Economics Concepts II - JRM

1. Economics Concepts:
• Downward Sloping Curve
• Anti-Competitive Policy
• Rent-Seeking behavior and Monopoly Inefficiency
• Oligopoly Methods
• Pricing concepts in Economics
• Price Discrimination
From:
Jay R Modi
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2. Jay Modi
Economics
#1. Assume that AJAX Corporation faces a downward sloped demand curve.
Explain why AJAX will likely under-produce relative to the socially optimal output.
When any firms faces a downward sloped demand curve, it is due to decrease in the per
unit price which results in increase in demand. In case of monopoly, because of the
inverse relationship between price and demand, the demand curve will be considered as a
market demand curve. It provides the monopoly firm with an advantage to become a
price maker and preventing other firms to enter the market by offering unique product or
services. By choosing optimal level of output, if AJAX Corporation produces one more
product than the price per unit will decrease and at the same time if AJAX produces one
less product than the price per unit will increase i.e. it provides opportunity to AJAX to
earn high revenue by producing fewer products. On the other hand, if we consider AJAX
in perfect competition market than it is going to follow the price prevailing in a market.
Table 1
Price (p) Quantity (q) Total Revenue (p.q) Marginal Revenue
(MR)
$10 0 $10
9 1 9 9
8 2 16 7
7 3 21 5
6 4 24 3
5 5 25 1
4 6 24 -1
3 7 21 -3
2 8 16 -5
1 9 9 -7
0 10 0 -9
Now in order to maximize the profit AJAX will produce the output at which it can sell
maximum possible quantity by earning the positive or zero marginal revenue. Therefore
it can produce maximum 5 quantities at price $5 where it is earning marginal revenue of
$1. In contrast, if AJAX will produce more quantity than 5 than it lead negative marginal
revenue. For example, if AJAX produces 6 quantities at price $4 than the marginal
revenue will be -1. As the price is higher than MR, monopolist will produce lower output
to maximize the profit.
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3. Jay Modi
Economics
Figure 1:
10
A
P1-$7
P2-$6 B
Price
Demand
0 1 2 3 4 10
Q1 Q2 Quantity
From the above figure it is clear that if a firm sells four products instead of three, revenue
will be$24 rather than $21. Marginal revenue from the sale of the fourth product is
therefore $3. This represents the gain of $6 from the sale of the fourth product less the
decline in revenue of $3 as a result of the fall in price for the first product three from $7
to $6.
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4. Jay Modi
Economics
#2, Businesses such as Best Buy has a policy to match lowest prices. On the surface
such a policy would seem to be good for consumers. Make an argument that such a
policy might in-fact be anti-competitive.
When Businesses such as Best Buy follows the policy to match the lowest price, it is
considered as anti-competitive because such strategies will force the competitor to go out
of the business. In a short term it will be good for the consumers because they are getting
the product at fewer prices. But for long-run it will lead to consumer discrimination as
there will be no competitor in the market and Best Buy may charge highest price. Apart
from discouraging competition Best Buy can also become a price leader because if any
new firm wants to enter the market than it has no other option other than to follow the
price set by Best Buy. Adding to it first by lowering the price Best Buy has discouraged
perfect competition and than it has targeted oligopoly market by becoming a price leader.
Therefore, it is clear that a policy to match lowest price is good only for short-term but
for long run it is considered as anti-competitive.
#3. Explain the concept of rent-seeking behavior. Explain how rent-seeking may
increase the level of monopoly inefficiency.
Rent seeking generally implies the extraction of uncompensated value from others
without making any contribution to productivity, such as by gaining control of land and
other pre-existing natural resources, or by imposing burdensome regulations or other
government decisions that may affect consumers or businesses. In simple words, rent
seeking occurs when an individual, organization or firm seeks to make money by
manipulating the economic and/or legal environment rather than by trade and production
of wealth. Examples of rent-seeking behavior would include all of the various ways by
which individuals or groups lobby government for taxing, spending and regulatory
policies that confer financial benefits or other special advantages upon them at the
expense of the taxpayers or of consumers with which the beneficiaries may be in
economic competition.
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5. Jay Modi
Economics
Several times it has been seen that firms spend a huge amount in order to maintain a
monopoly granted by a government through an exclusive license. Such expenditure adds
to the social cost of a firm. First, there is the allocative welfare loss, which is exacerbated
by the cost shift. Second, there are the costs of attempts to acquire the right to receive the
transfer. These acquisition costs are sunk and therefore have no effect on marginal cost or
output. Third, there are continuing costs of maintaining and protecting the rent flow.
Therefore strategic entry deterrence in unregulated monopoly markets and non-price
competition in both unregulated and regulated markets may represent continuing rent
seeking activities and social costs. For instance, when rent seeking takes the form of
bribes to government officials, real resources will be wasted by those who then compete
for scarce government jobs which make it possible to access the bribes. Therefore it is
clear that rent seeking increases the level of monopoly inefficiency in many ways like:
turnkey Government project generates the employment but cost incurred will be greater
than the actual benefit.
#4. Briefly explain the following models of oligopoly.
a. Cartel
A cartel is a formal (explicit) agreement among firms which usually occur in an
oligopolistic industry, where there are a small number of sellers and usually involve
homogeneous products. Cartel members may agree on such matters as price fixing, total
industry output, market shares, allocation of customers, allocation of territories,
establishment of common sales agencies, and the division of profits or combination of
these. The aim of such collusion is to increase individual member's profits by reducing
competition. There are several factors that will affect the firms' ability to monitor a cartel.
