15.1: Sources of Inefficiency

15.1.1: Asymmetric Information: Adverse Selection and Moral Hazard

Learning Objective

Examine the concept of adverse selection in the context of imperfect information

Key Points

• Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information, also known as asymmetric information.
• Asymmetric information causes an imbalance of power.
• A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk.
• A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure.

Key Terms

adverse selection

The process by which the price and quantity of goods or services in a given market is altered due to one party having information that the other party cannot have at reasonable cost.

moral hazard

A situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk.

Asymmetric Information

Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power. For example, when you are trying to negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not know the minimum you will be willing to accept.

Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead to market failure.

Adverse Selection

Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of goods or services in a market to shift. This results in “bad” products or services being selected. For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers. The individual price would generate a low profit for the bank.

Moral Hazards and Market Failure

In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk . A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk. For example, moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision making will occur.

Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure. A market failure is any scenario where an individual or firm’s pursuit of pure self interest leads to inefficient results.

15.1.2: Principle-Agent Problem

Learning Objective

Explain the Principal-Agent Problem

Key Points

• A business contract creates a straightforward connection between agent performance and profitability.
• In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties.
• Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.

Key Terms

subjective

Formed, as in opinions, based upon a person’s feelings or intuition, not upon observation or reasoning; coming more from within the observer than from observations of the external environment.

Objective

Agreed upon by all parties present (or nearly all); based on consensually observed facts.

incentive

Something that motivates, rouses, or encourages.

Principal-Agent Problem

In economics, the principal-agent problem (also known as an agency dilemma) exists when conflicts of interest arise between a principal and an agent in a business setting . Conflicts usually exist when contracts are written due to uncertainty and risk taken on by both parties. The principal hires the agent to perform specific to duties that represent its best interest. The work that is performed can be costly to the agent and not in the principal’s best interest. In short, the work done by the agent doesn’t actually reflect the best interests of the principal. Examples of relationships that can experience the principal-agent problem include:

• Management (agent) and shareholders (principal)
• Politicians (agent) and voters (principal)

The conflict of interest potentially arises in almost any context where one party is being paid by another to do something, whether it is in formal employment or a negotiated deal. The two parties have different interests and asymmetric information. The deviation of the agent from the principals interest is referred to as “agency costs. “

Contract Design

In order to minimize and control economic conflict, principals and agents design and agree on a contract. It serves as a guide and agreement to safeguard the best interests of both parties. The linear model is used to determine incentive compensation in a contract: w = a + b(e + x + gy).

In the linear model w is the wage, a is a constant, e is the unobserved effort, x is the unobserved exogenous effects on outcomes, and y is the observed exogenous effects; while g and a represent the weight given to y, and the base salary.

A business contract creates a straightforward connection between agent performance and profitability. This connection sets the standard for judging the performance of the agent.

Performance Evaluation

In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties. There are two forms of performance evaluation:

• objective performance evaluation – takes into account how fast a task can be completed. The evaluation compares the performance of an agent by comparing the work completed by peers within the industry.
• subjective performance evaluation – involves the principal directly evaluating the performance of the agent. In this case, the evaluation is based on opinions instead of observations or reasoning. .

Incentive Structures

Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.

Principals offer various incentive structures, which are rewards or motivating factors that drive the agent to work in the best interest of the principal and complete tasks efficiently. Incentive structures include price rates/commissions, profit sharing, and efficiency wages.

It is usually in best interest of both parties to work together. For the principal, agent inefficiency results in sub-optimal results and low welfare. For the agent, efficiency is important in order to receive payment for work completed.

15.1.3: Public Choice: Median Voters and Inefficient Voting Outcomes

Learning Objective

Use the Condorcet paradox to evaluate voting systems

Key Points

• A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum.
• The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another.
• The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates.
• Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, ect.

Key Terms

paradox

A counter-intuitive conclusion or outcome.

public choice theory

The use of modern economic tools to study problems that traditionally are in the province of political science.

voting system

A system used to determine the result of an election based on voters’ preferences.

A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum. The system enforces rules to ensure valid voting, accurate tabulation, and a final result. Common voting systems include majority rule, proportional representation, or plurality voting. The study of voting systems is called voting theory. Voting theory is a subfield of economics.

Public Choice Theory

No matter what voting system is used, the act of voting gives the public the ability to choose a candidate or influence a decision. Obviously, when voting takes place not everyone will agree with the outcome, but everyone has the ability to participate in the process. Public choice is described as “the use of economic tools to deal with traditional problems of political science. ” In microeconomics, public choice analyses collective decision making and studies economic models of political processes including rent-seeking, elections, legislatures, and voting behavior.

Since not every voter participates in an election, not every voter will have full information, and not every voter will vote based on what s/he perceives as the best long-term outcome, voting outcomes may be inefficient. Elections do not necessarily reflect the best long-term outcome, what the active voters thought was best given their criteria at the time.

Condorcet Paradox

The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another. Conflicting majorities are made up of different groups of individuals. For example, the Condorcet paradox can be compared to the game rock/paper/scissors. For each candidate, there can be another that is preferred by some majority. The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates. Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, etc.

An example of a voting paradox can be seen in a simple voting scenario. There are three candidates including 1, 2, and 3. There are three voters with preferences. Each voter ranks the candidates from most to least favored . If the results are determined and 3 is the winner, it can be argued that another candidate should have won due to the number of preferred votes verse the first choice of each voter. In this case, the requirement of majority rule does not provide a clear winner. According to the Condorcet paradox additional methods would be needed to determine the winner since the voting process is complex and each voter provides preferences instead of only selecting one candidate.

The Condorcet paradox means that there is not a clear winner and ambiguities must be resolved to determine the election results.

15.1.4: Behavioral Economics: Irrational Actions

Learning Objective

Paraphrase the history and characteristics of behavioral economics

Key Points

• Behavioral economics studies the consequences for market prices, returns, and resource allocation. It focuses on the bounds of rationality of economic agents.
• Behavioral economics analyzes behavioral finance, financial models, and the behavioral game theory in order to gain insight into why certain economic decisions are made.
• Three prevalent themes in behavioral economics are heuristics, framing, and market inefficiencies, though there are many more.
• Throughout its history, behavioral economics has analyzed psychology and economic findings to determine how and why economic decisions are made. Areas of focus included fairness, justice, and utility.

Key Terms

behavioral economics

Study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and resource allocation.

heuristic

Relating to general strategies or methods for solving problems.

Behavioral economics is the study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions. It also studies the consequences for market prices, returns, and resource allocation. Behavioral economics focuses on the bounds of rationality of economic agents.

Characteristics

Behavioral economics has specific characteristics based on what is studied. Areas of focus include:

• Behavioral finance: the intent is to explain why market participants make systematic errors. Errors impact prices and returns which the create market inefficiencies. It also looks at how other participants take advantage of market inefficiencies.
• Financial models: some financial models used in money management incorporate behavioral financial parameters. Examples of areas studied include overreaction and irrational purchasing habits.
• Behavioral game theory: analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology. Studies interactive learning, social preferences, altruism, framing, and fairness.

There are many aspects in behavioral economics, and three of the most prevalent are:

• Heuristics: people make decisions based on approximate rules and not strict logic.
• Framing: using a collection of anecdotes and stereotypes that make up the mental and emotional filters that individuals rely on the understand and respond to events.
• Market inefficiencies: include the study non-rational decision making and incorrect pricing.

Behavioral economics focuses on the study of how and why individuals and institutions make economic decisions .

History

Behavioral economics was born out of the combination of economics and psychology. By 1979, economists used cognitive psychology to explain economic decision making, which included an editing stage and an evaluation stage. The editing stage simplified risky situations using heuristics of choice. The evaluation stage evaluated risky alternatives through the study of dependence, loss aversion, non-linear probability weighting, and sensitivity to gains and losses. Throughout its history, behavioral economics has studied the economic choices of individuals and institutions by analyzing psychology against economic research. The study of behavioral economics shows both the strengths and weaknesses in decision making tendencies and how the decisions impact economic choices.

15.1.5: Government Failure

Learning Objective

Analyze situations in which the government has failed to act in an economically optimal way

Key Points

• Government failure, also known as non-market failure, is the public sector version of market failure.
• Government failures can occur in relation to both supply and demand within a market.
• Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue.
• Inefficient government regulation contributes to market and government failure.

Key Terms

expenditure

Act of expending or paying out.

arbitrage

Taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance; the profit made between price differences.

Government Failure

Government failure, also known as non-market failure, is the public sector version of market failure . The market fails and government intervention causes a more inefficient allocation of goods and resources than would occur without the intervention. It occurs when the market inadequacies are not compared and analyzed against possible interventions before action is taken. Government failure can be described as providing “only limited help in prescribing therapies for government success. “

A government failure is not the failure of the government to enact a solution to a failure, but rather it is a systematic problem that prevents an efficient government solution to the problem. Government failures can occur in relation to both supply and demand within a market. Demand failures are the result of preference/revelation problems and the imbalance of voting and collective behavior. Supply failures are usually the result of principal-agent problems. In this case, the failure occurs in trying to get one party (agent) to work in the best interest of another party (principal).

Economic Crowding Out

There are specific scenarios that are directly associated with government failure. Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue which crowds out private sector investment due to higher interest rates. Government spending also crowds out private spending.

