exam 3 - lecture 2

FOR STARTERS Go back to Lecture One; this is the same. For the time being, we?re going to focus on product markets and leave of the complex effin? wold behind. PRODUCERS There?s a straight-forward concept in this slide and one that?s a bit more slippery. First the Structure-Conduct-Performance arrows to the right reflect a very common way of looking at markets. First, we look at the structure of the market ? now many firms are there, are they just alike, do they all produce the same things, etc. Next, we consider, given the structure, how do these firms behave (or conduct themselves)? What do they make, how do they price things, do they advertise, etc.? Finally, we consider how the structure and resulting conduct affect economic outcomes. A.k.a., how does the market perform? The more slippery bit has to do with the collection of shapes held within the market boundary. This is intended to give you some since of what the real world is really like. Some firms are big; some are small. Some look similar to one another; some look very, very different. Moreover, they can all be spatially dispersed ? a fact that is bound to affect the way they interact. See how this market definition stuff can get tough? MARKET DEFINITION This is based on the US Department of Justice Merger Guidelines, but it is typically applied in nearly every setting where market definition is needed. The same framework is used to address two different facts of market definition ? the geographic dimension and the product dimension. In both cases, however, the same question is asked ? Could a monopoly seller in the market as currently defined impose a permanent and profitable price increase? If the answer is yes, then the market definition (regardless of dimension) is broad enough and may need to be made more narrow. If the answer is no, then the currently defined market is not broad enough and needs to be bigger to include more products or a larger geographic area. MARKET STRUCTURE These are just some comment elements of market structures. The thing that?s not included here is that the market structure (and resulting behaviors) from past periods may affect the market structure observed today or in the future. MARKET SHARES (1) Boring definitions for two measures of market concentration (how many firms, relative size). MARKET SHARES (2) Boring application of the last slide ? EXCEPT that this application shows you how these differing measures can point to very different results. MARKET CONDUCT This slide indicates a number of areas in which firms necessarily make periodic decisions. If market structure represents the ?rules? of the game, market conduct reflects the strategies that firms engage in given the apparent rules. The list included in this slide is, in no way, comprehensive. PROFIT MAX (1) In the real world profit maximization is not the universal goal evident in firm decision made every day of every year, but it is the underlying rule. Moreover, to the extent that markets are increasingly competitive, it becomes harder and harder for firms and their managers to deviate from this aim. The math here (and elsewhere) makes the quantity of output per time period the choice variable. In more complex settings this choice variable can be changed. In the current setting, however, profit maximization requires that firms choose a quantity of output per time period so that the marginal cost (MC) is equal to the Marginal Revenue (MR). To understand why this must be true, consider the cases when it is not true, where ? MC > MR or MR > MC. In the first case, a quantity (Q) has been chosen so that the additions to costs is greater than the addition to revenue attributable to the last unit produced. Should it have been produced? Similarly, if MR is greater than MC, it implies that when the firm stopped producing output that the addition to revenues attributable to the last unit produced was greater than the associated costs of that unit. Should the firm have stopped there? ? MAX (2) We?ll talk about these alternatives. Perhaps, the most interesting is ?profit-constrained managerial utility.? Think about it and see if it doesn?t sound appealing from the manager?s point of view. COMPETITION (1) ?Pure? competition involves an ?infinite? number of atomistic sellers. This can?t exist in reality, so we more generally talk about ?perfect? competition. In this setting there is a sufficient number of firms so that no single seller can affect the market price regardless of its behaviors. The second assumption is a lack of barriers to entry and exit. As I?ll preach over and over and over again, competition relies on entry in response to profit or exit in response to loss to function properly. This is, therefore, a powerful and important assumption. ?Homogeneous outputs? just means that the output of one seller can?t be distinguished from the output of other producing firms. Think about it; to the extinct that your product is a little better or a little worse that someone else?s, it could induce price variations that can?t be sustained in a competitive market. Finally, equal access to information assures that competitive markets will adjust quickly through the behaviors of other incumbent sellers and through the actions of potential entrants. COMPETITION (2) Ok, this is a little smarmy, but I?m trying to make a point. Competitive markets are made by the collective behaviors of individual firms that, independently, can not change those outcomes. In this slide, the point is that