CV 2014 August 9 - 31

August 15
PRODUCTIVITY DIFFERENCES why does an acre of land to build a house in rural Mississippi cost so much less than an acre of land in Carmel California? ALL LAND NOT CREATED EQUALLY thus far we have assumed that all units of land are of the same grade. clearly not so different acres of land vary greatly in productivity these productivity differences stem primarily from differences in soil fertility and such climatic factors as rainfall and temperature these productivity differences will be reflected in RESOURCE DEMAND just as productivity is important in explaining differences in land rent so too is LOCATION other things equal business renters will pay more for a unit of land which is strategically located with respect to materials labor and customers than for a unit of land that is remote from the markets # 1: RENT ALLOCATES LAND RESOURCES although rising economic rents do not increase the quantity of land supplied, rents do have a certain economic function in particular, rents serve to allocate a scarce factor among competing uses more importantly, the most valuable use will determine the market rent #2: QUASI-RENTS the concept of rents has been extended by economists to include any payment to a factor resource above its opportunity cost -- that is, above the amount it would receive in its next-best use SUPERSTARS AND QUASI-RENTS this quasi-rent situation looks a lot like the market for superstars the demand for these performers is very high because they can generate substantial revenues for their musical comedic and athletic talents however the salaries these superstars command are significantly above the salaries they might earn in their next best job A GREAT HISTORICAL EXAMPLE Michael Jordan one of the greatest players in history quit to play baseball he not only couldn't hit a curve ball, he earned a small fraction of his basketball salary # 3: RENT SEEKING the broadened definition of rent has led economists to the insight that if individuals could somehow restrict the supply of a factor the rent they could receive for the factor would be higher RENT SEEKING: name given to the restricting of supply in order to increase the price suppliers receive an attempt to create either ownership rights or institutional structures that favor you

August 15
THE SINGLE TAX MOVEMENT in Poverty and Progress published in 1879 Henry George called for financing government principally through property taxes on land use this single tax to cut or eliminate all other taxes on capital labor and improvements on the land such a tax would not only be more fair it would also be more efficient THE MODERN ECONOMIST CRITIQUE George was absolutely right that such a tax could improve the distribution of income without harming the productivity of the economy demonstrate the Georgist argument and in doing so prove this: KEYPOINT: a tax on pure economic rent will result in no distortions or allocative inefficiencies THE EFFICIENCY OF A LAND TAX suppose the government introduces a 50% tax on all land rent paid by farmers to landowners this is a pure tax on land alone this is not a a tax on the buildings on the land nor is it a tax on building improvements THIS CLARIFICATION IS IMPORTANT while the supply curve for land is vertical the supply curve for buildings and building improvements is upward sloping this is because the price of such improvements surely affects their supply GRAPH after tax is imposed quantity of land supplied and demanded remains the same BUT, who actually winds up bearing the burden of paying this tax, the farmer or the landowner? the total amount that the farmer pays out for the land remains the same at 200 however the landlord now keeps half that amount and must give the other half to the government thus, in economics, we say that the landlord "bears the burden" of the tax -> this is an example of TAX INCIDENCE ANALYSIS EQUALLY INTERESTING QUESTION: what will the allocative efficiency be or the deadweight loss associated with this tax? A SURPRISING ANSWER a tax on pure economic rent leads to NO allocative efficiency or dead weight loss! reason: a tax on pure economic rent does not change anyone's behavior NO CHANGE IN BEHAVIOR consumers are unaffected by the tax because price has not changed behavior of landlords is unaffected because the supply of  land is fixed and therefore cannot react hence, the economy operates after the tax exactly as it did before the tax -- with no distortions or inefficiencies arising as a result of the land tax CRITICISMS OF GEORGIST THEORY if the arguments offered by Henry George in defense of a single tax on land are so strong from both an  economic and equity perspective, it is probably useful to point out why such a tax has never been implemented one obvious problem is that current levels of government spendings are such that a land tax alone would not bring in enough revenues second problem: land is typically improved in some manner by productive effort and economic rent cannot be  readily disentangled from payments for capital improvements third problem: historically a piece of land is likely to  have changed ownership many times thus, while former owners may have been the beneficiaries of past increases in land rent, it would hardly be fair to tax current owners who paid who paid the competitive market price for land

August 15
THE CORN WARS in 19th century England, English consumers became increasingly concerned about the rapid escalation in the price of  various cereal grains that they called "corn" why was the price of corn rising so rapidly? THE MOST COMMON EXPLANATION landlords were raising the rent they were charging farmers for the use of their land thereby forcing farmers to pass on the increase in land costs to consumers DAVID RICARDO SEZ..... the price of corn is not high because a rent is paid rather, rent is high because the price of corn is high in this scenario the root cause of the problem was increased demand for corn which, in turn was driving up rent for corn land supply decisions are based on MARGINAL COST not FIXED costs such as the cost of land WHAT THIS SHOWS an increase in price in the PRODUCT market in this case corn results in an increase in the price of the FACTOR of production, in this case land and note that we will find this to be the case for ALL FACTORS of production A WINDFALL PROFIT FOR LANDLORDS? THE SINGLE TAX MOVEMENT America's population was expanding rapidly as people migrated to the US with this growth and the expansion of the railroads into the American West, land rents soared creating handsome profits for those who were lucky or  farsighted enough to buy land early HENRY GEORGE'S QUESTION if land is a free gift of nature, if it costs nothing to produce and it would be available even without rental payments, why should rent be  unfairly paid to those who by historical accident by inheritance or by luck happened to be landowners? THE SOCIALIST VIEW socialists like Henry George have long argued that since all land rents are unearned incomes land should be  nationalized it should be owned by the state so that any payments for its use can be used by the government to further the well-being of the entire population rather than simply enriching a small minority of land owners PROPERTY RIGHTS rights given to people to use specific property as  they see fit and in modern societies such rights are protected by a complex set of laws that's why you can own your home and the parcel it resides on and that's why you don't have to share your home your car or your shoes with anyone not of your own choosing in earlier societies there was no such thing as PROPERTY RIGHTS IN FEUDAL TIMES land belonged to everyone or at least to all the peasants in that time that used it it was common land--a communally held resource THE INDUSTRIAL AGE as the economy evolved into a market economy the land was appropriated by individuals these individuals in turn became landowners who could determine the use of land and who could receive rent for allowing the other individuals to use that land PROPERTY RIGHTS AND ZONING LAWS in our society there is not only a very well-defined system of property rights and a CONTRACTUAL LEGAL SYSTEM to enforce these rights there are complex mechanisms such as ZONING LAWS that limit or modify property rights EXAMPLE: you own a half acre parcel of land on the coast of California in most cases you would be allowed to build a house on   that land but zoning laws would prohibit you from building a 30-story hotel or a toxic waste dump

August 15
HOW IS LAND PRICED? what accounts for the big difference in price for an acre of dirt? more fundamentally, how is land priced in the real estate market? WHY LAND IS DIFFERENT to answer this question, let's first talk about what makes land different from most other factors of production hint: WIll Rogers once said "Land is a good investment: they ain't making it no more" answer: QUANTITY IS FIXED the essential feature of land is that its quantity is fixed and completely unresponsive to price PURE ECONOMIC RENT the price paid for the use of land and other natural resources which are completely fixed in supply it is the fixed nature of the supply of land that makes rental payments clearly distinguishable from the prices paid to the other factors of production AN IMPORTANT POINT pure economic rent as defined by economists is not the same thing as the rent people pay for their homes or apartments RENT VS ECONOMIC RENT rental payment made to landlord typically includes compensation for: 1 the use of capital such as the building structure 2 labor, including maintenance and management 3 the use of utility services such as water electricity and gas KEYPOINT: in most cases only a very small fraction of  rental payment represents pure economic rent ELASTICITY OF LAND given that the supply of land is fixed how would you draw the supply curve and what would its elasticity be? supply curve is vertical and perfectly inelastic demand and supply curves cross at the equilibrium point E it is towards this factor price that the rent for the land must tend why? if rent were above the equilibrium price, the amount of land demanded by all firms would be less than the existing amount that would be supplied some property owners would be unable to rent their land so they would lower their price by similar reasoning the rent could not remain below the equilibrium intersection for long if it did the bidding of under supplied firms would force the factor price back up towards the equilibrium level

