suppose oligopolistic firms exploited their interdependence by engaging in collusion, price-fixing,cartel behavior? Such a strategy is illegal in U.S. by antitrust law, considered "restraint of trade." TheOPEC cartel for oil formed because it was outside the control of the Dept of Justice, they agreed torestrict output, raise price and make economic profits for the members, see page 535 (Exhibit 5 graph)and page 535 (OPEC discussed). Perfect Cooperation (cartel) result: Pm and Qm, resulting in PositiveEcon Profits, purple shaded rectangle, for the cartel firms to share.A cartel is an example of Perfect Cooperation, with the same outcome as a monopolist. The colludingfirms, by joining together as a unified group, are just like a single monopoly firm, with the result ofpotentially sustainable profits.In the real world, the actual outcome would probably lie between the extremes of perfect cooperation(Pm, Qm) and perfect competition (Pc, Qc). Oligopolistic firms can never act totally like a monopolist,because: 1) it is illegal, and 2) competitive pressure exists. However, because of interdependence,firms know that they can all benefit by not avoiding vigorous price competition, resulting in P > ATC,possible sustainable econ profits.OBSTACLES TO COLLUSIONA cartel is an example of collusion, an anti-competitive agreement to restrict output, raise price andavoid competitive practices, especially price reduction/competition. Collusion can either be a formalagreement, like OPEC, or informal, tacit, implicit collusion. Obvious collusion is illegal (conspiracy torestrain trade), tacit collusion may be hard to detect.Conflicting pressures for arrangements to collude:1. Cooperate with rivals/partners to maximize joint profit, avoid competition.2. Secretly cheat on collusive agreement to increase an individual firms share of profits, by loweringits price. By secretly lowering price, the cheater can sell to: a) customers who wont buy at the highcollusive price and b) customers of the rivals. Steal customers from partners. Cartels/collusiveagreements are very unstable.See Exhibit 6, page 535. Industry demand and supply conditions suggest a market price for the cartelof Pi, which will max profits for the cartel as a group. However, the demand curve facing an individualfirm is much more elastic, panel b, so the ideal price for the firm would be Pf, a lower price than theagreed upon cartel price of Pi. The firm can increase its individual profits by cheating, taking a greatershare of the group profits, i.e. stealing from its partners by secretly lowering price. Increasing marketshare at the expense of partners.POINT: Cartels inherently unstable, and unsustainable in LR, and often break down on their own.SPECIFIC OBSTACLES to COLLUSION1. As the number of firms increases, the harder it is to effectively collude, because it will be moredifficult to achieve unity on pricing/output decisions, and more difficult to negotiate and enforce theagreements. The more firms, the more potential conflicts. 17MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  18. 18. 2. The more difficult it is to police, detect and prevent cheating, the less collusion will take place.Cheating can be subtle and may not just involve price cutting. How could an OPEC producer attractcustomers besides cutting prices?? How could they effectively lower the price without actually cuttingthe price?? And what enforcement mechanism is there to discipline cheaters?3. Low barriers to entry are an obstacle to collusion. The smell of profits from the colluders will attractcompetition. If barriers to entry are low, collusion will be unsustainable. Example: if all theaccountants/lawyers/physicians/plumbers in Flint agreed to raise prices, low barriers to entry wouldresult in increased competition in the future. During OPEC, the high oil prices encouraged: a) oilexploration by US, non-OPEC countries, and b) alternative fuel research. In many cases, thecartels/colluders cant prevent new entry, making the arrangement unstable.4. Unstable (stable) demand makes collusion less (more) likely. If demand is unstable, it will be harderto agree on the level of reduced output required to raise the price to an optimal amount. Collusionrequires consensus and agreement, which is harder when demand is uncertain.5. Collusion is illegal. Vigorous enforcement of antitrust laws will minimize collusion. Fines/penaltiesare severe - triple damages, and participants (corporate officers) can be held personally liable. Secretagreements might be hard to detect.DEFECTS OF MARKETS WITH HIGH ENTRY BARRIERSWhat are the problems when competition is restricted by high entry barriers?1. High entry barriers reduce competitiveness of the market, and limit options available toconsumers. Insulated from competition by high entry barriers, protected firms or individuals cancharge high prices and offer poor service, behavior that competitive firms cannot get away with. Whois more responsive to customers? Target, or the Department of Motor Vehicles? With high entrybarriers, the discipline of the market is reduced, the responsiveness of producers to consumers isweakened. Reduction of "consumer