ECO IV J

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit III At the end of this unit, you should be able to:

1. Evaluate the ethical outcomes of free market outcomes using supply and demand models. 1.3 Compare and contrast the effect perfect competition and monopoly have on total welfare.

3. Analyze how price and output influence profit maximization under different market structures.

3.1 Compare and contrast the market outcomes for perfect competition, monopoly, oligopoly, and monopolistic competition.

Required Unit Resources Chapter 8: Understanding Markets and Industry Changes (ULO 3.1) Chapter 9: Market Structure and Long-Run Equilibrium (ULO 3.1) Chapter 10: Strategy: The Quest to Keep Profit from Eroding (ULO 1.3) Article: Price Caps, Oligopoly, and Entry (ULO 3.1) Unit Lesson Unit Material (ULO 2.1) This unit’s material focuses on different types of market structures and how firms in those markets seek profit. Before getting into market structures, we will discuss a bit about markets in general. All markets are affected by supply and demand. The type of market structure in question will primarily affect how supply behaves, but important information for firms comes from demand. This unit’s material focuses on different types of market structures and how firms in those markets seek profit. Before getting into market structures, we will discuss a bit about markets in general. All markets are affected by supply and demand. The type of market structure in question will primarily affect how supply behaves, but important information for firms comes from demand.

Supply and Demand In a market, supply and demand come together to determine the equilibrium price and quantity. When demand increases, price and quantity increase. When supply increases price decreases and quantity increases.

UNIT III STUDY GUIDE Market Structures and Profit

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

Factors Affecting Demand There are several factors that can cause demand to change. Economists group these reasons into five main factors:

Businesses need to know not just these factors but how these factors affect the industry of their business. Changes in income, for example, do not affect all businesses the same. Economists categorize goods as normal goods, which are goods whose demand increases as income increases, and inferior goods, which are goods whose demand increases as income decreases. An example of a normal good would be eating out. The more income a person has, the more likely they are to eat at restaurants rather than prepare meals at home. Candy, possibly surprisingly, is an inferior good. When people experience lower incomes, they cannot afford as much entertainment as before, so candy offers an inexpensive pleasure. Changes in the price of related goods is another factor that can have different effects based on specific circumstances. Some goods are related in consumption. These are called complements. Peanut butter and jelly are an example of complements. If the price of a complement decreases (say, peanut butter), then the demand for the good in question (say, jelly) will go up. After all, if you are buying more peanut butter, you are going to need more jelly to go with it. Substitutes are goods that compete in consumption. Coke and Dr Pepper, for example, are substitutes. If the price of Coke goes down, consumers are more likely to buy Coke, and, thus, less likely to buy Dr Pepper. So if the price of a substitute good decreases, the demand for the good in question goes down. Most of the remaining factors work as might be expected. If the number of demands increases, demand for a particular good will increase. Imagine sitting in a waiting room as your oil gets changed. There is a vending machine there. You might be tempted to get something. If another person walks into the waiting room, they will also be tempted to get something. As more and more people enter the waiting room, the likelihood that somebody will purchase from the vending machine increases. Most likely, multiple people will make a purchase from the vending machine. In other words, demand will increase. Add in tastes and preferences. If a particular product becomes popular (perhaps because of positive press, perhaps the product is seasonal, perhaps the product has experienced a change in quality), then more people are likely to want the product. In other words, demand increases. Finally, look at expectations. Expectations might be a little confusing. The important thing to remember is that when looking at the effects of changes in demand, the time frame is immediate. That is, the expectation is for some time in the future, but the analysis is what happens to demand right now. So, if consumers expect prices to increase in the future, they will want to buy more before prices rise. That is, demand will increase.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Factors Affecting Supply There are also factors that can affect supply (as opposed to demand). Most of these factors are pretty straight forward. As the price of inputs increase, costs to the producers go up, so naturally the supply will decrease. For example, if the price of oranges goes up, the supply of orange juice will decrease. If the price of a similarly produced product increases, then the supply of the good in question will decrease. For example, if looking at the supply of vanilla ice cream and the price of chocolate ice cream increases, then the supply of vanilla ice cream will decrease as the resources used to make vanilla ice cream will be shifted over to make more chocolate ice cream to take advantage of the higher price. As with demand, the number of suppliers matters to supply. The more suppliers there are, the more production there is. This is fairly simple and straightforward. Technology is also an important factor for supply. An improvement in technology that makes production easier and cheaper will lead to an increase in the supply. It is unlikely that a firm would actually adopt new technology unless it had the express purpose of making production easier or cheaper. For example, self- checkout kiosks at grocery stores or fast food restaurants are technology that make the production process (or service delivery process) cheaper for companies. They do require an upfront investment in technology, but the payoff is lower operating costs in the future. Finally, expectations are important for supply and the same caution that applied to expectations with demand apply here. Firms respond now to expectations about the future. Another important note is that while it can often be easy to think of supply as production, it is better defined as what producers bring to market. So, if producers expect a price decrease in the future, they will want to rush to market what they can to take advantage of the relatively higher price. That is, the expectation of a future price decrease will result in an increase in supply right now. To learn how to draw a supply and demand graph in Microsoft Word, view the video How to Graph in Word. You can access closed-captioning once you access the video.