Government Regulation

When analyzing government failure, inefficient regulation contributes to market failure. The are three specific regulatory inefficiencies:

• Regulatory arbitrage occurs when a regulated institution takes advantage of the difference between its real risk and the regulatory position.
• Regulatory capture occurs when regulatory agencies co-opt whether its the members or the entire regulated industry. Mechanisms that allows regulatory capture include rent seeking and rational ignorance.
• Regulatory risk is a risk faced by private sector firms when there is a chance that regulatory changes will negatively affect their business.

Recent evidence has suggested that even when democracies are economically stable, transparency, media freedom, and a larger government all contribute to increased government corruption. Government corruption leads to both market and government failure.

14.1: Demand for Labor

14.1.1: Marginal Product of Labor (Physical)

Learning Objective

Define the marginal product of labor

Key Points

• The marginal product of labor is not always equivalent to the output directly produced by that added unit of labor.
• When production is discrete, we can define the marginal product of labor (MPL) as ΔY/ΔL.
• When production is continuous, the MPL is the first derivative of the production function in terms of L.
• Graphically, the MPL is the slope of the production function.
• The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing.

Key Terms

returns to scale

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

marginal product

The extra output that can be produced by using one more unit of the input.

In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. This is not always equivalent to the output directly produced by that added unit of labor; for example, employing an additional cook at a restaurant may make the other cooks more efficient by allowing more specialization of tasks, creating a marginal product that is greater than that produced directly by the new employee. Conversely, hiring an additional worker onto an already crowded factory floor may make the other employees less productive, leading to a marginal product that is lower than the work done by the additional employee.

When production is discrete, we can define the marginal product of labor as ΔY/ΔL where Y is output. If a factory that is initially producing 100 widgets hires another employee and is then able to produce 106 widgets, the MPL is simply six. When production is continuous, the MPL is the first derivative of the production function in terms of L. Graphically, the MPL is the slope of the production function.

gives another example of marginal product of labor. The second column shows total production with different quantities of labor, while the third column shows the increase (or decrease) as labor is added to the production process.

The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing. The law states that “as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline. ” The law of diminishing marginal returns applies regardless of whether the production function exhibits increasing, decreasing or constant returns to scale. The key factor is that the variable input is being changed while all other factors of production are being held constant. Under such circumstances diminishing marginal returns are inevitable at some level of production.

14.1.2: Marginal Product of Labor (Revenue)

Learning Objective

Define the marginal product of labor under the marginal revenue productivity theory of wages

Key Points

• The marginal revenue product of a worker is equal to the product of the marginal product of labor (MP:) and the marginal revenue (MR) of output.
• The marginal revenue productivity theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate.
• The change in output from hiring one more employee is not limited to that directly attributable to the additional worker.

Key Terms

diminishing marginal returns

The decrease in the per-unit output of a production process as the amount of a single factor of production is increased.

marginal product

The extra output that can be produced by using one more unit of the input.

The marginal revenue product of labor (MRPL) is the change in revenue that results from employing an additional unit of labor, holding all other inputs constant. The marginal revenue product of a worker is equal to the product of the marginal product of labor (MPL) and the marginal revenue (MR) of output, given by MR×MP: = MRPL. This can be used to determine the optimal number of workers to employ at an exogenously determined market wage rate. Theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate, because it is not efficient for a firm to pay its workers more than it will earn in revenues from their labor.

For example, if a firm can sell t-shirts for $10 each and the wage rate is $20/hour, the firm will continue to hire workers until the marginal product of an additional hour of work is two t-shirts. If the MPL is three t-shirts the first will hire more workers until the MPL reaches two; if the MPL is one t-shirt then the firm will remove workers until the MPL reaches two.

Let TR=Total Revenue; L=Labor; Q=Quantity. Mathematically:

• MRPL= ∆TR/∆L
• MR = ∆TR/∆Q
• MPL = ∆Q/∆L
• MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L

Note that the change in output is not limited to that directly attributable to the additional worker. Assuming that the firm is operating with diminishing marginal returns then the addition of an extra worker reduces the average productivity of every other worker (and every other worker affects the marginal productivity of the additional worker) – in other words, everybody is getting in each other’s way.

Because the MRPL is equal to the marginal product of labor times the price of output, any variable that affects either MPL or price will affect the MRPL. For example, changes in technology or the quantity of other inputs will change the marginal product of labor, and changes in the product demand or changes in the price of complements or substitutes will affect the price of output. These will all cause shifts in the MRPL.

14.1.3: Deriving the Labor Demand Curve

Learning Objective

Explain how a company uses marginal revenue product in hiring decisions

Key Points

• The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor by the price of output.
• Firms will demand labor until the MRPL equals the wage rate.
• The demand curve for labor can be shifted by shifted by changes in the productivity of labor, the relative price of labor, or the price of the output.
• It will also change as a result of a change in technology, a change in the price of the good being produced, or a change in the number of firms hiring the labor.

Key Terms

marginal revenue product

The change in total revenue earned by a firm that results from employing one more unit of labor.

factor of production

A resource employed to produce goods and services, such as labor, land, and capital.

Firms demand labor and an input to production. The cost of labor to a firm is called the wage rate. This can be thought of as the firm’s marginal cost. The additional revenue generated by hiring one more unit of labor is the marginal revenue product of labor (MRPL). This can be thought of as the marginal benefit.

The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor (MPL) – the amount of additional output one additional worker can generate – by the price of output. If an employee of a customer support call center can take eight calls an hour (the MPL) and each call earns the company $3, then the MRPL is $24.

We can use the MRPL curve to determine the quantity of labor a company will hire. Suppose workers are available at an hourly rate of $10. The amount a factor adds to a firm’s total cost per period is the marginal cost of that factor, so in this case the marginal cost of labor is $10. Firms maximize profit when marginal costs equal marginal revenues, and in the labor market this means that firms will hire more employees until the wage rate (marginal cost of labor) equals the MRPL. At a price of $10, the company will hire workers until the last worker hired gives a marginal revenue product of $10 .

Thus, the downward-sloping portion of the marginal revenue product curve shows the number of employees a company will hire at each price (wage), so we can interpret this part of the curve as the firm’s demand for labor. As with other demand curves, the market demand curve for labor is the sum of all firm’s individual demand curves.

Shifting the Demand for Labor

There are three main reasons why the demand curve for labor may shift:

1. Changes to the marginal productivity of labor: Technology, for instance, may increase the marginal productivity of labor, shifting the demand curve to the right. For example, computer technology has increased the productivity (marginal product) of many types of workers. This has led to an increase in the marginal revenue product of labor for these jobs, shifting firms’ demand for labor to the right. This both increases the number of employed workers and increases the wage rate.
2. The prices of other factors of production: The change in the relative price of labor will increase or decrease demand for labor. For example, is capital becomes more expensive relative to labor, the demand for labor will increase as firms seek to substitute labor for capital.
3. The price of the firm’s output: Since the price of the output is a component of MRPL, changes will shift the demand curve for labor. If the price that a firm can charge for its output increases, for example, the MRPL will increase. This is reflected in an outward shift of the demand for labor.

13.1: Prerequisites of Oligopoly

13.1.1: Few Sellers

Learning Objective

Explain how increasing returns to scale will cause a higher prevalence of oligopolies

Key Points

• The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market.
• Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output.
• Monopolies and oligopolies often form when an industry has increasing returns to scale at relatively high output levels.

Key Terms

oligopoly

An economic condition in which a small number of sellers exert control over the market of a commodity.

returns to scale

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

Oligopoly Structure

In an oligopoly market structure, a few large firms dominate the market, and each firm recognizes that every time it takes an action it will provoke a response among the other firms. These actions, in turn, will affect the original firm. Each firm, therefore, recognizes that it is interdependent with the other firms in the industry. This interdependence is unique to the oligopoly market structure; in perfect and monopolistic competition, we assume that each firm is small enough that the rest of the market will ignore its actions.

Increasing Returns to Scale

The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market. One source of this power is increasing returns to scale. Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output. Increasing returns to scale implies that larger firms will face lower average costs than smaller firms because they are able to take advantage of added efficiency at higher levels of production.

Types of Returns to Scale

Most industries exhibit different types of returns to scale in different ranges of output. Typically in competitive markets, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges. Monopolies and oligopolies, however, often form when an industry has increasing returns to scale at relatively high output levels. When a few large firms already exist in this type of market, any new competitor will be smaller and therefore have higher average costs of production. This will make it difficult to compete with the already-established firms. Therefore, the oligopoly firms have a built-in defense against new competition.

Take the example of the cell phone industry in the United States. As of the fourth quarter of 2008, Verizon, AT&T, Sprint, and T-Mobile together controlled 89% of the U.S. cell phone market. The cell phone industry has increasing returns to scale: the cost of providing cellular access to 100,000 people is more than half the cost of providing cellular access to 200,000 people. Any new entrant into the cell phone market will either need to pay one of the larger companies for access to its already-existing network, or try to build a network from scratch. Both options result in higher costs, higher prices, and difficulty in competing with the major networks .

13.1.2: Product Differentiation

Learning Objective

Explain the relationship between product differentiation and the existence of an oligopoly

Key Points

• Product differentiation is the process of distinguishing a product or service from others, to make it more attractive to a particular target market.
• The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition.
• Many oligopolies make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal, and soft drinks.
• Although product differentiation is not required for an oligopoly to form, if a firm can successfully differentiate its products it will gain market power and resist competition more easily.

Key Term

product differentiation

Perceived differences between the product of one firm and that of its rivals so that some customers value it more.

Product differentiation (or simply differentiation) is the process of distinguishing a product or service from others, to make it more attractive to a particular target market. This involves differentiating it from competitors’ products as well as a firm’s own products. In economics, successful product differentiation is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes.

