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15.
What is Monopolistic Competition?
Monopolistic competition is characterized by four factors: a large number of firms,
product differentiation, competition on price, product quality, and marketing, and firms
are free to enter and exit.
A. A Large Number of Firms
The large number of firms implies
1. A small market share for each firm.
2. No market dominance by a single firm, so no one’s firm’s actions directly
affect the actions of other firms.
3. Collusion is impossible because there are so many firms.
B. Product Differentiation
Product differentiation is making a product that is slightly different from the
products of competing firms. As a result there are no perfect substitutes and so
the firm in monopolistic competition faces a downward-sloping demand curve.
C. Competing on Quality, Price, and Marketing
A firm in monopolistic competition will compete on:
1. Quality
A firm promotes the idea that its product has better attributes than its
competitors’ products. These attributes include design, reliability, the
service provided to the buyer, and the buyer’s ease of access to the
product.
2. Price
A firm in monopolistic competition faces a downward-sloping demand
curve so the firm can set both its price and its output.
3. Marketing
A firm uses advertising and packaging to publicize its product’s
uniqueness.
D. Entry and Exit
If firms in monopolistic competition earn an economic profit in the short run, new
firms enter the market. This increase in supply decreases each firm’s demand
and lowers the price until only a normal profit is earned. If firms incur economic
losses in the short run, some firms exit the industry. The price rises until a normal
profit is earned by the remaining firms.
E. Identifying Monopolistic Competition.
1. The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage of the value of sales
accounted for by the four largest firms in an industry. A four-firm
concentration ratio that exceeds 60 percent is regarded as an indication of
a market that is highly concentrated and dominated by a few firms in an
oligopoly. A ratio of less than 40 percent is regarded as an indication of a
competitive market—monopolistic competition.
2. Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is the square of the percentage
market share of each firm summed over the 50 largest firms (or summed
over all the firms if there are fewer than 50) in a market. If the HHI is
greater than 1,800, the market is regarded as being uncompetitive. This
measure is used as a guideline by the Justice Department for decisions
regarding whether to challenge a merger.
3. Limitations of Concentration Ratios
a. Geographic Scope of the Market
Concentration ratios take a national view of the market but some
goods are sold in regional markets (in which case the extent of
competition might be overstated) and others in global markets (in
which case the extent of competition might be understated).
b. Barriers to Entry and Firm Turnover
Concentration ratios don’t take account of the absence or presence
of barriers to entry.
These 10 industries are examples of monopolistic competition. They have a large number of
firms, shown in brackets after the name of the industry. The bars measure the percentage of
industry total revenue received by the 20 largest firms. The number on the rights is the
Herfindahl-Hirshman Index
Output and Price Decisions
A. The Firm’s Profit-Maximizing Decision
1. Facing a downward-sloping demand curve, a firm in monopolistic
competition chooses its profit-maximizing price and quantity as does a
monopoly.
2. The firm produces at the quantity that sets marginal revenue equal to
marginal cost. The firm charges the price that buyers are willing to pay for
this quantity, which is determined by the demand curve.
3. Economic profit in the short run is possible and average total cost).
(price equals quantity
(1) Profit is maximized where marginal revenue equals marginal cost. (2) The profitmaximizing quantity is 125 pairs of Tommy jeans a day. (3) The price of $75 a pair
exceeds the average total cost of $25 a pair, so the firm makes an economic profit of
$50 a pair. (4) The blue rectangle illustrates economic profit, which equals $6,250 a day
($50 a pair multiplied by 125 pairs).
B. Profit Maximizing Might Be Loss Minimizing
If price is less than average total cost, a firm in monopolistic competition incurs
an economic loss.
(1) Profit is maximized and loss is minimized where marginal revenue equals marginal
cost.
(2) The loss-minimizing quantity is 40,000 customers connected.
(3) The price of $40 a month is less than the average total cost of $50 a month, so the
firm incurs an economic loss of $10 a customer.
(4) The red rectangle illustrates economic loss, which equals $400,000 a month ($10 a
customer multiplied by 40,000 customers).
C. Long Run: Zero Economic Profit
1. There is no restriction on entry in monopolistic competition, so if firms in
monopolistic competition are earning an economic profit, other firms to enter the
industry. As new firms enter, an individual firm’s demand and marginal revenue
decrease. New firms enter until economic profit disappears and the remaining
firms earn normal profit.
2. If firms in monopolistic competition are incurring an economic loss, some firms
leave the industry. As firms exit, a remaining firm’s demand and marginal
revenue increase. Firms exit until economic loss disappears and the remaining
firms earn normal profit.
Economic profit encourages entry, which decreases the demand for each firm's product.
Economic loss encourages exit, which increases the demand for each firm's product.
When the demand curve touches the average total cost curve at the quantity at which
marginal revenue equals marginal cost, the market is in long-run equilibrium. (1) The
output that maximizes profit is 75 pairs of Tommy jeans a day, and (2) the price, $50 a
pair, equals average total cost. (3) Economic profit is zero.
