Exam 3 notes

CHAPTER 22 - PRICE TAKERS AND THE COMPETITIVE PROCESS

Last chapter looked at production costs. In next two chapters, we look at the interaction of prices,
profits and production for two groups of firms:

PRICE TAKERS - Firms that must take/accept the market price, no control over setting price.
Markets where:

1. Homogeneous, identical products: coffee, sugar, steel, oil, gold, beef, milk, corn, wheat, soybeans,
eggs, etc.
2. Many small firms whose output is small relative to the market: e.g. wheat farms.
3. Sellers/producers can sell all output at the market price, but cannot sell at a price above market
price. No pricing decision.
4. No barriers to entering the market/industry. Easy to get into the business, easy to get out.

PRICE SEARCHERS (next chapter, CH 23) -

1. Downward sloping demand curve.
2. Products are not identical.
3. Firms may or may not be small relative to the market.
4. Firm faces a pricing decision, know that if it raises (lowers) prices, it will sell less (more).
Examples: Nike, GM, Coke, Disney, Mars, etc.

Most firms are price searchers. Why study price-takers?

1. Many industries are price-taker markets: agriculture, energy and utilities, commodities, currency,
credit markets, etc.

2. Price taker markets are also known as "perfectly competitive markets" or markets with "pure or
perfect competition" and they help us understand competition in the economy, e.g. competitive markets
and competitive behavior. Price-searcher markets can be just as competitive as price-taker markets,
they are not necessarily "less pure" than price-taker markets.

Perfectly competitive markets: large numbers of small firms producing an identical, homogeneous
product. "No brand names/no advertising" e.g. wheat farms. No barriers to entry or exit: easy to get in,
easy to get out.

Barriers to entry: obstacles to entering and competing in a market/industry. Occupational licensure
for example (lawyers, doctors, accountants, barbers, plumbers, etc.).

See page 486, Exhibit 1. Market prices are determined by market forces in the overall, world market
for corn, soybeans, wheat, beef, etc. (Panel b) The individual firm/farm then faces a horizontal demand
curve (panel a). If the price of wheat is $5/bu., the wheat farmer can sell his/her entire crop at $5/bu.,
but would find no buyers at $5.01/bu. There would be no reason to accept $4.99/bu., so the farmer is a
"price taker" at $5/bu., and his/her output decision cannot influence the market price because their

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MGT 551: BUSINESS ECONOMICS CH – 21 Professor Mark J. Perry

output is so small relative to the overall market.

OUTPUT IN THE SR

Firm's output decision is based on comparing Benefits (additional or marginal revenue, MR) vs. Costs
of additional or marginal units of output (MC).

MR = Δ Total Revenue / Δ Output = ΔTR/ ΔQ (where Δ = change)

Due to the Law of Diminishing Marginal Returns, MC will eventually rise, and so will ATC. In the
SR, profit-maximizing Price-Taker will expand output as long as MR > MC, and will stop when
MR=MC. Beyond that level of output, MC > MR and firm would lose money on those units.

RULE: PRODUCE ADDITIONAL UNITS UNTIL MR = MC, TO MAX PROFITS (OR MIN
LOSSES).

See page 487, Exhibit 2. Demand (d) = P = MR. If market price is $5/bu., that's the firm's Price, and
also is the firm's MR, since each additional bushel generates $5 in revenue. Firm would continue
producing to Output level "q" to maximize profits.

TR($) = (P x q) = 0PBq = Rectangle area for Total Revenue.

Remember that: ATC = TC / q, therefore TC = ATC x q (or TC = C x q). (TC = Average cost (C) per
unit ($) x the number of units (q)).

TC = C x q = OCAq = Rectangle area for Total Cost.

TR ($) - TC($) = Profits ($) = Rectangle area CPBA

Entrepreneur probably doesn't actually make decisions based on considering MR and MC curves, ATC
curves, etc., but follows this process intuitively. To Max Profits, you want to sell output where the
Price > Costs of Production, you don't want to sell units where the Cost > Price. Without formal
understanding of economics, the entrepreneur follows economic principles - "organized common
sense." Music example.

PROFIT MAX - EXAMPLE, see page 489, Exhibit 3.

At 1-10 units of output, and when Q >= 20, profits are negative, in both cases P < ATC and TR < TC.
Between 11-19 units, profits are positive, TR > TC. Profits are maximized when Q = 15, which is
when MR = MC approx. When Q > 15, MC > MR of $5, and profits fall. See graphs page 490,
Exhibit 4.

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LOSSES and GOING OUT OF BUSINESS

Firm should always produce where MR = MC, to either MAX profits or MIN loss. Profits/loss
involves comparing ATC v P. What if firm is producing where MR = MC, but P < ATC, so that firm is
losing money? See page 491, Exhibit 5, what to do? Three options for firm losing money:

1. Continue to operate in SR, and lose money.
2. Shut down temporarily.
3. Shut down permanently (go out of business).

If the situation is permanent (P < ATC), firm should go out of business, since there is no possibility that
the firm will ever make money. If the firm expects that eventually P > ATC, then they have to decide
whether to operate in SR or shut down in SR. That decision is based on comparing P v AVC (average
variable cost). Can the firm at least cover its average variable costs? If the firm can cover its variable
costs (P > AVC or TR > VC), then it makes sense to operate in SR, since it can make some money
(profits) to cover FC (fixed costs). If P < AVC (TR < VC), then the firm is better off shutting down in
the SR, since it will lose more money by operating than by shutting down temporarily.

Example: restaurant near GM plant. Fixed costs are $1000/month (rent, etc.) or $250/week and
variable costs are $500/week (labor, food, electricity, etc.). UAW goes on strike, business drops
dramatically from $1000/wk down to ???. Should the restaurant operate during the strike or
shutdown? Depends on Total Revenue vs. VC of $500. If they can generate at $600 in sales, then they
should stay open, since $600 > $500. They would then make $100 contribution towards FC of
$250/week). The Loss = - $150/week (TR - TC = $600 - $750) ($500 VC + $250 FC = $750 TC).
The firm would lose more money (-$250) by shutting down versus staying open (loss = -$150).

