MECO 6303
• My name is Stan Liebowitz
• Pronounced: Lee – bow –wits
• Reading list:
Course Syllabus for Business Economics MECO 6303
Professor Contact Information
Professor Stan Liebowitz; Office: SM 3.801; Telephone: 972-883-2807
email: liebowit@utdallas.edu; homepage: www.utdallas.edu/~liebowit/ ;
Office Hours: T 3pm or by appointment
Course Pre-requisites
Calculus can be helpful but plays only a very minor role in the material. I do not assume that you
have prior knowledge of economics although most students have had prior courses.
Course Description
This is basically a course in microeconomic analysis. That means that it focuses on individual
markets, not on the national economy as a whole. The emphasis will be on applied fundamental
aspects of economic analysis.
An older and somewhat different version of this course was taught as an online course through
the UT Telecampus. There are powerpoint slides for the lectures with audio that is matched to the
slides. If you miss a class, or want to double check on what happened (e.g., foreign students who
want to replay the lecture) you can download the slides.
Student Learning Objectives/Outcomes
Understand how markets work and be able to apply this knowledge to make better business
decisions.
Required Textbooks and Materials
Main Text: Business Economics Landsburg/Mankiw. UTD Edition, 2006. Notes
for the course, old exams, and so forth can be found on my home page.
Assignments & Academic Calendar
Approximate schedule:
Weeks 1-2 (August 22, 29): Chapter 14 (477-498), Chapter 1 (1-32), 4.4 (86-91). Topics:
Assumptions, Opportunity Cost, Scarcity, Economic Goods, Production Possibility
curves, Demand and Supply, equilibrium, Elasticiticity. Illustrations: When Should a
firm raise its price? Elasticity for firm and industry.
Weeks 3-4 (September 5, 12): Chapter 8.1, 8.2 (229-249), the meaning of price and
value, Economic Efficiency, consumer and producer surplus; maximizing behavior
of firms. Illustrations: Diamond-water paradox, costs of theft, and Comparable
Worth
Week 5-6 (Sept 19, 26): Chapter 8.3 (249-263) who pays for a tax?, impact of price
controls.. Illustrations: Labor unions; farm price supports
Week 7 (October 3): Midterm,
Week 8-9 (October 10,17). Chapters 5, 6.1 (121-155) Topic:
Production, Costs,
equimarginal principal, Competition and Monopoly. Illustrations: Impact of Sunk
costs on firm behavior; Long run and short run effects of price changes.
• 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

Economics as Science- abstract model
simplifies, requires simplifying assumptions.
Major actors: consumers and producers.


Economic actors are rational: voluntary actions
are only undertaken when they are expected to
make people better off.
Consumers try to maximize happiness (utility)

