157 Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date

represents a copyright violation.

MyEconlab MyEconlab helps you master each objective and study more efficiently.

• Identify the trade-offs associated with a patent.

• Describe the practice of price discrimination.

• Describe and explain a monopolist's output decision.

• Explain the negative consequences of monopoly

'01)

LEARNING OBJECTIVES

On college campuses across the country, beverage cornpanies like Coca-Cola and Pepsi pay cash in exchanqe for monopoly power- exclusive rights to sell beverages on campus.

For example, under the Coca-Gola agreement with the University of California Berkeley that expired in 2011. the company paid an average of $615,000 per year to support recreational sports, intercollegiate athletic programs, and various student groups. The exclusive agreement bans competing products Qlfl campus, and directs the university to "maximize the sale and dtstributlon of (Coca-Cola) Products, including hawking Products ... at all sportililg events." As we'll see in this chapter, a firm is willing to pay for the rights to monopoly because the exclusion of competing products allows th§) monopolist to charge higher prices.

In recent years, the battles over campus beverage monopolies have 15ecome heated and more lucrative. In 2011, UC Berkeley responded to student concerns about the business praetices of Coca-Cola by signing an exclusive contract with Pepsi. Under the new agreement, Pepsi will pay the university $1.6 million per year .

. ""'

7

Like other firms, a monopolist must decide how much output to produce, given its objective of maximizing its profit. We learned about production costs in an earlier chapter, so we start our discussion of the monopolist's output decision with the revenue side of the profit picture. Then we show how a monopolist picks the profit-maximizing quantity.

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

- The Monopolist's Output Decision

water systems.

In this chapter, we will discuss "unnatural" monopolies, which result from artificial barriers to entry. Later in die book, we'll explore the reasons for natural monopolies and various public policies to control them.

This chapter examines the production and pricing decisions of a monopoly and explores the implications for society as a whole. As we'll see, monopoly is problematic from society's perspective because it produces too little output. We'll also discuss the trade-offs with patents, which lead to monopoly and higher prices but also encourage .innovati.on. We'll also explore the issue of price discrimination, which occurs when firms such as airlines and movie theaters charge different prices to different types of consumers. Although we discuss price discrimination in a monopoly, it also happens in markets with more firms, including oligopoly (a few firms) and monopolistic competition (many firms selling differentiated products).

Z n the previous chapter we explored the decisions made by firms in a perfectly competitive market, a market in which there are many firms. This chapter deals with the opposite extreme: a monopoly, a market in which a single firm sells a product that does not have any close substitutes. In contrast with a perfectly competitive, or price-taking, firm, a monopolist controls the price of its product, so we can refer to a monopolist as a price maker. A monopolist has market power, the ability to affect the price of its product. Of course, consumers obey the law of demand, and the higher the monopolist's price, the smaller the quantity it will sell.

A monopoly occurs when a barrier to entry prevents a second firm from entering a profitable market. Among the possible barriers to entry are patents, network externalities, government licensing, the ownership or control of a key resource, and large economies of scale in production:

• A patent grants an inventor the exclusive right to sell a new product for some period of time, currently 20 years under international rules.

• When the value of a product to a consumer increases with the number of consumers who use it, network externalities are at work. For example, the larger the nurnber of people on an online social network, the greater the opportunities or interaction. Similarly, the larger the number of people using a software application such as a word processor, the greater the opportunities to share files. Network externalities provide an advantage to existing firms and may inhibit the entry of new ones.

• Under a licensing policy, th g0vernment chooses a single firm to sell a particular product. Some examples are licensing for radio and television stations, off-street parking in cities, and vendors in national parks.

• If a firm owns or controls a key resource, the firm can prevent enny by refusing to sell the input to other firms. The classic eyample is DeBeers, the South African company that controls about 80 percent of the world's production of diamonds. Before the 1940s, the Aluminum Compa11y of .America-ALCOA- had long-term contracts to buy most of the world's availabJeJiauxi.te, a key input to the production of aluminum.

• A natural monopoly occurs when the scale economies in producrion are so large that only a single large firm can earn a profit. The market can support only one profitable firm, because if a second firm entered the market, both firms would lose money. Some examples are cable TV service, electricity transmission, and

natural monopoly A market in which the economics of scale in production are so large that only a single large firm can earn a profit.

barrier to entry Something that prevents-;G:mns . .fro)ll enter- ing a profitable market.

patent The exclusive right to sell a new good for some period of time.

network externalities The value of a product to a consumer increases with the number of other con- suruers who use it.

market power The abifity <la finn to affect the price of its product.

monopoly A market in which a single firm sells a product that does not have any close su:J)stimtes.

158 CHAPTER 7 • MONOPOLY AND PRICE DISCRIMINATION ~~~ .

The firm's marginal revenue is defined as the change in total revenue that results from selling one more unit of output. You can see this in column 4 of the table in Figure 7.1. For example, the marginal revenue for the third unit is $6, equal to the total revenue from selling three units ($30) minus the total revenue from selling only two units ($24). As shown in the table, marginal revenue is positive for the first four units sold. Beyond that point, selling an additional unit actually decreases total revenue, so marginal revenue is negative. For example, the marginal revenue for the fifth unit is -$2, and the marginal revenue for the sixth unit is -$6.

Plinled by DAIFALLAHALSHAIKHI ([email protected]) on 10nt2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the authonzed user or valid subscrtption date represents a copylight violation.

(3) Total Revenue (4) Marginal Revenue (1) Price (P) (2) Quantity Sold (Q) (TR= P x Q) MR= HR/t:.Q

$16 0 0 14 $14 $14

12 2 24 10

10 3 30 6

8 4 32 2

6 5 30 -2

4 6 24 -6

-6

<? Quantity sold

..,. FIGURE 7.1 The Demand Curve and the Marginal-Revenue Curve Marginal revenue equals the price for the first unit sold, but is less than the price for additional units sold. To sell an additional unit, the firm cuts the price and receives less revenue on the units that could have been sold at the higher price. The marginal revenue is positive for the first four units, and negative for larger quantities.

-2

a <o, $14

(J /::) "' 12 :::i = "' s > 10 1: Ol

~/'&() = 8 ·;;;, ..., "' ' B 6 _____ 1 _____ ... 0

"' .S1 4 -----L----- ct: 2

A firm's total revenue-the money it gets by selling its product-equals the price times the quantity sold. In this part of the chapter, we'll assume that the monopolist charges the same price to each customer. The table in Figure 7. l shows how to use a demand schedule (in columns 1 and 2) to compute a firm's total revenue (in column 3). At a price.of Sl c, the firrn doesn't sell anything, so its total revenue is zero. To sell the first unit, the furn must cut its price to $14, so its total revenue is $14. To get consumers to buy two units instead of just one, the firm must cut its price to $12, so the total revenue for selling two units is $24. As the price continues to drop and the quantity sold increases, total revenue increases for a while but then starts falling. To sell five units instead of four, the firm cuts its price from $8 to $6, and total revenue decreases from $32 to $30. The total revenue for selling six units is even lower, only $24.

Total Revenue and Marginal Revenue

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1..;;.5...;.9 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

We can use a simple formula to compute marginal revenue, 'FJ1e formula quantifies the good news and bad news from selling one more unit:

marginal revenue = new price + (slope of demand curve X oJd \Juantity) The first part of the formula is the good news, tbe money received for the extra unit sold. The second part is the bad news from selling one more unit, the revenue lost by cutting the price for the original customers. The revenue change equals the price change required to sell one more unit=-the slope of the demand curve, which is a negative nmnber-times the number of original customers who get a price cut.

We can illustrate this formula with an example. Suppose the monopolist wants to increase the quantity sold from two to three, so it cuts the price from $12 to $10. The new price is $10, the old quantity is two units, and the slope of the demand curve is -$2, so marginal revenue is $6:

marginal revenue = $10 - ( $2 per unit X 2 units ) = $6

Similarly, to sell the fifth unit, the firm would cut the price from $8 to $6, and marginal revenue is actually negative:

marginal revenue = $6 - ( $2 per unit x 4 units) = -$2 Marginal revenue is negative because the $8 revenue lost from the original customers exceeds the $6 gain from the new customer. This happens because there are so many original customers who get a price cut. If a monopolist continues to cut its price, marginal revenue will eventually become negative because there will be so many consumers who get price cuts.

The graph in Figure 7 .1 shows the demand curve and marginal-revenue curve for the data shown in the table. For the first unit sold, the marginal revenue equals the price. Because the firm must cut its price to sell more output, the marginal-revenue curve lies below the demand curve. For example, the demand curve shows that the

A Formula for Marginal Revenue

The table in Figure 7.1 illustrates the trade-offs faced by a monopolist in cutting the price to sell a larger quantity. When the firm cuts its price from $12 to $10, there is good news and bad news:

•Good news: The firm collects $10 from the new customer (the third), so revenue increases by $10.

• Bad news: The firm cuts the price for all its customers, so it gets less revenue from the customers who would have been willing to pay the higher price of $12. Specifically, the firm collects $2 less from each of the two original customers, so revenue from the original customers decreases by $4.

The combination of good news and bad news leads to a net increase in total revenue of only $6, equal to $10 gained from the new customer minus $4 lost on the first two customers.

Our discussion of good news and bad news has revealed a key feature of a mor(op(i)ly: Marginal revenue is less than price. To sell one more unit, the monopolist must cut its price, and the difference between marginal revenue and price is the bad news-the loss in revenue from consumers who would have bought the good at the higher price. In fact, this is true for any firm that must cut its price to sell more.

You may recall //om the previous chapter that marginal revenue is different for a perfectly competitive fi;:;m,, which can sell as much as it wants at the market price. If a perfectly competitive firm sells one unit at $12, it can sell a second unit at the same price, so its marginal revenue is $12 for the second unit sold, just as it was $12 for the first unit sold. For a perfectly coffil?'etitive firm, marginal revenue is always equal to the price, no matter how many units the firm sells. A perfectly competitive firm does not cut the price to sell more, so there is na bad news associated with selling more.

__ 1_6~0 CHAPTER 7 •MONOPOLY AND PRICE DISCRIMINATION

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

.,. FIGURE 7.2 The Monopolist Picks a Quantity and a Price To maximize profit, the monopolist picks point a, where marginal revenue equals marginal cost. The monopolist produces 900 doses per hour at a price of $15 (point b). The average cost is $8 (point c), so the profit per dose is $7 (equal to the $15 price minus the $8 average cost) and the total profit Is $6,300 (equal to $7 per dose times 900 doses). The profit is shown by the shaded rectangle.

Marginal revenue

0 600 900 Doses of drug per hour

(1) (2) (3):_1 (4) (5) ~

(6) (7) Price (P) Quantity Marginal Marginal Total Revenue Total Cost Profit

S~d (qL Revenue Cost (Tf! = ~x Q) (7:.C'.~ (TR - TC) - $18 600 $12 $4.00 $10,800 $5,710 $5,090 17 700 10 4.60 11,900 6,140 5,760

16 800 8 5.30 12,800 6,635 6,165

15 900 6 6.00 13,500 7,200 €3,300 14 1,000 4 6.70 14,000 7,835 6,165

13 1,100 2 7.80 14,300 8,5t30 5,740

12 1,200 0 900 14,400 9,400 5,000

$18

15 iA 0

-0 12 '" " Cl. " (.) d:

The firm's activity is producing the cold drug, and it wilr-;pick the quantity at which the marginal revenue from selling one more dose equals the m·ai;gjnal cost of production.

In Figure 7 .2, the first two columns of the table show there1ationship between the price of the cold drug and the quantity demanded. We can use these -numhers to draw the market demand curve, as shown in the graph in Figure 7.2. Because the firm is a monopolist=-the only seller of the drug= the market demand curve shows how much the firm wiJJ se!J at each price. The demand curve is negatively sloped, consistent with.

Increase the level of an- activity as long as its marginal benefit exceeds

its marginal cost. Choose the level at which the marginal benefit

equals the marginal cost.

MARGINAL PRINCIPLE

Using the Marginal Principle A monopolist can use the marginal principle to decide how much output to produce. Suppose a firm called Curall holds a patent on a new drug that cures the common cold and must decide how much of the drug to produce.

firm will sell three units at a price of $10 (point c), but the marginal revenue for this quantity is only $6 (point h). The firm will sell five units at a price of $6 (point e), but the marginal revenue for th.is quantity is -$2 (point 1). The marginal revenue is positive for the first four units and negative for larger quantities.

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1..;..6_1 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Anthony Kraurmanu and David Berri, "Can we find it at the concession? Understanding price elasticity in professional sports," Journal ofSports Economics 8 (2007), pp. 183-191.

In this case, cutting the price to sell one more ticket generates good news ($24 coUected from the new fan) that is less than the bad news (the $40 lost on the 20,000 fans who would have paid the higher price). The marginal revenue is negative, so the team could increase its total revenue from tickets by increasing the price and decreasing the quantity of tickets sold. Why don't MLB teams increase their ticket prices?

The solution to this puzzle is concessions. Suppose the average MLB fan spends $20 per game on merchandise that costs the owner about $4 to provide. In this case, each ticket sold generates an additional $16 in net concession revenue to the owner, just enough to offset the $16 revenue loss on ticket sales. Once we expand the definition of marginal revenue to include the net revenue from concessions, the owner's choice is consistent with profit-maximization. What appears to be too low a price could be just about right. Related to Exercises 1.8 and 1.9.

MlR = $24 - 0.002 x 20,000 = -$16.

APPLYING THE CONCEPTS #1: How does a monopolist maximize profit?

We expect the owner of a MLB (major-league baseball) team to choose the quantity (the number of fans at the game) at which marginal revenue equals marginal cost (MR = MC). The marginal cost of an additional fan is close to zero, so the profit-maximization rule simplifies to MR= 0. And yet for the typical team, it appears that MR is actually negative: adding fans by selling more tickets actually decreases total revenue from tickets ... What explains this puzzling behavior?

We can illustrate the puzzle with a simple example. Suppose that with a ticket price of $24, the team sells 20,000 tickets. If the slope of the demand curve is -0.002, marginal revenue is -$16:

MARGINAL REVENUE FROM A BASEBALL FAN

Why should the firm stop at 900 doses? Beyond 900 doses, the marginal revenue from an additional dose will be less than the marg.inal cost associated with producing it. Although the firm could cut its price and sell a larger quantity, an additional dose would add less to revenue than it adds to cost, so the firm's total profit would decrease. As shown in the fifth row in the table in Figure 7 .2, the firm could sell 1,000 doses at a fJrice of $14, but the marginal revenue at th.is quantity is only $4, while the marginal cost at this quantity is $6. 70. Producing the ] ,OOOth dose would decrease the firm's profit; by $2.70. For any quantity exceeding 900 closes, the marginal revenue is less than tile margi1rnJ cost. Therefore, the firm should produce exactly 900 doses.

Let's review what .)Ve've learned about how a monopolist picks a quantity and how to compute the monopoly profit. The three-step process is as follows:

1 Find the quantity thar satisfies the marginal principle, that is, the quantity at which marginal rev~rne equals marginal cost. In the example shown in Figure 7 .2, marginal revenue eguals marginal cost at point a, so the monopolist produces 900 doses.

2 Using the demand curve, find the price associated with the monopolist's chosen quantity. In Figure 7 .2, the price required to seJl 900 doses is $15 (point b).

3 Compute the monopolist's profit. The profit per unit sold equals the price minus the average cost, and the total profit equals the profit per unit times the number of units sold. In Figure 7 .2, the profit is shown by the shaded rectangle, with height equal to the profit per unit sold and width equal to the number of units sold.

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1..;..6...;;3 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

~ FIGURE 7.3 Monopoly versus Perfect Competition: Its Effect on Price and Quantity {A) The monopolist picks the quantity at which the long-run marginal cost equals marginal revenue-200 doses per hour, as shown by point a. As shown by point b on the demand curve, the price required to sell this quantity is $18 per dose. {B) The long-run supply curve of a perfectly competitive, constant-cost industry intersects the demand curve at point c. The equilibrium price is $8, and the equilibrium quantity is 400 doses.

Doses of drug per hour (B) Perfect Competition

Doses of drug per hour (A) Monopoly

400 0 200 0

' ! Marginal revenue '

Long-run supply $81--~~~~~~~ .... ~~~

(!) co 0

-0 $18 ----- ~ 0.. (!) u

65

How does a monopoly differ from a perfectly competitive market? To show the difference, let's consider an example of an arthritis drug that could be produced by a monopoly or a perfectly competitive industry. Let's take the long-run perspective-a period of time long enough that a firm is perfectly flexible in its choice of inputs and can enter or leave the market.

Consider the monopoly outcome first. Let's assume the long-run average cost of producing the arthritis drug is constant at $8 per dose. As we saw in the chapter on production and CO!)tb if average cost is constant, the marginal cost equals the average cost. In Panel A of Figure 7.3, the long-run marginal-cost curve is the same as the long-run average-cost. curve. Given the demand and marginal-revenue curves in

Deadweight Loss from Monopoly

Why should we as a society be concerned about monopoly? Most people are not surprised to hear that a monopolist uses its market power to charge a relatively high price. If this were the end of the story, a monopolist would simply gain at the expense of consumers. As we'll see in this part of the chapter, the social consequences of monopoly go beyond a higher price: A monopolist produces less output.

- The Consequences of Monopoly

__ 1_6~4 CHAPTER 7 • MONOPOLY AND PRICE DISCRIMINATION

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

rent seeking The process of using public policy to gain economic profit.

Given the consequences of monopoly, the government uses a number of policies to intervene in markets dominated by a single firm or likely to become a monopoly. We'll examine these policies later in the book. In the case of natural monopoly-a market that can support only a single firm-the government can intervene by regulating the price the natural monopolist charges. In other markets, the government uses antitrust policies to break monopolies into smaller companies and prevent corporate mergers that would lead to others. These policies are designed to promote competition, leading to lower prices and more production.

Monopoly and Public Policy

Another consequence of monopoly is the use of resources to acquire monopoly power. Because a monopoly is likely to earn a 2rofit, fii:ms are willing to spend money to persuade the government to erect barriers to entry that grant monopoly power through licenses, franchises, and tariffs. In Figure 7 .3, a firm would be willing to spend up to $2,000 per hour to get a monopoly on the arthritis drug. One way to get monopoly power is to hire lobbyists to persuade legislators and other policymakers to grant monopoly power. Rent seeking is the process of using p11!51iG Holicy to gain economic profit.

Rent seeking is inefficient because it uses resources that could be used in other ways. For example, the people employed as lobbyists could instead produce goods and services. A classic study of rent seeking by economist Richard Posner fountl that firms in some industries spent up to 30 percent of their total revenue to geL monopoly power. 1

The chapter opener provides an example of rent seeking. Beverage companies pay millions of dollars to universities to get a monopoly on campus beverages. Like any monopolist, a beverage company will use its monopoly power to charge higher prices, so students pay, indirectly, for the programs supported by the beverage companies, for example recreational sports and intercollegiate athletic programs.

Rent Seeking: Using Resources to Get Monopoly Power

Panel A of Figure 7.3, the monopolist will maximize profit where marginal revenue equals marginal cost (point a), producing 200 doses per hour at a price of $18 per dose (point b). The monopolist's profit is $2,000 per hour-a $10 profit per dose ($18 - $8) times 200 doses.

Consider next the market for the arthritis drug under perfect competition. We're assuming the arthritis drug industry is a constant-cost industry: Input prices do not change as the industry grows, so the long-run market supply curve is honzontal at the long-run average cost of producing the drug, which is $8 per dose. Tu ,£.1.'nel B of Figure 7.3, the horizontal long-run supply curve intersects the dcrfiand curve at point c, with an equilibrium price of $8 and an equilibrium quantity of 400 doses per hour. Compared to a monopoly outcome, the perfectly competitive outcome has a lower price ($8 instead of $18 per dose) and a larger quantity (400 doses instead of200).

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1-'-6-'-5 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Let's use the arthritis drug to show why a patent encourages innovation. Suppose a firm called Flexjoi.nt hasn't yet developed the drng but believes the potential benefits and costs of doing so are as follows:

• The economic cost of research and development will be $14 million, including all the opportunity costs of the project.

• The estimated annual economic profit from a monopoly will be $2 million (in today's dollars).

• Flexjoint's competitors will need three years to develop and produce their own versions of the drug, so if Flexjoint isn't protected by a patent, its monopoly will last only three years.

Based on these numbers, Flexjoint won't develop the drug unless the firm receives a patent that lasts at least 7 years. That's the length of time the firm needs to recover the research and development costs of $14 million ($2 million per year times 7 years).

Incentives for Innovation

One source of monopoly power is a:g9v.ernment patent that gives a firm the exclusive right to produce a product for 20 years. As we'll see, a patent encourages .innovation because the innovators know they will earn moqoP,oly profits on a new product over the period covered by the patent. If the monop0~y profits are large enough to offset the substantial research and development costs of a new product, a firm will develop the product and become a monopolist. Granting monopoly power through a patent may be efficient from the social perspective because it may eneomage the development of products that would otherwise not be developed.

- Patents and Monopoly Power

SO URGE: B.<l:sed OJl Sherri Buri, "Creswell Casino Wins Few Friends," E11gene Register Guard, April 2, 1996) I.

A developer interested in building a casino in Creswell, Oregon, placed a curious announcement in the local newspaper. If local voters approved the casino, the developer promised to give citizens a total of $2 million per year. With an adult population of about 1,600, each adult in Creswell would receive a cash payment of $1,250 per year. Why did the developers propose this deal? This is an example of rent seeking: The casino developer was seeking the profits that would come from having a monopoly in the casino market, and was willing to pay at least $2 million to gee'it. Related to Exercises 2.5, 2.6, and 2.7.

APPLYING THE CONCEPTS #1: What is the value of a monopoly?

A CASINO MONOPOLY IN CRESWELL, OREGON?

__ 1_6~6 CHAPTER 7 • MONOPOLY AND PRICE DISCRIMINATION

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Federal Trade Commission, "Commission Rules Schering-Plough, Upsher, and AfIP Illegally Delayed Entry of Lower-Cost Generic Drug," www.Ftc.gov/opa/2003/12/schering.hu:n (accessed j uly 9, 2006).

APPLYING THE CONCEPTS #3: What happens when a patent expires and a monopoly ends?

When a patent expires, new firms enter the market, and the resulting corrrpetition for consumers decreases prices and increases quantities. In the pharmaceutical 8J:ug market, when the patent for a brand-name drug expires, other firms introduce generic versions of the drug. The generics are virtually identical to the original branded drug, but they sell at a much lower price. The producers of branded drugs have an incentive to delay the introduction of generic drugs and sometimes use illegal means to do so.

In recent years, the Federal Trade Commission (FTC) has investigated allegations that the makers of branded drugs made deals with generic suppliers to keep generics off the market. The alleged practices included cash payments and exclusive licenses for new versions of the branded drug. In 2003, the FTC ruled that two drug makers had entered into an illegal agreement when Schering-Plough paid Upsher-Srnith Laboratories $60 million to delay the introduction of a low-price alternative to its prescription drug K-Dur 20, which is used to treat people with low potassium.

Another tactic is to claim that generics are not as good as the branded drug. DuPont has claimed that generic versions of its Coumadin (a blood thinner) are not equivalent to Coumadin and may pose risks to patients. Because generic versions are virtually identical to the branded drugs, such claims are not based on science. Related to Exercises 3.4 and 3.5.

BRIBING THE MAKERS OF GENERIC DRUGS A

Is the patent for Flexjoint's drug beneficial from the social perspective? The patent grants monop_oly power to the firm, am! the firm responds by charging a higher price and prodi!cing less than the quantity that would be produced in a perfectly competitive market. Looking back at Figure 7.3, a monopolist produces 200 doses per hour instead of 400,. From society's perspective, 400 doses is better than 200 closes, but we don't have that choice. Flexjoint won't develop the drug unless a patent protects the firm f~oJ!l com~etition for at least seven years. Therefore, society's choice is between the monnp.61y outcome of 200 doses or 0 doses. Because

Trade-Offs from Patents

If there is no patent and the firm loses its monopoly in 3 years, it will earn a profit of $6 million, which is less than the cost of research and development. In comparison, with a 20-year patent the firm will earn $40 million, which is more than enough to recover its $14 million cost.

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1..;..6_7 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Up to this point in the book, we've assumed a firm charges the same price to all its customers. As we'll see in this pan of the chapter, however, a firm may be able to divide consumers into two or more gmups and sell the good at a different price to each, a practice known as price discrimination. FQr example, airlines offer discount tickets to travelers who are flexible in their Clq;iar:tlire times, and movie theaters have lower prices for senior citizens. The only legal res!:tie"tion on price discrimination is that a firm cannot use it to drive rival firms out of busins_ss.

Although price discrimination is widespread, it is not always possible. A firm has an opportunity for price discrimination if three conditions are met:

Market power. The firm must have some control over its price, facing a neg- atively sloped demand curve for its product. Although we will discuss price discrimination by a monopolist, any firm that faces a negatively sloped demand curve can charge different prices to different consumers. In fact, the only type of firm that cannot engage in price discrimination is a perfectly competitive price- taking firm. Such a firm faces a horizontal demand curve, taking the market price as given. For all other types of markets-monopoly, oligopoly, and monopolistic competition-price discrimination is possible.

2 Different consumer groups. Consumers must differ in their willingness to pay for the product or in their responsiveness to changes in price, as measured by the price elasticity of demand. In addition, the firm must be able to identify different groups of consumers. For example, an airline must be able to distinguish between business travelers and tourists, and a movie theater must be able to distinguish between seniors and nonseniors,

3 Resale is not possible. It must be impractical for one consumer to resell the product to another consumer. Airlines prohibit consumers from buying and reselling tickets. If airlines allowed consumers to sell discount tickets to each

- Price Dlscrtmlnation

a quantity of 200 doses is clearly better than none, the patent is beneficial from society's perspective.

What about a product a firm develops without the protection of a patent? Suppose we change the Flexjoint example by altering one number: The cost of research and development is only $5 million, not $14 million. Suppose it still takes Flexjoint's competitors three years to develop a substitute, and Flexjoint's profit per year is still $2 million. Without a patent, Flexjoint would earn an economic profit of $6 million during its three-year monopoly ($2 million per year times three years), which is more than the $5 million cost of research and development. Therefore, the firm would develop the new drug even without a patent. In this case, a patent would merely prolong a monopoly, and so it would be inefficient from society's perspective.

What are the general conclusions about the merits of the patent system? It is sensible for a govermnent to grant a patent for a product that would otherwise not b€ developed, but it is not sensible for other products. Unfortunately, no one knows in advance whether a particular product would be developed without a patent, so the government can't be selective in granting patents. In some cases, patents lead to new products, ~though in other cases, they merely prolong monopoly power.

price discrimination The practice of selling a good at different prices to different consumers.

__ 1_6~8 CHAPTER 7 • MONOPOLY AND PRICE DISCRIMINATION

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Consider a restaurant whose patrons fall into two groups, senior citizens and others. In Figure 7 .4, the demand curve for senior citizens is lower than the demand curve for other groups, reflecting the assumption that the typical senior is willing to pay less than the typical nonsenior. Their lower willingness to pay could result from having lower income or more time to shop for low prices.

Senior Discounts in Restaurants

One approach to price discrimination is to identify consumers who are not willing to pay the regular price and offer them a discount. Here are some examples:

• Discounts on airline tickets. Airlines offer discount tickets to travelers who spend Saturday night away from home because they are likely to be tourists, not business travelers. The typical tourist is not willing to pay as much for air travel as the typical business traveler. Airlines also offer discount tickets to people whoJP1an weeks ahead, because tourists plan further ahead than business travelers. '

= Discount coupons for groceries and restaurant food. The typical coupon-clipper is not willing to pay as much as the typical consumer.

• Manufacturers' rebates for appli:tnces. A person who takes the trouble to mail a rebate form to the manufacturer is not willing to pay as much as the typical consumer.

• Senior-citizen discounts on airline tickets, restaurant food, drugs, and entertainment. Some seniors have more time to sl:i.op for bargains, and are thus more sensitive to prices. Other seniors have relatively law income, and are willing to pay less than the typical consumer. ~

• Student discounts on movies and concerts. The typical stud~nt has less income than the typical consumer, and is thus willing to pay less for movies,

The challenge for a firm is to figure out which groups of consumers shoul get discounts. Firms can experiment with different prices and identify groups of consumers that are most sensitive to price. In September 2000, Amazon.com started charging different prices for different types of consumers. For example, consumers who used Netscape's browser paid $65 for the Planet of the Apes DVD, while Internet Explorer users paid $7 5 for the same DVD.2 Prices also varied with the consumer's Internet service provider and the number of previous purchases from Amazon. An Amazon spokeswoman said the company varied prices in a random fashion, as part of ongoing tests to see how consumers respond to price changes. In other words, it appears that Amazon was assessing tbe willingness to pay of different types of consumers. In principle, Amazon could use the data collected to develop systems of price discrimination, giving discounts to the most price-sensitive consumers. After widespread protests of the Amazon pricing experiments, the company stopped the practice and issued refunds to about 7,000 consumers who had paid relatively high prices.

other, you could go into business as a ticket broker, buying discount airline tickets one month ahead and then selling them to business travelers one week before the travel date. In general, the possibility of resale causes price discrimination to break clown.

