60 CHAPTER 10 PERFECT COMPETITION Assumptions of Perfect Competition The most competitive market structure is pure or perfect competition, which is as competitive as possible. As previously mentioned, market structures are models that summarize how certain markets are organized and behave. For each market structure we have a set of assumptions or characteristics that tell us what kind of industries the model will explain. Only industries that meet the assumptions will behave in the way the model predicts. The assumptions of perfect competition are: Many buyers and sellers: There are so many buyers and sellers in perfect competition that no one of them has any influence whatsoever on the market. The number of consumers and producers is so great that any one of them is like a cup of water in the ocean – their presence or absence makes no difference at all to the market. Identical or homogenous product: Every producer in the market makes exactly the same product – consumers are not able to distinguish between the output of one firm and the output of another. There are no labels, brands or any other distinguishing features used to make a product look distinct. Excellent information: Both buyers and sellers in this market have good information about the product, especially the fact that there are many other producers all making the same product. Relatively free entry and exit: Firms are able to move resources in and out of this market relatively easily with little expense. This makes firms especially quick to respond to changing consumer demand. As you would expect from this list, there are few markets that come close to fitting these assumptions. The most common example used for perfect competition is agriculture. While agriculture does not fit these assumptions perfectly, it comes closer to perfect competition than to any other market structure. In the major commodity markets, there are so many producers that any one producer has no effect on the market. If you are one producer of hard red winter wheat out of thousands, it does not affect market supply or price if you produce more or less this year. You are so insignificant to the market that you cannot even set your own price, but have the price set for you in the market – perfectly competitive firms are price takers, their only choice is to take the market price and sell, or leave it and sell nothing. In the major commodity markets the product is identical from producer to producer – there is no difference in the hard red winter wheat of Farmer Smith in Nebraska and Farmer Jones in South Dakota. If consumers were presented with a bucket of each, they could not tell any difference. In the major commodity markets, all the buyers know that the product is identical, they know what current prices are, and they know how to grade the product. If the going price of hard red 61 winter wheat were $3 a bushel, a farmer who tried to set his/her price at $3.01 a bushel would sell no wheat. All the buyers know they can get all the wheat they want at $3. Producers have no power over the market price. In the major commodity markets there is relatively free entry and exit, stress on the word relatively. While it is expensive to enter and exit farming in general, it is relatively inexpensive to move from one agricultural market to another related one. For example, areas suitable to growing corn are generally also very suitable to grow soybeans. Similar equipment is used to plant, cultivate and harvest corn and soybeans. If corn prices have been low, corn farmers could easily switch to growing soybeans the next year. In recent years we have seen a growing deviation from the perfect competition pattern in agriculture in that the buyers of agricultural crops are consolidating in some markets. For example, there are a limited number of meat processors that handle pork and poultry reducing the competition on the buying side of the market. In time, we may have to adjust our interpretation of at least some of the agricultural markets, but for the moment the best fit still appears to be perfect competition. In general, the pattern for this market is a very large number of small powerless producers making absolutely the same product in a market where they have no influence on price. Competition is so great that individual firms have no alternative but to operate efficiently in order to survive. The Perfectly Competitive Model in the Short-run In the graph on the left one can see that the price of a product, here wheat, is determined by the overall market supply and demand. Once the price has adjusted to the supply and demand in the commodities market, the current going price of wheat has been established, here $5. From the point of an individual producer, this going market price is set for them and it appears to them that they can sell any quantity of wheat they wish at this market price, but cannot charge one cent over or they will sell nothing at all. The demand curve they face is perfectly elastic. The Wheat Market Individual Wheat Producer 7 7 S 6 6 5 5 4 4 D Price Price 3 3 D 2 2 1 1 0 0 50 150 250 350 450 550 650 50 150 250 350 450 550 650 Quantity of Output Quantity of Output 62 This is the only market structure where the demand curve facing an individual producer is perfectly elastic. This is also the only market structure where the firm’s marginal revenue curve is the same as its demand curve. Remember that the marginal revenue is the change in total revenue (P x Q) divided by the change in quantity of the good. Since we never have to lower price to sell another unit, every unit adds a constant amount to total revenue, here $5. Once we have the marginal revenue curve, we only need a marginal cost curve to predict the profit maximizing point of production (Q*). This producer would want to set production where MR = MC, a Output Determination quantity of 550 bushels. Farmers will decide how much to plant at the 7 beginning of the season based on an MC estimate of the price they expect at the 6 end of the year. This price will be developed from the prices of the 5 previous year or two, current planting MR estimates, current weather forecasts 4 etc. The futures commodities market Price provides an invaluable service, both 3 because it has thousands of 2 participants factoring in these variables, but also because it allows 1 farmers to lock in a price in the future. This takes the risk off of price and 0 puts it on production – the farmer has 50 150 250 350 450 550 650 committed to selling a certain quantity Quantity of Output at the futures price on the specified date. Output Determination If we added the average cost curve, $7.00 then we could calculate the profit of MC the perfectly competitive firm. At a $6.00 price of $5, this firm is best producing MR 550 bushels. If they make 550 $5.00 bushels then the average cost per ATC Price $4.00 bushel is $4.50. This means the firm $3.00 is making a profit on each bushel of $.5 – the $5 price minus the $4.50 $2.00 cost. Since the firm is making $.5 a $1.00 bushel on 550 bushels, the firm’s profit is $275. Remember, this is an $0.00 economic profit – they are making 50 150 250 350 450 550 650 $275 more than they could growing Quantity of Output the next best crop. Use the following steps to find profit for any price in a perfectly competitive market. Draw a horizontal line at the going price that is the MR curve. Find the point where MR = MC to establish Q*. Come up from the Q* quantity until you hit the ATC – that is the cost per unit. The price minus the cost per unit is the profit per unit. Unit profit times Q* gives the total profit. 63 Calculate the production Economic Profit Levels level, average cost and economic profit for this $11 perfectly competitive firm if the going market price is $10 MC $8.50. $5.50. $9 $8 ATC $7 $6 $5 $4 AVC $3 $2 $1 $0 50 100 150 200 250 300 350 400 At $8.50 this firm made a positive economic profit; however, at $5.50 the firm made a negative economic profit. As price falls the positive economic profit gets smaller and smaller until it eventually disappears and becomes negative. There is a specific point that separates the range of prices that results in positive economic profit from the range of prices that results in negative economic profit. That point is known as the breakeven point – this is the point where the firm makes zero economic profit, or a normal rate of return. If the firm is producing at this level, it must be a Q*, which means that MR = MC. If there is zero economic profit, then P = ATC. In perfect competition P = MR. Put these facts together and you have that ATC = P = MR = MC. There is only one point on this curve where the MC and the ATC curve intersect. That is the breakeven point. In any perfectly competitive firm’s graph, the breakeven point is always located at the bottom of the ATC curve where ATC intersects MC. At all prices above this the firm will make positive economic profit; at all prices below this the firm will make negative economic profit. The reaction of the firm to negative economic profit depends on the time horizon. The firm does not have the option of exiting the industry in the short run - in the short run the firm is stuck with some of its factors of production and therefore some of its costs. The firm’s only option is to stay open or close down. If it stays open, it will make the profit that exists at Q* even if that is negative. If it shuts down, it will automatically lose an amount equal to its fixed costs because if it shuts down both revenue and variable cost disappear but fixed costs remain. The firm’s short run decision to produce or not is based upon where does it lose the least amount of money. If the negative economic profits of Q* are less than negative economic profits of losing FC, the firm will remain open. 64 Since ATC = AFC + AVC, then the firm will lose an amount exactly equal to FC if and only if the price of the product is equal to the AVC. At that point the revenue of the firm is just sufficient to pay for the costs of staying open – the variable costs. There is no revenue left over to pay any of the FC. At that point the firm would lose the same amount of money whether it stayed open or shutdown. This is known as the short-run shutdown point. If the firm is producing at this level, it must be a Q*, which means that MR = MC. If the firm covers its variable costs but not fixed, P = AVC. In perfect competition P = MR. Put these facts together and you have that AVC = P = MR = MC. There is only one point on this curve where the MC and the AVC curve intersect. That is the short-run shutdown point. In any perfectly competitive firm’s graph, the shutdown point is always located at the bottom of the AVC curve where AVC intersects MC. At all prices below the short-run shutdown point the firm would be better to close operations and swallow their fixed costs - the price will not even cover the costs of remaining open. At all prices above the short-run shutdown point the firm would be better to remain open – the price will cover the costs of remaining open and something extra to pay for part of the fixed costs. For example, you raise beef cattle and the price of beef falls so low it does not cover your feed bills, labor costs and vet bills. You will sell or slaughter your young stock and have no beef to sell later in the year. When the US government under President Nixon put price ceilings on common consumer necessities like food, including beef, but did not put ceilings on the feed, cattle medicines, electricity for heating barns, etc, farmers slaughtered their young stock and all but the best of their breeding stock. The US had a lot of beef for a few