Chapter 5

Economics of Organization

For many years, the field of microeconomics focused primarily on the relationship between firms and the outside
environment of consumers, suppliers, competitors, and regulators. Internally, it was assumed that a firm was able to
measure the costs associated with any pattern of exchanges with the outside environment in order to determine the
best production and marketing decisions. However, the conduct of the actual processes involved in production was
not regarded as an issue of economics in itself. Rather, these matters were treated as issues of organizational behavior
and organizational design to best assign, coordinate, and motivate employees, much like a military unit.

In recent decades, economists have applied and developed economic principles that inform a better understanding of
activity inside the firm. One focus in this newer endeavor is the firm’s decisions on which goods and services they will
provide. A related topic of interest to economists is how much of the production activity will be done by the firm and
how much will be purchased from other firms or contracted out to other businesses.

When a business elects to provide a large number of goods and services or has complex, multistage production
operations, operations must be assigned to departments or divisions and the firm faces challenges in coordinating
these units. Although organizational psychologists have addressed these issues for many years, economics has been
able to provide some new insights.

Another issue in the design of a firm is motivation of units and individuals. In analyses based on organizational
behavior, individuals are regarded as having psychological needs and the challenge to the organization is how to
design procedures to meet those needs so that employees better support the needs of the organization. The new
perspective from economics views an employee as an independent agent whose primary objective is to maximize his
own welfare and the challenge to the organization is to structure incentives in a manner that aligns the economic
interests of the firm with economic interests of the employee.

5.1 Reasons to Expand an Enterprise

Businesses usually sell multiple products or services, and they alter the collection of goods and services provided over
time. Several factors motivate changes in this composition and can result in decisions either to expand an enterprise
by increasing the range of goods and services offered or to contract the enterprise by suspending production and sale
of some goods and services. In this section, we will list some key motivations for expanding the range of an enterprise.
Bear in mind that when these motivations are absent or reversed, the same considerations can lead to decisions to
contract the range of the enterprise.

1. Earlier, in Chapter 4 "Cost and Production", we discussed the concepts of economies of scale (cost per unit
decreases as volume increases) and economies of scope (costs per unit of different goods can be reduced by
producing multiple products using the same production resources). Businesses often expand to exploit these
economies.

2. As we will see in Chapter 7 "Firm Competition and Market Structure", in markets with few sellers that each
provide a large fraction of the goods or services available, the sellers possess an advantage over buyers in
commanding higher prices. Businesses will often either buy out competitors or increase production with the
intent to drive competitors out of the seller market in order to gain market power.

3. Many businesses sell products that are intermediate, rather than final, goods. Their customers are other
businesses that take the goods or services they purchase and combine or enhance them to provide other
goods and services. As a result, the profit that is earned in the production of a final product will be
distributed across several firms that contributed to the creation of that good. However, the profit may not be
evenly distributed across the contributing firms or proportional to their costs. Sometimes a firm will
 recognize the higher profit potential of the firms that supply them or the firms to which they are suppliers
and will decide to participate in those more lucrative production stages.

4. Due to the considerable uncertainties of future costs, revenues, and profits and the need for firms to commit
resources before these uncertainties are resolved, business is a risky prospect. Just as investors can mitigate
the inherent risk of owning stocks by purchasing shares in different firms across somewhat unrelated
industries, large firms can reduce some of their risk by producing unrelated products or services.
Additionally, there may be increased efficiencies in movement of resources between different production
operations when done by the same company.

5.2 Classifying Business Expansion in Terms of Value Chains

We noted earlier that many businesses sell goods or services that are intended to help other businesses in the creation
of their goods and services. Many of the goods we consume as individuals are the result of a sequence of production
operations that may involve several firms. If the final goods are traced backward through the intermediate goods that
were acquired and utilized, we can usually envision the participant firms in a creation process as a network of
production activities or a sequence of production stages.

For example, consider a loaf of bread purchased at a grocery store. The grocery store may purchase the loaf from a
distributor of bakery products. The distributor likely purchased the loaf from a baking company. In order to produce
the loaf of bread, the bakery would need flour and yeast, along with packaging material. These may be purchased from
other businesses. The flour came from a grain grinding process that may have been done by a different business. The
business that ground the grain would need grain that may have come from an agricultural cooperative, which in turn
was the recipient of the grain from a farmer. In order to grow and harvest the grain, the farmer needs seed, tractors,
and fuel, which are usually obtained from other sources.

Each of the firms or production operations that contributes to the creation of the final product can be considered as
adding value to the resources they acquire in their completion of a stage of the creation process. Since the network of
operations that account for the creation of a product can often be represented by a sequence of stages, the network is
commonly called the value chain for the product.

Figure 5.1 "Generic Value Chain for a Manufactured Good" shows a generic value chain for a manufactured good. This
value chain begins with the raw materials that eventually go into the product that must be acquired, possibly by
mining (e.g., metal) or harvesting (e.g., wood). Next, the raw material is processed into a material that can be used to
create parts in the next stage. Using these parts, the next stage of the value chain is the assembly of the product. Once
assembled, the product must be distributed to the point of sale. In the final stage, a retailer sells the finished product
to the consumer.

Business expansions are classified based on the relationship of the newly integrated activity to prior activities engaged
in by the firm. If the new activity is in the same stage of that value chain or a similar value chain, the expansion is
called horizontal integration. If the new activity is in the same value chain but at a different stage, the expansion is
called vertical integration. If the new activity is part of a quite different value chain, the new combined entity
would be called a conglomerate merger.

Figure 5.1 Generic Value Chain for a Manufactured Good

5.3 Horizontal Integration

In horizontal integration, a firm either increases the volume of current production activities or expands to similar
kinds of production activities. Consider a television manufacturer that operates at the assembly stage of its value
chain. If that company bought out another manufacturer of television sets, this would be horizontal integration. If the
company were to decide to assemble computer monitors, the product would be a form of horizontal integration due to
the high similarity in the two products and type of activity within those value chains.

Cost efficiencies in the form of economies of scale from higher volumes or economies of scope from producing related
products are primary driving factors in horizontal integration. When a firm expands to a new product that is similar
to its current products, usually there is a transfer of knowledge and experience that allows the expanding firm to start
with higher cost efficiency than a firm that is entering this market with no related experience. If an enterprise
possesses core competencies in the form of production processes that it can perform as well or better than others in
the market, and can identify other products that can employ those core competencies, the enterprise can enter new
markets as a serious competitor.

Market power from holding a higher share of all sales in a market is the other major motivation for horizontal
integration. As we will discuss in later chapters, the possible gains from increased market power are often so
significant that the governments in charge of overseeing those markets may limit or forbid horizontal mergers where
one company buys out or combines with a competitor.

Since most firms are buyers as well as sellers, horizontal integration can create an advantage for large firms in
demanding lower prices for goods and services they purchase. For example, a national chain like Walmart may be the
principal customer of one of its suppliers. If Walmart decides to use a different supplier, the former supplier may have
difficulty remaining in business. Consequently, the supplier may have little choice about accepting reduced prices.

5.4 Vertical Integration

Vertical integration occurs when a firm expands into a different stage of a value chain in which it already operates.
For example, suppose the television manufacturing firm had been purchasing the electronic circuit boards that it uses
in its television set products but decides to either buy the supplier or start a new operation to make those parts for
itself. This would be vertical integration.

Usually vertical integration will extend to a neighboring stage in the value chain. When a business expands into an
earlier stage in the value chain, the business is said to be doing upstream integration. When the expansion is to a
later stage of the value chain, the result is downstream integration.

A major motivation for vertical integration is the potential for improved profitability. As noted earlier, firms at some
stages of the value chain may enjoy better market conditions in terms of profitability and stability. If two stages of the
value chain are performed by two divisions of the same company rather than by two separate companies, there is less
haggling over price and other conditions of sale. In some cases, through a process that economists call double
marginalization,A nice discussion of double marginalization appears in Shugart, Chappell, and Cottle (1994). it is
possible that a single vertically integrated firm can realize higher profit than the total of two independent firms
operating at different stages and making exchanges. An independent partner may not conduct its business the way
that the firm would prefer, and possibly the only means to make sure other stages of the value chain operate as a firm
would like is for the firm to actually manage the operations in those stages.

Another possible motivation for vertical integration is risk reduction. If a firm is highly dependent on the goods and
services of a particular supplier or purchases by a particular buyer, the firm may find itself in jeopardy if that supplier
or buyer were to suddenly decide to switch to other clients or cease operations. For example, if the supplier of
electronic circuit boards were to cancel future agreements to sell parts to the television manufacturer and instead sell
to a competitor that assembles television sets, the television company may not be able to respond quickly to the loss of
supply and may decide it needs to either buy out the supplier or start its own electronic parts division. From the
circuit board supplier’s perspective, there is also risk to them if they invest in production capacity to meet the specific
part designs for the television company and then the television company decides to get the circuit boards elsewhere.
By having both operations within the boundaries of a single enterprise, there is little risk of unilateral action by one
producer to the detriment of the other producer.

5.5 Alternatives to Vertical Integration

If the reduction of risk related to the actions of an independent supplier or buyer is a motivation for vertical
integration, the firm may have alternatives to formally integrating into another stage of the value chain through use of
a carefully constructed agreement with a supplier or buyer. Done correctly, these agreements can result in some of the
gains a business might expect from formal integration of the other stage of value-adding activity.

If the concern is about the reliability of continued exchanges, the supplier firm can establish a long-term agreement to
be the exclusive dealer to the buyer firm, or the buyer firm can contract to be the exclusive buyer from the seller firm.
In the retail business, these sometimes take the form of franchise outlets, where the franchise enjoys the assurance
that their product will not be sold by a competitor within a certain distance and the supplier is assured of having a
retailer that features their goods exclusively.

In some cases, the concern may be about future prices. If the upstream firm is concerned that the downstream firm
will charge too little and hurt their profitability, the upstream firm can insist on a resale price maintenance clause. If
the downstream firm is concerned that the upstream firm will use their exchanges to build up a business and then
seek additional business with other downstream clients at lower prices, the downstream firm can ask for a best price
policy that guarantees them the lowest price charged to any of the upstream firm’s customers.

Some upstream suppliers may produce a variety of goods and rely on downstream distributors to sell these goods to
consumers. However, the downstream firm may find that selling just a portion of the upstream firm’s product line is
more lucrative and will not willingly distribute the upstream firm’s entire line of products. If this is a concern to the
upstream firm, it can insist on the composition of products a distributor will offer as a condition of being a distributor
of any of its products.
One way firms protect themselves from supply shortages is by maintaining sizeable inventories of parts. However,
maintaining inventory costs money. Firms that exchange goods in a value chain can reduce the need for large
inventories with coordinated schedules like just-in-time systems.The best-selling book by Womack, Jones, and Roos
(1990) describes the just-in-time philosophy. In situations where quality of the good is of key concern, and not just
the price, the downstream firm can require documentation of quality control processes in the upstream firm.

When upstream firms are concerned that they may not realize a sufficient volume of exchanges over time to justify the
investment in fixed assets, the upstream firm can demand a take-or-pay contract that obligates the buyer to either
fulfill its intended purchases or compensate the supplier to offset losses that will occur. This type of agreement is
particularly important in the case of “specific assets” in economics, where the supplier would have no viable
alternative for redeploying the fixed assets to another use.

Although some of these measures may obviate the need for a firm to expand vertically in a value chain, in some
circumstances forming the necessary agreements is difficult to accomplish. This is especially the case when one party
in a vertical arrangement maintains private information that can be used to its advantage to create a better deal for
itself but potentially will be a bad arrangement for the party that does not have that information in advance. As a
result, parties that are aware of their limited information about the other party will tend to be more conservative in
their agreement terms by assuming pessimistic circumstances and will not be able to reach an agreement. This
reaction is called adverse selection in economic literature.Nobel laureate George Akerlof (1970) wrote a seminal
paper examining adverse selection in the context of used cars.

In some cases, one party in a vertical arrangement may have production or planning secrets that do not affect the
agreement per se but risk being discovered by the other party as the result of any exchange transactions. These secrets
may be the result of costly research and development but may pass to the other party at essentially no cost, and the
other party may take advantage of that easily obtained information. This is a version of what economists call the free
rider problem.See the text by Brickley, Smith, and Zimmerman (2001) for more about the free rider problem in
economics of organizations. Due to the difficulty of protecting against problems of adverse selection and free riders,
firms may conclude that vertical integration is the better option.

5.6 Conglomerates

As stated earlier, a conglomerate is a business enterprise that participates in multiple value chains that are different
in nature. An example of a conglomerate is General Electric, which engages in the manufacture of appliances,
construction of energy facilities, financing of projects, and media ventures, just to name a portion of its product
portfolio.

One attraction of conglomerates is the ability to diversify so that the firm can withstand difficult times in one industry
by having a presence in other kinds of markets. Beyond diversification, a conglomerate can move capital from one of
its businesses to another business without the cost and difficulties of using outside capital markets. Often
conglomerates will have some divisions that are cash cows in being profitable operations in mature markets, and
other businesses that have great potential but require sizeable investment that can be funded by profits from the
cash-cow businesses.The concept of cash-cow businesses is an aspect of the Boston Consulting Group matrix for
corporate strategy (1970).

Another argument for conglomerates is that companies with very talented management staffs may be capable of
excelling in more than one type of business. For instance, the former chairman of General Electric, Jack Welch, was
widely praised as providing superior senior management for the wide range of businesses in which General Electric
participated.
5.7 Transaction Costs and Boundaries of the Firm

We have discussed several reasons a firm may decide to expand. At first glance, it may seem that expanding a
business is often a good idea and has little downside risk if the larger enterprise is managed properly. In fact, during
the last century successful businesses often engaged in horizontal and vertical integration and even became
conglomerates due to such reasoning.

However, as many of these large corporations learned, it is possible to become too large, too complex, or too
diversified. One consequence of a corporation growing large and complex is that it needs a management structure
that is large and complex. There needs to be some specialization among managers, much as there is specialization in
its labor force. Each manager only understands a small piece of the corporation’s operations, so there needs to be
efficient communication between managers to be able to take advantage of the opportunities of integration and
conglomeration. This requires additional management to manage the managers.

Large firms usually have some form of layered or pyramid management both to allow specialization of management
and to facilitate communication. Still, as the number of layers increases, the complexity of communication grows
faster than the size of the management staff. Information overload results in the failure of key information to arrive to
the right person at the right time. In effect, at some point the firm can experience diseconomies of scale and
diseconomies of scope as the result of management complexity increasing faster than the rate of growth in the overall
enterprise.

Another problem with expansion, especially in the cases of vertical integration and conglomerates, is that different
kinds of businesses may do better with different styles of management. The culture of a successful manufacturer of
consumer goods is not necessarily the culture of a startup software company. When many kinds of businesses are part
of the same corporation, it may be difficult to synchronize different business cultures.

