INTRODUCTION. Two uses of price theory: 1. Descriptive (Positive Theory) 2. Prescriptive (Normative Theory)

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1 INTRODUCTION This course covers the field of microeconomics. Microeconomics addresses individual behavior in markets and the interrelationships between markets. This is quite different from macroeconomics, which focuses on economy-wide issues. As we will see, microeconomics focuses on how prices determine resource allocation. Accordingly, microeconomics is also referred to as price theory. Resource allocation addresses the following questions: (1) What s produced?, (2) How to produce?, and (3) Who gets it? Consider the who gets it? question. What systems could be used to answer this question? Two uses of price theory: 1. Descriptive (Positive Theory) 2. Prescriptive (Normative Theory) 1

2 Underlying our discussions will be the Fundamental Premise of Economics, which simply means that individuals are rational to the extent that they can weigh the benefits and costs of various options and pick that option which gives them the highest net benefit (Net Benefit = Benefit - Cost). 2

3 DEMAND AND SUPPLY What determines the price of a product? The demand and supply model is a simple way of answering this question. Consumer Side: Demand refers to the relationship between the quantity of a good or service that consumers are willing and able to buy during a specific time period and the determinants of that amount. Depending on the issue, we may look at individual, group, or market demand. Let s look at some of the determinants of the quantity consumers are willing and able to buy. We invoke ceteris paribus. [1] Price 3

4 Other determinants: (These shift the demand curve.) [2] Income [3] Prices of Related Goods 4

5 [4] Tastes and Preferences [5] Price and Income Expectations [6] Population of Buyers 5

6 Demand Function: Example: = 100-2P A + ½I + 2P B Generalize: Market Demand = Horizontal sum of all individual consumer demands. 6

7 Producer Side: Supply refers to the relationship between the quantity of a good or service that producers are willing and able to sell during a specific time period and the determinants of that amount. Similar to demand, we may speak of an individual firm, a group of firms, or a market supply. Some determinants: [1] Price 7

8 Other determinants: (These shift the supply curve.): [2] Input Prices and Technology [3] Prices of Related Goods or Services [4] Price Expectations 8

9 [5] Environment [6] Population of Sellers 9

10 Supply Function: Example: = P A + 3P B - ½W Generalize: Market supply = horizontal sum of individual firm supplies. 10

11 What are the market price and quantity? We determine this by solving for the market equilibrium. Equilibrium = A condition, which once achieved, tends to persist. 11

12 Comparative Statics: What happens if demand and/or supply shift? Consider some different scenarios: [1] Drought in California: impacts on water and tomato markets [2] Increase in the price of beef: impact on pork market (assuming beef and pork are substitutes in consumption) [3] Increase in the price of soybeans: impact on the corn market (assuming soybeans and corn are substitutes in production) 12

13 Consider a numerical example: Suppose the market demand and supply of beef are given by the following: Demand: Supply: where and are the quantities demanded and supplied of beef (in pounds), respectively. P B is the price of beef (in dollars), I is per capita consumer income (in dollars), and P C is the price of corn (in dollars). A. Currently, per capita consumer income is $50,000 and the price of corn is $4. Let s sketch the current market demand and supply curves for beef (being careful to determine the values of the horizontal- and vertical-axis intercepts) and determine the market equilibrium price and quantity of beef. B. Now, suppose per capita consumer income doubles to $100,000. Let s illustrate the impact on the beef market. 13

14 What if both demand and supply change? Then it gets a little more difficult predicting the outcome. Consider: 14

15 How can governments influence a market? Consider two cases: [1] Price Controls [2] Taxes (we ll focus on the consumer side) Excise Tax - In this case, consumers are charged $t per unit consumed. 15

16 ELASTICITY A very useful tool to a decision-maker is elasticity. Elasticity provides us with a tool to measure the effect of different factors on demand and/or supply. Consider the function: Y = f(x). In general, the elasticity of Y with respect to X equals: with and such that Interpretation: Consider: Y = 10-2X. 16

17 One problem is that the elasticity value depends on whether we move up or down the curve. To get around this problem, we will calculate the point elasticity. Point elasticity - rather than deal with large changes in X and Y, we deal with infinitesimally small changes, which in effect calculates the elasticity at a point on the curve. In this case, 17

