Micro Test 3

Oligopoly

- markets with a handful of large sellers - sellers have some market power ex. cell phone companies

How to Solve Hold Up Problem

- write long term contracts that commit both sides to specific terms for the direction of their relationship - reputation and repeated interactions - vertical integration

Total Revenue (TR)

P x Q

Profit (pi)

TR-TC or (P-ATC) x Q

Bargaining Power

ability to negotiate deal - next best alternative determines your bargaining power - other sides next best alternative determines their bargaining power

Perfect Competition

- all businesses in an industry sell an identical good - many buyers and sellers who are small relative to the market - sellers have no market power - least market power - rarely occurs - no point having ads

Increasing Competition Can Lead to Better Outcomes

- competition leads to lower prices and a higher quantity - the underproduction problem: market power leads businesses to produce a lower quantity and sell a higher price

Basic Rules for Product Positioning

- if price competition is intense you want to differentiate your product -- ex. coke and pepsi - if price competition is subdued the you want to minimize any differences so that you can appeal to as many people as possible

Strategic Actors: Existing Competitors

- more rivals yield more intense competition -- extreme case: perfect competition so no long run profit - you can compete on price and product -- price competition: competing to win customers by offering lower prices --- easiest when products are extremely similar, prices are easily observable and switching costs are low -- non-price competition: competition to win customers by differentiating your product (market positioning) --- this makes it harder for your rivals to win you a customer with a price cut --- attract sticky customers through product differentiation --- ex. different features, quality, customer service, design, style, reliability, location, convenience, and advertising

Role of Advertising

- one approach to position your product - aims to shift and steepen your demand curve - only firms selling differentiated products should advertise - goal is to increase your firm demand not market demand -- emphasize the unique value of you firm

How to Deter Entry: regulatory strategies: mobilize the government to prevent entry

- patents give you the right to be the only producer - regulations make it difficult for new businesses to enter your market - compulsory licenses can limit competition - lobby can create new regulatory barriers

Imperfect Competition

- situation of facing at least some competitors and/ or selling products that differ from competitors - Most businesses operate in imperfectly competitive markets

Profit Maximization

calculate weekly profit that someone will make for each price and quantity combination

Marginal Cost (MC)

change in total cost (TC) = change in quantity

Barriers to Entry

obstacles that make it difficult for new firms to enter - firms ongoing profitability depends on their barriers to entry

Profit Margin

price - average cost

Market Power vs Perfect Competition

1. market power leads to higher prices 2. market power leads to inefficiently smaller quantities 3. market power yields larger economic profits 4. businesses with market power can survive even with inefficiently high costs

Average Fixed Cost (AFC)

FC/Q

How to Deter Entry: deterrence strategies: convince potential entrants that you will crush them

- build excess capacity so that your rivals expect fierce competition - financial resources signal you can survive a costly fight - brand proliferation can ensure there are no profitable niches for a rival to exploit - your reputation for fighting can be helpful too

Marginal Revenue Curve

- good decisions focus on marginal revenue -- marginal revenue is the addition to total revenue you get from selling one more unit --- calculate as change in total revenue from selling one more unit -- for firms with market power marginal revenue lies below the demand curve and declines faster

Public Policy and Market Power: laws that ensure that competition thrives

- anti-collusion laws prevent businesses from agreeing not to compete - merger laws prevent competing businesses from combining to consolidate market power - some laws thwart abuses of market power - international trade foster competition

Long Run

horizon over which you or your rivals may expand or contract production capacity and new rivals may enter the market or existing firms may exit - LR is important for planning economic profit is important in the long run - with free entry and exit p = avg cost and economic profits will be zero

Group Pricing

price discrimination by changing different prices to different groups of people - groups are effective if they have a relationship to the expected marginal benefit - group pricing involves offering different prices to groups that differ by their age, location, purchase history or any other identifiable characteristic ex. books cheaper in India, internet companies charge lower prices for residential than business, movie theaters offer student discounts

Setting Group Prices

step 1: what quantity should you produce? - keep selling until marginal revenue equals marginal cost step 2: what should you charge? - look up to your firms demand curve to find the highest price you can set and still sell this quantity

Market Power

the extent to which a seller can charge a higher price without losing many sales to competing businesses - market could mean goods and services or labor - demand curve gets steeper the more power a company has Problems with Market Power - MP distorts market forces leading to worse outcomes -- ex life-saving drugs are expensive- sellers exploit market power