August 15
INTRODUCTION TO LAND AND RENT a nation's GDP is the most common measure of its productive output one way of measuring the GDP is to add up all the income that people receive each year from producing the year's  output using the three major FACTORS OF PRODUCTION 1 land 2 labor 3 capital LAND LABOR CAPITAL: THE MAIN FACTORS OF PRODUCTION each factor input has a price PRICE OF LABOR: the wage rate PRICE OF CAPITAL: related to both the interest rate and the profits earned on capital PRICE OF LAND: the rent the firm must pay for it  KEYPOINT: economista have a much narrower definition of rent than we are used to! AN IMPORTANT FORMULA GDP = Wages (Workers) + Rents (Property owners) + Interests (Lenders) + Profits (Firms) WHY IS THIS IMPORTANT? the DISTRIBUTION OF INCOME in a country is determined in large part by the price for which each of the major factors of production can be sold or rented in personal terms, this means FACTOR PRICES will be  a major determinant of annual income YOUR FUTURE INCOME DEPENDS ON... the wages you earn at your job the interest and profits derived from any stocks and bonds or other typical capital that you hold the rents from any land that you might own RESOURCE ALLOCATION the fact that your future income will depend on  FACTOR PRICING is a great reason to study this topic but it's not the only reason from a broader economic view, factor pricing also guides RESOURCE ALLOCATIONS RESOURCE PRICES just as product prices ration finished goods and services to consumers so do resource prices allocate scarce resources among industries and firms an understanding of how resource prices affect resource allocation is particularly significant since the efficient allocation of resources over time calls for continuing shifts in resources among alternative uses FACTOR PRICING ILLUSTRATES COST MINIMIZATION to maximize profits your firm must produce the PROFIT-MAXIMIZING output with the least costly combination of factor resources given technology resource prices will play the major role in determining the quantities of land, labor, capital and entrepreneurial activity that you will use in your production process ETHICAL QUESTIONS, POLICY ISSUES should the government use tax policy to redistribute income from the upper and middle-classes to the poor? should the government tax the EXCESS PROFITS of corporations put a cap or ceiling on the sometimes exorbitant interest rates charged by credit card companies or  provide workers with a wage floor in the form of   a MINIMUM WAGE? do labor unions actually raise the wages of workers and if so do unions do so at the expense of jobs?

August 14
THE GUIDING PHILOSOPHY you will pick your strategy by asking what makes most sense assuming that your rival is analyzing your strategy and acting in his or her own best interest WHY GAME THEORY IS IMPORTANT: #1 the many different possible games help capture the essence and complexity of oligopoly conduct with mutual interdependence recognized oligopoly conduct becomes a game of strategy such as poker chess or bridge the best way to play your hand in a poker game depends on the way rivals play theirs! WHY GAME THEORY IS IMPORTANT: #2 game theory sheds light on the importance of collusion in driving socially undesirable economic outcomes the insights of game theory thereby help to underscore why such collusion is often made illegal in a given economic system THE PRISONER'S DILEMMA demonstrates the difficulty of cooperative behavior in certain circumstances two suspects in a bank robbery - Bonnie and Clyde are arrested and interrogated in separate rooms each of the prisoners is offered the following options: 1 if one prisoner confesses and the other does not the one who confesses will go free and the other will be given a 20-year sentence 2 if both confess each will receive a 5 year sentence 3 if neither confesses each will be given a 6month sentence on a minor charge WHY BOTH CONFESS if both prisoners could talk to one another after they are arrested they could collusively agree not to  confess and both would get light sentences if they kept the bargain in the absence of collusion however there is great pressure on each prisoner to confess because he or she knows that if he doesn't confess and his partner does he'll get a very long sentence IN THE ABSENCE OF COLLUSION the typical result is that both prisoners confess and get medium sentences this is because the only other way out of the PRISONER'S DILEMMA is trust but trust is something that is very hard to come by  unless there is an explicit ENFORCEMENT MECHANISM SO FAR SO GOOD entertain the possibility that while the 2 duopolists fully collude and shake hands on the deal one of them is a no-good back-stabbing four-flushing varmint who decides to cheat this example should demonstrate clearly the often huge incentives to cheat that colluding oligopolists face THE PAYOFF MATRIX game theory was developed to provide insight into this type of strategic situation does so by analyzing the strategies of both firms under all circumstances and placing the combinations in a PAYOFF MATRIX or PAYOFF TABLE the non-collusive outcome is called the NASH EQUILIBRIUM NASH EQUILIBRIUM describes a situation in which no player can improve his or her payoff given the other player's strategy often describes a non-cooperative equilibrium in the absence of collusion, each party chooses that strategy which is best for itself

August 14
PRICE LEADERSHIP provides insight into how firms in an industry might tacitly collude as well as how firms which refuse to collude might be punished in the price leadership model, the policing or enforcement mechanism used is often punishment by the price leader usually the biggest or dominant firm in the industry THE DOMINANT FIRM AS ENFORCER with price leadership, executives within the industry don't have to slip off to a secret rendezvous in Vegas to set prices rather a practice evolves where the "dominant firm" usually the largest firm initiates a price change and all other firms more or less automatically follow that price change LEADER AND FOLLOWERS if one or more firms refuse to follow suit the price leader may choose to back down alternatively it may punish the non-cooperative firms by significantly lowering prices for a while forcing the followers to incur losses in this way the oligopoly can maintain PRICE DISCIPLINE THE KINKED DEMAND CURVE this model helps to explain why prices are "sticky" in oligopolistic industries, that ie, why prices don't rapidly adjust to changes in supply and demand the model also helps explain why prices may be high relative to the perfect competition outcome, even if there is no collusion AN EXAMPLE imagine an oligopolistic industry with three firms A B and C each of which have one-third of the total market further assume that each firm sets its price independently meaning that there is no collusion question: what does the firm's demand curve look like? the firm's perceived demand curve has a kink in it that is, when we draw the relevant marginal revenue curve for this kink demand curve we see that it has a gap in it therefore the relatively large shifts in marginal costs between will not change the price or the output that maximizes profits since they do not change the intersection of marginal cost and marginal revenue KEY POINTS 1 prices will be STICKY 2 if set high, prices will remain high even in the absence of collusion

August 14
COLLUSIVE MONOPOLY / JOINT PROFIT MAXIMIZATION the cartel model provides insight into the price and quantity that oligopolies are likely to set when they can collude successfully consider a four-firm industry in which each firm has grown tired of ruinous price wars during the industry's annual trade show in Las Vegas CEOs of all four companies ignore antitrust laws against explicit collusion and risk a possible jail sentence as they slip off to a secret rendezvous they then negotiate what price should be charged for their product of course as part of their secret cartel agreement each firm will also have to agree to restrict its output so the price can be maintained in the market where will the oligopolists set price? KEY INSIGHT: if oligopolists can truly coordinate their activities the obvious price to set is the same as that which would be set by a monopolist: MR=MC price will be set by the profit-maximizing rule of marginal revenue equals marginal cost if price is set at that point, the oligopolists will jointly maximize their profits which is why this model is often called the JOINT PROFIT MAXIMIZATION MODEL A CARTEL'S ACHILLES HEEL in order for the monopoly price to hold in the marketplace total industry output must equal the monopoly output this is where problems with the cartel are likely to emerge if any one firm in the oligopoly decides to cheat by producing more than its agreed upon share of output it can make higher profits than if it adheres to the cartel agreement