18 Demand Elasticities: Price Elasticity of Demand å p = Point: Consider: Q = 100-2P 18

19 Categories of elasticity: A. Elastic: å p < -1 B. Inelastic: -1 < å p < 0 C. Unit Elastic: å p = -1 D. Perfectly Elastic: å p = - E. Perfectly Inelastic: å p = 0 Notice, with the linear demand equation above, the price elasticity varies along the curve. In the upper half, it is elastic. In the lower half, it is inelastic. At center, it is unit elastic. 19

20 Consider some price elasticities: Product Price Elasticity Cigarettes Beer Marijuana Horse Racing Fresh Tomatoes Housing Factors affecting å p : 1. Number and closeness of substitutes 2. The degree of necessity 3. The percentage of overall consumer expenditure dedicated to the good 4. Length of time over which consumers respond to price changes 20

21 One use of the price elasticity of demand is to infer the effect on total revenue (P x Q), which is the same as total expenditure of consumers, of a price change. For a firm, is it always best to increase its price? A knee-jerk reaction might be to say yes, but the answer depends on å p. Scenarios: 1. å p < < å p < 0 3. å p = -1 21

22 These three situations suggest a relationship between Q and TR, which is given below: For a firm interested in maximizing its profit, it should never operate in the inelastic region of its demand. Why? 22

23 Other Demand Elasticities: Cross Elasticity of Demand Point: Cases: Application: Market Definition and Antitrust - Du Pont (1947) 23

24 Income Elasticity of Demand å I = Point: Cases: 24

25 Consider a demand function: 25

26 Supply Elasticities: Price Elasticity of Supply (å S ) å S = Point: Similar categories with demand: Elastic, Inelastic, and Unit Elastic. Examples: 26

27 What Affects the Value of ç S? 1. Length of time over which producers respond to price changes 2. Substitutability of Inputs (Resources) across Production: 3. Possibilities of Storing the Product 27

28 THEORY OF THE CONSUMER Since demand addresses consumer behavior, several theories have been offered to explain consumer behavior. Consumer theory focuses on preferences. Also, consumers derive satisfaction (utility) from the consumption of goods or services. Three key assumptions: Completeness Transitivity Non-Satiation 28

29 Now, there are two approaches to address the theory. One is the cardinal approach, while the other is the ordinal approach. We will focus on the ordinal approach. Key to the ordinal approach is to model preferences with indifference schedules and indifference curves. Indifference schedule = Listing of different bundles that bring an individual the same satisfaction (i.e., utility). Consider an individual who can consume either milk and/or bread: Group 1 Indifference Schedule Group 2 Indifference Schedule Bundle Milk Bread Bundle Milk Bread A 10 qts 0 loaves E 12 qts 0 loaves B 7 1 F 10 1 C 5 2 G 8 2 D 4 4 H 6 4 Graph: 29

30 Properties: [1] Provided we are looking at two goods (i.e., two products for which more is preferred to less (non-satiation), then bundles on higher indifference curves coincide with greater utility. That is, utility higher indifference curves correspond to higher utility. [2] For two goods, indifference curves have a negative slope (due to non-satiation). 30

31 [3] Indifference curves cannot intersect each other (due to transitivity). [4] Indifference curves must pass through every point in the commodity space (due to completeness). 31

32 [5] Indifference curves are convex to the origin (due to the Law of Diminishing Marginal Utility). From the cardinal approach: According to the Law of Diminishing Marginal Utility, although total satisfaction increases as more of a good is consumed (i.e., non-satiation), the increases in satisfaction associated with additional consumption must eventually diminish. Consider: Number of times eat chicken for dinner per week Total Utility Marginal Utility 0 0 utils Now, Marginal Rate of Substitution (MRS) = The rate at which a consumer is willing to trade the consumption of one commodity for another, while maintaining satisfaction. It is an indication of the relative importance the consumer attaches to one commodity relative to another commodity. MRS = slope of the indifference curve < 0 Or, So, if indifference curves are convex, then MRS (in absolute value) falls as we slide down the indifference curve. 32

33 It turns out: How much bread and milk will the individual consume? We need to bring in the consumer s budget constraint. That is, I = income = budget = 33

34 Equilibrium of the consumer: Following the Fundamental Premise of Economics, consumers seek to maximize their satisfaction subject to the budget constraint. That is, Given a budget and prices, consumers will choose to consume somewhere on their budget line. Why? Where is the best point? That is, given the consumer will lie on the budget line, which bundle yields the highest satisfaction? 34

