TEST 3 STUDY GUIDE
Game Theory Overview
2 competitors 2 price strategies Each strategy has a payoff matrix Greatest combined profit Independent actions stimulate a response Independently lowered prices in expectation of greater profit leads to worst combined outcome Eventually low outcomes make firms return to higher prices.
Overt Collusion
A cartel is a group of firms or nations that collude Formally agreeing to the price Sets output levels for members Collusion is illegal in the United States OPEC A cartel is defined as a group of firms or nations joining together and formally agreeing as to the price they will charge and the output levels of each member. It is illegal in the US; however, business with the OPEC cartel is conducted every day. In the past, OPEC has been successful in increasing the price of the oil they sell by restricting supply.
Wage Increases and Job Loss
Are unions successful? Wages 15% higher on average Consequences: Higher unemployment Restricted ability to demand higher wages NOTE: There is much debate as to whether or not labor unions have been successful at raising the wages of their members. Some evidence suggests that union wages are on average 15% higher than the wages of non-union workers. However, both exclusive and inclusive unionism tends to reduce employment in unionized firms. This decline in employment has the effect of restricting the ability of the union to demand higher wages. Workers will balk against wage rate requests so high that many workers might lose jobs.
Craft Union Model
As craft unions decrease the supply of labor, the wage rate increases. The number of workers employed will also decrease.
Marginal Productivity Theory of Resource Demand
Assume perfectly competition Product markets Resource markets Derived demand for resources depends on Marginal product of the resource (MP) Price of the product it produces (P) NOTE: To keep the example simple, assume that resources are bought and sold in perfectly competitive markets and that the products produced by the resources are also bought and sold in perfectly competitive markets. Note that there is a derived demand for resources since we do not consume resources directly but indirectly through the consumption of the goods and services produced with the resources. The strength of the demand depends on the productivity of that resource in helping to create a good or service and the market value or price of the good or service it helps produce.
Input Substitution: The Case of ATMS
Banks use ATMS instead of human tellers Least cost combination of resources ATMS debuted about 45 years ago 80 billion US transactions per year Former tellers find new jobs Customer convenience NOTE: The proliferation of ATMs illustrates the input substitution effect. Banks are using more automatic teller machines and employing fewer human tellers. While the loss of the teller jobs may hurt some workers, the cost-savings to the banks and the increased customer convenience means that society as a whole comes out ahead. Society obtains more convenient banking along with the increased output the "freed-up" labor resources can help produce.
Economic Rent
Because the supply of land is perfectly inelastic, demand is the sole determinant of land rent. An increase in demand from D2 to D1 or a decrease in demand from D2 to D3 will cause a considerable change in rent. The amount of land will always stay the same. If demand is very weak (D4) relative to supply, land will be a "free good," commanding no rent.
Obstacles to Collusion
Demand and cost differences Number of firms Cheating Recession New entrants Legal obstacles NOTE: Because demand and cost differences exist between members, it will be difficult for all members to charge the same price. The more firms who are part of the agreement, the harder it is to maintain. There is always a tendency for members to cheat and this erodes the cartel's power over time. See the Prisoner's dilemma. Overall demand declines during recessions making cheating more attractive. New producers will be drawn to the industry because of the greater prices and profits which will increase market supply and decrease prices. Laws prohibit cartels and price collusion in the United States.
Profit Maximizing Rule
Each resource is employed to the point where its MRP is equal to its price PL = MRPL and Pc = MRPc MRPl MRPc ------- = --------- = 1 Pl Pc NOTE: Just minimizing costs is not enough for maximizing profit. There is only one unique level of output that will maximize profit. Profit maximization occurs where marginal revenue equals marginal cost. A firm will achieve its profit-maximizing combination of resources when each resource is employed to the point at which its marginal revenue product equals its resource price.
The Short Run: Profit
Firms produce the quantity where MR = MC just like in other industries. It is possible to make a profit in the short run. (Price - ATC) * Q = Economic profit. At the profit maximizing output, price is higher than ATC and the firms enjoy an economic profit in the short run.
