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MECO 6303

• My name is Stan Liebowitz


• Pronounced: Lee – bow –wits
Course Syllabus for Business Economics MECO 6303

• Reading list:
Professor Contact Information
Professor Stan Liebowitz; Office: SM 3.801; Telephone: 972-883-2807
email: liebowit@utdallas.edu; homepage: www.utdallas.edu/~liebowit/ ;
Office Hours: T 3pm or by appointment
Course Pre-requisites
Calculus can be helpful but plays only a very minor role in the material. I do not assume that you
have prior knowledge of economics a lthough most students have had prior courses.

• Web Page http://www.utdallas.edu/~liebowit/


Course Description
This is basically a course in microeconomic analysis. That means that it focuses on individual
markets, not on the national economy as a whole. The emphasis will be on applied fundamental
aspects of economic analysis.
An older and somewhat different version of this course was taught as an online course through
the UT Telecampus. There are powerpoint slides for the lectures with audio that is matched to the
slides. If you miss a class, or wan t to double check on what happened (e.g., foreign students who
want to replay the lecture) you can download the slides.

Student Learning Objectives/Outcomes


Understand how markets work and be able to apply this knowledge to make better business
decisions.

Required Textbooks and Materials


Main Text: Business Economics Landsburg/Mankiw. UTD Edition, 2006. Notes
for the course, old exams, and so forth can be found on my home page.

Assignments & Academic Calendar


Approximate schedule:
Weeks 1-2 (August 22, 29): Chapter 14 (477-498), Chapter 1 (1-32), 4.4 (86-91). Topics:
Assumptions, Opportunity Cost, Scarcity, Economic Goods, Production Possibility
curves, Demand and Supply, equilibrium, Elasticiticity. Illustrations: When Should a
firm raise its price? Elasticity for firm and industry.
Weeks 3-4 (September 5, 12): Chapter 8.1, 8.2 (229-249), the meaning of price and
value, Economic Efficiency, consumer and producer surplus; maximizing behavior
of firms. Illustrations: Diamond-water paradox, costs of theft, and Comparable
Worth
Week 5-6 (Sept 19, 26): Chapter 8.3 (249-263) who pays for a tax?, impact of price
controls.. Illustrations: Labor unions; farm price supports
Week 7 (October 3): Midterm,
Week 8-9 (October 10,17). Chapters 5, 6.1 (121-155) Topic: Production, Costs,
equimarginal principal, Competition and Monopoly. Illustrations: Impact of Sunk
costs on firm behavior; Long run and short run effects of price changes. 1
Basics of Course
What is economics about? Micro economics.?
– Current def: whatever economists study - not a very
useful definition of a discipline.
– Historical and more useful definition: allocation of scarce
goods for competing ends.
– In reality, it focuses mainly on how free markets,
consisting of voluntary participants, operate.
– It can also be used to analyze other non-market forms of
production and distribution.

2
What Types Of Questions Do Micro-
economists Try To Answer?
– What pricing strategies allow firms to maximize
profits?
– When should a firm produce a product in house, and
when should it purchase from outside vendors?
– Can a firm pass on a tax? What is the effect of taxes on
the profit maximizing behavior of firms?
– What is the impact of airline deregulation?
– What is the optimal amount of pollution?
– Do women get paid less then men? Why?

3
Assumptions In Economics
 Economics as Science- abstract model
simplifies, requires simplifying assumptions.
 Major actors: consumers and producers.
 Economic actors are rational: voluntary actions
are only undertaken when they are expected to
make people better off.
 Consumers try to maximize happiness (utility)
 Producers try to maximize profits
 Our wants are greater than our abilities to fulfill
them (scarcity)
4
Assumptions: Economic Actors
Are Rational
1.Voluntary actions are only undertaken when
they are expected to make people better off.
2.Even people in asylums act economically
rationally in most instances, according to
experiments.

5
Assumptions: People Try to
Maximize Happiness (Utility)

1. This does not imply selfish behavior.


2.If giving to others is what makes you
happy, that is what maximizes your utility.
3.Rationality in this case implies that you
wish to maximize your giving to others, not
to just have the money wasted.

6
Assumptions: Firms Try to
Maximize Profits
1. Private for-profit firms are supposed to work for their
shareholders, who usually are interested in stock price
appreciation, which results from profit maximization.
2. But, many organizations are not for-profit firms –
clubs, government, charities, and so forth. But even if
they don’t maximize profits, they still should be
interested in efficiency, and also in what happens to
the demand for their product when conditions change.
3. This assumption leads to good predictions about firms
behavior, so it doesn’t need to be always true.

7
Assumptions: Scarcity
1. Our wants are greater than our abilities to fulfill
them (scarcity). Factually correct throughout
history.
2. If we do not have scarcity, then everyone has as
much of all products as they want. There would be
no trading, no markets, and no prices.
3. The problem of scarcity could in principle be
‘solved’ either by increasing output or decreasing
wants. Some religious or philosophical
movements work on decreasing wants; Capitalism
tends to go the increasing output route. ‘Problem’
will never be solved.

8
Some Basic Definitions
• Goods: things people want :
• Economic goods: goods that are scarce.
– Question- must goods have a positive price? Are all
positive priced items economic goods?
• Opportunity cost: what you give up when you
engage in an activity. Measured as the value of
your next best activity (the activity you would
have engaged in if you didn’t choose the first
activity). Example: opportunity cost of going to
college.

9
Production Possibility Curves.

– Illustrates concepts of efficiency, scarcity,


opportunity cost.
– Assumes society with two goods (perhaps
Robinson Crusoe with fish and fruit).
– Indicates combinations of each good that can be
produced.
– Example for farmer: amount of two possible
commodities he might grow.

10
Two questions
• A financial analyst on TV said the impacts
of the hurricane on the country wouldn’t be
so bad since most of the damaged property
was insured. Is this a correct statement?
• Oil prices rise when a hurricane is predicted
to impact oil rigs and refineries. What is
that about? Is it ‘profiteering’?

