MECO 6303 My name is Stan Liebowitz Pronounced

MECO 6303 • My name is Stan Liebowitz • Pronounced: Lee – bow –wits • Reading list: • Web Page http: //www. utdallas. edu/~liebowit/ 1

Basics of Course What is economics about? Micro economics. ? – Current def: whatever economists study - not a very useful definition of a discipline. – Historical and more useful definition: allocation of scarce goods for competing ends. – In reality, it focuses mainly on how free markets, consisting of voluntary participants, operate. – It can also be used to analyze other non-market forms of production and distribution. 2

What Types Of Questions Do Microeconomists Try To Answer? – What pricing strategies allow firms to maximize profits? – When should a firm produce a product in house, and when should it purchase from outside vendors? – Can a firm pass on a tax? What is the effect of taxes on the profit maximizing behavior of firms? – What is the impact of airline deregulation? – What is the optimal amount of pollution? – Do women get paid less then men? Why? 3

Assumptions In Economics Ø Economics as Science- abstract model simplifies, requires simplifying assumptions. Ø Major actors: consumers and producers. Ø Ø Economic actors are rational: voluntary actions are only undertaken when they are expected to make people better off. Consumers try to maximize happiness (utility) Ø Producers try to maximize profits Ø Our wants are greater than our abilities to fulfill them (scarcity) 4

Assumptions: Economic Actors Are Rational 1. Voluntary actions are only undertaken when they are expected to make people better off. 2. Even people in asylums act economically rationally in most instances, according to experiments. 5

Assumptions: People Try to Maximize Happiness (Utility) 1. This does not imply selfish behavior. 2. If giving to others is what makes you happy, that is what maximizes your utility. 3. Rationality in this case implies that you wish to maximize your giving to others, not to just have the money wasted. 6

Assumptions: Firms Try to Maximize Profits 1. Private for-profit firms are supposed to work for their shareholders, who usually are interested in stock price appreciation, which results from profit maximization. 2. But, many organizations are not for-profit firms – clubs, government, charities, and so forth. But even if they don’t maximize profits, they still should be interested in efficiency, and also in what happens to the demand for their product when conditions change. 3. This assumption leads to good predictions about firms behavior, so it doesn’t need to be always true. 7

Assumptions: Scarcity 1. Our wants are greater than our abilities to fulfill them (scarcity). Factually correct throughout history. 2. If we do not have scarcity, then everyone has as much of all products as they want. There would be no trading, no markets, and no prices. 3. The problem of scarcity could in principle be ‘solved’ either by increasing output or decreasing wants. Some religious or philosophical movements work on decreasing wants; Capitalism tends to go the increasing output route. ‘Problem’ will never be solved. 8

Some Basic Definitions • Goods: things people want : • Economic goods: goods that are scarce. – Question- must goods have a positive price? Are all positive priced items economic goods? • Opportunity cost: what you give up when you engage in an activity. Measured as the value of your next best activity (the activity you would have engaged in if you didn’t choose the first activity). Example: opportunity cost of going to college. 9

Production Possibility Curves. – Illustrates concepts of efficiency, scarcity, opportunity cost. – Assumes society with two goods (perhaps Robinson Crusoe with fish and fruit). – Indicates combinations of each good that can be produced. – Example for farmer: amount of two possible commodities he might grow. 10

Two questions • A financial analyst on TV said the impacts of the hurricane on the country wouldn’t be so bad since most of the damaged property was insured. Is this a correct statement? • Oil prices rise when a hurricane is predicted to impact oil rigs and refineries. What is that about? Is it ‘profiteering’? 11

Production Possibility Curve Fruit A slope of line indicates tradeoff in ability to produce different types of goods B Fish B 1 12

No Specialized Resources-PPC Straight A 2 Production Possibility Curves under 2 scenarios Fruit slope of line indicates tradeoff in ability to produce different types of goods B Fish B 1 13

Specialized Resources- PPC Curved Line Production Possibility Curve Fruit A Fish B 14

Demand • • Defined for a single market – particular product and particular consumers. Each unit of the good is identical to all other units. Represents highest price consumers are willing to pay, and quantity they want at a given price. Time dimensions Holds everything but price and quantity constant (income, tastes, price of other goods, gravity, Y 2 k problems…. ) law of demand – demand slopes down – based on empirical observation. movement along versus movement on 15

