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CHAPTER 3: THE MARKET FORCES OF SUPPLY AND DEMAND The assumptions of the competitive market model The terms ‘supply’ and ‘demand’ refer to the behavior of people as they interact with one another in markets. Market= a group of buyers and sellers of a particular good or service. The market model represents a neo-classical explanation of how resources are allocated: One of the funda-mental outcomes of the market model is that if the assumptions hold, the resulting allocation of resources will be ‘efficient’. What this means is that the price buyers pay for goods in the market is a reflection of the utility/value they get from acquiring the goods. The competitive model pf supply and demand is based on the following assumptions: There are many buyers and sellers in the market No individual buyer and seller is big enough or has the power to be able to influence price There is freedom of entry and exit to and from the market Goods produced are homogenous (identical) Buyers and sellers act independently and only consider their own position in making decisions There are clearly defined property rights which mean that producers and consumers consider all costs and benefits when making decisions Competitive markets Competitive market= a market in which there are many buyers and sellers so that each has a negligible impact on the market price ( it means that none of them can influence the price and they are price-takers each seller has no control on the price). Because products are homogeneous, a seller has little reason to charge less than the going price, and if they charge more, buyers will make their purchase somewhere else. Similarly, no single buyer can influence the price because each of them purchase only a small amount relative to the size of the market: they just make their decisions based on the utility they gain from consumption and in doing so they are independent of the decisions of suppliers (no need of advertising or branding). Example: there are some markets in which the assumption of perfect competition applies to a degree, such as the EU market of agricultural products, in which there are about 14 million farmers who sell the different goods, so no single seller can influence the price of those products and each take the market price as given and sell all of their output at that price. Demand Quantity demanded= the amount of a good that buyers are willing and able to purchase at different prices Law of demand= the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises. Demand schedule= a table that shows the relationship between the price of a good and the quantity demanded. Demand curve= a graph of the relationship between the price of a good and the quantity demanded. Movement along the Demand curve If we assume that the price of milk falls, this will lead to an increase in quantity demanded. There are two reasons for this increase: The income effect= if we assume that incomes remain constant, then a fall in the price of milk means that consumers can now afford to buy more with their income. The substitution effect= Now that milk is lower in price compared to other products such as fruit juice, some consumers will choose to substitute the more expensive drinks with the now cheaper milk. This switch accounts for the remaining part of the increase in quantity demanded. Market Demand vs Individual demand Remember: A change in quantity demanded refers to the increase or decrease in demand because of a change in the price, holding all other Tactors influencing demand constant. A change in quantity demanded is shown ova movement along the demand curve. Shift vs movements along the demand curve Shift in the demand curve= if one or more factors are influencing demand other than price changes. Prices of other (Related) Goods: Substitutes= two goods for which an increase in the price of one leads to an increase in the demand for the other (and vice versa) Complements= two goods for which an increase in the price of one leads to a decrease in the demand of the other one. Income: changes in income affect demand Normal good= a good for which, ceteris paribus, an increase in income leads to an increase in demand (and vice versa). Inferior good= a good for which, ceteris paribus, an increase in income leads to a decrease in demand (and vice versa). Tastes= it is a key determinant of demand, since according to their taste each buyer is going to buy more or less of a product. The size and structure of the population= because market demand is derived from individual demands, it follows that the more buyers there are, the higher the demand is likely to be. The size of the population, therefore, is a determinant of the demand, as well as changes in the structure of the population. Advertising= firms advertise their products in many different ways, and it is likely that if a firm embarks on an advertising campaign then the demand for that product will increase. Expectations of consumers= for example, if it was announced that the price of milk was expected to rise next month, consumers may be more willing to buy milk at today’s price. Supply Quantity supplied= the amount of a good that sellers are willing and able to sell at different prices. Law of supply= the claim that, ceteris paribus, the quantity supplied of a good rises when the price of a good rise. Supply schedule= a table that shows the relationship between the price of a good and the quantity supplied. Supply curve= a graph of the relationship between the price of a good and the quantity supplied. If the price of a good rises, ceteris paribus, there is a change in quantity supplied. This is represented graphically as a movement along the supply curve. Market supply VS Individual supply The market supply comes from the sum of all of the individual curves. Remember…A change in quantity supplied refers to the increase or decrease in supply as a result of a change in the price holding, all other factors influencing supply being constant. A change in quantity supplied is shown by a movement along the supply curve. Shifts in the Supply Curve Any change that raises quantity supplied at every price shifts the supply curve to the right and is called an increase in supply. Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply. Proﬁtability of Other Goods in Production and Prices of Goods in Joint Supply Firms have some ﬂexibility in the supply of products and in some cases can switch production to other goods . Technology Advances in technology increase productivity allowing more to be produced using fewer factor inputs. As a result, both total and unit costs may fall and supply increases. Natural/Social Factors There are often many natural or social factors that affect supply. Input Prices: The Prices of Factors of Production To produce any output, sellers use various inputs collectively referred to as land, labor and capital. Expectations of Producers Output levels can vary according to the expectations of producers about the future state of the market. Number of Sellers If there are more sellers in the market, then it makes sense that the supply would increase. Equally, if a number of dairy farms closed down then it is likely that the amount of milk supplied would also fall. The number of sellers in a market will be determined by the proﬁtability of the product in question and the ease of entry and exit into and from the market. Supply and Demand together Equilibrium or market price= the price where the quantity demanded is the same as the quantity supplied. Equilibrium quantity= the quantity bought and sold at the equilibrium price. Surplus= a situation in which the quantity supplied is greater than the quantity demanded at the going market price. Shortage= a situation in which quantity demanded is greater than quantity supplied at the going market price. A surplus exists when the amount sellers wish to sell is greater than the amount consumers wish to buy comparative statics: the comparison of one initial static equilibrium with another. A shortage occurs if the amount of consumers are willing and able to purchase at a price is greater than the amount of sellers are willing and able to offer for sale law of supply and demand= the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. Prices as signals Price as a signal to Buyers For buyers, price tells them something about what they must give up (usually an amount of money) to acquire the benefits that having the good will confer on them. These benefits are referred to as the utility or satisfaction derived from consumption and reflects the willingness to pay. Price as a signal to sellers For sellers, price acts as a signal in relation to the profitability of production. For many sellers, increasing the amount of a good produced will incur some additional input costs. A higher price is required to compensate for the additional cost and to enable the producer to gain some reward from the risk they are taking in production. That reward is termed profit. Rising Prices in a Competitive Market If prices are rising in a free market, this acts as a different but related signal to buyers and sellers. Rising prices to a seller means that there is a shortage and thus acts as a signal to expand production, because the seller knows that they will be able to sell what they produce. For buyers, a rising price changes the nature of the trade-off they face. Rising prices act as a signal that more will have to be given up acquiring the good. They must decide whether the value of the benefits they will gain from acquiring the good is worth the extra price they have to pay and the sacrifice of the value of the benefits of the next best alternative. Analyzing changes in equilibrium The equilibrium price and quantity depend on the position of the supply and demand curve. We use comparative statistic analysis to look at what happens when some event shifts one of these curves and causes the equilibrium market to change. To do this we proceed in three steps: We decide whether the event in question shifts the supply curve, the demand curve or, in some cases, both. We decide whether the curve shifts to the right or to the left. We use the supply and demand diagram to compare the initial and the new equilibrium, which shows how the shift affects the equilibrium price and quantity bought and sold. Elasticity Elasticity= a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Price elasticity of demand= a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. Determinants: Availability of Close Substitutes= Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and spreads are easily substitutable. Necessities versus Luxuries =Necessities tend to have relatively price inelastic demands, whereas luxuries have relatively price elastic demands. The reason is that most people view hot food and warm homes as necessities and a sailing dinghy as a luxury. Deﬁnition of the Market = The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly deﬁned markets tend to be associated with a more price elastic demand than broadly deﬁned markets, because it is easier to ﬁnd close substitutes for narrowly deﬁned goods. Proportion of Income= Devoted to the Product Some products have a relatively high price and take a larger proportion of income than others. Time Horizon= Goods tend to have more price elastic demand over longer time horizons. Computing the Price Elasticity of Demand: Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price. That is: Elasticity can have a value which lies between 0and infinity: Between 0and 1, elasticity is said to be price inelastic, that is the percentage change in quantity demanded is less than the percentage change in price. If elasticity is greater than 1it said to be price elastic – the percentage change in quantity demanded is greater than the percentage change in price. If the percentage change in quantity demanded is the same as the percentage change in price then the price elasticity is equal to 1and is called unit or unitary elasticity. Relative Elasticities We have and will use the term ‘relatively’ elastic or inelastic throughout our analysis. The use of this term is important. Calculating price elasticity: there are two methods commonly used to calculate price elasticity: Using the Midpoint (Arc Elasticity of Demand) Method= If you try calculating the price elasticity of demand between two points on a demand curve, you will notice that the elasticity from point A to point B seems different from the elasticity from point B to point A. For example, consider these numbers: Using the Point Elasticity of Demand Method= Rather than measuring elasticity between two points on the demand curve, point elasticity of demand measures elasticity at a particular point on the demand curve. Let us take our general formula for price elasticity given by: The variety of demand curves Because the price elasticity of demand measures how much quantity demanded responds to changes in the price, it is closely related to the slope of the demand curve. The following heuristic (rule of thumb) is a useful guide when the scales of the axes are the same: the flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand. Panels (b), (c) and (d) present demand curves that are flatter and flatter and represent greater degrees of elasticity. At the opposite extreme shown in panel (e), demand is perfectly elastic. This occurs as the price elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded. Total expenditure= the amount paid by buyers, computed as the price of the good times the quantity purchase. Business decision-making and price elasticity general rule: When demand is price inelastic (a price elasticity less than 1), price and total expenditure move in the same direction. When demand is price elastic (a price elasticity greater than 1), price and total expenditure move in opposite directions. If demand is unit price elastic (a price elasticity exactly equal to 1), total expenditure remains constant when the price changes. NB: elasticity of a Linear Demand Curve Other Demand Elasticities Income elasticity of