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1..;;.6..;;.9 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

We can use the concept of price elasticity of demand to explain why price discrimination increases me restaurant's profit. From the chapter on elasticity, we know that when demand is elastic (Ed> 1), there is a negative relationship between price and total revenue; When the price decreases, total revenue (price times quantity sold) increases because the percentage increase in the quantity demanded exceeds the percentage decrease in price.

Suppose the restaurant initially has a single price of $5 for both seniors and nonseniors. Compared to other consumers, senior citizens have more elastic demand for restaurant meals, in part because they have lower income and more time to shop

Price Discrimination and the Elasticity of Demand

Under a price-discrimination µhn, the restaurant will simply apply the marginal principle twice, once for seniors and a second time for nonseniors. TJ1is approach is sensible, because the two groups have different demands for restaurant meals, so the restaurant should treat them differently. Panel A of Figure 7.4 shows how to pick a price for senior citizens. The marginal principle=margina! revenue equals marginal cost-is satisfied at point a, with 280 senior meals per <:lay. :Pherefore, the appropriate price for seniors is $3, as shown by point b on the senior demana curve. In Panel B of Figure 7.4, the marginal principle is satisfied at point a Efr ~10nseniors, with 260 meals per day and a price of $6 per meal.

We know the application of the marginal principle maximizes profit in each segment of the market. Therefore, price discrimination=-with a price of $3 for seniors and $6 for everyone else-maximizes the restaurant's total profit. If the restaurant were instead to charge a single price of $5 for both groups, the profit from each group would be lower, so the restaurant's total profit would be Lower, too.

.._ FIGURE 7.4 The Mar@inal Prihciple and Price Discrimination To engage in. price oisermination, the firm divides potential customers into two groups and applies the marginal principle ttiice-once tor each group. Using the marginal principle, the profit-maximizing prices are $3 for seniors (point l:r)} ·and $6 for nonseniors (point cf'J.

(B) Nonseniors Number of nonsenior customers Number of senior customers

(A) Senior Citizens

100 280 0 260 300 0

$6 -------

Demand by Marginal

MC=AC

$3

__ 1-'-7-"-0 CHAPTER 7 • MONOPOLY AND PRICE DISCRIMINATION

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Why do senior citizens pay less than everyone else for admission to a movie, but the same as everyone else for popcorn? As we've seen, a senior discount is not an act of generosity by a firm, but an act of profit maximization. Senior citizens are typically willing to pay less than other citizens for movies, so a theater divides its consumers into two groups-seniors and others-e-and offers a discount to seniors. This price discrimination in favor of senior citizens increases the theater's profit. Why don't theaters offer a senior discount for popcorn? Unlike admission to the theater, popcorn can be easily transferred from one customer to another. If senior citizens could buy popcorn at half the regular price, many nonseniors would get seniors to buy popcorn for them, so the theater wouldn't sell as much popcorn at the regular price and its profit would decrease. In contrast, as long as ticket takers check consumers' admissions tickets, admission to the movie is not transferable.

Why are hardback books so much more expensive than paperback books? Most books are published in two forms-hardback and paperback. Although the cost of producing a hardback book is only about 20 percent higher than producing a paperback, the hardback price is typically three times the paperback price. The hardback edition comes first, and the paperback edition is published months, or even years, later. Booksellers use hardbacks and paperbacks to distinguish between two types of consumers: those who are willing to pay a lot and those who are willing to pay a little. Some people are eager to read a book when it first comes out, and publishers provide them with high-price hardbacks. The more casual readers are willing to wait for the lower-priced paperback. The pricing of hardback and paperback books is another example of price discrimination, under which consumers with less elastic demand pay a higher price.

Examples: Movie Admission versus Popcorh, arid Hardback versus Paperback Books

• Good news: Demand is highly elastic, so total revenue increases by a large amount.

• Bad news: More meals are served, so total cost increases.

"If the senior demand for meals is highly elastic, that is, Ed is well above 1.0, the good news will dominate the bad news: The increase in revenue will more than offset the increase ip C_i}St. Consequently, a price cut will increase the firm's profit.

For nons91i0rs, the firm will have an incentive to increase the price above the initial common~rice of $5. Suppose nonseniors have a mildly elastic demand for meals, with Ed just above 1.0~ price hike for nonseniors brings bad news on the revenue side and good new15.,::::}1e cost side:

• Bad news: Demand is mildly elastic, so total revenue decreases by a small amount.

• Good news: Fewer meals are served, so total cost decreases.

If the demand by nonseniors is mildly elastic, the good news will dominate the bad news: The savings in production costs will exceed the revenue loss. Consequently, the price hike for nonseniors will increase the firm's profit.

for low prices. A price cut for senior citizens brings good news and bad news for the restaurant:

MONOPOLY AND PRICE DISCRIMINATION• CHAPTER 7 _1_7 .... 1 __

Pnnled by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Compared to a perfectly competitive market, a market served by a monopolist will charge a higher price, produce a smaller quantity of output, and generate a deadweight loss to society.

2 Some firms use resources to acquire monopoly power, a process known as rent seeking.

3 Patents protect innovators from competition, leading to higher prices for new products but greater incentives to develop new products.

4 To engage in price discrimination, a firm divides its customers into two or more g:roups and charges lower prices to groups with more elastic demand.

5 Price discrimination is not an act of generosity; it's an act of profit maximization.

172

In this chapter, we've seen some of the subtleties of monopolies and their pricing policies. Compared to a perfectly competitive market, a monopoly charges a higher price, produces a smaller quantity, and wastes resources

in the pursuit of monopoly power. On the positive side, some of the products we use today might never have been invented without the patent system and the monopoly power it grants. Firms with market power often use price discrimination to increase their profits. Here are the main points of the chapter:

SOIJRCE: BJSed on Ricard Gil and Wesley Hartman, "Why Does Popcorn Cost So M.uc~,at t\1,e Movies? An Empirical Analysis of Metering Price Discrimination') (Research Paper 1983, Stanford Graduate Scbool.of'Business, 2008).

APPL YING THE CONCEPTS #4: When do firms have an opportunity to charge different prices to different consumers?

That $4 bucket of popcorn you get in the movie theater costs less than $0.10 to pro- duce. What explains the 4,000 percent markup? Economists have struggled with this question for years, and now we have an answer. Moviegoers vary in their willingness to pay for seeing a movie, and a movie theater has an incentive to identify the high demanders and charge them more, while keeping the price low for the low demand- ers. It turns out that a reliable predictor of tbe willingness to pay for a movie is the consumption of movie popcorn: The people who buy a lot of popcorn are the con- sumers who are willing to pay the most for a movie experience. So a convenient way for the theater to charge more to the consumers who are willing to pay more is to jack up the price of popcorn. As a result, the low demanders simply pay the admission price, while tfie high demanders pay the admission price plus the jacked-up price of a bucket of popcorn.

We can illustrate with a simple example. Suppose a low demander is willing to pay $11 for a movie, while atJ!j~:fi.tdemander is willing to pay $15 for a movie and popcorn. If the theater charges $10 for a(i!mission and $4 for popcorn, each consumer will get a consumer surplus of $1 (equal fo ~11 -$10 for the low demander and $15 - $14 for the high demander), so both consumers will see the movie. If instead the theater charged $12 for admission and $0.10 for popcorn, the high demander will see the movie, but the low demander won't. The theater's prising strategy gets the low demander into the theater at a price of $10, and because the marginal cost of an additional consumer is close to zero, the theater's profit increases. Related to Exercise 4.3.

WHY DOES MOVIE POPCORN COST SO MUCH?

ll-•&·'''''''·"*111-------------------

SUMMARY

a. What price will the publisher choose? b. Suppose that the author receives a royalty payment

equal to 10 percent of the total sales revenue from the book. If the author could choose a price, what would it be?

c. Why would the publisher and the author disagree about the price for the book?

d. Design an alternative author-compensation scheme under which the author and the publisher would choose the same price.

Price per book $44 $40 $36 $32 $30

Quantity of textbooks 80 100 120 140 1 50

b. Including both ticket sales and merchandise, the marginal fan contributes an additional----- to the team's total revenue. (Related to Application 1 on page 163.)

1.10 Book Pricing: Publisherf versus Authors. Consider the problem of setting a price\for~a book. The marginal cost of production is constant at $20 per book. The publisher knows from experience that the slope of the demand curve is -$0.20 per book: Starting with a price of $44, a price cut of $0.20 will increase the quantity demanded by one book. For example, here are some combinations of price and quantity:

173 Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription a

represents a copyright violation.

Tickets and Merchandise. Consider a baseball team that has a ticket price of $45 and sells 30,000 tickets at this price. The slope of the demand curve is -$0.002. The typical fan purchases $2 5 worth of merchandise that costs the owner $5 to provide. a'. The marginal revenue from ticket sales is

1.9

1.2 A monopoly that cuts its price gains revenue from its customers but loses revenue from its

----- customers. 1.3 At a price of $18 per CD, a firm sells 60 CDs. If the

slope of: the demand curve is -$0.10, marginal revenue for the 6 lst CD is. . The firm should cut the price to sell one more CD if the marginal cost is less than ,,_ _

1.4 Arrow up or clown: As the quantity produced by a monopolist increases, the gap between the marginal- revenue curve and demand curve-----

1.5 To maximize profit, a monopolist picks the quantity at which equals _

1.6 Arrows up or down: At a price of: $18 per CD, the marginal revenue of a CD seller is $12. If the marginal cost of CDs is $9, the firm should its price to the quantity.

1. 7 You want to determine the profit-maximizing quantity for a monopolist. You can ask the firm's accountant to draw the firm's revenue and costs curves, but each curve will cost you $1,000. From the following list, indicate which curves you will request: average total cost, average fixed cost, average variable cost, marginal cost, demand, marginal revenue.

1.8 The marginal cost of an additional baseball fan is zero, so the profit-maximizing condition simplifies to . (Related to Application 1 on page 163.)

- The Monopolist's Output Decision IC\

1.1 For a monopolist, marginal revenue is---\,,;".-~~. (greater/less) than price. ..._

EX E R C I S E S ) All problems are assignable in MyEconlab.

price discrimination, p. 168 rent seeking, p. 165

natural monopoly, p. 158 network externalities, p. 158 patent, p. 158

barrier to entry, p. 158 market power, p. 158 monqpoly, p. 158

KEY TERMS )

I. Richard A. Posner, "The Social Costs of Monopoly and Regulation," ]01m1al of Political Economy, 83 (1975): 807-827.

NOTES

An experiment shows how a monopolist-a museum-picks different prices for different consumer groups. Here is how the experiment works:

• The instructor picks a group of three to five students to represent the museum.

• Of the remaining students-e-potential museum patrons- half represent senior citizens with senior-citizen cards. Each consumer receives a number indicating how much be or she is willing to pay for a trip to a museum.

• In each round of the experiment, the museum posts two prices: one for senior citizens and one for nonseniors. Each consumer then decides whether to buy a ticket at the relevant posted price.

PRICE DISCRIMINATION

by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

2. Linda Rosencrance, "Amazon Charging Different Prices on Some DVDs," Comptuernorld, September 5, 2000, 23.

MyEconlab For additional economic experiments, please visit www.myeconlab.com.

• A consumer's score in a particular round equals the difference between his or her given willingness to pay and the amount he or she actually paid for admission.

• 1;'heu1mseum's score i11 each round equals its profit, or its tornl revenue minus its total cost. The total cost equals $2 per patron (for ticket-takers, guides, cleanup, and other tasks) times the number of tickets sold.

• The experiment ,i;uns jor five rounds. After the fifth round, each consumer computes his or her total score by adding up the round scores. ti.Che museum's score equals the sum of its profits from rhe five.rounds.

the merchants' profits, so we should decrease the merchants' taxes to offset their losses on senior-citizen discounts." Do you agree or disagree? Explain.

4.10 Airline Pricing. Consider an airline that initially has a single price of $300 for all consumers. At this price, it has 120 business travelers and 80 tourists. The airline's marginal cost is $100. The slope of the business demand curve is -$2 per traveler, and the slope of the tourist demand curve is -$1 per traveler. Does the single-price policy maximize the airline's profit? Hnot, how should it change its prices?

ECONOMIC EXPERIMENT

4.8 Haircuts in Mulletville. The town of Mullerville has a s.ingle hairstylist. The margina] cost of a haircut is the same for men and women ($10). The quantity of haircuts is 100 for men and 100 for women. The profit-maximizing price for women is $35, compared to $15 for men. a. \:M!1at explains the price difference? b. Illusirate with a complete graph.

4.9 Tax Cuts for; Discounters? Consider the following statement from a member of a city council: "Several of the mercharrts in bur city offer discounts to our senior citizens. These discounts obviously decrease

177 Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date

represents a copyright violation.

MyEconLab MyEconlab helps you master each objective and study more efficiently.

• Explain the effects of a low-price guarantee on the price.

• Explain the behavior of an insecure monopolist.

• Define a natural monopoly and explain the average-cost pricing policy.

• List three features of antitrust policy.

• Describe and explain the effects of market entry.

• List the conditions for equilibrium in monopolistic competition.

• Contrast monopolistic competition and perfect competition.

• Explain the role of advertising in monopolistic competition.

• Explain why a price-fixing cartel is difficult to maintain.

LEARNING OBJECTIVES

When total employment and income dropped, many consumers switched from buying new shoes to repairing old shoes, and the demand for shoe repair increased. In :mos the sales of adult footwear decreased by about 3 percent, and the volume of shoe repairs increased dramatically; newspapers reported that in some shops sales increased by 40 to 50 percent: Some consumers purchased used shoes in thrift shops and brougt'.it them to cobblers for repairs and reconditioning. The surge in sales increased the profits of shoe-repair shops, and firms entered the market by opening new shops. The entry of new firms reversed-at least temporarily-a long decline of shoe-repair shops. The number of shops in the United States decreased from 120,000 during the Great Depression to 7 ,000 in 2008. As the economy comes out of the recession, the question is whether the long-term trend of disappearing cobblers will be restored, or whether a new consumer thriftiness will allow more cobblers to stay in business.

In the recession that started in 2008, some industries actually experienced increases in demand that caused market entry- new firms entered the markets.1

Market Entry, Monopolistic Competition, and Oligopoly

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost.

MARGINAL PRINCIPLE

- The Effects of Market Entry Consider a market served by a single profitable firm, a monopolist. As we saw earlier in the book, a firm in any market can use the marginal principle to decide how much output to produce.

• Each firm in the market produces a good that is slightly different from the .goods of other firms, so each firm has a narrowly defined monopoly.

• The products sold by different firms in the market are close substitutes for one another, so there is intense competition between firms for consumers. For example, your local grocery store may stock several brands of toothbrushes with different design features. If the price of one brand increases, some loyal customers wil/ continue to buy the brand, but others will switch to different brands that are dose substitutes.

Some other examples ofmonojitilisjic competition are the markets for bread, clothing, restaurant meals, and gasol.ine. I each case, firms in the market sell products that are close, but not perfect, substitutes.

Later in the chapter, we look at an olig.op_oly, a market with just a few firms. Given the small number of firms in an oligopoly, the actions of one firm have a large effect on the other firms. Therefore,firms in an oligopoly act strategically. Before a firm takes a particular action, it considers the possible reactions of its rivals. W e'll use game theory, the study of behavior in strategic situations, to cli'sel1ss p,riee fixing (conspiring to fix) and entry deterrence (preventing another firm from entei:ing0a market).

The final two parts of the chapter look at v~rious public policie~ dealing with markets that are dommated by a small number of firms. We'll start v.;ith the case of natural monopoly, which occurs when the scale economies in production are so large that only a single large firm can survive. In this case, the government can intervene by regulating the price charged by the natural monopolist. Then we'll look at markets in which the government can affect the number of firms in the market by using vari- ous policies to promote competition. The government uses antitrust policies to break monopolies into several smaller companies, prevent corporate mergers that would reduce competition, and regulate business practices that tend to reduce competition.

A market served by many J;i:Rns that sell slightly different produq:~">

/

monopolistic competition

tu this chapter, we explore a firm's decisio. n to enter a market and examine the consequences of entry on prices and the profits of other firms. Firms will enter a market as long as they can make an economic profit. As we'll see, the entry of firms squeezes profit in three ways: The price decreases, the average cost of production increases, and the quantity sold per firm decreases. Eventually the entry process stops, and we can count the number of firms serving the market. If entry stops at a single firm, we have a natural monopoly, a topic we cover later in the book. If many firms enter the market, we have monopolistic competition, the topic of this chapter.

Monopolistic competition is a hybrid market structure, with features of both monopoly and perfect competition. The term may seem like an oxymoron-a pair of contradictory words-similar to "virtual reality" and "books on tape." However, the term actually conveys the two key features of the market:

c •

__ 1_;_7...;.8 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Entry Squeezes Profits from Three Sides Suppose a second firm, producing a slightly different toothbrush, enters the market. When the second firm enters, the firm-specific demand curve for the original firm will shift to the left. At any particular price, some consumers will patronize the new firm, so there will be fewer consumers for the original firm: The original firm will sell

As we saw in the previous chapter, a monopolist maximizes profit by picking the quantity at which marginal revenue equals marginal cost. In Figure 8.1, this happens at point a, with a quantity of 300 toothbrushes. From point b on the demand curve, the price associated with this quantity is $2.00. From point con the average-cost curve, we see that the average cost of this quantity is $0.90. The firm's profit, shown by the shaded rectangle, is $330:

profit= (price - average cost) X quantity= ($2.00 - $0.90) X 300 = $3 30

Given the large profits in. the toothbrush market, will a second firm enter the market?

& FIGURE 8.1 Market Entry Decreases Price and Squeezes Profit (A) A monopolist maximizes profit at point a, where marginal revenue equals marginal cost. The firm sells 300 toothbrushes at a price of $2.00 (point b) and an average cost of $0.90 (point c). The profit of $330 is shown by the shaded rectangle. (B) The entry of a second firm shifts the firm-specific demand curve for the original firm to the left. The firm produces only 200 toothbrushes (point d) at a lower price ($1 .80, shown by point e) and a higher average cost ($1.00, shown by point r). The firm's profit, shown by the shaded rectangle, shrinks to $160.

Toothbrushes per minute Toothbrushes per minute

(B) Two Firms (A) Single Firm

200 0 300 0

Marginal cost>' Marginal revenue for monopolist

Marginal cost

Consider a firm whose activity is producing toothbrushes. On the cost side, the firm has the conventional cost curves: For small quantities produced, the average-cost curve is negatively sloped and marginal cost is less than average cost. On the benefit side, the marginal benefit of producing toothbrushes is the marginal revenue from selling one more brush. In Panel A of Figure 8.1, if a single firm produces tooth- brushes, the firm-specific demand curve (the demand curve applicable to a specific firm) i~ the same as the market demand curve. As we saw in the chapter on monopoly, the fi111n'$ marginal-revenue curve lies below the demand curve because a monopolist must cut i't;i price-to sell more output.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY• CHAPTER 8 _1_7...;;.9 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

To illustrate the effects of entry on price, cost, and profit, imagine tli~t you just inher- ited enough money to start your own car-stereo business. Suppose that the existing monopolist sells 10 stereos per day at a price of $230 and an average cost of $200 per stereo, for a profit of$30 per stereo. If you enter the market, the increased competition will drop the price below $230, and if you sell fewer than 10 stereos (the monopoly quantity), your average will be greater than $200 because you will spread your fixed costs over fewer units. In other words, your entry squeezes profit per unit from both sides. For example, if the market price drops to $215 and the average cost increases to $205, your profit per stereo will be $10, significantly less than the monopolist's initial profit of $30 per stereo.

Vi/hat happens when the government eliminates artificial barriers to entry? The Motor Carrier Act of 1980 eliminated the government's entry restrictions on the trucking industry, most of which had been in place since the 1930s. New firms entered the trucking market, and freight prices dropped by about 22 percent. The market value of a firm's trucking license indicates how much profit the firm can earn in the market. Deregulation increased competition and decreased prices and profits, and the average value of a trucking license dropped from $579,000 in 1977 to less than $15,000 in 1982.2

Empirical studies of other markets provide ample evidence that entry decreases market prices and firms' profits. In other words, consumers pay less for goods and services, and firms earn lower profits. In one study of the retail pricing of tires, a market with only two tire stores had a price of $5 5 per tire, compared to a price of $53 in a market with three stores, $51 with four stores, and $50 with five stores. The larger the number of stores, the lower the price of tires.3

Examples of Entry: Car Stereos, Truckinq, and Tires

fewer brushes at each price. In Panel B of Figure 8.1, the firm-specific demand curve for the original monopolist shifts to the left, and profit decreases for three reasons:

The market price drops. The marginal principle is satisfied at point d, so the original firm now produces 200 toothbrushes at a price of $1.80 (point e). The competition between the two firms causes the price to drop, from $2.00 to $1.80.

2 The quantity produced by the first Jinn decreases. The original firm produces only 200 toothbrushes, down from the 300 it produced as a monopolist.

3 The first firm's average cost of production increases. The decrease in the quantity produced causes the firm to move upward along its negatively sloped average-cost curve to a higher average cost per toothbrush, from $0.90 to $1.00 (point/).

The effects of entry are shown by comparing the profit rectangles in Panels A and B of Figure 8.1. Entry shrinks the firm's profit rectangle because it is squeezed fioih three directions. The top of the rectangle drops because the price decreases. q:'J e bottom of the rectangle rises because the average cost increases. The right side of the rectangle-moves to the left because the quantity decreases. In this example, profit drops from $cHO to $160:

profit= (Prie~ - average cost) X quantity= ($1.80 - 1.00) X 200 = $160

What about the second firm? If we assume the second firm has access to the same production technology as~ the<jirst firm and pays the same prices for its inputs, the cost curves for the second firm \V.ill be the same as the cost curves for the first firm. If the product of the second firm. is 1rnarly identical to the product of the first firm, the firm-specific demand curve for the second firm will be nearly identical to the firm-specific demand curve of the first firm. ru an approximation, we can use Panel B of Figure 8.1 to represent both firms. Each firm produces 200 toothbrushes at an average cost of $1.00 per toothbrush and sells illem at ~rice of $1.80.

__ 1_8~0 CHAPTER 8 • MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

product differentiation The process used by firms to distinguish their products from the products of com- peting firms,

We've seen that the entry of a firm in a profitable market decreases the price and the profit per firm. Under a market strucrure called monopolistic competition, firms will continue to enter the market until economic profit is zero. Here are the features. 0£ monopolistic competition:

• Many firms. Because there are relatively small economies of scale, a small firm can produce its product at about the same average cost as a large firm. For example, a small donut shop can produce donuts and coffee at about the same average cost as a large shop. Because even a small firm can cover its costs, the market can support many firms.

• A differentiated product. Firms engage in product differentiation, the process used by firms to distinguish their products from the products of competing firms. product differentiation, the process used by firms to distinguish their products from the products of competing firms. A firm can distinguish its products from the products of other firms by offering a different performance level or appearance. For example, automobiles differ in horsepower and fuel efficiency, and toothpastes differ in flavor and their ability to clean teeth. Some products are differentiated by the services that come with them. For example, some stores provide informative and helpful salespeople, whereas others require consumers to make decisions on their own. Some pizza firms offer home delivery, and some software producers offer free technical assistance. As we'll see later in the chapter, some products are differentiated by where they are sold.

• No artificial barriers to entry. There are no patents or regulations that could prevent firms from entering the market.

These characteristics explain the logic behind the label "monopolistic competition." Product differentiation means each firm is the sole seller of a narrowly defined good. For example, each firm in the toothbrush market has a unique design for its toothhrushes, so each is a monopolist in the narrowly defined market for that design. Because the products from different firms are close substitutes, there .is keen competition for consumers. When one toothbrush maker increases its price,

- Monopolistic Competition

SOURCE': Based on Chenghuan Chu, "The effect of satellite entry ~n cable television prices and product quality," RAND Jotm"'I of Economics 41 (2010), pp. 730-764.

Gonsider the market for television signals provided to residential consumers. How will an existing cable-TV provider respond to the entry of a firm that provides TV signals via satellite? In most cases, the entry of a satellite firm causes the cable firm to improve the quality of service and decrease its price, so consumer surplus increases. In some cases, the cable company improves the quality of service and increases price. Because the service'irnprdvement is typically large relative to the price hike, consumer surplus increases in this case too. On average, the entry of a satellite firm increases the monthly consumer surplu per consumer from $3.96 to $5.22, an increase of 3 2 percent. Related to Exercises 1.6 and'1.8.

APPLYING THE CONCEPTS #1: How does market entry affect prices?

SATELLITE v CABLE

11.1;.1111111.11wml-------------------

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1...;;.8_1 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

• FIGURE 8.2 Long-Run Equilibrium with Monopolistic Competition Under monopolistic competition, firms continue to enter the market until economic profit is zero. Entry shifts the firm-specific demand curve to the left. The typical firm maximizes profit at point a, where marginal revenue equals marginal cost. At a quantity of 80 toothbrushes, price equals average cost (shown by point b), so economic profit is zero.

0 80 Toothbrushes per minute

Marginal revenue with six firms

We'll use the toothbrush example to illustrate the features of monopolistic competition. The producers of toothbrushes differentiate their products with respect to color, bristle design, handle size and shape, and durability. As we saw earlier, after a second firm enters the toothbrush market, both firms still make a profit. Will a third firm enter this lucrative market? The entry of a third firm will shift the firm-specific demand curve for each firm further to the left. As we saw earlier, a leftward shift of a firm's demand curve decreases the market price, decreases the quantity produced per Url'li), and increases the average cost per toothbrush. If after the third firm enters tbe market all thre;: firms still earn positive profit, a fourth firm will enter.

Because there are no barriers to entering the toothbrush market, firms will continue to enter until each firm makes zero economic profit. Figure 8.2 shows the long-run equilibrium from the perspective of the typical firm. Suppose a total of six firms are in the toothbrush market. Given the firm-specific demand curve in a market with six firms, the typical firm satisfies the marginal principle at point a by selling 80 brushes per minute at:apnce of$1.40 (point b) and an average cost of$1.40. Because the price equals the average cost, the typical firm makes zero economic profit. Each firm's revenue is high enough to cove): ill its costs-including the opportunity cost of all its inputs=but not enough to cause additional firms to enter the market 111 other words, each firm makes just enough money, ta'stay i.n business.

When Entry Stops: Long-Run Equilibrium

many of its consumers will switch to the similar toothbrushes produced by other firms. In other words, the demand for the product of a monopolistically competitive firm is very price elastic: An increase in price decreases the quantity demanded by a relatively large amount because consumers can easily switch to another firm selling a similar product.

__ 1_8.;........2 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

• FIGURE 8.3 Long-Run Equilibrium with Spatial Competition Bookstores and other retailers differentiate their products by selling them at different locations. The typical bookstore chooses the quantity of books at which its marginal revenue equals its marginal cost (point a). Economic profit is zero because the price equals average cost (point b).

Books per hour 0 70

Finn-specific demand of typical store

In some monopoli~tically competitive markets, differentiation is simply a matter of location. Some 'e'xamples are gas stations, music stores, bookstores, grocery stores, movie theaters, and ice-erearqparlors. In each case, marry firms sell the same product at different locations. Y'onr crity probably has several bookstores, each of which sells a particular book at about ~;;sarn\'l. price. Everything else being equal, you are likely to purchase books from the most corwenient store, hut if a store across town offers lower prices, you might purchase yow books there instead. In other words, each store has a monopoly in its own neighborhood, but competes with bookstores in the rest of the city.

Figure 8.3 shows the long-nm equilibrium in jlte niarket for books. Because there are no barriers to entering the market, new bookstores will enter the market until each store makes zero economic profit. The typical bookstore satisfies the marginal principle at point a, selling 70 books per hour at a price of $14-µer book (point b) and an average cost of $14 per book. The price equals the stor&'.s aY,erage cost, so the typical store makes zero economic profit. Each store's revenue is high enough to cover all its costs-including the opportunity cost of all its inputs=-bur-iiot enough to cause additional stores to enter the market. In other words, the firm makes just enough money to stay in business.

