Agricultural Economics H. Evan Drummond John W. Goodwin Third Edition......

Transcription

1 Agricultural Economics H. Evan Drummond John W. Goodwin Third Edition......

2 Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: Pearson Education Limited 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN 10: ISBN 10: ISBN 13: ISBN 13: British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Printed in the United States of America

3 A product that is basically homogeneous but is subject to minor product differentiation through techniques such as location, advertising, spice blends, additional services, or frequent flyer programs. (What real difference is there between Exxon and Shell or between Delta and United?) Conduct The decisions as to pricing and output by each oligopolistic firm will have a definite impact on the volume of sales and profits realized by all other firms in the industry. Thus, any time one oligopolistic firm changes its pattern of operations, it is a pretty good bet that the competing oligopolists who share that market are going to retaliate. It is this interdependence of firms in the industry that is the distinguishing characteristic of the oligopoly market structure. A classic example of oligopoly is provided by the retail gasoline industry. Almost every community has at least two service stations that are affiliated with different oil companies. If one should attempt to increase its volume of sales by cutting the price of gasoline by a few cents per gallon, what happens? We all know from experience (pleasant experience, unless you happen to own a filling station) that a full-scale price war may well be in the making. Price wars, a form of competitive retaliation, are characteristic of oligopolistic industries. In perfect competition, producers and consumers are passive price takers. Not so in the case of oligopoly. The chieftains of oligopolistic firms spend lots of time looking over their shoulder to see what their competitor is doing and plotting how to react to any changes that occur. Oligopolies live in a world of action and reaction action and retaliation. It is a highly visceral form of competition. Managers in an oligopolistic industry are apt to be very, very cautious about reducing prices. They must consider the impact that their actions will have on their rivals and the retaliatory measures that those rivals may adopt. Rather than competing on the basis of price, firms operating under oligopolistic conditions are more likely to rely on advertising and devices such as special services, frequent flyer programs, or trading stamps, since the reaction to these techniques is generally less immediate and less disastrous than the reaction to a price reduction. In a long-run equilibrium situation, each competing oligopolist will have a market share that all participants in the market perceive to be normal. Prices tend to be uniform among the firms in the market, and prices are very sticky that is, not prone to change. At that normal volume of sales, if the oligopolist firm increases its price, its customers desert it fleeing to its rivals who are charging lower prices. If it lowers its price, its rivals respond to this action with price reductions of their own, and all the competing oligopolists simply pick up their normal share of the increased volume sold in the total market. Game Theory Perhaps the best way to understand the behavior of an oligopolistic firm manager is through the use of game theory. Game theory emphasizes firm behavior in an interdependent, noncooperative environment of action and reaction. Each action is viewed as having a payoff (profit) that depends not only on what action the firm takes but also on the reaction of the competitors. To keep things simple, let s assume we have an industry with two firms selling grain on the world market Cargill and Archer Daniels Midland (ADM). Each firm must make a pricing decision whether to price the grain it offers for sale at a high price or at a low price. Based on experience, the managers know what happens to profits in each of the four pricing possibilities shown in Figure

4 Figure 8 Payoff matrix for two interdependent oligopoly firms. Cargill s Price ADM s Price Cargill s Profit ADM s Profit High High High 18 6 High If Cargill opts for a high price and ADM matches its high price, then they both earn 14 and the total profit between them is 28 the highest total profit possible. But if Cargill opts for the high price, ADM can improve its lot from 14 to 18 by selecting a low price and buying market share away from Cargill. In this case, Cargill s reaction is clear: it can earn either 6 with high prices or 8 by matching the low price of ADM, so they both end up with low prices and total profits of 16. Clearly, it is in their joint interest that both select high prices, and they both know that. But how far do you trust your competitor to work in your joint interests rather than in his or her individual self-interest? If either foregoes high prices, the other will also and they are equally worse off. When one firm in the industry lowers its price, the others will retaliate by lowering theirs to protect their market share. Price reductions are always matched; however, price increases may or may not be. This illustrates another characteristic of oligopoly market structure the existence of price leaders. On any given day, American, United, and Continental airlines all charge the same fare on the very competitive New York to Los Angeles route. One day the price leader, American, announces a 5 percent increase in its fares on that route. How do United and Continental react? They both realize that if they go along with American, they will be 5 percent better off with constant market shares. Suppose United goes along and increases its fares by 5 percent. Now Continental is in the catbird seat. It must weigh the advantage of a 5 percent fare increase against an expected increase in market share if it doesn t go along. After much thought, Continental decides a 10 percent increase in market share at existing prices is better than a 5 percent fare increase at existing market shares. What must United and American do now? Each realizes that it stands to lose market share to Continental. Reacting to Continental s move, they both will have to announce that they have rescinded the 5 percent fare increase immediately. This kind of interdependent action-reaction pricing goes on daily on hundreds of airline routes and at thousands of gas stations. GOVERNMENT REGULATION The game theory illustration shows that competition among oligopolists inevitably leads both companies to accept low prices and hence low profits. This less-thandesirable result (from the perspective of the oligopolists) became very obvious to the robber barons of the late 19th century. The industrial revolution led to the development of large corporations. The titans of these industries quickly learned that competition was not in their best interest and that profit could be increased if they cooperated with one another. There were basically two approaches to avoiding competition, illustrated by the railroads and Standard Oil. Railroads The rail bosses learned early on that competition was not in the best interest of either party, so they simply engaged in collusion to divide the market into geographic districts with the understanding that no one would invade another s territory. That 126

