Unit 6 Lecture Notes


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Unit 6 Lecture Notes

  1. 1. General Comments Joseph Schumpeter, as mentioned in class two, essentially viewed business cycles as being driven by entrepreneurs. Schumpeter was writing his book on "Capitalism, Socialism and Democracy" and his two-volume "Business Cycles" in the 1930s and reflecting on the past. He observed the roaring 1920s - a period of rapid technological change and economic growth accompanied by low inflation. That was followed by a period of major economic contraction and economic stagnation. He was not pessimistic about the future during the 1930s, as he didn't believe capitalism could destroy itself by creating economic problems. Instead Schumpeter thought capitalism might be destroyed by its successes. Schumpeter viewed entrepreneurs and their innovating activity as the source of profit. Entrepreneurs were not normal business people following established routines but were people that introduced change and competition into the economic system creating disturbances. Schumpeter says " … competition of the kind we now have in mind acts not only when in being but also when it is merely an ever-present threat. It disciplines before it attacks. The businessman feels himself to be in a competitive situation even if he is alone in his field or if, though not alone, he holds a position such investigating government experts fail to see any effective competition between him and any other firms in the same or a neighboring field and in consequence conclude that his talk, under examination, about his competitive sorrows is all make-believe." Microsoft is essentially alone in its field; it created a monopoly and monopoly profits. Microsoft probably felt pressures of changing technologies in competing industries closing in on their software business. Microsoft made a natural business response - transformation, using its monopoly position in the operating system field, to also emerge as a player in the Internet business. Competitors saw, heard and felt the competitive pressures of a giant business in transformation. Competitors cried uncle and ran to bureaucrats for protection. Bureaucrats responded. Microsoft behavior is what one expects when a monopoly player, in this case Microsoft, feels its traditional business lines threatened. They use their monopoly power both to protect their existing business and to transform themselves into a new business. Mr. Gates knows that competition from within his industry is not important since he is a monopolist. Instead it is technology changes and competition in other industries that would, in the end, destroy his business unless Microsoft took action. Suppose that in the future, the bulk of memory and software that currently is on personal computers will be held at central locations until needed by the user. At that time, it will be pointless to have sophisticated PCs loaded with software sitting around either individually or hooked to each other. Microsoft may be attempting to position itself for and compete with companies already engaged in this business. Microsoft, ideally, might like a large piece of the
  2. 2. storage, software and personalized database market of the corporate and consumer markets in order to capture flows of monthly fees -- similar to monthly fees that phone companies capture. Microsoft has the ability to position itself for that. The Internet constitutes a major technological change in the economic system that creates and delivers goods and services from business to business, business to consumers as well as the government-taxpayer relationship. Microsoft no doubt would like to be a part of the value-added business to business and business to consumer. Microsoft is a classic case of a business attempting to reposition itself. Microsoft probably would like to maintain its monopoly position in the software and operating system business and develop a strong Internet position -- the classic textbook monopoly model in one business and a major player in an oligopoly model in another. Two business market models Microsoft doesn't want to be in are perfect competition and monopolistic competition as they are characterized by smaller and more numerous competitors. Market Structures and Characteristics A key theme of economics is scarcity. Consumers have unlimited needs and wants but resources to achieve those needs are scarce. In market economies, suppliers provide the types of products and services customers want and can afford. The market environment differs for various suppliers. There are four types of market structures -- perfect competition (also referred to as pure competition), monopoly, monopolistic competition, and oligopoly. Producers in these markets sell product and services. There are not necessarily clear "break points" between different market structures, as in some cases hybrid types of market structures evolve. Perfect Competition Characteristics of perfect competition include: 1. Large number of buyers and sellers 2. Buyers and sellers have perfect information on prices and products 3. Homogeneous, non-differentiable products (i.e. commodities) 4. Low barriers to entry and exit 5. Price-taking firms Agricultural commodity markets are a good example of perfect competition. There are hundreds of thousands of farmers that sell their products to thousands of grain elevators. Buyers and sellers know prices, product, and quality issues associated with various agricultural commodities, such as corn, soybeans, and wheat. Products are largely homogeneous -- commodities, with adjustments for factors such as moisture content. This makes it very difficult to differentiate the product.