Market Structure As mentioned in the beginning of the lesson, underlying the supply curve is the market structure. Economists differentiate market structures (identified by name later in the course) based on three characteristics. Those three characteristics are:

• the number of sellers in a market (The number of buyers matters too, but that does not change among these four market structures.);

• the homogeneity of production (This means how different the production is from one producer to the next; another way to think about this is whether you can identify the producer based on the product.); and

• the existence, or not, of barriers to entry (also phrased free entry and exit). At one extreme of the market structures is perfect competition. Perfect competition is characterized by:

• lots of sellers, • selling identical products, and • no barriers to entry (free entry and exit).

At the other extreme of market structures is monopoly. Monopoly is characterized by:

• one producer—and only one (If it is even two producers, it is a different market structure.), • selling a product that is unique in the market such that there are no close substitutes, and • impossible for competitors to enter.

As you can see from the characteristics, monopoly is the opposite of perfect competition. These differences lead to some important outcomes for the different markets.

ECO 6301, Economics for Managers 4

UNIT x STUDY GUIDE Title

Since there are many producers producing exactly the same thing, perfectly competitive firms do not have any influence on the overall market. They are very much a “drop in the bucket” relative to the market. Perfectly competitive firms must accept whatever the market price is. Monopolies, on the other hand, are the only supplier in their market, so their decisions have a big influence on the market outcome. Monopolists cannot exactly set their price; they must be mindful of their consumers. When deciding what price to set, monopolists have to balance the revenue they would gain from raising their prices with the revenue they would lose by selling a lower quantity (and vice versa if they are considering a price decrease). Without barriers to entry, if a firm can make excessive profits (known as economic profit), then other firms will enter the market, taking some of that profit away. Monopolies are protected by barriers to entry, so if they can earn large economic profits, there will not be any competition to come along and take those profits away. Perfectly competitive markets are the most efficient. They must be. If a firm is not as efficient as possible, it will be run out of the market. Monopolies do not need to be efficient since they are protected by barriers to entry. Monopolists, just like every firm, want to maximize profits. Maximizing profit for a monopolist, however, means not producing as much as they could so that they can charge a higher price. In between these extremes are monopolistic competition and oligopoly. Monopolistic competition is a lot like perfect competition, except that rather than producing identical products, the firms produce slightly different products. The difference might be slight, and they might even be just perceived, but they matter, at least somewhat, to the consumer. Think about hair stylists and barbers, for example. Some people have certain people they like to cut their hair. Some people do not care but might still base their purchasing decision on proximity or availability. These differentiations introduce a slight amount of pricing power into the market. The differentiations also give rise to the need for firms to advertise what it is about their product that sets them apart from competitors. Differentiation can also be a feature of oligopolies. Oligopolies are a lot like monopolies except there are some firms, not one, in the market. Think of it this way, if you can name the firms that account for a strong majority of the market share off the top of your head, the industry is an oligopoly. Oil/Gas companies, airlines, and automobile companies are examples of oligopoly markets. The barriers to entry are high but not insurmountable. This feature leads to strategic behavior between the firms as the action of one firm affects the outcomes of other firms in the market. Strategic behavior will be an important topic explored in future units.

