The Government and Economic Policy

Governments have two different options in terms of economic policy.
-They can enforce economic regulation (and punish firms who misbehave)
-They can draft competition policy (and create an economic environment conducive to competition)

The big issue here is market power versus rivalry. Generally, market structures closer to perfect competition are seen as preferable, but this must be qualified- perfect competition and efficiency are not always the best outcomes for society.
-Efficiency is not always the only goal for society. For instance, an industry may be the most cost efficient if it outsources labour to a Malaysian sweatshop, but but many people see wage slavery as unethical, and would rather pay a higher price for FAIR TRADE goods than inexpensive but guilt-inducing free-trade products
-Private Costs to Industries do not include social costs, such as environmental damage. A highly economically efficient production process may incur a high external cost to society through the accumulation of dangerous pollution, etc.
-Costs are not independent of market structure. If there are economies of scale inherent in the market, perfect competition may divide up market shares to the point where the minimum efficiency scale would provide for more products than is suitable for each firm to maximize profit. As such, a shift to a monopoly structure may be more efficient (as in the power industry, landline telephones, and other tentacle industries)
-Monopolies may be necessary for innovation. Generally, the size and profits of monopolies give them more economic freedom to invest in research and development (for an example, drug companies receive patents which grant them the exclusive right to sell new drugs they develop because this monopoly profit incentive drives new research)
-Also a competitive desire from external firms hoping to enter an industry may drive innovation (as seen in cell phones, email, solar panels, and other new technologies which de-emphasize monopoly power in certain sectors.
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Economic Regulation to Promote Efficiency!

Controlling Natural Monopolies (Industries where scale economies and high fixed costs permit only one firm to operate at minimum efficiency scale, and discourage other firms from entering the industry- tentacle industries like electric companies): There are two options
-Buy up the monopoly and turn it into a state-owned Crown Corporation
-Allow private ownership to continue, but regulate the monopoly firm (using bodies like the Canadian Radio and Television Commission, for instance)

If the government chooses to regulate, or if it chooses to buy up a tentacle it must dictate the pricing policy for that industry:
-It can induce marginal cost pricing, and sell where the demand-determined price is equal to the marginal cost of producing the final unit
-It can induce average cost pricing, and sell where the demand-determined price is equal to the average cost of producing the final unit
-It can induce a "rate of return" legislation, where regulated firms are allowed to a small percentage of returns (eg: 5% profit)

MARGINAL COST PRICING:

Here, demand = supply, and price = marginal cost. The major benefit of this pricing model is that it allows for allocative efficiency (so there is no deadweight social loss). However, this is not the profit maximizing output where marginal revenue is equal to marginal costs, so there is an inherent conflict between the governments desire for allocative efficiency, and the firm's desire for profit.

As is shown be the green box in the diagram, when a natural monopoly with falling average costs uses marginal cost pricing, it incurs an economic loss (the price is lower than the average cost here, thus a loss is generated by producing at this output level). Usually, this loss must be offset with government subsidies (aka: taxpayer money)

REMEMBER: TR (Price at output level X output produced) - TC (average cost at output level X output produced) = A LOSS IN THIS CASE
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AVERAGE COST PRICING

Here, monopolies are forced to produce an output where demanded determined prices are equal to the average cost of producing at that output level. This means that total costs will = total revenues, so the firms here will make normal profits, and there will be no need for a subsidy. On the other hand, this pricing model is less allocatively efficient, as Price is not equal to the marginal cost of production here, and the quantity produced is less than what is required for maximum total economic surplus (so a deadweight loss is generated).

Which is better? Well, that's a value judgement. Marginal Cost Pricing is allocatively efficient, but requires costly subsidies. Average cost pricing is not allocatively efficient, but will not require subsidies.

Rate of Return pricing lets monopolies keep a "fair" profit. Here, allocative efficiency is ignored. A big problem with this pricing model is determining what is "fair".
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DIRECT CONTROL OF OLIGOPOLIES

-Historically, the government has controlled entry into certain industries (such as postal services and air travel) in order to protect crown corporations from competition.
-Recently, however, government intervention has become less popular. Crown corporations are increasingly becoming privatized, while regulated industries are becoming deregulated. An example of this is the open skies policy for airlines. Originally, Air Canada operated as a monopoly in Canadian air travel, and would often cross-subsidize airfare (so flyers traveling from Calgary to Toronto would pay extra so that travelers going from Vancouver from Nunavut would not have to pay as much [The UBC bookstore also does this to find student activities]). Now, Westjet has broken up that monopoly, but there is still legislation in place to prevent non-Canadian airlines from carrying passengers from one Canadian city to another.

Why is the government moving out of direct control for oligopoly markets?
-Oligopolies are a good source of innovation
-Cross subsidization which was used by crown corporations in the past is now not seen as economically sound
-There has been a great deal of corruption and cross fertilization between regulators and the industries they supposedly regulate (often, because employees at regulatory agencies later wish to seek employment in the industries they have previously regulated in order to make more money and help firms find regulatory loopholes)
-As such, regulators often favor producers over consumers
-Crown corporations do not improve labour relations and efficiency (just take Canada Post, and disgruntled postal unions for an example)
-International competition makes subsidies inefficient

The government strives to "maintain and encourage competition in Canada" - section 2 of the competition act
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CANADIAN COMPETITION POLICY (The carrot approach)
-Using this, the government tries to create a good balance between market power and efficiency.

In the combines investigation act (1889), the government created explicit restrictions in terms on non-competitive behavior under the larger legal umbrella of criminal law. There were four basic areas.
a) Conspiracy (this forbade explicit collusion)
b) Merger (this forbade companies from joining together or buying their competitors. Amusingly, this was originally intended to break unions apart, as unions were seen as creating a monopoly in labour markets and restricting trade and efficiency)
c) Monopoly-abuse of dominant position (Although this was seen as hypocritical by many firms, as the government favored competition, yet would penalize firms who were successful in negotiating markets and eliminating their competitors)
d) unfair trade practices

In 1986, this was replaced with the Competition Act, and the competition tribunal (a special economic court with economists acting as judges). Its purpose is to "maintain and encourage competition in Canada".

INDICTABLE OFFENSES (Things you can go to jail for doing)
-Conspiracy (explicit collusion)
-Bid Rigging (for firms who do contract work, bid rigging is a method of collusion)
-Illegal Trade Practices (such as giving certain buyers preferential discounts
-Misrepresentation (lying about costs or profits for instance)
-Telemarketing
-Double ticketing (having two sticker prices for a particular good)
-Pyramid Selling

Matters Reviewable by Tribunal (slightly less bad, but still suspicious)
Abuse of dominant position
-squeezing
-fighting brands (like the 'life' brand)
-Pre-emption (preventing entry)
-Predation (predatory pricing to eliminate competition over the long run)
-Mergers (Which cause a significant loss of competitive behavior) *** unless the raised consumer prices faced due to decreased competition can be offset by the productivity gains and lowered production costs brought about by the merger

THATS ALL!

Productive and Allocative Efficiency for different market structure

We know that there are 4 different market structures in economics.


Now we're going to explore the idea of efficiency


PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms

OR

-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)

In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.

CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient


ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"

CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient

ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss

-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!

To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
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PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve

ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient

ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.

It is possible to produce too much or too little of either product.

REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
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EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES

PERFECT COMPETITION

CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!

As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!

In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized

Any output greater than or less than QE will reduce the total sum of producer and consumer surplus

IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient



MONOPOLIES AND EFFICIENCY

Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)

Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct

P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss

WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS

See?