Producers try to maximize profits

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
A
slope of line indicates tradeoff
in ability to produce different types of
goods
B
Fish
B1
12
No Specialized Resources-PPC Straight
A
2 Production Possibility Curves under
2 scenarios
slope of line indicates tradeoff
in ability to produce different types of
goods
B
Fish
B1
13
Specialized Resources- PPC Curved Line
Production Possibility Curve
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,
Y2k 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, Y2k
problems….)
time dimensions
law of demand – demand slopes down – based on
empirical observation.
movement along versus movement on
17
Demand for RNE*
P1
P2
PWLM
D
Q1
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
D1
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
D with zero elasticity
P
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 VideoTape 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 amount consumed
after longer period after short period
of adjustment\
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
P2
minimum price firm is willing
to accept. Should be equal to the
cost of producing the additional output
P1
Q1
Q2
28
Long Run/Short Run Oil?
Ss
SL
P2
P1
Q1 Q2007
Q2011
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
P1
Pe
P2
Shortage
D
Q1
Qe
Q2
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
S1
2
P2
P4
4
S2
1
P1
D2
3
P3
D1
Q1
Q2Q3
Q4
33
Lesson 3
1. The Meaning of Price, Value, and Economic
Efficiency.
2. Consumer and Producer Surplus.
3. Diamond Water Paradox.
4. Efficiency of Competitive Market equilibrium
5. Efficiency Implications of Price Controls and
Taxes.
34
Area under demand = total value of
that output
1
P1
2
3
Pe
5
4
D
Q1
Total Value of Q1 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)
P1
Pe
1
2
Q1
Qe
Increase in Total Cost when output increases from Q1 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
46
47
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
P1
1
3
Pe
4
2
Q1
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 P1
1
P1
7
2
3
Pe
8
5
4
P2
6
Q1
CS Before Price Control= 1+2+3
Ps Before Price Control = 4+5+6
Qe
Q2
CS After Price Control = 1
PS After Price Control = 2+4+6
51
Price Floor at P1 AND wrong producers
1
P1
2
Pe
4
7
8
3
5
6
Q1
Q0
CS Before Price Control= 1+2+3+8
Ps Before Price Control = 4+5+6
Qe
Q2
CS After Price Control = 1
PS After Price Control = 2
52
Rent Control (Price Ceiling)
1
2
3
Pe
4
7
Prc
5
transfer
6
Q1
CS Before Price Control= 1+2+3
Ps Before Price Control = 4+5+6
Qe
Q2
CS After Price Control = 1+2+4
PS After Price Control = 6
53
Government guarantees price at P1 and and sells output at
market clearing price
S
1
P1
7
2
3
Pe
8
5
4
10
6
Pclearing
9
D
Revenue from Consumers
Q1
Qe
Q2
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 P1 and burns any output it
can not sell at that price
1
P1
2
Pe
4
Pclearing
7
3
8
5
9
Q1
CS Before Price Control= 1+2+3
Ps Before Price Control = 4+5+9
6
11
10
12
Qe
Q2
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
Tax from consumer’s vantage
St
Price Paid by Consumer
S
}amount of tax
P1
Pe
D
Q1
Qe
58
Tax from producer’s vantage
Price received by Producer
S
P1
Pe
P0
}amount of tax
D
Q1
Qe
Dt
59
Price Paid by Consumer
Distortion from Tax
St
S
}amount of tax
P1
Pe
P0
D
Q1
Qe
60
Instance of Tax borne by Producer
S1
P
Price Paid by Consumer
S
P1
D with infinite elasticity
Q1
Q2
Q
61
Instance of Tax borne by Consumer
P
D with zero elasticity
S1
Price Paid by Consumer
S
P1
P0
Q0
Q
62
Instance of Tax borne by Consumer
Price Received by Producer
P
S with infinite elasticity
P0
Dt
Q1
Q0
D
Q
63
Instances of Tax borne by producer
Price Received by Producer
P
S with zero elasticity
P0
P1
Dt
Q0
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.
Price
75
60
48
35
26
17
11
6
2.5
1
Note Relationship between elasticity
and Marginal Revenue.
Quantity
Demanded
1
2
3
4
5
6
7
8
9
10
Total
Marginal Arc Elasticity (based on
Revenue Revenue
average Q and P)
75
75
120
45
3
144
24
1.8
140
-4
0.9121
130
-10
0.7531
102
-28
0.4343
77
-25
0.3590
48
-29
0.2267
22.5
-25.5
0.1429
10
-12.5
0.1228
67
More Marginal Analysis
Price
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Quantity
Demanded
60
66
74
83
96
110
130
165
190
225
250
270
285
290
294
Total
Revenue
900
924
962
996
1056
1100
1170
1320
1330
1350
1250
1080
855
580
294
Marginal
Revenue
Arc Elasticity (based on
average Q and P)
4.0000
4.7500
3.7778
4.6154
3.1429
3.5000
4.2857
0.4000
0.5714
-4.0000
-8.5000
-15.0000
-55.0000
-71.5000
1.3810
1.5429
1.4331
1.6704
1.4272
1.5833
2.0169
1.0563
1.0964
0.5789
0.3462
0.1892
0.0435
0.0205
68
Marginal Costs and Profit
Quantity
Used
0
1
2
3
4
5
6
7
8
9
Output
10
15
25
42
58
73.5
87
100
110
115
Fertilizer
Output Price
Price
12
150
Marginal
Product
Marginal
Revenue
Product
5
10
17
16
15.5
13.5
13
10
5
60
120
204
192
186
162
156
120
60
Total Revenue
120
180
300
504
696
882
1044
1200
1320
1380
Marginal
Fertilizer
Total Cost
Cost
0
150
150
300
150
450
150
600
150
750
150
900
150
1050
150
1200
150
1350
150
Profit
120
30
0
54
96
132
144
150
120
30
69
Profit Maximization
• Marginal Analysis
•
•
•
•
TR= PxQ
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