P Demand D Q 16

Demand • • Defined for a single market – particular product and particular consumers. Each unit of the good is identical to all other units. represents highest price consumers are willing to pay. Holds everything but price and quantity constant (income, price of other goods, gravity, Y 2 k problems…. ) time dimensions law of demand – demand slopes down – based on empirical observation. movement along versus movement on 17

Demand for RNE* P 1 P 2 PWLM D Q 1 Q 2 QE *“Rethinking the Network Economy” 18

Shift in Demand for RNE P Perhaps a positive review in the Economist leads to an increase in demand curve D 1 D Q 19

Price Elasticity Of Demand • def: percentage change in quantity divided by percentage change in price • (ΔQ/Q)/(ΔP/P) or (ΔQ/ΔP) (P/Q) • measure of responsiveness 1. 2. 3. 4. If Elasticity is >1 known as elastic (responsive customers) If Elasticity is =1 ; unit elastic If Elasticity is <1; inelastic (less responsive customers) Infinite and zero elasticity 20

Illustrations of elasticity P D with zero elasticity D with infinite elasticity Q 21

Elasticity and TR • When elasticity is greater than 1 (elastic) increases in price lead to decreases in revenue and vice-versa • When elasticity is equal to 1, changes in price lead to no change in revenues • When elasticity is less than 1 (inelastic) increases in price lead to increases in revenue. 22

• Using Wall Street Journal; NY Times; Wash Post. • In early 1930, shortly after the stock market crash, what were the current conditions and what was being said about the economy by economists, financial pundits, and the media in general? What was predicted for the future? • In early 1932, what were the current conditions and what was being said about the economy by economists, financial pundits, and the media in general? What was predicted for the future? • 1982 what were the current conditions and what was being said about the economy by economists, financial pundits, and the media in general? What was predicted for the future? What were comparisons to the great depression? • Same for 2008, 9 23

Implications of Elasticity • • • If Elasticity is <1, firm can always increase Profit by increasing price (revenues increase and costs decrease because output decreases) If Elasticity =1, firm can always increase profit by increasing price If Elasticity>1 firm can not necessarily increase its profits by a change in price. Thus firms that maximize profits must have elasticities >1. Example of Video. Tape Pricing History Demonstrates Importance of knowing elasticity. 24

Long Run and Short Run Elasticities • Elasticity is greater in the long run – consumers have more time to react to price changes – For example, if the price of gasoline goes up, consumers at first can try to reduce the amount they drive, but this is often difficult. Over time, they can by more fuel efficient cars or move closer to their work. 25

P new higher price original price D after consumers have time to adjust to price change D before consumers have much time to adjust amount consumed after longer period after short period of adjustment Q 26

Supply: • Represents minimum price sellers require to voluntarily provide the product. • assume it slopes up for now. In reality it depends on the cost conditions of the firm. • Same assumptions as with demand: everything else is held constant. 27

Meaning of Supply S P 2 minimum price firm is willing to accept. Should be equal to the cost of producing the additional output P 1 Q 2 28

Long Run/Short Run Oil? Ss SL P 2 P 1 Q 2007 Q 2011 29

Meaning of (Stable) Equilibrium • A situation such that the variables of interest remain at rest until disturbed by some outside force. For stability, the variables must return to the equilibrium after being disturbed by some force. • Gravity and the resting place of tennis balls. • We assume many producers and consumers to start the analysis. • Surplus and shortages take the place of gravity in these markets. 30

Illustration of Supply Demand Equilibrium S Surplus P 1 Pe P 2 Shortage D Q 1 Qe Q 2 31

Examples of changes in Equilibrium • Supply and Demand analysis assumes that market moves from one equilibrium position to another. • Shifts in D or S alter equilibrium. For example, how would you expect the price and quantity of Pepsi Cola to change when: – – – Price of Coca Cola falls. Price of fructose goes up Surgeon general warns of soda threat to health. Winter changes to summer. TV ads for cola banned 1. Answers on next slide. 32