• Number of firms in the industry.
• Characteristics of the products sold by the firms.
• Production costs of each member.
• Behavior of demand.
• Frequency of sales and their characteristics.
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6. Jay Modi
Economics
One of the famous example of using Cartel and facing charges is of De Beers, In 2004,
De Beers paid a $10 million fine to the United States Department of Justice to settle a
1994 charge that De Beers had conspired with General Electric to fix the price of
industrial diamonds (i.e. diamonds used for industrial purposes such as abrasives on
drills). General Electric had been to court to face the charges, but the case was thrown out
for lack of evidence. De Beers did not appear in court, but ten years later paid $10 million
to settle all outstanding charges.
Therefore Cartel acts as a multi-plant monopoly and produces in each of its ‘plants’ (in
each firm in cartel) where marginal revenue is equal to marginal cost. Assuming, as
before, that these marginal costs are equal and constant for all firms, the output choice is
indicated by point M in Figure 2. Because this coordinated plan requires a specific
output level for each firm, the plan also dictates how monopoly profits earned by a cartel
are to be shared by its members.
Figure 2:
Price
MC
P2 M
R
P1 Total quantit y
Q2 Q1
MR Quantity
When demand Q1 is in effect, the price will be P1. When Q2 is occurring, the price will
be P2. Since the supply is fixed, any shifts in demand will only affect price
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7. Jay Modi
Economics
b. Price Leadership
Price Leadership model is a type of model where in a market one firm or group of firms
is looked upon as a leader in pricing, and all firms adjust their prices to what this leader
does. For example, IBM’s pricing ‘umbrella’ in the formative years of the computer
industry. A formal model of pricing in a market dominated by a leading firm is
presented in Figure 3. The industry is assumed to be composed of a single price-
setting leader and a competitive fringe of forms who take the leader’s price as given in
their decisions.
Figure 3:
SC
Price
P1
D’
PL
P2
MC
MR Demand
QC QL QT
Quantity
The curve D’ shows the demand curve facing the price leader. It is derived by
subtracting what is produced by the competitive fringe of firms (SC) from market
demand (D). Given D’, the firms profit maximizing output level is QL, and a price of
PL will prevail in the market. Therefore this model does not answer such important
questions as to how the price leader in an industry is chosen, or what happens when a
member of a fringe decides to challenge the leader for its position
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8. Jay Modi
Economics
#5. Assume a monopoly firm sells its output at a single profit-maximizing price.
Now assume that this monopoly discovers a costless way to segment its market and
increase its profit by charging different prices in the different market segments.
a. What economic concept determines which segments are charged the higher
prices?
An important aspect of a product's demand curve is how much the quantity demanded
changes when the price changes. The economic measure of this response is the price
elasticity of demand which is used to determine the segments charged with higher price.
For example, a state automobile registration authority considers a price hike in
personalized "vanity" license plates. The current annual price is $35 per year, and the
registration office is considering increasing the price to $40 per year in an effort to
increase revenue. Suppose that the registration office knows that the price elasticity of
demand from $35 to $40 is 1.3. The determinants of price elasticity of demand which
affects the higher price in a particular market segment are:
• Availability of substitutes: the greater the number of substitute products, the
greater the elasticity.
• Degree of necessity or luxury: luxury products tend to have greater elasticity than
necessities. Some products that initially have a low degree of necessity are habit
forming and can become "necessities" to some consumers.
• Proportion of income required by the item: products requiring a larger portion of
the consumer's income tend to have greater elasticity.
• Time period considered: elasticity tends to be greater over the long run because
consumers have more time to adjust their behavior to price changes.
• Permanent or temporary price change: a one-day sale will result in a different
response than a permanent price decrease of the same magnitude.
• Price points: decreasing the price from $2.00 to $1.99 may result in greater
increase in quantity demanded than decreasing it from $1.99 to $1.98.
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9. Jay Modi
Economics
Another concept is Income elasticity of demand which measures the relationship between
income changes and changes in quantity demanded. It categorizes the customers into two
groups where customers who are willing to pay high price for a given product and
regarded as high value customer whereas customer who pay less price for a given product
are considered as low value customers. In the figure 4 Q (h) is regarded as high value
customers, Q (l) as low value customer and Q (t) as total value for both the customers.
Figure 4:
Price
P (h)
Additional Benef it
P (l)
MC
MR
MR
(High)
(Low)
High Value Low Value
Group Group
Demand
0 Q (h) Q (l)
Quantity
Q (T)
b. Explain how such a strategy of price discrimination may reduce the social
inefficiency associated with monopoly production.
Under monopoly a firm was assumed to be unwilling or unable to adopt different prices
for different buyers for its product. There are two consequences of such a policy. First the
monopoly must forsake some transactions that would in fact be mutually beneficial if
they could be conducted at lower price. Second, although the monopoly does not succeed
in transferring a portion of consumer surplus into monopoly profits, it still leave some
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10. Jay Modi
Economics
consumer surplus to those individuals who value the output more highly than the price
that the monopolist charges. The existence of both these areas of untapped opportunities
suggests that a monopoly has the possibility of increasing its profit even further by
practicing price discrimination.
Figure 5:
D
P2 B
E MC
P1
Price
MR
0
Quantity
The monopolist’s price-output choice (P2, Q2) provides target for additional profits
through successful price discrimination. It may obtain a portion of the consumer surplus
given by area DBP2 through discriminatory entry fees, whereas it can create additional
mutually beneficial transactions by area BEA through quantity discounts.
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