Market OutcomesExecutive MBA 512

Session #11Presented byBrian Greber

November 15, 2012

5-1

Cleaning Up Supply from Last Class

5-29

Market vs Individual Supply?• In contrast to individual consumers, it is often

important to understand the economic supplies of individual firms:• Your firm• Concentrated Industries

• From a price and market perspective the focus becomes “market supply”• the collective supply of all firms. • We infer this from historic price/production

behavior

5-29

What causes supply to shift?• Number of sellers• Anything that shifts marginal costs:

• Resource prices• Technology• Taxes and subsidies• Prices of other goods (opportunity costs)

• Producer expectations

5-4

Shape/slope of supply

• Note, the shape is measuring the responsiveness of cost to changes in quantity supplied

• Inversely, the shape reflects the responsiveness of quantity supplied to changes in price• What economists call “price elasticity” of

demand

Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

EsX=

5-5

Price Elasticity of Supply

Extreme cases• Perfectly inelastic supply• Perfectly elastic supply• Unitary Elasticity

p

Q

p

Q

p

Q

S

S

Examples?

S

5-6

What influences slope of supply• Shape of curve for inputs

• Diminishing returns• Time

• Market period• Perfectly inelastic supply

• Short run• Fixed plant size

• Long run• Adjustable plant size

• Supply more elastic• More elastic in the long run

5-7

January 2012 Article on End of Elastic Oil

• How did they characterize the overall elasticity of supply for oil?• How did they say it differed between the

OPEC countries and the US? Why• Is the elasticity of oil greater in the long

run or the short run? Why?• Did the article contend that the short-run

elasticty of supply is getting “more or less” elastic through time? Why?

• Dies this contradict the preceding point?• Diminishing returns• Time

• Market period• Perfectly inelastic supply

• Short run• Fixed plant size

• Long run• Adjustable plant size

• Supply more elastic• More elastic in the long run

5-8

Cross Price elasticity of supply• Elasticity > 0, production complements …..

Examples?• Elasticity < 0, production competitors ….

Examples?Percentage Change in Quantity

Supplied of Product XPercentage Change in Price

of Product Y

EsXY=

5-9

Law of Diminishing Returns

• Fixed technology• Add variable

resource to fixed resource

• Marginal product will decline• Beyond some point• The faster the rate

of decline, the steeper the marginal cost/supply curve

They Need a Heavier Donkey...

5-10

IncreasingMarginalReturns

Law of Diminishing Returns

(1)Units of the

Variable Resource(Labor)

(2)Total Product

(TP)

(3)Marginal Product

(MP),Change in (2)/Change in (1)

(3)AverageProduct

(AP),(2)/(1)

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01025456070757570

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50

-5

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DiminishingMarginalReturns

NegativeMarginalReturns

5-11

0

10

20

30

Tota

l Pro

duct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gina

l Pro

duct

, MP

1 2 3 4 5 6 7 8 9

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Law of Diminishing Returns

5-12

Aver

age

Prod

uct a

ndM

argi

nal P

rodu

ctCo

st (D

olla

rs)

Graphical Relationships

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

5-13

Costs and decisions• Average fixed cost

• Understand effect of scale on “leveraging” costs• Average variable cost

• Key controllable cost on a day-to-day basis; key to shut down economics

• Produce as long as P > AVC• Average total cost

• Standard for “cost accounting”• Marginal cost = Supply

• Key to determining profit maximizing output levels• Competitive firm Produce to where P=MC

5-14

Key take away: Supply • Supply reflects the marginal cost of production

• Any market or policy changes that influence marginal costs will shift supply.

5-15

July 2012 Article on Ethanol and Corn & October Article on Yeast• If requirements for ethanol use stay the same and the

price of gasoline rises, what is apt to happen to the supply of corn for food purposes ? What does that say about the cross price elasticity of supply?• What would happen to food prices related to corn as

a feed, grain, or vegetable?• If the demand and price of corn for ethanol falls, what

would happen to the demand for yeast?• What does that say about the cross price elasticity of

demand for yeast? • So what does that mean that an increase in oil prices

will eventually do to yeast prices?• Now you are thinking like an economist…….