11
Production Possibility Curve
slope of line indicates tradeoff
in ability to produce different types of
A goods
Fruit

B Fish B1
12
No Specialized Resources-PPC Straight

2 Production Possibility Curves under


A 2 scenarios

slope of line indicates tradeoff


in ability to produce different types of
goods
Fruit

B Fish B1
13
Specialized Resources- PPC Curved
Line
Production Possibility Curve
A
Fruit

Fish B

14
Demand
• Defined for a single market – particular product
and particular consumers.
• Each unit of the good is identical to all other
units.
• Represents highest price consumers are willing to
pay, and quantity they want at a given price.
• Time dimensions
• Holds everything but price and quantity constant
(income, tastes, price of other goods, gravity,
Y2k problems….)
• law of demand – demand slopes down – based on
empirical observation.
• movement along versus movement on

15
P
Demand

16
Demand
• Defined for a single market – particular product
and particular consumers.
• Each unit of the good is identical to all other
units.
• represents highest price consumers are willing to
pay.
• Holds everything but price and quantity constant
(income, price of other goods, gravity, Y2k
problems….)
• time dimensions
• law of demand – demand slopes down – based on
empirical observation.
• movement along versus movement on

17
Demand for RNE*
P1

P2

PWLM

Q1 Q2 QE
*“Rethinking the Network
Economy”
18
Shift in Demand for RNE
P
Perhaps a positive review in the
Economist leads to an
increase in demand curve

D1

19
Price Elasticity Of Demand

• def: percentage change in quantity divided


by percentage change in price
• (ΔQ/Q)/(ΔP/P) or (ΔQ/ΔP) (P/Q)
• measure of responsiveness
1. If Elasticity is >1 known as elastic (responsive
customers)
2. If Elasticity is =1 ; unit elastic
3. If Elasticity is <1; inelastic (less responsive customers)
4. Infinite and zero elasticity

20
Illustrations of elasticity
D with zero elasticity
P

D with infinite elasticity

Q
21
Elasticity and TR
• When elasticity is greater than 1 (elastic)
increases in price lead to decreases in
revenue and vice-versa
• When elasticity is equal to 1, changes in
price lead to no change in revenues
• When elasticity is less than 1 (inelastic)
increases in price lead to increases in
revenue.

22
• Using Wall Street Journal; NY Times; Wash Post.
• In early 1930, shortly after the stock market crash, what
were the current conditions and what was being said about
the economy by economists, financial pundits, and the
media in general? What was predicted for the future?
• In early 1932, what were the current conditions and what
was being said about the economy by economists,
financial pundits, and the media in general? What was
predicted for the future?
• 1982 what were the current conditions and what was being
said about the economy by economists, financial pundits,
and the media in general? What was predicted for the
future? What were comparisons to the great depression?
• Same for 2008,9

23
Implications of Elasticity

• If Elasticity is <1, firm can always increase


Profit by increasing price (revenues increase and
costs decrease because output decreases)
• If Elasticity =1, firm can always increase profit
by increasing price
• If Elasticity>1 firm can not necessarily increase
its profits by a change in price.
• Thus firms that maximize profits must have
elasticities >1.
• Example of VideoTape Pricing History
Demonstrates Importance of knowing elasticity.

24
Long Run and Short Run Elasticities

• Elasticity is greater in the long run


– consumers have more time to react to price
changes
– For example, if the price of gasoline goes up,
consumers at first can try to reduce the amount
they drive, but this is often difficult. Over time,
they can by more fuel efficient cars or move
closer to their work.

25
P

new higher price

D after consumers
original price have time to adjust to price change

D before consumers
have much time to adjust

amount consumed amount consumed


after longer period after short period Q
of adjustment\ of adjustment\
26
Supply:
• Represents minimum price sellers require to
voluntarily provide the product.
• assume it slopes up for now. In reality it
depends on the cost conditions of the firm.
• Same assumptions as with demand:
everything else is held constant.

27
Meaning of Supply
S

P2 minimum price firm is willing


to accept. Should be equal to the
cost of producing the additional output

P1

Q1 Q2

28
Long Run/Short Run Oil?
Ss SL
P2

P1

Q1 Q2007 Q2011

29
Meaning of (Stable)
Equilibrium
• A situation such that the variables of interest
remain at rest until disturbed by some outside
force. For stability, the variables must return to the
equilibrium after being disturbed by some force.
• Gravity and the resting place of tennis balls.
• We assume many producers and consumers to
start the analysis.
• Surplus and shortages take the place of gravity in
these markets.

30
Illustration of Supply Demand
Equilibrium S
Surplus
P1

Pe

P2
Shortage
D

Q1 Qe Q2

31
Examples of changes in
Equilibrium
• Supply and Demand analysis assumes that market
moves from one equilibrium position to another.
• Shifts in D or S alter equilibrium. For example,
how would you expect the price and quantity of
Pepsi Cola to change when:
– Price of Coca Cola falls.
– Price of fructose goes up
– Surgeon general warns of soda threat to health.
– Winter changes to summer.
– TV ads for cola banned
1.Answers on next slide.

32
Changing Equilibrium
S1
2
P2
4
S2
P4
1
P1
D2
3
P3
D1

Q1 Q2 Q3 Q4

33
Lesson 3

1. The Meaning of Price, Value, and Economic


Efficiency.
2. Consumer and Producer Surplus.
3. Diamond Water Paradox.
4. Efficiency of Competitive Market equilibrium
5. Efficiency Implications of Price Controls and
Taxes.

34
Area under demand = total value of
that output

1
P1
2 3
Pe

4 5
D

Q1 Qe
Total Value of Q1 Units= 1+2+4 Total Value of Qe Units= 1+2+3+4+5
35
Area under supply = total cost (net of fixed costs)

P1

Pe

Q1 Qe
Increase in Total Cost when output increases from Q1 to Qe =1+2

36
What about Comparable Worth
• An issue in J Roberts Supreme Court
nomination—he suggested it was ‘anti-
capitalist’. Was he correct?
• What is comparable worth?
• What arguments are given by its defenders?
• What are the arguments if its detractors?

