CFA Level I Book 1-140-162 PDF

READING 12 FIRMS AND MARKET STRUCTURES MODULE 12.1: BREAKEVEN, SHUTDOWN, AND SCALE Video covering this content is...

READING 12 FIRMS AND MARKET STRUCTURES MODULE 12.1: BREAKEVEN, SHUTDOWN, AND SCALE Video covering this content is available online. LOS 12.a: Determine and interpret breakeven and shutdown points of production, as well as how economies and diseconomies of scale affect costs under perfect and imperfect competition. In economics, we de ine the short run for a irm as the time period over which some factors of production are ixed. Typically, we assume that capital is ixed in the short run so that a irm cannot change its scale of operations (plant and equipment) over the short run. All factors of production (costs) are variable in the long run. The irm can let its leases expire and sell its equipment, thereby avoiding costs that are ixed in the short run. Shutdown and Breakeven Under Perfect Competition As a simple example of shutdown and breakeven analysis, consider a retail store with a one-year lease ( ixed cost) and one employee (quasi- ixed cost), so that variable costs are simply the store’s cost of merchandise. If the total sales (total revenue) just cover both ixed and variable costs, price equals both average revenue and average total cost —so we are at the breakeven output quantity, and economic pro it equals zero. During the period of the lease (the short run), as long as items are being sold for more than their variable cost, the store should continue to operate to minimize losses. If items are being sold for less than their average variable cost, losses would be reduced by shutting down the business in the short run. In the long run, a irm should shut down if the price is less than average total cost, regardless of the relation between price and average variable cost. For a irm under perfect competition (a price-taker), we can use a graph of cost functions to examine the pro itability of the irm at different output prices. In Figure 12.1, at price P1, price and average revenue equal average total cost. At the output level of Point A, the irm is making an economic pro it of zero. At a price above P1, economic pro it is positive, and at prices less than P1, economic pro it is negative (the irm has economic losses). Figure 12.1: Shutdown and Breakeven Because some costs are ixed in the short run, it will be better for the irm to continue production in the short run as long as average revenue is greater than average variable costs. At prices between P1 and P2 in Figure 12.1, the irm has losses, but the losses are smaller than would occur if all production were stopped. As long as total revenue is greater than total variable cost, at least some of the irm’s ixed costs are covered by continuing to produce and sell its product. If the irm were to shut down, losses would be equal to the ixed costs that still must be paid. As long as price is greater than average variable costs, the irm will minimize its losses in the short run by continuing in business. If average revenue is less than average variable cost, the irm’s losses are greater than its ixed costs, and it will minimize its losses by shutting down production in the short run. In this case (a price less than P2 in Figure 12.1), the loss from continuing to operate is greater than the loss (total ixed costs) if the irm is shut down. In the long run, all costs are variable, so a irm can avoid its (short-run) ixed costs by shutting down. For this reason, if price is expected to remain below minimum average total cost (Point A in Figure 12.1) in the long run, the irm will shut down rather than continue to generate losses. To sum up, if average revenue is less than average variable cost in the short run, the irm should shut down. This is its short-run shutdown point. If average revenue is greater than average variable cost in the short run, the irm should continue to operate, even if it has losses. In the long run, the irm should shut down if average revenue is less than average total cost. This is the long-run shutdown point. If average revenue is just equal to average total cost, total revenue is just equal to total (economic) cost, and this is the irm’s breakeven point. If AR ≥ ATC, the irm should stay in the market in both the short and long run. If AR ≥ AVC, but AR < ATC, the irm should stay in the market in the short run but will exit the market in the long run. If AR < AVC, the irm should shut down in the short run and exit the market in the long run. Shutdown and Breakeven Under Imperfect Competition For price-searcher irms (those that face downward-sloping demand curves), we could compare average revenue to ATC and AVC, just as we did for price-taker irms, to identify shutdown and breakeven points. However, marginal revenue is no longer equal to price. We can, however, still identify the conditions under which a irm is breaking even, should shut down in the short run, and should shut down in the long run in terms of total costs and total revenue. These conditions are as follows: TR = TC: break even TC > TR > TVC: irm should continue to operate in the short run but shut down in the long run TR < TVC: irm should shut down in the short run and the long run Because price does not equal marginal revenue for a irm in imperfect competition, analysis based on total costs and revenues is better suited for examining breakeven and shutdown points. The previously described relations hold for both price-taker and price-searcher irms. We illustrate these relations in Figure 12.2 for a price-taker irm (TR increases at a constant rate with quantity). Total cost equals total revenue at the breakeven quantities QBE1 and QBE2. The quantity for which economic pro it is maximized is shown as Qmax. Figure 12.2: Breakeven Point Using the Total Revenue/Total Cost Approach If the entire TC curve exceeds TR (i.e., no breakeven point), the irm will want to minimize the economic loss in the short run by