Micro 091021 by dfhdhdhdhjr


									      Micro 091125

Competitive markets; Monopoly
       Competitive markets and resource allocation

• Consider S=D in long-run equilibrium in a perfectly
  competitive market
• Every consumer has allocated his budget so that his
  MRS of money for an additional unit of this good equals
  the market price
   – there is a consumer surplus on each unit consumed per month,
     except for the last one
• In LR equilibrium, each firm has chosen its factor inputs
  so as to produce each its output at the lowest possible
   – for simplicity, assume each firm has the same technology
• Each firm is producing at the minimum point on its LAC
  curve, which is also the minimum point of its SAC curve
  (why)? It is earning zero economic profits (meaning
       Competitive markets and resource allocation
• The firm’s SR supply curve is its short-run MC curve
  above the minimum point of the AVC curve (why?)
• It’s LR supply curve is it LMC curve (constructed from
  the LAC curve), above the minimum point of the LAC
  curve (why?)
• The number of firms has adjusted so that the total Q
  supplied equals total Q demanded
• Now suppose this is a normal good, and that average
  consumer income rises; so each individual demand
  curve, and hence the market demand curve, shifts to the
• What happens in the short run? A: in response to the
  tendency toward excess demand, the market price will
               Allocation in competitive markets

• the rise in price will reduce quantity demanded (moving
  up the new demand curve); it will also increase supply as
  each firm’s MC at the new price is less than the higher P
• So firms buy more variable factors (labor) and increase
  production, until MC has risen to the level of the new
   – that is, each firm increases the quantity supplied along its supply
     function, increasing market supply in the short run
• Note that there are increases in both consumer and
  producer surplus, in comparison with the old equilibrium
• At the higher price, each firm now earns positive
  economic profits in the short run
• In the long run, the positive economic profits will cause
  new firms to enter the industry
             Allocation in competitive markets

• The higher price will also cause existing firms to increase
  its use of the fixed factor (capital). (Why?)
• However, over time, the inflow of new firms will shift the
  short-run market supply curve to the right, causing price
  to fall
• In the long run, therefore, the equilibrium market price
  will be the same as before, each firm will produce the
  same quantity (at min LAC as before), using the same
  input combination, and once again earn zero economic
• The only thing that has changed is that there are more
  firms, so that together they produce the higher quantity
  that is demanded at the higher income
              Allocation in competitive markets
• Note also that in the new equilibrium there is higher
  producer and consumer surplus, and both the short-run
  and long-run sum of consumer and producer surplus is
  maximized, given the quantity that is produced
• Note again that in this example, it will necessarily be true
  that the long-run market supply curve is inifinitely elastic
  (“flat”) as long as the prices of all inputs in producing this
  good stay unchanged
• However as discussed earlier, we can also construct a
  long-run supply curve on the assumption that in each
  industry there is some specific factor that rises in price
  as more output is produced
• If we draw a LR industry supply curve on this
  assumption, it may slope upward even if all firms have
  access to the same technology
               Allocation in competitive markets

• In this case, we can interpret the area above the long-
  run upward-sloping supply curve and the price as either
  producer surplus or rent earned by the owners of the
  specific factors whose prices will rise as industry output
   – note: these specific factors cannot be things like labor and
     capital, since those factors can be used in other industries
• As another example, we can analyze an industry that
  produces a good for which there is a substitute, and the
  price of the substitute falls
• As a result, the market price for our good will fall in the
  short run, in response to a tendency toward excess
   – in discussing this example, pay attention to the AVC curve
   Effects of government policies in competitive markets
• First consider the standard example of a 10% excise tax
  that is imposed in a market that is originally in
  equilibrium at price P0
   – assume that we define the market price as the price before tax,
     so that the buyer has to pay 0.1 P0 to the government when
     buying one unit of the good
• Focus first on the case where the supply curve slopes
• The new equlibrium will be at a quantity where the
  quantity supplied at new price P1 is equal to the quantity
  that is demanded at 1.1 P1 (see diagram on board)
• As a result of the tax, there are decreases in both
  consumer and producer surplus, but some revenue goes
  to the government
                       The excise tax case
• The tax will have a deadweight loss defined as (loss of
  CS)+(loss of PS) – Tax Revenue
   – the deadweight loss is also called an “excess burden” or an
     “efficiency loss”
   – by definition, an equilibrium in which there is a deadweight loss
     is not Pareto-optimal
• We can use the concept of elasticity to calculate how the
  excess burden will be shared between consumers and
• Suppose we have estimates of Es and Ed, the
  elasticities of supply and demand in the market
• Note that in the new equilibrium, the percentage
  reduction in the quantities demanded and supplied must
  be the same; call this change d ln Q
                     The excise tax case