37
Role of Price
• Mechanism for Allocating Goods in
Markets: willingness to pay.
• What are alternative mechanisms?
– First come, first served
– Strongest and most Powerful
– Random Selection
– Friends and relatives

38
Meaning of Price
• What is the meaning of price when it is
used to allocate goods? What does a high,
or a low, price tell us about the product?
• Diamond-Water paradox: why are
diamonds expensive when water is so
cheap?

39
Meaning of Price (diamond-water
Paradox

Average Value Water


PA

Dwater
Swater
Pw

Total Value of Water is entire area Qw


Average value of water is mid value of water used. So what does price measure?

40
Meaning of Price (continued)

Sdiamonds

Pd Average Value Diamonds

Ddiamonds

QDiamonds
value of diamonds

41
Meaning of Price (continued)

Sdiamonds
Average Value Water

Pd Average Value Diamonds

Dwater
Swater
Pw
Ddiamonds
QDiamonds Qw
Total Value of Water is greater than value of diamonds
Average value of water is also greater. So what does price measure?

42
Meaning of Price in Markets
• Price Measures the value of the last unit
sold, or marginal unit.
• Price, therefore, is unrelated to average or
total value of a product.
• Salary, which is the price of labor, need not
be related to the “value” of the worker or
the work.
• How can one group of workers generate
higher wages for themselves?

43
What about Comparable Worth
• What can we say about it now?

44
WSJ on Economics Wage Market
• economics job market.pdf

45
46
47
Consumer and Producer
Surplus
• Consumer surplus is the difference between
the price paid and the higher price that
consumers would have been willing to pay
for the product.
• Producer surplus is the difference between
the payment received and the minimum
payment that producers would have
accepted.

48
Consumer and Producer Surplus

P1
1
3
Pe
4
2

Q1 Qe
CS = 1 PS = 2 DWL = 3+4
49
Price Controls
• Artificial Government Restraint of Price
• Can be a floor, or a ceiling
• Popular during wars, or in non-market
economies
• Simple view: distortion in output
• More complete view: wrong consumers get
product.

50
Price Floor at P1

1
P1
2 7
3
Pe 8
4 5

P2
6

Q1 Qe Q2
CS Before Price Control= 1+2+3 CS After Price Control = 1
Ps Before Price Control = 4+5+6 PS After Price Control =
2+4+6 51
Price Floor at P1 AND wrong producers

1
P1
2 7
8 3
Pe
4 5

Q0 Q1 Qe Q2
CS Before Price Control= 1+2+3+8 CS After Price Control = 1
Ps Before Price Control = 4+5+6 PS After Price Control = 2
52
Rent Control (Price Ceiling)

2 3
Pe
4 transfer 5
7
Prc
6

Q1 Qe Q2
CS Before Price Control= 1+2+3 CS After Price Control = 1+2+4
Ps Before Price Control = 4+5+6 PS After Price Control = 6
53
Government guarantees price at P1 and and sells output at
market clearing price
S
1
P1
2 7
3
Pe 8
4 5
6 10
Pclearing
9 D
Revenue from Consumers
Q1 Qe Q2
CS After Price Control = 1+2+3+4+5+6+10
CS Before Price Control= 1+2+3 PS After Price Control = 2+3+4+5+7+9
Ps Before Price Control = 4+5+9 Taxpayers = 2+3+4+5+6+7+8+10
54
Government guarantees price at P1 and burns any output it
can not sell at that price

1
P1
2 7
3
Pe 8
4 5
6 10
Pclearing
9 11 12

Q1 Qe Q2
CS Before Price Control= 1+2+3 CS After Price Control = 1
Ps Before Price Control = 4+5+9 PS After Price Control = 2+3+4+5+7+9
Taxpayers = 3+5+6+7+8+10+11+12
55
Price Gouging
• How would it be defined?
• Should it be illegal?
– What are the plusses and minuses?
– What are the two roles that price plays in the
economy?
– What impact does it have on distant future
behavior?
• Which is better: windfall profits tax, or
price gouging law?
56
Who Pays For A Tax?
• Terminology in Book is not exactly correct.
• Two forms of analysis: decreasing supply
or decreasing demand.
• Tax burden is shared depending on slope of
both curves.

57
Tax from consumer’s vantage
St
S
Price Paid by Consumer

P1
}amount of tax
Pe

Q1 Qe

58
Tax from producer’s vantage
S
Price received by Producer

P1
Pe
P0
}amount of tax

Q1 Qe
Dt

59
Price Paid by Consumer
Distortion from Tax St S

P1
}amount of tax
Pe
P0

Q1 Qe

60
Instance of Tax borne by Producer
P S1
S

P1
Price Paid by

D with infinite elasticity


Consumer

Q1 Q2 Q
61
Instance of Tax borne by Consumer
P D with zero elasticity S1
S

P1
Price Paid by

P0
Consumer

Q0 Q
62
Instance of Tax borne by Consumer
P

S with infinite elasticity


Price Received by

P0
Producer

D
Dt

Q1 Q0 Q
63
Instances of Tax borne by producer
P S with zero elasticity

P0
Price Received by

P1
Producer

Dt D

Q0 Q
64
Firms: Legal Forms

• Corporation and Proprietorships.


• Corporations which use stock have two advantages:
limited liability and transferability of ownership.
Disadvantages: the corporate income tax and costs
of incorporation.
• Proprietorships have unlimited liability and can not
be transferred. They do not have to pay corporate
income tax, however. (New hybrid forms).
• Firms in our theory produce output in order to
maximize profit. Marginal Analysis will help us
understand profit maximization.

65
Marginal Analysis

• Relationship between Total, Average, and


Marginal Magnitudes?
• You already have experience – you have been
calculating your ‘average’ since elementary school.
Each test is a ‘marginal’ score.
• Useful in Understanding Profit Maximization.
• Total Revenue is defined as Price multiplied by
Quantity.
• MR is the change in TR when another unit is
sold.