operating at the quantity corresponding to the smallest (negative) value of TR − TC. EXAMPLE: Short-run shutdown decision For the last iscal year, Legion Gaming reported total revenue of $700,000, total variable costs of $800,000, and total ixed costs of $400,000. Should the irm  continue to operate in the short run? Answer: The irm should shut down. Total revenue of $700,000 is less than total costs of $1,200,000, and it is also less than total variable costs of $800,000. By shutting down, the irm will lose an amount equal to ixed costs of $400,000. This is less than the loss of operating, which is TR − TC = $500,000. EXAMPLE: Long-run shutdown decision Suppose, instead, that Legion Gaming reported total revenue of $850,000. Should the irm continue to operate in the short run? Should it continue to operate in the long run? Answer: In the short run, TR > TVC, and the irm should continue operating. The irm should consider exiting the market in the long run, as TR is not suf icient to cover all of the ixed costs and variable costs. Economies and Diseconomies of Scale While plant size is ixed in the short run, in the long run, irms can choose their most pro itable scale of operations. Because the long-run average total cost (LRATC) curve is drawn for many different plant sizes or scales of operation, each point along the curve represents the minimum ATC for a given plant size or scale of operations. In Figure 12.3, we show a irm’s LRATC curve along with short-run average total cost (SRATC) curves for many different plant sizes, with SRATCn+1 representing a larger scale of operations than SRATCn. Figure 12.3: Economies and Diseconomies of Scale We draw the LRATC curve as U-shaped. Average total costs irst decrease with larger scale, but eventually begin to increase with larger scale. The lowest point on the LRATC corresponds to the scale or plant size at which the average total cost of production is at a minimum. This scale is sometimes called the minimum ef icient scale. Under perfect competition, irms must operate at minimum ef icient scale in long-run equilibrium, and LRATC will equal the market price. Recall that under perfect competition, irms earn zero economic pro it in long-run equilibrium. Firms that have chosen a different scale of operations with higher average total costs will have economic losses and must either leave the industry or change to the minimum ef icient scale. The downward-sloping segment of the LRATC curve presented in Figure 12.3 indicates that economies of scale (or increasing returns to scale) are present. Economies of scale result from factors such as labor specialization, mass production, and investment in more ef icient equipment and technology. In addition, the irm may be able to negotiate lower input prices with suppliers as it increases in size and purchases more resources. A irm operating with economies of scale can increase its competitiveness by expanding production and reducing costs. The upward-sloping segment of the LRATC curve indicates that diseconomies of scale are present. Diseconomies of scale may result as the increasing bureaucracy of larger irms leads to inef iciency, problems with motivating a larger workforce, and greater barriers to innovation and entrepreneurial activity. A irm operating under diseconomies of scale will want to decrease output and move back toward the minimum ef icient scale. The U.S. auto industry is an example of an industry that has exhibited diseconomies of scale. There may be a relatively lat portion at the bottom of the LRATC curve that exhibits constant returns to scale, or relatively constant costs across a range of plant sizes. MODULE QUIZ 12.1 1. In a purely competitive market, economic losses indicate that: A. price is below average total costs. B. collusion is occurring in the marketplace. C. firms need to expand output to reduce costs. 2. A firm is likely to operate in the short run as long as price is at least as great as: A. marginal cost. B. average total cost. C. average variable cost. 3. A firm’s average revenue is greater than its average variable cost and less than its average total cost. If this situation is expected to persist, the firm should: A. shut down in the short run and in the long run. B. shut down in the short run, but operate in the long run. C. operate in the short run, but shut down in the long run. 4. If a firm increases its plant size by 10% and its minimum average total cost increases by 10%, the firm is experiencing: A. constant returns to scale. B. diseconomies of scale.  C. economies of scale. MODULE 12.2: CHARACTERISTICS OF MARKET STRUCTURES Video covering this content is available online. LOS 12.b: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Recall from the prerequisite readings that perfect competition results in irm demand that is horizontal (perfectly elastic) at the market price. The irm demand curves for the three other market structures we discuss are all downward sloping. When a irm’s demand curve slopes downward, marginal revenue (MR) is less than price. For both horizontal and downward-sloping demand curves, a irm will maximize pro its by producing the quantity for which MR is just equal to marginal cost. While it may not be true in every case, it may be useful to think of irms under pure monopoly as having the steepest demand curves. Firms under monopolistic competition typically have relatively elastic downward-sloping demand curves, while irms in an oligopoly market will face downward-sloping demand curves somewhere between these two extremes. We can analyze where a market falls along the spectrum from perfect competition to pure monopoly by examining ive factors: 1. Number of irms and their relative sizes 2. Degree to which irms differentiate their products 3. Bargaining power of irms with respect to pricing 4. Barriers to entry into or exit from the industry 5. Degree to which irms compete on factors other than price Perfect competition refers to a market in