But if the firm can only generate $400/week in sales, then it should shut down since $400 < $500, it
can't even cover its variable costs. It will lose even more money by operating (-$350) than by not
operating (-$250).

In fact, several restaurants, bars, sandwich shops near GM plants in Flint did shut down during the
strike in June and July 1998.

If they never expected TR > $3000 per month ($1000 FC + $2000 VC), then they should shut down
permanently. They can avoid FC by shutting down.

OUTPUT IN THE LONG RUN (LR)

In the LR, firm can make major changes (expansion or contraction) in output. New firms can enter,
existing firms can exit.

Price taker market in LR equilibrium (p. 494, Exhibit 7):
1. Qd = Qs = Market Price
2. Economic profits = 0. (P = ATC and TR = TC)

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Why? Positive Economic Profits attract entry (P > ATC and TR > TC). Positive economic profits
means that firms in the industry are earning abnormally high risk-adjusted returns, which will attract
entry. Existing firms will increase production and new firms will enter, so Supply increases, P falls
back to ATC.

Negative economic profits, P < ATC. Firms will exit industry and/or contract production, Supply falls,
Upward pressure on Price. P rises to ATC, normal profits are restored.

"Rate-of-return Equalization Principle." Highly profitable industries attract entry, competition
increases, leading to normal, risk-adjusted returns in LR. In unprofitable industries, firms exit, there is
less competition, and normal profitability is restored in LR.

INCREASE IN MARKET DEMAND, see page 495, Exhibit 8.

Demand increases from D1 to D2 in the market (panel b), from d1 to d2 for a price-taking firm (panel a),
market price rises from P1 to P2 in both markets. Firm initially make economic profits, since P2 >
ATC. Profits attract entry from new firms and existing firms expands output to take advantage of high
profits. Market Supply shifts from S1 to S2 (panel b) as new firms enter the industry and existing firms
increase output. Market price eventually returns from P2 to P1. Short run profits are eliminated.

DECREASE IN DEMAND, see page 496, Exhibit 9.

Market Demand falls from D1 to D2 (panel b), from d1 to d2 for price-taker firm (panel a), and market
price falls from P1 to P2. Price is now < ATC, firms lose money. Firms cut back on production, and
some firms go out of business. Supply shifts back from S1 to S2, and Price goes back up to P1 from P2.
Short run losses are eliminated.

See p. 496, coffee market as an example of price-taker industry.

LR SUPPLY

Long-run Market Supply curve shows the minimum price at which firms will supply output, given
enough time to adjust to market conditions. Shows the cost of production as the entire industry's output
changes. Three possibilities:

1. Constant-cost industries. Input prices, resource prices, factor prices remain constant at output is
expanded or contracted. LR Supply curve would be horizontal, perfectly elastic. In both cases on
pages 495 and 496 the LR supply curve was perfectly elastic, indicating a constant-cost industry.

Example: industry where the resources used are very small relative to the entire supply/demand for
these resources. Match industry - the demand for wood in the match industry is small relative to the
entire market for wood, so that if the output of matches doubled, there would not be any upward
pressure on prices for wood. If the output of matches fell significantly, there would likewise be no
effect on the market price of wood.

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2. Increasing-cost industries. More realistic for many industries. As industry expands output, the
demand for inputs/resources/raw materials/labor increases, which puts upward pressure on resource
prices as prices for materials and labor get bid up. Rising prices for resources means that the industry
faces increasing-costs as output/supply increases, resulting in an upward sloping market supply curve.

Example: Demand for new houses rises, due to population increases, low interest rates, rising income,
changes in tax laws, etc. More homes are built, but resources for houses have to be bid away from
other uses for wood, labor, supplies, etc. The cost of supplying housing will eventually rise.

See page 498, Exhibit 10. D1 to D2 for market demand (panel b), d1 to d2 for price-taker firm (panel a),
price goes from P1 to P2. P is initially > ATC, Supply increases from S1 to S2. New long-run
equilibrium is established. Market Supply curve in LR (Slr) is now upward sloping, reflecting
increasing costs of production in the industry.

3. Decreasing cost industry. Industry where input costs decline as output expands. Not as common as
increasing cost industries. Could happen if expanded production lowers component prices, e.g.
electronic industry. Market Supply curve would slope downward.

SUPPLY ELASTICITY and TIME

See page 499, Exhibit 11. Suppose market P rises from P1 to P2. Firms in the industry will expand
output from Q1 to Q2 initially. Over time, firms will gradually adjust to higher price, by expanding
output gradually to Q3, Q4, Q5. Why not expand right away? Might be too costly, "cost penalty" for
immediate increases in output. Might take time to find new sources of inputs/raw material, best
sources of capital (credit card vs. bank loan), new employees (vs. overtime), etc. Supply curve is more
elastic over time, as firms can adjust to higher levels of output.

PROFITS and LOSSES

The role of economic profits is clearly illustrated in the Price-Taker model.

1. Free entry (or low barriers to entry) serves consumers, protects them from producers, and ensures
low or competitive prices. Example: taxi cabs in D.C. versus NYC.

2. Profits and losses communicate signals to producers from consumers, about how well they are doing
at pleasing consumers, creating value for consumers. Profits are rewards to successful producers for
creating value, losses are penalties to firms that are unsuccessful at pleasing consumers. Profit/loss
system is a very effective disciplining system, rewarding success, efficiency, value, service in the
market and penalizing inefficiency, poor service, low value in the market. Successful firms are
rewarded with profits, and they attract resources to expand. Unsuccessful firms face the discipline of
the market, they are forced to operate more efficiently, serve customers more effectively, create more
consumer value, or they will be forced out of business.

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3. Market system of Economic Profits and Losses produces a continual reallocation of scarce resources,
away from unsuccessful, inefficient firms, towards successful, efficient firms. Success = pleasing
consumers. "Consumer sovereignty." " Incentives matter." Important role of the entrepreneur.

