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Chapter 6 Prices and Decision Making Prices Price—monetary value of a product as established by supply and demand Prices communicate info to buyers/sellers High prices=producers produce more, buyers buy less Low prices=producers produce less, buyers buy more Prices Prices are the link between producers and consumers Price Adjustment Process Transactions in a market economy are voluntary, because of that the compromise that eventually takes place must be to the benefit of both parties Economic Model Helps to analyze behavior and predict outcomes Market Equilibrium Situation where prices are stable and quantity of goods/services are equal to quantity demanded The market economy finds this by trial and error Surplus Situation in which the quantity supplied is greater than the quantity demanded at a given price Surplus Surplus shows up as unsold products on shelves, sellers know price is too high Prices tend to go down as a result of surplus Shortage Situation in which the quantity demanded is greater than the quantity supplied at a given price Shortage Results in quantity and price both going down Equilibrium Price Price that “clears the market” by leaving neither a surplus or a shortage Market will seek its own equilibrium Social Goals vs. Market Efficiency Gov’t tends to get involved in the market to secure economic goals of equity and security One of the common ways of achieving social goals involves setting prices at “socially desirable” levels When this happens, prices are not allowed to adjust to their equilibrium levels Government Intervention Condition when gov’t sets the prices Occurs when gov’t feels the market system is not working Gov’t can set price ceilings and price floors Price Ceilings Maximum legal price that can be charged for a product Gov’t does then when they feel prices are too high for a product Will cause shortages Price Floors Lowest legal price that can be paid for a good Gov’t does then when they feel prices are too low Minimum wage is an example Agricultural Price Supports Price supports are most evident in agriculture US Department of Agriculture tinkers with free market system using target prices, land banking, price supports to alter market forces Chapter 7 Market Structures Bell Ringer 10/17 Market Structure The competition among firms operating in the same industry Market Organization 1. Perfect Competition 2. Monopolistic Competition 3. Oligopoly 4. Monopoly Market Structure Characteristics 1. Number of firms in industry 2. Influence over price 3. Product differentiation 4. Advertising 5. Ease of entering or leaving the market What Is Perfect Competition? 1) In perfect competition, all consumers and producers are price takers. 2) This means that neither consumers nor producers can do anything to change price. 3) Consumers rarely affect price, so we will focus on the producer. 4) The supply and demand model is a model of a perfectly competitive market. Equilibrium Price Producers The Two Main Characteristics There are two conditions necessary for a perfectly competitive market to exist. 1) Numerous Sellers = A) Generally there are hundreds or even thousands of sellers. B) No seller can have a large market share. C) This means no seller can produce more than a small fraction of the total market supply. = = B) They do not have to be identical, consumers just have to think they are. = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = 2) Standardized Product A) Consumers must regard all products to be identical. = = = = = 2. Monopolistic Competition Market organization in which many firms produce goods that are similar enough (a little different) to be substitutes Example: gas stations, fast food industry, soft drink industry Characteristics Monopolistic competition has characteristics that make it similar to both monopoly and perfect competition. 1) Many Sellers Each firm has a small amount of market power, but there is no possibility for collusion. Shampoo is a great example of just how many different firms can exist in a single market, all with differing prices and qualities. Characteristics Monopolistic competition has characteristics that make it similar to both monopoly and perfect competition. 1) Many Sellers Each firm has a small amount of market power, but there is no possibility for collusion. 2) Differentiated Products Firms produce imperfect substitutes, products that are close substitutes but are still distinct. Cheeseburgers from McDonald’s and Burger King could be considered substitutes, but most consumers consider them to be very different. Characteristics Monopolistic competition has characteristics that make it similar to both monopoly and perfect competition. 1) Many Sellers Each firm has a small amount of market power, but there is no possibility for collusion. 2) Differentiated Products Firms produce imperfect substitutes, products that are close substitutes but are still distinct. 