months and then a severe shortage for a couple of years until the herds could be bred back up. As soon as the price ceilings were taken off, the price of beef skyrocketed. Under the controls the ranchers were operating below the short-run shutdown point. Suppose the price of beef were low enough that we covered the costs of maintaining the herds but not enough to cover property taxes, long term barn maintenance and make a normal return on our investment. We are above the short-run shutdown price but below the breakeven price. We would not slaughter our herds in the short run as we would be better off to continue selling beef as normal. Economic Profit Levels MC ATC Breakeven Pt. AVC SRSD Pt. 65 The Perfectly Competitive Long-run Equilibrium In the long run, perfectly competitive firms will not continue to produce at a negative economic profit. If they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what some of them would do. As those firms leave the industry, the price will rise for the remaining firms – this process will continue until all negative economic profits have been eliminated. If a farmer is consistently growing corn for an 8% accounting profit and could grow soybeans for a 10% accounting profit, then he is making a –2% economic profit. He/she will finish the current corn crop and then plant soybeans. This changes the market supply of both corn and soybeans, reducing the first and increasing the second. This pushes the price of corn up and the price of soybeans down until, relative to the cost of producing them, they both yield the same accounting profit. CORN One Corn Farmer S2 S1 D2 D1 D While the market supply of corn decreases, an individual farmer who continues to grow corn will see the demand for his/her corn rise with the new higher market price, reducing the negative economic profit. Exit will continue until there are no negative economic profits left. SOYBEANS One Soybean Farmer S1 S2 D1 D2 D While the market supply of soybeans increases, an individual farmer who already grew soybeans will see the demand for his/her soybeans fall with the new lower market price, reducing the positive economic profit growing soybeans. Entry will continue until there are no positive economic profits left. 66 Exit eliminates negative economic profits and entry eliminates positive economic profits. Perfectly competitive firms makes zero economic profit in the long run. Remember that the breakeven point is at the bottom of the ATC curve – so perfectly competitive firms are driven to the lowest possible average cost, all other things equal – there is no way to be more efficient. What if all other things are not equal? What if the firm experiences economies of scale? The firm will move from one average total cost curve to another as it expands its capacity. Eventually, it will reach ATC curves that exist at the most efficient scale and then the firm will be pushed to the breakeven point on that ATC curve. Let’s take the long run cost curve from chapter 3 and combine it with our current analysis. $ LRAC (Long-Run Average Cost) Plant 1 Plant 2 Economies Plant 3 Diseconomies of Scale of Scale Constant Returns To Scale Q Scale When the firm is moving toward the breakeven point operating with the 1st plant, we reach a point where it is cheaper to shift to a larger plant, plant 2, than to continue expanding production in plant 1. As we move closer to the breakeven point operating the 2nd plant, we also reach a point where it becomes cheaper to expand the size of the company again. Finally, with the 3 rd plant we reach not only the minimum average cost on the short run curve, but also the minimum average long run cost as well. Now the firm is operating at the minimum average cost possible in this industry. When the Classical economists modeled the efficiency of the free market system and discussed how responsive it was to consumers, what they really had in mind were perfectly competitive or almost perfectly competitive industries. The problem is that there are very few of these industries in the economy. Journal Topics: Complete the following assignment. Minimum of 2 pages Richard Salsman has been heavily attacking the perfectly competitive model as the basis for government antitrust law. Read and critique his representation of the model in the handout. 67 CHAPTER 11 MONOPOLISTIC COMPETITION Equilibrium in Perfect Competition and the Other Market Structures Once we are out of perfect competition, certain features are common to all the remaining market structures. The demand curve for a firm’s output is downward sloping, i.e. the firm will have to lower price in order to increase sales. This means that the marginal revenue curve is a different curve, distinct from the demand curve. These two features will lead the other market structures to select an output level that is not socially optimal. All other things equal, the three other market structures will not be as efficient as perfect competition. All other things equal (no externalities, public goods or other market breakdowns), the demand curve represents the value of a good or service to society. Remember the discussion of consumer surplus in chapter 2 – any point on the demand curve represents the value of the last unit bought to consumers so the demand curve summarizes the value of all the previous units. All other things equal, the supply curve represents the cost of a good or service to society, including the alternative production sacrificed. In perfect competition the demand curve is also the marginal revenue curve, so when a perfectly competitive firm has a horizontal demand curve set at the market equilibrium price, it is setting Q* at the point where the marginal benefit the good to society is equal to the marginal cost of the good to society. This is not the case in the other three markets. Perfectly Competitive equilibrium Perfectly Competitive equilibrium MC MC Firm's D Mket D The intersection of the MC curve – the representation of social cost – and the market demand curve – the representation of social benefit – is the socially optimal point of production. Each individual firm in this market sees a horizontal demand curve set at the equilibrium price. Since the firm’s demand curve is also its MR curve, the firm will set its production accordingly. The firms are all using the MC curve as their supply curve and end up at the socially optimal equilibrium. This is the only market structure where that is true. Once you are out of perfect competition, the individual firm sees a downward sloping demand curve and a separate marginal revenue curve. Firms are price makers – they have some power over their own price. They will not be using the MC curve as a supply curve – they will not come over horizontally from the price to the MC curve to establish the level of production. Since Q* is 68 being set by MR and MC not supply and demand their equilibrium will not be the socially optimal decision. Because a firm in any of the other three market structures must lower its price to sell more units, the marginal revenue curve is set below the demand curve. Imagine you are currently selling 500 units a week at a price of $3 a unit for a TR of $1500. If you want to raise your sales, say to 1000 a week, you must lower your price. If price had to be dropped to $2.00 in order to sell 1000 a week, then TR would be $2000. The marginal revenue would then be $500/500 units or $1. The MR is less than either the old or new price. Even though we added 500 units to sales, we dropped the price on the existing sales by $1 lowering the benefit to revenue. The non-perfectly competitive firm will still maximize profit at the point where MR = Non-Perfectly Competitive MC. In perfect competition that was where equilibrium the firm’s demand curve intersected MC but here it is at a lower Q. The non-perfectly MC competitive firm will then set price at the P maximum level consumers will pay for Q* which is set by the demand curve. Because Firm's D we have reduced the equilibrium Q, we have pushed up the equilibrium P. From a social point of view, the benefit to consumers justifies making more units up until the demand curve intersects the MC curve, but MR from a business point of view such an expansion would not be profitable. There is a loss of benefit to society – a deadweight loss that occurs from the lack of Q* competition. The deadweight loss is the lined triangle. These non-perfectly competitive markets end up with higher prices and less output, all other things equal. They will not be pushed to a long run equilibrium that combines a lack of excess profits with the lowest possible average cost of production. The bottom of the ATC is the intersection point with the MC curve, if we are producing at maximum efficiency then ATC = MC. Since MC must equal MR and MR is less than P, we would have excess profits in the industry. If we have zero economic profit, then P = ATC, but P is greater than MR, while MR = MC. MC would then be less than ATC and we would be producing for a higher average cost than the minimum. The structure of non-perfectly competitive markets is less efficient than perfect competition. Monopolistic Competition The first of the non-perfectly competitive markets is known as monopolistic competition – this is a market structure marked by a high degree of competition – it’s just not perfectly competitive. Each individual company has its own version of a product, so in one respect it is the only seller of this version. However, this version is very similar to the other goods in the market so there is a large amount of competition. Numerically, this is by far the most common market structure in the US as most proprietorships are in monopolistic competition, and proprietorships are the most 69 common form of business organization in the US. These firms, however, do not have strong individual power. The assumptions of monopolistic competition are: Many buyers and sellers: There are so many buyers and sellers in monopolistic competition that no one of them has any significant influence on the market. The number of consumers and producers is not as great as in perfect competition but is still sufficient to be very competitive. Similar or heterogeneous product: Every producer in the market makes a similar, but not identical product – consumers are able to distinguish between the output of one firm and the output of another. There can be labels, brands or any other distinguishing features used to make a product look distinct – a process known as product differentiation. This is the biggest difference between perfect and monopolistic competition. Relatively good information: Both buyers and sellers in this market have information about the product, but not as good as in perfect competition. Because the products are somewhat different, each one has to be investigated separately and consumers do not usually have the time or inclination to do those completely. Instead, we rely on word of mouth, trial and error and advertising in order to find goods we are satisfied with. We do not generally proceed to the point that we know we have the BEST product for the money. Relatively free entry and exit: Firms are able to move resources in and out of this market relatively easily with little expense. This makes firms especially quick to respond to changing consumer demand. This can be a highly competitive market and consumers usually fare well under monopolistic competition. There are many producers of a similar product – not only is there good competition, but there is great variety in the nature of the product. This gives consumers a lot of choices. Product differentiation involves a number