BC807 Chapter 11: Performance and Strategy in Competitive Markets

Chapter Outline 1. Competitive Market Efficiency 2. Market Failure 3. Role for Government 4. Subsidy and Tax Policy 5. Tax Incidence and Burden 6. Price Controls 7. Business Profit Rates 8. Market Structure and Profit Rates 9. Competitive Market Strategy 1. Competitive Market Efficiency (How to measure Consumer and Producer Surplus) Why it is Called Perfect Competition and what is Welfare Economics? It is the best interest of the society to maximize the total benefits generated from consumption (by the consumers) and from production (by the producers) of goods and services in the society. Equilibrium quantity and price creates a perfect balance in a competitive market that maximizes the total Social Welfare from consumption and production. The Consumer Surplus is defined as the difference between the maximum amount ($) a consumer is willing to pay and the amount he/she actually pays. Higher the consumer surplus higher is the economic well-being of the consumer. The consumer surplus is closely related to the demand curve for a product, also called buyers maximum willingness to pay curve. The Producer Surplus is closely related to the supply curve of a product. In a competitive market the long run market supply curve is the portion of the marginal cost curve (MC) above the average total cost curve (ATC) that reflects the minimum price required by the sellers to bring a product in the market for sale. Supply curve is also called sellers willingness to accept, the minimum price curve. Producer surplus is measured as the difference between the minimum amount ($) a producer is willing to accept and the amount he actually accepts. Social welfare is measured by the sum of the net benefits derived by the consumers and producers and it is most efficient in the competitive market because, (i) market equilibrium allocated the goods and services to those consumers who place highest value on them; and (ii) production of goods and services is allocated to the most efficient producers. See Fig-11.1 below

Deadweight Loss Problem Deadweight loss problem is associated with deviations from competitive market equilibrium. It happens when government policies or any type of market imperfections (such as, monopoly power, pollution externality etc.) causes economic loss suffered by the consumers and/or producers. In Fig-11.2 assume that due to government supply restrictions caused the amount produced in the economy reduced from Q1 to Q2 as a result, the market prices increased from P1 to P2. Due to price rise the amount of consumer surplus is now reduced by the area P1P2AB. Notice this area is actually the amount of additional revenue received by the producers who are benefitted by the higher prices. Hence, it is a transfer of benefit directly from the consumers to the producers. The new market equilibrium reduced the consumer surplus (CS) by the area of a triangle ABD ($?). This is in addition to the reduction of CS by the area P1P2AB which is transferred to the producers. So the total loss to consumers due to higher price and lower quantity purchased is the area P1P2AD out of which P1P2AB went to the producers but the small triangle ABD went to none hence, it is a deadweight loss. If we analyze what happened to the producer surplus before and after the price increase and quantity decrease we will find that the small triangle BCD is also lost from the revenue of the producers but was not transferred to anyone. This is also a measure of deadweight loss. Remember, if any loss of CS is exactly matched by the gain of producer surplus (PS) then there is no deadweight loss. The total benefit remains same.

Note: Follow the Deadweight Loss Illustration from your textbook Page-414.

2. Market Failure - When market price favor either the buyers or the sellers, or buyers or sellers neglect the social cost and benefits of their actions then market fails to allocate the resources efficiently. In such cases the optimum price and quantity is not determined by the market forces of demand and supply. For example, when there is externality and market power, market fails. Structural Problems Market failure due to structural problem occurs when a competitive market does not have a large number of buyers and/or sellers. For example, water, power, electric utility market is most efficiently served by a single firm hence, such providers enjoy market power. They can earn excess profit by limiting output and charging higher price. Because of this, utility prices and profits are regulated by the government regulatory authority whose objectives are to provide efficiency of large-scale production and preventing high price and excess profits. Incentive Problems Externality arises due to uncompensated impact of one persons action on the well-being of a bystander. If the activity is beneficial it is called positive (i.e., flu shots) and if it is harmful called negative externality (i.e., pollution). Externalities lead to a difference between private and social costs and benefits of an activity. Positive externalities can result if an increase in firms activity reduces costs for its suppliers, who pass these cost savings on to their other customers. This has happened to semi-conductor industry and increased computer use has reduced the price of computers and video games industry. Firms that produce substantial positive externalities without incentives are unlikely to produce socially optimum level. To the contrary, firms producing negative externalities such as, environmental pollution or creates hazardous working condition for its employees, since they do not pay the full costs of production they tend to over utilize social resources and produce quantity more than socially desirable.