August 14
TACIT VS EXPLICIT COLLUSION it is not just explicit collusion that is the problem with oligopoly broader problem is with implicit or tacit collusion that arises precisely because explicit collusion is illegal tacit means to "express or carry on without words or speech" TACIT COLLUSION occurs when firms in an industry refrain from competition without explicit agreements HOW DO EXECUTIVES TACITLY COLLUDE? how do they communicate with one another without surreptitious phone calls or secret meetings? one common vehicle is PUBLIC SPEECHES given by leading executives in some of those speeches when executives are talking about say how costs are rising in an industry and why it might be time to raise prices, they are not just talking to who's in the room they are talking through the media to the other top executives in the industry - and it's all quite legal industry TRADE ASSOCIATIONS can play an important role in tacit collusion such trade associations can act as a conduit and clearing house for information about prices and costs in an industry from such information executives can better glean what their rivals are doing and in some cases then coordinate their activities THE UPSHOT when firms tacitly collude they often quote identical high prices which push up profits and decrease the risk of doing business THE MAJOR POINTS 1 there is no unified theory of oligopoly but rather many different models - each of which may have some application to specific industries 2 we can only scratch the surface of INDUSTRIAL ORGANIZATION and GAME THEORY so what will be presented will be more illustrative than definitive THREE BASIC OLIGOPOLY MODELS 1 cartel 2 price leader 3 kinked demand THE CARTEL MODEL provides insight into the price and quantity that oligopolists are likely to set when they can successfully collude THE PRICE LEADERSHIP MODEL provides insight into how firms in an industry might tacitly collude as well as how firms in that industry which refuse to collude might be punished for failing to FOLLOW THE LEADER THE KINKED DEMAND THEORY offers an explanation other than collusion as to  why prices in an oligopoly might be set higher than the perfectly competitive outcome

August 14
MARKET POWER signifies the degree of control that a firm or a small number of firms has over the price and production decisions in an industry most common measure: FOUR-FIRM CONCENTRATION RATIO the percent of total industry output accounted for by the four largest firms STRATEGIC INTERACTION CONCENTRATION RATIOS are important because they help serve as an indicator of the degree of strategic interaction that might occur in an industry STRATEGIC INTERACTION is a term that describes how each firm's business strategy depends on their rivals' strategies MUTUAL INTERDEPENDENCE RECOGNIZED as the number of firms in an industry shrink and industry concentration grows each firm is more likely to base pricing and output decisions on how other firms are likely to respond once this mutual interdependence is recognized firms have a choice between pursuing cooperative and noncooperative behavior NONCOOPERATIVE BEHAVIOR firms act non-cooperatively when they act on their own without any explicit or implicit agreements with other firms typically characterizes monopolistic competition COOPERATIVE BEHAVIOR firms operate in a cooperative mode when they try to minimize competition by agreeing explicitly or tacitly on price and output and other market issues the clear danger of oligopoly is that it is fertile ground for cooperative behavior COLLUSIVE OLIGOPOLY when firms in an oligopoly act cooperatively they must engage in some for of COLLUSION collusion occurs when one or more firms jointly set prices or outputs, divide the market among themselves, or make other business decisions jointly such collusion can be either EXPLICIT or TACIT ANTITRUST LAWS DON'T ALWAYS ACT AS A DETERRENT the lure of lavish profits have tempted many a business executive to skirt the law and many have wound up in a small prison cell rather than in a big mansion for their efforts THE POINT: the lure of economic profits is often irresistible and drives many a firm and too many executives to bend and often break America's antitrust laws

August 14
OLIGOPOLY: A FASCINATING TOPIC it is within oligopolistic industries that we observe the most complex and diverse examples of market conduct and corporate strategy OLIGOPOLY DEFINED exists when a small number of typically large firms dominate an industry central element is STRATEGIC INTERACTION in particular, given the small number of firms each firm must take into account the expected reaction of the other firms because of this MUTUAL INTERDEPENDENCE RECOGNIZED oligopolistic firms engage in strategic decision making when setting price quantity and product quality given the small number of firms oligopolists have a much better chance of COLLUDING than monopolistic competitors it is this strategic decision making and possibility of COLLUSIVE BEHAVIOR that makes oligopoly so interesting SOURCE OF OLIGOPOLY it is the same BARRIERS TO ENTRY that give rise to pure monopoly that are important in explaining oligopoly # 1: SCALE-ECONOMY BARRIERS TO ENTRY with monopoly AC decreases throughout the relevant range of production one firm drives out all other firms with oligopoly a few firms drive every one else out MINIMUM EFFICIENT SCALE: smallest level of output at which a firm can minimize long-run average costs with the case of natural monopolies like railroads and utilities small firms cannot realize the MES so there is only one seller a large minimum efficient scale can also give rise to oligopoly THE ENTRY DILEMMA assume three big firms all produce an output of AC       at their MES with an equal share of the market MARKET SHARE: percentage of market output produced by a firm the dilemma for a new firm trying to enter the industry: if the new firm tries to enter the industry at a plant size less than the MES it will be a higher cost producer than its rivals and will be highly vulnerable to being driven out of the industry by its competitors all its rivals need to do is set price below the new firm's costs for a while, cause it to incur heavy losses and eventually it will withdraw ENTRY DETERRED if the firm builds a plant size at the MES to be competitive it will have to seize a sizeable market share from its rivals to achieve efficient production it would to cut each of its rivals back from a third to a forth of the national market; and the likely result would be losses for everyone it is perhaps not surprising that scale-economy barriers deter entry into the industry and preserve the oligopolistic structure # 2: LARGE CAPITAL REQUIREMENTS characterizes industries like cigarette autos steel and petroleum refining simply requires a lot of capital investment to set up the elaborate plant and equipment necessary to produce the broader problem is that established firms with a track record may have better access to lower cost capital than new entrants for example, a large existing firm with an established reputation will likely be able to borrow money at a significantly lower interest rate than a new firm without a track record # 3: ABSOLUTE COST ADVANTAGE one source of such barriers is that established firms may possess valuable know-how in production or so-called TRADE SECRETS an existing firm may have PATENTS granting it exclusive rights to certain product features or  production processes RAW MATERIALS: this type of absolute-cost barrier explains the historic dominance of Alcoa in the production of aluminum ingots # 4: PRODUCT DIFFERENTIATION an important barrier to entry in an industry if a firm has an established brand name with consumers it has a distinct cost advantage any new firm entering the market would have to incur substantial advertising costs just to enjoy the same size and inelasticity of demand for its product THE BOTTOM LINE barriers to entry play a very important role in creating and sustaining oligopolistic industries why should we worry about this particular market structure? answer lies in better understanding the concepts of market power and market concentration

August 13
NON-PRICE COMPETITION AND EXCESSIVE ADVERTISING the fact that monopolistic competition is both allocative and productively inefficient relative to perfect competition is not the only problem with market performance at least some economists argue that monopolistic competition leads to both EXCESSIVE ADVERTISING and needless BRAND PROLIFERATION INCREASED PROFITS this possibility follows directly from the fact that in the long run, economic profits are zero therefore in order to improve upon this situation firms will engage in additional product differentiation and development and rely upon advertising to create real or perceived differences in their product with consumers while these efforts cost money, they also increase demand and demand inelasticity so that a firm can improve its profit position BRAND PROLIFERATION such market conduct is not always graded as a plus by economists economists usually have to point no further than the cereal aisle at their local supermarket where a dizzying array of brands proliferate BRAND PROLIFERATION & SOCIETAL WELFARE it is hard to argue that being able to choose over 50 different ways to eat sugared grain adds significantly to societal welfare nor is it always easy to understand the logic of having a different brand of gasoline available on every corner of an intersection or a hundred shades of pink lipstick DIVERSITY CAN BE GOOD reducing the number of monopolistic competitors while cutting costs might well end up  lowering consumer welfare because it would reduce the diversity of available goods and services THE COMMUNIST EXAMPLE to bolster this argument economists need point no further than the globe's centrally planned socialist and communist economies which have tried to standardize output on a small number of varieties and in the process left consumers highly unsatisfied

