Economics Lecture Eight

Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

Let’s pause for a moment and divide economics into three categories: Introductory, Intermediate and Honors:

Introductory

microeconomics (the study of individual “micro” market decisions, companies, consumers)

P (price) & Q (quantity or output)

graphing supply and demand curves (with P on y-axis, and Q on x-axis)

supply meets demand: this defines the market price and quantity in a free, competitive market

scarcity: wants exceed free availability. Scarcity is what makes economics meaningful.

opportunity cost

transaction cost

rational economic action

utility

net benefits

equilibrium

firm = company = supplier = seller

marginal benefit of a firm’s output decision for producing one more Q: marginal benefit is P (price it is sold at)

monopoly

price discrimination

Law of Demand: when price goes up, then demand goes down. YOU MUST USE THIS LAW.

supply side

demand side

Intermediate

substitutes

complements

fixed costs (FC) (these are costs that do not vary with a company’s output. E.g., rent payments)

variable costs (VC) (costs that do vary directly with output. E.g., fuel, labor)

average total cost (ATC) (this is all the costs divided by the quantity of output Q)

average variable costs (AVC) (total variable costs divided by the quantity of output Q)

total costs (TC = TVC + TFC)

elastic demand

inelastic demand

price elasticity of demand (percent change in quantity demanded divided by percent change in price, dropping the negative sign)

marginal cost (MC = change in total cost (TC) due to producing one more unit of output Q)

(note: total fixed costs (TFC) do not change as more is produced, thus MC = change in TVC due to one more output Q)

marginal revenue (MR)

short run (period when only some inputs are increased in order to increase output; e.g. overtime)

long run (period when any and all inputs are increased to increase output; e.g., build new stadium)

alternative definition of the “long run”: enough time to adjust all inputs in order to produce a given Q at the lowest possible cost

variable inputs (inputs that are increased to produce more Q in the short run)

fixed inputs (inputs that cannot be increased in the short run to produce more Q)

returns to scale (increasing, decreasing or constant? Look at whether output Q increases for increase in input I)

income effect

substitution effect

inferior good (a good that sees a decrease in demand when income increases, and vice-versa)

marginal product (increase in output due to additional input: Q = sum MP)

barriers to entry

oligopoly

law of diminishing marginal return

perfect competition (know the conditions for it)

economic point at which firms sell their goods (where MR=MC)

accounting profit (total revenue minus explicit cost)

economic profit (total revenue minus both explicit and implicit costs)

natural monopoly (a company that has increasing economies of scale, such that long-run average costs of production decrease, like power companies or railroads)

In a perfectly competitive market ...

the increase in profit from an additional Q = P - MC

the firm increases Q only if P > MC

the optimal level of Q is where P = MC

the company stays in business in the short run at level Q only if P equals or exceeds AVC

otherwise the company changes Q until it equals or exceeds AVC

if no such Q exists then the company is better off shutting down

In a natural monopoly, there is falling ATC and MC, so ATC > MC.

A monopoly shuts down in the short run if when MR = MC, AVC > P.

A monopoly shuts down in the long run if when MR = MC, ATC > P.

Honors

monopolistic competition

perfectly contestable markets

cartels

monopsony (a “buyer’s monopoly” – i.e., only one buyer)

cross-elasticity of demand (percent change in demand for good X divided by percent change in price for good Y)

income elasticity of demand (percent change in demand for good X divided by percent change in income)

consumer surplus (savings by consumers who would pay more than the market price for a good)

social cost (P-MC summed over the Q not produced due to a monopoly)

indifference curve

law of equiproportional marginal benefit

condition for reducing production (MC>MR)

condition for shutting down (P<AVC in short run or P<ATC in long run)

kinked demand curve model for oligopoly

dominant demand curve model for oligopoly

Equations

At Q = 0, TC = TFC

At Q = 1, MC = TVC

At all Q > 0, AVC = TVC / Q

At all Q > 0, AFC = TFC / Q

At all Q, ATC = AVC + AFC

MC = W / MP (where W is wage per unit of labor, and labor is the only input)

TVC = sum of MC

AVC = W / AP when labor is the only input and W is the wage or cost of the labor

TFC = Q x AFC

TVC = Q x AVC

TC = Q x ATC

long run average costs (LRAC) are never more than short run average costs (SRAC) for a given Q. Why? See the alternative definition of “long run” in “Medium” list above

LRAC = P x (I / Q), where I is input and Q is output and P is price of the input

<move some of the remaining material to next class?>

<add section about Intellectual Property, including trademarks and copyright; they are monopolies>

<discuss Microsoft here>

<two monopolies: KJV and NIV translations of the Bible, and what the NIV owner plans to do next>

<tale of two towers: WTC and Sears Tower>

<Hunt Brothers trying to corner silver market>

Example: Homeschool Dinner Event

To illustrate the practical aspects of microeconomics, consider a dinner event we held in 2004 and 2005. The goal was to maximize attendance while making a small profit. To maximize efficiency, we set up committees to handle a division of labor.