3. Role of Government: How Government Influence Competitive Markets Government affects what and how firms produce, influences conditions of entry and exit, dictates marketing practices, prescribes hiring and personnel policies on private enterprises. For example, Franchises confer the right to a telephone company to offer cellular phone service in a major metropolitan area worth millions of dollars and can be awarded by only FCC in the US. The Federal government also spends hundreds of millions of dollars per year to maintain artificially high support price for selected agricultural products such as milk and grain. Although all sectors of the US economy are regulated to some degree, the method and scope of regulation vary by industry and nature of produce/business. For example in the financial and public utility sectors, the firms must comply with the financial regulations in addition to some operating control such as, product packaging, labeling, worker safety, etc. When making decisions on what and how to tax or regulate business, economic and social considerations come first. From social efficiency and equity point of view the question often asked is if the market competition is sufficient for equity and efficiency or it needs to be regulated? If the social benefit of regulation and tax in terms of efficiency exceeds the social cost, then government intervention is necessary.

Two Broad Social Considerations Consumer Sovereignty: One of the two most important feature of competitive markets is consumer choice or sovereignty. By encouraging and rewarding individual initiatives, competition greatly enhances personal freedom and firms in the competitive markets determine optimal output based on market prices, and have no control on prices. Hence, public policy is a valuable tool to control unfairly gained market power by any firm and restore control over price and quantity decisions. Limit Concentration of Economic Power: Government intervention limits concentration of economic and political power, which contradicts with the democratic process. The large scale modern corporations sometimes diminish the controlling influence of individual stockholders hence public policies and regulations limit the growth of large firms.

4. Subsidy and Tax Policy Government subsidy is a positive incentive for desirable performances and tax confer penalty to limit undesirable performances. Subsidy Policy: Some positive externalities are encouraged by the government by providing direct or indirect subsidies. Why - when producing or consuming goods/services that generate positive externality firms and consumers do not consider the external value (social value) of their productions and consumptions. As a result the market equilibrium quantity of production or consumption is always less than the social optimum quantity (i.e., college education). The example of indirect government subsidy is like government built new highways and bridges that benefit the private trucking industry. The example of direct subsidy is agricultural payment-inkind programs, special tax treatment programs, and government provided low-cost financing. Government also introduced Tradable Pollution Permits (also called tradable emission permits) which allows firms the right to pollute provided the total amount of pollution remain within the limits not hazardous to human health (determined by EPA). This allows some firms to reduce investment on new equipment, raw material, etc., but use the money to buy tradable emission permits form other firms who can reduce their own emission at a lower cost and sell the permits to other firms at an auction. Remember, tradable pollution permits do not offer new license to pollute, it merely transfer the licenses from one polluter to the other polluter.

5. Deadweight Loss from Taxes We all know that local, state, and federal government impose various type of taxes, some are for revenue generating some are for penalizing for negative externalities. For negative externality, determining per unit tax is extremely difficult because it is hard to estimate the magnitude to negative externality. For some negative externality it is relatively easy to determine the social cost of air or noise pollution, such as frequent house painting, or playing loud music at night.