 Q
=
=
TR
 TR
 Q
-
 TC
 Q
Max


so
=
where
P
=
( 1
e
+
P
=
-
MR

 Q
Also
=
P

TC
=
MR
TR
 TR
 Q
-
=
MC
0
MC

Q
 Q
 P
+ Q

 Q
 Q
 P
1
) =
P ( 1  Q
e
Q

P
=
elasticity
of
demand
)
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
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
q1
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
AC2
MC
AC1
P*
Profits2
AC*
Profits1
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
AC
80
Long Run AC
LRAC
MC1 SRAC1
SRAC3
MC3
MC2 SRAC2
Q1
81
Do average costs fall over time, or is average cost downward sloping?
AC1990
AC1991
P*
AC1992
AC1993
AC1994
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
1
P*
D = MR
Profits
ACq*
q*
87
P
supply curve of firm is the mc above avc
AC
S
MC
AVC
p3
p2
p1
AFC
q1
q2 q3
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
p1
p2
qa1 qa
q
qc
Q=qa1 Qa+b+c
b
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
p1
Q1
q
91
This represents a competitive industry in a long run equilibrium (price
P3). 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
S1
P
S2
AC
P
S3
p1
p2
p3
Q1 Q2 Q3
q q1
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, 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
AC
P
P
P1
"Representative" Firm in Industry
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 (Q1)
AC (Q2)
AC (Q3)
Q
100
Long run supply in decreasing cost competitive industry
P
AC (Q1)
AC (Q2)
AC (Q3)
Q
Q1
Q2
Q3
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
P2
MC
P1
t
a
x
D
Q2
Q1
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
P1
Pcontrol
D
Q1
Q2
MR
105
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
P1
Pcontrol
D
Q3
Q1
MR
Q2
106
107
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.
P1
P3
S
P6
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
P1
price before discrimination
P2
D
mr2
D
mr
Q2
Q1
mr1
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
115
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
AC
MC
Qm Qr
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. Firms try to collectively act like a monopolist.
This means restricting output to raise price.
2. What are the impediments?
1. KEY POINT: FIRMS HAVE AN
INCENTIVE TO CHEAT because their
elasticity is greater than the industry as a
whole.
3. Even if firms can reach an agreement, how can it
be enforced?
123
Cartels
1. 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.
2. Detection: How can the cartel determine when
someone has violated the agreement?
3. (1) Can it use police power of the state?
4. (2) Can it use its own enforcement agency?
Mafia, etc.
124
Cartels
1. Can the Cartel punish one firm without hurting
member firms to the same extent?
2. Can they all target their punishment to harm only
the one cheating firm?
3. Is OPEC a cartel?
4. 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
P4
ΣD
P3
P2
D3
D2
D1
P1
Q
Q1
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
P4
P3
ΣD
P2
P1
Q
Q1
Q2
130
Production of a Single book title
Pm
1
2
4
3
7
MC of printing
5
6
8
D
Qm
number of copies of a title
MR
131
•
Market Demand for Titles
Pm
Qm
Q**
Q*
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
p3
p2
p1
AFC
Q
136
Resale Price Maintenance
1. 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.
2. 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
2PL
PP-PL
MC=AC left or right shoes
PL
MR
Q1
D pairs of shoes
Q
140
PD version of Tie-In Story