Economic Profit
Insurable risks Uninsurable risks Changes in economic environment Structure of economy Government policy New products of production methods
Least Cost Rule
Minimize cost of producing a given output Last dollar spent on each resource yields the same marginal product Marginal product Marginal product of capital (MPC) of labor (MPL) ------------------- --------------------- Price of labor (PL) Price of Capital (PC)
Interest
Price paid for use of money Stated as a percentage Money is not a resource Interest rates and interest income Range of interest rates Risk Maturity Loan size Taxability
GAME THEORY STRAT
Strategies The strategies of a game are all the possible outcomes of each player. The strategies in the prisoners' dilemma are Confess to the bank robbery. Deny the bank robbery.
GAME THEORY CONTD
The Prisoners' Dilemma Art and Bob have been caught stealing a car: sentence is 2 years in jail. DA wants to convict them of a big bank robbery: sentence is 10 years in jail. DA has no evidence and to get the conviction, he makes the prisoners play a game.
GAME THEORY VISUAL
The prisoners' dilemma payoff matrix for Art and Bob.
Wage Differentials
The wage differential between labor markets (a) and (b) above results solely from differences in labor demand. In labor markets (c) and (d) above, differences in labor supply are the sole cause of the wage differential.
High Concentration Industries
This table displays a few high-concentration U.S. manufacturing industries. A 4-firm concentration ratio of 40% or more is indicative of an oligopolist.
Negative Effects of Advertising
Can be manipulative Contain misleading claims that confuse consumers Consumers may pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product
The Short Run: Loss
Firms will produce the quantity where MR = MC to maximize profits. It is possible to make a loss in the short run. (Price - ATC) * Q = Economic profit or loss. At the profit maximizing output, price is below ATC and therefore a loss is incurred.
Oligopolistic Industries
Four-firm concentration ratio 40% or more to be an oligopoly Shortcomings Localized markets Interindustry competition Import competition Dominant firms NOTE: To be an oligopoly, the 4-firm concentration ratio must be at least 40%. Based on this rule of thumb, about 50% of U.S. manufacturing is oligopolistic. Here are four shortcoming to be aware of when using these ratios. Localized markets may have just one producer which is a monopoly, while a low 4-firm concentration ratio indicates a lot of competition in the national industry. Interindustry competition occurs when industries like glass and plastic compete with each other. This competition is not reflected in their high 4-firm concentration ratios. Competition from imports due to world trade is not taken into account when calculating concentration ratios. There may be a dominant firm in the industry exhibiting domination that may be disguised and not reflected in the 4-firm concentration ratio.
GAME THEORY
Game theory is the tool used to analyze strategic behavior—behavior that recognizes mutual interdependence and takes account of the expected behavior of others.
Wage Differentials
Hourly wage rates and annual salaries differ greatly among occupations. This table lists average annual salaries for a number of different occupations to illustrate such occupational wage differentials.
Bilateral Monopoly Model
In the graph of the bilateral monopoly labor market, we can see the different forces at work. Which force wins out cannot be predicted by economic theory. This situation may be more economically desirable as the most likely outcome is a higher wage rate than under pure competition but more workers are employed than under monopsonistic conditions.
The Long Run: Only a Normal Profit
In the long run firms still produce the quantity where MR = MC. In the long run firms will enter the industry if economic profits were enjoyed, shifting demand left and profits fall. In the long run firms will exit the industry if there are economic losses, shifting demand to the right and losses shrink. This will continue until the price settles where it just equals ATC at the MR=MC output. At this price, the monopolistically competitive firm earns a normal profit.
Monopolistically Competitive Industries
Industry concentration Measured by 4-firm concentration ratio Percentage of sales by 4 largest firms 4-firm CR = output of four largest firms ----------------------------------- total output in the industry Herfindahl index Sum of squared market shares HI = (%S1)^2 + (%S2)^2 + (%S3)^2 + .... + (%Sn)^2
Three Oligopoly Models
Kinked-demand curve Collusive pricing Price leadership Reasons for 3 models Diversity of oligopolies Complications of interdependence NOTE There are two reasons that there is not just a single model to explain this type of market. Oligopoly encompasses a great range and diversity of market structures. The decisions depend on the actions of the rivals, making it more difficult to explain the behaviors without several models. Each of these models are described on the following slides.