Economic Profit

total revenue - explicit costs - implicit costs

Strategic Actors: Bargaining Power of Buyers

- buyers can force you to offer lower prices ex. GM (buyer) has many options to buy parts from or they could just make them themselves

Free Exit

- ensures industries won't remain unprofitable in the long run

Exit Increases Your Demand and Your Profits

- existing competitors exit unprofitable markets which help restore profitability -- the rational rule for exit says to exit the market if you expect to earn a negative economic profit which occurs if price < average cost - use the cost-benefit principle to decide whether to enter or exit - if economic profits are negative: some rivals exit which increases your market share and market power which makes you increase your quantity and price which increases your economic profits

Public Policy and Market Power: laws that minimize the harmful ways that businesses might exploit their market power

- government can implement price ceilings to limit market power -- set price = marginal cost which eliminates discount effect and underproduction -- perfectly competitive markets: price ceilings reduce economic surplus -- imperfectly competitive markets: price ceiling increase economic surplus - laws to link prices to costs -- eliminates the incentive to produce high quality goods -- reduce incentives for managers to keep down costs

Efficiency of Price Discrimination

- increases the quantity you sell -- selective discounts induce additional sales - selective discounts help solve the underproduction problem -- when you don't price discriminate: the discount applies to all customer -- when you do price discriminate: offer the right discount to the right person (and only that person) and you'll make a sale you wouldn't have before -- keep offering discounts until marginal cost equals your last customer's marginal benefit and you'll produce the efficient quantity

How to Deter Entry: supply-side strategies: develop unique cost advantages

- learning by doing means that experience yields efficiency goals - benefits of mass production can keep small firms from being competitive entrants - research and development can create cost disadvantages - relationships with suppliers can get you cheaper outputs - access to key inputs can freeze out your competitors

Natural Monopoly

- market in which it is cheapest for a single business to serve the market -- ex water, gas, or electricity - society's best interest: price = marginal cost - but price < avg cost so suppliers would lose money -- suppliers can stay in business only by offering prices that are too high - solution: government provides goods -- set price = marginal cost and tax revenue pays for loses

Monopoly

- markets in which there is only 1 seller - seller has a lot of market power - ex ykk zippers - most market power because they are the only business and have a unique product - rarely occurs

Monopolistic Competition

- markets which many small businesses compete each selling differentiated products -- product differentiation is efforts by sellers to make their product different from their competitors - sellers have some market power

Entry Decreases Demand and Your Profits

- new competitors will enter profitable markets -- the rational rule for entry says you should enter a market if you expect to earn a positive economic profit which occurs when the price > average cost - new competitors will make your market less profitable - when more firms enter demand becomes more inelastic - if economic profits are positive: new rivals enter which decreases your market share and market power which makes you reduce your quantity and price which decreases your economic profits

Strategic Actors: Potential Competitors

- new entry can increase supply and intensify competition -- entrepreneurs launch start ups, existing businesses expand and current competitors enter new distribution channels - threat of entry depends on the extent to which barriers to entry shield existing businesses from competition by new entrants - strategic management can deter entry

Hold Up Problem

- once you have made a relationship-specific investment, the other side may try to renegotiate so they get a better deal -- relationship-specific investment: investments that are more valuable if the current business relationship continues - can lead to underinvestment -- lower investment in actions that would lower bargaining power -- forces people to settle

Strategic Actors: Competitors in Other Markets

- potential substitutes can come from unrelated industries - substitutes come from innovation that offers better performance - but often the disruption comes in the form of cheaper alternatives - substitutes are a bigger threat when switching costs are low - complements can point to new opportunities

Free Entry

- pushes economic profit to zero in the long run -- no economic profits does not mean no accounting profits - free entry occurs when there are no factors making it particularly difficult or costly for a business to enter or exit an industry

Types of Advertising

- search goods use informative advertising -- search goods: good that you can easily evaluate before buying -- informative advertising: informs customers - persuasive advertising aims to persuade -- persuasive advertising aims to persuade or manipulate you to believe you will like the product - a lot of advertising is useless

Price Discrimination

- selling the same product at different prices -- set prices close to and just below marginal price - price differentiation increases producer surplus and quantity

