Econ 1014 Exam 3

invisible hand properties

• short run: by maximizing profits and producing where P=MC, firms minimize total industry production costs

• long run: by responding to profits in a market/industry, firms assure that resources move toward their most productive use and the balance of industries is efficient

• ONLY WORKS with no externalities and competitive market (no monopoly/oligopoly)

competitive market

• free entry/exit of firms

• many buyers and sellers

• each buyer/seller is a price-taker

monopoly

• barriers to entry

• may be (regulatory) barriers to exit

• one seller, many buyers

• downward-sloping demand curve

• not a price-taker

• inefficient

• P>MC → DWL

natural monopolies

• large fixed costs, relatively low marginal costs

• increasing returns to scale over the relevant range of output

• imply that AC>MC

• a single firm can produce the good much more cheaply than several smaller firms

price discrimination

charging more than one price for the same product

• can increase surplus as compared to simple monopoly

• simple case: 2 markets or groups with different demand curves (third degree price discrimination)

• identical marginal cost for both groups

• key assumption: no arbitrage

• monopolists can increase profits by charging different prices in the different markets

• elasticity=escape

principles of price discrimination

• if the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets (firm wants to price discriminate)

• to maximize profits, the monopolist should set a higher price in markets with more inelastic demand

• arbitrage may make it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination

perfect price discrimination

charging each buyer their maximum willingness to pay

• need to prevent arbitrage (resale)

• difficult to implement because it requires very detailed information on consumers’ maximum willingness to pay

  • still, producers go to great lengths to gather information on their consumers

tying

consumption of one good requires the consumption of a second good produced by the same firm

• allows firms to price discriminate by pricing the base good below cost and the variable good above cost

• consumers reveal their willingness to pay through the variable good

bundling

requiring that a good be bought along with other goods

• most beneficial in high fixed cost, low marginal cost industries where consumers value the bundle similarly but differ in which of the individual components they view as high vs. low value

quality discrimination (versioning)

when firms sell different versions of a product with different features at different prices (and the price difference > cost difference)

• lower priced version costs more to produce

cartel

attempts to move a market from a competitive one to what would occur if the market were controlled by a monopoly

• undifferentiated product (Q)

• small number of producers

• when firms form one:

  • set overall production level at the monopolist quantity where industry profits are maximized

  • once overall production level set, set a production quota for each cartel member

• work best for commodities with limited geographic options for entry

• most successful ones operate with explicit support of (and enforcement by) the government

redeeming quality of oligopoly

• pursuit of market power can lead to innovation and product differentiation

• one reason firms innovate is to produce a product with fewer substitutes

• fewer substitutes → more inelastic demand → higher prices/profits

• firms also compete by differentiating their products with different styles/features

network goods

a good whose value to one customer increases the more that other customers use the good

• usually produced by monopolies or oligopolies

• competition is “for the market” rather than “in the market”

• best product may not always win (suboptimal equilibrium)

• contestability matters

• network externality (positive externality)

• typically involve one firm providing a dominant standard at a high price

  • markets usually also include a number of other smaller firms offering a slightly different product

    • tend to service niche areas in the market

platform firms

connect two or more sides of a market

• seek to maximize total transaction value

• lowering transaction costs → facilitates trade and helps transfer resources from low to high-value uses

• increasing the number of transactions by expanding the 2 sides of the market (network externalities)

• providing the product for free to one side of the market can be a profit-maximizing strategy

• as they have grown, their policies have sometimes become as powerful as government regulations

Nash equilibrium

a situation in which neither player has an incentive to change their behavior or response

• no player wants to unilaterally defect, i.e. knowing the other player’s strategy wouldn’t cause either to change their strategy

contestability

occurs if a competitor could credibly enter and take business away from the incumbent

• fixed costs of entry are low

• few/no legal barriers to entry

• incumbent has no unique or hard-to-replicate resource

• consumers are open to the prospect of dealing with a new product

• winner may not last for long

• firms may try to limit it with consumer loyalty plans, increase switching costs

monopolistic competition

• lots of competitors

• differentiated products

  • in the minds of consumers, the products are good, but not perfect, substitutes

  • advertising produces product differentiation (feature of monopolistically competitive and oligopolistic markets)

• zero economic profits in long-run equilibrium

• inefficiency

  • not producing at minimum AC (excess capacity) (not productively efficient)

  • not producing where P=MC (not allocatively efficient)

• added variety may make up for lost efficiency

• downward-sloping demand curve

informative advertising

price, quality, and availability information

advertising as a signal

“if they’re spending so much money on advertising for this product, they must expect it to be profitable and around a long time, so it must be good”

advertising as part of the product

even if no information is given, “branding” might make the product more enjoyable

• tasters enjoy it more if it’s labeled as Coke

arguments in favor of advertising

• informs consumers

• may enhance enjoyment of the product

• lowers prices of some products

arguments against advertising

• can be manipulative

• can increase monopoly power

• provides a barrier to entry

marginal product of labor (MPL)

increase in revenue created by hiring an additional worker

• falls as more labor is used

  • diminishing returns to labor/any factor of production

  • holding capital constant, just varying labor

human capital theory

treats acquisition of education and training as “investment” decisions by individuals

• assumes individuals treat these decisions as rational investment decisions and compare benefits (future earnings gains) against costs (opportunity cost of time, tuition, etc.)

compensating differential

a difference in wages that offsets differences in working conditions

• fewer people are willing to work in dangerous or unpleasant jobs, so the supply of labor is reduced and the wage is increased

statistical discrimination

decisions about individuals based on group characteristics

preference-based discrimination

can be employer-based, employee-based, customer-based, or governmental