Changing Equilibrium S 1 2 P 4 P 1 4 S 2 1 D 2 3 P 3 D 1 Q 2 Q 3 Q 4 33

Lesson 3 1. 2. 3. 4. 5. The Meaning of Price, Value, and Economic Efficiency. Consumer and Producer Surplus. Diamond Water Paradox. Efficiency of Competitive Market equilibrium Efficiency Implications of Price Controls and Taxes. 34

Area under demand = total value of that output 1 P 1 2 3 Pe 5 4 D Q 1 Total Value of Q 1 Units= 1+2+4 Qe Total Value of Qe Units= 1+2+3+4+5 35

Area under supply = total cost (net of fixed costs) P 1 Pe 1 2 Q 1 Qe Increase in Total Cost when output increases from Q 1 to Qe =1+2 36

What about Comparable Worth • An issue in J Roberts Supreme Court nomination—he suggested it was ‘anticapitalist’. Was he correct? • What is comparable worth? • What arguments are given by its defenders? • What are the arguments if its detractors? 37

Role of Price • Mechanism for Allocating Goods in Markets: willingness to pay. • What are alternative mechanisms? – First come, first served – Strongest and most Powerful – Random Selection – Friends and relatives 38

Meaning of Price • What is the meaning of price when it is used to allocate goods? What does a high, or a low, price tell us about the product? • Diamond-Water paradox: why are diamonds expensive when water is so cheap? 39

Meaning of Price (diamond-water Paradox Average Value Water PA Dwater Swater Pw Total Value of Water is entire area Qw Average value of water is mid value of water used. So what does price measure? 40

Meaning of Price (continued) Sdiamonds Average Value Diamonds Pd Ddiamonds QDiamonds value of diamonds 41

Meaning of Price (continued) Sdiamonds Average Value Water Average Value Diamonds Pd Dwater Swater Pw Ddiamonds QDiamonds Total Value of Water is greater than value of diamonds Qw Average value of water is also greater. So what does price measure? 42

Meaning of Price in Markets • Price Measures the value of the last unit sold, or marginal unit. • Price, therefore, is unrelated to average or total value of a product. • Salary, which is the price of labor, need not be related to the “value” of the worker or the work. • How can one group of workers generate higher wages for themselves? 43

What about Comparable Worth • What can we say about it now? 44

WSJ on Economics Wage Market • economics job market. pdf 45

Consumer and Producer Surplus • Consumer surplus is the difference between the price paid and the higher price that consumers would have been willing to pay for the product. • Producer surplus is the difference between the payment received and the minimum payment that producers would have accepted. 48

Consumer and Producer Surplus P 1 1 3 Pe 4 2 Q 1 CS = 1 PS = 2 Qe DWL = 3+4 49

Price Controls • Artificial Government Restraint of Price • Can be a floor, or a ceiling • Popular during wars, or in non-market economies • Simple view: distortion in output • More complete view: wrong consumers get product. 50

Price Floor at P 1 1 P 1 2 3 Pe 8 5 4 P 2 7 6 Q 1 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 Qe Q 2 CS After Price Control = 1 PS After Price Control = 2+4+6 51

Price Floor at P 1 AND wrong producers 1 P 1 2 Pe 4 8 3 7 5 6 Q 1 Q 0 CS Before Price Control= 1+2+3+8 Ps Before Price Control = 4+5+6 Qe Q 2 CS After Price Control = 1 PS After Price Control = 2 52

Rent Control (Price Ceiling) 1 2 Pe Prc 4 7 3 5 transfer 6 Q 1 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 Qe Q 2 CS After Price Control = 1+2+4 PS After Price Control = 6 53

Government guarantees price at P 1 and sells output at market clearing price S 1 P 1 7 2 3 Pe 8 5 4 10 6 Pclearing 9 D Revenue from Consumers Q 1 Qe Q 2 CS After Price Control = 1+2+3+4+5+6+10 CS Before Price Control= 1+2+3 PS After Price Control = 2+3+4+5+7+9 Ps Before Price Control = 4+5+9 Taxpayers = 2+3+4+5+6+7+8+10 54

Government guarantees price at P 1 and burns any output it can not sell at that price P 1 1 2 Pe Pclearing 4 7 3 5 9 Q 1 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+9 8 6 11 10 12 Qe Q 2 CS After Price Control = 1 PS After Price Control = 2+3+4+5+7+9 Taxpayers = 3+5+6+7+8+10+11+12 55