Example: Videotape rental market. Market with low barriers to entry. In 1982, market was just
developing, there were only 5000 stores in US, prices were $5/day. Profits were very high in the
videotape rental market, attracting entry, increasing supply to 25,000 stores in 1990. Prices came down
to $1-2/day, due to intense competition. Producers responded to the consumer preferences, profits
attracted resources to an expanding industry. Consumers were served by the producers. Profits in the
LR were restored to normal level. Some firms left the industry, because it was so highly competitive.

PRICE TAKERS, COMPETITION AND PROSPERITY

1. Price-taker firms have no control over price, they have to take the market price. However, they can
control their costs, so there is a strong incentive to reduce costs of production, and invest in cost-saving
technology, to operate more efficiently. Eggs - physical product has not changed over time, but costs
of production have been reduced by 80% over time, due to intense competition.

2. Firms face the competitive pressure of the market - forces them to be serve consumers, operate at
maximum efficiency - or they go out of business. Invisible hand - Adam Smith. See quote page 502.

Main point: "Competition breeds competence."

See "Outstanding Economist" on p. 501, Nobel prize economist Hayek - "spontaneous order" and "the
fatal conceit."

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Chapter 23 - COMPETITIVE PRICE-SEARCHER MARKETS WITH LOW ENTRY BARRIERS

Firms who are Price-takers just take the market price - there is no pricing decision, no advertising, no
marketing, etc. They can adjust their output (expand/contract) and they can try to reduce costs of
production, but they have NO pricing decision (corn farmer).

We now look at Competitive Price-Searcher Markets, where:

1) firms face a downward sloping demand curve for their product or service, and
2) there is easy entry and exit . With low entry barriers, the "smell of profits" will attract competition.

Price-searching firms face a more complex set of decisions - see opening quote on p. 490. Firms never
really directly observe demand curves, so they have to engage in a process of trial-and-error to search
for the price that maximizes profits. Since markets are continually changing, the price searching
process is continual and ongoing, e.g. airlines, long distance, computers, online services, etc.

Firms are now selling differentiated products with brand names and have pricing decisions - how to
market, advertising, bundling (computer + printer), specials, discounts, promotions, rebates, coupons,
quantity discounts, senior citizen discounts, price discrimination, etc.

However, there are usually many close substitutes so these price-searcher markets are highly
competitive - fast food, cell phones, airlines, computers, athletic shoes, etc. A price-searching firm can
raise its prices and NOT lose all its customers, unlike a price-taker. However, because there are lots of
close substitutes, the demand curve facing an individual price-search firm will be highly ELASTIC.

The firm faces stiff competition from two sources:
1) all existing firms in the industry and
2) potential rivals or competitors who will enter the industry if profits are high, e.g. coffee shops,
online services. "The smell of profits."

Firms can set price, but then market forces determine how much is actually sold at a given price. Firms
attempt to find the Price-Quantity combinations that MAX PROFITS.

Firms also can control more than just Price, they can control other non-Price factors that affect
consumer value: Quality, location, service, advertising, convenience, bonuses (frequent flier miles), etc.
Main Point: price-searching firms face a complex set of decisions, compared to price-taker.

PRICE AND OUTPUT

How does a price-searcher decide on the Price-Output combination that MAX PROFITS?

A firm faces a trade-off when changing its price. If price is lowered, more units are sold, but at a lower
price for ALL units. If price is raised, fewer units are sold, but at a higher price for ALL units. See
Exhibit 1, page 508. Firm lowers price from P1 to P2 and output expands from q1 to q2. There are two
effects:

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1. (P2 - P1) x q1 = Loss of Total Revenue from selling the original units (q1) at a new lower price (P2),
since the new price (P2) applies to both new customers and old customers.

2. (q2 - q1) x P2 = Gain in Total Revenue from attracting more customers (q2 - q1) times the new Price
(P2).

Because of these conflicting forces on TR, the marginal revenue (MR) will always be less than Price,
and the MR curve will always be below the Demand curve, see Exhibit 1.

PROFIT MAX RULE: Expand output as long as MR > MC. See Exhibit 2, page 509. At all units up
to q, MR > MC, which increases profits. Beyond q, MC > MR, which will reduce profits. Firm should
produce q units to Max Profits (Min losses).

General Procedure:
1. MR = MC determines profit maximizing (loss minimizing) level of output (q or Q*).
2. Based on Profit Max output level (q or Q*), we can determine the profit-maximizing price (P*) from
the Demand curve (d).
3. Based on P*, we can determine profits (losses) by comparing P* vs. ATC.

Exhibit 2: TR = 0PAq and TC = 0CBq. Since TR - TC = PROFITS, the brown shaded area represents
Economic Profits.

The positive Economic Profits of the firm will now attract competition into the market since barriers to
entry are low - competitors will expand output and new firms will enter the industry. Eventually, other
firms will take away some the original firm's business and the demand curve will shift back until the
firm will just cover its costs of production and P = ATC as on Exhibit 3, page 510. Economic Profits
will be zero (TR = TC; and P = ATC) and there will be no more pressure to enter the industry.

In the long run, the economic conditions of a representative competitive price-searching firm are
illustrated in Exhibit 3. P = ATC, firms are covering all costs of production (including opp costs of
capital, etc.), economic profits are zero, firms are earning a positive, risk-adjusted normal rate of return.

In the SR, price-searching firms can either make economic profits or economic losses. Economic
profits attract entry and drive prices down to ATC. Economic losses cause competitors to leave the
industry, surviving firms can eventually raise prices to cover ATC, economic profits will return to zero.

LR = Zero Economic Profits = Risk-adjusted Normal Rate of Return = Rate-of- Return Equalization
Principle.

BUSINESS FAILURE

The profit-loss system imposes strict discipline on firms. Firms that suffer economic losses must
eventually fail and go out of business. Business failures, although painful for workers who lose their
jobs, and investors and creditors who lose money, play an important role for the economy as a whole.
Business failures free up and release valuable and scarce resources (labor, land, capital, credit, real

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estate, machinery, etc.), that then become available for use by others in the economy who can use them
more productively. Reallocation of resources away from inefficient uses to more efficient uses.
Without the release of these resources, economic expansion for profitable firms and the whole
economy would be slower. Point: Business failures don't destroy the assets of the firm or the talents of
the workers, they are released for use by other more profitable and successful firms. In the long run,
even many of the workers are usually better off.