which many irms produce identical products, barriers to entry into the market are very low, and irms compete for sales only on the basis of price. Firms face perfectly elastic (horizontal) demand curves at the price determined in the market because no irm has a large enough portion of the overall market to affect the market price of the good. The market for wheat in a region is a good approximation of such a market. Overall market supply and demand determine the price of wheat, and each producer can sell all that they choose to at that price. Monopolistic competition differs from perfect competition in that products are not identical. Each irm differentiates its product(s) from those of other irms through some combination of differences in product quality, product features, and marketing. The demand curve faced by each irm is downward sloping (i.e., neither perfectly elastic nor perfectly inelastic). Prices that producers charge are not identical because of perceived differences among their products, and typically, barriers to entry are low. The market for toothpaste is a good example of monopolistic competition. Firms differentiate their products through features and marketing with claims of more attractiveness, whiter teeth, fresher breath, and even actually cleaning your teeth and preventing decay. If the price of your personal favorite increases, you are not likely to immediately switch to another brand as we assume under perfect competition. Some customers may switch brands in response to a 10% increase in price, and some may not. This is why irm demand is downward sloping rather than perfectly elastic. The most important characteristic of an oligopoly market is that only a few irms are in the industry. In such a market, each irm must consider the actions and responses of other irms in setting price and business strategy. We say that such irms are interdependent. While the irms’ products are typically good substitutes for each other, they may be either quite similar or differentiated through features, branding, marketing, and quality. Barriers to entry are typically high, often because of economies of scale in production or marketing, which accounts for the existence of a small number of irms with relatively large market shares. Demand can be more or less elastic than for irms in monopolistic competition. The automobile market is dominated by a small number of large irms and can be characterized as an oligopoly. The product and pricing decisions of Toyota certainly affect those of Ford, and vice versa. Automobile makers compete based on price, but they also compete through marketing, product features, and quality, which are often signaled strongly through the brand name. The oil industry also has a few irms with large market shares, but their products are, in most cases, good substitutes for each other. A monopoly market is characterized by a single seller of a product with no good substitutes. This fact alone means that the irm faces a downward-sloping demand curve (the market demand curve) and has the power to choose the price at which it sells its product. High barriers to entry protect a monopoly producer from competition. One source of monopoly power is the protection offered by copyrights and patents. Another possible source of monopoly power is control over a resource speci ically needed to produce the product. Most frequently, monopoly power is supported by speci ic laws or government regulation (e.g., a local electric utility). Figure 12.4 shows the key features of each market structure. Figure 12.4: Characteristics of Market Structures LOS 12.c: Explain supply and demand relationships under monopolistic competition, including the optimal price and output for irms as well as pricing strategy. Monopolistic competition has the following market characteristics: A large number of independent sellers. (1) Each irm has a relatively small market share, so no individual irm has any signi icant power over price. (2) Firms only need to pay attention to average market price, not the prices of individual competitors. (3) There are too many irms in the industry for collusion (price- ixing) to be possible. Differentiated products. Each producer has a product that is, in some way, different from those of its competitors (in the minds of consumers). The competing products are considered close substitutes for one another. Firms compete less on price and more on marketing, perceived quality, and differences in features. Firms must make price and output decisions because they face downward-sloping demand curves. Low barriers to entry. The cost of entering the market and exiting the market are relatively low. Think about the market for toothpaste. Brands of toothpaste are quite similar, and it is reasonable to assume that toothpaste is not too dif icult or costly to produce. But brands are differentiated based on speci ic features, on in luential advertising and marketing, and on the reputations of the producers. The price/output decision for monopolistic competition is illustrated in Figure 12.5. Panel A of Figure 12.5 illustrates the short-run price/output characteristics of monopolistic competition for a single irm. As indicated, irms in monopolistic competition maximize economic pro its by producing where marginal revenue (MR) equals marginal cost (MC), and by charging the price for that quantity from the demand curve, D. Here, the irm earns positive economic pro its because price, P*, exceeds average total cost, ATC*. Due to low barriers to entry, competitors can enter the market in pursuit of these economic pro its. Figure 12.5: Short-Run and Long-Run Output Under Monopolistic Competition Panel B of Figure 12.5 illustrates long-run equilibrium for a representative irm after new irms have entered the market. As indicated, the entry of new irms shifts the demand curve faced by each individual irm down to the point where price equals average total cost (P* = ATC*), such that economic pro