Role of Productivity
Labor demand depends on productivity U.S. labor is highly productive Plentiful capital Access to abundant natural resources Advanced technology Labor quality Other factors NOTE: The demand for labor, like other resources, depends on its productivity. The greater the productivity of labor, the greater is the demand for it. And if the supply of labor is relatively fixed, that means the average level of real wages will be higher. The U.S. and other advanced economies benefit from highly productive labor. This is due to the plentiful capital available in these nations, access to abundant natural resources, advanced technology, the quality of the labor, and other less obvious factors such as a social and political environment that emphasizes production and productivity.
Economic Rent
Land ownership: fairness vs. allocative efficiency Application: a single tax on land Henry George's proposal Single-tax movement Criticisms
Positive Effects of Advertising
Low-cost way of providing information to consumers Enhances competition Speeds up technological progress Can help firms obtain economies of scale NOTE: Advertising is a low-cost way of providing information to consumers about different options and it reduces the consumer's search time for products. Advertising also enhances competition between firms and thus aids in economic efficiency. It speeds up technological progress by introducing new products. Advertising can help firms obtain economies of scale by reducing long run average costs.
Marginal Productivity Theory of Resource Demand
MRP = MRC rule To maximize profit, hire additional resources as long as the additional product produced adds more to revenues than to costs MRP schedule equals the firm's demand for labor MRC exactly equal to wage rate
Income Distribution
Marginal productivity theory of income distribution Paid according to value of service Workers Resource owners Inequality Productive resources unequally distributed Market imperfections NOTE: Income is distributed according to how the resource has contributed or has been applied in creating society's output. Income payments based on marginal revenue product provide a fair and equitable distribution of society's income. It is not a perfect system, however, as it can result in a highly unequal distribution. This may be because production resources were unequally distributed in the first place. Market imperfections can also result in unequal distributions. In some labor markets, employers are able to exert their wage-setting power to pay less-than-competitive wages.
Marginal Productivity Theory of Resource Demand
Marginal resource cost (MRC) Change in total resource cost resulting from unit change in resource input (labor) Marginal change in total cost revenue = ------------------------------ cost change in resource quantity
Marginal Productivity Theory of Resource Demand
Marginal revenue product (MRP) Change in total revenue resulting from unit change in resource input (labor) Marginal change in total revenue revenue = ------------------------------ product change in resource quantity
Kinked-Demand Theory
Noncollusive oligopoly Uncertainty about rivals reactions Rivals match any price change Rivals ignore any price change Assume combined strategy Match price reductions Ignore price increases NOTE: The kinked demand model is used for noncollusive oligopolies to explain their behaviors and pricing strategies. Since the firms do not collude, none of the firms know with certainty what their rivals are going to do. However, the firms assume that their rivals will match any price reductions in an effort to maintain their customers. On the other hand, it is reasonable to assume that if a firm raises its price, its rivals will ignore the price change in an effort to steal customers from the firm raising its price.
Oligopoly and Efficiency
Oligopolies are inefficient Productively inefficient because P > min ATC Allocatively inefficient because P > MC Qualifications Increased foreign competition Limit pricing Technological advance NOTE: Productive efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Neither efficiencies occur in oligopolistic markets. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm's profits they have a means to invest in new technologies.
Oligopoly and Advertising
Oligopolies commonly compete though product development and advertising Less easily duplicated than a price change Financially able to advertise NOTE: In differentiated oligopolies advertising is the best way to communicate a firm's product differences. Product improvements revealed through advertising can be successful in increasing market share and revenues because product innovations are more difficult to copy by a competitor than a price change. Oligopolists are financially able to advertise due to economic profits earned in the past.
Oligopoly Behavior
Oligopolies display strategic behavior Mutual interdependence Collusion Incentive to cheat Game theory Prisoner's dilemma NOTE: Strategic pricing behavior refers to how a firm's decisions are based on the actions and reactions of rivals. Mutual interdependence exists when each firm's profit depends on its own pricing strategy and that of its rivals. Collusion is defined as cooperating with rivals and can benefit the firm. There is an incentive for firms to cheat on their agreement to collude because cheating can result in increased revenues for the cheater. Game theory is the study of how people behave in strategic situations. The Prisoner's dilemma is a classic example of mutual interdependence and game theory.