of business activities. We may vary the physical properties of the product – adding scents, flavors, textures and colors, changing the shape of the product or the materials it’s made of. You can buy soap that has oil added to protect dry skin or soap that has agents in it to strip oil from oily skin. You can buy soap that is yellow or blue or pink. There is soap that smells like roses and soap that smells like lavender and soap that smells like pine. There is soap that has oatmeal in it to remove dead skin or ground up rock in it to remove embedded dirt by removing the top layer of skin. You can buy soap that is pressed into the shape of seashells or roses. We can vary the service offered, either as an independent service or in combination with a good. We can have a 24-hour store, or free delivery or an extended warranty. Out tech support people can come to your house and move all your old programs onto your new computer. We can accept returns, no questions asked, or special order material. Stores can be located on major streets with drive through windows. Finally, we can vary the marketing. The product and service itself might not have any substantive differences but we could change the package and labeling. Advertising might be used to give our product a certain image that other versions of this product lack. Prestige and status, attractiveness and sex appeal, safety and reliability, economy and thriftiness are all common themes stressed in the image of certain products. Generally, major investments in this kind of marketing are most 70 seen in the next market structure, but to a lesser extent it can be found in monopolistic competition. Product differentiation gives consumers a range of choices in the product and service. It is likely, however, to also raise the cost of production. All other things equal, the cost per unit of producing goods with special features or extra service will be greater than the cost of making all the goods exactly alike with the minimum features necessary. All other things equal, the money spent on advertising, packaging and labeling will raise the cost per unit of the good. All other things equal, the entire ATC curve is higher with product differentiation. Advertising may allow the firm to increase its size and enjoy economies of scale. In this case the advertising might result in a more efficient company rather than a less. Since monopolistic competition is generally marked by smaller companies that operate in a highly competitive industry, it seems likely that the economies of scale are limited. Large economies of scale tend to result in very large producers and that seems more relevant to the next two market structures. Short-run equilibrium in Monopolistic Competition In monopolistic competition the production decision will look like this. Q* is set at the intersection of the marginal cost and marginal revenue, while P is set by the demand curve at Q*. If we add an average total cost curve to the graph, we can calculate the cost per unit of Q*. Short-run equilibrium in Short-run equilibrium in Monopolistic Competition Monopolistic Competition MC MC P ATC Firm's D ATC Firm's D MR MR Q* Q* Short-run equilibrium in The firm makes a profit on each unit equal to Monopolistic Competition the price minus the unit cost. This is the vertical distance between the demand and MC ATC curve at the Q* quantity. The firm’s P ATC total profit is the profit per unit times the ATC Firm's D number of units – Q*. Since Q* is the horizontal distance from the vertical axis out to the Q* quantity, total profit is the area of the rectangle as shown to the left. The height MR is profit per unit, the width is the number of units and the product (the area) is the total Q* profit. 71 Long-run equilibrium in Monopolistic Competition The same process works in monopolistic competition that we see in perfect competition. Relatively free entry and exit will push the industry to a breakeven point. The breakeven point is not located in the same place, however. In the long run, monopolistic competitive firms will not continue to produce at a negative economic profit. If they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what some of them would do. As those firms leave the industry, the price will rise for the remaining firms – this process will continue until all negative economic profits have been eliminated. In the long run, monopolistic competitive firms will not continue to produce at a positive economic profit. If they are making more money than elsewhere and it is relatively easy to exit and enter the markets, that is exactly what some of the firms will do in the other industries. As those firms exit their market and enter this market, the price will fall for the original firms – this process will continue until all positive economic profits have been eliminated. The monopolistically competitive firm Short-run equilibrium in Long Run Equilibrium on the left is at a breakeven point. Monopolistic Competition In Monopolistic Competition The firm sets production at Q* - the point where MR = MC. The demand MC curve establishes P, but since the ATC curve is tangent to the demand curve ATC at that point, the P = ATC. We are P = ATC breaking even. Notice that the firm, although breaking even, is not operating at peak Firm's D efficiency. There is room to lower the ATC by expanding production; MR however, in order to sell the good the price would have to fall even more. Expansion is therefore not profitable Q* and does not occur. This is the trade-off in monopolistic competition – consumers gain variety at the expense of some efficiency. If the product differentiation raised the ATC curve, then consumers lose even more efficiency. Journal Topics: Complete the following assignment. Minimum of 2 pages 1) Find several examples of product differentiation and describe them. Use examples with different kinds of differentiation. 2) Describe several industries that would fall under the monopolistic competitive model. 72 CHAPTER 12 OLIGOPOLY Characteristics of Oligopoly Oligopoly is the first of the market structures that is marked by a limited degree of competition. Oligopoly covers a multitude of markets from those that are fairly competitive to some that have very little competition at all. Consumers will face more limited choices in oligopoly and it is within this market structure that the balance of power shifts against the consumer. This is the market structure containing the industries that drive the US economy. The major corporations are in this market structure, and although they are not as numerous as monopolistic competitive firms, they are far larger, more powerful and account for more production. These companies often hold significant political influence in addition to their economic influence. The assumptions of oligopoly are: Relatively few sellers: There are few enough sellers in oligopoly that they can individually have influence on the market. Producers in oligopoly are interdependent – a firm’s success can be as influenced by the actions of a competitor as its own. The cut-off for oligopoly is arbitrarily chosen to be a concentration ratio of .4 or over. In other words, if the top four firms in the industry have 40% of sales or more, then it is considered to have relatively few sellers. When firms are this large and control this much market share, then the actions of one significantly affects its competitors. Identical or Similar product: In some oligopolies, such as the steel industry, the product can be identical from producer to producer. In other oligopolies, such as the auto industry, the product is only similar from company to company. AOTE, the more similar the goods the more competitively the market will behave. This is because it is easier for consumers to switch from one good to another reducing the firm’s power over price. Good or poor information: Both buyers and sellers in this market could have good information about the product or not. Good information is more likely to occur when the products are identical or very similar. The more differences between versions of a good the more data the consumer has to gather to have good information for comparison. AOTE, the better the information the more competitively the market will behave. Firms will be pressured to keep quality and price in line with other producers – if they fail to do so, consumers have the knowledge to go buy the better value. Barriers to Entry: Firms are not able to move resources in and out of this market relatively easily with little expense. The barriers to entry are of two types. Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage (where the size of a system of associated services is part of the attractiveness of the good) and high start-up costs. 73 Natural barrier: there is one natural barrier – large economies of scale – that discourages new producers from even trying to enter. There is such a cost advantage to being big that a few huge firms control this market. A new producer is reluctant to enter because they can’t produce for as low a cost. Oligopolies vary in the degree of competition – some are competitive enough that they are only slightly different than the least competitive firms in monopolistic competition. Some are uncompetitive enough that they are almost a monopoly. While there is disagreement among economists on any rule of thumb to categorize oligopolies, we will use the following generalizations. Concentration ratio of .4 to .6 Weak Oligopoly, not strongly concentrated Concentration ratio of .6 to .8 Standard Oligopoly neither weak nor strong Concentration ratio of .8 or over Strong Oligopoly, strongly concentrated Competitive Oligopolies If an oligopoly market has at least a moderate number of producers that are truly competing with one another – i.e. no cooperation and no basis for anticipating the decisions of the other firms - they may exhibit an unusual shaped demand curve. Suppose you are running a firm in such a market, and you are considering changing your price as you search for the profit maximizing point of production. You have to consider how your competitors will react when you change price, because that reaction will change the profitability of any decision you could make. You are currently selling 600 units a week at a price of $6. You are not sure that this is the profit maximizing point of production and are considering change price to find out. You could lower price and hope to make up on volume what you lose on profit per unit; you could raise price and hope that the higher profit margin makes up for a drop in sales. The effect you see will depend on whether the other firms in the industry ignore your price change, keeping theirs about where it was before or match it. In this case the competition decided to ignore your price change. If you raise Competition Ignores price you will be the only firm to do so and you will see a large drop in sales. $12 Some of your consumers are going to go $10 buy the product from someone else. If you lower price you will also be the $8 only firm to do so and you will see a Price $6 large rise in sales. The demand curve is $4 relatively elastic. D $2 If this were the situation in the market, it $0 would suggest that you either leave 200 400 600 800 1000 prices alone or cut them. A price increase is very unlikely to raise profits; Quantity of Output on the contrary, it will probably lower them. 74 In this case the competition decided to Competition Matches match your price change. If you raise price, so too do the other firms and there $12 will be a small drop in sales. Consumers have nowhere to go but out $10 of the market. If you lower