Economists have developed a theory called transaction cost economics to try to explain when a firm should
expand and when it should not, or even when the firm would do better to either break apart or sell off some of its
business units. A transaction cost is the cost involved in making an exchange. An exchange can be external or internal.
An external exchange occurs when two separate businesses are involved, like the television manufacturer and its parts
supplier in the earlier example. Prior to the actual exchange of parts for cash, there is a period in which the companies
need to come to agreement on price and other terms. The external transaction costs are the costs to create and
monitor this agreement.

If a firm decides to expand its boundaries to handle the exchange internally, there are new internal transaction costs.
These would be the costs to plan and coordinate these internal exchanges. If exchanges of this nature have not been
done before, these internal transaction costs can be significant.

Nobel Prize laureate Ronald Coase introduced the concept of transaction costs and also proposed a principle for
determining when to expand known as the Coase hypothesis.The initial article that stimulated later development of
the transaction cost concept was by Ronald Coase (1937). Essentially, the principle states that firms should continue
to expand as long as internal transaction costs are less than external transaction costs for the same kind of exchange.

5.8 Cost Centers Versus Profit Centers

One internal transaction cost in multiple-division companies is how to coordinate the divisions that make internal
exchanges so they will achieve what is best for the overall corporation. This challenge is not merely a matter of
communication but of providing proper motivation for the individual units.

Large vertically integrated companies often have at least one upstream division that creates a product and a
downstream division that distributes it or sells it to consumers. One design for such companies is to have a central
upper management that decides what activities and activity levels should be provided by each division. These
instructions are given to the division managers. With the output goals of each division established, each division will
best contribute to the overall profitability of the corporation by trying to meet its output goals at minimum cost. As
such, divisions operating under this philosophy are called cost centers.

Although the cost center design may sound workable in principle, there is some risk in the division having an overall
objective of minimizing cost and divisional management evaluated in terms of that objective. The response to this
objective is that the firm may cut corners on quality as much as possible and avoid considering innovations that
would incur higher initial costs but ultimately result in a better product for the long run. Unless the top-level
management is aware of these issues and sets quality requirements properly, opportunities may be missed.

Another problem with cost centers, particularly in the nonprofit and public sectors, is that the compensation and
prestige afforded to division managers may be related to the size of division operations. Consequently, the incentive
for managers is to try to justify larger cost budgets rather than limit costs.

An alternative to the cost center approach is to treat a division as if it were like a business that had its own revenues
and costs. The goal of each division is to create the most value in terms of the difference between its revenues and
costs. This is known as a profit center. Division managers of profit centers not only have incentives to avoid waste and
improve efficiencies like cost centers but also have an incentive to improve the product in ways that create better
value.

5.9 Transfer Pricing

The profit center model treats a corporate division as if it were an autonomous business within a business. However,
often the reason for having multiple divisions in an enterprise is because there is vertical integration, meaning that
some divisions are providing goods and services to other divisions in the enterprise. If the two divisions in an
exchange are to be treated as if they were separate businesses, what price should be charged by the supplying
division? Even if there is no actual cash being tendered by the acquiring division, some measurement of value for the
exchange is needed to serve as the revenue for the selling division and the cost for the acquiring division. The
established value assigned to the exchanged item is called a transfer price.

One possibility for establishing a transfer price is for the two divisions to negotiate a price as they would if they were
indeed independent businesses. Unfortunately, this approach sacrifices one of the benefits of vertical
integration—namely, the avoidance of the transaction costs that are incurred on external changes—without avoiding
all the internal transaction costs.

Another approach to the problem of pricing interdivision exchanges is to base prices on principles rather than
negotiation. Academic research has concluded a number of principles for different kinds of situations. In this section,
we will limit our consideration to two of these situations.

Suppose two divisions in an enterprise, Division A and Division B, exchange a good that is only produced by Division
A. More specifically, there is no other division either inside or outside the enterprise that currently produces the good.
Division B is the only user of this good, either inside or outside of the enterprise. Under these conditions, theoretically
the best transfer price is the marginal cost of the good incurred by Division A.

No formal proof of this principle will be offered here, but a brief defense of this principle would be as follows: Suppose
the price charged was less than the marginal cost. If Division A decides on the production volume that would
maximize its internal divisional profit, then by reducing its volume somewhat, Division A would avoid more cost than
it loses in forgone transfer revenue. So Division A would elect to provide fewer units than Division B would want.

On the other hand, suppose the transfer price was set at a level higher than the marginal cost. Since the transfer cost
becomes a component of cost to receiving Division B, in determining its optimal volume of production, Division B will
see a higher marginal cost than is actually the case (or would be the case if Divisions A and B functioned as a single
unit). As a result, Division B may decide on a production level that is not optimal for the overall enterprise. By setting
the transfer price equal to Division A’s marginal cost, the decision by Division B should be the same as it would be if
the two divisions operated as one.

Although the principle is reasonably clear and defensible in theory, the participating divisions in an actual setting may
raise objections. If the average cost of the item to Division A is less than the marginal cost, Division B may complain
that they should not need to pay a transfer price above the average cost because that is what the actual cost per item is
to Division A and the enterprise overall. If the average cost per item exceeds the marginal cost, Division A may
complain that setting the transfer price to the marginal cost requires their division to operate at a loss for this item
and they should be credited with at least the average cost. Nonetheless, the best decisions by Divisions A and B for the
overall profit of the enterprise will occur when the transfer price is based on the marginal cost to Division A in this
situation.

As a second case situation, suppose the good transferred from Division A to Division B is a good that is both produced
and consumed outside the enterprise and there is a highly competitive market for both buyers and sellers. In this
instance the best internal transfer price between Division A and Division B would be the external market price.

A supporting argument for this principle is this: If the transfer price were higher than the outside market price,
Division B could reduce its costs by purchasing the good in the outside market rather than obtaining it from Division
A. If the outside market price were higher than the set transfer price, Division A would make higher divisional profit
by selling the good on the outside market than by transferring it to Division B.

5.10 Employee Motivation

Earlier we considered how to motivate divisions within a large organization with appropriate transfer pricing. How
about motivation within the divisions? As noted in the introduction to this chapter, in recent decades economists have
addressed this matter from a new perspective.

The traditional approach to motivation inside a division or modest-sized business was typically regarded as matters of
organizational design and organizational behavior. Once the employee agreed to employment in return for salary or
wages and benefits, his services were subject to direction by management within the scope of human resource policies
in terms of hours worked and work conditions. Ensuring good performance by employees was basically a matter of
appropriate supervision, encouragement, and feedback. In cases where employees were not performing adequately,
they would be notified of the problem, possibly disciplined, or even dismissed and replaced. From this perspective,
managing employees is much like managing military troops, differing largely in terms of the degree of control on the
individual’s free time and movements.

The new perspective on employee motivation is to consider the employee more like an individual contractor rather
than an enlisted soldier. Just as microeconomics viewed each consumer as an entity trying to maximize the utility for
his household, an individual employee is a decision-making unit who agrees to an employment relationship if he
believes this is the best utilization of his productive abilities. The challenge for business management is to structure
compensation, incentives, and personnel policies that induce employees to contribute near their productive capacities
but not overreward employees beyond what makes economic sense for the business.

One contribution from this economic perspective is the notion of an efficiency wage.See Milgrom and Roberts
(1992). The classical approach to setting wages is that the wage paid to an employee should be no more than the
marginal revenue product corresponding to her effort. However, if an employee is paid barely what her efforts are
worth to the firm at the margin and if there is a competitive market for the employee’s services in other firms, the
employee may not be motivated to work at maximum capacity or avoid engaging in behaviors that are detrimental to
the firm because she can earn as much elsewhere if she is dismissed. An efficiency wage is a wage that is set somewhat
above the marginal revenue product of the employee to give the employee an incentive to be productive and retain
this job because the employee would sacrifice the difference between the efficiency wage and marginal revenue
product if she sought employment elsewhere. This incentive is worthwhile to the firm because it avoids the
transaction costs of finding and hiring a new employee.

Another contribution of this economic viewpoint of employee motivation is an examination of employee contracts to
deal with what is called the principal-agent problem. In this context, the hiring business is a principal that hires
an employee (agent) to act on its behalf. The problem occurs when the agent is motivated to take actions that are not
necessarily what the employer would want, but the employer is not able to monitor all the activities of the employee
and has insufficient information.

In the employment relationship the employer evaluates the employee on the basis of her contribution to profit or
other objective of the firm. However, the employee evaluates her activities based on the amount of effort involved. To
the degree that employees see their compensation and incentives connected to the intensity of effort, the more likely
the employee will invest additional effort because there is reduced risk that her efforts will go unrewarded.

For example, if employee incentives are based on the overall performance of a team of employees without any
discrimination between individual employees, there is an incentive for employees to shirk in performance of their jobs
because they still benefit if others do the work and they do not risk putting in an extra effort to see the reward
diminished by sharing the incentives with others who did not put in the same effort. The informativeness
principle suggests that measures of performance that reflect individual employee effort be included in employee
contracts.A good description of the informativeness principle appears in Samuelson and Marks (2010).

A third interesting contribution of this perspective on employee motivation is the concept of signaling.Nobel
laureate Michael Spence (1974) introduced the economics of signaling. When employers hire, they face a pool of
possible employees. Some employees will perform well, whereas others will not due to either lack of skills or lack of
character. In the interview process, the employer will try to assess which applicants will be good employees, but these
evaluation processes are imperfect. The real intentions of the applicant if and when he becomes an employee are
largely private information until the person is actually hired and on the job for a while. As a result, employers face an
adverse selection problem similar to what was discussed earlier in the context of vertical integration and will often
protect against the risk by lowering the compensation offered, even though they would be willing to pay a motivated,
qualified employee more.

One response to the adverse selection problem by the employee is to take actions on his own that will help distinguish
him from others in the applicant pool, which are observable and serve as a signal to the employer. Seeking a college
degree has been cited as a kind of signal. Even though much of what the employee learned as part of obtaining the
college degree may be of little use in the prospective employment relationship, the fact that the applicant was willing
to endure the cost and effort for a college degree, particularly a degree supported with good grades, is evidence that
the applicant is more likely to be a dedicated and competent employee.

Applicants for employment or hire often have several employment relationships over time. By attaching importance
to reputation, employers can both motivate employees to be more diligent in their current positions and establish a
mechanism to help distinguish high-quality workers from low-quality workers in future hiring.

5.11 Manager Motivation and Executive Pay

In businesses where the manager is not the owner, there is another manifestation of the principal-agent problem. For
example, in a typical corporation, the owners are stockholders, many of whom are not involved in the actual
production activities. The board of directors hires executive management to act as the agents of the shareholders, who
are the principals in this context. The intent of the arrangement is that the executives will manage the corporation in
the best long-term interests of the shareholders. However, the executives, though they may own some of the
corporation’s shares, are largely rewarded via salaries, bonuses, and other perquisites. Structuring executive contracts
that both motivate the executive and represent the owners’ interests is a challenge.
The executives in corporations are often paid highly, certainly well above the opportunity cost of their labor in a
nonexecutive setting. There are multiple theories for these high executive salaries. One argument is based on
economic rent, namely, that talented executives are like star athletes and art performers, being in relatively short
supply, so corporations must pay well above their opportunity cost to have their services.

Another argument for high executive pay is that they need to be not only compensated for their effort but rewarded
for the value they create on behalf of the owners. So part of the higher salary is a share of the profits resulting from
their execution of management duties.

A third argument for high executive salaries is that firms must often take significant risks to succeed in competitive
markets and uncertain conditions. If the firm fails or falls short when its performance is assessed after the fact, the
executive may lose his job. In response to this, the executive may avoid bold moves that have a significant risk of
failure. In paying an executive highly, the executive is compensated for the additional personal risk he assumes by
being willing to take reasonable chances that the corporation must tolerate.

Another interesting argument for high executive pay is called tournament theory.See Milgrom and Roberts (1992).
This applies to large enterprises with a sizeable team of executives, with a highly paid chief executive officer (CEO),
along with several other vice presidents who are in line for consideration to become a future CEO. By paying the CEO
generously and well beyond what is economically justifiable on the basis of the CEO’s contributions per se, there is a
strong incentive for the other executives to put in extra effort so they will become that chief executive, with all the
high pay and perquisites, in the future. From the perspective of the shareholders, the gain from those collective extra
efforts is worth the high salary to the last winner of the CEO “tournament.”
Chapter 6

Market Equilibrium and the Perfect Competition Model

The remaining chapters of this text are devoted to the operations of markets. In economics, a market refers to the
collective activity of buyers and sellers for a particular product or service.

In this chapter we will focus on what might be considered the gold standard of a market: the perfect competition
model. The operations of actual markets deviate from the perfect competition model, sometimes substantially. Still,
this model serves as both a good initial framework for describing how a market functions and a reference base for
evaluating any market.

6.1 Assumptions of the Perfect Competition Model

The perfect competition model is built on five assumptions:

1. The market consists of many buyers. Any single buyer represents a very small fraction of all the purchases in
a market. Due to its insignificant impact on the market, the buyer acts as a price taker, meaning the buyer
presumes her purchase decision has no impact on the price charged for the good. The buyer takes the price
as given and decides the amount to purchase that best serves the utility of her household.

2. The market consists of many sellers. Any single seller represents a very small fraction of all the purchases in
a market. Due to its insignificant impact on the market, the seller acts as a price taker, meaning the seller
presumes its production decisions have no impact on the price charged for the good by other sellers. The
seller takes the price as given and decides the amount to produce that will generate the greatest profit.

3. Firms that sell in the market are free to either enter or exit the market. Firms that are not currently sellers in
the market may enter as sellers if they find the market attractive. Firms currently selling in the market may
discontinue participation as sellers if they find the market unattractive. Existing firms may also continue to
participate at different production levels as conditions change.

4. The good sold by all sellers in the market is assumed to be homogeneous. This means every seller sells the
same good, or stated another way, the buyer does not care which seller he uses if all sellers charge the same
price.

5. Buyers and sellers in the market are assumed to have perfect information. Producers understand the
production capabilities known to other producers in the market and have immediate access to any resources
used by other sellers in producing a good. Both buyers and sellers know all the prices being charged by other
sellers.

6.2 Operation of a Perfectly Competitive Market in the Short Run

The consequence of the preceding assumptions is that all exchanges in a perfectly competitive market will quickly
converge to a single price. Since the good is viewed as being of identical quality and utility, regardless of the seller,
and the buyers have perfect information about seller prices, if one seller is charging less than another seller, no buyer
will purchase from the higher priced seller. As a result, all sellers that elect to remain in the market will quickly settle
at charging the same price.

In Chapter 2 "Key Measures and Relationships" and Chapter 3 "Demand and Pricing", we examined the demand
curves seen by a firm. In the case of the perfect competition model, since sellers are price takers and their presence in
the market is of small consequence, the demand curve they see is a flat curve, such that they can produce and sell any
quantity between zero and their production limit for the next period, but the price will remain constant (see Figure 6.1
"Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market").

