Chapter 12

The Monopoly Model

• Monopoly = one seller.
• The monopoly model assumes
  • a single seller
  • a unique product
  • high barriers to entry
• Monopolists can
  • restrict output
  • set prices

Barriers to Entry

We can measure the importance of barriers to entry by comparing the monopoly price with the minimum AC. The larger this difference, the stronger the barriers to entry.

• "Natural" barriers to entry
  • economies of scale
  • exclusive ownership of resources
  • high fixed costs
• Legal_ barriers to entry
  • exclusive government franchises
  • patents and copyrights
  • import restrictions

Monopoly Price

• The monopoly faces a downward sloping market demand curve.
  • This means the monopolist must lower its price in order to sell more.

Monopoly MR

Monopoly Profit

• To maximize profits a monopoly equates MR and MC and then sets the price based on the market demand.

Price Elasticity: 1

• Price Elasticity of Demand = the % ² in quantity demanded divided by the % ² in price.

Revenue & Elasticity

• Total Revenue (TR) is price times quantity. TR = P x Q

If demand is price inelastic, then an increase in price results in a relatively smaller decrease in quantity. Therefore TR increases.

Demand & Elasticity

• Demand is elastic when

MR > 0

• If MR < 0, then as Q increases, TR declines (MR < 0). In this case, % ² P > % ² Q and demand is inelastic.

Price & MR

• The monopolist maximizes profits at the point where

MR = MC

• At this point

P > MR & P > MC

The value of an additional unit of output exceeds the value of the additional inputs. Thus, we do not have allocative efficiency.

Price Discrimination: 1

• Price discrimination = charging different prices to different buyers for the same item.
• Price discrimination allows a monopoly to earn higher profits.
• The requirements for price discrimination are :
  • a firm must be able to set prices
  • different customers must have demands with different price elasticities
  • the monopoly must be able to separate customer groups to avoid reselling.

Price Discrimination: 2

• Price discrimination reduces consumers surplus and increases monopoly profits.

Price Discrimination: 3

• Examples of price discrimination
  • Airline fares
  • Doctors' fees
  • Electric utility rates
  • Phone services
• Is price discrimination
  • Legal ?
  • Bad ?
  • Dishonest ?

Monopoly vs. Competition

• Compared to perfect competition, monopoly results in less output at higher prices -- other things the same.

Producer Surplus

• Producer surplus is the difference between a producer's revenue and the opportunity cost of production.

Redistribution_

Monopolists capture part of consumer surplus. In the process, some consumer and producer surplus is lost. This lost is called a "dead weight" loss.

Economies of Scope

• Economies of scope arise when an increase in the range of goods produced brings a decrease in average total cost.
• Large firms may be able enjoy both economies of scale and economies of scope.

If economies of scale and scope are large enough, a monopoly may be able to sell at a lower price than is possible under perfect competition.

Gains From Monopoly

• If economies of scale and scope are large enough, it is possible that PM < PC.

Equilibrium Wages

Chapter 13

Oligopoly

• Oligopoly = a market
  • dominated by a few firms
  • protected by barriers to entry
  • selling slightly differentiated products
• Frequently we have 3 to 8 major firms with 10 to 50 smaller firms serving niche markets.
• The key feature of oligopolistic markets is recognized interdependence.

Oligopoly_ Prices

• Firms in an oligopoly recognize they are mutually interdependent. (What one firm does, affects other firms.)

They also recognize that, beyond a point, competition can ruin them -- especially price competition. They respond to this recognition with :

• Collusion (explicit & implicit)
• Price leadership
• Cartels
• Sticky prices.

Evaluating Oligopoly

We commonly believe that oligopoly output is lower and prices higher than for pure competition -- if the firms are being compared have the same cost structure -- which they seldom do.

• Regardless of the cost structure, oligopolies are :
  • inefficient producers ( P > ACmin )
  • misallocate resources ( P > MC )
• We just don't know the extent of inefficiency and misallocation.

Concentration Ratios

• Four firm concentration ratios range from 96 % of output controlled by four firms in chewing gum to 7 % in commercial printing.
  • The big four auto makers control 90 % of U.S. production.
  • Four cereal companies control 87 % of all breakfast cereal sales.
• Regional and local concentration ratios are higher than national ratios.
  • Four hotels probably control 90 % of the hotel business in Ames but the national four firm ratio is very small.

HHI Index

• The Herfindal-Hirschman Index of industrial concentration is:

HHI =  Bi2 for i = 1 to 50

Where Bi is the market share of firm i.

• The U. S. Justice Department considers an industry with a HHI less than 1800 to be competitive.
• For monopoly, HHI = 10,000
• HHI is one of many measures of industrial concentration.

