A Level Revision: Contestable Markets

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

If only the Greeks could be like the Dutch at growing tomatoes.

Time magazine ran an interesting article on the tomato market in the Holland and Greece. The Greeks produces twice as many tomatoes than the Dutch but very little of it is sold in export markets. This is a concern in that it is a missed opportunity for the Greeks to earn income. What is more ironic is the fact that in the summer imports of tomatoes come in from Holland because the Greek farmers are still struggling to grow a crop during the hottest time of the year – Holland employs high-tech green houses and is able to produce significantly more during the summer months than Greece.

However, Greece has the potential to produce tomatoes for domestic consumption as well as for export but only has two harvests a year and is at the mercy of the elements – poor weather = poor harvest. The Dutch in contrast have temperature controlled greenhouses helping to create ideal growing conditions and they can produce 70kg of tomatoes in a square metre of his greenhouse whilst the Mediterranean grower gets approximately 7kg. They can also produce all year round.

Single Currency and Productivity

With the introduction of the euro in 2002 Greece could no longer devalue its currency to control the price of its products. With a weaker currency their exports were much more competitive but this had the effect of making the Dutch work even harder to achieve more efficiency and greater economies of scale. Therefore the only way that the Greeks can now compete is by cutting costs and embracing technology.

But it is not just the tomato market that has been hard hit. Greece’s agricultural sector’s productivity levels are 44% below the European average and labour costs have increased by approximately 90% and this is in contrast to Germany where unions agreed to a 3% rise. What is more concerning is that the acreage given over to growing tomatoes in Greece is 10 times that in Holland but they hardly export any of them. The Dutch have seen their exports increase by 30% since 2005. Some economists have laid the blame on the oligopoly market structure that controls the distribution. These middlemen pay farmers low prices and take a big mark-up on tomatoes even as they have failed to put in place a more efficient distribution system, including for exports.

The Greeks could become a thriving exporter of tomatoes once again but will need to embrace the Dutch technology and make use of its natural conditions – sunshine.

Price discrimination: Auckland – London flights

I came across a useful blog post by Ben Cahill (Senior College) on the Tutor2u site. It involves the price of airfares. The New Zealand Herald found that flights originating in London were significantly cheaper than NZ deals on equivalent trips leaving Auckland.

Fares for Departing April and returning May:
London – Auckland return – booked in UK = NZ$1,620 equivalent
Auckland – London return – booked in NZ = $3,189 (difference of $1569)

Flights out of NZ can’t be booked on Air NZ’s UK website – discrimination by location (third degree discrimination). In the UK the cost of a one-way fare is similar to that of a return.

Reasons for differences:
Greater demand for flights out of Auckland to London.
Exchange rate – 2003 difference would have been $616 instead of $1569

However airline pricing is based on many considerations and is ideal for price discrimination for the following reasons:

* Airlines has some control on the price,
* Buyers have different price elasticities of demand – business travelers vs. vacation travelers (see graph below)
* Each ticket can be sold at a different price, depending on when you book, how you book, the day you book, and so on.
* Software programmes can constantly calculate the empty seats remaining and price them while maximising returns. Yet, competition eats away all those margins. Hence, the tendency to raise revenues from wherever possible.

To maximize profit, the firm sets a price for each group by equating marginal revenue and marginal cost.

Source: Tutor2u

When Economies of Scale have been exhausted.

The Economist Free Exchange looked at how economies of scale for some firms have started to run out. When the average cost curve slopes downwards it means that average costs are decreasing as output increases. Whenever this happens the firm is experiencing economies of scale. If on the other hand the average costs are increasing as output increases the firm is experiencing diseconomies of scale – see graph below A-C economies of scale and C-D diseconomies of scale.

Container ship are a good example of economies of scale.
* 1950’s – they could carry 480 twnety-foot equivalent (TEU) containers
* 2006 – they could carrry 15,000 TEUs
* By 2013 – they will be able to carry 18,000 TEUs

As shipping costs per container keeps coming down container ships are expected to keep getting bigger.

Diseconomies – Skyscrapers and European Farmers

However, the idea of building something bigger will generate increasing economies of scale is not always the case. Think about a skyscraper, as you start to get above a certain height the cost per floor level starts to increase as there are structural aspects of the buidling that must be addressed and also with the core of the building getting larger as teh the building gets taller the amount of useable office space get reduced. Therefore if developers were looking at cost structures for buildings they would probably build mid-size buildings.