Labor, Wages, and Earnings
Wages Price paid for labor Direct pay plus fringe benefits Wage rate Nominal wage Real wage General level of wages NOTE: The term "labor" is used to refer to virtually any type of worker: blue-collar, white-collar, hourly, salaried, professional, etc. Wages, the price paid for labor, include not only direct money payments but also fringe benefits like vacations and health insurance. A nominal wage is the amount of money received per hour, day, or year. A real wage is the quantity of goods and services a worker can obtain with nominal wages or the "purchasing power" of nominal wages. Wage rates differ greatly among nations, regions, occupations, and individuals.
Monopolistic Competition and Efficiency
We can see the inefficiency of monopolistic competition. In long-run equilibrium a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4. Allocative efficiency is not achieved because the product price P3 exceeds the marginal cost. The results are an underallocation of resources as well as an efficiency loss and excess production capacity for every firm in the industry. This firm's excess production capacity is Q4 - Q3.
GAME THEORY PT 2
What Is a Game? All games involve three features: Rules Strategies Payoffs Prisoners' dilemma is a game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.
Optimal Combination of Resources
What combination of resources will minimize costs at a specific output level? Least-cost combination of resources Least cost rule What combination of resources will maximize profit? Profit-maximizing combination of resources Profit maximizing rule
Wage Differentials
Workers prevented from moving to higher paying jobs Market imperfections Lack of job information Geographic immobility Unions and government restraints Discrimination NOTE: Why don't workers just move from lower-paying jobs to higher-paying jobs? Several reasons can be the cause. Frequently there are market imperfections at work. Workers may not be aware that there are higher-paying jobs for which they qualify. They may not be able to move to locations where higher-paying jobs exist because they do not want to leave their families or friends. Unions and other government restraints may also artificially reinforce wage differentials. And in spite of legislation to the contrary, discrimination in the workforce still results in lower wages frequently being paid to women and minority groups.
The Minimum Wage Controversy
Case against minimum wage Case for minimum wage State and locally set rates Evidence and conclusions NOTE Since the passage of the Fair Labor Standards Act in 1938, the United States has had a federal minimum wage designed to ensure workers earn at least an amount sufficient to support themselves and their families at a basic subsistence level. Some states have passed minimum wage laws of their own with a higher rate than the federal minimum rate. The federal minimum wage was most recently raised to $7.25 per hour (July 2009). Critics argue that the minimum wage, if it is above the equilibrium wage rate, will cause employers to hire fewer workers and may even force some firms out of business since they cannot afford to pay the higher rate. They also argue that many of the workers who receive this minimum rate, such as teenagers, do not actually live in impoverished households and are not self-supporting so do not need a guaranteed minimum.
Determinants of Resource Demand
Changes in price of substitute resources Substitution effect Output effect Net effect Changes in the price of complementary resources NOTE: Changes in the prices of substitute resources may affect the demand for a specific resource. The substitution effect tells us that a firm will purchase more of an input whose relative price has declined and, conversely, use less of an input whose relative price has increased. The output effect indicates that the firm will purchase more of one particular input when the price of the other input falls and less of that particular input when the price of the other input rises. Netting the two together will determine the final total change. With complementary resources the changes in demand for each resource will be directly related, meaning they will rise and fall together.
Determinants of Resource Demand
Changes in product demand Changes in productivity Quantities of other resources Technological advance Quality of the variable resource
KINKED DEMAND CURVE
Criticisms Explains inflexibility, not price Prices are not that rigid Price war NOTE: There are a few criticisms of the kinked demand curve. First, the demand curve was created around the current price that was already being charged, but it never actually explained how the current price was determined. This is very similar to putting the cart before the horse. We have seen that prices are rigid for reasons on the demand and cost side, but prices in oligopolies are not nearly as rigid as this model implies. Lastly, there is always a chance that changing prices could result in a price war.
Price and Output in Monopolistic Competition
Demand is highly elastic Short run profit or loss Produce where MR = MC Long run only a normal profit Entry and exit NOTE: The firm's demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly's demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller's product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry.
