Chapter 27

Chapter 27 – The Demand for Resources

Significance of Resource Pricing

Income determination – Resource prices determine the income of households

Resource Allocation – Resource prices allocate resources among industries/firms

Cost Minimalization – Must produce profit-maximizing output with the most efficient combination of resources

Policy Issues – To what extent should the gov’t regulate wages

Marginal Productivity Theory of Resource Demand – Firm is a resource price “pricetaker”

Resource Demand as a Derived Demand

Derived Demand – Demand for Resources is derived from the products they help produce

Marginal Revenue Product – Strength of Demand depends on…Productivity of the Resource, The Market Value of the product

Productivity – Marginal Product – additional output resulting from using each additional unit of labor

Product Price – Marginal Revenue Product – the change in total revenue resulting from the use of each additional unit of a resource

Rule for Employing Resources – MRP = MRC

MRP schedule is the demand schedule for labor

Marginal resource cost (MRC) – additional in resource cost for each additional resource unit

It is profitable to hire resources until MRP = MRC

MRP as Resource Demand Schedule – In a competitive labor market, each firm is a wagetaker, hire to the point where MRP exceeds MRC. Each point on the MRP schedule constitutes a firm’s demand for labor

Resource Demand under Imperfect Product market competition

When the firm is a price maker, product price must be lowered to sell the marginal product of additional workers

Marginal Product diminishes and Product price falls as output increases

Lower price applies to all units sold

D = MRP in imperfect competition, broken line curve is that of a purely competitive seller

Resource demand curve of an imperfectly competitive seller is less elastic than that of a purely competitive seller

Downward slope is greater for a imperfectly competitive seller because the purely competitor can sell additional output a a constant price

Market Demand for a resource – sum up all the firms demands (MRP curves)

Determinants of Resource Demand – Resource demand is shifted by….

Changes in Product demand – increase in the demand for a product will increase the demand for resources used in its production, decrease in product demand will decrease the resource demand. Decline in the product demand/price will shift the resource demand curve to the left

Changes in Productivity – Increase in productivity, increase in demand. Depends on Quantities of other resources, Technological advance – lead to better quality capital

Quality of variable resource – increase in labor quantity would make a new demand curve

Changes in the Price of Other Resources

Substitute Resources – Substitution effect says that if another resource is cheaper, it will be substituted

Output effect – With lower production costs comes the increase in demand and thus need more workers

Net Effect – If Substitution effect > output effect, decrease in demand for labor and vice versa

Complementary Resources

If two resources must be used in a fixed proportion, then there is no substitution effect, only output effect

When labor and capital are complementary, a decline in the price of one increases the need for the other

Demand for labor increases when the demand for products increases, the Productivity of labor increases, The price of a substitute input decreases (if output effect > substitution effect), price of a substitute input increases (if sub effect > Output effet)

Occupational employment Trends – Increase in labor demanded results in increases in employment in that field

Fastest growing fields – in the service industry

Fastest shrinking fields – manufacturing jobs that can be automated

Elasticity of Resource Demand

Elasticity of Resource Demand = % Change in resource quantity/% change in price

Ease of Resource Substitutability – the greater the number of substitute goods, the greater the elasticity of demand for that resource

Elasticity of Product Demand – the greater the product demand elasticity, the greater the elasticity for the resources

Ratio of Resource Cost to Total Cost – The greater the percentage of cost to produce for an item, the more elastic it is

Optimal Combination of Resources

Least Cost Rule – producing at the least cost when the last dollar spent on each resource yields the same marginal product

Profit maximizing rule – Only one unique level of production that maximizes profit

MRP(resource) = P(resource) at maximum profit

Profit maximizing combination of resources – each resource follows the MRP = P rule

Producing at Least Cost – find the combination of labor and capital that will create the lowest total costs

Marginal Productivity theory of Income Distribution – income gets distributed according to contribution societies output. Workers get paid for their marginal contributions to their firmsPeople criticize this system for…

Inequality – productive resources (intelligence, physical attributes, opportunity in life) are distributed unequally. In this system, retarded people, some of whom make no contribution to society would not get paid

