Apr 19

Supply and demand

Demand and supply are possibly the two most fundamental concepts used in economics. The concept of market is usually defined as a number of buyers and sellers of a given good or service that are willing to negotiate in order to exchange those goods. We will first explain them separately and then jointly to show their interaction.

Demand:

Demand is the global market value that expresses the purchasing intentions of consumers. The demand curve shows the quantity of a specific product that individuals or society are willing to buy according to its price and their income. This curve shows an inverse relationship between price and quantity demanded giving it a downward slope. The reason why this happens is known as the law of demand: ceteris paribus, and considering ordinary goods, the higher the price the lower the quantity demanded, and vice versa.

We can start by analysing demand from a purely microeconomic point of view: a single individual, let’s say her name is Joan. Joan’s demand for, let’s say, books, is such as shown in the adjacent graph. If the price of a book is $35 or more, Joan won’t demand any (point a), given her preferences (basically, she would rather spend her money on something else). However, if the price of books goes down to $30, she will want to buy one (point b). If it decreases to $20, Joan will buy two books (point c), and so on. By joining all the points (a-h), we’ll get Joan’s demand curve. It’s worth mentioning that, for simplicity’s sake (though violating monotonicity), we consider that the demand curve ends at the axes.

From a macroeconomic point of view, the demand curve is just the aggregation of all demand curves from all buyers in a particular market. Let’s say the market for books has only two buyers: Joan and her classmate Edward. The horizontal sum of Joan and Edward’s demand curves will give us the market demand:

Supply:

On the other side, supply is the set of offers made in the market for the sale of goods and services. The supply curve records the location of the points corresponding to the amount offered for a particular good or service at the different prices. This curve shows a direct relationship between price and quantity supplied, giving it an upward slope. The reason why this happens is known as the law of supply: ceteris paribus, and considering ordinary goods, the higher the price the higher the quantity supplied, and vice versa.

Let’s see how the supply curve can be built, starting with an individual’s offer, let’s say his name is Robert. Robert is willing to supply books for $10 or more, this is, Robert won’t supply any books for $5 (point a). However, if the price of books goes up to $10, he will be willing to sell one book (point b). If it increases to $15, Robert will sell two books (point c), and so on. By joining all the points (a-g), we’ll get Robert’s supply curve. Notice that the supply curve goes up and seems not to have limits, an assumption made for simplicity’s sake. Of course Robert will have troubles to supply more than a certain amount of books, but let’s keep it simple and not think about the upper end of the supply curve.

Again, the market’s supply curve is just the aggregation of all supply curves from all sellers in a particular market. Let’s say the market for books has only two sellers: Robert and the librarian next door, Gregory. The horizontal sum of Robert and Gregory’s supply curves will give us the market supply:

Equilibrium and market clearing:

The demand and supply curves define the market clearing, that is, where the demand of the products meets its supply. At this point we have what is known as, an equilibrium point, with its corresponding price and quantity of equilibrium.

It is possible for disequilibrium to occur when the amount demanded does not equal the amount supplied. There are a series of scenarios in which this can happen. In situations in which the quantity demanded is higher than the quantity supplied, the market is suffering from an excess demand. When the opposite occurs we will be talking about an excess supply. Prices will have to gradually adjust through different market mechanisms until the equilibrium price is met.

Movements vs. shifts:

When analysing demand and supply and their respective curves, it is important to distinguish between two aspects: movements along curves and shifts in curves.

A movement refers to a change in either the demand or supply curve, which occurs when a change in the quantity is caused by a change in price and vice versa. An increase in the price of a good or service would cause a movement along its demand curve, decreasing the amount demanded. In the case of supply curves, as we previously saw, an increase in price would also increase quantity. It’s important to understand that movement along the curves does never actually change the equilibrium point, as movements along the curves do not affect it. In the adjacent figure we can see a price increase (let’s say, because an increase of VAT), which causes a movement along the demand curve.