35 That is, the budget line will be tangent to the indifference curve at the best bundle possible. Or, 35

36 What happens if income or prices change? Price-Consumption Curve and Income- Consumption Curve: 36

37 Recall when the price changes, the consumer changes consumption because of the substitution effect and the income effect. Let s formalize this in terms of ordinal utility theory. Suppose the price of bread increases, graphically The substitution effect is the change in quantity purchased attributable to the change in price, independent of the gain of loss in utility. The income effect is the change in quantity purchased that is attributable solely to the gain or loss in utility. Graphically, 37

38 Derivation of individual demand: 38

39 THEORY OF THE FIRM In this next section of the course we will get behind the supply curve. That is, we will address the production of a good or service. A firm is an organization that uses inputs to produce outputs. What are the goals of a firm? But the choices available to a firm are limited. For example, profit is constrained by market demand, input supply, and technology. Now, as we said, firms use inputs to produce output. This is reflected in the production function, given by: Example: Q = X 1 + 3X 2 Note: Just like demand and supply, the time period is important. Key to the time issue is the substitutability of inputs. Couple assumptions: 1. Technology is given. 2. Firms operate efficiently. 39

40 Role of time: Depending on the time frame, some inputs may be fixed. For example, consider weekly production of a textile mill. It must make choices knowing that the number of looms it has are fixed. Yet labor may be variable. If, instead, we looked at production on a minute-by-minute basis, all inputs may be fixed. We capture the role of time by splitting it into two periods: the short run (SR) and the long run (LR). SR = a period of time short enough that at least one input is fixed. LR = a period of time sufficiently long that all inputs are variable. So, we have fixed and variable inputs, depending on the period of time we are looking at. 40

41 For simplicity, let s collapse all of our inputs down to just two: capital (K) and labor (L). Let s look at a fictitious newspaper company. Start with daily production, assuming this is the short run. So, Q = number of newspapers produced per day L = number of workers employed per day K = number of printing presses used per day - assume fixed at 3 Q (TP) L K AP MP

42 General shapes: 1. If MP > AP, AP is rising. 2. If MP < AP, AP is falling. 3. MP = AP at maximum of AP. 4. It is irrational to operate where MP < Law of Diminishing Marginal Returns: As additional units of a variable input are combined with a fixed input, at some point the additional output (MP) must diminish. In our case, diminishing returns begins with the hiring of the 5 th worker. 42

43 We can use production functions to help us figure out the optimal amount of an input to use. Consider a cement company interested in hiring the optimal number of workers per day. Currently, it receives $15/ton for its cement (output price), and pays a typical worker $30/day (input price). Suppose it is currently employing 20 workers, and the marginal product of the 21 st worker is 4 tons of cement. Should it hire the 21 st worker? Instead, suppose the firm is employing 30 workers, and the marginal product of the 30 th worker is 1. What should it do? 43

44 Define: Marginal Revenue Product = change in total revenue due to a change in an input. In our first example, MRP = $60. In our second example, MRP = $15. Rule: If P INPUT < MRP INPUT, then hire more of the input. If P INPUT > MRP INPUT, then hire less of the input. So, to maximize profit, the firm should hire to the point where P INPUT = MRP INPUT. In our example, the marginal revenue product of labor equals (Note: This assumes that the firm is purely competitive (also called perfectly competitive), which we will address later.): 44

45 Long Run Production: Now, let s suppose that the time interval for production decisions is sufficiently long that all inputs are variable (i.e., the long run). Consider an example of a firm that cuts chords of wood. It is interested in daily production, which is sufficiently long that its inputs (chain saws (K) and labor (L)) are both variable. Let s look at the production table: Notice: There are more choices on how to produce a given output. That is, when we move the long run, the there are less constraints on production. Consider, for example, that K were fixed at 6, then there would be only one way to produce 16 chords of wood (hire 2 workers). Now, with K and L variable, there are two ways to produce 16 chords of wood. So, the key to the long run is the substitutability of inputs. If one chooses to maintain production, they can trade off one input for another. What should guide your decision? Should you be labor-intensive or capital-intensive? Notice that the table does illustrate some short run issues. Namely, if we hold one input fixed and vary the other input, then marginal product is positive and the firm is encountering diminishing returns. 45

46 Let s graph the production table: This leads to a series of isoquants ( same quantity ). Each isoquant represents a different level of production. Properties of isoquants: Higher isoquants yield greater output. Why? MP s > 0 (rational firms) 46