Many of the eastern bloc countries in the European Union are economic basket cases, still struggling to pick themselves up after the fall of communism in the early 1990’s, and this worries exporters who fear the big Western European economies maybe dragged down by their influence. The majority of their economies are weighed down by inefficient agricultural sectors inherited from the communist era and massive diseconomies of scale. If we look at Poland’s milk production, it is equivalent to New Zealand’s however this is spread over 500,000 farms and processed by 414 processing applications (US Department of Agriculture statistics). In New Zealand there are approximately 12,000 dairy farms.

Economics games for the classroom

Following on from Geoff Riley’s blog post (see below) on the Tutor2u site here are the games that he was alluding to.

In this blog I am reprising an article produced by our good friend Mark Johnston from New Zealand in an early edition of the now discontinued Latte Magazine(2007). I am doing so because I know that many colleagues are interested in trying some experimental games with their students for example when teaching game theory, behavioural economics and the provision of public goods.

Click the link for the games in pdf format from the Latte Magazine
winter07-economicsgames

Here is another that I have used recently on Oligopolies.
Oligopoly Game

A2 – Oligopolies – revision presentation

Here is another presentation from the Khan Academy which covers the oligopoly market structure. An oligopoly is a market dominated by a few producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales.

Characteristics of an oligopoly
There is no single theory of how firms determine price and output under conditions of oligopoly. If a price war breaks out, oligopolists will produce and price much as a perfectly competitive industry would; at other times they act like a pure monopoly. But an oligopoly exhibits the following features:

1. Product branding: Each firm in the market is selling a branded (differentiated) product

2. Entry barriers: Significant entry barriers into the market prevent the dilution of competition in the long run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output

3. Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to consider a rival’s response when choosing output and price.

4. Non-price competition: Non-price competition s a consistent feature of the competitive strategies of oligopolistic firms. Examples of non-price competition includes:

a. Free deliveries and installation
b. Extended warranties for consumers and credit facilities
c. Longer opening hours (e.g. supermarkets and petrol stations)
d. Branding of products and heavy spending on advertising and marketing
e. Extensive after-sales service
f. Expanding into new markets + diversification of the product range

A2 Unit 2 – Perfect Competition

With the mock exams approaching for southern hemisphere students here is another of Phil Holden’s revision presentations. This one is on Perfect Competition. Remember the following characteristics:

• All units of the commodity are homogeneous (i.e. one unit is exactly like another). If this condition exists, buyers will have no preference for the goods of any particular seller.

• There must be many buyers and sellers so that the behaviour of any one buyer, or any one seller, has no influence on the market price. Each individual buyer comprises such a small part of total demand and each seller is responsible for such a small part of total supply that any change in their plans will have no influence on the market price.

• Buyers are assumed to have perfect knowledge of market conditions; they know what prices are being asked for the commodity in every part of the market. Equally sellers are fully aware of the activities of buyer and sellers.

• There must be no barriers to the movement of buyers from one seller to another. Since all units of the commodity are identical, buyers will always approach the seller quoting the lowest price.

• Finally, it is assumed that there are no restrictions on the entry of firms into the market or on their exit from it.

Aircraft Manufacturing Duopolies – Long-Haul and Regional

On my way up to the 10th Anniversary Tutor2u conference in London this week and I have plenty of time to catch-up on reading and some blog posts. Flying on an Air New Zealand Boeing 777 200ER from Auckland to London (via Hong Kong) – flight time 24 hours 35 minutes. Free Internet access at HK meant a few blog post were able to be published.

However flying up on Boeing one thought of the duopoly market that pervades the aircraft industry. In the long haul market we all know about Boeing and Airbus but in the regional markets there are two competitors that are starting to make their presence felt with the established duopoly. At the moment the regional jet market is dominated by:

Brazil’s “Embraer”
Canada’s “Bombardier”

However two other manufacturers are starting to break into the short-haul market and they are:

Russia’s “Superjet”
China’s “ARJ21”

Even for the airlines with long haul flights, which has been dominated by Boeing and Airbus planes, Russia’s MC-21 and China’s C919 are being developed and are potential threats to the Boeing 737 and the Airbus 320. Although both Boeing and Airbus have successfully launched modified versions of the above which should maintain their competitive edge. However according to The Economist the money is the Chinese to come out with the best plane in the end.

What your airline fare is spent on

Here is a great article, graphic and video from the Wall Street Journal. They look at an average of 100 passengers on a flight and what each passenger pays for.

29 cover fuel
20 cover salaries of airlines
16 cover ownership costs
14 cover Government fees taxes
11 cover Maintenance
9 cover other costs – catering etc
1 = Profit

But airline operating costs are off the charts compared with other industries. In a business where much of the work is done outside, routine storms can eat into margins. And there are many moving parts to flying people through the air, and many safety costs required by regulation.