• (In this example, we are using the approximation that
  says that the change in the logarithm of a variable is the
  same as the percentage change in the variable)
• That is, it must be true that Es*d ln P = Ed*(.1+ d ln P)
   – remember that we have defined P as the price received by the
     producer, before the tax
• This equation can be solved to yield
     d ln P =.1 * [Ed/(Es-Ed)]
• [experiment with different special cases here, keeping in
  mind that Ed<0]
• The text goes on to consider the effects of many different
  types of government interventions in competitive markets
             Interventions in competitive markets

• Fig 9-2 considers imposition of a maximum price that is
  lower than the market price
   – in this case, pay particular attention to the discussion of how
     large the loss of consumer surplus is, and the question whether
     consumers who have bought the good at the controlled price are
     allowed to resell it, and whether it is possible for consumers to
     pay bribes to sellers (on top of the regulated market price)
• Figures 9-7 and 9-8 and 9.10 consider the effects of
  regulations that stipulate minimum prices (for example,
  for some agricultural commodities in the US and
  Europe,or minimum wages in labor markets)
• In the case of agricultural markets, the effects depend on
  what happens to output that consumers don’t buy; in the
  case of minimum wages, who gets a job?
           Interventions in competitive markets

• Figures 9-14 and 9-15 considers the case of goods that
  can either be supplied by domestic producers, or
• In these cases, it is assumed that the market that we are
  analyzing is small enough compared to the world market
  so that we can import as much as we like at a fixed
  international price
• So the analysis here must distinguish between quantities
  supplied by domestic producers, quantities imported,
  and quantities demanded
• The interventions considered include prohibiting imports,
  imposing tariffs, and imposing import quotas
                 Interventions, concluded

• In all cases, we now must keep track of consumer
  surplus, producer surplus, and any surplus going to
  foreign nationals, as well as deadweight losses
• Some questions here: first, what is the opportunity cost
  of imports?
• Second, how do variations in exchange rates affect the
  analysis here?
• Third, how would the analysis change if we were
  analyzing international markets for goods that we can
• We can show that for a domestic good, there is a
  deadweight loss if we subsidize production of a good in a
  competitive market. Is this true if we subsidize exports?