it is zero. At this point, there is no longer an incentive for new irms to enter the market, and long-run market equilibrium is established. A irm in monopolistic competition continues to produce at the quantity where MR = MC, but it no longer earns positive economic pro its. We can get to a similar long-run equilibrium even without entry of new irms if each irm increases its marketing spending (a component of ATC) to either increase or defend its market share until ATC has increased to that shown in Panel B. If all irms compete in this way, each irm will produce Q* and sell at P* but earn no economic pro it because marketing costs have increased ATC to ATC*, which is equal to price. Advertising expenses are often relatively high for irms in monopolistic competition. Figure 12.6 illustrates the differences between long-run equilibrium in markets with monopolistic competition and markets with perfect competition. Note that with monopolistic competition, price is greater than MC (i.e., producers can realize an economic pro it), average total cost is not at a minimum for the quantity produced (suggesting excess capacity, or an inef icient scale of production), and the price is slightly higher than under perfect competition. The point to consider here, however, is that perfect competition is characterized by no product differentiation. The question of the ef iciency of monopolistic competition becomes, “Is there an economically ef icient amount of product differentiation?” Figure 12.6: Firm Output Under Monopolistic and Perfect Competition In a world with only one brand of toothpaste, clearly, average production costs would be lower. That fact alone probably does not mean that a world with only one brand or type of toothpaste would be a better world. While product differentiation has costs, it also has bene its to consumers. Consider the market for a pharmaceutical that reduces blood pressure to prolong life. There may be several competing drugs that are more or less effective for, or well or poorly tolerated by, different groups of patients. In this case, we may ind that irm demand curves are relatively steep compared to those for brands of toothpaste, indicating that the competing drugs are not considered good substitutes for many patients. LOS 12.d: Explain supply and demand relationships under oligopoly, including the optimal price and output for irms as well as pricing strategy. Compared to monopolistic competition, an oligopoly market has higher barriers to entry and fewer irms. The other key difference is that the irms are interdependent; a price change by one irm can be expected to be met by a price change by its competitors in response. This means that the actions of another irm will directly affect a given irm’s demand curve for the product. Given this complicating fact, models of oligopoly pricing and pro its must make numerous important assumptions. In the following, we describe four of these models and their implications for price and quantity: 1. Kinked demand curve model 2. Cournot duopoly model 3. Nash equilibrium model 4. Stackelberg dominant irm model One traditional model of oligopoly, the kinked demand curve model, is based on the assumption that competitors are unlikely to match a price increase by a competitor, but very likely to match a price decrease by a competitor. This results in a kink in the demand curves faced by each producer, at the current market price. Each irm believes that it faces a demand curve that is more elastic ( latter) above the current price (the kink in the demand curve) than it is below the given price. The kinked demand curve model is illustrated in Figure 12.7. The kink price is at price PK, where a irm produces QK. A irm believes that if it raises its price above PK, its competitors will remain at PK, and it will lose market share because it has the highest price. Above PK, the demand curve is considered to be relatively elastic (i.e., a small price increase will result in a large decrease in demand). On the other hand, if a irm decreases its price below PK, other irms will match the price cut, and all irms will experience a relatively small increase in sales relative to any price reduction. Therefore, QK is the pro it-maximizing level of output. Figure 12.7: Kinked Demand Curve Model With a kink in the demand curve, we also get a gap in the associated MR curve, as shown in Figure 12.8. For any irm with a MC curve passing through this gap, the price where the kink is located is the irm’s pro it-maximizing price. Figure 12.8: Marginal Revenue With Kinked Demand Curve We say that the decisions of irms in an oligopoly are interdependent; that is, the pricing decision of one irm depends on the pricing decisions of other irms. Some models of market price equilibrium have a set of rules for the actions of oligopolists. These rules assume they choose prices based on the choices of the other irms. By specifying the decision rules that each irm follows, we can design a model that allows us to determine the equilibrium prices and quantities for irms operating in an oligopoly market. An early model of oligopoly pricing decisions is the Cournot model. In Cournot’s duopoly model, two irms with identical MC curves each choose their preferred selling price based on the price the other irm chose in the previous period. Firms assume that the competitor’s price will not change. The long-run equilibrium for an oligopoly with two irms (duopoly), in the Cournot model, is for both irms to sell the same quantity, dividing the market equally at the equilibrium price. The equilibrium price is less than the price that a single monopolist would charge, but greater than the equilibrium price that would result under perfect competition. With a greater number of producers, the long-run market equilibrium price moves toward the competitive price. Another model, the Stackelberg model, uses a different set of rules and produces a different result. While the Cournot model