The Economist wrote in one its ‘Leaders’ that macro economists could learn a lot from their micro economist colleagues. Micro economists tend to focus more on individual markets or firms and through the use of technology are able to acquire huge amounts of data on each producing amazingly accurate forecasts of human behaviour. Rather than taking the standard textbook supply and demand, the new breed of micro economists help nudge the two into line. An example that they use is Uber – the taxi service – where prices surge during peak hours and this attracts more drivers onto the road.
Another example that The Economist use is the online book market. Research from MIT showed that used books (335 titles) typically sold for $17.50 which is 50% more than in book stores. By accessing all the readers interested in a book through the Internet you create more demand for the book which translate into higher prices. Furthermore the reader is better off as without the Internet they would not have found the book. One of the authors of the research bought a 30 year old book on pharmaceuticals online as the MIT library didn’t have it. She paid $20 for the book but was surprised to see that on the inside cover it had been priced in the second hand bookshop at $0.75.
The macro economists seem to create theoretical models before testing them against the data whilst the micro economists let computers spot patterns from the actual data.
With the A2 essay paper tomorrow here is a quick revision note on monopolistic competition. This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Notice on the diagram that the firm initially makes supernormal profit at Q0 – at MC=MR Price = P0 and Cost = AC0. However with weak barriers to entry these profits are competed away and they now produce at Q1 where at MC=MR and the Price and Cost = AC1
Modern capitalism is characterised by a large number of ‘limited’ monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position, but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power – how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.
Advertising is employed to heighten in the consumer’s mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer’s mind, then these products are different from our point of view because the consumer will be prepared to pay different prices for them.
For all the python fans here is some very amusing footage from the Holy Grail which focuses on Marginal Analysis. Put together by Mr Clifford of EconMovies. Worth a look.
I went through this graph with my A2 class today. Note that the firm’s short-run supply curve starts at P4. Useful for multiple-choice questions.
Here is a video from the Khan Academy on Perfect Competition – good for revision of A2 Unit 2 Market Structures.
I picked up this natural monopoly theory from University of Waikato Senior Economics Lecturer Michael Cameron on his excellent blog entitled Sex, Drugs and Economics. This is very useful for A2 students when studying market structures.
A natural monopoly arises where one producer of a product is so much more efficient (by efficient I mean they produce at lower cost) than many suppliers that new entrants into the market would find it difficult, if not impossible, to compete with them. It is this cost advantage that creates a barrier to entry for other firms, and leads to a monopoly. Natural monopolies typically arise where there are large economies of scale (when, as a firm produces more of a product, their average costs of production fall). Economies of scale are common when there is a very large up-front (fixed) cost of production, and the marginal costs (the cost of supplying an additional unit of the product) are small (the cost structure is shown in the figure below, with a simplifying assumption that the marginal cost of production is low and constant). The markets for utilities, where the up-front cost includes the cost of having all of the infrastructure in place, are good examples. Rail is another example, since you need the tracks, the rolling stock, and the associated stations and other buildings in place before you can start to provide rail services.
Now natural monopolies, like other firms, are assumed to be profit maximisers. That is, they will operate at the point where marginal revenue is equal to marginal cost. That is, they will operate at the price PM and the quantity QM in the diagram above. At that point, the producer surplus is the area PMBHPS, while the firm’s profit is the area PMBKL (the difference between profit and producer surplus arises because of the large up-front fixed costs, which are subtracted from profits, but not from producer surplus). However, consumer surplus in this market is GBPM, and total welfare is GBHPS. This leaves a deadweight loss equal to the area BEH.
Now, if the government owned the natural monopoly, it doesn’t necessarily have to profit maximise if it doesn’t want to. Government could choose to maximise total welfare instead. It would do this by setting the price at the point where marginal social benefit is equal to marginal social cost. That is, the market will operate at the price PS and the quantity QS. At that point, producer surplus is zero (since every unit is sold for marginal cost), but the profit is negative (JDEPS) because price is below average cost. On the other hand, consumer surplus is GEPS, and total welfare is maximised at GEPS.
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.