Differentiation is due to buyers perceiving a difference; hence, causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The major sources of product differentiation are as follows:

• Differences in quality which are usually accompanied by differences in price
• Differences in functional features or design
• Ignorance on the part of buyers regarding the essential characteristics and qualities of goods they are purchasing
• Sales promotion activities of sellers and, in particular, advertising
• Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition: As the product becomes more differentiated, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move a product from competing based primarily on price to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).

Product Differentiation and Oligopolies

While some oligopoly industries make standardized products – tools, copper, and steep pipes, for example – others make differentiated products: cars, cigarettes, soda, and cell phone manufacturers. Product differentiation is not necessary for the existence of an oligopoly, but if a firm can successfully engage in product differentiation it can more easily gain market power and dominate at least part of the industry.

For example, the soft drink industry in the US is an oligopoly dominated by the Coca-Cola Company, the Dr. Pepper Snapple Group, and PepsiCo. These companies are able to differentiate their products (e.g. by taste), and are therefore able to gain market power .

13.1.3: Entry Barriers

Learning Objective

Explain the necessity of entry barriers for the existence of an oligopoly

Key Points

• Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.
• The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants.
• In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization.

Key Terms

incumbent

A firm that is an established player in the market.

research and development

The process of discovering and creating new knowledge about scientific and technological topics in order to develop new products

patent

A declaration issued by a government agency declaring someone the inventor of a new invention and having the privilege of stopping others from making, using, or selling the claimed invention.

One important source of oligopoly power is barriers to entry. Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry—such as government regulation and patents, or a large, established firm taking advantage of economies of scale—or those an individual faces in trying to gain entrance to a profession—such as education or licensing requirements. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.

The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants. For example, microprocessing companies face high research and development costs before possibly making a profit. This means that new firms cannot enter the market whenever existing firms are making a positive economic profit, as is the case in perfect competition. Pharmaceutical manufacturers are one type of company that generally rely on patents, which makes competition irrelevant for a period of time after development: competitors can’t legally begin manufacturing the product until the patent expires.

Additional sources of barriers to entry often result from government regulation favoring existing firms. For example, requirements for licenses and permits may raise the investment needed to enter a market, creating an effective barrier to entry.

In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. For example, there are now only a small number of manufacturers of civil passenger aircraft. Oligopolies have also formed in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate .

13.1.4: Price Leadership

Learning Objective

Define price leadership within the context of an oligopoly

Key Points

• Oligopolies are defined by one firm’s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected.
• When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.
• An alternative to overt collusion is tacit collusion, an unwritten, unspoken understanding through which firms agree to limit their competition.
• One strategy is to follow the price leadership of a particular firm, raising or lowering prices when the leader makes such a change. The price leader may be the largest firm in the industry, or it may be a firm that has been particularly good at assessing changes in demand or cost.

Key Terms

Price leadership

The action taken by a leader in an oligopolistic industry to determine prices for the entire industry.

collude

To act in concert with; to conspire.

Cartel

A group of businesses or nations that collude explicitly to limit competition within an industry or market.

Oligopoly

Oligopolies are defined by one firm’s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected. Unlike perfect competition and monopoly, uncertainty about how rival firms interact makes the specification of a single model of oligopoly impossible. Economists often simplify firm behavior into two strategies: firm can compete, in which case the market outcome will resemble that in perfect competition; or they can collude, in which case the market outcome will more closely resemble monopoly. When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.

Price Leadership

Firms can collude explicitly, as in the case of cartels, but this type of behavior is illegal in many parts of the world. An alternative to overt collusion is tacit collusion, in which firms have an unspoken understanding that limits their competition. One way in which firms achieve this is price leadership, in which one firm serves as an industry leader and sets prices, while other firms raise and lower their prices to match. For example, the steel, cars, and breakfast cereals industries have all been accused of engaging in tacit collusion..

Tacit collusion can be difficult to identify. The fact that a price change by one firm is follwed by similar price changes among other firms doesn’t necessarily mean that tacit collusion exists. After all, in a perfectly competitive industry, economists expect prices to move together because all firms face similar changes in demand and the cost of inputs.

For example, imagine that a town has three gas stations. Without any way to communicate, all three will lower their prices in an attempt to capture the entire market, stopping only when marginal cost equals marginal revenue. If the firms could cooperate, however, they would be better off if all set the price of gas at $0.20 above marginal cost. Each would have slightly lower sales but would have much higher revenue. Although explicit communication about prices is illegal, the firms might tacitly agree that whenever one station raises its prices, the other two will follow suit. In this way, all three can receive the benefits of oligopoly . The gas station that first raises its prices, and that the other two follow, is called the price leader.

12.1: Monopolistic Competition

12.1.1: Defining Monopolistic Competition

Learning Objective

Evaluate the characteristics and outcomes of markets with imperfect competition

Key Points

• Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market.
• Markets that have monopolistic competition are inefficient for two reasons. First, at its optimum output the firm charges a price that exceeds marginal costs. The second source of inefficiency is the fact that these firms operate with excess capacity.
• Monopolistic competitive markets have highly differentiated products; have many firms providing the good or service; firms can freely enter and exits in the long-run; firms can make decisions independently; there is some degree of market power; and buyers and sellers have imperfect information.

Key Terms

monopoly

A market where one company is the sole supplier.

Monopolistic competition

A type of imperfect competition such that one or two producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location).

Monopolistic Competition

Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.

Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities .

Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market. The demand is inelastic and the market is inefficient.

Monopolistic competitive markets:

• have products that are highly differentiated, meaning that there is a perception that the goods are different for reasons other than price;
• have many firms providing the good or service;
• firms can freely enter and exits in the long-run;
• firms can make decisions independently;
• there is some degree of market power, meaning producers have some control over price; and
• buyers and sellers have imperfect information.

Sources of Market Inefficiency

Markets that have monopolistic competition are inefficient for two reasons. The first source of inefficiency is due to the fact that at its optimum output, the firm charges a price that exceeds marginal costs. The monopolistic competitive firm maximizes profits where marginal revenue equals marginal cost. A monopolistic competitive firm’s demand curve is downward sloping, which means it will charge a price that exceeds marginal costs. The market power possessed by a monopolistic competitive firm means that at its profit maximizing level of production there will be a net loss of consumer and producer surplus.

The second source of inefficiency is the fact that these firms operate with excess capacity. The firm’s profit maximizing output is less than the output associated with minimum average cost. All firms, regardless of the type of market it operates in, will produce to a point where demand or price equals average cost. In a perfectly competitive market, this occurs where the perfectly elastic demand curve equals minimum average cost. In a monopolistic competitive market, the demand curve is downward sloping. In the long run, this leads to excess capacity.

12.1.2: Product Differentiation

Learning Objective

Define product differentiation

Key Points

• Differentiation occurs because buyers perceive a difference between products. Causes of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.
• Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.
• There are three types of product differentiation: simple, horizontal, and vertical.

Key Term

product differentiation

Perceived differences between the product of one firm and that of its rivals so that some customers value it more.

One of the defining traits of a monopolistically competitive market is that there is a significant amount of non-price competition. This means that product differentiation is key for any monopolistically competitive firm. Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market .

Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences; differentiation is not the process of creating the differences between the products. Product differentiation is done in order to demonstrate the unique aspects of a firm’s product and to create a sense of value.

In economics, successful product differentiation is inconsistent with the conditions of perfect competition, which require products of competing firms to be perfect substitutes.

Consumers do not need to know everything about the product for differentiation to work. So long as the consumers perceive that there is a difference in the products, they do not need to know how or why one product might be of higher quality than another. For example, a generic brand of cereal might be exactly the same as a brand name in terms of quality. However, consumers might be willing to pay more for the brand name despite the fact that they cannot identify why the more expensive cereal is of higher “quality. “

There are three types of product differentiation:

• Simple: the products are differentiated based on a variety of characteristics;
• Horizontal: the products are differentiated based on a single characteristic, but consumers are not clear on which product is of higher quality; and
• Vertical: the products are differentiated based on a single characteristic and consumers are clear on which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it. The major sources of product differentiation are as follows:

• Differences in quality, which are usually accompanied by differences in price;
• Differences in functional features or design;
• Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing;
• Sales promotion activities of sellers, particularly advertising; and
• Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition. A successful product differentiation strategy will move the product from competing on price to competing on non-price factors.

12.1.3: Demand Curve

Learning Objective

Explain how the shape of the demand curve affects the firms that exist in a market with monopolistic competition

Key Points

• The downward slope of a monopolistically competitive demand curve signifies that the firms in this industry have market power.
• Market power allows firms to increase their prices without losing all of their customers.
• The downward slope of the demand curve contributes to the inefficiency of the market, leading to a loss in consumer surplus, deadweight loss, and excess production capacity.

Key Terms

market power

The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.

elastic

Sensitive to changes in price.

The demand curve of a monopolistic competitive market slopes downward. This means that as price decreases, the quantity demanded for that good increases. While this appears to be relatively straightforward, the shape of the demand curve has several important implications for firms in a monopolistic competitive market.

Market Power

The demand curve for an individual firm is downward sloping in monopolistic competition, in contrast to perfect competition where the firm’s individual demand curve is perfectly elastic. This is due to the fact that firms have market power: they can raise prices without losing all of their customers. In this type of market, these firms have a limited ability to dictate the price of its products; a firm is a price setter not a price taker (at least to some degree). The source of the market power is that there are comparatively fewer competitors than in a competitive market, so businesses focus on product differentiation, or differences unrelated to price. By differentiating its products, firms in a monopolistically competitive market ensure that its products are imperfect substitutes for each other. As a result, a business that works on its branding can increase its prices without risking its consumer base.

