Econ 101 exam 3

Regulation of Monopolies b/c of negative effects

1) Break-up Monopoly. Anti-trust legislation - broke up AT&T and Rockerfeller 2)Price Regulation (Price Ceiling) If set at proper amount can get rid of welfare losses. 3) Increase competition. Grant more licenses. Reduce trade barriers for foreign firms. Alter patent laws. Subsidize competing firms (offer tax breaks)

Overcome Prisoners dilemma

1) Repeated Game - if game is played repeatedly cooperation may occur because long term benefits from cooperating would exceed the short term gain from not cooperating 2) Tit for tat strategy - involves playing cooperatively at first, then doing whatever the other player did in the previous period. As long as observe player acting cooperatively then continue to act cooperatively. (For example, if provoked, a player will subsequently respond with retaliation, but if they are not provoked, the player will subsequently cooperate.) 3) Enforceable contract - both sides sign an enforceable contract to take mutually beneficial action. But may be illegal to do so. 4) Trust each other??

Barriers to Entry for Monopoly

1. Control of scarce resource or input 2. Cost advantage ➢ Large fixed costs, High initial set-up costs. Cheaper for big company to make it than smaller companies ➢ Natural monopoly ➢ Local utilities: water, gas, electricity 3. Government Created Monopoly ➢ Government License.Patents and Copyrights - to create innovation

Price Discrimination Success factors

1. Firm must have market power ➢ Monopoly, Oligopoly ➢ Perfectly competitive firms do not 2. Firm must be able to identify differences in willingness to pay between consumers 3. Firm must be able to limit resales

Multi-Market Price Discrimination - How to identify which group an individual belongs to

1. Observable Characteristics ➢ Age, location (countries) - student discount 2. Get Consumers to "self-select" themselves into different groups ➢ Our behavior places us into different groups ➢ Coupons ➢ Airline tickets

Types of Price Discrimination - 4

1. Perfect Price Discrimination ➢ Charge the maximum amount each consumer is willing to pay 2. Quantity Discrimination ➢ Firm charges a different price for large quantities than for small quantities 3. Multi-Market Price Discrimination ➢ Charge different groups of customers different prices 4. Two-Part Tariff ➢ Charge customer a lump-sum fee for the right to buy the good at specified price

Solution to Externality Problem

1. Private Solution:  Coase Theorem:  If property rights are clearly defined and transaction costs are low then can get an efficient outcome through bargaining regardless of who owns the economic property rights  Efficient, not equitable: Who is assigned the property rights will influence the income distribution  Not a real solution. A demonstration that lack of clearly defined property rights are the root of the problem

Perfectly Competitive Markets in the Short-Run Production decision and Shutdown decision

1. Production Decision ➢ Produce quantity where Price (MR) = Marginal Cost (MC) ➢ Profit maximizing condition for a perfectly competitive firm: P = MC 2. Shutdown Decision ➢ Shutdown if Price < Average Variable Cost ➢ Fixed inputs cannot be changed in the Short-Run. Fixed Costs can't change.

Perfectly Competitive Markets in the Long-Run

1. Production Decision ➢ Produce quantity where Price (MR) = Marginal Cost (MC) b/c maximizes profit 2. Shutdown Decision ➢ All costs are avoidable in the long-run ➢ Shutdown if Price < Average Total Cost // TR >= TC ➢ P < ATC ➢ When p>=atc you are profiting/breaking even, still operates

Conditions for Cooperation

1. Repeated Interactions Over time ➢ Tit for Tat strategy 2. Easy to monitor other firms ➢ Good information concerning prices and output levels 3. Little Product Differentiation ➢ Easier to maintain if selling "same" product 4. Entry by non-colluding firms difficult ➢ Easier to successfully collude if collectively hold high market share 5. Merge ➢ To avoid problem of cheating some firms merge into single entity ➢ Mergers may reduce costs and increase efficiency ➢ Subject to approval by Government

Antitrust Legislation

1. Restrict the formation of cartels and prohibit other collusive practices regarded as being in restraint of trade 2. Restrict mergers and acquisitions of organizations which could substantially lessen competition 3. Restrict the creation of a monopoly and abuse of monopoly power  Sherman Antitrust Act (1890)  Clayton Act (1914)  Federal Trade Commission Act (1914)  Robinson-Putnam Act (1936)

Solution to Externality Problem

2. Government intervention  Positive Externality  Subsidy  Negative Externality  Pollution  Corrective Tax (Pigouvian Tax) :: Tax = MEC  Command and Control Policy  Tradable Permits  Traffic Congestion

Nash Equilibrium

5. Equilibrium ➢ Each player attempts to maximize their individual payoffs  Nash Equilibrium  Occurs when, holding the strategies of all other players constant, no player can obtain a higher payoff by choosing a different strategy.