Game Theory Pt. 2

In Oligopolies, and in game theory, there are also sequential games. Chess is a good example of a sequential game. In sequential games, there is time-sensitive sequencing, OR simultaneous knowledge of the other player's decision by both players. As such, we use decision trees to mark off the outcomes of sequential games.


DIFFERENT PATHS: The first player to move can use BACKWARDS INDUCTION to predict which moves their opponent will make given their move. The first mover here can predict all of the outcomes, and will probably choose the "large" strategy, because they will receive 30 points in every outcome for the large scenario. Given that the first player will always choose the "large" strategy, the second mover will always choose the large strategy as well, because they prefer having 3 points to having 0.3 points. AS SUCH, we know that there is a NASH EQUILIBRIUM, because both players are playing their best strategy given the strategy of the other play. Additionally, this is Pareto, as we cannot make either player better off.

ULTIMATUM BARGAINING GAME: In an ultimatum, the first player imposes a "take it or leave it offer". For an example, lets say that my mom gives my sister a dollar. My mom tells my sister that she must take that dollar and share some of it with me, or else she will take it away. In other words, my sister will offer me a portion of the money she has received, and I can accept it, or decline it. If I reject the offer, then neither me nor my sister will get a dollar. This is the payoff tree:

SISTER will propose $X for herself, and $(1-X) for me. If I accept this offer, I will get $(1-X), and my sister gets $X. If I reject this offer, we both get nothing.

Nash Equilibrium Occurs where I accept my sister's offer (regardless of the offer). This is because I would rather get a little bit of money than no money. Neither me nor my sister has any incentive to use any strategy other than this.

WHAT SHOULD MY SISTER'S STRATEGY BE? She should offer me the smallest amount as possible, because it is to my advantage to accept ANY offer. SO...

If my sister offers me 1 cent, it is still in my best interest to accept it, because 1 cent is better than nothing. In this scenario, my sister will get to keep 99 cents, and I will get 1 cent!

ULTIMATUM BARGAINING WITH AN ACCEPTANCE THRESHOLD: This is a version of ultimatum bargaining, but here, the second mover (me) can declare a minimum acceptance threshold (Y) in advance. This changes the payoff tree.

My sister can either propose an offer greater or equal to my minimum acceptance threshold (100-X > or = Y), or lower than it (100-X < Y). If she offers me an amount equal to or greater than my minimum acceptance threshold, then I will get $1-X, and she will get $X. If she offers me an amount lower than my minimum acceptance threshold, then I will reject the offer, and we will both get nothing.

Here, Nash Equilibrium occurs where my sister accepts my minimum acceptance threshold. This is because she would rather have a little bit of money than no money. Given my minimum acceptance threshold, it is always in my sister's best interests to offer an amount which complies with it.

SO WHAT IS MY BEST STRATEGY? Well, because it is always in my sister's best interest to accept my threshold, I stand to make the most money by setting my threshold as high as possible (99 cents). If I do this, then I will make 99 cents, and my sister will only make one cent.

KIDNAPPER GAMES ARE ALSO IMPORTANT, AS ARE COMPETITIVE MARKETS, but my internet just died and deleted all of the previous crap I typed up, and I am NOT spending another hour and typing it all up again. FORGET IT!

Oligopolies and Game Theory

Today, we begin game theory, which is interesting and exciting- probably one of the neatest things you will learn in Microeconomics.

Oligopolies use game theory, because decision-making is strategic- it hinges on the decisions of other firms.

OLIGOPOLY CHARACTERISTICS
-Several Sellers (but not many: 2 or 3 is most common)
-They must sell a similar, but differentiated good (ie: coke and pepsi both sell soda, but they are well-differentiated. GM and Ford both sell cars, but the brands are different, as are the cars).
-Entry and exit from the industry is possible, but very very difficult
-All of the firms can act as price setters within a reasonable limit.

REASONS FOR OLIGOPOLY

1: STRATEGIC BEHAVIOR (It benefits the firms in the oligopoly industry, so firms will actively vie to maintain oligopoly conditions)
-Merger and acquisitions (bigger companies buy up smaller companies, so that in the long run, in major industries, there are only a few large companies competing)
-With fewer rivals, the remaining players reap larger profits
-This can only occur if there are substantial barriers to entry

2: NATURAL CAUSES
-Economies of Scale: Bigger, well established companies have bigger cost savings, and are more able to approach the minimum efficiency scale than newer entrants
-Economies of Scope: It is cheaper for a company to produce two products together
-Oil and gad had both economies of scale and scope working in favor of established companies, because larger firms have an advantage over smaller firms (especially in unstable economic times, when many smaller firms go under)

3: ARTIFICIAL CAUSES
-Oligopolies due to government policies
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GAME THEORY/STRATEGIC BEHAVIOR: Decisions that are based on what other people do. (This section will HURT your brain)

Game: A decision making process of two or more players who are interdependent. There are two different kinds of games:
a) Simultaneous Game: Where both players make their decisions are the same time (or alternately, they don't know what the other player is going to do). An example of this would be rock-paper-scissors.
b) Sequential Game: One player makes a decision, then the other player reacts (sort of like a game of chess).

Player: The decision maker/strategist. In economics, this usually refers to the firm

Strategy: An interdependent decision (for example, choosing to move a pawn or a bishop could be two different strategies: choosing to cooperate with other firms and form a cartel or or choosing to compete and try to make more profit than other firms could be two different strategies)

Payoff: The outcome of a game: profits!

TODAY: WE ARE LEARNING ABOUT SIMULTANEOUS GAMES

Here are a few different important terms:

NASH EQUILIBRIUM: When each player's best strategy is to maintain its present behavior, given the present behavior of the rival. Given the behavior of the other, both players are simultaneously playing their best strategy. Both players have a best strategy, and "my best strategy is to keep doing what I'm doing as long as you keep doing what you're doing
-Nash EQ is stable, because both firms end up in a Nash Equilibrium scenario (both players want to play their best strategy)
-Nash EQ is an equilibrium, because neither firm will benefit from departing from it (in this way, equilibrium could have nothing to do with maintaining supply and demand)
-Nash EQ is self-policing, because there is no need for group behavior to enforce it (players will naturally adopt their best strategies)
-Stable equilibrium is reached by rational non-cooperation (if both players pursue self-interests, they will reach a Nash Equilibrium)
-THE DOMINANT STRATEGY is the strategy that yields a higher payoff, regardless of the strategy of the other player!
-THE DOMINATED STRATEGY is the strategy that yields a lower payoff than an alternate strategy, regardless of the strategy of the other player. This is the strategy, which logically should never be played because it will always lead to a lower payoff than different strategies.

NOTES:

-If two players are in a game, and both are playing their dominant strategy, then there is a Nash Equilibrium
-BUT a Nash equilibrium can be reached when not ALL parties have a dominant strategy

THE PRISONER'S DILEMMA: A dilemma which faces some players in a Nash Equilibrium (so this is still a type of Nash Equilibrium). In a prisoner's dilemma scenario, both players have a dominant strategy, but if they both play their dominant strategy, the resulting payoff is lower than if they had both played their dominated strategy.
-An example of this is studying. In order to get good marks in a class, each student's dominant strategy is to study. Interestingly, if none of the students in a particular class studied and they all go abysmally low marks, then the prof would have no choice but to scale their marks up, so that the average would end up being the same as it would if all of the students had studied. In this case, each student would have gotten the same mark-payoff, but for a minimal effort.
-The prisoner's dilemma highlights the difference between the narrow self interest of individual players, and the broad collective interest of a group.
-Other examples? -Advertising, Cellphones, Everyone Standing at a concert, everyone shouting at a party, CARTELS

CARTELS ARE AN EXAMPLE OF THE PRISONER'S DILEMMA SCENARIO: If all of the firms abide by the rules set by the cartel and actually restrict their outputs as agreed, all of the firm can generate economic profit (their collective payoff is higher than if they compete)
-If one member of a cartel cheats, however, they can potentially earn even GREATER profits than if they acted according to the restrictions of the Cartel
-If all members of a Cartel cheat, however, the Cartel will break apart and all of the firms will be in competition.

