Chapter 11 Introduction to Imperfect Markets

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Chapter 11Introduction to Imperfect Markets
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Extending the Basic Competitive Model

• Here the assumptions of perfect competition will
  be relaxed to yield more realistic models.
• In the basic competitive model we assumed
• There are many buyers and sellers they are price
  takers.
• In real markets firms have some market power.
• Kodak can charge a slightly higher price than
  Fuji.

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Homogeneity and Perfect Information Assumptions

• In the basic competitive model we assumed
• Goods were homogenous, or identical
• In modern economies brands exist.
• Consumers and firms have perfect information.
• But real consumers and businesses rarely have
  perfect information.
• Consumers may not have perfect information about
  the quality of goods like used cars.
• Firms do not have perfect information on the
  productivity of workers.

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Private Costs Assumption

• In the basic competitive model we assumed
• Firms and consumers bear all the consequences of
  their actions so that there is no effect on
  others.
• Externalitiesactions by a consumer or firm that
  have an effect on others for which the actor
  neither pays nor is paid compensationexist in
  real life.
• What you do does affects others.
• Hiker who litters deep in the woods
• Messy roommate
• Pollution

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Rivalrous Goods Assumption

• In the basic competitive model we assumed
• All goods were rivalrous when one consumer buys
  a gallon of gasoline that gallon is unavailable
  for others.
• Public goods exist they represent extreme cases
  of positive externalities.
• Public goods are non-rivalrous one's use does
  not limit others' use.
• Public goods are non-excludable there are very
  high costs to preventing others from using them.
• Example national defense

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Market Failures

• Imperfect competition, imperfect information,
  externalities, and public goods lead to market
  failures.
• These failures may permit a role for government
  intervention to improve economic efficiency.

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Monopoly

• Monopoly A single seller of a product
• Example is a local electrical company.
• Barriers to entry usually exist.

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Oligopoly

• Oligopoly A few, usually large sellers of a
  product
• Example is the U.S. auto industry.
• There is some degree of competition.
• Firms take into account their rivals' actions.

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Monopolistic Competition

• Monopolistic competition many firms, each with
  some monopoly power due to brand loyalty.
• Laptop computersDell, Gateway, Compaq, HP,
  Apple, Sony, and Toshiba
• Products are different enough to limit
  competition somewhat.
• A firm can raise its price and not lose all of
  its customers to rivals due to loyalty.

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Perfect Competition

• If a firm raises its price it loses all of its
  customers firms are price takers.
• Price is constant to a competitive firm.
• A soybean farmer cannot influence the price of
  soybeans.
• Firm can always sell the next unit at the going
  price
• MR Price
• Profit maximization P MC
• Consumers pay the true cost of making the good.

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Imperfect Competition

• Imperfect competition a market structure where
  firms have some ability to influence or set the
  price
• To sell one more unit, the firm must lower its
  price.
• The firm gains from the sale but loses a small
  amount on each of the previous units sold.
• p MR and since profit maximization requires MR
  MC
• We have p MC
• This means consumers pay more than the true cost
  of producing the product
• This is inefficient.
• In addition, if the price is too high, then too
  little is produced and consumed.

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Government Policy

• Inefficiency in imperfectly competitive markets
  means government policies may play a role in
  achieving efficiency.
• Government may act to limit market power.
• U.S. vs. Microsoft
• Windows operating system gives the company unfair
  market power.
• Solutions include breaking up the company,
  regulating its prices, or overseeing its business
  practices.
• Government may permit a monopoly to exist, then
  regulate its pricemonopolies like cable TV,
  electric utilities, and telephone services.

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The Information Problem

• Do consumers and firms have all the information
  they need?
• Did you know when applying to college how much
  you would enjoy or benefit from college?
• Do firms know their workers' productivity?
• Does a model of imperfect information provide a
  better description of modern economies?

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How Prices Convey Information

• Prices convey the scarcity of goods or inputs.
• Steel companies need not know how much iron ore
  is left in the ground, the costs of refining, or
  other details they need only know the price.
• When the price of iron ore rises, steel companies
  conserve iron ore.

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Markets for Information

• Information is exchanged in markets for
  information.
• Information has value since people are willing to
  pay for it.

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Information is a Public Good

• One person's knowledge of the information does
  not reduce anyone else's your learning in
  lecture does not prevent other students from
  learning.
• However, unlike other goods and services, you
  cannot test drive information once revealed to
  you, it cannot be withdrawn.

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Government Policies

• Consumer protection legislation makes deceptive
  trade practices illegal.
• Important information may not stand out.
• It may be drowned by other information.
• In advertising there is no clear distinction
  between persuasion and deception.
• The SEC prosecuted executives of Enron and the
  accounting company Arthur Andersen for making
  misleading financial statements.

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Externalities

• Firms and individuals do not bear all of the
  consequences or reap all of the rewards of their
  actions.
• Externalities may be positive or negative.
• A positive externality
• A neighbor maintains a pretty flower garden.
• Positive externalities are undersupplied in free,
  private markets.
• Your neighbor pays all of the costs but does not
  receive all of the benefits.
• A negative externality
• Pollution
• Negative externalities are oversupplied in free,
  private markets.

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Steel Mill Example

• A steel mill produces steel and pollution.
• Production reflects only the private costs of
  iron ore, labor, energy, and so on.
• Production does not reflect the social costs of
  polluting the environment.
• If the social costs were internalized (i.e. paid)
  by the steel mill, less steel and less pollution
  would be produced.

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Government Policies toward Externalities

• Impose a tax equal to the social harm.
• Firms would pay the social costs of their
  actions.
• Since goods and services that generate positive
  externalities are in undersupply, the government
  could act to enlarge the supply.

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Public Goods (a)

• Public goods are non-rivalrous and
  non-excludable.
• A pure public good
• The marginal cost of supplying the good to
  another person is zero while the marginal cost of
  excluding someone from enjoying it is very high.
• National defense
• Streetlights
• Public goods are undersupplied.
• Public goods are an extreme case of positive
  externalities.

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Public Goods (b)
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The Free-Rider Problem

• A lighthousea good thing for sailors at night or
  in fog.
• Suppose all the sailors decide to chip in to
  build a lighthouse.
• Any one sailor has an incentive to renege on her
  contribution.
• She figures the lighthouse will be built anyway
  with the contributions of others.
• If she reneges on her contribution, she can save
  money.
• Since all the sailors have the same incentives,
  contributions will be less than expected and the
  lighthouse may not get built.
• The free-rider problem leads to an undersupply of
  public goods by private markets.
• Government has a role in supplying these kinds of
  goods.