assumes the competitors choose price simultaneously each period, the Stackelberg model assumes pricing decisions are made sequentially. One irm, the “leader,” chooses its price irst, and the other irm chooses a price based on the leader’s price. In long-run equilibrium, under these rules, the leader charges a higher price and receives a greater proportion of the irms’ total pro its. These models are early versions of rules-based models, which fall under the heading of what are now generally termed strategic games. Strategic games comprise decision models in which the best choice for a irm depends on the expected actions (reactions) of other irms. A more general model of strategic games was developed by Nobel Prize winner John Nash, who developed the concept of a Nash equilibrium. A Nash equilibrium is reached when the choices of all irms are such that there is no other choice that makes any irm better off (increases pro its or decreases losses). The Cournot model results in a Nash equilibrium. In equilibrium, neither competitor can increase pro its by changing the price they charge. The concept of a Nash equilibrium can be illustrated with the situation presented in Figure 12.9, which shows the choices and resulting pro its for two irms. Each irm can charge either a high price or a low price. If both irms charge a high price, Firm A earns 1,000 and Firm B earns 600. While Firm A would not charge the low price (it would earn less regardless of Firm B’s decision), Firm B can increase pro its to 700 by charging a low price. With Firm A charging a high price and Firm B charging a low price, neither irm can increase pro its by unilaterally changing its price strategy. Thus, we can identify the Nash equilibrium in this scenario as Firm B charging a low price and Firm A charging a high price. Figure 12.9: Nash Equilibrium Thus far, we have assumed that irms act competitively to maximize their individual pro its. We can illustrate the potential of cooperative behavior among producers to increase the total pro its of all irms in the market. Collusion refers to competitors making a joint agreement to charge a given price—or, alternatively, to agree to speci ic levels of output. In Figure 12.9, the greatest joint pro its (1,600) are earned when both irms charge a high price. If Firm A offers to pay Firm B 200 for charging a high price, Firm A’s pro its increase from 600 to 1,000. After paying 200 to Firm B, Firm A still gains 200. Firm B’s pro its (including the payment of 200) increase from 700 to 800. Collusion, in this case, increases the pro its of both irms, compared to the Nash equilibrium. If irms can enter into and enforce an agreement regarding pricing and output, often they can all bene it. Such agreements among producers are illegal in many countries because they reduce competition. An example of a collusive agreement is the OPEC cartel. Cartel-member countries agree to restrict their oil production to increase the world price of oil. Members sometimes choose to “cheat” on the cartel agreement by producing more than the amount of oil they have agreed to produce. If members of a cartel do not adhere to the agreement (taking advantage of the higher market price but failing to restrict output to the agreed-upon amount), the agreement can quickly break down. In general, collusive agreements to increase price in an oligopoly market will be more successful (have less cheating) under the following conditions: There are fewer irms. Products are more similar (less differentiated). Cost structures are more similar. Purchases are relatively small and frequent. Retaliation by other irms for cheating is more certain and more severe. There is less actual or potential competition from irms outside the cartel. A inal model of oligopoly behavior to consider is the dominant irm model. In this model, a single irm has a signi icantly large market share because of its greater scale and lower cost structure—the dominant irm (DF). In such a model, the market price is essentially determined by the DF, and the other competitive irms (CFs) take this market price as given. The DF believes that the quantity supplied by the other irms decreases at lower prices, so that the DF’s demand curve is related to the market demand curve, as shown in Figure 12.10. Based on this demand curve (DDF) and its associated marginal revenue (MRDF) curve, the irm will maximize pro its at a price of P*. The CFs maximize pro its by producing the quantity for which their marginal cost (MCCF) equals P*, quantity QCF. Figure 12.10: Dominant Firm Oligopoly A price decrease by one of the CFs, which increases QCF in the short run, will lead to a decrease in price by the DF, and CFs will decrease output or exit the industry in the long run. The long-run result of such a price decrease by competitors below P* would then be to decrease the overall market share of competitor irms and increase the market share of the DF. Clearly, oligopoly markets exhibit many possible outcomes that depend on the characteristics of the irms and of the market itself. The important point is that the irms’ decisions are interdependent so that the expected reactions of other irms are an important consideration. Overall, the resulting price will be somewhere between the price based on perfect collusion that would maximize total pro its to all irms in the market (which is actually the monopoly price), and the price that would result from perfect competition and generate zero economic pro its in the long run. These two limiting outcomes are illustrated in Figure 12.11 as Pcollusion with Qcollusion for perfect collusion, and Pcompetition and Qcompetition for perfect competition. Figure 12.11: Collusion vs. Perfect Competition MODULE QUIZ 12.2 1. The demand for products from monopolistic competitors is relatively elastic due to: A. high barriers to entry. B. the availability of many close substitutes. C. the availability of many complementary goods. 