No Such Thing as a Free Lunch: Principles of Economics (Part 74)

“Suckers think that you cure greed with money, addiction with substances, expert problems with experts, banking with bankers, economics with economists, and debt crises with debt spending”

― Nassim Nicholas Taleb, The Bed of Procrustes: Philosophical and Practical Aphorisms

Externalities, Public Goods, Imperfect Information, and Social Choice

(Part A)

by

Charles Lamson

So far in this analysis, we built a complete model of a perfectly competitive economy under a set of assumptions; we had demonstrated that the allocation of resources under perfect competition is efficient, and we began to relax some of the assumptions on which the perfectly competitive model is based; we introduced the idea of market failure, and most recently we talked about three kinds of imperfect markets: monopoly, oligopoly, and monopolistic competitive competition. We also discussed some of the ways government has responded to the inefficiencies of imperfect markets and to the development of market power.

As we continue our examination of market failure, we look first at externalities as a source of inefficiency. Often when we engage in transactions or make economic decisions, second or third parties suffer consequences that decision-makers have no incentive to consider. For example, for many years manufacturing firms and power plants had no reason to worry about the impact of smoke from their operations on the quality of the air we breathe. Now we know that air pollution---an externality---harms people.

Next, we consider a second type of market failure that involves products private firms find unprofitable to produce even if members of society want them. These products are called public goods or social goods. Public goods yield collective benefits, and in most societies, governments produce them or arrange to provide them. The process of choosing what social goods to produce is very different from the process of private choice.

A third source of market failure is imperfect information. When information is imperfect, misallocation of resources may result.

Finally, while the existence of public goods, externalities, and imperfect information are examples of market failure, it is not necessarily true that government involvement will always improve matters. Just as markets can fail, so too can governments. When we look at the incentives facing government decision makers, we find several reasons behind government failure.

Externalities and Environmental Economics

An externality exists when the actions or decisions of one person or group impose a cost or bestow a benefit on second or third parties. Externalities are sometimes called spillovers or neighborhood effects. Inefficient decisions result when decision makers fail to consider social costs and benefits.

The presence of externalities is a significant phenomenon in modern life. Examples are everywhere: air, water, land, sight, and sound pollution; traffic congestion; automobile accidents; abandoned housing; nuclear accidents; and secondhand cigarette smoke are only a few. The study of externalities is a major concern of environmental economics.

The opening of Eastern Europe in 1989 and 1990 revealed that environmental externalities are not limited to free market economies. Part of the logic of a planned economy is that when economic decisions are made socially (by the government, presumably acting on behalf of the people) instead of privately, planners can and will take all costs---private and social---into account. This has not been the case, however. When east and west Germany were reunited and the borders of Europe were opened, we saw the disastrous condition of the environment in virtually all Eastern Europe.

As societies become more urbanized, externalities become more important: when we live closer together, our actions are more likely to affect others.

Marginal Social Cost and Marginal Cost Pricing

 Profit-maximizing perfectly competitive firms will produce output up to the point at which price is equal to marginal cost (P = MC). Let us take a moment here to review why this is essential to the proposition that perfectly competitive markets produce what people want---an efficient mix of output.

When a firm weighs price and marginal cost and externalities exist, it is weighing the full benefits to society of additional production against the full costs to society of that production. Those who benefit from the production of a product are the people or households who end up consuming it. The price of a product is a good measure of what an additional unit of that product is "worth," because those who value it more highly already buy it. People who value it less than the current price are not buying it. If marginal cost includes all costs---that is, all costs to society of producing a marginal unit of a good, then additional production is efficient, provided that P is greater than MC. Up to the point where P = MC, each unit of production yields benefits in excess of cost.

Consider a firm in the business of producing laundry detergent. As long as the price per unit that consumers pay for that detergent exceeds the cost of the resources needed to produce one marginal unit of it, the firm will continue to produce. Producing up to the point where P = MC is efficient, because for every unit of detergent produced, consumers derive benefits that exceed the cost of the resources needed to produce it. Producing at a point where MC is greater than P is inefficient, because marginal cost will rise above the unit price of the detergent. For every unit produced beyond the level at which P = MC, society uses up resources that cost more than the benefits that consumers place on detergent. Figure 1(a) shows a firm in an industry in which no externalities exist.

Suppose, however, that the production of the firm's product imposes external costs on society as well. If it does not factor those additional costs into its decision the firm is likely to overproduce. In Figure 1(b), a certain measure of external costs is added to the firm's marginal cost curve. We see these external costs in the diagram, but the firm is ignoring them. The curve labeled MSC, marginal social cost, is the sum of the marginal costs of producing the product plus the correctly measured damage costs imposed in the process of production.

If the firm does not have to pay for these damage costs, it will produce exactly the same level of output (q*) as before, and price (P*) will continue to reflect only the costs that the firm actually pays to produce its product. The firms in this industry will continue to produce, and consumers will continue to consume their product, but the market price takes into account only part of the full cost of producing the good. At equilibrium (q*), marginal social costs are considerably greater than price. Price is a measure of the full value to consumers of a unit of the product at the margin.

Decision makers at the manufacturing firms and public utilities weigh these costs, but there is another side to this story. Burning cheap coal and not worrying about the acid rain that may be falling on someone else means jobs and cheap power for residents of the Midwest. Forcing coal-burning plants to pay for past damages from acid rain and even requiring them to weigh the costs that they are presently imposing undoubtedly raises electricity prices and production costs in the Midwest. Some firms have been driven out of business and some jobs have been lost. However, if the electricity and other products produced in the Midwest are worth the full costs imposed by acid rain, plants would not shut down; consumers would pay higher prices. If those goods are not worth the full cost, they should not be produced.

The case of acid rain highlights the fact that efficiency analysis ignores the distribution of gains and losses. That is, to establish efficiency we need only to demonstrate that the total value of the gains exceeds the total value of the losses. If Midwestern producers and consumers of their products were forced to pay an amount equal to the damages they caused, the gains from damage in the East and in Canada would be at least as great as costs in the Midwest. The beneficiaries of forcing Midwestern firms to consider these costs would be the households and firms in the East and in Canada. After many years of debate, Congress passed and President Bush signed the Clean Air Act of 1990. Included in the law are strict emissions standards aimed, in part, at controlling the production and distribution of acid rain. An interesting provision of the Clean Air Act is its use of "tradable pollution rights," which we discuss in a later post.

Other Externalities Other examples of external effects are all around us. When you drive your car into the center of the city at rush hour, you contribute to the congestion and impose costs (in the form of lost time and auto emissions) on others. One focus of environmental activists is the possibility of worldwide climate warming as a result of "greenhouse emissions" (like carbon dioxide) from industrial plants and automobiles. While potential costs are high, great uncertainty, both in the scientific evidence and in the magnitude of the potential costs, surrounds the issue.

Secondhand cigarette smoke has become a matter of public concern. In December 1994, a judge in Florida ruled that nonsmokers could bring a class action suit based on the health consequences of passive smoke. Smoking has been banned on domestic air carriers, and many states have passed laws severely restricting smoking in public places.

In 1997, the big tobacco firms initiated an agreement to pay over $350 billion to compensate those harmed by smoke and to reimburse states for smoking-related medicinal expenses paid under the Medicaid program.

Despite these problems, not all externalities are negative: An abandoned house in an urban neighborhood that is restored and occupied makes the neighborhood better and adds value to the neighbors' homes. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 305-308*

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Tolerance in Islamic Spain - Myth or Reality? - WOTW EP 6 P1

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No Such Thing as a Free Lunch: Principles of Economics (Part 73)

“What I'm saying to you this morning is that Communism forgets that life is individual. Capitalism forgets that life is social, and the Kingdom of Brotherhood is found neither in the thesis of Communism nor the antithesis of capitalism but in a higher synthesis.”

― Martin Luther King Jr.

Monopolistic Competition and Oligopoly (Part H)

by

Charles Lamson

The Role of Government

Regulation of Mergers

The Clayton Act of 1914 (as mentioned in part 63 of this analysis) had given government the authority to limit mergers that might "substantially lessen competition in an industry." The Celler-Kefauver Act of 1950 enabled the Justice Department to monitor and enforce these provisions.

In 1968, the Justice Department issued its first guidelines designed to reduce uncertainty about the mergers it would find acceptable. The 1968 guidelines were strict. For example, if the largest four firms in an industry controlled 75 percent or more of a market, an acquiring firm with a 15 percent market share would be challenged if it wanted to acquire a firm that controlled as little as an additional 1 percent of the market.

In 1982, the Antitrust Division---in keeping with President Reagan's hands-off policy toward big business---issued a new set of far more lenient guidelines. Revised in 1984, they remain in place today. The 1982/1984 standards are based on a measure of market structure called the Herfindahl-Hirschman Index (HHI). The HHI is calculated by expressing the market share of each firm in the industry as a percentage, squaring these figures, and adding. For example, in an industry in which two firms each control 50 percent of the market, the index is:

Table 5 shows HHI calculations for several hypothetical industries. The Justice Department's courses of action, summarized in Figure 10 are as follows: If the Herfindahl-Hirschman index is less than 1,000, the industry is considered unconcentrated, and any proposed merger will go unchallenged by the justice department. If the index is between 1,000 and 1,800, the department will challenge any merger that would increase the index by over 100 points. Herfindahl indexes above 1,800 mean that the industry is considered concentrated already, and the justice department will challenge any merger that pushes the index up more than 50 points.

In 1992 the Department of Justice and the Federal Trade Commission (FTC) issued joint horizontal merger guidelines updating and expanding the 1984 guidelines. The most interesting part of the new provisions is that the government will examine each potential merger to determine if it enhances the firms' power to engage in "coordinated interaction" with other firms in the industry. The guidelines define "coordinated interaction" as:

actions by a group of firms that are profitable for each of them only as the result of the accommodating reactions of others. This behavior includes tacit or express collision, and may or may not be lawful in and of itself.

 

A Proper Role?

Certainly there is much to guard against in the behavior of large, concentrated industries. Barriers to entry, large size, and product differentiation all lead to market power and to potential inefficiency. Barriers to entry and collusive behavior stop the market from working toward an efficient allocation of resources.

For several reasons, however, economists no longer attack industry concentration with the same fervor they once did. First, the theory of contestable markets shows that even firms in highly concentrated industries can be pushed to produce efficiently under certain market circumstances. Second, the benefits of product differentiation and product competition are real, at least in part. After all, a constant stream of new products and new variations of old products comes to the market almost daily. Third, the effects of concentration on the rate of research and development spending are, at worst, mixed. It is certainly true that large firms do a substantial amount of the total research in the United States. Finally in some industries, substantial economies of scale simply preclude a completely competitive structure. 

In addition to the debate over the desirability of industrial concentration, there is a never-ending debate concerning the role of government in regulating markets. One view is that high levels of concentration lead to an efficiency and that government should act to improve the allocation of resources---to help the market work more efficiently. This logic has been used to justify the laws and other regulations aimed at moderating noncompetitive behavior.

An opposing view holds that the clearest examples of effective barriers to entry are those actually created by governments. this view holds that government regulation in past years has been ultimately anticompetitive and has made the allocation of resources less efficient than it would have been with no government involvement. Those who earn positive profits have an incentive to spend resources to protect themselves and their profits from competitors. This rent-seeking behavior may include using the power of government.

Complicating the debate further there is international competition. Increasingly, firms are faced with competition from foreign firms in domestic markets at the same time that they are competing with other multinational firms for a share of foreign markets. We live in a truly global economy today. Thus, firms that dominate a domestic market may be fierce competitors in the international arena. This has implications for the proper role of government. Some contend that instead of breaking up AT&T, the government should have allowed it to be a bigger, stronger international competitor. We will return to this debate in a future post. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 300-301* 

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The Legacy of Abd Al Rahman & The History of Almanzor - Moorish Spain WO...

No Such Thing as a Free Lunch: Principles of Economics (Part 72)

“If the ordinary wage-earner worked four hours a day, there would be enough for everybody and no unemployment -- assuming a certain very moderate amount of sensible organization. This idea shocks the well-to-do, because they are convinced that the poor would not know how to use so much leisure. In America men often work long hours even when they are well off; such men, naturally, are indignant at the idea of leisure for wage-earners, except as the grim punishment of unemployment; in fact, they dislike leisure even for their sons.”

― Bertrand Russell

Monopolistic Competition and Oligopoly

(Part G)

by

Charles Lamson

Oligopoly and Economic Performance

How well do oligopolies perform? Should they be regulated or changed? Are they efficient, or do they lead to an inefficient use of resources? On balance, are they good or bad?

With the exception of the contestable market model, all the models of oligopoly we have examined lead us to conclude that concentration in a market leads to pricing above marginal cost and output below the efficient level. When price is above marginal cost at equilibrium, consumers are paying more for the good than it costs to produce that good in terms of products forgone in other industries. To increase output would be to create value that exceeds the social cost of the good, but profit-maximizing oligopolists have an incentive not to increase output.

Entry barriers in many oligopolistic industries also prevent new capital and other resources from responding to profit signals. Under competitive conditions or in contestable markets, positive profits would attract new firms and increase production. This does not happen in most oligopolistic industries. The problem is most severe when entry barriers exist and firms explicitly or tacitly collude. The results of collusion are identical to the results of a monopoly. Firms jointly maximize profits by fixing prices at a high level and splitting up the profits.

Product differentiation under oligopoly presents us with the same dilemma that we encountered in monopolistic competition. On the one hand, vigorous product competition among oligopolistic competitors produces variety and leads to innovation in response to the wide variety of consumer tastes and preferences. It can thus be argued that vigorous product competition is efficient. On the other hand, product differentiation may lead to waste and inefficiency. Product differentiation accomplished through advertising may have nothing to do with product quality, and advertising itself may have little or no information content. If it serves as an entry barrier that blocks competition, product differentiation can cause the market allocation mechanism to fail.

Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons. First, profit-maximizing oligopolists are likely to produce above marginal cost. When price is above marginal cost, there is underproduction from society's point of view---in other words, society could get more for less, but it does not. Second, strategic behavior can lead to outcomes that are not in society's best interest. Specifically, strategically competitive firms can force themselves into deadlocks that waste resources. Finally, to the extent that oligopolists differentiate their products and advertise, there is the promise of new and exciting products. At the same time, however, there remains a real danger of waste and inefficiency.

Industrial Concentration and Technological Change

One of the major sources of economic growth and progress throughout history has been technological advance. Innovation, both in methods of production and in the creation of new and better products, is one of the engines of economic progress. Much innovation starts with research and development efforts undertaken by firms in search of profit.

Several economist's, notably Joseph Schumpeter and John Kenneth Galbraith, argued in works now considered classics that industrial concentration actually increases the rate of technological advance. As Schumpeter put it in 1942:

As soon as we . . . inquire into the individual items in which progress was most conspicuous, the trail leads not to the doors of those firms that work under conditions of comparatively free competition but precisely to the doors of the large concerns . . . and a shocking suspicion dawns upon us that big business may have had more to do with creating that standard of life than keeping it down.

 

This caused the economics profession to pause and take stock of its theories. The conventional wisdom had been that concentration and barriers to entry insulate firms from competition and lead to sluggish performance and slow growth.

The evidence concerning where innovation comes from is mixed. Certainly, most small businesses do not engage in research and development, and most large firms do. When R&D expenditures are considered as a percentage of sales, firms in industries with high concentration ratios spend more on research and development than firms in industries with low concentration ratios.

Oligopolistic companies such as AT&T have done a great deal of research. AT&T Bell Laboratories (now a separate company called Nokia Bell Labs) has probably done more important research over the last 5 decades than any other organization in the country (Case & Fair, p 289). It has been estimated that Bell Labs conducted 10 percent of all the basic industrial research in the United States during the 1970s. IBM, which despite its problems over the years set the industry standard in personal computers, has certainly introduced as much new technology to the computer industry as any other firm.

However, the "high-tech revolution" grew out of many tiny startup operations. Companies such as Sun Microsystems, Cisco Systems, and even Microsoft barely existed only a generation ago [Case & Fair (2004)]. The new biotechnology firms that are working miracles with genetic engineering started with research done by individual scientists and University Laboratories.

As with the debate about product differentiation and advertising, significant ambiguity on this subject remains. Indeed, there may be no right answer. Technological change seems to come in fits and starts, sometimes from small firms and sometimes from large ones. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 298-299*

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The Rise of Abd Al Rahman III - The History of Islamic Spain WOTW EP 5 P2

No Such Thing as a Free Lunch: Principles of Economics (Part 71)

“It is because every individual knows little and, in particular, because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it.”

― Friedrich August von Hayek, The Constitution of Liberty

Monopolistic Competition and Oligopoly

(Part F)

by

 Charles Lamson

Repeated Games

Clearly, games are not played once. Firms must decide on advertising budgets, investment strategies, and pricing policies continuously. While explicit collusion violates the antitrust statutes, strategic reaction does not. Yet, strategic reaction in a repeated game may have the same effect as tacit collusion.

Consider the game in Figure 9. Suppose that British Airways and Lufthansa were competing for business on the New York to London route during the off season. To lure travelers they were offering discount fares. The question is, how much to discount? Both airlines were considering a deep discount of $400 round trip or a moderate discount of $600. Since the average per trip cost to the airline is $200, each $600 ticket produces profit of $400, and each $400 ticket produces profit of $200.

Clearly, demand is sensitive to price. Assume that studies of demand elasticity have determined that if both airlines offer tickets for $600, they will attract 6000 passengers per week (3000 for each airline), and each airline will make a profit of $1.2 million per week ($400 profit * 3000 passengers).

However, if both Airlines offer the deep discount fares of $400 they will attract 2,000 additional customers per week for a total of 8000 (4000 for each airline). While they will have more passengers, each ticket brings in less profit and total profit falls to $800,000 per week ($200 profhet times 4000 passengers).

What if the two airlines offer different prices? To keep things simple we will ignore brand loyalty and assume that whichever airline offers the deep discount gets all of the eight thousand passengers. If British Airways offers the $400 fare it will sell 8000 tickets per week and make $200 profit each, for a total of $1.6 million. Since Lufthansa holds out for $600, they sell no tickets and make no profit. Similarly, if Lufthansa were to offer tickets for $400, it would make $1.6 million per week while British Airways would make zero.

It was precisely this logic that led American Airlines president Robert Crandall to suggest to Howard Putnam of Braniff Airways in 1983, "I think this is dumb as hell . . . To sit here and pound the @#%* out of each other and neither one of us making a @#%* dime." ... "I have a suggestion for you, raise your @#%* fares 20 percent. I'll raise mine the next morning."

Since competing firms are prohibited from even talking about prices, Crandall got into a lot of trouble with Justice Department when Putnam turned over a tape of the call in which these comments were made. 

If Lufthansa figures out that British Airways will simply play the same strategy that Lufthansa is playing, both will end up charging $600 per ticket and earning $1.2 million, instead of charging $400 and earning only $800,000 per week even though there has been no explicit price-fixing.

Game theory has been used to help understand many other phenomena from the provision of local public goods and services to nuclear war. It is clear, for example, that if government finance were done on a voluntary basis, households would have a strong incentive not to contribute. This example of a prisoners' dilemma will be discussed in some detail in upcoming posts. In addition, state and defense department analysts use game theory extensively to play out alternative strategies during times of conflict. Many believe that the arms race between the United States and the Soviet Union prior to 1989 was a simple prisoners' dilemma.

Contestable Markets Before we discuss the performance of oligopolies, we should note one relatively new theory of behavior that has limited applications but some important implications for understanding imperfectly competitive market behavior.

A market is perfectly contestable if entry to it and exit from it are costless. That is, a market is perfectly contestable if a firm can move into it in search of profits but lose nothing if it fails. To be part of a perfectly contestable market, a firm must have capital that is both mobile and easily transferable from one market to another.

Take, for example, a small airline that can move its capital stock from one market to another with little cost. Provincetown Boston Airlines (PBA) flies between Boston, Martha's Vineyard, Nantucket, and Cape Cod during the summer months. During the winter, the same planes are used in Florida, where they fly up and down that State's West Coast between Naples, Fort Myers, Tampa, and other cities. A similar situation may occur when a new industrial complex is built at a fairly remote site and a number of trucking companies offer their services. Because the trucking companies capital stock is mobile, they can move their trucks somewhere else at no great cost if business is not profitable.

Because entry is cheap, participants in a contestable market are continuously faced with competition or the threat of it. Even if there are only a few firms competing, the openness of the market forces all of them to produce efficiently or be driven out of business. This threat of competition remains high because new firms face little risk in going after a new market. If things do not work out in a crowded market, they do not lose their investment. They can simply transfer their capital to a different place or different use.

In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.

Review Oligopoly is a market structure that is consistent with a variety of behaviors. The only necessary condition of oligopoly is that firms are large enough to have some control over price. Oligopolies are concentrated industries. At one extreme is the cartel, in which a few firms get together and jointly maximize profits---in essence, acting as a monopolist. At the other extreme, the firms within the oligopoly vigorously compete for small contestable markets by moving capital quickly in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 296-298*

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