The next diagram illustrate that no matter how you impose tax, there will be some deadweight loss when a tax is imposed for negative externality. Figure -11.3

The above figure shows the price, output, and social welfare effects due to imposition of per unit tax on seller of a good/service. Notice before any tax was imposed the equilibrium price was Pe and quantity was Qe. When government imposed per unit tax t on the sellers, the market supply curve shifted to MC+t, the equilibrium output becomes Qt and price becomes Pb. But notice although price paid by the buyers now is Pb but the price received by the sellers is Ps the difference (Pb-Ps) = t the tax per unit that government collects for every units sold (total = OQt *t). Out of the t amount of tax imposed by the government, buyers pay (Pb-Pe), sellers pay (PePs). Due to the imposition of tax both producer and consumer surplus are affected. Before tax, total revenue received by the producers OPeEQe and producers surplus = area OPeE; Consumer Surplus = area AEPe. After tax, the total revenue received by the producers is OPSDQt, consumer surplus decreased to PbAB, and producer surplus decreased to OPsD. But there is a new tax revenue generated to the government equal to area rectangle PsPbBD. However, this additional revenue generated to the government partially compensates the loss of consumer and producer surplus, but an area equal to the area of the dark triangle BDE remain uncompensated is a social welfare loss called deadweight loss of taxation. The conclusion: per unit taxes cause deadweight losses because they reduce the amount of economic activity in competitive markets and prevent buyers and sellers from realizing some of the gains from trade. Remember, the loss of social welfare measured by the deadweight loss of taxation does not necessarily imply that per unit taxes are bad and/or should be avoided.

6. Price Controls Price Floors: US Department of Agriculture (USDA) has the price support program to help farmers grow certain crops whose prices have declined extensively due to its supply increased enormously over the last 50 years. Currently, only 2% of US population work on firms compared to 10% 50 years ago but America produces worlds largest agricultural products. This has happened due to extensive increase in agricultural productivity. Since agricultural products are price inelastic, demand of foodstuffs has not increased proportionate to the supply increase causing the prices to fall. The purpose of price floor is to help the producers when the market solution is not acceptable or fair to the producers. USDA has introduced a complex system of price floors, crop loans, production subsidies, and land set-aside programs to counteract the rising productivity and set the prices for some agricultural products above the equilibrium price. Figure 11.6

In the figure (11.6a) the equilibrium price is Pe and quantity is Qe, however when price floor is set above Pe there is some surplus created in the short-run because buyers demand less (from Qe to Qd) and sellers produce and supply more (from Qe to Qs) generating total surplus (Qd-Qs). Over the long-run buyers continue to demand less by substitution for products that are less costly and sellers continue to produce more than market equilibrium quantity resulting huge amount of excess foodstuffs that becomes spoiled or are put to less than their best use. While government purchase the surplus at the floor prices from the farmers and store it for delivery to the states in case of emergency and natural disaster or export them, however, surplus represents a serious economic problem since it represents a significant loss of economic resources. Price Ceilings: Price ceiling is a mechanism used to reduce excess demand for certain goods/services to match its limited supply. For example, rent control in New York City where landlords are restricted in terms of the rent they can charge to tenants. The purpose of price

ceiling is to help the consumers who cant afford the market determined rent for some urban areas or big cities. Figure 11.7(a)(b) explain the short-run and long-run impact of price ceiling. Figure 11.7

In Fig 11.7(a) a price ceiling set below the equilibrium price (Pe) will create a modest shortage of apartments by the amount (Qs-Qd), the gap is between the demand and supply of apartments. It is observed that the demand and supply curves are less elastic in the short-run (new apartments cant be supplied very fast or the demand is not adjusted fast in the short-run) however, over a long period of time landlords will build less apartments and consumers will demand more apartment at the ceiling prices. As a result the shortage (Qs2 Qd2) would be larger in the longrun (Fig 11.7b). Like the problem of surplus in case of price floor, shortage in price ceiling will cause a significant economic cost and represent economic problem that reduces social welfare.