  3. 3. There are low barriers to entry. Farmers can move in and out of markets quickly, by planting a different type of crop or no crop at all. Finally suppliers are "price-takers" as they take the price determined by global industry demand and supply. No producer has any influence on selling price but they do on their costs. Demand Curve under Perfect Competition The industry market conditions under perfect competition are typical of other markets in that they have a normal upward sloping supply curve and downward sloping demand curve. This is shown below. However, the individual producer in perfect competition faces a horizontal demand curve, or a perfectly elastic demand curve, relative to the x-axis. Click on this graph and understand the why the industry has a downward sloping demand curve while the firm in perfect competition faces a horizontal demand curve. Click here to see Graph 1. The key to the demand curve under perfect competition is that there is only one price in the market. Attempts by a single supplier or group to influence prices are futile. Raising prices under such a scenario immediately results in a zero demand for the product. In perfect competition one is a price taker. Short Run Profit Maximization - Perfect Competition Profit maximization is selling price equals marginal cost equal to or above average variable cost in the short run. In perfect competition the market price to the firm is equal to its marginal revenue. Price is not equal to marginal revenue in other market models as the demand curve slopes down. Under perfect competition the shutdown rule states that a firm should continue to operate in the short run as long as variable costs are being recovered. Fixed costs accrue whether production occurs or not. Only variable costs must be recovered in the short run, and as long as that is achieved, a firm should not shut down. Over the long run, all costs, fixed and variable, must be recovered. Shut-Down Rule (Short Run) The Profit-Maximization rule states that firms operating in all types of market environments, including monopoly, oligopoly, and monopolistic competition produce at the point where marginal cost equals marginal revenue when at or above minimum average variable cost - covering variable costs. If firms can't cover variable cost such as labor and material costs, they shut down. Companies with money in the bank such as .com companies can burn cash to pay variable costs. The IPO and secondary offerings put cash in the bank. A company could continue to operate in the shut down position as long as cash is present to cover variable costs. Marginal cost is the increase in total cost or variable cost associated with production of an additional unit of output. For some .com companies (ones that give their
  4. 4. product away) the marginal cost of an additional user is zero. Marginal revenue is the increase in total revenue associated with the sale of an additional unit of output. For perfect competition and its horizontal demand curve, marginal revenue is the same from the first to the last unit of sale and is the market price. In perfect competition, a profit-maximizing firm should operate at a production level where marginal cost equals price, or where the marginal cost curve intersects the perfectly elastic, horizontal demand curve. Note the following graph: In a perfectly competitive environment, the marginal cost curve also becomes the supply curve. How is that? Remember the intent is to produce where marginal cost equals price. Thus no matter where price settles, the profit-maximizing firm would want to be at point MC=MR=price as long as it covers variable cost. The firm's marginal cost curve intersects both the average variable and average total cost curves at their minimum. If the marginal is below the average, the average is going down. If the marginal is above the average, the average is increasing. The marginal must therefore equal the average at its minimum. Monopoly A monopoly exists when there is a single supplier of a product or service with no close substitutes. Closely associated with the concept of a single supplier are barriers to entry that restrict new entry. Examples of regulated monopolies are electric and water companies. Electric utilities are slowly being deregulated however. Characteristics of Monopoly
  5. 5. The characteristic that distinguishes monopoly from other market structures is that the firm's demand curve is the market demand curve plus its ability to restrict entry of new producers. The following are examples of methods that can be used to block entry of new firms. 1. Economies of Scale 2. Technology, Response Time, Innovation 3. Patents, Trademarks, Licensing, quotas, tariffs or other governmental powers 4. Distribution, shelf space, franchises 5. Control or ownership of raw materials A monopoly produces either commodity or differentiated products, faces a downward sloping demand and a marginal revenue curve that slopes down at 2X the rate of the demand curve. Marginal revenue is positive when price elasticity of demand is elastic, equal to zero when MR is -1 and negative when demand is inelastic. The firm produces at MR=MC as long as price is greater than AVC in the short run. The selling price corresponding to MR=MC is given by drawing a line from MR=MC up to the demand curve. The output is obtained by extending a line from MR=MC down to the X-axis. A normal profit for the monopolist occurs at P=ATC. Economic profit is when P>ATC. Maximum profit occurs where MR=MC and the firm is producing in the elastic region of its market demand curve. A firm is producing at less than maximum profit if production is in the inelastic portion. MR and MC are negative for a downward sloping demand curve and MC for a firm cannot be negative. Maximum total revenue occurs where price elasticity is equal to -1. Firms continually restructure to lower cost curves in order to lose less or earn more. Another point is substitutability. There are few substitutes for electricity, water, and other