YUP! difficult decisions to make for Cartel participants...

FINAL DEFINITION: PARETO OPTIMUM- "You cannot make someone better off without making someone else worse off"
-This is one concept of "the best"
-Synonyms? Allocative efficiency; Pareto Optimality; Pareto Efficiency
-EXAMPLE: I have a chocolate ice cream cone, and my friend Genya has a butterscotch ice cream cone. My favorite flavor of ice cream is butterscotch, and her favorite flavor is chocolate. Is this a scenario of Pareto Optimality?

NO!

This may be productively efficiency, but it is not allocatively efficient. We can trade our ice cream cones and BOTH of us will be better off. Let's say me and Genya trade ice cream cones. This is an example of a PARETO IMPROVEMENT

PARETO IMPROVEMENT: An action which causes someone to be better off without making someone else worse off. The opposite of a Pareto Improvement is a Pareto Dis-improvement, which is an action which makes someone worse off without causing someone else to be better off (so if a garbage truck came by and threw rotten garbage on me and Genya's ice cream cones, that would be a Pareto Disimprovement).

Pareto Optimum is ONE defition of a best-case scenario. There can also be many different Pareto optimums (for an example, if both me and Genya have rye crackers, and we both love rye crackers, that can also be a pareto optimum)

Here are some different scenarios!

1: NASH EQUILIBRIUM - BOTH DOMINANT - PARETO

HERE, Actor one's best strategy is C1, regardless of what Actor 2 does, and Actor 2's best strategy is C2, regardless of what actor one does. As such, both actor one and Actor 2 have a Dominant Strategy (C1 and C2 respectively).
This is Nash equilibrium, given the action of the other player, both players are simultaneously playing their best strategy. The Pareto Optimum here is the same as the Nash Equilibrium, as both actors get "8" points in Nash Equilibrium. You can't make either actor better off than they already are, so this is Pareto Optimum!

2: NASH EQUILIBRIUM - ONE DOMINANT -PARETO

Here, businessman M's dominant strategy is to sell meat. No matter what the other businessman does, M will have a bigger payoff is she sells meat.
Businessman P, on the other hand has no Dominant Strategy. If M sells meat, it is better for P to sell Potatoes. If M sells Potatos, P will have a bigger payoff selling meat.

NASH EQUILIBRIUM, therefore, is when M is selling meat, and P is selling potatoes. In this scenario, given the actions of either player, both players are simultaneously playing their best strategy.
Pareto Optimum is the same scenario as Nash Equilibrium here. Both players are receiving the must payoff they can receive give the situation, so there is no way to make either player better off.

3: BATTLE OF THE SEXES- DOUBLE NASH EQUILIBRIUM, NO DOMINANT STRATEGY, & PARETO
Let's say we have a nice, normal heterosexual couple. The man likes baseball, and the woman likes ballet (they follow typical gendered behavior, which is the sort of thing that nice normal heterosexual couples do). However, the man and the woman both love each other SO MUCH that they would rather be with each other and at an activity which isn't their favorite than go to their favorite activity alone.

If the man goes to the baseball game, the woman's best strategy is to go to the baseball game too. If the man goes to the ballet game, however, the lady's best strategy is to go to the ballet game, so she HAS NO DOMINANT STRATEGY.
If the woman goes to the ballet, the man's best strategy is to go with her to the ballet. If the woman goes to the baseball game, however, the man's best strategy is to choose baseball, so he HAS NO DOMINANT STRATEGY!

There are two different Nash Equilibrium Scenarios here- both the man and the lady go to a baseball game, or they both see the ballet. In either situation, each player is playing their best strategy given the actions of the other player. Here, there are two different Pareto Optimums. If the couple are at the baseball game, it IS possible to make the woman happier, but not without making the man worse off. Conversely, if the couple is at the ballet, it IS possible to make the man happier, but not without making the woman worse off. Because we cannot make either player better off without making the other one worse off, there are two Pareto Optimums.

4: CARTELS: A PRISONERS DILEMMA NASH EQUILIBRIUM: BOTH DOMINANT, BUT NOT PARETO
In Oligopolies, firms behave interdependently, so decision-making is strategic (it depends on the actions of other players). As such, firms must take the actions of their rivals into account.

The basic dilemma: Should firms cooperate and form a Cartel, or compete with one another?
If firms cooperate, the collective profits for all of the firms will be higher
If a firm decides to compete with rivals, that firm's individual profit will be higher.

Here, both player A and player B's dominant strategy is to compete! As a result, Nash equilibrium occurs when both players are competing. This is NOT pareto optimum, however, as a change to a cooperative strategy for both players would result in a Pareto Improvement (in other words, the players are in Nash Equilibrium, they can both better off without making somebody else worse off).

This is why cartels often collapse: because their dominant strategy is to cheat!

That's all

Introduction to Imperfect Competition

Monopolies and Perfect Competition are both fairly extreme market structures. In reality, most firms operate in conditions known as imperfect competition. There are two different kinds of imperfect competition: Monopolistic Competition and Oligopoly

THERE IS A SPECTRUM OF DIFFERENT MARKET STRUCTURES:

Monopoly---Duopoly---Oligopoly---Monopolistic Competition---Perfect Competition
Competition increases as we go to the right (with the exception of perfect competition, in which there is no competitive behavior)
Market power increases as we go to the left (remember, market power is the ability of a single firm to control the price of a good).

CANADA: A large country with a small population (but it's getting bigger).
-The large geographic area of Canada creates higher transportation costs and natural barriers to entry (for an example, atlantic fishers cannot enter the pacific fishing market, because the costs of transporting their goods to BC for sale are too high).
-Our small population causes excess capacity (in other words, most Canadian firms which only operate domestically do not get to reap the benefits of a minimum efficiency scale because demand in Canada is not high enough to warrant such a large scale of output. This is why Canada is a big proponent of free trade- Because Canadian industries must sell their goods on the international market in order to maximize profits- domestic demand is not high enough).

MONOPOLISTIC COMPETITION: A large number of small firms. (Ie: the canadian wine market, grocery stores, night clubs, restaurants)

OLIGOPOLY: A small number of large firms (Ie: banks, insurance industries, power companies)

THE INDUSTRIAL CONCENTRATION RATIO: This lets us know what fraction of total market sales (or shipments or orders or anything really) are controlled by a given number of an industries largest firms. For an example, CR4 could be the fraction of total market sales controlled by the top 4 firms of any industry.

The industrial concentration ratio is ONE indicator of market power and competition in any industry, and can help us decide whether a market is an Oligopoly, or Monopolistic Competition. AS A GENERAL RULE, HIGHER LEVELS OF MARKET CONCENTRATION IMPLY HIGHER LEVELS OF MARKET POWER. There are, however, some issues which arise when only using industrial concentration ratios as a barometer for a market.

1: It is difficult to define a relative market for any good- are we talking about domestic markets? International markets? Is a coke part of the pop market, or is it a part of the 'junk food' market, or is it part of the much larger food and beverage market?

2: Tying the degree of competitiveness in any market to the number of firms within that market can be deceptive. For an example, a market in which the CR4 = 100%, and the top four firms each control 25% of the market could still involve fierce competition between these 4 markets. In contrast, a different market's CR4 could be only 33%, but if one of those 4 largest firms controls 30% of the market, and the rest only control 1% if the market, the firm which controls 30% of the industry will be the market leader, and will effectively set the price of goods within that market, with the other firms acting as price takers. This market has a lower industrial concentration ratio, but involves much less competition.

