PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
Longrun Equilibrium
When a pharmaceutical product’s patent expires, generic
firms are usually legally permitted to enter.
• Are generic products very differentiated?
• Are there high entry barriers to generic entry?
• Do consumers have brand awareness of generic firms?
• So, do you think the generic drug industry is close to
“perfectly competitive”?
• How do makers of generic drugs earn profits?
Econ 5313
Perfect Competition
• A competitive firm is one that cannot affect price
• They produce a product or service with very close
substitutes so they have very elastic demand
• They have many rivals and no cost advantage over them.
• The industry has no barriers to entry or exit
• Competitive firms:
• Cannot affect price; they can choose only how much to produce
• Choose how much to sell at the competitive price, so MR = P
(sometimes called “price taking” behavior)
• So if P>MC, produce more and if P<MC, produce less
Econ 5313
Perfect Competition
• Perfect competition is a theoretical benchmark
• But, some industries come close; and
• The benchmark is valuable to expose the forces that move prices
and firm profit in the long run
• A competitive firm can earn positive or negative profit, but
only in the short-run. In the long run:
• Positive profit (P>AC) leads to entry, decreasing price and profit
• Negative profit (P<AC) leads to exit, increasing price and profit
• In the long-run, competitive firms are condemned to earn only an
average rate of return
• Proposition: In equilibrium, capital is indifferent between
entering one industry or any other, because P=AC
(economic profit is zero)
Econ 5313
Competition  Asset Flows
• Asset flows (entry/exit) force price to average cost, i.e.
economic profit will always revert back to zero
• We say that “profits exhibit mean reversion”
• Silver lining to dark cloud (low profits will increase as firms
exit the industry)
• Typical reversion speed is 38% per year
• So, if profits are 20% above the mean one year, in the next
year they will be only 12.4% above the mean, on average
• In the generic drug industry, margins with one firm ~50%
but margins with eight firms ~0%. Most markets attract
18+ entrants
Econ 5313
Mean Reversion
Econ 5313
Fashion Industry
• How does the process of mean reversion of profits play
out in the fashion industry?
• Many haute couture designers vie for the “Look” each
season
• Few succeed wildly – make lots but then ideas get stale
• Many succeed modestly – continue to another season
• Most fail – close shop
• The “Look” then gets copied (“knock-offs”)
• First, high end boutiques
• Next, “off-the-rack”
• Finally, discounters
• No IP protection for fashion implies fast profit dissipation
Econ 5313
Soybean Farming
There are about 21,000 soybean farmers in the US. Beans are
initially sold to large Ag companies like ADM and ConAgra
and are traded on the CBOT.
• Are soybeans very differentiated?
• Are there high entry barriers to soybean farming?
• Do consumers have brand awareness of different soybean
producers?
• So, do you think soybean farming is close to “perfectly
competitive”?
• How is it that some soybean farmers are quite wealthy?
Econ 5313
Immobile Assets
• The land that farmers work differs in its productivity
• Example Texas Blackland Prairies
• Can get much more produce per unit of labor but MC rising.
Increase farm size if P > MC
• The “marginal farmer” just breaks even but the infra-marginal
farmers can get rich
• This is because the “scarce productive asset” is not transferable
• So, selling on a competitive market but producing with
non-transferable scarce assets can generate sustainable
profits for infra-marginal firms
• Other examples?
• Human Capital
Econ 5313
The Indifference Principle
• The ability of assets to move from lower-valued to highervalued uses is the force that moves an industry toward
long-run equilibrium
• If an asset is mobile, then in long-run equilibrium, the
asset will be indifferent about where it is used; that is, it
will make the same profit no matter where it goes
• For most, San Diego, CA is a lot more attractive than
Arlington, TX
• What assets flow?
• Until what happens?
• Cost-of-living (mostly housing prices) is the cost of admission
Econ 5313
at&t Stadium
• In 2004-2005, the Arlington citizens agreed to increase
their sales taxes to help pay for the new Cowboys
Stadium. What effects could this have on Arlingtonians?
• Amenity Effects – new restaurants, business, etc. plus ‘warm
glow’ from being home of the Cowboys & hosting mega-events
• Direct Tax Effects – Have to pay higher sales taxes
• How to test if the net effect was positive or negative?
• Use the indifference principle!
• Are people moving into, or out, of Arlington?
• More precisely, is the cost of admission (the price of a house)
falling or rising?
• How has the city government of Detroit been doing?
Econ 5313
Smogville versus Clean City
• Landsburg’s example of Smogville that allows air pollution
versus Clean City that bans polluting emissions
• All else equal, do people prefer clean air?