Inefficiency in the Market

Monopolistically competitive firms maximize their profit when they produce at a level where its marginal costs equals its marginal revenues. Because the individual firm’s demand curve is downward sloping, reflecting market power, the price these firms will charge will exceed their marginal costs. Due to how products are priced in this market, consumer surplus decreases below the pareto optimal levels you would find in a perfectly competitive market, at least in the short run. As a result, the market will suffer deadweight loss. The suppliers in this market will also have excess production capacity.

12.1.4: Short Run Outcome of Monopolistic Competition

Learning Objective

Examine the concept of the short run and how it applies to firms in a monopolistic competition

Key Points

• The “short run” is the time period when one factor of production is fixed in terms of costs, while the other elements of production are variable.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run.
• Also like a monopoly, a monopolastic competitive firm will maximize its profits when its marginal revenues equals its marginal costs.

Key Term

short-run

The conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount.

In terms of production and supply, the “short run” is the time period when one factor of production is fixed in terms of costs while the other elements of production are variable. The most common example of this is the production of a good that requires a factory. If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows. This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory. You could sell the factory, but again that would take a significant amount of time. The “short run” is defined by how long it would take to alter that “fixed” aspect of production.

In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good. .

Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer’s point of view, is desirable because it allows them to earn a profit and increase their producer surplus.

Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.

12.1.5: Long Run Outcome of Monopolistic Competition

Learning Objective

Explain the concept of the long run and how it applies to a firms in monopolistic competition

Key Points

• In terms of production and supply, the “long-run” is the time period when all aspects of production are variable and can therefore be adjusted to meet shifts in demand.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run.
• Like a monopoly, a monopolastic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs.
• In the long-run, the demand curve of a firm in a monopolistic competitive market will shift so that it is tangent to the firm’s average total cost curve. As a result, this will make it impossible for the firm to make economic profit; it will only be able to break even.

Key Term

long-run

The conceptual time period in which there are no fixed factors of production.

In terms of production and supply, the “long-run” is the time period when there is no factor that is fixed and all aspects of production are variable and can therefore be adjusted to meet shifts in demand. Given a long enough time period, a firm can take the following actions in response to shifts in demand:

• Enter an industry;
• Exit an industry;
• Increase its capacity to produce more; and
• Decrease its capacity to produce less.

In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.

While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run. Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit .

12.1.6: Monopolistic Competition Compared to Perfect Competition

Learning Objective

Differentiate between monopolistic competition and perfect competition

Key Points

• Perfectly competitive markets have no barriers of entry or exit. Monopolistically competitive markets have a few barriers of entry and exit.
• The two markets are similar in terms of elasticity of demand, a firm’s ability to make profits in the long-run, and how to determine a firm’s profit maximizing quantity condition.
• In a perfectly competitive market, all goods are substitutes. In a monopolistically competitive market, there is a high degree of product differentiation.

Key Term

perfect competition

A type of market with many consumers and producers, all of whom are price takers

Examples

• The classic example of a monopoly is De Beers, who at one point in the 1980s reputably owned 90% of all the diamond supply to major markets. This results in a high degree of price control, as a lack of competitive forces will enable De Beers to essentially set the going price for diamonds (granted the control their distribution).
• A good example of monopolistic competition, on the other hand, would be the Some modern day apps in the app store (this is NOT to say the app stores themselves, which are something of an oligopoly). There are thousands upon thousands of apps, some are free, some are paid, and some have free versions with microtransactions. The key is that demand is highly elastic, and supply is nearly infinite, allowing consumers a great deal of freedom in their purchasing decisions.

Perfect competition and monopolistic competition are two types of economic markets.

Similarities

One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases. The two only differ in degree. Firm’s individual demand curves in perfectly competitive markets are perfectly elastic, which means that an incremental increase in price will cause demand for a product to vanish ). Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers.

Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services.

Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.

Differences

One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient. This means that the price is Pareto optimal, which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus, which is the sum of the producer and consumer surpluses, is maximized. The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service.

In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power. This decreases the consumer surplus, and by extension the market’s economic surplus, and creates deadweight loss.

Another key difference between the two is product differentiation. In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated. In fact, firms work hard to emphasize the non-price related differences between their products and their competitors’.

A final difference involves barriers to entry and exit. Perfectly competitive markets have no barriers to entry and exit; a firm can freely enter or leave an industry based on its perception of the market’s profitability. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market.

12.1.7: Efficiency of Monopolistic Competition

Learning Objective

Discuss the effect monopolistic competition has on overall market efficiency

Key Points

• Because a good is always priced higher than its marginal cost, a monopolistically competitive market can never achieve productive or allocative efficiency.
• Suppliers in monopolistically competitive firms will produce below their capacity.
• Because monopolistic firms set prices higher than marginal costs, consumer surplus is significantly less than it would be in a perfectly competitive market. This leads to deadweight loss and an overall decrease in economic surplus.

Key Terms

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

consumer surplus

The difference between the maximum price a consumer is willing to pay and the actual price they do pay.

Monopolistically competitive markets are less efficient than perfectly competitive markets.

Producer and Consumer Surplus

In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms. Both types of firms’ profit maximizing production levels occur when their marginal revenues equals their marginal costs. This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity.

Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.This price exceeds the firm’s marginal costs and is higher than what the firm would charge if the market was perfectly competitive. This means two things:

• Consumers will have to pay a higher price than they would in a perfectly competitive market, leading to a significant decline in consumer surplus; and
• Producers will sell less of their goods than they would have in a perfectly competitive market, which could offset their gains from charging a higher price and could result in a decline in producer surplus.

Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus .

Productive and Allocative Efficiency

Productive efficiency occurs when a market is using all of its resources efficiently. This occurs when a product’s price is set at its marginal cost, which also equals the product’s average total cost. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient.

Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. This occurs when a product’s price equals its marginal benefits, which is also equal to the product’s marginal costs. Again, since a good’s price in a monopolistic competitive market always exceeds its marginal cost, the market can never be allocatively efficient.

12.1.8: Advertising and Brand Management in Monopolistic Competition

Learning Objective

Evaluate whether advertising is beneficial or detrimental to consumers

Key Points

• A company’s brand can help promote quality in that company’s products.
• Advertising helps inform consumers about products, which decreases selection costs.
• Costs associated with advertising and branding include higher prices, customers mislead by false advertisements, and negative societal affects such as perpetuating stereotypes and spam.

Key Terms

brand

The reputation of an organization, a product, or a person among some segment of the population.

advertising

Communication with the purpose of influencing potential customers about products and services

One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Advertising is generally used by businesses to cultivate a brand . A brand is a company’s reputation in relation to products or services sold under a specific name or logo.

Benefits of Advertising and Branding

The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. A brand and the associated reputation are built on advertising and consumers’ past experiences with the products associated with that brand.

Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality. This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.

Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Advertising and brands can help minimize the costs of choosing between different products because of consumers’ familiarity with the firms and their quality.

Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.

Costs of Advertising and Branding

There are some concerns about how advertising can harm consumers and society as well. Some believe that advertising and branding induces customers to spend more on products because of the name associated with them rather than because of rational factors. Further, there is no guarantee that advertisements accurately describe products; they can mislead consumers. Finally, advertising can have negative societal effects such as the perpetuation of negative stereotypes or the nuisance of “spam. “

11.1: Introduction to Monopoly

11.1.1: Defining Monopoly

Learning Objective

Differentiate monopolies and competitive markets

Key Points

• A monopoly market is characterized by the profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Monopoly characteristics include profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Sources of monopoly power include economies of scale, capital requirements, technological superiority, no substitute goods, control of natural resources, legal barriers, and deliberate actions.
• There are a few similarities between a monopoly and competitive market: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.
• Differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve.
• The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.

Key Terms

monopoly

A market where one company is the sole supplier.

differentiation

The act of distinguishing a product from the others in the market.

A monopoly is a specific type of economic market structure. A monopoly exists when a specific person or enterprise is the only supplier of a particular good. As a result, monopolies are characterized by a lack of competition within the market producing a good or service .

Characteristics of a Monopoly

A monopoly can be recognized by certain characteristics that set it aside from the other market structures:

• Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm can charge a set price above what would be charged in a competitive market, thereby maximizing its revenue.
• Price maker: the monopoly decides the price of the good or product being sold. The price is set by determining the quantity in order to demand the price desired by the firm (maximizes revenue).
• High barriers to entry: other sellers are unable to enter the market of the monopoly.
• Single seller: in a monopoly one seller produces all of the output for a good or service. The entire market is served by a single firm. For practical purposes the firm is the same as the industry.
• Price discrimination: in a monopoly the firm can change the price and quantity of the good or service. In an elastic market the firm will sell a high quantity of the good if the price is less. If the price is high, the firm will sell a reduced quantity in an elastic market.

Sources of Monopoly Power

In a monopoly, specific sources generate the individual control of the market. Sources of power include:

• Economies of scale
• Capital requirements
• Technological superiority
• No substitute goods
• Control of natural resources
• Network externalities
• Legal barriers
• Deliberate actions

Monopoly vs. Competitive Market

Monopolies and competitive markets mark the extremes in regards to market structure. There are a few similarities between the two including: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.

However, there are noticeable differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve. The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.