While ticket revenue pays the bulk of these costs, “ancillary revenue” supplements the flight by another $18 per person on a 100-passenger flight. That includes fees for checked baggage, seat assignments, ticket penalties and revenue from cargo.

To go to the full article, graphic and video – click link below:

How airlines spend your airfare

Oligopoly and the kinked demand curve – download

I alluded to in the last post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

Raw Game Theory – Split or Steal?

I got this clip from a tweet by Mo Tanweer of Oundle School in the UK. For those studying market structures it is a mistake to believe that ALL oligopolists face a KINKED DEMAND CURVE. Oligopolists may either:

a) COMPETE VIGOROUSLY or
b) COLLUDE (e.g. in cartels) or
c) PLAY SAFE (as in Kinked Demand Curve Theory)

In recent years game theory has become a popular way of examining the strategies that oligopolists may adopt in a market. Game theory involves studying the alternative strategies oligopolists may choose to adopt depending on their assumptions about their rivals’ behaviour. This clip is game theory in its rawest form. Very entertaining and a worth a look.

How to buy a car using “Game Theory”

Just covering market structures at present with my A2 class and came across this video clip on the Business Insider website.

Bruce Bueno de Mesquita, a political scientist and professor at NYU, who explains how to purchase a car using game theory.

He says that you should first establish a radius for however far you are willing to go to purchase the car. You then call a car dealer and make this statement. “My name is (your name here), I plan to buy (whatever car it is) at 5:00pm. I am going to buy it from the dealer who gives me the best price. What is your best price.”

The dealer will commonly respond with “You can’t buy a car on the telephone.”

Bruce then elaborates that the response to this is “I know I can buy a car this way, because I know that many cars have been purchased this way. If you do not quote a price for me, I understand that you are telling me that you know you don’t have the best price, I appreciate you saving my time.”

Bruce then says that the dealer will worry that you are just going to take his price and use it in negotiations with another dealer, essentially using him to lower your price.

You then explain that you will buy from whoever gives you the lowest price. You will not discuss the price when you get there and you will show up to the dealership with the check in your hand. If the dealer reneges, you will move on to the second best price as you have that check in your pocket as well. You then end by asking for the dealer’s best price.

It may sound silly, but apparently it actually works.

Ludicrous regulations of the US Airline Industry

I use this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:

When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn

When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.

State Capitalism – the new paradigm?

The Economist recently had a special report on “State Capitalism” and although it is a long read here are some prevalent points which could be used in AS or A2 essays especially in the discussion parts of questions.

Basically state capitalism attempts to combine the control of the state with the potential of capitalist system. It relies on the government to select and fund organisations which it sees as potential successes and uses the capitalist toolbox of raising finance through the stockmarket and adopt globalisation. Historically this was type of system was evident in Japan in the post WWII period as it started to rebuild its economy. However one only needs to look at China to see the success of state capitalism – over the past 30 years its economy has:

- grown on averge 9.5%
- international trade has grown by 18% in volume terms
- GDP has more trebled in the last 10 years to $11 trillion
- it has over taken Japan as the second largest economy
- it has over taken the US as the world’s biggest market for consumer goods

A key point in these achievements is that the Chinese government is the biggest shareholder in the country’s 150 biggest companies and manages and incentivises thousands more.

State capitalism is also very prevalent in big firms. The 13 biggest oil firms which supply 75% of all oil reserves as state backed. Some other examples from The Economist include:

- Gazprom – biggest natural gas company
- China Mobile – has 600m customers
- Saudi Basic Industries – world’s most profitable chemical company
- Sberbank – Russian Bank and 3rd largest in Europe by market capitalisation
- Dubai Ports – third largest port in the world by volume
- Emirates – airline that is growing at 20% a year.

On stockmarkets State companies are also very prevalent – see graph below:

- 80% of stockmarket in China
- 62% of stockmarket in Russia
- 38% of stockmarket in Brazil

Remember the above are very much emerging economies and make up 3 of the countries in the BRIC group. Also the Crysler building in New York is owned by Abu Dhabi and Manchester City football club is now owned by Qatar. The Chinese have a phrase “The State advances whilst the private sector retreats”

Monopolies and Market failure – ppt download

Here is a powerpoint presentation on market failure. It includes:
- Reasons for failure
- Monopolies
- Deadweight Loss
- Policies to correct
- Effectiveness of policies

It also goes through some essays questions with suggested answers in the AS CIE Economics Paper 2 – essay and data response. Click Market Failure Keynote to download.