D. Monopolistic Competition and Perfect Competition
1. Excess Capacity
Excess capacity occurs when the quantity that a firm produces is less than
the quantity at which average total cost is a minimum. A firm with excess
capacity produces below its efficient scale, which is the quantity at which
average total cost is a minimum.
2. Markup
Markup is the amount by which price exceeds marginal cost. A firm in
monopolistic competition has a markup because price exceeds marginal
cost but a firm in perfect competition has no markup.
(a) (1) The efficient scale is 100 pairs a day. In monopolistic competition in the long run,
the quantity produced is less than the efficient scale and the firm has (2) excess
capacity. (3) Price exceeds (4) marginal cost by the amount of the (5) markup.
(b) In contrast, because in perfect competition demand is perfectly elastic, (1) the
quantity produced equals the efficient scale and (2) price equals marginal cost.
E. Monopolistic Competition and Efficiency
1. Making the Relevant Comparison
A firm in monopolistic competition chooses a profit-maximizing quantity
where the markup is positive (price is greater than marginal cost), which
means that marginal benefit exceeds marginal cost. This choice implies
that the firm inefficiently uses resources. (Efficiency requires that price =
marginal benefit = marginal cost). But a benefit of monopolistic
competition is that it creates product variety.
2. The Bottom Line
Compared to the alternative—complete product uniformity—monopolistic
competition is efficient.
Product Development and Marketing
A. Innovation and Product Development
A firm in monopolistic competition will continuously develop new products so that
it can continue to earn an economic profit. If the firm does not innovate, new
firms will enter the market and capture the existing firm’s economic profit.
1. Cost Versus Benefit of Product Innovation
To decide the degree to which it will innovate, a firm compares the
marginal cost of innovation to the marginal benefit of innovation.
2. Efficiency and Product Innovation
On one hand, product innovation brings to market many improved
products that have great benefits to consumers. On the other hand, many
so-called improvements amount to little more than packaging changes.
B. Advertising
A firm uses advertising and packaging to convince consumers that its product
differs from and is better than other products. These differences can be real or
perceived.
1. Advertising Expenditures
The cost of selling a good can represent a large portion of the price that
consumers pay for a product.
Advertising expenditures are a large part of total revenue for producers of cleaning
supplies, toys, confectionery, and cosmetics.
2. Selling Costs and Total Costs
Selling costs, such as advertising expenditures are fixed costs and
increase total costs. These expenditures shift the average total cost curve
upward. If advertising expenditures increase sales enough, the average
total cost of the amount produced might decrease.
Selling costs such as the cost of advertising are fixed costs. (1) When advertising costs
are added to (2) the average total cost of production, (3) average total cost increases by
more at small outputs than at large outputs. (4) If advertising enables sales to increase
from 25 pairs of jeans a day to 100 pairs a day, it lowers average total cost from $60 a
pair to $40 a pair.
3. Selling Costs and Demand
Advertising might increase demand for a firm’s product (by taking away
other firms’ customers) or might decrease demand (as new firms enter the
market trying to earn an economic profit).
(a) (1) With no firms advertising, demand is low and not very elastic, so the (2) markup
is large.
(b) (3) Advertising increases average total cost (shifts the average total cost curve
upward from ATC0 to ATC1) and makes demand more elastic. (4) With all firms
advertising, the price falls and the markup shrinks.
4.
The
Selling
Cost of
a Pair
of
Runni
ng
Shoes
The Plastic and other materials from which a running shoe is made, the cost of labor, and
import duties total $20. The other $50 of a $70 pair of shoe is selling costs
C. Using Advertising to Signal Quality
A signal is an action taken by an informed person (or firm) to send a message to
uninformed people. A firm uses advertising to signal consumers that its product
differs from and is better than other products.
D. Brand Names
Brand names provide information to consumers about the quality of a product
and provide an incentive to producers to keep the quality high and consistent.
E. Efficiency of Advertising and Brand Names
Whether advertising and brand names lead to efficiency is ambiguous. We must
compare the benefits of the information provided by these means with the
opportunity cost of the additional information.
16.
Oligopoly
Oligopoly is characterized by having a small number of firms competing and natural or
legal barriers preventing the entry of new firms.
A. Small Number of Firms
1. Interdependence
With only a small number of firms in a market, each firm’s actions
influence the profits of the other firms.
2. Temptation to Collude
To maximize profit, firms in an oligopoly might choose to form a cartel. A
cartel is a group of firms acting together to limit output, raise price, and
increase economic profit. Cartels are illegal in the United States.
B. Barriers to Entry
A duopoly is a market with only two firms. A natural oligopoly occurs when a few
firms can supply the market more cheaply than many firms. A legal oligopoly
exists when a legal barrier to entry protects the small number of firms in a
market.
(a) (1) The lowest possible price is $10 a ride, which is the minimum average total cost.