Reference Reynolds, S. S., & Rietzke, D. (2018). Price caps, oligopoly, and entry. Economic Theory, 66(3), 707–745.

https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=132338488&site=ehost-live&scope=site

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit IV At the end of this unit, you should be able to:

5. Apply game theory to pricing and to output decisions in an oligopoly market. 5.1 Explain how game theory can lead to fierce competition even with only a few competitors in a

market.

6. Analyze the basis of trade. 6.3 Describe how countries opening to international trade affect the market structure of domestic

industries. Required Unit Resources Chapter 11: Foreign Exchange, Trade, and Bubbles (ULO 6.3) Chapter 15: Strategic Games (ULO 5.1) Chapter 16: Bargaining (ULO 5.1) Unit Lesson Lesson: International Trade and Strategic Behavior (ULOs 5.1, 6.3) This lesson will introduce you to the topics of international trade and strategic behavior that are the focus of this unit. Trade goes back to the dawn of civilization. As travel has become easier and more accessible, international trade has connected regions from across the globe. Unit I introduced the benefits of trade with the Starburst example. The same benefits hold when the exchange crosses international borders. In the Starburst example, the benefits of trade arose from differences in flavor preferences. Generally speaking, the benefits of trade arise from differences in opportunity costs. The opportunity costs are not about what we give up when we consume, but what we give up when we produce. That is, there are differences in production capabilities between people, regions, and countries. Iowa and Nebraska, for example are well equipped for producing corn. Colombia is well equipped for producing coffee. Countries with large populations and limited capital are well equipped for producing labor intensive goods. Countries with smaller populations but more capital are well equipped for producing capital intensive goods.

If a Country Can Be Self-Sufficient, Should it Be? Even if a country can produce everything it needs, it is still better off trading due to differences in opportunity costs. Opportunity costs are the value of what you give up when making a choice. The United States might be able to produce bananas, but the resources required to produce enough bananas for the entire population could be used to produce other things. Producing enough bananas would take more land. Producing enough bananas would likely take more buildings and energy to create the proper tropical climate to grow bananas. This would all take resources away from producing corn or cars. The labor required to grow more bananas would also take labor away from software development or education. Growing bananas in the United States would mean giving up a lot of corn (or cars or software development or education), but producing corn (or cars or software or education) would not result in losing much banana production.

UNIT IV STUDY GUIDE International Trade and Strategic Behavior

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

Having a lower opportunity cost to produce a certain good is called having a comparative advantage in that good. Basing production on comparative advantage leads to more overall production that can then be traded for other goods. In addition to benefiting from a lower opportunity cost, focusing production on specific goods also allows for specialization so producers get even better at producing their goods. By specializing, people get better at their tasks and also have time to develop new and better ways of producing. If people are trying to produce multiple things, they cannot put the same level of attention into improving specific processes. You might be familiar with the phrase “a jack of all trades, but a master of none.” That is what happens without specialization. Despite the benefits of trade, fear of international trade is common. There are concerns that jobs are lost to foreign competition. Certainly, there are specific jobs that will no longer be needed domestically. If the United States, for example, had been self-sufficiently producing bananas and then opened up to international trade and started importing bananas, jobs in the banana production market would no longer be needed. That does not mean, however, that overall jobs are lost to international trade. Jobs are gained from the ability to export goods. Jobs are also gained because the resources that were previously used to grow bananas can now be used to produce other goods. Also, the lower prices for bananas enable consumers to redirect their spending to other goods.