2. Compared to a perfectly competitive industry, in an industry characterized by monopolistic competition: A. both price and quantity are likely to be lower. B. price is likely to be higher, and quantity is likely to be lower. C. quantity is likely to be higher, and price is likely to be lower. 3. A firm will most likely maximize profits at the quantity of output for which: A. price equals marginal cost. B. price equals marginal revenue. C. marginal cost equals marginal revenue. 4. An oligopolistic industry has: A. few barriers to entry. B. few economies of scale. C. a great deal of interdependence among firms. 5. Consider a firm in an oligopoly market that believes the demand curve for its product is more elastic above a certain price than below this price. This belief fits most  appropriately to which of the following models? A. Cournot model. B. Dominant firm model. C. Kinked demand model. 6. Consider an agreement between France and Germany that will restrict wine production so that maximum economic profit can be realized. The possible outcomes of the agreement are presented in the following table. Based on the concept of a Nash equilibrium, the most likely strategy followed by the two countries with respect to whether they comply with or default on the agreement will be: A. both countries will default. B. both countries will comply. C. one country will default and the other will comply. MODULE 12.3: IDENTIFYING MARKET STRUCTURES Video covering this content is available online. LOS 12.e: Identify the type of market structure within which a irm operates and describe the use and limitations of concentration measures. We can use the characteristics we outlined earlier to identify the type of market structure within which a irm is operating. Our earlier table is repeated here in Figure 12.12. For an analyst attempting to determine the degree of pricing power that irms in the industry have, the focus is on the number of irms in the industry, its barriers to entry, the nature of substitute products, and the nature of industry competition. Signi icant interdependence among irm pricing and output decisions is a characteristic of all oligopoly markets, although some interdependence may be present under monopolistic competition—even with many more irms than for an oligopoly structure. The following table illustrates the differences in characteristics among the various market structures. Figure 12.12: Characteristics of Market Structures Given the differences in cost structures, suitability of substitutes, and the degree of differentiation, simply classifying the primary characteristics of a market does not tell us the degree of pricing power for individual irms or the magnitude of the difference between market prices and the prices implied by perfect competition. What we would really like (especially for the regulation of markets) is to be able to measure the elasticity of irm demand directly, but that is dif icult and subject to estimation error. Consequently, regulators often use market shares (percentages of market sales) to measure the degree of monopoly or market power of irms in an industry. Often, mergers or acquisitions of companies in the same industry or market are not permitted by government authorities when they determine that the market share of the combined irms will be too high and, therefore, detrimental to the economy. Market or industry concentration measures are often used as an indicator of market power. One concentration measure is the N- irm concentration ratio, which is calculated as the sum of the percentage market shares of the largest N irms in a market. While this measure is simple to calculate and understand, it does not directly measure market power or elasticity of demand. One limitation of the N- irm concentration ratio is that it may be relatively insensitive to mergers of irms within an industry. This problem is reduced by using an alternative measure of market concentration, the Her indahl-Hirschman Index (HHI). The HHI is calculated as the sum of the squares of the market shares of the largest irms in the market. The following example illustrates this difference between the two measures and their calculation. EXAMPLE: 4- irm concentration ratio and 4- irm HHI Given the market shares of the following irms, calculate the 4- irm concentration ratio and the 4- irm HHI, both before and after a merger of Acme and Blake.  Answer: Before the merger, the 4- irm concentration ratio for the market is 25 + 15 + 15 + 10 = 65%. After the merger, the Acme + Blake irm has 40% of the market, and the 4- irm concentration ratio is 40 + 15 + 10 + 5 = 70%. Although the 4- irm concentration ratio has only increased slightly, the market power of the largest irm in the industry has increased signi icantly, from 25% to 40%. Before the merger, the 4- irm HHI is 0.252 + 0.152 + 0.152 + 0.102 = 0.1175. After the merger, the 4- irm HHI is 0.402 + 0.152 + 0.102 + 0.052 = 0.1950, a signi icant increase. A limitation that applies to both of our simple concentration measures is that barriers to entry are not considered in either case. Even a irm with high market share may not have much pricing power if barriers to entry are low and there is potential competition. With low barriers to entry, it may be the case that other irms stand ready to enter the market if irms currently in the market attempt to increase prices signi icantly. In this case, the elasticity of demand for existing irms may be high, even though they have relatively high market shares and industry concentration measures. MODULE QUIZ 12.3 1. Which of the following is most likely an advantage of the Herfindahl-Hirschman Index (HHI) relative to the N-firm concentration ratio? A. The HHI is simpler to calculate. B. The HHI considers barriers to entry. C. The HHI is more sensitive to mergers. 