demand= a measure of how much quantity demanded of a good respond to a change in consumers’ income, computed as the percentage quantity demanded divided by the percentage change in income. Cross-price elasticity of demand= a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the ﬁrst good divided by the percentage change in the price of the second good. Price elasticity of supply Price elasticity of supply= a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. The Price Elasticity of Supply and Its DeterminantsThe price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce in response to changes in price. Elasticity can take any value greater than or equal to 0. The closer to 0the more price inelastic, and the closer to infinity the more price elastic. The following subsections look at the key determinants of the price elasticity of supply: The Time Period= In most markets, a key determinant of the price elasticity of supply is the time period being considered. Supply is usually more price elastic in the long run than in the short run. Over very short periods of time, ﬁrms may ﬁnd it impossible to respond to a change in price by changing output. In the short run, ﬁrms cannot easily change the size of their factories or productive capacity to make more or less of a good but may have some ﬂexibility. Productive Capacity= Most businesses, in the short run, will have a ﬁnite capacity – an upper limit to the amount that they can produce at any one time determined by the amount of factor inputs they possess. The Size of the Firm/Industry= It is possible that, as a general rule, supply may be more price elastic in smaller ﬁrms or industries than in larger ones. The mobility of factors of production= The mobility of factors of production refers to how easily resources like land, labor, or capital can be shifted to respond to changing market conditions. High mobility: When factors are easily transferable, supply tends to be price elastic, meaning it can quickly adapt to price changes. Low mobility: When factors are not easily transferable, supply is less elastic, making it harder to respond swiftly to price changes. Ease of Storing Stock/Inventory= In some ﬁrms, stocks can be built up to enable the ﬁrm to respond more ﬂexibly to changes in prices. Computing the price elasticity of supply= the price elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. That is: The Midpoint (Arc) Method of Calculating the Elasticity of Supply= As with the price elasticity of demand, the midpoint method for the price elasticity of supply between two points, denoted QP(,)11and QP(,)22, has the following formula: The numerator is the percentage change in quantity supplied computed using the midpoint method, and the denominator is the percentage change in price computed using the midpoint method. Point Elasticity of Supply Method= As with point elasticity of demand, point elasticity of supply measures elasticity at a particular point on the supply curve. Exactly the same principles apply as with point elasticity of demand, so the formula for point elasticity of supply is given by: The variety of supply curves: Because the price elasticity of supply measures the responsiveness of quantity supplied to changes in price, it is reflected in the appearance of the supply curve. Total revenue= the amount received by sellers of a good, computed as the price of the good times the quantity sold. CHAPTER 11 MARKET STRUCTURE 1: MONOPOLY Imperfect competition Imperfect competition exists where ﬁrms can differentiate their product in some way and so have some inﬂuence over price. Market share= the proportion of total sales in a market accounted for by a particular ﬁrm. Why monopoly arise Monopoly= a ﬁrm that is the sole seller of a product without close substitutes. While this is the strict definition of a monopoly, as we have seen, firms are said to have monopoly power if they are a dominant seller in the market and are able to exert some control over the market as a result. In the analysis that follows, however, the assumption is that there is only one seller. The fundamental cause of monopoly is barriers to entry: Barriers to entry= anything which prevents a ﬁrm from entering a market or industry. A monopoly can remain the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have four main sources: A key resource is owned by a single ﬁrm= The simplest way for a monopoly to arise is for a single firm to own a key resource. For example, consider the market for water in a small town on a remote island, not served by the water company from the mainland. If there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist could command quite a high price, even if the marginal cost is low. The government gives a single ﬁrm the exclusive right to produce some good or service= In many cases, monopolies arise because the government has given one firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be monopolist. The patent and copyright laws are two important examples of how the government creates a monopoly to serve the public interest. Patent= the right conferred on the owner to prevent anyone else making or using an invention or manufacturing process without permission. Copyright= the right of an individual or organization to own things they create in the same way as a physical object, to prevent others from copying or reproducing the creation. The costs of production make a single producer more efﬁcient than many producers= Natural monopoly= a monopoly that arises because a single ﬁrm can supply a good or service to an entire market at a smaller cost than could two or more ﬁrms. When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. Normally, a firm has trouble maintaining a monopoly position without ownership of a key resource or protection from the government. However, the monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. By contrast, entering a market in which another firm has a natural monopoly is unattractive. Would-be entrants know that they cannot achieve the same low costs that the monopolist enjoys because, after entry, each firm would have a smaller piece of the market. A ﬁrm can gain control of other ﬁrms in the market and thus grow in size= Many of the largest firms in the world have grown partly through acquisition, merger or takeover of other firms. As they do so, the industry becomes more concentrated; there are fewer firms in the industry. One effect of this is that a firm might be able to develop monopoly power over its rivals and erect barriers to entry to make it harder for new firms to enter. It is for this reason that governments monitor such acquisitions to see if there are implications for competition. How monopolies make production and pricing decisions Monopoly versus Competition= The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. A competitive firm is small relative to the market in which it operates and, therefore, takes the price of its output as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. NB: For a monopoly, marginal revenue is lower than price because a monopoly faces a downwards sloping demand curve. To increase the amount sold, a monopoly firm must lower the price of its good. Hence, to sell the fourth litre of water, the monopolist must get less revenue for each of the first 3litres.Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, it has two effects on total revenue: The output effect. More output is sold, so Q is higher, which tends to increase total revenue. The price effect. The price falls, so P is lower, which tends to decrease total revenue. Profit Maximization Remember that competitive firms maximize profit at the quantity of output at which marginal revenue equals marginal cost. In following this rule for profit maximization, competitive firms and monopolies are alike. But there is also an important difference between these types of firm: the marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is: Monopoly’s Profit The welfare cost of monopoly The deadweight loss The fact that the market outcome under monopoly is different from that under conditions of perfect competition means there is a deadweight loss associated with monopoly. Total surplus equals the value of the good to consumers minus the costs of making the good incurred by the monopoly producer. The efficient outcome would be where the demand curve intersects the marginal cost curve, where P=MC. Because this price would give consumers an accurate signal about the cost of producing the good, consumers would buy the efficient quantity. The monopolist chooses the profit-maximizing output where the marginal revenue and marginal cost curves intersect, but this is not the same as the socially efficient output where the demand and marginal cost curves intersect. Price discrimination Price discrimination= the business practice of selling the same good at different prices to different costumers. Profit Maximization: Price discrimination is a rational strategy for a profit-maximizing monopolist. By charging different prices to different customers based on their willingness to pay, a monopolist can increase its profit. This allows the monopolist to capture more value from each customer than would be possible with a single uniform price. Customer Segmentation: Successful price discrimination requires the ability to separate customers according to their willingness to pay. This separation can be based on factors such as geography, age, income, or demand elasticity. For example, companies like energy providers and rail companies set different prices at different times or for different customer segments to optimize revenue. Price discrimination takes advantage of variations in demand elasticity. Arbitrage= the process of buying a good in one market at a low price and selling it in another market at a higher price to proﬁt from the price difference. Efficiency and Welfare: Price discrimination can lead to higher economic welfare by eliminating the inefficiencies inherent in monopoly pricing. The increase in welfare primarily benefits the producer in the form of higher profit, rather than providing consumer surplus. In essence, price discrimination can be a beneficial strategy for firms to maximize profit while potentially improving resource allocation and reducing inefficiencies, though it may not necessarily lead to increased consumer welfare. Perfect price discrimination= a situation in which the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Examples of price discriminants: Firms employ various pricing strategies to charge different prices to different customers: Cinema Tickets: Cinemas charge lower prices for children and seniors due to differences in willingness to pay, often in non-competitive markets. Airline Prices: Airlines offer discounts for Saturday night stays to distinguish between business and leisure travelers, effectively price discriminating. Discount Coupons: Companies use coupons to target customers willing to invest time in cutting them, often related to lower willingness to pay. Quantity Discounts: Firms offer lower unit prices for larger quantities, capitalizing on the decreasing willingness to pay as customers buy more. In summary, these strategies enable firms to maximize profits by recognizing variations in customer behavior and willingness to pay. Public policies toward monopolies Monopolies can lead to reduced output and higher prices, prompting government intervention. Policymakers have several options: Promoting Competition: Encourage competition in monopolized industries. Regulation: Regulate the behavior and pricing of monopolies, especially in natural monopolies like utilities. Public Ownership: Nationalize industries by bringing them under government control. Anti-Trust Laws: Enforce anti-trust laws to prevent monopolistic behavior. Regulators often face challenges in setting prices to balance efficiency and sustainability. Marginal cost pricing may lead to losses for natural monopolies, while average cost pricing can create deadweight losses. Regulators may use mechanisms like price caps to motivate cost reduction. The public vs. private ownership debate centers on cost efficiency. Private firms have profit incentives to minimize costs, while government-owned firms rely on political processes and may lack efficiency incentives. The choice between the two depends on various factors and judgments. Synergies= where the perceived beneﬁts of the combined operations of a merged organization are greater than those which would arise if the ﬁrms stayed separate. CHAPTER 12 MARKET STRUCTURES II: MONOPOLISTIC COMPETITION This market structure is called monopolistic competition, another example of imperfect competition. Monopolistic competition describes a market with the following attributes: Many sellers. There are many ﬁrms competing for the same group of customers. Product differentiation. Each ﬁrm produces a product that is at least slightly different from those of other ﬁrms, whether physically different or whether perceived as being different by consumers. The ﬁrm has some control over the extent to which it can differentiate its product from its rivals, thus reducing the degree of substitutability and garnering an element of customer or brand loyalty. Therefore, rather than being a price-taker, each ﬁrm faces a downwards sloping demand curve. Free entry. Firms can enter (or exit) the market without restriction. Thus, the number of ﬁrms in the market adjusts until economic proﬁts are driven to zero. Monopolistic competition= a market structure in which many ﬁrms sell products that are similar but not identical. Competition with differentiated products The monopolistically competitive firm in the short run In monopolistically competitive markets, each firm behaves much like a monopoly. This is because they offer differentiated products and face a downward-sloping demand curve. To maximize profit, they produce where marginal revenue equals marginal cost and then set the corresponding price based on their demand curve. In the short run, both monopolistic and monopolistic competitive firms follow similar profit-maximizing