5-16

Today’s New Objectives• Review the neo-classical “competitive” market and

discuss exceptions. These will include non-competitive markets, imperfect information, and externalities.

• Enable a structured approach to thinking through trends, cycles, and fluctuations in market prices and quantities.

• Provide basic framework for thinking through the “conduct” of consumers, suppliers, and producers (competitors).

• Place these concepts into a strategic planning framework and understand their implications for government policy.

5-17

Pure Competition ?

5-18

Assumptions for efficient market • Private property

• Yields investment, innovation, exchange, maintenance,

& growth.• Freedom of enterprise and choice

• Scalability, Entry and exit• Self-interest

• Creates “checks and balances”• Costs and benefits understood, and internalized

• Information• Lack of “side effects”

• Fair Competition among players• Many players on “both sides of the market”• No lying, cheating, stealing, colluding, ….

• Markets and prices allowed to function ans supported with viable currency

5-19

Market Equilibrium ….. • The meeting of the minds that balances price

and quantity• Avoids surplus and shortage• Uses price for Rationing • Leads to Efficient allocation

• Productive efficiency• Allocative efficiency among consumers and

producers

5-20

Putting D&S together

5-21

Competitive Equilibrium is Good!

5-22

D

Pric

e (P

er B

ag)

P1

Q1

Quantity (Bags)

ConsumerSurplus

Equilibrium Price = $8

5-22

S

Pric

e (P

er B

ag)

P1

Q1

Quantity (Bags)

ProducerSurplus Equilibrium

Price = $8

5-23

Competitive Equilibrium is Good!

Competitive Equilibrium is Good!

D

S

Pric

e (P

er B

ag)

P1

Q1

Quantity (Bags)

ConsumerSurplus

ProducerSurplus

Equilibrium Price = $8

5-24

Putting D&S together What happens if you instill quotas, price ceilings, or floors?

5-25

Truth is ….. The market is rarely at a competitive equilibrium!

5-29

5-27

• How do I know what price to charge?• What happens if I charge too much?• What happens if I charge too little?• What actually happens in the market is sometimes called “the cobweb effect”

Market Cycles: Imperfect Information Causes “Oscillations” in Prices, Outputs, and Inventories

Market Cycles: Imperfect Information Causes “Oscillations” in Prices, Outputs, and Inventories

5-28

Time

Price/Production Q

Inventory

New York Times Article on Inventories

Market Trends: Inertia/Momentum causes supply/demand to continually shift through time

5-29

• Population• Productivity• Scarcity (?)• Other ????•

5-30

Market Equilibrium: Use BoardSupply shift out;

Demand decreaseSupply shift in;

Demand increaseSupply shift out;

Demand increaseSupply shift in ;

Demand decrease

Price Quantity

?

?

?

?5-30

Market Shocks: One time events, start the cobweb, again!

5-31

Time

Price/Production Q

Inventory

Trend and Cycle

Time

Price or Quant

TrendTrend & Cycle

Full disclosure and “internalization” of all costs/benefits is critical to efficient markets …..

5-29

Asymmetric Information: Bad thing!

5-34

See: Law school debt, Reebok articlesConsider: What happens when consumer lies on insurance formsInformation witheld by buyer or seller is inefficient.

0

D

S

St

Overallocation

Hidden costs St

Overerallocation

Mis-represented

benefits

Qo QeQe Qo

P P

0 Q Q

D

Dt

Externalities

9-35

Inefficient Equilibrium: Externalities

5-36

Inefficient Equilibrium: Externalities

5-37

Negative Externalities

Positive Externalities

0

D

S

St

Overallocation

NegativeExternalities St

Underallocation

PositiveExternalities

Qo QoQe Qe

P P

0 Q Q

D

Dt

Number of players influences market outcomes…..