Trade Protection What you might have picked up from the example of the bananas is that despite the benefits of trade, banana producers would still have a strong incentive to prevent competition from foreign banana producers. Banana producers then have an incentive to lobby the government for protection from foreign competition. This protection usually comes in the form of tariffs (there are other forms of trade protection, such as quotas, but tariffs are by far the most common). Tariffs are in the news a lot, particularly between China and the United States in 2019. Basic economic theory tells us that tariffs are simply passed on to consumers. This is not, however, what we necessarily see in practice. Elasticity is an important determinant in tax incidence (that is, who bears the burden of a tax). Tax incidence is determined by the relative elasticities between supply and demand. From a trade perspective, exchange rates can serve as a way for countries to absorb the tariff without having to raise their prices. China lets their currency depreciate to keep the prices of their products the same. When this happens, anybody holding Chinese currency essentially pays the tariff. Of course, that does not mean there are not costs to the United States from assessing tariffs. When China devalues their currency, U.S. produced goods become more expensive in China, so quantity demanded for U.S. exports goes down. Ultimately, both countries bear some of the burden from tariffs. So why assess tariffs? The most obvious reason is as described above: to help domestic interest groups. There can be other reasons, however, and to see that, we have to introduce some game theory.

Game Theory Game theory is applied to decision-making where one party’s actions affect another party’s outcome. Game theory is not applicable to perfectly competitive markets because individual producers cannot affect the market outcome. Game theory is not applicable to monopoly because there is only one producer in a monopoly. Game theory is applicable to oligopolies where there are a handful of producers; so what one producer does affects the other producers. If Coke, for example, comes out with a new product, that new product will likely affect Pepsi and Dr Pepper. If Coke changes their price or embarks on a new marketing campaign, Pepsi and Dr Pepper will likely be affected. Pepsi and Dr Pepper, thus, need to decide how they will respond to Coke’s actions. Coke will also need to anticipate Pepsi and Dr Pepper’s response when deciding the action they take (you can think of it like the Battle of Wits from The Princess Bride). The optimal strategy for a “game” is determined by evaluating likely strategies by opponents and expected outcomes. Optimal strategies can also be affected by the structure of a game. Some games are sequential, where one player makes a decision and then the other player makes a decision in response to the first player’s decision. Other games are simultaneous where players make their decision at the same time. Ultimately, the outcome of a game is driven by the likely outcomes.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Game theory can also be applied to bargaining situations, for example, when bargaining over trade agreements. Trade agreements are often termed “free trade agreements,” but that is a bit of a misnomer. Certainly, most trade agreements eliminate tariffs, but if that is all that was involved, the agreement could be written on a cocktail napkin. Instead, trade agreements often include restrictions or allowances for subsidies, requirement wages, environmental rules, and rules of origin (rules of origin are requirements on the countries where intermediate goods in the production process were produced). All of these requirements can move the agreement away from free trade. This is where game theory and bargaining can play a role. Consider trade between the United States and China. China places considerable trade restrictions on imports from the United States, and the United States has historically not put many on imports from China. Now, per trade theory, this is still beneficial to the United States. That is, the United States still benefits from getting goods produced at a lower cost than companies in the United States could produce them. The United States would benefit even more, however, if China did not have trade restrictions. China, however, feels they benefit from their trade restrictions (standard economic theory would say they do not). So how does the United States get China to reduce their trade restrictions? One possible approach is to employ trade restrictions against Chinese products. This can be thought of as a game of chicken, except where the costs are steeper for China than for the United States. The risk, of course, for the United States, is that the costs are actually steeper for the United States. There are other factors that can matter for a negotiation as well. You might be familiar with the phrase, “Whoever gives a number first, loses.” That would suggest that being a first mover could put a bargainer at a disadvantage. This is because moving first reveals information to your opponent that they can use to decide the action. Credibility to commit to a position matters too. In a repeated game, if one party cannot credibly stick to their position through multiple iterations of a game, then the other party can benefit by simply waiting out the other party. In the case of the United States and China, the frequency of elections can be a handicap. The Chinese government will likely be in power for the foreseeable future, while any given United States administration only has certainty of four years at a time to be in power. Fortunately, you can see a lot of these concepts play out in the real world by paying attention to the news.

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit III At the end of this unit, you should be able to:

1. Evaluate the ethical outcomes of free market outcomes using supply and demand models. 1.3 Compare and contrast the effect perfect competition and monopoly have on total welfare.