strategies, producing where MR = MC. The key difference lies in their outcomes: monopolistic firms can make a profit when price exceeds average total cost, while others may only minimize losses when price falls below average total cost. The Long-Run equilibrium Notice that the demand curve in this figure is tangential to the average total cost curve. These two curves must be tangential once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curves touch each other without crossing. To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market: As in a monopoly market, price exceeds marginal cost. This conclusion arises because proﬁt maximization requires marginal revenue to equal marginal cost and because the downwards sloping demand curve makes marginal revenue less than the price. As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic proﬁt to zero. The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the eco-nomic profit of a firm in this type of market is driven to zero. Monopolistic VS Perfect competition Excess Capacity= The assumption of free entry and exit drive each ﬁrm in a monopolistically competitive market to a point of tangency between the demand and average total cost curves. Mark-Up over Marginal Cost= A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. Monopolistic competition and the welfare of society Monopolistic competition, characterized by price mark-ups over marginal cost and product differentiation, can lead to inefficiencies in terms of deadweight losses, like monopoly pricing. However, addressing these inefficiencies poses challenges for policymakers. Enforcing marginal cost pricing for differentiated products is administratively burdensome, given their prevalence in the economy. Regulating monopolistic competitors would resemble the complexities of regulating natural monopolies, potentially requiring government subsidies to prevent business closures. Additionally, the number of firms in a monopolistically competitive market may not be ideal due to externalities associated with entry. New firms bring positive externalities in terms of product variety for consumers but impose negative externalities by taking customers from existing firms. While monopolistic competition doesn't achieve all the welfare properties of perfect competition, the subtlety and complexity of its inefficiencies make it challenging for public policy to significantly improve market outcomes. Advertising and Branding The debate over advertising Assessing the social value of advertising is a complex debate in economics, with arguments on both sides: Critique of Advertising: Critics argue that advertising is often manipulative, aiming to shape people's preferences rather than provide information. It can create desires that might not exist naturally. Advertising can hinder competition by exaggerating product differences and fostering brand loyalty. This reduced price sensitivity allows firms to charge higher mark-ups over marginal costs. Defense of Advertising: Advocates contend that advertising serves an informative role by conveying product prices, features, qualities, new offerings, and retail locations. This information helps consumers make better choices and enhances market resource allocation efficiency. Advertising fosters competition by ensuring consumers are well-informed about available firms and products. This, in turn, empowers customers to take advantage of price differences and allows new entrants to attract customers from existing firms. The impact of advertising on society's resources and well-being is a topic of ongoing debate, with no easy consensus on its overall value. Advertising as a signal of quality Advertising, even when seemingly lacking product information, can signal product quality to consumers. When firms invest significantly in advertising, it suggests confidence in their product's quality. Consumers may rationally try advertised products based on this signal. The content of the ad matters less than the fact that ads are costly, as cheap advertising doesn't effectively convey quality signals. Branding and brand names Branding= the means by which a business creates an identity for itself and highlights the way in which it differs from its rivals. The economics of brand names and branding are a subject of debate: Critics argue that branding can lead consumers to perceive differences that may not actually exist between brand name and generic products. They view consumers' willingness to pay more for brand name goods as a form of irrationality driven by advertising. Defenders of brand names argue that they serve as a valuable way for consumers to ensure product quality. Brand names provide information that is not easily discernible before purchase and give firms an incentive to maintain quality to protect their brand's reputation. The debate hinges on whether consumers' preference for brand names is rational or influenced primarily by advertising. Critics emphasize irrationality, while defenders stress the value of quality assurance through branding. CHAPTER 13 MARKET STRUCTURES III: OLIGOPOLY Oligopoly= competition among the few – a market structure in which only a few sellers offer similar or identical products and dominate the market. The market is said to be concentrated in the hands of a few firms. The concentration ratio refers to the proportion of total market share accounted for by a particular number of firms. Concentration ratio= the proportion of total market share accounted for by a particular number of ﬁrms. Characteristics of oligopoly The main characteristic of oligopolistic markets is that there are a relatively small number of dominant firms in the market: Differentiation= firms in oligopolistic market structures do sell products that are similar but may seek to differentiate them-selves in some way. Market segments: the breaking down of customers into groups with similar buying habits or characteristics. Interdependence= what one firm does has some influence on the others and each firm may or may not react to the decisions of others. Each firm in the industry will be considering its own actions, but its behavior will be influenced by what it thinks the action and reaction of its rivals will be. A result of this interdependence is that tension can arise between firms of whether to cooperate or act purely in self-interest. Duopoly example= it is the simplest type of oligopoly. n a duopoly, there are only two firms competing in an oligopoly, making it the simplest form of oligopoly. This scenario can be illustrated by considering a town with two residents, Jacques and Joelle, who own wells that produce drinking water. They decide how much water to pump and sell in the town each Saturday, with a marginal cost of production of zero. The town's demand schedule shows that as the total quantity of water sold increases, the price per liter decreases, following the typical downward-sloping demand curve. Competition, monopolies and cartels= The tension between self-interest and cooperation arises due to interdependence in