Monopoly ❖ Market served by only one firm. ❖ Monopolies may be promoted by government for things such as patents, licenses, and copyrights to spur innovation ❖ (Qm, Pm) ❖ Will never operate on the inelastic portion of the D curve bc MR < 0 ❖ Extreme scale economy ➢ Natural monopoly: market in which it is more efficient for a single firm to produce the entire industry output ➢ Splitting output across firms raises avg cost of production Lerner Index ❖ Measure of a firm’s markup, which indicates the degree of market power the firm enjoys. ❖ Markup Rule (markup is the percentage of firm’s price that is greater than its marginal cost) 𝑃−𝑀𝐶 1 ➢ 𝑃 =− 𝐸𝑑 ➢𝑃 = 𝑀𝐶 1+ 1 𝐸𝑑 ❖ As demand becomes more elastic, the optimal markup falls. ➢ More sensitive consumers are to price changes (more elastic) the less the firm can take advantage of them Price discrimination ❖ Practice of charging different prices to different consumers for the same product. ❖ In order for a firm to price discriminate: ➢ Firm must have market power ■ Without, firm must charge all customers market price ➢ Firm must prevent resale and arbitrage (arbitrage is practice of reselling product at higher price than original price) ■ If this is not met, customers subject to a lower price could purchase excess product and resell to those facing higher price ❖ . First degree (perfect) price discrimination ❖ Firm has complete information about every customer. ❖ When to use it ➢ Firm has market power and can prevent resale ➢ Firm’s customers have different demand curves ➢ Firm has complete info about every customer and can identify each one’s level of demand before purchase ❖ Firms can charge different prices to different customers based on observable characteristics of the customers. ➢ Firm charges each customer exactly according to their willingness to pay ❖ Consumer surplus is driven to zero ❖ No DW loss Second degree (indirect) price discrimination ❖ Customers pick among a variety of pricing options offered by the firm. ❖ When to use: ➢ Firm has market power and can prevent resale ➢ Firm’s customers have different demand curves ➢ Firm cannot directly identify which customers have which type of demand before purchase ❖ Often use quantity discounts to price-discriminate (buying in bulk) ➢ Relies on incentive compatibility ■ Price offered to each consumer group be chosen by that group ■ Firms cannot discount too steeply on large quantities or they will cannibalize consumers from uninterested consumer segment. ❖ Can also utilize Versioning ➢ Firm offers different product options designed to attract different types of consumers (air travel for leisure VS business passengers) ➢ For this to work, marginal cost of products offered to different consumers need not be equal. ➢ Markup must be higher for the segment with the less elastic demand ❖ Externality (negative/positive, consumption/production) ❖ Effect of one party’s economic activities on another party that is not taken into account by the price system ❖ With externalities, private costs and benefits will differ from social costs and benefits. ❖ An efficient market takes into account all costs and benefits. ❖ Tragedy of the commons ➢ Free access of resource so it it used more intensively than it would be if privately owned, leading to decline in its value for everyone ❖ Negative externality “too much of a bad thing”: ➢ EXAMPLE ■ Production: power plant pollutes air, construction project loud noise ■ Consumption: smoker harms health of those around them ➢ Action of one agent results in uncompensated harm to others ■ Consumption/production decision based on private costs/benefits ■ Does not consider harm to others when they consume/produce ■ Agent will consume/produce more than socially optimal ➢ External marginal cost (EMC): cost imposed on third party when an additional unit of a good is produced/consumed ➢ SMC = MC + EMC ❖ Positive externality “not enough of a good thing”: ❖ ❖ ❖ ❖ ➢ EXAMPLE: ■ Production: beekeeper bee produces honey and helps pollinate plants for neighboring farmers, firms basic research provides knowledge that is useful for other firms ■ Consumption: vaccination for contagious disease, more education fosters technological innovation, homeowner doing home improvement projects improve home values for neighborhood ➢ Action of one agent results in an uncompensated benefit to others ■ Consumption/production decision in the usual way, based on their own costs and benefits ■ Agent does not consider benefits to others when he consumes/produces ■ Agent will consume/produce less than is socially optimal ➢ External marginal benefit (EMB): benefit conferred on a third party when an additional unit of a good is produced/consumed ➢ SMC = Social Demand = D + EMB Social costs and social benefits differ from private costs and private benefits. True cost and benefit of a transaction to society counts both private and external. ➢ True, total costs and benefits to society are called social costs and benefits. ➢ True costs: SMC = MC - EMB To reduce DW loss due to an externality, try to make private decision makers perceive the social cost and social benefit. This is called internalizing. Can also use government solutions and private solutions. Optimal level is where marginal social costs equals marginal social benefit. Pigouvian tax ❖ Government solution ❖ Tax on activity that raises a good’s price to take into account the external marginal costs imposed by negative externality ❖ Designed to correct market failures and therefore improve societal welfare ❖ Pigouvian subsidy: ➢ In presence of positive externalities. ➢ Serves to equate the external marginal benefit imposed by an externality. ❖ Charge individuals for the external damage they do to the common resource Coase Theorem ❖ Private solution. ➢ Private market is inefficient ■ If private solutions not possible, government may have to intervene ❖ If negotiation costs are low enough, negotiation among market participants will lead to the efficient market outcome regardless of who holds legal property rights. ❖ If outcomes can be monitored and individuals can coordinate and negotiate at a low enough cost, parties should be able to reach the efficient outcome. ❖ Coordination is often very difficult especially with many participations and/or information problems. ❖ Does not lead to efficiency in many real-world problems ➢ Bargaining is often costly ➢ Property rights may not be adequately enforced ➢ May not be possible to assign property rights to some things like air ❖ How it works ➢ Property rights must be well defined and adequately enforced ➢ Bargaining/negotiation/coordination must be costless or have negligible cost ➢ Assigning property rights over to all assets creates markets for the production of all externalities ➢ Paying a price for each decision gives the decisionmaker a mechanism by which he internalizes the costs of his actions. Public goods ❖ Goods that benefit the individual consumer, even as others consume it ❖ Accessible to anyone who wants to consume them ❖ Similar to positive externalities since they can provide external benefits to individuals other than those who purchase them ❖ Has positive externalities, so tendency towards under-provision ❖ EXAMPLE: ➢ National defense, firework display, clean air, public park Nonrival goods ❖ One person’s consumption of the good does not diminish another consumer’s enjoyment of the same good Nonexcludable goods ❖ Consumers cannot be prevented from consuming the good Four Categories of Goods ❖ ❖ ❖ ❖ Private goods: goods that are rival and excludable Common resource goods: goods that are rival but nonexcludable Club goods: goods that are nonrival and excludable Pure public goods: goods that are nonrival and nonexcludable ❖ ❖ Market efficiency requires that a good be produced until marginal benefits of production are = to marginal costs. Free rider ❖ Results from the nonexcludability of public goods ❖ Source of inefficiency resulting from individuals consuming a public good or service without paying for it ❖ A person or group of people who earn benefits from the actions of others without paying compensation ❖ Big problem when number of people is higher since good cannot be adequately provided ❖ Government can step in and directly provide the good when public good is very expensive to provide or when free riding is a big problem ➢ Not a perfect solution due to pressure groups and bureaucracy, but its better than having a gross under-provision of the public good