On the “supply side”:

We established three different committees for the different tasks:

1. Selection Committee. This included choosing the location (such as a church or banquet hall), a caterer (we used a bidding process and selected a Long Valley restaurant), and a date (we chose a Thursday). 2. Presentation Committee. This included planning the evening program (designed to be informative about homeschooling) and picking an outside speaker (we chose Michael Farris at our first dinner). 3. Event Committee. This included designing and printing a written program for guests, and supervising the service of food to guests.

On the “demand side”:

Committees helped on the "demand side" also:

1. Ticket Sales Committee. This included setting the prices, marketing the event, and selling the tickets. 2. Program Sales Committee. This included seeking business, church and individual sponsors, in exchange for featuring them in the written program. 3. Door Committee (managing the door at the event itself: taking and selling tickets, collecting late payments, and making sure the customers are happy).

Consider for a moment how competition can be very beneficial to this effort, particularly on the “supply side.” To maximize the benefits of competition, the goal is to strive to satisfy the conditions of perfect competition.

In choosing the caterer, for example, we reduced our cost by considering several competitors. We asked each caterer for a bid, and then compare them. We asked if a discount is available for prompt payment, or even payment in advance. We inquired if costs can be reduced by holding the event on a weekday rather than a weekend.

Choosing a speaker requires an element of competition also. If you fix your mind on one person and do not consider alternatives, then you are unlikely to obtain your best speaker at the lowest possible cost. Again, the key is to consider several different possibilities. Consider why a speaker may want to talk to a group of homeschoolers. Advantages are the youth, intelligence and motivation of the audience. Perhaps the speaker could make more talking to a general audience, but he or she will not have as much influence. Realize that out-of-town speakers will have greater expenses for travel and opportunity costs.

Printing costs for a program can be reduced by using competition also. Copying costs vary widely among stores. Shop around. Quality is an issue here also, as not all types of copies are perfect substitutes for each other.

On the demand side, an opposite perspective must be taken. Here you want to reach the highest possible price in selling tickets or spaces for sponsors in the program. Good salesmen or sellers are often the opposite of good buyers. The roles are the inverse of each other.

What would entice someone to attend a dinner? How can you make the event look as attractive as possible? Could price discrimination be used to maximize the income? One possibility is to replace the speaker, who is a major cost item, with inexpensive music and dancing, which may actually be more popular.

Perhaps you would like to show initiative and organize the next homeschool dinner! Perhaps a Christmas event?

Introduction

We are now more than halfway through this course. We have already covered all of the basic concepts and are applying them to various new situations.

It is worth emphasizing two important points. First, keep “supply” and “demand” separate in your mind. When asked about “returns to scale,” for example, realize that is purely a function of supply. It has nothing to do with demand. Do not cite the demand when determining the returns to scale. This is a common mistake. Avoid it.

Second, realize that the market acts in ways that are contrary to what you would prefer. We may care what happened yesterday, for example, but the demand curve does not. Nor do stock buyers care if selling off their shares will cause a company to go out of business and everyone to lose their job. The market maximizes efficiency, which can sometimes have unfortunate or counterintuitive results. Someone who opposes communism in China can affect his own buying decisions, but do not confuse his views and utility with that of the market.

On to the topic of today: monopoly. Readers of the New Testament in Greek will know what a “monopoly” is by its roots: “monos” means one, and “polein” means “to sell.” A monopoly is only one seller in an industry. Examples are the United States Postal Service for regular mail, many local power companies for your gas or electricity, your cable television provider, and your local public school system.

Thousands of companies enjoy market power that are, in effect, monopolies. Microsoft is the most profitable example. It has over 90% of the market for computer operating systems, which is the software needed to make your computer work. Microsoft’s operating system is called “Windows”. There are other operating systems available (such as Linux), but Windows has nearly a complete monopoly.

For most of the last century, AT&T enjoyed a monopoly over telephones. It controlled local and long distance service and equipment, including the provision of actual telephones to residents and businesses.

IBM was the big monopoly in the computer industry for a long time, particularly for businesses. The popular saying was that “no one was ever fired for recommending to buy from IBM.”

Perhaps the most famous monopoly of all was John D. Rockefeller’s “Standard Oil,” which controlled most of the oil industry in America around 1900.

What do all these monopolies have in common? In their heyday, they made extraordinary profits. Microsoft still does.

