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In the fast food market, it is the legal practice of product differentiation that occupies the minds of marketing executives. Fast-food producers go to great lengths to convince you they have something special to offer beyond the ordinary burger: it’s flame broiled or 100% beef or super-thick or lathered with special sauce. Or maybe they offer chicken or fish or roast beef. And the differentiation dance goes on in the pizza industry as well. Pizza Hut offers cheese in the crust. Papa John’s claims “better ingredients.” Dominoes has a “new recipe,” and if you don’t want thin crust, the alternative isn’t “regular,” it’s “hand tossed”! The slogans and logos for fast-food restaurants often seem to differ more than the food itself. To understand why ADM engaged in illegal pricefixing and why fast-food joints go to great lengths to differentiate their patties and pizzas, we need to understand the two market structures in between perfect competition and monopoly in the spectrum of market power—oligopoly and monopolistic competition. The models of these two market structures are at the same time more complicated and more realistic than those we studied in the previous section. Indeed, they describe the behavior of most of the firms in the real world. 637 What you will learn in this Module: • Why oligopolists have an incentive to act in ways that reduce their combined profit • Why oligopolies can benefit from collusion Module 64 Introduction to Oligopoly In Module 57 we learned that an oligopoly is an industry with only a few sellers. But what number constitutes a “few”? There is no universal answer, and it is not always easy to determine an industry’s market structure just by looking at the number of sellers. Economists use various measures to gain a better picture of market structure, including concentration ratios and the Herfindahl-Hirschman Index, as explained in Module 57. In addition to having a small number of sellers in the industry, an oligopoly is characterized by interdependence, a relationship in which the outcome (profit) of each firm depends on the actions of the other firms in the market. This is not true for monopolies because, by definition, they have no other firms to consider. On the other hand, competitive markets contain so many firms that no one firm has a significant effect on the outcome of the others. However, in
an oligopoly, an industry with few sellers, the outcome for each seller depends on the behavior of the others. Interdependence makes studying a market much more interesting because firms must observe and predict the behavior of other firms. But it is also more complicated. To understand the strategies of oligopolists, we must do more than find the point where the MC and MR curves intersect! Understanding Oligopoly How much will a firm produce? Up to this point, we have always answered: the quantity that maximizes its profit. When a firm is a perfect competitor or a monopolist, we can assume that the firm will use its cost curves to determine its profit-maximizing output. When it comes to oligopoly, however, we run into some difficulties. A Duopoly Example Let’s begin looking at the puzzle of oligopoly with the simplest version, an industry in which there are only two firms—a duopoly—and each is known as a duopolist. Firms are interdependent when the outcome (profit) of each firm depends on the actions of the other firms in the market. An oligopoly consisting of only two firms is a duopoly. Each firm is known as a duopolist. 638 Imagine that there are only two producers of lysine (the animal feed additive mentioned in the section opener). To make things even simpler, suppose that once a company has incurred the fixed cost needed to produce lysine, the marginal cost of producing another pound is zero. So the companies are concerned only with the revenue they receive from sales. Table 64.1 shows a hypothetical demand schedule for lysine and the total revenue of the industry at each price–quantity combination. Sellers engage in collusion when they cooperate to raise their joint profits. A cartel is a group of producers that agree to restrict output in order to increase prices and their joint profits. t a b l e 64.1 Demand Schedule for Lysine Price of lysine (per pound) Quantity of lysine demanded (millions of pounds) Total revenue (millions) $12 11 10 10 20 30 40 50 60 70 80 90 100 110 120 $0 110 200 270 320 350 360 350 320 270 200 110 0 If this were a perfectly competitive industry, each firm would have an incentive to produce more as long as the market price was above marginal cost. Since the marginal cost is assumed to be zero, this would mean that at equilibrium, lysine would be provided for free. Firms would
produce until price equals zero, yielding a total output of 120 million pounds and zero revenue for both firms. However, with only two firms in the industry, it would seem foolish to allow price and revenue to plummet to zero. Each would realize that with more production comes a lower market price. So each firm would, like a monopolist, see that profits would be higher if it and its rival limited their production. So how much will the two firms produce? One possibility is that the two companies will engage in collusion— they will cooperate to raise their joint profits. The strongest form of collusion is a cartel, a group of producers with an agreement to work together to limit output and increase price, and therefore profit. The world’s most famous cartel is the Organization of Petroleum Exporting Countries (OPEC). As its name indicates, OPEC is actually a cartel made up of govern ments rather than firms. There’s a reason for this: cartels among firms are illegal in the United States and many other jurisdictions. But let’s ignore the law for a moment. Suppose the firms producing lysine were to form a cartel and that this cartel decided to act OPEC representatives discuss the cartel’s policies of cooperation 639 as if it were a monopolist, maximizing total industry profits. It’s obvious from Table 64.1 that in order to maximize the combined profits of the firms, this cartel should set total industry output at 60 million pounds of lysine, which would sell at a price of $6 per pound, leading to revenue of $360 million, the maximum possible. Then the only question would be how much of that 60 million pounds each firm gets to produce. A “fair” solution might be for each firm to produce 30 million pounds and receive revenues of $180 million. But even if the two firms agreed on such a deal, they might have a problem: each of the firms would have an incentive to break its word and produce more than the agreedupon quantity. Collusion and Competition Suppose that the presidents of the two lysine producers were to agree that each would produce 30 million pounds of lysine over the next year. Both would understand that this plan maximizes their combined profits. And both would have an incentive to cheat. To see why, consider what would happen if one firm honored its agreement, producing only 30 million pounds, but the other ignored its promise and produced 40 million pounds. This increase in total output would drive the price down from $6 to $
5 per pound, the price at which 70 million pounds are demanded. The industry’s total revenue would fall from $360 million ($6 × 60 million pounds) to $350 million ($5 × 70 million pounds). However, the cheating firm’s revenue would rise, from $180 million to $200 million. Since we are assuming a marginal cost of zero, this would mean a $20 million increase in profits. But both firms’ presidents might make exactly the same calculation. And if both firms were to produce 40 million pounds of lysine, the price would drop to $4 per pound. So each firm’s profits would fall, from $180 million to $160 million. The incentive to cheat motivates the firms to produce more than the quantity that maximizes their joint profits rather than limiting output as a true monopolist would. We know that a profit-maximizing monopolist sets marginal cost (which in this case is zero) equal to marginal revenue. But what is marginal revenue? Recall that producing an additional unit of a good has two effects: 1. A positive quantity effect: one more unit is sold, increasing total revenue by the price at which that unit is sold. 2. A negative price effect: in order to sell one more unit, the monopolist must cut the market price on all units sold. The negative price effect is the reason marginal revenue for a monopolist is less than the market price. But when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not on those of its fellow oligopolists. In the lysine example, both duopolists suffer a negative price effect if one firm decides to produce extra lysine and so drives down the price. But each firm cares only about the portion of the negative price effect that falls on the lysine it produces. This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than a monopolist; therefore, the marginal revenue that such a firm calculates is higher. So it will seem to be profitable for any one firm in an oligopoly to increase production, even if that increase reduces the profits of the industry as a whole. But if everyone thinks that way, the result is that everyone earns a lower profit! Until now, we have been able to analyze producer behavior by asking what a producer should do to maximize profits. But even if the duopolists are both trying to
maximize profits, what does this predict about their behavior? Will they engage in collusion, reaching and holding to an agreement that maximizes their combined profits? Or will they engage in noncooperative behavior, with each firm acting in its own self-interest, even though this has the effect of driving down everyone’s profits? Both strategies can be carried out with a goal of profit maximization. Which will actually describe their behavior? When firms ignore the effects of their actions on each other’s profits, they engage in noncooperative behavior. 640 Now you see why oligopoly presents a puzzle: there are only a small number of players, making collusion a real possibility. If there were dozens or hundreds of firms, it would be safe to assume they would behave noncooperatively. Yet, when there are only a handful of firms in an industry, it’s hard to determine whether collusion will actually occur. Since collusion is ultimately more profitable than noncooperative behavior, firms have an incentive to collude if they can. One way to do so is to formalize it—sign an agreement (maybe even make a legal contract) or establish some financial incentives for the companies to set their prices high. But in the United States and many other nations, firms can’t do that—at least not legally. A contract among firms to keep prices high would be unenforceable, and it could be a one-way ticket to jail. The same goes for an informal agreement. In fact, executives from rival firms rarely meet without lawyers present, who make sure that the conversation does not stray into inappropriate territory. Even hinting at how nice it would be if prices were higher can bring an unwelcome interview with the Justice Department or the Federal Trade Commission. For example, in 2003 the Justice Department launched a price-fixing case against Monsanto and other large producers of genetically modified seed. The Justice Department was alerted by a series of meetings held between Monsanto and Pioneer Hi-Bred International, two companies that account for 60% of the U.S. market in maize and soybean seed. These companies, parties to a licensing agreement involving genetically modified seed, claimed that no illegal discussions of price-fixing occurred in those meetings. But the fact that the two firms discussed prices as part of the licensing agreement was enough to trigger action by the Justice Department Competing with Prices versus Competing with Quantities Sometimes, as we’ve seen, oligopolistic firms just ignore the rules. But more often they develop
strategies for making the best of the situation depending on what they know, or assume, about the other firms’ behavior. The uncertainties of oligopoly behavior make it harder to model than the behavior of monopolists or perfectly competitive firms, but models do exist. One such model is an example of price competition developed by French economist Joseph Bertrand. According to the Bertrand model, oligopolists repeatedly undercut each others’ prices—charging a bit less than the others to steal their customers—until price reaches the level of marginal cost, as under perfect competition. Another French economist, Augustin Cournot, focused instead on quantity competition, which had oligopolists choosing quantities and charging as much as possible for those quantities, rather than choosing prices and selling as much as possible at those prices. According to the Cournot model, each oligopolist treats the output of its competitors as fixed, and restricts output to that quantity that will maximize profit given the fixed output of others. The firms’ restriction of output in the Cournot model results in lower overall output levels, and higher prices, than under perfect competition, and each firm earns a positive economic profit. Consider American Airlines and British Airways, which we will assume are duopolists with exclusive rights to fly the Chicago–London route. When the economy is strong and lots of people want to fly between Chicago and London, American Airlines and British Airways might assume the number of passengers the other can carry is constrained, for example by the number of landing slots or terminal gates available. In this environment they are likely to behave according to the Cournot model and price above marginal cost—say, charging $800 per round trip. But when the business climate is poor, the two airlines are likely to find that they have lots of empty seats at a fare of $800 and that capacity constraints are no longer an issue. What will they do 641 Recent history tells us they will engage in a price war by slashing ticket prices. If American Airlines were to try to maintain a price of $800, it would soon find itself undercut by British Airways, which would charge $750 and steal its customers. In turn, American Airlines would undercut British Airways by charging $700—and so on. As long as each firm finds that it can capture the customers by cutting price, each will continue cutting until price is equal to marginal cost. (Going any lower would cause them to incur an avoidable loss.) This is the outcome Bertrand predicted. Oligopolists would, understandably, prefer to avoid Bertrand
behavior because it earns them zero profits. Lacking an environment that imposes constraints on their output capacity, firms try other means of avoiding direct price competition—such as producing products that are not perfect substitutes but are instead differentiated. We’ll examine this strategy in more detail in Module 68. For now, we note that producing differentiated products allows oligopolists to cultivate a loyal set of customers and to charge prices higher than marginal cost. Collusion is another approach to dodging the profit-suppressing effects of competition. In the next module, we’ll see why informal collusion often works but sometimes fails. In the absence of collusion, price competition among oligopolists can be intense, as with the airfare war between Jetstar and Virgin Blue that has led to $300 fares to Bali. fy i The Great Vitamin Conspiracy It was a bitter pill to swallow. In the late 1990s, some of the world’s largest drug companies (mainly European and Japanese) agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspiracy began in 1989 when the Swiss company Roche and the German company BASF began secret talks about raising prices for vitamins. Soon a French company, Rhone-Poulenc, joined in, followed by several Japanese companies and other companies around the world. The members of the group, which referred to itself as “Vitamins, Inc.,” met regularly—sometimes at hotels, sometimes at the private homes of executives—to set prices and divide up markets for “bulk” vitamins (like vitamin A, vitamin C, and so on). These bulk vitamins are sold mainly to other companies, such as animal feed makers, food producers, and so on, which include them in their products. Indeed, it was the animal feed companies that grew suspicious about the prices they were being charged, which led to a series of investigations. The case eventually broke open when Rhone-Poulenc made a deal with U.S. officials to provide evidence of the conspiracy. The French company was concerned that rumors about price-fixing would lead U.S. officials to block its planned merger with another company. How could it have happened? The main answer probably lies in different na- tional traditions about how to treat oligopolists. The United States has a long tradition of taking tough legal action against price-fixing. European governments, however, have historically been much less stringent. Indeed, in the
past some European governments have actually encouraged major companies to form cartels. But European antitrust law has changed recently to become more like U.S. antitrust law. Despite this change, however, the cultural tradition of forming cartels as normal business practice lingers within the boardrooms of some European companies. M o d u l e 64 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain whether each of the following characteristics will increase or decrease the likelihood that a firm will collude with other firms in an oligopoly to restrict output. a. The firm’s initial market share is small. (Hint: Think about the price effect.) b. The firm has a cost advantage over its rivals. c. The firm’s customers face additional costs when they switch from one firm’s product to another firm’s product. d. The firm and its rivals are currently operating at maximum production capacity, which cannot be altered in the short run. 642 Tackle the Test: Multiple-Choice Questions 1. When firms cooperate to raise their joint profits, they are 3. An agreement among several producers to restrict output necessarily a. colluding. b. in a cartel. c. a monopoly. d. in a duopoly. e. in a competitive industry. 2. Use the information in the table below on market shares in the search engine industry and measures of market power (defined in Section 10) to determine which of the following statements are correct. Search Engine Google Yahoo MSN AOL Ask Other Market share 44% 29 13 6 5 3 I. The 4-firm concentration ratio is 92. II. The Herfindahl-Hirschman index is 3,016. III. The industry is likely to be an oligopoly. a. I only b. II only c. III only d. I and II only I, II, and III e. and increase profit is necessary for a. cooperation. b. collusion. c. monopolization. d. a cartel. e. competition. 4. Oligopolists engage in which of the following types of behavior? I. quantity competition II. price competition III. cooperative behavior a. I only b. II only c. III only d. I and II only I, II, and III e. 5. Which of the following will make it easier for firms in an industry to maintain positive economic profit? a. a ban on cartels b. a small number of firms in the industry c.