3: The standard concentration ratio in Canada overstates the degree of industrial concentration in Canada due to the openness of the Canadian economy (because we lack trade barriers).

IMPERFECT COMPETITION: Rivalrous behavior with some market power to set a price within a range (a combination of perfect competition and monopoly). Basically, any intermediate market structure

There are 2 types of imperfect competition:
-Monopolistic Competition (involves non-strategic behavior)
-Oligopoly (involves strategic behavior)

In Imperfect Competition There Are:
-Many Sellers
-Selling a differentiated product
-Entry and exit are possible, but not easy
-Each firm acts as a price setter within a range

MARKET CHARACTERISTICS FOR IMPERFECT COMPETITION:

1: Firms select their products (each firm decides what sort of a product they are going to produce. Often this involves product differentiation, in which the producers must somehow distinguish their product from competitor products in the eyes of the consumer. This involves associating certain products with happiness, beauty or sex appeal through clever advertising. This also ensures that different products from different producers are not PERFECT substitutes for each other. For this reason, crest toothpaste is considered a different good than oral-b toothpaste).

2: Firms select their prices (The individual firms decide what price to sell their goods at... within a reasonable range with reference to supply and demand. For instance, a sock firm knows better than to try and charge consumers $400 for a pair of socks. Firms then, act as price setters and let demand determine sales. If demand changes, firms can gage this through increased or declining sales for their goods.

3: Prices are sticky in the short run (In perfect competition, prices change in response to supply and demand. In imperfect competition, however, it is much easier for firms to directly alter their output in response to changes in demand than it is to change the price of a product (ie: for vending machines, this would take considerable effort). Price DO change in the long run, but in the short run, they tend to remain the same, regardless of demand (ie: a dairy queen blizzard costs the same in winter as it does in summer).

4: Non-price competition versus price competition.
Traditionally, people believe that firms can compete in ways other than lowering the price of a good. For instance, they can
-Create funny advertisements which entice consumers to purchase their product
-Cash in on their brand appeal
-Offer additional services (real people on the help lines)
-Guarantee Quality
-Have various warrantees of guarantees
-Have contests

According to Gateman, these are all just different forms of price competition- consumers are just getting more goods (ie: a telephone line, and nice, even-tempered technicians to help with troubleshooting) for the same price. This is economically similar to lowering the price of the good- consumers can still get more for less.

5: Barriers to entry. Unlike in markets of monopolies, these are not insurmountable.

MONOPOLISTIC COMPETITION:
-Many Sellers (so sellers will ignore each others actions, and engage in non-strategic behavior)
-Differentiated Goods (So different firms try and sell their BRANDS)
-Entry and exit CAN and DO occur (like in perfect competition)
-The firms set prices within a range (prices are sticky- they tend to stay put for a while, but firms can change them if they have to [usually, in the short run, it isn't worth their trouble])
-It is different from perfect competition because of differentiated brands (thus, demand curve is downward sloping for each firm, as they each have a slightly different product)
-Different from monopolies because of entry and exit (so demand can shift!)

PROFIT MAXIMIZATION FOR MONOPOLISTIC COMPETITION: In the short run, this is similar to monopoly profits.



-In the short run, firms can enjoy economic profits.
-These profits signal other firms to enter the industry
-As more firms enter the industry, set industry demand is divided further and further amongst competing firms. The demand for each individual firm will thus DECREASE
-Once each firm is only making normal profit (when the price is tangent to average total costs--see graph above), no new firms will enter the industry.

EXCESS CAPACITY: The difference between the minimum efficiency scale and the quantity actually produced in long run equilibrium.

In perfect competition, there is no excess capacity for individual firms in the long run.
In imperfect competition, there is excess capacity for individual firms in the long run. This means that compared to perfect competition, firms in imperfect competition will produce fewer goods at higher prices. In this way, brands (what differentiates perfectly competitive markets from imperfectly competitive markets) create a deadweight social loss (when production is limited, deadweight social loss occurs).

That's all

Barriers to Entry and Multi-Price Monopolists

REVIEW: Difference between perfect competition and monopolies

PERFECT COMPETITION:
-Horizontal Demand Curve for Individual Firms
-Marginal Revenue = Average Revenue
-Price = Marginal Cost at the profit maximizing output level
-Perfectly elastic firm demand, while market demand elasticity can be anything
-In the long run, firms will only make normal profits

MONOPOLIES
-Downward Sloping Demand for the Firm
-Marginal Revenue is less than Average Revenue
-Price is greater than Marginal Cost at the profit maximizing level
-Elasticity is greater than 1, or the firm will not produce
-In the long run, monopolies can make economic profits

In a monopoly, there is no 'market supply curve', because the monopoly IS the market. Also, there is no difference between the long run and the short run, due to barriers to entry, which prevent other firms from entering the monopolist's industry.
---------------------------------------------
BARRIERS TO ENTRY: These can be natural or artificial

Profits still act as a signal for other firms to enter a monopolist's industry. Various BTEs (Barriers to Entry) prevent new firms from entering this market, however. As a result, market supply remains stable, and thus, a monopoly can still make economic profits over the long run.

Natural Barriers to Entry:

Economies of Scale and Scope- larger, well established firms are more able to access the cost-cutting benefits which are part and parcel to economies of scale. In a natural monopoly, one firm can remain in business because demand conditions prevent smaller, less efficient firms from competing and selling their products at a comparable price. EG: It's much less expensive to buy electricity from a pre-existing power company which already has a large, efficient power grid in place than it is to purchase electricity from a tiny solar farm which does not have the same economies of scale. Consumers choose the cheaper product, hence a natural monopoly.

Startup Costs- For larger industries, this can make entry impossible for all but the wealthiest of firms. EG: a nuclear reactor can cost billions in startup costs.

Artificial Barriers to Entry (Most of these are created or perpetuated by the government)
-Patents (These are prevalent in the pharmaceuticals industry, and they create legal monopolies on certain drugs for 20 years)
-Franchises (If you want to make big macs, then you need to buy a Mickie-Dee's franchise)
-Charters (These required for professionals like lawyers)
-Licenses (Eg: for farming or hunting or busking)
-Environmental Regulations (These force products to be up to certain environmental standards in order for them to be sold in a certain place. California is notorious for having very high environmental regulations, thus preventing the sale of many automobiles in the state of California)
-Red Tape (Aka: administrative forms which take a while for competing foreign firms to fill out before they can sell their product in a certain country)
-Government Procurement Policies (ie: Obama urges everybody to "buy American")
-Predatory Pricing (Safeway lowers its prices to the point where competing 'mom and pop' grocers can no longer compete. The rest of the safeway empire effectively subsidizes that one store, and the once the competition goes out of business, they raise their prices even higher than the competitions was in order to recap losses)
-Product Differentiation (This is psychological, and creates an artificial monopoly for stupid things like shampoo and toothpaste, which by all accounts, accomplish the same task regardless of brand).
-Etc.

In monopolies, barriers to entry prevent other firms from entering an industry in reaction to perceived profits, so monopolies CAN reap long run economic profits.

CARTELS: Voluntary Associations of producers who agree to act as a monopoly to maximize joint profits (ie: OPEC and DeBeers (a diamond wholesaler famous for paying hollywood to use expensive diamonds in movies to somehow ingrain the idea of diamonds symbolizing love into our public consciousness). When a cartel forms, all of the firms within the cartel are able to enjoy monopoly profit maximization (aka, they can sell less of their product for more money)

Problems:
-Enforcement Issues: Firms within a cartel have a large incentive to "cheat" and increase their own profits at the expense of everyone else in the cartel (backstabbing and cheating often cause cartels to collapse).
-Restrictive Entry: The profits create incentive for new entry.