August 13
WHY COLLUSION IS DIFFICULT IN MONOPOLISTIC COMPETITION 1 there is a very large number of firms in the industry 2 even if the large number of firms in an industry were to successfully collude they wouldn't be able to  stop a flood of new firms from entering the market to take advantage of any COLLUSIVE MONOPOLY PRICING this is because entry is easy NON-COLLUSIVE OLIGOPOLY for these 2 reasons, monopolistic competition is sometimes called non-collusive oligopoly market conduct is very different in the presence versus the absence of collusion THE SHORT VS LONG RUN in the short run monopolistic competitors may well earn monopoly profits under certain circumstances however in long run equilibrium, economic profits in the industry will be driven to zero - just as in  perfect competition MONOPOLISTIC COMPETITION AND ALLOCATIVE EFFICIENCY important difference between perfect competition and monopolistic competition in the long run: under monopolistic competition, prices will be above marginal cost, indicating a deadweight efficiency loss firm uses profit maximizing rule to set prices where marginal revenue equals marginal cost with the lure of large economic profits, firms rapidly enter the industry this causes the typical sellers original profitable demand curves to shift downward and leftward by the entry of new arrivals, and price falls at what point will entry cease? entry will cease only when each seller has been forced into a long run, no profit tangency note that at this long run equilibrium, price remains above marginal cost and each producer is on the left hand declining branch of its long run average cost curve this means in the long run, monopolistic competition is neither allocatively or productively efficient in particular an underallocation of resources occurs in the industry because the product price exceeds marginal cost at the same time productive efficiency is not realized because production occurs at a point where the average total cost exceeds the minimum attainable cost

August 13
MONOPOLISTIC COMPETITION VS PERFECT COMPETITION monopolistic competition resembles perfect competition in 3 ways: 1 numerous buyers and sellers 2 entry and exit are easy 3 firms are price takers big difference: with monopolistic competition there is PRODUCT DIFFERENTIATION PRICE COMPETITION purely competitive firms produce a standardized or HOMOGENEOUS PRODUCT this means consumers will have no basis other than price for preferring one firm's product over another's and price competition is the norm NON-PRICE COMPETITION monopolistically competitive producers turn out many variations of a particular product because of such product differentiation consumers have reasons other than price to prefer one product over another therefore economic rivalry typically takes the form of         NON-PRICE COMPETITION FORMS OF PRODUCT DIFFERENTIATION competition comes primarily in the way that firms differentiate their products such differentiation can be accomplished in many ways: 1 product quality 2 conditions of sale and service 3 location 4 advertising 5 packaging # 1: DIFFERENCES IN ACTUAL QUALITY product differentiation may take the form of differences in actual product quality due to ENGINEERING, PROCESSING, or STYLING differences # 2: CONDITIONS OF SALE AND SERVICE beyond physical characteristics and product quality products may also be differentiated in other ways such as: 1 amount of service 2 conditions of sale # 3: LOCATION & ACCESSIBILITY small convenience stores successfully compete with big supermarkets even though they offer much less choice and much higher prices they can do so because they are often closer to customers and stay open for 24 hours a gas station's proximity to a freeway or busy intersection gives it a LOCATIONAL ADVANTAGE which may allow it to sell gas at a higher price than a gas station several miles away # 4: ADVERTISING AND PACKAGING while there are many aspirin-type products PROMOTION and ADVERTISING may convince headache sufferers that Bayer or Anacin are superior and worth a higher price than a GENERIC SUBSTITUTE BRANDING: a celebrity's name associated with jeans or perfume may enhance those products in the minds of buyers GOALS OF PRODUCT DIFFERENTIATION 1 increase consumer demand and thereby shift the firm's demand curve outwards and increase firm's market share 2 increase the inelasticity of the demand curve for its product by creating BRAND LOYALTY among consumers through advertising thereby creating a stronger preference for the firm's product STRATEGIC OPPORTUNITIES increased inelasticity increases the STRATEGIC OPPORTUNITIES of the firm rather than being a price taker, the firm becomes a         price maker albeit with less flexibility than a pure monopolist because the firm can now react to changing market conditions by changing the traits of its product, it can also engage in non-price competition

August 13
MOST INDUSTRIES pure monopoly together with a polar case of pure competition are the exceptions not the rule in our economy the market structures of most industries fall somewhere in between these two extremes and can be classified either by monopolistic competition oroligopoly MONOPOLISTIC COMPETITION defining characteristics: 1 relatively large number of sellers 2 easy entry to, and exit from the industry 3 product differentiation 1, 2 provide the "competitive" aspect 3 contributes the "monopolistic" aspect A PREVALENT MARKET STRUCTURE from mattresses to men's suits, from book publishing to paperboard boxes, and from upholstered furniture to fur goods, all these industries are monopolistically competitive just as are the industries producing the several hundred magazines on a newsstand rack and the fifty or so competing brands of personal computers KEY DIFFERENCES B/W OLIGOPOLY & MONOPOLISTIC COMPETITION # 1: monopolistically competitive industry is   relatively unconcentrated each firm in a monopolistically competitive industry has a comparatively small percentage of the total market share so that each has limited control over the market price in oligopoly MARKET CONCENTRATION is relatively high and so too is the oligopolists price making power this is because there are only a small number of firms in concentrated oligopoly so that each has a relatively large share of the market THE CONCENTRATION RATIO there are a number of different measures of market concentration the FOUR-FIRM CONCENTRATION RATIO is defined as the percent of total industry output accounted for by the four largest firms C4 = (q1+q2+q3+q4)/Q important in studying market structure because they help serve as an indicator of STRATEGIC INTERACTION that might occur in an industry STRATEGIC INTERACTION describes how each firm's BUSINESS STRATEGY depends on their rivals' strategies KEYPOINT: as the number of firms in an industry shrinks and industry concentration grows each firm is more likely to base pricing and output decisions on how other firms in the industry are likely to respond MUTUAL INTERDEPENDENCE RECOGNIZED each firm is more likely to want to COLLUDE with the others when setting price and quantity COLLUSION: the concerted action by firms to   restrict output and fix price this observation leads to two additional important distinctions between oligopoly and monopolistic competition # 2: collusion in oligopoly vs monopolistic competition because of the small number of firms in an oligopoly collusion is possible however the relatively large number of firms in a   monopolistically competitive industry ensures that collusion is all but impossible # 3: independent action with numerous firms in the industry there is no   feeling of MUTUAL INTERDEPENDENCE among monopolistically competitive firms each firm determines its policies without considering possible reactions of its rivals this is a very reasonable way to act in a market in which there are numerous rivals FOR EXAMPLE the 10 or 15% increase in sales a firm may realize by cutting prices will be spread so thinly over its rivals that the impact on their sales will be imperceptible rivals' reactions can be ignored because the impact of one firm's actions on each of its many rivals is so small that these rivals will have no reason to react