a lack of product differentiation d. low start-up costs for new firms e. the assumption by firms that other firms have variable output levels Tackle the Test: Free-Response Questions 1. Refer to the table provided to answer the following questions. Assume that marginal cost is zero. Answer (7 points) Demand Schedule Quantity Price 0 $24 1 22 2 20 3 18 4 16 5 14 6 12 7 10 8 8 9 6 10 4 11 2 12 0 a. If the market is perfectly competitive, what will the market equilibrium price and quantity be in the long run? Explain. b. If the market is a duopoly and the firms collude to maximize joint profits, what will market price and quantity be? Explain. If the market is a duopoly and the firms collude to maximize joint profits, what is each firm’s total revenue if the firms split the market equally? c. 1 point: If the market is perfectly competitive, price will be zero. 1 point: If the market is perfectly competitive, quantity will be 12. 1 point: Price equals marginal cost in the long-run equilibrium of a perfectly competitive market, so price will be zero, at which price the quantity is 12. 1 point: If the market is a duopoly, price will be $12. 1 point: If the market is a duopoly, quantity will be 6. 1 point: In order to maximize joint profits, the two firms would act as a monopoly, setting marginal revenue equal to marginal cost and finding price on the demand curve above the profit-maximizing quantity. Marginal revenue passes through zero (going from 2 to − 2) after the 6th unit, making 6 the profit-maximizing quantity. The most consumers would pay for 6 units is $12, so that is the profit-maximizing price. 1 point: Total revenue is $12 × 6 = $72. By dividing this equally, each firm receives $36. 2. a. What are the two major reasons we don’t see cartels among oligopolistic industries in the United States? b. Explain the difference between behavior under the Cournot model and behavior under the Bertrand model 643 What you will learn in this Module: • How our understanding of oligopoly can be enhanced by using game theory • The concept of the prisoners’ dilemma • How repeated interactions among oligopolists can result in collusion in the absence of any formal agreement The study of behavior in situations of interdependence is known as game
theory. The reward received by a player in a game, such as the profit earned by an oligopolist, is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two-player game depends on the actions of both. Such a matrix helps us analyze situations of interdependence. Module 65 Game Theory Games Oligopolists Play In our duopoly example and in real life, each oligopolistic firm realizes both that its profit depends on what its competitor does and that its competitor’s profit depends on what it does. That is, the two firms are in a situation of interdependence, whereby each firm’s decision significantly affects the profit of the other firm (or firms, in the case of more than two). In effect, the two firms are playing a “game” in which the profit of each player depends not only on its own actions but on those of the other player (or players). In order to understand more fully how oligopolists behave, economists, along with mathematicians, developed the area of study of such games, known as game theory. It has many applications, not just to economics but also to military strategy, politics, and other social sciences. Let’s see how game theory helps us understand oligopoly. The Prisoners’ Dilemma Game theory deals with any situation in which the reward to any one player—the payoff—depends not only on his or her own actions but also on those of other players in the game. In the case of oligopolistic firms, the payoff is simply the firm’s profit. When there are only two players, as in a lysine duopoly, the interdependence between the players can be represented with a payoff matrix like that shown in Figure 65.1. Each row corresponds to an action by one player; each column corresponds to an action by the other. For simplicity, let’s assume that each firm can pick only one of two alternatives: produce 30 million pounds of lysine or produce 40 million pounds. The matrix contains four boxes, each divided by a diagonal line. Each box shows the payoff to the two firms that results from a pair of choices; the number below the diagonal shows Firm 1’s profits, the number above the diagonal shows Firm 2’s profits. These payoffs show what we concluded from our earlier analysis: the combined profit of the two firms is maximized if they each produce 30
million pounds. Either firm can, however, increase its own profits by producing 40 million pounds if the other produces only 30 million pounds. But if both produce the larger quantity, both will have lower profits than if they had both held their output down. 644 65.1 A Payoff Matrix Two firms must decide how much lysine to produce. The profits of the two firms are interdependent: each firm’s profit depends not only on its own decision but also on the other’s decision. Each row represents an action by Firm 1, each column one by Firm 2. Both firms will be better off if they both choose the lower output; but it is in each firm’s individual interest to choose the higher output. Firm 2 Produce 30 million pounds Produce 40 million pounds Firm 2 makes $180 million profit. Firm 2 makes $200 million profit. Firm 1 makes $180 million profit. Firm 1 makes $150 million profit. Firm 2 makes $150 million profit. Firm 2 makes $160 million profit. Firm 1 makes $200 million profit. Firm 1 makes $160 million profit. 1 m r i F Produce 30 million pounds Produce 40 million pounds The particular situation shown here is a version of a famous—and seemingly paradoxical—case of interdependence that appears in many contexts. Known as the prisoners’ dilemma, it is a type of game in which the payoff matrix implies the following: ■ Each player has an incentive, regardless of what the other player does, to cheat—to take an action that benefits it at the other’s expense. ■ When both players cheat, both are worse off than they would have been if neither had cheated. The original illustration of the prisoners’ dilemma occurred in a fictional story about two accomplices in crime—let’s call them Thelma and Louise—who have been caught by the police. The police have enough evidence to put them behind bars for 5 years. They also know that the pair have committed a more serious crime, one that carries a 20-year sentence; unfortunately, they don’t have enough evidence to convict the women on that charge. To do so, they would need each of the prisoners to implicate the other in the second crime. The prisoners’ dilemma is a game based on two premises: (1) Each player has an incentive to choose an action that benefits itself at the other player’s expense; and (2) When both players act in this way,
both are worse off than if they had acted cooperatively. So the police put the miscreants in separate cells and say the following to each: “Here’s the deal: if neither of you confesses, you know that we’ll send you to jail for 5 years. If you confess and implicate your partner, and she doesn’t do the same, we reduce your sentence from 5 years to 2. But if your partner confesses and you don’t, you’ll get the maximum 20 years. And if both of you confess, we’ll give you both 15 years.” Figure 65.2 on the next page shows the payoffs that face the prisoners, depending on the decision of each to remain silent or to confess. (Usually the payoff matrix reflects the players’ payoffs, and higher payoffs are better than lower payoffs. This case is an exception: a higher number of years in prison is bad, not good!) Let’s assume that the prisoners have no way to communicate and that they have not sworn an oath not to harm each other or anything of that sort. So each acts in her own self-interest. What will they do? The critically acclaimed 1991 movie Thelma and Louise was innovative in depicting two female characters running from the law 645 f i g u r e 65.2 The Prisoners’ Dilemma Each of two prisoners, held in separate cells, is offered a deal by the police—a light sentence if she confesses and implicates her accomplice but her accomplice does not do the same, a heavy sentence if she does not confess but her accomplice does, and so on. It is in the joint interest of both prisoners not to confess; it is in each one’s individual interest to confess. Louise Don’t confess Confess Louise gets 5-year sentence. Louise gets 2-year sentence. Thelma gets 5-year sentence. Thelma gets 20-year sentence. Louise gets 20-year sentence. Louise gets 15-year sentence. Thelma gets 2-year sentence. Thelma gets 15-year sentence. Don’t confess Confess a m l e h T An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses
the action that maximizes his or her payoff, given the actions of other players Mathematician and Nobel Laureate John Forbes Nash proposed one of the key ideas in game theory. The answer is clear: both will confess. Look at it first from Thelma’s point of view: she is better off confessing, regardless of what Louise does. If Louise doesn’t confess, Thelma’s confession reduces her own sentence from 5 years to 2. If Louise does confess, Thelma’s confession reduces her sentence from 20 to 15 years. Either way, it’s clearly in Thelma’s interest to confess. And because she faces the same incentives, it’s clearly in Louise’s interest to confess, too. To confess in this situation is a type of action that economists call a dominant strategy. An action is a dominant strategy when it is the player’s best action regardless of the action taken by the other player. It’s important to note that not all games have a dominant strategy—it depends on the structure of payoffs in the game. But in the case of Thelma and Louise, it is clearly in the interest of the police to structure the payoffs so that confessing is a dominant strategy for each person. As long as the two prisoners have no way to make an enforceable agreement that neither will confess (something they can’t do if they can’t communicate, and the police certainly won’t allow them to do so because the police want to compel each one to confess), the dominant strategy exists as the best alternative. So if each prisoner acts rationally in her own interest, both will confess. Yet if neither of them had confessed, both would have received a much lighter sentence! In a prisoners’ dilemma, each player has a clear incentive to act in a way that hurts the other player—but when both make that choice, it leaves both of them worse off. When Thelma and Louise both confess, they reach an equilibrium of the game. We have used the concept of equilibrium many times in this book; it is an outcome in which no individual or firm has any incentive to change his or her action. In game theory, this kind of equilibrium, in which each player takes the action that is best for her, given the actions taken by other players, is known as a Nash equilibrium, after the mathematician and Nobel Laureate John Nash. (Nash�
�s life was chronicled in the bestselling biography A Beautiful Mind, which was made into a movie.) Because the players in a Nash equilibrium do not take into account the effect of their actions on others, this is also known as a noncooperative equilibrium. In the prisoners’ dilemma, the Nash equilibrium happens to be an equilibrium of two dominant strategies—a dominant strategy equilibrium—but Nash equilibria can exist 646 when there is no dominant strategy at all. For example, suppose that after serving time in jail, Thelma and Louise are disheartened by the mutual distrust that led them to confess, and each wants nothing more than to avoid seeing the other. On a Saturday night, they might each have to choose between going to the nightclub and going to the movie theater. Neither has a dominant strategy because the best strategy for each depends on what the other is doing. However, Thelma going to the nightclub and Louise going to the movie theater is a Nash equilibrium because each player takes the action that is best given the action of the other. Thelma going to the movie theater and Louise going to the nightclub is also a Nash equilibrium, because again, neither wants to change her behavior given what the other is doing. Now look back at Figure 65.1: the two firms face a prisoners’ dilemma just like Thelma and Louise did after the crimes. Each firm is better off producing the higher output, regardless of what the other firm does. Yet if both produce 40 million pounds, both are worse off than if they had followed their agreement and produced only 30 million pounds. In both cases, then, the pursuit of individual self-interest— the effort to maximize profits or to minimize jail time—has the perverse effect of hurting both players. Prisoners’ dilemmas appear in many situations. The upcoming FYI describes an example from the days of the Cold War. Clearly, the players in any prisoners’ dilemma would be better off if they had some way of enforcing cooperative behavior: if Thelma and Louise had both sworn to a code of silence, or if the two firms had signed an enforceable agreement not to produce more than 30 million pounds of lysine. But we know that in the United States an agreement setting the output levels of two oligopolists isn’t just unenforceable, it’s illegal. So it seems that a noncooperative equilibrium is the only possible outcome. Or is it? Overcoming the Prisoners’
Dilemma: Repeated Interaction and Tacit Collusion Thelma and Louise are playing what is known as a one-shot game—they play the game with each other only once. They get to choose once and for all whether to confess or deny, and that’s it. However, most of the games that oligopolists play aren’t one-shot games; instead, the players expect to play the game repeatedly with the same rivals. An oligopolist usually expects to be in business for many years, and knows that a decision today about whether to cheat is likely to affect the decisions of other firms in the future. So a smart oligopolist doesn’t just decide what to do based on the effect on profit in the short run. Instead, it engages in strategic behavior, taking into account the effects of its action on the future actions of other players. And under some conditions oligopolists that behave strategically can manage to behave as if they had a formal agreement to collude. Suppose that our two firms expect to be in the lysine business for many years and therefore expect to play the game of cheat versus collude shown in Figure 65.1 many times. Would they really betray each other time and again? Probably not. Suppose that each firm considers two strategies. In one strategy it always cheats, producing 40 million pounds of lysine each year, regardless of what the other firm does. In the other strategy, it starts with good behavior, producing only 30 million pounds in the first year, and watches to see what its rival does. If the other firm also keeps its production down, each firm will stay cooperative, producing 30 million pounds again for the next year. But if one firm produces 40 million pounds, the other firm will take the gloves off and also produce 40 million pounds next year. This latter strategy—start by behaving cooperatively, but thereafter do whatever the other player did in the previous period—is generally known as tit for tat. Playing “tit for tat” is a form of strategic behavior because it is intended to influence the future actions of other players. The “tit for tat” strategy offers a reward to A firm engages in strategic behavior when it attempts to influence the future behavior of other firms. A strategy of tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period 647 the other player for cooperative behavior—if you behave cooperatively, so
will I. It also provides a punishment for cheating—if you cheat, don’t expect me to be nice in the future. The payoff to each firm of each of these strategies would depend on which strategy the other chooses. Consider the four possibilities, shown in Figure 65.3: 1. If one firm plays “tit for tat” and so does the other, both firms will make a profit of $180 million each year. 2. If one firm plays “always cheat” but the other plays “tit for tat,” one makes a profit of $200 million the first year but only $160 million per year thereafter. 3. If one firm plays “tit for tat” but the other plays “always cheat,” one makes a profit of only $150 million in the first year but $160 million per year thereafter. 4. If one firm plays “always cheat” and the other does the same, both firms will make a profit of $160 million each year. f i g u r e 65.3 How Repeated Interaction Can Support Collusion A strategy of “tit for tat” involves playing cooperatively at first, then following the other player’s move. This rewards good behavior and punishes bad behavior. If the other player cheats, playing “tit for tat” will lead to only a short-term loss in comparison to playing “always cheat.” But if the other player plays “tit for tat,” also playing “tit for tat” leads to a longterm gain. So a firm that expects other firms to play “tit for tat” may well choose to do the same, leading to successful tacit collusion. Firm 2 Tit for tat Always cheat Firm 2 makes $180 million profit each year. Firm 1 makes $180 million profit each year. Firm 2 makes $150 million profit 1st year, $160 million profit each later year. Firm 1 makes $200 million profit 1st year, $160 million profit each later year. Firm 2 makes $200 million profit 1st year, $160 million profit each later year. Firm 1 makes $150 million profit 1st year, $160 million profit each later year. Firm 2 makes $160 million profit each year. Firm 1 makes $160 million profit each year. 1 m r i F Tit for tat
Always cheat Which strategy is better? In the first year, one firm does better playing “always cheat,” whatever its rival’s strategy: it assures itself that it will get either $200 million or $160 million. (Which of the two payoffs it actually receives depends on whether the other plays “tit for tat” or “always cheat.”) This is better than what it would get in the first year if it played “tit for tat”: either $180 million or $150 million. But by the second year, a strategy of “always cheat” gains the firm only $160 million per year for the second and all subsequent years, regardless of the other firm’s actions. Over time, the total amount gained by playing “always cheat” is less than the amount gained by playing “tit for tat”: for the second and all subsequent years, it would never get any less than $160 million and would get as much as $180 million if the other firm played “tit for tat” as well. Which strategy, “always cheat” or “tit for tat,” is more 648 profitable depends on two things: how many years each firm expects to play the game and what strategy its rival follows. If the firm expects the lysine business to end in the near future, it is in effect playing a one-shot game. So it might as well cheat and grab what it can. Even if the firm expects to remain in the lysine business for many years (therefore to find itself repeatedly playing this game) and, for some reason, expects the other firm will always cheat, it should also always cheat. That is, the firm should follow the old rule, “Do unto others before they do unto you.” But if the firm expects to be in the business for a long time and thinks the other firm is likely to play “tit for tat,” it will make more profits over the long run by playing “tit for tat,” too. It could have made some extra short-term profit by cheating at the beginning, but this would provoke the other firm into cheating, too, and would, in the end, mean less profit. The lesson of this story is that when oligopolists expect to compete with each other over an extended period of time,
each individual firm will often conclude that it is in its own best interest to be helpful to the other firms in the industry. So it will restrict its output in a way that raises the profit of the other firms, expecting them to return the favor. Despite the fact that firms have no way of making an enforceable agreement to limit output and raise prices (and are in legal jeopardy if they even discuss prices), they manage to act “as if ” they had such an agreement. When this type of unspoken agreement comes about, we say that the firms are engaging in tacit collusion. When firms limit production and raise prices in a way that raises each other’s profits, even though they have not made any formal agreement, they are engaged in tacit collusion fyi Prisoners of the Arms Race Between World War II and the late 1980s, the United States and the Soviet Union were locked in a seemingly endless struggle that never broke out into open war. During this Cold War, both countries spent huge sums on arms, sums that were a significant drain on the U.S. economy and eventually proved a crippling burden for the Soviet Union, whose underlying economic base was much weaker. Yet neither country was ever able to achieve a decisive military advantage. As many people pointed out, both nations would have been better off if they had both spent less on arms. Yet the arms race continued for 40 years. Why? As political scientists were quick to notice, one way to explain the arms race was to suppose that the two countries were locked in a classic prisoners’ dilemma. Each government would have liked to achieve decisive mil- itary superiority, and each feared military inferiority. But both would have preferred a stalemate with low military spending to one with high spending. However, each government rationally chose to engage in high spending. If its rival did not spend heavily, this would lead to military superiority; not spending heavily would lead to inferiority if the other government continued its arms buildup. So the countries were trapped. The answer to this trap could have been an agreement not to spend as much; indeed, the two sides tried repeatedly to negotiate limits on some kinds of weapons. But these agreements weren’t very effective. In the end the issue was resolved as heavy military spending hastened the collapse of the Soviet Union in 1991. Unfortunately, the logic of an arms race has not disappeared. A nuclear arms race has devel oped between Pakistan and India, neighboring countries with a history of mutual antagonism. In 1998 the two
countries confirmed the unrelenting logic of the prisoners’ dilemma: both publicly tested their nuclear weapons in a tit-for-tat sequence, each seeking to prove to the other that it could inflict just as much damage as its rival 649 M o d u l e 65 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Suppose world leaders Nikita and Margaret are engaged in an arms race and face the decision of whether to build a missile. Answer the following questions using the information in the payoff matrix below, which shows how each set of actions will affect the utility of the players (the numbers represent utils gained or lost). Build missile Nikita Don’t build missile –10 –20 Build missile Margaret Don’t build missile –10 –20 8 8 0 a. Identify any Nash equilibria that exist in this game, and explain why they do or do not exist. b. Which set of actions maximizes the total payoff for Nikita and Margaret? c. Why is it unlikely that they will choose the payoff-maximizing set of actions without some communication? 2. For each of the following characteristics of an industry, explain whether the characteristic makes it more likely that oligopolists will play noncooperatively rather than engaging in tacit collusion. a. Each oligopolist expects several new firms to enter the market in the future. b. It is very difficult for a firm to detect whether another firm has raised output. 0 c. The firms have coexisted while maintaining high prices for a long time. Tackle the Test: Multiple-Choice Questions 1. Each player has an incentive to choose an action that, when both players choose it, makes them both worse off. This situation describes a. a dominant strategy. b. the prisoners’ dilemma. c. interdependence. d. Nash equilibrium. e. tit for tat. 2. Which of the following types of oligopoly behavior is/are illegal? I. tacit collusion II. cartel formation III. tit for tat a. I only b. II only III only c. d. I and II only I, II, and III e. 3. A situation in which each player in a game chooses the action that maximizes his or her payoff, given the actions of the other players, ignoring the effects of his or her action on the payoffs received by others, is known as a: a. dominant strategy. b. cooperative equilibrium.
