Economics Unit 3 Terms and Ideas

Perfect Competition

-S and D forces generate the market price which the PC firm must charge. If it charges a higher or lower price, it reduces profits . -Firm's technology captured by the SR cost pitchfork. We usually just show the ATC and MC curves, but the AVC and AFC curves are there (in spirit).

strategic behavior

-Actions a firm takes to influence the market environment so as to increase its profits. - The market environment comprises all factors that influence the market outcome (prices, quantities, profits, welfare), including the beliefs of customers and of rivals, the number of actual and potential rivals, the production technology of each firm, and the costs or speed with which a rival can enter the market. -SB usually involves making a commitment today that changes incentives tomorrow. -SB often involves actions that may look foolish to the naïve, myopic eye, but make good sense when the long-run implications become clear.

Reasons Monopoly Harmful to Society

-Allocative Inefficiency -Productive Inefficiency -Dynamic (Technological) Inefficiency -Managerial (X-) Inefficiency -Rent Seeking

Implications of Perfect Competition

-Buyers and sellers act as Price-Takers -Law of One Price holds (given perfect info and identical products) -Free Entry/Exit: if (un)profitable, we expect to see new firms enter (exit) the mkt

Four Elements of a Well-Defined Economic Problem

-Economic Actor: who is the decision maker? --firms, individuals/households, nonprofits, governments -Objective: what is the primary goal? what motivates the actor? --maximize profit or utility or social welfare or market share or sales revenue; minimize input costs or tax bill or legal costs -Choice: what is under the actor's control? what are the options? --Price, capacity, location, product launch timing, spending on R and D or ads or lobbying, inputs, contract terms (e.g., free royalties) -Economic Environment: what other essential facts, constraints and assumptions must we consider to analyze and understand this scenario/ --all relevant conditions about demand, costs, timing, information, rivals, and how choices affect objectives. we might assume particular market demand and cost functions, and simultaneous pricing choice bw 2 firms.

Mass Production

-Exploit economies of scale: minimize unit costs by spreading fixed costs over high volume. TC=FC+VC where FC large (think: a natural oligopoly). -protect against price undercutting by rivals by constantly innovating and becoming more efficient -expand mkt share in recession at expense of weaker firms; kill 'em off and buy 'em up! run at full cpaacity - always!

Conditions that Facilitate Collusion

-High Industry Concentration -Significant Entry Barriers -Frequent and Regular Orders -Stable Mkt Conditions -Rapid Mkt Growth -Technological or Cost Symmetry -Multi-Mkt Contact -Product homogeneity -Observable, Basing-Point Pricing -Trade Associations or Centralized Sales Agencies -Most-Favored-Customer or Meet-the-Competition Clauses

Horizontal Restraints of Trade (Antitrust No-Nos!)

-Horizontal: involving rival firms in the same industry --vertical-involving firms at each different stages of the supply chain, such as upstream wholesalers and downstream retailers -Horizontal restraints of particular interest: --price-fixing: --bid-rigging: --market-allocation: --tacit cooperation by oligopolists: --joint ventures: --information exchanges:

Science management (Frederick Taylor)

-Idea: engineers shd break down production process into simple tasks, use timed motion studies to id optimal process, mechanize, and hire hundreds of semi-/un-skilled workers at low wages in giant plants. Learning times dx, task-switching dx, spoilage dx, dexterity inx, innovation inx, thus productivity inx. Pay "piece rates" instead of hourly wages, control work pace. -Results: industrialization. mgmt by engineers. dehumanization. urbanization. exploitation?

Characteristics of Perfect Competition

-Industry is fragmented (each player's actions have no mkt impact) -Firms produce (undifferentiated products (perfect substitutes) -Consumers hv perfect info abt prices -All firms (incumbents or entrants) hv equal access to resources

Common Entry Barriers to a Monopolistic Market

-Large fixed cost K investments (power lines) --entrant may lack the resources to build --entrant may lack reputation (risky to back a firm facing a well-entrenched incumbent) --entrant may lack industry connections (venture capital funds for young firms, I-bankers for older firms) --are current market conditions favorable? -control of key input (DeBeer's diamonds) -unique geographic location (bridges, canals) -positive network externalities (Fb's social network) -customer loyalty (advil's name and reputation) -switching costs (frequent fliers in customer loyalty program) -intellectual property: patents, copyright, trademark, trade secrets (coke's formula) -gov-sanctioned Monopoly (USPS's 1st-class mail) -Aggressive entry deterrence (airline's fighting reputation)