It must be noted that although each firm in the market perceives a flat demand curve, the demand curve representing
the behavior of all buyers in the market need not be a flat line. Since some buyers will value the item more than others
and even individual buyers will have decreasing utility for additional units of the item, the total market demand curve
will generally take the shape of a downward sloping curve, such as Figure 6.2 "Demand Curve as Seen for All Sellers in
a Market".

Figure 6.1 Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market

Any amount the firm offers for sale during a production period (up to its maximum possible production level) will
sell at the market price.

The downward sloping nature of the market demand curve in Figure 6.2 "Demand Curve as Seen for All Sellers in a
Market" may seem to contradict the flat demand curve for a single firm depicted in Figure 6.1 "Flat Demand Curve as
Seen by an Individual Seller in a Perfectly Competitive Market". This difference can be explained by the fact that any
single seller is viewed as being a very small component of the market. Whether a single firm operated at its maximum
possible level or dropped out entirely, the impact on the overall market price or total market quantity would be
negligible.
Although all firms will be forced to charge the same price under perfect competition and firms have perfect
information about the production technologies of other firms, firms may not be identical in the short run. Some may
have lower costs or higher capacities. Consequently, not all firms will earn the same amount of profit.

Figure 6.2 Demand Curve as Seen for All Sellers in a Market

Although one seller sees a fixed price for its supply, if all sellers were to increase production, the maximum price
that customers would pay to buy all the units offered would drop.

As described in the description of the shutdown rule in Chapter 2 "Key Measures and Relationships", some firms only
operate at an economic profit because they have considerable sunk costs that are not considered in determining
whether it is profitable to operate in the short run. Thus not only are there differences in profits among firms in the
short run, but even if the market price were to remain the same, not all the firms would be able to justify remaining in
the market when their fixed costs need to be replenished, unless they were able to adapt their production to match the
more successful operators.

6.3 Perfect Competition in the Long Run

As described in Chapter 4 "Cost and Production", a long-run time frame for a producer is enough time for the
producer to implement any changes to its processes. In the short run, there may be differences in size and production
processes of the firms selling in the market. Some sellers may be able to make a healthy economic profit, whereas
others may only barely make enough to justify continued operation and, as noted earlier, may not have sustainable
operations although they may continue to operate for a while since a substantial portion of their short-run costs are
sunk costs.
Due to the assumption of perfect information, all sellers know the production techniques of their competitors. As a
result, any firm that intends to remain in the market will revise its operations to mimic the operations of the most
successful firms in the market. In theory, in the long run all firms would either have the most cost-efficient operations
or abandon the market.

However, when all firms use the same processes, the possibility for firms to continue to earn positive economic profits
will disappear. Suppose all firms are earning a positive profit at the going market price. One firm will see the
opportunity to drop its price a small amount, still be able to earn an economic profit, and with the freedom to redefine
itself in the long run, no longer be constrained by short-run production limits. Of course, when one firm succeeds in
gaining greater profit by cutting its prices, the other firms will have no choice but to follow or exit the market, since
buyers in perfect competition will only be willing to purchase the good from the seller who has the lowest price. Since
the price has been lowered, all firms will have a lower economic profit than they had collectively before they lowered
the price.

Some firms may realize they can even drive the price lower, again take sales from their competitors, and increase
economic profit. Once again, all firms will be required to follow their lead or drop out of the market because firms that
do not drop the price again will lose all their customers. And once again, as all firms match the lowered price, the
economic profits are diminished.

In theory, due to competition, homogeneous goods, and perfect information, firms will continue to match and
undercut other firms on the price, until the price drops to the point where all remaining firms make an economic
profit of zero. As we explained earlier, an economic profit of zero is sufficient to sustain operations, but the firm will
no longer be earning an accounting profit beyond the opportunity costs of the resources employed in their ventures.

Another necessary development in the long run under perfect competition is that all firms will need to be large
enough to reach minimum efficient scale. Recall from Chapter 4 "Cost and Production" that minimum efficient scale
is the minimum production rate necessary to get the average cost per item as low as possible. Firms operating at
minimum efficient scale could charge a price equal to that minimum average cost and still be viable. Smaller firms
with higher average costs will not be able to compete because they will have losses if they charge those prices yet will
lose customers to the large firms with lower prices if they do not match their prices. So, in the long run, firms that
have operations smaller than minimum efficient scale will need to either grow to at least minimum efficient scale or
leave the market.

6.4 Firm Supply Curves and Market Supply Curves

The demand curve describes how either one consumer or a group of consumers would change the amount they would
purchase if the price were to change. Producers may also adjust the amounts they sell if the market price changes.

Recall from Chapter 2 "Key Measures and Relationships" the principle that a firm should operate in the short run if
they can achieve an economic profit; otherwise the firm should shut down in the short run. If the firm decides it is
profitable to operate, another principle from Chapter 2 "Key Measures and Relationships" stated that the firm should
increase production up to the level where marginal cost equals marginal revenue.

In the case of a flat demand curve, the marginal revenue to a firm is equal to the market price. Based on this principle,
we can prescribe the best operating level for the firm in response to the market price as follows:

● If the price is too low to earn an economic profit at any possible operating level, shut down.

● If the price is higher than the marginal cost when production is at the maximum possible level in the short
run, the firm should operate at that maximum level.

● Otherwise, the firm should operate at the level where price is equal to marginal cost.
Figure 6.3 "Relationship of Average Cost Curve, Marginal Cost Curve, and Firm Supply Curve for a Single Seller in a
Perfectly Competitive Market" shows a generic situation with average (economic) cost and marginal cost curves.
Based on the preceding rule, a relationship between the market price and the optimal quantity supplied is the
segment of the marginal cost curve that is above the shutdown price level and where the marginal cost curve is
increasing, up to the point of maximum production. For prices higher than the marginal cost at maximum
production, the firm would operate at maximum production.

Figure 6.3 Relationship of Average Cost Curve, Marginal Cost Curve, and Firm Supply Curve for a Single Seller in a
Perfectly Competitive Market

This curve segment provides an analogue to the demand curve to describe the best response of sellers to market prices
and is called the firm supply curve. As is done with demand curves, the convention in economics is to place the
quantity on the horizontal axis and price on the vertical axis. Note that although demand curves are typically
downward sloping to reflect that consumers’ utility for a good diminishes with increased consumption, firm supply
curves are generally upward sloping. The upward sloping character reflects that firms will be willing to increase
production in response to a higher market price because the higher price may make additional production profitable.
Due to differences in capacities and production technologies, seller firms may have different firm supply curves.

If we were to examine all firm supply curves to determine the total quantity that sellers would provide at any given
price and determined the relationship between the total quantity provided and the market price, the result would be
the market supply curve. As with firm supply curves, market supply curves are generally upward sloping and
reflect both the willingness of firms to push production higher in relation to improved profitability and the willingness
of some firms to come out of a short-run shutdown when the price improves sufficiently.
6.5 Market Equilibrium

The market demand curve indicates the maximum price that buyers will pay to purchase a given quantity of the
market product. The market supply curve indicates the minimum price that suppliers would accept to be willing to
provide a given supply of the market product. In order to have buyers and sellers agree on the quantity that would be
provided and purchased, the price needs to be a right level.

The market equilibrium is the quantity and associated price at which there is concurrence between sellers and
buyers. If the market demand curve and market supply curve are displayed on the same graph, the market
equilibrium occurs at the point where the two curves intersect (see Figure 6.4 "Market Equilibrium as the Coordinates
for Quantity and Price Where the Market Demand Curve Crosses the Market Supply Curve").

Recall that the perfect competition model assumes all buyers and sellers in the market are price takers. This raises an
interesting question: If all the actors in the market take the price as given condition, how does the market get to an
equilibrium price?

One answer to this question was provided by the person who is often described as the first economist, Adam Smith.
Adam Smith lived in the late 18th century, many years before a formal field of economics was recognized. In his own
time, Smith was probably regarded as a philosopher. He wrote a treatise called The Wealth of Nations,See Smith
(1776). in which he attempted to explain the prosperity that erupted in Europe as the result of expanded commercial
trade and the industrial revolution.

Smith ascribed the mechanism that moves a market to equilibrium as a force he called the invisible hand. In effect,
if the price is not at the equilibrium level, sellers will detect an imbalance between supply and demand and some will
be motivated to test other prices. If existing market price is below the equilibrium price, the provided supply will be
insufficient to meet the demand. Sensing this, some suppliers will try a slightly higher price and learn that, despite
perfect information among buyers, some buyers will be willing to pay the higher price if an additional amount would
be supplied. Other sellers will see that the higher price has enough demand and raise their prices as well. The new
price may still be below equilibrium, so a few sellers will test a higher price again, and the process will repeat until
there is no longer a perception of excess demand beyond the amount buyers want at the current price.

Figure 6.4 Market Equilibrium as the Coordinates for Quantity and Price Where the Market Demand Curve Crosses
the Market Supply Curve
If the market price is higher than the equilibrium price, sellers will initially respond with increased rates of
production but will realize that buyers are not willing to purchase all the goods available. Some sellers will consider
lowering the price slightly to make a sale of goods that would otherwise go unsold. Seeing this is successful in
encouraging more demand, and due to buyers being able to shift their consumption to the lower priced sellers, all
sellers will be forced to accept the lower price. As a result, some sellers will produce less based on the change in their
firm supply curve and other sellers may shut down entirely, so the total market supply will contract. This process may
be repeated until the price lowers to the level where the quantity supplied is in equilibrium with the quantity
demanded.

In actual markets, equilibrium is probably more a target toward which prices and market quantity move rather than a
state that is achieved. Further, the equilibrium itself is subject to change due to events that change the demand
behavior of buyers and production economics of suppliers. Changes in climate, unexpected outages, and accidental
events are examples of factors that can alter the market equilibrium. As a result, the market price and quantity is
often in a constant state of flux, due to both usually being out of equilibrium and trying to reach an equilibrium that is
itself a moving target.

6.6 Shifts in Supply and Demand Curves

In addition to the factors that cause fluctuations in the market equilibrium, some developments may lead to sustained
changes in the market equilibrium. For example, if a new product becomes available that is a viable substitute for an
existing product, there is likely to be either a persistent drop in the quantity consumed of the existing good or a
reduction in the market price for the existing good.

The impact of these persistent changes can be viewed in the context of changes in the behavior of buyers or the
operations of sellers that cause a shift in the demand curve or the supply curve, respectively. In the case of the new
availability of a close substitute for an existing product, we would expect the demand curve to shift to the left,
indicating that at any market price for the existing good, demand will be less than it was prior to introduction of the
substitute. As another example, consider the supply curve for gasoline after an increase in the price of crude oil. Since
the cost of producing a gallon of gasoline will increase, the marginal cost of gasoline will increase at any level of
production and the result will be an upward shift in the supply curve.

It is often of interest to determine the impact of a changing factor on the market equilibrium. Will the equilibrium
quantity increase or decrease? Will the equilibrium price increase or decrease? Will the shift in the equilibrium point
be more of a change in price or a change in quantity? The examination of the impact of a change on the equilibrium
point is known in economics as comparative statics.

In the case of a shifting demand curve, since the supply curve is generally upward sloping, a shift of the demand curve
either upward or to the right will result in both a higher equilibrium price and equilibrium quantity. Likewise, a shift
in the demand curve either downward or to the left will usually result in a lower equilibrium price and a lower
equilibrium quantity. So in response to the introduction of a new substitute good where we would expect a leftward
shift in the demand curve, both the equilibrium price and quantity for the existing good can be expected to decrease
(see Figure 6.5 "Shift of Market Demand to the Left in Response to a New Substitute and Change in the Market
Equilibrium").

Whether a shift in the demand curve results in a greater relative change in the equilibrium price or the equilibrium
quantity depends on the shape of the supply curve. If the supply curve is fairly flat, or elastic, the change will be
primarily in the equilibrium quantity (see Figure 6.6 "Impact of Elasticity of the Supply Curve on the Impact of a Shift
in the Demand Curve"). An elastic supply curve means that a small change in price typically results in a greater
response in the provided quantity. If the supply curve is fairly vertical, or inelastic, the change in equilibrium will be
mostly seen as a price change (see Figure 6.7 "Impact of Elasticity of the Supply Curve on the Impact of a Shift in the
Demand Curve").
Figure 6.5 Shift of Market Demand to the Left in Response to a New Substitute and Change in the Market
Equilibrium

Figure 6.6 Impact of Elasticity of the Supply Curve on the Impact of a Shift in the Demand Curve
The shift is generally in terms of the quantity when the supply curve is elastic.

Figure 6.7 Impact of Elasticity of the Supply Curve on the Impact of a Shift in the Demand Curve

The shift is generally in terms of the price when the supply curve is inelastic.

A shift in the supply curve has a different effect on the equilibrium. Because the demand curve is generally downward
sloping, a shift in the supply curve either upward or to the left will result in a higher equilibrium price and a lower
equilibrium quantity. However, a shift in the supply either downward or to the right will result in a lower equilibrium
price and a higher equilibrium quantity. So for the example of the gasoline market where the supply curve shifts
upward, we can expect prices to rise and the quantity sold to decrease (see Figure 6.8 "Shift of Market Supply Upward
in Response to an Increase in the Price of Crude Oil and Change in the Market Equilibrium").

The shape of the demand curve dictates whether a shift in the supply curve will result in more change in the
equilibrium price or the equilibrium quantity. With a demand curve that is flat, or elastic, a shift in supply curve will
change the equilibrium quantity more than the price (see Figure 6.9 "Impact of Elasticity of the Demand Curve on the
Impact of a Shift in the Supply Curve"). With a demand curve that is vertical, or inelastic, a shift in the supply curve
will change the equilibrium price more than the equilibrium quantity (see Figure 6.10 "Impact of Elasticity of the
Demand Curve on the Impact of a Shift in the Supply Curve").

The characterization of a demand curve as being elastic or inelastic corresponds to the measure of price elasticity that
was discussed in Chapter 3 "Demand and Pricing". Recall from the discussion of short-run versus long-run demand
that in the short run, customers are limited in their options by their consumption patterns and technologies. This is
particularly true in the case of gasoline consumption. Consequently, short-run demand curves for gasoline tend to be
very inelastic. As a result, if changing crude oil prices results in an upward shift in the supply curve for gasoline, we
should expect the result to be a substantial increase in the price of gasoline and only a fairly modest decrease in the
amount of gasoline consumed.

Figure 6.8 Shift of Market Supply Upward in Response to an Increase in the Price of Crude Oil and Change in the
Market Equilibrium

Figure 6.9 Impact of Elasticity of the Demand Curve on the Impact of a Shift in the Supply Curve
The shift is generally in terms of the quantity when the demand curve is elastic.