Price Gouging • How would it be defined? • Should it be illegal? – What are the plusses and minuses? – What are the two roles that price plays in the economy? – What impact does it have on distant future behavior? • Which is better: windfall profits tax, or price gouging law? 56

Who Pays For A Tax? • Terminology in Book is not exactly correct. • Two forms of analysis: decreasing supply or decreasing demand. • Tax burden is shared depending on slope of both curves. 57

Price Paid by Consumer Tax from consumer’s vantage St S }amount of tax P 1 Pe D Q 1 Qe 58

Tax from producer’s vantage Price received by Producer S P 1 Pe P 0 }amount of tax D Q 1 Qe Dt 59

Price Paid by Consumer Distortion from Tax St S }amount of tax P 1 Pe P 0 D Q 1 Qe 60

Instance of Tax borne by Producer S 1 P Price Paid by Consumer S P 1 D with infinite elasticity Q 1 Q 2 Q 61

Instance of Tax borne by Consumer P D with zero elasticity S 1 Price Paid by Consumer S P 1 P 0 Q 62

Instance of Tax borne by Consumer Price Received by Producer P S with infinite elasticity P 0 Dt Q 1 Q 0 D Q 63

Instances of Tax borne by producer Price Received by Producer P S with zero elasticity P 0 P 1 Dt Q 0 D Q 64

Firms: Legal Forms • Corporation and Proprietorships. • Corporations which use stock have two advantages: limited liability and transferability of ownership. Disadvantages: the corporate income tax and costs of incorporation. • Proprietorships have unlimited liability and can not be transferred. They do not have to pay corporate income tax, however. (New hybrid forms). • Firms in our theory produce output in order to maximize profit. Marginal Analysis will help us understand profit maximization. 65

Marginal Analysis • Relationship between Total, Average, and Marginal Magnitudes? • You already have experience – you have been calculating your ‘average’ since elementary school. Each test is a ‘marginal’ score. • Useful in Understanding Profit Maximization. • Total Revenue is defined as Price multiplied by Quantity. • MR is the change in TR when another unit is sold. 66

Marginal Analysis - Demand 1. Note Relationship between elasticity and Marginal Revenue. 67

More Marginal Analysis 68

Marginal Costs and Profit 69

Profit Maximization • Marginal Analysis • • TR= Px. Q Calculus leads to MR=MC conclusion; Alternatives to Calculus AR = demand curve; marginal revenue curve must lie below demand curve • Profit maximized when TR-TC is greatest (vertical difference) • this implies slope of TR = slope of TC which means that MR=MC 70

Some simple Calculus p ¶p ¶ Q = = TR ¶ Q - ¶ TC ¶ Q Max p Þ so = where P = ( 1 e + P = - MR ¶p ¶ Q Also = P · TC = MR TR ¶ Q - = MC 0 MC · Q ¶ P + Q · ¶ Q ¶ P 1 ) = P ( 1 ¶ Q e Q · P = elasticity of ) demand 71

The Intuition Marginal Revenue = D in Revenue when Q + 1 units are sold instead of Q units. Last Unit brings revenues = price of last unit + DP · Q for Q units which go down in price. MR is less than P because of this DP effect. So MR = P - ( DP · Q) where DQ = 1 DP · Q 1 MR = P(1 ) or MR = P (1 - )where DQ · P e e = elasticity of demand 72

Profit Maximization TC $ TR max Rev q* Max Profit D Output MR 73

Another Angle AC MC P* Profits D q* MR 74

The Firm's Inputs And Costs • Fixed And Variable Costs. – Fixed Costs: Costs that do not change when output changes. – Variable costs: Costs that do change when output changes. • Long Run and Short run. – Long Run: A long enough period of Time such that all costs are variable – Short Run: A period of time such that at least one input (cost) is fixed. 75

TC=FC+VC; TC/Q = FC/Q +VC/Q AFC +AVC which is ATC= Fixed and Variable Costs AC P AVC Total Fixed AFC Total Fixed q 1 Q 76