Assumptions of Perfect Competition

-Many buyers and sellers -Homogenous products -Free entry and exit -No externalities or public goods -Perfect Information -No transactions cost

Monopolistic Competition

-Many rivals selling close substitutes and serving tiny niches (think Vietnamese restaurants on argyle street) -as the name implies, is a hybrid of monopoly and perfect competition Assumptions: 1. standard cost pitchfork 2. mostly elastic demand 3. reasonably close substitutes 4. large # of rival firms 5. SR profits > 0 6. Free entry (wannabes!) 7. demand shifts LEFT (and flattens b/c closer rivals) 8. LR Profit -> 0 9. Firm advertises or innovates to create new niche

Natural Monopoly

-Minimum Efficient Scale is "large" relative to mkt demand, so the total cost of serving the mkt is lowest when the mkt is served by only one firm. there are usually large fixed cost investments to build and maintain a network, which results in scale economies over a very large range of output levels. -electricity/water suppliers are the ideal natural monopoly; requires a large fixed-cost that dissuades entry into mkt, plus costs much less to have one or two major firms drawing on these resources and redistributing them then having a bunch of small firms having to individually build pipes/wires to each individual home.

Competitive Market Structure

-Minimum Efficient Scale is small relative to mkt demand, so many firms can fit into the mkt (think of laundromats; makes no sense for them to be on an industrial scale since only serving a local population).

Types of Market Structures

-Perfect Competition -Monopoly -Monopolistic Competition -Oligopoly

Anticompetitive Behavoir

-Promote competition by enforcing antitrust laws -watching for entry deterrence, predatory pricing, price fixing, bid rigging, horizontal mergers

Entry and Exit Decisions

-SR profits attract attention and lead to entry, which pushes mkt supply rightward and prices down -SR losses drive some firms out of the mkt, so mkt supply shifts left and prices rise -Entry and exit always work thru mkt supply, which is based on individual firm supply, which is based on profit-maximizing choices of q*.

Government-Sanctioned or -Protected Monopoly

-USPS --only USPS has the right to deliver first-class mail--not FedEx, UPS, or you. -Tollway Oasis --if you don't want to leave the turnpike, you may have few choices when filling your gas tank.

Vertical Mergers

-between adjacent stages in supply chain (aka vertical integration) --upstream: acquire a supplier/manufacturer --downstream: acquire a buyer/distributor/retailer -think of these in terms of transaction costs and the make or buy decision. if it's cheap, easy, fast and reliable to rely the market, do that that. if not, then expand firm's boundaries to handle it internally.

Horizontal Mergers

-between direct rivals: same product and region (coke and DP, for ex).

Concentration Ratios

-by summing the mkt shares of the n LARGEST firms, we calculate the n-firm CONCENTRATION RATIO, written CRn.

Strategic Entry Barriers: Entry Deterrence Strategies by Incumbent(s)

-capacity expansion --building an additional factory allows you to credibly threaten to flood the market. -Product Proliferation --by filling up the shelves of the cereal aisle, you make it difficult for a new cereal to find space -Learning by Doing --overproducing today may seem foolish, but if you slide further down the learning curve today, you'll have lower costs tomorrow, making you a stronger fighter (the cheesecake factory story). -Raising Rivals' Costs --tie up your rival with bureaucratic red tape or costly legal distractions. if your rival uses relatively more labor inputs, lobby for wage increases. tie up suppliers with LR contracts. -Aggressive Reputation --make the potential entrant worry that you will respond forcefully to even a minor provocation

Financial Distress

-current or anticipate difficulty meeting obligations. firm expects more money out than in due to weak mktg, inefficient production, litigation, regulatory action, foreign competition, rising costs, tight capital mkts. -Result: concerned they won't be repaid, aggressive creditors, hassle debtors in a swarm, which can create a bank panic-like situation. gov can intervene.