Sometimes the market suffers from changes due to a displacement (shift) of the demand and/or the supply curve. This shift in curves will always result in a new market equilibrium. When a shift occurs, the curve moves, meaning that for each price there will be a new different quantity being demanded or offered. This curve shifts can occur in two directions, upwards and downwards, or if preferred, rightwards and leftwards. Depending in what curve we are considering one is equal to another one.

Demand curves may shift for multiple reasons, for example, an increase in the consumers’ level of income would increase the aggregate demand of a normal good for each price, and hence shift the demand curve to the right (left figure). Other examples would include changes in the price of competitors (substitute goods), changes in complementary goods, tastes, expectations, number of buyers, seasonality, etc. Supply curve shifts may be also motivated by a variety of different reasons, such as input prices: an increase on the price of paper would shift the supply curve to the left, since the same quantity would be sold at a higher price (right figure). Other variables that can shift the supply curve include technological progress, expectations, number of sellers, etc.

Apr 17

Lope Gallego

Monopoly

Monopoly (from the greek «mónos», single, and «polein», to sell) is a form of market structure of imperfect competition, mainly characterized by the existence of a sole seller and many buyers. This kind of market is normally associated with entry and exit barriers.

All of these features give the monopolist the ability to set prices with the only limitation of consumers’ willingness to pay. Therefore, in monopolies, the seller is a price-maker and consumers will be price-takers. The firm will choose its production output (q) and price (p) in order to maximise revenue (π). The optimal condition, where we’ll have marginal cost (MC) equals marginal revenue (MR), is given by:

The extent to which a firm can take advantage of its monopolistic condition will highly depend on the flexibility of its demand curve. If it is more rigid (steeper), it will only have to reduce its production in order to achieve a higher price. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices. This relationship between price elasticity of demand and market power can be described using the Lerner index. This index measures the firm’s level of market power by relating price to marginal cost,

The result will always be between 0 and 1: the closer it is to 0, the closer it is to perfect competition; the closer it is to 1, the higher market power the seller has and hence closer to a monopoly. A monopolist seeking to maximise profits will never be on the inelastic part of the demand curve, E < 1, which is why elasticity will always be such as ∞ ≥ E ≥ 1. The Lerner index is equivalent to the inverse of the elasticity in its absolute value faced by the firm when price is set to maximise profits.

The implications of monopolies in terms of loss of efficiency and social welfare have been largely studied and discussed. If we compare the monopolistic price setting with the perfect competition one, we will find that while in the former price is greater than marginal cost, in the latter, they are equal. This implies that in general, price will be higher and output lower, if a firm behaves in a monopolistic manner, instead of a competitive one. And also in general, results for the firms will be to be better off, while it will be just the opposite for consumers. However, the gain for the firm will not sum up the total loss for the consumers. This is known as the deadweight loss of monopoly that comes as a result of the Pareto inefficiency of monopolies. From the equilibrium output of a monopoly to that of a perfectly competitive market, the consumers will be willing to pay more than marginal cost. This leaves space for improving efficiency, but monopolistic firms choose to produce less and set higher prices. This deadweight loss is represented by the areas A and B in the adjacent figure: while the monopolist gains area Cˈ and loses B, consumers transfer area Cˈ and lose A. As a result, firms increase their surplus, consumers lose part of it and in aggregate terms, society as a whole, will bury the deadweight loss.

Types of monopolies:

As we have previously explained, monopolistic firms maximise their profits with the level of output in which marginal cost equals marginal revenue. However we can distinguish different types of monopolies depending on how they achieve this. We can distinguish different types of monopolies:

Multiplant monopoly: firms which have many production plants and hence different marginal cost functions will have to choose the individual output level for each plant.

Bilateral monopoly: this market structure consists of a single buyer (monopsony) and a single seller (monopoly). Depending on who has greater negotiation power there can be different outcomes. Two possible scenarios may be in either one of them having all of the power, an intermediate solution may be found or a vertical integration may occur.