August 12
PRICE REGULATION if breaking up a natural monopoly is a bad idea, what can you do to address public policy concerns? WHERE TO SET PRICE? at point where P=AC point where P=MC may seem the best price at this point price regulation would effectively simulate the outcome in a perfectly competitive market and therefore be allocatively efficient PROBLEM: monopolist would be forced to lose money equal to P*AC-Revenues the only way the monopolist could stay in business over time would be to receive a subsidy from the government equal to its loss likely to be a politically unattractive option point where P=AC more feasible option monopolists earns zero economic profits enough to stay in business but does so without gouging consumers dead weight loss is considerable smaller than under pure monopoly P=AC IS NOT A PERFECT SOLUTION! there is never any free lunch in economics, only hard choices seems to solve a lot of problems with monopoly, but can also create additional problems X-INEFFICIENCY concept first introduced by Harvard economist Harvey Liebenstein suppose you are the CEO of a regulated electric utility and price is set by P=AC rule what does this do to your incentive to maximize profits? COST PLUS PRICING under the P=AC rule you are basically guaranteed the recovery of any costs incurred that's why this type of regulation is known as COST-PLUS PRICING under cost-plus pricing, regulated industries no longer have the incentive to minimize costs and therefore maximize profits instead there is a perverse incentive to increase costs for the benefit of the executives operating the firm X-INEFFICIENCY THEORY PREDICTS executives in regulated industries will tend to hire more staff, buy thicker carpets, build larger offices, and engage in more business travel than they otherwise would under strict profit maximization What would such behavior do to the observed ATC curve and deregulated price? would raise the AC curve and lead to a higher regulated price firms are operating well above their potential ATC THE PUNCH LINE in some cases, any increase in allocative efficiency achieved by regulating a monopolist might be more than offset by an increase in X-inefficiency due to cost-plus pricing THE BROADER POINT monopoly and the appropriate public policy response raises many thorny issues DYNAMIC EFFICIENCY measures the rate of technological change and innovation in an industry the faster this rate, the better the industry will perform and the faster the economy will grow ARE MONOPOLISTS BAD? question first raised by Harvard economist Joseph Schumpeter: are monopolies likely to outperform competitive industries in the dynamic efficiency dimension Profound Implication: if answer is yes, then perhaps we should just leave monopolies alone SCHUMPETER'S DYNAMIC EFFICIENCY ARGUMENT since monopolists are likely to earn a higher level of profit than competitive industries they will have deeper pockets to engage in longer term strategic activities such as research and development they will also have a much bigger cash fund with which to make investments to speed the diffusion of the technology COUNTERING SCHUMPETER the monopolist may have deep pockets to spend on developing new technologies however, that same monopolist has little incentive in the absence of competitors to introduce the technology so technological progress is actually slowed

August 12
A DEFINITION OF COMPETITION "Competition is when everyone tries to get a monopoly" KEYPOINT: Prices are generally higher and outputs are lower under imperfect competition than under perfect competition BENEFITS TO IMPERFECT COMPETITION 1 exploitation of ECONOMIES OF SCALE to lower costs 2 acceleration of TECHNOLOGICAL CHANGE to promote long term growth KEYPOINT: If you understand how imperfectly competitive markets work, you will understand better how our economy and the economies of other industrialized nations function ROCKEFELLER INVENTS THE TRUST Shareholders turned their shares over to trustees who would then manage the industry to maximize its profits these trusts essentially were CARTELS CARTEL: an organization of independent firms producing similar products that work together to raise prices and restrict output this trust device worked so well that other industries soon imitated Rockefeller's Standard Oil Trust to consolidate their monopoly power ANTITRUST LAWS in 1910 the Congress passed antitrust laws to break up  the trusts, ban cartels, and even regulate the prices of many of the industries today unregulated monopolies are rare while the monopolies that exist tend to be subject to a very special form of price regulation MONOPOLY exists when there is only one seller in the market selling a product for which there are no close substitutes monopolist is a PRICE MAKER rather than a PRICE TAKER exerts considerable control over what the market price will be monopolist has this power because it also controls quantity supplied in the market MONOPOLY'S PROFIT MAXIMIZING RULE MR=MC ALL profit-maximizing firms will set price where the marginal revenue from an additional unit sold equals its marginal cost PUBLIC POLICY monopoly is both inefficient and redistributes income in a way that many would describe as unfair NATURAL MONOPOLY characterized by increasing returns to scale over the relevant range of output suppose some irate congressman decide to launch a crusade against monopoly and sponsors antitrust legislation to break up every monopoly into many small firms is this a good idea? breaking up some monopolies might be a very good idea indeed however breaking a natural monopoly up into many small firms is likely to be a very bad idea this is because each of the smaller firms will produce at a significantly higher unit cose than the monopolist each of the smaller firm will be unable to achieve the same MINIMUM EFFICIENT SCALE as the monopolist thus, while this artificially created competitive market may indeed yield a competitive price where P=MC it may also be the case that this price is well above the natural monopolist's price

August 11
TWO CHEERS FOR PERFECT COMPETITION We've proven that a perfectly competitive market yields the most efficient use and allocation of resources - as embodied in productive and allocative efficiency Yet still there are several problems THE REAL WORLD PC is rarely if indeed ever totally mirrored in reality Too many restrictive assumptions to be met When one or more assumptions fail, we get any one of a number of market failures ranging from imperfect competition and externalities to the public goods problem WHY STUDY PC? Gives a benchmark against which to measure how other three market structures perform Gives appropriate guidance as to when and how to intervene in the market to CORRECT MARKET FAILURES as well as how to measure success or failure at doing so THE EQUITY PROBLEM While its results may be efficient, not necessarily fair KEYPOINT: Efficient allocation of resources achieved by PC is contingent on the initial distribution of  income! This means if you change the distribution of income you can get a different efficient allocation of resources and by implication a different consumption pattern LARGE DIFFERENCES IN INCOME CAN BE EFFICIENT Yet if income were distributed more evenly, we'd see an equally efficient allocation of resources but one with a very different structure of demand More people could afford to buy housing and refrigerators and air conditioners and motor scooters and small cars while the consumption of villas and limos and steaks would go way down WHICH OUTCOME IS MORE FAIR? A NORMATIVE or prescriptive question, one that asks "What should be?" Deciding normative questions are more properly the domain of politicians and philosophers and voters at the ballot box or revolutionaries in the jungle POSITIVE ECONOMICS The more proper role of the economist is POSITIVE or DESCRIPTIVE analysis: Describing what is rather than what should be Can offer great insights about how different types of government policies can affect distribution of income and consumption Therefore POSITIVE ECONOMIC analysis is essential in many NORMATIVE policy debates

August 11
PRODUCTIVE EFFICIENCY Occurs when price equals minimum average total cost Holds when a competitive industry is in long run equilibrium Means the firm is using the minimum amount of resources to produce any particular output Firm is using best available, least cost technology, if it doesn't it will not survive ALLOCATIVE EFFICIENCY Slightly more difficult concept PARETO OPTIMALITY <-- one of the most cumbersome definition An allocation of resources is Pareto Optimal when no possible reorganization of production can make anyone better off without making someone else worse off PRODUCTION POSSIBILITY FRONTIER (PPF) An economy is clearly inefficient if it operates inside the PPF and no one need suffer a decline in utility by moving to the PPF Therefore, at a minimum an efficient economy is on its PPF Nonetheless, allocative efficiency goes one step further and requires not only that the right mix of goods be produced but also that these goods be allocated among consumers to maximize consumer satisfaction PERFECT COMPETITION IS ALLOCATIVELY EFFICIENT! Perfect competition yields best possible allocation of society's resources Demand curve reflects willingness of consumers to pay for a product Under the assumptions of perfect competition, demand curve therefore must reflect the SOCIAL BENEFITS of that product Supply curve reflects the costs of production and therefore must reflect the social costs of producing the product KEYPOINT: In a perfectly competitive market, equilibrium occurs where supply intersects demand so that social benefits equal social costs At this equilibrium point, the marginal cost of production exactly equals the marginal benefit or utility of consumption We know this to be true because from consumer theory we know that consumers choose purchases up to the point where price equals marginal utility At the same time, we've already proven that in a competitive market, P=MC Therefore MU MUST EQUAL MC CONSUMER SURPLUS The area under the demand curve Provides a dollar measure of the difference between what consumers would have been willing to pay and what they actually pay PRODUCER SURPLUS The area above the surplus curve Measure the difference between the price at which producers would have been willing to supply a good and the price they actually receive MEASURING EFFICIENCY LOSS We can use the concepts of producer and consumer surplus to measure both the efficiency loss of a deviation from the perfect competition equilibrium as well as its distributional implications KEYPOINT C and E measure the loss in allocative efficiency from the monopoly pricing Economists call this the DEADWEIGHT LOSS WHY PEOPLE DON'T LIKE MONOPOLIES Transfers income from the many to the few Creates an efficiency loss