Chasing the ‘Apple’ Cart

Many thanks to Apple devotee David Parr for this piece from techcrunch.com. Here are some stats which are truly remarkable:

- Apple ranks at 18 for the largest corporate annual earnings of all time – the vast majority of firms above them being oil and gas. Apple’s profits place them on this exclusive list of the most profitable quarters among corporations. You’ll note that Apple is the only company on the list that’s not an oil and gas company. And they’re a “mere” $3.2 billion from the top spot.

- Apple’s profits for the last quarter exceed Google’s entire revenue for the last quarter – and it’s not even close ($13 billion to $10.6 billion).

- Apple’s revenues, while massive, are nothing compared to a company like Walmart, which reported $109.5 billion in revenue last quarter. BUT that $109.5 billion only turned into $3.3 billion of actual income for the quarter. In other words, Walmart has more than double the revenues of Apple, but Apple has more than four times the profits of Walmart. That’s remarkable.

Read the full article by clicking here.

Frankly its got to be Darwin

Here is a clip from Paul Solman’s ‘Making Sense of Financial News’ which is part of the PBS Newshour in the US. Here he interviews Professor Robert Frank (author of ‘The Economic Naturalist’) who predicts that within the next century Darwin will unseat Smith as the intellectual founder of economics. The reason being that Darwin’s understanding of competition describes economic reality far more accurately than Smith’s. The failure to recognize that we live in Darwin’s world rather than Smith’s is putting us all at risk by preventing us from seeing that competition alone will not solve our problems. Enjoy the interview at the Darwin Exhibiton – Fernbank Museum of Natural History in Atlanta.

Economies of Scale – Sending a T Shirt from China to Europe for 2.5 cents.

The Economist had interesting piece on the economics of very big ships. If you wanted a good example of economies of scale look no further than sending a T shirt from China to Europe – 2.5cents is the cost. What allows it to be so cheap is the enormous scale of the new container ships that are now being produced – mainly in South Korea.

Maersk container ships transport a considerable percent of the world’s ocean freight and they have a fleet of over 500 container ships that sail every major trade lane. The big ships are 400m long and the ship can carry 7,500 40ft containers each of which can hold 70,000 T shirts – that makes a total of 525,000,000 T Shirts per container ship. Furthermore it only takes 3 weeks for the T shirts to arrive in Europe and the combination of the largest combustion engine ever built and a minimum crew of 13 personel to run the ship leads to signifiacnt economies of scale (see graph below – Point A being the lowest point on the long-run average cost curve LAC).

Given the rising price of fuel many companies feel they need bigger ships to improve efficiency and ultimately improve their margins. Maersk are looking to increase the size of container ship so that it can hold 18,000 x 20ft units. Freight rates have dropped significantly over the last year with the downturn in global demand and the oversupply of container ships in the market – the main players are:

Maersk – Neptune – K Line – Orient Overseas

According to The Economist shippers will seek economies of scale not only from bigger ships but also from mergers.

A2 Revision: The Perfectly Competitive Firm and the Market

Supernormal, normal, and subnormal profit only identified what happens to the firm. However it is important to be aware of what is happening in the market as a whole. Take for instance a firm making supernormal profits. The price that the firm charges is determined by what is happening in the market (supply and demand). If a firm makes supernormal profits this attracts other firms into the industry to take advantage of these profits. Therefore the supply of firms in the market increases which in turn reduces the price that firms can charge and they now make normal profits and are in the long-run see fig below.

A2 Revision – Monopoly and Deadweight Loss

Thanks to Ben Cahill of Senior College for organising an A2 revision day at Event Cinemas on Queen Street – myself, Ben, and Alex Marshall (Westlake Boys’ HS) all presented a range of A2 topics. A topic I covered was on Market Failure with special emphasis on Monopoly and Deadweight Loss.

In Perfect Competition we stated that the force of supply and demand establish an equilibrium situation in which resources are used most efficiently – MC (Supply) = AR(Demand) . Furthermore, in perfect competition the firm produces at MC = MR (profit max) which is also the same as producing at MC = AR (allocative efficiency). This is because AR and MR are the same in perfect competition. Therefore the same output represents allocative efficiency and profit max. Remember that long-run Perfect Competition is a significant output as it is where:
MC = MR – Maximum Profit or Minimum Loss
MC = AR – Allocative Efficiency (Supply = Demand)
AC = MC – Technical Optimum – Productive Efficiency

However for a monopolist because the AR and the MR curves are different we get separate outputs for Allocative Efficiency and Profit Max. The graph below shows that at profit maximising equilibrium, output Q2 is less than that in a competitive market (Q1), and the demand and supply (MC) curves do not intersect. Q1 represents the Allocative Efficiency level of output and P1 the price. The shaded area therefore represents the loss of allocative efficiency or the deadweight loss.