Differentiation by Location

What are the implications of market entry for the market as a whole? In Figure 8.2, each of the six firms in the market produces 80 toothbrushes at a price of $1.40, so the total quantity produced is 480. In contrast, we started with a monopoly that had a price of $2.00 and a quantity of 300 toothbrushes. In other words, market entry ~creased the price from $2.00 to $1.40 and increased the total quantity demanded from 300 to 480, consistent with the law of demand.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY• CHAPTER 8 _1...;;.8_3 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

There are some trade-offs associated with monopolistic competition. Although the average cost of production is higher than the minimum, there is also more product variety. In a market with many toothbrush firms, consumers can choose from a wide

Average Cost and Variety

We've seen that market entry leads to lower prices and a larger total quantity in the market. At the same time, entry decreases the output per firm and increases the average cost of production. As shown in Figure 8.2 and 8.3, mouopolisticaLly competitive firms operate on the negatively sloped portion of their average-cost curves, so average cost is higher than the minimum. In other words, the average cost of production would be lower if a single toothbrush firm served the entire market by providing a single type of toothbrush. What are the other consequences of entry and monopolistic competition?

- Trade-Offs with Entry and Monopolistic Competition

SOURCE: Based on data from W&W.entreprencm:com. (accessed October 8, 20 I 0).

$40,000 2Q,OOO 24,000 35,080

Dunkin' Donuts: Coffee and donuts Great Clips: Haircuts Glass Doctor: Mobile windshield repair Flowerama: Flowers, plants, gifts

- Royalty Rate Franchising Fee 5.9% 6 4-7 5

Brand and Product

TABLE 8 1 Franchlsinq Fees and Royalties

APPL YING THE CONCEPTS #2: Are monopolistically competitive firms profitable?

One way to get into a monopolistically competitive market is to get a franchise for a nationally advertised product. If you want to get into the donut market, you could pay a franchise fee of $40,000 to Allied Domecq, the parent company of Dunkin' Donuts. That gives you the right to sell donuts under the Dunkin' Donuts brand. You'll also get a few weeks of training at the corporate headquarters in Massachusetts and some help in organizing a grand opening. Once you start making money, you'll pay;a royalty to the parent company equal to 5. 9 percent of your sales.

How much money are you likely to make in your donut shop? You will compete for donut consumers with other donut shops, bakeries, grocery stores, and coffee shops. Given the small barriers to entering the donut business, you should expect keen com~ecitiou for consumers. Although your brand-name donuts will give you an edge over your cojnpetirors, remember that you must pay the franchise fee and royalties. In the monopolistically competitive donut market, you should expect to make zero economic p ofj;t, with total revenue equal to total cost. Your total cost includes the franchise fee'and royalties, as well as the opportunity cost of your time and the opportunity cost of any funds you invest in the business.

Table 8.1 shows the franchise fees and royalty rates for several franchising opportunities. The fees indicate how much entrepreneurs are willing to pay for the right to sell a brand-name product. Related to Exercises 2.4 and 2.5.

OPENING A DUNKIN' DONUTS SHOP

s1a.1111111.11a91-------------------

'( ~

__ 1_8.;;.._4 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

A FIGURE 8.4 Monopolistic Competition versus Perfect Competition (A) In a perfectly competitive market, the firm-specific demand curve is horizontal at the market price, and marginal revenue equals price. In equilibrium, price= marginal cost= average cost. The equilibrium occurs at the minimum of the average-cost curve. (B) In a monopolistically competitive market, the firm-specific demand curve is negatively sloped and marginal revenue is less than price. In equilibrium, marginal revenue equals marginal cost (point b) and price equals average cost (point c).

Quantity produced 0

1 Marginal revenue

Q, Quantity produced

0

Product differentiation is what makes monopolistic competition cl1ferent from perfect competition. Perfectly competitive firms produce homogeneous products, while monopolistically competitive firms produce differentiated products. Panel A of Figure 8.4 shows the equilibrium for a perfectly competitive firm. Each price.,taking firm has a horizontal demand curve. Point a shows the long-run equilibrium because the typical firm (I) satisfies the marginal principle, choosing the quantity where marginal revenue equals marginal cost, and (2) earns zero economic profit because price equals average cost:

price = marginal cost= average cost

The only place where price equals both marginal cost and average cost is the minimum point of the average-cost curve, shown by point a.

Monopolistic Competition versus Perteet 0ompetition

What are the trade-offs 'hen products a.re differentiated by location? When firms sell tl1e same product at different laca.tfo.ns, the larger the number of firms, the higher the average cost of production. But when firms are numerous, consumers travel shorter dis- tances to get the product. Therefore, higher production costs are at least partly offset by lower travel costs. If a large metropolitan area Aad onLy o e bookstore, the average cost of books would be lower, but consumers would spend more time traveling to get the books.

c variety of designs, so the higher average cost is at least partly offset by greater product variety. Here are two other examples of the benefits of product variety:

• Restaurant meals. The typical large city has dozens ofltalian restaurants, ea.ch of which has a different menu and prepares its food in different ways. Consumers can pick from restaurants offering a wide variety of menus and preparation techniques. Although a city with a single Italian restaurant would have a lower average cost of preparing Italian meals, consumers would get less variety.

•Shoes and clothing. Shoes are differentiated according to their style and performance, If we all wore the same type of shoes, the average cost of producing shoes would be lower, but consumers would be unable to match their shoe preferences with suitable shoes. Similarly, if we all wore uniforms, the average cost of clothing would'lee lower, but that would eliminate doming choice.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1...;;.8...;.5 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

We've seen that product differentiation is a key feature of monopolistic competition. A firm can use advertising to inform consumers about the features of.its product and thus distinguish its product from the products of other firms. In addition, advertisements

- Advertising for Product Differentiation

Panel B shows the equilibrium for a monopolistically rnmpeti.,cive firm. The firm has a differentiated product, so its demand curve is negatively sloped and marginal revenue is less than the price. With a negatively sloped demand curve, the zero-profit condition-price equals average cost-will be satisfied along the negatively sloped portion of the average-cost curve. In other words, the only place where a tangency can occur is along the negatively sloped portion of the average-cost curve. Compared to a perfectly competitive firm, a monopolistically competitive firm produces less output at a higher average cost. In Figure 8.4, the average cost for the monopolistically competitive firm is P2, compared to P1 for a perfectly competitive firm.

To illustrate the difference between the two market structures, imagine that product differentiation diminishes. Suppose, for example, that consumers decide that the distinguishing features of toothbrushes-color, shape, and bristle design-don't matter. As a result, the products of competing firms will become better substitutes, so the demand for a particular firm's product will become more elastic. In Panel B of Figure 8.4 the firm-specific demand curve will become flatter and will be tangent to the average-cost curve at a larger quantity, closer to the perfectly competitive quantity Q1. As differentiation continues to diminish, the firm's demand curve will become flatter and flatter, and we will get closer and closer to the perfectly competitive out- come, where the average cost reaches its minimum.

SOURCE: Based on Mark Fisher, "Happy Hour Economics, or klpw an Increase in Demand Can Produce a Decrease in Price," Economic Reuiem; Fedeml Reserve Bank of Atlanta (Second Qu:iiter1005), pp. 25~34.

APPLYING THE CONCEPTS #3: How does monopolistic competition compare to perfect competition?

Consider the phenomenon of "happy hour." Many bars and restaurants near work- places face an increase in demand for food and drink around 5:00 p.m., and many cut their prices for an hour or two. According to the model of perfect competition, an increase in demand will lead to higher, not lower prices. What explains the happy- hour combination of higher demand and lower prices?

Bars are subject to monopolistic competition. Each bar has a local monopoly within its neighborhood, but faces competition from other bars outside its neighborhood. For fill in div' dual consumer, the higher the demand for food and drink, the greater the incen- tive to.consider alternatives to the nearest bar. Hyou expect to purchase large quantities of bar fQ.od and drink, the savings achieved by finding a lower price at an alternative bar will be relatively large. In other words, when individual demand increases, each bar faces a more elastic demand for its products. In a market subject to monopolistic competition, the bar's rational response to more elastic demand (more sensitive consumers) is to decrease its price. In graffihipl terms, the demand curve facing each bar becomes flatter, and the demand curve will 'be tangent to the average-cost curve at a larger quantity and a lower price and average cost. Related to Exercise 3.6.

HAPPY HOUR PRICING

__ 1_8.;;....;.6 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

HHI = 102 x 10 = 100 x 10 = 1,000 According to the guidelines established by the U.S. Department of]ustice in 1992, a market is "uoconceotrated" if the HHI is below 1,000 and "highly concentrated" if it is above 1,800. For example, a market with five firms, each with a 20 percent market share, has an HBI of 2,000 and would be considered highly concentrated:

HHI = 202 x 5 = 400 x 5 = 2,000

In contrast, for a market with I 0 firms, each with a I 0 percent market share, the HHI is 1,000:

In an oligopoly, a few firms have market power-the power to control prices. Economists use concentration ratios to measure tbe degree of ctmceutration in a market, computed as the percentage of the market output produced by the largest firms. For example, a four-firm concentration ratio is the percentage of total output in a market produced by the four largest firms. In Table 8.3, the four-firm concentration ratio for house slippers is 97 percent, indicating that the largest four firms produce 97 percent of house slippers in the United States.

An alternative measure of market concentration is the Herfindabl-Hirsclrman Index (HHI). It is calculated by squaring the market share of each firm in the market and then summing the resulting numbers. For example, consider a market with two firms, one with a 60 percent market share and a second with a 40 percent share. The HHI for the market is 5,200:

HHI = 602 + 402 = 3,600 + 1,600 = 5,200

- Oligopoly and Pricing

SOURCE: Based on Maeianue Bertrand, itt;}ell.n Karlan, Sendhil Mullainathau, Edda- Shafir, Jonathan Zinman, "What's Advertising Content Worth? Evidence from a Consumer Credit Nlarkccing Field Experiment," Quarterly Journal of Economics 125 (2010), pp. 263-306.

APPLYING THE CONCEPT #4: How does advertising affect consumer choices?

A South African consumer lender decided to use a mass mailing of 53,000 loan offers to test the sensitivity of consumers to variations in interest rates and other features ofloan offers. The interest rates in the offer letters ranged from 3.75% to 11.75% per month. As expected, the uptake rate (the number of consumers who accepted a particular loan offer) was higher for offer letters with low interest rates. The elasticity of the uptake rate with respect to the interest rate was -0.34: a 10% decrease in the interest rate (from say an interest rate of 7 .0% to 6.3 % ) increased the uptake rate by 3 .4%.

More surprising was the finding that the uptake rate among men was much higher wheu the offer letter included a picture of a woman rather than a picture of a man. Replacing a fale model with a female model was equivalent to cutting the interest rate by 25 percent, for example, from 7.0 percent to 5.25 percent. In contrast, the uptake rate for women consumers was unaffected by the gender of the model. Related to Exercises 4.4 and 4.5,

PICTURE OF MAN VERSUS PICTURE OF WOMAN

915.111;111.;;w 111-------------------

concentration ratios The percentage of the marker output produced by the largest firms.

oligopoly A market served by a few firms.

__ 1_8.;....;;.8 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

One of the virtues of a market economy is that firms compete with one another for customers, and this leads to lower prices and larger quantities. But in some markets, firms cooperate instead of competing with one another. Eighteenth-century economist Adam Smith recognized! the possibility that firms would conspire to raise prices: "People of the same trade seldom meet togetber, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."? We'll see that raising prices is not simply a matter of firms getting together and agreein.g on higher prices. An agreement to raise prices is likely to break down unless the firms find some way to punish a firm that violates the agreement.

Cartel Pricing and the Duopolists' Dilemma

2 Economies of scale in production. A~ we saw in Chapter 2 5, a natural monopoly occurs when there are relatively large economies of scale in production, so a single firm produces for the entire market. In some cases, scale economies are not large enough to generate a natural monopoly, but are large enough to generate a natural oligopoly, with a few firms serving the entire market.

3 Advertising campaigns. In some markets, a firm cannot enter a market without a substantial investment in an advertising campaign. For example, the breakfast- cereal oligopoly results from the huge advertising campaigns required to get a foothold in the market. As in the case of economies of scale in production, just a few firms will enter the market.

1 Government barriers to entry. As we saw in Chapters 21 and 2 5, the government may limit the number of firms in a market by issuing patents or controlling the number of business licenses.

An oligopoly-a market with just a few firms-occurs for three reasons:

SOURCE: U.S. Bureau of the Census, 2002 Economic Census, Manufacturing, Concentratfop f,jali@s; 2002 (Washington, D.C.: U.S. Government Printing Office, 2006).

Primary battery manufacturing

Beet sugar processing

Household refriqerators and freezers Small arms (weapons)

Breakfast cereals Motor vehicles.and ear bodies

Flavoring syrup

Eleetric lamp bulbs

Military vehicles

Four-Firm Concentration Eight-Firm Concentration Ratio(%) Ratio(%)

99 Not available 97 99 96 99 95 99 95 99 93 Not available 91 94 89 90 88 93

v 87 99 85 98 85 95 84 90 82 93 81 91

Not available 89

Industry

Primary copper smelting House slippers

Guided· [Tlissiles and space vehicles

Cigarettes

Soybean processing

Household laundry equipment Breweries

TABLE 8.3 Concentration Ratios m Selected Manufacturing Industries

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1..;;.8...;;.9 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

game tree A graphical representation of the consequences of different actions in a strategic setting.

<11FIGURE8.6 Competing Duopolists Pick a Lower Price (A) ll1e typical firm maximizes profit at point a, where marginal revenue equals marginal cost. The firm has 40 passengers. (B) At the market level, the duopoly outcome is shown by point d, with a price of $300 and 80 passengers. The cartel outcome, shown by point c, has a higher price and a smaller total quantity.

Clearly, each firm will earn more profit under a price-fixing cartel, but will a cartel succeed, or will firms cheat on a cartel agreement? We can answer this question with the help of a game tree, a graphical representation of the consequences of different actions in a strategic setting. Each firm must choose a price for airline tickets, either the high price (the $400 cartel price) or the low price (the duopoly price of $300). Each furn can use the game tree to pick a price, knowing that the other firm is picking a price too.

Figure 8.7 shows the game tree for the price-fixing game. Let's call the managers of the airlines Jack and jill. The game tree has three components:

• The squares are decision nodes. Each square has a player CT ack or Jill) and a list of tbe player's possible actions. For example, the game starts at square A, where Jill has two options: high price or low price.

• The arrows show the possible paths of the game from left to right. Jill. chooses her price first, so we move from square A to one of Jack's decision nodes, either square B or square C. If Jill chooses the high price, we move from square A to square B. Once we reach one of Jack's decision nodes, he chooses a price- high or low-and then we move to one of the rectangles. For example, if Jack chooses the high price too, we move from square B to rectangle L

• The rectangles show the profits for the two firms. When we reach a rectangle, the game is over, and the players receive the profits shown in the rectangle. There is a profit rectangle for each of the four possible outcomes of the price- fixing game.

Price Fixing and the Game Tree

Panel A in Figure 8.6 shows the quantity and price choice of an individual firm. Given the firm-specific demand curve and marginal-revenue cu~e', the marginal principle is satisfied at point a, where marginal revenue equals marginal cost. The firm has 40 passengers at a price of $300 (point b). The two firms are identical, so each. has 40 passengers at a price of $300. Given an average cost of $100, each firm earns a profit of $8,000:

profit = (price - average cost) X quantity per firm = (300 - 100) X 40 = 8,000

(B~Market (A) Individual Firm

80 60 Passengers per day

- Marginal

, reveo efor : typical duopolist

40 Passengers per day

100

' - - - - - - - -- -- - - -- - - - - - - -- - - -·- - - -- - --- - 300

Demand for typical duopolist $400

Market demand

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1-'-9_1 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Nash equilibrium An outcome of a game in which each player is doing the best he or sbe can, given the action of the other players.

duop?lists' dilemma A situation in which both firms in a marker-would be better off if both chose tbc high priec, but each chooses the low price. '

dominant strategy An action that is the best choice for a player, no matter what the other player does.

We have used a game tree to find the equilibrium in a price-fixing game. It is an equilibrium in the sense that each player (firm) is doing the best he or she can, given the actions of another player. The label for such an equilibrium is Nash equilibrium. This concept is named after John Nash, the recipient of the 1994 Nobel Prize in economics, who developed his equilibrium concept as a 21-year-old graduate student at Princeton University. Nash's life story, which includes a 25-year bout with schizophrenia and a dramatic recovery, is chronicled in the book A Beautiful Mind, later made into a movie starring Russell Crowe as Nash.6

In the Nash equilibrium for the price-fixing game, both firms pick the low price. Each firm is doing the best it can, given the action of the other firm:

• If Jill picks the low price, Jack's best action is to pick the low price. • If Jack picks the low price, Jill's best action is to pick the low price.

What about the other potential outcomes? Consider first the possibility that both firms pick the high price. This is not a Nash equilibrium because neither firm is doing the best it can, given the action of the other firm:

• If Jill picks the high price, Jack's best action is to pick the low price. • If Jack picks the high price, Jill's best action is to pick the low price.

Nash Equilibrium

We can predict the equilibrium of the price-fixing game by a process of elimination. We'll eliminate the rectangles that would require one or both firms to act irrationally, leaving us with the rectangle showing the equilibrium of the game:

• If Jill chooses the high price, we'll move along the upper branches of the tree and eventually reach rectangle 1 or 2, depending on what Jack does. Although Jill would like Jack to choose the high price too, this would be irrational for JacK. He can earn $12,000 profit by choosing the low price, compared to $9,000 with the high price. Therefore, we can eliminate rectangle 1.

• If Jill ch(<Joses die low price, we'll move along the lower branches of the tree and eventualfy reacl1 rectangle 3 or 4, depending on Jack's choice. Jack won't choose the high pricl bec~use he can earn $8,000 with the low price, compared to $3,000 with the highprice. Therefore, we can eliminate rectangle 3.

We've eliminated the two profit redangks that represent a high price for Jack- rectangles l and 3. For Jack, the low price is a dominant strategy: Regardless of what Jill does,Jack's best choice is the low price.

Two profit rectangles are left-2 and 4-and Jill's action will determine which rectangle is the equilibrium. Jill knows Jack will choose the low price regardless of what she does. She could choose the high price and allew J~k to capture most of the market, leaving her with a profit of only $3,000 in rectangle 2. I\ better choice is to pick the low price and get a profit of $8,000 in rectangle 4. In oilier W.ords, it would be irrational for Jill to allow herself to be underpriced, so the outcome of the game is shown by profit rectangle 4: Each player chooses the low price. The thick arrows show the equilibrium path of the game, from square A to square C to rectangle 4.

Both firms will be unhappy with this equilibrium because each could earn a lii:gj1er profit with rectangle 1. To get there, however, each firm must choose the high price. The duopolists' dilemma is that although both firms would be better off if they both chose the high price, each firm chooses the low price. The dilemma occurs because there is a big payoff from underpricing the other firm and a big penalty from being underpriced, so both firms pick the low price. As we'll see later in the chapter, to avoid the dilemma, the firms must find some way to prevent underpricing.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1.,;,.9-'3 __

Equilibrium of the Price-Fixing Game

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Jill's low-price guarantee is a credible promise because she announces it in the newspaper.

The duopolists' dilemma occurs because the payoff from underpricing the other firm is too lucrative to miss. To eliminate the possibility of underpricing, one firm can guarantee it will match a lower price of a competitor. Suppose Jill places the following advertisement in the local newspaper:

If you buy an airline ticket from me and then discover that Jack offers the same trip at a lower price, I will pay you the price difference. Ifl charge you $400 and Jack's price is only $300, I will pay you $100.

Low-Price Guarantees

- Overcoming the Duopolists' Dilemma The duopolists' dilemma occurs because die two firms are unable to coordinate their pricing decisions and act as one. Each firm has an incentive to unclerprice the other because the low-price firm will capture a larger share of the market and earn a larger profit. Firms can avoid the dilemma in two ways: low-price guarantees and repetition of the pricing game, with retaliation for underpricing.

Consider next the possibility that Jill picks the low price and Jack picks the high price. This is not a Nash equilibrium becauseJack is not doing die best he can, give11 Jill's choice:

•If Jill picks the low price,Jack's best acfion is to pick the low price.

The concept of the Nash equilibrium has been applied to.a wide variety of decisions. Analysts have used it to study the nuclear arms race, terrerisrn; evolutionary biology, art auctions, environmental policy, and urban development. Later=in the chapter, we will use it to predict the outcomes of games of entry deterrence and advertising.

SOURCE: Based on Margaret Levenstein, "Mass Production Conquers the Pool: Finn Organization and the .Natuce of Competition in the 'Ninercerith Ccnru~," The Journal ef£:onomic History 55 (1995)1 pp. 575-611.

APPL YING THE CONCEPTS #5: Why do cartels sometimes fail to keep prices high?

At the beginning of the nineteenth century, high overland transportation costs protected salt producers from competition with one another, generating local salt monopolies. Over the course of the nineteenth century, decreases i.n overland transportation costs increased competition between salt producers and decreased prices. In response to the increased competition, salt producers colluded by forming salt pools, enterprises that set a uniform price and distributed the salt of all participating producers. Some pools established output quotas or paid firms not to produce salt for a year, a practice known as "dead-renting" a salt furnace. Every salt pool eventually broke down, usually within a year or-two of its formation. In some cases, .individual firms cheated on the cartel by selling salt outside the cartel. In other cases the artificially high price caused new firms to enter dm market and underprice the salt pool. Related to Exercise 5.9.

FAILURE OF THE SALT CARTEL

low-price guarantee A promise to match a lower price of a competitor.

__ 1_9"'--4 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

.._ FIGURE8.9 A Tit-for-Tat Pricing Strategy Under tit-for-tat retaliation, the first firm (Jill, the square) chooses whatever price the second firm (Jack, the circle) chose the preceding month.

Month 5 Cartel Underpricing Duopoly Cartel

4 Underpricing

3 2

(].) o ~ 300

! ~· [j.

I • J

$400

Repeated Pricing Games with Retaliation for Underpricing Up to this point, we've assumed the price-fixing game is played only once. Each firm chooses a price and keeps it for the lifetime of the firm. What happens when two firms play the game repeatedly, picking prices over an extended period of time? We'll see that repetition makes price fixing more likely because firms can punish a firm that cheats on a pr.ice-fixing agreement, whether it's formal or informal.

1 A duopoly pricing strategy. Jill chooses the lower duopoly price for the remaining lifetime of her firm. Once Jill is underpriced, she abandons the idea of cartel pricing and accepts the duopoly outcome, which is less profitable than the cartel outcoms but more profitable than being underpriced by the other firm.

2 A grim-f]igger strategy. When Jack underprices Jill, she responds by dropping her price to a level at which each firm will make zero economic profit. This is called the grim-trigger strategy because grim consequences are triggered by Jack's underpricing.

3 A tit-for-tat strategy. Starring in the second month, Jill chooses whatever price Jack chose the preceding montJt. Th.is is the tit-for-tat strategy-one film chooses whatever price the otlie( firm chose in the preceding period. As long as Jack chooses the cartel price, the cartel arrangement will persist. But if Jack underprices Jill, the cartel will break down. Figure 8. 9 shows how a tit-for-tat system wOPk~.'Ja,ek.underpricesJill in the second

month, so Jill chooses the low price for the third mmnth, resulting in the duopoly outcome. To restore the cartel outcome, Jack must eventually ehoose the high price, allowing Jill to underprice him for one month. This happens 1p the fourth month, and the cartel is restored in the fifth month. Although Jack can gain at Jill's expense in the second month, if he wants to restore cartel pricing, he must allow her to gain at his expense during some other month. Under a tit-for-tat strategy, a duopolist does exactly what his or her rival did the last round. This encourages firms to cooperate rather than compete. Several studies have shown that a tit-for-tat strategy is the most effective strategy to promote cooperation.7

fact, Jill doesn't have to worry about giving refunds because Jack will also choose the high price. In other words, the promise to issue refunds is an empty promise. Although consumers might think that a low-price guarantee will protect them from high prices, it means they are more likely to pay the high price.

grim-trigger strategy A strntegy where a firm responds to underpricing by choosing a price so low that each firm makes zero economic profit.

tit-for-tat strategy A strategy where one firm chooses whatever price the other firm chose in the preceding period.

__ 1_9""-'-6 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

price leadership A system under which one firm in an oligopoly takes the lead in setting prices.

Because explicit price fixing is illegal, firms sometimes rely on implicit pricing agreements to fix prices at the monopoly level. Under the model of price leadership, one of the oligopolists plays the role of price leader. The leading firm picks a price, and other firms match the price. Such an agreement allows firms to cooperate without actually discussing their pricing strategies.

Price Leadership

Price Fixing and the Law Under the Sherman Antitrust Act of 1890 and subse~uent legislation, explicit price fixing is illegal. It is illegal for firms to discuss pricing srrategies or methods of punishing a firm that underprices other firms. In one of the early ~ce-fixing cases (Addyston Pipe, 1899), six manufacturers of cast-iron pipe met to ~x pi;ices. Several months after the Supreme Court ruled that their cartel pricing was illegal, the firms merged into a single firm, so instead of acting like a monopolist, they became a monopolist. Here are some other examples of price fixing:

Electric generaton (1961). Executives from General Electric and Westinghouse were convicted of fixing prices for electrical generators, resulting in fines of over $2 million and imprisonment or probation for 30 corporate executives.

2 Carton-board pricing in Europe (1994). The European Union Commission fined 19 manufacturers of carton board a total of 132 million euros ($165 million) for operating a cartel that fixed prices at secret meetings in luxury Zurich hotels.

3 Food additives (1996). An employee of Archer Daniels Midland (ADM), a huge food company, provided audio and videotapes of ADM executives conspiring to fix prices. ADM pleaded guilty to the charges of price fixing and was fined $100 million.

4 Music distribution (2000). In exchange for advertising subsidies, music retailers agreed to adhere to the minimum advertised prices (MAP) specified by distributors. Any retailer that advertised a CD for less than the MAP would lose all of its "cooperative advertising" funds from the distributor. In May 2000, the Federal Trade Commission reached an agreement with music distributors to end the MAP scheme. The FTC estimated that the MAP scheme imposed an annual cost of $160 million on U.S. music consumers.8

5 Industrial diamonds (2004). DeBeers, the world's largest diamond producer, plead guilty to conspiring with General Electric to fix the price of industrial diamonds, and paid a fine ofSt O million.

These three pricing schemes promote cartel pricing by penalizing the firm that underprices the other firm. To decide whether to underprice Jill,Jack must weigh the short-term benefit against the long-term cost:

• The short-term benefit is the increase in profit in the current period. If Jack

C underprices Jill, he can increase his profit from the cartel profit of $9,000 to the $12,000 earned by a firm that underprices the other firm. Therefore, the short- tei;m benefit of underpricing is $3 ,000.

• Th~long-term cost is the loss of profit in later periods.Jill will respond to Jack's undei;~ing by cutting her price, and this decreases Jack's profit. For example, ifJill retali'ates with the duopoly price, Jack's future profit will be $8,000 per day instead of the;,$9,00D he could have earned by going along with the cartel price. The cost of l111deupri<iing1s the daily loss of $1,000 in profit.

'- 1 If the two firms expect to sha-re th'e'Inarket for a long time, the long-term cost of underpricing will exceed the short-term benefit, so underpricing is less likely. The threat of punishment makes it easier to resist the temptation to cheat on the cartel.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1.,;,.9,,,;.7 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Vl e've seen what happens when two duopolists try to act as one, fixing the price at the monopoly level. Consider next how a monopolist might try to prevent a second firm from entering its market. We will use some of the numbers from our airline example, although we will look at a different city with a different cast of characters.

Suppose Mona initially has a secure monopoly in the market for air travel between two cities. When there is no threat of entry, Mona uses the marginal principle (marginal revenue equals marginal cost) to pick a quantity and a price. In Figure 8.10, we start at point con the market demand curve, with a quantity of 60 passengers per day and a price of $400 per passenger. Her profit is $18,000:

profit = (price - average cost) X quantity per firm = (400 - 100) X 60 = 18,000

- The Insecure Monopolist and Entry Deterrence

The problem with an implicit pricing agreement is that it relies on indirect signals that are often garbled and misinterpreted. Suppose two firms have cooperated for several years, both sticking to the cartel price. When one. firm suddenly drops its price, the otber firm could interpret the price cut in one of two ways:

• A change in market conditions. Perhaps the first firm otisctrv.ed a change in demand or production cost and decides that both firms would benefit from a lower price.

• Underpricing. Perhaps the first firm is trying to increase its market share and profit at the expense of the second firm.

The first interpretation would probably cause the second firm to match the lower price of the first firm, and price fixing would continue at the lower price. In contrast, the second interpretation could trigger a price war, undermining the price-fixing agreement.