47 Isoquants have a negative slope. Why? MP s > 0 Isoquants are convex to the origin. Why? Law of Diminishing Marginal Returns. Define: Marginal rate of technical substitution (MRTS) = slope of the isoquant. The MRTS represents the rate of tradeoff of one input for another, such that production is maintained at a certain level. 47

48 Note: So, by being convex to the origin, the MRTS (in absolute value) falls as we slide down the isoquant. Also, Let s see why. Consider the isoquant below: Imagine moving from point A to point B. But do it in two steps, via point C. Consider step 1: Holding K constant, we increase L, leading to a higher isoquant (and therefore a higher production). Consider step 2: Holding L constant, we decrease K, leading us back to the original isoquant (and therefore a lower production). 48

49 So, it must be that the increase in Q in step 1 (+) is offset by the decrease in Q in step 2 (-). Or, Or, + - Or, So, why is the isoquant convex? Diminishing returns. 49

50 When we speak of long run production, we characterize production by returns to scale. Three types: Increasing returns to scale (economies of scale) Decreasing returns to scale (diseconomies of scale) Constant returns to scale Cobb-Douglas Production Function: 50

51 How should we select the optimal combination of capital and labor? In addition to the isoquant (production), we will need to look at the relative costs of the two inputs. This is captured by the isocost ( same cost ) line Isocost = all combinations of variable inputs that yield the same cost (outlay). Note: M = total outlay = Example: Monthly outlay with P L = 1000 and P K = 500 (price per input per month) So, M = 1000L + 500K Now, what if we had $10,000 allocated in expenditure? What combinations of K and L could spend $10,000? Graph: In general, for a given M, the equation of the isocost is: 51

52 What happens when M, P L, or P K change? How select the inputs? Note: This assumes a purely competitive firm. Two approaches: A. Minimize the expenditure given some output. That is, produce an output as cheaply as possible. B. Maximize the output given some expenditure. That is, produce the most from some given outlay. Both A and B are centered on maximizing profit. 52

53 Let s simply consider A. Both A and B lead to the same input combination. Look at the following graph: The best combination of K and L is where the (given) isoquant is tangent to the isocost. That is, they have the same slope. Slope of Isoquant = Slope of Isocost = So, the best combination of K and L is where 53

54 That is, equate the marginal products per dollar. If, then increase L and decrease K. If, then decrease L and increase K. So, if you have many inputs, determine optimal mix by finding: 54

55 Cost: How are production and cost related? Intuitively, greater production coincides with greater cost. Now, economists view costs differently from accountants. Two types of costs: 1. Accounting Cost (Explicit Cost) Accounting profit (Að) = total revenue - accounting cost 2. Opportunity Cost (Implicit Cost) Economic cost = accounting cost + opportunity cost Economic profit (Eð) = total revenue - economic cost = total revenue - (accounting cost + opportunity cost) = Að - opportunity cost Economic profit guides decisions. Consider a farmer. The farmer can grow corn or wheat. By growing corn, the farmer gives up the opportunity to grow wheat. So, imagine that the farmer s opportunity cost of growing corn is the accounting profit she gives up by not growing wheat (Að wheat ). Suppose: Að wheat = $30,000 Að corn = $20,000 What should the farmer do? 55

56 Let s look more closely at the relationship between production and cost. Consider an example of a golf ball company. It produces golf balls with labor (L) and machinery (K), with the following Cobb-Douglas production function:, where Q is the number of cases produced, L is the number of workers hired, and K is the number of machines utilized. Now suppose this is the short run (e.g., daily), with K fixed at 4, such that the short run production function becomes: Further, let P L = $30 and P K = $1000. Think of the price of capital as perhaps the daily lease on a golf ball machine. What is the total cost per day? TC = 1000K + 30L = L (Same as total outlay from before) Consider different scenarios: L = 4 L = 16 L = 1 Let s derive the short run total cost function: 56

57 Notice that short run total cost consists of two parts: Total fixed cost = cost associated with the fixed input(s). It is the portion of total cost that does not vary with output. Total variable cost = cost associated with the variable input(s). It is the portion of total cost that does vary with output. Let s graphically derive these curves using another example: 57

58 Back to our newspaper example: Suppose P K = $100 and P L = $50 Q (TP) L K AP MP TVC TFC TC $0 $300 $ $50 $300 $ $100 $300 $ $150 $300 $ $200 $300 $ $250 $300 $ $300 $300 $ $350 $300 $650 58

59 Other short run costs: = change in TC or TVC due to a change in Q Q L K AP MP TVC TFC TC AVC AFC ATC MC $0 $300 $ $50 $300 $ $100 $300 $ $150 $300 $ $200 $300 $ $250 $300 $ $300 $300 $ $350 $300 $650 59