Multiproduct monopoly: instead of selling one product, the monopoly sells several. The firm will have to take into account how the changes in the price of one affect the rest of its products.

Discriminating monopoly: firms may want to charge different prices to different consumers, depending on their willingness to pay. Depending on the level of discrimination we have different degrees. The first degree or perfect discrimination is given when the monopolist sets the highest price that each consumer is willing to be pay. The second degree or nonlinear price fixing is given when price depends on the amount bought by the consumer. And finally, the third degree or market segmentation of price discrimination occurs when there are several differentiated consumers segments to which the firm will apply different prices, e.g. student or third age discounts.

Natural monopoly: this kind of monopoly occurs in industries in which, due to cost-technological factors, it is more efficient to have a single firm dealing with all of the production, as average costs are lower in the long run; a phenomenon known as subadditivity.

Apr 16

Lope Gallego

Bertrand duopoly

In some cases, competition in terms of price changes seems more logical than quantity competition, especially in the short run. Besides, one of the assumptions of Cournot’s duopoly model is that firms supply a homogeneous product. Considering this, Bertrand proposed an alternative to Cournot. Considering Bertrand’s model from a game theory perspective, it can be analysed as a simultaneous game where the strategic choice is on prices, rather than quantities.

In this model, consumers will buy from the firm that offers the lowest price, so we can easily have the intuition that the Nash equilibrium is going to be the two firms setting the same price.

Assuming equal and constant cost functions, the demand for each firm is as follows:

Bertrand’s equilibrium occurs when P₁=P₂=MC, being MC the marginal cost, yielding the same result as perfect competition.

The logic is simple: if the price set by both firms is the same but the marginal cost is lower, there will be an incentive for both firms to lower their prices and seize the market. Therefore, the only equilibrium in which none of the firms will be willing to deviate is when price equals marginal cost.

The result of the model creates a paradox, known as Bertrand’s paradox: in a case of imperfect competition (here, a duopoly), where there is a strong incentive to collude, we end up with the same outcome as in perfect competition. The equilibrium does not hold with asymmetric cost functions since the firm with the lowest marginal cost would seize the entire market and become a monopoly. A great analysis of this paradox, known as Edgeworth duopoly model or Bertrand-Edgeworth duopoly, was developed by Francis Y. Edgeworth in his paper “The Pure Theory of Monopoly”, 1897.

Apr 15

Lope Gallego

Monopolistic competition

Monopolistic competition is a market structure defined by four main characteristics: large numbers of buyers and sellers; perfect information; low entry and exit barriers; similar but differentiated goods. This last one is key to distinguish monopolistic competition from perfect competition since in the latter all products are homogenous. This product differentiation leads consumers to perceive products in this market as unique, providing firms with a monopolistic-like property that enables them having price-making power. There is a distinction to be made between horizontally and vertically differentiated products in order to be able to understand different strategies that monopolistic firms might adopt. The former is given when consumers base their purchasing decision on subjective preferences when comparing products, e.g. colours or flavours. The latter occurs when the product can be evaluated with another one in terms of measurable and qualitative factors, e.g. technological differences or technical properties in engines.

The extent to which each firm can take advantage of their monopoly condition depends on the flexibility of their demand curve. If it is too rigid (steeper), in order for the monopolist to achieve a higher price, it has only to reduce some of its production. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices. Naturally, every monopolist in an imperfect market tries to expand the size of the market in which its product dominates. For this they have to compete with other monopolists leading them to a series of costs other than production (manufacturing and transportation costs), which are defined as selling expenses. These expenses are incurred with the aim of modifying the demand curve so quantities demanded for the product increase for each level of prices.

If a firm fails to have its product differentiated, the market would be shared with other firms, turning into a duopoly, oligopoly or even, if other conditions are met, a perfectly competitive market.

Within the field and existing research of monopolistic competition, the most prominent model is the one devised by Edward H. Chamberlin (the Chamberlin model), which he developed from monopoly models. Even though there are other models and theories, most have followed Chamberlin’s model, being this the most widely used and recognized in economics.