They were able to garner enormous profits for one simple reason: they had no competition. As a monopoly increases its price, there is no other company to take customers away from it with a lower price. If Microsoft increases (or fails to reduce) its price on Windows, there is almost nothing the consumer can do about it except pay. If you want a computer that is compatible with all the other computers out there, then you will likely buy Windows even if overpriced.

Is the monopoly able to increase its price without limitation? No. Demand will decrease as the price increases simply because people have limits on what they can spend. Even a monopoly has to live with the demand curve. The marginal revenue is not always positive as price increases, even for a monopoly. At some high price, a further increase in price causes a larger drop in quantity and the marginal revenue goes down. A monopoly does not increase its price when its marginal revenue is less than zero, or when it is less than its marginal cost.

How Monopolies Arise

Monopolies arise in a variety of ways. Government sometimes creates monopolies by operation of law. A maker of a vaccine will enjoy a profitable monopoly if it can lobby state legislatures to require vaccination for all children. A cable television company can obtain a monopoly over a region by winning a franchise from the local town. Once a monopoly forms this way, there are then “legal barriers to entry” by other firms who want to compete. The law prevents competition.

There are several other “barriers to entry” that prevent competition. They are listed and described below:

The licensing of professionals creates a barrier to entry. The medical profession has made it very difficult to become a doctor. People have to go to accredited medical schools (which usually take four years), and then pass certain exams. Most doctors also spend several years doing internships and residencies in hospitals. Attorneys, electricians, barbers, and just about every other line of work have a licensing procedure that is a “legal barrier to entry” to reduce competition.

Control of a valuable resource can also support a monopoly. If you owned all the oil wells in the world, then you would essentially have a monopoly. In fact, you would be the wealthiest person in the world. A company called DeBeers controlled the vast majority of diamond production, giving it a monopoly.

Large economies of scale can create a monopoly by rewarding the biggest company with the lowest average cost. Wal-Mart fits this description, though it does not have a true monopoly yet. There still are competitors to Wal-Mart. But Wal-Mart is able to negotiate lower and lower costs by virtue of its enormous size, and thereby obtain enormous economic advantage.

Finally, but perhaps most importantly, are government grants of monopoly such as patents and copyrights. Thomas Edison still holds the record for receiving the most number of patents for his inventions. He created more economic wealth than any American, or perhaps anyone in history. (Except for Jesus, that is, whose teachings created the potential for unlimited economic wealth in addition to the obvious spiritual wealth.)

Copyrights are essential to protecting the Microsoft monopoly. It holds and defends copyrights on its software, including Windows and Microsoft Word and Excel and Internet Explorer. Hollywood also uses copyrights to profit from its movies and prevent sales by others. The “Passion of Christ” is copyrighted and Mel Gibson continues to control its distribution. Unauthorized “competition” with respect to this movie are prohibited by law.

Like all “barriers to entry,” they can be misused to suppress competition or even criticism. Should copyright law limit or prevent the copying of the Bible, or competition in selling the Bible?

Pricing by Monopoly

Even Bill Gates and the Microsoft monopoly is limited by the demand curve. A monopoly will not charge the highest price that the wealthiest buyer can pay. A monopoly makes more profit by lowering price until marginal revenue (MR) equals marginal cost (MC). Memorize this and use it on the homework: MR=MC. When MC=0, then profit is maximized by finding the price when MR=0 also.

Even for a monopoly, the higher its price, the lower its quantity sold. Overall revenue is price times quantity, so a monopoly does not maximize revenue simply by maximizing its price.

You will need this for several homework problems: when the demand curve is a straight line, the curve for the marginal revenue of a monopoly intersects the x-axis at exactly half the quantity of the demand curve. Let’s illustrate this by an example.

If the demand curve is P= 1000 - 100Q, then at P=0, Q=10. That curve intersects the x-axis at Q=10. According to the above rule, the curve for the marginal revenue of a monopoly should intersect the x-axis at Q=5. Its equation should be P=1000 - 200Q. Is it?

At Q=5 on the demand curve, P=$500. The revenue at this point is PxQ=$2500. If Q moves to 4 units, then P moves to $600 and the revenue decreases to PxQ=$2400. If Q moves to 6 units, then P moves to $400 and PxQ=$2400 again. Moving quantity in either direction causes revenue to decline, so revenue is at its maximum. Marginal revenue, therefore, is no longer greater than zero. In fact, MR=0 at this point. (If you changed Q by a tiny fraction less than one unit, then you would see that marginal revenue is actually zero at Q=5).

Revenue is maximized by setting Q to equal one-half the value of Q when P=0. This is very useful when MC=0. Because a monopoly sets its price at MR=MC, when MC=0 then MR=0 can be easily determined when the demand curve is a straight line.