August 11
LONG RUN EQUILIBRIUM While a firm can lose money in the short run no firm can keep doing it forever KEY RULE: In the long run, a perfectly competitive industry will be in equilibrium where price equals average total cost At this point, firms will earn what economists call alternatively either NORMAL PROFITS or ZERO ECONOMIC PROFITS ACCOUNTING PROFITS calculated simply by subtracting total revenues and total costs What is left over after taxes is available to be distributed as DIVIDENDS or kept by the firm as RETAINED EARNINGS! OPPORTUNITY COSTS Suppose you go into business and you have to forego a 40,000 a year, after-tax salary That's the OPPORTUNITY COST of your own resources of going into business If you wind up at the end of the year with accounting profits of 40,000 you've earned ZERO ECONOMIC PROFITS because accounting profits just cover opportunity costs If you wind up with less than 40,000 your economic profits are negative and more than 40,000 your economic profits are positive ECONOMIC VS. ACCOUNTING PROFIT The real rate of return will be roughly 3 percentage points above the return you could have earned investing in risk free government bonds So, after adjusting for risk, any investment yielding you that return would be considered a normal profit or zero economic profits NOTE: from an accounting standpoint, your profit isn't zero You've simply been fairly compensated for your equity capital - no more and no less LONG RUN EQUILIBRIUM In the long run, a perfectly competitive industry will produce where price equals average total cost durve at its minium and earn zero economic profits How does the industry remarkably wind up at this particular point? Answer lies in one of original assumptions: FREE ENTRY AND EXIT into the market Why does the process always stop at zero economic profits? In the short run firms can incur losses but over the long run they exit the industry This shifts the supply curve in, driving up prices and driving economic profits back to zero Thus in the long run perfectly competitive firms earn a normal profit, no more and no less EFFICIENCY IMPLICATIONS Importance of this conclusion about long run equilibrium lies in its implications for the efficiency of the perfectly competitive market We can think of efficiency in at least 2 dimensions of market performance: 1. ALLOCATIVE EFFICIENCY 2. PRODUCTIVE EFFICIENCY

August 11
PRICING AND PRODUCTION RULES Question: Given a market structure of perfect competition what kind of conduct with respect to pricing can we expect? P=MR=MC P=MR because the profit-maximizing, perfectly competitive form is a PRICE TAKER in the market place Therefore, the firm faces a horizontal or perfectly elastic demand curve so the firm's marginal revenue must be equal to price MR=MC <-- The Profit Maximizing Rule an accurate guide to profit maximization for all firms not just perfectly competitive ones P=MC is simply a special case of the MR=MC profit- maximizing rule for perfect competition KEYPOINT If the profit-maximizing firm always sets its output at a level where MC=MR, then it must be true that a firm's marginal cost curve must also be its supply curve THE SHUTDOWN RULE The surprising answer is that, at least in the short run the firm should remain in business even in the face of negative profits Reason has to do with what's called by varying names as the SHUTDOWN RULE, SHUTDOWN CONDITION or CLOSE-DOWN CASE THE SHUTDOWN POINT Comes where revenues just cover variable costs or where losses are equal to fixed costs When price falls below the level where revenues are equal to variable costs, the firm will minimize its losses by shutting down To fully understand this rule, remember that a firm must still cover its contractual commitments even when it produces nothing In the short run, firm must still pay fixed costs such as rent interest on bank loans, and salaries to key management personnel A REALLY TOUGH QUESTION In light of the shutdown rule, how must we change our definition of the firm's supply curve as it relates to marginal cost? The firm's marginal cost curve is still its supply curve -- but this is true only for that portion of the marginal cost curve that lies above the AVC HIGH FIXED COSTS Lots of industries go through cycles of large short run losses without shutting down Which type of industry is more likely to incur such losses? --> A capital-intensive industry with high fixed costs like automobiles and the airlines The higher the firm's fixed costs, the more it has to lose by shutting down!

August 11
IMPERFECT COMPETITION failure of one or more of the assumptions in perfect competition to hold leads to this catch-all term that includes 3 major market structures: 1. monopoly 2. oligopoly 3. monopolistic competition not the only possible market failure associated with failure of the assumptions of PC to hold FIFTH ASSUMPTION OF PC The demand curve accurately measures the BENEFITS of consumption to society The supply curve accurately measures the COSTS of production to society If this assumption holds, what then must be the case, where the demand, and supply curves cross, in a competitive equilibrium? <-- hard question with interesting answer: If demand curve measures social benefits, and supply curve measure social costs, then it must be true that where the demand and supply curves cross at market equilibrium. Social Benefits = Social Costs <-- This is an efficient outcome for society's resources When this assumption fails, we have what is called the: EXTERNALITIES PROBLEM include things like pollution and congestion in the presence of externalities, government intervention may be warranted SIXTH ASSUMPTION OF PC market demand curve is the horizontal sum of the individual demand curves When this fails, we have what is called the PUBLIC GOODS problem PUBLIC GOODS include things like national defense, roads, bridges In the presence of the public goods market failure government may have to step in and provide the goods MARKET FAILURE one of the most important concept in all of economics This concept is the theoretical foundation upon which much of the economic rationale for modern government rests A justification for government intervention Helps explain the existence of a wide range of government activities and agencies, e.g Pentagon, Federal Trade Commission, Environmental Protection Agency, National Institutes of Health

August 11
PERFECTLY COMPETITIVE MARKET where numerous buyers and sellers meet, consumers pay the lowest price for the most goods, and all resources are allocated efficiently the market structure by which economists measure all other market structures PERFECT COMPETITION is the most efficient type of market structure IRONY: Few industries meet the very restrictive assumptions of perfect competition ASSUMPTION #1: NUMEROUS BUYERS AND SELLERS when met, any one firm's output is miniscule compared to market output (like a grain of sand compared to a beach) therefore, what one firm does has no influence on what other firms do important because it is one of the primary reasons why perfectly competitive firms are PRICE TAKERS rather than PRICE MAKERS If one firm tries to raise its price above P* customers will simply buy their widgets from any one of thousands of other firms so quantity demanded falls to zero From the perspective of the firm, the individual firm's demand curve isn't downward sloping at all but rather perfectly horizontal: demand is perfectly elastic Next: figure out what any one firm's marginal revenue is so we can figure out how that firm will maximize its profits MARGINAL REVENUE additional revenue earned by the firm from the sale of one additional unit Question: What is the relationship between industry market price and the firm's marginal revenue in a perfectly competitive industry? P=MR, which follows directly from the PRICE TAKER assumption and a perfectly elastic demand curve ASSUMPTION #2: HOMOGENEOUS PRODUCTS product such that each firm's output is indistinguishable from any other firm's output, e.g wheat and coal contrast with PRODUCT DIFFERENTIATION you can buy 30 different brands of many different kinds of DIFFERENTIATED PRODUCTS This assumption means that every firm in the industry is selling exactly the same product So the only thing that firms can compete on is PRICE and not on other things such as PRODUCT DESIGN and PRODUCT QUALITY KEY DIFFERENCE BETWEEN PERFECT & MONOPOLISTIC COMPETITION with monopolistically competitive firms, products are differentiated and NONPRICE COMPETITION is common ASSUMPTION #3: FREE ENTRY AND EXIT additional firms may freely enter an industry when prices and profits rise and just as easily exit in the presence of losses in order for this free entry condition to hold there must be no barriers to entry barriers: range from exclusive patents, large capital requirements (symptomatic of natural monopolies) to ownership of valuable resources such as the bauxite reserves owned by Alcoa, the world's largest aluminum producer Important assumption because it helps insure and efficient allocation of resources over the longer run ASSUMPTION #4: PERFECT OR COMPLETE INFORMATION Both consumers and producers will be fully informed instantaneously of market prices and any changes in prices This ensures consumers will always pay the lowest price available because they will always know what that price is If any one producer makes a technological breakthrough and is able to produce a product more cheaply all other firms will be able to use the same technology instantaneously