Examples: McDonald's vs. Sandy's and Henry's. Venture capitalist activity in Russia.

CONTESTABLE MARKETS

Very competitive price-searching markets where:

1. Barriers to entry and exit are low. Easy for firms to enter/exit the industry.
2. Zero economic profits in LR (P = ATC)
3. Minimum cost/most efficient method of production will prevail since both high prices and
high/inefficient production costs will attract entry.

Potential competition, as well as current/existing competition, will discipline firms in contestable
markets. Implication of this is that even an industry with one dominant firm (software industry,
Microsoft) can be contestable (competitive) if the threat of competition is sufficient to discipline the
dominant firm. The dominant firm has incentive to keep prices so low that no other firm can
successfully challenge their position. Example: Alcoa Aluminum.

Policy implication: If an industry is seen as not sufficiently competitive, we should look at what can be
done to make the industry more contestable. What barriers to entry exist that can be removed or
reduced? In many cases the way to make the industry more competitive is to DEREGULATE the
industry, since regulations form a barrier to entry. Deregulation (regulation) makes markets more (less)
contestable, more (less) competitive.

Examples:
Airline Industry
Trucking
Occupational Licensing - MDs , JDs Barbers, etc.
Handicap Accessible
Zoning
Car Wash
Shoe Shine

THE LEFT-OUT VARIABLE: ENTREPRENEURSHIP

Our economic model provides a general framework for analyzing the decision making elements
common to all firms - sole proprietorships to GM and Microsoft. What we can accurately model is the
general behavior that describes Profit Maximizing behavior by firms. We know that successful firms
do something that accounts for their business success over time - Microsoft and GM engage in decision

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making that is consistent with our economic models even though Bill Gates may have never taken an
economics class. Many successful entrepreneurs make decisions intuitively, and pure entrepreneurial
behavior can not accurately be modeled with graphs and equations. There is no way to precisely
model complex decision making of an entrepreneur involving uncertainty, risk, discovery, innovation,
creativity, etc.

Entrepreneurs are at the center of economic activity in the real world, even though they are not in
economic models. Business is part art and part science, we can model the scientific part much easier
than the part of business that is an "art."

Music example. We can study and analyze Mozart or Beethoven, put their music into a formal musical
model of sheet music, musical notation, musical score, etc. We don't try to model the creativity behind
the music, we just respect it and appreciate it. Same thing for business. Even though we don't model
entrepreneurship, the role of entrepreneurs as "agents of economic progress" is very clear.

Entrepreneurship and Economic Progress:

Quote (p. 515): "The entrepreneurial discovery and development of improved products and production
processes is a central element of economic progress." In a dynamic, highly competitive economic
system, the role of entrepreneurs is critical and highly important. The market economy, more than any
other economic arrangement, nurtures, promotes and supports entrepreneurial talent. Economy vs.
sports example - discuss in class.

See story on "Five entrepreneurs who have changed our lives," p. 516-517.

PRICE-TAKER AND COMPETITIVE PRICE-SEARCHER MARKETS (See Exhibit 4, p. 519)

Similarities between Price-Taker and Price-Searcher Markets:

1. P = ATC, Economic profits are 0. Competition prevents positive economic profits in LR. Firms
have strong incentive to operate as efficiently as possible, try to lower ATC, to make SR profits.

In both markets, an increase in demand will result in: higher prices, SR economic profits, expansion of
output by existing firms, and entry by new firms, increase in market supply, downward pressure on
price, price will eventually fall to ATC, all SR economic profits will be squeezed out.

Differences:
1. For Price-Taker market, P = MC, for Price-Searcher Market P > MC.
2. For Price-Taker market, output level minimizes ATC, for Price-Taker market, output does not
minimize ATC.
3. Price is slightly higher in the Price-Searcher market ($1 vs. 97 cents for Price-Taker) for identical
cost conditions.

Debate: Are competitive Price-Searcher markets inefficient?

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Conventional View: Prices are higher, due to costly replication, too many firms operating below the
capacity that would min ATC. Example: too many small gas stations and convenience stores located
too close together, resulting in higher prices than if there were fewer, large gas stations and grocery
stores spread further apart.

Also, conventional view says that firms waste money trying to differentiate their products and spending
money on advertising, resulting in higher prices for consumers.

Modern View: Even though prices might be slightly higher, consumers receive benefits from price-
searcher behavior. Advertising is costly, but consumers value the information transmitted by
advertising, it reduces search time, gives valuable information about new products and new firms, etc.
Consumers also benefit from differentiated, brand-name products even though prices are higher -
consumers value designer clothing even though prices are higher. Consumers value unique products
that may reflect their personality.

Example: vehicles. Consumers value a wide selection of vehicles even though prices are higher than if
we all were willing to accept a standardized vehicle in one color with a standard set of options, etc.
Consumers also value the convenience of having many gas stations, convenience stores, fast food
restaurants, etc even if prices are slightly higher, compared to the alternative: fewer stores, more
congested, located further apart.

And if consumers don't value higher priced differentiated brand name products that are heavily
advertised, they can always buy low priced, generic products.

SPECIAL PRICE-SEARCHER CASE: PRICE DISCRIMINATION

So far, we have always assumed that there is a single price (P) and that all consumers pay the same
price - the Market Price (P). Price discrimination is where a firm charges different customers different
prices for the same product or service.

Examples: airfares, coupons, senior citizen discounts, tuition, car sales, weekend specials at hotels or
ski resorts, telephone service for business vs. residential, etc.

Price Discrimination involves:
1. Identifying and separating two or more groups with different elasticities of demand. Charge a higher
price to the group with the more INELASTIC demand, a lower price to the group with more ELASTIC
demand.
2. Preventing resale from the Elastic group (low price) to the Inelastic group (high price).
3. Controlling resentment, so that the Inelastic group doesn't resent paying higher prices. (not in book)

Example: Exhibit 5, p. 521, Airline fares. Panel a, shows a uniform, single price of $400 per ticket,
and output of 100 passengers, for TR = $40,000. That is the Profit Max level of output, where MR =
MC. MC is fixed at $100/person, so those costs are $10,000 (100 passengers x $100), operating profits
are $40,000 - $10,000 = $30,000.

