Economics 2023-02

1. Economics 2023-02 Class 17

2. Today’s class • We begin talking about different market structures, which are closer to the real world than the ideal type ‘perfect competition’ • We begin by reviewing perfect competition, and then define our other ideal types • The major market structures we will address are monopoly, oligopoly, and monopolistic competition. We begin with detail on the other ideal type, pure monopoly. • It will take us today and next week, three classes, to cover chapters 10 and 11.

3. The Perfectly Competitive Firm Is a Price Taker (Recap) The perfectly competitive firm has no influence over the market price. It can sell as many units as it wishes at that price. Typically, a "perfectly" competitive industry is one that consists of a large number of sellers, each of which makes a highly standardized product.

4. Which of the following is sold in a market most closely resembling perfect competition? • Milk in Tallahassee • GM stock on the New York Stock Exchange • Pickup trucks in Atlanta • Haircuts in Tallahassee • Tickets for final four NCAA basketball games

5. Corn Production

6. Profit-maximization for the perfectly competitive firm Profit = Total revenue - total cost Q. How much output should a perfectly competitive firm produce if its goal is to earn as much profit as possible? A. It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost.

7. The marginal benefit of expanding output by one unit is the market price; we call that Marginal Revenue, MR. The marginal cost of expanding production by one unit is the firm's marginal cost at its current production level.

8. Example 17.1. If this grower can sell as many bushels of corn as he chooses to at a price of $5 per bushel, how many bushels should he sell in order to maximize profit?

9. The profit-maximizing quantity for the perfectly competitive firm is the one for which price = MR = MC.

11. Kinds of “Imperfect Competition” Monopoly = "single seller" Oligopoly = "few sellers" Monopolistic competition: Many sellers, each with a differentiated product Differentiated product means there is some [real or asserted] difference between what one seller provides and what others do.

12. Monopoly: Comcast Cable in the Tallahassee market for cable TV service

13. Oligopoly: The market for wireless telephone service T Mobile Cingular

14. Monopolistic competition: Local gasoline retailing

15. Monopolistic competition: Convenience Stores

17. How come not perfect competition? • There are two basic possibilities: • Goods or services are easy to differentiate, i.e. not ‘homogeneous;’ A few commodities are homogeneous [e.g. No 8 Winter Wheat], but most are not [gasoline is ‘branded,’ bread is somebody’s kind of bread, not somebody else’s]. • Many markets have ‘barriers to entry’ – i.e. there are things that make it difficult for firms to enter the market, so the firms in it can grow large relative to the market. Once a firm is large relative to the market, it is no longer a ‘price taker’ because how much it sells will affect market price. • Our next step is to look at sources of market power – i.e., the barriers to entry.

18. Five Sources of Monopoly 1. Exclusive control over important inputs Example: Perrier's mineral spring

19. 2. Economies of Scale (Natural monopoly) Example: Local land-line telephone service

20. Natural Monopoly and Economies of Scale • A ‘Natural Monopoly’ is an activity where the fixed costs of the firm are so large relative to variable costs that ATC, average total cost, falls over the whole of the relevant range of output. • This implies that once a firm is established, its ATC will be lower than any new entrant’s, so it can always undercut the new entrant and keep the whole market. • A good example is household water supply in cities. Who would lay a second set of pipes?

21. 3. Patents Example: Prescription drugs

22. 4. Government licenses or franchises Example: Burger King on Mass Pike

23. 5. Network Economies Example: Microsoft Windows

24. Sony Playstation library: Over 1000 games that will not play on other formats

25. Network economies may be thought of as a kind of economy of scale. This is jargon: an economy of scale exists when average total cost declines as output increases, i.e. as scale goes up, unit cost goes down. The most enduring source of monopoly is probably economies of scale. With growth of research and development expenses, economies of scale are becoming more important.

26. Example: First, The Old Economy Two widget producers, Acme and Ajax Each has fixed costs of $200,000, and variable costs of $0.80 per widget.

27. Acme Ajax annual production: 1,000,000 1,200,000 fixed costs: $200,000 $200,000 variable costs: $800,000 $960,000 total costs: $1,000,000 $1,160,000 cost per widget: $1.00 $0.97 Ajax, the higher volume producer, has only a small cost advantage.

28. Second, The New Economy In the new economy, fixed costs are $800,000, reflecting the growing importance of the information and ideas in the product. Suppose now variable costs are only $0.20/widget.