1. Seller is thought to have two types of customers
– heavy versus light users.
2. Tied good is thought to ‘meter’ the use of the
tying good, to separate heavy from light users.
3. By lowering price of tying good, and raising
price of tied-good, producer increases payments
made by heavy user relative to light user.
4. 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. Consumers are unsure how much use they will
get from the tying good (machine).
2. This riskiness causes them not to be willing to
pay the full expected (predicted) value of the
product.
3. Seller has many such customers and can provide
‘insurance’ since the large numbers makes
overall results predictable.
4. 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
143
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Yearly Home Ownership Rates (US Census)
70%
69%
68%
67%
66%
65%
64%
63%
62%
61%
60%
144
2008-1
2007-1
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987-1
Figure 1: Quarterly Real
Home Prices Index (Case Shiller National)
100
90
80
70
60
50
40
30
20
145
Yearly Nominal Home Prices (Case Shiller National; 2008 based on 3
quarter)
200.00
180.00
160.00
140.00
120.00
100.00
80.00
60.00
146
2008-1
2007-1
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987-1
40.00
Q4_1979
Q4_1980
Q4_1981
Q4_1982
Q4_1983
Q4_1984
Q4_1985
Q4_1986
Q4_1987
Q4_1988
Q4_1989
Q4_1990
Q4_1991
Q4_1992
Q4_1993
Q4_1994
Q4_1995
Q4_1996
Q4_1997
Q4_1998
Q4_1999
Q4_2000
Q4_2001
Q4_2002
Q4_2003
Q4_2004
Q4_2005
Q4_2006
Q4_2007
Q4_2008
Share of Mortgages (%)
Foreclosures Started
1.2
1.0
0.8
0.6
0.4
0.2
0.0
147
148
149
Excess Foreclosures by Type of Loan
160,000
Subprime Mortgages
140,000
Prime Mortgages
120,000
100,000
80,000
60,000
40,000
20,000
150
Q3_2008
Q2_2008
Q1_2008
Q4_2007
Q3_2007
Q2_2007
Q1_2007
Q4_2006
Q3_2006
0
Figure 7: Fixed and Adjustable Prime Foreclosures Started
2.0
1.8
Prime Adjustable Mortgages
Prime Fixed-Rate Mortgages
1.4
1.2
1.0
0.8
0.6
0.4
0.2
151
Q4_2008
Q4_2007
Q4_2006
Q4_2005
Q4_2004
Q4_2003
Q4_2002
Q4_2001
Q4_2000
Q4_1999
0.0
Q4_1998
Share of Mortgages (%)
1.6
152
Yearly Change in Home Prices (Case Shiller National; 2008 based on
2 quarter)
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
nominal
real
-10.00%
-15.00%
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
-25.00%
1988
-20.00%
153
Figure 8: Fixed and Adjustable Mortgage Rates
10%
9%
8%
7%
6%
5%
4%
adjustable rate
fixed rate
3%
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
2%
154
155
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
Measurement of US audio files exchanged per month
Webnoize 2001
1,000,000,000
Idate high statement for all of 2003
5,000,000,000
Idate low statement for all of 2003
1,000,000,000
NPD average based on first half 2004
183,694,429
Inspires confidence, doesn’t it?
161
8
6
3
2
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Albums Sold Per Person
Filesharing
Albums Sold per capita
Predicted Sales (based on historic growth)
7
Predicted Sales (based on disp inc)
5
4
Napster Begins
Actual Sales
1
162
What Did Napster “Victory” Do?
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
Napster Decision
Napster
Napster plus Alternatives
Feb-00
Mar-00
Apr-00
May-00
Jun-00
Jul-00
Aug-00
Sep-00
Oct-00
Nov-00
Dec-00
Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Jul-01
Aug-01
Sep-01
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Users
Figure 2: American File Sharers at Home (000s)