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Panel b - airline now has two prices, $500 for traveler's with Inelastic demand, mostly business
travelers, or those who have to travel at the last minute, etc. Fares are reduced to $300 for traveler's
with Elastic demand - tourists, students, vacationers, etc. To get the low price, you must make
reservations far in advance, have flexible travel dates, fly during off-peak hours, stay over a weekend,
etc.

Result: 60 people fly for business, pay $500 and 60 people fly for leisure pay $300. Total Revenue is
now: (60 x $500) + (60 x $300) = $48,000. Costs are: 120 x $100 = $12,000, leaving $36,000 in
operating profits.

Bottom Line: Using price discrimination (two prices instead of one price), the airline raises TR by
$8,000 and operating profits by $6,000. This example illustrates the general principle that price
discrimination can increase profits. Also, the more price discrimination the firm uses, the higher the
potential profits. Going from one price to two prices raised profits, going from two prices to three could
raise profits even higher, and then why not try 4 prices, 5 prices, 6 prices, etc. Airlines are masters of
price discrimination.

Also, in this case, output increased, from 100 passengers to 120 passengers, volume of trade (air travel)
increased. This increase in trade can increase the overall gains from trade, increases welfare. And in
some cases, price discrimination might allow trade/production to take place where none would
otherwise occur. Example: small town in Montana may only be able to attract a physician if they can
price discriminate, charge higher prices to higher income patients.

Price discrimination is so common, is it really a "special" case?

COMPETITION INCREASES PROSPERITY (from the 9th edition):

1. Competition forces producers to operate efficiently and cater to consumers, weeds out the inefficient,
reward the firms who are successful at pleasing consumers. What makes McDonald's, Wal-Mart, GM
successful? Competition. If they try to raise prices, offer poor service, low quality products, consumers
will to Burger King, Target or Toyota.

2. Competition provides strong incentives to operate efficiently and to constantly innovate, either to
improve production, raise quality, develop new products. Think of all the money spent on research and
development, firms are in a constant process of innovation, trying to develop and make new products -
microwave ovens, fax machines, cell phones, CD players, VCRs, bypass surgery, etc. The role of the
entrepreneur is to engage in the discovery process, finding new products that create value for
consumers. Entrepreneurs must face the market test - "reality check" imposed by consumers.

3. Competition also forces firms to discover the most efficient type and size of business organization
that creates value for consumers. Market economy does not impose a certain size on producers, firms
can operate as sole proprietorships or huge conglomerates with thousands of employees - GM, Coca-
Cola, etc. Efficient organizations will be rewarded and inefficient ones will be penalized. If a firm is
too large or too small, and unit costs are high, the firm will be penalized with losses. Part of the

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competitive market process is searching for the most efficient form of business organization that will
result in the lowest ATC/unit.

Examples: Assembly line production, JIT Inventory, Modular assembly, Downsizing, Restructuring,
Internal vs External production, etc.

Summary: Competition harnesses personal self-interest and promotes a higher standard of living.
Rival firms struggle for the dollar votes of consumers. Continual market referendum on consumer
preferences. Market economy as a "virtual voting booth."

Chapter 24 - PRICE-SEARCHER MARKETS WITH HIGH ENTRY BARRIERS
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So far we have assumed that price-taker and price-searcher markets are competitive, due to low barriers
to entry (and exit). We now look at industries where the barriers to entry/exit are high.

WHY ARE BARRIERS TO ENTRY SOMETIMES HIGH?

1. Economies of scale. If ATC is declining over the entire range of output that consumers are willing
to buy, a single firm may dominate the industry. The cost advantage may protect the firm from
competition, including potential rivals. The barrier to entry is the cost advantage that a single, very
large firm may have. Example: ALCOA, dominated the aluminum industry for years.

2. Government Licensing. Legal barriers are the oldest and most effective way to get protection from
competition, coercive monopoly. Using the power of the government to eliminate, reduce
competition. Examples: post office, utilities, cable TV, radio/TV stations, Dept of Motor Vehicles, etc.

Occupational licensing or business licensing - limits entry/competition. Examples: Physicians, lawyers,
hair stylists, taxicabs, accountants, etc. Advantage: ensures minimum standards. Disadvantages: raises
costs, reduces competition, puts in place barriers to enter the profession. Who generally asks for
increased regulation - industry or consumers? Example: CPAs - new 150 credit hour requirement.
("When buying and selling are controlled by legislation, the first things to be bought and sold are
legislators."--P.J. O'Rourke)

3. Patents, other intellectual property rights. Examples?? Most countries have copyright laws to
grant legal protection to inventors, authors, songwriters, etc. Patents give owners an exclusive legal
right to be protected from competition for 17 years in U.S. Advantages: stimulates research,
development of new products, fosters innovation, creative discovery process. Without legal protection
for intellectual property, there would less innovation, fewer new products, etc. Disadvantage: prices
are higher during the patent period, owner has a temporary monopoly.

4. Control over an Essential Resource. Firm has exclusive control over a natural resource, usually
only temporarily, due to substitutes, discoveries, etc. Examples: 1) Aluminum before WWII. 2)
Diamonds are only found in a few places on the planet, mostly South Africa. One company dominates
the diamond market, De Beers.

THE CASE OF MONOPOLY

Monopoly literally means "single seller." In economic terms, a monopoly is a market where there:
1) is a single seller of a good for which there are no good substitutes, and
2) are high barriers to entry.
However, "no good substitutes" and "high barriers" are somewhat vague.

For example, barriers to enter the auto industry might be considered high, because you would need to
operate at a huge scale to be competitive, and the large amount of financial capital necessary might be a
barrier to entry. However, capital markets are efficient, there are thousands of global investors, so if
there was a profitable opportunity, capital could be raised to compete against GM. Also, there are
substitutes for everything, so there are very few situations where no good substitutes exist.
14

Monopoly is always a matter of degree. For example, US Post Office is the single provider of first
class mail, and it is a protected, coercive monopoly with a legal protection from competition.
However, there are good substitutes for first class mail, such as ????