Significance of Resource Pricing
Determines money income for the household Cost minimization Resource allocation Policy issues NOTE: Studying resource pricing aids in the understanding of economic activity in several ways. Resource prices are a major factor in determining the income of households. To firms, resource prices represent costs. To make the most money, firms must produce at the profit-maximizing output with the least costly combination of resources. Resource prices help in the allocation of resources among the various industries and firms that need them. And finally, many policy issues like: CEO pay, labor unions, and minimum wage increases are based on resource pricing. While the focus in this chapter is on the labor resource, the principles apply just as well to the other economic resources: land, capital, and entrepreneurial ability.
Wage Differentials
Differences across occupations What explains wage differentials? Marginal revenue productivity Noncompeting groups Ability Education and training Compensating differences NOTE: Wages differentials are created by many different forces and can arise from either the supply or the demand side of the labor market. Even across one occupation, wage differentials can occur. For example, a surgeon just starting out would expect to make much less than one who has many years of experience. If we focus on the affect of the labor demand on the wage differential, we can see that the strength of the labor demand varies greatly among occupations due to differences in how much various occupational groups contribute to the revenue of their respective employers. The marginal revenue productivity of these types of workers is high. We can see this illustrated in the demand for professional athletes. On the supply side, workers differ greatly in their mental and physical characteristics and in their education and training. In some groups, there may be fewer qualified workers than in other groups, leading to higher wages rates for those limited workers. Compensating differences are paid to compensate for non-monetary differences in various jobs. Undesirable jobs must pay higher wages to recruit workers who could just as easily qualify for less demanding positions.
Wage Differentials
Education can be a significant source of wage differentials, as illustrated in this figure. Investment in education yields a return in the form of earnings differences enjoyed over one's work life.
The Price of Credit
Effective interest rates Discounting a loan Repaying a loan in installments Effects of compounding Truth in Lending Act 1968 Truth in Savings Act 1991 Fees and teaser rates Let the borrower beware NOTE: There are many different forms of borrowing and the interest paid on those loans can sometimes be deceiving. It is important for an individual to pay attention to exactly how the interest is being calculated. Two pieces of legislation, the Truth in Lending Act of 1968 and the Truth in Savings Act of 1991, have attempted to clarify interest charges and payments for consumers. The old adage "let the borrower beware" is still a fitting motto in the world of credit.
Craft Union Model
Effectively reduce supply of labor Restrict immigration Reduce child labor Compulsory retirement Shorter workweek Exclusive unionism Occupational licensing Some unions attempt to restrict the supply of labor available and thus affect the wage rate paid. Labor unions have supported legislation that has restricted immigration, reduced child labor, encouraged compulsory retirements, and created a shorter workweek. Craft unions especially tend to control the supply of labor by requiring workers to belong to the union in order to obtain certain jobs. They may force employers to agree to hire only craft union members. The craft union then maintains restrictive membership policies to control the labor supply. A similar situation exists in many professional occupations which may push for legislation requiring occupational licensing as a way to control the supply of labor.
Elasticity of Resource Demand
Elasticity of resource demand percentage change in resource quantity Erd =---------------------------------------------- percentage change in resource price Ease of resource substitutability Elasticity of product demand Ratio of resource cost to total cost
Monopsony Model
Employer has buying power Characteristics Single buyer Labor immobile Firm is a "wage maker" Upsloping labor supply to firm MRC higher than wage rate Equilibrium NOTE: In a monopsony market, there is only one buyer for labor. The workers who provide the type of labor needed have few employment options other than working for the monopsony, maybe because they are geographically immobile or their skills are not transferable to other jobs. This makes the firm a "wage maker," meaning that the wage rate it must pay varies directly with the number of workers available. In this case, the firm's labor supply curve will be upward sloping and the MRC will be higher than the wage rate. To maximize profit, the monopsonist will employ the quantity of labor at which MRC and MRP are equal.
GAME THEORY CONTS
Equilibrium Occurs when each player takes the best possible action given the action of the other player. Nash equilibrium is an equilibrium in which each player takes the best possible action given the action of the other player. The Nash equilibrium for Art and Bob is to confess. The equilibrium of the prisoners' dilemma is not the best outcome for the players.
