1 meco 6303 my name is stan liebowitz pronounced: lee – bow –wits reading list: web page...

1 MECO 6303 My name is Stan Liebowitz Pronounced: Lee bow wits Reading list: Web Page http://www.utdallas.edu/~liebowit/http://www.utdallas.edu/~liebowit/

2 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.

3 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?

4 Economic actors are rational: voluntary actions are only undertaken when they are expected to make people better off. Assumptions In Economics Major actors: consumers and producers. Economics as Science- abstract model simplifies, requires simplifying assumptions. Consumers try to maximize happiness (utility) Our wants are greater than our abilities to fulfill them (scarcity) Producers try to maximize profits

5 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.

6 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.

7 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 dont 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 doesnt need to be always true.

8 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.

9 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 didnt choose the first activity). Example: opportunity cost of going to college.

10 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. Production Possibility Curves.

11 Two questions A financial analyst on TV said the impacts of the hurricane on the country wouldnt 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?

12 Production Possibility Curve Fish Fruit slope of line indicates tradeoff in ability to produce different types of goods A BB1

13 No Specialized Resources-PPC Straight 2 Production Possibility Curves under 2 scenarios Fish Fruit slope of line indicates tradeoff in ability to produce different types of goods A BB1

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

15 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

16 D P Q Demand

17 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

18 P1P1 P WLM QEQE Q2Q2 D Demand for RNE* Q1Q1 P2P2 *Rethinking the Network Economy

19 D D1 P Q Perhaps a positive review in the Economist leads to an increase in demand curve Shift in Demand for RNE

20 Price Elasticity Of Demand def: percentage change in quantity divided by percentage change in price (Q/Q)/(P/P) or (Q/P) (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

24 Implications of Elasticity If Elasticity is 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.

25 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.

26 D before consumers have much time to adjust P Q original price D after consumers have time to adjust to price change amount consumed after short period of adjustment\ amount consumed after longer period of adjustment\ new higher price

27 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.

28 P2P2 P1P1 Q2Q2 Q1Q1 S minimum price firm is willing to accept. Should be equal to the cost of producing the additional output Meaning of Supply

29 P1P1 P2P2 Q1Q1 Q 2007 SLSL Long Run/Short Run Oil? SsSs Q 2011

30 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.

31 P1P1 PePe QeQe Q1Q1 S D Surplus Shortage P2P2 Q2Q2 Illustration of Supply Demand Equilibrium

32 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.

33 P2P2 Q2Q2 Q1Q1 S1 D1 P3P3 Q4Q4 Changing Equilibrium S2 D2 P1P1 P4P4 Q3Q3 1 3 2 4

34 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.

35 Area under demand = total value of that output Total Value of Q 1 Units= 1+2+4 Total Value of Q e Units= 1+2+3+4+5 QeQe Q1Q1 P1P1 PePe 1 2 3 4 5 D

36 Area under supply = total cost (net of fixed costs) P1P1 PePe 1 2 Increase in Total Cost when output increases from Q 1 to Q e =1+2 QeQe Q1Q1

37 What about Comparable Worth An issue in J Roberts Supreme Court nominationhe 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?

38 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

39 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?

40 PwPw S water QwQw Total Value of Water is entire area D water Average Value Water Average value of water is mid value of water used. So what does price measure? Meaning of Price (diamond-water Paradox PAPA

41 PdPd value of diamonds Average Value Diamonds Q Diamonds S diamonds D diamonds Meaning of Price (continued)

42 PdPd PwPw S water QwQw Total Value of Water is greater than value of diamonds Average Value Diamonds Q Diamonds D water S diamonds D diamonds Average Value Water Average value of water is also greater. So what does price measure? Meaning of Price (continued)

43 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?

44 What about Comparable Worth What can we say about it now?

45 WSJ on Economics Wage Market economics job market.pdf

48 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.

49 P1P1 PePe 1 2 CS = 1 PS = 2 QeQe Consumer and Producer Surplus Q1Q1 4 3 DWL = 3+4

50 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.