2. A market characterized by low barriers to entry, good substitutes, limited pricing power, and marketing of product features is best characterized as: A. oligopoly. B. perfect competition. C. monopolistic competition. KEY CONCEPTS LOS 12.a The breakeven quantity of production is the quantity for which price (P) = average total cost (ATC), and total revenue (TR) = total cost (TC). A irm should shut down in the long run if P < ATC so that TR < TC. A irm should shut down in the short run (and the long run) if P < average variable cost (AVC) so that TR < total variable cost (TVC). The long-run average total cost (LRATC) curve shows the minimum average total cost for each level of output, assuming that the plant size (scale of the irm) can be adjusted. A downward-sloping segment of an LRATC curve indicates economies of scale (increasing returns to scale). Over such a segment, increasing the scale of the irm reduces ATC. An upward-sloping segment of an LRATC curve indicates diseconomies of scale, where average unit costs will rise as the scale of the business (and long-run output) increases. LOS 12.b Perfect competition is characterized by the following: Many irms, each small relative to the market Very low barriers to entry into or exit from the industry Homogeneous products that are perfect substitutes; no advertising or branding No pricing power Monopoly is characterized by the following: A single irm that comprises the whole market Very high barriers to entry into or exit from the industry Advertising used to compete with substitute products Signi icant pricing power Monopolistic competition is characterized by the following: Many irms Low barriers to entry into or exit from the industry Differentiated products; heavy advertising and marketing expenditure Some pricing power Oligopoly markets are characterized by the following: Few sellers High barriers to entry into or exit from the industry Products that may be homogeneous or differentiated by branding and advertising Firms that may have signi icant pricing power LOS 12.c Under monopolistic competition, irms face downward-sloping demand curves so that marginal revenue is less than price, and the price from the demand curve at the pro it- maximizing quantity is the price at the optimal (pro it-maximizing) level of output. Resources expended on product differentiation may increase ATC so that there are no economic pro its at long-run equilibrium. There is no well-de ined irm supply curve. Monopolistic competition: Price > marginal revenue = marginal cost (in equilibrium) Zero economic pro it in long-run equilibrium LOS 12.d Under oligopoly, the pricing strategy is not clear. Because irm decisions are interdependent, the optimal pricing and output strategy depends on assumptions made about other irms’ cost structures and about competitors’ responses to a irm’s price changes. Models of oligopoly pricing include the following: Cournot. Firms with a given MC that make pricing decisions simultaneously share the market equally in LR equilibrium. Stackelberg. When irm pricing decisions are sequential, the irst irm to set its price (price leader) will maintain a larger share of the market, even in the long run. Dominant irm. A irm with a signi icantly lower cost of production will gain a disproportionate share of the market and essentially set the price that other competitors can charge. In general, in the absence of collusion, the long-run oligopoly equilibrium is Nash equilibrium, one in which no competitor can unilaterally change price to increase its pro its. There is no well-de ined irm supply curve. Oligopoly: Price > marginal revenue = marginal cost (in equilibrium) May have positive economic pro it in long-run equilibrium, but may move toward zero economic pro it over time LOS 12.e To identify the market structure in which a irm is operating, we can examine the number of irms in its industry, the prevalence of nonprice competition, and barriers to entry, then compare these to the characteristics that de ine each market structure. However, none of this provides us with the elasticity of irm demand. Because direct estimation of the elasticity of irm demand is statistically dif icult and imprecise, industry concentration measures are often used as a proxy for the degree of competition. A concentration ratio for N irms is calculated as the percentage of market sales accounted for by the N largest irms in the industry and is used as a simple measure of market structure and market power. The Her indahl-Hirschman Index measure of concentration is calculated as the sum of the squared market shares of the largest N irms in an industry and better re lects the effect of mergers on industry concentration. Neither measure indicates market power directly. Both can be misleading when potential competition restricts pricing power. ANSWER KEY FOR MODULE QUIZZES Module Quiz 12.1 1. A In a purely competitive market, economic losses indicate that irms are overproducing, causing prices to fall below average total costs. This can occur in the short run. In the long run, however, market supply will decrease as irms exit the industry, and prices will rise to the point where economic pro its are zero. (LOS 12.a) 2. C If price is greater than average variable cost, a irm will continue to operate in the short run because it is covering at least some of its ixed costs. (LOS 12.a) 3. C If a irm is generating suf icient revenue to cover its variable costs and part of its ixed costs, it should continue to operate in the short run. If average revenue is likely to remain below average total costs in the long run, the irm should shut down. (LOS 12.a) 4. B If minimum average total costs increase as plant size is increased, the irm is experiencing diseconomies of scale. (LOS 12.a) Module Quiz 12.2 1. B The demand for products from irms competing in monopolistic competition is relatively elastic due to the availability of many close substitutes. If a irm increases its product price, it will lose customers to irms selling substitute products at lower prices. (LOS 12.c) 2. B Monopolistic competition is likely to result in a higher