c. Nash equilibrium. d. strategic situation. e. prisoners’ dilemma. 4. In the context of the Thelma and Louise story in the module, suppose that Louise discovers Thelma’s action (confess or don’t confess) before choosing her own action. Louise Don’t confess Confess Louise gets 5-year sentence. Louise gets 2-year sentence. Thelma gets 5-year sentence. Thelma gets 20-year sentence. Louise gets 20-year sentence. Louise gets 15-year sentence. Thelma gets 2-year sentence. Thelma gets 15-year sentence. Don’t confess Confess a m l e h T Based on the payoff matrix provided, Louise will a. confess whether or not Thelma confessed. b. not confess only if Thelma confessed. c. not confess only if Thelma didn’t confess. d. not confess regardless of whether or not Thelma confessed. e. confess only if Thelma did not confess. 650. Which of the following is true on the basis of the payoff matrix provided in Question 4? a. Louise has no dominant strategy, but Thelma does. b. Thelma has no dominant strategy, but Louise does. c. Both Thelma and Louise have a dominant strategy. d. Neither Thelma nor Louise has a dominant strategy. e. Louise has a dominant strategy only if Thelma confesses. Tackle the Test: Free-Response Questions 1. Refer to the payoff matrix provided. You and your competitor must decide whether or not to market a new product. You Market Don’t market Market Don’t market $100 $100 $400 $400 $0 $0 $0 $0 a. If you market the new product and your competitor does not, how much profit will you earn? b. If you market the new product, what should your competitor do? c. Do you have a dominant strategy? Explain. d. Does this situation have a Nash equilibrium? Explain. Answer (6 points) 1 point: $400 1 point: Market the new product. 1 point: Yes 1 point: Profits are greater (either $100 or $400 versus $0) if I market the new product, regardless of what my competitor does. 1 point: Yes 1 point: Both players marketing the product is a Nash equilibrium because neither side wants to change to not marketing, given what the other
side is doing. (In fact, in this case both sides want to market the product regardless of what the other side is doing, so it is a dominant strategy equilibrium as well as a Nash equilibrium.) 2. Draw a clearly labeled payoff matrix illustrating the following situation. There are two firms, “Firm A” and “Firm B.” Each firm must decide whether to charge a high price or a low price. If one firm charges a high price and the other a low price, the firm charging the high price will earn low profits while the firm charging the low price will earn high profits. If both firms charge a high price, both earn high profits and if both firms charge low prices, both earn low profits 651 What you will learn in this Module: • The legal constraints of antitrust policy • The factors that limit tacit collusion • The cause and effect of price wars, product differentiation, price leadership, and nonprice competition • The importance of oligopoly in the real world Module 66 Oligopoly in Practice Previously, we described the cartel known as “Vitamins, Inc.,” which effectively sustained collusion for many years. The conspiratorial dealings of the vitamin makers were not, fortunately, the norm. But how do oligopolies usually work in practice? The answer depends both on the legal framework that limits what firms can do and on the underlying ability of firms in a given industry to cooperate without formal agreements. In this module we will explore a variety of oligopoly behaviors and how antitrust laws limit oligopolists’ attempts to maximize their profits. The Legal Framework To understand oligopoly pricing in practice, we must be familiar with the legal constraints under which oligopolistic firms operate. In the United States, oligopoly first became an issue during the second half of the nineteenth century, when the growth of railroads—themselves an oligopolistic industry—created a national market for many goods. Large firms producing oil, steel, and many other products soon emerged. The industrialists quickly realized that profits would be higher if they could limit price competition. So many industries formed cartels—that is, they signed formal agreements to limit production and raise prices. Until 1890, when the first federal legislation against such cartels was passed, this was perfectly legal. However, although these cartels were legal, their agreements weren’t legally enforceable— members of a cartel couldn’t ask the courts to force a firm that was violating its agreement to reduce its production. And firms often did violate their
agreements, for the reason already suggested by our duopoly example in Module 65: there is always a temptation for each firm in a cartel to produce more than it is supposed to. In 1881 clever lawyers at John D. Rockefeller’s Standard Oil Company came up with a solution—the so-called trust. In a trust, shareholders of all the major companies in an industry placed their shares in the hands of a board of trustees who controlled the companies. This, in effect, merged the companies into a single firm that could then engage in monopoly pricing. In this way, the Standard Oil Trust established what was essentially a monopoly of the oil industry, and it was soon followed by trusts in sugar, whiskey, lead, cottonseed oil, and linseed oil. Eventually, there was a public backlash, driven partly by concern about the economic effects of the trust movement and partly by fear that the owners of the trusts 652 Antitrust policy involves efforts by the government to prevent oligopolistic industries from becoming or behaving like monopolies In 1911, Standard Oil was broken up into 34 separate companies, 3 of which later became Chevron, Conoco, and Exxon. were simply becoming too powerful. The result was the Sherman Antitrust Act of 1890, which was intended both to prevent the creation of more monopolies and to break up existing ones. At first this law went largely unenforced. But over the decades that followed, the federal government became increasingly committed to making it difficult for oligopolistic industries either to become monopolies or to behave like them. Such efforts are known to this day as antitrust policy. One of the most striking early actions of antitrust policy was the breakup of Standard Oil in 1911. Its components formed the nuclei of many of today’s large oil companies— Standard Oil of New Jersey became Exxon, Standard Oil of New York became Mobil, and so on. In the 1980s a long-running case led to the breakup of Bell Telephone, which once had a monopoly on both local and long-distance phone service in the United States. As we mentioned earlier, the Justice Department reviews proposed mergers between companies in the same industry and will bar mergers that it believes will reduce competition. Among advanced countries, the United States is unique in its long tradition of antitrust policy. Until recently, other advanced countries did not have policies against pricefixing, and some even supported the creation of cartels, believing that it would help their own firms compete against foreign rivals. But the situation has changed radically over the past
20 years, as the European Union (EU)—an international body with the duty of enforcing antitrust policy for its member countries—has converged toward U.S. practices. Today, EU and U.S. regulators often target the same firms because price-fixing has “gone global” as international trade has expanded. During the early 1990s, the United States instituted an amnesty program in which a price-fixer receives a much-reduced penalty if it provides information on its co-conspirators. (Remember that the Great Vitamin Conspiracy was busted when a French company, Rhone-Poulenc, revealed the cartel in order to get favorable treatment from U.S. regulators.) In addition, Congress substantially increased maximum fines levied upon conviction. These two new policies clearly made informing on cartel partners a dominant strategy, and it has paid off: in recent years, executives from Belgium, Britain, Canada, France, Germany, Italy, Mexico, the Netherlands, South Korea, and Switzerland, as well as from the United States, have been convicted in U.S. courts of cartel crimes. As one lawyer commented, “You get a race to the courthouse” as each conspirator seeks to be the first to come clean. Life has gotten much tougher over the past few years if you want to operate a cartel. So what’s an oligopolist to do? Tacit Collusion and Price Wars If real life were as simple as our lysine story, it probably wouldn’t be necessary for the company presidents to meet or do anything that could land them in jail. Both firms would realize that it was in their mutual interest to restrict output to 30 million pounds each and that any short-term gains to either firm from producing more would be much less than the later losses as the other firm retaliated. So even without any explicit agreement, the firms would probably have achieved the tacit collusion needed to maximize their combined profits. Real industries are nowhere near that simple; nonetheless, in most oligopolistic industries, most of the time, the sellers do appear to succeed in keeping prices above their noncooperative level. Tacit collusion, in other words, is the normal state of oligopoly. Although tacit collusion is common, it rarely allows an industry to push prices all the way up to their monopoly level; collusion is usually far from perfect. A variety of factors make it hard for an industry to coordinate on high prices. Large Numbers Suppose that there were three instead of two firms in
the lysine industry and that each was currently producing only 20 million pounds. In that case any one firm that decided to produce an extra 10 million pounds would gain more in short-term profits— and lose less once another firm responded in kind—than in our original example because it has fewer units on which to feel the price effect. The general point is that the 653 more firms there are in an oligopoly, the less is the incentive of any one firm to behave cooperatively, taking into account the impact of its actions on the profits of the other firms. Large numbers of firms in an industry also make the monitoring of price and output levels more difficult, and typically indicate low barriers to entry. Complex Products and Pricing Schemes In our simplified lysine example the two firms produce only one product. In reality, however, oligopolists often sell thousands or even tens of thousands of different products. A Walmart Supercenter sells over 100,000 items! Under these circumstances, as when there are a large number of firms, keeping track of what other firms are producing and what prices they are charging is difficult. This makes it hard to determine whether a firm is cheating on the tacit agreement. Differences in Interests In the lysine example, a tacit agreement for the firms to split the market equally is a natural outcome, probably acceptable to both firms. In other situations, however, firms often differ both in their perceptions about what is fair and in their real interests. For example, suppose that one firm in a duopoly was a long-established producer and the other a more recent entrant into the industry. The long-established firm might feel that it deserved to continue producing more than the newer firm, but the newer firm might feel that it was entitled to 50% of the business. Alternatively, suppose that the newer firm’s marginal costs were lower than the long-established firm’s. Even if they could agree on market shares, they would then disagree about the profit-maximizing level of output. Bargaining Power of Buyers Often oligopolists sell not to individual consumers but to large buyers—other industrial enterprises, nationwide chains of stores, and so on. These large buyers are in a position to bargain for lower prices from the oligopolists: they can ask for a discount from an oligopolist, and warn that they will go to a competitor if they don’t get it. An important reason large retailers like Target are able to offer lower prices to customers than small retailers is
precisely their ability to use their size to extract lower prices from their suppliers. These difficulties in enforcing tacit collusion have sometimes led companies to defy the law and create illegal cartels. We’ve already examined the cases of the lysine industry and the bulk vitamin industry. An older, classic example was the U.S. electrical equipment conspiracy of the 1950s, which led to the indictment of and jail sentences for some executives. The industry was one in which tacit collusion was especially difficult because of all the reasons just mentioned. There were many firms—40 companies were indicted. They produced a very complex array of products, often more or less custom-built for particular clients. They differed greatly in size, from giants like General Electric to family firms with only a few dozen employees. And the customers in many cases were large buyers like electrical utilities, which would normally try to force suppliers to compete for their business. Tacit collusion just didn’t seem practical—so executives met secretly and illegally to decide who would bid what price for which contract. The FYI describes yet another price-fixing conspiracy: the one between the very posh auction houses Sotheby’s and Christie’s. Because tacit collusion is often hard to achieve, most oligopolies charge prices that are well below what the same industry would charge if it were controlled by a monopolist—or what they would charge if they were able to collude explicitly. In addition, sometimes tacit collusion breaks down and aggressive price competition amounts to a price war. A price war sometimes precipitates a collapse of prices to their noncooperative level, or even lower, as sellers try to put each other out of business or at least punish what they regard as cheating. A price war occurs when tacit collusion breaks down and aggressive price competition causes prices to collapse. 654 fyi The Art of Conspiracy If you want to sell a valuable work of art, there are really only two places to go: Christie’s, the London-based auction house, or Sotheby’s, its New York counterpart and competitor. Both are classy operations—literally: many of the employees of Christie’s come from Britain’s aristocracy, and many of Sotheby’s come from blue-blooded American families that might as well have titles. They’re not the sort of people you would expect to be seeking plea bargains from prosecutors. But on October 6, 2000, Diana D. Brooks, the very upper-class former president of
Sotheby’s, pleaded guilty to a conspiracy. With her counterpart at Christie’s, she had engaged in the illegal practice of price-fixing—agreeing on the fees they would charge people who sold artwork through either house. As part of her guilty plea, and in an effort to avoid going to jail, she agreed to help in the investigation of her boss, the former chairman of Sotheby’s. Why would such upper-crust types engage in illegal practices? For the same reasons that respectable electrical equipment industry executives did. By definition, no two works of art are alike; it wasn’t easy for the two houses to collude tacitly because it was too hard to determine what commissions they were charging on any given transaction. To increase profits, then, the companies felt that they needed to reach a detailed agreement. They did, and they got caught. Product Differentiation and Price Leadership In many oligopolies, however, firms produce products that consumers regard as similar but not identical. A $10 difference in the price won’t make many customers switch from a Ford to a Chrysler, or vice versa. Sometimes the differences between products are real, like differences between Froot Loops and Wheaties; sometimes, they exist mainly in the minds of consumers, like differences between brands of vodka (which is supposed to be tasteless). Either way, the effect is to reduce the intensity of competition among the firms: consumers will not all rush to buy whichever product is cheapest. As you might imagine, oligopolists welcome the extra market power that comes when consumers think that their product is different from that of competitors. So in many oligopolistic industries, firms make considerable efforts to create the perception that their product is different—that is, they engage in product differentiation. A firm that tries to differentiate its product may do so by altering what it actually produces, adding “extras,” or choosing a different design. It may also use advertising and marketing campaigns to create a differentiation in the minds of consumers, even though its product is more or less identical to the products of rivals. A classic case of how products may be perceived as different even when they are really pretty much the same is over-the-counter medication. For many years there were only three widely sold pain relievers—aspirin, ibuprofen, and acetaminophen. Yet each of these generic pain relievers were marketed under a number of brand names. And each brand used a marketing
campaign implying some special superiority. Whatever the nature of product differentiation, oligopolists producing differentiated products often reach a tacit understanding not to compete on price. For example, during the years when the great majority of cars sold in the United States were produced by the Big Three auto companies (General Motors, Ford, and Chrysler), there was an unwritten rule that none of the three companies would try to gain market share by making its cars noticeably cheaper than those of the other two. But then who would decide on the overall price of cars? The answer was normally General Motors: as the biggest of the three, it would announce its prices for the year Product differentiation is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry 655 In price leadership, one firm sets its price first, and other firms then follow. Firms that have a tacit understanding not to compete on price often engage in intense nonprice competition, using advertising and other means to try to increase their sales. o t o h P P A Cars line up for gasoline in 1973 after the U.S. government imposed price controls. first; and the other companies would adopt similar prices. This pattern of behavior, in which one company tacitly sets prices for the industry as a whole, is known as price leadership. Interestingly, firms that have a tacit agreement not to compete on price often engage in vigorous nonprice competition—adding new features to their products, spending large sums on ads that proclaim the inferiority of their rivals’ offerings, and so on. Perhaps the best way to understand the mix of cooperation and competition in such industries is with a political analogy. During the long Cold War between the United States and the Soviet Union, the two countries engaged in intense rivalry for global influence. They not only provided financial and military aid to their allies; they sometimes supported forces trying to overthrow governments allied with their rival (as the Soviet Union did in Vietnam in the 1960s and early 1970s, and as the United States did in Afghanistan from 1979 until the collapse of the Soviet Union in 1991). They even sent their own soldiers to support allied governments against rebels (as the United States did in Vietnam and the Soviet Union did in Afghanistan). But they did not get into direct military confrontations with each other; open warfare between the two superpowers was regarded by both as too dangerous—and tacitly avoided. Price wars aren’t as serious as shooting wars, but the principle is the same. How Important Is Oligopoly? We
have seen that, across industries, oligopoly is far more common than either perfect competition or monopoly. When we try to analyze oligopoly, the economist’s usual way of thinking—asking how self-interested individuals would behave, then analyzing their interaction—does not work as well as we might hope because we do not know whether rival firms will engage in noncooperative behavior or manage to engage in some kind of collusion. Given the prevalence of oligopoly, then, is the analysis we developed in earlier modules, which was based on perfect competition, still useful? The conclusion of the great majority of economists is yes. For one thing, important parts of the economy are fairly well described by perfect competition. And even though many industries are oligopolistic, in many cases the limits to collusion keep prices relatively close to marginal costs—in other words, the industry behaves “almost” as if it were perfectly competitive. It is also true that predictions from supply and demand analysis are often valid for oligopolies. For example, we saw that price controls will produce shortages. Strictly speaking, this conclusion is certain only for perfectly competitive industries. But in the 1970s, when the U.S. government imposed price controls on the definitely oligopolistic oil industry, the result was indeed to produce shortages and lines at the gas pumps. So how important is it to take account of oligopoly? Most economists adopt a pragmatic approach. As we have seen here, the analysis of oligopoly is far more difficult and messy than that of perfect competition; so in situations where they do not expect the complications associated with oligopoly to be crucial, economists prefer to adopt the working assumption of perfectly competitive markets. They always keep in mind the possibility that oligopoly might be important; they recognize that there are important issues, from antitrust policies to price wars, that make trying to understand oligopolistic behavior crucial. 656 66 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. For each of the following industry practices, explain whether b. There has been considerable variation in the market the practice supports the conclusion that there is tacit collusion in this industry. a. For many years the price in the industry has changed infrequently, and all the firms in the industry charge the same price. The largest firm publishes a catalog containing a “suggested” retail price. Changes in price coincide with changes in the catalog. shares of the firms in the industry over time. c. Firms in the
industry build into their products unnecessary features that make it hard for consumers to switch from one company’s products to another’s. d. Firms meet yearly to discuss their annual sales forecasts. e. Firms tend to adjust their prices upward at the same times. Tackle the Test: Multiple-Choice Questions 1. Having which of the following makes it easier for oligopolies to 3. When was the first federal legislation against cartels passed? coordinate on raising prices? a. a large number of firms b. differentiated products c. buyers with bargaining power d. identical perceptions of fairness e. complex pricing schemes 2. Which of the following led to the passage of the first antitrust laws? I. growth of the railroad industry II. the emergence of the Standard Oil Company III. increased competition in agricultural industries a. I only b. II only c. III only d. I and II only I, II, and III e. a. 1776 b. 1800 c. 1890 d. 1900 e. 1980 4. Which of the following industries has been prosecuted for creating an illegal cartel? a. the lysine industry b. the art auction house industry c. the U.S. electrical equipment industry d. the bulk vitamin industry e. all of the above 5. Oligopolists engage in tacit collusion in order to increase output. a. raise prices. b. c. share profits. d. increase market share. e. all of the above. Tackle the Test: Free-Response Questions 1. Like other firms, universities face temptations to collude in c. Explain one way in which universities could engage in illegal order to limit the effects of competition and avoid price wars. (In fact, the U.S. Department of Justice formally accused a group of universities of price-fixing in 1991.) Answer the following questions about behavior in the market for higher education. a. Describe one factor of the market for higher education that collusion. d. What are three ways in which universities engage in product differentiation? e. Explain how price leadership might work in the university setting. f. What forms of nonprice competition do you see universities invites tacit collusion. engaged in? b. Describe one factor of the market for higher education that works against tacit collusion 657 2. List four factors that make it difficult for firms to form a cartel. Explain each. Answer (6 points) 1 point: The fact that universities offer a small number of products—enrollment into a small number of programs—inv
ites tacit collusion. They may also have similar perceptions of fairness. 1 point: Factors that work against tacit collusion in the market for higher education include the large number of universities and the bargaining power of the better applicants. 1 point: Universities could engage in illegal collusion by holding meetings to establish uniform tuition rates, divvying up applicants so that each is accepted by a limited number of schools (to avoid competition), or sharing information on scholarship offerings so that applicants will receive similar offers from the competing schools. 1 point: Universities seek product differentiation in regard to athletic programs, facilities, academic standards, location, overseas programs, faculty, graduation requirements, and class size, among other areas. 1 point: Price leadership could be achieved in the university setting if one school, perhaps a large or prestigious university, announced its tuition early and then other schools based their tuition on that announcement. 1 point: Universities can engage in nonprice competition by offering better food, bigger dorm rooms, more accomplished faculty members, plush student centers, and similar amenities. 658 What you will learn in this Module: • How prices and profits are determined in monopolistic competition, both in the short run and in the long run • How monopolistic competition can lead to inefficiency and excess capacity Module 67 Introduction to Monopolistic Competition Understanding Monopolistic Competition Suppose an industry is monopolistically competitive: it consists of many producers, all competing for the same consumers but offering differentiated products. How does such an industry behave? As the term monopolistic competition suggests, this market structure combines some features typical of monopoly with others typical of perfect competition. Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downwardsloping demand curve and has some market power—the ability within limits to determine the price of its product. However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry. The same, of course, is true of an oligopoly. In a monopolistically competitive industry, however, there are many producers, as opposed to the small number that defines an oligopoly. This means that the “puzzle” of oligopoly—whether firms will collude or behave noncooperatively—does not arise in the case of monopolistically competitive industries. True, if all the gas stations or all the restaurants in a town could agree—explicitly or tacitly—to raise prices, it would