66
Marginal Analysis - Demand

1. Note Relationship between elasticity


and Marginal Revenue.
Quantity Total Marginal Arc Elasticity (
Price Demanded Revenue Revenue average Q a
75 1 75 75
60 2 120 45 3
48 3 144 24 1.8
35 4 140 -4 0.9121
26 5 130 -10 0.7531
17 6 102 -28 0.4343
11 7 77 -25 0.3590
6 8 48 -29 0.2267
2.5 9 22.5 -25.5 0.1429
1 10 10 -12.5 670.1228
More Marginal Analysis
Quantity Total Marginal Arc Elasticity (
Price Demanded Revenue Revenue average Q a
15 60 900
14 66 924 4.0000 1.3810
13 74 962 4.7500 1.5429
12 83 996 3.7778 1.4331
11 96 1056 4.6154 1.6704
10 110 1100 3.1429 1.4272
9 130 1170 3.5000 1.5833
8 165 1320 4.2857 2.0169
7 190 1330 0.4000 1.0563
6 225 1350 0.5714 1.0964
5 250 1250 -4.0000 0.5789
4 270 1080 -8.5000 0.3462
3 285 855 -15.0000 68 0.1892
Marginal Costs and Profit

Marginal Margin
Quantity Marginal Revenue Fertiliz
Used Output Product Product Total Revenue Total Cost Cost
0 10 120 0
1 15 5 60 180 150 150
2 25 10 120 300 300 150
3 42 17 204 504 450 150
4 58 16 192 696 600 150
5 73.5 15.5 186 882 750 150
6 87 13.5 162 1044 900 150
7 100 13 156 1200 1050 150
8 110 10 120 1320 1200 150
9 115 5 60 1380 1350 150
Fertilizer
Output Price Price
69
12 150
Profit Maximization
• Marginal Analysis

• Calculus leads to MR=MC conclusion;
• Alternatives to Calculus
• AR = demand curve; marginal revenue curve
must lie below demand curve
• Profit maximized when TR-TC is greatest
(vertical difference)
• this implies slope of TR = slope of TC which
means that MR=MC

70
Some simple Calculus

π = TR − TC
∂π ∂ TR ∂ TC
= − = MR − MC
∂ Q ∂ Q ∂ Q
∂π
Max π ⇒ = 0
∂ Q
so MR = MC
Also
TR = P • Q
∂ TR ∂ Q ∂ P
= P • + Q •
∂ Q ∂ Q ∂ Q
Q ∂ P 1
= P ( 1 + • ) = P ( 1 − )
P ∂ Q ε
where ε = elasticity of demand
The Intuition

Marginal Revenue = ∆ in Revenue when Q + 1


units are sold instead of Q units.
Last Unit brings revenues = price of last unit +
∆ P •Q for Q units which go down in price.
MR is less than P because of this ∆ P effect.
So MR = P - (∆ P •Q) where ∆ Q = 1
∆ P •Q 1
MR = P(1 - =
) or MR P (1 − )where
∆ Q •P ε
ε = elasticity of demand
Profit Maximization

TC

TR

max Rev D

q* Output
Max Profit MR
73
Another Angle
AC
MC

P*

Profits

D
q*

MR
74
The Firm's Inputs And Costs

• Fixed And Variable Costs.

– Fixed Costs: Costs that do not change when output


changes.

– Variable costs: Costs that do change when output changes.

• Long Run and Short run.

– Long Run: A long enough period of Time such that all costs
are variable

– Short Run: A period of time such that at least one input


(cost) is fixed.

75
TC=FC+VC; TC/Q = FC/Q +VC/Q which is ATC=
AFC +AVC

Fixed and Variable Costs


P AC
AVC

Total Fixed

Total Fixed AFC

q1 Q

76
Irrelevance of Fixed Costs if you stay in
Business
• Changes in Fixed costs don't alter profit
maximizing P and Q because fixed Costs
don’t impact Marginal Costs.
• Fixed Costs do impact profits, and may cause firm
to decide the leave industry.
• Same with lump sum taxes.

77
Impact of Fixed Costs on Profit
AC2
AC1
MC

P*

Profits2
AC*
Profits1

AC**
D

q MR
* 78
Economies and
Diseconomies of Scale
• What does this imply about the AC curve?
• defined simply as whether or not AC rises or falls

• long run AC Vs. short run AC

• Distinguishing between economies of scale and


improvements in technology very important.
• Can firms have diseconomies of scale but industries have
economies of scale?

79
Ec
no o
mi
es
fS o
ca
le

D
Sc isec
al on
e o m
ie
s of
AC

80
Long Run AC
LRAC
MC1 SRAC1
SRAC3
MC3

MC2 SRAC2

Q1
81
Do average costs fall over time, or is average cost downward sloping?

AC1990
AC1991

P* AC1992

AC1993
AC1994

q
*
82
Can firms have diseconomies of scale but
industries have economies of scale?
• External Effects – Industry output effects
the costs of individual firms.
• Positive External Effects can cause AC for
industry to fall even though each firm has
upward sloping AC curve.
• Used to explain apparent decreasing costs
but multiple firms in industry.

83
• Midterm goes only up to this point

84
perfect competition
• Many participants, buyers and sellers.
• Sellers are infinitesimally small.
• Homogeneous products.
• Free entry and exit.
• Perfect information.

85
1. Competitive Firms
• a. In the short run almost horizontal demand.

• b. supply curve of firm is the MC above AVC.

• c. Industry supply horizontal sum of firms mcs


(the sum of their output at a price).

86
Short Run Profit Maximizing solution for a competitive firm; MC
seems to be the supply curve.
MC AC1

P* D = MR
Profits
ACq*

q
*
87
supply curve of firm is the mc above avc
AC
P
S
AVC
MC

p3

p2

p1

AFC
q1 q2 q3 Q

88
supply curve of industry is the horizontal sum of each individual
firm’s supply.