7. Business Profit Rates ROE Return on stockholders equity is net income divided by the book value of stockholders equity, where stockholders equity is total asset minus total liability. ROE = Net Income/Equity = [Net Income/Sales] X [Sales/Total Assets] X [Total Assets/Equity] = Profit Margin X [Total Asset/Turnover] X Leverage Profit margin is the amount of profit earned per dollar of sales. Holding capital requirements constant, profit margin is a useful indicator of managerial efficiency in responding to rapidly growing demand and an effective measure of cost minimization. Total asset turnover is sales revenue divided by the book value of total assets. When total asset turnover is high the firm makes its investment generate large amount of sales revenue. For

example, despite modest profit margins Wal-Mart Stores report very high ROE compared to the retail industry and corporate norms. Leverage is often defined as the ratio of total assets divided by stockholders equity. Leverage amplifies firm profit rates over the business cycle. During economic booms, leverage can increase dramatically firms profit rates and the reverse can happen during recessions. 8. Market Structure and Profit Rates In a perfectly competitive market profit margins are low because P = MC = AC. In a competitive market the average cost includes a risk-adjusted normal rate of return on investment. Hence, profit margin measured as (P-AC)/P, which is actually the normal rate of return, is also very low. Table 11.1 shows corporate profit rates for a large number of competitive industry groups. Mean Reversion in Profit Rates One of the major characteristics of the competitive markets is free entry and free exit of firms in the industry. Over time when the competitive firms grow and earn above-normal profits, some new firms enter the industry and reduce the profits for all firms to a mean profit. On the other hand, if firms are earning below-normal profits, some firms go bankrupt and exit, as a result, the remaining firms move toward the normal and mean profit in the long-run. The tendency of firm profit to converge over time toward long-run averages is called reversion to the mean (Figure 11.8). Economic theory suggests high business profits often lead to booming capital expenditures and higher employment. Eventually such expansion causes the marginal rate of return on investment to fall. Conversely, low business profits typically lead to falling capital expenditures, layoffs, and plant closings. Eventually, industry contraction leads to rising rates of returns for survivors. Figure 11.8

Example-1: Deadweight Loss of Taxation. To many upscale homeowners, no other flooring offers the warmth, beauty, and value of wood. New technology in stains and finishes call for regular cleaning that takes little more than sweeping and/or vacuuming, with occasional use of a professional wood floor cleaning product. Wood floors are also ecologically friendly because wood is both renewable and recyclable. Buyers looking for traditional oak, rustic pine, trendy mahogany, or bamboo can choose from a wide assortment. At the wholesale level, wood flooring is a commodity-like product sold with rigid product specifications. Price competition is ferocious among hundreds of domestic manufacturers and importers. Assume that market supply and demand conditions for mahogany wood flooring are: QS = -10 + 2P (Market Supply) QD = 320 - 4P (Market Demand) where Q is output in square yards of floor covering (000), and P is the market price per square yard. A.Graph and calculate the equilibrium price/output solution before and after imposition of a $9 per unit tax. B.Calculate the deadweight loss to taxation caused by imposition of the $9 per unit tax. How much of this deadweight loss was suffered by consumers versus producers? Explain. SOLUTION A. The market supply curve is given by the equation QS = -10 + 2P or, solving for price, 2P = 10 + QS P = $5 + $0.5QS The market demand curve is given by the equation QD = 320 - 4P or, solving for price, 4P = 320 - QD P = $80 - $0.25QD To find the market equilibrium levels for price and quantity, simply set the market supply and market demand curves equal to one another so that QS = QD. For example, to find the market equilibrium price, equate the market demand and market supply curves where quantity is expressed as a function of price: Supply = Demand -10 + 2P = 320 - 4P 6P = 330 P = $55 To find the market equilibrium quantity, set equal the market supply and market demand curves where price is expressed as a function of quantity, and QS = QD: Supply = Demand $5 + $0.5Q = $80 - $0.25Q 0.75Q = 75 Q = 100 (000)

