ECON 101 EXAM 3

Barrier to Entry Strategy #2: Supply-Side and Cost Advantages

A. Learning by doing means that experience yields efficiency gains -you can streamline to make production for efficient B. Economies of scale -mass production is more efficient than producing small quantities -difficult and costly for newcomers to establish mass prodution C. Research and development can create cost advantages -make existing products more cheaply -develop more effective management techniques D. relationships with suppliers can get you cheaper inputs -bulk discounts E. Access to key inputs can freeze you competitors out

Barrier to entry strategy #3 : regulation and government policy

A. Patents - no company can use your idea without your permission -automatically creates monopoly -alternative: keep invention a secret B. Regulation -can make it difficult to start a new business -incumbent business often lobby for more regulation C. Licensing -businesses need government-issued license to enter a market -if licenses are scarce or costly, can deter entry --examples: taxis, liquor stores, childcare centers, many occupations

Barrier to Entry Strategy #1:Demand-Side Advantages

A. Switching costs lock your customers in o Any impediment that makes it difficult or costly for customers to switch to buying from another business. Examples: iPhone apps, camera lenses, frequent flyer miles, bank bill-pay service B. Reputation and goodwill keep your customers loyal. o Build a good reputation, develop relationships. Examples: Doctors, mechanics, plumbers, electricians C. Network effects o Product becomes more useful the more others use it.o Consumers will only use popular products. → Helps incumbents. Can lead bad products to succeed Examples: WhatsApp, Amazon reviews, eBay, StubHub, car repair networks, Windows, QWERTY keyboards31

Market Power vs Perfect Competition

A. market power: set quantity by producing until marginal revenue = marginal cost, then set price by looking up to the firm demand curve B. perfect competition : keep producing until price = marginal cost

Rivals Exiting Makes Your Market More Profitable11Price Firm demand curveQuantity demanded

Effect of exit of existing firms for incumbents: 1. Increased demand o Gain some customers from the exiting firm. o Shifts demand curve right(↑quantity for each price). 2. Increases your market power.o Customers have fewer choices. o Demand curve becomes steeper.

New Competitors Make Your Market Less Profitable

Effect of new entrants on incumbents: 1. Decreased demand o Lose some existing customers to the new firm. o Shifts demand curve left(↓ quantity for each price). 2. Reduces your market power o Customers have more choices. o Demand curve becomes flatter.

Policymaker

Eliminate barriers to entry. o Want to maximize economic surplus o Enhance competition o Requires free entry o More competition translates int o lowerprices and profits Yielding a higher quantity Offsetting the underproduction problem Increasing economic surplus Role for gov't to try to foster and enhance competition

cost advantages generate lasting economic profits

Marginal principle says the last firm that enters a market will earn zero economic profit. o If your costs are lower than the costs of the marginal firm, you can continue to earn economic profits Cost advantages can deter entry.o New firms won't enter a market to compete with a low-cost incumbent in a price wa

smaller quantity is not best for society

Socially optimal outcomeMarginal benefit = Marginal cost o Perfect competition achieves this:Price = Marginal cost o Market power yields a different outcome:Marginal revenue = Marginal cost

enter the market if

accounting profits> implicit opportunity costs implies: enter if economic profit > 0

non-price competition

attract "sticky" customers through product differentiation : different features, quality, customer service, design, etc

Economic profits in the short run

average revenue: a firm's total revenue divided by quantity supplied -if you charge all customers the same price: average revenue = price

Accounting profits:

The total revenue your firmreceives, minus your total costs. o All of the money that goes into and out of a business. o Focused only on out-of-pocket costs.

Free entry

eliminates positive economic profit in the long run o If economic profits are positive : New firms enter (or existing firms expand) Causing profits of incumbents to fall o Continues until there is no incentive fornew firms to enter. o Equilibrium: Economic profits = 0

free exit

ensures industries won't remain unprofitable in the long run o If economic profits are negative: Existing firms exit (or contract) Causing profits of remaining firms to riseo Continues until there is no incentive forfirms to exit.o Equilibrium: Economic profits = 0

when will new rivals enter your market - OC

enter this market "or what?" -or earn a reasonable return on time and money from investing in another industry -"implicit opportunity costs"

conflicting interests in barriers to entry

entrepreneurs: build barriers to entry policymaker: eliminate barriers to entry

If economic profit is becoming negative

expect firms to exit your market

measuring your market power

experiment with different prices -charge different prices over time, charge different prices in different locations, offer different prices to different groups of customers