Source: ComScore Media Metrix
163
0.00
April, 2005
March, 2005
February, 2005
January, 2005
December, 2004
November, 2004
October, 2004
September, 2004
August, 2004
July, 2004
June, 2004
May, 2004
April, 2004
March, 2004
February, 2004
January, 2004
December, 2003
November, 2003
October, 2003
September, 2003
August, 2003
July, 2003
June, 2003
May, 2003
April, 2003
March, 2003
2.00
February, 2003
January - 2003
December - 2002
November - 2002
October - 2002
September - 2002
August - 2002
The blip in 2004 and Measurement Issues
Figure 2: Various Measurements of File-Sharing
2.50
Big Champagne (Users of Filesharing Networks)
NPD (MP3 Files transferred)
comScore (users of filesharing programs)
BGLM (Number of Files made Available)
1.50
1.00
0.50
164
No Change in Substitute Markets
in the Period around 1999
Figure 2: Movies and VideoGames
2.50
Normalized Videogame Revenue Per Capita
Normalized Box Office Per Capita
2.00
1.50
1.00
0.50
Source: Ebrain and M PAA
0.00
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
165
DVD growth was close, but no
cigar.
Figure 4: Growth in Pre-Recorded Movie Sales and Rentals
$60
Real Per Capita $ Sales of PreRecorded Movies (right axis)
$50
$40
$30
$20
Source: Adams Media Research (2003$)
$10
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
$0
166
Overall, it can’t explain the CD
decline
Figure 4: Growth in Pre-Recorded Movie Sales and Rentals
$50
$30
Real Per Capita $ on Sales and Rentals of PreRecorded Movies
Real Per Capita $ Sales of PreRecorded Movies (right axis)
$45
$25
$40
$35
$20
$30
$25
$15
$20
$10
$15
$10
$5
Source: Adams Media Research (1983$)
$5
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
$0
1981
$0
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
Table 4: Album Sales (000s)
harm. Total Alternative Classical
Country
Hard
Jazz
R&B
Rap
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
% change 00-03
614,669
616,172
616,642
651,978
728,268
754,835
785,138
762,781
680,960
656,293
-16.41%
82,164
94,004
105,175
106,690
116,489
120,952
131,138
131,594
125,752
128,344
-2.13%
27,003
23,836
21,456
19,148
16,948
17,311
16,403
15,846
14,776
17,727
8.07%
75,976
76,095
66,883
70,702
74,043
69,300
67,115
67,241
75,362
70,944
5.71%
38,739
31,101
26,409
28,983
30,086
82,698
89,924
88,158
74,677
74,629
-17.01%
16,546
14,797
21,794
20,042
18,123
19,557
18,416
19,514
19,901
22,366
21.45%
80,819
80,718
74,035
141,613
166,379
175,339
197,141
195,498
160,183
149,972
-23.93%
40,995
41,537
56,343
61,709
83,641
87,663
105,515
89,279
83,346
75,854
-28.11%
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.
Figure 3: Measures of File-sharing Activity
1.6
RIAA announces (June 25) and then begins lawsuits
(September 8).
1.4
1.2
1
0.8
0.6
0.4
0.2
Pew Surveys
ComScore Media Metrix
Bhattacharjee et. al.
Big Champagne
0
March-May 2003
Jun-03
Nov-03
Feb-04
169
May-June-04
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
Fishermen on Lake
Fishermen Fish per Fisherman Total Catch Marginal Catch
1
10
10
2
9
18
8
3
8
24
6
4
7
28
4
5
6
30
2
6
5
30
0
7
4
28
-2
173
Illustrating Overuse
Fish per
Fishermen Fisherman
1
10
2
9
3
8
4
7
5
6
6
5
7
4
Total
Catch
10
18
24
28
30
30
28
Marginal Opportunity
Catch
Cost
6
8
12
6
18
4
24
2
30
0
36
-2
42
Net
Value
4
6
6
4
0
-6
-14
174
Business Applications
• Should a firm have internal charges when
one division helps another (e.g. technical
support)?
• Network Effects (again).
175