Shutdown Decision Monopoly

Monopolists shutdown  Shutdown if:  Short-Run: P < AVC  Long-Run: P < ATC  Monopolist can charge higher price than perfectly competitive firm

Nothing

Nothing

Price Takers Vs. Price Searchers

Price Takers  Individual firms that have no impact on market price (One strawberry farmer)  Face horizontal, perfectly elastic demand curve  Perfect Competition Price Searcher  Firms that have at least some influence on market price. Big firms.  Face downward sloping demand curve  Monopoly, Oligopoly  Have Market Power: The ability of a firm to raise its price above the competitive level.

Dominant Strategy

Strategy that gives the player a higher payoff no matter what strategy the opponent is playing.

Shape of the Total Revenue Curve

• At low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. • As output rises beyond 10, total revenue actually falls. • This reflects the fact that at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large.

Price and Quantity Effects

• Key Point: In order to attract new customers, the monopolist must lower price. This has two effects on revenue. 1)A quantity effect: one more unit is sold, increasing total revenue by the price at which the unit is sold. 2)A price effect: in order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.

Reasons Monopolies Exist

 A monopolist has market power.  In order for profits to persist in the long-run, some form of barrier to entry must be in place.

Perfect competition

 A perfectly competitive market is a market in which all market participants are price-takers. So both producers and consumers are price takers which means their actions have no effect on market price

Prisoners Dilemma Dominant Strategy

 Both Prisoners have a dominant strategy to confess  It is in the joint interests of both prisoners not to confess, but it is in the individual interest to confess  Outcome is the worst possible outcome, collectively  Both players are worse off than they would have been had they cooperated

Oligopoly options

 Compete or Collude

Imperfect Competition- types of industries

 Competition among firms who have some market power 1) Oligopoly - few producers industry 2)Duopoly - two producers industry 1. Non-Cooperative  Each firm makes decisions about output and price independently 2. Cooperative  Decisions made jointly  Price or Quantity Setting (illegal)  Collusion, no competition

Quantity Discrimination

 Firm charges a different price for large quantities than for small quantities of a good. All customers who buy a given quantity pay the same price. Takes advantage of downward sloping demand curves  Ex. Buy one, get one half off  Example: Consumer willing to pay $8 for the first item and $4 for the second (Diminishing marginal value)  Marginal cost = $2 per unit  Single price = 8 - consumer buys 1 item, firm earns $6 profit  Single price = 4 - consumer buys 2 items, firm earns $2 profit  Buy one get one half off - consumer buys 2 items, firm earns $8 profit

Multi Market Price Discrimination

 Firm charges different groups different prices according to willingness to pay for the group. Most common type of Price Discrimination. Identify different groups of customers.Charge each group a different price. Essentially act a single price monopolist within each group. Won't know individual willingness to pay, but have some idea about willingness to pay for groups. Need to identify which group individual belongs

Simple Example: Coase Theorem

 Firm in a small town plans on opening a factory.  Factory will emit pollution, reducing air quality for townspeople (Negative Externality)  Expected economic profit from factory: $4,000 per month  Citizens of town collectively value fresh air at $5,000 per month  Efficient Outcome:  No factory is built. From societal perspective the costs of building the refinery ($5,000 per month) are greater than the benefits ($4,000 per month) A. If Townspeople own the property rights:  Factory will not be build: B. If Firm owns the property rights:  Factory will not be build:

Marginal Revenue Curve

 For a Monopolist, at any given quantity, the marginal revenue will be less than price due to Price Effect.  The Marginal Revenue Curve then will be lower than the Demand curve at any given quantity produced because when the producer lowers price sufficiently to sell products the price effect is bigger than quantity effect so MR must be less than price.  Price effect > quantity effect

Monopoly and Marginal Revenue

 For price takers (Perfect Competition) Marginal revenue equals price. Firm has horizontal demand curve. Can sell all they want at the market price b/c no individual firm large enough to influence market price.  When the monopolist is the market F]firm faces downward sloping, market demand curve because if the monopolist wants to sell more they have to lower prices. As a result: Marginal revenue will not equal price

Herfindahl-Hirschman Index

 Herfindahl-Hirschman Index (HHI)  Measure of market concentration  Justic Department  Calculating the HHI for an industry:  Square each firm's share of market sales  Add together the squared market shares for all firms in the industry.