Firm A Firm B Firm C


s Industry
s
s
S

p1
p2

qa1 qa qb qc Q=qa1 Qa+b+c

89
Competitive Equilibrium
• a. fixed number of firms in SR!! no entry or exit
allowed; therefore, industry supply can not change
• b. for firm: d=mr=p=mc
• c. In longer run, profits draw entry of firms,
increasing industry supply, lowering price and
profits down to zero; negative profits cause exit,
decreasing supply, raising price and bring profit
back to zero.

90
This represents a competitive industry in a short run equilibrium.
Meaning that until entry or exit can occur, nothing will change since
the price equalizes quantity demanded and supplied. But the typical
firm earns profits (right hand picture) and entry will increase industry
supply in long run, lowering price.

Competitive Industry "Representative" Firm in Industry


AC
P P

p1

Q1 q
91
This represents a competitive industry in a long run equilibrium (price
P3). Once achieved, nothing will change since the price equalizes
quantity demanded and supplied. Since the typical firm earns no
profits (right hand picture) no further entry or exit will occur.

Competitive Industry "Representative" Firm in Industry


S1 AC
P S2 P
S3

p1
p2
p3

Q 1 Q2 Q3 q q1
92
Efficiency of Competition
• a. no deadweight losses-- i.e. on prod poss frontier

• b. each firm at bottom of ac--- seems good, but actually


irrelevant for economic efficiency

• c. consumers vote with dollars. Popular products make


money, drawing entry until enough of the product is
produced. The drive for profits makes firms efficient and
efficient firms drive out inefficient firms (Darwin and
Economics).

93
The right hand diagram represents the typical firm in long run equilibrium.
The firm is at the bottom of the AC, meaning that costs are minimized.
Industry has zero deadweight loss.

Competitive Industry "Representative" Firm in Industry

AC
P P

CS=1 PS=2 q
94
Efficiency of Competition (rpt)
• a. no deadweight losses-- i.e. on prod poss frontier

• b. each firm at bottom of ac--- seems good, but actually


irrelevant for economic efficiency

• c. consumers vote with dollars. Popular products make


money, drawing entry until enough of the product is
produced. The drive for profits makes firms efficient and
efficient firms drive out inefficient firms (Darwin and
Economics).

95
Competitive Markets that aren’t
• Example of taxi-cab medallions
• Television station licenses.
• Medical doctors
• Many, many, more.

96
Long Run Supply: No External
Effects
• Competitive industry must have constant
costs in this case.
• Long run industry supply must be
horizontal at the bottom of the AC of
representative firm.
• Long run industry output changes only
through entry and exit of new firms.

97
The typical firm in long run equilibrium at the bottom of its AC,
meaning that costs are minimized. With no external effects, each firm
always produces ‘q’ and long run industry output only changes when
the number of firms changes.

Competitive Industry "Representative" Firm in Industry


AC
P P

R S
S
P1
LRS

q
98
Long Run Supply with External
Effects
• Competitive industry may have increasing
or decreasing costs in this case.
• Long run industry supply changes only as
the bottom of the AC of representative firm
changes.

99
AC for representative firm as industry output Q increases.
P AC (Q1)

AC (Q2)

AC (Q3)

100
Long run supply in decreasing cost competitive industry
P AC (Q1)
AC (Q2)
AC (Q3)

LRS

Q
Q2 Q3
Q1
101
Monopoly Vs. Competition
• Monopoly versus competition (smaller q, higher p)
• Imposing a tax on a monopolist similar to competition in
that producer still bears part of it.
• Price controls and monopoly ...a case where controls may
increase efficiency.
• Price discrimination.
• The tradeoff associated with patents and copyright -
deadweight loss in consumption versus possible new
products.

102
Monopoly charges higher price, produces smaller quantity.
Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to
producer from consumer

MC
S

Pm
3 4 1
Pc
2

Qm Qc
MR
103
Tax on Monopoly: price goes up by less than tax, so burden of tax is
still shared. Monopolist tends to pay bigger share than would
competitors. Deadweight loss grows.

MC+t

P2
MC
P1

t
a
x
D

Q2 Q1
MR

104
A Price Control on a monopolist. Since p cannot go above Pcontrol the
MR is equal to Pcontrol , output may increase (if price control is not too
low, and deadweight loss may decrease.

MC
P1

Pcontrol

Q1 Q2
MR
105
A Price Control on a monopolist. Since p cannot go above Pcontrol the
MR is equal to Pcontrol , output may increase (if price control is not too
low, and deadweight loss may decrease.

MC
P1
Pcontrol

Q1 Q3 Q2
MR
106
107
Perfect Price Discrimination
• Theoretical ideal. Cannot be fully achieved.
• Find maximum price that every consumer is
willing to pay and charge them that price.
• Requires more information than any firm has, and
the prevention of arbitrage.
• Demand Curve becomes MR curve.
• No Deadweight Loss.
• Approximate examples: automobile dealers,
doctors in the old days.

108
Perfect Price Discrimination.
P1
P3 S
P6

109
Price Discrimination
• If markets for a single product have different
MRs, profits can be increased by shifting output
from low MR markets to high MR markets.
• Raise price in low MR market and lower price in
high MR market.
• High MR market is high elasticity market.
• Need to Prevent Arbitrage.
• Examples: Airlines with business travelers and
vacationers. Coupons.

110
Market 2 Market 1

P1
price before discrimination

P2

D
mr2
D
mr

Q2 Q1
mr1
MR
MR

111
Price Discrimination Rules
• Raise price in market with lower elasticity
(lower responsiveness)
• Lower price in market with higher
elasticity.
• Do this until MRs are equalized. But prices
will not be equalized.
• Examples: Airlines with business travelers
and vacationers.

112
Monopsony
• Single buyer instead of single seller.
• Price paid is less than competitive level.
Quantity purchased is also less.
• Deadweight loss, similar but inverted
compared to monopoly.