• Chapter 10 in the text considers markets in which selling
  firms have some degree of monopoly
• Literally, “monopoly” means “single seller”. More
  generally, a firm is defined as having some degree of
  monopoly power if it believes that the price per unit it can
  sell its goods for during a given time period depends on
  what quantity it produces and sells
• This is different from a producer in a competitive market.
  In a competitive market, the producer believes that it can
  sell as many units as it can produce at a given (market)
• The assumption in this chapter also is that the
  monopolist must sell every unit it produces and sells in a
  given time period, at a single price
                        Monopoly pricing
• The idea that each unit is sold at the same price can be
  justified if one thinks of a price being advertised in
  advance so that every buyer knows what every other
  buyer is paying
   – a good example is the price that the publisher sets for a newly
     published book (it is sometimes printed on the back of the book)
• Effectively, a monopolist must simultaneously decide
  what price to set, and how many units to produce (since
  the number of units it will sell depends on the price it
• So a monopolist must estimate the position and slope of
  the demand curve for its product before deciding
• A producer in a competitive market doesn’t care about
  the market demand curve, only about the market price
                        Monopoly pricing
• Writing the monopolist’s profits as π(q) = TR(q) – TC(q),
  the monopolist determines q by finding the q at which π
  is maximized (that is, where π’(q)=0)
• But π’(q) = TR’(q) – TC’(q) (where ‘ means derivative)
• TR(q) for any seller is P times q. However, the
  monopolist will recognize that P = P(q)
• Hence for the monopolist, the first-order condition can
  also be written π’(q) = (P + q P’(q)) – MC(q)
• We can also define TR’(q)= (P + q P’(q)) = MR(q), so in
  the end, the condition just is that profit is maximized at
  the quantity where MR(q)=MC(q)
   – Note: this is the same as the condition for a competitive
     producer. The difference, however, is that for a competitive
     producer, MR(q) is just P, the market price
                          Monopoly pricing
• Question: if we consider a given demand curve and say
  that a monopolist must take into account the fact that
  “selling an additional unit will lead to a small decrease in
  price” (that is, that P’(q)<0), wouldn’t that also be true if
  we consider a competitive firm selling an additional unit
  in a market with the same demand curve?
• The answer is that yes, in principle it is true for a
  competitive producer as well. However, the difference is
  that in a competitive market, each individual producer
  sells only a small share of the total output, so that most
  of the effect of a small reduction in the market price
  when an additional unit is sold, falls on other producers
   – illustrate on the board. Note the implication of the profitability of
     collusion among competitive producers
                     Monopoly pricing

• We have written MR = (P + q P’(q)) where P’(q) is the
  derivative of price with respect to q. Have we seen that
  derivative before?
• Answ: yes, we have, except we have mostly looked at its
  inverse: that is, the derivative of the quantity demanded
  with respect to price
   – since P’(q)=dP/dq, the slope of the market demand
     curve dq/dP is just 1/(P’(q))
• So we can write the expression for MR as follows:

               dP        q dP         1         
    MR  P  q     P1 
                                P1            
               dq        P dq 
                                     
                                         D
                         Monopoly pricing

• Here ηd<0 is the price elasticity of demand
• Note what this implies regarding MR for different values
  of the (negative) demand elasticity: -1? values <-1? if the
  monopolist sets P high enough, what will be true about
  the demand elasticity in most cases?
   – so one conclusion of this is: a monopolist will always set a price
     high enough so that it operates on the elastic portion of its
     demand curve (make sure you understand exactly what this
     means, and why it makes sense in most markets)
• Noting that the monopolist’s optimum position is where
  MC(q)=MR(q), the formula can be used to derive rules
  for a monopolist’s pricing behavior and markup:
   (P-MC)/P=(-1/ηd); equivalently, P=MC/[1+(1/ ηd)]
                       Monopoly pricing

• We can confirm these formulae for the case of a linear
  demand curve (on the board)
• Now consider two questions: 1) what happens if the
  demand curve shifts outwards? 2) what happens if the
  government puts a tax on the commodity sold in the
   – Note: in the case of a competitive market, the answer to both
     questions depends on the relative size of the demand and
     supply elasticities. In the monopoly case?
   – On the board, illustrate both answers by the case of a linear
     demand curve with equation q=200-P, and MC curves of either
     MC = 0 or MC = q
• What happens if the government imposes a lumpsum tax
  of T on a monopolist? T/n on each of n producers in a
  competitive market?
                        Monopoly pricing

• One message from these examples: a monopolist has
  no supply curve
   – make sure you know exactly what this means
• The text also considers the problem facing a monopolist
  with several (two) production facilities (both facilities
  produce identical units of output)
   – its profits can be written π = TR (q1+q2)– TC(q1)-TC(q2)
   – For a given demand curve q(P), how does it maximize profits?
• The next question we should consider is: is monopoly
   – We know that the answer is “no”, but can we illustrate the
     answer precisely, using the concepts of CS and PS?
• Answer on the board (text Fig 10.10)
          Defining and measuring monopoly power