price, the $8 other firms will match you and you will Price $6 all gain very few sales, only receive less profit per unit. The demand curve is $4 relatively inelastic. $2 D $0 If this were the situation in the market, it would suggest that you either leave 200 400 600 800 1000 prices alone or raise them. A price Quantity of Output decrease is very unlikely to raise profits; only the consumers win a price war. Since these two possibilities suggest two contradictory price policies, the question becomes which is true? The answer might be both of them, depending on the nature of the price change. Oligopoly firms which are truly competing may match a price decrease but ignore a price increase. Game Theory To see why a price decrease would be matched while a price increase is ignored, we can model the decision making of the firm. The firm controls part of what goes on in the market, but in an environment of no cooperation or shared information does not know what decisions will be made at the other firms. It must consider each scenario that would occur depending on the different combinations it and the others could select. Game theory is a way of representing the various options available to a decision maker and then showing how they tend to select strategies. In some cases there is a clear choice - no matter what the other side does, this choice is the best for the firm - this is known as a dominant strategy. In other cases the best choice is unclear since it depends on the decisions made by the other player(s). It isn’t very useful to model the dominant strategy because if it is the best choice regardless of the decisions of the other firms, then there is no reason to study their decisions and the impact they will have. It is the case where there is no dominant strategy that game theory excels in showing why firms may make a decision which in the aggregate is not the best selection, but on the individual level may be. Suppose that Honda announces it will increase car prices next quarter (assume the auto industry meets the competitive criteria). The management at Ford is considering whether or not they should follow Honda and increase prices as well. The results at Ford will be affected by the decisions made, not only at Ford but also General Motors, Toyota, and the other car companies. 75 Suppose Ford's current profit is $4 million and the following reflects Ford's best estimates of what will happen to Ford under the different possible outcomes: FORD RAISES FORD DOESN'T PRICE RAISE PRICE Higher car prices in general Only Ford has older, lower mean consumers have few prices. Ford steals market GM AND OTHERS choices. Each company share from all the other RAISE PRICE loses some sales but not a companies. lot. Ford's profit $4.6 million Ford's profit $5 million Only Ford and Honda have Only Honda has the new, the new, higher prices. higher prices. Ford and the GM AND OTHERS They lose market share to other car companies steal DON'T RAISE PRICE everyone. market share from Honda. Ford's profit $4.1 million Ford's profit $3.4 million There is no dominant strategy here, Ford would do best raising prices IF it knew GM and the other companies would as well. Given that this is a dangerous strategy for a firm to attempt - they could also end up with the worst outcome; a company in this situation is most likely to take the safe strategy - Ford cannot lose maintaining the old prices here. They will probably not follow Honda, unless they can acquire some information about or cooperation with GM and the other companies. The Kinked Demand Curve If firms ignore a price increase then the demand curve will be fairly flat or elastic Kinked Demand Curve at prices higher than the current one. If firms match a price decrease then the $12 demand curve will be fairly steep or inelastic at prices lower than the current $10 one. $8 Price This gives us a demand curve that is bent $6 or kinked. The bend occurs at the existing $4 price in the market. $2 D In this situation, the firm is best leaving $0 the price where it is. Prices in such a market will be very stable unless 200 400 600 800 1000 underlying costs change or the whole Quantity of Output demand curve shifts significantly. 76 Price Leadership It’s understandable how the corner or kinked price persists, but how did the industry establish the corner price to begin with? In some industries there is an acknowledged leader – a firm which is looked to by the other firms when it is time to set a new industry price structure or technology. This may be because of its size, or technological dominance, or history. In times of turmoil, when external forces such as a changing technological base or significantly changing consumer demand render the old equilibrium obsolete, firms will look to this leader to establish the new stable order in the industry. But, we may have now relaxed one of the assumptions under the competitive oligopoly model – that there is no basis for anticipating the decisions of the other firms. The industry leader has a past precedent that other firms follow its lead – it may decide to risk raising price when there are no external forces at work. Kellogg’s is the leader in the cereal industry. If Kellogg’s knows that every time corn prices change, General Mills and General Foods follow Kellogg’s lead in setting the new price and the timing of the price change, then Kellogg’s knows there is a good possibility that they will follow its lead if it raises cereal prices when costs aren’t rising. The likelihood of this happening is related to the number of major firms in the industry. If there are only 3 or 4 dominant firms, then if one changes price the other three only have to worry about what 2 other firms are going to do. The probability of a firm taking the risk to follow a price increase by one competitor is much higher if the number of businesses in the industry is small. Traditionally, in the cereal industry there were only 3 producers making about 85% of the output. This can lead to the industry leader essentially setting price for the entire industry – a phenomenon known as price leadership. Price leadership can be used as a way of establishing a near monopoly price as long as the other firms do not use the opportunity to gain short run sales at the expense of long run profit. Provided the firms do not actually coordinate their strategy, it is unclear if this behavior is illegal. Anti-trust Law and Collusion By the late 1800s, the Federal government was becoming concerned about the noncompetitive behavior of some American firms. Some companies were cooperating to establish “trusts” – legal agreements that coordinated the production, pricing and distribution decisions of separate companies in a way to remove choice from consumers and establish high prices. A company literally signed over these decisions to a group of trustees to run the industry to the benefit of the major producers. Small or independent producers were run out of the market by a variety of tactics which by the best interpretation were unethical. Powerful monopolies were also rising during this time period – people like Rockefeller were establishing the one company domination of industries like oil refining. Again, this reduces the choices available to consumers, increases price, as well as reduces production and probably quality. Because of this the government passed laws to limit the ability of firms to behave in uncompetitive ways, and these were known as anti-trust laws. 77 1890 Sherman Anti-Trust Act: The Sherman Act made it illegal for firms to restrain trade and conspire to create a monopoly in interstate commerce. There were several loopholes in the Sherman Act that weakened its impact. First, only monopolizing behavior in commerce over state lines was illegal. Second, the term "restraint of trade" was not clearly defined. Price fixing, where firms cooperate to establish price together, also known as collusion, was one activity clearly considered to be restraining trade, and therefore illegal. Third, it only outlawed trying to create a monopoly, not having one. In other words, the government had to demonstrate that you behaved in ways designed to eliminate competition; it was considered acceptable to have a monopoly by consumer choice. Although weak, and not upheld by all Presidents or the Courts in general, the Sherman Act was not useless. Theodore Roosevelt was able to break up several powerful trusts or monopolies (like Standard Oil) armed with nothing more than the Sherman Act. 1914 Clayton Act: The Clayton Act more specifically outlawed activities that were considered to threaten competition. The Clayton Act makes illegal to engage in: tying contracts: These require a customer to buy goods they do not want, in order to acquire the good that they do want. interlocking directorates: These exist when some of the same individuals serve on the Board of Directors for competing companies. price discrimination: This is the practice of charging one set of customers a very different price than another set, without a demonstrable cost basis. The Clayton Act also granted labor unions an exemption to anti-trust law and limited the scope of mergers. If a merger significantly reduces competition in an industry, the firms must seek the approval of the government before combining. 1914 Federal Trade Commission Act: The FTC Act created the Federal Trade Commission, whose role it was to oversee the level of competition and to investigate mergers. In the early days of the commission, they had broad powers to define "unfair" business practices and then issue cease and desist orders to stop the activities. Later these powers were trimmed, but the FTC was also given regulatory authority over advertising. They are the agency which oversees mergers and must grant approval for significant mergers. The FTC typically uses the Herfindahl- Hirschman Index to decide if the merger should be blocked – typically if the HHI is over 1800 or rises by more than 200, the FTC is reluctant to allow a merger to occur. Throughout much of the early 20th Century, the courts were disinclined to uphold anti-trust law with any vigor. The "Rule of Reason" was a legal precedent used to limit the scope of the laws and make it more difficult for the government to prove its case. The rule of reason basically said that the government had to prove that the noncompetitive structure of the market had been deliberately sought rather than the result of natural market force. In other words, it was fine to have a monopoly or powerful oligopoly if it occurred without intention as the result of making a good product at a good price. Essentially, the government had to prove that consumers were being hurt by the anti-trust violations. The rule was abandoned in the 1945 Alcoa case, where Alcoa lost even though their product was good, prices were low and customers were satisfied. By the 1980s the rule is sneaking back into interpretations of the law and is a key part of the debate over the Microsoft case. Is the purpose of anti-trust law to protect firms against large competitors or to protect consumers against noncompetitive markets pushing price up and quantity/quality down? 78 Cartels US anti-trust law regulates the behavior of American firms or foreign firms doing business in the US, but our laws do not have jurisdiction over foreign firms operating in foreign countries. In some parts of the world companies or governments have created cartels - formal organizations to control the production and, therefore, price of a commodity. The track record of cartels is a mixed bag with a few being very successful and many struggling to coordinate the cooperation. OPEC, the