Market Imperfections – assumes a perfectly competitive market, real world imperfections can distort wages

Chapter 26

Chapter 26 – Technology, R&D and Efficiency

Invention Innovation and Diffusion

In the long run, technology is constant but firms can change their plans and are free to enter and exit industries

Very long run – tech can change and firms can develop and offer new products

Invention - the discovery of a product or process through the use of imagination, Patent – the exclusive right to produce and sell any new and usefull process, machine or product for a length of time

Innovation - The first use of an invention, a process, a new business venture etc. Either product or process innovation

Allows firms to leapfrog over other firms, existing firms have a strong incentive for R&D

Diffusion – the spread of an innovation through imitation or copying

R&D expenditures

US firms channeled 72% of R-D funds towards development, 22% on applied research and 6% to basic research

Modern View of Tech Advance

Modern economists see capitalism as the driving force of technological advance, even advances in pure science are often motivatied by commercial ventures

Role of Entrepreneurs and Other Innovators

Entrepreneur – risk bearer

Other innovators – other people in R-D that don’t bear risk

Forming Start-ups

Focus on starting a new idea from scratch

Innovating with existing firms

Often pay innovators bonuses for innovation, have spinoff firms for R-D

Anticipating the Future – try to gauge how tech will develop

Exploiting University and Government Scientific Research

The 6% allocated to basic scientific research is small because that research can not be capitalized on

A Firm’s optimal amount of R-D

Expand an activity until Marginal Benefit = Marginal Cost

Interest Rate Cost of Funds

Bank Loans – The cost of using the funds is the interest paid to the lender, The marginal cost is the interest rate for each additional dollar

Bonds – May be able to raise funds by selling bonds. Cost is the interest paid to the lenders-the bondholders

Retained Earnings – Well established firms may be able to draw on company savings

Venture Capital – Part of household savings that finance a startup in exchange for shares in the profit

Personal Savings – entrepreneurs savings, the marginal cost is the foregone interest rate

Interest rate cost of funds curve - A graph of interest rate vs amount borrowed

Expected rate of return

Marginal benefit is the expected profit form the last dollar

Expected-rate-of-return curve – Marginal benefit of each dollar of expenditure on R-D

Slopes downward b/c diminishing rate of returns

Allocates money to have the highest rate of return

Optimal R-D Expenditure

Interest-rate-of-return curve and expected-rate-of-return curve intersect at the Optimal amount of R-D (where rate of return and interest rate are equal)

Optimal vs Affordable – R-D may be affordable beyond the optimal amount

Expected, not guaranteed returns – they are an informed gamble

Adjustments – Adjust the R-D expenditure when return on various projects Change

Increased profit via Innovation

Increased Revenue via Product Innovation

Consumers purchase the highest marginal utility per dollar

Consumers will buy a new product only if it increases the total utility they obtain from their limited incomes

Important factors – Importance of price, Unsuccessful new products – R-D is wasted, Product improvements

Reduced Cost via Process Innovation – better processes lower ATC and increase TP (total product)

Imitation and R-D incentives

Imitation problem – if a rival company copies a product then the first companies R-D profits are diminished

Fast-second strategy – a dominant firm may let little companies do the R-D and then copy them quickly

Benefits of being first

Patents, Copyrights and trademarks, Brand name recognition, Trade Secrets and Learning by doing – ie Coke recipe, Time lags – have some time to make a big profit, Profitable buyouts – small company may be purchased for a lot of money

Role of Market structure

Market structure and Technological Advance –

Pure competition – provides an incentive to develop, expected return from R-D may be much less, in highly competitive firms such as agriculture, development comes from outside (gov’t),

Monopolistic Competition – Strong profit incentive to innovate, unique products = monopoly, most monopolies are small so its tough for them to get capital for R-D

Oligopoly – Can finance, can maintain economic profit, broad scope offsets the misses, however Oligopoly breeds complacency, competing with itself

Pure Monopoly – little incentive for R-D, only to reduce the risk of being blindside by a new development

Inverted U Theory

Graph of R&D expenditures vs Concentration ratio is an inverted U

Low concentration firms are competitive, with easy entry

High concentration – monopoly profit is already pretty high and R-D won’t add much to the profit