3) Low Barriers to Entry In the long run, firms are free to enter or exit the industry. Markets, such as hair salons, can see lots of new entrants in a short time if the market can support them. Likewise, many can fail quickly, too. Product Differentiation One of the key features of monopolistic competition is product differentiation. Firms can differentiate their products in one of three ways. Product Differentiation One of the key features of monopolistic competition is product differentiation. Firms can differentiate their products in one of three ways. 1) By Style or Type Includes differences in features, design, packaging, or service. No two hair salons are alike. Each offers different hair styles based on gender, age, culture, income, preference, etc. Product Differentiation One of the key features of monopolistic competition is product differentiation. Firms can differentiate their products in one of three ways. 1) By Style or Type Includes differences in features, design, packaging, or service. 2) By Location Consumers often choose a product based on convenience even if it is more expensive. Many small hair salons can succeed because people are likely choose one that is close to their house. Product Differentiation One of the key features of monopolistic competition is product differentiation. Firms can differentiate their products in one of three ways. 1) By Style or Type Includes differences in features, design, packaging, or service. 2) By Location Consumers often choose a product based on convenience even if it is more expensive. 3) By Quality Some consumers are willing to pay more for higher quality products. Some professional stylists can charge hundreds of dollars per customer, but most consumers settle for something cheaper than that. 3. Oligopoly Market structure in which very few large firms dominate the industry Examples: Automobiles, TV companies, cell phone companies What Is Oligopoly? Oligopolies share many characteristics with monopolies, but the forces that create oligopolies are not as strong as those that create monopolies. 1) A Few Large Firms Generally, the four-firm concentration is above 50%, meaning together they share significant market power. Market Concentration Largest Firms Light Bulbs 75.4 % General Electric, Sylvania, Philips, Westinghouse Cereals 80.4 % Kellogg’s, General Mills, Post, Quaker Batteries 88.0 % Duracell, Energizer, Panasonic, Rayovac This means the four largest firms account for at least 50% of all sales. There may be many smaller sellers, but they do not have any market power. What Is Oligopoly? Oligopolies share many characteristics with monopolies, but the forces that create oligopolies are not as strong as those that create monopolies. 1) A Few Large Firms Generally, the four-firm concentration is above 50%, meaning together they share significant market power. 2) Identical or Differentiated Products Oligopolists can either create identical products or varied products. For example, light bulbs of a similar size are all essentially identical. The cereal industry, however, has a seemingly endless variety of products to choose from. What Is Oligopoly? Oligopolies share many characteristics with monopolies, but the forces that create oligopolies are not as strong as those that create monopolies. 1) A Few Large Firms Generally, the four-firm concentration is above 50%, meaning together they share significant market power. 2) Identical or Differentiated Products Oligopolists can either create identical products or varied products. 3) High Barriers to Entry Barriers (usually high start-up costs) prevent competing firms from opening. Manufacturing industries, such as batteries, require a great deal of technology, machinery, and patents. What Is Oligopoly? Oligopolies share many characteristics with monopolies, but the forces that create oligopolies are not as strong as those that create monopolies. 1) A Few Large Firms Generally, the four-firm concentration is above 50%, meaning together they share significant market power. 2) Identical or Differentiated Products Oligopolists can either create identical products or varied products. 3) High Barriers to Entry Barriers (usually high start-up costs) prevent competing firms from opening. 4) Interdependence An individual firm’s profits are highly dependent on its competitors’ prices. The airline industry is a great example of how one oligopolist’s profits are largely determined by his/her competitors’ prices. 4. Monopoly Form of market organization in which there is only 1 seller of a product Example: No perfect example, best is gov’t controlled water companies Characteristics of Monopoly There are several traits that characterize a monopoly. The four most important ones are described here. Characteristics of Monopoly There are several traits that characterize a monopoly. The four most important ones are described here. 1) One Seller Monopolies exist when one firm controls an entire market (or almost all of it). Microsoft owns over 95% of the operating system market, but it does have competition from Mac and Linux operating systems. Characteristics of Monopoly There are several traits that characterize a monopoly. The four most important ones are described here. 1) One Seller Monopolies exist when one firm controls an entire market (or almost all of it). 