Firms with market power

face a downward sloping demand curve

collusion

firms in the same market cooperate to raise profits

The firm's cost structure

focus on quantity -average costs- the firm will decide on a quantity Q to produce, the how much question that is answered by considering MB >= MC -Average fixed costs always decreases with output -Average variable cost - increasing with output at the profit maximizing quantity -Average cost - relevant for understanding the profit associated with any Q

Importance of barriers to entry

free entry: long run economic profits are zero == long run profitability depends on barriers to entry

experience good

good which you have to consume in order to evaluate -use persuasive advertising

Location Choices also affects Price Competition

if you locate right next to your rival -you are selling an identical product -remember bertrand paradox: price competition will drive profit margins to zero -locating far from rivals = product differentiation

exit the market if

implicit opportunity costs > accounting profits implies: exit if economic profit < 0

Free Entry Eliminates Profit Opportunities

in the long run -all supermarket lines are the same length o Profit opportunity: One queue is shorter o Free entry to "profitable" (shorter) queues continues until no queue is profitable (shorter) -All labor markets offer similar job prospects. o Profit opportunity: New York's labor market offers better prospects o Free entry by workers to "profitable" labor markets continues until no labor market offers better prospects -All nightclubs offer similar romantic prospects o Profit opportunity: A nightclub offers better romantic prospects(Perhaps because of an asymmetric gender ratio) o Free entry by those looking for romance continues until no nightclub offers better romantic prospects

informative advertising

informs potential customers about a product

keep selling until

marginal revenue = marginal cost

Price discrimination sets prices just below marginal benefit

o Charge higher prices to high marginal-benefit customers. o Offer selective discounts to low marginal-benefit customers.

barriers to entry

obstacles that make it difficult for new firms to enter a market -not naturally occurring defenses -barriers to entry are shaped by incumbent firms

Non-Price Competition Yields Market Power

offer a product that better serves the needs of some customers

monopoly

only one seller -raising prices : won't lose customers to competitors -market demand curve = firm demand curve -downward sloping demand curve

persuasive advertising

persuades or manipulates potential customers into believing they will enjoy a product -usually not informative -fragrance ads

in the long run

price = average cost -if price > average cost --economic profit > 0 --new firms enter --price falls --process continues until economic profit = 0 -if price < average cost --economic profit < 0 --existing firms exit --price rises -process continues until economic profit = 0x

businesses with market power can increase profits through

price discrimination

prevent resale

price discrimination doesn't work if discounted products can be resold at higher price -successful price discrimination requires preventing resale

If you only compete on price your profits are easily driven to zero

price war continues until price equals marginal cost example: the market for gas - two stations across the street from each other

price discrimination redistributes and increases economic surplus

producers: -gain producer surplus from consumers from charging higher prices -create extra producer surplus from increasing the size of the market consumers: -lose consumer surplus to producers from higher prices -gain small amounts of consumer surplus from increasing the size of the market

firm profits depend on

profit for a unit sold depends on it its price and its cost -Fixed Costs - Any productive input that doesn'tincrease when output increases (storefronts, factories,super expensive equipment) -Variable Costs - Any productive input that does scale with output (raw materials or "parts", workers, packaging and shipping) total cost = fixed costs + variable costs

output effect

sell one more unit, the revenue increases by the price of the additional item sold

price discrimination

selling the same good at different prices

price discrimination: the pink tax

some retailers charge more for products marketed to women -unlikely due to higher marginal costs -likely due to price discrimination -some cities and states ban price discrimination based on gender

market power is defined as

the ability for a firm to incrementally increase prices without losing a substantial number of customers

Market power

the ability to raise prices without losing too many customers to competitors o The more market power you have, the greater your profits