SOURCE: Maria Arbatskaya, Morten Hviid, Gr.cg Shaffer, "Promises to Match or Be<IC the Competition," Advances in AppliedNlicroecnmnuic'i 8 (1999), pp. 123-138.

APPL YING THE CONCEPTS #6: Do low-price guarantees generate higher or lower prices?

In two successive months (November and December), a Florida tire retailer listed prices for 35 types of tires in newspaper advertisements. In November the average price was $45, and in December the average price was $55. Tbe December advertise- ment was different in another way: it included a low-price guarantee under which the retailer agreed to match any lower advertised price (and also pay the customer some percentage of the price gap). In fact, for each of the 3 5 types of tires, the December price was the same or higher than the November price. In this case, a low-price guarantee generated higher prices.

I~ the relationship between low-price guarantees and prices apparent or real? A careful stt~y of the retail tire market suggests that prices are generally higher in markets wl~ei;e firms offer low-price guarantees. On average, the presence of a low- price guarantee increases prices by $4 per tire, or about l 0 percent of the price. Related to Exercise 6.5.

LOW-PRICE GUARANTEE INCREASES TIRE PRICES

__ 1_9.;;....;;.8 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

<11 FIGURE 8.10 Deterring Entry with Limit Pricing Point c shows a secure monopoly, point d shows a duopoly, and point z shows the zero-profit outcome. The minimum entry quantity is 20 passengers, so the entry-deterring quantity is 100 (equal to 120 - 20), as shown by point e. The limit price is $200.

The second option is to take actions to prevent the second firm from entering the market. To decide whether to deter the entry of the other firm, Mona must answer two questions:

• What must she do to deter entry? • Given what she must do to deter entry, is deterrence more profitable than being

passive and sharing the market with the second firm?

To prevent the second firm from entering the market, .Mona must commit her- self to serving a large number of passengers. If she commits to a large passenger load, there won't be enough passengers left for a potential entrant to make a profit. Suppose there are economies of scale in providing air travel, and the minimum entry quantity is 20 passengers per day: That is, it would be impractical for a firm to serve fewer than 20 passengers. In Figure 8.10, the long-run average cost curve is negatively sloped for relatively low levels of output, and the average cost for the minimum entry quantity of 20 passengers is just over $100, say $101.

Mona must compute the quantity of output that is just large enough to prevent the second firm from entering the market. In Figure 8.10, point z shows the point of zero economic profit in the market: If the two firms serve a total of 120 passengers per day and split the market equally, with 60 passengers each, the price ($100) equals average cost, so each firm would earn zero economic profit. The quantity required to prevent the entry of the second firm is computed as follows:

deterring quantity = zero profit quantity - minimum entry quantity 100 = 120 ~ 20

Entry Deterrence and Limit Pricing

If Mona discovers that a second airline is thinking about entering the market, what will she do? Now that her monopoly is insecure, she ha} two options: She can be passive and allow the second airline to enter the market, or she can try to prevent the other firm from entering the market.

The passive approach will lead to the duopoly outcome we saw earlier i.n the chap- ter. In Figure 8.10, if the second firm enters the market, we move downward f(ong the market demand curve from point c to point d. In a duopoly, each firm charges a wide of $300 and serves 40 passengers, half the total quantity demanded at a price of $3a'O. For each duopolist, the daily profit is $8,000:

profit = (price ~ average cost) X quantity per firm = (300 ~ 100) X 40 = 8,000

Passengers per day LOO 110 120 ~o 60 20 0

! Loilg-fcan : average cos f\ ' ' I'

300 -----------------------

$400

Market demand

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _1-'-9-'-9 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

contestable market A market with low entry and exit costs.

limit price The price that is just low enough to deter entry.

limit pricing The strategy of reducing the price to deter entry.

110 = 120 - 10

Although our example shows that entry deterrence is the best strategy for Mona, it won't be the best strategy for all insecure monopolists. The key variable is the mini- mum entry quantity. Suppose that the scale economies in air travel were relatively small, so a second firm could enter the market with as few as 10 passengers. In this case, if Mona commits to serving only 100 passengers, that won't be enough to deter entry: A firm entering with 10 passengers will still make a profit. If the minimum entry quantity is 10 passengers, the entry-deterring quantity rises to 110 passengers:

deterring quantity = zero profit quantity - minimum entry quantity

When Is the Passive Approach Better?

We've seen that an insecure monopolist may cut its price to prevent a second firm from entering the market. The same logic applies to a market that has a few firms but could have many. The mere existence of a monopoly or oligopoly does not necessarily generate high prices and large profits. To protect its market share, an oligopolist may act like a firm in a market with many firms, leading to relatively low prices.

The threat of entry faced by an insecure monopolist underlies the theory of market con testability. A contestable market is a market with low entry and exit costs. The few firms in a contestable market will be threatened constantly by the entry of new firms, so prices and profits will be relatively low. In the extreme case of perfect contestahility, firms can enter and exit a market at zero cost. In this case, the price will be the same as the price that would occur in a competitive market. Although few markets are perfectly contestable, many markets are contestable to a certain degree, and the threat of entry tends to decrease prices and profits.

Entry Deterrence and Contestable Markets

Examples: Aluminum and Campus Bookstores For an exampl~b£limit pricing, consider the Aluminum Company of America (Alcoa). Between 1893 and 19>!'.0, Alcoa had a monopoly on aluminum production in the United States. During this pe,riod, Alcoa kept other firms out of the market by producing a large quantity and keeping 'tsrpdce relatively low. Although a higher price would have generated more profit in th~_b.drt run, the entry of other firms would eventually have reduced Alcoa's profit.

We can apply the notion of enntY, deterrence to your favorite monopoly: your campus bookstore. On most college campuses, other organizations are prohibited, usually by the state government or the college, fret selling textbooks on campus. Internet commerce has given students another optio~n: Order textbooks online and have them shipped by mail, UPS, FedEx, or DHL. Se:veral online booksellers charge less than the campus bookstore, and the growth of Intern el 00ok sales thus threatens the campus bookstore monopoly. If your campus bookstore suCla\:nly feels insecure about its monopoly position, it could cut its prices to prevent online 1i<s>oksellers from capturing too many of its customers. If it does this, you will pay lowefi:f1fices even if you don't patronize the Internet seller.

Mona's entry-deterrence strategy generates a market price of $200, which is less than the $400 price charged by a secure monopolist and less than the $300 price with two competing firms. Mona can keep the second firm out of the market, but only by producing a large quantity and charging a relatively low price. This is known as limit pricing: To prevent a firm from entering the market, the firm reduces its price. The price that is just low enough to prevent entry is known as the limit price.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 _2.,;;,0.,..1 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based ou Robert E. Hall, "Pocenrial Competition, Limit Pricing, and Price Elevation from Exclusionary Con- duct," Chapter 18 in issues in Competition Law and Poliq I (2008, ABA Publishing Chicago), pp. 4 3 3-448.

APPL YING THE CONCEPT #7: How does a monopolist respond to the threat of entry?

Microsoft bas a virtual monopoly in the market for personal-computer operating systems and business software. But there is a constant threat mat another firm will launch competing products, so Microsoft engages in limit pricing to deter entry into its key markets. A recent study revealed some of the numbers behind the insecure monopoly.

1 The pure monopoly price for a software bundle of the Windows operating system and the Office Suite of business tools is about $354, but the actual price (the limit price) is about $143. The estimated cost for a second firm to develop, maintain, and market an alternative software bundle is about $38 billion, and Microsoft's actual price is just low enough to make such an investment unprofitable.

2 The pure monopoly profit would be about $191 billion, while the profit under Microsoft's limit pricing is about $15 3 billion. Although the profit under the entry-deterrence strategy is less than the pure monopoly profit, it is greater than the profit Microsoft would earn if it allowed a second firm to enter the market ($148 bilLion). In other words, entry deterrence is the best strategy. Related to Exercise 7 .8.

MICROSOFT AS AN INSECURE MONOPOLIST

/ 11.1;,;;;;;;;,1,w111-----,..-I------------

(150 - 100) x 110 = 5,500 This is less than the $8,000 profit she could earn by being passive and letting the second firm enter the market. In this case, the minimum entry quantity is relatively small, so the entry-deterring quantity is large and the limit price is low. As a result, sharing a duopoly is more profitable than increasing output and cutting the price to keep the other firm out.

For another example of the passive response to market entry, consider me ballpoint pen, introduced in 1945 by Reynolds International Pen Corporation." For three years Reynolds earned enormous profits producing mis revolutionary product anJ selling it-lpr $12.50, about 16 times the average production cost of $0.80. Then in 1948, Rey1~a~ds stopped producing pens, dropping out of the market entirely. Why? Other producers could easily copy the simple production technology of me ballpoint pen. The limit price was tlrns so low that it was better for Reynolds to charge a high price and squeeze out a1 much profit as possible from a short-lived monopoly while it lasted. By 1948, a total of 1'00 firms had entered the ballpoint market, and the price bad fallen to the average cost \Of pr.oduction, so each firm made zero economic profit.

Mona can commit to serving 110 passengers and thus prevent the second firm from entering the market, but is this the most profitable strategy? A~ shown by pointf in Figure 8.10, the limit price associated with an entry-deterring quantity is $150. Mona's profit from entry deterrence would be $5,500:

profit = (price - average cost) X quantity per firm

__ 2..;..0..;...._2 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Ptinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authotized to use until 10/14/2013. Use beyond the authotized user or valid subsctiption date represents a copy tight violation.

"' FIGURE 8.12 A Natural Monopoly Uses the Marginal Principle to Pick Quantity and Price Because of an indivisible input (the pipe system), the long-run average-cost curve is negatively sloped. The monopolist chooses riOiFlt a, where marginal revenue equals tnarg)nal cost. The firm sells 70 million u,nits of water at a price of $2.70 (point b) and an average cost of $2.1 O (point c). The profit per unit of water is $0.60 (equal to $2.70- $2.10).

What about the long-run marginal cost-the cost of an additional cubic meter of water delivered to a customer-once the system .is built? For each additional unit, a water company incurs a cost for the energy required to pump the unit from the water source to a customer. The pumping cost depends on the distance (horizontal and vertical) from the source to the customer. To simplify matters, we'll assume that the marginal cost is constant at $0.80 per cubic meter.

Mill.ion cubic meters of water

70 0

Monopolist's (market) demand revenue

Long-run marginal cost o.soi--~~~~~~ ... ~~~~~~~~~ ..... ,,._~ ......... ~~

2.10 - --- --- ---

Figure 8.12 shows the long-run acerage-cost curve for water service in a particular city. The curve is negatively sloped and steep, reflecting the large economies of scale that occur because water service requires a costly sylltem of pipes, and the cost is the same whether the firm pipes 70 or 70 million cubic meters of water. As the quantity of water increases, the average cost per unit decreases because the cost of the pipe system is spread over a larger volume of water.

Picking an Output Level

In an earlier chapter, we considered monopolies that resulted from artificial barriers to entry, such as patents and government licenses. In this chapter, we'll look at natural m\0nopolies, which occur when the economies of scale for producing a product are so large that only a single firm can survive. Some examples of natural monopolies are water systems, natural gas distribution, electricity transmission, and cable TV service. It is efficient for ll city to have a single supplier of water service because a second sup- plier would install a second set of water pipes when a single set of pipes would suffice. Similarly, it is effic'rent to have a single set of transmission lines for electricity and a single set of cables for ::rv service.

- Natural Monopoly

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY• CHAPTER 8 '-2-'-0_3 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Million cubic meters of water

70 35 0

Monopolist's (market) demand, 01

' ; Firm-specific demand ' with two firms, D2

' ' j ! - - - - - - - - i- -- -'"i - - - j

' j j

j I

2.10

'I Long-run average cost

If there are no artificial barriers re ent[}], a second firm could enter the water market. What would happen if a second firm entered t e market? In Figure 8. 13, the entry of a second firm would shift the demand curve of the first firm-the former monopo- list-to the left, from D1 to D2: At each price, the.first firm will sell less water because it now shares the market with another firm. For example, at a price of$2.70, a total of 70 million units are sold, or 35 million for each firm ~p9int 4). In general, the larger the number of firms, the lower the demand curve for the 'ty,piQ'a[ ;firm.

Will a Second Firm Enter?

If a single firm-a monopolist-provides water, the firm-specific demand curve is the same as the market demand curve: The market demand curve shows, for each price, the number of units sold by the monopolist. From the firm's perspective, the maJFgilal benefit of a cubic meter of water is the increase in revenue-the marginal revenue. The marginal principle is satisfied at point a, with 70 million cubic meters. The price associated with this quantity is $2. 70 per unit (shown by point b), and the average cost is $2.JD per unit (shown by point c), so the profit per unit is $0.60. The price exceeds the avel'..(lge cost, so the water company will earn a profit.

Increase the level of an activity as long as its marginal benefit exceeds

its marginal cost. Choose the level at which the marginal benefit

equals the marginal cost.

MARGINAL PRINCIPLE

Figure 8.12 shows how to use the cost curves and revenue curves to pick the output level that maximizes profit. Like other firms, the provider of water can use the marg.inal principle.

.,. FIGURE 8.13 Will a Second Firm Enter the Market? The entry of a second firm would shift the demand curve of the typical firm to the left. After entry, the firm's demand curve lies entirely below the lonqrun averaqe cost curve. No matter what price the firm charges, it will lose money. Therefore, a second firm will not enter the market.

__ 2..;..0~4 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

..,. FIGURE 8.14 Regulators Use Average-Cost Pricing to Pick a Monopoly's Quantity and Price Under an average-cost pricing policy, the government chooses the price at which the demand curve intersects the long-run average-cost curve. Regulation decreases the price and increases the quantity.

Mi llion cubic meters of water 150 70 0

Demand ! Marginal revenue

Long-run margi naJ cost 0.801-------'P--------"'"'llr------

1.20

Unregulated monopoly

When a natural monopoly is.inevitable, the government often sets a maximum price that the monopolist can charge consumers. There are many examples of natural monopolies that are subject to maximum prices, Local gove.rnments regulate utilities and firms that provide water, electricity, cable service, and local telephone service. Many state governments use public utility commr sions (PUCs) to regulate the electric power industry.

We can use the water market to explain the effeets of government regulation on a natural monopoly. Suppose the government sets a maximum price for water and requires the water company to serve all consumers who are :willing to pay the maximum price. In other words, the government-not the fmn-pieks a point on the market demand curve. Under an avemge-cost pricing policy, the gevefrfment picks the price at which the market demand curve intersects the monopolist's longt-run average-cost curve. In Figure 8.14, the average-cost curve intersects the demal\c;I curve at point e, with a price of $1.20 per cubic meter. This is much lower than the profit-maximizing price of $2.70. As a result, the total quantity of water demanded is much larger-150 million units compared to 70 million. The purpose of the average- cost pricing policy is to get the lowest feasible price. The water company would lose money at any price less than $1.20, so a lower price isn't feasible.

Price Controls for a Natural Monopoly

Will a second firm enter the market? Notice that the demand curve of the typical firm in a two-firm market lies entirely below the long-run average-cost curve, so there is no quantity at which the price exceeds the average cost of production. No matter what price the typical firm charges, it will lose money. The firm's demand curve lies below the average-cost curve because the average-cost curve is steep, reflecting the large economies of scale for water provision. A second firm-with half tlie rnarket-v-would have a ve1y high average cost and wouldn't be able to charge a price high enough to cover the cost of building the pipe system in the first place. Therefore, the.second firm will not enter the market, so there will be a single firm, a natural monopoly.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY• CHAPTER 8 '-2-'-0_5 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees. The purpose of antitrust policy is to promote competition among firms, which leads to lower prices for consumers.

Two government organizations, the Antitrust Division of the Department of Justice and the Federal Trade Commission, are responsible for initiating actions against individuals or firms that may be violating antitrust laws. The courts have the

- Antitrust Policy

How will this regulatory policy affect the monopolist's production costs? Under average-cost pricing, a change in the monopolist's production cost will have little effect on its profit, because the government will soon adjust the regulated price to keep the price equal to the average cost. The government will increase the regulated price when the monopolist's cost increases and decrease the price when the monopo- list's cost decreases. Because the monopolist has no incentive to cut costs and faces no penalty for higher costs, its costs are likely to creep upward. As average cost increases, the regulated price will too.

SOURCE: J. S .. Hassan, "The Growth and Impact of the British Water Industry in the Nineteenth Century," The Economic History Review 38 (1985), 531-547.

APPL YING THE CONCEPTS #8: What is the rationale for regulating a natural monopoly?

In the middle part of the nineteenth century, the British parliament staged an experiment in private enterprise. In the early part of the century, water was drawn from local rivers, stored in ponds on higher ground, and then distributed by wooden pipes to customers. In most urban areas, this primitive water system was run by local government. The Industrial Revolution caused the rapid growth of urban areas, and local governments lacked explicit powers to borrow money to finance the expansion of their water systems. The policies of Parliament caused many towns and cities to swit<tn o private water companies, and by 1851 about three-6 fths of the urban popu- lati<;m got their water from private companies. There were many problems with the private provisjjm of water, including low pressure that sometimes made firefighting ineffectivehnd water hardness (high mineral content) that damaged industrial boilers and reduced the quality of silk products. The control of the water supply gradually returned to local gove(lil.ments, and by 1891 only one-sixth of the urban population was served by private ~ter companies. In addition to improving water pressure and water softness, the move tb tnuuici~al provision increased total consumption of water and decreased the capital cost per'j1111it of water.

What does the British experience wii:h water privatization tell us? The distribution of water is a natural monopoly, meaning that although a si.ngl.e firm will be profitable, two firms will not. The private water companies established under the policies of Parliament were unregulated natural moncjfolies. As we've seen, an unregulated monopoly is socially inefficient. In this case, the inefficiemcy resulted in a low-quality product (hard water), low service (low pressure), low output (small. quantity of water per capita), and high capital cost. 1f the water monopolies hao been regulated in an efficient manner, the experience with privatization of the water sup,ply might have been different. Related to Exercises 8.5 and 8.9.

PUBLIC VERSUS PRIVATE WATERWORKS

trust An arrangen1ent under which the owners of several companies transfer their decision-making powers to a small group of trustees.

__ 2..;..0"'-'-6 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

merger A process in which two or more firms combine their operations.

A merger occurs when two or more firms combine their operations. A horizontal merger involves two firms producing a similar product, for example, two producers of pet food. A vertical merger involves two firms at different stages of the production process, for example, a sugar refiner and a candy producer. A second type of antitrust policy is to block corporate mergers that would reduce competition and lead to higher prices. We saw in an earlier chapter that as the number of firms in a market increases, competition among firms drives down prices. Because a merger decreases the number of firms in a market, it is likely to lead to higher prices. In 1994, Microsoft tried to purchase Intuit, the maker of Quicken, a personal-finance software package that was a substitute for a similar Microsoft product. The merger would have reduced competi- tion in the personal-finance software market, so the government blocked it.

Of course, the government does not oppose all corporate mergers. One possible benefit from a merger is that the new firm could combine production, marketing, and administrative operations, producing products at a lower average cost. Consumers might reap the rewards in the form of lower prices. In 1997, the Justice Department

Blocking Mergers

One form of autitrust policy is to break up a monopoly into several smaller firms. The labe'l "antitrust" comes from the names of the early conglomerates that the government broke U)h- The classic example is John D. Rockefeller's Standard Oil Trust, which was formed in 1882 when the owners of 40 oil companies empowered nine trustees to make the decisions for all 40 companies. The trust controlled over 90 percent of the market for tefined petroleum products, and the trustees ran it like a monopoly. In 1911, the government' oi;cl'ered its breakup. The Supreme Court found that Rockefeller had used "unnatural methods" to maintain bis monopoly power and drive his rivals out of business. In addition to forming the trust, he coerced railroads to give him special rates for shipping, and he spied on his competitors. The government broke up Standard Oil into 34 separate companies, · reluding the corporate ancestors of Exxon, Mobil, Chevron, and Amoco.

The American Tobacco Company started in 1890 as a 1ne~;ger of several tobacco firms. By 1907, the company had acquired over 200 rival firms and controlled 95 per- cent of the U.S. cigarette market. The Supreme Court found that Ain(l.r.ican Tobacco maintained its monopoly power by driving rivals out of business and agreeing to exclusive contracts with wholesalers that prevented them from purchasing cigarettes from other companies. The court-ordered breakup in 1911 led to new companies, including several of today's big cigarette companies: Reynolds, Liggett and Mej(~i:s, and P. Lorillard.

In 1982, the government broke up American Telephone and Telegraph (AT&T) into seven regional phone companies. AT&T had used its legal monopoly in local telephone service to prevent competition in the markets for long-distance service and communications equipment. After an eight-year legal battle, AT&T agreed to form seven Regional Bell Operating Companies, transforming "Ma Bell" into seven "Baby Bells." The new AT&T was allowed to compete in the market for long-distance service, where .it faced competition from newcomers MCI and Sprint. AT&T was also allowed to operate in the market for communications equipment, where it faced competition from newcomers Mitel and Northern Telecom.

Breaking Up Monopolies

power to impose penalties on the executives found to be in violation of the laws, includ- ing fines and prison sentences. In some cases, the government seeks no penalties but directs the firm to discontinue illegal practices and take other measures to promote competition. We'll explore three types of antitrust policies: breaking up monopolies, blocking mergers, and regulating business practices.

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 """2-'-0-'-7 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

How would a merger affect the incentives to raise prices? After a merger, a sing.le company would earn the profits from both brands (Wonder and Interstate) and pick both prices. Suppose the new company increased the price of Interstate bread to $2.20 but kept the price of Wonder bread at $2.00. The price hike would bring bad news and good news for the new company:

• Bad news: Less profit on Interstate Bread. As shown in columns 3 and 4, the price bike decreases the quantity of Interstate bread from 100 to 70 loaves. Although the profit per loaf increases to $0. 70 (the new price of $2.20 minus the average cost of $1.50), only 70 loaves are sold, so the profit from the brand drops to $49, down from $50. The bad news is the $1 loss of profit on Interstate Bread.

• Good news: More profit on Wonder bread. As shown in columns 1 and 2, the increase in the price of Interstate Bread increases the quantity of Wonder bread sold from 100 to 110 loaves. The profit per loaf is still $0.50 per bread, so the profit on Wonder bread increases to $55, up from $50. The good news is the extra $5 of profit on Wonder bread.

After Merger

6

Total

180

$104

Wonder Brand Interstate Brand

t 2 t 3 4 5 Before After Merger Before After Merger Before Merger Merger Merger

>0 $1.50 $1.50 $1.50 $1.50

Price $2.00 $2.00 $2.00 $2.20 Ouantity 100 110 100 70 200

Profit $ 50 $ 55 $ 50 $ 49 $100

TABLE 8.5 A Merger Increases Prices

In some cases, the governuieitt.allows-a merger to happen but imposes restrictions on the new company. In 1995, Interstate Bakeries, the nation's third-largest wholesale baker, tried to buy Continental Blfug, the maker ofWonder bread. Based on grocery store seamier data, the government concluded nhat Wonder bread is a close substi- tute for Interstate's bread: The demand for 'W0nder> bread increases when the price of lnterstate's bread increases, and vice versa.11 T:l:ie scanner data showed that when Interstate increased its price, many consumers switched to Wonder bread, so their bread money went to Continental .instead oflnterstate. The-sabstitutabiliry of the two brands discouraged Interstate from increasing its prices.

Table 8.5 shows an examp.le of a merger leading to higher. prices and smaller quantities. Let's assume that the average cost per loaf of bread rs $) .50, and this doesn't change with a merger. The situation before the merger is shown in columns 1 and 3: For each brand, the price per loaf of bread is $2.00, the quantity is 100 loaves, and the profit is $50 (the profit $0.50 per Ioaf times 100 loaves).

Merger Remedy for Wonder Bread

Evidence from the companies' pricing data showed that the merger would have allowed S~aplt;s to increase its prices by about 13 percent. According to an FTC study, blocking th<t'mer.gtir saved consumers an estimated $1.1 billion over five years.

direct evidence shows that by eliminating Staples' most significant, and in many markets, only, rival, the merger would allow Staples to increase prices or otherwise maintain prices at an anticompetitive level.

The FTC used this logic to convince the court that the proposed merger of Staples and Office Depot would lead to higher prices. The judge in the case observed that,

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 ""-2-'-0-'-9 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

A Brief History of U.S. Antitrust Policy Table 8.6 provides a brief summary of the history of antitrust policy. The first legisla- tion was the Sherman Antitrust Act of 1890, which made it illegal to monopolize a market or to engage in practices that result in a restraint of trade. Because the act did not specify which practices were illegal, it led to conflicting court rulings.

Many of the ambiguities of the Sherman Act were resolved by the Clayton Act of 1914. The Clayton Act outlawed specific practices that discourage competition, including tie-in sales contracts and price discrimination that reduces competition. The act also outlawed mergers resulting from the purchase of a competitor's stock when such a merger would substantially reduce competition.

The third type of antitrust policy involves the regulation of business practices. As we saw in the previous chapter, price fixing-a cooperative agreement among firms to collude rather than compete-is illegal. Under the law, firms cannot discuss their pricing strategies with their competitors.

The government may intervene when a specific business practice increases market concentration i11 an already concentrated market. A tie-in sale occurs when a busi- ness forces the buyer of one-product to purchase another product. The FTC recently charged a pharmaceutical compa~y with tying the sale of clozapine, an antipsychotic drug, to a blood testing and monitoring system. Another illegal business practice is a cooperative agreement to limit advertising. ~he FTC recently charged a group of auto dealers with restricting comparative <me! discount advertising.

The Robinson-Patman Act prohibits the selling. of products at "unreasonably low prices" with the intent of reducing competition, a p1mctice known as predatory pricing. A firm engages in predatory pricing when it seJ.ls a prndyct at a price below its production costs, with the objective of driving a rival oue ef business. Once the predator's rivals drop out of the market, the firm then charges a monopoly price, well above its production cost. This strategy will be profitable if the firm can charge the monopoly price for a long enough period to offset the losses it experienced while driv- ing its rivals out of business.

But is predatory pricing really practical? Consider a market with two Finns, one of which is determined to have the market to itself. By cutting its price below its cost, the firm can drive its competitor out of business, losing perhaps $10 million in the process. If it increases its price next year, there may he nothing to prevent a new firm from entering the market. If so, it would have to cut its price below its cost again to drive the new firm out. The problem with predatory pricing is that it never ends. The firm must repeatedly lose money to drive out an endless series of competitors.

Regulating Business Practices

In this case, the good news ($5 more profit from Wonder) exceeds the bad news ($1 less profit from Interstate), so the price hike increases the total profit of the merged company. This is shown in columns 5 and 6. Although the total quantity drops, total profit increases by $4. A merger means that the good news from a price hike stays within the larger firm, encouraging that firm to increase prices.

The lesson from this example is that a merger of two firms selling close substitutes may lead to higher prices. That's what the Department of Justice concluded in the case of Interstate Bakeries and Continental Bakery. The govern- ment allowed the merger between the two companies but forced Interstate to sell some of its brands and bakeries. For example, Interstate sold the rights to sell its Weber brand bread to Four-S Baking Company. The idea was to ensure that other companies would be able to compete with the newly merged company.

predatory pricing A firm sells a product at a price below its production cost to drive a rival out of business and then increases the price.

tie-in sale A business practice under which a business requires a consumer of one product to purchase another product.

__ 2.;;._1...;.0 CHAPTER 8 •MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Odey Ashenfelter and Daniel Hosken, "The effects of mergers on consumer prices: Evidence from five selected case studies," i\'llER Werking Poper (2008).

In 1998, Pennzoil Motor Oils purchased Quaker State Motor oils in an acquisition valued at $1 billion. The merger brought together two of the five brands of premium motor oil, with a combined market share of 38% (29% for Pennzoil ancl 9% for Quaker State). The antitrust agencies approved the merger without any modifications. A recent study of the merger concludes that the new company increased the price of the Quaker State products by roughly 5%, but did not change the price of Pennzoil products. The market share of Pennzoil products increased, while the market shares of Quaker State products decreased.

The study also examines the price effects of four other mergers. In three of four cases, the merger increased prices, with price hikes between 3 and 7 percent. The modest price effects might be surprising to (1) people who expect relatively large positive price effects as firms exploit their greater market power and (2) people who expect negative price effects as the firms become more efficient. Related to Exercise 9.5.

APPLYING THE CONCEPTS #9: How does a merger affect prices?

MERGER OF PENNZOIL AND QUAKER STATE

Subsequent legislation clarified and extended antitrust laws. The Robinson- Patman Act of 1936 prohibited predatory pricing. The Celle,t-Kefauver Act of 1950 closed a loophole in the Clayton Act by prohibiting one firm from purchasing another firm's physical assets, such as buildings and equipment, when the acquis'.tion would reduce competition substantially. The Hart-Scott-Rodino Act of 19.SO e te~ed antitrust legislation to proprietorships and partnerships. Before this act, antit~t legislation applied only to corporations.

f-------\.l'c~;C. (/()

Regulation Enacted

Made it illegal to monopolize a market or to engage in practices that result in a restraint of trade.

