Category Archives: Basic Market Structure and Perfect Competition

QUESTIONS FOR CLASSROOM DISCUSSION ON BASIC MARKET STRUCTURE AND PERFECT COMPETITION

This real-world application is a bit different than our other applications because it actually doubts the economic theory we have been working with all semester. Could the supply curve actually be downward sloping in the “new economy?” Consider the following:

  • The author states that the products of the ‘new economy,’ “cost nothing at all to produce and distribute, and never get used up.” Do you agree with this statement?
  • Can you imagine a good or service with NEGATIVE marginal cost?!

Our classroom discussion will take place after exam #2!  

Posted by Prof. C-S

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/

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)

Michael Kinsley starts out by comparing market forces to that of the cross. Following this comparison he provides definitions of both the demand curve as well as the equilibrium point but leaves out the definition for the supply curve.  He then goes into the main focus of the article by calling into question the common notion that the supply curve is always upward sloping. He argues that the problem lies within the concept of marginal cost because “marginal costs determine the supply curve” (Kinsley 1). Kinsley takes this argument further by pointing out the difficulty inherent within the two major assumptions that comprise marginal cost. He cites airplane seats, prescription drugs and software as products that have high initial costs with low marginal costs, which violate the assumptions of upward sloping supply curves. He ends his article by pointing out that this potential problem, due to marginal costs could result in a new economy.

This article is relevant to our classroom theory because it provides examples of instances where supply and demand curves may not behave in the manner we have discussed in class. This is important because if the issues Kinsley discusses are true then we are in a new economy that is driven by marginal costs that have high initial costs but cheap marginal cost.

Doctrine states that in a free market, competition will make price equal to marginal costs, because as production increases the marginal cost of producing another product increases. Thereby resulting in an upward sloping supply curve. In the instance of airline seats, prescription drugs, and software, the high initial costs cause the marginal cost function not to be upward sloping. This is because it is more expensive for the initial consumers because they have to absorb the high initial costs compared to later consumers who have low marginal cost. For example in the airplane situation some customers have to pay a higher price to cover the costs of the flight. However the marginal cost of an airplane that is flying regardless of capacity is practically nothing because the marginal cost of adding another passenger is just the cost of printing another ticket. In the prescription drug example marginal cost is downward sloping because the initial drugs are more expensive due to research and development costs but the cost of producing the pills later is very low. Likewise, in the software example there are high development cost but low disc production costs, which results in marginal cost not being upward sloping.

A real world application of this concept of downward sloping supply curves is clearly present in the film industry. In the film industry the initial costs to produce a film tend to be very expensive. However the actual marginal cost of distributing the film to more consumers in different theaters around the world is fairly cheap, given the advent of digital media. Therefore the film company will attempt to play their film in as many locations as possible because they will receive additional revenue in the form of tickets sales and the cost of reproducing the film in an additional theater is inexpensive.

Posted by Joe, John and Jim (Section 3)

Resources:

Kinsley, Michael. “So What’s New? Is the “New Economy” Really Different from the Old One?” Slate. 22 Aug. 2000. Web. 19 Mar. 2012. <http://www.slate.com/formatdynamics/CleanPrintProxy.aspx?1295416032412&gt;.

Collett-Schmitt, Kristen. FIN 30210: Managerial Economics. University of Notre Dame, 2011. Print.

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)

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

This article begins by comically comparing the economic model of supply and demand, with the Church and its use of the crucifix. It prefaces the argument by explaining the concepts of a market in equilibrium, as well as identifying other factors that affect the supply and demand model, such as marginal cost and the likeliness that it will eventually be equal to the price of a good as the market reaches equilibrium.

The author, Michael Kinsley, then explains that he has two concerns about the design of the model: 1. That marginal cost must be rising, and 2. That marginal cost must always be higher than average cost in order for a firm to cover all costs. He explains that in today’s economy, marginal costs are lower than average costs. He uses airline tickets as an example, saying that low priced tickets are used to cover the marginal costs, while identical tickets that are higher in price are covering all the other costs associated with operating the flight.

Kinsley explains that the basic concepts of supply, demand, and equilibrium do exist, but in today’s economy, there is no one making sure that market equilibrium is reached. This is what is causing the system to skew, and what is causing average costs to soar above marginal costs in many different markets. He identifies that in this day in age, marginal costs are not only not rising, some are in fact declining. As average costs and prices soar, marginal costs remain somewhat unaffected.

 Commentary

This article is slightly confusing (I’ve been talking myself in circles in my head!), because when we first learned of the supply curve, it was defined as amount that suppliers are willing to sell at a given point.  If a supplier can make more money per unit, the opportunity cost of producing an extra unit is greater than the gained utility of not producing the extra unit.  This is what makes the supply curve bend upward.

Understanding, though, that this assumes that marginal costs stays the same, the idea of decreasing marginal cost (due to economies of scale or other factors) adds complexity to the model.  Were marginal costs to stay the same the entire time, the increase in price would add an increasing amount of profits every time the price is raised.  Taking diminishing marginal cost into consideration, as price increases, units also increase, and as units increase, marginal costs decrease.  Thus, profits increase more in the second scenario than the first.  Suppliers are more willing to sell at a higher price point, and as an added bonus, the lower costs create more profits.  Thus, the curve still slants upward.

The problem with this model happens when price, not quantity, becomes the dependent variable.  At a higher number of units, a firm is willing to sell each individual unit for less money because the average cost per unit decreases as quantity increases.  Thus, a firm can still make a larger profit by charging less for each individual unit.

 Real World Application

An additional real-world application of the perfectly competitive market is in the fresh produce market. Traditionally known as the “classic case” of perfect competition, the fresh produce market was once characterized by a virtually unlimited number of producers selling identical goods to “large numbers of local and regional retail grocery chains” at market equilibrium prices. However, as the food industry (and the fresh produce market) have evolved over recent decades, the market has consolidated considerably with fewer, larger buyers mostly replacing the traditional local and regional grocery chains. As “value-oriented retailers,” such as Wal-Mart, and “upscale specialty stores,” such as Trader Joe’s and Whole Foods, have come to dominate the food market, most fresh produce is purchased directly from the producer by the retailer. In this market structure, producers are no longer perceived to be selling identical goods as specialty stores and value-oriented chains claim to be selling produce of varying quality. In addition, the transactions between producers and retailers now often include more than just the price of the produce. In today’s market, additional components are frequently included in fresh produce transactions, including “off-invoice fees” (rebates, discounts, and promotional fees), pre-negotiated volume commitments, and required “third-party food safety certification.” These additional components effectively limit entry into the fresh produce market, which is dominated by the mega retailers, violating the criteria of a perfectly competitive market. Once considered the best example of a perfectly competitive market, the fresh produce market has become far less competitive with the emergence of a few powerful retail chains that have altered the perception of seemingly identical producers and imposed restrictions on the entry of producers into the market.

Posted by Emma, Trevor, Elizabeth and Kristoff (Section 1)

Resources:

Dr. Roberta L. Cook. “Supermarket Challenges and Opportunities for Fresh Fruit and Vegetable Producers and Shippers: Lessons from the US Experience .” University of California, Davis. 24 May 2004. http://www.agmrc.org/media/cms/supermarketchallenges_01985EE36887A.pdf)