Organization of Petroleum Exporting Countries, is among the best known of the cartels. Formed in 1960, OPEC is infamous for the large crude oil price increases it was able to achieve in the 1970s triggering simultaneous serious unemployment and inflation – stagflation - in the US economy. OPEC however, saw its control of oil markets erode in the 1980s and 1990s, only successfully bringing oil prices back near their 1981 highs at the turn of the century. In order to be successful, cartels need to have certain factors on their side. In some years OPEC had these and in others they did not. Control of the market: In order to be successful, a cartel must have sufficient control of the market to be able to dominate production level and price. If the cartel does not sufficiently control the market its production cuts will merely boost price for nonmembers. The greater the control the better, but a cartel probably needs about 75%- 80% control of an industry to truly be successful in the long-run. Ability to enforce production agreements: Cartels raise the price of the good they sell by limiting the production of it. This is one of the greatest challenges of any cartel, trust or collusive conspiracy – keeping the agreement. There is an incentive for the individual members to cheat on their production quota. If I produce more while everyone else follows the accord, then I get both the high price and high sales. Since everyone faces the same temptation it is likely that cheating will occur – this is known as the cartel problem. There are a couple of ways that this issue can be reduced or controlled. Relatively few members: - all other things equal, a cartel will be more successful controlling the production and price if it has a smaller number of producers. It is generally easier to come to an agreement, the consequences of cheating are greater (i.e. one firm’s cheating has a larger impact on market price when the firms are big) and it’s easier to figure out who is cheating when there are only a small number of participants. Dominant producer – all other things equal, a cartel will be more successful controlling the production and price if it has one large producer. That large producer is the natural leader of the cartel and can exert influence on the other members. If the dominant producer threatens to forego the production quota, it will often hurt the other members more than it would itself, which is a negotiation weapon. Similar production costs: Each producer in a cartel will want to set price at the point that maximizes its own profit. A low cost producer will find it most profitable to produce a higher level of output than a high cost producer, and a low cost producer will be reluctant to maintain the large production cuts necessary to keep the price anywhere near 79 the level a high cost producer would prefer. It will be difficult for them to agree on a target price in the first place and harder for them to maintain that target price. High and inelastic demand: A cartel will not be successful if the good it sells has a very low demand – this is the main reason the lead cartel failed. The strategy of cartels is to cut production in order to boost price; this will only work if the buyers keep buying the product. If the good has elastic demand, then a rise in price will cause a larger drop in sales, in proportional terms. Total revenue follows quantity when demand is elastic. The good needs to be one that consumers have a high necessity for and few substitutes so that they will keep buying it at the higher price. When demand is inelastic, total revenue will follow price, which the cartel is raising. Cartels can be the victim of their own successes – as they boost price higher and higher they encourage the entry of new producers into the market. As OPEC pushed the price of oil from several dollars a barrel to $35 dollars a barrel in less than ten years, a flood of oil exploration and new oil fields resulted. This reduced OPEC’s clout during the 1980s and 1990s. The cartel can be thought of as operating in a gray area between the oligopoly and monopoly market structures. It is a market with a few large producers which fits the oligopoly profile; however, it is trying to operate as a single producer which fits the monopoly profile. The more cohesive the cartel the more the market will behave as a monopoly. Most cartels, however, struggle to coordinate the disparate needs of the individual members, and in general, behave as oligopolies. Another case that falls between the two market structures is the oligopoly market with one huge dominate producer. There comes a point where the dominating firm can be thought of as having achieved virtual monopoly status even though it has not eliminated all vestiges of competition. Both AT&T and Microsoft reached near 90% market share or beyond, in industries that had no other major producers; as this occurred we have shifted them into the monopoly market structure. Journal Topics: Complete the following assignment: Use the Commerce Department handout and find 2 examples each of: monopolistic competitive weak oligopoly standard oligopoly strong oligopoly case where the HHI indicates a highly concentrated market and the concentration ratio does not. Find and summarize a web site on cartels or game theory. Minimum of one page 80 CHAPTER 13 MONOPOLY Monopoly is the least competitive market structure of all. A pure monopoly is a market with only one producer who produces 100% of the output. In a pure monopoly the HHI is 10,000, the highest HHI possible. Consumers have the least choice in a monopoly market – buy from the monopolist or don’t buy. AOTE, we would expect a monopoly market to have the highest price and the lowest total production of any market structure. The assumptions of monopoly are: One seller: The classic monopoly has only one seller by definition. In actuality, we also use the market structure to analyze industries that have essentially one producer controlling almost all the output. Unique product: Since there is only one producer, or effectively one producer, the product they make cannot be compared to alternatives. It is unique. This is important in understanding why a company like Pepsi is not a monopoly even though it is the only company that can produce its version. The product is not unique. Good or poor information is largely irrelevant: Whether the information is good or bad is essentially irrelevant since there is no other product to compare this one to. Barriers to Entry: As in oligopoly, firms are not able to move resources in, and out of this market relatively easily with little expense. The barriers to entry are higher in monopoly and also include the same two types. Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage and high start-up costs. A monopoly that mainly exists because of artificial barriers is called a non-natural monopoly. Since there are no or few cost advantages to this company, it will result in higher prices and lower output for the consumer. Natural barrier: there is one natural barrier – large economies of scale – that discourages new producers from even trying to enter. There is such a cost advantage to being big that the industry has ended up with only one producer. A new producer is reluctant to enter because they can’t produce for as low a cost. A monopoly that mainly exists because of economies of scale is called a natural monopoly. The cost efficiency would, by itself, lower price and raise output, but the lack of competition works in the opposite direction. We are, therefore, not able to predict the effect on price and quantity in the case of a natural monopoly. If the economies of scale are large enough, it is possible that the consumer could get more output at a lower price than if the market were competitive. Monopolies may not always be bad for consumers. Natural monopolies have large cost efficiencies; consumers may benefit from having a large unified network; and the temporary monopolies caused by patents may foster the development of new products and technology. In 81 general, though, we view this market structure with suspicion for the likelihood that the company will make greater than normal profits and be less responsive to consumers. The monopoly sees the entire market demand curve - the market demand curve is less elastic than the firm’s demand curve allowing the monopolist to raise price more than a single competitor could or even than a cartel which has to coordinate and defend the collusion price. This is the main reason why anti- trust law was passed. The government has four potential policy paths to pursue when faced with a monopoly or powerful oligopoly – it can ignore it, break it up, regulate it or nationalize it. The course of action selected depends on the nature of the market. Leave it alone If the noncompetitive market is temporary based on patents, it would make no sense for the government to intervene. The whole purpose of patent law is to give the innovator a temporary period of market power as an inducement to invest in research and development and as a compensation for the risks involved in new products. Certainly, this is the easiest and cheapest policy. If the noncompetitive market has very large economies of scale or network advantages then the consumers may actually be better off with the monopoly or powerful oligopoly than with a more competitive industry. This is most likely to be true if the good or service being sold has an elastic demand – if firms were to raise price, they would lose a lot of sales. In the early days of the telephone industry there were large economies of scale and even larger network advantages – large companies could offer larger networks of people to call and were therefore more attractive. It made sense to have one integrated telephone network that used common technology and systems. The phone was a luxury to most people, which gave the phone company relatively little power. Under the Kingsbury Agreement, the US government agreed to leave the emerging virtual monopoly AT&T alone in return for the promise to create universal telephone access even in rural isolated communities. There are those who claim that the government should leave the high-tech industries alone, since rapid technological change has tended to reduce yesterday’s monarchs to today’s has-beens (both IBM and Apple dominated the computer industries and then lost much of their market power). Companies have to stay on the cutting edge – producing the best product possible at the best price or be eliminated by new upstart companies with better systems. By this argument, market dominance in high tech is built upon consumer benefit; the logical implication is that this is desirable and the government should not interfere. To paraphrase the position in one of the antitrust cases of recent years, “The purpose of anti-trust law is not to protect the consumer from good products at low prices”. Break it up If there are no patents, large economies of scale or network advantages, then consumers are gaining no benefit from the lack of competition. The only effect of the noncompetitive structure will be to raise price, lower quantity and reduce the incentive of firms to be responsive to the 82 needs and wants of consumers. In such a case it appears the best action would be to break the company up. Early in the 1900s the US government broke up American Tobacco, the railroad and sugar trusts and Standard Oil under this logic. In 1982, the government broke up AT&T, a monopoly that had been largely left alone for many decades, even though the company did not meet the criteria for this tactic. AT&T had large economies