PRICE AND OUTPUT UNDER MONOPOLY

Suppose you have a patent on a new invention, so you are legally protected from competition for 17
years. You face the cost curves on page 530, Exhibit 1. You are the only seller, so the market demand
curve is also the demand curve the firm (patent holder) faces.

The general rule is exactly the same as before for price-searchers and price-takers:

1. Expand output as long as MR > MC. Stop producing when MR = MC, at Q* (profit max output
level).

2. That level of output (Q*) will determine the market price (P*), from the demand curve.

3. Comparing P* vs. ATC will determine the profit per unit, and total profits.

See page 530, Exhibit 2, for a numerical example of a monopoly. Firm would expand as long as MR
(Column 7) > MC (Column 6). At Q=8, MR > MC ($8.50 > $5.75). At Q = 9, MC > MR ($6.25 >
$6). Firm's profit would be slightly higher at Q = 8 than Q = 9 ($29.50>$29.25). PROFIT MAX: Q* =
8 and P* = $17.25.

Important Points for Monopoly:

1. Firm can sustain LR positive Economic Profits since P > ATC will not attract direct competition for
a monopolist, at least during the 17 year period of a monopoly. Patent protection insulates the firm
from direct competition.

2. Even monopolists cannot get away with charging whatever price it wants, it still faces a downward
sloping demand curve. Remember, firms want to maximize profits, NOT price. If the monopoly on
page 530 tried to raise Price (P*) from $17.25 to $18.50, demand would FALL from 8 to 7 units per
day, and profits would FALL from $29.50/day to $26.75.

3. Even though the patent holder has a monopoly, it doesn't mean that a profit is guaranteed. There are
thousands of patented products that are never produced because the demand-cost conditions are not
favorable, see Exhibit 3, page 531. P < ATC, monopolist firm suffers economic losses, and will shut
down, or never operate in the first place. (Note: If conditions on p. 531 are permanent, firm should
shut down, or not operate in the first place. If temporary, it should continue production in SR if P >
AVC. If P < AVC, firm should shut down in SR.)

As before with the price-taker and price-searcher, the monopolist never actually observes demand
curve and cost curves. Like other price searchers, the monopolist has a strong incentive to find the
profit maximizing price and output, and the firm will act as if MR and MC had been used in
determining the profit-maximizing P* and Q*. The actual business owner of a patent will act more on
15

intuition, trial-and-error, discovery process, "seat-of- the-pants" approach, but his/her decision making
process will be consistent with economic theory.

OLIGOPOLY

Monopoly = single seller. Oligopoly = several large, dominant firms/sellers compose the entire
industry. Examples: automobiles, steel, cigarettes, aircraft, pianos, TV (before cable - ABC, CBS,
NBC), computers, retail office supplies (Office Depot, Staples and Office Max), retail discount stores
(Wal-Mart, K-Mart and Target).

Oligopolistic markets are characterized by:

1. Small number of very large, dominant rival firms where sellers produce either identical
(gasoline) or differentiated products (cars).

2. Interdependence among firms. "Strategic interdependence." Since there are only 3 or 4 firms in
the entire industry, the reactions of rivals play an important role in strategic decisions. For example, if
GM is thinking of a price increase (reduction), it has to think of how Ford will react. Oligopolistic
firms are more inter-related than firms in other industries.

3. Economies of scale, large scale production results in only a few, very large firms. Example: auto
industry, page 516. The entire market demand is 6m cars per year at P*. To be competitive, a single
car company has to produce at least 1m cars per years. In this case, the entire industry can maybe only
support 3 cost-efficient firms, no more than 5-6 firms.

4. High entry barriers. Economies of scale are usually the entry barrier that limits competition in
ologopolistic markets. In the auto industry, it is difficult to start out small, and gradually grow to the
optimal size, you would have to start at the optimal size immediately. It would be very difficult to
compete with GM producing 1000 cars per year, you would have to produce 1m cars/year to be
competitive. Domino's Pizza was able to start small, and eventually grow large and compete with
McDonald's, but no U.S. startup firm has been able to challenge the position of GM, Ford and Chrysler
for 50 years. Fast food would be more contestable, automobile industry has very high barriers to entry.

PRICE AND OUTPUT FOR OLIGOPOLY
Firm considers not only how customers will react to a change in price or quality, but how rivals will
react to price increase/decrease. Page 534, Exhibit 5: If firms act competitively, Price will get driven
down to LRATC, economic profits = 0, and Output is Qc and Price is Pc. If the market price is
temporarily above Pc, then P > LRATC, firms are making econ profits. Firms will have an incentive to
cut price to Pc, attract customers from rivals, leading to additional price-cutting, reducing price back
down to Pc. Therefore, when competition prevails, Price = LRATC in a competitive oligopolisitc
market. Oligopoly doesn't necessarily mean anti-competitive behavior, market can be competitive
(Target vs. Wal-Mart, or GM vs. FMC).

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Suppose oligopolistic firms exploited their interdependence by engaging in collusion, price-fixing,
cartel behavior? Such a strategy is illegal in U.S. by antitrust law, considered "restraint of trade." The
OPEC cartel for oil formed because it was outside the control of the Dept of Justice, they agreed to
restrict output, raise price and make economic profits for the members, see page 535 (Exhibit 5 graph)
and page 535 (OPEC discussed). Perfect Cooperation (cartel) result: Pm and Qm, resulting in Positive
Econ Profits, purple shaded rectangle, for the cartel firms to share.

A cartel is an example of Perfect Cooperation, with the same outcome as a monopolist. The colluding
firms, by joining together as a unified group, are just like a single monopoly firm, with the result of
potentially sustainable profits.

In the real world, the actual outcome would probably lie between the extremes of perfect cooperation
(Pm, Qm) and perfect competition (Pc, Qc). Oligopolistic firms can never act totally like a monopolist,
because: 1) it is illegal, and 2) competitive pressure exists. However, because of interdependence,
firms know that they can all benefit by not avoiding vigorous price competition, resulting in P > ATC,
possible sustainable econ profits.