Apr 12

Lope Gallego

Duopoly

Duopoly (from the Greek «duo», two, and «polein», to sell) is a type of oligopoly. This kind of imperfect competition is characterized by having only two firms in the market producing a homogeneous good. For simplicity purposes, oligopolies are normally studied by analysing duopolies. What strategies firms follow and their interactions are a key feature of this market structure.

In duopolies there are two variables of interest: the prices set by each firm and the quantity produced by each firm. Several models have been developed through time, from which we must highlight the Cournot, Stackelberg, Bertrand and the Edgeworth solution. The first two models seek the optimum quantity a firm should produce. Both have different conclusions as they have a different initial assumption. With time, and as the next two models proved, the focus changed to target the optimum price a firm should set in order to maximise profits.

There are also different perspectives in the analysis of duopolies, which deal with game theory. While the models by Antoine Cournot and Joseph Bertrand occur under a basis of simultaneous games, Heinrich von Stackelberg’s model depends on sequential games.

In the real world, firms interact with each other and have to consider the potential negative effects a price war may report in the long-run. Edward Chamberlin suggested that in an oligopolistic market, firms would soon recognise their interdependence and hold monopolistic prices without the implications of collusion, but that would give the same equilibrium point. Collusion equilibrium will be maintained for as long as a firm finds it more beneficial to do so. The moment a firm thinks it can achieve higher profits by deviating from it, it will do so.

Apr 11

Lope Gallego

Allais paradox

The Allais paradox was developed by Maurice Allais in his paper “Le Comportement de l’homme rationnel devant le risque: critique des postulats et axiomes de l’école américaine”, 1953 and it describes the empirically demonstrated fact that individuals’ decisions can be inconsistent with expected utility theory. This paradox is usually explained with Allais experiment (you may try it yourself), which is:

An individual is asked to choose one between the following gambles:

Gamble A: 100% chance of receiving 100 millions

Gamble B: 10% chance of receiving 500 millions,

89% chance of receiving 100 millions,

1% chance of receiving nothing

And another amongst the following:

Gamble C: 11% chance of receiving 100 millions,

89% chance of receiving nothing

Gamble D: 10% chance of receiving 500 millions,

90% chance of receiving nothing

If expected utility axiomatic was applied, the preference A > B should imply that C > D. However, the experiment shows that most rational individuals would choose so that A > B but C < D, even though it can be easily seen that the expected value of each gamble is a=100, b=139, c=11 and d=50.

In the first gamble the less risky choice is preferred over a higher expected utility, while in the second gamble a higher expected utility is preferred over a less risky choice.

This paradox relies in the fact that in certain types of gambling, although people usually prefer certainty to uncertainty, if they are approached differently, they will prefer the uncertainty that was previously rejected. Therefore we can extract a series of conclusions. First, as we have seen, in the real world expected utility theory does not really applied, therefore its many critiques and alternative approaches. Second, people tend to give an extra value to total absence of risk on the contrary to remote and highly uncertain risk. Third and last, when the differences in probabilities are very small, people tend to ignore them and the expected utility is the alternative.

Apr 8

Lope Gallego

Ellsberg paradox

The Ellsberg’s paradox was developed by Daniel Ellsberg in his paper “Risk, Ambiguity, and the Savage Axioms”, 1961. It concerns subjective probability theory, which fails to follow the expected utility theory, and confirms Keynes’ 1921 previous formulation. This paradox is usually explained with the next experiment (you may try it yourself):

An individual is told that an urn contains 90 balls from which 30 are known to be red and the remaining 60 are either black or yellow. He is asked to choose between the following gambles:

Gamble A: – $100 if the ball is red

Gamble B: – $100 if the ball is black

And one between the following:

Gamble C: – $100 if the ball is not black

Gamble D: – $100 if the ball is not red

In most cases people will choose A over B and D over C. It is thought that betting for or against the known information (red ball) is safer than betting for or against the unknown (black ball). Nevertheless, these choices of preferences result in a violation of the sure-thing principle, which would require the ordering of A to B to be preserved in C to D.