10.1: Perfect Competition

10.1.1: Definition of Perfect Competition

Learning Objective

Describe degrees of competition in different market structures

Key Points

• The major types of market structure include monopoly, monopolistic competition, oligopoly, and perfect competition.
• Perfect competition is an industry structure in which there are many firms producing homogeneous products. None of the firms are large enough to influence the industry.
• The characteristics of a perfectly competitive market include insignificant contributions from the producers, homogenous products, perfect information about products, no transaction costs, and no long-term economic profits.
• In practice, very few industries can be described as perfectly competitive, though agriculture comes close.

Key Terms

oligopoly

An economic condition in which a small number of sellers exert control over the market of a commodity.

Monopolistic competition

A market structure in which there is a large number of firms, each having a small proportion of the market share and slightly differentiated products.

monopoly

A situation, by legal privilege or other agreement, in which solely one party (company, cartel etc. ) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.

Market structure is determined by the number and size distribution of firms in a market, entry conditions, and the extent of product differentiation. The major types of market structure include the following:

• Monopoly: An industry structure where a single firm produces a product for which there are no close substitutes. Monopolists are price makers. Barriers to entry and exit exist, and, in order to ensure profits, a monopoly will attempt to maintain them.
• Monopolistic competition: A market structure in which there is a large number of firms, each having a small portion of the market share and slightly differentiated products. There are close substitutes for the product of any given firm, so competitors have slight control over price. There are relatively insignificant barriers to entry or exit, and success invites new competitors into the industry.
• Oligopoly: An industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated. Each firm is large enough to influence the industry. Barriers to entry exist.
• Perfect competition: An industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.

Perfect competition leads to the Pareto-efficient allocation of economic resources. Because of this it serves as a natural benchmark against which to contrast other market structures. However, in practice, very few industries can be described as perfectly competitive. Nevertheless, it is used because it provides important insights.

A perfectly competitive market has several important characteristics:

• All producers contribute insignificantly to the market. Their own production levels do not change the supply curve.
• All producers are price takers. They cannot influence the market. If a firm tries to raise its price consumers would buy from a competitor with a lower price instead.
• Products are homogeneous. The characteristics of a good or service do not vary between suppliers.
• Producers enter and exit the market freely.
• Both buyers and sellers have perfect information about the price, utility, quality, and production methods of products.
• There are no transaction costs. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
• Producers earn zero economic profits in the long run.

10.1.2: Conditions of Perfect Competition

Learning Objective

Calculate total revenue, average revenue, and marginal revenue for a firm in a perfectly competitive market

Key Points

• A perfectly competitive market is characterized by many buyers and sellers, undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect information about the price of a good.
• The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). The average revenue is calculated by dividing total revenue by quantity. Marginal revenue is calculated by dividing the change in total revenue by change in quantity.
• A firm in a competitive market tries to maximize profits. In the short-run, it is possible for a firm’s economic profits to be positive, negative, or zero. Economic profits will be zero in the long-run.
• In the short-run, if a firm has a negative economic profit, it should continue to operate if its price exceeds its average variable cost. It should shut down if its price is below its average variable cost.

Key Term

economic profit

The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm.

The concept of perfect competition applies when there are many producers and consumers in the market and no single company can influence the pricing. A perfectly competitive market has the following characteristics:

• There are many buyers and sellers in the market.
• Each company makes a similar product.
• Buyers and sellers have access to perfect information about price.
• There are no transaction costs.
• There are no barriers to entry into or exit from the market.

All goods in a perfectly competitive market are considered perfect substitutes, and the demand curve is perfectly elastic for each of the small, individual firms that participate in the market. These firms are price takers–if one firm tries to raise its price, there would be no demand for that firm’s product. Consumers would buy from another firm at a lower price instead.

Firm Revenues

A firm in a competitive market wants to maximize profits just like any other firm. The profit is the difference between a firm’s total revenue and its total cost. For a firm operating in a perfectly competitive market, the revenue is calculated as follows:

• Total Revenue = Price * Quantity
• AR (Average Revenue) = Total Revenue / Quantity
• MR (Marginal Revenue) = Change in Total Revenue / Change in Quantity

The average revenue (AR) is the amount of revenue a firm receives for each unit of output. The marginal revenue (MR) is the change in total revenue from an additional unit of output sold. For all firms in a competitive market, both AR and MR will be equal to the price.

Profit Maximization

In order to maximize profits in a perfectly competitive market, firms set marginal revenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve, which is also equal to the demand curve (D) and price (P). In the short-term, it is possible for economic profits to be positive, zero, or negative . When price is greater than average total cost, the firm is making a profit. When price is less than average total cost, the firm is making a loss in the market.

Over the long-run, if firms in a perfectly competitive market are earning positive economic profits, more firms will enter the market, which will shift the supply curve to the right. As the supply curve shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will decrease until they become zero.

When price is less than average total cost, firms are making a loss. Over the long-run, if firms in a perfectly competitive market are earning negative economic profits, more firms will leave the market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As the price goes up, economic profits will increase until they become zero.

In sum, in the long-run, companies that are engaged in a perfectly competitive market earn zero economic profits . The long-run equilibrium point for a perfectly competitive market occurs where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve.

10.1.3: The Demand Curve in Perfect Competition

Learning Objective

Describe the demand for goods in perfectly competitive markets

Key Points

• In a perfectly competitive market individual firms are price takers. The price is determined by the intersection of the market supply and demand curves.
• The demand curve for an individual firm is different from a market demand curve. The market demand curve slopes downward, while the firm’s demand curve is a horizontal line.
• The firm’s horizontal demand curve indicates a price elasticity of demand that is perfectly elastic.

Key Term

Perfectly elastic

Describes a situation when any increase in the price, no matter how small, will cause demand for a good to drop to zero.

In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the fact that as the price of an ordinary good increases, the quantity demanded of that good decreases. Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition. Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price (keep in mind the key conditions of perfect competition). The demand curve for an individual firm is thus equal to the equilibrium price of the market .

The demand curve for a firm in a perfectly competitive market varies significantly from that of the entire market.The market demand curve slopes downward, while the perfectly competitive firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above market price, it would not sell any products.

A strategy often used to increase market share is to offer a firm’s product at a lower price than the competitors. In a perfectly competitive market, firms cannot decrease their product price without making a negative profit. Instead, assuming that the firm is a profit-maximizer, it will sell its goods at the market price.

9.1: The Production Function

9.1.1: Defining the Production Function

Learning Objective

Define the production function

Key Points

• The production function describes a boundary or frontier representing the limit of output obtainable from each feasible combination of inputs.
• Firms use the production function to determine how much output they should produce given the price of a good, and what combination of inputs they should use to produce given the price of capital and labor.
• The production function also gives information about increasing or decreasing returns to scale and the marginal products of labor and capital.

Key Terms

marginal cost

The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.

Production function

Relates physical output of a production process to physical inputs or factors of production.

output

Production; quantity produced, created, or completed.

In economics, a production function relates physical output of a production process to physical inputs or factors of production. It is a mathematical function that relates the maximum amount of output that can be obtained from a given number of inputs – generally capital and labor. The production function, therefore, describes a boundary or frontier representing the limit of output obtainable from each feasible combination of inputs.

Firms use the production function to determine how much output they should produce given the price of a good, and what combination of inputs they should use to produce given the price of capital and labor (). When firms are deciding how much to produce they typically find that at high levels of production, their marginal costs begin increasing. This is also known as diminishing returns to scale – increasing the quantity of inputs creates a less-than-proportional increase in the quantity of output. If it weren’t for diminishing returns to scale, supply could expand without limits without increasing the price of a good.

Increasing marginal costs can be identified using the production function. If a firm has a production function Q=F(K,L) (that is, the quantity of output (Q) is some function of capital (K) and labor (L)), then if 2Q<F(2K,2L), the production function has increasing marginal costs and diminishing returns to scale. Similarly, if 2Q>F(2K,2L), there are increasing returns to scale, and if 2Q=F(2K,2L), there are constant returns to scale.

Examples of Common Production Functions

One very simple example of a production function might be Q=K+L, where Q is the quantity of output, K is the amount of capital, and L is the amount of labor used in production. This production function says that a firm can produce one unit of output for every unit of capital or labor it employs. From this production function we can see that this industry has constant returns to scale – that is, the amount of output will increase proportionally to any increase in the amount of inputs.

Another common production function is the Cobb-Douglas production function. One example of this type of function is Q=K^0.5L^0.5. This describes a firm that requires the least total number of inputs when the combination of inputs is relatively equal. For example, the firm could produce 25 units of output by using 25 units of capital and 25 of labor, or it could produce the same 25 units of output with 125 units of labor and only one unit of capital.

Finally, the Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those proportions, if usage of one input is increased without another being increased, output will not change. This production function is given by Q=Min(K,L). For example, a firm with five employees will produce five units of output as long as it has at least five units of capital.

9.1.2: The Law of Diminishing Returns

Learning Objective

Explain the Law of Diminishing Returns

Key Points

• One consequence of the law of diminishing returns is that producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less effectively.
• The marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise.
• The SRAC is typically U-shaped with its minimum at the point where it intersect the marginal cost curve. This is caused by the first increasing, and then decreasing, marginal returns to labor.
• The typical LRAC curve is also U-shaped, reflecting increasing returns of scale where negatively-sloped, constant returns to scale where horizontal and decreasing returns where positively sloped.

Key Terms

returns to scale

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

marginal cost

The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.

In economics, diminishing returns (also called diminishing marginal returns) is the decrease in the marginal output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant. The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant (“ceteris paribus”), will at some point yield lower per-unit returns . The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.