Focus on marginal revenue

the addition to total revenue you get from selling one more unit

how do you suspect the demand curve for amazon changed during the pandemic

the demand curve became steeper

the next best alternatives determine the range of possible outcomes

the final price must be: -higher than the seller's next best alternative and lower than the buyers next best alternative example: Your current job pays $75,000 and Google can hire someone else for the job for $100,000

short run

the horizon over which the production capacity and the number and type of competitors you face cannot change -our implicit assumption in previous classes -number and type of competitors is fixed -pricing decisions

long run

the horizon over which you or your rivals may expand or contract your production capacity, and new rivals may enter the market, or existing firms may exit -new rivals may enter or expand into your market; existing rivals may leave -planning decisions

reservation price

the maximum price a buyer will pay for a product

the better your next best alternative

the more bargaining power you have

discount effect

to sell one more unit, you have to lower the price on all units sold.

next best alternative

value of the best option, outside of the deal -the or what from the opportunity cost principle

Bertrand Paradox

with no product differentiation, even one competitor can force your economic profits to zero problem: there is an irresistible incentive for your rival to undercut you -demand is perfectly elastic (perfect competition) solution: product differentiation reduces the incentive for your rival to undercut you -less elastic demanded reduces the incentive for your rival to undercut your price

why do suppliers choose to underproduce

-Businesses worry about the discount effect. --Lower prices are bad for their bottom line. -But the discount effect is irrelevant from society's perspective. --Lower prices merely transfer surplus from sellers to buyers. -discounts are like a positive externality for buyers, which businesses don't internalize

Four strategies for creating barriers to entry

1. Demand-side strategies: Find ways to create customer lock-in. 2. Supply-side strategies: Develop unique cost advantages. 3. Regulation: Mobilize the government to prevent entry. 4. Deterrence strategies: Scare away potential entrants with credible threats

Market power examples

-HIV drugs and daraprim -price is much greater than the marginal cost of producing these drugs -the price of prison phone calls

the underproduction problem

-Higher prices under market power are a problem for consumers, but an off-setting benefit to producer - results in redistribution, not loss in economic surplus - not socially optimal

quantity discounts are a form of group discount

-discount on a second pizza is only offered to those who have already bought a first pizza -targets those with a lower willingness to pay

Force #3 Competitors in Other Markets: Threat of Substitution

-firms in other industries may produce products that are potential substitutes for yours -think expansively --potential substitutes can come from unrelated industries --other substitutes include : buying second-hand, making something yourself , doing without --threat of disruption: cheaper nearly as good alternative -substitutes presents a larger threat when customers have low switching costs

ensure competition thrives

-government outlaws some strategies that create market power

Force #1Existing Competitors: Type and Intensity of Competition

-a rivalry is more intense when more competitors are producing similar goods -type of competition --price comp: repeated rounds of comp will lower your profits --non-price comp: firms compete through product differentiation

Threat #4 Suppliers: Seller Bargaining Power

-ability of suppliers to charge high prices depends on their bargaining power

Force #5 Customers: buyer bargaining power

-buyers can force you to lower prices

what does advertising do

-creates product differentiation -increases demand for you product (shift demand curve right) -makes customers more loyal, gain market power (steepens demand curve)

The product position trade-off

-demand-side: want to be close to your competitor --increase your share of potential customers --increase quantity -supply-side : want to be far from your competitor --increase market power and prices --increase profit margin -real world entrepreneurs choose product positioning to balance these factors

Lobbying is often about erecting barriers to entry

-lobbying is an enormous industry -involves incumbent businesses -losers from barriers to entry are rarely represented --consumers, potential entrants

perfect competition

-many buyers - each is small relative to the market -many firms - each is small relative to the market -identical goods -no market power -buyers and sellers are price-takers

offer group discounts to those with low reservation prices

-movie theaters, software, books, internet service, dry cleaners, hairdressers

Force #2 Potential Competitors: Threat of Entry

-new entry can increase supply and intensify comp -strategic management can deter entry

Preventing monopolization

-not illegal to be a monopoly --hold and exploit market power over consumers --charge high prices -it is illegal to attempt to monopolize. take actions to exclude competitors or prevent new competition

market power depends on

-number of competitors -successful product differentiation

minimize harm from exercising market power

-regulating maximum prices --set price = marginal cost implication: -perfectly competitive markets: price caps reduce economic surplus -imperfectly competitive markets: price caps can increase economic surplus

determinants of long-term profitability

-type and intensity of competitive forces -decisions you make in response to these forces

making price and quantity decisions with market power

1. Choose your quantity: o Keep producing until Marginal revenue = Marginal cost o Look down to see the quantity 2. Choose your price: o Set the highest price at which you can sell this quantity. o Look up to the demand curve to find the highest price you can charge to sell this quantity