Economic Profit
Explicit costs Implicit costs Pure profit Total revenue less explicit and implicit costs Role of the entrepreneur Normal profit
Loanable Funds Theory
Extending the model Financial institutions Changes in supply Household thrift Changes in demand Rate of return on investment Other participants
Competitive Labor Market
Market demand for labor Sum of firm demand Example: carpenters Market supply for labor Upward sloping Competition among industries Labor market equilibrium MRP = MRC rule NOTE Because wage rates vary greatly by occupation, it is useful to look at the factors that determine the wage rate paid for a specific type of labor under different conditions. We begin by examining labor supply and demand in a purely competitive labor market. The market demand for labor is determined by the horizontal sum of the labor demand curves of the individual firms. The market supply for labor is illustrated by an upward-sloping supply curve, indicating that employers must pay higher wage rates to obtain more workers. The labor market equilibrium is determined by the intersection of the market labor demand curve and the market labor supply curve.
Monopsony Power
Maximize profit by hiring smaller number of workers Examples of monopsony power Nurses Professional Athletes Teachers Three union models NOTE: The monopsonist will maximize profits by employing a smaller number of workers and paying a lower wage than the competitive market. Society will obtain a smaller output and workers receive a wage rate that is less than their marginal revenue product. While monopsonistic labor markets are uncommon in the United States, there are a few examples. In the medical area, nurses are typically limited in their choice of employers to the relatively small number of hospitals that may be in their area. Likewise, professional athletes are limited through player drafts to specific employers only. In some situations, labor market workers unionize and create their own monopsonistic power.
Time-Value of Money
Money is more valuable the sooner it is obtained Ability to earn interest Compound interest Future value Present value NOTE: Interest is central to understanding the time-value of money or the concept that a specific amount of money is more valuable to a person the sooner it is obtained. Compound interest is the total interest that accumulates over time on money that is placed into an interest-bearing account. Future value is the amount to which some current amount of money will grow as interest compounds over time. Present value is today's value of some amount of money to be received in the future.
Monopolistic Competition
Monopolistic competition Relatively large number of sellers Product differentiation Easy entry and exit Nonprice competition like advertising
Monopolistic Competition and Efficiency
Monopolistic competition inefficient Productive inefficiency because P > min ATC Allocative inefficiency because P > MC Excess capacity Productive efficiency means that the firm is producing in the least costly way and is found when P = minimum ATC. Allocative efficiency means that the firm is producing the right amount of product and is found when P = MC. Neither condition is met in monopolistic competition. As we examine the industry, we will find that it is inefficient. There is excess capacity in the industry which means that the plant and equipment are underutilized because firms are producing below minimum ATC output.
Bilateral Monopoly Model
Monopsony and inclusive unionism Single buyer and seller Not uncommon Indeterminate outcome Desirability NOTE: Bilateral monopolies occur when there is a strong industrial union in a monopsonist labor market. In this case, there is both a single buyer and seller of labor. The effect on the wage rate is indeterminate since it will depend on which party has the greater bargaining power.
Industrial Union Model
Most unions seek to organize all available workers, rather than just a select few. Industrial unions seek all available unskilled, semiskilled, and skilled workers in an industry. By including such a large amount of workers, the union can put the firm under great pressure to agree to its wage demands, especially due to its legal right to strike. By agreeing to the union's wage demand, the firm becomes a wage taker. The labor supply becomes perfectly elastic, creating a higher wage rate but again, reducing the number of workers employed.
Oligopoly
Oligopoly A few large producers Homogeneous oligopoly Differentiated oligopoly Limited control over price Entry barriers Mergers NOTE: The entry barriers in oligopoly are not as great as in monopoly, thus we have a few producers. There are homogeneous or standardized oligopolies like the steel and aluminum markets. There are also be differentiated oligopolies like the markets for automobiles, electronics equipment, and breakfast cereals. Control over price is limited because there are just a few sellers in the market and rivals may respond in a way that would be detrimental to the firm that just changed the price. Entry barriers are more substantial than in monopolistic competition which is why there are just a few producers in the market. Although some firms have become dominant as a result of internal growth, others have gained dominance through mergers.
GAME THEORY PAYOFF
Payoffs Four outcomes: Both confess. Both deny. Art confesses and Bob denies. Bob confesses and Art denies. A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.