For example, the use of fertilizer improves crop production on farms and in gardens; but at some point, adding more and more fertilizer improves the yield less per unit of fertilizer, and excessive quantities can even reduce the yield. A common sort of example is adding more workers to a job, such as assembling a car on a factory floor. At some point, adding more workers causes problems such as workers getting in each other’s way or frequently finding themselves waiting for access to a part. In all of these processes, producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less effectively.

This increase in the marginal cost of output as production increases can be graphed as the marginal cost curve, with quantity of output on the x axis and marginal cost on the y axis. For many firms, the marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise, representing the higher and higher marginal costs associated with additional output.

The Law of Diminishing Returns and Average Cost

The average total cost of production is the total cost of producing all output divided by the number of units produced. For example, if the car factory can produce 20 cars at a total cost of $200,000, the average cost of production is $10,000. Average total cost is interpreted as the the cost of a typical unit of production. So in our example each of the 20 cars produced had a typical cost per unit of $10,000. Average total cost can also be graphed with quantity of output on the x axis and average cost on the y-axis.

What will this average total cost curve look like? In the short run, a firm has a set amount of capital and can only increase or decrease production by hiring more or less labor. The fixed costs of capital are high, but the variable costs of labor are low, so costs increase more slowly than output as production increases. As long as the marginal cost of production is lower than the average total cost of production, the average cost is decreasing. However, as marginal costs increase due to the law of diminishing returns, the marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase. The short run average total cost curve (SRAC) will therefore be U-shaped for most firms .

The long-run average cost curve (LRAC) depicts the cost per unit of output in the long run—that is, when all productive inputs’ usage levels can be varied. The typical LRAC curve is also U-shaped but for different reasons: it reflects increasing returns to scale where negatively-sloped, constant returns to scale where horizontal, and decreasing returns (due to increases in factor prices) where positively sloped.

9.1.3: Inputs and Outputs of the Function

Learning Objective

Describe the inputs and outputs in a generalized production function

Key Points

• Capital refers to the material objects necessary for production. In the short run, economists assume that the level of capital is fixed.
• Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of production.
• The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be found by taking the derivative of the production function in terms of the relevant input.

Key Terms

rental rate

The price of capital.

capital

Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).

marginal product

The extra output that can be produced by using one more unit of the input.

A production function relates the input of factors of production to the output of goods. In the basic production function inputs are typically capital and labor, though more expansive and complex production functions may include other variables such as land or natural resources. Output may be any consumer good produced by a firm. Cars, clothing, sandwiches, and toys are all examples of output.

Capital refers to the material objects necessary for production. Machinery, factory space, and tools are all types of capital. In the short run, economists assume that the level of capital is fixed – firms can’t sell machinery the moment it’s no longer needed, nor can they build a new factory and start producing goods there immediately. When looking at the production function in the short run, therefore, capital will be a constant rather than a variable. Although in reality a firm may own the capital that it uses, economists typically refer to the ongoing cost of employing capital as the rental rate because the opportunity cost of employing capital is the income that a firm could receive by renting it out. Thus, the price of capital is the rental rate.

Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of production; it can be increased or decreased in the short run in order to produce more or less output. The price of labor is the prevailing wage rate, since wages are the cost of hiring an additional unit of capital.

The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be found by taking the derivative of the production function in terms of the relevant input. For example, if the production function is Q=3K+2L (where K represents units of capital and L represents units of labor), then the marginal product of capital is simply three; every additional unit of capital will produce an additional three units of output. Inputs are typically subject to the law of diminishing returns: as the amount of one factor of production increases, after a certain point the marginal product of that factor declines.

8.1: Public Goods

8.1.1: Defining a Good

Learning Objective

Define a good

Key Points

• Private goods are excludable and rival. Examples of private goods include food and clothes.
• Common goods are non-excludable and rival. A classic example is fish stocks in international waters.
• Club goods are excludable but non-rival. Cable television is an example.
• Public goods are non-excludable and non-rival. They include public parks and the air we breathe.

Key Terms

Rival

A good whose consumption by one consumer prevents simultaneous consumption by other consumers

Excludable

A good for which it is possible to prevent consumers who have not paid for it from having access to it.

There are four categories of goods in economics, which are defined based on two attributes. The first attribute is excludability, or whether people can be prevented from using the good. The second is whether a good is rival in consumption: whether one person’s use of the good reduces another person’s ability to use it.

National defense provides an example of a good that is non-excludable. America’s national defense establishment offers protection to everyone in the country. Items on sale in a store, on the other hand, are excludable. The store owner can prevent a customer from obtaining a good unless the customer pays for it. National defense also provides an example of a good that is non-rivalrous. One person’s protection does not prevent another person from receiving protection. In contrast, shoes are rivalrous. Only one person can wear a pair of shoes at a time.

Combinations of these two attributes create four categories of goods :

• Private goods: Private goods are excludable and rival. Examples of private goods include food, clothes, and flowers. There are usually limited quantities of these goods, and owners or sellers can prevent other individuals from enjoying their benefits. Because of their relative scarcity, many private goods are exchanged for payment.
• Common goods: Common goods are non-excludable and rival. Because of these traits, common goods are easily over-consumed, leading to a phenomenon called “tragedy of the commons. ” In this situation, people withdraw resources to secure short-term gains without regard for the long-term consequences. A classic example of a common good are fish stocks in international waters. No one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for later fishermen are depleted.
• Club goods: Club goods are excludable but non-rival. This type of good often requires a “membership” payment in order to enjoy the benefits of the goods. Non-payers can be prevented from access to the goods. Cable television is a classic example. It requires a monthly fee, but is non-rival after the payment.
• Public goods: Public goods are non-excludable and non-rival. Individuals cannot be effectively excluded from using them, and use by one individual does not reduce the good’s availability to others. Examples of public goods include the air we breathe, public parks, and street lights. Public goods may give rise to the “free rider problem. ” A free-rider is a person who receives the benefit of a good without paying for it. This may lead to the under-provision of certain goods or services.

8.1.2: Private Goods

Learning Objective

Define a private good

Key Points

• The owners or sellers of private goods exercise private property rights over them.
• A consumer generally has to pay for a private good.
• Generally, the market will efficiently allocate resources for the production of private goods.

Key Terms

Excludable

A good for which it is possible to prevent consumers who have not paid for it from having access to it.

Rivalrous

A good whose consumption by one consumer prevents simultaneous consumption by other consumers.

In economics, a private good is defined as an asset that is both excludable and rivalrous. It is excludable in that it is possible to exercise private property rights over it, preventing those who have not paid from using the good or consuming its benefits. For example, person A may have the means and will to pay $20 for a t-shirt. Person B may not wish to pay $20 or may not be able to do so. Person B would not be able to purchase the t-shirt. Additionally, the private good is rivalrous in that its consumption by one person necessarily prevents consumption by another. When person A purchases and drinks a bottle of water, the same bottle of water is not available for person B to purchase and consume.

A private good is a scare economic resource, which causes competition for it. Generally, people have to pay to enjoy the benefits of a private good. Because people have to pay to obtain it, private goods are much less likely to encounter a free-rider problem than public goods. Thus, generally, the market will efficiently allocate resources to produce private goods.

In daily life, examples of private goods abound, including food, clothing, and most other goods that can be purchased in a store. Take an example of an ice cream cone . It is both excludable and rivalrous. It is possible to prevent someone from consuming the ice cream by simply refusing to sell it to them. Additionally, it can be consumed only once, so its consumption by one individual would definitely reduce others’ ability to consume it.

8.1.3: Public Goods

Learning Objective

Define a public good

Key Points

• A public good is both non-excludable and non-rivalrous.
• Pure public goods are perfectly non-rival in consumption and non-excludable. Impure public goods satisfy those conditions to some extent, but not perfectly.
• Public goods provide an example of market failure. Because of the free-rider problem, they may be underpoduced.

Key Terms

free rider

Someone who enjoys the benefits of a good without paying for it

Non-excludable

Non-paying consumers cannot be prevented from accessing a good

Non-rivalrous

A good whose consumption by one consumer does not prevent simultaneous consumption by other consumers

A public good is a good that is both non-excludable and non-rivalrous. This means that individuals cannot be effectively excluded from its use, and use by one individual does not reduce its availability to others. Examples of public goods include fresh air, knowledge, lighthouses, national defense, flood control systems, and street lighting .

Public goods can be pure or impure. Pure public goods are those that are perfectly non-rivalrous in consumption and non-excludable. Impure public goods are those that satisfy the two conditions to some extent, but not fully.

The production of public goods results in positive externalities for which producers don’t receive full payment. Consumers can take advantage of public goods without paying for them. This is called the “free-rider problem. ” If too many consumers decide to “free-ride,” private costs to producers will exceed private benefits, and the incentive to provide the good or service through the market will disappear. The market will thus fail to provide enough of the good or service for which there is a need.

For example, a local public radio station relies on support from listeners to operate. The station holds pledge drives several times a year, asking listeners to make contributions or face possible reduction in programming. Yet only a small percentage of the audience makes contributions. Some audience members may even listen to the station for years without ever making a payment. Those listeners who do not make a contribution are “free-riders. ” If the station relies solely on funds contributed by listeners, it would under-produce programming. It must obtain additional funding from other sources (such as the government) in order to continue to operate.

8.1.4: Optimal Quantity of a Public Good

Learning Objective

Explain the optimal quantity of a public good

Key Points

• Collective demand for a public good is the vertical summation of individual demand curves. It shows the price society is willing to pay for a given quantity of a public good.
• The demand curve for a public good is downward sloping, due to the law of diminishing marginal utility. The supply curve is upward sloping, due to the law of diminishing returns.
• The optimal quantity of a public good occurs where the demand (marginal benefit) curve intersects the supply (marginal cost) curve.
• The government uses cost-benefit analysis to decide whether to provide a particular good. If MB is greater than MC there is an underallocation of a public good. If MC is greater than MB there is an overallocation of a public good. When MC = MB then there is an optimal allocation of public goods.