3. Analyze how price and output influence profit maximization under different market structures.

3.1 Compare and contrast the market outcomes for perfect competition, monopoly, oligopoly, and monopolistic competition.

Required Unit Resources Chapter 8: Understanding Markets and Industry Changes (ULO 3.1) Chapter 9: Market Structure and Long-Run Equilibrium (ULO 3.1) Chapter 10: Strategy: The Quest to Keep Profit from Eroding (ULO 1.3) Article: Price Caps, Oligopoly, and Entry (ULO 3.1) Unit Lesson Unit Material (ULO 2.1) This unit’s material focuses on different types of market structures and how firms in those markets seek profit. Before getting into market structures, we will discuss a bit about markets in general. All markets are affected by supply and demand. The type of market structure in question will primarily affect how supply behaves, but important information for firms comes from demand. This unit’s material focuses on different types of market structures and how firms in those markets seek profit. Before getting into market structures, we will discuss a bit about markets in general. All markets are affected by supply and demand. The type of market structure in question will primarily affect how supply behaves, but important information for firms comes from demand.

Supply and Demand In a market, supply and demand come together to determine the equilibrium price and quantity. When demand increases, price and quantity increase. When supply increases price decreases and quantity increases.

UNIT III STUDY GUIDE Market Structures and Profit

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

Factors Affecting Demand There are several factors that can cause demand to change. Economists group these reasons into five main factors:

Businesses need to know not just these factors but how these factors affect the industry of their business. Changes in income, for example, do not affect all businesses the same. Economists categorize goods as normal goods, which are goods whose demand increases as income increases, and inferior goods, which are goods whose demand increases as income decreases. An example of a normal good would be eating out. The more income a person has, the more likely they are to eat at restaurants rather than prepare meals at home. Candy, possibly surprisingly, is an inferior good. When people experience lower incomes, they cannot afford as much entertainment as before, so candy offers an inexpensive pleasure. Changes in the price of related goods is another factor that can have different effects based on specific circumstances. Some goods are related in consumption. These are called complements. Peanut butter and jelly are an example of complements. If the price of a complement decreases (say, peanut butter), then the demand for the good in question (say, jelly) will go up. After all, if you are buying more peanut butter, you are going to need more jelly to go with it. Substitutes are goods that compete in consumption. Coke and Dr Pepper, for example, are substitutes. If the price of Coke goes down, consumers are more likely to buy Coke, and, thus, less likely to buy Dr Pepper. So if the price of a substitute good decreases, the demand for the good in question goes down. Most of the remaining factors work as might be expected. If the number of demands increases, demand for a particular good will increase. Imagine sitting in a waiting room as your oil gets changed. There is a vending machine there. You might be tempted to get something. If another person walks into the waiting room, they will also be tempted to get something. As more and more people enter the waiting room, the likelihood that somebody will purchase from the vending machine increases. Most likely, multiple people will make a purchase from the vending machine. In other words, demand will increase. Add in tastes and preferences. If a particular product becomes popular (perhaps because of positive press, perhaps the product is seasonal, perhaps the product has experienced a change in quality), then more people are likely to want the product. In other words, demand increases. Finally, look at expectations. Expectations might be a little confusing. The important thing to remember is that when looking at the effects of changes in demand, the time frame is immediate. That is, the expectation is for some time in the future, but the analysis is what happens to demand right now. So, if consumers expect prices to increase in the future, they will want to buy more before prices rise. That is, demand will increase.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Factors Affecting Supply There are also factors that can affect supply (as opposed to demand). Most of these factors are pretty straight forward. As the price of inputs increase, costs to the producers go up, so naturally the supply will decrease. For example, if the price of oranges goes up, the supply of orange juice will decrease. If the price of a similarly produced product increases, then the supply of the good in question will decrease. For example, if looking at the supply of vanilla ice cream and the price of chocolate ice cream increases, then the supply of vanilla ice cream will decrease as the resources used to make vanilla ice cream will be shifted over to make more chocolate ice cream to take advantage of the higher price. As with demand, the number of suppliers matters to supply. The more suppliers there are, the more production there is. This is fairly simple and straightforward. Technology is also an important factor for supply. An improvement in technology that makes production easier and cheaper will lead to an increase in the supply. It is unlikely that a firm would actually adopt new technology unless it had the express purpose of making production easier or cheaper. For example, self- checkout kiosks at grocery stores or fast food restaurants are technology that make the production process (or service delivery process) cheaper for companies. They do require an upfront investment in technology, but the payoff is lower operating costs in the future. Finally, expectations are important for supply and the same caution that applied to expectations with demand apply here. Firms respond now to expectations about the future. Another important note is that while it can often be easy to think of supply as production, it is better defined as what producers bring to market. So, if producers expect a price decrease in the future, they will want to rush to market what they can to take advantage of the relatively higher price. That is, the expectation of a future price decrease will result in an increase in supply right now. To learn how to draw a supply and demand graph in Microsoft Word, view the video How to Graph in Word. You can access closed-captioning once you access the video.