Price Leadership Model
Price leadership Dominant firm initiates price changes Other firms follow the leader Use limit pricing to block entry of new firms Possible price war NOTE: Price Leadership is an economic model where a dominant firm initiates price changes and the others in the industry follow the leader. The leader communicates price changes through speeches, press releases, or articles in trade journals. One result is infrequent price changes since the leader is never certain that the other firms will follow and there is always the threat of a price war.
Economic Rent
Price paid for land and other natural resources Perfectly inelasticity supply Changes in demand A surplus payment NOTE: Economists use the term "rent" to mean economic rent. Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply. This fixed overall supply distinguishes rental payments from wage, interest, and profit payments. For all practical purposes, the supply of land is perfectly inelastic, resulting in a vertical supply curve. Because the supply of land is fixed, demand is the only active determinant of land rent. The demand for land is driven by the productivity of the land, the demand for the products produced on the land and the prices of other resources that are combined with the land. Given the fact that land has a perfectly inelastic supply, there are no incentive payments associated with land. Economists therefore consider land rents to be surplus payments that are not necessary to ensure that land is made available for economic use. No matter what rent is paid, the land will always be there.
Economic Profit
Profit is compensation for bearing uninsurable risks Sources of economic profit Create new products Reduce production costs Create and maintain a profitable monopoly NOTE: Profits serve as compensation to the entrepreneur for personally taking on the uninsurable risks of running a business. Basically, in exchange for making sure that everyone else gets paid if things go wrong, the entrepreneur gets to keep the firm's profits when things go right. There are three main ways in which entrepreneurs can generate economic profits. They can create a popular new product that people desire, they can implement more-efficient production methods for existing products or they can create and maintain a monopoly for their product.
Economic Profit
Profit rations entrepreneurship Profit aids in resource allocation Profit and corporate stockholders NOTE: Profit can be thought of as the price that allocates the scarce resource of entrepreneurship toward different possible economic activities. Economic profits are distributed widely beyond the entrepreneurs who first start new businesses. The corporate structure of business enterprise has allowed millions of individuals to participate and therefore share the risks and rewards of ownership. By sharing the profits with these individuals, society is able to indicate which businesses it desires to continue.
Demand Enhancement Model
Union model Increase demand for union labor by altering price of other inputs NOTE: Unions have a limited ability to influence the demand for labor. However, an increase in the demand for union labor will create a higher union wage along with more jobs. In this graph, we can see the effect of an increase in the demand for labor on the wage rate.
Role of Interest Rates
Relationship to: Total output Allocation of capital R&D spending Nominal and real rates Application: Usury Laws Nonmarket rationing Gainers and losers Inefficiency NOTE: Lower equilibrium interest rates encourage businesses to borrow more for investment, resulting in total spending in the economy rising. Since interest rates are prices, they allow for the allocation of the available supply of loanable investment funds to investment projects that have expected returns at or above the interest rate of the borrowed funds. Decisions to spend on R & D will also be influenced by the interest rate. It is important to distinguish between nominal and real interest rates. The nominal interest rate is the rate of interest expressed in dollars of current value. The real interest rate is the rate of interest expressed in purchasing power, adjusted for inflation. It is the real interest rate that affects investment and R & D decisions. Many states have passed what are referred to as usury laws, which specify a maximum interest rate at which loans can be made. By specifying a maximum rate, the government is interfering with the equilibrium rate. This can cause nonmarket rationing in which there is a shortage of loanable funds since the rate is below the equilibrium rate. Creditworthy borrowers gain from usury laws because they pay below-market interest rates and the below-market rates will promote inefficiency in the marketplace since less productive projects may receive financing.
Occupational Employment Trends
Rising employment in health services Personal care aides Home health aides Biomedical engineers Declining employment Shoe machine operators Postal service mail sorters Postal service clerks
GAME THEORY CONTD
Rules Players cannot communicate with one another. If both confess to the larger crime, each will receive a sentence of 3 years for both crimes. If one confesses and the accomplice does not, the one who confesses will receive a 1-year sentence, while the accomplice receives a 10-year sentence. If neither confesses, both receive a 2-year sentence.