MONOPOLIES and CARTELS USUALLY DO NOT LAST FOREVER! Why? CREATIVE DESTRUCTION (Schumpeter 1883-1950)!
-Creative new ideas destroy old ideas and structures, thus creating economic growth
-In the very long run, new products or processes ultimately circumvent barriers to entry (for an example, the explosion in online media distribution has caused many recording artists to completely cut out the middle man [record labels] and start selling their music directly to their fans through their own websites).
-Because of this, monopolies don't tend to stick around for very long unless they are protected by the government.

PRICE DISCRIMINATION & MULTI-PRICE MONOPOLISTS

Price Discrimination is when the same producer charges different prices for different units of the same good for reasons other than costs. There are a few ways of doing price discrimination:

1: You can charge the same buyer two different prices for the same good (ie: quantity discounts, wholesale versus retail, or the fact the certain goods are much cheaper in different locations [Buying textbooks in India will maybe set you back $50- not $500])
2: You can charge different buyers different prices for the same good

EG:
-Wholesale food products versus retail food products (same product, but it is cheaper to buy it wholesale)
-Telephone (residential phones are less expensive than business phones, even though it is the same service)
-Hydroelectric (After you have used up a certain amount of power, often, power becomes cheaper by the Kilowatt-hour)
-Airlines
-Seniors/Students/Children's Discounts (like for translink)
-Dumping
-Hurdle Pricing (new technology is often extremely expensive initially, because many people are willing to buy new technology at a much higher price. After a few months, the price decreases).

CONDITIONS FOR PRICE DISCRIMINATION TO OCCUR:
-Monopoly Power must be Established (price takers cannot offer different prices, and firms must be able to 'segment' up the market in order to utilize price discrimination)
-Consumers must value different units of the same product differently (this means that demand must be negatively sloped for the firm. This means either than each individual consumer values a product less as they increase consumption, or that different groups of consumers are willing to purchase the same good at different prices)
-No Arbitrage/Resale Market (Price discriminating monopolies must avoid pricing a product so low for one market segment that a third party could buy their product at the lower price and then resell it at a higher price. This would effectively destroy their monopoly power).


ADVANTAGES OF PRICE DISCRIMINATION:
-Multiprice monopolists effectively cut into consumer surplus and take is as profit. By selling at many different prices for different quantities, they are able to raise the price closer to what the consumers value the product at for each level of output. Profits increase, and consumer surplus decreases.
-In a perfect price discrimination scenario, the monopolist charges the demand curve price (the reservation price) for each quantity of a good. As a result, the marginal revenue becomes the price line. Output is the same as it would be for perfect competition, and all consumer surplus has been converted into profits.

RESULTS OF PRICE DISCRIMINATION:
-Higher Profits (for each output, profits will be higher for a multi-price monopolist than for a single-price monopolist)
-Higher Output (Output can be higher for multi-price monopolists than for single-price monopolists because a multi-price monopolist can continue to produce until price = marginal cost)
-The Market is very efficient this way- consumers may hate it, but it allows for much higher productivity than other systems.
-The total economic surplus from economic exchange is much greater due to this increase productivity.
-The firms, however, see all of the surplus, while the consumers get no surplus
-Different people with different opinions will judge this as "right or wrong" based on value judgements

RECAP:

Things to ask when looking at a graph

1- Is this for the individual firm, or for the entire industry
2- Is this the short run, or the long run?
3- Is this perfect competition, monopoly, or a different market structure?

That's all

Monopolies! OH NO!

Making money is so fun, we've even made a game out of it. And then we made money by selling that game to consumers. Coincidence? I think not!

TODAY: Monopolies! We already have a pretty good idea about how markets work in perfect competition. Not all markets are perfectly competitive though: ENTER THE MONOPOLY!

Most Important: There is no competition, and no competitive behavior in monopolies, because in a monopoly market structure, one firm has absolute market power (power to raise and lower the price of a product without losing buyers to competitors).

CHARACTERISTICS OF MONOPOLIES:

1: There is only one seller, so THE FIRM IS THE INDUSTRY

2: This firm is selling a unique, exclusive good which other firms cannot sell (ie: exclusive pharmaceutical drugs which cannot be copied by non-name brand drug companies due to patent restrictions)

3: Entry and Exit into and out of the industry is impossible. In other words, there are insurmountable barriers to entry (and they are often created by the government).

MONOPOLIES ARE PRICE SETTERS! They choose which price to sell their product at.

Let's just do a quick recap for comparison's sake.

PERFECT COMPETITION
-Many Firms
-Selling a Homogenous Good
-Entry and Exit is Easy
-Firms are Price Takers

MONOPOLIES
-Single Firm
-Selling a Unique Good
-Entry and Exit is Impossible
-The Firm is the Price Setter

So, for the most part, a monopoly is the total opposite of perfect competition. The only similarity they share is a total lack of competitive behavior within the market.
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THE DEMAND CURVE FOR THE FIRM IN A MONOPOLY

Well: In a monopoly, the firms is the industry. Logically then, the industry demand is the same as the demand curve for the firm. This means that the demand curve for firms is DOWNWARD SLOPING in monopolies.


We know that monopolists have the freedom to set the price at any level. We know that in a situation of downward sloping demand, consumer demand for a particular good decreases as the price increases. We also know that monopolists, like all producers, will seek to maximize their profits. The question we have to answer then is this:

AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?

In order to answer this question, we first need to understand how revenue curves for monopolies work.
First, a chart for revenues with downward sloping demand in effect.

Quantity Demanded--Price--Total Revenue---Average Revenue---Marginal Revenue
0----------------100---0------------------------------------------
1----------------90----90-------------90-----------------90-------
2----------------80----160------------80-----------------70-------
3----------------70----210------------70-----------------50-------
4----------------60----240------------60-----------------30-------
5----------------50----250------------50-----------------10-------
6----------------40----240------------40----------------(-10)------
7----------------30----210------------30----------------(-30)------
8----------------20----160------------20----------------(-50)------
9----------------10----90-------------10----------------(-70)------
10---------------0-----0--------------0-----------------(-90)------

Things you should notice: The average revenue for each of these different potential prices is still equal to the price (just like it was in perfect competition). Marginal revenue, on the other hand, falls twice as quickly as average revenue.



NOTE: As long as marginal revenue is positive, elasticity of demand is greater than one. When marginal revenue = zero, elasticity of demand = 1. When marginal revenue is negative, elasticity of demand is a fraction smaller than 1.

So, why is the marginal revenue always lower than the price (average revenue) for monopolists? Well, in order to sell one more unit of their good, monopolists have to lower the price of that good. This increases demand, so more units will be sold, but at the same time, that lower price will apply to the entire quantity of products sold, including the additional unit which required a lower price in order to sell. As such, the marginal revenue for the 20,323rd iphone sold by apple will be slightly less than the marginal revenue for the 20,322nd iphone.

Monopolists will never produce when the elasticity of demand is negative and marginal revenue is less than zero. Why? because this implies that the firm's total revenue is falling. Firms will not produce extra units if the price adjustment required to sell those extra units creates negative marginal revenue. Firms like profits. Monopolists do not like producing extra units which cost more to produce, and lower total revenue when sold.

When drawing marginal revenue lines, just draw the x-intercept of the marginal revenue line at the midway point between the x intercept of demand and the origin (just trust me, it works)

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SHORT RUN PROFIT MAXIMIZATION: AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?