Outlawed specific practices that discourage competition, including tie-in sales contracts, price diScrimination for the purpose of reducing competition, and stock-purchase mergers that would substantially reduce competition.

Gr.eated a mechanism to enforce antitrust laws.

Prohibited selling products at "unreasonably low prices" with the intent of reducing competition.

Outlawed asset-purchase mergers that would substantially reduce competition.

Extentled antitrust legislation to proprietorships ao,g partnerships.

Law Date Enacted

Sherman Act 1890

H!la~o~ Act 1914

YrJ· Federal Trade Commission Abt 1914 Robinson-Patman Act

I 1936

Geller-Kefauver Act 1950

Hart-Scott-Rodino Act 1980

TABLE 8.6 Key Antitrust l.eqislation

MARKET ENTRY, MONOPOLISTIC COMPETITION, AND OLIGOPOLY • CHAPTER 8 .;_2_1_1 __

1.1 A profit-maximizing firm picks the quantity of output at which equals _

1.2 Arrows up or down: At a finn's current level of output, marginal revenue exceeds the marginal cost. The firm should its output and its price.

1.3 The entry of a second firm shifts the firm-specific demand curve of the first firm to the ----- (left/right).

1.4 Arrows up or down: The entry of a third firm into a market with two original firms the market price, the average production cost, the quantity produced per firm, and profit of each original firm.

- The Effects of Market Entry

by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

1.5 Arrows up or down: Changes in regulatory policy in the 1980s the price of trucking services and the profits of trucking firms.

1.6 Arrows up or down: The entry of a satellite TV firm consumer surplus, in part because the

cable company the quality of service while either price or price by a relatively small amount. (Related to Application 1 on page 181.)

1.7 Bidding for Bookstore Licenses. Paige initially has the only license to operate a bookstore in Bookville. She charges a price of$9 per book, has an average cost of $4 per book, and sells 1,001 books per year. 'When Paige's license expires, the city decides to auction two bookstore licenses to the highest bidders. Suppose the relevant variables (price, average cost, and output

All problems are assignable in MyEconlab. EXERCISES

predatory pricing, p. 210 price fixing, p. 1 go price leadership, p. 1g7 product differentlatlon, p. 181 tie-in sales, p. 21 O tit-for-tat strategy, p. 190

trust, p. 206

limit price, p. 201 limit pricing, p. 201 low-price guarantee, p. 1 g4 merger, p. 207 monopolistic competition, p. 178 Nash equilibrium, p. 193 oligopoly, p. 188

2 In the long-run equilibrium with mohopolistlc competition, marginal revenue equals marginal cost, price equals average cost, and economic profit is zero.

3 A firm can use celebrity endorsements and other costly adver- tisements to signal its belief that a product will be appealing.

4 Each firm in an oligopoly has an incentive to underprice the other firms, so price fixing will be unsuccessful unless firms have some way of enforcing a price-fixing agreement.

5 To prevent a second firm from entering a market, an insecure monopolist may commit itself to producing a relatively large quantity and accepting a relatively low price.

6 Under an average-cost pricing policy, the regulated price for a natural monopoly is equal to the average cost of production.

7 The government uses antitrust policy to break up some dominant firms, prevent some corporate mergers, and regulate business practices that reduce competition.

cartel, p. 190 concentration ratio, p. 188 contestable market, p. 201 dominant strategy, p. 1 g3 duopolists' dilemma, p. 1 g3

duopoly, p. 190 game tree, p. 1g1 grim-trigger strategy, p. 1 g5

KEY TERMS

This chapter is about market entry, monopolistic competition, and oligopoly. In a monopolistically competitive market, firms differentiate their prod- ucts, and entry continues until each firm in the mar- ket makes zero economic

profit. In an oligopoly, a few firms serve a market, and firms have an incentive to act strategically: They may cooperate to fix prices, and may price their products strategically to keep other firms·out of the market. In markets with a small number qi firms, the role of public policy is to regulate monopolists and promote corripetfU,on. Here are the main points of the chapter:

The entry of a firm into a market decreases the ~arket price, decreases output per firm, and increases the average cost of production.

SUMMARY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription a represents a copyright violation.

219

• The experiment has two stages. In the first stage, each potential firm decides whether to enter the market. The entry decision is sequential: The instructor will go down the list of potential firms, one at a time, and give each firm the option of entering the market. The entry decisions are public knowledge. When a firm enters the market, it incurs a fixed costof$14.

• There are 16 potential consumers. Each potential consumer is willing to pay a different amount to have his or her lawn cut. Here is an experiment that shows the implications of entry

for prices and profits. Students play the role of entrepre- neurs who must decide whether to enter the market for lawn cutting. If they decide to enter the market, they must then decide how much to charge for cutting lawns.

• There are eight potential lawn-cutting firms, each represented by one to three students. The firms have two sorts of costs: a fixed cost per day and a marginal cost of cutting each lawn. Each firm can cut up to two lawns per day.

ECON 0 MIC EXPERIMENT )1-------------------- FIXED COSTS AND ENTRY

b. Before the merger, raismg the price would ______ the firm's profit. After the merger, raising the price would the firm's profit.

c. Why is it reasonable to assume that the merger will decrease the elasticity of demand for each firm's products?

9.9 Recovering the Acquisition Cost. The long-run average cost of production is constant at $6 per unit, Suppose firm X acquires Y at a cost of $24 million and increases the price to $14. At the new price, X sells 1.5 million units per year. a. How does the acquisition affect X's annual profit? b. How many years will it take for X to recover the

cost of acquiring Y? 9.10 Check YellowPages.com? On Yelli.n's first day on

the job as an economist with the FTC, she was put on a team examining a proposed merger between the country's second- and fourth-Iargest hardware store chains. Her job was to predict whether a merger would increase hardware prices. Her boss handed her some CDs with checkout scanner data from the second-largest chain. Each CD contained scanner data fo01n one. small town, listing the prices and quantities of harn. · ers, wrenches, nuts, bolts, rakes, glue, drills, and hundreds of other hardware products. Her boss also gave he.r the Web address for YellowPages.com. How can she use the information in the disks and YellowPages.c01~1 rumal{e a,prediction?

9.11 Cost Savings from a Merger. Consider the follow- ing statement from a firm i'hllJ has proposed a merger between two companies: "The two companies could save about $50 million per year by combining our production, marketing, and administrative operations. In other words, we could realize substantial economies of scale. Therefore, the government should allow the merger." In light of the new guidelines concerning mergers, how would you react to this statement?

Total Total Price Quantity Revenue Cost Profit

Initial: $10 100 $1,000 $500 $500 New: $11 Before merger: Elasticity of demand = 3.0 New: $11 After merger: Elasticity of demand = 1 .50

9.4 In the Interstate Baking case discussed in this chapter, scanner data showed that the products of Interstate and Continental Baking were , so a merger would lead to higher _

9.5 Predatory pricing provides a practical and effective means of getting and keeping a monopoly. _____ (True/False)

9.6 The merger of companies with two of the top five brands oii motor oil (Pennzoil and Quaker State) increased the price of one of the brands by roughly ----- percent (1, 5, 20, 50) percent. (Related to Application 9 0~1 p11g~-2l1.)

9.7 Pricing below a com~tor'1>, cost is (legal/illegal). Pricing below your ewn cost is illegal if it is part of a strategy to and then ----- prices.

9.8 Incentive to Raise Prices after a Merger. SuRpose the merger of two firms, Heinz and Beech-Nut, will reduce the price elasticity of demand for each fiRm's product from 3.0 to 1.50. For each firm, the average cost of production ]s constant at $5 per unit. Suppose Heinz initiaUy has a price of $10 and is considering raising the price to $11. a. Fill in the blanks in the following table, showing

the payoffs from raising the price before the merger (elasticity = 3.0) and after the merger (elasticity= 1.50).

221 Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date

represents a copyright violation.

MyEconlab MyEconlab helps you master each objective and study more efficiently.

• Describe the role of taxation In promoting efficient environmental policy.

• Explain the superiority of taxation over traditional regulation.

• Describe the virtues of marketable pollution permits and the factors that determine their price.

• Explain the notion of adverse selection for buyers.

• Discuss the possible responses to adverse selection for buyers.

• Explain the notion of moral hazard. • Define a public good and the free rider

problem. • Use the marginal principle to describe the

optimum level of pollution.

LEARNING OBJECTIVES

"So, why are you selling this used car?" The buyers of'used cars ask this question frequently and then listen carefully to the a1?1swer. Assuming the car seller is honest, the answer the buyer hopes for is "Because I need a different car for my new job," or "I buy a new 'car every three years." The buyer wants to avoid sellers who are trying to get rid of a "lemon" -a car that breaks down frequently and generates large repair bills. People don't ask this sort of question in other markets. for example, no one ever asks, "So, why are you selling this pizza?'""

"Does my insurance policy cover accidental death from bungee jumping?" Life is risky, and people buy insurance to decrease their financial losses from events such as theft, sickness, injury, and death. The qL.Jecstion from the potential bungee jumper reveals an important fact about insurance: It causes people to take greater r,is~ because they know insurance will cover part of the cost of an accident.

Imperfect Information, External Benefits, and External Costs

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

How much is a consumer willing to pay for a used car that could be either a lemon or a plum? To determine a consumer's willingness to pay in a mixed market with both lemons and plums, we must answer three questions:

1 How much is the consumer willing to pay for a plum?

Uninformed Buyers and Knowledgeable Sellers mixed market A market in which goods of different qualities are sold for the same price.

- Adverse Selection for Buyers: The Lemons Problem The classic example of a market with imperfect information is the market for used cars.1 Suppose there are two types of cars, low quality and high quality. A low-quality car, also known as a "lemon," breaks down frequently and has relatively high repair costs. A high-quality car, also known as a "plum," is reliable and has relatively low repair costs. Suppose buyers cannot distinguish between lemons and plums. Although a buyer can get some information about a particular car by looking at the car and taking it for a test drive, the informati on gleaned from this kind of inspection is not enough to determine the quality of the car. In contrast, a person selling a car after owning it for a while knows from experience whether the car is a lemon or a plum. We say there is asymmetric information in a market if one side of the market-e-either buyers or sellers-has better information than the other side. Because buyers cannot distinguish between lemons and plums, there will be a single market for used automo- biles: Borh types of cars will be sold together in this mixed market for the same price.

asynunetric information A situation in which one side of the market-either buyers or sellets=-has better information than the other.

earlier in the book we used the model of demand and supply to show how individual decisions in markets generate equilibrium prices and quantities. Adam Smith used the metaphor of the invisible hand to explain how individuals in markets, each acting in his or her own self-interest may actually promote the interest

C of society as a whole (reference 1): 0 It is not from the benevolence of the butcher, the brewer, or the baker that we expect our , n dinner, but from their regard to their own interest. We address ourselves, not to their NJ,,.~ • humanity bur to their self-love, and never talk to them of our own necessities bur of their Y'J" advantages [Man is] led by an invisible hand to promote an end which was no part of this

r r'f A intention By pursuing his own interest he frequently promotes that of the society more \YI J'f effectually than when he really intends to promote it .... Nobody but a beggar chooses to © depend chiefly upon the benevolence of his fellow citizens.

In th.is chapter we will explore the circumstances under the decisions of individu- ~s do not promote the social interest.

• Imperfect information: One side of the market, buyers or sellers, does not know enough about the product to make informed decisions about whether to buy or sell i.tvln a world of folly informed buyers and sellers, markets oper- ate smoothly, g1merating an equilibrium price and an equilibrium quantity for each good. In a-world with imperfect information, some goods will be sold in very small numbers, _pr rrot sold at all. In addition, buyers and sellers will use resources to acquire infbefrratien to help make better decisions.

• External benefits: The benefits of-a product are not confined to the person who pays for it. For example, if a farmer builds a levee for flood protection, other farmers in the flood plain will benefit from the levee. When there are external benefits, collective decision making will imp~ove efficiency.

• External costs: The cost of producing a pro'Cluct is .not confined to the per- son who sells it. For example, producing electricity from~coal fouls the air and imposes costs on people who suffer from asthma. The. economic approach to are external costs, is to internalize the costs, forcing polluters o pay for pollu- tion in the same way that they pay for raw materials and labor.

__ 2.;;;._2_2 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

In this equilibrium, no plums are bought or sold, so eve1y buyer will get a lemon. People get exactly what they pay for: They are willing to pay $2,000 for a service- able hut low-quality car, and that's what each consumer gets. The domination of the used-car market by lemons is an example of the adverse-selection problem. The uninformed side of the market (buyers in this case) must choose from an undesirable or adverse selection of used cars. The asymmetric information in the market generates a downward spiral of price and quality:

•The presence of low-quality goods on the market pulls down the price consum- ers are willing to pay.

• The decrease in price decreases the number of high-quality goods supplied, decreasing the average quality of goods on the market.

80 20

100 80%

45 0

45 100%

Supply Side of Market Number of lemons supplied Number of glums supplied Total number of used cars supplied Actual chance of getting a lemon

-- ~

$2,000 $2,000 $4,000 $4,QOO

50% 100% 50% 0%

$3,000 $2,000

Demand Si'31e of Market Amount buyer is willing to pay for a lemon Amount buyer is willi~g to pay for a plum Assumed chance of getting a lemon Assumed chance of gelling a plum Amount buyer is willing to pay for a used car in mixed market

Equilibrium: Pessimistic Expectations

Buyer.s Initially, Have 50-50 Expe"iati'ons

TABLE 9 1 Equilibrium with All Low-Quality Goods

Table 9.1 shows two scenarios for our hypothetical used-car market, based on the supply curves shown in Figure 9.1. ln the first column, we assume buyers have 50-50 expectations about the quality of used cars. As we saw earlier, if buyers expect a 50-50 split between lemons and plums, the typical buyer will be willing to pay $3,000 for a used car. From the supply curves in Figure 9.1, we know that at this price 20 plums and 80 lemons will be supplied, so 80 percent of the used cars (80 of 100) will be lemons. In this case, consumers are too optimistic and underestimate the chance of getting a lemon.

The experiences of these 100 consumers show that the actual chance of getting a lemon is 80 percent, not 50 percent as initially assumed. Once future buyers realize this, they will of course become more pessimistic about the used-car market. Suppose they assume that all the used cars on the market will be lemons. Under this assump- tiow,<the typ.ical buyer will be willing to pay only $2,000 (the value of a lemon) for a used cal·;,.As shown in Figure 9.1, tbis price is less than the $2,500 minimum price for supplying plums, so plums will disappear from the used-car market. At a price of $2 ,000, the quantity of plums supplied is zero, but the quantity of lemons supplied is 45 (point c). In other words, all the used cars will be lemons, so consumers' pessimism is justified. Because coi surners' expectations are consistent with their actual experi- ences in the market, die e9_uilibriurn price of used cars is $2 ,000. The equilibrium in the used-car market is showFJ in the second column of Table 9 .1.

Equilibrium with All Low-Quality Goods

adverse-selection problem A situation in which the uninformed side of the market must choose from an unde- sirable or adverse selection of goods.

__ 2.;;;._2_4 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

& FIGURE 9.2 The Market for High-Quality Cars (Plums) Is Thin If buyers are pessimistic and assume that only lemons will be sold, they are willing to pay $2,000 for a used car. At this price, 5 plums are supplied (point a), along with 45 lemons (point b). This is not an equilibrium because 10 percent of consumers get plums, contrary to their expectations. If consumers assume that there is a 25 percent chance of getting a plum, they are willing to pay $2,500 for a used car. At this price, 20 plums are supplied (point c), along with 60 lemons (point d). This is an equilibrium because 25 percent of consumers get plums, consistent with their expectations. Consumer expectations are realized, so the equilibrium is shown by points c and d.

Number of used cars sold per day 60 45 20 0 5

500

t.,i--~---~ ... -~------- Willingness to pay with pessimistic expectations

~ "' $2,500 o ~ Q.) 0. Q) 2,000 u ;t· 1,833

Supply of high-quality S 1 fl 1.1 upp y o · ow-qua 1 y cars (plums) cars (lemons)

Willingness to pay with equilibrium expectations

thin market A market in which some h.igh~quality goods are sold but fewer than would be sold in a market with perfect information.

The d,isap,pearance of plums from our hypothetical used-car market is an extreme case. The plums disappeared from the market because informed plum owners decided to keep their cars rather than sell them at a relatively low price in the used-car market. This outcome would change if the minimum supply price of plums were lower, specif- ically if it were below-$2'1000. In this case, most but not al.I the used cars on the market will be lemons, and some lucky Ji>uyers will get plums. In this case, we say asymmetric information generates a t:hi:h-fuarke~: Some high-quality goods are sold, but fewer than would be sold in a market with i;ierfoct information.

Figure 9.2 shows the situation that leads to a thin market. The minimum sup- ply price for plums is $1,833, and the quantity. of plums supplied increases with the price of used cars. Suppose consumers are initially pessimistic, assuming all cars for sale will be lemons. This means consumers are willing to pay only $2,000 for a used car. Because the minimum supply price for plums GIS!,iS,33) is now less than the willingness to pay for a lemon, some plums will be supplied at=a price of $2,000. In Figure 9.2, 5 plums and 45 lemons are supplied at this price, sq I of_every 10 buyers

A Thin Market: Equilibrium with Some High-Quality Goods

•This decrease in the average quality of goods on the market pulls down the price consumers are willing to pay again.

In the extreme case, the downward spiral continues until all the cars on the market are lemons.

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 '-2-'-2_5 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

The lemons model makes two predictions about markets with asymmetric informa- tion. First, the presence of low-quality goods in a market will at least reduce the num- ber of high-quality goods in the market and may even eliminate them. Second, buyers and sellers will respond to the lemons problem by investing in information and other means of distinguishing between low-quality and high-quality goods. What is the evi- dence for the lemons model?

Studies of the market for used pickup trucks have provided mixed results con- cerning the lemons problem.2 It appears that for trucks less than 10 years old, those sold on the market are just as reliable, on average, as those that remain with their cur- rent owners. These studies provide support for the second implication of the theory of lemons, that people acquire information and develop effective means to deal with the problem of asymmetric information. In contrast, there does seem to be a lemons problem for trucks at least 10 years old, which represent about one-third of transac- tions. Compared to old trucks that remain with their current owners, old trucks that are sold have significantly higher repair costs, with a difference in cost of about 45 percent. Old trucks that a.re sold have a much higher probability of requiring engine and transmission repairs.

Evidence of the Lemons Problem

60 20 80

45 5

§0 90%

Supply Side of Market

Number of lemons supplied Number of plums supplies

Total number of used cars supplied Actual chance of getting a lemon 75%

Initial Pessimistic Equilibrium: 75-25 Expectations Expectations

$2,000 $2,000 $4,000 $4,000

100% 75%

0% 25% $2,000 $2,500

Demand Side of Market

Amount buyer is willing"lo pay fora lemon Amount buyer is willing to pay tori a l'!lucn Assumed chance of gettinlJ a lemon Assumed chance of getting a plum

Amount buyer is willing to pay for a used car ih mixed market

TABLE 9 2 A Thin Market for H1gh-Quahty Goods

will get a plum. In this case, pessimism is not an equilibrium, because some buyers will get plums when they expect lemons. This is also shown in the first column of Table 9.2.

In equilibrium, consumer expectations about the chances of getting the two types of cars are realized. Suppose consumers expect one of every four cars to be a plum. Let's assume each consumer is willing to pay $2,500 for a used car under these circumstances. Consumers are willing to pay a bit more than the value of a lemon because there is a small cha.nee of getting a plum. In Figure 9.2, at this price 20 plums are supplied (point c) and 60 lemons are supplied (point d), so in fact one in four con- sumers actually gets a plum. This is an equilibrium because 2 5 percent of the cars sold are plums and 7 5 percent are lemons, consistent with consumers' expectations. This is also shown in the second column of Table 9.2.

__ 2.;;;._2-'-6 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

In a market with asymmetric information, there are sn·ong incentives for buyers and sellers to solve the lemons problem. In our example of a thin market, the price of a used car is $2,500, but consumers are willing to pay $4,000 for a plum. This $1,500 gap between the willingness to pay for a plum and the price in the mixed market provides an opportunity for mutually beneficial exchange. A person who owns a high-quality

- Responding to the Lemons Problem

SOURCES: Based on Kenneth Lehn, "Information Asymmetries in Baseball's Free Agent .iVla.c±et," Economic Inquiry 22 (lanuary 1984): 37-44; Associated Press, "Free Agents at End of Baseballs Earth," Conmttis Gazette-Times, April .15, 1995.

APPLYING THE CONCEPTS #1: What is adverse selection for buyers?

Professional baseball teams compete with each other for players. After six years of play in the major leagues, a player has the option of becoming a free agent and offering his services to the highest bidder. A player is likely to switch teams if the new team offers him a higher salary than his original team. A puzzling feature of the free-agent market is that pitchers who switch teams are more prone to injuries than pitchers who don't. On average, pitchers who switch teams spend 28 days per season on the disabled list, compared to only 5 days for pitchers who do not switch teams. This doesn't mean that all the switching pitchers are lemons; many are injury-free and are valuable additions to their new teams. But on average, switching pitchers spend five times longer recov- ering from injuries.

This puzzling feature of the free-agent market is explained by asymmetric infor- mation and adverse selection. Because the'coaebh, physicians, and trainers from the player's original team have interacted with the player on a daily basis for several years, they know from experience whether he is likely to suffer from injuries that prevent him from playing. In contrast, the new team has much ie~s information. Its physicians can examine the pitcher, and the team can check league 1<ec0nls to see how long the pitcher has spent on the disabled list, but these measures do not ~iminate the asym- metric information, The original team has several years of daily exilerieD.fe with the pitcher and has better information about the pitcher's physical health.

Now consider the incentives for a team to outbid another team for a pitsHer. Suppose the market price for pitchers is $1 million per year, and a pitcher'wfao fa currently with the Detroit Tigers is offered this salary by another team. If the Tigers think the pitcher is likely to spend a lot of time next season recovering from injuries, they won't try to outbid the other team for the pitcher: They will let the pitcher switch teams. But if the Tigers think the pitcher will be injury-free and productive, he will be worth more than $1 million to them, and they will outbid other teams and keep him. That's why an injury-prone pitcher is more likely to switch teams. As in the used-car market, there are many "lemons'' on the used-pitcher market. The market for baseball players playing other positions does not suffer from adverse selection, perhaps because the injuries that affect their performance are easier for other teams to detect.

Although you may think it's bizarre to compare baseball pitchers to used cars, people in baseball don't think so. They recognize the similarity between the two mar- kets. Jackie Moore, who managed a free-agent camp where teams looking for players can see free agents in action, sounded like a used-car salesman: "We want to get play- ers off the lot. We want to cut a deal. How many camps can you go into where you can look at a player and take him home with you?" Related to Exercises 1. 7, 1.8, and 1.16.

ARE BASEBALL PITCHERS LIKE USED CARS?

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 '-2-'-2 __ 7 __

11.;;1.1111111.1.wml-------------------

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Used-car sellers also have an incentive to solve the lemons problem. If a plum owner persuades a buyer that his or her car is a plum and then sells the car for $4,000 rather than $2,500, the seller's gain is $1,500. Sellers can identify a car as a plum in a sea of lemons by offering one of the following guarantees:

•Money-back guarantees.The seller could promise to refund the $4,000 price if the car turns out to be a lemon. Because the car is in fact a plum-a fact known by the seller-the buyer will not ask for a refund, so both the buyer and the seller will be happy with the transaction.

Guarantees and Lemons Laws

The problem of asymmetric information in consumer goods such as cars also occurs for some types of consumer services4 Most consumers can't easily determine the quality of service they will receive from an auto repair shop, a landscaper, or a plumber. How can a high-quality service p;:pvider distinguish itself from low-qual- ity providers?

Some organizations provide information a1Jo·ut firms that provide consum- ers services such as landscaping, auto repair, and ~home improvement. ValueStar is a consumer guide and business directory that uses customer satisfaction surveys to determine how well a firm does relative to .its competitors iivpro:vid.ing quality service. To earn the right to display a Customer-Rated seal from ValueStar, a firm must prove that it has all the required licenses and insurance and must agree to p~ for a survey of its past customers. ValueStar uses consumer surveys to compute a consumer-sat- isfaction score for each company. Any company receiving a score of at least 85 out of 100 has the right to display a Customer-Rated Gold seal for a one-year period. In New York City, servicemagic.com rates all kinds of contractors and household service providers, with scores based on reports from consumers.

Online consumers help each other by rating online sellers. On eBay, buyers must rely on sellers to honestly disclose the quality of the goods they are auctioning and to promptly ship them once a consumer pays. Buyers help other purchasers distin- guish "good" from "bad" sellers on eBay by rating them online with "stars," indicating their satisfaction with their transactions. The same sort of information is provided by people who buy second-hand books.

Consumer Satisfaction Scores from ValueStar and eBay

Buyers Invest in Information In our model of the thin market, one in four buyers pays $2,500 to get a plum worth $4,000. The more information a buyer has, the greater the chance of picking a plum from the cars in the mixed market. Suppose a buyer gets enough information to iden- tify the plums in a market. The buyer could purchase a plum worth $4,000 at the pre- vailing price of $2,500, generating a gain of $1,500. A buyer can get information about individual cars by taking the car to a mechanic for a careful inspection. In addition, a buyer can get general information about the reliability of different models from maga- zines and the Internet. Consumer Reports publishes information on repair histories of different models and computes a "Trouble" index, scoring each model on a scale of 1 to 5. Bf consulting these information sources, a buyer improves the chances of getting a high-qualio/ car. Another information source is Carfax.corn, which provides infor- mation on individual cars, including their accident histories.

car may not be willing to sell it for $2,500, but might accept something closer to $4,000, an amount a buyer is willing to pay. The challenge is to identify a high-quality car in the mixed market.

__ 2_2..;;.8 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Christopher Ferguson and Hoy Carman, "Kiwifruit and the 'Lemon' Problem: Do Minimum Quality Standards Work?" (working paper, International Food and Agribusiness Management Association, 1999).

APPLYING THE CONCEPTS #2: How can government solve the adverse- selection problem?

Kiwifruit is subject to imperfect information because buyers cannot determine its sweetness-its quality level-by simple inspection. The sweetness level at the time of consumption is determined by the fruit's maturity-its sugar content at the time of harvest. Kiwifruit continues to convert starch into sugar after it is picked, but fruit that is picked early has a low sugar content at harvest time and never tastes sweet. There is asymmetric information because producers know the maturity of the fruit, but fruit wholesalers and grocery stores, who buy fruit at the time of harvest, cannot determine whether a piece of fruit will ultimately be sweet or sour.

Before 1987, kiwifruit from California suffered from the "lemons" problem. Maturity levels of the fruit varied across producers. On average, the sugar content at the time of harvest was below the industry standard, established by kiwifruit from New Zealand. Given the large number of "lemons" among California kiwifruit, gro- cery stores were not willing to pay as much for California fruit. In other words, the preseuce of low-quality (immature) fruit in the mixed market pulled down the price of California fruit. Mature kiwifruit is more costly to produce than immature fruit, and the low price decreased the production of mature fruit. This result is similar to the way low used-car prices decrease the number of high-quality used cars on the market. In general, adverse selection led to low prices and a relatively large volume of low- quality kiwifruit from California.

In 198 7, California producers implemented a federal marketing order to address the lemon-kiwi problem. The federal order specified a minimum maturity standard, and as the average quality of California fruit increased, so did the price. Within a few years, the gap between California and New Zealand prices had decreased signifi- cantly. Related to Exercises 2.3 and 2.6.

REGULATION OF THE CALIFORNIA KIWIFRUIT MARKET

Many states have laws that require automakers to buy back cars that experience frequent problems in the first year of use. For example, under California's Song- B~verly Consumer Warranty Act, also known as the "Lemons Law," auto dealers are required to repurchase vehicles that have been brought back for repair at least four times for the same problem or have been in the mechanic's shop for at least 30 calendar days ill!4tl.1e first year following purchase. A vehicle repurchased under the lemons law mustbe fi ed before it is sold to another customer and must be identi- fied as a lemon with a stamp on the title and a sticker on the car that says "lemons law buyback." One problem with enforcing these laws is that lemons can cross state lines without a paper trail. Tlle interstate commerce in lemons bas led to new laws in some states requiring the branding of lemons on vehicle titles to follow the car when it crosses state lines.