Because a monopoly owns its industry, all of its focus is on the demand curve. There are no competitors. Accordingly, there is no supply curve for any competitors either. Essentially, all the competitors produce Q=0 goods.

If a firm can raise the price of its goods or services and still hold on to some of its customers, then it must possess at least some monopoly power. Professional athletes and actors enjoys a bit of a monopoly on their own fans, but competition does exist for those fans.

Social Costs

Adam Smith, the founder of the “invisible hand” in economics, was an opponent of monopolies created by the government. He viewed them as very hurtful, and wrote brilliant criticisms of them. Monopolies impose a social cost on everyone else. They produce less and cost more. They maximize their profit by increasing the price and reducing the quantity sold. They are also less efficient and less innovative than a competitive company.

Even worse, a monopoly will do counterproductive things to preserve its power. Microsoft makes its software incompatible with competitors in order to force consumers to buy Microsoft products. Users cannot copy text from a Microsoft Word document and paste into a competitive product like WordPerfect, for example.

Economists measure the “social cost” imposed by monopolies in terms of the reduced output Q sold by a monopoly compared to the sales in a competitive environment. Social cost is the disutility imposed on society by a company or particular act.

For a monopoly, its social cost is defined as Price minus marginal cost (P-MC) summed over all of the output not sold by the monopoly that would have been sold in a competitive industry. In a competitive industry, P and Q are determined by where supply meets demand. The higher price charged by a monopoly summed over the reduced quantity yields the social cost it imposes.

Note that the net loss to society, or the social cost, is not the amount the consumers overpay to the monopoly. That is simply a transfer in wealth, without any overall loss in societal wealth. Instead, the social cost is only the suppression in sales, or reduction in Q. It is similar to the burden on society of a price control or rationing system, which also suppresses the output Q. On a graph it is the area enclosed by three points: the equilibrium P and Q in a competitive market (where supply meets demand), the higher P and lower Q charged by a monopoly because there is no competition, and the lower supply cost at that lower Q.

Let’s look at an example. Suppose a monopoly cuts its output by two units that would have sold for $80, in order to reduce supply and increase the sales price to $95 for all his units. Suppose further that the marginal cost of those eliminated units is $80, and in a competitive environment all the goods would sell for $80. The social cost of reducing the production is (P-MC) = $95-80 = $15. That is multiplied by the number of eliminated units, which is two here. Total social cost is therefore $15 x 2 = $30.

There are several important differences between a monopoly and competitive industry. The biggest difference is that consumers obtain goods at cheaper prices when there is competition than when there is a monopoly. Competitive companies will produce goods at their minimum average total cost in the long run. Monopolies usually do not.

Quality may also be better in a competitive industry. Microsoft Windows is not only expensive, but many think it is not as good as a competitive operating system would be. For example, it frequently “hangs” such that people have to reboot their computers. That annoyance is neither efficient nor competitive.

Another difference is that an increase in demand does not necessarily cause a monopoly to supply more. In contrast, in a competitive industry, an increase in demand always forces an increase in supply (greater Q).

Assignment

Read and, if necessary, reread the above lecture.

Introductory

1. A monopoly can be extraordinarily profitable because there is no __________.

2. Provide three specific examples of monopolies and describe briefly what they do.

3. Given an example of how you lose time, money, or efficiency due to a specific monopoly.

Intermediate

4. “Monopolies may be bad, but government regulations of monopolies are even worse!” Do you agree? Explain.

5. List ways that monopolies can be established.

6. Suppose Katie likes to paint for money or even for free, but will not pay extra to paint. Suppose also that the monthly demand for her paintings is P = $500 - 50Q. How many paintings does she create each month?

7. List some differences between a monopoly and a competitive industry.

8. Suppose Anthony owns a company having marginal costs of $5 for all his units. If he sells only one, then he reaps $11; selling two fetches a price of $10 piece; selling 3 attains a price of $9; selling four reaps $8; Q=5 would have P=$7; Q=6 has P=$6, etc. A competitive firm would have the same cost and demand numbers. What does Anthony sell at, and what is the social cost of his monopoly?

Honors

9. Estimates are not very accurate about homeschooling, but some guess that 1 out of every 25 students is homeschooled. At what level or fraction would homeschooling end the public school monopoly? Discuss.

10. Suppose you live in a valley where water flows freely and abundantly from a spring. Suppose your entire family uses on average 80 gallons a day. But then a company bought the spring. If the demand curve is a straight line from P=$100, Q=0 to P=$0, Q=80, at what price and quantity would the company sell water?

11. Monopolies: should the government regulate them? If so, how?