Key Term

Cost-benefit analysis

A systematic process for calculating and comparing the marginal benefits and marginal costs of a project or activity.

To determine the optimal quantity of a public good, it is necessary to first determine the demand for it. Demand for public goods is represented through price-quantity schedules, which show the price someone is willing to pay for the extra unit of each possible quantity. Unlike the market demand curve for private goods, where individual demand curves are summed horizontally, individual demand curves for public goods are summed vertically to get the market demand curve. As a result, the market demand curve for public goods gives the price society is willing to pay for a given quantity. It is equal to the marginal benefit curve. Due to the law of diminishing marginal utility, the demand curve is downward sloping.

Often, the government supplies the public good. The supply curve for a public good is equal to its marginal cost curve. Because of the law of diminishing returns, the marginal cost increases as the quantity of the good produced increases. The supply curve therefore has an upward slope.

As already noted, the demand curve is equal to the marginal benefit curve, while the supply curve is equal to the marginal cost curve. The optimal quantity of the public good occurs where MB (society’s marginal benefit) equals MC (provider’s marginal cost), or where the two curves intersect . When MB = MC, resources have been allocated efficiently.

The public good provider uses cost-benefit analysis to decide whether to provide a particular good by comparing marginal costs and marginal benefits. Cost-benefit analysis can also help the provider decide the extent to which a project should be pursued. Output activity should be increased as long as the marginal benefit exceeds the marginal cost. An activity should not be pursued when the marginal benefit is less than the marginal cost. An activity should be stopped at the point where MB equals MC. This is the MC=MB rule, by which the provider of the public good can determine which plan, will give society maximum net benefit.

8.1.5: Demand for Public Goods

Learning Objective

Analyze the demand for a public good.

Key Points

• For public goods, aggregate demand is the sum of marginal benefits to each person at each quantity of the good provided.
• As for private goods, the individual demand curves show the price someone is willing to pay for an extra unit of each possible quantity of a good.
• The efficient quantity of a public good is the quantity at which marginal benefit equals marginal cost.
• The efficient quantity of a public good is the quantity at which marginal benefit equals marginal cost.

Key Term

public good

A good that is non-rivalrous and non-excludable.

The aggregate demand for a public good is derived differently from the aggregate demand for private goods.

To an individual consumer, the total benefit of a public good is the dollar value that he or she places on a given level of provision of the good. The marginal benefit for an individual is the increase in the total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes as the level of the good provided increases.

Public goods are non-rivalrous, so everyone can consume each unit of a public good. They also have a fixed market quantity: everyone in society must agree on consuming the same amount of the good. However, each individual’s willingness to pay for the quantity provided may be different. The individual demand curves show the price someone is willing to pay for an extra unit of each possible quantity of the public good.

The aggregate demand for a public good is the sum of marginal benefits to each person at each quantity of the good provided . The economy’s marginal benefit curve (demand curve) for a public good is thus the vertical sum all individual’s marginal benefit curves. The vertical summation of individual demand curves for public goods also gives the aggregate willingness to pay for a given quantity of the good.

This is in contrast to the aggregate demand curve for a private good, which is the horizontal sum of the individual demand curves at each price. Unlike public goods, society does not have to agree on a given quantity of a private good, and any one person can consume more of the private good than another at a given price.

The efficient quantity of a public good is the quantity that maximizes net benefit (total benefit minus total cost), which is the same as the quantity at which marginal benefit equals marginal cost.

8.1.6: Cost-Benefit Analysis

Learning Objective

Explain how to determine the net cost/benefit of providing a public good

Key Points

• Cost-benefit analysis is a systematic way of calculating the costs and benefits of a project to society as a whole.
• Benefits and costs are expressed in monetary terms and are adjusted for the time-value of money.
• Financial costs are much easier to capture in the analysis than non-financial welfare impacts, such as impacts on human life or the environment.
• The government should provide a public good if the benefits to society outweigh the costs.

Key Term

net present value

The present value of a project determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.

The government uses cost-benefit analysis to decide whether to provide a particular public good and how much of it to provide. Cost-benefit analysis, which is also sometimes called benefit-cost analysis, is a systematic process for calculating the benefits and costs of a project to society as a whole.

The positive and negative effects captured by cost-benefit analysis may include effects on consumers, effects on non-consumers, externality effects, or other social benefits or costs. The guiding principle is to list all parties affected by a project and add a negative or positive value that they ascribe to the project’s effect on their welfare. Benefits and costs are expressed in monetary terms, and are adjusted for the time value of money, so that all flows of benefits and costs over time are expressed on a common basis in terms of their net present value. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to relatively abundant market data. It is much more difficult to capture non-financial welfare impacts. For example, it is very difficult to place a dollar value on human life, consumers’ time, or environmental impact.

Imagine that the government is considering a project to widen a highway . The benefits side of the analysis might include time savings for passengers who can now avoid traffic, an increase in the number of passenger trips (as more people could now use the road), and lives saved by dint of fewer car accidents. The cost side of the analysis would include the cost of land that must be acquired prior to construction, construction, and maintenance. These costs and benefits will need to be translated into monetary terms for the sake of analysis.

The procedure for conducting cost-benefit analysis is as follows:

1. Identify project(s) to be analyzed.
2. Estimate all costs and benefits to society associated with the project(s) over a relevant time horizon.
3. Assign a monetary value to all costs and benefits.
4. Calculate the net benefit of the project (total benefit minus total cost).
5. Adjust for inflation and apply the discount rate to calculate present value of the project.
6. Calculate the net present value for the project(s).
7. Make recommendation about project(s). If the benefit outweighs the cost, then the government should proceed with the project.

7.1: Introducing Market Failure

7.1.1: Defining Market Failure

Learning Objective

Identify common market failures and governmental responses

Key Points

• Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption.
• The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods.
• Government responses to market failure include legislation, direct provision of merit goods and public goods, taxation, subsidies, tradable permits, extension of property rights, advertising, and international cooperation among governments.

Key Terms

merit good

A commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay.

public good

A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good. The market will fail by not supplying the socially optimal amount of the good.

Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.

The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party which is caused by the production or consumption of a good or service .

During market failures the government usually responds to varying degrees. Possible government responses include:

• legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
• direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.
• taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
• subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.
• tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
• extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for polluting certain areas.
• advertising – encourages or discourages consumption.
• international cooperation among governments – governments work together on issues that affect the future of the environment.

7.1.2: Causes of Market Failure

Learning Objective

Explain some common causes of market failure

Key Points

• A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.
• Due to the structure of markets, it may be impossible for them to be perfect.
• Reasons for market failure include: positive and negative externalities, environmental concerns, lack of public goods, underprovision of merit goods, overprovision of demerit goods, and abuse of monopoly power.

Key Terms

free rider

One who obtains benefit from a public good without paying for it directly.

public good

A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.

monopoly

A market where one company is the sole supplier.

Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.

In order to fully understand market failure, it is important to recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result, most markets are not successful and require forms of intervention.

Reasons for market failure include:

• Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service . A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
• Environmental concerns: effects on the environment as important considerations as well as sustainable development.
• Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the free rider problem.
• Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
• Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
• Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.

When a market fails, the government usually intervenes depending on the reason for the failure.

7.1.3: Introducing Externalities

Learning Objective

Give examples of externalities that exist in different parts of socity

Key Points

• In regards to externalities, the cost and benefit to society is the sum of the benefits and costs for all parties involved.
• Market failure occurs when the price mechanism fails to consider all of the costs and benefits necessary for providing and consuming a good.
• In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not feasible. When externalities exist, it is possible that the particular industry will experience market failure.
• In many cases, the government intervenes when there is market failure.

Key Terms

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

intervene

To interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder an action.

In economics, an externality is a cost or benefit resulting from an activity or transaction, that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit . An example of an externality is pollution. Health and clean-up costs from pollution impact all of society, not just individuals within the manufacturing industries. In regards to externalities, the cost and benefit to society is the sum of the value of the benefits and costs for all parties involved.

Negative vs. Positive

A negative externality is an result of a product that inflicts a negative effect on a third party . In contrast, positive externality is an action of a product that provides a positive effect on a third party.

Externalities originate within voluntary exchanges. Although the parties directly involved benefit from the exchange, third parties can experience additional effects. For those involuntarily impacted, the effects can be negative (pollution from a factory) or positive (domestic bees kept for honey production, pollinate the neighboring crops).

Economic Strain

Neoclassical welfare economics explains that under plausible conditions, externalities cause economic results that are not ideal for society. The third parties who experience external costs from a negative externality do so without consent, while the individuals who receive external benefits do not pay a cost. The existence of externalities can cause ethical and political problems within society.

In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not financially possible. Governments may step in to correct such market failures.

7.1.4: Externality Impacts on Efficiency

Learning Objective

Analyze the effects of externalities on efficiency

Key Points

• An economically efficient society can produce more goods or services than another society without using more resources.
• An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.
• Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole.
• In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.
• In order for economic efficiency to be achieved, one defining rule is that no one can be made better off without making someone else worse off. When externalities are present, not everyone benefits from the production of the good or service.

Key Terms

efficient

Making good, thorough, or careful use of resources; not consuming extra. Especially, making good use of time or energy.