Figure 6.10 Impact of Elasticity of the Demand Curve on the Impact of a Shift in the Supply Curve

The shift is generally in terms of the price when the demand curve is inelastic.

6.7 Why Perfect Competition Is Desirable

In a simple market under perfect competition, equilibrium occurs at a quantity and price where the marginal cost of
attracting one more unit from one supplier is equal to the highest price that will attract the purchase of one more unit
from a buyer. At the price charged at equilibrium, some buyers are getting a bargain of sorts because they would have
been willing to purchase at least some units even if the price had been somewhat higher. The fact that market demand
curves are downward sloping rather than perfectly flat reflects willingness of customers to make purchases at higher
prices.

At least in theory, we could imagine taking all the units that would be purchased at the equilibrium price and using
the location of each unit purchase on the demand curve to determine the maximum amount that the buyer would
have been willing to pay to purchase that unit. The difference between what the customer would have paid to buy a
unit and the lower equilibrium price he actually paid constitutes a kind of surplus that goes to the buyer. If we
determined this surplus for each item purchased and accumulated the surplus, we would have a quantity called
consumer surplus. Using a graph of a demand curve, we can view consumer surplus as the area under the demand
curve down to the horizontal line corresponding to the price being charged, as shown in Figure 6.11 "Graph of Market
Demand and Market Supply Curves Showing the Consumer Surplus and Producer Surplus When the Market Is in
Perfect Competition Equilibrium".

On the supplier side, there is also a potential for a kind of surplus. Since market supply curves are usually upward
sloping, there are some sellers who would have been willing to sell the product even if the price had been lower
because the marginal cost of the item was below the market price, and in perfect competition, a producer will always
sell another item if the price is at least as high as the marginal cost. If, as before, we assessed each item sold in terms
of its marginal cost, calculated the difference between the price and the marginal cost, and then accumulated those
differences, the sum would be a quantity called the producer surplus.

Figure 6.11 Graph of Market Demand and Market Supply Curves Showing the Consumer Surplus and Producer
Surplus When the Market Is in Perfect Competition Equilibrium

The producer surplus reflects the combined economic profit of all sellers in the short run. For a graph of the supply
curve, the producer surplus corresponds to the area above the supply curve up to the horizontal line at the market
price, again as shown in Figure 6.11 "Graph of Market Demand and Market Supply Curves Showing the Consumer
Surplus and Producer Surplus When the Market Is in Perfect Competition Equilibrium".

Consumer surplus will increase as the price gets lower (assuming sellers are willing to supply at the level on the
demand curve) and producer surplus will increase as the prices gets higher (assuming buyers are willing to purchase
the added amount as you move up the supply curve). If we asked the question, at what price would the sum of
consumer surplus plus producer surplus would be greatest, the answer is at the equilibrium price, where the demand
curve and supply curve cross.

To support this claim, suppose sellers decided to increase the price above the equilibrium price. Since consumers
would purchase fewer items, the quantity they could sell is dictated by the demand curve. The new producer surplus,
as seen in Figure 6.12 "Change in Consumer Surplus and Producer Surplus When Sellers Increase Price Above the
Equilibrium Price", might be higher than the producer surplus at the equilibrium price, but the consumer surplus
would be decidedly lower. So any increase in producer surplus comes from what had been consumer surplus.
However, there is a triangular area in Figure 6.12 "Change in Consumer Surplus and Producer Surplus When Sellers
Increase Price Above the Equilibrium Price", between the supply and demand curve and to the right of the new
quantity level, which represents former surplus that no longer goes to either consumers or producers. Economists call
this lost surplus a deadweight loss.

If the price were lower than the equilibrium price, we encounter a situation where producer surplus decreases and at
best only some of that decrease transfers to consumers. The rest of the lost producer surplus is again a deadweight
loss, as seen in Figure 6.13 "Change in Consumer Surplus and Producer Surplus When Buyers Force the Price Below
the Equilibrium Price".

The important point is that changing the price is worse than just a shift of surplus from consumers to producers, or
vice versa. If the entire sum of consumer surplus and producer surplus could grow at a different price, it could be
argued that the government could use a tax to take some of the excess received by one group and redistribute it to the
other party so everyone was as well off or better off. Unfortunately, due to the deadweight loss, the gain to one of two
parties will not offset the loss to the other party. So the equilibrium point is not only a price and quantity where we
have agreement between the demand curve and supply curve, but also the point at which the greatest collective
surplus is realized.

Figure 6.12 Change in Consumer Surplus and Producer Surplus When Sellers Increase Price Above the Equilibrium
Price

Note the creation of a deadweight loss that was formerly part of either consumer surplus or producer surplus when
the market operated at the perfect competition equilibrium.
Figure 6.13 Change in Consumer Surplus and Producer Surplus When Buyers Force the Price Below the Equilibrium
Price

Note the creation of a deadweight loss that was formerly part of either consumer surplus or producer surplus when
the market operated at the perfect competition equilibrium.

6.8 Monopolistic Competition

Next we will consider some slight variations on the perfect competition model. The first is the oddly named
monopolistic competition model,The monopolistic competition model is discussed in Samuelson and Marks
(2010). which uses the same assumptions as the perfect competition model with one difference: The good sold may be
heterogeneous. This means that while all sellers in the market sell a similar good that serves the same basic need of
the consumer, some sellers can make slight variations in their version of the good sold in the market.

As an example, consider midsized passenger automobiles. Some firms may sell cars that are a different color or
different shape, have different configurations of onboard electronics like GPS systems, and so on. Some firms may
make the cars more reliable or built to last longer.

Variation in the product by sellers will only make sense if consumers are responsive to these differences and are
willing to pay a slightly higher price for the variation they prefer. The reason that slightly higher prices will be
necessary is that in order to support variation in product supplied, sellers may no longer be able to operate at the
same minimum efficient scale that was possible when there was one version of the good that every seller produced in
a manner that was indistinguishable from the good of other sellers.
The fact that firms may be able to charge a higher price may suggest that firms can now have sustained positive
economic profits, particularly if they have a variation of the product that is preferred by a sizeable group of buyers.
Unfortunately, even under monopolistic competition, firms can expect to do no better than a zero economic profit in
the long run. The rationale for this is as follows: Suppose a firm has discovered a niche variation that is able to sustain
a premium price and earn a positive economic profit. Another firm selling in the market or a new entrant in the
market will be attracted to mimic the successful firm. Due to free entry and perfect information, the successful firm
will not be able to stop the copycats. Once the copycats are selling a copy of this product variation, a process of price
undercutting will commence as was described for perfect information, and prices will continue to drop until the price
equals average cost and firms are earning only a zero economic profit.

6.9 Contestable Market Model

The contestable market modelThe key text on the contestable market model is by Baumol, Panzar, and Willig
(1982). alters a different assumption of the perfect competition model: the existence of many sellers, each of which is
a barely discernable portion of all sales in the market. When we consider most of the markets that exist in the real
world, it is rare that this condition of the perfect competition model applies. Rather, most markets have sellers that
represent a substantial presence and would noticeably change the market if any one of them would suddenly suspend
production and sales. Also, in many industries, the minimum efficient scale is so large that any firm that manages to
increase to that size will be necessarily contributing a substantial fraction of all market sales.

In the contestable market model, there can be a modest number of sellers, each of which represents a sizeable portion
of overall market sales. However, the assumptions of free entry and exit and perfect information need to be retained
and play a key role in the theory underlying this model. If buyers in the market know which seller has the lowest price
and will promptly transfer their business to the lowest price seller, once again any firm trying to sell at a higher price
will lose all its customers or will need to match the lowest price.

Of course, it may be argued that the selling firms, by virtue of their size and being of limited number, could all agree
to keep prices above their average cost so they can sustain positive economic profits. However, here is where the
assumption of free entry spoils the party. A new entrant could see the positive economic profits of the existing sellers,
enter the market at a slightly lower price, and still earn an economic profit. Once it is clear that firms are unable to
sustain a pact to maintain above cost prices, price competition will drive the price to where firms will get zero
economic profits.

In the late 1970s, the U.S. government changed its policy on the passenger airline market from a tightly regulated
market with few approved air carriers to a deregulated market open to new entrants. The belief that airlines could
behave as a contestable market model was the basis for this change. Previously, the philosophy was that airline
operations required too much capital to sustain more than a small number of companies, so it was better to limit the
number of commercial passenger airlines and regulate them. The change in the 1970s was that consumers would
benefit by allowing free entry and exit in the passenger air travel market. Initially, the change resulted in several new
airlines and increases in the ranges of operations for existing airlines, as well as more flight options and lower airfares
for consumers. After a time, however, some of the larger airlines were able to thwart free entry by dominating airport
gates and controlling proprietary reservation systems, causing a departure from the contestable market model.A good
account of airline industry deregulation is in chapter 9 of Brock (2009).

6.10 Firm Strategies in Highly Competitive Markets

Markets that closely resemble the perfect competition model or its variants might be ideal from the standpoint of
market customers and as a means of increasing social surplus. From the perspective of individual selling firms, highly
competitive markets require that sellers carefully attend to cost and market conditions, while promising only modest
returns on assets and invested capital for those firms that manage to survive. Despite the limited opportunity for
profit in these markets over the long run, good and well-executed strategies can help firms in these markets be among
the survivors and perhaps extend the period in which they can do better than sell products at average cost.
Michael Porter of Harvard University prepared a guidebook for firms to prevail in these competitive markets in his
text Competitive Strategy.See Porter (1980). Basically, he advises that firms adopt an aggressive program to either
keep their costs below the costs of other sellers (called a cost leadership strategy) or keep their products
distinguishable from the competition (called a product differentiation strategy). The logic of either of these
strategies can be viewed as trying to delay the development of the assumed conditions of perfect competition, so as to
delay its long-run conclusions of zero economic profit.

The perfect competition model allows that some firms will do better than others in the short run by being able to
produce a good or service at lower cost, due to having better cost management, production technologies, or economies
of scale or scope. However, the model assumption of perfect information means that any firms with cost advantages
will soon be discovered and mimicked. The cost leadership strategy prescribes that firms need to continually look for
ways to continue to drive costs down, so that by the time the competition copies their technology and practices, they
have already progressed to an even lower average cost. To succeed, these programs need to be ongoing, not just done
once.

The monopolistic competition model allows for some differentiation in a product and the opportunity to charge a
higher price because buyers are willing to pay a premium for this. However, any short-run opportunity for increased
economic profit from selling a unique version of the product will dissipate as the competition takes notice and copies
the successful variant. Porter’s product differentiation strategy is basically a steady pursuit of new product variants
that will be prized by the consumer, with the intent of extending the opportunity for above-normal profits. However,
as with the cost leadership strategy, to be successful, a firm must commit itself to continued product differentiation
with up-front investment in development and market research.

Porter suggests that each of his two strategies may be geared toward participation in a broader market or limited to a
particular segment of the market, which he calls a focus strategy. A focus strategy endeavors to take advantage of
market segmentation. As we discussed in Chapter 3 "Demand and Pricing", the population of buyers is not usually
homogeneous; some are willing to pay a higher price (less price elastic) and some are willing to purchase in greater
volume. By focusing on a particular segment, a firm may be able to maintain an advantage over other sellers and
again forestall the onset of the long-run limitations on seller profits. The goal of the focus strategy is to be able to
serve this segment either at lower cost or with product variations that are valued by the customer segment. Of course,
by focusing on just one or a subset of buyer segments, a firm loses the opportunity for profits in other segments, so
depending on the product, the circumstances of the market, and the assets of the firm, a broader application of cost
leadership or product differentiation may be better.

The potential for success using a cost leadership strategy or a product differentiation strategy might suggest that a
firm can do even better by practicing both cost leadership and product differentiation. Porter advises against this,
saying that firms that try to use both strategies risk being “stuck in the middle.” A firm that tries to be a cost leader
will typically try to take advantage of scale economies that favor volume over product features and attract customers
who are sensitive to price. Product differentiation seeks to attract the less price sensitive customer who is willing to
pay more, but the firm may need to spend more to create a product that does this. Firms that try to provide a good or
service that costs less than the competition and yet is seen as better than the competition are endeavoring to achieve
two somewhat opposing objectives at the same time.
Chapter 7

Firm Competition and Market Structure

Although highly competitive markets similar to the models in the previous chapter are desirable for an economy and
occur for some goods and services, many important markets deviate significantly from the assumptions made in that
discussion and operate differently. In this chapter we will consider some concepts and theories that help explain some
of these other markets.

7.1 Why Perfect Competition Usually Does Not Happen

The perfect competition model (and its variants like monopolistic competition and contestable markets) represents
an ideal operation of a market. As we noted in Chapter 6 "Market Equilibrium and the Perfect Competition Model",
not only do the conditions of these models encourage aggressive competition that keeps prices as low as possible for
buyers, but the resulting dynamics create the greatest value for all participants in the market in terms of surplus for
consumers and producers.

Some markets resemble perfect competition more than others. Agricultural markets, particularly up through the
beginning of the 20th century, were viewed as being close to a real-world version of a perfectly competitive market.
There were many farmers and many consumers. No farmer and no consumer individually constituted sizeable
fractions of the market activity, and both groups acted as price takers. With a modest amount of capital, one could
acquire land, equipment, and seed or breeding stock to begin farming, especially when the United States was
expanding and large volumes of unused land were available for purchase or homesteading. Although some farmers
had better land and climate or were better suited for farming, the key information about how to farm was not
impossible to learn.

However, in recent decades circumstances have changed, even for farming, in a way that deviates from the
assumptions of perfect competition. Now farmers are unlikely to sell directly to consumers. Instead, they sell to food
processing companies, large distributors, or grocery store chains that are not small and often not price takers. Many
farming operations have changed from small, family-run businesses to large corporate enterprises. Even in markets
where farming operations are still relatively small, the farmers form cooperatives that have market power.
Additionally, the government takes an active role in the agriculture market with price supports and subsidies that
alter farm production decisions.

One reason so few markets are perfectly competitive is that minimum efficient scales are so high that eventually the
market can support only a few sellers. Although the contestable market model suggests that this factor alone does not
preclude aggressive price competition between sellers, in most cases there is not really free entry for new firms. A new
entrant will often face enormous startup capital requirements that prohibit entry by most modest-sized companies or
individual entrepreneurs. Many markets are now influenced by brand recognition, so a new firm that lacks brand
recognition faces the prospect of large promotional expenses and several periods with losses before being able to turn
a profit. To justify the losses in the startup period, new entrants must expect they will see positive economic profits
later to justify these losses, so the market is not likely to reach the stage of zero economic profit even if the new
entrants join.

Due to economies of scope, few sellers offer just one product or are organized internally such that production of that
one product is largely independent of the other products sold by that business. Consequently, it will be very difficult
for a competitor, especially a new entrant in the market, to readily copy the breadth of operations of the most
profitable sellers and immediately benefit from potential economies of scope.