be in their mutual interest to do so. But such collusion is virtually impossible when the number of firms is large and, by implication, there are no barriers to entry. So in situations of monopolistic competition, we can safely assume that firms behave noncooperatively and ignore the potential for collusion. Monopolistic Competition in the Short Run We introduced the distinction between short-run and long-run equilibrium when we studied perfect competition. The short-run equilibrium of an industry takes the number of firms as given. The long-run equilibrium, by contrast, is reached only after 659 enough time has elapsed for firms to enter or exit the industry. To analyze monopolistic competition, we focus first on the short run and then on how an industry moves from the short run to the long run. Panels (a) and (b) of Figure 67.1 show two possible situations that a typical firm in a monopolistically competitive industry might face in the short run. In each case, the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve. We assume that every firm has an upward-sloping marginal cost curve but that it also faces some fixed costs, so that its average total cost curve is U-shaped. This assumption doesn’t matter in the short run; but, as we’ll see shortly, it is crucial to understanding the long-run equilibrium. In each case the firm, in order to maximize profit, sets marginal revenue equal to marginal cost. So how do these two figures differ? In panel (a) the firm is profitable; in panel (b) it is unprofitable. (Recall that we are referring always to economic profit and not accounting profit—that is, a profit given that all factors of production are earning their opportunity costs.) In panel (a) the firm faces the demand curve DP and the marginal revenue curve MRP. It produces the profit-maximizing output QP, the quantity at which marginal revenue is equal to marginal cost, and sells it at the price PP. This price is above the average total cost at this output, ATCP. The firm’s profit is indicated by the area of the shaded rectangle. In panel (b) the firm faces the demand curve DU and the marginal revenue curve MRU. It chooses the quantity QU at which marginal revenue is equal to marginal cost. f i g u r e 67.1 The
Monopolistically Competitive Firm in the Short Run (a) A Proﬁtable Firm (b) An Unproﬁtable Firm Price, cost, marginal revenue PP ATCP Proﬁt Price, cost, marginal revenue MC ATC ATCU PU Loss MC ATC MRP QP DP Quantity DU MRU QU Quantity Proﬁt-maximizing quantity Loss-minimizing quantity The firm in panel (a) can be profitable for some output quantities: the quantities for which its average total cost curve, ATC, lies below its demand curve, DP. The profit-maximizing output quantity is QP, the output at which marginal revenue, MRP, is equal to marginal cost, MC. The firm charges price PP and earns a profit, represented by the area of the green shaded rectangle. The firm in panel (b), however, can never be profitable because its average total cost curve lies above its demand curve, DU, for every output quantity. The best that it can do if it produces at all is to produce quantity QU and charge price PU. This generates a loss, indicated by the area of the yellow shaded rectangle. Any other output quantity results in a greater loss. 660 However, in this case the price PU is below the average total cost ATCU ; so at this quantity the firm loses money. Its loss is equal to the area of the shaded rectangle. Since QU is the profit-maximizing quantity—which means, in this case, the loss-minimizing quantity—there is no way for a firm in this situation to make a profit. We can confirm this by noting that at any quantity of output, the average total cost curve in panel (b) lies above the demand curve DU. Because ATC > P at all quantities of output, this firm always suffers a loss. As this comparison suggests, the key to whether a firm with market power is profitable or unprofitable in the short run lies in the relationship between its demand curve and its average total cost curve. In panel (a) the demand curve DP crosses the average total cost curve, meaning that some of the demand curve lies above the average total cost curve. So there are some price–quantity combinations available at which price is higher than average total cost, indicating that the firm can choose a quantity at which it makes positive profit. In panel (b), by contrast, the demand curve DU does not cross the average total cost curve—
it always lies below it. So the price corresponding to each quantity demanded is always less than the average total cost of producing that quantity. There is no quantity at which the firm can avoid losing money. These figures, showing firms facing downward-sloping demand curves and their associated marginal revenue curves, look just like ordinary monopoly graphs. The “competition” aspect of monopolistic competition comes into play, however, when we move from the short run to the long run. Monopolistic Competition in the Long Run Obviously, an industry in which existing firms are losing money, like the one in panel (b) of Figure 67.1, is not in long-run equilibrium. When existing firms are losing money, some firms will exit the industry. The industry will not be in long-run equilibrium until the persistent losses have been eliminated by the exit of some firms. It may be less obvious that an industry in which existing firms are earning profits, like the one in panel (a) of Figure 67.1, is also not in long-run equilibrium. Given there is free entry into the industry, persistent profits earned by the existing firms will lead to the entry of additional producers. The industry will not be in longrun equilibrium until the persistent profits have been eliminated by the entry of new producers. How will entry or exit by other firms affect the profit of a typical existing firm? Because the differentiated products offered by firms in a monopolistically competitive industry are available to the same set of customers, entry or exit by other firms will affect the demand curve facing every existing producer. If new gas stations open along a highway, each of the existing gas stations will no longer be able to sell as much gas as before at any given price. So, as illustrated in panel (a) of Figure 67.2 on the next page, entry of additional producers into a monopolistically competitive industry will lead to a leftward shift of the demand curve and the marginal revenue curve facing a typical existing producer © Conversely, suppose that some of the gas stations along the highway close. Then each of the remaining stations will be able to sell more gasoline at any given price. So as illustrated in panel (b), exit of firms from an industry leads to a rightward shift of the demand curve and marginal revenue curve facing a typical remaining producer. The industry will be in long-run equilibrium when there is neither entry nor exit. This will occur only when every firm earns zero profit. So in the long run, a monopolistically competitive industry will end up in zero
-profit equilibrium, in which firms just manage to cover their costs at their profit-maximizing output quantities. We have seen that a firm facing a downward-sloping demand curve will earn positive profit if any part of that demand curve lies above its average total cost curve; it In the long-run, profit lures new firms to enter an industry. In the long run, a monopolistically competitive industry ends up in zero-profit equilibrium: each firm makes zero profit at its profit-maximizing quantity 661 f i g u r e 67.2 Entry and Exit Shift Existing Firms’ Demand Curves and Marginal Revenue Curves (a) Effects of Entry (b) Effects of Exit Price, marginal revenue Price, marginal revenue Entry shifts the existing ﬁrm’s demand curve and its marginal revenue curve leftward. Exit shifts the existing ﬁrm’s demand curve and its marginal revenue curve rightward. MR2 MR1 D2 D1 Quantity MR1 MR2 D1 D2 Quantity Entry will occur in the long run when existing firms are profitable. In panel (a), entry causes each existing firm’s demand curve and marginal revenue curve to shift to the left. The firm receives a lower price for every unit it sells, and its profit falls. Entry will cease when firms make zero profit. Exit will occur in the long run when existing firms are unprofitable. In panel (b), exit from the industry shifts each remaining firm’s demand curve and marginal revenue curve to the right. The firm receives a higher price for every unit it sells, and profit rises. Exit will cease when the remaining firms make zero profit. will incur a loss if its entire demand curve lies below its average total cost curve. So in zero-profit equilibrium, the firm must be in a borderline position between these two cases; its demand curve must just touch its average total cost curve. That is, the demand curve must be just tangent to the average total cost curve at the firm’s profitmaximizing output quantity—the output quantity at which marginal revenue equals marginal cost. If this is not the case, the firm operating at its profit-maximizing quantity will find itself making either a profit or loss, as illustrated in the panels of Figure 67.1. But we also know that free entry and exit means that this cannot be a long-run equilibrium. Why? In the case of a profit, new firms will enter the industry,
shifting the demand curve of every existing firm leftward until all profit is eliminated. In the case of a loss, some existing firms exit and so shift the demand curve of every remaining firm to the right until all losses are eliminated. All entry and exit ceases only when every existing firm makes zero profit at its profit-maximizing quantity of output. Figure 67.3 shows a typical monopolistically competitive firm in such a zero-profit equilibrium. The firm produces QMC, the output at which MRMC = MC, and charges price PMC. At this price and quantity, represented by point Z, the demand curve is just tangent to its average total cost curve. The firm earns zero profit because price, PMC, is equal to average total cost, ATCMC. The normal long-run condition of a monopolistically competitive industry, then, is that each producer is in the situation shown in Figure 67.3. Each producer acts like a monopolist, facing a downward-sloping demand curve and setting marginal cost equal to marginal revenue so as to maximize profit. But this is just enough to achieve zero economic profit. The producers in the industry are like monopolists without monopoly profit. 662 67.3 The Long-Run Zero-Profit Equilibrium If existing firms are profitable, entry will occur and shift each existing firm’s demand curve leftward. If existing firms are unprofitable, each remaining firm’s demand curve shifts rightward as some firms exit the industry. Entry and exit will cease when every existing firm makes zero profit at its profitmaximizing quantity. So, in long-run zeroprofit equilibrium, the demand curve of each firm is tangent to its average total cost curve at its profit-maximizing quantity: at the profit-maximizing quantity, QMC, price, PMC, equals average total cost, ATCMC. A monopolistically competitive firm is like a monopolist without monopoly profits. Price, cost, marginal revenue PMC = ATCMC Z Point of tangency MC ATC MRMC QMC DMC Quantity fyi Hits and Flops On the face of it, the movie business seems to meet the criteria for monopolistic competition. Movies compete for the same consumers; each movie is different from the others; new companies can and do enter the business. But where’s the zero-profit equilibrium? After all, some movies are enormously profitable. The key is to realize that for every successful blockbuster, there are
several flops—and that the movie studios don’t know in advance which will be which. (One observer of Hollywood summed up his conclusions as follows: “Nobody knows anything.”) And by the time it becomes clear that a movie will be a flop, it’s too late to cancel it. in this section is that the fixed costs of making a movie are also sunk costs—once they’ve been incurred, they can’t be recovered. Yet there is still, in a way, a zero-profit equilibrium. If movies on average were highly profitable, more studios would enter the industry and more movies would be made. If movies on average lost money, fewer movies would be made. In fact, as you might expect, the movie industry on average earns just about enough to cover the cost of production—that is, it earns roughly zero economic profit. This kind of situation—in which firms The difference between movie-making and the type of monopolistic competition we model earn zero profit on average but have a mixture of highly profitable hits and money-losing flops—can be found in other industries characterized by high up-front sunk costs. A notable example is the pharmaceutical industry, in which many research projects lead nowhere but a few lead to highly profitable drugs. Monopolistic Competition versus Perfect Competition In a way, long-run equilibrium in a monopolistically competitive industry looks a lot like long-run equilibrium in a perfectly competitive industry. In both cases, there are many firms; in both cases, profits have been competed away; in both cases, the price received by every firm is equal to the average total cost of production 663 However, the two versions of long-run equilibrium are different—in ways that are economically significant. Price, Marginal Cost, and Average Total Cost Figure 67.4 compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry. Panel (a) shows a perfectly competitive firm facing a market price equal to its minimum average total cost; panel (b) reproduces Figure 67.3. Comparing the panels, we see two important differences. f i g u r e 67.4 Comparing Long-Run Equilibrium in Perfect Competition and Monopolistic Competition Price, cost, marginal revenue PPC = MCPC = ATCPC (a) Long-Run Equilibrium in Perfect Competition (b) Long-Run Equilibrium in Monopolistic Competition MC
ATC Price, cost, marginal revenue MC ATC D = MR = PPC PMC = ATCMC MCMC QPC Quantity MRMC QMC DMC Quantity Minimum-cost output Minimum-cost output Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly competitive industry. The firm operates at the minimum-cost output QPC, sells at the competitive market price PPC, and makes zero profit. It is indifferent to selling another unit of output because PPC is equal to its marginal cost, MCPC. Panel (b) shows the situation of the typical firm in long-run equi- librium in a monopolistically competitive industry. At QMC it makes zero profit because its price PMC just equals average total cost, ATCMC. At QMC the firm would like to sell another unit at price PMC since PMC exceeds marginal cost, MCMC. But it is unwilling to lower price to make more sales. It therefore operates to the left of the minimum-cost output level and has excess capacity. First, in the case of the perfectly competitive firm shown in panel (a), the price, PPC, received by the firm at the profit-maximizing quantity, Q PC, is equal to the firm’s marginal cost of production, MCPC, at that quantity of output. By contrast, at the profitmaximizing quantity chosen by the monopolistically competitive firm in panel (b), QMC, the price, PMC, is higher than the marginal cost of production, MCMC. This difference translates into a difference in the attitude of firms toward consumers. A wheat farmer, who can sell as much wheat as he likes at the going market price, would not get particularly excited if you offered to buy some more wheat at the market price. Since he has no desire to produce more at that price and can sell the wheat to someone else, you are not doing him a favor. 664 Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized But if you decide to fill up your tank at Jamil’s gas station rather than at Katy’s, you are doing Jamil a favor. He is not willing to cut his price to get more customers—he’s already made the best of that trade-off. But if he gets a few more customers than he expected at the posted price, that’s good news: an additional
sale at the posted price increases his revenue more than it increases his cost because the posted price exceeds marginal cost. The fact that monopolistic competitors, unlike perfect competitors, want to sell more at the going price is crucial to understanding why they engage in activities like advertising that help increase sales. The other difference between monopolistic competition and perfect competition that is visible in Figure 67.4 involves the position of each firm on its average total cost curve. In panel (a), the perfectly competitive firm produces at point Q PC, at the bottom of the U-shaped ATC curve. That is, each firm produces the quantity at which average total cost is minimized—the minimum-cost output. As a consequence, the total cost of industry output is also minimized. Under monopolistic competition, in panel (b), the firm produces at Q MC, on the downward-sloping part of the U-shaped ATC curve: it produces less than the quantity that would minimize average total cost. This failure to produce enough to minimize average total cost is sometimes described as the excess capacity issue. The typical vendor in a food court or a gas station along a road is not big enough to take maximum advantage of available cost savings. So the total cost of industry output is not minimized in the case of a monopolistically competitive industry. Some people have argued that, because every monopolistic competitor has excess capacity, monopolistically competitive industries are inefficient. But the issue of efficiency under monopolistic competition turns out to be a subtle one that does not have a clear answer. Is Monopolistic Competition Inefficient? A monopolistic competitor, like a monopolist, charges a price that is above marginal cost. As a result, some people who are willing to pay at least as much for an egg roll at Wonderful Wok as it costs to produce it are deterred from doing so. In monopolistic competition, some mutually beneficial transactions go unexploited. Furthermore, it is often argued that monopolistic competition is subject to a further kind of inefficiency: that the excess capacity of every monopolistic competitor implies wasteful duplication because monopolistically competitive industries offer too many varieties. According to this argument, it would be better if there were only two or three vendors in the food court, not six or seven. If there were fewer vendors, they would each have lower average total costs and so could offer food more cheaply. Is this argument against monopolistic competition right—that it lowers total surplus by causing inefficiency? Not necessarily. It’s true that if there were fewer gas stations
along a highway, each gas station would sell more gasoline and so would have a lower cost per gallon. But there is a drawback: motorists would be inconvenienced because gas stations would be farther apart. The point is that the diversity of products offered in a monopolistically competitive industry is beneficial to consumers. So the higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity. There is, in other words, a trade-off: more producers mean higher average total costs but also greater product diversity. Does a monopolistically competitive industry arrive at the socially optimal point in this trade-off? Probably not—but it is hard to say whether there are too many firms or too few! Most economists now believe that duplication of effort and excess capacity in monopolistically competitive industries are not large problems in practice 665 M o d u l e 67 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Suppose a monopolistically competitive industry composed of firms with U-shaped average total cost curves is in long-run equilibrium. For each of the following changes, explain how the industry is affected in the short run and how it adjusts to a new long-run equilibrium. a. a technological change that increases fixed cost for every firm in the industry b. a technological change that decreases marginal cost for every firm in the industry 2. Why is it impossible for firms in a monopolistically competitive industry to join together to form a monopoly that is capable of maintaining positive economic profit in the long run? 3. Indicate whether the following statements are true or false, and explain your answers. a. Like a firm in a perfectly competitive industry, a firm in a monopolistically competitive industry is willing to sell a good at any price that equals or exceeds marginal cost. b. Suppose there is a monopolistically competitive industry in long-run equilibrium that possesses excess capacity. All the firms in the industry would be better off if they merged into a single firm and produced a single product, but whether consumers would be made better off by this is ambiguous. c. Fads and fashions are more likely to arise in industries characterized by monopolistic competition or oligopoly than in those characterized by perfect competition or monopoly. Tackle the Test: Multiple-Choice Questions 1. Which of the following is a characteristic of monopolistic 4. Which of the following best describes a monopolistic competition? a. a standardized product b. many sellers c. barriers to entry d. positive long-run profits
e. a perfectly elastic demand curve competitor’s demand curve? a. upward sloping b. downward sloping c. U-shaped d. horizontal e. vertical 2. Which of the following results is possible for a monopolistic 5. The long-run outcome in a monopolistically competitive inefficiency because firms earn positive economic profits. industry results in a. b. efficiency due to excess capacity. c. d. efficiency because price exceeds marginal cost. e. a trade-off between higher average total cost and more inefficiency due to product diversity. product diversity. competitor in the short run? I. positive economic profit II. normal profit III. loss a. I only b. II only c. III only d. I and II only I, II, and III e. 3. Which of the following results is possible for a monopolistic competitor in the long run? I. positive economic profit II. normal profit III. loss a. I only b. II only III only c. d. I and II only I, II, and III e. 666 Tackle the Test: Free-Response Questions 1. Draw a correctly labeled graph for a monopolistically 2. Draw a correctly labeled graph for a monopolistically competitive firm that is unprofitable in the short run. Shade the area that represents the firm’s losses. competitive firm in long-run equilibrium. Label the distance on the quantity axis that represents excess capacity. Answer (7 points) Price, cost, marginal revenue ATCU PU Loss MC ATC DU MRU QU Loss-minimizing quantity Quantity 1 point: Correctly labeled axes 1 point: Downward-sloping demand curve 1 point: Marginal revenue curve below the demand curve 1 point: Loss-minimizing quantity where MC = MR 1 point: Loss-minimizing price on demand curve above where MC = MR 1 point: U-shaped average total cost curve above the demand curve at every quantity 1 point: Correct loss area shaded 667 What you will learn in this Module: • Why oligopolists and monopolistic competitors differentiate their products • The economic significance of advertising and brand names Module 68 Product Differentiation and Advertising In Module 66 we saw that product differentiation often plays an important role in oligopolistic industries. In such industries, product differentiation reduces the intensity of competition between firms when tacit collusion cannot be achieved. Product differentiation plays an even more crucial role in monopolistically competitive industries. Because tacit collusion is virtually impossible when there are many producers, product differentiation is
the only way monopolistically competitive firms can acquire some market power. In this module, we look at how oligopolists and monopolistic competitors differentiate their products in order to maximize profits. How Firms Differentiate Their Products How do firms in the same industry—such as fast-food vendors, gas stations, or chocolate makers—differentiate their products? Sometimes the difference is mainly in the minds of consumers rather than in the products themselves. We’ll discuss the role of advertising and the importance of brand names in achieving this kind of product differentiation later. But, in general, firms differentiate their products by—surprise!—actually making them different. The key to product differentiation is that consumers have different preferences and are willing to pay somewhat more to satisfy those preferences. Each producer can carve out a market niche by producing something that caters to the particular preferences of some group of consumers better than the products of other firms. There are three important forms of product differentiation: differentiation by style or type, differentiation by location, and differentiation by quality. Differentiation by Style or Type The sellers in Leo’s food court offer different types of fast food: hamburgers, pizza, Chinese food, Mexican food, and so on. Each consumer arrives at the food court with some preference for one or another of these offerings. This preference may depend on 668 the consumer’s mood, her diet, or what she has already eaten that day. These preferences will not make consumers indifferent to price: if Wonderful Wok were to charge $15 for an egg roll, everybody would go to Bodacious Burgers or Pizza Paradise instead. But some people will choose a more expensive meal if that type of food is closer to their preference. So the products of the different vendors are substitutes, but they aren’t perfect substitutes—they are imperfect substitutes. Vendors in a food court aren’t the only sellers who differentiate their offerings by type. Clothing stores concentrate on women’s or men’s clothes, on business attire or sportswear, on trendy or classic styles, and so on. Auto manufacturers offer sedans, minivans, sportutility vehicles, and sports cars, each type aimed at drivers with different needs and tastes. Books offer yet another example of differentiation by type and style. Mysteries are differentiated from romances; among mysteries, we can differentiate among hardboiled detective stories, whodunits, and police procedurals. And no two writers of hard-boiled detective stories are exactly