2) No Substitutes If there are substitutes to the product supplied by the monopolist, he/she cannot exercise monopoly power. The National Football League (NFL) has no close substitutes. Yes, there are other similar leagues, but none that compare to the NFL. Characteristics of Monopoly There are several traits that characterize a monopoly. The four most important ones are described here. 1) One Seller Monopolies exist when one firm controls an entire market (or almost all of it). 2) No Substitutes If there are substitutes to the product supplied by the monopolist, he/she cannot exercise monopoly power. 3) High Barriers to Entry A monopolist remains the single seller in a market only because he/she can keep others from entering the market. A barrier to having competing electrical companies is that cities are not willing to have more than one set of power lines. Characteristics of Monopoly There are several traits that characterize a monopoly. The four most important ones are described here. 1) One Seller Monopolies exist when one firm controls an entire market (or almost all of it). 2) No Substitutes If there are substitutes to the product supplied by the monopolist, he/she cannot exercise monopoly power. 3) High Barriers to Entry A monopolist remains the single seller in a market only because he/she can keep others from entering the market. 4) Control Over Price A true monopolist can change price and quantity to maximize profits. De Beers, a company that controls most of the world’s supply of diamonds, artificially increases price by limiting its output. Barriers to Entry A monopolist’s profits do not go unnoticed. So why don’t other firms enter the market? One of the following barriers keeps others from entering the market. Barriers to Entry 1) Control of a Resource If a firm controls all or most of a scarce resource, it is easy to keep other firms from obtaining it. De Beers controls most of the world’s diamond supply, making entry into the market very difficult. Barriers to Entry 1) Control of a Resource If a firm controls all or most of a scarce resource, it is easy to keep other firms from obtaining it. 2) Technological Superiority Firms can gain a technological advantage over competitors that can lead to a monopoly. Intel produces the chips that run computers. For many years no other firms were able to match their microprocessor technology. Barriers to Entry 1) Control of a Resource If a firm controls all or most of a scarce resource, it is easy to keep other firms from obtaining it. 2) Technological Superiority Firms can gain a technological advantage over competitors that can lead to a monopoly. 3) Government Involvement The government can restrict firms from entering a market through patents, copyrights, and laws. Sometimes government will actually run a monopolistic business, or it can issue patents and copyrights. Barriers to Entry 1) Control of a Resource If a firm controls all or most of a scarce resource, it is easy to keep other firms from obtaining it. 2) Technological Superiority Firms can gain a technological advantage over competitors that can lead to a monopoly. 3) Government Involvement The government can restrict firms from entering a market through patents, copyrights, and laws. 4) Economies of Scale A monopoly can exist if one company has a cost advantage over new firms. The enormous upfront costs of power companies makes it very difficult to start a competing business. Types of Monopoly There are four types of monopolies. Each one gets its market power from the way in which it bars entry into the market. Types of Monopoly 1) Geographic Monopoly If there is only one store in a location, it acts as a monopoly since it has no local competition. A single gas station along a lonely road in the desert is an example of a geographic monopoly. Types of Monopoly 1) Geographic Monopoly If there is only one store in a location, it acts as a monopoly since it has no local competition. 2) Technological Monopoly Although firms can enjoy a technological edge in the short run, other firms will soon copy it. Despite Intel’s early success, it now experiences a tremendous amount of competition. Types of Monopoly 1) Geographic Monopoly If there is only one store in a location, it acts as a monopoly since it has no local competition. 2) Technological Monopoly Although firms can enjoy a technological edge in the short run, other firms will soon copy it. 3) Legal Monopoly Sometimes the government deems it necessary to create a monopoly. By allowing drug companies to patent their discoveries for 20 years, it encourages heavy investment in research and development. Types of Monopoly 1) Geographic Monopoly If there is only one store in a location, it acts as a monopoly since it has no local competition. 2) Technological Monopoly Although firms can enjoy a technological edge in the short run, other firms will soon copy it. 3) Legal Monopoly D Economies of Scale Diseconomies of Scale ATC Sometimes the government deems it necessary to create a monopoly. 