• Warranties and repair guarantees.The seller could promise to cover any extraordinary repair costs for one year. Because the car is a plum, there won't be any extraordinary costs, so both the buyer and the seller will be happy with the transaction.

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 '-2-'-2-'-9 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Insurance companies use various measures to decrease the moral-hazard problem. Many insurance policies have a deductible-a dollar amount that a policy holder must pay before getting compensation from the insurance company. For example, if your car insurance policy has a $500 deductible and the damage from a collision is $900, the insurance company will pay you only $400. You pay the other $500 as your deductible. Deductibles reduce the moral-hazard problem because they shift to the policy holder part of the cost of a claim on the policy. Like a deductible, an insurance copayment shifts part of the cost of risky behavior to policy holders and thus reduces the moral-hazard problem.

Savvy insurance companies anticipate moral hazard. To illnstrate, suppose 1 of 10 bicycles on your campus was stolen in 2008. If you decide to be the first to offer bicycle theft insurance, you might naively assume that the theft rate wouldn't change. But the moral-hazard problem tells us that people with insurance take greater risks, so we'd expect a higher theft rate on a campus where insurance is widespread. Students who buy theft insurance are likely to be less careful in protecting their bikes, perhaps using flimsy locks or no locks at all Or they might start leaving their bikes on campus

Insurance Companies and Moral Hazard

• Will Irma buy a fire extinguisher for her kitchen? If she had to pay for any property damage caused by a fire, she would definitely buy a fire extinguisher. But because her homeowner's insurance covers property damage from fires, she doesn't buy a fire extinguisher.

• Will Harry drive his car carefully? If he had to pay for all repairs resulting from a collision out of his own pocket, he would drive very carefully. But because his auto insurance covers some of the repair costs, he drives fast and recklessly.

• Wjll Flo fly on a commercial airline or hitch a ride with her pilot friend in a four-sear airplane? Traveling in small airplanes is much riskier. H Flo dies in an airrplane crash, her family will lose the income she would otherwise earn. If she didn't have life insurance to offset these income losses, she would he less likely to risk harthing her family by Hying on the small plane instead of the com- mercial airline, But' because she knows her family will collect $1 million in life insurance, she is willing o take the risk.

The risky behavior triggetd:l by insurance is an example of the moral-hazard problem. Moral hazard occurs when one side of an economic relationship takes undesirable or costly actions that the other side of the relationship cannot observe. For example, Irma's insurance company d0{:s11't'Miow whether she has a fire extin- gu.isher. If there is a fire, Irma's hidden action-going without an extinguisher-.is costly for the insurance company. Similarly, Harry's-insurance company doesn't know how fast and recklessly he drives, and insurance encourages him to drive recklessly. His bidden action of reckless driving increases the likelihood cf a <eQstly accident. Just as collision insurance encourages risky driving, life insurance enqm,rages risk)' activi- ties such as flying small airplanes, parachuting, and bungee jumping. SJhilarly, health insurance encourages risky behavior such as smoking, drinking, and unhealthy diets.

moral hazard A situation in which one side of an economic relationship takes undesirable or costly actions that the other side of the relationship cannot observe.

Does insurance affect people's risk-taking behavior? The answer is yes. Insurance causes people to take greater risks because they know part of the cost of an undesir- able outcome will be borne by their insurance companies. Here are some examples of people taking greater risks because they have insurance:

- Insurance and Moral Hazard

__ 2-""3-'--'-0 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based ou.Alma Cohen and Rajeev Dehejia, "Tbc Effect of Automobile Insurance and Accidenr Liabiliry Laws on Tr-Jffic Fatalities," Jonnwi of Law and Economics X1,\llI (2004): 357-393.

The theory of moral hazard suggests that an insured driver, who bears less than the full cost of a collision, will drive less carefully than an uninsured driver. A recent study suggests that the moral-hazard cost of automobile insurance is substantial. When a state makes car insurance compulsory and thus decreases the number of uninsured drivers, roads become more hazardous: The number of collisions and the number of traffic deaths increase. Roads become more dangerous because the newly insured drivers drive less cautiously. The study estimates that a one percentage point decrease in the share of uninsured drivers increases the number of traffic fatalities by 2 percent. Of course, there are benefits associated with compulsory insurance, but in the inter- ests of efficiency, we must compare the benefits to tbe costs, including the increase in fatalities on more hazardous roads. Related to Exercises 3.5 and 3.11.

APPLYING THE CONCEPTS #3: What is moral hazard in car insurance?

CAR INSURANCE AND RISKY DRIVING

For another example of moral hazard, consider the insurance provided for bank tleposits. When you deposit money in a Savings and Loan (S&L), the money doesn't just sit in a vault, The S&L will invest the money, loaning it out and expecting to make a profi when loans are repaid with interest. Unfortunately, some loans are not repaid, and the S&L could lose money and be unable to return your money. To protect people who pu,t their money in S&Ls and other banks, the Federal Deposit Insurance Corpm:atlon ~FDIC) insures the first $250,000 of your deposit, so if the S&L goes bankrupt, you'll srilJ'get your money back. The government enacted the federal deposit insurance l~~ 1933 in response to the bank failures of the Great Depression.

How does deposit insurance affect you and the people who manage the S&L? If you know you'll get your money back no matter what happens to the S&L, )'OU may deposit your money there without evaluating the .eerformance of the S&L and the riskiness of its loans to borrowers and investments in.the stock market. The manager of an S&L will also be more likely to make risky investments knowing that if it doesn't pay off and the S&L goes bankrupt, the federal governmenc will reimburse deposi- tors. Recognizing this moral hazard problem, the federal government has historically limited S&Ls to relatively safe investments.

In the 1980s, the federal government loosened some of the investment restric- tions on S&Ls, and S&L managers began investing in volatile securities, including high-risk commercial mortgages and junk bonds. When these risky investments failed, marry of the S&Ls went into bankruptcy. The government then bailed out the failed S&Ls, at a total cost to taxpayers of about $200 billion.

Deposit Insurance for Savings and Loans

overnight. A savvy insurance company would assume a theft rate higher than 10 per- cent and set its price accordingly.

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 '-2 __ 3_1 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

The dam is an example of a public good. A public gaocl,is available for everyone to utilize, regardless of who pays for it and who doesn't. More, precisely, a public good is nonriua! in consumption: The fact that one person benefits from a good does not prevent another person from benefiting, For example, the fact tnan I benefit from a flood-control dam doesn't reduce your benefit from the clam. Public goods are also nonexcludable. It is impractical to exclude people who don't pay. Some examples of public goods are national defense, law enforcement, space exploration, the preserva- tion of endangered species, the protection of the earth's ozone layer, and fireworks shows. If someone refuses to pay for one of these public goods, it would be impractical to prevent that person from consuming or benefiting from the good.

In contrast with public goods, each unit of a private good is consumed by a single person or household. For example, only one person can eat a hot dog, so it is a pri- vate good. If a government hands out free cheese, is the free cheese a public good or a private good? Although anyone can get in line for the cheese, only one person can actually consume a particular piece of cheese, so the free cheese is a private good that happens to be available free of charge from the government. Similarly, an apartment in a public housing project can be occupied by a single household, so it is a private good provided by the government.

Most public goods are supported by taxes. What would happen if we eliminated taxes and asked people to contribute money to pay for national defense, dams, city streets, and the police? Would people contribute enough money to support these pro- grams at the efficient level? The problem with using voluntary contributions to sup- port public goods is known as the free-rider problem. A free rider is a person who gets the benefit from a good but does not pay for it. Each person has a financial incentive to try to get the benefits of a public good without paying for it. That is, some people wilJ try to get a "free ride" at the expense of others who do pay. Of course, if everyone tries to get a free ride there will be no money to support the public good, so it won't be provided.

Public Goods and the Free-Ri,Qer Problem

For most goods, the benefits of consumption are confined to the person who buys the good. The benefit experienced by a buyer is called a private benefit. In contrast, when someone else benefits from a good, the good generates an external benefit. To illustrate the idea of external benefits and inefficiency, consider a dam built for flood- control purposes. One thousand people would be protected by the clam, and each per- son would get a $50 benefit. If one person builds a dam, the private benefit is $50 and the external benefit is $49,950, or $50 for each of the 999 other people who benefit. If the cost of building the dam is $20,000, no single person will build it because the cost exceeds the $50 private benefit. In other words, if we rely on the forces of supply and demand, with each person considering only the private benefits and costs of the dam, it.won't be built.

When there are external benefits from a good, collective decision making gener- ates mere efficient choices. In the case of the dam, the total benefit of $50,000 exceeds the $20,0eJO cost, so the clam is efficient and society as a whole will be better off if it is built."'T~1e~gove.mment can solve this problem by collecting enough tax revenue to pay for the clam. Suppose the government proposes to collect $20 per person to pay for the clam. The sax raises $20,000 in tax revenue ($20 per person times 1,000 people), which is just 11ig.ll'<enough to pay the $20,000 cost of the clam. Most people will support this proposal beca._use the $20 tax per person is less than the $50 benefit per person. The government can use its taxing power to provide a good that would otherwise not be provided.

- External Benefits and Public Goods

free rider A person who gets the benefit from a good but does not pay for it.

private good A good that is consumed by a single person or household; a good that is rival in consumption and excludable.

public good A good that is available for everyone to consume, regardless of who pays and who doesn't; a good that is nonrival in consumption and nonexcludable,

external benefit A ~en-e~r (rom a good experienced by someone.other tlrnn the person who buys the good.

__ 2-""3-'--2 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

5 3 7

7 Abatement (tons) Discharge (tons)

6 2

0 8

(1

;:; 2,200 ---------- ·~o t;; ~

"' $4,500 0 o 0

Marginal cost of abatement

Consider the effect of a pollution tax on tile market for the product produced by polluting firms. For example, a tax on S02 increases the cost of producing electricity because firms pay for abatement and also pay pollution taxes on any remaining waste they generate. As we saw in an earlier chapter on mark.et ef!Jciency,. a tax shifts the supply curve upward by the amount of the tax, decreasing i:be>eqmhbnum quantity and increasing the equilibrium price.

Consider the effects of pollution taxes on the market for electricity. The produc- tion of electricity generates two major pollutants:

• Sulfur dioxide, Electric power plants are responsible for about two-thirds of S02 emissions. As we saw earlier in the chapter, the marginal damage from S02 is $3,500 per ton, so that's the appropriate pollution tax .

The Market Effects of a Pollution Tax

A poUuting firm will respond to a pollution tax in the same way it responds to the prices of labor and materials. The 6rm will use the marginal principle to decide how much waste to generate and how much to abate. The firm will increase the level of abatement as long as the marginal benefit exceeds the marginal cost and stop when the marginal benefit equals the marginal cost.

Figure 9.5 shows an electricity producer's marginal benefits and costs of abat- ing S02. The marginal cost is $2,200 for the first ton abated (point a), and the mar- ginal cost increases with the level of abatement to $3,500 for the sixth ton abated (point c) and $4,500 for the seventh ton (point d). The marginal cost increases with the amount abated because the firm must use progressively more costly means to cut emissions. From the firm's perspective, the benefit of abating pollution is that it can avoid paying the pollution tax. The marginal benefit of abatement is the $3,SQO, savings in pollution taxes from abating a ton of S02 rather than discharging it> into the air.

'The"'firm satisfies the marginal principle at point c, with six tons of abatement. For the first s.ix tons abated, tbe marginal benefit of abatement-avoiding the $3,500 tax-is greater than or equal to the marginal cost. The firm stops at six tons because the marginal cost of a,b<!,tiJ1g a seventh ton ($4,500, as shown by point d), exceeds the marginal benefit (the $'3,500 tax avoided). Instead of paying $4,500 to abate one more ton, the firm will instead pal-the $3,500 tax.

A Firm 's Response to a Po II u ti on Tax

.,. FIGURE 9.5 The Firm's Response to an 802 Tax From the perspective of a firm subject to a pollution tax, the marginal benefit of abatement is the $3,500 pollution tax that can be avoided by cutting pollution by one ton. The firm satisfies the marginal principle at point c, with six tons of abate- ment, leaving two tons of 802 discharged into the atmosphere.

__ 2.;;..3~8 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

pollution tax: A tax or charge equal to the external cost per unit of pollution.

social cost of production Private cost plus external cost.

external cost of production A cost incurred by someone other than the producer.

private cost of production The production cost borne by a producer, which typically includes the costs of labor, capital, and materials.

- Taxing Pollution The economic approach to pollution is to get producers to pay for the waste they generate, just as they pay for labor, capital, and materials. The costs of labor, capital, and materials are the private cost of production, the cost borne by the producer of the product. The external cost of production is the cost incurred by someone other than the producer, for example, the cost associated with health problems and premature deaths from sulfur dioxide. The social cost of production is the sum of the private cost and the external cost. The idea of a pollution tax equal to the external cost per unit of pollution is to "internalize" the externaliry-s-to make the producer responsible for the external cost of production. When the tax equals the external cost imposed on others, the externality is inter- nalized. In the example of sulfur dioxide pollution, the appropriate pollution tax is the external cost of $3 ,500 per ton.

who owns the lake as Jong as someone owns it. Of course, the assignment of property rights has important equity implications: Whoever owns the lake collects the side pay- ments from the party that doesn't.

Under what circumstances can we rely on Coase bargaining to generate the socially efficient outcome? In our example, bargaining is plausible because there are only two parties. In contrast, if there were several polluting and fishing firms, bargaining among all the affected parties would probably be unwieldy. In general, Cease bargaining requires a small number of affected parties and small transac- tions costs (the costs of arranging side payments). When the number of affected parties is large, the bargaining process won't work, and the solution to a spillover problem requires a centralized policy such as pollution taxes, regulations, or mar- ketable permits.

SOURCE: Based on U.S. Environmental Protection Agency, "U.S. Methane Emissions 1990-2020: Invcnroricg Prajpctions and Opportunities for Reductions,', EPA 430-R-99-0J 3 (September 1999).

APPLYING THE CONCEPTS #5: How do we determine the optimum level of pollLJition?

Methane is one of the greenhouse gases that contribute to global warming. It is releasecl into the atmosphere from landfills, natural gas systems, coal mining, and livestock managelr\t;nt. In this case, abatement of emissions requires methane recov- ery=-capturing the gas before it is released into the atmosphere and then using it to generate heat or elecnricity.):he marginal cost of abatement is less than $10 per ton for the first 36 million metric tons, and increases at an increasing rate, reaching $150 per ton at 69 million metric tons. Ids relatively cheap to recover moderate amounts of methane from landfills and coal mitres and to reduce leaks in the distribution of natu- ral gas. As the volume recovered increases, however, the abatement systems become progressively more expensive. For example, it is relatively cheap to reduce natural-gas leakage by maintaining surface facilities such. as pipelines, but relatively expensive to reduce venting at production sites.

What is the optimal level of methane abatement? .It depends on the marginal benefit of abatement. For example, if the marginal benefit is '10 the optimum level is about 36 million metric tons. But if the marginal benefit is $150, tfie optimum level of abatement is about 69 million metric tons. Related to Exercises 5.6 and 5.4.

REDUCING METHANE EMISSIONS

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 '-2 __ 3_7 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Nicholas Z. Muller and Hobert Mendelsohn, "Efficient Pollution Regulation: Getting the Prices Right," American Economic Reote» 99, no. 5 (2009): 1714-1739.

APPLYING THE CONCEPTS #6: How do pollution taxes vary across space?

A recent study estimates the marginal damages (marginal external cost) for I 0,000 sources of air pollution in the United States. The study reveals substantial spatial variation in the marginal damage from pollution, a result of differences in popula- tion densities around the pollution sources. For example, the marginal damage from S02 is $220 per ton for an electricity-generating unit in rural Oregon, compared to $10,860 per ton for a generator upwind of New York City. The appropriate pollution tax equals the marginal damage from pollution, so the tax on a polluter in an urban area would be much higher than the tax on a rural polluter. One response to a system of efficient pollution taxes would be to shift pollution to less densely populated areas, where damages from pollution are much lower. Related to Exercise 6.6

POLLUTION TAXES IN RURAL AND URBAN AREAS

An ongoing environmental issue is how to respond to the problem of global warm- ing caused by greenlfou9e gases. One approach is to tax carbon-based fuels. A carbon tax of $100 per ton of carbon content would translate into taxes of $0.28 per gallon of gasoline, $12 per barrel of oil, and $70 per ton of coal. The tax on coal would be relatively high because of its hi.gher carbon content.

A carbon tax would reduce greelthouse emissions in several ways:

• The price of gasoline would increase, causing people to drive less and buy more energy-efficient vehicles.

• The tax would increase the price of electricity, decreasing the quantity of elec- tricity demanded and the quantity of fossil fuels burne<;i.

• The higher price of home beating would cause people to mm clown their ther- mostats and improve the heating efficiency of their homes, pe1haps by installing energy-efficient windows or more insulation.

• Some electricity producers would switch from coal to natural gas, which has a lower carbon content, and thus a lower carbon tax. Others would switch to noncarbon energy sources such as wind power, solar power, and geothermal sources.

Example: A Carbon Tax

which is more expensive but reduces their S02 taxes. The share of power generated with low-sulfur coal increases from 0.43 to 0.53. The taxes increase the cost of using coal relative to the cost of using natural gas and nuclear power, so the share of electric- ity from these other sources increases while the share of power from coal decreases. As firms shift to cleaner energy sources, the amount of S02 and NOx emissions per unit of electricity generated decreases.

These pollution taxes decrease the total amount of air pollution for two reasons. First, as shown in Figure 9.6, the increase in the price of electricity decreases the quantity of electricity demanded by 1 percent. Second, as shown in Figure 9.7, the shift to cleaner energy sources means that each unit of electricity generates less pollu- tion. The combined effect of these two changes is a substantial reduction in pollution: S02 decreases to 11 percent of its initial volume, and NOx decreases to 30 percent of its initial volume. An added bonus of the pollution tax is that the government could use, the revenue from the tax to cut other taxes, for example, the payroll tax or the ineome tax.

__ 2..;..4_0 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

A policy of uniform abatement is inefficient because it does not take advantage of the differences in abatement costs between the two firms. In contrast, a pollution tax encourages abatement by the most efficient abaters, When we treat firms equally in terms of the consequences of their pollution (each pays the same tax per ton), "We get an efficient response. The low-cost firm incurs abatement costs to avoid the tax, while the high-cost firm incurs tax costs to avoid costly abatement.

Marginal Uniform Pollution Tax= Abatement Cost Abatement Policy $3,000 per Ton

$2,000 $2,000 $4,000 $5,000 $5,000 $ 0

$7,000 $4,000

Low-Cost Firm High-Cost Firm

Total

Abatement Cost

TABLE 9 3 Uniform Reduction versus Pollution Tax

Uniform Abatement with Permits To illustrate the effects ofregulation, consider an area with two e!ectricity generators, firm L (for low cost) and firm .H (for high cost). Suppose that in the absence of po!Ju- tion-abatement efforts, each firm would discharge two tons of pollution per hour. The government sets a target abatement level of two tons of 502 per hour, diviiled equally between the two firms. Under this uniform abatement policy, the government will issue four poLlution permits to each firm, forcing each firm to cut pollution from two tons to one ton.

Table 9.3 shows the numbers behind the example. Tbe margi.nal abatement cost of firm Lis $2,000 and the marginal abatement cost for firm.His $5,000. Under the uniform-abatement policy, the total cost of abatement is $2,000 for firm L and $5 ,000 for firm H, for a total of $7,000. Suppose instead the government imposes a pollution tax of $3 ,000 per ton. Firm L will respond by abating two tons because the marginal cost of abatement ($2,000) is less than the tax. In contrast, firm H will pay the tax because the marginal cost of abatement ($5 ,000) exceeds the tax. When the low-cost firm does all the abating, the total cost of reducing pollu- tion by two tons is only $4,000.

- Traditional R-egulation Although the economic appr;;"aclito pollution is to get polluters to pay for the waste they generate, governments often tak,e a different approach. Under a traditional regu- lation policy, the government tells each firm how much pollution to abate and what abatement techniques to use.

Carbon taxes have been imposed by governments around the world. In Canada, the province of British Columbia has a revenue-neutral carbon tax of $30 per ton of C02. The revenue raised from the carbon tax is returned to taxpayers through reductions in taxes on personal and business income. Since 2008, per-capita fuel consumption in the province has decreased by 4.5 percent, and citizens use less fuel-and pay lower income taxes-than elsewhere in Canada. According to local observers, the tax bas been good for the environment and taxpayers, and hasn't harmed the economy.' In the U.S., the city of Boulder, Colorado has a tax on carbon emissions from electricity. In Europe, there are carbon taxes in Britain, Finland, and Sweden.

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 ""-2_4_1 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

We've seen that one problem with traditional environmental policy is that it is inflex- ible. It doesn't allow firms to use the most efficient abatement methods available. An example of different abatement strategies comes from advice columnist Abigail Van Buren.4 A person with the moniker "Dreading Winter" sought advice about how to deal with a pollution problem. Her neighbors heated their home with a wood-burning stove, and the smell and smoke from the wood fire gave Dreading Winter burning eyes, a stuffy nose, and painful sinuses. She offered the neighbors $500 to stop burn- ing wood, but they declined the offer. The readers of "Dear Abby" offered the follow- ing suggestions to Dreading Winter:

• Buy the neighbors a catalytic acid-on for the wood stove or a wood-chip gasifier for an oil furnace. In either case, there would be much less air pollution from burning wood.

Lesson from Dear Abby: Opt ions for Pollution Abatement

Market Effects of Pollution Regulations How do the market effects of pollution regulation compare to the effects of a pollu- tion tax? Recall that the uniform abatement poli.cy a,chieves the same reduction in pol- lution at a higher cost because it doesn't exploit Clifferences in abatement costs across firms. In addition, the control part of command and ~ntrnl may lead to relatively costly abatement techniques because there's no incentive to devel<?J) better ones. This will cause the supply curve for the polluting good to shift uprvar.dDlf a larger amount than it would with a tax. A larger supply shift causes a larger increase in the equilib- rium price and a larger reduction in quantity. The inefficiency of regulations is passed on to consumers, who pay higher prices.

One advantage of the command-and-control policy is its predictability. Tbe policy specifies how much waste each firm can produce, so we can predict the total volume of waste. In contrast, we don't know exactly how firms will respond to the pollution tax-they could pollute a little or a lot, depending on the tax and the cost of abating pollution-so it is difficult to predict the total volume of waste that will be emitted.

Traditional regulation policies have another dimension that contributes to higher compliance costs. Under a command-and-control policy, the government requires each firm to produce no more than a certain volume of pollution and requires the

C abatement be done with a particular technology. The problem with this approach is 0 that the mandated abatement technology-the control part of the policy-is unlikely 'X) to be the most efficient technology for two reasons: ~r • •The regulatory policy specifies a single abatement technology for all firms. '/A~ Because the producers of a polluting good often use different materials and pro-

\':::?) duction techniques, an abatement technology that is efficient for one firm may 't be inefficient for others. © • The regulatory policy decreases the incentives to develop more efficient abate- ~ ment technologies. The command part of the policy specifies a maximum vol-

"' urne of waste for each firm, so there is no incentive to cut the volume of waste bet0{v the maximum allowed. In other words, the benefit of developing new techncMgies is relatively small because there is no payoff from using them. In confl.ast, a;ollution tax provides the right incentives: If the firm develops a new technology that cuts pollution, it will pay less in pollution taxes.

A command-and-con rnf policy causes firms to use inefficient abatement technolo- gies, so production costs will be higher than they would be under a pollution tax.

Command and Control

__ 2_4_2 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

marketable pollution permits A system under which the government picks a target pollution level for a par- ticular area, issues just enough pollution permits to meet the pollution target, and allows firms to buy and sell the permits, also known as a cap-and-trade system.

In recent years, policymakers have developed a new approach to environmental policy. The approach uses marketable pollution permits, sometimes called pollution allowances. Here is how a government runs a system of marketable pollution permits:

• Pick a target pollution level for a particular area. • Issue just enough permits to meet the pollution target. • Allow firms to buy and sell the permits.

In the policy world, this is known as a cap-and-trade system: The government "caps" the total emissions by issuing a fixed number of permits, and then allows firms to trade the permits.

- Marketable Pollution Permits

• Soak a towel in water, swish it around the room, and watch the smoke disappear. • Leave a saucer of vinegar in each room to eliminate the smoke odor. • Pay your neighbors to hire a chimney sweep to clean their flue. • Seal and caulk your windows to keep the smoke outside at a cost of less than $500. • Use the $500 to purchase an air purifier for your home.

These suggestions demonstrate a fundamental idea behind environmental eco- nomics: There is usually more than one way to deal with a pollution problem. The economic question is "What is the most efficient and least costly way to reduce the problem?" In some cases, it may be more efficient to prevent pollution (by modifying the stove or switching to an alternative fuel) than to let pollution happen and then clean up the environment (by using an air purifier). In other cases, cleanup will be more efficient than prevention.

SOURCE: Based on Magnus Eide, Tore Longva, Peter Hoffmann, Oyving Endresen, Stig Balsso~'{i1Future cost scenarios for reduction of ship CO"!.," Mmithne Poliq1Vlanage:mem 38 (2011), pp. ll-37.

Related to Exercise 7. 7.

International shipping is responsible for about 3 % of global C02 emissions, and there are many ways to reduce (abate) C02 emissions. As a tool for comparing the cost of alternative i:educfion methods, policy analysts compute the marginal abatement cost (MAC) of each metho~, defined as the cost per ton of C02 abated. For low-cost methods such as propeller maintenance and weather-sensitive routing, the fuel savings cover the cost of the abatement method, so the MAC for these methods is close to zero. For other abatement methods, the WAC are higher:

• Switch from diesel to gas-powered engines: $20 per ton • Reduce speed and increase fleet size: $QO per ton • Install fixed sails and wings to tap wind power: $105 per toll

APPLYING THE CONCEPTS #7: What is the most efficient way to reduce poflution?

OPTIONS FOR REDUCING C02 EMISSIONS FROM INTERNATIONAL SHIPPING

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 .;_2_4_3 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Firms will buy and sell pollution permits only when an exchange will make both firms better off. This happens when the firms have different abatement costs.

To illustrate the effects of marketable permits, let's return to tbe example of the two electricjty generators with different abatement costs shown in Table 9.3. Suppose the government issues each firm one permit (one less than the initial level of pollu- tion). In other words, i:l1e,.government will reduce pollution by two tons. Can the two firms make a deal for a permit?

•Firm His willing to pay a maximum of $5,000 for a permit because that's how much it costs to abate a ton of pollution.

• Firm Lis willing to accept a minimum of$2,000 for a permit because that's how much it costs to abate a ton of pollution.

Firm His willing to pay up to $5,000 and firm Lis Wi]ljng to accept as little as $2,000, so there is an opportunity for mutually benefici~l e1'.cl:iange. If the two firms split the difference, the price of a permit is $3,500, and eacl\finn gains $1,500 from the transaction. Firm H pays $3,500 to save $5,000 on abatement cost, for a savings of $1,500. Firm L gets $3,500 but pays an additional $2,000 in a!Jate · ent cost, for a benefit of $1,500.

How does the marketability of permits affect the total cost of abatement? In our example, the total cost with nonmarketable permits is $7,000, including $2,000 for firm L and $5 ,000 for firm H. In contrast, when a single firm does all the abating, the cost for two tons of abatement is $4,000 (two tons times $2,000 per ton). The savings of $3,000 equals the gap between the abatement cost of the high-cost and low-cost firm. Making the permits marketable exploits differences in abatement costs across firms, so we get the same level of abatement at a lower total cost.

The first program of marketable pollution permits, started in 1976 by the U.S. Environmental Protection Agency, allowed limited trading of permits for several air- borne pollutants. Trading was later extended to lead in gasoline (in 1985) and to the chemicals responsible for the depletion of the ozone layer (in 1988).

The Clean Air Act of 1990 established a system of marketable pollution permits (also known as allowances) for S02. Under the cap-and-trade program, in 1990 the government issued permits for S02 emissions based on a firm's emission levels 10 years earlier. Each company initially received enough permits to discharge between 50 and 70 percent of the volume it had discharged a decade earlier, and over time the number of permits will decrease. Firms ca.n a.lso trade the permits. For example, if one firm has an abatement cost of $140 and a second firm has an abatement cost of $180, the low-cost firm could sell a permit to the high-cost firm at a price of $160, giving each firm a benefit of $20: The low-cost firm gets $160 for a permit and incurs an abatement cost of $140; the high-cost firm pays $160 for a permit but saves $180 in abatement cost. A report from the National Acid Precipitation Assessment Program (NAPAP) showed that being able to buy and sell permits lowered firms' total cost of abatement by 15 to 20 percent.

A voluntary exchange between two people makes both people

better off.