Market Structure and Technological Advance: the Evidence

Best mix is Oligopoly with smaller firms

Technological Advance and Efficiency

Productive Efficiency – Enables society to produce the same amount of a particular good or service while using fewer scarce resources, freeing the unused resources to produce something else

Allocative Efficiency – New product gives more utility/dollar, Profit-maimizing monopolist restricts output to keep its product price above marginal cost

Creative Destruction – Innovation can destroy monopolies, in CD, new products will put monopolistic industries for old products out of business

Chapter 25

Chapter 25 – Monopolist Competition and Oligopoly

Monopolistic competition – a) relatively large number of sellers b) Differentiated products c) Easy entrance and exit from the economy

Relatively large number of sellers – maybe 25 – 70 but not the thousands as in complete competition

No Collusion – enough firms that price setting/collusion is improbable

Independent action – No feel of interdependence, if one firm lowers prices, another one wouldn’t feel much of an effect

Differentiated Products – unlike pure competition, the products differ slightly by…Product Attributes, Service, Location (of purchase), Brand names and packaging – advertising and brand loyalty, Some Control over price – Sellers may pay a little more to choose a brand they think is better so not completely price takers

Easy Entry and Exit – because the firms are relatively smaller, it is not as hard to raise capital or achieve economy of scale

Advertisements – the goal of advertising is to differentiate products and encourage non-price competition – to make price less of a factor

Price and Output in Monopolistic Competition

The firms demand curve – Elasticity of demand faced by a monopolistically competitive firm is highly elastic but not perfectly elastic. Elasticity of demand depends on the number of rivals and the degree of product differentiation

The short run: Profit or Loss – mazimize profit/minimize loss by making MC = MR

The Long Run: Only a Normal Profit – In the long run, a monopolistically competitive industry will earn only a normal profit

Profits: Firms enter – Economic profit attracts new rivals, because entry to the industry is relatively easy, as more firms join, the demand curve will fall until it is tangent to the ATC curve, at this point the firms only produce a normal profit so there is no incentive for new firms to enter the business

Losses: Firms leave – Short term losses will push some firms out of the business, this will shift the demand curve (of the individual firm) to the right and thus restore normal profits

Complications – if a firm has sufficient product differentiation such that they cannot be copied, then they may be able to sustain modest economic profits in the long run or it might not be quite as free to enter the market due to product differentiation

Monopolistic Competition and Efficiency – the equality of price and marginal cost yields allocative efficiency

Neither Productive nor allocative efficiency – neither productive nor allocative efficiency occurs in long-run equilibrium. Profit maximizing price exceeds the lowest averacte total cost, therefore, the firms ATC is higher than optimal from society’s perspective. Also the Profit maximizing price exceeds marginal cost meaning that monopolistic competition causes an underallocation of resources, therefore it is not allocatively efficient either. Monopolistic competitors must charge a higher than competitive price in the long run to achieve a normal profit

Excess Capability – the difference between the minimum-ATC and the profit-maximizing ATC

Product Variety

Benefits of Product Variety – Product variety and product improvement of monopolistic competition may offset the inefficiency

Further Complexity – Graph 25.1 assumes no product development/fixed level of advertising, Competitive firm juggles price, product and advertising – In practice, this is determined by trial and error

Oligopoly

A Few Large Producers – when only a few companies 3-5 are in competition

Homogenous or Differentiated Products – May be a homogenous oligopoly or a differentiated oligopoly depending on whether or not the products are differentiated

Control over Price, but Mutual Interdependence – Price maker but must be careful that rivals wont undercut them significantly.