OBSTACLES TO COLLUSION

A cartel is an example of collusion, an anti-competitive agreement to restrict output, raise price and
avoid competitive practices, especially price reduction/competition. Collusion can either be a formal
agreement, like OPEC, or informal, tacit, implicit collusion. Obvious collusion is illegal (conspiracy to
restrain trade), tacit collusion may be hard to detect.

Conflicting pressures for arrangements to collude:
1. Cooperate with rivals/partners to maximize joint profit, avoid competition.
2. Secretly cheat on collusive agreement to increase an individual firm's share of profits, by lowering
its price. By secretly lowering price, the cheater can sell to: a) customers who won't buy at the high
collusive price and b) customers of the rivals. Steal customers from partners. Cartels/collusive
agreements are very unstable.

See Exhibit 6, page 535. Industry demand and supply conditions suggest a market price for the cartel
of Pi, which will max profits for the cartel as a group. However, the demand curve facing an individual
firm is much more elastic, panel b, so the ideal price for the firm would be Pf, a lower price than the
agreed upon cartel price of Pi. The firm can increase its individual profits by cheating, taking a greater
share of the group profits, i.e. stealing from its partners by secretly lowering price. Increasing market
share at the expense of partners.

POINT: Cartels inherently unstable, and unsustainable in LR, and often break down on their own.

SPECIFIC OBSTACLES to COLLUSION

1. As the number of firms increases, the harder it is to effectively collude, because it will be more
difficult to achieve unity on pricing/output decisions, and more difficult to negotiate and enforce the
agreements. The more firms, the more potential conflicts.
17

2. The more difficult it is to police, detect and prevent cheating, the less collusion will take place.
Cheating can be subtle and may not just involve price cutting. How could an OPEC producer attract
customers besides cutting prices?? How could they effectively lower the price without actually cutting
the price?? And what enforcement mechanism is there to discipline cheaters?

3. Low barriers to entry are an obstacle to collusion. The smell of profits from the colluders will attract
competition. If barriers to entry are low, collusion will be unsustainable. Example: if all the
accountants/lawyers/physicians/plumbers in Flint agreed to raise prices, low barriers to entry would
result in increased competition in the future. During OPEC, the high oil prices encouraged: a) oil
exploration by US, non-OPEC countries, and b) alternative fuel research. In many cases, the
cartels/colluders can't prevent new entry, making the arrangement unstable.

4. Unstable (stable) demand makes collusion less (more) likely. If demand is unstable, it will be harder
to agree on the level of reduced output required to raise the price to an optimal amount. Collusion
requires consensus and agreement, which is harder when demand is uncertain.

5. Collusion is illegal. Vigorous enforcement of antitrust laws will minimize collusion. Fines/penalties
are severe - triple damages, and participants (corporate officers) can be held personally liable. Secret
agreements might be hard to detect.

DEFECTS OF MARKETS WITH HIGH ENTRY BARRIERS

What are the problems when competition is restricted by high entry barriers?

1. High entry barriers reduce competitiveness of the market, and limit options available to
consumers. Insulated from competition by high entry barriers, protected firms or individuals can
charge high prices and offer poor service, behavior that competitive firms cannot get away with. Who
is more responsive to customers? Target, or the Department of Motor Vehicles? With high entry
barriers, the discipline of the market is reduced, the responsiveness of producers to consumers is
weakened. Reduction of "consumer sovereignty."

2. Reduced competition results in inefficiency. W/protection from competition, monopolists or
cartels, can charge P > ATC, make economic profits, not attract entry to drive P down to ATC. By
restricting output and raising P, the optimal amount of trade does not take place. Society is worse off
from the "restraint of trade," mutually beneficial trade does NOT take place is a loss of wealth.
Reduction of our standard of living from higher prices and lower output, v. competitive market.

3. Barriers to entry encourage "rent seeking." Grants of special favor (protection from competition)
will lead to resources being devoted to rent seeking - lobbying, campaign contributions, etc. Some or
all of rent seeking will be inefficient because resources are being diverted from productive activities
(output) to potential wasteful activities. Could be an overall reduction in welfare for society from the
inefficient allocation of resources, contributing to the allocative inefficiency discussed in #2.

Example: Suppose a city or state (or federal) government considers granting a limited number of
licenses providing a seller with some exclusive right to sell liquor, operate a taxicab, operate a car

18

wash, offer legal/medical services, operate a cable TV company, inspect homes, cut hair, tow cars for
the city, etc. Suppose this is new legislation being considered and assume that the legal protection
from competition is worth $100,000 over the life of the license. How much would individual sellers be
willing to spend to get the license? Other potential suppliers would also be willing to spend that
amount trying to convince public officials that they will best "serve the public interest", resulting in
more resources being spent collectively than $100,000, resulting in economic waste.

Example: Halloween costume party with a prize for best costume of $1000.

POLICY ALTERNATIVES WHEN ENTRY BARRIERS ARE HIGH

Economists suggest four policy options when barriers are high.

1. Restructure the industry to increase the number of firms - maybe. In some cases, it is possible
that a single dominant large firm has a "natural monopoly," since it has significant cost advantages over
smaller firms. ATC is declining over the entire range of market demand. In this case, breaking up the
monopoly would actually be inefficient, since the result would be more, smaller firms with higher
costs. As long as there is a threat of potential competition, low entry barriers, the market is contestable
and therefore efficient and competitive even with one or two dominant firms. Examples: a) single drug
store, hardware store, restaurant in a small town, b) ALCOA, c) Microsoft? FTC and DOJ regulate the
economy to prevent "restraint of trade" and "monopoly." 90% of antitrust action is a result of one firm
suing a competitor.

2. Reduce artificial barriers to trade - tariffs, quotas, licensing requirements, regulations.
Deregulate the industry, open it up to competition, e.g., trucking and airlines in the early 80s. In many
(most?) cases, the source of barriers to entry is the government itself, since it is government that is
passing laws to restrict competition - tariffs, occupational licensing, regulations, etc. usually at the
request of the industry itself to limit competition.