First-Degree Price Discrimination

-firm extracts 100% of potential surplus to each customer's WTP (cough cough financial aid cough cough); but there are issues. -Information: the firm must know WTP for each PoBuyer. -Resale: The firm must stop it or else the arbitrageurs will run off with the surplus. -Bargaining: the firm prefers making acceptable take-it-or-leave-it offers of P(i)=WTP(i) to compromising after negotiating with PoBuyers; seller tries to keep other PoBuyers in the dark! -Discrimination: 1DPD cd be illegal if tied to racial discrimination -Embarrassing if caught: could lead to consumer revolt (happened when amazon charged different customers different prices for the same product)

Marginal Analysis

-hallmark of economic thinking: think of what each additional unit does. if marginal benefit exceeds the marginal cost, do it, and if not, don't do it. Keep applying until MB/MR=MC. -PROFIT-MAXIMIZING OUTPUT LEVEL IS THE Q* THAT SETS MR=MC. -even tho business managers may not literally (or consciously) set MR=MC, they make choices that effectively do, because if they didn't they wouldn't maximize profits. Our economic model IS useful in helping us predict the behavior of profit-seeking firms.

Zero Accounting Profit

-in contrast, Zero Accounting Profit omits opportunity costs (e.g., the normal return for shareholders). Accountants use historical costs (i.e., what you paid when you bought it) whereas economists use opportunity cost, the current market value.

Market Shares

-once we've used CPED to settle on a particular market, we assess the relative market power of the firms -First, compute market shares per firm, which is that firm's annual revenue/sales as a percentage of mkt's total revenues. Alternatively, sometimes know number of units sold.

Why M&A May Fail

-overconfidence: overestimated synergies and potential benefits --economies of scale/scope/experience/etc. to materialize -divergence bw managerial and shareholder objectives --by building an empire, a CEO may improve her development opportunities --CEO may enjoy the pecuniary and non-pecuniary advantages of managing large firms -Post Merger Failure to Integrate --cultural or strategic incompatibilities b/t mgmts, L --Mgmt unable to impose its leadership style --lack of communication; lack of clear vision for the future of the business --william mcgee, of the Consumers Union, warned that "a clash of corporate cultures" is virtually guaranteed, particularly after layoffs.

Price Competition Insights

-price wars can be very intense, even with only 2 rivals even tho there are only 2 firms, we can get a P.C. result: P=Mc -a firm with a slight cost advantage could drive its rival out of the market by forcing the firm to incur a loss if it doesn't shut down (or exit in the LR). -as usual, firms have an incentive to cut costs -firms have an incentive to differentiate their products through brands and advertising in order to weaken the intensity of the price competition. firms try to create market failures to escape cutthroat competition.

Oligopoly

-relatively few large firms...typically 2-10 --high market concentration --often can set prices -strategic interaction --my mgrl decisions will impact my rivals and their decisions will impact my firm, so our fates are linked. this is like a zero-sum game (what one player wins, the other player loses). -many varieties: entry barriers, differences in products, technologies, managerial abilities, and/or access to information -complex interaction -> many models

Antitrust

-series of federal laws that prohibit anti-competitive business practices, particularly "monopolization," which may take form of --price fixing (agreeing to set high prices) --collusion (besides agreeing on high prices, conspirators might collectively agree to restrict output or rig bids) --predatory pricing (setting sub-cost price to drive out rivals) --mergers between close rivals --Sherman Antitrust act (magna carta of free enterprise was the main vehicle for destroying these badboys, though the language is vague enough that modern oligopolies can act largely unhindered a lot of the time --only makes sense to dismantle a monopoly if the cost to do so is less than the DWL created by the firm

When to Shut Down (be temporarily idle; to produce Q=0)

-sometimes you'll lose money regardless of whether you are actively producing, so shut down when you'd lose more money by staying open. Maximizing profit is the same as minimizing loss! -If you shut down, then you only pay TFC (e.g., rent, loans) since you can avoid TVC; however, you have to pay ALL of the rent. So you shd stay open only if you can cover TVC and pay at least part of TFC. If you can't even cover labor costs, then shut down to avoid digging yourself into an even deeper hole (assuming all fixed costs are sunk). -RULE: SHUT DOWN IF P<=minAVC