4) Natural Monopoly Exist when 1 company can produce items cheaper than 2 competing firms. If Average Total Cost (ATC) is still decreasing at the output level, the firm is still in the economy of scale portion of the graph. Advertising Advertising is a controversial economic subject, but it is generally considered that it does affect the demand curve and increases revenue. Advertising 1) Why do firms advertise? A) It helps differentiate their products from other firms. B) Differentiated products give firms more market power, allowing them to charge higher prices. Advertising 1) Why do firms advertise? A) It helps differentiate their products from other firms. B) Differentiated products give firms more market power, allowing them to charge higher prices. 2) Why Can They Charge More? A) Demand increases since consumer tastes and brand loyalty are affected. D1 B) Demand also increases since the perceived utility of the item increases. Remember, whenever demand increases, it means more output is being sold at a higher price. D2 Branding Branding refers to the distinctive identity that a particular name, phrase, or symbol bestows on a firm and its products. Branding 1) It provides quality assurance. A) Consumers are willing to pay for a brand name for its quality. Consumers are often willing to spend more on a pricey brand name television simply because of its reputation for quality. Branding 1) It provides quality assurance. A) Consumers are willing to pay for a brand name for its quality. B) If a brand name fails in its quality, it will be punished by the market. When the E. coli bacteria was found in some Jack-in-theBox hamburger meat in 1993, its sales and stock plummeted. Branding 1) It provides quality assurance. A) Consumers are willing to pay for a brand name for its quality. B) If a brand name fails in its quality, it will be punished by the market. 2) It provides information. A) Especially in new situations, consumers turn to known brands. Imagine you are in an unfamiliar town and need a hotel for the night. You are much more likely to stay at a brand name hotel even if it costs more. Branding 1) It provides quality assurance. A) Consumers are willing to pay for a brand name for its quality. B) If a brand name fails in its quality, it will be punished by the market. 2) It provides information. A) Especially in new situations, consumers turn to known brands. B) Consumers are more likely to purchase new products if it has a familiar brand name. Suppose you have a favorite shampoo brand. If you are in need of face wash, hand lotion, or sunscreen, you may use the same brand. Market Failures The allocation of goods and services by a free market that is not efficient…there is a better way for participants to be better-off and not make someone else worse-off Most common market failures involve: 1.inadequate competition 2. inadequate information 3. externalities 1. Inadequate Competition A decrease in competition has several consequences: 1. inefficient resource allocations (waste of resources)—why would a firm with few competitors have incentive to use resources carefully? 2. higher prices 3. may enable a business to influence politics—example: big company to demand tax breaks or move elsewhere 2. Inadequate Information Information is needed to make economic decisions, if not available to buyers than it is an example of a market failure 3. Externalities Unintended side effects Negative externality—harm, cost, or inconvenience suffered by a 3rd party because of actions of another (example: pollution of steel plant, traffic congestion due to plant) Role of Government In the Market The marketplace usually keep businesses competitive with one another The Government has the power to regulate markets when needed by establishing rules and laws to protect consumers The most important laws are called antitrust legislation which give them the power to control and break up monopolies The government can also keep trusts from forming and can regulate business mergers as needed Role of Government In the Market In the late 1800s, U.S. government passed laws to restrict monopolies and trusts (to prevent market failures due to inadequate competition) The U.S. government has created several agencies to monitor and restrict markets/companies Federal Trade Commission (FTC)1914 Administers antitrust laws forbidding unfair competition They monitor unfair business practices, including deceptive advertising Food and Drug Administration (FDA)1906 Protects consumers from unsafe foods, drugs, or cosmetics; requires truth in labeling of these products Securities and Exchange Commission (SEC) 1934 Regulates and monitors the stock market to protect investors Occupational Safety and Health Administration (OSHA) 1970 Enforces regulations to protect employees at work Investigates accidents at the workplace Federal Communications Commission (FCC) Regulates the communications industry, including radio, television, cable, and telephone services Environmental Protection Agency (EPA) Protects human health by enforcing environmental laws regarding pollution and hazardous materials Role of Government In the Market The government also tries to make sure that businesses do not engage in practices that would reduce competition Price fixing occurs when businesses agree to set prices for competing products The government can issue a cease and desist order that requires a firm to stop an unfair business practice