60 Let s put it all together: 60

61 One more illustration of the linkage between cost and production. Suppose we have a firm operating in the short run with two inputs, capital (K) and labor (L), where K is fixed and L is variable. Accordingly, [1] [2] 61

62 What about long run cost? In the long run all inputs are variable. Often, the long run is viewed as a planning horizon, in the sense that firms decide on a particular production level and then build a plant to meet that desired level. Let s see (Derivation of long run average cost): The shape of the long run average cost curve is linked to returns to scale. When LR average cost is declining, the firm operates under economies of scale. When LR average cost is rising, the firm operates under diseconomies of scale. 62

63 Adhering to the Fundamental Premise of Economics, firms wish to maximize profit. So, let s determine the price and quantity that will maximize profit. Ultimately, as we will see later, this depends upon the market in which the firm operates. Yet we can discuss some preliminary concepts at this point. Recall: Recall, Profit (ð) = Total Revenue (TR) - Total Cost (TC) Example: Suppose you own an ice cream shop. How much ice cream should you sell per day and at what price? Suppose you are currently producing 100 gallons a day at a price of $10 per gallon, such that TR = $1000. Moreover, suppose TC = $900. Next, suppose to sell one more gallon (Q = 101) you must drop the price to $9.99 (recall the demand curve). Also, by producing more, your total cost increases to $905. Should you produce and sell 101 units? Suppose you are currently at Q = 100 and P = $10, with TC = $900. What if you cut Q to 99? Suppose by doing this, TR becomes $995 and TC becomes $850. Should you cut production? Definitions: Marginal Revenue (MR) = change in TR due to a change in Q Marginal Cost (MC) = change in TC due to a change in Q 63

64 Rules: If MR > MC, firm should produce and sell more to increase profit. IF MR < MC, firm should produce and sell less to increase profit. Hence, profit is maximized at the quantity where MR = MC. This is the profit maximizing rule we will follow. Graphically: MR = slope of TR MC = slope of TC 64

65 STRUCTURE, CONDUCT, PERFORMANCE So far we have not incorporated market structure into our analysis. We have essentially assumed the firm is not affected by rival behavior. Obviously, this is not the case - in many markets firms behave according to the perceived behavior of rivals. Traditionally, the approach to analyze such issues is captured by the structureconduct-performance paradigm (SCPP). According to the SCPP, market structure affects firm conduct which ultimately affects the performance of the market. Elements of Market Structure: 1. Concentration - focuses on the number and size distribution of firms in a market. 65

66 Some other elements of market structure - 2. Product Differentiation - 3. Entry and Exit Conditions - A barrier to entry is anything that limits the entry of firms into a market. Or, by the same token, any cost that must be encountered by entrants but not by existing firms. 4. Cost structures - 5. Level of integration - mergers and acquisitions 66

67 Elements of Firm Conduct: 1. Pricing behavior - 2. Product strategy and advertisement - 3. Research and development - 4. Plant investment - 5. Legal tactics - 67

68 Elements of Market Performance: 1. Profit - 2. Equity - 3. Employment - 4. Quality - 5. Market Welfare - 68

69 Consider some market structures: Perfect Competition: Market Structure - Many buyers and sellers Firms sell a homogeneous product Perfect knowledge of existing market conditions Free entry and exit 69

70 Implications: SR Conduct - Goal is to maximize profit. 70

71 Consider a loss situation: Example: At P = MC, P Q TFC TVC TC What should the firm do? 71

72 Instead, what if at P = MC: TR TFC TVC TC What should the firm do? Short run Supply: 72

73 What about long run conduct in perfect competition? The essence of the long run is the growth and decline of industries. Industries grow by firms entering or existing firms expanding their capital stock. Industries decline by firms exiting or existing firms reducing their capital stock. In both cases, the capital stock of the industry changing, which is a long run issue. What prompts entry? What prompts exit? Implications: So, what we get out of a perfectly competitive market are the following: 1. price taking - no control over price - very intense competition. 2. economic profits driven away in the long run. 73

74 Monopoly: Market Structure - A. Single seller B. Significant barriers to entry Three Types 1. Natural Barriers: Advantages held by incumbents not owing to actions taken by them or the government to deter entry. Absolute cost advantages Economies of scale 74