of scale, a network advantage and major patent development. Furthermore, the company was broken up into regional monopolies rather than a truly competitive industry. As a consequence, the average American telephone consumer saw their phone bill rise significantly in the first year after the breakup. At that time many economists stated their preference for using the next policy rather than creating a series of regional “Baby Bells”. Regulate it If the noncompetitive market offers advantages to consumers such as economies of scale or network advantage that we do not wish to lose but is abusing their market power or has too much potential to abuse their market power, we could regulate them. Under this strategy the government would oversee the industry, setting limits on their actions and prices, but allow the company or companies to continue to exist as noncompetitive entities. Electric utilities are a common example of regulated regional monopolies. The economies of scale are enormous but electricity is such a necessity to households, businesses and communities that, if left alone, the monopolies would have too much power. As a result, they are regulated. Ideally, the regulatory body would like to replicate the socially optimal production and price combination that a highly competitive industry would naturally create. In reality, this is unlikely to happen even if the board is objective and is honestly trying to find the socially optimal point - no one else in the market wishes them to find it. In order to prevent excessive profits the regulatory commission or agency could regulate the noncompetitive industry by setting its price. The problem is that the firm wants the price to be above the competitive market solution so that it can maximize profits, while the consumers want the price to be below the competitive market solution so that they save money. Both sides have no interest in aiding the regulatory board in finding the best long-term solution to price from society’s point of view. If price is set too high, the buyers of this product will have less money for other purchases and activities. It will represent a needless hardship to buyers with inadequate financial resources. Small businesses may move or shut down if electric rates are excessive costing the community jobs. Low-income consumers could lack sufficient heat or cooling because of high electric rates. If price is set too low, the sellers of this product will not make a normal rate of return on their investment. They are likely to cut service, quality, maintenance or investment in order to boost their profits back up. Over time, insufficient maintenance may cause large costs to repair or replace equipment and facilities – at that time the board would have no choice but to raise price to cover necessary expenses. Insufficient investment may mean that the industry will not be producing all the good or service needed in the future. This is particularly a problem in industries like electric utilities, where the lead-time on new facilities takes several years. 83 A perfectly competitive industry automatically sets price equal to marginal cost – this is called marginal cost pricing. Since the marginal cost is relatively easy to calculate, the government could use this strategy to set the price for a monopoly. The problem is that the usual reason we are regulating this industry instead of breaking it up involves large economies of scale. If there are still economies of scale in the industry, then by definition the average cost of production is falling. If the average cost is falling, then marginal cost must be below it. If the average cost of production is falling each time we get bigger and $ produce more units, then the cost of the next unit must be smaller than the current average. (If your GPA were falling then your new or marginal grades must be lower than the previous Economies average.) The marginal cost curve must of Scale be below the average cost curve. LRAC Remember that any average cost curve falls until it intersects the marginal cost MC curve. If we set price by the MC curve while Q the cost of production is off the LRAC Scale curve, then this firm will be making a negative economic profit. In addition, if the industry is one where the input prices regularly fluctuate – as electricity is given the volatility of oil prices – then even if the original approved rate were perfect, it would not long remain so. The firm lacks the flexibility to raise price when production costs rise and the incentive to lower price when production costs fall. The regulatory body could try to limit the power of a noncompetitive industry while avoiding these issues by regulating the profit rate. This would allow the firm to set price at a level consistent with good service, maintenance and investment and force them to adjust price as costs change to prevent excessive profit. Unfortunately, this eliminates the incentive for the firm to keep costs down once the maximum profit allowed has been achieved. The management of the firm may inflate costs beyond what they would pay if the money were coming out of their own pockets. Extra money is likely to be spent on fancy offices, expensive business trips, higher wages than those paid by the unregulated private sector, etc. Decision makers are maximizing a combination of profit and personal benefit rather than profit alone – this is known as satisficing. All of the previous discussion assumed that the regulatory body was objective and honestly seeking the socially optimal price and production combination. What if this were not true? It is possible that regulatory agencies can be dominated by the interests of one market participant or another – a situation known as capture. A regulatory body is said to be “captured” when one side or the other has an edge – is able to dominate the process. Originally, it was thought that capture would always be by the industry if it existed at all. This is very logical given that we appoint experts on the industry to the regulatory board or commission and most experts on an industry work in that industry. You are taking people out of the companies being regulated, putting them in the regulatory process, and when they leave the government position, they usually go back to the industry that they just finished regulating. It is 84 reasonable to assume a conflict of interest here. The availability of jobs and the level of salaries could be influenced by how “friendly” the regulator was to the industry while in office. We certainly can find industries in which many economists are convinced the government body has been captured. Many analysts have claimed that the Federal Aviation Authority has been captured by the airline industry – their resistance to changing regulations when new problems arise has often only been overcome when a major accident or pattern of accidents occurs. Surprisingly, studies in the late 1970s suggested that sometimes consumers capture a regulatory body. The difference appears related to how the members of the price board are selected. If the regulators are directly elected by the public, the group is more likely to be dominated by consumers. This is understandable, since the number of voters who are consumers far outnumber the voters who work for or own the industry. The more layers of appointment protecting the price board and the people who select them from the voter, the more likely the regulatory agency will be dominated by the industry it regulates. Regulation is the most expensive strategy for the government to pursue. The costs of regulation are high and continual – every year we must pay to keep the regulatory bureaucracy operating. Some conservative economists and politicians have argued that the costs of regulation coupled with its inexactness result in a “cure” that is worse than the “disease” the regulation was trying to alleviate – the lack of competition. They argue that firms become so inefficient when faced with the rules and charges resulting from regulation that the prices are higher and the firms less responsive to market conditions than if we left the noncompetitive industry alone. This claim was heavily advanced during the 1980s and the deregulation” of the Reagan administration. This deregulation appears to have been successful, at least in the short-run in lowering prices in the airline and trucking industries. More liberal economists and politicians point to problems in some of the markets that were deregulated as reasons why the regulations were necessary. So far, attempts to deregulate the electric industry have not been successful – witness the California energy crisis that appears to have been manipulated if not created by some of the energy companies. Middlemen who move electricity and oil, such as Enron, appear to have at least taken advantage of the market situation to charge prices far above that of a competitive market, making enormous profits. Nationalize it The last possible strategy the government could use with a noncompetitive industry is to actually take it over and run the industry itself. This is called nationalizing. If the noncompetitive market offers advantages to consumers such as economies of scale or network advantage that we do not wish to lose, but is abusing their market power or has too much potential to abuse their market power, we could take them over. Under this strategy the industry would be part of government and the employees would be government employees. There would be no profits being received by owners – any money made by the industry would just be part of government revenue. This alternative has been largely rejected by the American population and government. Nationalization is an alternative to regulation. In both cases there are strong reasons not to break the company up, but the company has too much power to leave alone. There are a several reasons why one might support nationalizing an industry rather than regulating it. The first is the industry is going bankrupt – this has been the only case where the US took over an industry when 85 passenger rail service became government run in the 1970s. Even then, Reagan sold some of the Amtrak lines back to the private sector in the 1980s. The second reason for nationalization is if people believe the good is so vital to society’s well- being that the government must run it to ensure that enough is made and that it is fairly distributed. This is particularly important if the good has large external benefit or is largely a public good. The private sector would underproduce it. Many countries have chosen to nationalize or partially nationalize their health care sector using this argument. Health care is vital to the well being of individuals and society. There are large external benefits to having healthy workers and citizens and in a private market system low income families will be unable to acquire all the necessary basic health care. The third reason to nationalize rather than regulate is if one believes that the public sector is more efficient at managing production than the private sector. Again, if the good were very important to society we might decide that it belongs to the public sector. In general, Americans do not have great faith in the ability of their government to efficiently run things and for this reason generally think poorly of attempts to raise government management of industries. In addition, nationalization has been rejected on ideological grounds as moving toward socialism – an economic system where the government owns and/or controls the factors of production. Journal Topics: Complete one of the following assignments. 