Sellers that are vertically integrated may have control of upstream or downstream markets that make competition
difficult for firms that focus on one stage in the value chain. For example, one firm may have control of key resources
required in the production process, in terms of either the overall market supply or those resources of superior quality,
making it hard for other firms to match their product in both cost and quality. Alternatively, a firm may control a
downstream stage in the value chain, making it difficult for competitors to expand their sales, even if they price their
products competitively.

As we will discuss in the next chapter, markets are subject to regulation by government and related public agencies. In
the process of dealing with some perceived issues in these markets, these agencies will often block free entry of new
firms and free exit of existing firms.

In our complex technological world, perfect information among all sellers and buyers is not always a reasonable
assumption. Some sellers may possess special knowledge that is not readily known by their competition. Some
producers may have protection of patents and exclusive rights to technology that gives them a sustained advantage
that cannot be readily copied. On the buyer side, consumers usually have a limited perspective on the prices and
products of all sellers and may not always pay the lowest price available for a good or service (although the Internet
may be changing this to some degree).

Finally, for the perfect competition model to play out according to theory, there needs to be a reasonable level of
stability so that there is sufficient time for the long-run consequences of perfect competition to occur. However, in our
fast-changing world, the choices of goods and services available to consumers, the technologies for producing those
products and services, and the costs involved in production are increasingly subject to rapid change. Before market
forces can begin to gel to create price competition and firms can modify their operations to copy the most successful
sellers, changes in circumstances may stir enough such that the market formation process starts anew.

7.2 Monopoly

Often, the main deterrent to a highly competitive market is market power possessed by sellers. In this section, we will
consider the strongest form of seller market power, called a monopoly. In a monopoly there is only one seller, called
a monopolist.

Recall that in perfect competition, each firm sees the demand curve it faces as a flat line, so it presumes it can sell as
much as it wants, up to its production limit, at the prevailing market price. Even though the overall market demand
curve decreases with increased sales volume, the single firm in perfect competition has a different perception because
it is a small participant in the market and takes prices as given. In the case of flat demand curves, price and marginal
revenue are the same, and since a profit-maximizing producer decides whether to increase or decrease production
volume by comparing its marginal cost to marginal revenue, in this case the producer in perfect competition will sell
more (if it has the capability) up the point where marginal cost equals price.

In a monopoly, the demand curve seen by the single selling firm is the entire market demand curve. If the market
demand curve is downward sloping, the monopolist knows that marginal revenue will not equal price. As we
discussed in Chapter 2 "Key Measures and Relationships", when the demand curve is downward sloping, the marginal
revenue corresponding to any quantity and price on the demand curve is less than the price (see Figure 7.1 "Graph
Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market Equilibrium Price and
Quantity"). Because the condition for optimal seller profit is where marginal revenue equals marginal cost, the
monopolist will elect to operate at a quantity where those two quantities are in balance, which will be at volume
marked QM in Figure 7.1 "Graph Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market
Equilibrium Price and Quantity".

Since the monopolist has complete control on sales, it will only sell at the quantity where marginal revenue equals
marginal cost but will sell at the higher price associated with that quantity on the demand curve, PM, rather than the
marginal cost at a quantity of QM.
Figure 7.1 Graph Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market Equilibrium
Price and Quantity

If the marginal cost curve for the monopolist were instead the combined marginal cost curves of small firms in perfect
competition, the marginal cost curve would correspond to the market supply curve. The perfect competition market
equilibrium would occur at a volume QC, with a price PC. The monopolist could afford to function at this same volume
and price and may even earn some economic profit. However, at this volume, marginal cost is greater than marginal
revenue, indicating greater profit by operating at a lower volume at a higher price. The highest profit will result from
selling QM units at a price of PM. Unfortunately, consumers do worse at the monopolist’s optimal operation as they pay
a higher price and purchase fewer units. And as we noted in the previous chapter, the loss in consumer surplus will
exceed the profit gain to the monopolist. This is the main reason monopolies are discouraged, if not outlawed, by
governments.

7.3 Oligopoly and Cartels

Unless a monopoly is allowed to exist due to a government license or protection from a strong patent, markets have at
least a few sellers. When a market has multiple sellers, at least some of which provide a significant portion of sales
and recognize (like the monopolist) that their decisions on output volume will have an effect on market price, the
arrangement is called an oligopoly.

At the extreme, sellers in an oligopoly could wield as much market power as a monopolist. This occurs in an oligopoly
arrangement called a cartel, where the sellers coordinate their activities so well that they behave in effect like
divisions of one enterprise, rather than as a competing business, that make independent decisions on quantity and
price. (You may be familiar with the term cartel from the OPEC oil exporting group that is frequently described as a
cartel. However, though OPEC has considerable market power and influence on prices, there are oil exporters that are
not in OPEC, and internally OPEC only sets member targets rather than fully coordinating their operations.)
In theory, a cartel would operate at the same production volume and price as it would if its productive resources were
all run by a monopolist. In a cartel, every member firm would sell at the same price and each firm would set its
individual production volume such that every firm operates at the same marginal cost.

For the same reason that monopolies are considered harmful, cartels are usually not tolerated by governments for the
regions in which those markets operate. Even the collusion that is a necessary component of a true cartel is illegal.

However, although cartels could theoretically function with the same power as a monopolist, if the cartel truly
contains multiple members making independent decisions, there is a potential instability that can undo the cartel
arrangement. Because monopolists gain added profit by reducing production volume and selling at a price above
marginal cost, individual members may see an opportunity to defect, particularly if they can do so without being
easily detected. Since the cartel price will be well above their marginal cost, they could profit individually by
increasing their own production. Of course, if the defection is discovered and the other members retaliate by
increasing their volumes as well, the result could be a substantially lower market price and lower economic profits for
all cartel members.

Another problem for cartels is how to divide the profits. Suppose a cartel had two member firms, A and B. Firm A has
more efficient facilities than Firm B, so the cartel solution will be to allow Firm A to provide the bulk of the
production volume. However, if Firm A claims its share of the profits should be proportional to its share of the
production volume, Firm B may object to voluntarily withholding its production only to allow to Firm A to grab most
of the sales and profit, and the arrangement could end.

Also, since optimal cartel operation means that all firms set production so all have the same marginal cost, the firms
need to share internal information for the cartel to determine the total volume where marginal revenue equals
marginal cost and how that volume gets divided between firms. Again, some firms may have the incentive to keep the
details of their operations private from other firms in the cartel.

7.4 Production Decisions in Noncartel Oligopolies

Oligopolies exist widely in modern economies. However, due to the reasons just cited, most do not function as cartels.
Still, since these markets have relatively few sellers and each has a significant share of market sales, in many cases the
total market production by oligopoly firms is less than would be expected if the market were perfectly competitive,
and prices will be somewhat higher.

From the point of theory, the expected operation of the firm in perfect competition or in monopoly/cartel is
straightforward. Assuming the firm in the perfect competition sufficiently understands its production costs, it will
increase volume up to the point where its marginal cost exceeds the price. For a monopolist or cartel, production
should increase up to point where marginal cost equals marginal revenue.

Oligopolies fall somewhere in between perfect competition and a cartel. However, the prescription of how to set
optimal production volume is considerably more complex than either of the extremes. Like the monopolist, the
oligopoly firm is aware that significant changes in its production level will have a significant effect on the market
supply quantity, requiring a change in the market price to be in agreement with a downward sloping demand curve.
However, while the firm is aware its production decisions will affect the market price, it is difficult to forecast the
actual impact on price, even if the firm knows the behavior of the market demand curve.

A major reason for the complexity in determining the optimal production level is that the firm does not know how its
oligopoly competitors will respond to its production decisions. For example, suppose a firm looks at the current
market price and decides based on the market demand curve that it could increase its production volume by 1000
units per day and make a greater profit, even if the price dropped according to the market demand curve. Other
sellers in the market will see the action taken and may decide that if the price is dropping and market demand is
increasing that they could benefit by increasing their production to take advantage. As a consequence, the total
market volume may increase more than expected, prices will drop more than expected, and the resulting gain in profit
will be less than what the initial firm expected when it did its analysis.

Trying to figure out how to deal with reactions of other sellers not only is a vexing problem for sellers in oligopolies
but has been a difficult challenge for academic economists who try to develop theories of oligopoly. The scholarly
literature of economics is filled with elaborate mathematical models that attempt to address oligopoly operation. Next
we will consider some of the insights of these analyses without the mathematics.

One approach that economists have used to model the behavior of oligopoly firms, known as the Bertrand model or
price competition, is to assume all firms can anticipate the prices that will be charged by their competitors. If firms
can reasonably anticipate the prices that other firms will charge and have a reasonable understanding of market
demand, each firm can determine how customers would react to its own price and decide what production level and
price leads to highest profit. The soft drink market is an example of a market that could operate in this manner.

Another approach for modeling oligopoly behavior, known as the Cournot model or quantity competition, is to
assume all firms can determine the upcoming production levels or operating capacities of their competitors. For
example, in the airline industry, schedules and gate arrangements are made months in advance. In essence, the
airlines have committed to a schedule, their flying capacities are somewhat fixed, and what remains is to make the
necessary adjustments to price to use the committed capacity effectively.

In comparing models where firms anticipate price to those where firms anticipate production volume or capacity
commitment, firms that anticipate quantity levels tend to operate at lower production levels and charge higher prices.
This occurs because in a quantity competition model, firms subtract the planned operation of their rivals from the
market demand curve and assume the residual is the demand curve they will face. This leads to the presumption that
the price elasticity of their own demand is the same as the price elasticity of overall market demand, whereas in price
competition models the elasticity of the firm’s own demand is seen as greater than the price elasticity of overall
market demand (as was the case in the perfect competition model).

The number of selling firms also has an effect on the likely outcome of oligopoly competition. As the number of firms
increases, the market equilibrium moves toward the equilibrium that would be expected in a perfectly competitive
market of firms with the same aggregate production resources.

Another issue that can affect the prices and quantity volumes in an oligopoly market is the existence of a “leader”
firm. A leader firm will make a decision on either its price or its volume/capacity commitment and then the
remaining “follower firms” determine how they will react. An example of a leader firm in an industry might be
Apple in the portable media player market. Apple decides on how it will price its iPod products and other
manufacturers then decide how to price their products. Although the leader firm commits first in these models, in
order to determine its own best course of action, it needs to anticipate how the follower firms will react to its decision.

7.5 Seller Concentration

Sellers in oligopolies can limit competition by driving out competitors, blocking entry by new competitors, or
cooperating with other sellers with market power to keep prices higher than would be the case in a market with strong
price competition. In order for sellers to exercise market power, either the market will have fairly few selling firms or
there will be some selling firms that account for a large portion of all the market sales. When this happens, the market
is said to have high seller concentration. Although high seller concentration in itself is not sufficient for exercise of
seller power, it is generally a necessary condition and constitutes a potential for the exercise of seller power in the
future. In this section, we will consider two numerical measures of market concentration: concentration ratios and the
Herfindahl-Hirschmann Index (HHI).

Both measures of seller concentration are based on seller market shares. A firm’s market share is the percentage of
all market sales that are purchased from that firm. The highest possible market share is 100%, which is the market
share of a monopolist. Market shares may be based either on the number of units sold or in terms of monetary value
of sales. The latter use of monetary value is convenient when there are variations in the good or service sold and
different prices are charged.

Concentration ratios are the result of sorting all sellers on the basis of market share, selecting a specified number
of the firms with the highest market shares, and adding the market shares for those firms. For example, the
concentration ratio CR4 is the sum of the market shares for the four largest firms in terms of volume in a market and
CR8 is the sum of the eight largest firms in terms of volume. The U.S. Census Bureau periodically publishes
concentration ratios for different industries in the United States.See U.S. Census Bureau (2010).

Suppose a market has 10 sellers with market shares (ranked from high to low) of 18%, 17%, 15%, 13%, 12%, 8%, 7%,
5%, 3%, and 2%. The CR4 ratio for this market would be 63 (18 + 17 + 15 + 13), and the CR8 ratio would be 95 (18 + 17
+ 15 + 13 + 12 + 8 + 7 + 5).

Although concentration ratios are easy to calculate and easily understood, there are two shortcomings. First, the
number of firms in the ratio is arbitrary. There is no reason that a four-firm concentration ratio indicates
concentration potential any better than a three-firm or five-firm concentration ratio. Second, the ratio does not
indicate whether there are one or two very large firms that clearly dominate all other firms in market share or the
market shares for the firms included in the concentration ratio are about the same.

An alternative concentration measure that avoids these problems is the HHI. This index is computed by taking the
market shares of all firms in the market, squaring the individual market shares, and finally summing them. The
squaring has the effect of amplifying the larger market shares. The highest possible value of the HHI is 10,000, which
occurs in the case of a monopoly (10,000 = 1002). If, on the other hand, you had a market that had 100 firms that
each had a market share of 1%, the HHI would be 100 (1 = 12, summed 100 times). For the previous 10-firm example,
the HHI would be 1302. Although there is no inherent reason for squaring market shares, the HHI includes all firms
in the computation (avoiding the issue of how many firms to include) and reflects the variation in magnitude of
market shares.

As far as interpreting these concentration measures, the following statements provide some guidance on the potential
for market power by sellers:

● If CR4 is less than 40 or the HHI is less than 1000, the market has fairly low concentration and should be
reasonably competitive.

● If CR4 is between 40 and 60 or the HHI is between 1000 and 2000, there is a loose oligopoly that probably
will not result in significant exercise of market power by sellers.

● If CR4 is above 60 or the HHI is above 2000, then there is a tight oligopoly that has significant potential for
exercise of seller power.

● If CR1 is above 90 or the HHI is above 8000, one firm will be a clear leader and may function effectively as a
monopoly.

Again, a high concentration measure indicates a potential for exploitation of seller power but not proof it will actually
happen. Another important caution about these measures is that the scope of the market needs to be considered. In
the case of banking services, even with the mergers that have resulted in higher seller concentration, if you look at
measures of bank concentration at the national level, there seems be a loose oligopoly. However, if you limit the scope
to banking in a single city or region, it is very likely that only few banks serve those areas. There can be modest
concentrations when examining national markets but high concentration at the local level.

7.6 Competing in Tight Oligopolies: Pricing Strategies

In recent decades, economists have employed the applied mathematical tools of game theory to try to capture the
dynamics of oligopoly markets. The initial research papers are generally abstract and very technical, but the acquired
insights of some of this research have been presented in textbooks geared to nontechnical readers.A text that applies
game theory to management is Brandenburger and Nalebuff (1996). Game theory is outside the scope of this text, but
we will consider some of the insights gained from the application of game theory in discussions about strategy in this
and the following sections.

In this section, we will consider the economics underlying some of pricing strategies used by firms in monopolies and
tight oligopolies.