5 made each rail tycoon a local monopolist in the designated area, able to earn monopoly profits because entry was blocked by the secret agreement. These agreements among owners of independent railroads became known as trusts. They were very effective at creating a number of rail millionaires who depended on the power of the trust to maintain their local monopolies. Trusts noncompete agreements among oligopoly firms. Standard Oil John D. Rockefeller was facing the same problem in the oligopolistic petroleum industry about the same time. His approach was a little different. If another firm attempted to compete with Standard Oil, Rockefeller would simply merge the competitor into Standard Oil and, thus, regain control of pricing. Over time, Rockefeller merged with most of the competition, turning Standard Oil into a near monopoly in the petroleum business. The basic philosophy here is that it is better to merge and cooperate than to compete. Antitrust By the late 1880s, it was clear that the public interest was not being served by the railroad trusts and other monopolists. Particularly disadvantaged were the farmers streaming into the Great Plains, who were totally dependent on the railroads to ship their crops to the markets in the East. Agrarian unrest finally led to the passage of the Interstate Commerce Act regulating railroads in This act required railroads to publish and post freight rates, and it created the Interstate Commerce Commission to regulate those rates to be certain they were reasonable and just. Three years later, the Sherman Antitrust Act made mergers that create monopolies illegal and prohibited practices that result in a restraint of trade. These acts and subsequent legislation are known collectively as antitrust legislation. Today, these laws are still on the books. They prohibit price fixing, collusion, and other anticompetitive activity. Proposed mergers that might restrain competition must be approved by the Federal Trade Commission a regulatory branch of the federal government. So, while it would be in their collective best interest for Cargill and ADM in Figure 8 to get together and agree on high prices, it would, under current antitrust law, be illegal to do so. Antitrust laws prohibiting business behavior that threatens competition, such as price-fixing, collusion, and anticompetitive mergers. Natural Monopolies We saw earlier that some monopolies are in the best interest of the public. We call these natural monopolies. They usually occur in industries with very high fixed costs such that if two or more firms divided the market among themselves, the cost to the consumer would be higher than if a monopoly provided the service. From an economic perspective, a natural monopoly is a firm operating on the downward-sloping portion of the average total cost curve. Examples of natural monopolies include the utilities (gas, water, sewer, electricity, garbage, cable, phone, and so on), mass transit, airports, and the like. In the case of a natural monopoly, the best public policy is to grant a franchise to the monopoly firm giving that firm exclusive rights to provide the service as a monopolist. In return, the franchisee is limited to charging consumers no more than its average total costs of production (including normal profits). State and local governments usually have regulatory commissions that are responsible for making certain the franchised monopoly provides the required service and that the prices charged are reasonable. In this way, consumers get the advantages of the natural monopoly without paying for monopoly profits. Natural monopolies high fixed-cost industries in which the costs of a monopoly firm are lower than would be the costs of several competitive firms. 127