(2) When a firm produces 30 rides a day, the efficient scale, (3) two firms can satisfy the
market demand. This natural oligopoly has two firms--a natural duopoly.
(b) (4) When the efficient scale of one firm is 20 rides a day, (5) three firms can satisfy
the market demand at the lowest possible price. This natural oligopoly has three firms.
C. Identifying Oligopoly
The key feature that determines whether a market is an oligopoly is whether the
firms are interdependent. As a practical matter, a market in which the HHI
exceeds 1,800 is usually an example of oligopoly.
The Range of Oligopoly Outcomes
A. Duopoly in Airplanes
1. Competitive Outcome
A competitive outcome occurs when the firms produce the level of output
determined by the intersection of the industry supply curve (the marginal
cost curve) and the market demand curve.
2. Monopoly Outcome
A monopoly outcome occurs when the firms produce the same level of
output as a single-price monopoly at the intersection of the marginal cost
and marginal revenue curves.
3. Possible Oligopoly Outcomes
An oligopoly will produce the quantity of output ranging from the quantity
produced by a perfectly competitive market and to that produced by a
single-price monopoly.
B. Collusion Versus Competition
Boeing and Airbus can collude so each produces 3 airplanes a week and
together they produce the monopoly output of 6 airplanes a week.
1. Boeing Increases Output to 4 Airplanes a Week
Boeing can increase its profit if it increases its output to 4 airplanes a
week. In this case, Airbus’s profit decreases and it decreases by more
than the increase in Boeing’s profit.
2. Airbus Increases Output to 4 Airplanes a Week
Once Boeing has increased its output to 4 airplanes a week, Airbus can
increase its profit if it increases its output to 4 airplanes a week. In this
case, Boeing’s profit decreases and it decreases by more than the
increase in Airbus’s profit.
3. Boeing Increases Output to 5 Airplanes a Week
Once Airbus has increased its output to 4 airplanes a week, neither
Boeing nor Airbus can increase its profit by further increasing its
production.
4.
The Kinked Demand Curve Theory
Born in 1910, Paul M. Sweezy was an economics undergraduate at Harvard during the
Great Depression years of the 1930s. Like many of his contemporaries, he became
convinced that the capitalist market economy was doomed and embraced the teachings
of Karl Marx He believed that communism offered the solution to the nation's and the
world's economic ills. Unlike most of his contemporaries, Paul Sweezy never came to
doubt the teachings of Marx and the belief that communism held the answers. In 1949,
he founded the Monthly Review, a journal devoted to the analysis of economic and
social issues from a Marxian perspective.
Paul Sweezy made many contributions to economic thought, but one of his most
influential and enduring is a theory about the demand for the product of a firm in
oligopoly: the kinked demand curve theory--or Akinky demand curve theory,@ as he
called it when he first presented it in the Journal of Political Economy in 1939.
The kinked demand curve theory is based on the assumption that each firm believes
that 1) if it raises its prices, others will not follow, and 2) if it cuts its prices, the other
firms will cut theirs too.
The figure shows the demand curve (D) that a firm believes it faces on the basis of
Sweezy's assumptions. The demand curve has a kink at the current price, P, and
quantity, Q.
At prices above P, a small price rise brings a big decrease in the quantity sold. The
other firms hold their current price and the firm has the highest price for the good, so it
loses market share.
At prices below P, even a large price cut brings only a small increase in the quantity
sold. In this case, other firms match the price cut, so the firm gets no price advantage
over its competitors.
The kink in the demand curve creates a break in the marginal revenue curve (MR). To
maximize profit, the firm produces the quantity at which marginal cost equals marginal
revenue. That quantity, Q, is where the marginal cost curve passes through the gap AB
in the marginal revenue curve. If marginal cost fluctuates between A and B, like the
marginal cost curves MC0 and MC1, the firm does not change its price or its output.
Only if marginal cost fluctuates outside the range AB does the firm change its price and
output. So the kinked demand curve model predicts that price and quantity are
insensitive to small cost changes.
A problem with the kinked demand curve model is that the firms' beliefs about the
demand curve are not always correct and firms can figure out that they are not correct.
If marginal cost increases by enough to cause the firm to increase its price and if all
firms experience the same increase in marginal cost, they all increase their prices
together. The firm's belief that others will not join it in a price rise is incorrect. A firm that
bases its actions on beliefs that are wrong does not maximize profit and might even end
up incurring an economic loss.
Game Theory
Game theory is the tool economists use to analyze strategic behavior—behavior that
recognizes mutual interdependence and takes account of the expected behavior of
others.
A. What Is a Game?
A game is defined by its rules, strategies, and payoffs.