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Economic Efficiency

In economics, the term “economic efficiency” is defined as the use of resources in order to maximize the production of goods and services. An economically efficient society can produce more goods or services than another society without using more resources.

A market is said to be economically efficient if:

• No one can be made better off without making someone else worse off.
• No additional output can be obtained without increasing the amounts of inputs.
• Production proceeds at the lowest possible cost per unit.

Externalities

An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit . Externalities are either positive or negative depending on the nature of the impact on the third party. An example of a negative externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution. An example of a positive externality would be an individual who lives by a bee farm. The third parties’ flowers are pollinated by the neighbor’s bees. They have no cost or investment in the business, but they benefit from the bees.

Externalities and Efficiency

Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole. In the case of negative externalities, third parties experience negative effects from an activity or transaction in which they did not choose to be involved. In order to compensate for negative externalities, the market as a whole is reducing its profits in order to repair the damage that was caused which decreases efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social welfare is improved, but the providers of the benefit do not make any money from the shared benefit. As a result, less of the good is produced or profited from which is less optimal society and decreases economic efficiency.

In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional funds in order to make up for damages incurred. Benefits are also internalized because they are viewed as goods produced and used by third parties with no monetary gain for the market. Internalizing costs and benefits is not always feasible, especially when the monetary value or a good or service cannot be determined.

Externalities directly impact efficiency because the production of goods is not efficient when costs are incurred due to damages. Efficiency also decreases when potential money earned is lost on non-paying third parties.

In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.

6.1: Price Elasticity of Demand

6.1.1: Defining Price Elasticity of Demand

Learning Objective

Define the price elasticity of demand.

Key Points

• The PED is the percentage change in quantity demanded in response to a one percent change in price.
• The PED coefficient is usually negative, although economists often ignore the sign.
• Demand for a good is relatively inelastic if the PED coefficient is less than one (in absolute value).
• Demand for a good is relatively elastic if the PED coefficient is greater than one (in absolute value).
• Demand for a good is unit elastic when the PED coefficient is equal to one.

Key Terms

Unit Elastic

Demand for a good is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price.

elastic

Demand for a good is elastic when a change in price has a relatively large effect on the quantity of the good demanded.

inelastic

Demand for a good is inelastic when a change in price has a relatively small effect on the quantity of the good demanded.

The price elasticity of demand (PED) is a measure that captures the responsiveness of a good’s quantity demanded to a change in its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all other determinants of demand are held constant.

The formula for the coefficient of PED is:

The law of demand states that there is an inverse relationship between price and demand for a good. As a result, the PED coefficient is almost always negative. However, economists tend to ignore the sign in everyday use. Only goods that do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.

The numerical values for the PED coefficient could range from zero to infinity. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a less than proportional effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one. In this case, changes in price have a more than proportional effect on the quantity of a good demanded.

A PED coefficient equal to one indicates demand that is unit elastic; any change in price leads to an exactly proportional change in demand (i.e. a 1% reduction in demand would lead to a 1% reduction in price).

A PED coefficient equal to zero indicates perfectly inelastic demand. This means that demand for a good does not change in response to price .

Finally, demand is said to be perfectly elastic when the PED coefficient is equal to infinity. When demand is perfectly elastic, buyers will only buy at one price and no other .

6.1.2: Measuring the Price Elasticity of Demand

Learning Objective

Calculate the own-price elasticity of demand

Key Points

• PED captures the change in quantity demanded in response to a change in the good’s own price (as opposed to the price of some other good).
• The formula for price elasticity yields a value that is negative, pure, and ranges from zero to negative infinity.
• The result provided by the formula will be accurate only if the changes in price and quantity demanded are small.

Key Terms

Cross-price elasticity of demand

Measures the responsiveness of the demand for a good to a change in the price of another good.

Own-price elasticity of demand

Responsiveness of quantity demanded to a change in the good’s own price

The price elasticity of demand (PED) captures how price-sensitive consumers are for a given product or service by measuring the responsiveness of quantity demanded to changes in the good’s own price. This is in contrast to measuring the responsiveness of the good’s demand to a change in price for some other good (a complement or substitute), which is called the cross-price elasticity of demand. The own-price elasticity of demand is often simply called the price elasticity.

The following formula is used to calculate the own-price elasticity of demand:

The formula above usually yields a negative value because of the inverse relationship between price and quantity demanded . However, economists often disregard the negative sign and report the elasticity as an absolute value. For example, if the price of a good increases by 5 percent and the quantity demanded decreases by 5 percent, then the elasticity at the initial price and quantity is -5%/5% = -1. This number is likely to be reported simply as 1.

There are a few other important points to note about the coefficient value provided by this formula. First, the elasticity coefficient is a pure number, meaning that it does not have units of measurement associated with it. Second, the coefficient value can range from zero to negative infinity. Finally, the result provided by the formula will be accurate only when the changes in price and quantity are small. The result will be less accurate when the changes are large.

Since PED is based off of percent changes, the starting nominal quantity and price matter. At low prices and high quantities, the PED is therefore more inelastic. For example, a drop in the price of $1 from a starting price of $100 is a 1% drop, but if the starting price is $10, it is a 10% drop. Similarly, at high prices and low quantities, PED is more elastic .

6.1.3: Interpretations of Price Elasticity of Demand

Learning Objective

Describe the relationship between price elasticity and the shape of the demand curve.

Key Points

• Elastic PED can be interpreted as consumers being very sensitive to changes in price.
• Inelastic PED can be interpreted as consumes being insensitive to changes in price.
• Firms use PED to figure out how to change their prices in order to increase revenue.
• PED varies along a straight demand curve.

Key Term

Price elasticity of demand

The percent change in quantity demanded due to a 1% change in price.

The price elasticity of demand (PED) is a measure of the responsiveness of the quantity demanded of a good to a change in its price. It can be calculated from the following formula:

When PED is greater than one, demand is elastic. This can be interpreted as consumers being very sensitive to changes in price: a 1% increase in price will lead to a drop in quantity demanded of more than 1%.

When PED is less than one, demand is inelastic. This can be interpreted as consumers being insensitive to changes in price: a 1% increase in price will lead to a drop in quantity demanded of less than 1%.

The effect of price changes on total revenue PED may be important for businesses attempting to distinguish how to maximize revenue For example, if a business finds out its PED is very inelastic, it may want to raise its prices because it knows that it can sell its products for a higher price without losing many sales. Conversely, if a business finds that its PED is very elastic, it may wish to lower its prices. This would allow the business to dramatically increase the number of units sold without losing much revenue per unit.

There are two notable cases of PED. The first is when demand is perfectly elastic. Perfectly elastic demand is represented graphically as a horizontal line . In this case, any increase in price will lead to zero units demanded.

The second is perfectly inelastic demand. Perfectly inelastic demand is graphed as a vertical line and indicates a price elasticity of zero at every point of the curve. This means that the same quantity will be demanded regardless of the price.

Since PED is measured based on percent changes in price, the nominal price and quantity mean that demand curves have different elasticities at different points along the curve. Elasticity along a straight line demand curve varies from zero at the quantity axis to infinity at the price axis . Below the midpoint of a straight line demand curve, elasticity is less than one and the firm wants to raise price to increase total revenue. Above the midpoint, elasticity is greater than one and the firm wants to lower price to increase total revenue. At the midpoint, E1, elasticity is equal to one, or unit elastic.

6.1.4: Determinants of Price Elasticity of Demand

Learning Objective

Explain how a good’s price elasticity of demand may be different in the short term than in the long term

Key Points

• A good with more close substitutes will likely have a higher elasticity.
• The higher the percentage of a consumer’s income used to pay for the product, the higher the elasticity tends to be.
• For non-durable goods, the longer a price change holds, the higher the elasticity is likely to be.
• The more necessary a good is, the lower the price elasticity of demand.

Key Term

Substitute Good

A good that fulfills a consumer need in a way that is similar to another good.

The price elasticity of demand (PED) is a measure of how much the quantity demanded changes with a change in price. The PED for a given good is determined by one or a combination of the following factors:

• Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity. When several close substitutes are available, consumers can easily switch from one good to another even if there is only a small change in price . Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.
• Proportion of the purchaser’s budget consumed by the item: Products that consume a large portion of the purchaser’s budget tend to have greater elasticity. The relative high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes. In contrast, demand will tend to be inelastic when a good represents only a negligible portion of the budget.
• Degree of necessity: The greater the necessity for a good, the lower the elasticity. Consumers will attempt to buy necessary products (e.g. critical medications like insulin) regardless of the price. Luxury products, on the other hand, tend to have greater elasticity. However, some goods that initially have a low degree of necessity are habit-forming and can become “necessities” to consumers (e.g. coffee or cigarettes).
• Duration of price change: For non-durable goods, elasticity tends to be greater over the long-run than the short-run. In the short-term it may be difficult for consumers to find substitutes in response to a price change, but, over a longer time period, consumers can adjust their behavior. For example, if there is a sudden increase in gasoline prices, consumers may continue to fuel their cars with gas in the short-run, but may lower their demand for gas by switching to public transportation, carpooling, or buying more fuel-efficient vehicles over a longer period of time. However, this tendency does not hold for consumer durables. The demand for durables (cars, for example) tends to be less elastic, as it becomes necessary for consumers to replace them with time.
• Breadth of definition of a good: The broader the definition of a good, the lower the elasticity. For example, potato chips have a relatively high elasticity of demand because many substitutes are available. Food in general would have an extremely low PED because no substitutes exist.
• Brand loyalty: An attachment to a certain brand (either out of tradition or because of proprietary barriers) can override sensitivity to price changes, resulting in more inelastic demand.