6 Marketing Orders in Agriculture In 1937, Congress passed legislation that allows the secretary of agriculture to create marketing orders to regulate processors or handlers (e.g., packers) of highly perishable agricultural commodities. The marketing orders were created because farmers of perishable commodities (fruits, vegetables, and milk) felt that processors or handlers of their products were taking advantage of farmers who had little market power. Marketing orders are requested by a vote of farmers and imposed on the processors or handlers. The orders basically require the processors to collude on behalf of the farmers and exempt them from antitrust when they do so. This, of course, is detrimental to the consumer of products that are processed under marketing orders. The most common elements of marketing orders are uniform grades and standards and flow control mechanisms. Marketing orders in agriculture are very controversial. In any other industry, such behavior would fall under antitrust scrutiny. In the last couple of decades, the number of marketing orders has been declining as secretaries of agriculture have canceled orders considered to be no longer necessary for orderly marketing. Nonetheless, virtually all milk processed in the United States is processed under the directives of a marketing order assuring both farmer and consumer of high milk prices. SUMMARY Market structure refers to the number of firms in an industry and relationship among them. The only market structure that has been examined to this point is perfect competition. In this chapter, some of the restrictive assumptions of the perfectly competitive model are relaxed in the examination of three additional market structures. In each case, we will find that the market structure determines the conduct of the typical firm in the industry. Monopoly is a market structure in which there is only one firm in the industry. In order for a monopoly to exist there must be no close substitutes for the product and there must be barriers to the entry of additional firms to the industry. The most common form of barrier to entry is a patent on the product. The cost structure of a monopoly is identical to that of a perfectly competitive firm. The revenue side of the firm is very different, however. Since the demand curve of the market is the demand curve of the firm, the firm faces a downward-sloping demand curve such that if the monopoly firm changes its level of output, the price that it can command in the market will change. The market demand curve is the firm s average revenue curve. The marginal revenue is also downward sloping and lies below and to the left of the average revenue curve. As with any other profit-maximizing/loss-minimizing firm, the monopolist adjusts output to that level at which marginal revenue is equal to marginal cost. At that level of output, the average revenue (demand) curve shows the price that can be charged. In most cases, the monopoly firm will earn economic profits beyond average total cost, but being a monopoly does not guarantee economic profits. The unique characteristic of a monopoly is that because of the barriers to entry, the firm can earn economic profits in the long run as well as the short run. In most cases, monopolies result in higher prices and lower quantities traded than would be the case in competition. However, there are two situations in which monopolies can be justified. Local monopolies are those that exist in markets so small that having more than one firm is not economically viable. Many rural farm towns can support only one feed store, so that store becomes a local monopoly. A second type of acceptable monopoly is called a natural monopoly. These exist in industries with high fixed costs such that the monopoly firm produces in the downward-sloping portion of the average total cost curve. In this case, if the market were split in two, both firms would have higher costs than the monopolist. Natural monopolies are usually found in the utilities such as electric, gas, and water. In the case of a natural monopoly, the appropriate public policy is to grant the monopoly firm a franchise and then regulate the price charged to the customers. Monopolistic competition is a market structure that is very common in many consumer goods. As its name implies, this is a structure with some characteristics of monopoly and some characteristics of competition. In 128

7 the short run, the firm behaves as a monopolist, and in the long run, the firm behaves as a competitor. There are typically a few or many firms in the industry, and entry is easy. The key and distinguishing characteristic of this market structure is product differentiation. The firm seeks to differentiate its product by adding features that competitors products do not have. At the time a new feature differentiating the product is introduced, the firm has a monopoly on that product feature. As competitors match the feature, the short-run monopoly position is lost. Features that are frequently used to differentiate include brand names, minor ingredients, packaging, and products designed for a segment of a market. A product as mundane as laundry detergent is subject to product differentiation. Almost every year, the market leader comes out with a new and improved product. Then it is up to competitors to match the improvements and recapture market share. If the differentiating feature can be patented, then the firm has the prospect of a longer-term monopoly position. Then competitors will have to trump the patent with an even better product a practice that is common in the pharmaceutical business. As with a monopolist, in the short run, the firm is the market and the firm adjusts output to equate marginal revenue and marginal cost. Price is the average revenue at this output level. As other firms enter the market, the monopolist loses market share, and the average revenue curve shifts downward, reducing the amount of economic profits earned. This process continues until there are enough firms in the market to drive the price down to the average total cost of each firm such that there are zero economic profits. In the terminology of marketing, the product has matured. In the short run, the firm is a monopolist and is able to charge monopoly prices that generate economic profits to the firm. Long-run competition drives prices down to the average total cost, and economic profits disappear. While consumers pay more in the short run, they are continuously provided with more and more product features. An inevitable consequence of this market structure is advertising. A third form of imperfect competition is called oligopoly. In an oligopolistic market structure, there are few firms, but those firms are able to saturate the market. The product is fairly homogeneous (in spite of great efforts to differentiate it). The distinguishing characteristic of oligopoly market structure is that the firms are interdependent. A classic example of an industry characterized by oligopoly is the airline industry. If one airline lowers its price on a route, other airlines will react by making similar price reductions. If one airline increases the price on a route, others might match the increase or not. If they don t match the increase, then the airline initiating the increase will rescind it or face the prospect of losing market share. One approach to evaluating the behavior of firms in an oligopoly is game theory. This is a mathematical technique that can be used to explain the rational behavior of interdependent firms. In most cases, the interdependent behavior of oligopoly firms is not consistent with the collective best interest of all firms. As a result, the potential returns to collusion, price fixing, and other noncompetitive behaviors among oligopoly firms are substantial. Since economic returns to noncompetitive behavior can be very substantial, a network of federal laws known as antitrust laws has evolved to protect the consumer from noncompetitive behaviors. Practices that are prohibited include collusion, price fixing, lowering prices to run competitors out of business, and mergers to eliminate competition. A form of government-sponsored imperfect competition that is unique to agriculture is called marketing orders. Marketing orders are government directives imposed on the processors of perishable commodities that require the processor to behave in the best interest of the producer (the farmer) rather than the self-interest of the processor. The net effect of marketing orders is to create cartels, which ultimately result in higher prices to consumers and higher returns for producers than would exist in a competitive realm. In recent years, several marketing orders have been eliminated. KEY TERMS Antitrust Conduct Differentiated products Market structure Monopolistic competition Monopoly Natural monopolies Oligopoly Patent Trusts 129