Irrelevance of Fixed Costs if you stay in Business • Changes in Fixed costs don't alter profit maximizing P and Q because fixed Costs don’t impact Marginal Costs. • Fixed Costs do impact profits, and may cause firm to decide the leave industry. • Same with lump sum taxes. 77

Impact of Fixed Costs on Profit AC 2 MC AC 1 P* Profits 2 AC* Profits 1 AC** D q* MR 78

Economies and Diseconomies of Scale • What does this imply about the AC curve? • defined simply as whether or not AC rises or falls • long run AC Vs. short run AC • Distinguishing between economies of scale and improvements in technology very important. • Can firms have diseconomies of scale but industries have economies of scale? 79

of Sc ale Sc isec al on e o f so ie m ies om on Ec D AC 80

Long Run AC LRAC MC 1 SRAC 3 MC 2 SRAC 2 Q 1 81

Do average costs fall over time, or is average cost downward sloping? AC 1990 AC 1991 P* AC 1992 AC 1993 AC 1994 q* 82

Can firms have diseconomies of scale but industries have economies of scale? • External Effects – Industry output effects the costs of individual firms. • Positive External Effects can cause AC for industry to fall even though each firm has upward sloping AC curve. • Used to explain apparent decreasing costs but multiple firms in industry. 83

• Midterm goes only up to this point 84

perfect competition • Many participants, buyers and sellers. • Sellers are infinitesimally small. • Homogeneous products. • Free entry and exit. • Perfect information. 85

1. Competitive Firms • a. In the short run almost horizontal demand. • b. supply curve of firm is the MC above AVC. • c. Industry supply horizontal sum of firms mcs (the sum of their output at a price). 86

Short Run Profit Maximizing solution for a competitive firm; MC seems to be the supply curve. MC AC P* 1 D = MR Profits ACq* q* 87

P supply curve of firm is the mc above avc AC S MC AVC p 3 p 2 p 1 AFC q 1 q 2 q 3 Q 88

supply curve of industry is the horizontal sum of each individual firm’s supply. Firm A Firm C Firm B s s Industry s S p 1 p 2 qa 1 qa qb qc Q=qa 1 Qa+b+c 89

Competitive Equilibrium • a. fixed number of firms in SR!! no entry or exit allowed; therefore, industry supply can not change • b. for firm: d=mr=p=mc • c. In longer run, profits draw entry of firms, increasing industry supply, lowering price and profits down to zero; negative profits cause exit, decreasing supply, raising price and bring profit back to zero. 90

This represents a competitive industry in a short run equilibrium. Meaning that until entry or exit can occur, nothing will change since the price equalizes quantity demanded and supplied. But the typical firm earns profits (right hand picture) and entry will increase industry supply in long run, lowering price. Competitive Industry P "Representative" Firm in Industry AC P p 1 Q 1 q 91

This represents a competitive industry in a long run equilibrium (price P 3). Once achieved, nothing will change since the price equalizes quantity demanded and supplied. Since the typical firm earns no profits (right hand picture) no further entry or exit will occur. Competitive Industry "Representative" Firm in Industry S 1 P S 2 AC P S 3 p 1 p 2 p 3 Q 1 Q 2 Q 3 q q 1 92

Efficiency of Competition • a. no deadweight losses-- i. e. on prod poss frontier • b. each firm at bottom of ac--- seems good, but actually irrelevant for economic efficiency • c. consumers vote with dollars. Popular products make money, drawing entry until enough of the product is produced. The drive for profits makes firms efficient and efficient firms drive out inefficient firms (Darwin and Economics). 93

The right hand diagram represents the typical firm in long run equilibrium. The firm is at the bottom of the AC, meaning that costs are minimized. Industry has zero deadweight loss. Competitive Industry "Representative" Firm in Industry AC P P 1 2 CS=1 PS=2 q 94

Efficiency of Competition (rpt) • a. no deadweight losses-- i. e. on prod poss frontier • b. each firm at bottom of ac--- seems good, but actually irrelevant for economic efficiency • c. consumers vote with dollars. Popular products make money, drawing entry until enough of the product is produced. The drive for profits makes firms efficient and efficient firms drive out inefficient firms (Darwin and Economics). 95