alike: Raymond Chandler and Sue Grafton each have their devoted fans. In fact, product differentiation is characteristic of most consumer goods. As long as people differ in their tastes, producers find it possible and profitable to offer variety. Differentiation by Location Gas stations along a road offer differentiated products. True, the gas may be exactly the same. But the location of the stations is different, and location matters to consumers: it’s more convenient to stop for gas near your home, near your workplace, or near wherever you are when the gas gauge gets low. In fact, many monopolistically competitive industries supply goods differentiated by location. This is especially true in service industries, from dry cleaners to hairdressers, where customers often choose the seller who is closest rather than cheapest. Differentiation by Quality Do you have a craving for chocolate? How much are you willing to spend on it? You see, there’s chocolate and then there’s chocolate: although ordinary chocolate may not be very expensive, gourmet chocolate can cost several dollars per bite. With chocolate, as with many goods, there is a range of possible qualities. You can get a usable bicycle for less than $100; you can get a much fancier bicycle for 10 times as much. It all depends on how much the additional quality matters to you and how much you will miss the other things you could have purchased with that money. Because consumers vary in what they are willing to pay for higher quality, producers can differentiate their products by quality—some offering lower-quality, inexpensive products and others offering higher-quality products at a higher price Product differentiation, then, can take several forms. Whatever form it takes, however, there are two important features of industries with differentiated products: competition among sellers and value in diversity. Competition among sellers means that even though sellers of differentiated products are not offering identical goods, they are to some extent competing for a limited market. If more businesses enter the market, each will find that it sells a lower quantity at any given price. For example, if a new gas station opens along a road, each of the existing gas stations will sell a bit less. Value in diversity refers to the gain to consumers from the proliferation of differentiated products. A food court with eight vendors makes consumers happier than one with only six vendors, even if the prices are the same, because some customers will get a meal that is closer to what they had in mind. A road on which there is a gas station every two miles is more convenient for
motorists than a road where gas stations are five miles apart. When a product is available in many different qualities, fewer people are forced to pay for more quality than they need or to settle for lower quality than they 669 fy i Any Color, So Long as It’s Black The early history of the auto industry offers a classic illustration of the power of product differentiation. The modern automobile industry was created by Henry Ford, who first introduced assembly-line production. This technique made it possible for him to offer the famous Model T at a far lower price than anyone else was charging for a car; by 1920, Ford dominated the automobile business. Ford’s strategy was to offer just one style of car, which maximized his economies of scale in production but made no concessions to differences in consumers’ tastes. He supposedly declared that customers could get the Model T in “any color, so long as it’s black.” This strategy was challenged by Alfred P. Sloan, who had merged a number of smaller automobile companies into General Motors. Sloan’s strategy was to offer a range of car types, differentiated by quality and price. Chevrolets were basic cars that directly challenged the Model T, Buicks were bigger and more expensive, and so on up to Cadillacs. And you could get each model in several different colors. By the 1930s the verdict was clear: customers preferred a range of styles, and General Motors, not Ford, became the dominant auto manufacturer for the rest of the twentieth century. want. There are, in other words, benefits to consumers from a greater diversity of available products. As we’ll see next, competition among the sellers of differentiated products is the key to understanding how monopolistic competition works. Controversies About Product Differentiation Up to this point, we have assumed that products are differentiated in a way that corresponds to some real desire of consumers. There is real convenience in having a gas station in your neighborhood; Chinese food and Mexican food are really different from each other. In the real world, however, some instances of product differentiation can seem puzzling if you think about them. What is the real difference between Crest and Colgate toothpaste? Between Energizer and Duracell batteries? Or a Marriott and a Hilton hotel room? Most people would be hard-pressed to answer any of these questions. Yet the producers of these goods make considerable efforts to convince consumers that their products are different from and better than those of their competitors. No discussion
of product differentiation is complete without spending at least a bit of time on the two related issues—and puzzles—of advertising and brand names. The Role of Advertising Wheat farmers don’t advertise their wares on TV, but car dealers do. That’s not because farmers are shy and car dealers are outgoing; it’s because advertising is worthwhile only in industries in which firms have at least some market power. The purpose of advertisements is to persuade people to buy more of a seller’s product at the going price. A perfectly competitive firm, which can sell as much as it likes at the going market price, has no incentive to spend money persuading consumers to buy more. Only a firm that has some market power, and which therefore charges a price that is above marginal cost, can gain from advertising. (Industries that are more or less perfectly competitive, like the milk industry, do advertise—but these ads are sponsored by an association on behalf of the industry as a whole, not on behalf of a particular farm.) Given that advertising “works,” it’s not hard to see why firms with market power would spend money on it. But the big question about advertising is, why does it work? A related question is whether advertising is, from society’s point of view, a waste of resources. 670 Not all advertising poses a puzzle. Much of it is straightforward: it’s a way for sellers to inform potential buyers about what they have to offer (or, occasionally, for buyers to inform potential sellers about what they want). Nor is there much controversy about the economic usefulness of ads that provide information: the real estate ad that declares “sunny, charming, 2 bedrooms, 1 bath, a/c” tells you things you need to know (even if a few euphemisms are involved—“charming,” of course, means “small”). But what information is being conveyed when a TV actress proclaims the virtues of one or another toothpaste or a sports hero declares that some company’s batteries are better than those inside that pink mechanical rabbit? Surely nobody believes that the sports star is an expert on batteries—or that he chose the company that he personally believes makes the best batteries, as opposed to the company that offered to pay him the most. Yet companies believe, with good reason, that money spent on such promotions increases their sales—and that they would be in big trouble if they stopped advertising but their competitors
continued to do so Why are consumers influenced by ads that do not really provide any information about the product? One answer is that consumers are not as rational as economists typically assume. Perhaps consumers’ judgments, or even their tastes, can be influenced by things that economists think ought to be irrelevant, such as which company has hired the most charismatic celebrity to endorse its product. And there is surely some truth to this. Consumer rationality is a useful working assumption; it is not an absolute truth. However, another answer is that consumer response to advertising is not entirely irrational because ads can serve as indirect “signals” in a world where consumers don’t have good information about products. Suppose, to take a common example, that you need to avail yourself of some local service that you don’t use regularly—body work on your car, say, or furniture moving. You turn to the Yellow Pages, where you see a number of small listings and several large display ads. You know that those display ads are large because the firms paid extra for them; still, it may be quite rational to call one of the firms with a big display ad. After all, the big ad probably means that it’s a relatively large, successful company—otherwise, the company wouldn’t have found it worth spending the money for the larger ad. The same principle may partly explain why ads feature celebrities. You don’t really believe that the supermodel prefers that watch; but the fact that the watch manufacturer is willing and able to pay her fee tells you that it is a major company that is likely to stand behind its product. According to this reasoning, an expensive advertisement serves to establish the quality of a firm’s products in the eyes of consumers. The possibility that it is rational for consumers to respond to advertising also has some bearing on the question of whether advertising is a waste of resources. If ads work by manipulating only the weak-minded, the $149 billion U.S. businesses spent on advertising in 2007 would have been an economic waste—except to the extent that ads sometimes provide entertainment. To the extent that advertising conveys important information, however, it is an economically productive activity after all. Brand Names You’ve been driving all day, and you decide that it’s time to find a place to sleep. On your right, you see a sign for the Bates Motel; on your left, you see a sign for a Motel 6, or a Best Western, or
some other national chain. Which one do you choose 671 brand name is a name owned by a particular firm that distinguishes its products from those of other firms. Unless they were familiar with the area, most people would head for the chain. In fact, most motels in the United States are members of major chains; the same is true of most fast-food restaurants and many, if not most, stores in shopping malls. Motel chains and fast-food restaurants are only one aspect of a broader phenomenon: the role of brand names, names owned by particular companies that differentiate their products in the minds of consumers. In many cases, a company’s brand name is the most important asset it possesses: clearly, McDonald’s is worth far more than the sum of the deep-fat fryers and hamburger grills the company owns. In fact, companies often go to considerable lengths to defend their brand names, suing anyone else who uses them without permission. You may talk about blowing your nose on a kleenex or xeroxing a term paper, but unless the product in question comes from Kleenex or Xerox, legally the seller must describe it as a facial tissue or a photocopier. As with advertising, with which they are closely linked, the social usefulness of brand names is a source of dispute. Does the preference of consumers for known brands reflect consumer irrationality? Or do brand names convey real information? That is, do brand names create unnecessary market power, or do they serve a real purpose? As in the case of advertising, the answer is probably some of both. On the one hand, brand names often do create unjustified market power. Consumers often pay more for brand-name goods in the supermarket even though consumer experts assure us that the cheaper store brands are equally good. Similarly, many common medicines, like aspirin, are cheaper—with no loss of quality—in their generic form. On the other hand, for many products the brand name does convey information. A traveler arriving in a strange town can be sure of what awaits in a Holiday Inn or a McDonald’s; a tired and hungry traveler may find this preferable to trying an independent hotel or restaurant that might be better—but might be worse. In addition, brand names offer some assurance that the seller is engaged in repeated interaction with its customers and so has a reputation to protect. If a traveler eats a bad meal at a restaurant in a tourist trap and vows never to eat there again, the restaurant owner may not care
, since the chance is small that the traveler will be in the same area again in the future. But if that traveler eats a bad meal at McDonald’s and vows never to eat at a McDonald’s again, that matters to the company. This gives McDonald’s an incentive to provide consistent quality, thereby assuring travelers that quality controls are in place. M o d u l e 68 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. For each of the following types of advertising, explain whether it is likely to be useful or wasteful from the standpoint of consumers. a. advertisements explaining the benefits of aspirin b. advertisements for Bayer aspirin c. advertisements that state how long a plumber or an electrician has been in business 2. Some industry analysts have stated that a successful brand name is like a barrier to entry. Explain why this might be true. 672 Tackle the Test: Multiple-Choice Questions 1. Which of the following is a form of product differentiation? 3. Advertising is an attempt to affect which of the following? I. style or type II. location III. quality a. I only b. II only c. III only d. I and II only I, II, and III e. 2. In which of the following market structures will individual firms advertise? I. perfect competition II. oligopoly III. monopolistic competition a. I only b. II only III only c. d. II and III only I, II, and III e. Tackle the Test: Free-Response Questions 1. Refer to the table below showing the effects of running television commercials on a firm’s total revenue. Assume that each commercial costs $1,000 to run. Number of Commercials 0 1 2 3 4 5 6 Total revenue $20,000 30,000 38,000 44,000 48,000 50,000 50,500 a. What is the marginal revenue from running the second commercial? b. Should the firm run a third commercial? Explain. c. If the firm has no variable costs aside from the cost of commercials, how many commercials should the firm run to maximize profits? Explain. S e c t i o n 12 Review Summary 1. Many industries are oligopolies, characterized by a small number of sellers. The smallest type of oligopoly, a duopoly, has only two sellers. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form
. They are characterized by imperfect competition: firms compete but possess market power. a. consumer tastes and preferences b. consumer income c. the price of complements d. the price of substitutes e. input prices 4. Brand names generally serve to a. waste resources. b. decrease firm profits. c. confuse consumers. d. decrease information. e. signal quality. 5. Which of the following is true of advertising expenditures in monopolistic competition? Monopolistic competitors a. will not advertise. b. use only informational advertising. c. waste resources on advertising. d. attempt to create popular brand names. e. earn long-run profits through advertising. Answer (5 points) 1 point: $8,000 1 point: Yes. 1 point: Because the marginal revenue of $6,000 exceeds the marginal cost of $1,000. 1 point: 5 1 point: Marginal revenue exceeds marginal cost for the first 5 commercials. Marginal revenue is less than marginal cost for the 6th commercial. 2. When is product differentiation socially efficient? Explain. When is it not socially efficient? Explain. 2. Predicting the behavior of oligopolists poses something of a puzzle. The firms in an oligopoly could maximize their combined profits by acting as a cartel, setting output levels for each firm as if they were a single monopolist; to the extent that firms manage to do this, they engage in collusion. But each individual 673 firm has an incentive to produce more than the agreed upon quantity of output—to engage in noncooperative behavior. Informal collusion is likely to be easier to achieve in industries in which firms face capacity constraints. 3. The situation of interdependence, in which each firm’s profit depends noticeably on what other firms do, is the subject of game theory. In the case of a game with two players, the payoff of each player depends on both its own actions and on the actions of the other; this interdependence can be shown in a payoff matrix. Depending on the structure of payoffs in the payoff matrix, a player may have a dominant strategy—an action that is always the best regardless of the other player’s actions. 4. Some duopolists face a particular type of game known as a prisoners’ dilemma; if each acts independently on its own interest, the resulting Nash equilibrium or noncooperative equilibrium will be bad for both. However, firms that expect to play a game repeatedly tend to engage in strategic behavior, trying to influence each
other’s future actions. A particular strategy that seems to work well in such situations is tit for tat, which often leads to tacit collusion. 5. In order to limit the ability of oligopolists to collude and act like monopolists, most governments pursue antitrust policy designed to make collusion more difficult. In practice, however, tacit collusion is widespread. 6. A variety of factors make tacit collusion difficult: a large numbers of firms, complex products and pricing, differences in interests, and buyers with bargaining power. When tacit collusion breaks down, there can be a price war. Oligopolists try to avoid price wars in various ways, such as through product differentiation and through price leader- ship, in which one firm sets prices for the industry. Another approach is nonprice competition, such as advertising. 7. Monopolistic competition is a market structure in which there are many competing producers, each producing a differentiated product, and there is free entry and exit in the long run. 8. Short-run profits will attract the entry of new firms in the long run. This reduces the quantity each existing producer sells at any given price and shifts its demand curve to the left. Short-run losses will induce exit by some firms in the long run. This shifts the demand curve of each remaining firm to the right. 9. In the long run, a monopolistically competitive industry is in zero-profit equilibrium: at its profitmaximizing quantity, the demand curve for each existing firm is tangent to its average total cost curve. There are zero profits in the industry and no entry or exit. 10. In long-run equilibrium, firms in a monopolistically competitive industry sell at a price greater than marginal cost. They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive industry. Whether or not monopolistic competition is inefficient is ambiguous because consumers value the product diversity that it creates. 11. Product differentiation takes three main forms: style or type, location, or quality. Firms will engage in advertising to increase demand for their products and enhance their market power. Advertising and brand names that provide useful information to consumers are valuable to society. Advertisements can be wasteful from a societal standpoint when their only purpose is to create market power. Key Terms Interdependence, p. 638 Duopoly, p. 638 Duopolist, p. 638 Collusion, p. 639 Cartel, p. 639 Pay
off matrix, p. 644 Prisoners’ dilemma, p. 645 Dominant strategy, p. 646 Nash equilibrium, p. 646 Antitrust policy, p. 653 Price war, p. 654 Product differentiation, p. 655 Price leadership, p. 656 Noncooperative equilibrium, p. 646 Nonprice competition, p. 656 Noncooperative behavior, p. 640 Strategic behavior, p. 647 Zero-profit equilibrium, p. 661 Game theory, p. 644 Payoff, p. 644 Tit for tat, p. 647 Tacit collusion, p. 649 Excess capacity, p. 665 Brand name, p. 672 674 Problems 1. The accompanying table presents market share data for the U.S. breakfast cereal market in 2006. no fixed cost. The accompanying table gives the market demand schedule for olive oil. Section 12 Summary Company Kellogg General Mills PepsiCo (Quaker Oats) Kraft Private Label Other Source: Advertising Age Market Share 30% 26 14 13 11 6 a. Use the data provided to calculate the Herfindahl– Hirschman Index (HHI) for the market. b. Based on this HHI, what type of market structure is the U.S. breakfast cereal market? 2. The accompanying table shows the demand schedule for vitamin D. Suppose that the marginal cost of producing vitamin D is zero. Price of vitamin D (per ton) Quantity of vitamin D demanded (tons) $8 7 6 5 4 3 2 1 0 10 20 30 40 50 60 70 a. Assume that BASF is the only producer of vitamin D and acts as a monopolist. It currently produces 40 tons of vitamin D at $4 per ton. If BASF were to produce 10 more tons, what would be the price effect for BASF? What would be the quantity effect? Would BASF have an incentive to produce those 10 additional tons? b. Now assume that Roche enters the market by also producing vitamin D and the market is now a duopoly. BASF and Roche agree to produce 40 tons of vitamin D in total, 20 tons each. BASF cannot be punished for deviating from the agreement with Roche. If BASF, on its own, were to deviate from that agreement and produce 10 more tons, what would be the price effect for BASF? What would be the quantity effect for BASF? Would BASF have an incentive to produce those 10 additional tons
? 3. The market for olive oil in New York City is controlled by two families, the Sopranos and the Contraltos. Both families will ruthlessly eliminate any other family that attempts to enter the New York City olive oil market. The marginal cost of producing olive oil is constant and equal to $40 per gallon. There is Price of olive oil (per gallon) $100 90 80 70 60 50 40 30 20 10 Quantity of olive oil demanded (gallons) 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 a. Suppose the Sopranos and the Contraltos form a cartel. For each of the quantities given in the table, calculate the total revenue for their cartel and the marginal revenue for each additional gallon. How many gallons of olive oil would the cartel sell in total and at what price? The two families share the market equally (each produces half of the total output of the cartel). How much profit does each family make? b. Uncle Junior, the head of the Soprano family, breaks the agreement and sells 500 more gallons of olive oil than under the cartel agreement. Assuming the Contraltos maintain the agreement, how does this affect the price for olive oil and the profits earned by each family? c. Anthony Contralto, the head of the Contralto family, decides to punish Uncle Junior by increasing his sales by 500 gallons as well. How much profit does each family earn now? 4. In France, the market for bottled water is controlled by two large firms, Perrier and Evian. Each firm has a fixed cost of €1 million and a constant marginal cost of €2 per liter of bottled water (€1 = 1 euro). The following table gives the market demand schedule for bottled water in France. Price of bottled water (per liter) Quantity of bottled water demanded (millions of liters) €10 675 a. Suppose the two firms form a cartel and act as a monopo- list. Calculate marginal revenue for the cartel. What will the monopoly price and output be? Assuming the firms divided the output evenly, how much will each produce and what will each firm’s profits be? b. Now suppose Perrier decides to increase production by 1 million liters. Evian doesn’t change its production. What will the new market price and output be? What is Perrier’s profit? What is Evian
’s profit? c. What if Perrier increases production by 3 million liters? Evian doesn’t change its production. What would its output and profits be relative to those in part b? d. What do your results tell you about the likelihood of cheat- ing on such agreements? 5. To preserve the North Atlantic fish stocks, it is decided that only two fishing fleets, one from the United States and the other from the European Union (EU), can fish in those waters. The accompanying table shows the market demand schedule per week for fish from these waters. The only costs are fixed costs, so fishing fleets maximize profit by maximizing revenue. Price of fish (per pound) Quantity of fish demanded (pounds) $17 16 15 14 12 1,800 2,000 2,100 2,200 2,300 a. If both fishing fleets collude, what is the revenue-maximizing output for the North Atlantic fishery? What price will a pound of fish sell for? b. If both fishing fleets collude and share the output equally, what is the revenue to the EU fleet? To the U.S. fleet? c. Suppose the EU fleet cheats by expanding its own catch by 100 pounds per week. The U.S. fleet doesn’t change its catch. What is the revenue to the U.S. fleet? To the EU fleet? d. In retaliation for the cheating by the EU fleet, the U.S. fleet also expands its catch by 100 pounds per week. What is the revenue to the U.S. fleet? To the EU fleet? 6. Suppose that the fisheries agreement in Problem 5 breaks down, so that the fleets behave noncooperatively. Assume that the United States and the EU each can send out either one or two fleets. The more fleets in the area, the more fish they catch in total but the lower the catch of each fleet. The accompany- ing matrix shows the profit (in dollars) per week earned by the two sides. EU 1 ﬂeet 2 ﬂeets $10,000 proﬁt $12,000 proﬁt. S. U 1 ﬂeet 2 ﬂeets $10,000 proﬁt $4,000 proﬁt $4,000 proﬁt $7,500 proﬁt $12,000 proﬁt $7,