sovereignty."2. Reduced competition results in inefficiency. W/protection from competition, monopolists orcartels, can charge P > ATC, make economic profits, not attract entry to drive P down to ATC. Byrestricting output and raising P, the optimal amount of trade does not take place. Society is worse offfrom the "restraint of trade," mutually beneficial trade does NOT take place is a loss of wealth.Reduction of our standard of living from higher prices and lower output, v. competitive market.3. Barriers to entry encourage "rent seeking." Grants of special favor (protection from competition)will lead to resources being devoted to rent seeking - lobbying, campaign contributions, etc. Some orall of rent seeking will be inefficient because resources are being diverted from productive activities(output) to potential wasteful activities. Could be an overall reduction in welfare for society from theinefficient allocation of resources, contributing to the allocative inefficiency discussed in #2.Example: Suppose a city or state (or federal) government considers granting a limited number oflicenses providing a seller with some exclusive right to sell liquor, operate a taxicab, operate a car 18MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  19. 19. wash, offer legal/medical services, operate a cable TV company, inspect homes, cut hair, tow cars forthe city, etc. Suppose this is new legislation being considered and assume that the legal protectionfrom competition is worth $100,000 over the life of the license. How much would individual sellers bewilling to spend to get the license? Other potential suppliers would also be willing to spend thatamount trying to convince public officials that they will best "serve the public interest", resulting inmore resources being spent collectively than $100,000, resulting in economic waste.Example: Halloween costume party with a prize for best costume of $1000.POLICY ALTERNATIVES WHEN ENTRY BARRIERS ARE HIGHEconomists suggest four policy options when barriers are high.1. Restructure the industry to increase the number of firms - maybe. In some cases, it is possiblethat a single dominant large firm has a "natural monopoly," since it has significant cost advantages oversmaller firms. ATC is declining over the entire range of market demand. In this case, breaking up themonopoly would actually be inefficient, since the result would be more, smaller firms with highercosts. As long as there is a threat of potential competition, low entry barriers, the market is contestableand therefore efficient and competitive even with one or two dominant firms. Examples: a) single drugstore, hardware store, restaurant in a small town, b) ALCOA, c) Microsoft? FTC and DOJ regulate theeconomy to prevent "restraint of trade" and "monopoly." 90% of antitrust action is a result of one firmsuing a competitor.2. Reduce artificial barriers to trade - tariffs, quotas, licensing requirements, regulations.Deregulate the industry, open it up to competition, e.g., trucking and airlines in the early 80s. In many(most?) cases, the source of barriers to entry is the government itself, since it is government that ispassing laws to restrict competition - tariffs, occupational licensing, regulations, etc. usually at therequest of the industry itself to limit competition.Example: tariffs are a barrier to entry, since they impose a tax on foreign goods, giving the domesticfirm a cost advantage by protecting them from competition. Protectionism protects the domestic firmsfrom competition. Domestic firms can be disciplined by foreign competition, serving the interests ofconsumers.Special interest issue. Domestic suppliers are concentrated and well-organized, and consumers arepoorly organized and widely dispersed. Special interest groups will take advantage of consumers,resulting in too much regulation/protectionism from an overall efficiency standpoint.Reducing artificial barriers to trade is economically desirable, but may not be politicallyrealistic/feasible.3. Regulate the protected producer, such as a regulated utility (phone, gas, electric companies,cable TV), being regulated by a state regulatory agency. See Exhibit 8, page 543. Unregulatedmonopolist would restrict output and produce Q0 units and charge price P0 (MR = MC), resulting in P >MC and P > LRATC, resulting in positive Econ Profits. 19MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  20. 