75 2. Government Imposed Barriers: Actions taken by the government to limit the number of firms in the market. Licenses Government franchise Patents 3. Strategic Barriers: Actions taken by incumbents to deter entry 75

76 Suppose that barriers to entry are such that the market can only sustain one firm (i.e., monopoly). In this case, the market demand is the firm demand. That is, in the short run: Numerical: 76

77 Similar to any market in the short run, as long as price exceeds average variable cost the firm should produce. If price drops below average variable cost, the firm should shutdown production. That is, In the long run, there is no threat of entry. Consequently, long run profit can be sustained. 77

78 Compare monopoly to perfect competition: The perfectly competitive market leads D = S, or P = MC. In monopoly, however, price exceeds marginal cost. Hence, the monopolist will tend to restrict output below the competitive level and as a result raise price. Graph: Market Welfare = sum of net gains to consumers and producers in a market. Consumer surplus (CS) = net gains to consumers in a market. 78

79 Producer surplus (PS) = net gains to producers in a market. Market welfare is higher under perfect competition than under monopoly. Indeed, the monopolist tends to win (higher profit) at the consumer s loss (higher price). This criticism of monopoly is the basis for antitrust law. Antitrust laws are designed to limit behavior that would increase the likelihood of monopoly. 79

80 Consider an alternative pricing scenario: Price Discrimination In many situations, it is more profitable for a firm to charge different prices to different consumers. Price Discrimination: Charging different prices to different consumers, not owing to cost differences. Scenarios: Senior discounts Quantity discounts Car dealerships Consider a car dealership. How does price discrimination emerge? Why is it profitable to price discriminate? 80

81 This is known as First Degree Price Discrimination. In this case, the price discriminator extracts all consumer surplus from the market. Accordingly, CS = 0 and W = PS. Now, for price discrimination to be profitable, two things must occur: 1. Price arbitrage must be prevented 2. Different consumers must be willing to pay different prices. This is equivalent to consumers facing different price elasticities. 81

82 First degree price discrimination is very difficult to do, since the firm must know the reservation price of every consumer. More commonly what we see is Third Degree Price Discrimination. This is the case when the firm segments its market into two or more groups, charging each group a different price. Consider the graphs below: Note: MR T is the total marginal revenue, which is the horizontal sum of the group A and B marginal revenue curves. Three questions that must be answered to maximize profit: How much to produce overall? How should this overall amount be allocated across the two groups? What price to charge each group? 82

83 The group charged the higher price is that which faces the less elastic demand. Why? Alternative Markets: Consider some examples - Local Fast food Auto industry 83

84 Monopolistic Competition: The vast majority of markets are neither perfectly competitive nor monopoly. Consider monopolistic competition: Market Structure: Many sellers in the market Firm produce slightly differentiated products Product differentiation: When buyers perceive differences among the brands of a product. This creates brand loyalty, leading to firms facing downward sloping demand curves. Examples: physical attributes, location, service. An implication: Firms advertise in this type of market to further differentiate their product from the competition. Easy entry and exit 84

85 Short run profit maximizing behavior: Long run profit maximizing behavior: Advantages: Advertising and product innovation Weaknesses: Price higher than under perfect competition. Also, advertising raises price. 85

86 Oligopoly: Market Structure: Few firms High concentration Mutual interdependence Substantial barriers to entry government imposed natural strategic Threat of Predatory Pricing Product Differentiation Control of Inputs Identical or differentiated products 86

87 Many different models to explain behavior. They differ in terms of how firms react to mutual interdependence. Due to mutual interdependence, firms must form expectations of how rivals will react to chosen actions. Examples of Beliefs: Two firms: A and B 1. Maximin Belief - Each believes the other firm s sole objective is to cause the most damage. 2. Cournot Belief - Each believes whatever it does the other firm will not respond. Let s look at it from the perspective of choosing a quantity. Example: Firms produce a product, dump it on the market, and receive a price. This would apply in situations where inventory holdings are not feasible. For example, the corn wet milling industry has been determined to follow this situation. In terms of quantity, a Cournot belief is such that each firm treats the other firm s production as given when making its quantity choice. 87

88 Consider the market demand given by Q = P: Define: Firm (Residual) Demand = Market Demand - other firm production Suppose each firm has a total cost given by: TC A = 100q A and TC B = 100q B Thus, each firm has a marginal cost which is constant at 100. What if A believes B will produce zero? What if A believes B will produce 100? 88

89 What if A believes B will produce 200? A s Reaction Curve = Relationship between A s optimal production and B s production. B has a similar reaction curve. Graph: Can we predict an outcome? 89