Coordinating Decisions

Under oligopoly, firms recognize that it may be advantageous_ to coordinate decisions. There are a number of theories on how they do this.

• Kinked demand curve
• Dominate firm
• Game theories
• Collusion
• Cartels
• Trade associations

• Some types of coordination are illegal.

Kinked Demand: 1

• The Kinked Demand Theory tries to explain why prices sometimes remain fairly constant under oligopoly.
• It is argued that firms believe that:
  • If they increase prices, no one will follow.
  • If they lower prices, everyone else will do the same.
• This model does not explain the price level -- it focuses on price stability.

Kinked Demand: 2

The kink in the demand curve results in a break in the MR curve. Thus, MC can vary a great deal before it becomes worthwhile to adjust prices.

Dominate Firm

• A dominant firm has a cost or other advantage over smaller firms. It acts as the price maker for the market.
  • Other firms are price takers.

The dominate firm sees its demand as the total market demand less the supply of its small competitors. Using this demand, it sets price as if it was a monopoly.

• Dominant firms may control other aspects of the market offer in addition to price.

Game Theory

Game theory is a method of analyzing strategic behavior -- behavior that takes into account the expected behavior of others and mutual recognition of interdependence.

It establishes a set of rules, strategies, and payoffs for the firms under oligopoly -- and then tries to predict what actions the firms will take.

Contestable Markets

• A contestable market is one in which a small number of firms operate but entry by potential competitors is very easy.
  • The concentration ratio may be very high and yet we may observe very competitive prices.
• To deter entry firms may use limit pricing.

Limit pricing is the practice of charging a price below the profit maximizing price in order to discourage the entry of new firms.

Collusive Agreements

• Collusive agreements between firms take many forms. Regardless of the form, there is always the temptation to cheat.

When there are only two firms in the industry (duopoly) and they enter a collusive agreement, when one firm cheats, the other probably knows it.

When there are many firms involved under a collusive agreement, it is more difficult to tell who is cheating. Such collusive agreements are difficult to maintain.

Cartels

• A cartel is an agreement to act as a monopoly.
• Cartels must develop a process by which they can agree on :
  • price
  • total output
  • allocation of production
  • division of profits
• Formal cartels are usually illegal in the U.S.
• Many cartels last for a long time.

Monopolistic Competition : 1

• Monopolistic Competition is a market model in which :
  • there are many small sellers
  • entry and exit is fairly easy
  • products are differentiated
• Monopolistic competition is probably the most common market structure in the U.S.
  • Examples: supermarkets, magazine publishers, shoes, clothing stores

Monopolistic Competition : 2

• In the short-run a firm under monopolistic competition may earn a profit.

If so, entry takes place which forces firm demand down and costs up. This continues to the point where economic profits are zero.

• These firms are :
  • inefficient producers ( P > ACmin )
  • misallocate resources ( P > MC )

Monopolistic Competition : 3

• Under monopolistic competition firms have some control over price. In the short-run they can earn an economic profit.

Monopolistic Competition : 4

• In the long-run new entry shifts the firm's demand downward and eliminates economic profits.

Monopolistic Competition : 5

• Under monopolistic competition firms have an incentive to:
  • develop new products
  • improve old products
  • advertise
  • differentiate their products via
    • quality
    • packaging
    • distribution channels
    • design

Chapter 14

The Four Factors

• The four factors of production are:
  • Land
  • Labor
  • Capital
  • Entrepreneurship

• Factor Prices are opportunity costs.
  • Land Rent
  • Labor Wages
  • Capital Interest
  • Entrepreneurship Normal profit

Factor Demand

The demand for a factor of production is a derived demand. i.e. A demand for an item not for its own sake but for use in the production of goods and services.

• A firm's demand for a factor of production therefore depends on:
  • technology which affects the amount of output that can be produced with a given amount of a factor (MP)
  • the price of the item the factor is used to produce (MR).

Labor Demand: 1

• The demand for labor depends on:
  • The price of the firm's output.
  • The prices of other factors of production.
  • Technology
• Firms will employ labor up to the point where the value of the additional_ output is equal to the additional cost of labor.

(MR)(MPL) = MRPL = W

Labor Demand: 2

The short-run demand for labor curve reflects a negative_ relationship between the quantity of labor demanded and the wage rate.

L = F(W T, FP)

where

• L = labor
• W = the wage rate
• T = technology
• FP = other factor prices

Labor Demand: 3

• As more labor is used, other factors fixed, the MPL falls.
• As more output is produced the market price, P, falls which in turn reduces the MR.
• Therefore, MRPL falls because both MPL and MR fall as more labor is used.

