Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?”  (Slate Magazine, Aug. 22, 2000)

 Summary

In Michael Kinsley’s article “So What’s New? Is the “New Economy” really different from the old one?”, the author discusses the traditional assumptions that underlie the supply and demand model of the economy. According to basic economic theory, market equilibrium occurs at the intersection of the demand and supply curves, or where the price of a unit is equal to the marginal cost of producing one more unit. A firm will not produce more than this amount due to these marginal costs, which increase as more units are produced. Traditional economists have assumed that the supply curve is upward-sloping due to the presence of these increasing marginal costs. Kinsley argues against this belief and states that marginal costs, in fact, do not increase over time due to a variety of factors. He uses a variety of real-world examples to illustrate his argument. He first looks at the pharmaceutical industry to show that while high start-up costs mean that the marginal cost of producing the first few units is very high, these marginal costs diminish to almost zero as the number of pills produced increases. He also lists the example of airplane seats to illustrate that the marginal cost of filling the seat of a plane that will depart regardless of how many seats are filled is zero. Finally, he uses the software industry to show that marginal costs may even be negative due to the network effect – software becomes even more desirable to consumers as the number of users grows, while it costs nothing to produce and distribute more software.

This article is clearly relevant to managerial economics, a class which relies upon the supply and demand model as the basic foundation of managerial pursuits such as price-setting and demand modeling. In a firm without an upward-sloping supply curve, our assumptions are skewed and prices set by a firm may not be optimal.

 Commentary

Kinsley’s article questions the traditional assumption that the market supply curve is upward sloping.  To understand his critique, we must first understand why we make this assumption.  In general, it is intuitive that if a higher price is offered for the products in inventory (or those that could be produced for inventory), the seller will be willing to sell more, because of the increased benefits received.  Producers have more incentive to produce and sell their products as the difference between marginal benefit and marginal cost grows, because profits not only increase for each item, but increase more on a per item basis.

This basic assumption is difficult to reconcile with the concept of increasing marginal costs in several current markets.  Our supply curve assumptions lead us to assume increasing marginal costs that will be higher than average costs at the equilibrium point, and that companies will produce and sell to the point that marginal costs are equivalent to price.  However, in today’s economy multiple products do not follow this pattern.  Most of these examples have high initial start-up fixed costs with comparatively low variable costs later in production.  Airlines, for example, must absorb extremely high fixed costs to purchase a plane and fly it from airport to airport.  However, if a plane is already scheduled to fly, the marginal cost of one more passenger, assuming there’s a free seat, is next to nothing (53.7 cents to shred the boarding pass, says Kinsley).  After the first seat until the flight is full, marginal costs are extremely low, and never increase above average cost, but it is safe to assume that airlines will rarely charge a price equivalent to the 53.7 cent marginal cost (although a $1 ticket price would technically increase profits).  This poses problems for our basic upward-sloping supply curve assumption.

Prescription drugs and computer software are other examples.  There are high initial fixed costs associated with researching and developing new medications and software.  However, once the research is done, it costs very little to produce the millionth pill or write the millionth disc compared to the development costs of the first one.  While any price over the low marginal cost would increase profits and lower prices for everyone as development costs are absorbed, some buyers must pay relatively high prices or there would be no incentive to develop new drugs or software.

 Real-World Application

Another real-world application can be seen in the music industry (both online and CD’s). There are heavy start-up costs associated with recording an album and marketing both the music and the performer. It’s very difficult for the singer to become popular, but once he or she becomes popular and has put forth a new album there is very little cost associated with making more CD’s. If the artist decides to put their music online on software such as iTunes, there is absolutely no cost to selling another song (or album). In this situation, which is consistent with Kinsley’s argument, the marginal cost is not increasing at all, so the price of the song/album should not be equal to the marginal cost of creating another CD.

Posted by Helen, Jason and Maddie (Section 2)

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