Game Theory

 How economists model strategic behavior - payoff matrix  Elements of Game 1. Players - firms 2. Number of Periods - one period, or repeated 3. Order of Play - simultaneous or sequential 4. Strategies -what each firm does 5. Payoffs - rewards/profits

Marginal Revenue Curve

 If Demand Curve is Linear, then Marginal Revenue will be linear  Marginal Revenue Curve will intersect horizontal axis exactly halfway between the origin and where the Demand Curve intersects the horizontal axis.  Accident? No! Elasticity!

Elasticity, Total Revenue, and Marginal Revenue

 If demand for a good is elastic- The quantity effect will dominate the price effect. So a decrease in price will increase total revenue and if total revenue is increasing, marginal revenue must be positive  As the price continues to be lowered, the good becomes less elastic and marginal revenue becomes smaller.  If demand for a good is inelastic - the price effect will dominate the quantity effect. And a decrease in price will decrease total revenue, if total revenue is decreasing, marginal revenue must be Negative.  If demand for a good is unit elastic. The price and quantity effects will offset. Marginal revenue will be zero on horizontal axis

Monopolists Production Decision

 In order to maximize profit, the monopolist (like all firms) will continue to produce more units of a good until MR = MC  At that point profits are maximized  To find the profit maximizing quantity of output for a monopolist find Q when MR =MC

Monopolist Profit Maximizing Condition

 Keep producing as long as MR >= MC  Profit Maximizing Condition: Stop producing where MR = MC

Source of the Problem - externalities

 Lack of Clearly Defined Property Rights  Existence of clearly defined property rights is assumed for well functioning markets  If property rights were clearly delineated then all costs and benefits of an action would be fully internalized  Compensation for full costs (benefits) of actions would be included in the decision making process, market price would reflect this compensation

Property Rights

 Legal Property Rights:  Rights recognized and enforced, in part, by the government.  Economic Property Rights: - ability to use a good - I could steal a car and use it.  Individual's ability to exercise control over the use of a good  Legal property rights enhance economic rights but do not guarantee them.

Long-Run Supply Curve

 Long-Run supply curve is the portion of the marginal cost curve that lies above the ATC curve.  LRSC - MC curve above ATC  When below the ATC curve, the firm shuts down.

Market Failure

 Market Failure  The failure of a market to reach an efficient outcome where all gains from trade are exhausted  In real world always some deviation from efficient quantity  Occurs when the quantity transacted differs from the efficient (welfare maximizing) quantity  Results in Deadweight loss because deviate from welfare maximizing point  Examples: Monopoly, Externalities, public goods, price controls

Monopoly

 Market with a single supplier of a good  Monopolists actions influence market, so they take that into account and choose price and quantity to maximize profits  Constrained by the downward sloping demand curve

Welfare Effects

 Monopolist charges a price higher than marginal cost and produces output at a level lower than the efficient, perfectly competitive output level.  As a result, monopolies cause deadweight loss to society.

Negative Externalities

 Negative Externality  An action that imposes net costs on others without their being compensated  The individual decision maker does not have to pay these costs, so does not take them into account when making decisions  Examples:  Pollution, Smoking, traffic

Perfect Price Discrimination

 Perfect Price Discrimination:  Firm charges each customer exactly what they are willing to pay (maximum each is willing to pay) Price = Marginal Value  Stop producing when: Price = Marginal Cost  Perfectly Price Discriminating results in an efficient outcome. No DWL.  If able to do so, the Marginal Revenue curve becomes the Demand Curve

Monopoly Versus Perfect Competition

 Perfectly Competitive Firms produce where P = MC  Monopolies produce where P > MR = MC.  Compared with a competitive industry, a monopolist:  Produces a smaller quantity: Qm < Qc  Charges a higher price: Pm > Pc  Earns a profit.