• Which is the more general analysis of firm behavior, the
  analysis of competitive firms, or monopoly?
• For me, monopoly is more general because in reality
  most firms produce output that is at least slightly different
  from the output of all other firms
   – But every firm that produces a differentiated product has at least
     some degree of “pricing power” (meaning what?)
   – a “price-taking” competitive firm is a limiting case; it is a firm
     whose demand curve has a price elasticity approaching infinity
   – note the Lerner index as a measure: (P-MC)/P
• So theoretically, monopoly can be considered a more
  general case. However, in practice, many industries can
  be approximated by the perfectly competitive model
                  Measuring monopoly power
• One way of thinking of monopoly power is with reference
  to the elasticity of an individual firm’s demand curve
• The text gives the example of the toothbrush industry
   – one determinant of the elasticity is how similar consumers think
     that the toothbrushes of different producers are
   – if they think that they are “all about the same” (that is, that the
     products of the different producers are close substitutes), the
     individual firm’s demand curve will be quite elastic
• Another determinant is how the firms in the industry
   – if one firm thinks that an attempt by it to gain market share by
     reducing price will lead its competitors to also lower their prices,
     then this implies that it thinks of its individual demand curve as
     being quite elastic
                     Measuring monopoly

• The text also says that one determinant of the elasticity
  of an individual firm’s demand curve is the elasticity of
  the aggregate demand curve for the industry as a whole
• This makes sense intuitively (think of the case of
  toothbrushes), but one needs to be careful here: if the
  toothbrushes of different producers are not identical,
  does it make sense to think of a demand curve for all
  toothbrushes together?
   – perhaps a better way to think of the problem is to ask two
     hypothetical questions: 1) what would happen to each firm’s
     quantity demanded if all producers changed their prices
     together? 2) what would happen if the firm changed its price and
     all other firms held their prices constant?
• However, the second question may not be relevant in
                  Measuring monopoly power

• Another determinant of a firm’s degree of pricing power
  is the number of firms in the industry
   – but note: what exactly does one mean by “the industry” if
     products are differentiated?
• The text notes that sometimes monopoly power results
  from legislation
• Important examples are patent laws, copyright laws, and
  laws about brand names
   – all the rules in these laws confer some degree of monopoly
     power; why do governments encourage monopoly in such
• Another important source of monopoly power is
  economies of scale
                 Sources of monopoly power
• The importance of monopolies of scale can be illustrated
  in the extreme case of a natural monopoly
• Industries in which economies of scale are so strong that
  they are natural monopolies will require regulation of
  some sort in order not to lead to inefficient outcomes
   – we discuss on the board, using an example like Fig 10-12 in the
• The text also discusses the concept of rent seeking: it
  brings us close to the concept of political economy
• Rent seeking refers to the idea that, since monopoly can
  be very profitable, firms and individuals sometimes
  spend money and resources on activities to strengthen
  their monopoly power
   – advertising is one method; “lobbying” is another
               Monopsony, antitrust legislation

• The text has a section discussing monopsony
   – “monopsony” means a single buyer
• Monopsony is conceptually very similar to monopoly,
  except that the “pricing power” is on the buyer’s side
   – a good example in the text is General Motors as a buyer of
     rubber tires for cars
• I will leave you to study monopsony on your own, unless
  we have time left
• Finally, there is discussion about “anti-trust” legislation
   – a “trust” in US legal language refers to an agreement among
     producers in a market to reduce competition among themselves
   – if firms do this, a reasonably competitive market can be
     converted into an effective monopoly, to the detriment of
     consumers and the economy as a whole (PS, CS, …)
                          Competition law

• Many countries have some form of anti-trust legislation
  (often called “competition law”) to encourage competition
  among firms in order to promote economic efficiency and
  protect consumers
• Note that many countries also have specific laws that
  regulate competition in national markets from foreign
  producers; these are often different from the laws
  governing competition among national producers
   – unfortunately, the concept of rent-seeking is particularly relevant,
     in the US and other countries, with respect to attempts to
     influence this kind of legislation

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