1. Due to deregulation of the financial sector, banks, insurance companies, brokerages and other financial companies are able to offer a wider variety of services. They are also able to operate in more markets and merge more easily than in the past. A number of questions have arisen as a result of these changes; by the spring of 2002 accusations have been made that financial analysts and brokerage houses have been recommending stocks to their clients when they knew that the companies had serious problems. These brokerage firms made millions of dollars in fees for offering financial services to the companies whose stocks they recommended. Find 3 articles on this and write a 2 page paper summarizing the situation and giving your reaction. 2. The Microsoft case is the highest profile antitrust case in the last 20 years. The government claims that Microsoft is essentially a monopoly that acquired its market dominance through unfair practices and that they have stifled innovation and competition in the software market. Find at least one article for and one article against Microsoft and write a 2 page paper summarizing the situation and giving your reaction. Relate to the potential remedies that the government could use in such a situation. 86 CHAPTER 14 MARKETS AND GOVERNMENT The US Economy Given that markets break down when there is a lack of competition and good information, how well do markets work in the US? Obviously, this is a normative question and the answers received will vary greatly depending on the interpretations and priorities of each economist. We can discuss some of the patterns to competition and information in order to help you come to your own conclusions. The US has industries in every one of the four market structure – in fact, since each market structure is a broad category with differences in degree from end to end, we have industries across each market structure. The fewest firms are found at the two extremes. Very few markets meet the rigorous requirements of perfect competition; generally the market structure is used to analyze the major agricultural markets and the exchange markets (including in recent years on-line auctioning). These make up an extremely small percent of the US economy. Given that the free market model is largely based upon the functioning of perfectly competitive industries, this raises serious questions about the applicability of the Classical model. Since markets work the least efficiently in monopolies, aote, government regulation and/or breakup under antitrust law becomes very important. Today, monopolies are fairly rare in the US because of these antitrust laws. Many of the monopolies that do exist possess a monopoly status courtesy of the government. If government licenses only one provider, then we will have a monopolistic market. Government might only want to deal with one provider or believes that having one firm is more efficient. Sometimes when large scale physical infrastructure is involved, government wants to minimize disruption to the community. For example, laying a network of water and sewer pipes, electrical lines, TV. cable, telephone wires etc. involves tearing up streets or putting poles and wires across neighborhoods. It could be extremely difficult if multiple companies were all doing this. Most of the US economy is in monopolistic competition or oligopoly. Industries such as dry cleaning, restaurants, niche retailing, services, etc. tend to be in monopolistic competition, while almost all heavy manufacturing and much general retailing tend to be in oligopoly. The industries with more and smaller companies are generally more responsive to consumers and offer better service; the larger firms offer more variety and often better prices. Some industries have become more concentrated in the last 20 years, such as hardware stores, bookstores, drugstores, electronic stores. These all used to be dominated by small, local stores where owners and workers had a closer relationship with customers and were more directly affected by customer satisfaction. There has been some backlash against the large chain retailer – some communities have attempted to keep the mega chains, such WalMart from entering the market. Some markets are less competitive than they look. In retailing there may appear to be multiple brands competing but relatively few companies make those brands. Proctor and Gamble produces Tide, Cheer, Dreft, Bold and Gain laundry detergents. From the grocery store shelves, one would assume there is a great deal of competition in laundry detergents, in actuality there is a lot less. 87 Industries that develop with fewer and larger companies will often have lower prices and may offer more cutting edge technology. Two economists, Schumpeter, early in the 20 th century, and Galbraith, later in the 20th century, suggested that a less competitive market structure allowed for greater investment in research and development (R&D) and greater innovation. Large companies have greater revenue and therefore budgets for these kinds of activities. This view became known as the Schumpeter/Galbraith view. Other economists have disagreed with the position saying that large, noncompetitive firms have little incentive to change the status quo, since there are few or no other companies to innovate, they face little threat. In part, it probably depends on the importance of patents as a barrier to entry. If the noncompetitive market is the result of innovation, then continuing to innovate is the best way to defend that market. Large network advantages may present a greater barrier to innovation, since once a network platform has been established other companies have grave difficulty offering a different network even if it is superior. In these circumstances, there would be less incentive to innovate. Some highly concentrated industries have become more competitive in the last generation with increases in international trade. The US auto industry by the late 1960s had GM and Ford selling the large majority of cars sold in America – by the 1980s a number of foreign manufacturers were competing for the American consumer’s dollar. Many economists do not feel it is coincidence that the quality measures and consumer satisfaction with American cars is rising in the 1980s – this is what one would expect in a market with greater competition. Some markets are more competitive than they appear. This may be because other goods are close substitutes or because there is potential competition. In the 1970s the role of potential rather than actual competition arose in the study of contestable markets. Contestable Markets Contestable markets are those with very low net costs to entry and exit; where the presence of potential competition causes competitive results even when there are few current producers. The major markets this model has been applied to all have one thing in common – the nature of the good or service being produced and the resources being used are highly mobile. The airline and trucking industries are the markets the model grew out of, and some have argued that certain telecommunication services belong here too. Suppose that only one airline, for example, Delta, flies out of Kansas City. As a local monopoly one might expect that they could charge high rates and have poor service. After all, if you want to fly out of KC there is no choice. But suppose Delta tried to set price high and quality low; Northwest and American airlines could easily take planes off their Chicago/LA route or New York/LA route and make a stopover in Kansas City. The airplane and personnel are already mobile so changing the market they operate in has a low net cost. Since Delta knows this it will not push price up and quality down – the entry of potential competitors would be detrimental to its profit. The same kind of argument was made for the trucking industry. Under the model of contestable markets some politicians pushed for these two industries to be deregulated, claiming that government oversight in fact raised price and reduced quality over what an open market would produce. The government did deregulate as far as price and competition go but continues to regulate safety and security. As airlines have gone bankrupt or merged, we now have fewer airlines to serve as potential competitors. Airlines have also 88 managed to erect a barrier to entry for potential competitors through the development of “hub” cities. An airline promises to make an airport its regional hub – the center through which connecting flights come together. In return for this large amount of guaranteed business the airline receives attractive rates on gates and buys up most of the gates in the airport. It now becomes very difficult for new airlines to operate because they can’t get the gate space to load and unload airplanes. As technology continues to improve many telecommunication services could fit the contestable market model. If movies and other programming could be provided over the Internet, where there are a number of Internet Service Providers, then cable programming would be under the constraint of potential competitors. There would be no difference in a cable company in California sending programming to a customer in San Francisco or New York or Gainesville. When should government intervene because of poor competition and/or poor information? What about the other limits of the free market system – when and how should government intervene? Government behavior generally follows the basic decision making pattern that we have talked about with firms and consumers - maximization of benefit. Public Choice Theory Public choice theory is a model that attempts to explain political behavior through the principle of self-interest – that voters, politicians and bureaucrats make decisions based on where they get the most benefit. Let us apply that concept to anti-trust and regulation to make markets work better given that voters, politicians and bureaucrats have different goals and power. Many voters are consumers, in fact, in most markets the number of consumers far outweighs the number of voters who own or work for an industry. But each voter is considering the fact their vote, by itself, is unlikely to make a difference in an election. They may choose not to gather adequate information to make an informed vote or even choose not to vote at all. There decision is that the utility gained from participation in the democratic process is not sufficient to compensate for the cost in time, energy and money to fully participate. Since voters are more likely to participate if there is a policy that has a big impact on them personally, then those strongly affected by a policy will have a disportionate weight in public decision making. If, for example, breaking up the local cable monopoly will save each of 50,000 households $3 a month on its cable bill, ordinary voters are not likely to be sufficiently excited about such a referendum or candidate to vote in higher numbers than usual. Society, on this local level, will save $1.8 million a year. But if breaking up the local cable monopoly costs that company $500,000 a year, it and its employees are going to participate to the full extent of their power. They will have more likelihood of affecting the decision even though the benefit to those helped outweighs the cost to those hurt. Firms may participate to generally encourage the most beneficial (to them, of course) government environment. This is known as rent seeking. In economics the term rent is used to refer to payments above that necessary to have a good or service provided; a rent-seeking firm is trying to achieve profits higher than what a competitive