B. The Prisoners’ Dilemma
The prisoners’ dilemma is a game between two prisoners that shows why it is
hard to cooperate even when it would be beneficial to both players to do so. Two
prisoners are caught committing a crime for which they must serve a 2-year
sentence. The district attorney suspects they are the same criminals who
committed an earlier crime. To get the criminals to confess to the earlier crime,
the district attorney makes them play a game. The game is defined by the
following:
1. Rules
If both prisoners confess, each will receive a 3-year sentence. If one
prisoner confesses and his accomplice does not, the confessor receives a
1–year sentence while the accomplice receives a 10-year sentence. If
neither confess, each gets a 2-year sentence.
2. Strategies
Strategies are all the possible actions of each player in a game. In the
prisoners’ dilemma, the strategies are that the prisoners can confess to
the earlier crime or deny committing the crime.
3. Payoffs
A payoff matrix is a table that shows the payoffs for each player for every
possible combination of actions by the players. There are four possible
payoffs in the prisoners’ dilemma. If one prisoner (Art) confesses and the
other prisoner (Bob) does not, Art serves 1 year and Bob serves 10 years.
If Bob confesses and Art does not, Bob serves 1 year and Art serves 10
years. If both Art and Bob confess, each serves 3 years. If neither
confesses, they only serve the 2 years for the crime for which they were
caught red-handed.
Each square shows the payoffs for the two players, Art and Bob, for each possible pair
of actions. In each square, the red triangle shows Art’s payoff and the blue triangle
shows Bob’s. For example, if both confess, the payoffs are in the top left square.
4. Equilibrium
The game’s equilibrium occurs when each player chooses the best
possible action given the action of the other player. This equilibrium
concept is called Nash Equilibrium, named after John Nash who
proposed it. In the prisoner’s dilemma, each prisoner chooses to confess.
5. Not the Best Outcome
The equilibrium outcome is not the best for each prisoner. Without the
ability to communicate and cooperate, the prisoners choose to confess.
This choice produces a more severe sentence for each prisoner.
C. The Duopolists’ Dilemma
Airbus and Boeing play a game where each firm must choose how many
airplanes to produce. They can produce 3 or 4 airplanes each week.
1. The Payoff Matrix
If they want to maximize the industry’s profits ($72 million), each will
collude and produce 3 planes a week. If Airbus cheats on the agreement
to reduce output and produces 4 planes (while Boeing produces only 3
planes), Airbus makes $40 million and Boeing makes $30 million. If
Boeing cheats on the agreement to reduce output and produces 4 planes
(while Airbus produces only 3 planes), Boeing makes $40 million and
Airbus makes $30 million. If both firms cheat on the agreement and make
4 planes, each firm makes $32 million.
Each square shows the payoffs from a pair of actions. For example, if both firms
produce 3 airplanes a week, the payoffs are recorded in the bottom right square. The
red triangle shows Airbus’s payoff, and the blue triangle shows Boeing’s.
2. Equilibrium of the Duopolists’ Dilemma
The firms each decide that it is best off if it produces 4 airplanes per week.
The Nash equilibrium is for each firm to produce 4 airplanes a week.
3. Collusion is Profitable but Difficult to Achieve
Collusion is difficult to achieve because it is in each firm’s individual
interest to increase its production beyond the restricted limit assigned to it.
D. Other Oligopoly Games
Other interactions between firms in oligopoly, such as the amount of R&D to
conduct, can be analyzed using game theory.
The red triangle shows Procter & Gamble’s payoff, and the blue triangle shows
Kimberly-Clark’s.
If both firms undertake R&D, their payoffs are those shown in the top left square. If
neither firm undertakes R&D, their payoffs are in the bottom right square. When one
firm undertakes R&D and the other one does not, their payoffs are in the top right and
bottom left squares.
The Nash equilibrium for this game is for both firms to undertake R&D. The structure of
this game is the same as that of the prisoners’ dilemma.
E. Repeated Games
By repeating a game, firms in a duopoly are more likely to cooperate and earn a
monopoly profit. If a firm knows that it can be punished in subsequent games by
its competitors, it has an incentive not to cheat. This “tit for tat” strategy is likely to
produce a monopoly outcome.
F. Is Oligopoly Efficient?
If the oligopoly can restrict its output, it is inefficient.
Duopoly In Computer CPUs
The CPU in your computer is the central brainpower of the machine. Until 1995, one
firm produced all the CPU chips in PCS--Intel Corporation. Intel made a large economic
profit by producing the quantity of chips at which marginal cost equaled marginal
revenue and pricing the chips to ensure that the quantity demanded equaled the profitmaximizing quantity produced.
Then, in 1995, a small number of new firms entered the industry. One of them,
Advanced Micro Devices, Inc. (AMD), quickly established itself as a serious challenger
to Intel.
But in terms of market share and profit share, Intel dominates this market, as the pie
charts show. Both firms have a global market, with 55 percent of Intel's total revenue
and 60 percent of AMD's total revenue coming from outside of the United States.
If as new firms entered this industry, Intel and AMD had maintained Intel's price and
shared the market, together they could have made economic profits equal to Intel's
profit. But AMD and Intel were (and remain) in a duopolist's dilemma. Intel has no
interest in sharing its market with another producer. And to break into the market and
take revenue and profit away from Intel, AMD must either offer a clearly superior
product at the same price as Intel's or offer a similar product at a lower price.