utilities but different producers provide those products. Competition among producers, if allowed by regulatory authorities, usually results in lower prices for consumers. Customers decide what company to purchase an auto from. Why not the same for electricity? It is moving that way. Customers purchase a college and MBA education from the school they want to attend. Why not the same for grade and high school education? Certain airline hubs are close to fitting a monopoly model. American (directly and indirectly through Ft. Worth) fights the opening of Love Field in the Metroplex. For Metroplex consumers the opening of Love Field to all flights would result in lower airfares at both airports - a major plus for consumers. An open Love would provide for choice and lower fares - a competitive market and would end American's near monopoly at DFW. Stockholders of American would suffer however with an open Love. So American management should fight to restrict flights out of Love in the interest of its stockholders. Consumers and businesses with an interest in Love Field are doing
  6. 6. what they should -- fight to open Love - as it would mean more choice and lower fares to customers in the Metroplex. The Monopolist - A Price Searcher The monopolist is a price- searcher -- a firm that exhibits some degree of power or control over market prices as it faces a downward sloping demand curve. If the perfect competitor wants to increase the firm's revenue, it simply sells more at the same market price. The monopolist, however, may be required to lower its prices if it intends to sell more and gain market share if that is the objective. A monopolist that wants to maximize profitability will produce in the price elastic region of the market demand curve. Price-searching or price-maker firms are not necessarily limited to monopolists. The demand curve for the monopolist is downward sloping. The monopolist is earning an economic profit when the selling price is above average cost of production. But when selling price is equal to average cost the monopolist earns a normal profit. A less than normal profit occurs when the average cost of production is greater than the selling price. The latter case suggests a massive employee termination program and restructuring effort is on the way. The following links show each of the respective cases. Be sure to go through each of these to see how the average cost curve shifts for the different cases. Click here to see Graph 3. Click here to see Graph 4. Click here to see Graph 5. Monopolistic Competition Monopolistic competition is a market structure in which the premise is that a differentiated product or service is produced. The monopolistic competitor attempts to create a sense of superiority of the firm's products or services (actual or perceived) in the minds of the customer. There are four characteristics of a monopolistic competitive segment including 1. Relatively large number of sellers 2. Differentiated products or services 3. Relatively free entry to and exit from markets 4. Sellers attempt to be price searchers Examples of business segments fitting this model include downstream game software, educational software and neighborhood restaurants. The bottom end of the fast food hamburger market is monopolistic competition while the franchised top end that includes McDonald's is an oligopoly segment. The number of McDonald's outlets, brand name and market share put it into an oligopoly
  7. 7. for that segment of the fast food. One needs to define the business segment and close competitors in order to decide which market model fits. At times business segments represent a combination of models. Residential real estate is an example. There are many residential realtors and residential firms that sell houses. Entry and exit barriers are relatively low. That segment is monopolistic competition. But this segment has a monopoly characteristic -- the six-percent commission. Internet competition may alter that six-percent fee. The Demand Curve for the monopolistic competitive firm is downward sloping. Profit can be normal, above or less than normal as in monopoly. Oligopoly Oligopoly is the remaining structure. Oligopoly is a market structure in which there are usually a few large competitors operating within a uniquely dependent framework. Characteristics include: 1. A visible sense of mutual interdependence among suppliers 2. High barriers to entry 3. Price searching firms 4. Sometimes the presence of a "price leading" firm 5. A relatively small number of generally large producers in the industry segment 6. Commodity or differentiated products and services Examples of oligopoly segments -- soft drinks, beer, cigarettes, toothpaste and credit cards - a few producers in each of segments dominate. Producers have differentiated some of these products in the minds of the consumer. Many of the consumer product segments have oligopoly producers. This does not mean that competition is not intense in these segments. It means that the potential for collusion is greater when there are a small number of firms than in the case of many smaller producers. Oligopolies usually consist of large firms with long-established names and product lines with which consumers can easily identify. But oligopolies do not necessarily involve large firms. Isolated smaller towns may have oligopolies or a monopoly in the form of small businesses. The "Kinked" Demand Curve Under Oligopoly In certain oligopolies, for example the airline industry, there are no distinct price leaders nation-wide but there may be on certain routes. Different participants in this industry attempt to effect price changes, both increases and decreases. One of the firm's costs may change, enticing it to change prices accordingly. Or it could simply test the market. Usually other firms will follow a price decrease by one firm. If they don't, the price leader will gain market share. All firms decreasing price together means the demand curve they move along is the industry demand curve.