August 11
TOPICS COVERED UP AT THIS POINT 1. basics of supply and demand 2. consumer and producer theory NEXT: how industries and markets are organized Industry Structure 1. how many firms are in an industry 2. whether firms are big or small 3. what firms cost structure look like 4. how market share is divided among the firms Types: 1. perfect competition the market structure by which economists measure all other market structures 2. monopoly 3. monopolistic competition 4. oligopoly THE NEXT THREE LECTURES putting together everything learned about consumers and producers and supply and demand goal is to understand how American industries are structured and why different industries exhibit different kinds of MARKET CONDUCT and MARKET PERFORMANCE STRUCTURE-CONDUCT-PERFORMANCE PARADIGM industry structure determines market conduct and market conduct in turn helps determine market performance MARKET CONDUCT embodies various pricing and marketing tactics and strategies of businesses includes: at what level a firm or industry sets its price and output also includes: whether that firm or industry engages in various kinds of NON-PRICE COMPETITION through PRODUCT DIFFERENTIATION and ADVERTISING MARKET PERFORMANCE measured by yardsticks such as ALLOCATIVE EFFICIENCY and PRODUCTIVE EFFICIENCY these yardsticks can tell how well or poorly a society's resources are being used STRUCTURE -> CONDUCT -> PERFORMANCE STRUCTURE 1. perfect competition 2. monopoly 3. monopolistic competition 4. oligopoly CONDUCT 1. price competition 2. collusion 3. nonprice competition PERFORMANCE 1. allocative efficiency 2. productive efficiency 3. x-efficiency

August 10
COMMON TRAITS BETWEEN SUPPLY CURVE AND DEMAND CURVE 1. just as there is a law of demand, there is a law of supply as price increase, quantity supplied will increase supply curve is upward sloping 2. just as there is a price elasticity of demand, there is a price elasticity of supply (% change in Q) / (% change in P)   Determinants of Elasticity: most important determinant of the elasticity of supply is the number of substitues for the good: 1. if substitution is easy, supply will be elastic 2. if substitution is difficult, supply will be inelastic ECONOMIC VS. ACCOUNTING PROFITS how an economist measures a firm's costs and profits versus how an accountant measures them economist, as opposed to an accountant - will always count not only explicit costs but implicit costs as well EXPLICIT VS. IMPLICIT COSTS Explicit costs: monetary payments to "outsiders" for things like labor, materials, fuel, transportation and power Implicit costs: money payments you could have earned by employing your own resources in their best alternative use Opportunity costs: include all consequences, whether they reflect explicit monetary transactions or not example: the immediate dollar cost of going to a movie instead of reading your economics textbook is the price of the movie ticket opportunity cost also includes the possibility of    gaining a better understanding of macroeconomics and therefore becoming more successful in business YOU END UP BEING WORSE OF!!!!! Category/Opportunity Cost Your own financial capital 1500 Kicking out your tenant    9600 After tax salaries        90000 Total                    101100 Accounting profit         90450 Economic profit          -10650 Subtracting all implicit costs from the accounting profit you wind up for all your blood, sweat, and carrot juice with a negative economic profit of 10650. Not very good. In fact, people make mistakes like this all the time in both their personal and professional lives because they base important decisions on accounting rather than economic profits KEYPOINT Always consider your opportunity costs when you make a decision!

August 10
DISECONOMIES OF SCALE not just a firm can benefit from economies of scale so too can it be harmed by diseconomies of scale such diseconomies are characterized by higher unit costs as plant size increases beyond a certain point CAUSES OF DISECONOMIES OF SCALE 1. managerial problems efficiently controlling and coordinating a firm's operations as it becomes a large-scale producer at some point, a plant just gets too big for effective management 2. in massive production facilities workers may begin to feel alienated from their jobs and efficiency may suffer NARROW AND STEEP U-SHAPED LONG RUN COST CURVE economies of scale are exhausted quickly typical profile of an industry characterized by this kind of curve is numerous sellers in healthy competition e.g: retail trades, some types of farming, light manufacturing such as baking, clothing, shoes in such industries a particular level of consumer demand will support a large number of relatively small producers CURVE WITH LONG FLAT SPOT ON IN THE MIDDLE a case of CONSTANT RETURNS TO SCALE characterizes many American industries example: banking mergers in the 1980s most analysts thought unit costs would fall dramatically bank could close some of their branches and combine support services such as computer processing, advertising, auditing and legal work but, studies found that the mergers did not significantly reduce costs possible explanation: constant returns to scale over a broad spectrum of output CURVE THAT IS THE SIGNATURE OF NATURAL MONOPOLY one of most famous in economics unit costs steadily fall so that there is increasing returns to scale over the relevant range of output means that over time bigger producers drive out smaller producers until only one is left: the infamous monopolist as a result of this MARKET FAILURE, price will be set too high, output too low for market efficiency, and government regulation may be warranted e.g: railroad, cable tv, distribution of electricity, gas, local telephone service MINIMUM EFFICIENT SCALE (MES) smallest level of output at which a firm can minimize long-run average costs in the constant returns to scale curve figure, this point is reached at Q1 however, because of the extended range of constant returns to scale relatively large and relatively small firms can coexist and be equally viable the case in industries such as: apparel, food processing, furniture, wood products, small appliances NATURAL MONOPOLY small firms cannot realize the MES so there is only one seller OLIGOPOLY a large minimum efficient scale can also give rise to and _industry structure_ like this oligopolistic industry is characterized by a small number of large sellers e.g: automobiles, aluminium, steel, cigarettes THE BROADER POINT the shape of an industry's long run average cost curve has an enormous influence on the INDUSTRY STRUCTURE 1. perfect competition 2. oligopoly 3. monopoly 4. monopolistic competition these different market structure in turn determine the conduct of the firms and therefore the performance of the market CONDUCT: 1. price competition 2. collusion 3. nonprice competition PERFORMANCE: 1. allocative efficiency 2. productive efficiency 3. X-efficiency

August 10
LONG RUN COST ANALYSIS long run is when all factors are variable, including capital as demand expanded, you built more plant capacity suppose that this pattern kept repeating itself and that you kept building larger and larger plants what do you think would happen to your firm's average cost as plant scale increased? THE LONG RUN AVERAGE COST CURVE -- The long run average cost curve is the envelope of the short run average cost curves -- capital inputs are fixed in the short run and there is a point on the ATC curve where average cost is minimized now if you built a bigger plant, output will increase and there will be another short run ATC curve created If the number for possible plant sizes is very large the long run average cost curve approximates a smooth curve -- broad U shape. how to interpret this? the U shape of the long run average cost curve suggests that at least up until the point Q* (middle) the larger and larger plant size will mean a lower and lower unit cost however beyond Q* successively larger plants mean higher average total costs reason: NOT Law of Diminishing Returns which explained the U shaped short run average cost curve -- Law of Diminishing Returns does not apply in the long run because all factors are variable explanation lies in understanding this key conceptual triad: 1. economies of scale 2. diseconomies of scale 3. constant returns to scale ECONOMIES OF SCALE exist when the per-unit output cost of all inputs decreases as output increases may be traced to: 1. labor specialization means dividing and subdividing jobs as plant size increases instead of performing 5-6 jobs, a worker can focus on 1 greater specialization eliminates the loss of time that occurs when workers shift between jobs 2. managerial specialization supervisor who can handle 20 workers will be under-used in a small plant as will a sales specialist who may have to divide hi or her time between other managerial functions such as marketing, personnel and finance 3. efficient capital larger plant size facilitates the most efficient capital use 4. by-products larger scale production allows better use of by-products example: a large meat packing plant will also make glue fertilizer and pharmaceuticals from animal remains which otherwise would be discarded by smaller producers 5. other such factors e.g: design, development, other "start-up" costs that must be incurred irrespective of sales these costs per unit decline as output increases

