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 ‘So What’s New?,’ Michael Kinsley challenges the classical economic model of supply and demand and proposes the idea that supply curves could be downward sloping. 

Kinsley discusses the idea of supply curves as being derived from marginal costs, because “each producer increases production until the cost of producing the net unit starts to exceed the price she can get” (Kinsley).  He says that marginal costs must be increasing (so that supply and demand curves always cross) and also that marginal costs must exceed average costs at market equilibrium price because the price of producing one more item must not exceed the selling price of the item (you have to make money on the sale or you wouldn’t bother selling!)  The problem these days, Kinsley says, is that market controversies have been rising when marginal costs fail to rise.  Rather, they “start out below average cost and stay that way” (Kinsley) effectively undermining the basic assumption in economics that marginal costs rise.

Kinsley uses the example of airline tickets, in which two tickets for the same flight with the same levels of service can cost $501 and $105; the marginal cost of filling an empty seat on a plane is less than a dollar, but you must charge some people $501 to cover your average costs across the board.

He also discusses the case of prescription drugs, in which the cost of producing one more pill is extremely cheap (a few cents perhaps), compared to developing the first pill of its kind, so some people must pay much more than that marginal cost of the pill to cover (if you will) the relatively cheap selling price of that first expensive (relative to cost of production) pill.

Basically, Kinsley’s argument boils down to the fact that even though we often assume that they do, marginal cost curves are not always upward sloping, because at some points in the lifecycle of the product, marginal cost will greatly exceed the selling price of the product (such as at the beginning phases of the market introduction of a new drug, or on the ‘early-bird specials’ that can be found on airline ticketing sites) but at later points in the product lifecycle the selling price of a product will greatly exceed the marginal cost (like when mass-produced mature drugs are cheap to roll out onto shelves and are sold at relatively exorbitant prices, or when it would cost nothing to board an extra passenger on a flight but the ticket costs $501.)

Kinsley goes further to discuss the implications of these marginal cost issues on the “new economy” in which information and knowledge cost hardly anything to reproduce and distribute, so marginal costs are virtually negligible.  Kinsley argues that in such a “new economy,” basic economic theory won’t necessarily help you predict prices, and that market competition that drives down prices could be “ruinous.”

Commentary

The market supply curve is assumed to be upward curving because we assume that a higher market price will induce a producer to sell more of a good.

Originally, the marginal cost curve is ultimately upward sloping, indicating that in the long run marginal cost increases as quantity increases.  For airplane tickets, average costs need to be met and since seats are there whether anyone is in them or not, marginal cost lowers as time before the flight decreases.  So the last seat may cost less than other seats.  In this case, the marginal cost curve would be downward sloping.  Prescription drugs would be similar.  The cost for producing the first pill is very high and lessens over time, so it would be downward sloping.  This means that new drugs could be produced and later sales help to pay the cost for the high marginal costs in the beginning.  Software is similar to prescription drugs, in the fact that it has a high cost in the beginning to develop the software, and later it is cheaper to produce copies.  The marginal cost would be downward sloping because the first products costs would be high then lower dramatically once the program is developed.

Real-World Example

A real-world example would be new technological devices, like the iPad.  It costs the most to develop the design and concept as well the technology needed to make this product real.  After that the marginal cost lowers to just the parts necessary and pricing is effected by time.  When the iPad first came out the selling price was $499 and now is lowered to $399 and it only costs $259.60 to make.  Marginal cost is ultimately a flat straight line: the cost for the first iPad had the highest cost, then lowered and did not increase.  The supply curve is similar to the new economy that Kinsley described since new technological devices are similar to new software where most of the cost is in developing the first product.

Posted by Erin and Devlin (Section 4)

Resources:

http://www.fastcompany.com/article/apples-tablet-introduced?page=0%2C0

http://mashable.com/2010/04/07/isuppli-ipad-cost/

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