Labor Demand: 4

In the long-run, with all inputs variable, inputs will be employed up to the point where the ratios of the value of the marginal products to the prices of the inputs are the same.

MRPX / PX = MRPY / PY

• Thus, if the price of input Y goes up, producers will reduce the use of input Y and increase the use of input X.

Labor Elasticity

• The elasticity of demand for labor is:

EL = (%²L / L) / (%²W / W)

• It measures how sensitive the supply of labor is to changes in wages.
• This elasticity depends on:
  • The labor intensity of production.
  • How fast MPL declines.
  • The elasticity of demand for the product the labor is used to produce.
  • The substitutability of capital for labor.

Labor Supply: 1

• We assume that workers have a reservation wage. i.e. a wage rate below which they will not work.
• We assume that at high wages workers will begin to substitute leisure for work.

Labor Supply: 2

• The market supply of labor is the sum of the individual supplies.

In a competitive market, the wage rate is determined by the supply and demand of labor. The firm can hire all the labor it wants at the market wage rate.

Labor Market Realities

• Labor markets are not perfectly competitive.
• Workers are not identical_.
• Government regulations affect compensation packages.
• Wage offers are differentiated in many ways.
• Workers consider more than wages when selling labor.

Capital Supply: 1

• Households provide the financial capital that firms use to buy physical capital.
• Financial capital is a stock. Households add to it with savings -- which is a flow.
• Savings are determined by:
  • Household income.
  • the interest rate.

Capital Supply: 2

• The short-run supply of capital is very inelastic.
• The long-run supply of capital is highly elastic.

Land Supply

• In the short-run, the supply of land is fixed.
• In the long-run, the supply of land is very inelastic.

Economic Rent

Economic rent is the income received by the factor owner over and above the amount required to induce that owner to offer the factor for use.

• Economic rent is not the same as land rent.

Transfer Earnings

• Transfer earnings are the opportunity cost of using a factor of production.

Inelastic Supply

• If the supply of a factor of production is highly inelastic, a large part of the income for the factor is economic rent.

Elastic Supply

• If the supply of a factor of production is highly elastic, suppliers of the factor will receive_ very little economic rent.

Chapter 15

Skilled Labor

• Skilled labor earns a higher wage than unskilled labor because the demand is greater and the supply is less.

Union's Objectives

• The primary objectives of unions are to:
  • increase compensation
  • improve working conditions
  • expand job opportunities.
• Unions are most successful when they can control labor supplies.

Union Wages

• Higher wages result in higher unemployment for union members -- other things constant.

Monopsony: 1

• A monopsony is a market structure in which there is a single buyer.

A monopsony maximizes profits by equating the marginal cost of labor (MCL) to the marginal revenue product of labor (MRP) and setting the wage given by the supply curve of labor.

Monopsony: 2

• Monopsony is more likely to exist in isolated communities.
• Low cost transportation reduces monopsony power.

Unions can help offset monopsony power. They become a monopoly seller of labor. Under bilateral monopoly, the wage is set by bargaining between the union and the monopsony.

Monopsony: 3

• Minimum wage laws reduce monopsony power. As a result, both wages and employment increase.

Wage Differences

• Reasons for earnings differences include:
  • Job types
  • Discrimination
  • Differences in human capital
    • Years of schooling
    • Years of work experience
    • Number of job interruptions
  • Differences in degree of specialization

Chapter 16

Sources of Funds

• There are three main sources of funds for business.
  • Loans
  • Bonds
  • Stocks
• A firm's demand for financial capital stems from its demand for physical capital.

Stocks & Flows

• Capital is a stock. The amount of capital can be measured at any point in time.
• Gross investment is a flow. It is the purchase of new capital during a given time period.
• Net investment is gross investment minus depreciation.

Investment Decisions

• Firms use capital to the point where the marginal revenue product of capital (MRP) equals the price of capital.

Capital (a stock) generates a flow of future returns. The firm has to value this flow of returns in terms of its present value.

Net Present Value

• The present value of a stream of returns is equal to:

PV = ( FVt / (1+r)t )

• where the sum is over the time period t = 0, ..., n
• In other words, the present value of a stream or returns over n years is the sum of the annual present values.

• The Net Present Value is equal to Present Value minus the Cost of Capital.

Present Value

• The Present Value increases as the interest rate (discount rate) falls.
• Suppose we have a two year stream of returns equal to $1000 each year.
  • If r = 5% the present value is:

PV = $1000/1.05 + $1000/1.1025

= $952 + $907 = $1859

• If r = 10 % the present value is:

PV = $1000/1.10 + $1000/1.21

= $909 + $826 = $1735

• Thus, as interest rates fall it becomes profitable to make additional investments.