Competitive Markets that aren’t • Example of taxi-cab medallions • Television station licenses. • Medical doctors • Many, more. 96

Long Run Supply: No External Effects • Competitive industry must have constant costs in this case. • Long run industry supply must be horizontal at the bottom of the AC of representative firm. • Long run industry output changes only through entry and exit of new firms. 97

The typical firm in long run equilibrium at the bottom of its AC, meaning that costs are minimized. With no external effects, each firm always produces ‘q’ and long run industry output only changes when the number of firms changes. Competitive Industry "Representative" Firm in Industry AC P P S R S P 1 LRS q 98

Long Run Supply with External Effects • Competitive industry may have increasing or decreasing costs in this case. • Long run industry supply changes only as the bottom of the AC of representative firm changes. 99

P AC for representative firm as industry output Q increases. AC (Q 1) AC (Q 2) AC (Q 3) Q 100

Long run supply in decreasing cost competitive industry P AC (Q 1) AC (Q 2) AC (Q 3) LRS Q Q 1 Q 2 Q 3 101

Monopoly Vs. Competition • Monopoly versus competition (smaller q, higher p) • Imposing a tax on a monopolist similar to competition in that producer still bears part of it. • Price controls and monopoly. . . a case where controls may increase efficiency. • Price discrimination. • The tradeoff associated with patents and copyright deadweight loss in consumption versus possible new products. 102

Monopoly charges higher price, produces smaller quantity. Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from consumer MC S Pm 3 Pc 4 1 2 D Qm Qc MR 103

Tax on Monopoly: price goes up by less than tax, so burden of tax is still shared. Monopolist tends to pay bigger share than would competitors. Deadweight loss grows. MC+t P 2 MC P 1 t a x D Q 2 Q 1 MR 104

A Price Control on a monopolist. Since p cannot go above Pcontrol the MR is equal to Pcontrol , output may increase (if price control is not too low, and deadweight loss may decrease. MC P 1 Pcontrol D Q 1 MR Q 2 105

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Perfect Price Discrimination • Theoretical ideal. Cannot be fully achieved. • Find maximum price that every consumer is willing to pay and charge them that price. • Requires more information than any firm has, and the prevention of arbitrage. • Demand Curve becomes MR curve. • No Deadweight Loss. • Approximate examples: automobile dealers, doctors in the old days. 108

Perfect Price Discrimination. P 1 P 3 S P 6 D 109

Price Discrimination • If markets for a single product have different MRs, profits can be increased by shifting output from low MR markets to high MR markets. • Raise price in low MR market and lower price in high MR market. • High MR market is high elasticity market. • Need to Prevent Arbitrage. • Examples: Airlines with business travelers and vacationers. Coupons. 110

Market 2 Market 1 P 1 price before discrimination P 2 D mr Q 2 Q 1 mr 1 MR MR 111

Price Discrimination Rules • Raise price in market with lower elasticity (lower responsiveness) • Lower price in market with higher elasticity. • Do this until MRs are equalized. But prices will not be equalized. • Examples: Airlines with business travelers and vacationers. 112

Monopsony • Single buyer instead of single seller. • Price paid is less than competitive level. Quantity purchased is also less. • Deadweight loss, similar but inverted compared to monopoly. 113

Deadweight Loss 1+2. Area 5+4 is transfer to consumer from producer. S MFC 3 Pc Pm 8 1 4 6 5 2 7 D Qm Qc MR 114

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The Causes of Monopoly • Natural Monopoly and Network effects • Government grant (U. S. postal service, electric company), • Patents and Copyright. • Control of scarce resource. • Technical Superiority. • Attempts to Cartelize Industry 116

Natural Monopoly • Downward sloping AC curve. • More efficient to have 1 large firm than many small firms. • Rate of return regulation is how we regulate these firms. • Removes incentive to keep costs down. 117

Natural Monopoly Pm Unregulated Profit Pr Losses with efficient output PE R M D Qm Qr MC AC QE 118

Network Effects • Increased market size makes product more valuable to consumers. • This is just like an economy of scale in that it benefits large firms relative to small ones. Leads to natural monopoly. • It implies that demand increases for large networks, and that prices should rise. • In Microsoft case, judge decided that they are a barrier to entry. 119