113
Deadweight Loss 1+2. Area 5+4 is transfer to consumer from
producer.

MFC S

3
8 1
Pc
4 5 2

Pm
6 7
D

Qm Qc

114
MR
115
The Causes of Monopoly

• Natural Monopoly and Network effects


• Government grant (U.S. postal service, electric
company),
• Patents and Copyright.
• Control of scarce resource.
• Technical Superiority.
• Attempts to Cartelize Industry

116
Natural Monopoly
• Downward sloping AC curve.
• More efficient to have 1 large firm than many
small firms.
• Rate of return regulation is how we regulate
these firms.
• Removes incentive to keep costs down.

117
Natural Monopoly

Pm Unregulated Profit

Pr

Losses with efficient output

PE
MR

AC

D
MC
Qm Q QE
r

118
Network Effects
• Increased market size makes product more
valuable to consumers.
• This is just like an economy of scale in that it
benefits large firms relative to small ones. Leads
to natural monopoly.
• It implies that demand increases for large
networks, and that prices should rise.
• In Microsoft case, judge decided that they are a
barrier to entry.

119
Patent (copyright) tradeoff
• With no protection, creators do not reap
much of the rewards of their creations.
• They are given monopoly protection, which
increases their revenues, but raises price to
consumers.
• This increases the number of inventions, but
decreases the use of each invention?
• We do not know the optimal tradeoff.

120
Antitrust Rules against:
• Monopolization.
• Price Discrimination.
• Predatory Pricing.
• Tie-In Sales.

121
Monopolization
• If earned through better performance is not
illegal.
• Agreements to ‘restrain trade’ are per se
illegal.
• Definition of market is often crucial here.

122
Cartels

1. Firms try to collectively act like a monopolist.


This means restricting output to raise price.
2. What are the impediments?
1. KEY POINT: FIRMS HAVE AN
INCENTIVE TO CHEAT because their
elasticity is greater than the industry as a
whole.
3. Even if firms can reach an agreement, how can it
be enforced?

123
Cartels

1. Enforcement is the crucial problem for a cartel.


Since every firm individually has an incentive to
cheat, some impediment to cheating is required if
the cartel is to succeed. The usual impediments
to rule breaking are detection and punishment.
Cartels need to implement the same
impediments.
2. Detection: How can the cartel determine when
someone has violated the agreement?
3. (1) Can it use police power of the state?
4. (2) Can it use its own enforcement agency?
Mafia, etc.

124
Cartels

1. Can the Cartel punish one firm without hurting


member firms to the same extent?
2. Can they all target their punishment to harm only
the one cheating firm?
3. Is OPEC a cartel?
4. It is unclear whether OPEC is a classic cartel.
Did everyone in the organization have to cut
output?

125
Price Discrimination
• Illegal if it gives some firm an advantage over
other firms.
• If individuals are consumers, is not illegal.
• Price Discrimination is not likely to harm
efficiency. Perfect Price discrimination is perfectly
efficient.
• Intention of this rule was to protect ‘mom-and-
pop’ stores and grocers from department stores
and supermarkets. It was intended to reduce
competition.

126
Public Goods

1. Definition: Goods that do not get used up


when consumed. In other words, one
person’s consumption of a good doesn’t
reduce anyone else’s potential consumption
of the same good.
2. Obviously, these are not physical items that
get used up. Instead they are usually ideas
and artistic expressions.
3. They are at the core of the Information Age
Economy, since information is a public good.
4. The Demand for Public Goods is the vertical
sum of individual demands.
127
Vertical Addition of Demands

P4

ΣD

P3
P2
D3
P1 D2
D1 Q
Q1
128
Public Goods

1. Think of book titles as public goods, but


physical copies of single book title are
private goods that embody a public good.
2. Several questions arise: how many titles
are optimal to publish? How many copies
of each title would be optimal? How do
competitive markets work? Monopolies?
Finally, is it possible to produce public
goods efficiently?
129
In principle, a perfectly discriminating
monopolist can produce efficient amount of
public good.

S
P4

P3
ΣD
P2
P1
Q
Q1 Q2
130
title

1 2
Pm

4
3
7
MC of printing

5 8
6 D
Qm number of copies of a title
MR

131

Market Demand for Titles
r ti t le
t he
Pe i ng ano
rf D wri t
of
isc
rim MC
Pm
Att i na
ain tio
ab nD
le em
De and
ma for
nd titl
for es
titl
es

Qm Q** Q* number of titles written

132
Copyright Tradeoffs
• Underconsumption- too little consumption
of a particular title.
• Underproduction- too few titles.
• Due to public goods nature of books.
• Question: is this model actually the
appropriate model? Does copyright raise
price in the consumption market?

133
Copyright without higher prices
• How would copyright benefit owner if it
doesn’t raise price?
• Increasing the quantity might be beneficial
even at non monopoly price.
• Restricted entry prevents profits from being
driven down and that is the benefit of
copyright.

134
Predatory Pricing
• Current court-created definition (known as Areeda-
Turner rule) : price below average variable cost.
• Also requires that there be a serious likelihood of
driving prey out of business and of recouping
losses.
• Likely to lose money for the predator, and unlikely
to remove the prey.
• Can only succeed if prey is removed.
• Few real world examples. Standard Oil cases are
largely fictional.

135
Predatory Pricing AC
P
S
AVC
MC

p3

p2

p1

AFC
Q

136
Resale Price Maintenance

1. These are laws (also called ‘fair trade’ laws), at


the state level, that forbid retailers from charging
less than a price specified by a manufacturer.
2. Puzzle: why would manufacturers not be happy
to have retailers selling their product at low
prices, since that would seem to increase sales
and profits?

137
Resale Price Maintenance

1. Answer: Two possible answers


a. Firms are colluding and Resale Price
Maintenance removes the incentives to cheat
since if they lower their price to retailers it
won’t get passed on to consumers and it will
not increase their profits.
b. Goods need special treatment from retailer,
and free riding by some retailers will force
others to stop providing the treatment. RPM
stops some retailers from free riding off of
other retailers.