Strategic behavior – self-interested behavior

Mutual interdependence – each firms profit also depends on the prices/advertising of the other firms

Entry Barriers

Hard to enter because of often high capital requirements and need for economy of scale

Mergers – while sometimes firms grow into a oligopoly, often it is done by mergers. Beneficial because it makes the firm more monopolist in nature

Measures of Industry Concentration

Concentration Ration – percentage of total output controlled by the largest firm, when the largest four firms control over 40% of a market, it is considered an oligopoly

Localized Markets – CR’s are for the whole nation, but you can have oligopolies on a smaller level

Interindustry Competition – Sometimes industries compete with each other; for example motorcycle market competes with car market

World Trade – Import competition from foreign markets

Herfindahl Index – It could be possible if 4 companies controlled the whole industry that the four-firm CR was equal to a monopolized industry, the H index is the squared percentage market shares of all firms in the industry

The greater the H I, the greater the market power in the industry

Oligopoly and game theory

The study of how people behave in strategic systems is called game theory

Mutual Interdependence – Each firms profit depends on their pricing strategies and those of their rivals, one rivals high price strategy will only be profitable if the other one employs a high price strategy and vice versa

Collusive Tendencies – Collusion – cooperation with rivals (ie keep prices up for both firms)

Incentive to cheat – incentive to break price setting because then they could dominate the market

Three Oligopoly Models

Diversity of oligopolies – Tight Oligopolies – 3 or 4 control almost all, or Loose – 6-7 control 70% or so

Complications of interdependence – Firms cannot predict reactions so they cannot predict profit maximizing prices

Kinkead-Demand Thory: Non collusive Oligopoly

Match Price changes – If Company B and C react to Company As price decrease by matching A’s prices exactly then Arch’s demand and marginal revenue curves will look like straight lines

Ignore price change – Demand and MR curves faced by A will be straight lines, A would gain sales at the expensive of the other two companies, if it raised prices, A would lose many customers but not all of them because of product loyalty

A combined strategy

It is rational that B and C would lower their prices – but not raise them if Price was raised

Noncollusive oligopolies face the kinked-demand curve

Price Inflexibility

Either raising or lowering the price will result in smaller profits

Criticism of the Model – explains why price is pretty inflexible not what prices are set, When the macroeconomy is unstable, prices are instable. Price reductions lead to a price war

Cartels and other collusion – it would be profitable to collude and fix prices and create barriers to entry. Price and Output – each firm’s demand curve is indeterminate unless we know how the other firms will react. We will assume that they will match the price leaders price, so each demand curve is straight – therefore the same graph represents all three firms

If company A chooses where MC = MR = P (like a monopoly) the other firms will keep the same price and A’s demand curve will shift to the Left as customers shift loyalty

Each firm finds it profitable to charge where MC = MR, so they should collude to charge that price

Overt Collusions – the OPEC Cartel – cartel – a group of producers that typically creates a formal written agreement specifying how much each member will produce and forgo

Output must be controlled and divided up to maintain the agreed on price

OPEC controls 60% of oil traded internationally so they are able to drive prices up/lower them

Covert Collusion – also Tacit understandings – informal agreements about collusion

Obstacles to Collusion – Demand and Cost differences – difficult to agree on a price, Number of firms – The larger the number of firms, the harder it is to have a Cartel

Cheating – There is still a tendency to offer a lower price to steal competition

Recession – Slumping markets increase ATC

Potential Entry – Higher prices attract more firms

Legal Obstacles: Antitrust Law : prohibit cartels and price fixing

Price Leadership Model – Dominant firm initiates price changes and everyone else follows the leader

Leadership Tactics –

Infrequent price changes – Price is changed only when demand and cost has been changed significantly,

Communications – communicates the need to raise/lower prices so other firms can react,

Limit pricing – Set prices below profit-maximizing level in order to discourage other companies from entering the industry,

Breakdowns in Price Leadership: Price Wars – Price leadership usually ends when one company undercuts the other companies and a price war results

Oligopoly and Advertising – each firms share of the total market is best determined by product development and advertising

Product development and advertising are less easily duplicated then price cuts and therefore can produce longer lasting gains

Oligopolists generally have capital to put into product development

Advertising is prevalent in monopolistic and Oligopolistic competition

Positive effects of advertisements – Spreding info about products helps people make rational discussions and break up monopolies, enhances competition – greater economic efficiency

Negative effects of advertising – some ads convey little about product attributes, two costly advertising campaigns can be canceling

Oligopoly and efficiency

Productive and Allocative efficiency – P – minimum ATC