The Herfindahl-Hirshman Index
The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms in a market. For example, if four firms have market shares of 50 percent, 25 percent, 15 percent, and 10 percent, then HHI = 502 + 252 + 152 + 102 = 3,450. A market with an HHI of less than 1,000 is regarded as competitive and between 1,000 and 1,800 is moderately competitive.
Internet Oligopolies
The Internet became accessible to the average person in the mid 1990's Today it is dominated by a few very large firms Google, Facebook, Amazon, Microsoft, Apple Not satisfied with just revenues generated in their respective sectors Compete for advertising $s Compete with their own electronic devices NOTE: Google grew to be a near monopoly in search; Facebook advanced to be a near monopoly in social media; Amazon has established a near monopoly in retail; Microsoft has held a near monopoly in pc operating systems and software; Apple has dominance with its devices that run on Apple operating systems. These very successful technology companies are now competing outside of their respective sectors with each other in the quest to increase revenues and satisfy invertors. They compete for revenues collected from advertising and they compete by designing new consumer electronic products; this has led to a very competitive environment.
Global Perspective
The data shown here indicate that hourly compensation in the United States is not as high as in some European countries but is higher than other nations. Generally speaking, the level of real wages in the United States is relatively high as in most other industrially advanced economies. In those nations, the demand for labor is relatively large compared to the supply of labor.
Product Variety
The firm constantly manages price, product, and advertising Better product differentiation Better advertising The consumer benefits by greater array of choices and better products Types and styles Brands and quality
Are CEOs Overpaid?
U.S. CEO salaries relatively high Good decisions enhance productivity Limited supply, high MRP Incentive to raise productivity at all levels High salary bias by board members Unsettled issue NOTE: Much attention has been paid in recent years to the amount of compensation received by the CEOs of U.S. firms. In many cases, the compensation of these CEOs vastly exceeds the amounts paid to other workers. Defenders of the system argue that the high pay is justified by the direct or indirect marginal-revenue contributions of CEOs. Critics say the multi-million-dollar CEO pay bears little relationship to marginal revenue productivity and is unfair to ordinary stockholders. This issue continues to be unsettled between the two sides.
Pay for Performance
The principal-agent problem Incentive pay plan Piece rates Commissions or royalties Bonuses, stock options, and profit sharing Efficiency wages Negative side-effects NOTE: Pay schemes are typically much more complex than just a fixed hourly rate. Employers may use worker pay to encourage a desired level of performance from workers. In the principal-agent problem, the interests of workers and firms are not identical, resulting in situations where workers seek to increase their utility by working less than agreed upon. To prevent this, many firms employ incentive pay plans whereby worker compensation is tied to worker output or performance. This may be accomplished in several ways. Piece rates compensate employees according to the number of units of output a worker produces. Commission or royalties tie compensation to the value of sales. Bonuses, stock options and profit-sharing plans tie compensation to the profitability of the firm, and efficiency wages seek to enhance worker efficiency or basically encourage workers to work harder. Pay for performance plans do have their negative side-effects. Piece rates may encourage rapid production at the expense of product quality. Commissions, bonuses, stock option and profit-sharing plans can all lead to encouraging unethical behavior among employees in order to increase their own personal income at the expense of the firm.
Loanable Funds Theory
The upsloping supply curve for loanable funds in a specific lending market reflects the idea that at higher interest rates, households will defer more of their present consumption (save more), making more funds available for lending. The downsloping demand curve for loanable funds in such a market indicates that businesses will borrow more at lower interest rates than at higher interest rates. At the equilibrium interest rate, the quantities of loanable funds lent and borrowed will be equal.
Competitive Labor Market
These graphs demonstrate the labor supply and labor demand in a purely competitive labor market and a single competitive firm. In an individual firm, the labor supply curve is represented by a horizontal line because it is perfectly elastic. The labor demand curve for the individual firm is downward sloping reflecting the fact that to attract more workers, the firm must pay more. The firm will maximize profits by hiring workers up to where MRP = MRC.
Low Concentration Industries
This table shows some examples of U.S. manufacturing industries that are considered monopolistically competitive. The lower the 4-firm concentration ratio, the less concentration and subsequently, the more competitive the industry. Generally speaking, the lower the Herfindahl index, the lower the industry concentration. Source: Bureau of Census, Census of Manufacturers, 2007