138
Tie-In sales.
• Generally considered to be an ‘extension of
monopoly’ by courts. In other words, courts
believed it was an attempt to use one monopoly to
create a second.
• Tie-In sales are poorly understood by courts,
imperfectly understood by most economists.
• Frequently, tying good is sold very cheaply, while
tied good is very expensive. Famous cases: IBM
and computer cards, Xerox and toner, Canning
machines and tin plate.
• Two monopolies are not better than one if
products are used together (in fixed proportions).

139
Tie In Sale when products used
together
PP

MC=AC pairs of shoes


2PL
PP-PL

MC=AC left or right shoes


PL

D pairs of shoes
MR
Q1
Q
140
PD version of Tie-In Story

1. Seller is thought to have two types of customers


– heavy versus light users.
2. Tied good is thought to ‘meter’ the use of the
tying good, to separate heavy from light users.
3. By lowering price of tying good, and raising
price of tied-good, producer increases payments
made by heavy user relative to light user.
4. Problems: heavy users likely to use up machines
faster – tie-in may have no impact on relative
payments.

141
Risk Reduction version of Tie-In

1. Consumers are unsure how much use they will


get from the tying good (machine).
2. This riskiness causes them not to be willing to
pay the full expected (predicted) value of the
product.
3. Seller has many such customers and can provide
‘insurance’ since the large numbers makes
overall results predictable.
4. By lowering price of tying good, and raising
price of tied-good, producer provides insurance
for consumers afraid they might not have much
use for machine.
142
143
60%
61%
62%
63%
64%
65%
66%
67%
68%
69%
70%
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Yearly Home Ownership Rates (US Census)

2000
2001
2002
2003
2004
2005
2006
2007
144
20
30
40
50
60
70
80
90
100
1987-1
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Figure 1: Quarterly Real

2001
2002
Home Prices Index (Case Shiller National)

2003
2004
2005
2006
2007-1
2008-1
145
Yearly Nominal Home Prices (Case Shiller National; 2008 based on 3
quarter)

200.00

180.00

160.00

140.00

120.00

100.00

80.00

60.00

40.00
1987-1

1988

1989

1990

1991

1992

1993

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007-1

2008-1
1994

146
Share of Mortgages (%)

0.0
0.2
0.4
0.6
0.8
1.0
1.2
Q4_1979
Q4_1980
Q4_1981
Q4_1982
Q4_1983
Q4_1984
Q4_1985
Q4_1986
Q4_1987
Q4_1988
Q4_1989
Q4_1990
Q4_1991
Q4_1992
Q4_1993
Q4_1994
Q4_1995
Foreclosures Started

Q4_1996
Q4_1997
Q4_1998
Q4_1999
Q4_2000
Q4_2001
Q4_2002
Q4_2003
Q4_2004
Q4_2005
Q4_2006
Q4_2007
Q4_2008
147
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Q4_1998 4.5

Q4_1999

Q4_2000

Q4_2001

Q4_2002

Q4_2003

Q4_2004

Q4_2005

Q4_2006

Q4_2007
Figure 4: Subprime Foreclosures Started

Q4_2008
148
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
Q4_1998

Q4_1999

Q4_2000

Q4_2001

Q4_2002

Q4_2003

Q4_2004

Q4_2005

Q4_2006
Figure 5: Prime Foreclosures Started

Q4_2007

Q4_2008
149
Excess Foreclosures by Type of Loan
160,000

140,000
Subprime Mortgages
Prime Mortgages
120,000

100,000

80,000

60,000

40,000

20,000

0
Q1_2007

Q2_2007

Q3_2007

Q4_2007

Q1_2008
Q3_2006

Q4_2006

Q2_2008

Q3_2008 150
Figure 7: Fixed and Adjustable Prime Foreclosures Started

2.0

1.8
Prime Adjustable Mortgages
1.6
Prime Fixed-Rate Mortgages
1.4
Share of Mortgages (%)

1.2

1.0

0.8

0.6

0.4

0.2

0.0
Q4_2000

Q4_2002

Q4_2003
Q4_1998

Q4_1999

Q4_2001

Q4_2004

Q4_2005

Q4_2006

Q4_2007

Q4_2008
151
Figure 6: Fixed and Adjustable Subprime Foreclosures
Started
7.0

6.0 Suprime Fixed Rate


5.0 Subprime Adjustable

4.0

3.0

2.0

1.0

0.0
Q4_1998

Q4_1999

Q4_2000

Q4_2001

Q4_2002

Q4_2003

Q4_2004

Q4_2005

Q4_2006

Q4_2007

Q4_2008 152
Yearly Change in Home Prices (Case Shiller National; 2008 based on
2 quarter)

20.00%

15.00%

10.00%

5.00%

0.00%

-5.00%
nominal
real
-10.00%

-15.00%

-20.00%
1988
1989
1990
1991
1992

1993
1994
1995
1996
1997

1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
1998

-25.00%

153
Figure 8: Fixed and Adjustable Mortgage Rates
10%

9%

8%

7%

6%

5%

4%
adjustable rate
3% fixed rate
2%
Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-04

Jan-05

Jan-06
Jan-03

Jan-07

154
155
Economics in the Real World
• Should the Record Industry worry about
file-sharing?
• First you use economic theory.
• Then you perform empirical analysis based
upon economic understanding.

156
4 Possible Impacts of Copying on the Producer

• Substitution Effect: Copies replace the purchase of a work.

– This is most basic intuition.

– Clearly decreases sales. Not a problem for videotaping.

– Hard to imagine that it isn’t important for many forms of


copying. Particularly counterfeiting.

157
Indirect Appropriability
• Producers capture value of copies (Liebowitz, J. Political

Economy, 1985)

– Requires:

• Large variability in copies made per original

• inability to identify which originals are turned into copies

– This is the reason photocopying did not appear to harm


publishers.

