HT to past student Shelalé Mazari for the image below. Tom Goodwin wrote a very interesting article on the battle for the consumer interface.
Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.
He states that since the Industrial Revolution there are complex supply chains including manufacturers – importers – wholesalers – franchises – retailers. However the rapid rise in technology has allowed a number of these parts of the chain to be removed.
Uber, Facebook, Alibaba and Airnb are companies with, what Goodwin refers to as, thin layers that sit on top of vast supply systems (where the costs are) and interface with a huge number of people (where the money is). The New York Times needs to write, fact check, buy paper, print and distribute newspapers to get their ad money.
Here is a great video from Tyler Cowen of Marginal Revolution fame in which he explains Price discrimination – Unit 2 in the CIE Economic syllabus. Price discrimination is common: movie theaters charge seniors less money than they charge young adults. Computer software companies sell to businesses and students at different rates, often offering discounts to students. These price differences reflect variations in the elasticity of demand for these different groups. When demand curves are different, it is more profitable to set different prices in different markets. We’ll also cover arbitrage and take a look at some examples of price discrimination in the airline industry
I alluded to in a previous 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.
Having just completed Perfect Competition with my A2 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.
Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the perfectly competitive firm will produce at a rate of output where marginal revenue equals marginal cost. Marginal revenue, however, is equal to price. Therefore, the perfectly competitive firm produces at an output rate where marginal cost equals the price of output. Remember that the firm will make profits as long as the extra revenue brought in from selling the last unit of output(MR) is greater than the extra cost which is incurred in producing it(MC). Below are some of the graphs they created – subnormal profit and normal profit
For the last lesson before the Easter break I got students to do a variety of graphs using M&M’s. Long-run Perfect Competition, Short-run Perfect Competition, MC, AC and AVC to name just a few. A good exercise and an incentive to get them correct with the reward of eating the graph. Some creations below:
Here is another clip from Seinfeld which is an example of moral hazard and imperfect information.
Jerry’s car is stolen, so he rents a car. The rental company doesn’t give him the car he reserved; he gets a small economy car. They ask if he wants insurance, and he replies, “Yes, because I’m going to beat the hell out of this car.” Source: Seinfeld Economics
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.