duopoly. Jacques and Joelle, the two well owners, could collude by agreeing on the quantity of water to produce and its price, forming a cartel. In such a scenario, the market effectively operates as a monopoly, resulting in a total profit-maximizing outcome. Collusion= an agreement among ﬁrms in a market about quantities to produce or prices to charge. Cartel= a group of ﬁrms acting in unison. Equilibrium= In an oligopoly, firms often strive to form cartels and earn monopoly profits. However, competition laws and internal disagreements among cartel members can make this difficult. When firms independently decide how much to produce, it leads to a Nash equilibrium, where each firm chooses its best strategy given the others' choices. This equilibrium typically results in higher production than a monopoly but lower than perfect competition, with prices falling between monopoly and competitive levels. Oligopolists are motivated by self-interest, causing them to deviate from the monopoly outcome and fall short of perfect competition. Nash equilibrium= a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. How the size of an oligopoly affects the market outcome= As the number of sellers in an oligopoly increases, the likelihood of forming and enforcing a cartel diminishes. In such cases, each seller must independently decide how much to produce based on the interplay of two factors: the output effect and the price effect. The output effect pushes them to produce more as it raises profit, while the price effect dampens production due to its impact on market prices. As the size of the oligopoly grows larger, the price effect becomes less significant, and sellers become less concerned about their individual impact on market prices. Eventually, in very large oligopolies, the price effect disappears entirely, and firms behave more like competitive firms. Prices approach marginal cost, and the quantity produced approximates the socially efficient level. In essence, a large oligopoly behaves similarly to a competitive market. Game theory and the economics of cooperation Game theory= the study of how people behave in strategic situations. Payoff matrix= a table showing the possible combination of outcomes (payoffs) depending on the strategy chosen by each player. The ‘Prisoner’s Dilemma’ Prisoner’s dilemma= a particular ‘game’ between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. Dominant strategy= a strategy that is the best for a player in a game regardless of the strategies chosen by the other players. Oligopolies as a prisoner’s dilemma The tension between self-interest and cooperation, illustrated by the prisoner's dilemma, is analogous to the challenges faced by firms in imperfect competition, particularly in the context of oligopolies. Game theory has been extensively utilized to analyze such situations. For instance, let's consider an oligopoly involving two countries, Iran and Saudi Arabia, both major crude oil producers. After lengthy negotiations, these countries reach an agreement to limit oil production, thereby maintaining higher global oil prices. However, each country must then make an individual decision on whether to cooperate and adhere to the agreed-upon production limits or act independently by increasing production. This scenario reflects the dilemma faced by firms in an oligopoly, where they must balance their self-interest in pursuing greater profits through higher production with the potential benefits of cooperation, such as maintaining higher prices. Game theory provides a framework to analyze and understand these complex interactions among firms or countries in such situations. Other examples of the Prisoner’s Dilemma Advertising= When two ﬁrms advertise to attract the same customers, they face a problem similar to the prisoner’s dilemma. Common resources Nash Equilibrium Why people sometimes cooperate? The prisoner's dilemma illustrates that cooperation can be challenging to sustain, even when it would benefit all parties involved. Whether a lack of cooperation is problematic for society depends on the specific circumstances. In some cases, the absence of cooperation harms society as well as the individuals involved. For example, in the case of common resources like oil wells, where individual firms may overexploit resources, society suffers from waste. However, in situations involving oligopolists attempting to maintain monopoly profits, the lack of cooperation benefits society by preventing consumers from facing high prices. Cooperation can be encouraged when the game is played repeatedly. In such cases, players have incentives to cooperate because they anticipate future interactions. For instance, in a duopoly scenario with Jacques and Joelle, they might initially agree to produce less to achieve a (= the best of the worst outcome)come. Knowing that they will play the same game repeatedly, they can enforce their agreement by specifying penalties for defection. This threat of penalties can help maintain cooperation as long as the players. Tacit Collusion= A repeated games scenario might also lead to a market outcome in which some form of collusion is suspected but in fact has arisen out of ﬁrms recognizing that they are interdependent. When ﬁrm behavior results in a market outcome that appears to be anti-competitive but has arisen because ﬁrms acknowledge that they are interdependent, this is referred to as tacit collusion. An example can be seen in typical out of town shopping malls where several ﬁrms have outlets all selling similar goods – carpets, electrical goods, furniture and so on. Shopping around these stores, customers might have their suspicions aroused by the fact that regardless of the store, the prices are all very similar and, in some cases, identical. Even the promotional material promising to refund the difference if the customer can ﬁnd the same good elsewhere cheaper looks to be an empty promise given the price similarity. Tacit collusion= when ﬁrm behavior results in a market outcome that appears to be anti-competitive but has arisen because ﬁrms acknowledge they are interdependent. Sequential move games Sequential move games= games where players make decisions in sequence with some players able to observe the strategic choices of others. The nature of credibility In strategic interactions between firms, it's not enough for a firm to simply make a threat; the threat must be credible and believed by the rival firm. Credible threats can influence a rival firm's behavior in a way that benefits the threatening firm. For example, an existing supermarket facing new competition might threaten to match the prices and offers of the new entrant to deter them. However, for the threat to be effective, it must be believable. If the rival firm has information suggesting that the existing firm cannot sustain such pricing in the long term, the threat is considered empty and lacks credibility. Entry barriers in oligopoly Oligopolistic firms engage in strategic behavior, often benefiting from barriers to entry that limit competition. These