There are three rules which monopolists must follow to maximize profits.

Rule 1: Monopolists will not produce when elasticity of demand is less than 1. They can only produce when elasticity is equal to or greater than one, or where marginal revenue is equal to or greater than zero (when total revenue is rising). Why? Because for every level of output with elasticity lower than 1, there is another, lower level of output with higher elasticity which will yield the same total revenue, but for a much lower cost (remember, it costs firms to produce units of a good).

Rule 2: A profit maximizing monopolist will produce output where it covers day-to-day expenses (in other words, the price must be higher than the average variable cost)

Rule 3: A profit maximizing monopolist will produce output where marginal revenue equals marginal costs.

SUMMARY:
1: e > or = 1
2: P > or = AVC
3: MR = MC
---------------------------
DIFFERENT SHORT RUN REVENUE SCENARIOS: Here, we're going to look at different revenue scenarios which an affect firms in the short run.

First- we we find the point where MC = MR to determine the profit-maximizing quantity
Then, we find total revenue (price X quantity sold)
Then, we find total costs (average costs X quantity sold)
Finally, we subtract total costs from total revenues to find total profit

SCENARIO 1: Economic Profit!

Here, total revenue is greater than total costs, so economic profit is positive

SCENARIO 2: Normal Profit!

Here, total revenue is equal to total costs, so economic profit is zero

SCENARIO 3: Economic Loss!

Here, total revenue is less than total costs, so economic profit is negative

NOTE: Although there is only one output level which will completely maximize profits, any output quantity where the price (demand) is greater than average costs will render positive economic profits. This gives monopolies some flexibility- they can adjust output to comply with various regulations (ie: lower their output due to environmental legislation) and still reap positive profits.


That's all!

Perfect Competition and Long Run Production

OVER THE LONG RUN, FIRMS CAN ENTER AND EXIT DIFFERENT PERFECTLY COMPETITIVE INDUSTRIES (This is one of the defining traits of a perfectly competitive market structure. Remember, we assume in perfectly competitive markets that there are no barriers to entry, and that startup costs are relatively inexpensive).

The difference between the long run and the short run in perfect competition is the free entry and exit of different firms. There are three different short run scenarios which can predict the long-run movement of firms into and out of industries.

1: Economic Profits- New firms and capital enter the industry
2: Normal Profits- Firms neither exit nor enter the industry
3: Economic Loss- Firms and capital exit the industry

ENTRY INDUCING PRICE:

1: Firms could be making economic profit at the equilibrium price for S0.
2: This economic profit signals other firms to enter the industry to try and take some of that industry-profit for themselves. This increases the industry supply from S0 to S1
3: Due to supply shifting to the right, the industry equilibrium price decreases.
4: This decrease in price lowers the economic profits of each individual firm, and each individual firm must produce less in order for marginal costs to equal marginal revenue (the price). As industry output rises, individual firm output falls
5: This cycle continues until each firm is only making normal profit. After this point, no new firms will enter the industry, because there is no profit-incentive for them to do so.


Let's go over this again:
FIRST- In the short run, an industry sees economic profits
THEN- In the long run, this will adjust to only normal profits. Why?
-In the long run, economic profits act as a signal for new firms to enter the industry
-As new firms enter the industry, industry supply increases
-As such, the price for each individual firm is pushed down to the short-run-average-cost minimum (the lowest price each firm can charge without making an economic loss)
BUT REMEMBER- The Long Run Average Cost for any quantity of production is even lower than the minimum short run average cost for firms. So:
-Firms can lower their costs even further by changing their amount of capital (ie: office space or factory size)
-Economic profits would thus rise, due to decreased costs over the long run
-These economic profits signal more firms to enter the industry, and the cycle repeats itself

THE MORAL OF THE STORY: Firms will continue to increase output, and change their capital investment until they reach the minimum efficiency scale (the minimum quantity of production where the long run average cost is minimized). THIS IS LONG RUN EQUILIBRIUM IN PERFECT COMPETITION

EQUILIBRIUM:

There are 3 conditions for long run equilibrium in a perfectly competitive market.
1: Price must equal marginal costs for each firm (so each firm must be maximizing profits)
2: Price must be equal to minimum short run average cost. This ensures the each firm is only making normal profits.
3: Price must be equal to the minimum long run average cost. This ensures that firms cannot make further economic profits by increasing scale.

If this condition is met, no firms will enter or exit the industry in the long run (due to stable, normal economic profit), so industry supply will not change (STABILITY = EQUILIBRIUM).

LONG RUN SUPPLY: This is the supply curve when firms are no longer entering or exiting the industry (the supply when individual firms are making zero economic profits)
-This is caused by shifts in the long run average cost as the industry size changes
-DO NOT confuse this with short run supply
-"Decreasing cost industry" refers to an industry in which costs are decreasing over the long run
-"Decreasing costs" just refers an an individual firm facing decreasing costs over the short run

THIS IS HOW WE DERIVE LONG RUN SUPPLY:

-Start off with an autonomous increase in industry demand.
-This increases the price of the good over the short run
-Individual firms will make higher economic profits due to this increased price
-Economic profits signals more firms to enter
-Supply increases in the long run due to more firms entering
-LONG RUN SUPPLY IS A LINE CONNECTING ALL POINTS OF DEMAND-INDUCED SHIFTS IN SHORT RUN SUPPLY (so it only includes supply over the log run at points when there is no net entry or exit into firms)

AN INCREASING COST INDUSTRY: This is where long run supply is rising
-Division of labour, bulk discounts and the spreading of overhead occur in these industries
-Input prices rise as quantity increases
-This causes the cost curves to shift up
-The increases the price at which all firms will make zero economic profits

A CONSTANT COST INDUSTRY: This is where long run supply is constant, and horizontal
-Input prices are constant, and the long run average cost for firms does not rise or fall

A DECREASING COST INDUSTRY: This is where long run supply is falling
-Alienation of labour and middle management mush occur in these industries
-New entrants to the industry make it cost effective for suppliers
-Input prices fall as quantity increases

--------------------------------
LONG RUN MISCONCEPTIONS:

TECHNOLOGICAL CHANGE: We assume the technologies change and improve continuously for all firms. One might assume from this that all firms in perfect competition have the same cost curves. In reality, new firms can enter the industry with lower cost curves due to improved technology (ie: a new wool sweater factory will have more efficient equipment, and therefore lower long run average costs than an existing, older factory)

THERE ARE THREE CHARACTERISTICS FOR INDUSTRIES WITH CONTINUOUS TECHNOLOGICAL IMPROVEMENTS

1: Older firms with higher cost will continue to exist... for a while anyways
-As witnessed, new firms usually enter with improved technologies and lower average costs
-These new firms increase industry supply and push price down to a new average cost minimum
-Preexisting firms are stuck with higher production costs, and must produce at a lower marginal revenue rate (think GM after the more advanced Japanese car manufacturers entered the market)
-This may cause older firms to make an economic loss on production
-The older firms should continue to operate at an economic loss, however, as long as the price remains higher than their average variable costs (so they can cover their daily costs). Although this may not be the most efficient use of capital, this will still generate some accounting profits.

MISCONCEPTION: We should eliminate the use of older, higher cost plants as new technology exists.
THE TRUTH: Many different plants with different cost and different levels of technological advancement can exist in any industry and still continue to produce.