158
Sampling (Exposure Effect)
• Try out before purchase

– Defense in the Napster Case

– If cost of sampling low, it is efficiency enhancing. But not


necessarily revenue enhancing!
• Drunken Sailors Example

– Empirical evidence that sampling doesn’t increase sales.

• Superior choices of Cable TV generally doesn’t increase viewing


hours

• Radio doesn’t appear to increase record sales.

159
Network Effects
• Users have higher value because there are more other
users.

– It is not clear which products this might apply to, perhaps


business software.

• Users of Copies Increase Value to Purchasers

– Could in theory increase sales.

• Seems unlikely to be important in most instances of


copying.
160
More Measurement Problems

Measurement of US audio files exchanged per month


Webnoize 2001 1,000,000,000
Idate high statement for all of 2003 5,000,000,000
Idate low statement for all of 2003 1,000,000,000
NPD average based on first half 2004 183,694,429

Inspires confidence, doesn’t it?

161
Albums Sold Per Person

1
2
3
4
5
6
7
1973 8
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
Albums Sold per capita

1993
1994
1995
Napster Begins
Predicted Sales (based on disp inc)

1996
Predicted Sales (based on historic growth)

1997
1998
1999
Filesharing

2000
Actual Sales

2001
2002
2003
2004
162 2005
What Did Napster “Victory” Do?
Figure 2: American File Sharers at Home (000s)
18,000
16,000 Napster Decision
14,000
12,000
Users

10,000
8,000
6,000
4,000 Napster
2,000 Napster plus Alternatives
0
Jul-00
Jun-00

Aug-00

Nov-00

Jun-01
Jul-01

Nov-01
Aug-01
Feb-00

Sep-00

Sep-01

Feb-02
Apr-00
May-00

Jan-01
Feb-01

Apr-01
May-01

Jan-02
Mar-00

Oct-00

Dec-00

Mar-01

Oct-01

Dec-01
Source: ComScore Media Metrix

163
0.00
0.50
1.00
1.50
2.00
2.50
August - 2002
September - 2002
October - 2002
November - 2002
December - 2002
January - 2003
February, 2003
March, 2003
April, 2003
May, 2003
June, 2003
July, 2003
NPD (MP3 Files transferred)

August, 2003
September, 2003
October, 2003
BGLM (Number of Files made Available)
comScore (users of filesharing programs)

November, 2003
Big Champagne (Users of Filesharing Networks)

December, 2003
January, 2004
February, 2004
March, 2004
April, 2004
May, 2004
June, 2004
July, 2004
August, 2004
Figure 2: Various Measurements of File-Sharing

September, 2004
October, 2004
November, 2004
December, 2004
January, 2005
February, 2005
March, 2005
April, 2005
The blip in 2004 and Measurement Issues

164
No Change in Substitute Markets
in the Period around 1999
Figure 2: Movie s and Vide oGames
2.50
Normalized Videogame Revenue Per Capita
2.00 Normalized Box Office Per Capita

1.50

1.00

0.50
Source: Ebrain and M PAA
0.00
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003
165
DVD growth was close, but no
cigar.
Figure 4: Growth in Pre-Recorded Movie Sales and Rentals
$60

Real Per Capita $ Sales of PreRecorded Movies (right axis)


$50

$40

$30

$20

$10 Source: Adams Media Research (2003$)

$0
1986

1989

1993

1995

1997

2001
1981
1982
1983
1984
1985

1987
1988

1990
1991
1992

1994

1996

1998
1999
2000

2002
2003
166
Overall, it can’t explain the CD
decline
Figure 4: Growth in Pre-Recorded Movie Sales and Rentals
$50 $30
$45 Real Per Capita $ on Sales and Rentals of PreRecorded Movies
Real Per Capita $ Sales of PreRecorded Movies (right axis) $25
$40
$35
$20
$30
$25 $15
$20
$10
$15
$10
$5
$5 Source: Adams Media Research (1983$)

$0 $0
1981
1982

1985

1990

1996

1999
1983
1984

1986
1987
1988
1989

1991
1992
1993
1994
1995

1997
1998

2000
2001
2002
2003
167
Additional Evidence
It has been claimed (Oberholzer/Strumpf Grokster Amici brief) that genres of
music least likely to have been downloaded have shared in sales decline (in
particular Country Music), which would be inconsistent with downloading
causing the harm.

1994 168
The RIAA Law Suits had some Initial
Success
File-sharing declined in the first six months, consistent
with timing of RIAA lawsuits.
Sales increased as well during first six months,
consistent with assumption of file-sharing’s harm.
Figure 3: Measures of File-sharing Activity
1.6
RIAA announces (June 25) and then begins lawsuits
1.4 (September 8).

1.2

0.8

0.6

0.4 Pew Surveys


ComScore Media Metrix
Bhattacharjee et. al.
0.2 Big Champagne

0
March-May 2003 Jun-03 Nov-03 Feb-04 May-June-04

169
Statistical Study
• Compare sales change in cities based on change in
file-sharing, proxied by Internet usage.
• 1998 to 2003.
• Control for as many other variables as possible:
income, demographics, etc.
• By taking differences over a short time interval,
you control for characteristics of cities that do not
change over short intervals.

170
Result
• File-sharing has caused the entire decline in
sales, and prevented a robust period of
growth.

171
Tragedy of the Commons
• Common Property Resource – lake, forest,
any productive resource that allows free
use.
• The tragedy is that the resource is overused.
• Greater tragedy is that it is overused to the
point where its entire value might be
dissipated.

172
Fishermen on Lake

Fisherm enF ish per Fisherm an


Total Catc
1 10 10
2 9 18
3 8 24
4 7 28
5 6 30
6 5 30
173
Illustrating Overuse

Fish per Total M arginalO pp


Fisherm enFisherm an Catch C atch C
1 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0 174
Business Applications
• Should a firm have internal charges when
one division helps another (e.g. technical
support)?
• Network Effects (again).

175