barriers include economies of scale, high setup costs, and the potential use of advertising as a deterrent. Patents can also serve as barriers by allowing firms to charge higher prices and invest in research and development. Brand proliferation within oligopolistic markets can further hinder new entrants. These barriers collectively discourage competition and protect the market positions of existing oligopolistic firms. Brand proliferation= a strategy designed to deter entry to a market by producing a number of products within a product line as different brands. Public policy towards oligopolies Restraint of trade and competition law Competition law in Europe and North America discourages cooperation among competitors in order to prevent anti-competitive practices. Courts have historically refused to enforce agreements that reduce quantities and raise prices, considering them contrary to the public interest. The European Union, in particular, has established common policies under the Treaty of Rome to prohibit practices like price fixing and abuse of dominant market positions. The European Commission enforces these rules and has the authority to investigate and fine companies found in violation. National competition authorities and courts also play a role in upholding these prohibitions. Controversies over Competition Policy Over time, much controversy has centered on the question of what kinds of behavior competition law should prohibit. Most commentators agree that price fixing agreements among competing firms should be illegal. Yet competition law has been used to condemn some business practices whose effects are not obvious. Here we consider three examples: Resale price maintenance=Resale price maintenance, a controversial business practice, involves setting a fixed price at which retailers must sell a product. While it may seem anti-competitive, some economists argue that it has legitimate purposes, such as ensuring a pleasant shopping experience and preventing free riding on services provided by retailers. This example underscores the challenge of applying competition laws, as seemingly anti-competitive practices may have valid reasons behind them, making enforcement complex. Predatory pricing= a situation where ﬁrms hold price below average cost for a period to try and force out competitors or prevent new ﬁrms from entering the market. Tying= a controversial business practice, involves bundling two products together at a single price. Some argue that tying can be used to expand market power, while others view it as a form of price discrimination. The practice remains contentious, with examples like Microsoft and Google facing investigations and fines related to tying. Additionally, the analysis assumes rational decision-making with perfect information, which may not reflect real-world behavior accurately. Behavioral economics has gained popularity for offering insights into the complexities of real-world economic behavior, which often deviates from rationality. CHAPTER 18 INFORMATION AND BEHAVIOURAL ECONOMICS Economics is the study of how individuals make choices and interact with each other, with information playing a crucial role in shaping these decisions. Principal and Agent The principal-agent problem is a fundamental concept in economics that arises when one party (the principal) relies on another party (the agent) to perform an action or make decisions on their behalf. In such relationships, the agent often possesses information that is not known to the principal, leading to potential conflicts of interest and challenges. This problem is particularly relevant in various economic contexts, such as when consumers seek advice from professionals like travel agents. In these situations, consumers rely on the information provided by agents but may have concerns about the accuracy and alignment of interests. While the profit motive and the desire for repeat business can act as monitoring mechanisms to ensure agents act in the principal's best interest, the presence of hidden motivations and asymmetric information can complicate the relationship. In essence, the principal-agent problem underscores the difficulties that can arise when one party must trust another to act on their behalf when there is a disparity in information and incentives. Principal: a person for whom another person, called the agent, is performing some act Agent: a person who is performing an act for another person, called the principal Asymmetric information Many times in life, one individual, business or organization knows more about something than another. In economics, the different access to information of buyers and sellers or any two people is called asymmetric information. Asymmetric information: where two parties have access to different information. Examples abound: A worker knows more than their employer about how much effort they put into their job. A seller of a used car knows more than the buyer about the car’s condition. The first is an example of a hidden action, whereas the second is an example of a hidden characteristic. In each case, the party in the dark (the employer, the car buyer) would like to know the relevant information, but the informed party (the worker, the car seller) may have an incentive to conceal it. Hidden Actions and Moral Hazard Moral hazard is a problem that arises when the agent is performing some tasks on behalf of the principal. In many cases the principal is not able to monitor the behavior of the agent. This might be because the agent has speciﬁc expertise and the principal does not have the knowledge to monitor the agent’s behavior, and even if the agent explained it is not certain the principal could be sure that what. In the example of the travel agent, it is possible to do some research to check the information given by the agent as a means of monitoring the agent’s behaviour (at additional cost to the principal), but this is not always possible. Moral hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour. To mitigate this problem, employers can employ various strategies: Better Monitoring: Some employers may use monitoring techniques, such as hidden cameras, to observe and ensure responsible behavior by their workers, especially when they are not directly supervised. High Wages: Paying workers wages above the market equilibrium level, known as efficiency wages, can reduce shirking behavior. Workers with high-paying jobs may be less inclined to shirk, as losing such a job would be a significant financial setback. Delayed Payment: Firms can delay part of a worker's compensation, like year-end bonuses, to discourage shirking. This delayed payment strategy increases the penalty for shirking if the worker loses their job. Adverse Selection Moral hazard can lead to adverse selection. This means that the market process may end up with ‘bad’ outcomes because of asymmetric information. Adverse selection occurs when the buyer (principal) knows more about their situation than the seller (agent). The seller knows this and would rather avoid