Firm Demand Curve

- summarizes the quantity that buyers demand from an individual firm as it changes its price -- market demand is the quantity demanded across all firms -- firm demand is the quantity demanded from your firm -- individual demand is the quantity demanded by a single buyer -- your market power shapes your firm's demand curve

How to Deter Entry: demand-side strategies: find ways to create customer lock-in

- switching costs lock in your customers -- switching costs are impediments that make it costly for customers to switch to buying from another business ex changing banks - reputation and goodwill keep your customers loyal - network effect: means that your product becomes more useful the more people use it

Reservation Price

- the maximum price a customer will pay for a product

Product Positioning

- trade-off between demand side considerations and supply side concerns -- ex. as attractive to customers and different from competitors -- demand side: you want to be close to your competitors to increase share of potential customers and increase quantity -- supply side: you want to be far from your competitor to increase market power and prices and increase profit margin

Need for Product Differentiation

- with no price differentiation 1 competitor can force your economic profits to zero - problem: irresistible incentive for your rival to undercut you - solution: product differentiation reduces incentive to undercut -- raises bargaining power and profitability

Strategic Actors: Bargaining Power of Suppliers

- your suppliers can threaten your success by charging you higher prices - ability of your suppliers to charge you higher prices depends on the amount of bargaining power they have like refusing to do business or raising the price of inputs

Successful Price Discrimination Strategy

1. charge higher prices for some customers - they will keep buying the product - you receive greater profit margin on each sale - this transfer consumer surplus into producer surplus but total economic surplus is unchanged 2. charge lower prices to others - offer select discounts to increase the quantity you sell - profits increase - this increases the economic surplus enjoyed by both you businesses and customers

How Firms Set Prices and Quantities

1. keep selling until your marginal revenue equals your marginal cost - rational rule for sellers tells us to sell one more item if the marginal revenue is greater or equal to the marginal cost 2. set your price on the demand curve

Insights into Imperfect Competition

1. market power allows you to pursue independent pricing strategies 2. having more competitors leads to less market power 3. successful product differentiation gives you more market power 4. imperfect competition among buyers gives them bargaining power 5. your best choice depends on the actions that other businesses make

Average Total Cost (ATC)

TC/Q or AFC + AVC

Average Revenue (AR)

TR/Q - equal to P if you charge everyone the same price

Explicit Costs

The actual payments a firm makes to its factors of production and other suppliers.

Quantity Discounts

a per unit price that is lower when you buy a larger quantity - bundling creates a hurdle to getting the 2nd good at a lower price -ex. cable tv bundle

The Hurdle Method

apply the hurdle method to target your discounts yo those who value them - offering lower prices to buyers who are willing to overcome some hurdle or obstacle - key idea: set the hurdle so high that high marginal benefit customers will find it too costly yield self-selection: low marginal benefit customers leap the hurdle and pay the lower price while high marginal benefit customers don't bother and pay the higher price - ex. books come out in hard cover first and are double the price - ex. bargaining at stores

Marginal Revenue (MR)

change in TR/ change in quantity

Accounting Profit

total revenue - explicit costs

Perfect Price Discrimination

charging each customer its reservation price - achieve 2 profit boosting objectives 1. charge the highest price you possibly on each sale 2. make every possible sale where there's a customer whose marginal benefit exceeds your marginal cost

Average Variable Cost (AVC)

VC/Q

Total Cost (TC)

fixed costs (FC) + variable costs (VC) - can be explicit or implicit

Short Run

horizon over which the production capacity and the number and type of competitors you face cannot change

How to Segment your Market

1. segment your market into groups whose demand differs - use observable proxies (ex student) that are related to each customer's reservation price -- the better the proxy (the more closely it captures differences in reservation prices) the more successful you strategy will be - find how best to divide your market into segments with distinct patterns of demand -- this depends on what information is available to you 2. target your group discounts based on verifiable characteristics - ex. age, student status or address - the characteristics that are verifiable depend on what industry you are in 3. base group discounts based on difficult to change characteristics - this avoids the possibility that customers will switch into a different group in order to get a lower price - ex. student discounts, senior citizen discounts, regional discounts

Conditions for Price Discrimination

1. your business have market power 2. you can prevent resale 3. you can target the right price to the right customers

Implicit Costs

Indirect, non-purchased, or opportunity costs of resources provided by the entrepreneur