Bankruptcy

-state of insolvency; an inability to pay debts. may be voluntary (debtor-prompted) or involuntary (court petitioned by creditors). -by declaring bankruptcy, the firm publicly admits struggling financial status to obtain from govt some temporary relief from creditor hassles while determining how to pay its bills. under court supervision, and according to business law, the firm settles its obligations to creditors in an equitable manner. -there are multiple types of bankruptcy--Chapter 7 and Chapter 11 are the most common

Herfindahl Index

-the squared mkt shares of ALL firms in the mkt -closer you are to 10,000, the closer you are to a true monopoly

CPED and Monopolies

-to assess monopolization issues, one must first determine the relevant market -intuitively, what products are reasonably close substitutes? -formally, we compute the CPED which indicates the sensitivity of the quantity demanded of product X to changes in the price of product Y. -antitrust authorities define a mkt by asking whether a hypothetical seller could profitably impose "a small but significant non-transitory inx in price"

Why Merge?

-to gain market power (possibly to monopolize) --reduce # rivals; gain bargaining power with suppliers and distributors --enter new geographical mkts --access new products, new technology, or better human capital (aqui-hires = get not only K and ideas, but also specialized L (or pre-formed teams [google's talent war]) -To reduce cots --economies of scale (bigger batches) --economies of scope (make related products) --economies of experience (learn from trial and error) --eliminate redundancies or duplication; reallocate un(der)used assets --combine complementary inputs --- vertical integration: make instead of buy ---acquire new technology (portfolio of patents and patented tech) -for financial or personal reasons --tax benefits; get unused borrowing capacity; diversification; lower WACC (discount rate) --avoid bankruptcy; owner wants to retire or cash out --to enhance a CEO's power, prestige, compensation; Empire building -mergers have a high failure rate; academic studies find up to 50% M&A failure rate

Implicit Costs (aka Opportunity Cost

-what miss out on by using assets in a particular way -opportunity cost is the value of the best alternative foregone (always make sure the current value of your decision is higher than the opportunity cost!) -ex. if you work for your own business and pay yourself $50k, and choose not to take a job in NYC for $125K, then you forgo $75K in income

Why Zero Economic Profit is Fine

-zero economic profit allows firms to pay all of its bills (payroll, rent) AND for its shareholders to earn a normal rate of return. E.g., if they could earn 10% investing in shares of similar firms, then the opportunity cost is that 10% they must earn. Shareholders must be compensated for waiting and worrying!

Shutdown VS Exit Market

A firm must pay fixed costs (rent, heat) regardless of whether it produces, but its variable costs are typically avoidable if it shuts down. When prices are low enough that the firm cannot break even, the manager determines whether producing would allow the firm to cover its VC and part of its FC. If so, it shd produce, at least in the SR. But if producing would cause it to lose more money than just being idle, it should "turn off the lights and lock the door" in the SR. This is why beaches close during winter and most restaurants are closed Monday.

Cartel Incentive to Defect

CArtel's are HIGHLY unstable

(Dis)Economies of Scale and Minimum Efficient Scale

Causes of diseconomies of scale: -Bureaucratic costs: too many bosses who must approve an idea -communication and coordination costs: info dissemination slows, lack of focus -managerial problems: easier to shirk when many co-workers on a big project

Conditions Leading to Market Failure and Examples

Concentrated Structure -Monopoly -Oligopoly -Monopsony -Oligopsony Differentiated Products, Brands -advertising can create heterogenous goods (or imperfect substitutes), brand loyalty, switching costs Barriers to Entry -size-related cost advantage (like "very significant" economies of scale) Externalities -actions of private decision maker affect third parties (either neg pollution or pos network effects), so private and social decisions differ Public Goods -nonvrival goods (like public broadcasting). Consumption by one person does not affect the quantity that can be consumed by another person. -nonexclusive goods (like public parks). once produced, the good is available to everyone. Asymmetric Information (one party knows more about its own actions/characteristics than another party.) -moral hazard: hidden action: does a consumer drive less carefully when he knows he is insured? -adverse selection: hidden information: how much should i pay for a used car of uncertain quality? Trade frictions (aka Transaction costs) -costly search, coordination, bargaining, contracting, monitoring, enforcing -specific assets, hold-up

(Dis)Economies of Scale and MES

Efficient Scale (Syn: firm size, output, product): an output level that allows the firm to produce at minimum LRAC. Minimum Efficient Scale (MES): THE smallest output level that allows firm to produce at minimum LRAC.