MRP of Capital

• The Marginal Revenue Product (MRP) falls as net investment increases. There are two reasons for this:
  • MPK falls as more capital is used.
  • MR falls as more output is produced.

This results in a downward sloping demand curve for capital.

• Long-run factors affecting the demand for capital are:
  • Population Growth
  • Technological Change

Demand for Capital

• The quantity of capital demanded increases as interest rates fall.

K = f(r Pop, Tech)

Supply of Capital

• The main factors that determine household saving decisions are:
  • Income (Y)
  • Expected Future Income (EFY)
  • Interest Rate (r)

S = f(r Y, EFY)

Equilibrium rate

• The equilibrium interest rate is determined by the supply of household wealth and the demand for capital.

Natural Resources

• Natural resources are nonproduced factors of production. They are either:
  • exhaustible (oil)
  • nonexhaustible (rain)
• The stock of each natural resource is determined by nature and the previous rate of use (flow) of the resource.

Hotelling Principle

Equilibrium occurs in the market for the stock of a natural resource when the price is expected to rise at a rate equal to the interest rate on similarly risky stocks and bonds.

Resource Demand

• The demand for the use of a natural resource is a flow. It is a derived demand which depends on:
  • the productivity of the resource
  • the value of the product the resource is used to produce.
• i.e. The demand for the use of a natural resource depends on the MRP derived from the use of the resource.

Conservation

• Are we using exhaustible resources too fast?

Economists argue that competitive markets will lead to the efficient use of exhaustible resources unless there are external costs or benefits.

• If there are externalities, some type of government intervention may be needed.

Chapter 17

Uncertainty

• Uncertainty is a situation in which more than one event can occur but we do not know which one will.
• Risk is a situation in which more than one outcome may occur and the probability of each outcome can be estimated.

Risk Neutrality

A risk-neutral person is one for whom risk is costless. Such a person is only concerned with the expected payoff of an action not with how much uncertainty there is.

Risk Aversion

• Financial markets recognize that there are differences in people's willingness to accept risk.
• People are provided with opportunities to accept risks -- or try to avoid them.
  • Stock markets
  • Junk bonds
  • Insurance
  • Futures markets
  • Warranties
  • Guarantees

Insurance: 1

• Insurance works by pooling risks.
• If people are risk averse, their expected benefits from insurance may more than cover the cost of insurance.

Insurance: 2

• Types of insurance:
  • Life Insurance
    • Whole Life
    • Term
  • Health Insurance
    • Medical
    • Medicare Supplements
    • Dental
  • Property & Casualty
    • Home
    • Workers' Compensation
    • Malpractice Insurance
• What do these all have in common?

Information

• There is an opportunity cost of gathering economic information.
• The optimal search rule is to:
  • Seek information until the expected marginal benefit equals the marginal cost of searching.
  • At this point stop searching and buy.

Advertising: 1

• Advertising which provides useful information can help you make better decisions.
• Firms advertise to change the elasticity and location of the demand curves for their products.

Search Goods

• Search Goods are goods whose quality can be assessed before they are purchased.
  • Example: Steel, gasoline
  • Advertising for search goods mainly informs. (Provides technical information, prices, etc.)
• Experience Goods are goods whose quality can be assessed only after they are purchased.
  • Example: Cigarettes, soap, perfume
  • Advertising for experience goods mainly persuades.

Private Information

Private information is information available to one person and costly for someone else to obtain. It results in two types of problems:

• Moral Hazard
• Adverse Selection

Financial institutions have to find ways to reduce the costs associated with the risks resulting from moral hazard and adverse selection problems.

Moral Hazard

Moral Hazard exists when one of the parties to an agreement has an incentive, after the agreement is made, to act in a manner to benefit him or herself at the expense of the other party.

• Example: A bank makes you an unsecured loan to buy a car. You use the money for a trip to Las Vegas.
• How could the bank avoid this "moral hazard" situation?

Adverse Selection

Adverse Selection is the tendency of people to enter into agreements in which they can use their private information for their own advantage.

• Example: You know your computer has some problems so you buy an extended warranty.
• How can the computer company selling the extended warranty minimize_ the cost resulting from the "adverse selection" problem?

Financial Risks

• Financial markets use a wide variety of tools or approaches to reduce risks.
  • Diversification
  • Futures markets
  • Options markets
  • Insurance requirements
  • Personal guarantees
  • Loan sharing

Rational Expectations

The forecast that uses all the relevant information and has the smallest possible error is called a rational expectation forecast.

• Rational Expectations are "forward" looking.
  • What is your forecast of 1996 inflation?
  • You could make your forecast based entirely on the inflation rate for the past ten years.
  • Or you could take into account the expected actions of the FED, information on world trade, changes in national debt, etc.