Market Structure As mentioned in the beginning of the lesson, underlying the supply curve is the market structure. Economists differentiate market structures (identified by name later in the course) based on three characteristics. Those three characteristics are:

• the number of sellers in a market (The number of buyers matters too, but that does not change among these four market structures.);

• the homogeneity of production (This means how different the production is from one producer to the next; another way to think about this is whether you can identify the producer based on the product.); and

• the existence, or not, of barriers to entry (also phrased free entry and exit). At one extreme of the market structures is perfect competition. Perfect competition is characterized by:

• lots of sellers, • selling identical products, and • no barriers to entry (free entry and exit).

At the other extreme of market structures is monopoly. Monopoly is characterized by:

• one producer—and only one (If it is even two producers, it is a different market structure.), • selling a product that is unique in the market such that there are no close substitutes, and • impossible for competitors to enter.

As you can see from the characteristics, monopoly is the opposite of perfect competition. These differences lead to some important outcomes for the different markets.

ECO 6301, Economics for Managers 4

UNIT x STUDY GUIDE Title

Since there are many producers producing exactly the same thing, perfectly competitive firms do not have any influence on the overall market. They are very much a “drop in the bucket” relative to the market. Perfectly competitive firms must accept whatever the market price is. Monopolies, on the other hand, are the only supplier in their market, so their decisions have a big influence on the market outcome. Monopolists cannot exactly set their price; they must be mindful of their consumers. When deciding what price to set, monopolists have to balance the revenue they would gain from raising their prices with the revenue they would lose by selling a lower quantity (and vice versa if they are considering a price decrease). Without barriers to entry, if a firm can make excessive profits (known as economic profit), then other firms will enter the market, taking some of that profit away. Monopolies are protected by barriers to entry, so if they can earn large economic profits, there will not be any competition to come along and take those profits away. Perfectly competitive markets are the most efficient. They must be. If a firm is not as efficient as possible, it will be run out of the market. Monopolies do not need to be efficient since they are protected by barriers to entry. Monopolists, just like every firm, want to maximize profits. Maximizing profit for a monopolist, however, means not producing as much as they could so that they can charge a higher price. In between these extremes are monopolistic competition and oligopoly. Monopolistic competition is a lot like perfect competition, except that rather than producing identical products, the firms produce slightly different products. The difference might be slight, and they might even be just perceived, but they matter, at least somewhat, to the consumer. Think about hair stylists and barbers, for example. Some people have certain people they like to cut their hair. Some people do not care but might still base their purchasing decision on proximity or availability. These differentiations introduce a slight amount of pricing power into the market. The differentiations also give rise to the need for firms to advertise what it is about their product that sets them apart from competitors. Differentiation can also be a feature of oligopolies. Oligopolies are a lot like monopolies except there are some firms, not one, in the market. Think of it this way, if you can name the firms that account for a strong majority of the market share off the top of your head, the industry is an oligopoly. Oil/Gas companies, airlines, and automobile companies are examples of oligopoly markets. The barriers to entry are high but not insurmountable. This feature leads to strategic behavior between the firms as the action of one firm affects the outcomes of other firms in the market. Strategic behavior will be an important topic explored in future units.

Reference Reynolds, S. S., & Rietzke, D. (2018). Price caps, oligopoly, and entry. Economic Theory, 66(3), 707–745.

https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=132338488&site=ehost-live&scope=site