Patent (copyright) tradeoff • With no protection, creators do not reap much of the rewards of their creations. • They are given monopoly protection, which increases their revenues, but raises price to consumers. • This increases the number of inventions, but decreases the use of each invention? • We do not know the optimal tradeoff. 120

Antitrust Rules against: • • Monopolization. Price Discrimination. Predatory Pricing. Tie-In Sales. 121

Monopolization • If earned through better performance is not illegal. • Agreements to ‘restrain trade’ are per se illegal. • Definition of market is often crucial here. 122

Cartels 1. 2. 3. Firms try to collectively act like a monopolist. This means restricting output to raise price. What are the impediments? 1. KEY POINT: FIRMS HAVE AN INCENTIVE TO CHEAT because their elasticity is greater than the industry as a whole. Even if firms can reach an agreement, how can it be enforced? 123

Cartels 1. 2. 3. 4. Enforcement is the crucial problem for a cartel. Since every firm individually has an incentive to cheat, some impediment to cheating is required if the cartel is to succeed. The usual impediments to rule breaking are detection and punishment. Cartels need to implement the same impediments. Detection: How can the cartel determine when someone has violated the agreement? (1) Can it use police power of the state? (2) Can it use its own enforcement agency? Mafia, etc. 124

Cartels 1. 2. 3. 4. Can the Cartel punish one firm without hurting member firms to the same extent? Can they all target their punishment to harm only the one cheating firm? Is OPEC a cartel? It is unclear whether OPEC is a classic cartel. Did everyone in the organization have to cut output? 125

Price Discrimination • Illegal if it gives some firm an advantage over other firms. • If individuals are consumers, is not illegal. • Price Discrimination is not likely to harm efficiency. Perfect Price discrimination is perfectly efficient. • Intention of this rule was to protect ‘mom-andpop’ stores and grocers from department stores and supermarkets. It was intended to reduce competition. 126

Public Goods 1. 2. 3. 4. Definition: Goods that do not get used up when consumed. In other words, one person’s consumption of a good doesn’t reduce anyone else’s potential consumption of the same good. Obviously, these are not physical items that get used up. Instead they are usually ideas and artistic expressions. They are at the core of the Information Age Economy, since information is a public good. The Demand for Public Goods is the vertical sum of individual demands. 127

Vertical Addition of Demands P 4 ΣD P 3 P 2 D 3 D 2 D 1 P 1 Q Q 1 128

Public Goods 1. 2. Think of book titles as public goods, but physical copies of single book title are private goods that embody a public good. Several questions arise: how many titles are optimal to publish? How many copies of each title would be optimal? How do competitive markets work? Monopolies? Finally, is it possible to produce public goods efficiently? 129

In principle, a perfectly discriminating monopolist can produce efficient amount of public good. S P 4 P 3 ΣD P 2 P 1 Q Q 1 Q 2 130

Production of a Single book title Pm 1 2 4 3 7 5 6 MC of printing 8 D Qm number of copies of a title MR 131

• Market Demand for Titles Pe rf D isc Pm Att rim ain ab le MC ina Q** De ma Q* a riting w f o tio nd Qm itle er t h t o n n. D em and for title for titl es s number of titles written 132

Copyright Tradeoffs • Underconsumption- too little consumption of a particular title. • Underproduction- too few titles. • Due to public goods nature of books. • Question: is this model actually the appropriate model? Does copyright raise price in the consumption market? 133

Copyright without higher prices • How would copyright benefit owner if it doesn’t raise price? • Increasing the quantity might be beneficial even at non monopoly price. • Restricted entry prevents profits from being driven down and that is the benefit of copyright. 134

Predatory Pricing • Current court-created definition (known as Areeda -Turner rule) : price below average variable cost. • Also requires that there be a serious likelihood of driving prey out of business and of recouping losses. • Likely to lose money for the predator, and unlikely to remove the prey. • Can only succeed if prey is removed. • Few real world examples. Standard Oil cases are largely fictional. 135

Predatory Pricing P AC S MC AVC p 3 p 2 p 1 AFC Q 136

Resale Price Maintenance 1. 2. These are laws (also called ‘fair trade’ laws), at the state level, that forbid retailers from charging less than a price specified by a manufacturer. Puzzle: why would manufacturers not be happy to have retailers selling their product at low prices, since that would seem to increase sales and profits? 137