August 10
MARGINAL COST one of the most essential in microeconomics competitive firms will produce at a level where the price of the product equals their marginal cost P = MC SUPPLY CURVE that portion of the marginal cost curve above the average variable cost curve Average fixed costs (AFC) FC/Output AFC curve approaches zero because as a firm's output increases it spreads it fixed costs over a larger number of units so average fixed costs must fall in business, the name of the game is often to spread your fixed costs over as many units as possible Average variable costs (AVC) VC/Output AVC curve must approach the ATC curve as output increases Average total costs AFC+AVC TRICKIER QUESTION we know why ATC, AVC, and MC curves slope first down and then up -- it's the law of diminishing returns But, WHY does the MC curve intersect both the AVC and AC curves at their minimums? 1. if MC > ATC then ATC is rising 2. if MC = ATC then ATC is at its low point 3. if MC < ATC then ATC is falling If the production of an additional unit has a marginal cost greater than the average cost then production of that unit must drive the average up and conversely Thus, it must be that only when MC=ATC that ATC is at its lowest point MC=ATC means that a firm searching for the lowest average cost of production should look for the level of output at which marginal costs equal average cost THE POWER OF MARGINAL ANALYSIS when marginal cost is coupled with the concept of marginal revenue the firm is able to determine if it is profitable to expand or contract its production level

August 10
SHORT RUN COSTS CURVE Output Fixed costs (FC) sometimes called "overhead" or "sunk costs" costs that do not change with the level of output e.g: rent, interest on bonds, insurance premiums, salaries of top management, etc Variable costs (VC) costs that change with the level of output e.g. raw materials, fuel, wages Total costs (TC) simply variable costs + fixed costs Marginal costs (MC) change in total costs similar to Marginal utility: the additional utility a consumer gets from a one-unit consumption increase in consumption the additional cost incurred in producing one extra unit of output FIRST FALLS, THEN RISE. BUT WHY? answer lies in The Law of Diminishing Returns LAW OF DIMINISHING RETURNS in production theory remember that in the short run capital is fixed but factors like labor are variable in such a situation, adding more workers means that each additional unit of labor has less capital to work with at some point then, the extra or marginal product of each additional worker must begin to decrease MARGINAL PRODUCT marginal product of an input such as labor is the extra output added by one extra unit of the input, holding other things such as capital constant MP CANT KEEP RISING example: in car factory as more and more workers are added assembly line starts to get too crowded and workers have to wait in line to use the machines thus, at some point the total product or total output keeps increasing but begins to do so at a decreasing rate! as total product rises, it does so at a decreasing rate this translates to a falling marginal product curve THE SHAPES OF BOTH CURVES it should be clear that a rising marginal cost curve must follow directly from a falling marginal product curve shapes of both curves are attributable to the law of diminishing returns

August 10
NUTS AND BOLTS definitions and concepts that we need to hold together the real world can be made relevant to personal and professional experiences PRODUCTION FUNCTION specifies the maximum output that can be produced with a given quantity of inputs for a given state of engineering and technical knowledge Q = F(K,L,R) Q = quantity of cars to produce K = capital or plant and equipment needed for production L = number of employees or quantity of labor R = catch-all term for other things like raw materials and energy F = current state of technology in order to make millions, what combination of inputs are you going to choose and what will be the size of your automobile plant? THE SHORT RUN suppose the factory for energy efficient auto is producing 10,000 cars/year suppose further the OPEC cartel slaps an embargo on the US and quadruples the price of oil demand starts to increase dramatically as consumers seek to substitute your Gas Miser for their gas guzzlers WHAT TO DO? IN THE SHORT RUN: add two more shifts, hire more workers, use more energy and raw materials as you try to run your plant around the clock to meet increased demand only option as it would take over a year to build a new factory THE SHORT RUN period in which firms can adjust production only by changing variable factors such as materials and labor but cannot change fixed factors such as capital THE LONG RUN period sufficiently long enough so that all factors in the production function including capital can be adjusted in the example, this is the time it would take to expand existing factory or build a new one DISTINCTION between short run and long run is important because each period has its own kind of cost analysis

August 9
QUESTION If you raise the price of a product, will the total revenues from selling that product go up or down? TR = P * Q Total Revenues = Price * Quantity STUART APPLEGATE Just remember the case of Stuart Applegate from the first lecture He was the CEO who tried to bail out his software company by raising prices But demand was highly elastic, total revenues fell and his company went out of business MS. TWILLY'S PROMOTION facing a revenue shortfall, Jean ordered an analysis of the elasticity of demand for bus services when she found that bus demand was also highly elastic she recommended to her supervisor that the Transit Authority lower bus fares this pricing strategy did indeed increase ridership and boost total revenues Why do you think that many airlines offer fare discounts to people who stay over on a Saturday night? 1. Airlines are trying to sort out two different kinds of customers: business people with more inelastic demands who want to fly home on the weekends and perhaps be with their families 2. Pleasure travelers who don't mind staying over on a Saturday night By making this separation, the airlines can effectively charge two prices: a higher one to business travelers and a lower one to pleasure travelers This means more total passengers and total revenue Why don't most new cars sell at their sticker price? Why go in and haggle when you buy a car whereas if you go in and buy a gallon of milk, you pay the sticker price? COMPARISON VS IMPULSE BUYERS Car salespersons are trained to sort out "comparison shoppers" with more elastic demands from "impulse buyers" who have inelastic demands By not listing the selling price of cars the salespersons can charge the impulse buyers more PUBLIC POLICY APPLICATIONS The concept of price elasticities can help us think through a wide variety of public policy problems Example: The demand curve for a highly addictive drug like crack is almost perfectly inelastic Supply curve crosses the demand curve at point where price is $10 Question: What happens when the US escalates its war on drugs by interdicting large quantities of illegal shipments? Demand curve shifts inward The practical effect is to significantly raise the price but because demand is inelastic, this has little impact on reducing crack consumption Further problem: Because crack addicts have to now pay more for their "fix" crime tends to increase because it is through robberies and burglaries and prostitution that most addicts pay for their dope LEGALIZE DRUGS? Logical thing to do at least from an economic point of view would seem to be to just legalize drugs Beyond the obvious moral questions some economists have argued that while drug addicts are highly insensitive to price the "casual drug user" is highly price sensitive If the "war on drugs" has little effect on curbing consumption by drug addicts, it nonetheless may have a big effect on reducing consumption among casual users who presumably respond to prices hikes by substituting cheaper legal drugs like alcohol for more expensive drugs like cocaine AGRICULTURAL PRICE SUPPORTS Demand for farm products is highly inelastic During a year of bumper crops, Q will change only a little bit but food prices will plummet THE PARADOXICAL RESULT: many farmers go bankrupt when crops are plentiful One way to address this problem is to restrict farm output and this has been regularly done with many farm products from milk and oranges to corn and wheat EXCISE TAXES if government imposes a sales tax on a product that is highly elastic what will happen to total tax revenues? Total revenues fall so at least most legislatures are smart enough to seek out products with more inelastic demands to tax products like alcohol and tobacco Economics is not something to memorize but rather something to conceptualize So as you study it, think about it too. Your job and your business just might depend on it.