AMD opted mainly for the second approach (although some chip experts say that AMD
offers both a superior product and a lower price).
Setting aside the question of whether an AMD chip performs better than an Intel chip, it
is clear that AMD has brought the price of CPU chips down. The graph shows the prices
of the most popular CPU chips in October 2002. Notice that at comparable clock
speeds, AMD chips are cheaper than Intel chips.
Athlon chips, AMD's main range of chips, cost less than Intel Pentium chips of
comparable speed.
At the low end of the product range, AMD Duron chips are substantially cheaper than
Intel Pentium chips of comparable speed.
Notice, though, that to compete at this low end of the product range, Intel has
introduced the Celeron processor at a similar price to that of the cheapest AMD chips.
Competition between Intel and AMD is like the duopolists' dilemma that you've studied
in this chapter. The game is played on both price and product design and quality and
across a range of differentiated products.
In 2002, Intel remained vastly bigger than AMD, and AMD had a tough year. Its total
revenue fell in 2002, and its profit almost vanished. Intel's total revenue was steady, but
its profit also shrank. Before 2002, AMD was growing much faster than Intel.
This duopoly is an interesting one to keep an eye on.
17.
Regulation
Regulation is rules administered by a government agency to influence economic
activity by determining prices, product standards and types, and the conditions under
which new firms may enter an industry. Deregulation is the process of removing
restrictions on prices, product standards and types, and entry conditions.
A. The Changing Scope of Regulation
Regulation has evolved over the past 120 years in the United States.
1. The Interstate Commerce Commission, the first federal regulatory agency,
was organized in 1887 to regulate interstate railroads. It now regulates
several other industries, including oil pipelines and water carriers.
2. Since the 1930s, the number of regulatory agencies greatly increased (at
both the state and federal levels). By the 1970s, almost one quarter of all
industry was regulated. In the last 20 years, there has been a tendency for
deregulation.
B. The Regulatory Process
1. Regulatory agencies have certain characteristics including:
a. Governmental appointment of bureaucrats to manage the agencies.
b. Government funding of the agencies.
c. Adoption of operating practices for controlling prices and other
regulated aspects of the firm.
2. Regulatory agencies allow firms to choose production technology but do
not allow the firms to set prices, output, or markets served.
C. Economic Theory of Regulation
1. Public Interest Theory
Public interest theory is the theory that regulation seeks an efficient use of
resources.
2. Capture Theory
Capture theory is the theory that regulation helps producers to maximize
economic profit. It assumes that the cost of regulation is high, and as a
result, regulation will increase the surplus of small, easily identifiable
groups with low organization costs.
D. Natural Monopoly
1. A natural monopoly is an industry in which one firm can supply the market
at a lower cost than two or more firms can.
2. A natural monopoly’s average total cost curve slopes downward because
as the number of customers served increases, the large fixed cost is
spread over a larger number of households.
A cable TV operator faces the demand curve D. Its marginal cost MC is a constant $10
per household per month. Its fixed cost is large, and the average total cost curve, which
includes average fixed cost, is ATC.
(1) Price is set equal to marginal cost at $10 a month.
At this price, (2) the efficient quantity (8 million households) is served.
(3) Consumer surplus is maximized as shown by the green triangle.
(4) The firm incurs a loss on each household, shown by the red arrow.
E. Public Interest or Private Interest Regulation?
1. Marginal Cost Pricing
A marginal-cost pricing rule sets price equal to marginal cost to achieve an
efficient output in a regulated industry.
a. Because output is efficient, this regulation is public interest
regulation
b. The regulated firm incurs an economic loss because the price is
less than average total cost. If the firm cannot find a way to earn a
profit (perhaps by using a two-part tariff or price discrimination), the
government has to decide whether or not to subsidize the firm.
c. If the government levies a tax to fund the subsidy, society
experiences a deadweight loss. The regulator must determine
which deadweight loss is greater: the one created by taxation or the
one created by the inefficient use of resources.
2. Average Cost Pricing
An average-cost pricing rule sets price equal to average total cost to
enable a regulated firm to cover its costs
a. Average cost pricing generates a deadweight loss. This outcome is
considered efficient if the deadweight loss is less than the loss from
collecting the taxes to finance a subsidy under marginal cost
pricing.
3. Rate of Return Regulation
Rate of return regulation sets the price at a level that enables a regulated
firm to earn a specific target percent return on its capital.
a. If costs are correctly assessed, the regulated price equals average
total cost.
b. With rate of return regulation, firms have the incentive to
exaggerate their costs because higher costs are passed on to
consumers as higher prices. So, rate of return regulation can
generate an inefficient outcome.
(1) Price is set equal to average total cost at $15 a month.
At this price, (2) the quantity served (6 million households) is less than the efficient
quantity (8 million households).