Synonyms for SR Labor Cost Function

Cost of Required Labor Input, wL, Total Variable Cost, Wage Bill, Labor Cost, Payroll

Marginal Cost curve

Cuts through both ATC and AVC AT THEIR MINIMA. This is why you always charge where MC intersects with ATC; it minimizes cost.

Short Run Production Function in Terms of L (Step 1)

Don't hire past red part! for obvious reasons!

The Law of Diminishing Marginal Returns

Holding other inputs constant, if we increase the variable input L we expect MP(L) to eventually dx. This occurs so frequently we refer to it as a law.

Having Multiple Pitchforks

If have options of multiple factories or restaurants, will have multiple pitchforks (similar to having multiple labors--could think of it as a meta-pitchfork). We can find how many factories to operate in the long-run by finding what number of factories minimizes our costs.

Second-Best (Average Cost/Break-Even) Pricing

P=ATC; now, monopolists can break even, so incentivized to at least produce to a much more reasonable level to supply consumers at a price that matches their demand. still DWL, but a much less significant amount.

Pools

Informal, extra-legal associations. not legally enforcable

Long Run

Is just long enough that ALL of the inputs become variable. How long wd it take to build an ideal two factories that bring you to MES?

Variable Costs

Labor

Shapes of Curves

Quite Logical, when you think about it

Fixed Costs

Rent, Loans

Trusts

SHs assign stock in trust to powerful board of trustees. This is why US pro-competition; anti-monopoly laws called anti-trust laws.

The "Pitchfork"

The MC and ATC together. Once we have the pitchfork, can analyze any profit-maximizing firm (competitive, monopolistic, oligopolistic) in the short run. To find minATC use a derivative or (more easily) set ATC=MC. Given a SR total cost function C[Q], we can find the SR average total cost: ATC=C/Q. We can also find the marginal cost: MC=slope of C[Q] (derivative, my man!)

The Nash Equilibirum

a pair of best response strategies

True Monopoly

an incumbent (active) firm producing a product for which there exists no close substitutes; protected from potential rivals by high entry barriers, this single seller enjoys a 100% market share.

Near Monopoly

an incumbent firm that accounts for an overwhelming share of sales; it may face weak competition from rivals selling weak substitutes -this is what we tend to observe

Acquisition

assume ownership of another firm via purchase of stock; target may retain separate legal identity -friendly acquisition supported by current mgmt -hostile takeover when current mgmt opposed to acquisition

Allocative Efficiency

bc of the prices monopolies charge, the equilibrium quantity that would be reached in perfect competition isn't reached; so, from the perspective of perfect competition, resources are NOT allocated efficiently. Monopolies are productively inefficient (as a are monopolistic competition).

Holding Companies

central firm is majority SH in cooperating firms. Think standard oil of New Jersey

Tacit Collusion

collusion appears as the eq of a non-cooperative, repeated game (e.g., an infinitely repeated Cournot or /Bertrand game), so the firms don't have a binding agreement -e.g., execs anticipate that output restrictions will be rewarded while output expansions will be punished, so they restrict output, w/o ever talking to their co-conspirators

Mergers

consolidate assets thru union of corporations, especially direct rivals in a "horizontal merger." This loophole was largely closed by the clayton act (1914).

Game Theory

every game must address the following elements: -players: who faces an interesting choice? -choices: what can a player choose? actions, strategies -timing: are the moves simultaneous or sequential? -information: what does each player know when s/he moves? -payoffs: what motivates each player?

Cartel

explicit collusion; firms come to an agreement --e.g., execs hold secret meetings to fix prices

Chapter 7 Liquidation (aka "Straight Bankruptcy")

firm exits the business and "dies" in a legal sense. officially, a trustee assumes control from mgmt and auctions off assets, using proceeds to repay creditors. Corporate vultures swoop in, buy up and resell valuable assets.

Collusion

firms avoiding competition by setting prices or reducing joint Q

First-Best (Competitive) Pricing

forcing monopolists to set P=MC. Removes DWL, but also means, in a realistic firm, P=MC<ATC, meaning monopolists will suffer a loss this way; exact opposite goal of a monopoly.