29. Acme Ajax annual production: 1,000,000 1,200,000 fixed costs: $800,000 $800,000 variable costs: $200,000 $240,000 total costs: $1,000,000 $1,040,000 cost per widget: $1.00 $0.87 Now Ajax has a much larger cost advantage, although its scale advantage has not changed. But this means it is more likely to be able to grow …..

30. The cost advantage becomes self reinforcing, as more and more of the market goes to Ajax: Acme Ajax annual production: 500,000 1,700,000 fixed costs: $800,000 $800,000 variable costs: $100,000 $340,000 total costs: $900,000 $1,140,000 cost per widget: $1.80 $0.67 Acme is likely to go out of business, so Ajax will become a monopoly.

31. Which of the following is NOT potentially a high fixed cost limiting entry to the market? • Advertising to overcome established brands, e.g. for soft drinks • Plant and equipment, e.g. to make automobiles • Inventory, e.g. to establish a new car dealership • Personnel, e.g. to acquire relevant experience in retail sales and marketing • All the above are possibilities

32. In the extreme … • Complex software is probably the most extreme example of economies of scale • Fixed costs, the costs to develop, write, test, the software can be very high • Variable costs, the costs of duplicating and distributing copies of the software, are very low [a few dollars at most on CD, close to zero if downloaded from the internet] • Large established software firms have an advantage; but potential profits are very attractive to new entrants with a good idea ……

33. Monopoly, oligopoly, and monopolistically competitive firms have in common the fact that the demand curves faced by individual firms are downward sloping, unlike the horizontal demand curve faced by all firms in perfectly competitive industries.

34. Jargon: For convenience, we will refer to any of these three types of imperfectly competitive firms as ‘monopolists’. When we want to refer to a market with a single seller, we will call that ‘pure monopoly.’ We will now examine the pure monopoly case.

35. The demand curve facing a perfectly competitive firm is a horizontal straight line at the market price.

36. Marginal Revenue The marginal benefit to a competitive firm of selling an additional unit of output is simply the market price. So for the competitive firm, MR = P. By contrast, the marginal benefit to a monopolist of selling an additional unit of output is less than the market price – because if the monopolist sells more, the price will go down.

37. The reason MR < P for the monopolist is that price must be reduced in order to sell the extra unit of output – that is what the downward-sloping demand curve means. The monopolist will earn less on the output sold up to that point. [unless different customers can be charged different prices – but we’ll come back to that later; for now we focus on what in jargon is called a ‘single-price’ monopoly].

38. Example 17.2. If this monopolist is currently selling 3 units of output at a price of $7 per unit, what is the marginal benefit from selling an additional unit?

39. TR from the sale of 3 units = $7*3 = $21 TR from the sale of 4 units = $6*4 = $24

40. So Marginal Revenue MR from the fourth unit = $24 - $21 = $3, which is less than both the original price and the new price.

41. Example 17.3. If this monopolist is currently selling 4 units of output at a price of $6 per unit, what is its marginal benefit from selling an additional unit?

42. TR from the sale of 4 units = $6*4 = $24 TR from the sale of 5 units = $5*5 = $25 So MR from the fifth unit is $1.

43. Example 17.4. If this monopolist is currently selling 5 units of output at a price of $5 per unit, what is its marginal benefit from selling an additional unit?

44. TR from the sale of 5 units = $5*5 = $25 TR from the sale of 6 units = $4*6 = $24 So MR from the sixth unit is -$1 - negative $1.

45. If this monopolist was producing 2 units, sold for $8 each, what would be his marginal revenue? • $8 • $7 • $6 • $5 • $4

46. If this monopolist was producing 2 units, sold for $8 each, what would be his marginal revenue? • Currently, TR = $(2*8) = $16. • Sell one more unit, price falls to $7, TR = $(3*7) = $21 • So, MR = $(21 – 16) = $5

47. The Marginal Revenue Curve for the monopolist in the preceding examples:

48. More generally, MR for any monopolist with a straight-line demand curve:

49. Algebraically, For a straight-line demand curve, if: P = a - bQ The corresponding MR curve: MR = a - 2bQ

50. [For students who know calculus, MR is the rate of change of TR with respect to quantity, so: MR = dTR/dQ If P = a - bQ, TR = PQ = aQ - bQ2 so MR = a - 2bQ ]