(3) Consumer surplus shrinks to the smaller green triangle.
(4) A producer surplus enables the firm to pay its fixed cost and break even.
(5) A deadweight loss, shown by the gray triangle, arises.
c.
d. Regulating Electricity in California
e.
4. Price Cap Regulation
Price cap regulation specifies the highest price that a firm is permitted to
set—a price ceiling.
a. A correctly set price cap can lower the price and increase the
output.
b. Earnings sharing regulation requires firms make refunds to
customers when profits rise above a target level. Earnings sharing
regulation is often combined with price cap regulation in case the
regulator set the price cap too high.
(1) With no regulation, a cable TV operator serves 4 million households at a price of $20
a month.
(2) A price cap regulation sets the maximum price at $15 a month.
(3) Only when 6 million households are served can the firm break even and earn a
normal rate of return. (When less than 6 million households are served, and when
greater than 6 million households are served, the firm incurs an economic loss.) The
firm has an incentive to keep costs as low as possible and to produce the quantity
demanded at the price cap.
(4) The price cap regulation lowers the price and increases the quantity.
F. Oligopoly Regulation
A cartel, which can occur in oligopolistic markets, engages in illegal activity to
limit output, raise price, and increase economic profit.
1. According to public interest theory, the oligopoly is regulated so that a
competitive outcome occurs and resources are efficiently used.
2. According to capture theory, the cartel will influences the regulator so that
output is restricted to its monopoly level.
Ten trucking firms transport tomatoes from the San Joaquin Valley to Los Angeles. The
demand curve is D, and the industry marginal cost curve is MC. Under competition, the
MC curve is the industry supply curve.
(1) Public interest regulation will achieve the efficient competitive outcome: a price of
$20 a trip and 300 trips a week.
(2) Producer interest regulation will limit output to 200 trips a week (where industry
marginal revenue, MR, is equal to industry marginal cost, MC), and the price will be $30
a trip.
3.
4. Regulatory Roller Coaster
Antitrust Law
Antitrust law, enacted by Congress and enforced by the judicial system, is the body of
law that regulates and prohibits certain kinds of market behavior, such as monopoly and
monopolistic practices.
A. The Antitrust Laws
1. The Sherman Act, passed in 1890, was the first U.S. antitrust law. Section
1 of the Sherman Act outlaws “every contract, … or conspiracy in restraint
of trade.” Section 2 makes illegal “an attempt to monopolize.”
2. The Clayton Act, passed, in 1914, along with its two amendments, the
Robinson-Patman Act (1936) and the Celler-Kefauver Act (1950), prohibit
specific business practices “only if they substantially lessen competition or
create monopoly.” The practices are:
a. Price discrimination.
b. Tying arrangements.
c. Requirements contracts.
d. Exclusive dealing.
e. Territorial confinement.
f. Acquiring a competitor’s shares or assets
g. Becoming a director of a competing firm.
h.
B. Three Antitrust Policy Debates
1. Resale Price Maintenance
Resale price maintenance is an agreement between a manufacturer and a
distributor on the price at which a product may be sold.
a. Resale price maintenance is inefficient when it enables dealers to
operate a cartel and charge the monopoly price.
b. Resale price maintenance might be efficient if it enables a
manufacturer to induce dealers to provide the efficient standard of
service in selling a product.
2. Tying Arrangements
A tying arrangement is an agreement to sell one product only if the buyer
agrees to buy another, different product.
 There is no simple test of whether a firm is engaged in tying or
whether, by so doing, it has created inefficiency.
3. Predatory Pricing
Predatory pricing is setting a low price to drive competitors out of business
with the intention of setting a monopoly price when the competition has
gone.
 Economists are skeptical that predatory pricing occurs often
because the firm would be exchanging a high and certain loss for a
temporary and uncertain gain.
C. A Recent Antitrust Showcase: The United States Versus Microsoft
1. The Case against Microsoft.
The government charged Microsoft with the following:
. Possessing monopoly power in the PC operating system market.
a. Using predatory pricing and tying arrangements to achieve a
monopoly in the market for Web browsers.
b. Using other anticompetitive practices to restrict competition.
2. Microsoft’s Response
Microsoft challenged these charges and claimed that it was vulnerable to
competition and that integrating Internet Explorer with Windows provided
greater consumer value.
3. The Outcome
The court agreed that Microsoft was in violation of the Sherman Act and
ordered that it be split into two firms. But Microsoft successfully appealed
this ruling and in the final judgment Microsoft was ordered to disclose
details about its operating system so that its competitors could compete
more effectively.
D. Merger Rules
The Department of Justice uses guidelines based on the Herfindahl-Hirschman
index (HHI) to help decide whether or not to challenge mergers within a market.
1. An HHI between 1,000 and 1,800 shows a market is moderately
concentrated. The Department of Justice challenges any merger in this
range that will raise the HHI by more than 100 points.