90 3. Cooperative Belief - Firms see the market in a similar light and believe that each recognizes that cooperation is better than competition. There are two general forms of cooperation: Explicit Cooperation - Explicit arrangements to limit competition among firms in the same line of business. People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. - Adam Smith (The Wealth of Nations). Two common forms of explicit cooperation are cartels and price fixing conspiracies. Both yield similar outcomes - supracompetitive profits. A cartel refers to an agreement to act in unison with the goal of raising the collective profits of a group of firms. Price fixing schemes seek to maintain prices above levels they otherwise would be without cooperation. Implicit Cooperation - Due to market conditions, firms charge similar prices or otherwise act with the appearance of explicit cooperation. Examples: Markup Pricing, Price leadership. 90

91 Cartel: A cartel occurs when firms seek to maximize the joint profits of the members by using a series of quotas. Consider a market with two firms, A and B. If they form a cartel their goal is to maximize joint (cartel) profit, which is: ð C = ð A + ð B. Imagine these two firms pull their resources and effectively act as one firm (monopoly). Then MC C = horizontal sum of MC A and MC B. Acting in unison, the monopoly (cartel) output and price is Q C and P C, respectively. How should the cartel output be distributed? That is, quotas must be determined. Problem: Incentive to cheat (produce beyond the quota). Prediction: Cartels are unstable. If cartels are predicted to break-up, why do they occur? Role of punishments. 91

92 Consider some market structure factors that facilitate or hinder cooperation: 1. Number of Firms (concentration) 2. Mergers 3. Differentiated Products 4. Excess Capacity/High Inventories 5. Industry Council or Trade Association 92

93 Dominant Firm Price Leadership: In this situation a dominant firm (typically controlling 50-90% of the market) sets the price and others (followers) adjust to that price. Examples: Steel, Cigarettes, Banking Graph: 93

94 Emphasis of late in studies of oligopoly have focused on the use of game theory. Game theory is a formal technique of capturing rivalry. It was initially developed in World War II as a means of predicting Germany s response to Allied invasion plans. In the 1970s it began to gain acceptance as a means of modeling oligopoly behavior. It centers on a game, which has three components: Rules - Strategies - Payoffs - Example: Rock-Papers-Scissors Consider an advertising game between two firms: A and B Rules: Both select advertising level at the same time (simultaneous play). They play once. They have complete information - each knows the possible moves and payoffs of each player. Advertising does not affect the market demand. It only affects the distribution of market demand. If both select the same advertising level, they distribute the market demand 50/50. If one advertises more than the other, it receives a greater share of the market. Strategies: Each can select either a low or high advertising level. 94

95 Possible outcomes: Payoffs Firm A and B select low advertising ð A = $10m, ð B = $10m Firm A and B select high advertising ð A = $5m, ð B = $5m Firm A select high, Firm B select low ð A = $20m, ð B = $3m Firm A select low, Firm B select high ð A = $3m, ð B = $20m We illustrate this with a payoff matrix: L A H L 10, 10 20, 3 B H 3, 20 5, 5 What do we predict will be the outcome? Two approaches - Dominance Arguments - Equilibrium Arguments - 95

96 Prisoners Dilemma: Consider the Cournot game: Consider the Cartel game: 96

97 What about a dynamic game? This is where moves are sequential. With dynamic games, they can be represented with a game tree, which consists of nodes and branches. Example: Entry Game As we ve said, entry drives profits down. Consequently, incumbent firms are hurt when entrant firms come into a market. Can an incumbent deter entry? One potential method - threat of predatory pricing. Consider two firms - entrant (E) and incumbent (I). The entrant must decide whether or not to enter the market. If the entrant comes into the market, the incumbent must decide to fight (predatory price) or cooperate. This is illustrated below: What will happen? Backwards Induction - 97

98 Consider the ultimatum game. Suppose that $100 is to be divided up between two people. One person, the proposer, offers a certain distribution of the $100. The other person, the responder, then must decide to accept or not accept the offer. If the offer is not accepted, each gets $0. If the offer is accepted, each gets the offered amount. What is the Nash Equilibrium? 98

99 INPUT MARKETS Let s shift gears. Up to this point, we ve focused on output markets. However, there are also input markets. Analysis of these markets can help us answer such questions: What determines an input price? What determines income? Recall that optimal input usage (i.e., that which maximizes profit) occurs when the following holds: (Note: This assumes that input prices are given. In other words, the input buyers and sellers are price takers). But this is akin to: But recall: So, to maximize profit, firms should select inputs such that: 99