1. Deep discounting. One exercise of seller power is to try to drive out existing competition. Deep
discounting attempts to achieve this by setting the firm’s price below cost, or at least below the average cost
of a competitor. The intent is to attract customers from the competitor so that the competitor faces a
dilemma of losses from either lost sales or being forced to follow suit and also set its price below cost. The
firm initiating the deep discounting hopes that the competitor will decide that the best reaction is to exit the
market. In a market with economies of scale, a large firm can better handle the lower price, and the
technique may be especially effective in driving away a small competitor with a higher average cost. If and
when the competitor is driven out of the market, the initiating firm will have a greater market share and
increased market power that it can exploit in the form of higher prices and greater profits than before.

2. Limit pricing. A related technique for keeping out new firms is the technique of limit pricing. Again, the
basic idea is to use a low price, but this time to ward off a new entrant rather than scare away an existing
competitor. Existing firms typically have lower costs than a new entrant will initially, particularly if there are
economies of scale and high volume needed for minimum efficient scale. A limit price is enough for the
existing firm to make a small profit, but a new entrant that needs to match the price to compete in the
market will lose money. Again, when the new entrant is no longer a threat, the existing firm can reassert its
seller power and raise prices for a sustained period well above average cost. As a game of strategy, the new
entrant may reason that if it is willing to enter anyway and incur an initial loss, once its presence is in the
market is established, the existing firm will realize their use of limit pricing did not work and decide it would
be better to let prices go higher so that profits will increase, even if that allows the new entrant to be able to
remain in the market.

3. Yield management. Another method for taking advantage of the power to set prices is yield management,
where the firm abandons the practice of setting a fixed price and instead changes prices frequently. One goal
is to try to extract higher prices from customers who are willing to pay more for a product or service.
Normally, with a fixed announced price, customers who would have been willing to pay a significantly higher
price get the consumer surplus. Even if the firm employs third-degree price discrimination and charges
different prices to different market segments, some customers realize a surplus from a price well below the
maximum they would pay. Using sophisticated software to continuously readjust prices, it is possible to
capture higher prices from some of these customers. Yield management can also make it more difficult for
other firms to compete on the basis of price since it does not have a known, fixed price to work against.
A good example of yield management is the airline industry. Airlines have long employed price
discrimination in forms of different classes of customers, different rates for flyers traveling over a weekend,
and frequent flyer programs. However, in recent years, the price to buy a ticket can change daily, depending
on the amount of time until the flight occurs and the degree to which the flight has already filled seats.

4. Durable goods. When firms in monopolies and oligopolies sell long-lived durable goods like cars and
televisions, they have the option to sell to customers at different times and can attempt to do something
similar to first-degree price discrimination by setting the price very high at first. When the subset of
customers who are willing to pay the most have made their purchase, the firms can drop the price somewhat
and attract another tier of customers who are willing to pay slightly less than the first group. Progressively,
the price will be dropped over time to attract most customers at a price close to the maximum they would be
willing to pay.

However, economists have pointed out that customers may sense this strategy, and if patient, the customer can wait
and pay a much lower price than the perceived value of the item. Even if the firm has little competition from other
firms, a firm may find itself in the interesting situation of competing with itself in other production periods. In
theoretical analyses of monopolies that sold durable goods, it has been demonstrated that when durable goods last a
long time and customers are patient, even a monopolist can be driven to price items at marginal cost.The durable
goods problem is discussed in Kreps (2004).

One response to the durable goods dilemma is to sell goods with shorter product lives so that customers will need to
return sooner to make a purchase. U.S. car manufacturers endeavored to do this in the middle of the 20th century but
discovered that this opened the door for new entrants who sold cars that were designed to last longer.

Another response is to rent the use of the durable good rather than sell the good outright. This turns the good into a
service that is sold for a specified period of time rather than a long-lived asset that is sold once to the customer (for at
least a long time) and allows more standard oligopoly pricing that is applied for consumable goods and services. This
arrangement is common with office equipment like copiers.

7.7 Competing in Tight Oligopolies: Nonpricing Strategies

Oligopoly firms also use a number of strategies that involve measures other than pricing to compete and maintain
market power. Some of these strategies try to build barriers to entry by new entrants, whereas the intention of other
measures is to distinguish the firm from other existing competitors.

1. Advertising. As we noted in Chapter 3 "Demand and Pricing", most firms incur the expense of advertising.
To some extent, advertising is probably necessary because buyers, particularly household consumers, face a
plethora of goods and services and realistically can actively consider only a limited subset of what is
available. Advertising is a means of increasing the likelihood a firm’s product or service is among those
services actually considered.
When the firm is an upstream seller in a value chain with downstream markets, advertising may be directed
at buyers in downstream markets. The intent is to encourage downstream buyers to look for products that
incorporate the upstream firm’s output. An example of such advertising is in pharmaceuticals, where drug
manufacturers advertise in mass media with the intent of encouraging consumers to request a particular
drug from their physicians.
In tight oligopolies, firms may boost the intensity of advertising well beyond the amount needed to inform
buyers of the existence of their goods and services. Firms may advertise almost extravagantly with the idea of
not only establishing brand recognition but making strong brand recognition essential to successful
competition in the market. Once strong brand recognition takes hold in the market, new firms will need to
spend much more to establish brand recognition than existing firms spend to maintain brand recognition.
Hence new entrants are discouraged by what is perceived as a high startup fee, which is a type of barrier to
entry.

2. Excess capacity. Ordinarily a firm will plan for a capacity that is sufficient to support the production
volume. Because capacity is often planned in advance and actual production volume may vary from period to
period, the firm may have some excess capacity in some periods. And since there is inherent uncertainty in
future demand, firms may even invest in capacity that is never fully utilized.
However, firms in oligopolies may invest, or partially invest, in capacity well beyond what is needed to cover
fluctuations in volume and accommodation of uncertainty as a means of competing. If the sellers in an
oligopoly have been successful in collectively holding back on quantity to drive up the price and profits, since
the price is well above average cost, there is an opportunity for one firm to offer the product at a lower price,
attract a sizeable fraction of the new customers attracted by the lower price, and make a sizeable individual
gain in profit. This gambit may come from a new entrant or even an existing seller. This tactic may work, at
least for a time, if the firm introducing the lower price does it by surprise and the other firms are not
prepared to ramp up production rapidly to match the initiator’s move.
One way to protect against an attack of this nature is to have a significant amount of excess capacity, or at
least some additional capacity that could be upgraded and brought online quickly. The firm doing this may
even want to clearly reveal this to other sellers or potential sellers as a signal that if another firm were to try
an attack of this nature, they are prepared to respond quickly and make sure they take advantage of the
increased sales volume.

3. Reputation and warranties. As a result of fluctuations in cost or buyer demand, being a seller in a
market may be more attractive in some periods than others. During periods that are lucrative for being a
seller, some firms may be enticed to enter on a short-term basis, with minimal long-term commitments,
 enjoy a portion of the spoils of the favorable market, and then withdraw when demand declines or costs
increase.
Firms that intend to remain in the market on an ongoing basis would prefer that these hit-and-run entrants
not take away a share of the profits when the market is attractive. One measure to discourage this is to make
an ongoing presence desired by the customer so as to distinguish the product of the ongoing firms from the
product of the short-term sellers. As part of advertising, these firms may emphasize the importance of a
firm’s reputation in providing a quality product that the firm will stand behind.
Another measure is to make warranties a part of the product, a feature that is only of value to the buyer if
the seller is likely to be available when a warranty claim is made. Like high-cost advertising, even the scope
of the warranty may become a means of competition, as is seen in the automobile industry where warranties
may vary in time duration, number of driven miles, and systems covered.

4. Product bundling. In Chapter 3 "Demand and Pricing", we discussed the notion of complementary goods
and services. This is a relationship in which purchasers of one good or service become more likely to
purchase another good or service. Firms may take advantage of complementary relationships by selling
products together in a bundle, where consumers have the option to purchase multiple products as a single
item at lower total cost than if the items were purchased separately. This can be particularly effective if there
are natural production economies of scope in these complementary goods. If competitors are unable to
readily match the bundled product, the firm’s gain can be substantial.
A good example of successful product bundling is Microsoft Office. Microsoft had developed the word
processing software Word, the spreadsheet software Excel, the presentation software PowerPoint, and the
database software Access. Individually, each of these products was clearly outsold by other products in those
specialized markets. For example, the favored spreadsheet software in the late 1980s was Lotus 1-2-3. When
Microsoft decided to bundle the packages and sell them for a modest amount more than the price of a single
software package, customers perceived a gain in value, even if they did not actively use some of the packages.
Since all the components were software and distributed on floppy disks (and later on CDs and via web
downloads), there was a strong economy of scope. However, when Microsoft introduced the bundle, the
firms selling the leader products in the individual markets were not able to match the product bundling, even
though some attempted to do so after Microsoft has usurped the market. Consequently, not only was the
product bundle a success, but the individual components of Microsoft Office each became the dominant
products.

5. Network effects and standards. In some markets, the value of a product to a buyer may be affected by
the number of other buyers of the product. For example, a cell phone becomes more valuable if most of the
people you would like to phone quickly also carry a cell phone. Products that increase in value when the
adoption rate of the product increases, even if some units are sold by competitors, are said to have “network
effects.”

One impact of network effects is that industry standards become important. Often network effects occur because the
products purchased need to use compatible technologies with other products. In some markets, this may result in
some level of cooperation between firms, such as when appliance manufacturers agree to sell units with similar
dimensions or connections.

However, sometimes multiple standards emerge and firms may select to support one standard as a means of
competing against a firm that uses another standard. Sellers may group into alliances to help improve their success
via network effects. In the once-vibrant market for VCR tapes and tape players, the initial standard for producing
tapes was called Betamax. This Betamax standard was developed by Sony and used in the VCR players that Sony
produced. Soon after Betamax was introduced, the electronics manufacturer JVC introduced the VHS standard.
Consumers first had to purchase the VCR player, but the value of the product was affected by the availability and
variety of tapes they could acquire afterward, which was determined by whether their player used the Betamax
standard or the VHS standard. Eventually the VHS standard prevailed, favoring JVC and the other firms that allied
with JVC.

Up until the videotape was eclipsed by the DVD, the VCR industry moved to using the VHS standard almost
exclusively. This illustrates a frequent development in a market with strong network effects: a winner-take-all contest.
Another example of a winner-take-all situation can be seen with operating systems in personal computers. Although
there were multiple operating systems available for PCs in the 1980s, eventually Microsoft’s MS-DOS and later
Windows operating systems achieved a near monopoly in personal computer operating systems. Again, the driver is
network effects. Companies that produced software saw different markets depending on the operating system used by
the buyer. As MS-DOS/Windows increased its market share, companies were almost certain to sell a version of their
product for this operating system, usually as their first version and perhaps as their only version. This, in turn,
solidified Microsoft’s near monopoly. Although other operating systems still exist and the free operating system Linux
and the Apple Macintosh OS have succeeded in some niches, Microsoft Windows remains the dominant operating
system.

7.8 Buyer Power

The bulk of this chapter looked at facets of market power that is possessed and exploited by sellers. However, in
markets with a few buyers that individually make a sizeable fraction of total market purchases, buyers can exercise
power that will influence the market price and quantity.

The most extreme form of buyer power is when there is a single buyer, called a monopsony. If there is no market
power among the sellers, the buyer is in a position to push the price down to the minimum amount needed to induce a
seller to produce the last unit. The supply curve for seller designates this price for any given level of quantity.
Although the monopsonist could justify purchasing additional units up to the point where the supply curve crosses its
demand curve, the monopsonist can usually get a higher value by purchasing a smaller amount at a lower price at
another point on the supply curve.

Assuming the monopsonist is not able to discriminate in its purchases and buy each unit at the actual marginal cost of
the unit, rather buying all units at the marginal cost of the last unit acquired, the monopsonist is aware that when it
agrees to pay a slightly higher price to purchase an additional unit, the new price will apply to all units purchased. As
such, the marginal cost of increasing its consumption will be higher than the price charged for an additional unit. The
monopsonist will maximize its value gained from the purchases (amount paid plus consumer surplus) at the point
where the marginal cost of added consumption equals the marginal value of that additional unit, as reflected in its
demand curve. This optimal solution is depicted in Figure 7.2 "Graph Showing the Optimal Quantity and Price for a
Monopsonist Relative to the Free Market Equilibrium Price and Quantity", with the quantity QS being the amount it
will purchase and price PS being the price it can impose on the sellers. Note, as with the solution with a seller
monopoly, the quantity is less than would occur if the market demand curve were the composite of small buyers with
no market power. However, the monopsonist price is less than the monopoly price because the monopsonist can force
the price down to the supply curve rather than to what a unit is worth on the demand curve.

When there are multiple large buyers, there will be increased competition that will generally result in movement
along the supply curve toward the point where it crosses the market demand curve. However, unless these buyers are
aggressively competitive, they are likely to pay less than under the perfect competition solution by either cooperating
with other buyers to keep prices low or taking other actions intended to keep the other buyers out of the market.

An example of a monopsonist would be an employer in a small town with a single large business, like a mining
company in a mountain community. The sellers in this case are the laborers. If laborers have only one place to sell
their labor in the community, the employer possesses significant market power that it can use to drive down wages
and even change the nature of the service provided by demanding more tiring or dangerous working conditions.
When the industrial revolution created strong economies of scale that supported very large firms with strong
employer purchasing power, laborers faced a difficult situation of low pay and poor working conditions. One of the
reasons for the rise of the labor unions in the United States was as a way of creating power for the laborers by
requiring a single transaction between the employer and all laborers represented by the union.
Figure 7.2 Graph Showing the Optimal Quantity and Price for a Monopsonist Relative to the Free Market
Equilibrium Price and Quantity
Chapter 8

Market Regulation

In the previous chapter, we recognized the possibility that markets left to their own devices may not result in the best
outcomes when viewed from the perspective of the net impact on all participants in the market. In some cases, the
difference between an unregulated market and what might be possible with some outside influence invites the
consideration of measures that might be taken by a government or other monitoring agency. In this final chapter, we
will examine some of the key categories where intervention may be considered and what regulatory measures can be
taken.

8.1 Free Market Economies Versus Collectivist Economies

The well-being and stability of any society depends on whether the members of that society are able to acquire the
goods and services they need or want. In primitive societies, these issues were settled by either a recognized authority
figure (e.g., a king or military leader) or use of force. In modern times, even though we still have kings and dictators,
the source of authority is likely to be government laws and agencies. Societies that primarily use centralized
authorities to manage the creation and distribution of goods and services are called collectivist economies. The
philosophy of communism is based on the prescription that centralized authority is the best means of meeting the
needs and wants of its citizens.

For millennia, even collectivist societies have included some level of commerce in the form of trade or purchases with
currency. The use of the word “market” to describe the activities of buyers and sellers for goods and services derives
from town gathering areas where such exchanges took place. Early markets were limited in terms of how much of the
total goods and services in a society were negotiated, but in recent centuries, markets took an increasing role in the
allocation of goods and services, starting in Europe. Today, most developed countries operate in a manner where
exchange by markets is the rule rather than the exception. Societies that rely primarily on markets to determine the
creation of goods and services are called free market economies.