Zero Economic Profit in the Long-Run

 Perfectly competitive firms earn zero economic profit in the long-run  Due to free entry and exit  Firms will enter or exit based on profitability until....  Therefore, in long-run: P = AC = MC  Perfectly competitive firms earn economic profits in short run  But in short run firms could earn positive economic profit, but cannot alter one of the inputs. So some people cannot enter in short run because of fixed inputs.

Positive Externalities

 Positive Externality  An action that provides net benefits to others without their having to pay for it  The individual decision maker does not receive compensation for these benefits, so does not take into account when making decisions  Examples:Education, vaccines, bees, fire alarm

Price Discrimination

 Price Discrimination: Charging different prices to different consumers for the same good. Happens because firms can profit.  Key element is elasticity:  It is profit-maximizing to charge a higher price to consumers who are relatively more price inelastic and charge a lower price to consumers who are more price sensitive (elastic)

Supply and Demand Analysis: Positive Externalities

 Private Benefit:  Benefits enjoyed by the individual decision maker only  Marginal Private Benefit (MPB):  Incremental benefits to private owner  Individual marginal willingness to pay  Marginal External Benefit (MEB):  Uncompensated marginal benefits provided to others as a result of actions taken by individual decision maker  Social Benefit:  Total benefits enjoyed by society  Marginal Social Benefit (MSB):  Total marginal benefits to society  MPB + MEB = MSB

Supply and Demand Analysis: Negative Externalities

 Private Cost:  Cost incurred by the individual decision maker only  Marginal Private Cost (MPC):  Incremental costs to private owner  Marginal External Cost (MEC):  Uncompensated marginal costs imposed on others as a result of actions taken by individual decision maker  Social Cost:  Total costs incurred by society  Marginal Social Cost (MSC):  Total marginal costs to society  MPC + MEC = MSC

Short-Run Profit in PC and Summary

 Profits: (P - ATC)*Q  If P > ATC, the firm is profitable.  If P = ATC, the firm breaks even.  If P < ATC, the firm incurs a loss.  Firm should shutdown if:  P < Minimum AVC

Oligopoly

 Small number of producers  Firms have market power  Downward sloping demand curve  Decisions made by each firm has an impact on the market  Each firm must consider the actions of the other firms in the industry

Free Entry and Exit

 There is free entry and exit into and out of an industry when new producers can easily enter into or leave that industry.  Free entry and exit ensure:  the number of producers adjusts to changing market conditions; and  producers in an industry cannot artificially keep other firms out.

Finding the Monopoly Quantity

 To find the monopoly price, go up vertically from point A on the previous graph to the demand curve.  This is the maximum price consumers are willing to pay in order to sell the last unit produced at the profit maximizing quantity of output.

Transaction Costs

 Transaction Costs:  Costs associated with exercising economic property rights  Examples - Gathering information, Legal Service, Costs of communication among interested parties

Simple Example of Oligopoly

 Two identical firms  Firm A, Firm B  Identical product  Market Quantity Demanded = Q  Q = qA + qB  Marginal Costs are constant at $6 per unit  Fixed costs are zero  Profits = Total Revenue - Total Cost  Profits = P*Q - 6*Q

Necessary Conditions for Perfect Competition

 Two key conditions for perfect competition 1) Lots of producers with little market share 2) consumers regard the products of all producers as equivalent.  Homogeneous product (standardized product)

Two-Part Tariff

 Two-Part Tariff:  A pricing system in which the firm charges a customer a lump-sum fee for the right to buy as many units of the good as the consumer wants at a specified price  Lump Sum Fee (Part One)  Per-Unit Price (Part Two)

Profit Maximization For Perfectly Competitive Markets

 Under Perfect Competition: AR = MR = Price  The marginal revenue curve is flat  A price-taking firm's profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price. MC<=Price

Externalities

 When the activity of one entity (individual or firm) directly impacts the welfare of another in a way that is not reflected in the market price  "External" to the market.  Unintended impacts not taken into account by the individual decision makers

Monopoly Vs Duopoly who will cheat?

 Why does a colluding Duopolist have an incentive to change production levels when an monopolist does not?  Because the colluding duopolist only produces a portion of the monopoly output, the impact of lowering prices on existing customers is much lower (Smaller Price Effect)