500 proﬁt a. What is the noncooperative Nash equilibrium? Will each side choose to send out one or two fleets? b. Suppose that the fish stocks are being depleted. Each region considers the future and comes to a “tit-for-tat” agreement whereby each side will send only one fleet out as long as the other does the same. If either of them breaks the agreement and sends out a second fleet, the other will also send out two and will continue to do so until its competitor sends out only one fleet. If both play this “tit-for-tat” strategy, how much profit will each make every week? 7. Untied and Air “R” Us are the only two airlines operating flights between Collegeville and Bigtown. That is, they operate in a duopoly. Each airline can charge either a high price or a low price for a ticket. The accompanying matrix shows their payoffs, in profits per seat (in dollars), for any choice that the two airlines can make. Air “R” Us Low price High price $20 proﬁt $0 proﬁt d e i t n U Low price High price $20 proﬁt $50 proﬁt $50 proﬁt $40 proﬁt $0 proﬁt $40 proﬁt a. Suppose the two airlines play a one-shot game—that is, they interact only once and never again. What will be the Nash equilibrium in this one-shot game? 676. Now suppose the two airlines play this game twice. And suppose each airline can play one of two strategies: it can play either “always charge the low price” or “tit for tat”— that is, start off charging the high price in the first period, and then in the second period do whatever the other airline did in the previous period. Write down the payoffs to Untied from the following four possibilities: i. Untied plays “always charge the low price” when Air “R” Us also plays “always charge the low price.” ii. Untied plays “always charge the low price” when Air “R” Us plays “tit for tat.” iii. Untied plays “tit for tat” when Air “
R” Us plays “always charge the low price.” iv. Untied plays “tit for tat” when Air “R” Us also plays “tit for tat.” 8. Suppose that Coke and Pepsi are the only two producers of cola drinks, making them duopolists. Both companies have zero marginal cost and a fixed cost of $100,000. a. Assume first that consumers regard Coke and Pepsi as perfect substitutes. Currently both are sold for $0.20 per can, and at that price each company sells 4 million cans per day. i. How large is Pepsi’s profit? ii. If Pepsi were to raise its price to $0.30 cents per can, and Coke did not respond, what would happen to Pepsi’s profit? b. Now suppose that each company advertises to differentiate its product from the other company’s. As a result of advertising, Pepsi realizes that if it raises or lowers its price, it will sell less or more of its product, as shown by the demand schedule in the accompanying table. Price of Pepsi (per can) Quantity of Pepsi demanded (millions of cans) $0.10 0.20 0.30 0.40 0.50 5 4 3 2 1 If Pepsi now were to raise its price to $0.30 per can, what would happen to its profit? c. Comparing your answer to part a(i) and to part b, what is the maximum amount Pepsi would be willing to spend on advertising? 9. Philip Morris and R.J. Reynolds spend huge sums of money each year to advertise their tobacco products in an attempt to steal customers from each other. Suppose each year Philip Morris and R.J. Reynolds have to decide whether or not they want to spend money on advertising. If neither firm advertises, Section 12 Summary each will earn a profit of $2 million. If they both advertise, each will earn a profit of $1.5 million. If one firm advertises and the other does not, the firm that advertises will earn a profit of $2.8 million and the other firm will earn $1 million. a. Use a payoff matrix to depict this problem. b. Suppose Philip Morris and R.J. Reynolds can write an en- forceable contract about what they will do. What is the cooperative solution to this game? c. What is the Nash equilibrium without an enforceable con-
tract? Explain why this is the likely outcome. 10. Use the three conditions for monopolistic competition discussed in this section to decide which of the following firms are likely to be operating as monopolistic competitors. If they are not monopolistically competitive firms, are they monopolists, oligopolists, or perfectly competitive firms? a. a local band that plays for weddings, parties, and so on b. Minute Maid, a producer of individual-serving juice boxes c. your local dry cleaner d. a farmer who produces soybeans 11. You are thinking of setting up a coffee shop. The market structure for coffee shops is monopolistic competition. There are three Starbucks shops, and two other coffee shops very much like Starbucks, in your town already. In order for you to have some degree of market power, you may want to differentiate your coffee shop. Thinking about the three different ways in which products can be differentiated, explain how you would decide whether you should copy Starbucks or whether you should sell coffee in a completely different way. 12. The restaurant business in town is a monopolistically competitive industry in long-run equilibrium. One restaurant owner asks for your advice. She tells you that, each night, not all tables in her restaurant are full. She also tells you that if she lowered the prices on her menu, she would attract more customers and that doing so would lower her average total cost. Should she lower her prices? Draw a diagram showing the demand curve, marginal revenue curve, marginal cost curve, and average total cost curve for this restaurant to explain your advice. Show in your diagram what would happen to the restaurant owner’s profit if she were to lower the price so that she sells the minimum-cost output. 13. The market structure of the local gas station industry is monopolistic competition. Suppose that currently each gas station incurs a loss. Draw a diagram for a typical gas station to show this short-run situation. Then, in a separate diagram, show what will happen to the typical gas station in the long run. Explain your reasoning. 14. The local hairdresser industry has the market structure of monopolistic competition. Your hairdresser boasts that he is making a profit and that if he continues to do so, he will be able to S u m m a r y 677 retire in five years. Use a diagram to illustrate your hairdresser’s current situation. Do you expect this to last? In a separate diagram, draw what you expect to happen in the long run
. Explain your reasoning. 15. Magnificent Blooms is a florist in a monopolistically competitive industry. It is a successful operation, producing the quantity that minimizes its average total cost and making a profit. The owner also says that at its current level of output, its marginal cost is above marginal revenue. Illustrate the current situation of Magnificent Blooms in a diagram. Answer the following questions by illustrating with a diagram. a. In the short run, could Magnificent Blooms increase its profit? b. In the long run, could Magnificent Blooms increase its profit? 16. “In both the short run and in the long run, the typical firm in monopolistic competition and a monopolist each make a profit.” Do you agree with this statement? Explain your reasoning. 17. The market for clothes has the structure of monopolistic competition. What impact will fewer firms in this industry have on you as a consumer? Address the following issues: a. variety of clothes b. differences in quality of service c. price 18. For each of the following situations, decide whether advertising is directly informative about the product or simply an indirect signal of its quality. Explain your reasoning. a. Golf champion Tiger Woods drives a Buick in a TV commercial and claims that he prefers it to any other car. b. A newspaper ad states, “For sale: 1999 Honda Civic, 160,000 miles, new transmission.” c. McDonald’s spends millions of dollars on an advertising campaign that proclaims: “I’m lovin’ it.” d. Subway advertises one of its sandwiches by claiming that it contains 6 grams of fat and fewer than 300 calories. 19. In each of the following cases, explain how the advertisement functions as a signal to a potential buyer. Explain what information the buyer lacks that is being supplied by the advertisement and how the information supplied by the advertisement is likely to affect the buyer’s willingness to buy the good. a. “Looking for work. Excellent references from previous em- ployers available.” b. “Electronic equipment for sale. All merchandise carries a one-year, no-questions-asked warranty.” c. “Car for sale by original owner. All repair and maintenance records available.” 20. The accompanying table shows the Herfindahl–Hirschman Index (HHI) for the restaurant, cereal, movie,
and laundry detergent industries as well as the advertising expenditures of the top 10 firms in each industry in 2006. Use the information in the table to answer the following questions. Industry Restaurants Cereal Movie studios Laundry detergent HHI 179 2,098 918 2,068 Advertising expenditures (millions) $1,784 732 3,324 132 a. Which market structure—oligopoly or monopolistic competition—best characterizes each of the industries? b. Based on your answer to part a, which type of market structure has higher advertising expenditures? Use the characteristics of each market structure to explain why this relationship might exist. 678 Module 69: Introduction and Factor Demand Module 70: The Markets for Land and Capital Module 71: The Market for Labor Module 72: The Cost-Minimizing Input Combination Module 73: Theories of Income Distribution Economics by Example: “Immigration: How Welcoming Should Lady Liberty Be?” 13 Factor Markets Does higher education pay? Yes, it does: In the modern economy, employers are willing to pay a premium for workers with more education. And the size of that premium has increased a lot over the last few decades. Back in 1973 workers with advanced degrees, such as law degrees or MBAs, earned only 76% more than those who had only graduated from high school. By 2009, the premium for an advanced degree had risen to over 112%. Who decided that the wages of workers with advanced degrees would rise so much compared with those of high school grads? The answer, of course, is that nobody decided it. Wage rates are prices, the prices of different kinds of labor; and they are decided, like other prices, by supply and demand. Still, there is a qualitative difference between the wage rate of high school grads and the price of used textbooks: the wage rate isn’t the price of a good; it’s the price of a factor of production. And although markets for factors of production are in many ways similar to those for goods, there are also some important differences. In this section, we examine factor markets, the markets in which the factors of production such as labor, land, and capital are traded. Factor markets, like goods markets, play a crucial role in the economy: they allocate productive resources to firms and help ensure that those resources are used efficiently If you’ve ever had doubts about attending college, consider this: factory workers with only high school degrees will make much less than college grads
. The present discounted value of the difference in lifetime earnings is as much as $300,000. 679 What you will learn in this Module: • How factors of production—resources like land, labor, and capital—are traded in factor markets • How factor markets determine the factor distribution of income • How the demand for a factor of production is determined Module 69 Introduction and Factor Demand The Economy’s Factors of Production You may recall that we have already defined a factor of production in the context of the circular-flow diagram; it is any resource that is used by firms to produce goods and services, items that are consumed by households. The markets in which factors of production are bought and sold are called factor markets, and the prices in factor markets are known as factor prices. What are these factors of production, and why do factor prices matter? The Factors of Production Economists divide factors of production into four principal classes. The first is labor, the work done by human beings. The second is land, which encompasses resources provided by nature. The third is capital, which can be divided into two categories: physical capital—often referred to simply as “capital”—consists of manufactured resources such as equipment, buildings, tools, and machines. In the modern economy, human capital, the improvement in labor created by education and knowledge, and embodied in the workforce, is at least equally significant. Technological progress has boosted the importance of human capital and made technical sophistication essential to many jobs, thus helping to create the premium for workers with advanced degrees. The final factor of production, entrepreneurship, is a unique resource that is not purchased in an easily identifiable factor market like the other three. It refers to risk-taking activities that bring together resources for innovative production. Why Factor Prices Matter: The Allocation of Resources The factor prices determined in factor markets play a vital role in the important process of allocating resources among firms. Consider the example of Mississippi and Louisiana in the aftermath of Hurricane Katrina, the costliest hurricane ever to hit the U.S. mainland. The states had an urgent Physical capital—often referred to simply as “capital”—consists of manufactured productive resources such as equipment, buildings, tools, and machines. Human capital is the improvement in labor created by education and knowledge that is embodied in the workforce. 680 need for workers in the building trades—everything from excavation to roofing—to repair or replace damaged structures. What ensured that those needed workers actually came? The factor market: the high demand for
workers drove up wages. During 2005, the average U.S. wage grew at a rate of around 6%. But in areas heavily affected by Katrina, the average wage during the fall of 2005 grew by 30% more than the national rate, and some areas saw twice that rate of increase. Over time, these higher wages led large numbers of workers with the right skills to move temporarily to these states to do the work. In other words, the market for a factor of production— construction workers—allocated that factor of production to where it was needed. In this sense factor markets are similar to goods markets, which allocate goods among consumers. But there are two features that make factor markets special. Unlike in a goods market, demand in a factor market is what we call derived demand. That is, demand for the factor is derived from demand for the firm’s output. The second feature is that factor markets are where most of us get the largest shares of our income (government transfers being the next largest source of income in the economy). © In the months after Hurricane Katrina, home repair signs like these were abundant throughout New Orleans. Factor Incomes and the Distribution of Income Most American families get most of their income in the form of wages and salaries— that is, they get their income by selling labor. Some people, however, get most of their income from physical capital: when you own stock in a company, what you really own is a share of that company’s physical capital. Some people get much of their income from rents earned on land they own. And successful entrepreneurs earn income in the form of profits. Obviously, then, the prices of factors of production have a major impact on how the economic “pie” is sliced among different groups. For example, a higher wage rate, other things equal, means that a larger proportion of the total income in the economy goes to people who derive their income from labor and less goes to those who derive their income from capital, land, or entrepreneurship. Economists refer to how the economic pie is sliced as the “distribution of income.” Specifically, factor prices determine the factor distribution of income—how the total income of the economy is divided among labor, land, capital, and entrepreneurship. The factor distribution of income in the United States has been quite stable over the past few decades. In other times and places, however, large changes have taken place in the factor distribution. One notable example: during the Industrial Revolution, the share of total income earned by
landowners fell sharply, while the share earned by capital owners rose. The Factor Distribution of Income in the United States When we talk about the factor distribution of income, what are we talking about in practice? In the United States, as in all advanced economies, payments to labor account for most of the economy’s total income. Figure 69.1 on the next page shows the factor distribution of income in the United States in 2009: in that year, 70.9% of total income in the economy took the form of “compensation of employees”—a number that includes The demand for a factor is a derived demand. It results from (that is, it is derived from) the demand for the output being produced. The factor distribution of income is the division of total income among land, labor, capital, and entrepreneurship 681 69.1 Factor Distribution of Income in the United States in 2009 In 2009, compensation of employees accounted for most income earned in the United States—70.9% of the total. Most of the remainder—consisting of earnings paid in the form of interest, corporate profits, and rent—went to owners of physical capital. Finally, proprietors’ income—9.2% of the total—went to individual owners of businesses as compensation for their labor, entrepreneurship, and capital expended in their businesses. Source: Bureau of Economic Analysis. Compensation of employees 70.9% Interest 11.1% Corporate proﬁts 6.3% Rent 2.5% Proprietors’ income 9.2% both wages and benefits such as health insurance. This number has been quite stable over the long run; 37 years earlier, in 1972, compensation of employees was very similar, at 72.2% of total income. Much of what we call compensation of employees is really a return on human capital. A surgeon isn’t just supplying the services of a pair of ordinary hands (at least the patient hopes not!): that individual is also supplying the result of many years and hundreds of thousands of dollars invested in training and experience. We can’t directly measure what fraction of wages is really a payment for education and training, but many economists believe that labor resources created through additional human capital has become the most important factor of production in modern economies. Marginal Productivity and Factor Demand All economic decisions are about comparing costs and benefits—and usually about comparing marginal costs and marginal benefits. This goes both for a consumer, deciding whether to buy more goods or services,
and for a firm, deciding whether to hire an additional worker. Although there are some important exceptions, most factor markets in the modern American economy are perfectly competitive. This means that most buyers and sellers of factors are price-takers because they are too small relative to the market to do anything but accept the market price. And in a competitive labor market, it’s clear how to define the marginal cost an employer pays for a worker: it is simply the worker’s wage rate. But what is the marginal benefit of that worker? To answer that question, we return to the production function, which relates inputs to output. For now we assume that all firms are price-takers in their output markets—that is, they operate in a perfectly competitive industry. Value of the Marginal Product Figure 69.2 shows the production function for wheat on George and Martha’s farm, as introduced in Module 54. Panel (a) uses the total product curve to show how total wheat production depends on the number of workers employed on the farm; panel (b) shows how the marginal product of labor, the increase in output from employing one more worker, depends on the number of workers employed. Table 69.1 shows the 682 69.2 The Production Function for George and Martha’s Farm (a) Total Product (b) Marginal Product of Labor Quantity of wheat (bushels) 100 80 60 40 20 0 1 2 3 TP Marginal product of labor (bushels per worker) 19 17 15 13 11 9 7 5 MPL 5 4 Quantity of labor (workers Quantity of labor (workers) 7 6 8 Panel (a) shows how the quantity of output of wheat on George and Martha’s farm depends on the number of workers employed. Panel (b) shows how the marginal product of labor depends on the number of workers employed. numbers behind the figure. Note: sometimes the marginal product (MP) is called the marginal physical product or MPP. These two terms are the same; the extra “P” just emphasizes that the term refers to the quantity of physical output being produced, not the monetary value of that output. If workers are paid $200 each and wheat sells for $20 per bushel, how many workers should George and Martha employ to maximize profit? t a b l e 69.1 Employment and Output for George and Martha’s Farm Quantity of labor L (workers) Quantity of wheat Q (bushels) Marginal product of labor
MPL ΔQ ΔL (bushels per worker 19 36 51 64 75 84 91 96 19 17 15 13 11 683 The value of the marginal product of a factor is the value of the additional output generated by employing one more unit of that factor. The value of the marginal product curve of a factor shows how the value of the marginal product of that factor depends on the quantity of the factor employed. Earlier we showed how to answer this question in several steps. First, we used information from the production function to derive the firm’s total cost and its marginal cost. Then we used the price-taking firm’s optimal output rule: a price-taking firm’s profit is maximized by producing the quantity of output at which the marginal cost is equal to the market price. Having determined the optimal quantity of output, we went back to the production function to find the optimal number of workers—which was simply the number of workers needed to produce the optimal quantity of output. As you might have guessed, marginal analysis provides a more direct way to find the number of workers that maximizes a firm’s profit. This alternative approach is just a different way of looking at the same thing. But it gives us more insight into the demand for factors as opposed to the supply of goods. To see how this alternative approach works, suppose that George and Martha are deciding whether to employ another worker. The increase in cost from employing another worker is the wage rate, W. The benefit to George and Martha from employing another worker is the value of the extra output that worker can produce. What is this value? It is the marginal product of labor, MPL, multiplied by the price per unit of output, P. This amount—the extra value of output generated by employing one more unit of labor—is known as the value of the marginal product of labor, or VMPL: (69-1) Value of the marginal product of labor = VMPL = P × MPL So should George and Martha hire another worker? Yes, if the value of the extra output is more than the cost of the additional worker—that is, if VMPL > W. Otherwise, they should not. The hiring decision is made using marginal analysis, by comparing the marginal benefit from hiring another worker (VMPL) with the marginal cost (W ). And as with any decision that is made on the margin, the optimal choice is made by equating marginal benefit with marginal cost (or if they’re never equal, by
continuing to hire until the marginal cost of one more unit would exceed the marginal benefit). That is, to maximize profit, George and Martha will employ workers up to the point at which, for the last worker employed, (69-2) VMPL = W. This rule isn’t limited to labor; it applies to any factor of production. The value of the marginal product of any factor is its marginal product times the price of the good it produces. And as a general rule, profit-maximizing, price-taking firms will keep adding more units of each factor of production until the value of the marginal product of the last unit employed is equal to the factor’s price. This rule is consistent with our previous analysis. We saw that a profit-maximizing firm chooses the level of output at which the price of the good it produces equals the marginal cost of producing that good. It turns out that if the level of output is chosen so that price equals marginal cost, then it is also true that with the amount of labor required to produce that output level, the value of the marginal product of labor will equal the wage rate. Now let’s look more closely at why choosing the level of employment to equate VMPL and W works, and at how it helps us understand factor demand. Value of the Marginal Product and Factor Demand Table 69.2 shows the value of the marginal product of labor on George and Martha’s farm when the price of wheat is $20 per bushel. In Figure 69.3, the horizontal axis shows the number of workers employed; the vertical axis measures the value of the marginal product of labor and the wage rate. The curve shown is the value of the marginal product curve of labor. This curve, like the marginal product of labor curve, slopes downward because of diminishing returns to labor in production. That is, the value of the 684 69.2 Value of the Marginal Product of Labor for George and Martha’s Farm Quantity of labor L (workers) Marginal product of labor MPL (bushels per worker) Value of the marginal product of labor VMPL P × MPL 0 1 2 3 4 5 6 7 8 19 17 15 13 11 9 7 5 $380 340 300 260 220 180 140 100 marginal product of each worker is less than that of the preceding worker because the marginal product of each worker is less than that of the preceding worker. We have just seen that to maximize profit, George and Martha hire workers until the wage