Resale Price Maintenance 1. Answer: Two possible answers a. Firms are colluding and Resale Price Maintenance removes the incentives to cheat since if they lower their price to retailers it won’t get passed on to consumers and it will not increase their profits. b. Goods need special treatment from retailer, and free riding by some retailers will force others to stop providing the treatment. RPM stops some retailers from free riding off of other retailers. 138

Tie-In sales. • Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second. • Tie-In sales are poorly understood by courts, imperfectly understood by most economists. • Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate. • Two monopolies are not better than one if products are used together (in fixed proportions). 139

Tie In Sale when products used together PP MC=AC pairs of shoes 2 PL PP-PL MC=AC left or right shoes PL MR Q 1 D pairs of shoes Q 140

PD version of Tie-In Story 1. 2. 3. 4. Seller is thought to have two types of customers – heavy versus light users. Tied good is thought to ‘meter’ the use of the tying good, to separate heavy from light users. By lowering price of tying good, and raising price of tied-good, producer increases payments made by heavy user relative to light user. Problems: heavy users likely to use up machines faster – tie-in may have no impact on relative payments. 141

Risk Reduction version of Tie-In 1. 2. 3. 4. Consumers are unsure how much use they will get from the tying good (machine). This riskiness causes them not to be willing to pay the full expected (predicted) value of the product. Seller has many such customers and can provide ‘insurance’ since the large numbers makes overall results predictable. By lowering price of tying good, and raising price of tied-good, producer provides insurance for consumers afraid they might not have much use for machine. 142

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Economics in the Real World • Should the Record Industry worry about file -sharing? • First you use economic theory. • Then you perform empirical analysis based upon economic understanding. 156

4 Possible Impacts of Copying on the Producer • Substitution Effect: Copies replace the purchase of a work. – This is most basic intuition. – Clearly decreases sales. Not a problem for videotaping. – Hard to imagine that it isn’t important for many forms of copying. Particularly counterfeiting. 157

Indirect Appropriability • Producers capture value of copies (Liebowitz, J. Political Economy, 1985) – Requires: • Large variability in copies made per original • inability to identify which originals are turned into copies – This is the reason photocopying did not appear to harm publishers. 158

Sampling (Exposure Effect) • Try out before purchase – Defense in the Napster Case – If cost of sampling low, it is efficiency enhancing. But not necessarily revenue enhancing! • Drunken Sailors Example – Empirical evidence that sampling doesn’t increase sales. • Superior choices of Cable TV generally doesn’t increase viewing hours • Radio doesn’t appear to increase record sales. 159

Network Effects • Users have higher value because there are more other users. – It is not clear which products this might apply to, perhaps business software. • Users of Copies Increase Value to Purchasers – Could in theory increase sales. • Seems unlikely to be important in most instances of copying. 160

More Measurement Problems Inspires confidence, doesn’t it? 161

Filesharing 162

What Did Napster “Victory” Do? 163

The blip in 2004 and Measurement Issues 164

No Change in Substitute Markets in the Period around 1999 165

DVD growth was close, but no cigar. 166

Overall, it can’t explain the CD decline 167

Additional Evidence It has been claimed (Oberholzer/Strumpf Grokster Amici brief) that genres of music least likely to have been downloaded have shared in sales decline (in particular Country Music), which would be inconsistent with downloading causing the harm. 168

The RIAA Law Suits had some Initial Success File-sharing declined in the first six months, consistent with timing of RIAA lawsuits. Sales increased as well during first six months, consistent with assumption of file-sharing’s harm. 169

Statistical Study • Compare sales change in cities based on change in file-sharing, proxied by Internet usage. • 1998 to 2003. • Control for as many other variables as possible: income, demographics, etc. • By taking differences over a short time interval, you control for characteristics of cities that do not change over short intervals. 170

Result • File-sharing has caused the entire decline in sales, and prevented a robust period of growth. 171

Tragedy of the Commons • Common Property Resource – lake, forest, any productive resource that allows free use. • The tragedy is that the resource is overused. • Greater tragedy is that it is overused to the point where its entire value might be dissipated. 172