51 P1P1 PePe 1 2 3 4 5 6 7 8 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 CS After Price Control = 1 PS After Price Control = 2+4+6 QeQe Q1Q1 Price Floor at P 1 P2P2 Q2

52 P1P1 PePe 1 2 3 4 5 6 7 8 CS Before Price Control= 1+2+3+8 Ps Before Price Control = 4+5+6 CS After Price Control = 1 PS After Price Control = 2 QeQe Q1Q1 Price Floor at P 1 AND wrong producers Q2Q2 Q0Q0

53 P rc PePe 1 2 3 4 5 6 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 CS After Price Control = 1+2+4 PS After Price Control = 6 QeQe Q1Q1 transfer Rent Control (Price Ceiling) 7 Q2

54 Revenue from Consumers P1P1 PePe 1 2 3 4 5 6 7 8 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+9 Taxpayers = 2+3+4+5+6+7+8+10 QeQe Q1Q1 9 10 P clearing Government guarantees price at P 1 and and sells output at market clearing price Q2Q2 S D CS After Price Control = 1+2+3+4+5+6+10 PS After Price Control = 2+3+4+5+7+9

55 P1P1 PePe 1 2 3 4 5 6 7 8 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+9 CS After Price Control = 1 PS After Price Control = 2+3+4+5+7+9 Taxpayers = 3+5+6+7+8+10+11+12 QeQe Q1Q1 9 10 P clearing Government guarantees price at P 1 and burns any output it can not sell at that price Q2Q2 11 12

56 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?

57 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.

58 P1P1 PePe QeQe Q1Q1 Price Paid by Consumer } amount of tax D S StSt Tax from consumers vantage

59 P1P1 PePe QeQe Q1Q1 Price received by Producer } amount of tax D S DtDt Tax from producers vantage P0P0

60 P1P1 PePe QeQe Q1Q1 Price Paid by Consumer } amount of tax D S StSt Distortion from Tax P0P0

61 D with infinite elasticity P Q Instance of Tax borne by Producer Q1Q1 Q2Q2 S1S1 S P1P1 Price Paid by Consumer

62 D with zero elasticity P Q Instance of Tax borne by Consumer Price Paid by Consumer S S1S1 P0P0 P1P1 Q0Q0

63 S with infinite elasticity P Q Instance of Tax borne by Consumer Price Received by Producer P0P0 Q1Q1 Q0Q0 DtDt D

64 S with zero elasticityP Q Instances of Tax borne by producer Price Received by Producer P0P0 P1P1 DtDt D Q0Q0

65 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. Firms: Legal Forms

66 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.

67 Marginal Analysis - Demand 1. Note Relationship between elasticity and Marginal Revenue.

68 More Marginal Analysis

69 Marginal Costs and Profit

70 Profit Maximization Marginal Analysis TR= PxQ 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

demandofelasticitywhere P Q P P Q P Q P Q Q Q P Q TR QP Also MCMRso Q Max MCMR Q TC Q TR Q TCTR ) 1 1()1( 0 Some simple Calculus

The Intuition demandofelasticity wherePMRor are ) 1 1() PQ QP -P(1=MR 1=Q whereQ)P(-P= MRSo effect. P thisof because P thanless is MR price. in down go whichunits Qfor QP +unitlast of price=revenues bringsLast Unit units. Q of instead sold units 1+Q when Revenuein RevenueMarginal

73 D MR $ q* Max Profit TR TC max Rev Profit Maximization Output

74 AC MC D MR Profits P* q* Another Angle

75 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.

76 TC=FC+VC; TC/Q = FC/Q +VC/Q which is ATC= AFC +AVC AVC AC Fixed and Variable Costs AFC Total Fixed P Q q1

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

78 AC 1 MC D MR Profits2 P* q* AC 2 Impact of Fixed Costs on Profit Profits1 AC* AC**

79 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?

80 AC Economies of Scale Diseconomies of Scale

81 Long Run AC LRAC SRAC1 SRAC3 SRAC2 MC2 MC3 MC1 Q1

82 Do average costs fall over time, or is average cost downward sloping? AC1990 P* q* AC1991 AC1992 AC1993 AC1994

83 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.

84 Midterm goes only up to this point

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

86 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).

87 AC 1 MC D = MR P* q* Short Run Profit Maximizing solution for a competitive firm; MC seems to be the supply curve. AC q* Profits

88 AVC AC supply curve of firm is the mc above avc AFC P Q q1 q2 q3 p3 p2 p1 S MC

89 supply curve of industry is the horizontal sum of each individual firms supply. Firm A Firm B Firm C Industry qaqa qbqb qcqc Q a+b+c p1 s s s S q a1 Q = q a1 p2

90 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.

91 AC P "Representative" Firm in Industry P Competitive Industry 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. p1 qQ1Q1

92 AC P "Representative" Firm in Industry P Competitive Industry This represents a competitive industry in a long run equilibrium (price P 3 ). 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. S1 S3 p1 p2 S2 p3 Q1Q1 Q2Q2 Q3Q3 q q1q1

93 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).