Therefore, the equilibrium price-output combination is a market price of $55 with an equilibrium output of 100 (000) units. Following imposition of a $9 per unit tax, the new market supply curve is given by the equation P = $5 + $0.5QS + tax = $5 + $0.5QS + $9 = $14 + $0.5QS or, solving for quantity, P = $14 + $0.5QS 0.5QS = -14 + P QS = -28 + 2P The market demand curve is given by the equation QD = 320 - 4P or, solving for price, 4P = 320 - QD P = $80 - $0.25QD To find the market equilibrium price, equate the market demand and market supply curves where quantity is expressed as a function of price: Supply = Demand -28 + 2P = 320 - 4P 6P = 348 P = $58 To find the market equilibrium quantity, set equal the market supply and market demand curves where price is expressed as a function of quantity, and QS = QD: Supply = Demand $14 + $0.5Q = $80 - $0.25Q 0.75Q = 66 Q = 88 (000) Therefore, the equilibrium price-output combination with a $9 per unit tax is a market price of $58 with an equilibrium output of 88 (000) units.
Wood Flooring Equilibrium

$90 $80 $70 $60 $50 Price $40 $30 $20 $10 $0 0 10 20 30 40 50 60 70 80 90 100 110 120

Supply + tax Supply

A B C D
Demand

Quantity (000 sq. yd.)

B.The amount of deadweight loss due to taxation suffered by consumers is given by the triangle bounded by ABD. Because the area of such a triangle is one-half the value of the base times the height, the value of lost consumer surplus equals: Consumer Deadweight Loss = [(100 - 88) ($58 - $55)] = $18 (000) In the absence of a tax, a supply price of $49 [= $5 + $0.5(88)] would be associated with a quantity supplied of 88 (000) units. Therefore, amount of deadweight loss due to taxation suffered by producers is given by the triangle bounded by BCD. Because the area of such a triangle is one-half the value of the base times the height, the value of lost producer surplus equals: Producer Deadweight Loss = [(100 - 88) ($55 - $49)] = $36 (000) The total amount of deadweight loss due to taxation suffered by consumers and producers is given by the triangle bounded by ACD. The area of such a triangle is simply the amount of consumer deadweight loss plus producer deadweight loss: Total Deadweight Loss = Consumer Loss + Producer Loss = $18 (000) + $36 (000) = $54 (000)

Example-2: Competitive Strategy. Bob Ice owns and operates Bob's Music Center, Ltd., a small firm that offers music lessons in Huntsville, Alabama. Given the large number of competitors and the lack of entry barriers, it is reasonable to assume that the market for music lessons is perfectly competitive and that the average $60 per hour price equals marginal revenue, P = MR = $60. Assume that Bob's annual operating expenses are typical of several such firms and individuals operating in the local market, and can be expressed by the following total and marginal cost functions: TC = $100,000 + $10Q + $0.005Q2 MC = $10 + $0.01Q where TC is total cost per year, MC is marginal cost, and Q is the number lessons given. Total costs include a normal profit and allow for Bob's employment opportunity costs. A. Calculate Bob's profit-maximizing output level. 11

B. Calculate Bob's economic profits at this activity level. Is this activity level sustainable in the long run? SOLUTION A. The optimal output level can be determined by setting marginal revenue equal to marginal cost and solving for Q: MR = MC $60 = $10 + $0.01Q 0.01Q = 50 Q = 5,000 lessons per year B. Because the cost of capital and owner-operator employment opportunity costs are already included in the total cost function, any excess of revenues over total cost represents economic profits. At this output level, maximum economic profits per year are = TR - TC = $60Q - [$100,000 + $10Q + $0.005Q2] = $60(5,000) - [$100,000 + $10(5,000) + $0.005(5,0002)] = $25,000 The Q = 5,000 activity level results in economic profits of $25,000, meaning that Bob's is able to provide its owner-manager with an income level that is above employment opportunity costs and also cover the normal or risk-adjusted rate of return on investment. Either the local market is in disequilibrium and Bob's is earning temporary disequilibrium profits, or Bob's is especially capable and earning economic rents (Ricardian rents).

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