20. SOLUTIONS FOR REGULATING PROTECTED PRODUCER:a. Average Cost Pricing. The regulatory agency could force the monopolist (electric company) tocharge P = LRATC, which would be P1, resulting in increased output Q1 in Exhibit 8. Society is nowbetter off, lower price and higher output increases welfare.b. Marginal Cost Pricing. At P=ATC (P1), P>MC, and there would be welfare gains to society if Pwas reduced to P2 and output was increased to Q2. However, the problem is ??Problems with Regulating utilities, monopolies:1. Lack of accurate information. It might be hard to accurately determine P = LRATC, demand andcost curves are not easily observable. Usual solution: Regulated monopolist is supposed to earn a"normal accounting rate of return," which would be the same as "zero econ profits." If the utilitysreturns are too high (low), its regulated prices/rates are too high (low), and prices need to be lowered(raised). However, the protected monopolist would try to do what? Always report low profits tojustify rate (price) increases.2. Cost shifting/inefficiency. Regulated utilities have a fixed rate of return by the regulatory agency.Therefore, they will not have strong incentives to operate efficiently and minimize costs of production.If it find ways to reduce costs, its profits will rise, resulting in a price (rate) reduction by the regulatorsto reduce the "excessive" profits. On the other hand, if its cost of production rise, it knows it can applyto the regulatory agency for a rate increase. Managers of the utility, undisciplined by the market, willbe more likely to fly first class, attend conferences in exotic places, spend lots of money entertaining(maybe on regulators), give high wage increases, give jobs to family/friends, etc. "Shirking" behaviorby managers - increase personal benefits and increase costs, resulting in inefficiency, higher prices,rates.3. Special interest influence. Regulated firms will try to influence the political process of regulation,try to have regulators appointed who will be favorable to the monopoly. "Capture theory" - utilitybenefits from regulation if they can "capture" (persuade, bribe, or threaten) the regulators, so that theregulators are favorable to what the utility/monopoly wants. Inefficiency results because themonopolist controls (influences) the regulatory process in their favor. Also, incestuous, inbreedingbehavior is common - ex-regulators may be hired as a manager or "consultant" of the utility, managersof the utility may eventually become regulators, etc.Public choice theory of special interests again. Widely dispersed, poorly organized consumers aretaken advantage of by well-organized, concentrated special interest groups - the regulated monopolists.Consumers remain "rationally ignorant" of the regulatory process and have no incentive to invest time,money and resources following regulation, prices, attending public hearings, attempting to influencethe regulators, etc.POSSIBLE ALTERNATIVE TO A PRIVATE OR REGULATED MONOPOLY: Government-Operated Firm supplies the market, e.g., U.S. Post Office, Tennessee Valley Authority (electricutility), local public utilities (Lansing Board of Water and Light), public schools, roads, fire and policedepartments, etc. However, the same perverse managerial incentives apply as in the case of a regulated 20MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry
  21. 21. monopoly - government-run firms may ignore efficiency, promote personal objectives at the firmsexpense, etc. Reason: Govt.-operated firm is insulated from competition - no direct competitors - nothreat of hostile takeover. No reward for efficiency, cost effective operation. In fact, there is aperverse incentive to fail - why?Rationally ignorant voters-taxpayers dont have the incentive to monitor the govt monopoly. Result ofgovt. operated business - less efficient, higher cost operation compared to a private firm. U.S. PostOffice vs. UPS. Target vs. Dept of Motor Vehicles.Conclusion: Government intervention is a 2-edged sword. If used judiciously and wisely, it canincrease competition by enforcing contracts and property rights, prosecuting fraud, deceptive ormisleading business practices, providing a minimal regulatory framework, imposing standards.However, it can reduce overall economic efficiency by erecting barriers to entry, granting specialfavors to protected industries/firms, etc. Organized special interest groups engage in rent seeking,appealing to short-sighted politicians, taking advantage of rationally ignorant consumers/voters.Therefore, most govt solutions are not attractive, and not necessarily superior to the market outcome.The real danger is the "coercive monopoly," the firm that has some type of legal protection againstcompetition that erects legal barriers to entry. A "coercive" monopoly by definition requiresgovernment intervention, since a private firm cannot coercively restrict competition. HIGHBARRIERS TO ENTRY usually require GOVERNMENT INTERVENTION of THE MARKET.True monopolies are a creation of the govt, not of the market. Policy conclusion: minimizegovernment intervention.Dynamic, competitive nature of the market is demonstrated by the composition of firms in the economy- of the 500 firms in the 1980 Fortune 500 list only half made it to the 1990 list. Constant changedisciplines firms, successful firms attract resources to expand. The more the dynamic the economy, theless likely it is that regulations will be effective. Dynamic and intense competition is perhaps theultimate regulator. U.S. economy has become more competitive recently due to deregulation ofindustries (airlines and trucking), increased foreign competition, advances in communication andcomputer technology, Internet, etc.Example: Profit margins of manufacturing firms is 4-5%, extremely low, reflecting the intenseeconomic competition (in polls, people think profit margins are 29%!). 21MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry