Real Estate CE Course - Real Estate Economics

Real Estate Economics

by Lei Bao

The Real Estate Market

A market is a place where goods can be bought and sold. A market may be a specific physical place, such as a shopping mall. It also may be a vast, complex, economic system for moving goods and services throughout the world. In either case, the function of a market is to provide a setting in which supply and demand can establish market value, making it advantageous for buyers and sellers to trade.

Supply and Demand

Prices for goods and services in the market are established by the operation of supply and demand. The supply is the quantity of goods or services that can be sold at a given price. In the real estate market, the supply is made up of residential and commercial land and structures. Demand refers to the quantity of goods or services that consumers are willing and able to buy at a given price. In the real estate market, the number of homebuyers and businesses seeking to buy property can vary greatly depending on general economic conditions.

When supply and demand are roughly balanced, prices are stable and there is neither inflation (prices increasing) or deflation (prices decreasing). When supply increases and demand fails to increase commensurately, prices go down; when demand increases and supply fails to increase sufficiently to satisfy that demand, prices go up. Greater supply means producers need to attract more buyers, so they lower prices. Greater demand means producers can raise their prices because buyers compete for the product.

Supply and Demand in the Real Estate Market

Two characteristics of real estate govern the way the market reacts to the pressures of supply and demand: uniqueness and immobility. Uniqueness means that, no matter how identical they may appear, no two parcels of real estate are ever exactly alike; each occupies its own unique geographic location. Immobility refers to the fact that property cannot be relocated to satisfy demand where supply is low, nor can buyers always relocate to areas with greater supply. For these reasons, real estate markets are local markets. Each geographic area has different types of real estate and different conditions that drive prices. In these well-defined areas, real estate offices can keep track of the types of property that are in demand, as well as the properties that are available to meet that demand.

Because of real estate’s uniqueness and immobility, the market generally adjusts slowly to the forces of supply and demand. Though a home offered for sale can be withdrawn in response to low demand and high supply, it is just as likely that oversupply will result in lower prices. When supply is low, on the other hand, a high demand may not be met immediately because development and construction are lengthy processes. As a result, development tends to occur in uneven spurts of activity.

Even when supply and demand can be forecast with some accuracy, natural disasters such as hurricanes and earthquakes can disrupt market trends. Similarly, a sudden change in the national financial market, a local event such as a business closure, or a regional disruption caused by storm damage can dramatically disrupt a seemingly stable market.

Factors Affecting Supply

Factors that tend to affect the supply side of the real estate market’s supply and demand balance include labor force availability, construction and material costs, and governmental controls and financial policies.

Labor Force, Construction, and Material Costs

A shortage of skilled labor or building materials or an increase in the cost of materials can decrease the amount of new construction. High transfer costs, such as taxes and construction permit fees, can also discourage development. Increased construction costs may be passed along to buyers and tenants in the form of higher sales prices and increased rents that can further slow the market.

Governmental Controls and Monetary Policy

The government’s monetary policy can have a substantial impact on the real estate market. The Federal Reserve Board (the Fed) establishes a discount rate of interest for the money it lends to commercial banks. That discount rate has a direct impact on the interest rates the banks charge to borrowers, which in turn plays a significant part in people’s ability to buy homes. The Federal Housing Administration (FHA) and the Government National Mortgage Association (Ginnie Mae) can also affect the amount of money available to lenders for mortgage loans.

Even apart from financing concerns, virtually any government action has some effect on the real estate market. For instance, federal environmental regulations may increase or decrease the supply and value of land in a local market. Real estate taxation is one of the primary sources of revenue for local governments. Policies on taxation of real estate can have either positive or negative effects. While high taxes may deter investors, tax incentives may attract new businesses and industries and bring increased employment and expanded residential real estate markets.

Local governments also influence supply. Land-use controls, building codes, and zoning ordinances help shape the character of a community and control the use of land. Careful planning can help stabilize, and even increase, real estate values.

Factors Affecting Demand

Factors that tend to affect the demand side of the real estate market include population, demographics, and employment and wage levels.

Population

Because shelter is a basic human need, the demand for housing grows with the population. Although the total population of the country continues to rise, the demand for real estate increases faster in some areas than in others. In some locations, growth has ceased altogether or the population has declined. This may be due to economic changes (such as business closings), social concerns (such as the quality of schools or a desire for more open space), or population changes (such as population shifts from colder to warmer climates). The result can be a drop in demand for real estate in one area, which may be matched by increased demand elsewhere.

Demographics

The study and description of a population is called demographics. The population of a community is a major factor in determining the quantity and type of housing in that community. The number of occupants per household and their ages, the ratio of adults to children, the number of retirees, family income, and lifestyle are all demographic factors that contribute to the amount and type of housing needed.

Employment and Wage Levels

Decisions about whether to buy or rent and how much to spend on housing are closely related to income. When job opportunities are scarce or wage levels low, demand for real estate usually drops. The market might, in fact, be affected drastically by a single major employer moving in or shutting down. Real estate professionals should stay informed about the business plans of local employers.

Conclusion

As you have seen, the real estate market depends on a variety of economic forces, such as interest rates and employment levels. To be successful, real estate professionals must follow economic trends and anticipate where those trends will lead. How people use their income depends on consumer confidence, which is based not only on perceived job security but also on the availability of credit and the impact of inflation. General trends in the economy, such as the availability of mortgage money and the rate of inflation, will influence people’s spending decisions.

Elasticity

We have learned that an increase in price reduces the quantity demanded and increases the quantity supplied in a market. In this section, we will develop the concept of elasticity so that we can address how much the quantity demanded and the quantity supplied responds to changes in market conditions such as price.

The Elasticity of Demand

To measure the response of demand to changes in its determinants, we use the concept of elasticity. Price elasticity of demand measures how much the quantity demanded responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

If the quantity demanded changes substantially from a change in price, demand is elastic. If the quantity demanded changes little from a change in price, demand is inelastic. Whether a demand curve tends to be price elastic or inelastic depends on the following:

• Availability of close substitutes: The demand for goods with close substitutes is more sensitive to changes in prices and, thus, is more price elastic.

• Necessities versus luxuries: The demand for necessities is inelastic while the demand for luxuries is elastic. Because one cannot do without a necessity, an increase in the price has little impact on the quantity demanded. However, an increase in price greatly reduces the quantity demanded of a luxury.

• Definition of the market: The more narrowly we define the market, the more likely there are to be close substitutes and the more price elastic the demand curve.

• Time horizon: The longer the time period considered, the greater the availability of close substitutes and the more price elastic the demand curve.

The formula for computing the price elasticity of demand is:

Price elasticity of demand = $\frac{Percentage \ change \ in \ quantity \ demanded}{Percentage \ change \ in \ price}$

Because price elasticity of demand is always negative, it is customary to drop the negative sign.

When we compute price elasticity between any two points on a demand curve, we get a different answer depending on our chosen starting point and our chosen finishing point if we take the change in price and quantity as a percent of the starting value for each. To avoid this problem, economists often employ the midpoint method to calculate elasticities. With this method, the percentage changes in quantity and price are calculated by dividing the change in the variable by the average or midpoint value of the two points on the curve, not the starting point on the curve. Thus, the formula for the price elasticity of demand using the midpoint method is:

Price elasticity of demand = $\frac{(Q_2 - Q_1) / [(Q_2 + Q_1) / 2]}{(P_2 - P_1) / [(P_2 + P_1) / 2]}$

If price elasticity of demand is greater than one, demand is elastic. If elasticity is less than one, demand is inelastic. If elasticity is equal to one, demand is said to have unit elasticity. If elasticity is zero, demand is perfectly inelastic (vertical). If elasticity is infinite, demand is perfectly elastic (horizontal). In general, the flatter the demand curve, the more elastic. The steeper the demand curve, the more inelastic.

Total revenue is the amount paid by buyers and received by sellers, computed simply as price times quantity. The elasticity of demand determines the impact of a change in price on total revenue:

• If demand is price inelastic (less than one), an increase in price increases total revenue because the price increase is proportionately larger than the reduction in quantity demanded.

• If demand is price elastic (greater than one), an increase in price decreases total revenue because the decrease in the quantity demanded is proportionately larger than the increase in price.

• If demand is unit price elastic (exactly equal to one), a change in price has no impact on total revenue because the increase in price is proportionately equal to the decrease in quantity.

Along a linear demand curve, price elasticity is not constant. When price is high and quantity low, price elasticity is large because a change in price causes a larger percentage change in quantity. When price is low and quantity high, price elasticity is small because a change in price causes a smaller percentage change in quantity.

There are additional demand elasticities. The income elasticity of demand is a measure of how much the quantity demanded responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income or:

Income elasticity of demand = $\frac{Percentage \ change \ in \ quantity \ demanded}{Percentage \ change \ in \ income}$

For normal goods, income elasticity is positive. For inferior goods, income elasticity is negative. Within the group of normal goods, necessities like food have small income elasticities because the quantity demanded changes little when income changes. Luxuries have larger income elasticities.

The cross-price elasticity of demand is a measure of the response of the quantity demanded of one good to a change in the price of another good, computed as the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good or:

Cross-price elasticity of demand = $\frac{Percentage \ change \ in \ quantity \ demanded \ of \ good \ 1}{Percentage \ change \ in \ the \ price \ of \ good \ 2}$

The cross-price elasticity of demand is positive for substitutes and negative for complements.

The Elasticity of Supply

Price elasticity of supply measures how much the quantity supplied responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price.

If the quantity supplied changes substantially from a change in price, supply is elastic. If the quantity supplied changes little from a change in price, supply is inelastic. Supply is more elastic when the sellers have greater flexibility to change the amount of a good they produce in response to a change in price. Generally, the shorter the time period considered, the less flexibility the seller has in choosing how much to produce and the more inelastic the supply curve.

The formula for computing the price elasticity of supply is:

Price elasticity of supply = $\frac{Percentage \ change \ in \ quantity \ supplied}{Percentage \ change \ in \ price}$

If price elasticity of supply is greater than one, supply is elastic. If elasticity is less than one, supply is inelastic. If elasticity is equal to one, supply is said to have unit elasticity. If elasticity is zero, supply is perfectly inelastic (vertical). If elasticity is infinite, supply is perfectly elastic (horizontal). In general, the flatter the supply curve, the more elastic. The steeper the supply curve, the more inelastic.

Price elasticity of supply may not be constant along a given supply curve. At low quantities, a small increase in price may stimulate a large increase in quantity supplied because there is excess capacity in the production facility. Therefore, price elasticity is large. At high quantities, a large increase in price may cause only a small increase in quantity supplied because the production facility is at full capacity. Therefore, price elasticity is small.

Three Applications of Supply, Demand, and Elasticity

• The market for agricultural products: Advances in technology have shifted the supply curve for agricultural products to the right. The demand for food, however, is generally inelastic (steep) because food is inexpensive and a necessity. As a result, the rightward shift in supply has caused a great reduction in the equilibrium price and a small increase in the equilibrium quantity. Thus, ironically, technological advances in agriculture reduce total revenue paid to farmers as a group.

• The market for oil: In the 1970s and early 1980s, the Organization of Petroleum Exporting Countries (OPEC) reduced the supply of oil in order to raise its price. In the short run, the demand for oil tends to be inelastic (steep) because consumers cannot easily find substitutes. Thus, the decrease in supply raised the price substantially and increased total revenue to the producers. In the long run, however, consumers found substitutes and drove more fuel-efficient cars causing the demand for oil to become more elastic, and producers searched for more oil causing supply to become more elastic. As a result, while the price of oil rose a great deal in the short run, it did not rise much in the long run.

• The market for illegal drugs: In the short run, the demand for illegal addictive drugs is relatively inelastic. As a result, drug interdiction policies that reduce the supply of drugs tend to greatly increase the price of drugs while reducing the quantity consumed very little, and thus, total revenue paid by drug users increases. This need for additional funds by drug users may cause drug-related crime to rise. This increase in total revenue and in crime is likely to be smaller in the long run because the demand for illegal drugs becomes more elastic as time passes. Alternatively, policies aimed at reducing the demand for drugs reduce total revenue in the drug market and reduce drug-related crime.

Conclusion

The tools of supply and demand allow you to analyze the most important events and policies that shape the economy.

Consumers, Producers, and the Efficiency of Markets

In this section, we address welfare economics – the study of how the allocation of resources affects economic well-being. We measure the benefits that buyers and sellers receive from taking part in a market, and we discover that the equilibrium price and quantity in a market maximizes the total benefits received by buyers and sellers.

Consumer Surplus

Consumer surplus measures the benefits received by buyers from participating in a market. Each potential buyer in a market has some willingness to pay for a good. This willingness to pay is the maximum amount that a buyer will pay for the good. If we plot the value of the greatest willingness to pay for the first unit followed by the next greatest willingness to pay for the second unit and so on (on a price and quantity graph), we have plotted the market demand curve for the good. That is, the height of the demand curve is the marginal buyers’ willingness to pay. Because some buyers value a good more than other buyers, the demand curve is downward sloping.

Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. For example, if you are willing to pay $20 for a new CD by your favorite music artist and you are able to purchase it for $15, you receive consumer surplus on that CD of $5. In general, because the height of the demand curve measures the value buyers place on a good measured by the buyers’ willingness to pay, consumer surplus in a market is the area below the demand curve and above the price.

When the price of a good falls, consumer surplus increases for two reasons. First, existing buyers receive greater surplus because they are allowed to pay less for the quantities they were already going to purchase, and second, new buyers are brought into the market because the price is now lower than their willingness to pay.

Note that because the height of the demand curve is the value buyers place on a good measured by their willingness to pay, consumer surplus measures the benefits received by buyers as the buyers themselves perceive it. Therefore, consumer surplus is an appropriate measure of buyers’ benefits if policymakers respect the preferences of buyers. Economists generally believe that buyers are rational and that buyer preferences should be respected except possibly in cases of drug addiction and so on.

Producer Surplus

Producer surplus measures the benefits received by sellers from participating in a market. Each potential seller in a market has some cost of production. This cost is the value of everything a seller must give up to produce a good, and it should be interpreted as the producers’ opportunity cost of production – actual out-of-pocket expenses plus the value of the producers’ time. The cost of production is the minimum amount a seller is willing to accept in order to produce the good. If we plot the cost of the least cost producer of the first unit, then the next least cost producer of the second unit, and so on (on a price and quantity graph), we have plotted the market supply curve for the good. That is, the height of the supply curve is the marginal sellers’ cost of production. Because some sellers have a lower cost than other sellers, the supply curve is upward sloping.

Producer surplus is the amount a seller is paid for a good minus the seller’s cost of providing it. For example, if a musician can produce a CD for a cost of $10 and sell it for $15, the musician receives a producer surplus of $5 on that CD. In general, because the height of the supply curve measures the sellers’ costs, producer surplus in a market is the area below the price and above the supply curve.

When the price of a good rises, producer surplus increases for two reasons. First, existing sellers receive greater surplus because they receive more for the quantities they were already going to sell, and second, new sellers are brought into the market because the price is now higher than their cost.

Market Efficiency

We measure economic well-being with total surplus – the sum of consumer and producer surplus.

Total surplus = (value to buyers - amount paid by buyers) + (amount received by sellers - cost to sellers)

Total surplus = value to buyers - cost to sellers

Graphically, total surplus is the area below the demand curve and above the supply curve. Resource allocation is said to exhibit efficiency if it maximizes the total surplus received by all members of society. Free market equilibrium is efficient because it maximizes total surplus. This efficiency is demonstrated by the following observations:

• Free markets allocate output to the buyers who value it the most – those with a willingness to pay greater than or equal to the equilibrium price. Therefore, consumer surplus cannot be increased by moving consumption from a current buyer to any other nonbuyer.

• Free markets allocate buyers for goods to the sellers who can produce at the lowest cost – those with a cost of production less than or equal to the equilibrium price. Therefore, producer surplus cannot be increased by moving production from a current seller to any other nonseller.

• Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus or total surplus. If we produce less than the equilibrium quantity, we fail to produce units where the value to the marginal buyer exceeds the cost to the marginal seller. If we produce more than the equilibrium quantity, we produce units where the cost to the marginal seller exceeds the value to the marginal buyer.

Economists generally advocate free markets because they are efficient. Because markets are efficient, many believe that government policy should be laissez-faire, which means “leave to do” or “let people do as they will.” Adam Smith’s “invisible hand” of the marketplace guides buyers and sellers to an allocation of resources that maximizes total surplus. The efficient outcome cannot be improved upon by a benevolent social planner. In addition to efficiency, however, policymakers may also be concerned with equality – the uniformity of the distribution of well-being among the members of society.

Conclusion: Market Efficiency and Market Failure

There are two main reasons a free market may not be efficient:

• A market may not be perfectly competitive. If individual buyers or sellers (or small groups of them) can influence the price, they have market power and they may be able to keep the price and quantity away from equilibrium.

• A market may generate side effects, or externalities, which affect people who are not participants in the market at all. These side effects, such as pollution, are not taken into account by buyers and sellers in a market, so the market equilibrium may not be efficient for society as a whole.

Market power and externalities are two sources of market failure – the inability of some unregulated markets to allocate resources efficiently.

Government Policies

In prior sections, we acted as scientists because we built the model of supply and demand to describe the world as it is. In this section, we act as policy advisers because we address how government policies are used to try to improve the world. We address two policies: price controls and taxes. Sometimes these policies produce unintended consequences.

Controls on Prices

There are two types of controls on prices: price ceilings and price floors. A price ceiling sets a legal maximum on the price at which a good can be sold. A price floor sets a legal minimum on the price at which a good can be sold.

• Price Ceilings Suppose the government is persuaded by buyers to set a price ceiling. If the price ceiling is set above the equilibrium price, it is not binding. That is, it has no impact on the market because the price can move to equilibrium without restriction. If the price ceiling is set below the equilibrium price, it is a binding constraint because it does not allow the market to reach equilibrium. A binding price ceiling causes the quantity demanded to exceed the quantity supplied, or a shortage. Because there is a shortage, methods develop to ration the small quantity supplied across a large number of buyers. Buyers willing to wait in long lines might get the good, or sellers could sell only to their friends, family, or members of the same race. Lines are inefficient, and discrimination is both inefficient and unfair. Free markets are impersonal and ration goods with prices.

  Price ceilings are commonly found in the markets for gasoline and apartments. When OPEC restricted the quantity of petroleum in 1973, the supply of gasoline was reduced and the equilibrium price rose above the price ceiling and the price ceiling became binding. This caused a shortage of gas and long lines at the pump. In response, the price ceilings were later repealed. Price ceilings on apartments are known as rent controls. Binding rent controls create a shortage of housing. Both the demand and supply of housing are inelastic in the short run, so the initial shortage is small. In the long run, however, the supply and demand for housing become more elastic, and the shortage is more apparent. This causes waiting lists for apartments, bribes to landlords, unclean and unsafe buildings, and lower quality housing. Once established, however, rent controls are politically difficult to remove.

• Price Floors Suppose the government is persuaded by sellers to set a price floor. If the price floor is set below the equilibrium price, it is not binding. That is, it has no impact on the market because the price can move to equilibrium without restriction. If the price floor is set above the equilibrium price, it is a binding constraint because it does not allow the market to reach equilibrium. A binding price floor causes the quantity supplied to exceed the quantity demanded, or a surplus. In order to eliminate the surplus, sellers may appeal to the biases of the buyers and sell to buyers that are family, friends, or members of the same race. Free markets are impersonal and ration goods with prices.

  An important example of a price floor is the minimum wage. The minimum wage is a binding constraint in the market for young and unskilled workers. When the wage is set above the market equilibrium wage, the quantity supplied of labor exceeds the quantity demanded. The result is unemployment. Studies show that a 10 percent increase in the minimum wage depresses teenage employment by 1 to 3 percent. The minimum wage also causes teenagers to look for work and drop out of school.

  Price controls often hurt those they are trying to help – usually the poor. The minimum wage may help those who find work at the minimum wage but harm those who become unemployed because of the minimum wage. Rent controls reduce the quality and availability of housing.

Taxes

Governments use taxes to raise revenue. A tax on a good will affect the quantity sold and both the price paid by buyers and the price received by sellers. If the tax is collected from the sellers, supply shifts upward by the size of the tax per unit. As a result of the decrease in supply, the quantity sold decreases, the price paid by the buyer increases, and the price received by the seller decreases. If the tax is collected from the buyers, demand shifts downward by the size of the tax per unit. Because of the decrease in demand, the quantity sold decreases, the price paid by the buyer increases, and the price received by the seller decreases. Therefore, a tax levied on buyers has the same effect as a tax levied on sellers. After a tax has been placed on a good, the difference between what the buyer pays and the seller receives is the tax per unit and is known as the tax wedge. In summary:

• A tax discourages market activity. That is, the quantity sold is reduced.

• Buyers and sellers share the burden of a tax because the price paid by the buyers increases while the price received by the sellers decreases.

• The effect of a tax collected from buyers is equivalent to a tax collected from sellers.

• The government cannot legislate the relative burden of the tax between buyers and sellers. The relative burden of a tax is determined by the elasticity of supply and demand in that market.

Tax incidence is the manner in which the burden of a tax is shared among participants in a market. That is, it is the division of the tax burden. When a tax wedge is placed between buyers and sellers, the tax burden falls more heavily on the side of the market that is less elastic. That is, the tax burden falls more heavily on the side of the market that is less willing to leave the market when price movements are unfavorable to them. For example, in the market for cigarettes, because cigarettes are addictive, demand is likely to be less elastic than supply. Therefore, a tax on cigarettes tends to raise the price paid by buyers more than it reduces the price received by sellers, and as a result, the burden of a cigarette tax falls more heavily on the buyers of cigarettes. With regard to the payroll tax (Social Security and Medicare tax), because labor supply is less elastic than labor demand, most of the tax burden is borne by the workers as opposed to the 50-50 split intended by lawmakers.

Externality

An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. If the effect is beneficial, it is called a positive externality. If the effect is adverse, it is called a negative externality. Markets maximize total surplus to buyers and sellers in a market, and this is usually efficient. However, if a market generates an externality, the market equilibrium may not maximize the total benefit to society as a whole, and thus, the market is inefficient. Government policy may potentially improve efficiency. Examples of negative externalities are pollution from exhaust and noise. Examples of positive externalities are historic building restorations and research into new technologies.

Externalities and Market Inefficiency

The height of the demand curve measures the value of the good to the marginal consumer. The height of the supply curve measures the cost to the marginal producer. If there is no government intervention, the price adjusts to balance supply and demand. The quantity produced maximizes consumer and producer surplus. If there is no externality, the market solution is efficient because it maximizes the well-being of buyers and sellers in the market and their well-being is all that matters. However, if there is an externality and bystanders are affected by this market, the market does not maximize the total benefit to society as a whole because others beyond just the buyers and sellers in the market are affected.

There are two types of externalities:

• Negative externality: When the production of a good generates pollution, costs accrue to society beyond those that accrue to the producing firm. Thus, the social cost exceeds the private cost of production, and graphically, the social cost curve is above the supply curve (private cost curve). Total surplus is the value to the consumers minus the true social cost of production. Therefore, the optimal quantity that maximizes total surplus is less than the equilibrium quantity generated by the market.

• Positive externality: A good such as education generates benefits to people beyond just the buyers of education. As a result, the social value of education exceeds the private value. Graphically, the social value curve is above the demand curve (private value curve). Total surplus is the true social value minus the cost to producers. Therefore, the optimal quantity that maximizes total surplus is greater than the equilibrium quantity generated by the market.

Internalizing an externality is the altering of incentives so that people take into account the external effects of their actions. To internalize externalities, the government can create taxes and subsidies to shift the supply and demand curves until they are the same as the true social cost and social value curves. This will make the equilibrium quantity and the optimal quantity the same, and the market becomes efficient. Negative externalities can be internalized with taxes while positive externalities can be internalized with subsidies.

High technology production (robotics, etc.) generates a positive externality for other producers known as a technology spillover. Some economists consider this spillover effect to be so pervasive that they believe the government should have an industrial policy – government intervention to promote technology-enhancing industries. Other economists are skeptical. At present, the U.S. government provides a property right for new ideas in the form of patent protection and offers special tax breaks for expenditures on research and development.

Public Policies Toward Externalities

The government can sometimes improve the outcome by responding in one of two ways: command-and-control policies or market-based policies.

• Command-and-control policies are regulations that require or prohibit (or limit) certain behaviors. The problem here is that the regulator must know all of the details of an industry and alternative technologies in order to create the efficient rules. Prohibiting a behavior altogether can be best if the cost of a particular type of pollution is enormous.

• Market-based policies align private incentives with social efficiency. There are two types of market-based policies: corrective taxes and subsidies, and tradable pollution permits.

A tax enacted to correct the effects of a negative externality is known as a corrective tax or Pigovian tax. An ideal corrective tax or subsidy would equal the external cost or benefit from the activity generating the externality. Corrective taxes can reduce negative externalities at a lower cost than regulations because the tax essentially places a price on a negative externality, say pollution. Those firms that can reduce their pollution with the least cost reduce their pollution a great deal while other firms that have higher costs of reducing their pollution reduce their pollution very little. The same amount of total reduction in pollution can be achieved with the tax as with regulation but at lower cost. In addition, with the tax firms have incentive to develop cleaner technologies and reduce pollution even further than the regulation would have required. Unlike other taxes, corrective taxes enhance efficiency rather than reduce efficiency. For example, the tax on gasoline is a corrective tax, because, rather than causing a deadweight loss, it causes there to be less traffic congestion, safer roads, and a cleaner environment. Gasoline taxes are politically unpopular.

Tradable pollution permits allow the holder of the permit to pollute a certain amount. Those firms that have a high cost of reducing their pollution will be willing to pay a high price for the permits, and those firms that can reduce pollution at a low cost will sell their permits and will instead reduce their pollution. The initial allocation of the permits among industries does not affect the efficient outcome. This method is similar to a corrective tax. While a corrective tax sets the price of pollution (the tax), tradable pollution permits set the quantity of pollution permitted. In the market for pollution, either method can reach the efficient solution. Tradable pollution permits may be superior because the regulator does not need to know the demand to pollute in order to restrict pollution to a particular quantity. The EPA is increasingly and successfully using pollution permits to reduce pollution. At present, to reduce carbon emissions and global warming, the United States is moving toward a cap-and-trade system for carbon, which is very similar to a tax on carbon.

Some people object to an economic analysis of pollution. They feel that any pollution is too much and that putting a price on pollution is immoral. Because all economic activity creates pollution to some degree and all activities involve trade-offs, economists have little sympathy for this argument. Rich productive countries demand a cleaner environment, and market-based policies reduce pollution at a lower cost than alternatives, further increasing the demand for a clean environment.

Private Solutions to Externalities

Government action is not always needed to solve the externality problem. Some private solutions to the externality problem are as follows:

• Moral codes and social sanctions: People “do the right thing” and do not litter.

• Charities: People give tax-deductible gifts to environmental groups and private colleges and universities.

• Private markets that harness self-interest and cause efficient mergers: The beekeeper merges with the apple orchard, and the resulting firm produces more apples and more honey.

• Private markets that harness self-interest and create contracts among affected parties: The apple orchard and the beekeeper can agree to produce the optimal combined quantity of apples and honey.

The Coase theorem is the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. In other words, regardless of the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient. For example, if the value of peace and quiet exceeds the value of owning a barking dog, the party desiring quiet will buy the right to quiet from the dog owner and remove the dog, or the dog owner will fail to buy the right to own a barking dog from the owner of quiet space. Regardless of whether one has the property right to peace and quiet or the other has the right to make noise, there is no barking dog, which, in this case, is efficient. The result is the opposite and is also efficient if the value of owning a dog exceeds the value of peace and quiet.

Private parties often fail to reach efficient agreements, however, due to transaction costs. Transaction costs are the costs that parties incur in the process of agreeing and following through on a bargain. If transaction costs exceed the potential gains from the agreement, no private solution will occur. Some sources of high transaction costs are:

• lawyers’ fees to write the agreement

• costs of enforcing the agreement

• a breakdown in bargaining when there is a range of prices that would create efficiency

• a large number of interested parties.

Conclusion

Markets maximize total surplus to buyers and sellers in a market and this is usually efficient. However, if a market generates an externality, the market equilibrium may not maximize the total benefit to society as a whole, and thus, the market is inefficient. The Coase theorem says that people can bargain among themselves and reach an efficient solution. If transaction costs are high, however, government policy may be needed to improve efficiency. Corrective taxes and pollution permits are preferred to command-and-control policies because they reduce pollution at a lower cost and, therefore, increase the quantity demanded of a clean environment.

Public Goods and Common Resources

Some goods are free to the consumer – beaches, lakes, playgrounds. When goods are available without prices, market forces that normally allocate resources are absent. Therefore, free goods, such as playgrounds and public parks, may not be produced and consumed in the proper amounts. Government can potentially remedy this market failure and improve economic well-being.

The Different Kinds of Goods

There are two characteristics of goods that are useful when defining types of goods:

• Excludability: the property of a good whereby a person can be prevented from using it. A good is excludable if a seller can exclude nonpayers from using it (food in the grocery store) and not excludable if a seller cannot exclude nonpayers from using it (broadcast television or radio signal).

• Rivalry in consumption: the property of a good whereby one person’s use of a good diminishes other people’s use. A good is rival in consumption if only one person can consume the good (food) and not rival if the good can be consumed by more than one at the same time (streetlight).

With these characteristics, goods can be divided into four categories:

1. Private goods: Goods that are both excludable and rival in consumption. Most goods like bread and blue jeans are private goods and are allocated efficiently by supply and demand in markets.

2. Public goods: Goods that are neither excludable nor rival in consumption, such as national defense and streetlights.

3. Common resources: Goods that are rival in consumption but not excludable, such as fish in the ocean.

4. Club goods: Goods that are excludable but not rival in consumption, such as fire protection and cable television. Club goods are one type of natural monopoly.

This chapter examines the two types of goods that are not excludable and, thus, are free: public goods and common resources.

Public Goods

Public goods are difficult for a private market to provide because of the free-rider problem. A free rider is a person who receives the benefit of a good but avoids paying for it. Because public goods are not excludable, firms cannot prevent nonpayers from consuming the good, and thus, there is little incentive for a firm to produce a public good. The outcome of a public good is similar to that of a positive externality because consumers of a good fail to consume the efficient quantity of the good because they do not take into account the benefit to others.

For example, a streetlight may be valued at $1,000 by each of ten homeowners in a neighborhood. If the cost is $5,000, no individual will buy a streetlight because no one can sell the right to use the light to their neighbors for $1,000 each. This is because after the streetlight is in place, their neighbors can consume the light whether they pay or not. Even though the neighborhood values the streetlight at a total value of $10,000 and the cost of a streetlight is only $5,000, the private market will not be able to provide it. Public goods are related to positive externalities in that each neighbor ignores the external benefit provided to others when deciding whether to buy a streetlight. Often government steps in, provides goods, such as streetlights, where benefits exceed the costs, and pays for them with tax revenue. In this case, the government could provide the streetlight and tax each resident $500, and everyone would be better off.

Some important public goods are national defense, basic research that produces general knowledge, and programs to fight poverty.

Some goods can switch between being public goods and private goods depending on the circumstances. A lighthouse is a public good if the owner cannot charge each ship as it passes the light. A lighthouse becomes a private good if the owner can charge the port to which the ships are traveling.

When a private market cannot produce a public good, governments must decide whether to produce the good. Their decision tool is often cost-benefit analysis: a study that compares the costs and benefits to society of providing a public good. There are two problems with cost-benefit analysis:

• Quantifying benefits is difficult using the results of a questionnaire.

• Respondents have little incentive to tell the truth.

When governments decide whether to spend money on additional safety measures such as stoplights and stop signs, they must consider the value of a human life because the benefit of such an expenditure is the probability of saving a life times the value of a life. Studies suggest that the value of a human life is about $10 million.

Common Resources

Common resources are not excludable but are rival in consumption (say fish in the ocean). Therefore, common resources are free, but when one person uses it, it diminishes other people’s enjoyment of it. The outcome of a common resource is similar to that of a negative externality because consumers of a good do not take into account the negative impact on others from their consumption. The result is that common resources are used excessively.

The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. The town common (open land to be grazed) will be overgrazed to the point where it becomes barren because, since it is free, private incentives suggest that each individual should graze as many sheep as possible, yet this is overgrazing from a social perspective. Possible solutions are to regulate the number of sheep grazed, tax sheep, auction off sheep-grazing permits, or divide the land and sell it to individual sheep herders, making grazing land a private good.

Some important common resources are clean air and water, congested nontoll roads, and fish, whales, and other wildlife. Private decision makers use a common resource too much, so governments regulate behavior or impose fees to reduce the problem of overuse. For example, imposing tolls on congested roads reduces congestion and shortens travel times.

Conclusion: The Importance of Property Rights

In the case of public goods and common resources, markets fail to allocate resources efficiently because property rights are not clearly established. In a private market, no one owns the clean air so no one can charge people when they pollute. The result is that people pollute too much (externality example) or use too much clean air (common resource example). Furthermore, no one can charge those who are protected by national defense for the benefit they receive so people produce too little national defense (public good example).

The government can potentially solve these problems by selling pollution permits, regulating private behavior, or providing the public good.

Costs of Production

In previous sections, we summarized the firm’s production decisions by starting with the supply curve. Although this is suitable for answering many questions, it is now necessary to address the costs that underlie the supply curve in order to address the part of economics known as industrial organization – the study of how firms’ decisions about prices and quantities depend on the market conditions they face.

What Are Costs?

Economists generally assume that the goal of a firm is to maximize profits.

Profit = total revenue - total cost.

Total revenue is the quantity of output the firm produces times the price at which it sells the output. Total cost is more complex. An economist considers the firm’s cost of production to include all of the opportunity costs of producing its output. The total opportunity cost of production is the sum of the explicit and implicit costs of production. Explicit costs are input costs that require an outlay of money by the firm, such as when money flows out of a firm to pay for raw materials, workers’ wages, rent, and so on. Implicit costs are input costs that do not require an outlay of money by the firm. Implicit costs include the value of the income forgone by the owner of the firm had the owner worked for someone else plus the forgone interest on the financial capital that the owner invested in the firm.

Accountants are usually only concerned with the firm’s flow of money, so they record only explicit costs. Economists are concerned with the firm’s decision making, so they are concerned with total opportunity costs, which are the sum of explicit costs and implicit costs. Because accountants and economists view costs differently, they view profits differently:

• Economic profit = total revenue - (explicit costs + implicit costs)

• Accounting profit = total revenue - explicit costs

Because an accountant ignores implicit costs, accounting profit is greater than economic profit. A firm’s decision about supplying goods and services is motivated by economic profits.

Production and Costs

For the following discussion, we assume that the size of the production facility (factory) is fixed in the short run. Therefore, this analysis describes production decisions in the short run.

A firm’s costs reflect its production process. A production function shows the relationship between the quantity of inputs used to make a good (horizontal axis) and the quantity of output of that good (vertical axis). The marginal product of any input is the increase in output that arises from an additional unit of that input. The marginal product of an input can be measured as the slope of the production function or “rise over run.” Production functions exhibit diminishing marginal product – the property whereby the marginal product of an input declines as the quantity of the input increases. Hence, the slope of a production function gets flatter as more and more inputs are added to the production process.

The total-cost curve shows the relationship between the quantity of output produced and the total cost of production. Because the production process exhibits diminishing marginal product, the quantity of inputs necessary to produce equal increments of output rises as we produce more output, and thus, the total-cost curve rises at an increasing rate or gets steeper as the amount produced increases.

The Various Measures of Cost

Several measures of cost can be derived from data on the firm’s total cost. Costs can be divided into fixed costs and variable costs. Fixed costs are costs that do not vary with the quantity of output produced – for example, rent. Variable costs are costs that do vary with the quantity of output produced – for example, expenditures on raw materials and temporary workers. The sum of fixed and variable costs equals total costs.

In order to choose the optimal amount of output to produce, the producer needs to know the cost of the typical unit of output and the cost of producing one additional unit. The cost of the typical unit of output is measured by average total cost, which is total cost divided by the quantity of output. Average total cost is the sum of average fixed cost (fixed costs divided by the quantity of output) and average variable cost (variable costs divided by the quantity of output). Marginal cost is the cost of producing one additional unit. It is measured as the increase in total costs that arises from an extra unit of production. In symbols, if

• Q = quantity,

• TC = total cost,

• ATC = average total cost,

• FC = fixed costs,

• AFC = average fixed costs,

• VC = variable costs,

• AVC = average variable costs, and

• MC = marginal cost, then:

• ACT = TC/Q,

• AVC = VC/Q,

• AFC = FC/Q,

• MC = $\Delta$TC/$\Delta$Q,

When these cost curves are plotted on a graph with cost on the vertical axis and quantity produced on the horizontal axis, these cost curves will have predictable shapes. At low levels of production, the marginal product of an extra worker is large, so the marginal cost of another unit of output is small. At high levels of production, the marginal product of a worker is small, so the marginal cost of another unit is large. Therefore, because of diminishing marginal product, the marginal-cost curve is increasing or upward sloping. The average-total-cost curve is U-shaped because at low levels of output, average total costs are high due to high average fixed costs. As output increases, average total costs fall because fixed costs are spread across additional units of output. However, at some point, diminishing returns cause an increase in average variable costs, which in turn begins to increase average costs. The efficient scale of the firm is the quantity of output that minimizes average total cost. Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. Therefore, the marginal-cost curve crosses the average-total-cost curve at the efficient scale.

To this point, we have assumed that the production function exhibits diminishing marginal product at all levels of output, and therefore, there are rising marginal costs at all levels of output. Often, however, production first exhibits increasing marginal product and decreasing marginal costs at very low levels of output as the addition of workers allows for specialization of skills. At higher levels of output, diminishing returns eventually set in and marginal costs begin to rise, causing all cost-curve relationships previously described to continue to hold. In particular:

• Marginal cost eventually rises with the quantity of output.

• The average-total-cost curve is U-shaped.

• The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

Costs in the Short Run and in the Long Run

The division of costs between fixed and variable depends on the time horizon. In the short run, the size of the factory is fixed, and for many firms, the only way to vary output is hiring or firing workers. In the long run, the firm can change the size of the factory, and all costs are variable. The long-run average-total-cost curve, although flatter than the short-run average-total-cost curves, is still U-shaped. For each particular factory size, there is a short-run average-total-cost curve that lies on or above the long-run average-total-cost curve. In the long run, the firm gets to choose on which short-run curve it wants to operate. In the short run, it must operate on the short-run curve it chose in the past. Some firms reach the long run faster than do others because some firms can change the size of their factory relatively easily.

At low levels of output, firms tend to have economies of scale—the property whereby long-run average total cost falls as the quantity of output increases. At high levels of output, firms tend to have diseconomies of scale – the property whereby long-run average total cost rises as the quantity of output increases. At intermediate levels of output, firms tend to have constant returns to scale – the property whereby long-run average total cost stays the same as the quantity of output changes. Economies of scale may be caused by increased specialization among workers as the factory gets larger while diseconomies of scale may be caused by coordination problems inherent in extremely large organizations. Adam Smith, 200 years ago, recognized the efficiencies captured by large factories that allowed workers to specialize in particular jobs.

Conclusion

This chapter developed a typical firm’s cost curves. These cost curves will be used in the following chapters to see how firms make production and pricing decisions.

Perfect Competition

In this section, we examine the behavior of competitive firms – firms that do not have market power. Firms that have market power can influence the market price of the goods they sell. The cost curves developed in the previous chapter shed light on the decisions that lie behind the supply curve in a competitive market.

What Is a Competitive Market?

A competitive market has two main characteristics:

• There are many buyers and sellers in the market.

• The goods offered for sale are largely the same.

The result of these two conditions is that each buyer and seller is a price taker. A third condition sometimes thought to characterize perfectly competitive markets is:

• Firms can freely enter or exit the market.

Firms in competitive markets try to maximize profit, which equals total revenue minus total cost. Total revenue (TR) is P $\times$ Q. Because a competitive firm is small compared to the market, it takes the price as given. Thus, total revenue is proportional to the amount of output sold – doubling output sold doubles total revenue.

Average revenue (AR) equals total revenue (TR) divided by the quantity of output (Q) or AR = TR/Q. Because TR = P $\times$ Q, then AR = (P $\times$ Q)/Q = P. That is, for all firms, average revenue equals the price of the good.

Marginal revenue (MR) equals the change in total revenue from the sale of an additional unit of output or MR = $\Delta$TR/$\Delta$Q. When Q rises by one unit, total revenue rises by P dollars. Therefore, for competitive firms, marginal revenue equals the price of the good.

Profit Maximization and the Competitive Firm’s Supply Curve

Firms maximize profit by comparing marginal revenue and marginal cost. For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises. There are three general rules for profit maximization:

• If marginal revenue exceeds marginal cost, the firm should increase output to increase profit.

• If marginal cost exceeds marginal revenue, the firm should decrease output to increase profit.

• At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

A firm will temporarily shut down (produce nothing) if the revenue that it would get from producing is less than the variable costs (VC) of production. Examples of temporary shutdowns are farmers leaving land idle for a season and restaurants closing for lunch. For the temporary shutdown decision, the firm ignores fixed costs because these are considered to be sunk costs, or costs that are not recoverable because the firm must pay them whether they produce output or not. Mathematically, the firm should temporarily shut down if TR < VC. Divide by Q and get TR/Q < VC/Q, which is AR = MR = P < AVC. That is, the firm should shut down if P < AVC. Therefore, the competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above the average-variable-cost curve.

In general, beyond the example of a competitive firm, all rational decision makers think at the margin and ignore sunk costs when making economic decisions. Rational decision makers undertake activities where the marginal benefit exceeds the marginal cost.

In the long run, a firm will exit the market (permanently cease operations) if the revenue it would get from producing is less than its total costs. If the firm exits the industry, it avoids both its fixed and variable costs, or total costs. Mathematically, the firm should exit if TR < TC. Divide by Q and get TR/Q = TC/Q, which is AR = MR = P < ATC. That is, the firm should exit if P < ATC_. Therefore, the competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above the average-total-cost curve.

A competitive firm’s profit = TR - TC. Divide and multiply by Q and get profit = (TR/Q - TC/Q) $\times$ Q or profit = (P - ATC) $\times$ Q. If price is above ATC, the firm is profitable. If price is below ATC, the firm generates losses and would choose in the long run to exit the market.

The Supply Curve in a Competitive Market

In the short run, the number of firms in the market is fixed because firms cannot quickly enter or exit the market. Therefore, in the short run, the market supply curve is the horizontal sum of the portion of the individual firm’s marginal-cost curves that lie above their average-variable-cost curves. That is, the market supply curve is simply the sum of the quantities supplied by each firm in the market at each price. Because the individual marginal-cost curves are upward sloping, the short-run market supply curve is also upward sloping.

In the long run, firms are able to enter and exit the market. Suppose all firms have the same cost curves. If firms in the market are making profits, new firms will enter the market, increasing the quantity supplied and causing the price to fall until economic profits are zero. If firms in the market are making losses, some existing firms will exit the market, decreasing the quantity supplied and causing the price to rise until economic profits are zero. In the long run, firms that remain in the market must be making zero economic profit. Because profit = (P - ATC) $\times$ Q, profit equals zero only when P = ATC. For the competitive firm, P = MC and MC intersects ATC at the minimum of ATC. Thus, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. Also, because firms enter or exit the market if the price is above or below minimum ATC, the price always returns to the minimum of ATC for each firm, but the total quantity supplied in the market rises and falls with the number of firms. Thus, there is only one price consistent with zero profits, and the long-run market supply curve must be horizontal (perfectly elastic) at that price.

Competitive firms stay in business even though they are making zero economic profits in the long run. Recall that economists define total costs to include all the opportunity costs of the firm, so the zero-profit equilibrium is compensating the owners of the firm for their time and their money invested.

In the short run, an increase in demand increases the price of a good and existing firms make economic profits. In the long run, this attracts new firms to enter the market causing a corresponding increase in the market supply. This increase in supply reduces the price to its original level consistent with zero profits but the quantity sold in the market is now higher. Thus, if at present firms are earning high profits in a competitive industry, they can expect new firms to enter the market and prices and profits to fall in the future.

Although the standard case is one where the long-run market supply curve is perfectly elastic, the long-run market supply curve might be upward sloping for two reasons:

• If an input necessary for production is in limited supply, an expansion of firms in that industry will raise the costs for all existing firms and increase the price as output supplied increases.

• If firms have different costs (some are more efficient than others) in order to induce new less efficient firms to enter the market, the price must increase to cover the less efficient firm’s costs. In this case, only the marginal firm earns zero economic profits while more efficient firms earn profits in the long run.

Regardless, because firms can enter and exit more easily in the long run than in the short run, the long-run market supply curve is more elastic than the short-run market supply curve.

Conclusion: Behind the Supply Curve

The supply decision is based on marginal analysis. Profit-maximizing firms that supply goods in competitive markets produce where marginal cost equals price equals minimum average total cost.

Monopolist

Monopolists have market power because they can influence the price of their output. That is, monopolists are price makers as opposed to price takers. While competitive firms choose to produce a quantity of output such that the given market price equals the marginal cost of production, monopolists charge prices that exceed marginal costs. In this section, we examine the production and pricing decisions of monopolists, the social implications of their market power, and the ways in which governments might respond to the problems caused by monopolists.

Why Monopolies Arise

A monopoly is a firm that is the sole seller of a product without close substitutes. A monopoly is able to remain the only seller in a market only if there are barriers to entry. That is, other firms are unable to enter the market and compete with it. There are three sources of barriers to entry:

• Monopoly resources: A key resource required for production is owned by a single firm. For example, if a firm owns the only well in town, it has a monopoly for the sale of water. DeBeers essentially has a monopoly in the market for diamonds because it controls 80 percent of the world’s production of diamonds. This source of monopoly is somewhat rare.

• Government created monopolies: The government gives a single firm the exclusive right to produce some good. When the government grants patents (which last for twenty years) to inventors and copyrights to authors, it is giving someone the right to be the sole producer of that good. The benefit is that it increases incentives for creative activity. The costs will be discussed later in this chapter.

• Natural monopolies: The costs of production make a single producer more efficient than a large number of producers. A natural monopoly arises when a single firm can supply a good to an entire market at a smaller cost than could two or more firms. This happens when there are economies of scale over the relevant range of output. That is, the average-total-cost curve for an individual firm continually declines at least to the quantity that could supply the entire market. This cost advantage is a natural barrier to entry because firms with higher costs find it undesirable to enter the market. Common examples are utilities such as water and electricity distribution. Club goods are generally produced by natural monopolies.

How Monopolies Make Production and Pricing Decisions

A competitive firm is small relative to the market, so it takes the price of the good it produces as given. Because it can sell as much as it chooses at the given market price, the competitive firm faces a demand curve that is perfectly elastic at the market price. A monopoly is the sole producer in its market, so it faces the entire downward-sloping market demand curve. The monopolist can choose any price/quantity combination on the demand curve by choosing the quantity and seeing what price buyers will pay. As with competitive firms, monopolies choose a quantity of output that maximizes profit (total revenue minus total cost).

Because the monopolist faces a downward-sloping demand curve, it must lower the price of the good if it wishes to sell a greater quantity. Therefore, when it sells an additional unit, the sale of the additional unit has two effects on total revenue (P $\times$ Q):

• The output effect: Q is higher.

• The price effect: P is lower (on the marginal unit and on the units it was already selling).

Because the monopolist must reduce the price on every unit it sells when it expands output by one unit, marginal revenue ($\Delta$TR/AQ) for the monopolist declines as Q increases and marginal revenue is always less than the price of the good.

As with a competitive firm, the monopolist maximizes profit at the level of output where marginal revenue (MR) equals marginal cost (MC). As Q increases, MR decreases, and MC increases. Therefore, at low levels of output, MR > MC, and an increase in Q increases profit. At high levels of output, MC > MR, and a decrease in output increases profit. The monopolist, therefore, should produce up to the point where MR = MC. That is, the profit-maximizing level of output is determined by the intersection of the marginal-revenue and marginal-cost curves. Because the MR curve lies below the demand curve, the price the monopolist charges is found by reading up to the demand curve from the MR = MC intersection. That is, it charges the highest price consistent with that quantity.

Recall that for the competitive firm, because the demand curve facing the firm is perfectly elastic so that P = MR, the profit-maximizing equilibrium requires that P = MR = MC. However, for the monopoly firm, MR < P, so the profit-maximizing equilibrium requires that P > MR = MC. As a result, in competitive markets, price equals marginal cost while in monopolized markets, price exceeds marginal cost.

Evidence from the pharmaceutical drug market is consistent with our theory. While the patent is enforced, the price of a drug is high. When the patent expires and generic drugs become available, the price falls substantially.

As with the competitive firm, profit = (P - ATC) $\times$ Q, or profit equals the average profit per unit times the number of units sold.

The Welfare Cost of Monopolies

Does a monopoly market maximize economic well-being as measured by total surplus? Recall that total surplus is the sum of consumer surplus and producer surplus. Equilibrium of supply and demand in a competitive market naturally maximizes total surplus because all units are produced where the value to buyers is greater than or equal to the cost of production to the sellers.

For a monopolist to produce the socially efficient quantity (maximize total surplus by producing all units where the value to buyers exceeds or equals the cost of production), it would have to produce the level of output where the marginal-cost curve intersects the demand curve. However, the monopolist chooses to produce the level of output where the marginal-revenue curve intersects the marginal-cost curve. Because for the monopolist the marginal-revenue curve is always below the demand curve, the monopolist produces less than the socially efficient quantity of output.

The small quantity produced by the monopolist allows the monopolist to charge a price that exceeds the marginal cost of production. Therefore, the monopolist generates a deadweight loss because, at the high monopoly price, consumers fail to buy units of output where the value to them exceeds the cost to the monopolist.

The deadweight loss from a monopoly is similar to the deadweight loss from a tax, and the monopolist’s profit is similar to tax revenue except that the revenue is received by a private firm. Because the profit earned by a monopolist is simply a transfer of consumer surplus to producer surplus, a monopoly’s profit is not a social cost. The social cost of a monopoly is the deadweight loss generated when the monopolist produces a quantity of output below that which is efficient.

Price Discrimination

Price discrimination is the business practice of selling the same good at different prices to different customers. Price discrimination can only be practiced by a firm with market power such as a monopolist. There are three lessons to note about price discrimination:

• Price discrimination is a rational strategy for a profit-maximizing monopolist because a monopolist’s profits are increased when it charges each customer a price closer to his individual willingness to pay.

• Price discrimination is only possible if the monopolist is able to separate customers according to their willingness to pay – by age, income, location, etc. If there is arbitrage – the process of buying a good in one market at a low price and selling it in another market at a higher price – price discrimination is not possible.

• Price discrimination can raise economic welfare because output increases beyond that which would result under monopoly pricing. However, the additional surplus (reduced deadweight loss) is received by the producer, not the consumer.

Perfect price discrimination occurs when a monopolist charges each customer her exact willingness to pay. In this case, the efficient quantity is produced and consumed and there is no deadweight loss. However, total surplus goes to the monopolist in the form of profit. In reality, perfect price discrimination cannot be accomplished. Imperfect price discrimination may raise, lower, or leave unchanged total surplus in a market.

Examples of price discrimination include movie tickets, airline tickets, discount coupons, financial aid for college tuition, quantity discounts, and tickets for Broadway shows.

Public Policy Toward Monopolies

Monopolies fail to allocate resources efficiently because they produce less than the socially optimal quantity of output and charge prices that exceed marginal cost. Policymakers can respond to the problem of monopoly in one of four ways:

• By trying to make monopolized industries more competitive. The Justice Department can employ antitrust laws (statutes aimed at reducing monopoly power) to prevent mergers that reduce competition, break up extremely large companies to increase competition, and prevent companies from colluding. However, some mergers result in synergies that reduce costs and raise efficiency. Therefore, it is difficult for government to know which mergers to block and which ones to allow.

• By regulating the behavior of the monopolies. The prices charged by natural monopolies such as utilities are often regulated by government. If a natural monopoly is required to set its price equal to its marginal cost, the efficient quantity will be consumed, but the monopoly will lose money because marginal cost must be below average variable cost if average variable cost is declining. Thus, the monopolist will exit the industry. In response, regulators can subsidize a natural monopoly with tax revenue (which creates its own deadweight loss) or allow average-total-cost pricing, which is an improvement over monopoly pricing, but it is not as efficient as marginal-cost pricing. Another problem with regulating prices is that monopolists have no incentive to reduce costs because their prices are reduced when their costs are reduced.

• By turning some private monopolies into public enterprises. Instead of regulating the prices charged by a natural monopoly, the government can run the monopoly itself. The Postal Service is an example. Economists generally prefer private ownership to government ownership because private owners have a greater incentive to minimize costs.

• By doing nothing at all. Because each of the previously listed solutions has its own shortcomings, some economists urge that monopolies be left alone. They believe that the “political failure” in the real world is more costly than the “market failure” caused by monopoly pricing.

Conclusion: The Prevalence of Monopolies

In one sense, monopolies are common because most firms have some control over the prices they charge. On the other hand, firms with substantial monopoly power are rare. Monopoly power is a matter of degree.

Oligopoly

The market structure that lies between competition and monopoly is known as imperfect competition. One type of imperfectly competitive market is oligopoly – a market structure in which only a few sellers offer similar or identical products. Oligopoly differs from competition because in a competitive market, the decisions of one firm have no impact on the other firms in the market while in an oligopolistic market, the decisions of any one firm may affect the pricing and production decisions of other firms in the market. Oligopolistic firms are interdependent. Game theory is the study of how people behave in strategic situations. Strategic situations are when decision makers must consider how others might respond to their actions.

Markets with Only a Few Sellers

A duopoly is an oligopoly with only two firms. If a market were perfectly competitive, the price of output would equal marginal cost. If a market were monopolistic, the profit-maximizing price would exceed marginal cost and the result would be inefficient.

Collusion is an agreement among firms in a market about quantities to produce or prices to charge. A cartel is a group of firms acting in unison. If duopolists collude and form a cartel, the market solution is the same as if it were served by a monopolist, and the two firms divide the monopoly profits.

Oligopolists may fail to cooperate because self-interest makes it difficult to agree on how to divide the profits or because antitrust laws prohibit collusion. Without a binding agreement, each oligopolist will maximize its profit given the production levels of the other firms. A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. A Nash equilibrium is a type of oligopolistic equilibrium. When oligopolists individually choose production levels to maximize individual profits, they produce a quantity that is greater than the level produced by monopoly but less than that produced by perfect competition, and they will charge a price that is less than the monopoly price but greater than the competitive price.

The larger the oligopoly (more firms), the more difficult it is for them to form a cartel and behave as a monopolist. If they each choose their own level of production to maximize individual profits, they will make the marginal decision of whether to produce an additional unit based on the following:

• The output effect: Because price is above marginal cost, selling one more unit at the going price will raise profit.

• The price effect: Raising production one unit will increase the total sold, but it will lower the price and the profit on all of the other units sold.

If the output effect exceeds the price effect, the oligopolist will produce another unit, and it will continue to expand output until these two effects balance. The greater the number of sellers in an oligopoly, the smaller the price effect because each individual firm’s impact on the price is small. Thus, the level of output increases. As the number of sellers in an oligopoly grows larger, the price approaches marginal cost and the quantity approaches the socially efficient level. When there are a large number of firms, the price effect disappears altogether, and the market becomes competitive.

Unrestricted international trade increases the number of firms in domestic oligopolies and moves the outcome of the market closer to the competitive solution where prices are equal to marginal cost.

An example of a cartel is OPEC (Organization of Petroleum Exporting Countries), which limits the production of oil.

The Economics of Cooperation

Within the area of economic study known as game theory, the prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. The game applies to oligopoly because oligopolistic firms would always be better off to cooperate yet they often do not.

An example of a prisoners’ dilemma is the following: Two criminals are captured. If one confesses and the other does not, the confessor goes free while the other receives a long sentence. If both confess, they both receive an intermediate term. If neither confesses, they both receive a very short term. If the two could cooperate, the best strategy is for both of them to keep quiet. However, because they cannot guarantee cooperation after they are caught, the best strategy for each is to confess. That is, confessing is a dominant strategy – a strategy that is best for a player in a game regardless of the strategies chosen by the other players.

The prisoners’ dilemma applies to oligopoly in the following manner: Two oligopolists are better off if they cooperate by keeping production low and sharing the monopoly profits. However, after the agreement is made, the dominant strategy for each is to cheat and produce more than they agreed to produce to enhance their individual profits. The result is that profits fall for both. Self-interest makes it difficult to maintain cooperation.

The prisoners’ dilemma applies to the following:

• Arms races: Each country prefers to live in a safe world, but the dominant strategy is to increase armaments, and the world is less safe.

• Common resources: Users of a common resource would find it more profitable to jointly limit their use of the resource, but the dominant strategy is to overuse the resource, and joint profits fall.

Lack of cooperation in the cases previously described is harmful to society. However, lack of cooperation between oligopolists regarding the level of production may be bad for the oligopolists, but it is good from the standpoint of society as a whole.

Although cooperation is difficult to maintain, it is not impossible. If the game is repeated, the prisoners’ dilemma can be solved, and agreements can be maintained. For example, oligopolies may include a penalty for violation of the agreement. If the penalty is that they all maintain high production forever if someone cheats, then all should maintain low production levels and share monopoly profits. If the game is played on a periodic basis (each week, month, or year new production levels are chosen), then a simple strategy of tit-for-tat generates the greatest likelihood of cooperation. Tit-for-tat is when a player in a game starts by cooperating and then does whatever the other player did last period. If the first player cooperated last period, then the second player should cooperate the next period. If the first player defected (cheated) last period, then the second player should cheat the next period, and so on.

Public Policy Toward Oligopolies

Because cooperating oligopolists reduce output and raise prices, policymakers try to induce firms in an oligopoly market to compete rather than cooperate. The Sherman Antitrust Act of 1890 makes agreements not to compete (to reduce quantities or raise prices) a criminal conspiracy. The Clayton Act of 1914 allows individuals harmed by such agreements the right to sue for triple damages. Price fixing clearly reduces economic welfare and is illegal.

There is some disagreement over the use of antitrust laws against some business practices that appear like price fixing. For example:

• Resale price maintenance is when a manufacturer requires retailers to charge a certain price. This appears to prevent retailers from competing on price. However, some economists defend the practice as legitimate because

  1. if the manufacturer has market power, it is at wholesale not retail, and the manufacturer would not gain from eliminating competition at the retail level, and

  2. resale price maintenance stops discount retailers from free riding on the services provided by full-service retailers.

• Predatory pricing occurs when a firm cuts prices with the intention of driving competitors out of the market so that the firm can become a monopolist and later raise prices. Some economists think that this behavior is unlikely because it hurts the firm that is engaged in predatory pricing the most.

• Tying occurs when a manufacturer bundles two products together and sells them for one price. Courts argue that tying gives the firm more market power by connecting a weak product with a strong product. Some economists disagree. They suggest that it allows the firm to price discriminate, which may actually increase efficiency. Tying remains controversial.

Conclusion

Oligopolies will look more like a competitive market if there are a large number of firms and more like a monopoly if there are a small number of firms. The prisoners’ dilemma shows why cooperation is difficult to maintain even when it is in the best interest of the oligopolists. The use of antitrust laws against price fixing improves economic efficiency, but their use in other areas is more controversial.