100 Or:,, * * * But profit is maximized when MR = MC. So, the above is equivalent to:,, * * * 100

101 And by rearranging, we get: * * *,, Now, So, = marginal revenue product of input A (i.e., MRP A ). MRP measures the change in total revenue due to hiring one more unit of the input. Now, in the case of a purely competitive firm, marginal revenue equals price. So, MRP = P output * MP, which is the same expression we had before in the notes. In this case, with MRP = MR * MP, we generalize to any type of output market, whether it is perfectly or imperfectly competitive. Example: A firm currently has 5 machines. It s contemplating buying a 6 th machine, for which the marginal product is 1. Also, suppose MR = $80. If the price of the machine is $40, what should the firm do? 101

102 Indeed, from before: If P INPUT < MRP INPUT, then hire more of the input. If P INPUT > MRP INPUT, then hire less of the input. What we want to do is to predict how input markets will behave under different scenarios. Case I: Input and Output Market are Competitive In this case, all prices are taken as given. Buyers and sellers individually have no influence on input and output prices. So, for example, individual firms can t influence the prices they receive for their produce or the prices they pay for their inputs. As before, in terms of input selection, inputs should be hired to the point where the following holds: * *,, 102

103 Consider a simple scenario, where the firm only has one variable input. That is, except for input A, all other inputs are fixed (recall the short run). Go back to a competitive firm: In order to maximize profit, the firm will operate under diminishing returns in the short run. Accordingly, the MRP curve becomes: Indeed, the MRP curve is the firm s demand curve for input A. 103

104 Now, if more than one input is variable, it gets a little tricky. First, consider the case of a multifactor adjustment. This relates to the case where two variable inputs might be substitutes or complements to each other. Substitutes: Complements: Adjusting for this will modify the demand for the input (i.e., long run input demand). In particular, this adjustment impacts the marginal productivity of the input in question, such that: 104

105 Now, previously we dealt with the individual firm demand for an input. What if we want the market demand. We might be inclined to simply horizontally add up all the firm demands. However, this would be incorrect, since we need to account for the industry adjustment. Again, this will change the demand curve (i.e., input market demand): Market Equilibrium: 105

106 Case II: Input Market Competitive but Output Market not Competitive In this case, individual buyers of inputs take the input price as given, but individual sellers of outputs have some control over their price. For example, a local bar may operate in a monopolistically competitive output market but takes the price it pays for liquor as given. In this case, MRP = MR * MP, with P output > MR. Consider the case of a single variable input, A, with all other inputs fixed. Similar to before, the MRP curve is the firm s demand for the input. Except in this case, the graphical derivation of MRP is slightly changed: Now, if other inputs are variable, then just like before we have to take account of the multifactor adjustment. Accordingly, 106

107 To get the market demand for the input, then it is very tricky to derive the market demand, since we have to account for how input buyers compete against each other in the output market. We ll leave that for another class! Case III: Input Market not Competitive but Output Market Competitive In this case, input buyers (i.e., firms) sell their output in a competitive market. So, they take the price they receive for their product as given. However, they have some control over the price they pay for their input(s). For example, we might have a singly buyer of an input (i.e., a monopsony), such as a local steel mill. Or there might be a market with a few input buyers (i.e., oligopsony). Let s tackle the case of a monopsony. In this case, since the monopsonist is the only buyer of the input, the market supply of the input is the one faced buy the monopsonist. That is, in terms of input A: In the previous cases of competitive input markets, each buyer was so small that it simply took the input price as given when making its hiring decisions. This is akin to each firm having a perfectly elastic input supply curve, given by: 107

108 Consider a monopsonist who faces an upward sloping supply curve of input A. The supply schedule is given as: P A Q A Total Cost of Input A Marginal Expenditure for Input A $5 10 $ $7 11 $77 $27 $9 12 $108 $31 $11 13 $143 $35 $13 14 $182 $39 The marginal expenditure (ME) is the change in total cost of input A from hiring one more unit of the input. As you can see, ME A > P A. Graphically, 108

109 Now, how much of input A will the monopsonist wish to employ? If we assume all other inputs are fixed, except for input A, then the firm should hire to the point where: Let s see: 109

110 And if there are several inputs, then each input should be hired to the point such that the following holds: * * *,, Case IV: Both Input and Output Markets not Competitive 110