2: Price is eventually determined by the minimum average cost of production for new plants
-New firms with the latest technology have lower average costs than pre-existing firms, and will make comparative economic profits
-As more firms enter the industry due to economic profits, the price is bid down to the minimum average cost for the new firms (so at equilibrium, even the new firms are only making economic profit)

3: Old plants are shut down when they become economically obsolete
-Once price is lower than average variable costs for older firms, the plant should be shut down, because continuing production costs more than the product will sell for
MISCONCEPTION: Plants that can still produce products should not be shut down until they are physically obsolete (until the equipment no longer works)
THE TRUTH: Some plants are perfectly well equipped to continue to production, but it would be illogical for any firm to continue to produce goods with these plants, because the goods they could produce would sell for a price lower than the cost of making them.



DECLINING INDUSTRIES: Industries where the long run equilibrium is disturbed to a trend of decreasing consumer demand (think horseshoes and buggy whip industries, or the decline in demand for glass beverage containers following the rise of plastic)

The Response of Firms: Firms generally try to cut costs by forgoing necessary upgrades and equipment maintenance. This leads to further long run economic losses, which leads to further cost cutting measures (it's a slow and vicious cycle).

Government's role in failing industries:
MISCONCEPTION: The government should subsidize failing industries in order to save people's jobs (voters prefer to be employed than unemployed).
THE TRUTH: By subsidizing failing industries, the government is just delaying the inevitable (the industry will eventually become obsolete, and involved firms will go under). A better approach would be for the government to encourage workers to find new jobs with subsidized retraining and temporary income support.

THAT'S ALL!!!!!! =D

Short Run Decisions in Perfect Competition

REMEMBER:
-Demand in perfect competition is constant for individual firms (it does not change with quantity produced), and demand is equal to price, average revenue, and marginal revenue.
-Supply is equal to the marginal cost curve above the average variable cost curve.

We're going to look at some different scenarios for firms in perfect competition in the short run. For each of these, we try to calculate economic profit. Here's how:

-First, we find out which quantity will allow Marginal Revenues is equal to Marginal Costs
-Next we calculate total revenue, which is the price X the quantity exchanged
-Next we calculate the total cost, which is the average cost for this quantity X the quantity exchanged
-Finally we determine economic profit by subtracting the total costs from the total revenue. The remaining money is economic profit!

SCENARIO ONE: ECONOMIC PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is greater than the average costs. Because of this, revenue will exceed costs, thus creating positive economic profit in the short run. NOTE: This usually signals firms to enter the industry, which occurs over the long run.

SCENARIO TWO: NORMAL PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is just equal to average costs. Because of this, revenue will equal costs, thus creating zero economic profit (aka: normal profit). In a normal profit scenario, firms are making the same amount of accounting profits in this industry that they would anywhere else. There is no incentive for firms to enter or leave the industry.

SCENARIO THREE: ECONOMIC LOSS

Here. marginal revenue = marginal costs at a point where the average revenue (price) is lower than average costs. As a result, firms in this scenario will take an economic loss on production (they could still be making accounting profits on their business, but that money would make more profits if invested elsewhere). In the long run, economic losses act as a signal for firms to leave a business. However, firms which are operating at an economic loss should not necessarily exit the industry. As long as they continue to cover daily operating costs, they are 'breaking even' in an accounting sense, and should continue to produce.

SCENARIO FOUR: SHUT DOWN POINT

Here, total revenue is much lower than total costs (negative economic profit). Average revenue JUST equal average variable costs, which means that this firm can JUST cover daily expenses (zero accounting profit). Any point below this, and the firm will be operating at a loss, and should shut down.

-----------------------

SHORT RUN SUPPLY CURVES:
-a supply curve shows a firm's willingness to produce at any given price.

remember:
-a demand curve is derived using the principles of total utility maximization, so when price increases, quantity demanded decreases
-a supply curve is derived using the principles of profit maximization, so when the price increases, quantity supplied increases.

THE MARGINAL COST ABOVE THE AVERAGE VARIABLE COST CURVE IS THE SHORT RUN SUPPLY CURVE FOR FIRMS IN PERFECT COMPETITION! As the price increases, marginal costs will = marginal revenue at a greater quantity of production.


INDUSTRY SUPPLY IN THE SHORT RUN FOR PERFECT COMPETITION
Industry supply for the short run is just the horizontal sum of each individual firm's supply curves (aka their marginal cost curve above average variable cost)
-It is the short run, because the cost curves are holding capital constant (so individual firms cannot change their scale of production)

CONDITIONS FOR SHORT RUN INDUSTRY EQUILIBRIUM:
1-The demand and supply must be equal for the industry
2-Each firms must be maximizing profits (minimizing losses)
3-This does not necessarily mean that all of the firms will be making economic profit. If there are too many firms in the industry, in the short run, all of the firms may be making economic losses while operating at maximum profit

THATS ALL FOR NOW

Introduction to Revenue Curves: Perfect Competition

We're done learning about cost curves now! Unfortunately, cost is only one of the factors which determines profit. The other factor which determines profit is REVENUE, so for the next three weeks we're going to learning about different types of markets, and different kinds of revenue curves inherent in each of them.

What is a market structure? A market structure is the 'genetic' features of a market that affect firm behavior including:
-The numbers and sizes of the firms involved in the market (are there a whole bunch of firms, like the BC cafe/coffee market, or is there only one firm, like the BC hydroelectric market)
-The types of goods sold in the market (What does the good do? Is it unique to each firm (like artwork) or the same no matter where you buy it from (like coca cola)
-Freedom of firms to enter and exit the market (Can firms enter the market freely, or are their market barriers like licenses or qualification restrictions)

Different Market Structures disperse MARKET POWER in different ways

Market Power: The ability of a single firm to affect the market price. In other words, firms which have a large share of Market power can jack up prices and get away with it.

RIVALRY is the antidote to too much market power. Rivalry (competitive behavior, or competition) deflates the market power of any one firm, so rivalry is inverse related to market power. This is because rival companies can "steal" a firm's customers if that firm tries to jack up the price, so the market power of that firm is lessened.

THIS WEEK: We are learning about perfect competition!

In perfect competition, there is NO MARKET POWER!
Ironically, in markets which are perfectly competitive, there is no competitive behavior. As we will learn, in order for there to be competitive behavior, there needs to be SOME market power.

Here are ALL of the different market types:

Perfect Competition --> No Market Power
Imperfect Competition-> Some Market Power
Oligopoly-----------> Substantial Market Power
Monopoly-----------> Total Market Power

REMEMBER: The each of these market structures, the COST side of the analysis looks IDENTICAL. Only the revenue side changes. Each week, we will study revenues for each structure.

PERFECT COMPETITION: What assumptions can we make about this market structure?

1: Many Sellers (So one firm does not affect the industry's supply curve. In other words, the industry's supply curve is fairly constant. As such, each seller's minimum efficiency scale is quite small relative to the industry's level of output. An example of this would be gasoline stations in Vancouver, or coffee shops in the lower mainland)

2: Each seller is selling a homogenous (identical) product (this is what allows for 'perfect' competition. If one seller raises the price of an IDENTICAL product, consumers will simply obtain that product for a lower price elsewhere. If two gas stations are selling gas for different prices, you're probably going to buy gas from the cheaper station, because THE GAS IS THE SAME PRODUCT NO MATTER WHERE YOU BUY IT FROM)
NOTE: Identical products are very rare (ie: even coffee is not the same at every coffee shop), so perfect competition is very rare. Even arbitrary consumer preferences can turn an identical product into a non-identical product (eg: prefering Husky gas to Shell gas for ethical reasons).
This also gives markets of perfect competition a Horizontal Demand line (perfect elasticity), since an increase in price will simply cause consumers to cease buying the offered product from that firm.