We can derive a series of conclusions from this paradox. First, the appearances of a breach in the independence axiom, as common elements are considered in both gambles. Second, how individuals are reluctant to play in complex games, which shows their aversion to ambiguity. This statement also concerns the last conclusion which regards the disjunction effect. Decisions are postponed until having information, although this information may not have an influence is our final decision.

Apr 4

Lope Gallego

Oligopoly

Oligopoly (from the Greek «oligos», few, and «polein», to sell) is a form of market structure that is considered as half way between two extremes: perfect competition and monopolies. This kind of imperfect competition is characterized by having a relatively scarce amount of firms, but always more than one, which produce a homogeneous good. Due to the small number of firms in the market, the strategies between firms will be interdependent, thus implying that the profits of an oligopolistic firm will highly depend on their competitors’ actions.

Firms in oligopolistic market can have a wide range of behaviour patterns making it difficult to have a single model. Static models are used as they present a simple way of analysing equilibriums in this market. However, the maximisation problem faced by the firm will be marked by the different strategic interdependence context in which that market works. Therefore, the firm must estimate and collect the reactions of its competitors in its optimisation problem to choose the best strategy to follow. As a result we must propose a conjectural variation on how competitors modify their behaviour as the firm varies strategies.

Let’s see how conjectural variation affects each firm’s behaviour and final output. We start with the profit (π_i) maximisation problem, where Q is total output, q corresponds to each firm’s output and C is its production costs:

Setting this to zero for maximisation, we have:

Therefore, rearranging the previous function we have:

From this last function, we can assume the following:

-each firm’s profits are directly related to its competitors’ behaviour, which determines the conjectural variation (CV).

-each firm’s behaviour depends on the conjectural variation of their competitors: if CV>0, the firm will react by striking back with the same action (lowering prices, for example); if CV<0, the firm will choose the opposite strategy; if CV=0, the firm will accommodate its competitor’s strategy, as the Cournot duopoly model assumes.

-each firm’s behaviour, understood as reactions to each other’s strategies, define the market structure and the degree of competition.

For simplicity purposes, oligopolies are specially studied in cases in which there are only two competitors in the market. These are known as duopolies and its analysis and conclusions can be extrapolated for oligopolies.

Apr 2

Lope Gallego

Oligopsony

Oligopsony (from the greek «oligoi», few, and «opsõnía», purchase) is a market structure form of imperfect competition characterized by the existence of a relative small number of buyers, and many sellers. It is a similar case to oligopoly but were the oligopolistic powers come from the demand side. Monopsonies, a term first coined by Joan Robinson in her book “The Economics of Imperfect Competition”, 1933, are a particular case of oligopsonies, where there is only one buyer, which holds all the negotiating power.

Apr 1

Lope Gallego

Monopsony

Monopsony (from the greek «mónos», single, and «opsõnía», purchase) is a market structure form of imperfect competition characterized by the existence of a unique buyer and many sellers. It is a similar case to monopoly but were the monopolistic powers come from the demand side and not from the supply one. Joan Robinson first coined this term in her book “The Economics of Imperfect Competition” 1933.

There are not many cases of real monopsonies in the world, however the many occur in any input market. Examples of this include the one of the United States over defence and security assets in the economy, which started during the cold war. Nevertheless, the most significant case analysed is monoposony in the labour market. Frictions between the job searching progress and joining to it, causes employees to be uncomfortable about leaving their workplace.

This position gives the employer monopsonist powers and allows them to push wages down to the marginal revenue product providing them with higher profits. Governments have the possibility to set a minimum wage to prevent wages dropping to very low levels.

Markets with the same features as monopsonies but where there are more than one buyer, being the number of buyers still small enough, are known as oligopsonies.