2. An HHI greater than 1,800 shows a highly concentrated market. The
Department of Justice challenges a merger in this range if the merger will
raise the HHI by 50 points.
The Department of Justice scrutinizes proposed mergers if the HHI
exceeds 1,000. Proposed mergers between producers of carbonated soft
drinks were blocked in 1986 by application of these guidelines.
3.
4. The AOL Time Warner Merger
For this Chapter, students must do the following:
18.
The Anatomy of Factor Markets
Three factors of production—labor, capital and land—are traded in factor markets,
which are markets where the equilibrium quantity of the factor and the factor price are
determined. A fourth factor of production, entrepreneurship, creates firms and hires the
other factors.
A. Labor Markets
The labor market is a collection of people and firms who are trading labor
services. Some labor is traded on a daily basis called casual labor but most is
traded on a contract, called a job.
1. Human capital is an individual’s skills obtained from education, on-the-job
experience, and work experience.
2. The price of labor is the wage rate.
B. Financial Markets
Financial capital is the funds that firms use to buy and operate physical capital.
A financial market is a collection of people and firms who are lending and
borrowing to finance the purchase of physical capital.
1. Stock Market
A stock market is a market in which shares in the stocks of companies
are traded. A stock is an entitlement to a share in the company’s profits.
2. Bond Market
A bond market is a market in which bonds issued by firms and
governments are traded. A bond is a promise to pay specified sums of
money on specified dates.
C. Land Markets
Land consists of all the gifts of nature including metal ores, oil, and natural gas.
 A commodity market is the market in which raw materials are traded.
D. Competitive Factor Markets
Most factor markets are competitive, that is, there are many buyers and sellers.
The Demand for a Factor of Production
The demand for a factor of production is a derived demand, which is derived from the
demand for the goods and services it is used to produce.
A. Value of Marginal Product
The value of marginal product is the value to a firm of hiring one more unit of a
factor of production. The value of marginal product equals the price of a unit of
output multiplied by the marginal product of the factor of production.
1. The Value of Marginal Product Curve
The value of marginal product curve is graphed with the number of
workers on the x-axis and the value of marginal product on the y-axis. The
curve is downward sloping because the value of marginal product
decreases as the quantity of labor employed increases.
The price of a car wash is $3. The value of the marginal product of labor equals the
price of the product multiplied by marginal product of labor (column 3). The marginal
product of the second worker is 4 washes, so the value of the marginal product of the
second worker (in column 4) is $3 a wash multiplied by 4 washes, which is $12.
The blue bars show the value of the marginal product of the labor that Max hires based
on the numbers in Table 18.1. The orange line is the firm's value of the marginal
product of labor curve.
B. A Firm’s Demand for Labor
The value of marginal product and the wage rate determine the quantity of labor
demanded by a firm. The value of marginal product reflects the additional
revenue earned by the firm by hiring one more worker and the wage rate is the
additional cost the firm incurs by hiring the additional worker. To maximize
profits, a firm hires up to the point at which the value of marginal product equals
the wage rate.
1. A Firm’s Demand for Labor Curve
a. A firm’s demand for labor curve is also its value of marginal product
curve.
b. As the wage rate rises, a firm hires fewer workers and as the wage
rate decreases, a firm hires more workers. That is, as the wage rate
changes there is a change in the quantity demanded of labor or a
movement along the demand curve.
At a wage rate of $10.50 an hour, Max makes a profit on the first 2 workers but would
incur a loss on the third worker (part a), so the quantity of labor demanded is 2 workers
(part b). Max's demand for labor curve in part (b) is the same as the value of marginal
product curve. The demand for labor curve slopes downward because the value of the
marginal product of labor diminishes as the quantity of labor employed increases.
C. Changes in the Demand for Labor.
The demand for labor depends on three factors. Changes in these factors will
shift the demand for labor curve.
1. The Price of the Firm’s Output.
As the price of the firm’s product increases, the firm demands more labor
because an increase in the product’s price increases the value of marginal
product. The demand curve for labor shifts rightward.
2. The Prices of Other Factors of Production.
a. If the price of capital decreases relative to the wage rate, a firm
substitutes capital for labor. The firm’s demand for labor curve
shifts leftward.
b. If the decrease in the price of capital leads to a large enough
increase in the scale of production, a firm might buy additional
capital and hire more labor, which increases the demand for labor.
This change occurs in the long run.
3. Technology.
Depending on the type of technology, the demand for labor might increase
or decrease. An increase in technology might decrease the demand for
labor in that industry but increase the demand for labor in the industry that
produces and maintains the technology.
Wages and Employment
A. The Supply of Labor
1. A person supplies labor to earn an income. While the wage rate is a key
factor in the amount of labor a person supplies, there are other factors.
2. An individual’s labor supply curve is upward sloping at lower wage rates,
but eventually bends backward at high wage rates.
3. Market Supply Curve
The market supply curve is the sum of all labor supplied at various wage
rates. The market labor supply curve in a given job slopes upward.