rate is equal to the value of the marginal product of the last worker employed. Let’s use the example to see how this principle really works. f i g u r e 69.3 The Value of the Marginal Product Curve This curve shows how the value of the marginal product of labor depends on the number of workers employed. It slopes downward because of diminishing returns to labor in production. To maximize profit, George and Martha choose the level of employment at which the value of the marginal product of labor is equal to the market wage rate. For example, at a wage rate of $200 the profit-maximizing level of employment is 5 workers, shown by point A. The value of the marginal product curve of a factor is the producer’s individual demand curve for that factor. Wage rate, VMPL Market wage rate $400 300 200 100 0 Optimal point A Value of the marginal product of labor curve, VMPL 1 2 3 4 5 6 7 8 Quantity of labor (workers) Proﬁt-maximizing number of workers 685 Assume that George and Martha currently employ 3 workers and that these workers must be paid the market wage rate of $200. Should they employ an additional worker? Looking at Table 69.2, we see that if George and Martha currently employ 3 workers, the value of the marginal product of an additional worker is $260. So if they employ an additional worker, they will increase the value of their production by $260 but increase their cost by only $200, yielding an increased profit of $60. In fact, a firm can always increase profit by employing one more unit of a factor of production as long as the value of the marginal product produced by that unit exceeds the factor price. Alternatively, suppose that George and Martha employ 8 workers. By reducing the number of workers to 7, they can save $200 in wages. In addition, the value of the marginal product of the 8th worker is only $100. So, by reducing employment by one worker, they can increase profit by $200 − $100 = $100. In other words, a firm can always increase profit by employing one less unit of a factor of production as long as the value of the marginal product produced by that unit is less than the factor price. Using this method, we can see from Table 69.2 that the profit-maximizing employment level is 5 workers, given a wage rate of $200. The value of the marginal product of the 5th worker
is $220, so adding the 5th worker results in $20 of additional profit. But George and Martha should not hire more than 5 workers: the value of the marginal product of the 6th worker is only $180, $20 less than the cost of that worker. So, to maximize profit, George and Martha should employ workers up to but not beyond the point at which the value of the marginal product of the last worker employed is equal to the wage rate. Look again at the value of the marginal product curve in Figure 69.3. To determine the profit-maximizing level of employment, we set the value of the marginal product of labor equal to the price of labor—a wage rate of $200 per worker. This means that the profit-maximizing level of employment is at point A, corresponding to an employment level of 5 workers. If the wage rate were higher, we would simply move up the curve and decrease the number of workers employed: if the wage rate were lower than $200, we would move down the curve and increase the number of workers employed Firms keep hiring more workers until the value of the marginal product of labor equals the wage rate. In this example, George and Martha have a small farm in which the potential employment level varies from 0 to 8 workers, and they hire workers up to the point at which the value of the marginal product of another worker would fall below the wage rate. For a larger farm with many employees, the value of the marginal product of labor falls only slightly when an additional worker is employed. As a result, there will be some worker whose value of the marginal product almost exactly equals the wage rate. (In keeping with the George and Martha example, this means that some worker generates a value of the marginal product of approximately $200.) In this case, the firm maximizes profit by choosing a level of employment at which the value of the marginal product of the last worker hired equals (to a very good approximation) the wage rate. In the interest of simplicity, we will assume from now on that firms use this rule to determine the profit-maximizing level of employment. This means that the value of the marginal product of labor curve is the individual firm’s labor demand curve. And in general, a firm’s value of the marginal product curve for any factor of production is that firm’s individual demand curve for that factor of production. Shifts of the Factor Demand Curve As in the case of ordinary demand curves, it is important
to distinguish between movements along the factor demand curve and shifts of the factor demand curve. What causes factor demand curves to shift? There are three main causes: 686 ■ Changes in the prices of goods ■ Changes in the supply of other factors ■ Changes in technology Changes in the Prices of Goods Remember that factor demand is derived demand: if the price of the good that is produced with a factor changes, so will the value of the marginal product of the factor. That is, in the case of labor demand, if P changes, VMPL = P × MPL will change at any given level of employment. Figure 69.4 illustrates the effects of changes in the price of wheat, assuming that $200 is the current wage rate. Panel (a) shows the effect of an increase in the price of wheat. This shifts the value of the marginal product of labor curve upward because VMPL rises at any given level of employment. If the wage rate remains unchanged at $200, the optimal point moves from point A to point B: the profit-maximizing level of employment rises. Panel (b) shows the effect of a decrease in the price of wheat. This shifts the value of the marginal product of labor curve downward. If the wage rate remains unchanged at $200, the optimal point moves from point A to point C: the profit-maximizing level of employment falls 69.4 Shifts of the Value of the Marginal Product Curve (a) An Increase in the Price of Wheat (b) A Decrease in the Price of Wheat Wage rate, VMPL Market wage rate $200 Wage rate, VMPL A B $200 C A VMPL2 VMPL1 VMPL1 VMPL3 0 5 8 Quantity of labor (workers) 0 2 5 Quantity of labor (workers) Panel (a) shows the effect of an increase in the price of wheat on George and Martha’s demand for labor. The value of the marginal product of labor curve shifts upward, from VMPL1 to VMPL2. If the market wage rate remains at $200, profit-maximizing employment rises from 5 workers to 8 workers, shown by the movement from point A to point B. Panel (b) shows the effect of a decrease in the price of wheat. The value of the marginal product of labor curve shifts downward, from VMPL1 to VMPL3. At the market wage rate of $200, profit-maximizing employment falls from 5 workers to 2 workers, shown by the movement from
point A to point C. Changes in the Supply of Other Factors Suppose that George and Martha acquire more land to cultivate—say, by clearing a woodland on their property. Each worker now produces more wheat because each one has more land to work with. As a result, the marginal product of labor on the farm rises at any given level of employment. This has the same effect as an increase in the price of wheat, which is illustrated in panel (a) of Figure 69.4: the value of the marginal product of labor curve shifts upward, and at any given wage rate the profit-maximizing level of employment rises. Similarly, suppose 687 George and Martha cultivate less land. This leads to a fall in the marginal product of labor at any given employment level. Each worker produces less wheat because each has less land to work with. As a result, the value of the marginal product of labor curve shifts downward—as in panel (b) of Figure 69.4—and the profit-maximizing level of employment falls. Changes in Technology In general, the effect of technological progress on the demand for any given factor can go either way: improved technology can either increase or decrease the demand for a given factor of production. How can technological progress decrease factor demand? Consider horses, which were once an important factor of production. The development of substitutes for horse power, such as automobiles and tractors, greatly reduced the demand for horses. The usual effect of technological progress, however, is to increase the demand for a given factor, often because it raises the marginal product of the factor. In particular, although there have been persistent fears that machinery would reduce the demand for labor, over the long run the U.S. economy has seen both large wage increases and large increases in employment, suggesting that technological progress has greatly increased labor demand. M o d u l e 69 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Suppose that the government places price controls on the market for college professors, imposing a wage that is lower than the market wage. Describe the effect of this policy on the production of college degrees. What sectors of the economy do you think would be adversely affected by this policy? What sectors of the economy might benefit? 2. a. Suppose service industries, such as retailing and banking, experience an increase in demand. These industries use relatively more labor than nonservice industries. Does the demand curve for labor shift to the right, shift to the left,
or remain unchanged? b. Suppose diminishing fish populations off the coast of Maine lead to policies restricting the use of the most productive types of nets in that area. The result is a decrease in the number of fish caught per day by commercial fishers in Maine. The price of fish is unaffected. Does the demand curve for fishers in Maine shift to the right, shift to the left, or remain unchanged? Tackle the Test: Multiple-Choice Questions 1. Which of the following is an example of physical capital? 3. Factor market demand is called a derived demand because it a. manual labor b. welding equipment c. d. lumber e. education farm land is derived from the market wage received by workers. is derived from the productivity of workers. a. derives its name from the Latin factorus. b. c. d. is derived from the product market. e. derives its shape from the price of the factor. 2. Which of the following can shift the factor demand curve to the 4. Which factor of production receives the largest portion of right? I. an increase in the price of the good being produced II. an increase in the factor’s marginal productivity III. a technological advance a. I only b. II only c. III only d. I and II only I, II, and III e. 688 land labor income in the United States? a. b. c. physical capital d. entrepreneurship e. interest. The individual firm’s demand curve for labor is a. the VMPL curve. b. upward sloping. c. horizontal at the level of the product price. d. vertical. e. equal to the MPL curve. 1 point: Axes are correctly labeled. 1 point: VMPL is downward sloping and labeled. 1 point: VMPL is plotted using correct numbers (see graph). 1 point: The demand curve for labor shifts to the right. 1 point: VMPL curve is shown shifted to the right. 1 point: The new quantities produced are 600; 1,100; 1,400; 1,600; 1,700; and 1,780. 2. Draw a separate, correctly labeled graph illustrating the effect of each of the following changes on the demand for labor. Adopt the usual ceteris paribus assumption that all else remains unchanged in each case. a. The price of the product being produced decreases. b. Worker productivity increases. c. Firms invest in more capital to be used by workers. Tackle the Test
: Free-Response Questions 1. Refer to the table below. Assume the firm can sell all of the Quantity of output output it produces at a price of $15. Quantity of labor (workers) 0 1 2 3 4 5 6 0 300 550 700 800 850 890 a. What is the value of the marginal product of labor of the 3rd worker? b. Draw a correctly labeled graph showing the firm’s demand curve for labor. c. What happens to the demand curve for labor if the price of the product increases to $20? Show the result on your graph from part b. d. Assume that a technological advance doubles the productivity of workers. Calculate the total quantity that will now be produced with each quantity of workers. Answer (7 points) 1 point: VMPL = 150 × $15 = $2,250 VMPL 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 VMPL2 VMPL1 0 1 2 3 4 5 6 Quantity of labor (workers 689 What you will learn in this Module: • How to determine supply and demand in the markets for land and capital • How to find equilibrium in the land and capital markets • How the demand for factors leads to the marginal productivity theory of income distribution Module 70 The Markets for Land and Capital In Figure 69.1 we saw the factor distribution of income and found that approximately 70% of total income in the economy took the form of compensation for employees. Because labor is such an important resource, it is often used as the example in discussions of factor markets. But land and capital are critical resources as well, and their markets have unique characteristics worthy of examination. In this module we look more closely at the markets for land and capital before moving on to discuss the labor market further in Module 71. Land and Capital In the previous module we used a labor market example to explain why a firm’s individual demand curve for a factor is its value of the marginal product curve. Now we look at the distinguishing characteristics of demand and supply in land and capital markets, and how the equilibrium price and quantity of these factors are determined. Demand in the Markets for Land and Capital If we maintain the assumption that the markets for goods and services are perfectly competitive, the result that we derived for demand in the labor market also applies to other factors of production. Suppose, for example, that a farmer is considering whether to rent an additional acre of
land for the next year. He or she will compare the cost of renting that acre with the value of the additional output generated by employing an additional acre—the value of the marginal product of an acre of land. To maximize profit, the farmer will rent more land up until the value of the marginal product of an acre of land is equal to the rental rate per acre. The same is true for capital: the decision of whether to rent an additional piece of equipment comes down to a comparison of the additional cost of the equipment with the value of the additional output it generates. What if the farmer already owns the land or the firm already owns the equipment? As discussed in Module 52 in the context of Babette’s Cajun Café, even if you own land 690 The rental rate of either land or capital is the cost, explicit or implicit, of using a unit of that asset for a given period of time or capital, there is an implicit cost—the opportunity cost—of using it for a given activity because it could be used for something else, such as renting it out to other firms at the market rental rate. So a profit-maximizing firm employs additional units of land and capital until the cost of the last unit employed, explicit or implicit, is equal to the value of the marginal product of that unit. We call the explicit cost of renting a unit of land or capital for a set period of time its rental rate. As with labor, due to diminishing returns, the value of the marginal product curve and therefore the individual firm’s demand curves for land and capital slope downward. Supply in the Markets for Land and Capital Figure 70.1 illustrates the markets for land and capital. The red curve in panel (a) is the supply curve for land. As we have drawn it, the supply curve for land is relatively steep and therefore relatively inelastic. This reflects the fact that finding new supplies of land for production is typically difficult and expensive—for example, creating new farmland through expensive irrigation. The red curve in panel (b) is the supply curve for capital. In contrast to the supply curve for land, the supply curve for capital is relatively flat and therefore relatively elastic. That’s because the supply of capital is relatively responsive to price: capital is typically paid for with the savings of investors, and the amount of savings that investors make available is relatively responsive to the rental rate for capital. As in the case of supply curves for goods and services, the supply curve for a factor of
production will shift as the factor becomes more or less available. For example, the supply of farmland could decrease as a result of a drought or the supply of capital could increase as a result of a government policy to promote investment. Because of diminishing returns, when the supply of land or capital changes, its marginal product will change. f i g u r e 70.1 Equilibria in the Land and Capital Markets Rental rate RLand (a) The Market for Land (b) The Market for Capital SLand Rental rate RCapital DLand SCapital DCapital QLand Quantity of land QCapital Quantity of capital Panel (a) illustrates equilibrium in the market for land; panel (b) illustrates equilibrium in the market for capital. The supply curve for land is relatively steep, reflecting the high cost of increasing the quantity of productive land. The supply curve for capital, in contrast, is relatively flat, due to the relatively high responsiveness of savings to changes in the rental rate for capital. The equilibrium rental rates for land and capital, as well as the equilibrium quantities transacted, are given by the intersections of the demand and supply curves. In a competitive land market, each unit of land will be paid the equilibrium value of the marginal product of land, R Land. Likewise, in a competitive capital market, each unit of capital will be paid the equilibrium value of the marginal product of capital, RCapital 691 According to the marginal productivity theory of income distribution, every factor of production is paid the equilibrium value of its marginal product. When the supply of land or capital decreases, the marginal product and rental rate increase. For example, if the number of available delivery trucks decreased, the additional benefit from the last truck used would be higher than before—it would serve more critical delivery needs—and firms would pay more for it. Likewise, when the supply of land or capital increases, the marginal product and rental rate decrease. Equilibrium in Land and Capital Markets The equilibrium rental rate and quantity in the land and capital markets are found at the intersection of the supply and demand curves in Figure 70.1. Panel (a) shows the equilibrium in the market for land. Summing all of the firm demand curves for land gives us the market demand curve for land. The equilibrium rental rate for land is RLand, and the equilibrium quantity of land employed in production is QLand. In a competitive land market, each unit of land will be paid the equilibrium value of the marginal product of land.
Panel (b) shows the equilibrium in the market for capital. The equilibrium rental rate for capital is RCapital, and the equilibrium quantity of capital employed in production is QCapital. In a competitive capital market, each unit of capital will be paid the equilibrium value of the marginal product of capital. Now that we know how equilibrium rental rates and quantities are determined in land and capital markets, we can learn how these markets influence the factor distribution of income. To do this, we look more closely at marginal productivity in factor markets. Marginal Productivity Theory The marginal productivity theory of income distribution sums up what we have learned about payments to factors when goods markets and factor markets are perfectly competitive. According to this theory, each factor is paid the value of the output generated by the last unit of that factor employed in the factor market as a whole—its equilibrium value of the marginal product. To understand why the marginal productivity theory of income distribution is important, look back at Figure 69.1, which shows the factor distribution of income in the United States, and ask yourself this question: who or what determined that labor would get 70.9% of total U.S. income? Why not 90% or 50%? The answer, according to this theory, is that the division of income among the economy’s factors of production isn’t arbitrary: in the economy-wide factor market, the price paid for each factor is equal to the increase in the value of output generated by the last unit of that factor employed in the market. If a unit of labor is paid more than a unit of capital, it is because at the equilibrium quantity of each factor, the value of the marginal product of labor exceeds the value of the marginal product of capital. So far we have treated factor markets as if every unit of each factor were identical. That is, as if all land were identical, all labor were identical, and all capital were identical. But in reality factors differ considerably with respect to productivity. For instance, land resources differ in their ability to produce crops and workers have different skills and abilities. Rather than thinking of one land market for all land resources in an economy, and similarly one capital market and one labor market, we can instead think of different markets for different types of land, capital, and labor. For example, the market for computer programmers is different from the market for pastry chefs. When we consider that there are separate factor markets for different types of factors, the marginal productivity theory of income distribution still holds. That is,
when the labor market for computer programmers is in equilibrium, the wage rate earned by all computer programmers is equal to the market’s equilibrium value of the marginal product—the value of the marginal product of the last computer programmer hired in that market. The 692 fyi Help Wanted! Hamill Manufacturing of Pennsylvania makes precision components for military helicopters and nuclear submarines. Their highly skilled senior machinists are well paid compared to other workers in manufacturing, earning nearly $70,000 in 2006, excluding benefits. Like most skilled machinists in the United States, Hamill’s machinists are very productive: according to the National Mechanists Association, in 2006 each skilled American machinist generated approximately $120,000 in yearly revenue. But there is a $50,000 difference between the salary paid to Hamill machinists and the revenue they generate. Does this mean that the marginal productivity theory of income distribution doesn’t hold? Doesn’t the theory imply that machinists should be paid $120,000, the average revenue that each one generates? The answer is no, for two reasons. First, the $120,000 figure is averaged over all machinists currently employed. The theory says that machinists will be paid the value of the marginal product of the last machinist hired, and due to diminishing returns to labor, that value will be lower than the average over all machinists currently employed. Second, a worker’s equilibrium wage rate includes other costs, such as employee benefits, that have to be added to the $70,000 salary. The marginal productivity theory of income distribution says that workers are paid a wage rate, including all benefits, equal to the value of the marginal product. At Hamill, the machinists have job security and good benefits, which add to their salary. Including these benefits, machinists’ total compensation will be equal to the value of the marginal product of the last machinist employed. In Hamill’s case, there is yet another factor that explains the $50,000 gap: there are not enough machinists at the current wage rate. Although the company increased the number of employees from 85 in 2004 to 110 in 2006, they would like to hire more. Why doesn’t Hamill raise its wages in order to attract more skilled machinists? The problem is that the work they do is so specialized that it is hard to hire from the outside, even when the company
raises wages as an inducement. To address this problem, Hamill is now spending a significant amount of money training each new hire. In the end, it does appear that the marginal productivity theory of income distribution holds. marginal productivity theory can explain the distribution of income among different types of land, labor, and capital as well as the distribution of income among the factors of production. In Module 73 we look more closely at the distribution of income between different types of labor and the extent to which the marginal productivity theory of income distribution explains differences in workers’ wages. M o d u l e 70 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain how each of the following events would affect the equilibrium rental rate and the equilibrium quantity in the land market. a. Developers improve the process of filling in coastal waters with rocks and soil to form large new areas of land. b. New fertilizers improve the productivity of each acre of farmland. 2. Explain the following statement: “When firms in different industries all compete for the same land, the value of the marginal product of the last unit of land rented will be equal across all firms, regardless of whether they are in different industries.” 693 Tackle the Test: Multiple-Choice Questions 1. The implicit cost of capital that you own is 4. A firm will continue to employ more land until its value of the a. the rental rate. b. greater than the rental rate. c. the original purchase price of the capital. d. greater than the original purchase price of the capital. e. zero because you already own it. 2. Which of the following is true in relation to a very steep supply curve for land? marginal product of land is a. zero. b. maximized. c. equal to the rental rate. d. equal to the wage rate. e. equal to the value of the marginal product of labor and capital. I. It is relatively elastic. II. The quantity of land is very responsive to price changes. III. Finding new supplies of land is relatively expensive and 5. According to the marginal productivity theory of income distribution, a. each unit of a factor will be paid the value of its marginal difficult. a. I only b. II only c. III only d. I and II only I, II, and III e. product. b. as more of a factor is used, its marginal productivity increases. c. factors that receive higher payments are less productive.