Your Firm's Market power depends on

1. How few competitiors you face (market exit and entry) 2. How successfully you differentiate your product from others (Marketing-make your product different)

Entry deterrence strategy: build excess capacity

1. build more production capacity than you need -show you have the capacity to increase production and flood the market 2. maintain a financial war chest -show that you could sustain a price war for longer than your rival 3. brand proliferation -produce many varieties -ensures that there is no gap in the market 4. develop a reputation for competing hard with new entrants -a fierce reputation scares competitors away -as your reputation becomes more valuable, rivals understand that you will fight even harder to defend it

Set Prices Close to Each Customer's Marginal Benefit

1. charge higher prices to high customers with high reservation prices 2. Charge lower prices to customers with low reservation prices

Five Forces Framework

1. potential competitors 2. current competitors 3. customers 4. potential substitues 5. suppliers

offering group discounts

1. targeted at groups with a lower reservation price 2. qualify for discount based on verifiable characteristics 3. qualifying characteristics that are hard to change

Competition yields lower prices and higher quantity

1. the competitive price is lower than the market power price 2. the competitive quantity is greater than the market power quantity 3. a firm with market power earns greater profits 4. market power can raise costs

how to price discriminate

1. who gets a discount 2. everyone wants to pay a lower price

marginal revenue vs firm demand curve

1. your firm's demand curve is downward sloping reflecting you market power 2. marginal revenue lies below the demand curve reflecting the discount effect 3. marginal revenue is steeper, declining more rapidly -the discount effect is bigger, the larger the quantity you sell

Entrepreneur

Build barriers to entry. o Want to maximize firmprofits o Enhance market power o Requires high barriers to entry o More market power translates into higher prices and profits But lower quantity Exacerbating the underproduction problem Reducing economic surplus tendency for business to try to destroy competiton

When Will Existing Rivals Exit Your Market?- CB

Cost benefit principle: Exit the market if the benefits exceed the costs o Benefit: Invest your time and money in another industry o Cost: What is the cost of exiting this market?

Barrier to entry strategy #4 : entry deterrence

Goal: convince potential rivals that if they enter you will compete so vigorously that they will lose money -credibility problem: "cheap talk" -your rival understands this lack of credibility * entry deterrence strategies are all about how best to make you threat credible to potential rivals

search good

Good which you can evaluate before buying. -use informative advertising

when will new rivals enter your market - CB

cost benefit principle: enter a market if the benefits exceed the costs -benefit: the extra money you will earn -accounting profits: revenues - explicit costs

in the real world, all of the action is

IMPERFECT COMPETITION

The hurdle method

Offer lower prices only to buyers who are willing to overcome some hurdle -key idea: set the hurdle so that high reservation price customers will find it too costly -yields self-selection

When Will Existing Rivals Exit Your Market?- OC

Opportunity cost principle: Exit this market, "orwhat?" o Or enjoy the accounting profits offered in this market

bargaining power

Your ability to negotiate a better deal -sellers try to negotiate higher prices -buyers try to negotiate lower prices

Economic profits

Your firm's revenue, minus the explicit financial costs and implicit opportunity costs. o Accounts for implicit opportunity costs Next best use of entrepreneur's time Next best use of entrepreneur's money o Relevant to deciding whether to start a business, going to school, putting money into the US bond market

Oligopoly

a few large sellers -product may be similar or somewhat different -if you raise your price some customers would leave while some would stay -downward sloping demand curve

more market power

a higher price mark up above marginal cost

natural monopoly

a market in which it is cheapest for a single firm to service the whole market -competition will never occur because of incumbent's cost-advantage

monopolistic competition

a market structure in which many companies sell products that are similar but not identical -differentiated products --> monopolistic: you are the only seller of this precise style of jeans -many sellers --> competition: many sellers of jeans Different product attributes yields market power due to quality, customer service, reputation, location ex: starbucks for coffee, nike for athletic shoes

product differentiation raises

bargaining power and hence prices and profitability -payless vs nike

price discrimination and marginal benefit

charge each consumer the highest price you can