  8. 8. Should one airline increase price, however, other firms may not follow because the price leader in this case will lose market share to those that don't increase prices. In effect, an oligopoly firm in this situation faces what is called a "kinked" demand curve, in that it is more elastic than the industry demand for price increases as close competitors do not follow. Firms face the industry demand curve for price decreases as all firms move together. When firms don't follow on the upside the price leader faces a very elastic demand curve - the product line demand curve. In such cases, initial price increases may not "stick" resulting in the initiating firm dropping its price to be in line with other close competitors. This gives a "kinked" demand curve. Perfect Competition in the Long Run The long run is the time frame in which all inputs are variable so that the firm can change its plant size. Should above normal profits exist in the short run, existing firms are motivated to expand plant size and/or new firms are motivated to enter the industry segment. Likewise, the reverse process occurs if there are below normal profits. Result - in the long run the average firm in the industry approaches normal profit. All firms in the industry segment face the same selling price by definition of being a price taker. Textbooks assume that the minimum of the LRAC curve is the same for all firms in that segment and includes implicit costs. Realistically this is not the case and the textbook LRAC curve is a composite curve with firms having cost curves above and below. Increasing, Decreasing and Constant Cost Industries Constant Cost Industry Industry segments that expand through expansion by existing firms or entry of new firms in response to a higher selling price without increasing input costs have a horizontal long-run supply curve. Increasing Cost Industry Other industry segments can't expand production in response to a higher selling price (either from within or with new entrants) without the price of inputs increasing as their use increases. Cost of inputs increase and the marginal cost curve of each firm shifts left and, in turn, tends to shift the industry supply curve to the left. But more firms enter or existing firms expand so that by assumption the industry supply curve shifts right. Result - a positively sloping long-run supply curve. Decreasing Cost Industry
  9. 9. The industry segment is in balance, selling price increases and existing firms either increase production or there are new entrants. When this occurs, competitors use more inputs and they find that their cost of inputs decreases. A decrease in cost of inputs shifts the MC and industry supply curve to the right. Result - a negatively sloped long-run supply curve. The concept of decreasing cost industry segments is typical, in particular in technology segments. Computer box makers are an example as Dell has lower costs, in part, because cost of inputs that go inside the box have fallen. Technology spending increased rapidly during the 1990s and this technology allowed many companies to produce more at decreased per unit costs. Cost reductions occur as the industry expands. This may be due to technology improvements occurring in one sector and implementing those in another. Improvements and innovation in chip manufacturing result in lower per unit costs and quality improvements in chip production but also for downstream users. Other Market Models The long run in other models of monopolistic competition, oligopoly and monopoly resemble those in the short run. Most textbooks assume monopolistic competition will operate at normal profits in the longer run but there is no reason this needs to occur. Oligopoly and monopoly models in the long run may or may not continue to operate at normal, above or below normal profits. Much depends on whether technology helps or hurt that company or industry segment and shifts in its cost and demand curves.