Tuesday, September 14, 2010

Microeconomics: Chapter 14 More on Price-Making Firms

MicroeconomicsChapter 14 More on Price-Making Firms
A price-making buyer is a buyer whose purchase quantity affects the price that it has to pay.

14.1 Cartels
A cartel is an arrangement under which suppliers band together to restrict output and raise the market price.

Cartels in Product Markets
The Full Cartel Outcome
The full cartel outcome is the price and quantity at which suppliers’ joint profit is maximized.

Cheating on Cartel Agreements
The firms gain collectively from adherence to a cartel agreement does not mean that each firm will find adherence to the cartel agreement to be in its individual self-interest.

Entry as a Limit on Cartel Success
As a cartel limits output and increases prices, it will attract new firms to the market. This make the cartel break down.

Regulation as Cartel Enforcement
Government rules and regulations sometimes restrict both price and entry. This was true with the Civil Aeronautics Board limited air fare increases and blocked attempts to lower fares.

The Welfare Cost of Monopoly Reconsidered
Rent seeking refers to activities aimed at obtaining or preserving economic profits.

Labor Unions
Labor unions are an extremely important type of cartel in the U.S. economy. By acting together, workers may be able to collectively to behave like a price-making monopolist.

14.2 Monopolistic Competition
The Fundamental Assumptions
1. Sellers are price makers
2. Sellers do not behave strategically
3. Entry into the market is free
4. Buyers are price takers

The Appropriate Market Structure
1. The size and number of buyers. There must be many buyers so not one is large enough to influence the price.
2. The size and number of sellers. Monopolistic competition best applies to markets with many suppliers – this makes them more likely to be nonstrategic.
3. The degree of substitutability of different sellers’ products. Monopolistic competition includes price-making sellers, so the structure is one in which products are imperfect substitutes.  The products are heterogeneous (differentiated) – consumers view the products of the various producers as being somewhat different from one another.
4. The extent to which buyers are informed about prices and available alternatives. The monopolistic competition model encompasses both well-informed and poorly informed consumers.
5. The conditions of entry. The model assumes that entry is free.

Short-Run Equilibrium
Like any profit-maximizing firm, when a monopolistic competitor chooses not to shut down, it produces output where marginal revenue is equal to marginal cost.

Long-Run Equilibrium
Under monopolistic competition, entry into the industry is free and new firms enter as long as there is profit to be made.  In the long-run equilibrium, a representative firm produces an output level at which the demand curve and the average cost curve are tangent.

Normative Analysis of Monopolistic Competition
When the production of a good is characterized by economies of scale, variety is costly.

The So-Called Excess Capacity Theorem
The excess capacity theorem suggests that there may be too many firms in the market under long-run, monopolistically competitive equilibrium. A downward-sloping demand curve tells us that variety is costly, but it doesn’t explain how those costs compare with the benefits of variety.

The Market Equilibrium Compared with the Efficient Outcome
The long-run monopolistically competitive equilibrium may have too many or too few firms, depending on the cost and demand conditions.

14.3 Monopsony
The Fundamental Assumptions
1. Sellers are price takers.
2. Sellers do not behave strategically
3. The conditions of entry into industry supply may range from completely blocked to perfectly free.
4. Buyers are price makers.

The Appropriate Market Structure
1. The size and number of buyers. One buyer.
2. The size and number of sellers in the industry. Many sellers, no one of which is large relative to the overall market.
3. The degree of substitutability of different sellers’ products. The outputs of different sellers are homogeneous.
4.The extent to which buyers are informed about prices and availability. Buyer is well informed about the offerings of competing suppliers.
5. The conditions of entry. Technological and legal barriers to entry may or may not exist.

The Monopsonistic Equilibrium
The factor hiring rules states: A profit-maximizing firm should hire a factor up to the point at which its marginal revenue product is equal to its marginal factor cost (MRP=MFC).

Remember that marinal revenue product of a factor is equal to the factor’s marginal physical product (MPP) times the firm’s marginal revenue of output. If the monopsonist is a price maker, than it simply finds its marginal revenue curve the same way as a monopolist. The difference between a monopsonist and an input price taker comes in terms of the marginal factor cost.

Marginal Factor Cost for a Monopsonist
The monopsonist’s marginal factor cost curve is derived from the corresponding average revenue curve (demand curve). The monopsonist’s marginal factor cost (MFC) can be represented in terms of the price elasticity of supply for the input that the firm buys: MFC=p(1+1/εS)

The smaller the price elasticity of supply, the larger the monopsonist’s marginal factor cost. When supply is highly inelastic, it takes a large price increase to induce producers to supply a little bit more output, and the monopsonist counts this large price increase as a cost. In the extreme case of infinitely elastic supply, there is no loss on inframarginal units, the firm is a price taker, and MFC is equal to the price of the factor.

Because the factor supply curve facing a monopsonist slopes upward, the marginal factor cost curve lies above the supply curve.

Applying the factor hiring rule, a profit-maximizing firm purchases units up to the quantity at which the marginal factor cost is equal to the marginal revenue product. The equilibrium price is found by going down from this spot to the corresponding point on the supply curve.

A price-making buyer purchases less than would a price-taking buyer facing the same supply curve and having the same marginal revenue product curve.

Normative Analysis of a Monopsony
The change from price-taking to monopsony leads to a lower equilibrium factor price. This reduces the surplus of suppliers in the market. The buyer benefits from its ability to influence the price of the input. The monopsonist produces less of the final output. If the firm is a price-taker as a seller in the final market, then the price to consumers is unaffected. If it is a price-maker, then the price of the product to consumers rises, and consumers are worse off.

Partial Equilibrium Analysis: From an efficiency perspective, the monopsonist purchases too little of the input. The loss in total surplus that arises because a monopsonist purchases less than the total-surplus-maximizing amount of an output is referred to as the deadweight loss of monopsony.

General Equilibrium Analysis: Given the level of output that it chooses, a profit-maximizing monopsonist chooses a socially inefficient means of production. (The firm does not set the marginal rate of technical substitution equal to the ratio of the price of labor and capital, since it is a price-maker in the capital market.)

Buyer Cartels: Amateur and Professional Athletes
Numerous studies of professional sports have found that these buyers’ cartels have significant effects. Baseball players (in 1974) were paid far below their marginal revenue products. This is because there were reserve clauses in contracts that forced each professional baseball player to deal with only one team.

The most effective buyer cartel has been the one run by universities. They pay players only a tiny fraction of the revenues that these players generate for their schools. (In football, the university cartel gets help from the NFL, who won’t hire players until they’ve graduated from college.)

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