market would need. Firms will lobby, make political contributions and use the voting influence of its workers and owners to obtain legislation that is preferential to their company at the expense of consumers and/or taxpayers. Since the 89 benefit to firms on an individual level is much higher than the cost to consumers on an individual level, rent seeking often occurs in markets with government intervention. Firms wish to minimize regulation and intervention that hurts profit, and encourage regulation and intervention that helps profit. Consumers, workers and firms respond to incentives and penalties – the government encourages some behaviors and discourages other behaviors with many of their policies. Sometimes these effects are not what politicians anticipate. Moral hazard refers to a situation when a contractual agreement between parties alters the behavior of a participant in ways that shift cost to the other participant or participants. For example, some economists claim that the presence of FDIC encourages banks to engage in more aggressive lending and consumers to ignore bank risk in favor of higher interest rates because they know that the government will cover accounts if the banks fail. The protection provided by the government encouraged greater risk taking by the other participants in the program – that risk taking increased the cost of the program to the government. Let us examine some common government intervention programs to see the options available to government, the new incentives in place and how public choice may play a role. Safety Nets The unequal distribution of income can be a serious problem in the economy – some individuals will not have the financial resources needed to buy the necessary goods and services to maintain an acceptable standard of living. Safety nets refer to government programs to maintain a minimal standard of living for households. These include Social Security, welfare, unemployment compensation, food stamps and TANF. Many of these programs have assisted large numbers of Americans and saved them from the direst of poverty – many of these programs have been politically controversial. The Social Security Act of 1935 put in place a mandatory system where younger workers pay taxes into the system to support elderly retired workers with the promise that the next generation will pay to support them. Over the years the nature of Social Security has expanded – more people qualify; we now include dependents of workers and disabled workers and the basic philosophy of Social Security as a supplement to private savings has shifted to a minimal living income. Social Security taxes are collected both from current workers and their employers and the percentage taken has had to increase significantly over the last 25 years as people are living longer and Medicare expenses have risen. Some conservative economists argue that private savings and pensions have been reduced in attractiveness by the availability of Social Security. Workers would rather have and use their money today counting on Social Security to take care of them in retirement. Martin Feldstein, who was the chair of the Council of Economic Advisors under President Reagan, claimed that Social Security was a major culprit in the decline of the American savings rate for this reason. Other conservative economists have argued that private financial investment would on average yield a better return for the dollar than Social Security. The desire to take care of workers who have not paid enough into the system to receive the benefits they badly need brings down the return for the average worker. In response to this, proponents of the system point out that none of 90 us know if we will be one of those workers who will need more benefits – Social Security is a form of disability insurance as well as a retirement program. By taking care of a dependent after the worker’s death, Social Security is a form of life insurance as well. We don’t expect to get back what we pay into an insurance program – why should we expect Social Security to be different? In addition, the yield in private financial markets, such as the stock market, varies enormously from year to year. Look at the number of investors who have lost a large percent of their retirement portfolios in 2000-2003 of the stock market (including your economics professor). Social Security is the “safe” aspect of retirement – even if the company misuses your pension fund, even if your stock portfolio gets hit by an Enron, you still have Social Security. Social Security is a clear demonstration of public choice. As the number of retirees and people near retirement has increased, it has become harder and harder to make changes in Social Security that work against recipients. As a consequence Social Security has been the one transfer program to remain largely untouched by politicians. Older individuals tend to have a higher than average voting participation rate and a cut in Social Security benefits or increase in the Medicare co- payment will have a big difference on their lives, therefore they aggressively lobby. The American Association of Retired Persons, AARP, has reduced its membership age several times in order to increase its membership and hence political clout. Clearly, Social Security will not be able to provide the level of benefits to the baby boom generation as to previous ones – there are not as many workers in the next generation relative to the baby boom as the baby boom were to the generation before them. But, attempts to decrease benefits or slow down the rate their grow have been hard fought. Politicians are very reluctant to touch Social Security, particularly if they are from states with a large retired population, such as Florida. Poverty rates among the elderly are the lowest they have ever been, and many recipients are well off. On the other hand, programs to aid children, particularly low income children, have been cut or at least eroded by inflation. This is not surprising in public choice theory, as children do not vote and low-income adults have little money for lobbying coupled with a lower voting participation. Poverty rates among children are returning back to the level they were in the early 1960s – we have lost almost all the gains made during the 1960s and 1970s. Some liberal economists and politicians have suggested that we are, in effect, transferring income from the young to the old. Welfare and Aid to Families with Dependent Children have both been accused of encouraging adults not to work and not to acquire necessary training and education. Conservative economists and politicians have claimed that such programs create a permanent dependent underclass; while the first low paying job may compare poorly to government programs, as someone works and acquires experience their opportunities and income rise. Since these individuals never put their foot on the first rung of the ladder, they never climb out of poverty into independence. More liberal economists and politicians point out that the majority of individuals receiving these entitlement benefits are on them temporarily – typically less than two years. They also argue that climbing one’s way out of poverty is a good deal harder than conservatives claim. Both these programs have been radically altered in the last ten years. Welfare reform limits the time that individuals may spend on the program to two years at a time and a maximum of five years over their lifetime. AFDC has been changed to the Temporary Assistance for Needy Families which requires participants to work or participate in some kind of job training in order to receive benefits. Some states are now adjusting entitlement programs to discourage out of wedlock births – including counseling on the importance of marriage or changing benefit levels. It is ironic that in the early days of welfare the opposite incentive played a role – women and their children could not receive benefits if there was an able-bodied man in the household. The 91 resulting rise of female headed households in the US during that time period should come as no surprise. Again, as poverty rates have fallen, low income households have become politically marginalized and policies targeting the poor have generally failed to keep up with inflation, been cut, or redefined to meet other political/social goals. Regulation and Externalities. In a free market system, we will overproduce goods with external cost, such as pollution. Since firms do not pay the full cost of production, they see this good as more valuable than society does. Government can intervene to help reduce external cost production with taxes or regulations. Many economists have suggested that absolute pollution controls or taxes are inefficient. In these plans we would limit the amount of pollution that firms in an industry can have or tax if they don’t reduce pollution by a set percentage. The problem is that different sources of pollution have different consequences and require a different level of resources to clean up. For example, it is habitually estimated that 90% of auto emissions are coming from 10% of the vehicles on the road. A very expensive improvement to the emissions of new cars will have less impact than a much more modest and less expensive improvement to heavily polluting older cars and large trucks. Efficient policies will enable us to reduce pollution the most for the least cost. One possibility is to establish the overall level of pollution we are willing to accept from an industry and issue each firm “permits” for a certain share of that total. Firms that pollute less can sell the extra allowance to other firms. Firms that can more easily and cheaply reduce pollution have an incentive to do so because they can make money selling the permits. Other firms can save money by buying the pollution permits and keep production and jobs up. Overall, pollution drops by the desired amount with the least disruption to production and jobs as well as the least increase to consumer prices. They are also more acceptable to the industry than more draconian measures. Economists have been very supportive of this policy but it is often opposed by environmentalists and the general public as a ploy to allow rich firms to pollute. In a free market system, we will underproduce goods with external benefit such as education. Since firms do not receive the full value of production, they see this good as less valuable than society does. Government can intervene to help increase external benefit production with subsidies or providing these goods itself. Some economists and politicians have suggested that across the board subsidies or state provision is not efficient – that it is divorced from performance and that not all providers have equal value to society. The value to society of increasing a group of future workers’ skill from none to low is greater than increasing another group from very high to extremely high. Funding of local schools in depressed economic areas will lag even though society would probably benefit the most from an expansion of education in those areas. The government is unlikely to make up the difference since an economically depressed area will have little economic or political clout. Government provided education is more likely to be responsive to the dictates of the politicians than the desires of employers, students and student families. Journal Topics: Complete the following assignment: 1. Vouchers have been suggested as a way of improving the provision of education. Analyze the situation from both a pro and con point of view. 2. Find and summarize 2 web pages on contestable markets.