5-29

What limits competition?: Barriers to Entry

5-39

•Economies of scale•Legal barriers to entry

• Patents• Licenses

•Ownership or control of essential resources•Capital intensity•Pricing and other strategic barriers to entry

Market Structure (Models)

& exit

Demand to firm

Perfecty elastic –Price taker

Downward sloping = market D

Market Structure Continuum

Nearly Perfecty elastic –Price taker

Typically “kinked”

7-40

Monopoly Fundamentals

5-41

• Single firm faces entire demand schedule.• Firm’s output decision drives market rice (conversely price decision drives

market quantity).• MR curve is below price curve, because price change effects all prior units

of production.• Monopoly will produce where MR=MC;

• Outcome (assuming no cost advantage):• Lower Quantity• Higher Price

• Disproportionate allocation of market value to producer profits• Inefficiency compounded when monopolist price discriminates

Monopoly Fundamentals

5-42

PurelyCompetitive

Market

PureMonopoly

D D

S=MC MC

P=MC=Minimum

ATC

MR

Pc

Qc

Pc

Pm

QcQm

Pure competition is efficientMonopoly is inefficient

a

b

c

7-42

Monopoly Fundamentals

5-43

Oligopoly & Monopolistic Competition

5-44

Monopolistic Competition

5-45

• Fairly large number of suppliers• Easy entry and exit• Segmentable markets• Differentiation allows for non-price

competition• Enables firm’s some capability to

manage pricing.• Potentially inefficient, depending upon

pricing controlWhich industries?

Oligopoly

5-46

• A few large producers – enabled by entry barriers• Four-firm concentration ratio

• Needs to be more than 40%• Half of U.S. manufacturing

• Homogeneous or differentiated products• Collusion is mutually beneficial

• Enhances profit• Incentive to cheat

• Sans collusion – the “kinked demand curve”• Raise price, others don’t follow, big loss in

share• Lower price, others follow to preserve share

Oligopoly: Kinked Demand

5-47

Pric

e an

d Co

sts

Quantity

0

Rivals IgnorePrice Increase

Rivals MatchPrice Decrease

Can be complicated – simple version …

D2

D1

MR1Q0

P0

e

7-47

Oligopoly: Price Outcomes

5-48

• Wait for the “first to move” then follow• Less frequent price changes than competitive markets

Time

Price

Time

Price

Competitive Market

Oligopoly Market

Pulp – a relatively concentrated industry

Lumber – a highly competitive industry

Pricing Examples

Oligopoly: Issues/Options• Not productively efficient• Not allocatively efficient• Tendency to share the monopoly profit• Considerations

• Increased foreign competition• Technological advance

• Policies• Use antitrust laws

• Divide the firm• Natural monopoly

• Regulate price• Ignore

• Unstable in long run

5-51

Shape of industry supply curve and other cost considerations

Shape of industry demand curve and other demand factors

Factors influencing degree of competition in your industry

Dynamics of the “shoot-out”

Special Topics from the Anti-Text • Shapes of the cost curves

• To some extent the argument is irrelevant, one needs to believe in aggregate there is some form of upwards sloping supply function. Individual firms need not see significant price elasticity of supply.

• Switching suppliers (p. 107) – who can you turn to if all producers are already producing at optimal levels?

• Do we overstate the freedom of choice argument in markets?

• What does it depend upon? • Does that invalidate the basic market

model? Parts of it?5-52

Assignment• Using Excel graphically contrast historic market prices

and quantities of 4 assigned commodities and discuss reasons for the trends, cycles, and fluctuations. Summarize how market structure is apt to influence behavior and rivalry and show concrete examples. Support your graph with a reflection paper (no more than 2 pages). • Due 12/3• Instead of 4 assigned, use any 2 good(s) you wish;

ideally one is the same as that used in assignment for session #5.

• Find monthly data for at least 7 years.• 2 graphs – one of prices, one of quantities. Each

should have 2 lines on them (one for each of 2 goods)• I am looking for “likely” reasons for trends, cycles,

and “shocks”; not a statistical analysis.• I am looking for examples of behavior and rivalry that

might drive the observed prices and quantities. 5-53