Countries will lean toward being either more free market based or more collectivist, but no country is purely one or
the other. In the United States, which is predominantly a free market economy, some services, like fire protection, are
provided by public authorities. In China, which is a communist nation, free market activity has thrived in recent
decades. As we will discuss in this chapter, even when markets are the main vehicle for allocation, there is some
degree of regulation on their operation.

8.2 Efficiency and Equity

There is a subfield of economics called “welfare economics” that focuses on evaluating the performance of
markets. Two of the criteria used to assess markets are efficiency and equity.

Efficiency is a shortened reference to what economists call Pareto efficiency. The outcome of a set of exchanges
between decision-making units in a market or network of markets is called Pareto efficient if it would be impossible
to modify how the exchanges occurred to make one party better off without making another party decidedly worse off.
If there is a way to change the exchanges or conditions of the exchanges so that every party is at least as satisfied and
there is at least one party that is more satisfied, the existing collection of exchanges is not Pareto efficient.
Pure Pareto efficiency is an ideal rather than a condition that is possible in the complex world in which we live. Still,
in clear cases where some intervention in the market can result in significant overall improvement in the pattern of
exchanges, regulation merits consideration.

One circumstance where this notion of efficiency is not fulfilled is when there is waste of resources that could have
some productive value. When markets leave the useful resources stranded to spoil or be underutilized, there is
probably a way to reconfigure exchanges to create improvement for some and at a loss to no one.

In the case of monopoly, which we examined in Chapter 7 "Firm Competition and Market Structure", the price and
quantity selected by the monopolist is not efficient because it would be possible, at least in principle, to require the
monopolist to set the price at the perfect competition equilibrium, reclaim the deadweight loss in consumer surplus
and producer surplus, and redistribute enough of the surplus so the monopolist is as well off as it was at the monopoly
price and the consumers are better off.

Equity corresponds to the issue of whether the distribution of goods and services to individuals and the profits to
firms are fair. Unfortunately, there is no simple single principle, like Pareto efficiency, that has been adopted as the
primary standard for equity. Although there is general support for the idea that the distribution of goods and services
ought to favor those with greater talents or those who work harder, there are also those who view access to basic
goods and services as reasonable expectations of all citizens. Despite the impossibility of developing a general
consensus on what constitutes equity, when enough people become concerned that the distribution of goods and
services is too inequitable, there are likely to be pressures on those in political power or political unrest.

Most microeconomists tend to view active regulation of individual markets as worthy of consideration when there are
inefficiencies in the functioning of those markets. Since managerial economics (and this text) has a microeconomics
focus, we will address the merit of market regulation from this perspective as well.

Problems of inequity are usually regarded as a problem of macroeconomics, best handled by wealth transfers, such as
income taxes and welfare payments rather than intervention in the markets for goods and services. Still, there are
instances where regulatory actions directed at specific markets reflect equity concerns, such as requiring companies
to offer basic services at lifeline rates for low-income customers.

8.3 Circumstances in Which Market Regulation May Be Desirable

When a market operates inefficiently, economists call the situation a market failure. In this chapter, we will address
the generic types of market failure:

● Market failure caused by seller or buyer concentration

● Market failure that occurs when parties other than buyers and sellers are affected by market transactions but
do not participate in negotiating the transaction

● Market failure that occurs because an actual market will not emerge or cannot sustain operation due to the
presence of free riders who benefit from, but do not bear the full costs of, market exchanges

● Market failure caused by poor seller or buyer decisions, due to a lack of sufficient information or
understanding about the product or service

In all four situations, the case can be made that a significant degree of inefficiency results when the market is left to
proceed without regulation.
Economists are fond of repeating the maxim “There is no free lunch.” Regulation is not free and is difficult to apply
correctly. Regulation can create unexpected or undesirable effects in itself. At the conclusion of the chapter, we will
consider some of the limitations of regulation.

8.4 Regulation to Offset Market Power of Sellers or Buyers

In Chapter 7 "Firm Competition and Market Structure", we considered how monopolies and monopsonies would try
to force changes in the price and quantity to move the market to their advantage, but at an even greater cost to the
other side of the market. Again, this is not simply an equity concern that one party is getting most of the surplus
created by the market (although that may be a legitimate concern) but rather the exertion of market power results in a
net loss in total social surplus.

Seller competition is not only helpful in lowering prices and increasing volume and consumer surplus, but firms also
compete in terms of product differentiation. When a monopoly or oligopoly emerges and the seller(s) have a
sustainable arrangement that generates economic profits, the firms do not have the incentive to spend money in
developing better products. The stagnation of the product sold represents another loss in potential value to the
consumer.

Unfortunately, monopolies or tight oligopolies can readily develop in markets, especially when there are strong
economies of scale and market power effects. For this reason, there are general antitrust laws that empower
governments to prevent the emergence of monopolies and tight oligopolies. Some of these laws and regulations
actually cite measures of market concentration that can be used as a basis for opposing any buyouts or mergers that
will increase market concentration. Where market concentration has already advanced to high levels, firms can be
instructed to break up into separate companies. About a century ago, monopolies had developed in important U.S.
industries like petroleum, railroads, and electric power. Eventually, the U.S. federal government mandated these
monopolies split apart.

As mentioned in earlier chapters, the fact that there are a few large sellers does not automatically constitute abusive
use of market power if there is free entry and active competition between sellers. However, if those large sellers
collude to hold back production volumes and raise prices, there is a loss in market surplus. The United States has laws
that outlaw such collusion. While firms may be able to collude with indirect signals that are difficult for government
antitrust units to identify at the time, courts will consider testimony that demonstrates that collusion has taken place.

In Chapter 7 "Firm Competition and Market Structure", we discussed the market power tactics of using low prices to
drive out existing competitors and keep out new entrants. When the purpose of the price drop is merely to chase out
competition, the practice is labeled predatory pricing and is considered illegal. Of course, the firms engaging in
price decreases often take the position that they are in a competitive market and are simply competing on the basis of
reduced profit margins, just as firms are expected to compete according to the theory of the perfect competition
model. Courts are left to determine whether such actions are simply aggressive competition or are intended to create a
more concentrated market that allows for greater profits in the long run.

As an alternative to taking actions to limit large firms from exploiting their size, another form of regulation is to
encourage more competition by helping small or new competitors. Either subsidies or tax breaks may be offered to
help these firms offset the disadvantages of being small in the market and to eventually emerge as an independent
player in the market.

In cases where a concentrated seller market exists and the product or service is considered critical to the buyers and
the overall economy, the government may decide to intervene strongly by setting a limit on prices or mandating that
the product be provided at a minimum quantity and quality.

In situations where there is buyer power, the goal of regulation may be to push prices higher. For example, in
agriculture crop markets where the seller farmers often have little market power, but there is concentration on the
buyer side, the government will try to keep prices higher by mandating minimum prices or direct assistance to
farmers in the form of price support programs.

Another response to market power on one side of the market is to support market power on the other side of the
market. Using the crop market example again where there is buyer power, the government has sanctioned the
creation of grower cooperatives that control the quantity of the amount sold to processors and thus keep the price
higher.

8.5 Natural Monopoly

In industries where the minimum efficient scale is very high, it may be that the lowest average cost is achieved if there
is only one seller providing all the goods or services. Examples of such a service might be transmission and
distribution of electric power or telephone service. This situation often occurs when total costs are very high but
marginal costs are low. Economists call such markets natural monopolies.

Unfortunately, if just one firm is allowed to serve the entire market, the firm will be tempted to exploit the monopoly
position rather than pass its lower cost in the form of lower prices. One response to this situation is to conclude that
the service should be provided by a public agency rather than a private company. In the case of telephone service,
European countries often run the telephone system rather than a corporation like AT&T.

Another response is to go ahead and allow the private firm to be the sole seller but require regulatory approval for the
prices to be charged. These regulated monopolies are often called public utilities, even though the operator may be
a private corporation. In principle, this regulated monopoly could achieve the best of both worlds, letting a private
company serve the market, while making sure the buyer is enjoying the benefits of the low average cost. In fact, this
notion of a regulated monopoly was first proposed by AT&T when it feared that its near monopoly would be usurped
by the government. Governments create agencies like state public utility commissions to review cost information with
the public utility corporation in deciding on the prices or service rates that will be approved.

A potential concern when a single provider is allowed to operate as a regulated monopoly is that, without competition,
the provider has little incentive for innovation or cost cutting. This could be the case whether the provider operated as
a government agency or a public utility corporation. When a public utility corporation understands that it will be
reimbursed for its costs plus an amount to cover the opportunity costs of assets or capital contributed by the
corporation’s owners, the challenge is to be able to justify the costs rather than seek to trim its costs. Some regulatory
agencies try to motivate regulated monopolies to be innovative or cut costs by allowing them to keep some of the
surplus created in exchange for lower rates in the future. However, regulation is a game where the regulatory agency
and the public utility corporation are both competing and cooperating. And the transaction costs of outside oversight
of the regulatory monopoly are substantial. So, as noted earlier, there is no free lunch.

8.6 Externalities

The second generic type of market failure is when parties other than the buyer and seller are significantly affected by
the exchange between the buyer and seller. However, these other parties do not participate in the negotiation of the
sale. Consequently, the quantities sold and prices charged do not reflect the impacts on these parties.

Economists call the effects of market activity on the third parties externalities because they fall outside the
considerations of buyer and seller. Although the concern with significant externalities is usually due to harm to the
third party, externalities can be beneficial to third parties as well. Harmful externalities are called negative
externalities; beneficial externalities are called positive externalities.

Some examples of negative externalities are pollution of air or water that is experienced by persons other than those
directly related to the seller or buyer, injury or death to another person resulting from the market exchange,
inconvenience and annoyances caused by loud noise or congestion, and spoiling of natural habitats. Some examples
of positive externalities are spillover effects of research and development used for one product to other products or
other firms, training of a worker by one firm and thereby creating a more valuable worker for a future employer,
stimulation of additional economic activity outside the market, and outside benefactors of problem-solving services
like pest control.

Negative externalities clearly create an inequity because the third parties are harmed without any compensation.
However, significant negative externalities also create inefficiency. Recall that inefficiency means there is a way to
make someone better off and no one worse off. Take the case of a negative externality like air pollution caused when
an automobile owner purchases gasoline to use in his car. Hypothetically, if a representative for outside parties were
present at the negotiation for the sale, she might be willing to pay an amount to the buyer and an amount to the seller
in exchange for foregoing the sale by compensating the buyer with the consumer surplus they would have received
and the producer with the economic profit they would have received, with the sum of those payments being worth the
avoidance of the externality impact of the air pollution.

Even in the case of a positive externality, there is inefficiency. However, in this case, the third parties would actually
benefit from more market exchanges than the sellers and buyers would be willing to transact. In principle, if third
parties could participate in the market, they would be willing to pay the buyer or seller up to the value of the positive
externality if it would induce more market activity.

Regulation of externalities usually takes two forms: legal and economic. Legal measures are sanctions that forbid
market activity, restrict the volume of activity, or restrict those who are allowed to participate as buyers and sellers.
As examples of these, if an appliance is prone to start fires that might burn an entire apartment complex and injure
others besides the buyer, the sale of the appliance might be banned outright. If sales of water drawn from a river
would threaten a wildlife habit, sales may be limited to a maximum amount. A firearms manufacturer might be
allowed to sell firearms but would be restricted to sell only to people of at least a certain age who do not have a
criminal record. Because legal measures require monitoring and enforcement by the government, there are
transaction costs. When a legal measure is excessive, it may actually create a reverse form of inefficiency from denying
surplus value to buyers and sellers that exceeds the benefit to other parties.

8.7 Externality Taxes

The most practiced economic instrument to address market externality is a tax. Those who purchase gasoline are
likely to pay the sum of the price required by the gasoline station owner to cover his costs (and any economic profit he
has the power to generate) plus a tax on each unit of gasoline that covers the externality cost of gasoline consumption
such as air pollution, wear and tear on existing public roads, needs for expanding public roads to support more
driving, and policing of roads.

Theoretically, there is an optimal level for setting a tax. The optimum tax is the value of the marginal externality
damage created by consumption of an additional item from a market exchange. If each gallon of gasoline causes $1.50
worth of externality damage, that would be the correct tax.

In the case of positive externalities, the optimum tax is negative. In other words, the government actually pays the
seller an amount per unit in exchange for a reduction of an equal amount in the price. Theoretically, the optimum tax
would be the negative of the marginal value of a unit of consumption to third parties. For example, if the positive
externality from hiring an unemployed person and giving that person employment skills would be worth $2.00 per
hour, the employer could be subsidized $2.00 per hour to make it more attractive for them to hire that kind of person.

Although the notion of an externality tax sounds straightforward, actual implementation is difficult. Even when there
is general agreement that a significant externality exists, placing a dollar value on that externality can be extremely
difficult and controversial. The optimal tax is the marginal impact on third parties; however, there is no guarantee
that the total tax collected in this fashion will be the total amount needed to compensate for the total externality
impact. The total collected may be either too little or too much.
Also, recall the impact of a tax from the earlier discussion of comparative statics in competitive markets in Chapter 6
"Market Equilibrium and the Perfect Competition Model". A tax has the impact of either raising the supply curve
upward (if the seller pays the tax) or moving the demand curve downward (if the buyer pays the tax). See Figure 8.1
"Change in Market Equilibrium in Response to Imposing an Externality Tax" for a graphic illustration of a tax
charged to the buyer. To the extent that the supply and demand curves are price elastic, the tax will lower the amount
consumed, thereby diminishing the externality somewhat and possibly changing the marginal externality cost.
Consequently, actual externality taxes require considerable public transaction costs and may not be at the correct
level for the best improvement of market efficiency.

Figure 8.1 Change in Market Equilibrium in Response to Imposing an Externality Tax

Note the tax may cause a decrease in the equilibrium quantity, which may change the optimal externality tax.

8.8 Regulation of Externalities Through Property Rights

The economist Ronald Coase, whom we mentioned earlier in the context of the optimal boundaries of the firm and
transaction costs, postulated that the problem of externalities is really a problem of unclear or inadequate property
rights.See Coase (1960). If the imposition of negative externalities were considered to be a right owned by a firm, the
firm would have the option to resell those rights to another firm that was willing to pay more than the original owner
of the right would appreciate by keeping and exercising the privilege.