(1) At a wage rate of $10.50 an hour, (2) Larry is willing to supply 30 hours a week of
labor. (3) Larry's quantity of labor supplied (4) increases as the wage rate increases up
to (5) a maximum, and then (6) further increases in the wage rate bring a decrease in
the quantity of labor supplied. Larry's labor supply curve eventually bends backward.
4.
The supply curve of car wash workers shows how the quantity supplied changes when
the wage rate changes, other things remaining the same. In a market for a specific type
of labor, the quantity supplied increases as the wage rate increases, other things
remaining the same.
B. Influences on the Supply of Labor
The supply of labor depends on three key factors:
1. Adult Population
An increase in the adult population increases the supply of labor.
2. Preferences
As more women have chosen to work, the supply of labor has increased.
3. Time in School and Training
As more people remain in school for full-time education and training, the
supply of high-skilled labor increases and the supply of low-skilled labor
decreases.
C. Labor Market Equilibrium
The labor market equilibrium determines the wage rate and employment.
1. If the wage rate exceeds the equilibrium wage rate, there is a surplus of
labor and the wage rate falls.
2. If the wage rate is less than the equilibrium wage rate, there is a shortage
of labor and the wage rate rises.
The labor market coordinates firms' demand for labor and households' supply of labor
plans by changing the wage rate. The market is in equilibrium--the quantity of labor
demanded equals the quantity supplied. (1) The equilibrium wage rate is $10.50 an
hour and (2) the equilibrium quantity of labor is 300 workers.
If the wage rate exceeds $10.50 an hour, the quantity supplied exceeds the quantity
demanded and the wage rate falls. If the wage rate is below $10.50 an hour, the
quantity demanded exceeds the quantity supplied and the wage rate rises.
3.
Financial Markets
A. The Demand for Financial Capital
1. A firm’s demand for financial capital depends on its demand for physical
capital to produce goods and services. The quantity of physical capital that
a firm plans to use depends on the interest rate.
2. The higher the interest rate, the smaller the quantity of capital demanded.
3. The demand for financial capital depends on two main factors:
a. Population growth. As the population grows, the demand for all
goods and services increases, so the demand for the physical
capital that produces them increases.
b. Technological change. As technology advances, the demand for
some types of physical capital increases and the demand for other
types decreases.
B. The Supply of Financial Capital
The quantity of financial capital supplied results from people’s saving decisions.
1. The higher the interest rate, the more people save and the greater the
quantity of financial capital supplied.
2. The supply of financial capital depends on three main factors:
a. Population. An increase in the population increases the supply of
saving because it increases the number of potential savers.
b. Average income. The higher a household’s income, the more it
saves.
c. Expected future income. If a household’s expected future income is
low, its saving is high. If a household’s expected future income is
high, its saving is low.
C. Financial Market Equilibrium and the Interest Rate
The intersection of the demand for financial capital curve and the supply of
financial capital curve determines the equilibrium interest rate and the quantity of
capital.
1. Over time, both the demand for and supply of capital increase, which
leads to an increase in the quantity of capital but the interest rate does not
persistently increase or decrease.
The demand for financial capital is KD, and the supply of financial capital is KS. Market
equilibrium occurs at (1) an interest rate of 6 percent a year with a (2) quantity of
financial capital of $200 billion.
Land and Natural Resource Markets
All natural resources, called land, fall into two categories: renewable and nonrenewable.
Renewable natural resources are natural resources that can be used repeatedly.
Nonrenewable natural resources are natural resources that can be used only once
and cannot be replaced once they have been used.
A. The Market for Land (Renewable Natural Resources)
1. The higher the rent, the lower the quantity of land demanded.
2. The quantity of land is fixed, so regardless of the rent, the supply of land
does not change. The supply of each particular block of land is perfectly
inelastic.
The demand curve for a 10-acre block of land is D, and the supply curve is S.
Equilibrium occurs at a rent of $1,000 an acre per day.
B. Economic Rent and Opportunity Cost
1. Some human resources are so unique, for example Tiger Woods, that
they also are in fixed supply.
2. Economic rent is the income received by any factor of production over
and above the amount required to induce it’s a given quantity of the factor
to be supplied.
3. Opportunity cost is the income required to induce the supply of a given
quantity of a factor of production.
Part of the income of a factor of production is (1) opportunity cost (the red area), and
part is (2) economic rent (the green area). The figure shows the market for Tiger
Woods' labor. At $50,000 an hour, Tiger is willing to work 40 hours a week. Tiger earns
a large economic rent.
C. The Supply of a Nonrenewable Natural Resource
1. Over time, the quantity of a nonrenewable resource decreases, but its
known quantity increases as technology enables ever less accessible
sources of the resource to be discovered.
2. Using a nonrenewable resource reduces its supply and increases its price,
but as technology reveals new supply, the resource’s price can fall.
Recently, this the forces that bring lower prices have outweighed those
that bring higher prices and natural resource prices have fallen.