3: Firms can freely enter and exit the market (there are no barriers to entry [BTEs], and startup costs required to enter the industry are reasonable)

In a market of perfect competition, the larger market is composed of MANY MANY small firms, creating the entire market


THE DEMAND CURVE FOR A FIRM in PERFECT COMPETITION
-In perfect competition, firms are 'price takers' (they simply sell products at the market prices as a result of there being many firms which all sell identical products)
-The firm's demand is horizontal
-One firm more or less does not affect industry supply
SO: because demand is horizontal, a firm can sell all it wants to at the going price. If a firm raises prices, however, it loses all of its buyers. If it lowers it prices, and starts a price war, ALL of the other firms in the industry will eventually lower their prices as well, simply creating less profit for all firms within the industry. For this reason, price wars do not usually last very long in perfect competition (because they are bad for ALL firms within that market).

FOR THIS REASON, there is no competitive behavior in perfectly competitive markets: firms cannot raise prices for fear of either losing customers or profit.


As you can see, the industry sets the price, and each firm simply TAKES that price.

SO: Demanded Price = The Firm's selling price = The Average Revenue = The Marginal Revenue

HOW DOES REVENUE WORK?

Revenue is the amount of money firms receive from the sale of goods. In perfect competition, total revenue is a basic function of units sold

TOTAL REVENUE
TR = Quantity of Products sold X fixed price of sold Products
This is the total income of firms
In perfect competition, this is represented graphically by a straight line out from the origin (so it is a linear function)

AVERAGE REVENUE
AR = The total revenue/The quantity of products sold
In other words, this is the 'per unit' income of firms
This is represented graphically as the slope of the ray from the origin to total revenue (so it remains constant throughout the perfect competition revenue function)

MARGINAL REVENUE
MR = Change in total revenue / Change in quantity of products sold
In other words, this is the additional income the firm makes from the last output.
Graphically, this is the slope of the tangent to the total revenue function (so it remains the same throughout the perfect competition revenue function, and is equal to the average revenue)


Seeeee:

Quantity Price TR AR MR
1 $1 $1 $1 $1
2 $1 $2 $1 $1
3 $1 $3 $1 $1
4 $1 $4 $1 $1

Demand = Price = Average Revenue = Marginal Revenue!

Remember: Demand for the ENTIRE industry is downward-sloping, but demand for the INDIVIDUAL FIRM during the short run in a perfectly competitive market is HORIZONTAL!

SO... in a situation of perfect competition, how do firms maximize profits??
Well... there are two rules to follow:

Rule #1: The firms should be breaking even (in other words, the firm must be making more revenue on a daily basis than their average variable costs on a daily basis, or else the firm will LOSE MONEY) (Total fixed costs on the other hand can be paid off slowly over time, so it is not necessary to cover them on a daily basis).

In short: TR must > or = TVC
OR
P must > or = AVC
"You must cover day-to-day costs"

Rule #2: Firms should produce goods up until the point where marginal revenue = marginal costs. In other words, any extra average revenue above the cost of producing each unit gets added to the the total profits for that firm. If you sell cups of coffee for one dollar, as a firm, you'll be making total profits AS LONG AS YOU CAN SELL COFFEE FOR LESS THAN IT COSTS TO MAKE IT. SO, you sell until revenue = costs, and this MAXIMIZES PROFIT. Selling less than this leaves potential total profits unrealized, while selling more than this incurs unnecessary extra costs.


Profit = Total Revenue - Total Costs
Profit Maximization Occurs when the slope of total revenue (aka: the marginal revenue) equals the slope of the total costs (marginal costs)
SO: Profit is maximized when MR = MC

Another way of looking at this is seeing total profits as a bank account. As long as marginal revenues are greater than marginal costs, the bank account is growing. The instant marginal costs become greater than marginal revenues, the bank account starts to shrink.
That's all for today!

Isoquant and Isocost and The Very Long Run

Short Run:
-Fixed Factor
-Fixed Input Prices
-Fixed Technology
Grahpically: Short-run-average-cost

Long Run:
-All factors vary
-Price of inputs can be fixed, or can vary
-Technology is fixed
Graphically: Long -run-average-cost-curve (or shifts in the long-run-average-cost curve for the case of changes in factor prices)

THE VERY LONG RUN:
-Technology can vary
-Price of inputs can vary
Graphically: Shown by shifts in the long run average cost curve (generally, downward shifts)

3 types of changes in technology:
-Change in process (for an example, robotic assembly lines instead of human assembly lines. Bull dozers and forklifts instead of pickaxes and brute strength)
-Improved inputs (aluminum bikes instead of iron bikes)
-New Products (Ipods instead of portable walkmen)

Usually, a change in technology changes the productive process, and therefore, would change the production function (the functional relationship between inputs and outputs). Remember, productivity is output per input.

There are 2 theories about technological innovation. The second one is more correct.

Old Theory: Technological Changes were seen as exogenous, or independent variables unaffected by changes in the economy (think crazy old scientists sitting around in the their labs and coming up with new technologies "just because they want to").

New Theory: Technology Changes are endogenous, or dependent on the economy. A production-side want to innovate away from costly inputs often drives firms to finance new technological changes. It is a FEEDBACK MECHANISM (for instance, many oil producers are now looking into unconventional drilling methods which use water pressure to release the oil from rocks. This turns land which was previously unproductive and cheap into a great asset, and helps companies move away from pricier traditional drilling sites) .

GENERALLY, TECHNOLOGICAL CHANGES SHIFT THE DEMAND CURVE DOWNWARD!

So... in the very long run, firms can both substitute away from costly inputs, or innovate away from them.

OKAY! Isoquants and Isocosts! These are very similar to indifference curves and budget lines from chapter six!

Isocost Lines:

The isocost line reflects two things
-The total cost of inputs
-The factor prices of inputs

Each isocost line shows all possible combinations of factors available for a given cost (sort of like a budget line, except with inputs, not products)

For an example, an isocost line could show the amount of cooks and ingredients a restaurant can utilize for a set cost.

The formula: Total Cost = (Px X Qx) + (Py X Qy)
The slope: -Px/Py (I'm doing this by axes so not to confuse people, because technically, you could graph labour or capitol on either axis).

As your total costs increase, the isocost line moves out from the origin. Changes in input factor prices will cause the isocost line to tilt.

Isoquant Lines

Each isoquant line shows all possible combinations of the factors of production that yield a given level of output. (Sort of like an indifference curve, except with productive output held constant instead of total utility)
In other words, total product is constant: the /\TP = 0
The formula: /\x*MPx + /\y*MPy = 0
The slope: -MPx/MPy

Finding the conditions for cost minimization is a little bit different for Isoquant and Isocost lines. Instead of finding the optimal quantity level for a given budget (like we do for indifference curves), we figure out which level of production we need to meet (for example, how many teddy bears we want to produce in a day). We first draw the Isoquant line which corresponds to that level of production (so we would draw the isoquant line showing the combination of inputs needs to produce 100 bears in a day). After that, whichever isocost line is JUST tangent to the desired isoquant line will represent the minimum cost for that level of output, and the point of tangency will show the exact quantity of inputs required to achieve this minimum cost.


If an isocost line is not quite touching the isoquant line, then expenditure is not high enough to meet those production goals. Meanwhile, if an isocost line bisects the isoquant line, that production goal can be met, but efficiency is not being maximized, as that same level of production could be facilitated with a less-costly combination of inputs.

At the point of tangency, the slope of the isoquant line = the slope of the isocost line!
MPx/MPy = Px/Py
which is the same condition for marginal productivity maximization! (again, this parallels indifference curves in a BIG way)

REMEMBER, EFFICIENCY IS IMPORTANT!

SO... if you were to study efficiently, you should know that anything after this point will NOT be on the big, evil Gateman-style midterm this Friday!

It's hard to believe it's already November...