For those externalities that society is willing to tolerate at some level because the externality effects either are
acceptable if limited (e.g., the extraction of water from rivers) or come from consumption that society does not have a
sufficiently available alternative (e.g., air pollution caused by burning coal to generate electricity), the government
representatives can decide how much of the externality to allow and who should get the initial rights. The initial rights
might go to existing sellers in the markets currently creating the externalities or be sold by the government in an
auction.
An example of this form of economic regulation is the use of “cap and trade” programs designed to limit greenhouse
gas emissions. In cases where this has been implemented, new markets emerge for trading the rights. If the right is
worth more to another firm than to the owner, the opportunity cost of retaining that right to the current owner will be
high enough to justify selling some of those rights on the emissions market. If the opportunity cost is sufficiently high,
the owner may decide to sell all its emissions rights and either shut down its operations or switch to a technology that
generates no greenhouse gases.

If the value of emissions rights to any firm is less than the externality cost incurred if the right is exercised, the public
can also purchase those externality rights and either retire them permanently or hold them until a buyer comes along
that is willing to pay at least as much as the impact of the externality cost to parties outside the market exchange.

8.9 High Cost to Initial Entrant and the Risk of Free Rider Producers

Next, we will consider the third generic type of market failure, or the inability for a market to form or sustain
operation due to free riders, by looking at two causes of this kind of failure in this section and the next section.
Although the sources are different, both involve a situation where some party benefits from the market exchange
without incurring the same cost as other sellers or buyers.

New products and services are expensive for the first firm to bring them to market. There may be initial failures in the
development of a commercial product that add to the cost. The firm will start very high on the learning curve because
there is no other firm to copy or hire away its talent. The nature of buyer demand for the product is uncertain, and the
seller is likely to overcharge, undercharge, or alternatively set initial production targets that are too high or too low.

If the firm succeeds, it may initially have a monopoly, but unless there are barriers of entry, new entrant firms will be
attracted by the potential profits. These firms will be able to enter the market with less uncertainty about how to make
the product commercially viable and the nature of demand for the product. And these firms may be able to determine
how the initial entrant solved the problems of designing the product or service and copy the process at far less initial
cost than was borne by the initial entrant.

If the product sold by the initial firm and firms that enter the market later look equivalent to the buyer, the buyer will
not pay one of these firms more than another just based on its higher cost. If the market becomes competitive for
sellers, the price is likely to be driven by the marginal cost. New entrant firms may do well, but the initial entrant firm
is not likely to get a sufficient return on the productive assets it had invested from startup. In effect, the other firms
would be free riders that benefit from the startup costs of the initial entrant without having to contribute to that
cost.

The market failure occurs here because, prior to even commencing with a startup, the would-be initial entrant may
look ahead, see the potential for free riders and the inability to generate sufficient profits to justify the startup costs,
and decide to scrap the idea. This market failure is a market inefficiency because it is hypothetically possible for the
initial entrant, subsequent entrants, and buyers to sit at a negotiation and reach an arrangement where startup costs
are shared by the firms or buyer prices are set higher to cover the startup costs, so that all firms and buyers decide
they would be better off with that negotiated arrangement than if the market never materialized. Unfortunately, such
negotiations are unlikely to emerge from the unregulated activities of individual sellers and buyers.

One of the main regulatory measures to address this problem is to guarantee the initial entrant a high enough price
and sufficient volume of sales to justify the up-front investment. Patents are a means by which a product or service
that incorporates a new idea or process gives the developer a monopoly, at least for production that uses that process
or idea, for a certain period of time. Patents are an important element in the pharmaceutical industry in motivating
the development of new drugs because there is a long period of development and testing and a high rate of failure.
Companies selling patent-protected drugs will sell those products at monopoly prices. However, the process for
manufacturing the drug is usually readily reproducible by other companies, even small “generic” manufacturers, so
the price of the drug will drop precipitously when patent protection expires. In fact, patent-holding firms will usually
drop the price shortly prior to patent expiration in an attempt to extract sales from the lower portion of the demand
curve before other firms can enter.

In cases where there is not a patentable process, but nonetheless a high risk of market failure due to frightening away
the initial entrant, government authorities may decide to give exclusive operating rights for at least a period of time.
This tool was used to encourage the expansion of cable television to the initial entrant in a region to justify the high
up-front expenses.

Other government interventions can be the provision of subsidies to the initial entrant to get them to market a new
product. The government may decide to fund the up-front research and development and then make the acquired
knowledge available to any firm that enters the market so there is not such a difference between being the initial
entrant or a subsequent entrant. Another option is for the government itself to serve in the role of the initial entrant
and then, when the commercial viability is demonstrated, privatize the product or service.

8.10 Public Goods and the Risk of Free Rider Consumers

Most goods and services that are purchased are such that one person or a very limited group of persons can enjoy the
consumption of the good or, for a durable good, the use of that good at a specific time. For example, if a consumer
purchases an ice cream bar, she can have the pleasure of eating the ice cream bar or share it with perhaps one or two
other people at most. A television set can only be in one home at any given time. Economists call such products rival
goods.

In the case of rival goods, the party consuming the product is easily linked to the party that will purchase the product.
Whether the party purchases the product depends on whether the value obtained is at least as high as the price.

However, there are other goods that are largely nonrival. This means that several people might benefit from an item
produced and sold in the market without diminishing the benefit to others, especially the party that actually made the
purchase. For example, if a homeowner pays for eradication of mosquitoes around his house, he likely will
exterminate mosquitoes that would have affected his neighbors. The benefit obtained by the neighbors does not
detract from the benefit gained by the buyer. When benefits of a purchased good or service can benefit others without
detracting from the party making the purchase, economists call the product a public good.Public goods are
discussed in Baye (2010).

The difficulty with public goods is that the cost to create a public good by a seller may be substantially more than an
individual buyer is willing to pay but less than the collective value to all who would benefit from the purchase. For
example, take the cost of tracking down criminals. An individual citizen may benefit from the effort to locate and
arrest a criminal, but the individual is not able or willing to hire a police force of the scale needed to conduct such
operations. Even though the result of hiring a police force may be worth more to all citizens who benefit than what a
company would charge to do it, since there are no individual buyers, the market will not be able to function and there
is market failure.

As with the market failure for initial entrants with high startup cost, there is a potential agreement where all
benefactors would be willing to pay an amount corresponding to their value that, if collected, would cover the cost of
creating the good or service. The problem is that individuals would prefer to let someone else pay for it and be a free
rider. So the inability of the market to function is a case of inefficiency.

In perfect competition, the optimal price to be charged is the marginal cost of serving another customer. However, in
the case of public goods, the marginal cost of serving an additional benefactor can be essentially zero. This creates an
interesting dilemma whereby the theoretical optimal pricing for the good is to charge a price of zero. Of course, that
adds to the market failure problem because the cost of production of the good or service is not zero, so it is not
feasible to operate a market of private sellers and buyers in this manner.
Usually the only way to deal with a public good of sufficient value is for the government to provide the good or service
or pay a private organization to run the operation without charging users, or at least not fully charging users. This is
how key services like the military, police protection, fire stations, and public roadways are handled. There may be
some ability to charge users a modest fee for some services, but the revenue would not be sufficient to support a
market served by private firms. For example, governments build dams as a means of flood control, irrigation, and
water recreation. The agency that manages the dam may charge entry fees for boating on the lake or use of water
released from the dam. However, the agency still needs to remain a public agency and likely needs additional finances
from other public revenues like income or sales taxes to support its continued operations.

An interesting public good problem has emerged with the ability to make high-quality digital copies of books and
music at very low marginal cost. When someone purchases a music CD (or downloads a file of commercial music) and
then allows a copy to be made for someone else, the creation of the copy does not diminish the ability to enjoy the
music by the person who made the initial purchase. Artists and producers claim that the recipients of the copies are
enjoying the media products as free riders and denying the creators of the products full payment from all who enjoy
their products, although there is some debate whether copying is a bona fide market failure concern.See Shapiro and
Varian (1999). Nonetheless, publishers have pursued measures to discourage unauthorized copies, whether via legal
prohibition or technology built into the media, or media players, to thwart the ability to make a clean copy.

8.11 Market Failure Caused by Imperfect Information

In the earlier discussion of the perfect competition model, we noted the assumption of perfect information of buyers
and sellers. Theoretically, this means that buyers and sellers not only know the full array of prices being charged for
goods and services, but they also know the production capabilities of sellers and the utility preferences of buyers. As
part of that discussion, we noted that this assumption is not fully satisfied in real markets, yet sellers and buyers may
have a reasonably complete understanding of market conditions, particularly within the limits of the types of products
and geographic areas in which they normally participate.

Imperfect information can be due to ignorance or uncertainty. If the market participant is aware that better
information is available, information becomes another need or want. Information may be acquired through an
economic transaction and becomes a commodity that is a cost to the buyer or seller. Useful information is available as
a market product in forms like books, media broadcasts, and consulting services.

In some cases, uncertainty can be transferred to another party as an economic exchange. Insurance is an example of
product where the insurance company assumes the risk of defined uncertain outcomes for a fee.

Still, there remain circumstances where ignorance or risk is of considerable consequence and cannot be addressed by
an economic transaction. One such instance is where one party in an economic exchange deliberately exploits the
ignorance of another party in the transaction to its own advantage and to the disadvantage of the unknowing party.
This type of situation is called a moral hazard. For example, if an entrepreneur is raising capital from outside
investors, he may present a biased view of the prospects of the firm that only includes the good side of the venture to
attract the capital, but the outside investors eventually lose their money due to potentially knowable problems that
would have discouraged their investment if those problems had been known.

In some cases, the missing information is not technically hidden from the party, but the effective communication of
the key information does not occur. For example, a consumer might decide to acquire a credit card from a financial
institution and fail to note late payment provisions in the fine print that later become a negative surprise. Whether
such communication constitutes proper disclosure or moral hazard is debatable, but the consequences of the bad
decision occur nonetheless.

Exchanges with moral hazard create equity and efficiency concerns. If one party is taking advantage of another party’s
ignorance, there is an arguable equity issue. However, the inadequate disclosure results in a market failure when the
negative consequences to the ignorant party more than offset the gains to the parties that disguise key information.
This is an inefficient market because the losing parties could compensate the other party for its gains and still suffer
less than they did from the incidence of moral hazard.

Further, the impact of poor information may spread beyond the party that makes a poor decision out of ignorance. As
we have seen with the financial transactions in mortgage financing in the first decade of this century, the
consequences of moral hazard can be deep and widespread, resulting in a negative externality as well.

Market failures from imperfect information can occur even when there is no intended moral hazard. In Chapter 5
"Economics of Organization", we discussed the concept of adverse selection, where inherent risk from uncertainty
about the other party in an exchange causes a buyer or seller to assume a pessimistic outcome as a way of playing it
safe and minimizing the consequences of risk. However, a consequence of playing it safe is that parties may decide to
avoid agreements that actually could work. For example, a company might consider offering health insurance to
individuals. An analysis might indicate that such insurance is feasible based on average incidences of medical claims
and willingness of individuals to pay premiums. However, due to the risk that the insurance policies will be most
attractive to those who expect to submit high claims, the insurance company may decide to set its premiums a little
higher than average to protect itself. The higher premiums may scare away some potential clients who do not expect
to receive enough benefits to justify the premium. As a result, the customer base for the policy will tend even more
toward those individuals who will make high claims, and the company is likely to respond by charging even higher
premiums. Eventually, as the customer base grows smaller and more risky, the insurance company may withdraw the
health insurance product entirely.

Much of the regulation to offset problems caused by imperfect information is legal in nature. In cases where there is
asymmetric information that is known to one party but not to another party in a transaction, laws can place
responsibility on the first party to make sure the other party receives the information in an understandable format.
For example, truth-in-lending laws require that those making loans clearly disclose key provisions of the loan, to the
degree of requiring the borrower to put initials beside written statements. The Sarbanes-Oxley law, created following
the Enron crisis, places requirements on the conduct of corporations and their auditing firms to try to limit the
potential for moral hazard.

When one party in an exchange defrauds another party by providing a good or service that is not what was promised,
the first party can be fined or sued for its failure to protect against the outcomes to the other party. For example, if a
firm sells a defective product that causes harm to the buyer, the firm that either manufactured or sold the item to the
buyer could be held liable.

A defective product may be produced and sold because the safety risk is either difficult for the buyer to understand or
not anticipated because the buyer is unaware of the potential. Governments may impose safety standards and
periodic inspections on producers even though those measures would not have been demanded by the buyer. In
extreme cases, the government may direct a seller to stop selling a good or service.

Other regulatory options involve equipping the ignorant party with better information. Government agencies can
offer guidance in print or on Internet websites. Public schools may be required to make sure citizens have basic
financial skills and understand the risks created by consumption of goods and services to make prudent decisions.

Where adverse selection discourages the operations of markets, regulation may be created to limit the liability to the
parties involved. Individuals and businesses may be required to purchase or sell a product like insurance to increase
and diversify the pool of exchanges and, in turn, to reduce the risk of adverse selection and make a market operable.

8.12 Limitations of Market Regulation

Although regulation offers the possibility of addressing market failure and inefficiencies that would not resolve by
themselves in an unregulated free market economy, regulation is not easy or cost free.
Regulation requires expertise and incurs expenses. Regulation incurs a social transaction cost for market exchanges
that is borne by citizens and the affected parties. In some instances, the cost of the regulation may be higher than the
net efficiency gains it creates. Just as there are diminishing returns for producers and consumers, there are
diminishing returns to increased regulation, and at some point the regulation becomes too costly.

Regulators are agents who become part of market transactions representing the government and people the
government serves. Just as market participants deal with imperfect information, so do regulators. As such, regulators
can make errors.

In our discussions about economics of organization in Chapter 5 "Economics of Organization", we noted that
economics has approached the problem of motivating workers using the perspective that the workers’ primary goal is
their own welfare, not the welfare of the business that hires them. Unfortunately, the same may be said about
regulators. Regulators may be enticed to design regulatory actions that result in personal gain rather than what is best
for society as a whole in readjusting the market. For example, a regulator may go soft on an industry in hope of
getting a lucrative job after leaving public service. In essence, this is another case of moral hazard. One solution might
be to create another layer of regulation to regulate the regulators, but this adds to the expense and is likely
self-defeating.

When regulation assumes a major role in a market, powerful sellers or buyers are not likely to treat the regulatory
authority as an outside force over which they have no control. Often, these powerful parties will try to influence the
regulation via lobbying. Aside from diminishing the intent of outside regulation, these lobbying efforts constitute a
type of social waste that economists call influence costs, which are economically inefficient because these efforts
represent the use of resources that could otherwise be redirected for production of goods and services.

One theory about regulation, called the capture theory of regulation,The capture theory of regulation was
introduced by Stigler (1971). postulates that government regulation is actually executed so as to improve the
conditions for the parties being regulated and not necessarily to promote the public’s interest in reducing market
failure and market inefficiency. For example, in recent years there has been a struggle between traditional telephone
service providers and cable television service providers. Each side wants to enter the market of the other group yet
expects to maintain near monopoly power in its traditional market, and both sides pressure regulators to support
their positions. In some cases, it has been claimed that the actual language of regulatory laws was proposed by
representatives for the very firms that would be subject to the regulation.