having to do business with these buyers and so might be tempted to charge a higher price as a result. Adverse selection: where a principal knows more about their situation than the agent, leading to the agent preferring not to do business with the principal. The Market for Used Cars and the Lemons Problem In the market for used cars, there is a classic example of adverse selection known as the "Lemons Problem." This problem arises because sellers of used cars possess information about their vehicles' conditions, while buyers often do not have access to this information. Asymmetric Information: Sellers know the full history and condition of their cars, including whether they've been in accidents or have any hidden issues. Buyers, on the other hand, only have the seller's word and may lack the expertise to thoroughly evaluate the car's condition. This information asymmetry creates a problem. Two Types of Cars: Akerlof's model suggests that there are two types of cars in the market: good cars ("oranges") and bad cars ("lemons"). Buyers are willing to pay a reasonable price for a good car but not for a lemon. However, they can't determine the true quality of the car they're buying. Uncertainty for Buyers: When buyers visit a dealer to purchase a used car, they face uncertainty about whether the car is an orange or a lemon. Given their imperfect information, they don't know if they should pay a high price (e.g., €10,000) for a potential orange. Seller's Dilemma: Sellers who have oranges are reluctant to sell them for less than their true value, but buyers are hesitant to pay that much due to the risk of buying a lemon. Sellers with lemons, on the other hand, are willing to accept lower prices (e.g., €4,000) to get rid of them. Dominance of Lemons: As a result of this dilemma, the market becomes dominated by lemons. Sellers of good cars don't want to sell at a lower price, and buyers are wary of paying a higher price, leading to a prevalence of lower-quality vehicles in the market. Reduced Trust: The information asymmetry and prevalence of lemons reduce buyers' trust in the used car market. This lack of trust can explain why nearly new cars can be significantly cheaper than their new counterparts of the same make and model. Adverse Selection in the Labour Market Adverse selection occurs in the labour market due to efficiency wage theory. Workers possess varying skills and often know their abilities better than employers. When firms cut wages, the best workers are more likely to leave for better opportunities elsewhere. Alternatively, firms paying above-market wages can attract a higher-skilled workforce. For example, if a struggling firm needs to reduce labor costs, cutting wages may cause most high-skilled workers to quit. In contrast, random layoffs may lead only some high-skilled workers to leave. This illustrates how adverse selection impacts the labour market, affecting the workforce's composition based on wage decisions. Signalling to Convey Private Information Although asymmetric information is sometimes a motivation for public policy, it also motivates some individual behaviour that otherwise might be hard to explain. Markets respond to problems of asymmetric information in many ways. One of them is signalling, which refers to actions taken by an informed party for the sole purpose of credibly revealing private information. Signalling: an action taken by an informed party to reveal private information to an uninformed party. For example, firms invest in advertising to signal product quality, as it is more beneficial for firms with superior products to attract repeat customers. Similarly, individuals pursue education to signal their talent and abilities to potential employers, as it is more affordable for talented individuals to complete their education successfully. Screening to Induce Information Revelation When an uninformed party takes actions to induce the informed party to reveal private information, the phenomenon is called screening. Screening: an action taken by an uninformed party to induce an informed party to reveal information In some cases, screening is straightforward and common sense, such as having a used car inspected by a mechanic before purchasing. In more subtle cases, screening is used to distinguish between different groups, like safe and risky drivers seeking car insurance. Insurance companies can offer distinct policies, such as one with a high premium and full accident coverage and another with low premiums but a substantial deductible. Risky drivers, more likely to have accidents, find the deductible burdensome and opt for the high premium policy. Behavioral economics= A field that combines insights from economics and psychology to provide a deeper understanding of human behavior, particularly in decision-making and choice situations. While economics traditionally relies on the assumption of rational behavior, behavioral economics acknowledges that people often deviate from rationality in their decisions. People Aren’t Always Rational Herbert Simon, one of the first social scientists to work at the boundary of economics and psychology, suggested that humans should be viewed not as rational maximizers but as satisficers. Rather than always choosing the best course of action, they make decisions that are merely ‘good enough’, in other words, decisions may be made based on securing a satisfactory rather than optimal outcome. Satisﬁcers: those who make decisions based on securing a satisfactory rather than optimal outcome. What follows are some further findings which have an effect on consumer decision-making: Mental accounting: refers to the practice of separating money into different mental "accounts" based on various criteria. For example, some individuals allocate money in specific tins or accounts to cover future bills or expenses like electricity, gas, or holidays. While this may provide psychological comfort, it can also lead to irrational financial decisions. Herd Mentality: There are occasions when people make decisions which follow those of a much larger group – sometimes this group may not be tangible, but for some reason individuals are persuaded by the apparent power of the group. For example, in periods where house or stock prices are rising there may be a tendency for individuals to make decisions on the purchase of these assets which are at odds with their ‘true value’. Prospect Theory: Imagine that someone offered you the prospect of winning €200, but then a day later losing €100, or of winning €100. Which would you choose? Research suggests that more people would choose the second option. Closer inspection of the choices offered reveal that they are both the same in terms of the net gain to individuals – the net gain in each case is €100. So why do more people choose the second option if the net gain is the same? Prospect theory: a theory that suggests people attach different values to gains and losses and do so in relation to some reference point. This insight is importa

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