THE PRINCIPLE OF VOLUNTARY EXCHANGE

Making pollution permits marketable is sensible because it allows mutually beneficial exchanges between firms with different abatement costs. This is another illustration of the principle of voluntary exchange.

Voluntary Exchange and Marketable Permits

__ 2.;;..4_4 CHAPTER 9 • IMPERFECT INFORMATION, EXTERNAL BENEFITS, AND EXTERNAL COSTS

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

"'FIGURE 9.8 The Market for Pollution Permits The equilibrium price of permits is shown by the intersection of the demand curve and the vertical supply curve. The supply curve is vertical because each year the government specifies a fixed number of permits. A decrease in the number of permits shifts the supply curve to the left, increasing the equilibrium price.

Number of permits issued

100 30 0

7 ----------- ----------------------------

Supply of permits in 1994 Supply of permits in 2003

Demand for permits

Supply, Demand, and the Price of Marketable Permits We can use a model of supply and demand to represent the market for pollution per- mits. Figure 9.8 uepicts a trading system introduced in the Los Angeles basin for smog pollutants such as NO~. The supply curve For permits is vertical at the fixed number of permits provided by the government. The demand for permits comes from firms that can use a permit to avoid paying for=pollution abatement, and the willingness to pay for a permit equals the savings in abatement costs. In Figure 9.8 the demand curve for permits is negatively sloped, meaning that t;h,e larger the number of permits available, the lower the willingness to pay for a permit. Tfiis is sensible because with more per- mits and pollution, tbe marginal cost of abatement wi~be relatively low. With a fixed supply of 100 permits in 1994, tbe equilibrium price, sliown by tbe intersection of the demand curve and the 1994 supply curve at point a, is $iL

Under Los Angeles's smog program, the number ofNO"' per11Uts decreased each year, and in 2003 reached its goal of cutting NOx discharges te 301')ercent of the level attained nine years earlier.' In Figure 9.8, the decrease in the num&er of permits from 100 to 30 shifts the supply curve to the left, increasing the equilibriuti p.vice of permits from $7 at point a to $21 at point b. Polluters in Los Angeles responded to the higJJer permit prices by abating more. The Los Angeles Department of Water and Power installed abatement equipment-at a cost of $40 million-because abatement was cheaper than buying pollution permits. Libbey Glass Company installed low-pollution, burners in its plant, dropping its emissions below the volume allowed by its permits. The company sold its extra permits to other firms, generating income for Libbey. The firms that bought the permits from Libbey were able to continue production using their existing abatement equipment.

Each year the Environmental Protection Agency issues permits to existing 502 sources but withholds some for auction on the Chicago Board of Trade. In 2008, a total of 12 5 ,000 permits were auctioned at an average price of$390 per ton. Individuals and environmental groups are allowed to buy the permits and, if they wish, reduce -p-sillution by withdrawing them from the market. In 2001 a total of 31 permits went to schools and environmental groups.

IMPERFECT INFORMATION, EXTERNAL BENEFITS. AND EXTERNAL COSTS• CHAPTER 9 .;_2_4...;.5 __

Pnnled by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

3 A public good is available for everyone to consume (nonri- val in consumption), regardless of who pays and who doesn't (nonexcludable).

4 A system of voluntary contributions suffers from the free-rider problem: People do not have an incentive to support public goods.

5 The optimum level of pollution abatement is where the marginal benefit equals the marginal cost.

6 A tax on the emissions of electricity generators decreases total emissions as firms switch to cleaner fuels and consumers buy less electricity at the higher price.

7 Compared to a pollution tax, traditional pollution regulations lead to higher production costs and higher product prices.

8 Allowing firms to buy and sell pollution permits reduces the cost of abatement because low-cost firms do more of the abatement.

246

In this chapter, we've explored the implications of market fail- ure from imperfect informa- tion, external benefits, and external costs. Here are the main points of the chapter:

1 The adverse-selection problem occurs when one

side of the market cannot distinguish between high-quality and low-quality goods. The presence of low-quality goods pulls down the price that buyers are willing to pay, which decreases the quantity of high-quality goods supplied, which further decreases the average quality and the price. In the extreme case, only low- quality goods are sold.

2 Insurance encourages risky behavior because part of the cost of an unfavorable. outcome are paid by an insurance company.

SOURCE: Based on European Climate Exchange (www.ecx.eu).

APRL YING THE CONCEPTS #8: How is the price of pollution permits determined?

The Euroeean Climate exchange is a market for the C02 aJlowances issued to European Union (ETD) countries under the EU cap-and-trade system. The equilib- rium price of an allowance is determined by the interplay of supply and demand. The EU determines the rota quantity of allowances issued, and distributes the allowances to organizations in the energy-i1~tensive industries, including iron and steel produc- tion, building materials, pulp and p~per, electricity generators, and heat generators. The demand for the allowances ls determined by a number of factors, including the level of economic activity, fuel prices, and the weather.

The Nordic countries rely heavily on h¥<ifiele0tric power to generate electricity. In a dry year, the amount of power generated b:x ~~droelectric plants is relatively low, and the Nordic countries shift to coal-fired plants. F0)' example, in the exceptionally dry year of 1996, the emissions from power and heat.generation in Denmark were roughly 70 percent higher than the emissions in 1990, a relacfively wet year. A dry year will generate a relatively high demand for C02 emissions and thus v1crease the equi- librium price of the allowances. Related to Exercises 8.5 and 8.10.

WEATHER AND THE PRICE OF POLLUTION PERMITS

How do technological advances in abatement technology affect the price of pollu- tion permits? A pollution permit allows a firm to avoid paying for abatement, and the higher the abatement cost that can be avoided, the larger the amount a firm is willing to pay for a permit. A technological innovation that decreases abatement costs will encourage firms to use the new technology to abate pollution rather than buying per- mits that alJow pollution. As a result, the demand curve for permits shifts downward and to the left, and the equilibrium price of permits decreases.

SUMMARY

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription a represents a copyright violation.

1.9 Consunzer!R.e;;_orts. You want to buy a used car, specif- ica!Jy a 1999 2lephy_.r. According to Consumer Reports, half the l 999 Zephyrs~~ow on the road are lemons, meaning they break aowh frequently and generate large repair bills. Consumers are willing to pay $2,000 for a lemon, but $5 ,000 for a plimr, According to Ms. Wizard, "The equilibrium price of-used 1999 Zephyrs will be $2,000 in Sourland but $2,600 in Sweetland." a. Illustrate with a complete graph for each market. b. What is the fundamental difference between the

two markets? 1.10 Fashion and Prices. You are in the market for a used

car and have narrowed your options to two types of cars, type F and type P. According to Consumer Reports, the two types of cars have roughly the same frequency of lemons (50 percent). Like other consumers, you are willing to pay $ l ,000 for a lemon and $7 ,000 for a plum. The people who buy new F cars are fashion- conscious and purchase a new car every three years. The people who buy new P cars are insensitive to the whims of fashion. Predict the equilibrium prices of the two types of cars and defend your answer with two graphs, one for each type of car.

1.11 Double Ignorance. Suppose both buyers and sell- ers of used cars are ignorant: No one can distinguish between lemons and plums. Would you expect the market to be dominated by lemons? Illustrate with a completely labeled graph.

1.12 Groucho Club. Consider a classic quip from Groucho Marx: "I won't join any club that is willing to accept

1.8

Professional baseball pitchers are like used ----- because there is informa- tion: A player's has better information about the pitcher's health and likelihood of injury. (Related to Application l on page 227 .) Your favorite baseball team just announced that it signed a new pitcher from the free-agent market. We expect the new pitcher to be injured ----- ~lJtOre/less) often than free-agent pitchers who returned to their old teams. (Related to Application l

"""· on pag 227.)

1.7

1.4 We will have a thin market for used cars it the mini- mum supply price for plums (high quality) is -----(greater than/less than) the willingness to pay for a lemon.

1.5 Arrows up or down: A decrease in the minimum sup- ply price for a plum (high quality) shifts the plum sup- ply curve and the likelihood of buying a plum-----

1.6 Suppose you are willing to pay $1,000 for a low-qual- ity used car and $5,000 for a high-quality used car. If there is an 80 percent chance of getting a low-quality car and a 20 percent chance of getting a high-quality car, you are willing to pay for a used car.

Market A Market B Market C

Assumed chance of getting 60% 80% 95% a lemon

Willingness to pay for a $6,000 $5,000 $4,500 used car

Number of lemons supplied 70 40 90

Number of plums supplied 30 10 10 Total number of used cars 100 50 100 supplied

Equilibrium: Yes or No? I I If disequilibrium, will price I I then rise or drop?

1.1 There is asymmetric information in the used-ear mar- ket because (buyers/sellers) cannot dis- tinguish between lemons and plums but ------- (buyers/sellers) can.

1.2 The supply curve for high-quality used cars lies ----- (above/below) the supply curve for low- quality used cars.

1.3 The following table shows the prices and quantities in three different used-car markets. Complete the table by filling in the last two rows.

Adverse Selection for Buyers: The Lemons Problem -

EX E R C I S E S ) All problems are assignable in MyEconlab.

free rider, p. 232 private cost of production, p. 237

private good, p. 232 public good, p. 232 social cost of production, p. 237 thin market, p. 225

marketable pollution permits, p. 243 mixed market, p. 222 moral hazard, p. 230 pollution tax, p. 237

adverse-selection problem, p. 224 asymmetric information, p. 222 external benefit, p. 232 external cost of production, p. 237

KEY TERMS)

Plinled by DAIFALLAHALSHAIKHI ([email protected]) on 10nt2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the authonzed user or valid subscrtptlon a represents a copylight violation.

253

After completing the experiment, do the following exercise: Consider the contribution incentives for Margie, one of the 10 students in the experiment. She thinks in marginal terms and asks herself, "Ifl contribute one more dime, how would that affect my payoff from the experiment?" a. Answer Margie's question, assuming her contribution

does not affect the contributions of other students. b. If Margie uses the marginal principle to make all her

decisions, will she contribute the extra dime?

DEBRIEFING

• The instructor selects 10 students and gives each student 10 dimes.

• Each student can contribute money to support a public good by dropping l, 2, or 3 dimes into a public-good pot. Each student has the option of keeping all the dimes and not contributing anything. The contributions are anonymous: No one knows how much a particular stu- dent contributes.

• For each dime .in the pot, the instructor adds 2 dimes. For example, if the students contribute a total of 40 dimes, the instructor adds 80 dimes, for a total of 120 dimes in the pot. The two-for-one match represents the idea that the benefits of public goods exceed the costs. In this case, the benefit/cost ratio is three to one.

• The instructor divides the money in the public-good pot equally among the lO students. For example, if there are 120 dimes in the pot, each student receives 12 dimes.

• Steps 2 through 4 can be repeated four or five times.

We can change the experiment to mimic the compulsory tax system. The instructor could require each student to contribute 3 dimes, the maximum amount. Would a switch to a compulsory tax system make the students better or worse off?

Do people really try to get free rides? Or would most people contribute at least some money to support a public good? Here is a classroom experiment that helps to answer this question:

VOLUNTARY CONTRIBUTIONS

In this experiment, students play the role of consumers pur- chasing used cars. Over half the used cars on the road (57%) are plums, and the remaining cars (43%) are lemons. Each. consumer offers a price for a used car and then rolls a pair of dice to find out whether he or she gets a lemon or a plum. In general, rolling a big number is good news: To get a plum, you need to roll a big number. The higher the price you offer, the smalJer the number you must roll to get a plum. Here is how the experiment works:

• Each consumer tells the instructor how much he or she is offering for a used car and then rolls the dice.

• The instructor tells the consumer whether the number rolled is large enough to get a plum. If the number is not large enough, the consumer gets a lemon.

• The consumers' scores equal the difference between the maximum amount they are willing to pay for the type of car they got ($1,200 for a plum and $400 for a lemon) and the price they actually paid. For example, if Otto offers $500 and gets a plum, his score is $700. If Carla offers $600 and gets a lemon, her score is -$200.

• The instructor announces the result of each transaction to the class.

• There are three to five buying periods. At the end of the last trading period, each consumer adds up his or her score.

ECON 0 MIC EXPERIMENT )1------------------ ROLLING FOR LEMONS

8.10 Consider the demand for C02 allowances in the European Union. The supply of allowances is fixed, and the initial price is $20 per ton. Suppose that dry weather in the Nordic countries increases the demand for allowances by 6 percent, and the price elasticity of demand for permits is 2.0. Predict the new equi- librium price, and illustrate with a graph. (Related to Application 8 on page 246.)

electricity generators. Most of the permits were given to the utilities with the oldest generating facilities. One year later, none of the permits had been bought or sold. What could explain the absence of permit exchanges?

8.9 Lower Abatement Cost and Permit Prices. Suppose new technology decreases the cost of abating pollution by half. Depict graphically the implications of the decrease in abatement cost on the equilibrium price of marketable permits. Use Figure 9.8 on page 245 as a tarting point, with an initial permit price of $21 (point b). What's the new equilibrium price?

255 Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date

represents a copyright violation.

• Describe recent changes in the distribution of income.

• Describe the effects of government policies on poverty and the distribution of income.

• Explain why competition generates wages equal to marginal revenue product.

• Explain why an increase in the wage could increase, decrease, or not change hours worked.

• Explain why wages differ across occupations and levels of human capital.

MyEconlab MyEconlab helps you master each objective and study more efficiently.

LEARNING OBJECTIVES

A key factor in a worker's earnings is educationa[ .attainment. In 2009, the median a~1:.19l ei;l.rnings of high-school graduates were $32,600, compared to $.56.,700 for college graduates.1 In other words, the college premium-the increase in earnings from earning a college degree rather than stopping with a high school education-was 74 percent. 01Xer a lifetime, the payoff from a college degree was $964,000. Over tl'.le last several decades, the college premium has almost doubled.

The Labor Market and the Distribution of Income

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

The firm will pick the quantity of labor at which the marginal benefit of labor equals the marginal cost of labor. It can hire as many workers as it wants at the market wage, so the marginal cost of labor equals the hourly wage. If the wage is $8 per hour, the extra cost associated with one more hour of labor-the marginal cost-is $8, regardless of how many workers the firm hires.

Increase the level of an activity as long as its marginal benefit

exceeds its marginal cost. Choose the level at which the marginal

benefit equals the marginal cost.

MARGINAL PRINCIPLE

Consider a perfectly competitive firm that produces rubber balls. Because this firm is perfectly competitive, it takes the price of its output and the prices of its inputs as given. Because it hires a tiny fraction of the workers in the lali9t market, it takes the market wage as given and can hire as many workers as it wants at that wage. In addi- tion, the firm produces a tiny fraction of the rubber balls sold in tlie l)la,i){et, so it takes the price of its output as given. Let's say the price of rubber balls is $0.50.

Consider the firm's hiring decision in the short run, defined as the period during which at least one input-for example, .its factory-cannot be changed. We can use two of the key principles of economics to explain the firm's hiring decision. Recall the marginal principle.

Labor Demand by an Individual Flrm in the Short Run

We can use demand and supply curves to show how wages are determined and exam- ine how changes in the labor market affect wages and employment. We'll start with the demand side of the labor market, looking first at how an individual firm can use the key principles of economics to decide how many workers to hire.

The demand for labor and other productive inputs is different from the demand for consumer products such as iPods, books, haircuts, and pizza. Firms use work- ers to produce the products demanded by consumers, and so economists say that labor demand is a "derived demand." That is, it is determined by, or derived from, the demand for the products that workers produce. As we'll see in this chapter, the demand for labor is determined by the demand for consumer products and the price of those products.

- The Demand for Labor

Up to this point in the book, we have discussed the markets for final goods and services. In this chapter, we switch to the market for one of the factors of production=-Iabor. Labor costs are responsible for about three-fourths of production costs, and for most people labor income is by far the most important source of income. We'll use a model of demand and supply to see how wages are determined and why wages differ between college graduates and high-school graduates, men and women, and people in different occupations. We'll also take a look at recent changes in the distribution of income and the effects of government tax and transfer policies on poverty and the distribution of income.

__ 2-'-5-'--'-6 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

To draw the short-run market demand curve for labor, we acid the labor demands of all the firms that use a particular type of labor. In the simplest case, all firms are identical, and we simply multiply the number of firms by the quantity of labor demanded by the typical firm. If there were 100 firms and each hired 5 workers at a wage of $8, the market demand for labor would be 500 workers. Similarly, if the typical firm hired 3 workers at a wage of $11, the market demand would be 300 workers. In the more realistic case of non-identical firms, we use the same technique used for the market demand for a consumer good. We draw the individual

Market Demand for Labor in the Short Run

An increase in the price of the good produced by workers increases the marginal revenue product at each quantity of workers, shifting the demand curve to the right. At each wage, the firm will demand more workers. For example, at a wage of $8, the demand for labor increases from five workers (point b) to seven workers (point d).

& FIGURE 10.2 An Increase in the Price of Output Shifts the Labor-Demand Curve

Number of workers 7 5 0

Labor demand with higher Ol)lpt·p1jce

. Original labor ' demand

What sorts of changes would cause the demand curve to shift? To draw the labor-demand curve, we fix the price of the output and the productivity of workers. Therefore, an increase in the price of the output will increase the MRP of workers, shifting the entire demand curve for labor to the right: At each wage, the firm will hire -more workers. This is shown in Figure 10.2. An increase in the price of balls shifts the la&or-demand curve to the right. At a wage of $8, the firm hires seven workers instead of five, Similarly, if workers become more productive, the increase in the marginal product of lab;or will increase the MRP and shift the demand curve to the right. Conversely, a decrease i,ia price or labor productivity will shift the demand curve to the left.

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 .;_2..;.5..;;.9 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

• The output effect. An increase in the wage will increase the cost of produeing balls, and firms will pass on at least part of the higher labor cost to their consumers: Prices will increase. According to the law of demand, firms will sel1 fewer balls at the higher price, so they will need less of all inputs, including laBor.

• The input-substitution effect. An increase in the wage will cause the firm to substitute other input\for labor. At a wage of $4, it may not be sensible to use much machinery iri-the ball factory, but at a wage of $20, it may be sensible to mechanize the factory, using more machinery and fewer workers. This substitution of other inputs forzlabor decreases the labor input per unit of output.

The input-substitution effect decreases the labor input per unit of output while the output effect decreases total output. The two effects operate in the same direction, so the market demand curve is negatively sloped.

The notion of input substitution applies to other labor markets as well. For the most graphic examples of factor substitution, we can travel from a developed country, such as the United States, Canada, France, Germany, or Japan, to a less-developed country in South America, Africa, or Asia. Wages are much lower in the less-developed countries, so production tends to be more labor intensive. In other words, labor is less costly relative to machinery and equipment, so labor is substituted for these other inputs. Here are some examples:

•Mining. U.S. firms use huge earthmoving equipment to mine for minerals; firms in some less-developed countries use thousands of workers digging by hand.

• Furniture. Firms in developed countries manufacture furniture with sophisticated machinery and equipment; firms in some less-developed countries make furniture by hand.

•Accounting. Accountants in developed countries use computers and sophisticated software programs; some accountants in less-developed countries use simple calculators and ledger paper.

Recall that in the long run, firms can enter or leave the market and firms already in the market can change all their inputs, including their production facilities. The long-run demand curve for labor shows the relationship between the wage and the quantity of labor demanded over the long run, when the number of firms in the market can change and firms in the market can modify their production facilities.

AJthough there are no diminishing returns in the long run, the market demand curve is still negatively sloped. As the wage increases, the quantity of labor demanded decreases for two reasons:

Labor Demand in the Long Run

demand curves and then sum them horizontally to get the market demand curve. In other words, for each wage we add up the labor demands of all the firms to get the aggregate or market demand.

input-substitution effect The change in the quantity of labor demanded resulting from an increase in the price of labor relative to the price of other inputs.

output effect The change in the quantity of labor demanded resulting from a change in the quantity of output produced.

long-run demand curve for labor A curve showing the-reJ.lbtionship between the wage and the quanticy',gfJabor demanded over the long ;;~J«,hen the number of firms in the hiark'et can cha'nge and firms can modify their productd>n \ facilities. I -,,

__ 2_6~0 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

How does the short-run demand curve for labor compare to the long-run demand curve? There is less flexibility in the short run because firms cannot enter or leave the market and they cannot modify their production facilities. As a result, the demand for labor is less elastic in the short run. That means the short-run demand curve is steeper than the long-run demand curve. In the chapter on perfect competition we used the same logic to explain why the short-run supply curve for a product (plain cotton T-shirts) was steeper than the long-run supply curve for the product.

Short-Run versus Long-Run Demand

SOURCE: Based on Anthony Kraurmann, "What's Wrong with Scully-Estimates of a Player's .Marginal Revenue Produce: Economic Inquiry• 37 (1999), pp. 369-38).

APPLYING THE CONCEPTS #1: Are workers paid their marginal revenue pr,0duct (MRP)?

In 1011,, the average salary in Major League Baseball (MLB) was $3 .3 million. Are players reallyfwotth that much? A team will pay $3.3 million for a player only if the player's marginal¥evenue product (MRP) is at least $3.3 million. The MRP of a player equals his contribution to the firm's total revenue from ticket sales and television contracts. People are, -illing to pay for winners, and a player whose performance increases the team's winni1ogp~·centage increases its revenue from tickets and TV. For example, a player with a Fehtive!y high slugging percentage increases the team's winning percentage, increasing the--rev:enue from ticket sales and TV.

A recent study shows that for serne types of players, the salary is less than the player's MRP. Some MLB players are (!;ee agents, meaning that they are free to negotiate a contract with any MLB team. Given the competition between teams for the services of free agents, their salaries are close to their MRPs. In contrast, two types of players are not allowed to change teams, and tl~e limited competition for their services means that they earn relatively low salaries.

1 Journeymen (3-6 years in the league) are restricted to a single team, but can enter salary arbitration to change their salaries.

2 Apprentices (up to 3 years in the league) are restricted to a single team and cannot change their salaries.

Given the immobility of journeymen and apprentices, we expect them to be paid less than their l\1RPs. According to a recent study, the average MRP of journeymen is about $1.08 million, which is about 17 percent higher than the average journeyman salary. For apprentices, the average MRP is about $810,000, which is about 3.6 times the average apprentice salary. Related to Exercise 1.7.

MARGINAL REVENUE PRODUCT IN MAJOR LEAGUE BASEBALL

11.1;.1111111.1.wml-------------------

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 .;_2..;..6_1 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Let's start with an individual's decision about how many hours to work. The decision to work is a decision to sacrifice some leisure time for money: Each hour of work i;ed.uces· leisure time by one hour. Therefore, the demand for leisure is the flip side of the supply of labor. The price of leisure time is the income sacrificed for each hour of leisure, rhat is, the hourly wage. A substitution effect and an income effect. An increase in the wage-the price of leisure-has two effects. on the demand for leisure.

Consider first the substitution effect for leisure demand. The worker faces a trade-off between leisure time and consumer goods such as music, books, food, and entertainment. For each.hour 9£ leisure time Leah takes, she loses one hour of work time, and her income drops by<an a.Jllow1t equal to the wage. Therefore, she has less money to spend on consumer g@od~ . .lior example, if the wage is $8 per hour, each hour of leisure decreases the amount of Income available to spend on consumer goods by $8. When the wage increases to, say, $10,.,Leah will sacrifice more income-and consumer goods-for each 110ur of leisure sl~e takes. Given the larger sacrifice of consumer goods per hour of leisure time, she will dern tnd less leisure. That means she will work more hours and earn more money for consumer: goods. In other words, as the wage increases, she will substitute income-and the consutn~r goods it buys-for leisure time.

Consider next the income effect for leisure demand. For mo,t people, leisure is a normal good in the sense that the demand for leisure increases "as real income increases. An increase in the wage increases Leah's real income in the sense that she can afford more of all goods, including leisure time. Suppose Leah has a total of 100 hours per week to divide between leisure and work. At a wage of $10, she works 36 hours and has 64 hours of leisure. She also earns $360 ($10 per hour times 36 hours of work) and spends that amount on consumer goods. If her wage increases to $15, her real income increases because she can have more consumer goods and more leisure time. For example, if she worked only 30 hours, she could buy $450 worth of consumer goods ($15 per hour times 30 hours) and have 70 hours of leisure (100 hours per week minus 30 hours of work). The increase in real income causes Leab to consume more of all normal goods, including leisure time. The increase in real income causes her to demand more leisure and supply less labor.

In the labor market, the income and substitution effects of an increase in wages operate in opposite directions. The substitution effect decreases the desired leisure time, while the income effect increases the desired leisure time. Therefore, we can't

The Individual Labor-Supply Decision: How Many Hours?

The labor-supply curve answers the following question: How many hours of labor will be supplied at each wage? When we speak of a labor market, we are referring to the market for a specific occupation in a specific geographical area. Consider the supply for nurses in the hypothetical city of Florence. The supply question is "How many hours of nursing services will be supplied at each wage?" To answer that question, we must think about how many nurses are in the city and how many hours each nurse works.

- The Supply of Labor

income effect for leisure demand The change in leisure time resulting from a change in real income caused by a change in the wage.

substitution effect for leisure demand The change in leisure time resulting from a change in the wage (the price of leisure) relative to the price of other goods.

__ 2..;..6~2 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

market supply curve for labor A CU;:r.ve showing the relationship between i'he..:,age_and· the quantity of labor suppl,ief.

Now that we know how individual workers respond to changes in wages, \)'Je'~ ready to consider the supply side of the labor market. The market supply curve for labor shows the relationship between the wage and the quantity of labor supplied. In Figure l 0.3, the market supply curve for labor is positively sloped, consistent with the law of supply: There is a positive relationship between the wage (the price of labor) and the quantity of labor supplied, ceteris paribus. An increase in the wage affects the quantity of nursing supplied in three ways:

1 Hours worked per employee. When the wage increases, some nurses will work more hours, some will work fewer hours, and some will work the same number of hours. We don't know for certain whether the average number of work hours will increase, decrease, or stay the same, but the change in the average number of hours worked is likely to be relatively small.

2 Occupational choice. An increase in the nursing wage will cause some workers to switch from other occupations to nursing and motivate more new workers to pick nursing over other occupations.

3 Migration. Some nurses in other cities will move to Florence to earn the higher wages offered there,

'} The Market Supply Curve for Labor

An Example of Income and Substitution Effects A simple example will show why we can't predict a worker's response to an increase in the wage. Suppose each nurse in Florence initially works 36 hours per week at an hQJllly :wage of $10 and the wage increases to $12. The following are three reasonable resp._on~s to the higher wage:

Lester wod;s efi:wer hours. If Lester works 30 hours instead of 36 hours, he gets 6 hours of extra leisure time and still earns the same income per week ($360 = 30 houlj.$ >Z $lj_per hour).

2 Sam works the same numb'er if hours. If Sam continues to work 3 6 hours per week, he gets an additional $72 of income ($2 per hour x 36 hours) and the same amount of leisure time.

3 Maureen works more hours. If .M~u:reen works 43 hours instead of 36 hours, she sacrifices 7 hours of leisure time but earns-a total of $516, compared to only $360 at a wage of$10 per hour.

Empirical studies of the labor market confirm that each of these responses is reasonable. When the wage increases, some people workmore, others work less, and others work about the same amount. At the market level, tire ag~regate response to an increase in the wage varies across markets.

predict whether an increase in the wage will cause a worker to demand more leisure time (supply less labor) or less leisure (supply more labor).

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 _2..;;.6-'3 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCE: Based on Orley Ashenfelter, Kork Doran, Bruce Schaller," A Shred of Credible Evidence on the Long Run Elasticity of Labor Supply') (working Paper 551, Industrial Relations Section, Princeton University, 2009).

APPL YING THE CONCEPTS #2: When the wage increases, will the typical person work more hours or fewer hours?

Taxi drivers have a lot of flexibility in choosing their work hours-,.:and we can readily observe their response to an increase in the wage. An increase in the ta.Xi fare, which is regulated by cities, represents an increase in the wage earned by taxi drivers. A recent study of the taxi market in New York City shows that an increase in the regulated fare (an increase in the wage) actually decreases the quantity of labor supplied. In 2004 a 19 percent increase in the regulated fare decreased the miles driven per cabbie by 5 .6 percent. Overall, the elasticity of miles driven (quantity of labor supplied) with respect to the fare per mile (the wage) is -0.22. In other words, a 10 percent increase in the wage decreases the quantity of labor supplied by 2.2 percent. Related to Exercises 2.6 and 2.11.

CABBIES RESPOND TO AN INCREASE JN THE WAGE

914.1111111.1.aa ... n-,----------------

& FIGURE ~.P.3 Supply, Demand1 af'ld Labor Market Equilibrium At the market equilibrium s~n by point a, the wage is $15 per hour and the quantity of labor is 16,000 hours. The quantity supg)ied equals the quantity demanded, so there is neither excess demand for labor nor excess supply of labor-.