Example: tariffs are a barrier to entry, since they impose a tax on foreign goods, giving the domestic
firm a cost advantage by protecting them from competition. Protectionism protects the domestic firms
from competition. Domestic firms can be disciplined by foreign competition, serving the interests of
consumers.

Special interest issue. Domestic suppliers are concentrated and well-organized, and consumers are
poorly organized and widely dispersed. Special interest groups will take advantage of consumers,
resulting in too much regulation/protectionism from an overall efficiency standpoint.

Reducing artificial barriers to trade is economically desirable, but may not be politically
realistic/feasible.

3. Regulate the protected producer, such as a regulated utility (phone, gas, electric companies,
cable TV), being regulated by a state regulatory agency. See Exhibit 8, page 543. Unregulated
monopolist would restrict output and produce Q0 units and charge price P0 (MR = MC), resulting in P >
MC and P > LRATC, resulting in positive Econ Profits.
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SOLUTIONS FOR REGULATING PROTECTED PRODUCER:

a. Average Cost Pricing. The regulatory agency could force the monopolist (electric company) to
charge P = LRATC, which would be P1, resulting in increased output Q1 in Exhibit 8. Society is now
better off, lower price and higher output increases welfare.

b. Marginal Cost Pricing. At P=ATC (P1), P>MC, and there would be welfare gains to society if P
was reduced to P2 and output was increased to Q2. However, the problem is ??

Problems with Regulating utilities, monopolies:

1. Lack of accurate information. It might be hard to accurately determine P = LRATC, demand and
cost curves are not easily observable. Usual solution: Regulated monopolist is supposed to earn a
"normal accounting rate of return," which would be the same as "zero econ profits." If the utility's
returns are too high (low), its regulated prices/rates are too high (low), and prices need to be lowered
(raised). However, the protected monopolist would try to do what? Always report low profits to
justify rate (price) increases.

2. Cost shifting/inefficiency. Regulated utilities have a fixed rate of return by the regulatory agency.
Therefore, they will not have strong incentives to operate efficiently and minimize costs of production.
If it find ways to reduce costs, its profits will rise, resulting in a price (rate) reduction by the regulators
to reduce the "excessive" profits. On the other hand, if its cost of production rise, it knows it can apply
to the regulatory agency for a rate increase. Managers of the utility, undisciplined by the market, will
be more likely to fly first class, attend conferences in exotic places, spend lots of money entertaining
(maybe on regulators), give high wage increases, give jobs to family/friends, etc. "Shirking" behavior
by managers - increase personal benefits and increase costs, resulting in inefficiency, higher prices,
rates.

3. Special interest influence. Regulated firms will try to influence the political process of regulation,
try to have regulators appointed who will be favorable to the monopoly. "Capture theory" - utility
benefits from regulation if they can "capture" (persuade, bribe, or threaten) the regulators, so that the
regulators are favorable to what the utility/monopoly wants. Inefficiency results because the
monopolist controls (influences) the regulatory process in their favor. Also, incestuous, inbreeding
behavior is common - ex-regulators may be hired as a manager or "consultant" of the utility, managers
of the utility may eventually become regulators, etc.

Public choice theory of special interests again. Widely dispersed, poorly organized consumers are
taken advantage of by well-organized, concentrated special interest groups - the regulated monopolists.
Consumers remain "rationally ignorant" of the regulatory process and have no incentive to invest time,
money and resources following regulation, prices, attending public hearings, attempting to influence
the regulators, etc.

POSSIBLE ALTERNATIVE TO A PRIVATE OR REGULATED MONOPOLY: Government-
Operated Firm supplies the market, e.g., U.S. Post Office, Tennessee Valley Authority (electric
utility), local public utilities (Lansing Board of Water and Light), public schools, roads, fire and police
departments, etc. However, the same perverse managerial incentives apply as in the case of a regulated
20

monopoly - government-run firms may ignore efficiency, promote personal objectives at the firm's
expense, etc. Reason: Govt.-operated firm is insulated from competition - no direct competitors - no
threat of hostile takeover. No reward for efficiency, cost effective operation. In fact, there is a
perverse incentive to fail - why?

Rationally ignorant voters-taxpayers don't have the incentive to monitor the govt monopoly. Result of
govt. operated business - less efficient, higher cost operation compared to a private firm. U.S. Post
Office vs. UPS. Target vs. Dept of Motor Vehicles.

Conclusion: Government intervention is a 2-edged sword. If used judiciously and wisely, it can
increase competition by enforcing contracts and property rights, prosecuting fraud, deceptive or
misleading business practices, providing a minimal regulatory framework, imposing standards.
However, it can reduce overall economic efficiency by erecting barriers to entry, granting special
favors to protected industries/firms, etc. Organized special interest groups engage in rent seeking,
appealing to short-sighted politicians, taking advantage of rationally ignorant consumers/voters.
Therefore, most govt solutions are not attractive, and not necessarily superior to the market outcome.

The real danger is the "coercive monopoly," the firm that has some type of legal protection against
competition that erects legal barriers to entry. A "coercive" monopoly by definition requires
government intervention, since a private firm cannot coercively restrict competition. HIGH
BARRIERS TO ENTRY usually require GOVERNMENT INTERVENTION of THE MARKET.
True monopolies are a creation of the govt, not of the market. Policy conclusion: minimize
government intervention.

Dynamic, competitive nature of the market is demonstrated by the composition of firms in the economy
- of the 500 firms in the 1980 Fortune 500 list only half made it to the 1990 list. Constant change
disciplines firms, successful firms attract resources to expand. The more the dynamic the economy, the
less likely it is that regulations will be effective. Dynamic and intense competition is perhaps the
ultimate regulator. U.S. economy has become more competitive recently due to deregulation of
industries (airlines and trucking), increased foreign competition, advances in communication and
computer technology, Internet, etc.

Example: Profit margins of manufacturing firms is 4-5%, extremely low, reflecting the intense
economic competition (in polls, people think profit margins are 29%!).

21

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