price and lower quantity of output compared to perfect competition. (LOS 12.c) 3. C The pro it-maximizing output is the quantity at which marginal revenue equals marginal cost. In a price-searcher industry structure (i.e., any structure that is not perfect competition), price is greater than marginal revenue. (LOS 12.c) 4. C An oligopolistic industry has a great deal of interdependence among irms. One irm’s pricing decisions or advertising activities will affect the other irms. (LOS 12.d) 5. C The kinked demand model assumes that each irm in a market believes that at some price, demand is more elastic for a price increase than for a price decrease. (LOS 12.d) 6. A The Nash equilibrium results when each nation pursues the strategy that is best, given the strategy that is pursued by the other nation. Given that Germany complies with the agreement: France will get €8 billion if it complies, but €10 billion if it defaults. Therefore, France should default.  Given that Germany defaults: France will get €2 billion if it complies, but €4 billion if it defaults. Therefore, France should default. Because France is better off in either case by defaulting, France will default. Germany will follow the same logic and reach the same conclusion. (LOS 12.d) Module Quiz 12.3 1. C Although the N- irm concentration ratio is simple to calculate, it can be relatively insensitive to mergers between companies with large market shares. Neither the HHI nor the N- irm concentration ratio consider barriers to entry. (LOS 12.e) 2. C These characteristics are associated with a market structure of monopolistic competition. Firms in perfect competition do not compete on product features. Oligopolistic markets have high barriers to entry. (LOS 12.e) READING 13 UNDERSTANDING BUSINESS CYCLES MODULE 13.1: BUSINESS CYCLES Video covering LOS 13.a: Describe the business cycle and its phases. this content is available online. The business cycle is characterized by luctuations in economic activity. The business cycle has four phases: expansion (real GDP is increasing), peak (real GDP stops increasing and begins decreasing), contraction or recession (real GDP is decreasing), and trough (real GDP stops decreasing and begins increasing). The phases are illustrated in Figure 13.1. Figure 13.1: Business Cycle There are alternative ways to show business cycles. The curve in the igure illustrates the classical cycle, which is based on real GDP relative to a beginning value. The growth cycle refers to changes in the percentage difference between real GDP and its longer-term trend or potential value (shown as the “average” line in the igure). The growth rate cycle refers to changes in the annualized percentage growth rate from one period to the next and tends to show both peaks and troughs earlier than the other two measures. The growth rate cycle—which, like the growth cycle, shows GDP relative to a trend rate—is the preferred measure for economists and practitioners. An expansion features growth in most sectors of the economy, with increasing employment, consumer spending, and business investment. As an expansion approaches its peak, the rates of increase in spending, investment, and employment slow but remain positive, while in lation accelerates. A contraction or recession is associated with declines in most sectors, with in lation typically decreasing. When a contraction reaches a trough and the economy begins a new expansion or recovery, economic growth becomes positive again and in lation is typically moderate, but employment growth might not start to increase until the expansion has taken hold convincingly. Economists commonly consider two consecutive quarters of growth in real GDP to be the beginning of an expansion, and two consecutive quarters of declining real GDP to be the beginning of a contraction. Statistical agencies that date expansions and recessions, such as the National Bureau of Economic Research in the United States, look at a wider variety of additional economic data—especially unemployment, industrial production, and in lation—to identify turning points in the business cycle. A key aspect of business cycles is that they recur, but not at regular intervals. Past business cycles have been as short as a year, or longer than a decade. The idea of a business cycle applies to economies that consist mainly of businesses. For economies that are mostly subsistence agriculture or dominated by state planning, luctuations in activity are not really “business cycles” in the sense we are discussing here. LOS 13.b: Describe credit cycles. Credit cycles refer to cyclical luctuations in interest rates and the availability of loans (credit). Typically, lenders are more willing to lend, and tend to offer lower interest rates, during economic expansions. Conversely, they are less willing to lend, and require higher interest rates, when the economy is slowing (contracting). Credit cycles may amplify business cycles. Widely available or “loose” credit conditions during expansions can lead to “bubbles” (prices based on implausible expectations) in the markets for some assets, such as subprime mortgages in the period leading up to the inancial crisis of 2007–2009. Some research suggests that expansions tend to be stronger, and contractions deeper and longer lasting, when they coincide with credit cycles. They do not always coincide, however, as historical data suggest credit cycles have been longer in duration than business cycles on average. LOS 13.c: Describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business cycle and describe their measurement using economic indicators. Business Cycles and Resource Use Fluctuation Inventories are an important business cycle indicator. Firms try to keep enough inventory on hand to meet sales demand but do not want to keep too much of their capital tied up in inventory. As a result, the inventory-sales ratio in many industries tends toward a normal level in times of steady economic growth.