94 AC P "Representative" Firm in Industry P Competitive Industry 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. q 1 2 CS=1 PS=2

95 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).

96 Competitive Markets that arent Example of taxi-cab medallions Television station licenses. Medical doctors Many, many, more.

97 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.

98 AC P "Representative" Firm in Industry P Competitive Industry 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. q LRS SRS P1P1

99 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.

100 P Q AC for representative firm as industry output Q increases. AC (Q1) AC (Q2) AC (Q3)

101 P Q Q1 Q2 Q3 Long run supply in decreasing cost competitive industry AC (Q1) AC (Q2) AC (Q3) LRS

102 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.

103 S MR D PcPc QcQc PmPm QmQm 1 2 3 4 Monopoly charges higher price, produces smaller quantity. Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from consumer MC

104 MR D P1P1 MC+t P2P2 taxtax Q1Q1 MC Q2Q2 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.

105 MR D P1P1 P control Q1Q1 MC Q2Q2 A Price Control on a monopolist. Since p cannot go above P control the MR is equal to P control, output may increase (if price control is not too low, and deadweight loss may decrease.

106 MR D P1P1 P control Q1Q1 MC Q2Q2 A Price Control on a monopolist. Since p cannot go above P control the MR is equal to P control, output may increase (if price control is not too low, and deadweight loss may decrease. Q3Q3

108 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.

109 Perfect Price Discrimination. S P6 P3 P1 D

110 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.

111 price before discrimination mr1 mr2 MR D mr Market 1Market 2 Q1Q2 P1 P2 D MR

112 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.

113 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.

114 MR D PcPc QcQc PmPm QmQm 1 2 3 4 Monopsony pays lower price, consumes smaller quantity. Deadweight Loss 1+2. Area 5+4 is transfer to consumer from producer. S MFC 5 6 7 8

116 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

117 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.

118 AC PrPr QrQr MC QEQE D MR PEPE Losses with efficient output PmPm Qm Unregulated Profit Natural Monopoly

119 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.

120 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.

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

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

123 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?

124 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.

125 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?

126 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.

127 Public Goods 1. Definition: Goods that do not get used up when consumed. In other words, one persons consumption of a good doesnt reduce anyone elses 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.

128 Vertical Addition of Demands Q Q1 D D3D3 D2D2 D1D1 P1P1 P3P3 P2P2 P4P4

129 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?

130 Q Q1 Q2 D P1P1 P3P3 P2P2 P4P4 In principle, a perfectly discriminating monopolist can produce efficient amount of public good. S

131 number of copies of a title MC of printing 1 2 3 4 5 6 7 8 Pm Qm Production of a Single book title MR D

132 number of titles written MC of writing another title Pm Qm Perf Discrimination Demand for titles Q* Market Demand for Titles Attainable Demand for titles Q**

133 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?

134 Copyright without higher prices How would copyright benefit owner if it doesnt 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.

135 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.

136 AVC AC AFC P Q p3 p2 p1 S MC Predatory Pricing

137 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?

138 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 wont 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.

139 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).

140 P Q Tie In Sale when products used together PLPL Q1Q1 MR D pairs of shoes MC=AC left or right shoes MC=AC pairs of shoes 2P L P P -P L

141 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.

142 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.

156 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.

157 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 isnt important for many forms of copying. Particularly counterfeiting.

158 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.

159 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 doesnt increase sales. Superior choices of Cable TV generally doesnt increase viewing hours Radio doesnt appear to increase record sales. Sampling (Exposure Effect)

160 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. Network Effects

161 More Measurement Problems Inspires confidence, doesnt it?

162 Filesharing

163 What Did Napster Victory Do?

164 The blip in 2004 and Measurement Issues

165 No Change in Substitute Markets in the Period around 1999

166 DVD growth was close, but no cigar.

167 DVD Sales Rose, but Rentals Fell Overall, it cant explain the CD decline

168 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.

169 The RIAA Law Suits had some Initial Success Sales increased as well during first six months, consistent with assumption of file-sharings harm. File-sharing declined in the first six months, consistent with timing of RIAA lawsuits.

170 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.

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

172 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.

173 Fishermen on Lake

174 Illustrating Overuse

175 Business Applications Should a firm have internal charges when one division helps another (e.g. technical support)? Network Effects (again).

1 meco 6303 my name is stan liebowitz pronounced: lee – bow –wits reading list: web page...

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