• Is all else equal?
• What assets are mobile?
• Migration until what condition holds?
• Are the residents of Clean City better off because they
banned pollution?
• Are the residents of Smogville worse off because they
have to suffer pollution?
• Heterogeneity allows for sorting
Econ 5313
Arbitrage
• Indifference Principle is limited by the mobility of the
scarce asset
• The act of moving assets to take advantage of price
differentials is called “arbitrage”
• Seinfeld - Bottle Deposit Arbitrage
Econ 5313
Wage Differentials
• Wages adjust to restore equilibrium
• Called “Compensating Wage Differential”
• Why do embalmers earn more than rehabilitation
counselors?
• Why do garbage collectors earn more than nursery school
teachers?
• Why is there “hazard pay” for firefighters and for innercity school teachers?
• Why do accounting professors make 30% more than
economics professors?
• Compensating wage differentials where you work?
Econ 5313
Risk Premia
• Rates of Return adjust to riskiness of investment
• Called “Risk Premium”
• In equilibrium, differences in the rate of return reflect
differences in the riskiness of the investment
• Expected return = (E[Pt+1] - Pt)/Pt
• In equilibrium, differences in the rate of return reflect
differences in the riskiness of an investment
• Risk premia are analogous to compensating wage
differentials: just as workers are compensated for
unpleasant work, so too are investors compensated for
bearing unpleasant risks
Econ 5313
Risk Premia in Prison
• Bargain over the price of a contraband item
• Shawshank Redemtion scene at 1:00
Econ 5313
Stock Volitility
VIX measures volatility. Why does higher volatility
lead to lower stock prices? (HINT: investors must be
compensated for bearing risk)
Econ 5313
Measuring Risk Premia
• Gov’t bonds are considered risk-free, they returned 1.7%
versus stocks 6.9%. The difference is a risk premium that
compensates investors for holding the more risky stocks.
• Why were equity risk premia so small in 2002?
• What has happened since then?
Econ 5313
Staying Ahead of Asset Mobility
• 1983 Macintosh was priced very high when it first
appeared.
• Earned huge profits for a few years
• Eventually, though, Windows copied “look” of the OS, and
price was forced back down and sales plummeted
• Strategy for Apple has been to enter at the top of a new
market followed declining profits until the next
innovation:
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iPod
iTunes
iPhone
iPad
Econ 5313
Monopoly
• A monopoly firm is one that faces a downward sloping
demand curve.
• They produce a product or service with no close substitutes; they
have no rivals; and there are barriers to entry, so no other firms
can enter the industry
• If demand is inelastic enough P > AC and profits are earned
• In the very long run, even monopoly profits are driven to
zero by the same competitive forces.
• Entry makes demand more elastic (P-MC)/P=1/|e|, which forces
price back down towards MC.
• Asset mobility decreases cost advantages to infra-marginal firms
• Main difference is speed of the adjustments
Econ 5313
Tissue Monopoly
• How can you earn profits from tissue paper?
• In 1924, Kleenex tissue was invented as a means to
remove cold cream.
• After studying customer usage habits, however, the
manufacturer (Kimberly-Clark) realized that many
customers were using the product as a disposable
handkerchief. The company switched its advertising focus,
and sales more than doubled.
• Kimberly-Clark built a leadership position by creating an
innovative use for a relatively common product.
Econ 5313
Tissue Monopoly
• As others saw the profits, however, they moved into the
tissue market
• The managers of Kimberly-Clark maintained profitability
through a continuing stream of innovations and
investment in advertising/promotion
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Printed tissue in the 1930’s
Eyeglass tissue in the 1940’s
Space-saving packaging in the 1960’s
Lotion-filled tissue in the 1980’s.
• Without this continuing stream of innovations and brand
support, the product’s profits would have been slowly
eroded away by the forces of competition
Econ 5313
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From the Blog
Chapter 9
Risk-on, Risk-off trading
Entry into Medical Tests
Gender pay gap
The Internet and the music industry
Econ 5313
Main Points
• A competitive firm can earn profits (or losses) in the shortrun until assets flow to higher valued uses
• A monopoly earns profits because it is difficult for assets
flow to higher valued uses
• In the long-run, assets do flow to profitable enterprises
and even monopoly profits fall to competitive levels
• The Indifference Principle allows us to measure the cost of
moving an asset across uses
• Applications of the Indifference Principle include:
• Wage differentials
• Risk Premia
• Valuing housing amenities
Econ 5313
Main Points
• A monopoly continues to earn positive profits in the longrun by
• Blocking the movement of assets into its industry
• Continuously developing product innovations ahead of imitators