Long Run Average Cost Curve

is the lower envelope of the SR ATC curves. If we have N different levels of K to consider, then for each Q we always find the lowest SR pitchfork, or equivalently the lowest ATC.

Third-Degree Price Discrimination (aka Market Segmentation aka Group Pricing)

if: -the seller has market power (ability to set P>MC) -customers can be broken down into groups with different PEDS, -it is easy to distinguish between members of these groups, and -the seller can prevent resale between the groups then: -the firm may be able to inx profits by employing 3DPD, which involves charging different prices to members of the different groups -the more distinct groups into which the monopolist can separate its customers, the better (this is why airlines can make insane profits off of flights--they can charge each individual customer a unique ticket price based on browser cookies and other data they've collected on that specific consumer) -ideally, the monopolist would charge each of its customers an individualized price exactly set to that customer's WTP (like ****in' airlines, man).

Long Run Perfect Competition Equilibrium

in LR PC Equilibrium, the effects are: 1. firms earn ZERO ECONOMIC PROFIT 2. shareholders earn NORMAL RATES OF RETURN 3. Allocative Efficiency: P=LRMC and P=SRMC 4. Productive Efficency: Firm operates at minLRAC and minSRATC 5. Stability: no more incentive for entry or exit, so # firms stable (no turnover)

Merger

legal transaction s.t. assets combined + control transferred + 1 larger entity replace 2 (so 1 "dies")

Chapter 11 Reorganizations

more typical, though not the common understanding. here, a committee of interested parties negotiates to determine the immediate efforts of firm to escape financial distress and avoid liquidation. So SH + creditors + court collectively prepare a plan for repayment and new financing while normal biz activities continue. when terms are satisfied, firm "emerges" and case is closed. SH usually lose 100%!

Creative Destruction

the free market in capitalism is constantly self-cannabilizing to weed out the weak industries.

Marginal Revenue Curve

to maximize profits in a monopoly, monopolists set MR=MC and then move Q[MR=MC] and feed it into the demand curve.

Explicit costs

when you pay cash, write a check, or swipe a cc

X-Inefficency (Managerial)

without competition, utility-maximizing managers of monopolies get lazy and make decisions that do not maximize profits. Graphically, the firm may not capture the entire triangle if laziness causes costs to drift up.

Subgame Perfect Nash Equilibrium (SPNE)

• A SPNE features a NE in every subgame ▪ Assume the entire game is a subgame of itself • A subgame begins at every decision node ▪ NOTE: We are working with perfect info, so each info set is a singleton • Essentially, by checking to see if players are behaving rationally for every possible decision, we are eliminating non-credible threats (i.e., claims to take actions that wd not be consistent with self interest and payoff maximization). • We use SPNE to refine or narrow down the set of Nash Equilibria to a smaller set that is more reliable/believable. If an action isn't credible (i.e., it would make the player worse off even though it's their turn to make that action) then we can cross off that path. Players always choose the path that makes them best off for that round. • For the games we will study, there will usually be a unique SPNE. ▪ If there are multiple outcomes in which a player earns the same payoff, then s/he might be indifferent between playing multiple strategies.

Strategy

•IMPORTANT: A strategy is a set of written instructions that your roommate could follow under any set of circumstances, so it must direct him/her at every decision node, even those that will not be reached on the SPNE path. • How many strategies does F1 have? These will label the rows of your matrix. • How many does F2 have? These will label the columns of your matrix. • Convert this game tree to the payoff matrix (or "strategic form"). • Find all Nash Equilibria. These will be pairs of best response strategies. • Use the game tree to determine rational behavior at each of the 3 subgames. Add squiggles to your tree to illustrate the SPNE path. What is the unique SPNE? • Did you identify any non-credible threats? Explain.

Real Business Dynamic Games

▪Merge with another firm ▪ Enter a new market or exit a current market ▪ Affect tomorrow's costs through an R&D investment ▪ Affect tomorrow's market structure through patent licensing ▪ Change its location, physically or in terms of product characteristics ▪ Invest in lobbying to erect an entry barrier ▪ Invest in advertising to affect tomorrow's demand ▪ Offer to collude with a rival, promising future punishments or rewards ▪ Form an alliance or change relationships within a supply chain