individual sellers must take the market price and respond to it without any ability to individually affect that price. COMPETITION (3) This is the classic ?equilibrium? slide. The left-hand side shows the market outcome that individual firms must respond to. The right-hand side shows the outcome for a ?representative? firm. All the firms are assumed to look alike (which assumption(s)), so it?s only necessary to depict one of the myriad sellers. There?s a ton of stuff to note. First, observe that Marginal Revenue (MR), Average Revenue (AR) and price are all the same. This same line is, in effect, the demand curve faced by a single competitive seller. It can sell as much or as little at the prevailing market price as it may choose, but its choice doesn?t change that price. Note the following definitions AR = TR/Q MR = ?TR/?Q If TR = P x Q, then it?s clear that AR will always be the same as P. What however, do you make of the fact that, in this case, MR is also the same as P? The second thing to note is that this competitive seller is maximizing profits. Marginal Revenue and Marginal Cost are equal at a level above the minimum Average Total Cost. Next this firm (and all the rest) is not earning an economic profit. Average Revenue (AR) and Average Total Cost (ATC) You can prove this easily to yourself by noting that ? ? = TR ? TC then dividing each term by Q. Thus, one important requirement of a competitive equilibrium is that sellers earn all their costs, but nothing more. MECHANICS Any equilibrium represents an outcome that will not changed unless one of the underlying determinants is changed. Still, we live in a world where everything is always changing. How are equilibria maintained? The answer is through some very simple, but powerful market mechanics. This slide sums it up ? profits or losses are the signals and firm entry or exit are the corresponding behaviors that maintain competitive equilibria. DISTURBANCES (1) There are only two things that can disturb a competitive equilibrium, a change in demand conditions or a change in the costs that underlie market supply. The first of the two appropriate slides considers demand changes. Note that demand changes (shifts) are exogenous, that is they come from outside somewhere. While it?s interesting to understand the cause of a demand shift, it?s not necessary to the analysis. The second thing to note is that since underlying costs don?t change in this case the new equilibrium price will be the same as the initial equilibrium price. This is important. Prices will change temporarily, inducing firm entry or exit in response to evident profits or losses, but the changes to P are purely transient in this case. Finally, use the Identity Q=qN, where Q is the market quantity, q is the level of individual firm output and N is the number of participating market firms to explain the new equilibrium. DISTURBANCES (2) Again, the second type of competitive equilibrium disturbance is attributable to changing costs. The mechanics are the same, but some of the outcomes are different. In particular, given that underlying costs have changed, the new equilibrium price will be different than in the initial equilibrium. Remember, profits must be zero in the new equilibrium. Accordingly, if costs have gone up or gone down, what must happen to price? EFFICIENCY Efficiency is the holly grail in economics. There are, in fact three efficiency measures used to judge a market outcome. Competition scores well on two of these. Allocative Efficiency Perhaps the main function of an economic system is to allocate scarce resources among possible uses. Therefore, if we depend on market interactions to perform this allocation, we want it done efficiently. A market outcome is allocatively efficient if the marginal benefit to the consumer of the last transacted unit equal to the marginal cost of supplying that last unit. I?ll torture you at length with the intuition behind this, but basically it boils down to an outcome in which the market price (P) is equal to Marginal Cost (P = MC). Well functioning competitive markets reach this outcome every time. This is why economists are so in love with the competitive process. Technical Efficiency Not only do we want resources allocated in the best possible way, we want markets that make the best possible use of available technologies. A market outcome is technically efficient if producers choose a quantity of output that makes the best possible use of the best possible technology. In the strictest sense, this means that firms choose a quantity such that ATC is minimized in equilibrium. You can see this for competitive markets by reviewing the earlier slides. Which assumptions guarantee this competitive outcome and what can happen to costs as firms bring the market to a new equilibrium? Dynamic Efficiency Finally, we want markets that offer improved outcomes over time ? better stuff, lower costs, and lower prices. This is the goal, but there is no generally accepted, slick definition. Moreover, there?s plenty of controversy regarding how competitive markets perform when measured against this rather nebulous yardstick. Dynamic efficiency implies technological improvement which, in turn, implies successful Research & Development (R&D), but for firms to engage in R&D, they must have both the incentive and the ability to do so. What do the assumptions that underpin the model of competition imply about firms doing R&D? How could real-world departures from the competitive ideal affect your answer