Hours of nursing per day 24,000 16,000 8,000 0

Market supply Markel demand

__ 2..;..6~4 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

.&. FIGURE 10.4 The Market Effect of an Increase in Demand for Labor An increase in the demand for nursing services shifts the demand curve to the right, moving the equilibrium from point a to point b. The equilibrium wage increases from $15 to $17 per hour, and the equilibrium quantity increases from 16,000 hours to 19,000 hours.

Hours of nursing per day 16,000 19,000 0

Initial demand curve

New demand curve

How would a change in the demand for nurses affect the eqgilibrium wage of nurses? We know from Chapter 3 that a change in demand causes the e~.uwbrium price and the equilibrium quantity to move in the same direction: An increase in demand increases the equilibrium price and quantity, whereas a decrease in demand decreases lhe equilibrium price and quantity. For example, suppose the demand for medical care increases. Nu.rses help to provide medical care, so an increase in the quantity of medical care demanded will shift the demand curve for nurses to the right: At each wage, firms will demand more hours of nursing services. As shown in Figure 10.4, an increase in demand increases the equilibrium wage and the equilibrium quantity of.nursing services.

Changes in Demand and Supply

We're ready to :gufdemand and supply together to think about equilibrium in the labor market. A market equilibrium is a situation in which there is no pressure to change the price of a good G)t service. Figure 10.3 shows the.equilibrium in the market for nurses. The supply curve in,S..eTsect~ the demand curve at point a, so the equilibrium wage is $15 per hour and the equilibri]Jm quantity is 16,000 hours of nursing per day. At this wage, there is neither an excess demand for labor nor an excess supply oflabor, so the market has reached an equilibrium.

- Labor Market Equilibrium

The second and third effects reinforce one another, so an increase in the wage causes movement upward along the market supply curve. If the wage of Florence nurses increases from $10 to $15 per hour, the quantity of nurses supplied increases from 8,000 hours per day (point b) to L6,000 hours per day (point a). Although individual workers may nor work -more hours as the wage increases, the supply curve is positively sloped because an increase in the wage changes workers' occupational choices and causes migration.

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 .;_2..;;.6..;;.5 __

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

What are the trade-offs associated with the minimum wage? For restaurant workers and restaurant diners, there is good news and bad news:

• Good news for some restaurant workers. Some workers keep their jobs and receive a higher wage ($7 .2 5 per hour instead of $6.05 per hour).

"- FIGURE 10.5 The Market Effects of a Minimum Wage The market equilibrium Is shown by point a: The wage is $6.05 per hour, and the quantity of labor is 50,000 hours. A minimum wage of $7.25 decreases the quantity of labor demanded to 49,000 hours per day {point b). Although some workers receive a higher wage, others lose their jobs or work fewer hours.

Hours of restaurant labor per day (1,000)

50 49 0

$7.25

$6.05

We can use the model of the labor market to show how various public policies, such as the federally mandated minimum wage, affect total employment. In 2012 the federal minimum wage was $7 .25 per hour. Figure 10.5 shows the effects of a minimum wage on the 1@i:ket for restaurant workers. The market equilibrium is shown by point a: The supply 0t'restaurant workers equals demand at a wage of $6.05 and a quantity of 50,000 worker how~:> per clay. Suppose a minimum wage is established at $7 .25 per hour. At this wage., the quantity of labor demanded is only 49,000 hours (point b on the demand curve). --1.Rother words, the minimum wage decreases the quantity oflabor restaurants use by 1,000 :liours per day.

The Market Effects of the Minimum Wage

How would a change in supply of nurses affect the equilibrium wage of nurses' Vie know from Chapter 3 that a change in supply causes price and quantity to move in opposite directions: An increase in supply decreases the equilibrium price but increases the equilibrium quantity, whereas a decrease in supply increases the equilibrium price but decreases the equilibrium quantity. Suppose a new television program makes nursing look like an attractive occupation, causing a large number of young people to become nurses rather than accountants, lawyers, or doctors. The supply curve for nurses will shift to the right: At each wage, more nursing hours will be supplied. The equilibrium wage will decrease, and the equilibrium quantity will increase.

__ 2..;..6~6 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

The Gender Pay Gap Why do women, on average, earn less than men? b1 the United States, rhe typical woman earns about 80 percent as much as the typical m~n.'1 A recent study explored several factors that contribute to the gender pay gap.5 The studr observed a gap of about 20 percent among workers aged 26 to 34, and identified four factors that contribute to the gender gap:

• Difference in worker skills and productivity. On average, women have less education and work experience, so they are less productive and thus receive lower wages. An important factor in the lower level of work experience among women is that many women interrupt their careers to raise children. The study concluded that lower productivity is the most important factor in the gender gap.

«Differences in occupational preferences. Wages vary across occupations: Clerical and service occupations receive lower wages than craft and professional occupations. Compared to men, women express stronger preferences for low-wage occupations, such as clerical and service occupations, and weaker

another for skillful players, bidding up the wage. The same logic applies to other professional athletes, musicians, and actors. The few people who have the skills required for these occupations are paid high wages.

2 High training costs. The skills required for some occupations can be acquired only through education and training. For example, the skills required of a medical doctor call for medical school training, and legal skills must be acquired in law school. If it is costly to acquire these skills, a relatively small number of people will become skilled, and they will receive high wages. The higher wage compensates workers for their training costs.

3 Undesirable working conditions. Some occupations have undesirable working conditions, and workers demand higher wages as compensation. Wages are higher for jobs that are dirty or stressful or require people to work at odd hours.

1 Danger. Some jobs are dangerous, and wages are higher to compensate for the risk of injury or death. The workers with the greatest risk of losing their lives on the job are lumberjacks, boilermakers, taxicab drivers, and mine workers. To compensate for the higher risk of getting killed on the job, steelworkers receive a wagu1rem)um of 3.7 percent. In the United States, the average job fatality rate is 1 in 2:5,000 workers per year. For a worker who faces twice the average fatality rate, the rage is about 1 percent higher. The wage premium for jobs with an annual injury rate of 2 percent is 1.15 percent for men and 3 .68 percent forwomen.3

5 Artificial barriers to entrJ1. G0vernment and professional licensing boards re- strict the number of people in eertain occupations, and labor unions restrict their membership. These supply resttiotion.s increase wages.

__ 2_6.;;....;;.8 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Why Do College Graduates Earn Higher Wages? In 2009, the college premium-the increase in earnings from a college degree-was 74 percent. A college education provides the skills necessary to enter certain occupations, so a college graduate has more job options than a high-school graduate. Both high-school grads and college grads can fill jobs that require only a high-school education, so the supply of workers for these low-skill jobs is plentiful, and the equilibrium wage for these jobs is low. In contrast, there is a smaller supply of workers for jobs that require a college education, so the wages in these high-skill jobs are higher than the wages for low-skill

-:jobs. This is the learning effect of a college education: College students learn the skills requirntl for certain occupations, increasing their human capital.

A s~contl explanation of the college premium requires a different perspective on college a1~d its role in the labor market. Suppose certain skills are required for a particular job, Q.ut'an employer cannot determine whether a prospective employee has these skills. For exam.pie, most managerial jobs require the employee to manage time efficiently, but it is impussible for an employer to determine whether a prospective employee is a good manager of time. Suppose that these skills are also required to complete a college degree. For example, to get passing grades in all your classes, you must be able to use your time effie"ientl'y-. When you get a college degree, firms will conclude that you have some of the skills ther require, so they may hire you instead of a high-school graduate. This is the signaling effect of a college education: People who complete college provide a signal to employers about their skills. This second explanation suggests that colleges simply provide a ttisting ground where students can reveal their skills to potential employers.

The most important factor in the doubling of the rnltege ..rremium over the last few decades is technological change. Changes in technology have increased the demand for college graduates relative to the demand for other workers'. In all sectors of the economy, firms are switching to sophisticated machinery and equipment that require highly skilled workers. Consequently, the share of jobs that require a college education has increased steadily, increasing the demand for college graduates. Of course, the supply of college graduates has increased too, but not by as much as demand. Because the increase in demand is large relative to the increase in supply, the wages of college graduates have increased. Another factor in the growing college premium. is the pace of technological change. Workers with more education can more easily learn new skills and new jobs, so firms are willing to pay more for college graduates.

factors, including past discrimination that has inhibited the acquisition of job skills and differences in educational opportunities. For example, in urban areas about one-third of African-American high-school students have above-average scores on reading and math exams, compared to about two-thirds of white students.

signaling effect The information about a person's work skills conveyed by completing college.

learning effect 'The increase in a person's wage resulting from the learning of skills required for certain occupations.

__ 2__;_7-'-0 CHAPTER 10 • THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

labor union A group of workers organized to increase job security, improve working conditions, and increase wages and fringe benefits.

SOURCES: Based au Daniel Hamennesh and Jeff Biddle, "Beauty and the Labor Marker," American Economic Reuiets 84 (2001): 1174-1I94; "To Those That Have, Shall 13e Given," &·onomisr., December 22, 2007, 53-54.

APPLYING THE CONCEPTS #3: What explains differences in wages? How does physical attractiveness affect earnings? Studies of the U.S. labor market show that beautiful people earn more than people of average looks, and unattractive people earn less. The beauty premium is 5 percent for the 33 percent of workers who are considered beautiful or handsome, and the beauty premium is larger for men than for women. The penalty for bad looks is about 8 percent for the 10 percent of workers who are considered plain or unattractive, The beauty premium and the plain penalty have been observed in other countries and with.in specific occupations such as lawyers.

Why do beautiful people earn more income? According to biologists, beauty is a marker for underlying characteristics such as health and intelligence, and beautiful people start with a slight edge in the labor market. BeautifuJ people get more opportunities to learn through experience, and they also acquire better professional contacts. Because of these wider opportunities, a small difference in innate characteristics can be amplified into a large difference in earnings. Another factor i11 the beauty premium is that some workers and consumers simply like dealing with attractive people, so there is a higher demand for beautiful workers, resulting in higher wages. Related to Exercises 3.10 and 3.11.

THE BEAUTY PREMIUM

A labor union is a group of workers organized to increase job security, improve work- ing conditions, and increase wages and fringe benefits. 9 Acting as a group, union members have some control over the wages and fringe benefits they receive. In the U.S., about one in eight workers in the United States belongs to a union, down from abor t one in three workers in the 1950s. The unionization rate is 8.2 percent for private-sector workers, compared to 39.8 percent for public-sector workers. In the rest.of the1w<i>rld, unionization rates vary widely, from 2 percent in India to 78 percent in Sweden.

There is evidence that unions raise the wages of union workers. For the United States, the consensus is that union workers earn 10 to 20 percent more than nonunion workers doing the same wor~As we saw earlier in the chapter, an increase in the wage decreases the quantity_'otlabor demanded because of the output effect and the input-substitution effect. Given the rade-off between wages and employment, an increase in the union wage increases the lncome of the workers who keep their jobs, but also decreases the number of union jobs.

One response to the trade-off between :w'ag'es and jobs is to impose work rules that increase the amount of labor required to produce a g.iven quantity of output.

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 .;_2_7_1 __

Labor Unions and Wages

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

Market income is defined as all earnings received from labor and capital markets. It includes wages and salaries, as well as earnings from bonds, stocks, and real estate. Market income does not account for the effects of government tax and transfer payments. We'll discuss the effects of government tax and transfer programs in the next section of the chapter.

Income Distribution in 2007

- The Distribution of Income In 2009 the median household income in the United States was $49 777. In other words, half of households earned more tha.n $49, 777, and half earned less. There is substantial variation in household income, with some households earning much more and others earning much less. In this part of the chapter, we'll discuss the extent of income inequality in the United States and recent trends in the distribution of income. We'll also explore the effects of several government policies on the distribution of income.

This is called featherbedding. One example of featherbedding is requiring a minimum crew size, which forces a firm to hire more workers than it needs to perform a particular task. For example, the typical unionized airline hires three workers to guide an airplane into the gate, while nonunion airlines use only two workers. In the past, railroad unions forced railroads to use firemen (whose job was to shovel coal) on diesel-powered engines, which don't use coal.

Although featherbedding forces the firm to use more labor per unit of output, it also decreases the quantity of output produced. A firm that hires workers it doesn 't need will have higher production costs, resulting in a higher price for its product. Consumers respond to a higher price by purchasing less output, so although the firm may use more labor per unit of output, it sells less output. If output falls by a large amount, the quantity of labor demanded by the firm will actually decrease.

We've seen that unions lead to higher wages and may impose work rules that reduce productivity. In other words, unions increase production costs. What are the possible benefits of unions? First, unions may increase worker productivity by facili- tating communication between workers and managers. A second possible benefit of unions is Jfoy,er turnover among workers. If a worker is unhappy with a job, one option is to quit. From thssfirm's perspective, this is costly because the firm loses an experi- enced worker and must train a new one. A dissatisfied worker who belongs to a muon has a second option: 'The worker can use the union as an intermediary to discuss job issues with managers. This sort of communication can solve problems before they become so severe that the worke quits. There is evidence that firms whose workers are in unions have lower turnover=rates, in part because they facilitate communication between workers and managers. These lower turnover rates lead to lower training costs and a more experienced workforce. The savings from less turnover is equivalent to a 1 to 2 percent reduction in costs.

featherbedding Work rules that increase the amount of labor required to produce a given quantity of output. Featherbedding may actually decrease the demand for labor.

__ 2..;...;..7_2 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 autholized to use until 10/14/2013. Use beyond the autholized user or valid subscliption date represents a copylight violation.

Recent Changes in the Distribution of Income Table 10.2 shols changes in market income between 1979 and 2007. The last column shows the percent growth in income over the 28-year period for different groups of households. A!s we move down through the column to progressively higher income, the growth ratecof market income increases. For example, the growth rate for the poorest quintile was 18.~ percent,. compared to 43.3 for the fourth quintile and 7 5 .6 percent for the top q1tintile. For the one percenters, the growth rate was 277 .5 percent.

The second and third columns in the table show the changes in the income shares over the 28-year period. The shares of the bottom 99 percent of households (quintiles 1 through 4 and percentiles 80-99) decreased, while the share of the top one percent increased. Although the income share of the top quintile increased (from about 50 percent to about 60 percent), the increhse.in income was concentrated among the top one percent of households.

Over the period 1979-2 007, all major sources of income became less evenly distributed. Consider the income share of the bottom 80 percent qf households. As shown in Table 10.2, the share of overall income earned by thl 80 percenters decreased from 51.4 percent to 41.1 percent. This group's share of labor income decreased from 60 percent to 50 percent, while its share of income from capital, business, and capital gains decreased from 41 percent to 2 5 percent. Another factor in the increased concentration of income is that the share of income from capital gains (the most concentrated source of income) increased.

What explains the substantial differences in market income? There are three key reasons for income inequality in a market-based economy.

Differences in labor skills and effort. Some people have better labor skills- more human capital-than others, so they earn higher wages. Labor skills are determined by innate ability, education, and work experience. In addition, some people work longer hours or at more demanding jobs, so they earn more income.

2 Lucle and misfortune. Some people are luckier than others in investing their money, starting a business, or picking an occupation. Among the unlucky people are those who develop health problems that make it difficult to earn income. Among the lucky people are those who inherit wealth and earn income by investing their inheritance.

3 Discrimination. Some people are paid lower wages or have limited opportunities for education and work because of their race or gender.

__ 2__;_7_4 CHAPTER 10 • THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copyright violation.

SOURCES: Based on George Borjas, "The Economicsofli11migr-ation,"Ju11r1111lufBconomic Literature 32 (1994): 1667-J 717; George Borjas, "The Labor Demand Curve Is Downward Sloping: Reexamining the Impact of Immigration on the Labor Marker," Qum1ed)1 Jozmurl of Economics 108 (2003): 1335-1374; Giaruuarco Ottaviano and Giovanni Peri, "Rethinking the Gains from Immigration: Theory and Evidence from the U.S." (working paper 11672, NBER, 2005).

Since about 1850, international migration has played an important role in labor markets. In the first wave of immigration, ffom 1850 to 1913, over a million people migrated to the Americas each year. Most were from'European countries. After several decades of war and economic depressions, massive immigfarion resumed in 1945, and most of the immigrants were from less-developed countrie~. The,most recent wave of immigration started in 1990 and has increased the supply oflalfor'to the U.S. economy by about 10 percent per decade.

Immigration creates winners and losers within the economy. "Tl'ie increase in the supply of labor decreases wages for the native workers who have the same skill level as the immigrants. Because the average U.S. immigrant has less education 'and earns less income than the average native, immigrants compete with low-skill nafrv(ls, decreasing their wages. On the benefit side, the decrease in the wages of low-skill labor decreases production costs and product prices, so consumers benefit. In general, we expect low-skill workers to lose as a result of immigration because the lower wages will dominate the benefits of lower consumer prices. In contrast, we expect high-skill workers to benefit from lower prices.

Economists have estimated the net effect of immigration on the U.S. economy. George Borjas shows that immigration to the United States has a small positive effect, with the losses in wages of low-skilled workers more than offset by gains to consumers and firms. This conclusion is consistent with the idea that exchange increases efficiency and the size of the overall economic pie. Studies of the most recent wave of immigration suggest that immigration decreases the wages of high-school dropouts and other low-skilled workers. Related to Exercises 4.5, 4.6, and 4.7.

APPLYING THE CONCEPTS #2: Who benefits from the immigration of low-skilled workers?

TRADE-OFFS FROM IMMIGRATION

11.14.1114111.1.w 111-------------------

Why has labor income become less evenly distributed? It appears that the most important reason for growing inequality is what labor economists call an "increase in the demand for skill."8 In the labor market, the demand for highly skilled (highly educated) workers has increased relative to the demand for less-skilled (less-educated)

>Vorkers. As a result, the wage gap between the two groups has widened. Over the last few decades, the college premium doubled, and the advanced-degree premium-the increase in earnings from getting post-graduate degrees-has increased as well. At

THE LABOR MARKET AND THE DISTRIBUTION OF INCOME• CHAPTER 10 .;_2_7_5 __

Plinted by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription date represents a copy light violation.

Table 10.3 shows the shares of income for the five quintiles before and after accounting for federal taxes and transfers. The federal policies redistribute income from the top fifth, whose income share decreases by about 7 percentage points (from 59.9 percent to 52.7 percent) to the lowest four-fifths, which collectively gain about 7 percentage points. The largest gain occurs for the lowest fifth (2.6 percentage points), and the other three quintiles gain between 0.9 and 1.9 percentage points.

In the last few decades, the redistributional effects of federal tax and transfer policies have diminished. Between 1979 and 2007, the government took less from high-income households and gave less to low-income households because:

Although the total amount of transfer payments was roughly constant over the period, a decreasing share of payments were for means-tested programs (eligib.ility is determined by income) such as Temporary Assistance to Needy Farnilies

Effects of Tax and Transfer Policies on the, Distribution of Income

~

- Public Policy and the Distribution of Income Government policies affect the distriburioq of income through taxes and transfer policies. In this part of the chapter, we e1q~lm;eot;he broad effects of federal tax and transfer policies on the distribution of incoill,t;. We also discuss specific policies designed to boost the income and economic prospects gf the poor.

• Teclmological change. Advances in technology have simultaneously decreased the demand for less-educated workers and increased the demand for college graduates and people with advanced degrees. While the new teclmology has made it possible to replace many low-skilled workers with "smart" machines and computers, it has also increased the demand for workers who have the education and skills required to produce the new technology and use it.

• Increased international trade. An increase in international trade means more exports and imports. Trade allows developed countries like the United States to easily export goods produced with high-skilled labor and import goods produced with low-skilled labor. As a result, the expansion of international trade in the last three decades has increased the demand for high-skilled workers and ~e<;:teased the demand for low-skilled workers in the United States.

Economists have noLyet reached a consensus on the relative importance of these two factors.

the low end of educational attainment, the dropout penalty-the income loss from dropping out of high school, rather than simply graduating from high school-has nearly doubled.

Why did the demand for skilJ increase over the last three decades? Economists have explored this issue, and provide evidence for two key factors.

__ 2..;...;..7-'-6 CHAPTER 10 •THE LABOR MARKET AND THE DISTRIBUTION OF INCOME

Printed by DAIFALLAHALSHAIKHI ([email protected]) on 10n/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authorized user or valid subscription a represents a copyright violation.

means-tested programs, p. 279 output effect, p. 260 short-run demand curve for labor,

p. 258 signaling effect, p. 270 substitution effect for leisure

demand, p. 262

long-run demand curve for labor, p. 260

marginal product of labor, p. 257 marginal-revenue product of labor

(MRP), p. 257 market supply curve for labor,

p.263

3 The wage in a particular occupation will be relatively high if supply is small relative to demand. This will occur if (1) few people have the skills required for the occupation, (2) training costs are high, or (3) the job is dangerous or stressful.

4 College graduates earn more than high-school graduates because a college education provides new skills and allows people to reveal their skills to employers.

5 The trade-off with a minimum wage is that some workers earn higher income, but others lose their jobs.

6 Ln the last few decades, the distribution of income has become more unequal. Feqeral tax and transfer policies diminish income ineq1:1ali~ but the redistributional effect has diminished in recent decades,

7 Poverty rates ar~ relatively high among Blacks, Hispanics, high-school dropobts, and female-headed households.

KEY TERMS) featherbedding, p. 272 income effect for leisure demand,

p. 262 input-substitution effect, p. 260 labor union, p. 271 learning effect, p. 270

In this chapter, we've seen how wages are determined

·in perfectly competitive labor mat:Kets and why wages dif- fer. from one occupation to another, We'vrg, also looked at the distribution af'ii:icome

in the United States and explored possible reasons .for growing inequality. Here are the main points of the chapter:

The tonq-run demand curve for labor Is negatively sloped because the output and input-substitution effects operate in the same direction: An increase in the wage decreases labor per unit of output and decreases the total output produced.

2 An increase in the wage triggers income and substitution effects that operate in opposite directions, so an increase in the wage has an ambiguous effect on the quantity of labor supplied.

from 71 percent to 86 percent, and increases in the maximum credit over this period were responsible for a large share of the increase in the employment rate. Second, the EITC reduces poverty. In 2003, the program lifted 4.4 million people in low-income working families out of poverty. For the period 2002-2004, the EITC decreased the poverty rate among participants from 57 percent to 49 percent. For households below the poverty line, the EITC fiJJed 31 percent of the gap between income and the poverty line.

1.5 The input-substitution effect is that a decrease in the wage (increases/decreases) the quantity of labor per unit of , so the quantity of labor demanded (increases/decreases).

1.6 The short-nm market demand curve for labor is (steeper/flatter) than the long-run

demand because occur(s) in the short run.

1.7 Fill the blanks with 75, 100, 117, 200, or 360. In major league baseball, the marginal revenue product of the typical free agent is roughly percent of his salary, compared to percent for a journeyman and percent for an apprentice. (Related to Application l on page 261.)

1.8 Demand for News Kids. Consider the market for newspaper delivery kids in Kidsville. Each news kid receives a piece rate of $2 per subscriber per month and bas a fixed territory that initially has 100 subscribers. The price elasticity of demand for subscriptions is 2.0. Suppose the new city council of Kidsville passes a law that establishes a minimum piece

1.1 The .rnarginal revenue product of labor equals -----times-----

1.2 A profit-maximizing firm will hire the number of workers where equals -----

1.3 Your favorite professional team is considering hiring a new player for $3 million pet year. It will be sensible (profitable) to hire the pfayef if his is greater than the $3 million cost.

1.4 Arrows up or down: The logic of the ou~ut effect is that a decrease in the w~ge will . ( produc- non costs, so the pnce of output will and the quantity of output demanded will .1\:~. a result, the quantity of labor demanded wi ll

- The Demand for Labor

282 · I'd b . t' d t nn e by DAIFALLAHALSHAIKHI ([email protected]) on 10fi/2013 from 217.12.225.25 authorized to use until 10/14/2013. Use beyond the authonzed user orva 1 su scnp ion a e represents a copyright violation.

2.2 6-'rrows up or down: An increase in the wage ~~--- real income, and if leisure is a normal good this tends to leisure time and ----~ labor time.

2.3 We (oan/cannot) predict a worker's response to an increase in the wage because the -----effect and the effect work in -----(the same/opposite~ direction/s).

2.4 Your objective is to earn exactly $120 per week. If your wage decreases from $6 to $4 per hour, you respond by working hours instead of ----- hours. In other words, your labor-supply curve is sloped.

2.5 If every worker in a particular occupation works exactly 40 hours per week, regardless of the wage, the .individual supply curve is vertical. (True/False)

2.6 For cabbies in New York City, the elasticity of supply of labor is (positive/negative/zero). (Related to Application 2 on page 264.)

2.1 Arrows up or down: An increase in the wage the opportunity cost of leisure time,

which tends to leisure time and ----- labor time.

- The Supply of Labor

rate of $3 per subscriber per month. As a result, the publisher increases the monthly price of a subscription by 20 percent. How will the new law affect the monthly income of the typical news kid?

1.9 Demand for Airline Pilots. Comment on the following: "There is no substitute for an airline pilot: Someone has to fly the plane. Therefore, an increase in the wage of airline pilots will not change the number of pilots used by the airlines."

All problems are assignable in MyEconLab. EXERCISES

  • page 157
  • page 158
  • page 159
  • page 160
  • page 161
  • page 163
  • page 164
  • page 165
  • page 166
  • page 167
  • page 168
  • page 169
  • page 170
  • page 171
  • page 172
  • page 173
  • page 176
  • page 177
  • page 178
  • page 179
  • page 180
  • page 181
  • page 182
  • page 183
  • page 184
  • page 185
  • page 186
  • page 188
  • page 189
  • page 191
  • page 193
  • page 194
  • page 196
  • page 197
  • page 198
  • page 199
  • page 201
  • page 202
  • page 203
  • page 204
  • page 205
  • page 206
  • page 207
  • page 209
  • page 210
  • page 211
  • page 212
  • page 219
  • page 221
  • page 222
  • page 224
  • page 225
  • page 226
  • page 227
  • page 228
  • page 229
  • page 230
  • page 231
  • page 232
  • page 238
  • page 237
  • page 240
  • page 241
  • page 242
  • page 243
  • page 244
  • page 245
  • page 246
  • page 247
  • page 253
  • page 255
  • page 256
  • page 259
  • page 260
  • page 261
  • page 262
  • page 263
  • page 264
  • page 265
  • page 266
  • page 268
  • page 270
  • page 271
  • page 272
  • page 274
  • page 275
  • page 276
  • page 281
  • page 282

Regulations:

· This assignment is an individual assignment to be submitted in a word file.

· Students are encouraged to use their own words.

· Students must follow academic writing standards and APA style guidelines.

· Support your submission with course material concepts, principles, and theories from the textbook, along with at least two scholarly, peer-reviewed journal articles for each question.

· A mark of zero is awarded for any submission that includes copying from other resources without proper referencing it.

· Write at least 9 pages in length, excluding the title page and required reference page. Note: For all your answers support your views/opinions with at least two to three scholarly references, and a word count at least of 500 words for each answer.

·

· It is strongly encouraged that the student submits his/her assignment into the Safe Assignment Originality Check Plagiarism before sending it to your instructor for grading.

· Plagiarism less than 10%.

Questions:

Q1. Firms in oligopoly must constantly think in terms of how other firms in the industry will react to whatever they do. Why do they have to do this? Why is it that firms in perfect competition and in monopoly don’t have to worry about how other firms will react? (5 Marks)

Q2. Governments are frequently tempted to introduce price ceilings in markets. Use an example to explain why this is not such a good idea, at least when markets are competitive. Give some ideas as to what the government could do instead in order to help consumers in these markets. (5 Marks)

Q3. If perfectly competitive firms are price takers, and monopolistic, monopolistic competitive, and oligopolistic firms are price searchers, then it follows that three times as many firms in the real world are price searchers than are price takers. Do you agree or disagree? Explain your answer. (5 Marks)

Q4. Critically analyze the following statement with views of your own:

“There is no substitute for an airline pilot: Someone has to fly the plane. Therefore, an increase in the wage of airline pilots will not change the number of pilots used by the airlines.”(5 Marks)

Learning Resource: Chapters 7, 8 & 10 of the Text Book O’Sullivan, A., Sheffrin, S. M., & Perez, S.J. (2014).Survey of Economics: Principles, Applications, and Tools. (6th).Upper Saddle River, NJ: Pearson Education. Print version: ISBN-10: 0-13-294885-0 or ISBN-13: 978-0-13-294885-2.Digital version: ISBN-13:978-0-13-13-9370-7.

End of Page

Get help from top-rated tutors in any subject.

Efficiently complete your homework and academic assignments by getting help from the experts at homeworkarchive.com