d. capital should receive the highest portion of factor income. e. each factor is paid the equilibrium value of its marginal 3. The explicit cost of land you don’t own is equal to the product. interest rate. a. rental rate. b. c. profit received from using that land. d. market wage rate. e. marginal product of land. Tackle the Test: Free-Response Questions 1. Refer to the table below. Assume that the price of the product is $10 and the rental rate for capital is $100 per unit. Quantity of capital (units) 0 1 2 3 4 5 6 Quantity of output 0 30 55 70 78 85 89 a. What is the VMP of the 2nd unit of capital? b. Will the firm employ the 2nd unit of capital? Explain. c. How many units of capital will the firm hire? Explain. Answer (5 points) 1 point: VMP = 25 × $10 = $250 1 point: Yes 1 point: Because the VMP of $250 is greater than the rental rate of $100 1 point: 3 1 point: Because the VMP exceeds the rental rate for the first 3 units 2. Draw a correctly labeled graph showing how the market rental rate and quantity of land are determined in the land market. On your graph, be sure to include each of the following: the supply and demand curves for land, the equilibrium rental rate, the equilibrium quantity of land employed, and correct labels on the axes. 694 Module 71 The Market for Labor In Module 69 we looked at the determinants of labor demand and how the wage rate influences the quantity of labor demanded by firms. Now we complete our development of the labor market model by adding the supply of labor and exploring the determination of equilibrium wage and quantity in the labor market. The Supply of Labor There are only 24 hours in a day, so to supply labor is to give up leisure, which presents a dilemma of sorts. For this and other reasons, as we’ll see, the labor market looks different from markets for goods and services. Work versus Leisure In the labor market, the roles of firms and households are the reverse of what they are in markets for goods and services. A good such as wheat is supplied by firms and demanded by households; labor, though, is demanded by firms and supplied by households. How do people decide how much labor to supply? As a practical matter, most people have limited control over their work hours: sometimes a worker has little
choice but to take a job for a set number of hours per week. However, there is often flexibility to choose among different careers and employment situations that involve varying numbers of work hours. There is a range of part-time and full-time jobs; some are strictly 9:00 A.M. to 5:00 P.M., others have much longer or shorter work hours. Some people work two jobs; others don’t work at all. And self-employed people have many work-hour options. To simplify our study of labor supply, we will imagine an individual who can choose to work as many or as few hours as he or she likes. Why wouldn’t such an individual work as many hours as possible? Because workers are human beings, too, and have other uses for their time. An hour spent on the job is an hour not spent on other, presumably more pleasant, activities. So the decision about how much labor to supply involves making a decision about time allocation— how many hours to spend on different activities. By working, people earn income that they can use to buy goods. The more hours an individual works, the more goods he or she can afford to buy. But this increased purchasing What you will learn in this Module: • The way in which a worker’s decision about time preference gives rise to labor supply • How to find equilibrium in the labor market Decisions about labor supply result from decisions about time allocation: how many hours to spend on different activities 695 power comes at the expense of a reduction in leisure, the time spent not working. (Leisure doesn’t necessarily mean time goofing off. It could mean time spent with one’s family, pursuing hobbies, exercising, and so on.) And though purchased goods yield utility, so does leisure. Indeed, we can think of leisure itself as a normal good, which most people would like to consume more of as their incomes increase. How does a rational individual decide how much leisure to consume? By making a marginal comparison, of course. In analyzing consumer choice, we asked how a utility-maximizing consumer uses a marginal dollar. In analyzing labor supply, we ask how an individual uses a marginal hour. Consider Clive, an individual who likes both leisure and the goods money can buy. Suppose that his wage rate is $10 per hour. In deciding how many hours he wants to work, he must compare the marginal utility of an additional hour of leisure with the additional utility he gets from $10 worth
of goods. If $10 worth of goods adds more to his total utility than an additional hour of leisure, he can increase his total utility by giving up an hour of leisure in order to work an additional hour. If an extra hour of leisure adds more to his total utility than $10 worth of goods, he can increase his total utility by working one fewer hour in order to gain an hour of leisure. At Clive’s optimal level of labor supply, then, the marginal utility he receives from one hour of leisure is equal to the marginal utility he receives from the goods that his hourly wage can purchase. This is very similar to the optimal consumption rule we encountered previously, except that it is a rule about time rather than money. Our next step is to ask how Clive’s decision about time allocation is affected when his wage rate changes. Wages and Labor Supply Suppose that Clive’s wage rate doubles, from $10 to $20 per hour. How will he change his time allocation? You could argue that Clive will work longer hours because his incentive to work has increased: by giving up an hour of leisure, he can now gain twice as much money as before. But you could equally well argue that he will work less because he doesn’t need to work as many hours to generate the income required to pay for the goods he wants. As these opposing arguments suggest, the quantity of labor Clive supplies can either rise or fall when his wage rate rises. To understand why, let’s recall the distinction between substitution effects and income effects. We have seen that a price change affects consumer choice in two ways: by changing the opportunity cost of a good in terms of other goods (the substitution effect) and by making the consumer richer or poorer (the income effect). Now think about how a rise in Clive’s wage rate affects his demand for leisure. The opportunity cost of leisure—the amount of money he gives up by taking an hour off instead of working—rises. That substitution effect gives him an incentive, other things equal, to consume less leisure and work longer hours. Conversely, a higher wage rate makes Clive richer—and this income effect leads him, other things equal, to want to consume more leisure and supply less labor because leisure is a normal good. So in the case of labor supply, the substitution effect and the income effect work in opposite directions. If the substitution effect is so powerful that it dominates the income effect, an increase in Clive’s wage rate leads him to
supply more hours of labor. If the income effect is so powerful that it dominates the substitution effect, an increase in the wage rate leads him to supply fewer hours of labor. We see, then, that the individual labor supply curve—the relationship between the wage rate and the number of hours of labor supplied by an individual worker—does not necessarily slope upward. If the income effect dominates, a higher wage rate will reduce the quantity of labor supplied Leisure is time available for purposes other than earning money to buy marketed goods. The individual labor supply curve shows how the quantity of labor supplied by an individual depends on that individual’s wage rate. 696 Figure 71.1 illustrates the two possibilities for labor supply. If the substitution effect dominates the income effect, the individual labor supply curve slopes upward; panel (a) shows an increase in the wage rate from $10 to $20 per hour leading to a rise in the number of hours worked from 40 to 50. However, if the income effect dominates, the quantity of labor supplied goes down when the wage rate increases. Panel (b) shows the same rise in the wage rate leading to a fall in the number of hours worked from 40 to 30. Economists refer to an individual labor supply curve that contains both upwardsloping and downward-sloping segments as a “backward-bending labor supply curve.” At lower wage rates, the substitution effect dominates the income effect. At higher wage rates, the income effect eventually dominates the substitution effect 71.1 The Individual Labor Supply Curve (a) The Substitution Effect Dominates (b) The Income Effect Dominates Wage rate $20 10 0 Individual labor supply curve Wage rate $20 10 0 40 50 Quantity of labor (hours) Individual labor supply curve 30 40 Quantity of labor (hours) When the substitution effect of a wage increase dominates the income effect, the individual labor supply curve slopes upward, as in panel (a). Here a rise in the wage rate from $10 to $20 per hour increases the number of hours worked from 40 to 50. But when the income effect of a wage increase dominates the substitution effect, the individual labor supply curve slopes downward, as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30. Is a backward-bending labor supply curve a real possibility? Yes: many labor economists believe that income effects on the supply of labor may be somewhat stronger than substitution effects at high wage rates. The most compelling piece of evidence for this
belief comes from Americans’ increasing consumption of leisure over the past century. At the end of the nineteenth century, wages adjusted for inflation were only about one-eighth what they are today; the typical work week was 70 hours, and very few workers retired at age 65. Today the typical work week is less than 40 hours, and most people retire at age 65 or earlier. So it seems that Americans have chosen to take advantage of higher wages in part by consuming more leisure. Shifts of the Labor Supply Curve Now that we have examined how income and substitution effects shape the individual labor supply curve, we can turn to the market labor supply curve. In any labor market, the market supply curve is the horizontal sum of the individual labor supply curves of 697 all workers in that market. A change in any factor other than the wage that alters workers’ willingness to supply labor causes a shift of the labor supply curve. A variety of factors can lead to such shifts, including changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth. Changes in Preferences and Social Norms Changes in preferences and social norms can lead workers to increase or decrease their willingness to work at any given wage. A striking example of this phenomenon is the large increase in the number of employed women—particularly married, employed women—that has occurred in the United States since the 1960s. Until that time, women who could afford to largely avoided working outside the home. Changes in preferences and norms in post–World War II America (helped along by the invention of labor-saving home appliances such as washing machines, the trend for more people to live in cities, and higher female education levels) have induced large numbers of American women to join the workforce—a phenomenon often observed in other countries that experience similar social and technological changes. Changes in Population Changes in the population size generally lead to shifts of the labor supply curve. A larger population tends to shift the labor supply curve rightward as more workers are available at any given wage; a smaller population tends to shift the labor supply curve leftward due to fewer available workers. Currently the size of the U.S. labor force grows by approximately 1% per year, a result of immigration from other countries and, in comparison to other developed countries, a relatively high birth rate. As a result, the labor supply curve in the United States is shifting to the right. Changes in Opportunities At one time, teaching was the only occupation considered suitable for well-educated women. However, as
opportunities in other professions opened up to women starting in the 1960s, many women left teaching and chose other careers. This generated a leftward shift of the supply curve for teachers, reflecting a fall in the willingness to work at any given wage and forcing school districts to pay more to maintain an adequate teaching staff. These events illustrate a general result: when superior alternatives arise for workers in another labor market, the supply curve in the original labor market shifts leftward as workers move to the new opportunities. Similarly, when opportunities diminish in one labor market—say, layoffs in the manufacturing industry due to increased foreign competition—the supply in alternative labor markets increases as workers move to these other markets. Changes in Wealth A person whose wealth increases will buy more normal goods, including leisure. So when a class of workers experiences a general increase in wealth—say, due to a stock market boom—the income effect from the wealth increase will shift the labor supply curve associated with those workers leftward as workers consume more leisure and work less. Note that the income effect caused by a change in wealth shifts the labor supply curve, but the income effect from a wage rate increase—as we discussed in the case of the individual labor supply curve—is a movement along the labor supply curve. The following FYI illustrates how such a change in the wealth levels of many families during the late 1990s led to a shift of the market labor supply curve associated with their employable children. Women now choose among myriad careers. Equilibrium in the Labor Market Now that we have discussed the labor supply curve, we can use the supply and demand curves for labor to determine the equilibrium wage and level of employment in the labor market 698 fyi The Decline of the Summer Job Come summertime, resort towns along the New Jersey shore find themselves facing a recurring annual problem: a serious shortage of lifeguards. Traditionally, lifeguard positions, together with many other seasonal jobs, have been filled mainly by high school and college students. But in recent years a growing number of young Americans have chosen not to take summer jobs. In 1979, 71% of Americans between the ages of 16 and 19 were in the summer workforce. Twenty years later that number had fallen to 63%; and by 2009, it was 33%. Data show that young men in particular have become much less willing to take summer jobs. One explanation for the decline in the summer labor supply is that more students feel they should devote their summers to additional study. But an important factor in the decline is increasing household affluence. As a result
, many teenagers no longer feel pressured to contribute to household finances by taking a summer job; that is, the income effect leads to a reduced labor supply. Another factor points to the substitution effect: increased competition from immigrants, who are now doing the jobs typically done by teenagers (mowing lawns, delivering pizzas), has led to a decline in wages. So many teenagers forgo summer work and consume leisure instead. Figure 71.2 illustrates the labor market as a whole. The market labor demand curve, like the market demand curve for a good, is the horizontal sum of all the individual labor demand curves of all the firms that hire labor. And recall that a price-taking firm’s labor demand curve is the same as its value of the marginal product of labor curve. As discussed above, the labor supply curve is upward sloping. The equilibrium wage rate is the wage rate at which the quantity of labor supplied is equal to the quantity of labor demanded. In Figure 71.2, this leads to an equilibrium wage rate of W* and the corresponding equilibrium employment level of L. (The equilibrium wage rate is also known as the market wage rate.) But this labor market assumes we have perfect competition in both the product market and the factor market. What if either the product or factor market is not perfectly competitive? f i g u r e 71.2 Equilibrium in the Labor Market The market labor demand curve is the horizontal sum of the individual labor demand curves of all producers. Here the equilibrium wage rate is W , the equilibrium employment level is L, and every producer hires labor up to the point at which VMPL = W . So labor is paid its equilibrium value of the marginal product, that is, the value of the marginal product of the last worker hired in the labor market as a whole. Wage rate Equilibrium value of the marginal product of labor W* Market labor supply curve Market labor demand curve Quantity of labor (workers) E L* Equilibrium employment 699 When the Product Market Is Not Perfectly Competitive When the product market is perfectly competitive, the wage rate is equal to the value of the marginal product of labor at equilibrium. In other market structures this is not the case. For example, in a monopoly, the demand curve for the product faced by the mon opolist slopes downward. This means that to sell an additional unit of output, the monopolist must lower the price. As a result, the additional revenue received from selling one more unit for a monopolist is not simply the price
like it was for a perfect competitor. It is less than the price by the amount of the price effect explained previously—the decreased revenue on units that could have been sold at a higher price if the price hadn’t been lowered to sell another unit. How does this affect hiring? To determine its demand for workers, the monopolist must multiply the marginal product of labor by the marginal revenue received from selling the additional output. This is called the marginal revenue product of labor or MRPL. (71-1) MRPL = MPL × MR Table 71.1 shows the calculation of a firm’s marginal revenue product of labor. t a b l e 71.1 Marginal Revenue Product of Labor with Imperfect Competition in the Product Market Quantity of Labor (L) Quantity of Output (Q) Marginal Product of labor (MPL) Product Price (P ) Total Revenue (TR ) P Q Marginal Revenue (MR) ΔTR/ΔQ Marginal Revenue Product of labor (MRPL) MPLMR 0 1 2 3 4 5 0 10 19 27 34 40 10 9 8 7 6 $10.00 9.80 9.60 9.40 9.20 $0.00 100.00 186.20 259.20 319.60 368.00 $10.00 $100.00 9.58 9.13 8.63 8.07 86.20 73.00 60.40 48.40 For a perfectly competitive firm, marginal revenue equals price, so VMPL and MRPL are equivalent. The two concepts measure the same thing: the value to the firm of hiring an additional worker. The term MRPL is a more general term that applies to firms in both perfect competition and imperfect competition. The general rule is that a profitmaximizing firm in an imperfectly competitive product market employs each factor of production up to the point at which the marginal revenue product of the last unit of the factor employed is equal to that factor’s cost. In the case of a firm operating in an imperfectly competitive product market, the demand curve for a factor is the marginal revenue product curve, as shown in Figure 71.3. When the Labor Market Is Not Perfectly Competitive There are also important differences when considering an imperfectly competitive labor market rather than a perfectly competitive labor market. One major difference is the marginal factor cost. The marginal factor cost is the additional cost of hiring one more unit of a factor of production. For example, the marginal factor cost of labor (MFC
L) is the additional cost of hiring one more unit of labor. With perfect competition in the labor market, each firm is so small that it can hire as much labor as it wants at the market wage. The firm’s hiring decision does not affect the market. This means The demand curve for labor for a firm operating in an imperfectly competitive product market is the marginal revenue product of labor curve. The marginal revenue product of labor (MRPL) is equal to the marginal product of labor times the marginal revenue received from selling the additional output. The marginal revenue product of land and the marginal revenue product of capital are equivalent concepts. The marginal factor cost of labor (MFCL) is the additional cost of hiring an additional worker. The marginal factor cost of land and the marginal factor cost of capital are equivalent concepts. 700 71.3 Firm Labor Demand with Imperfect Competition A firm’s labor demand curve is the marginal revenue product of labor curve, which differs from the value of the marginal product of labor curve when there is imperfect competition in the product market (as with a monopoly, for example). With perfect competition, the marginal revenue product of labor (MPL × MR ) and the value of the marginal product of labor (MPL × P ) are the same because MR = P. Wage rate, MRPL Labor demand curve, MRPL Quantity of labor (workers) that with perfect competition in the labor market, the additional cost of hiring another worker (the MFCL) is always equal to the market wage, and the labor supply curve faced by an individual firm is horizontal, as shown in Figure 71.4. The labor supply curve faced by a firm is very different in a labor market characterized by imperfect competition: it is upward sloping and the marginal factor cost is above the market wage. Unlike a perfect competitor that is small and cannot affect the market, a firm in an imperfectly competitive labor market is large enough to affect the market wage. For example, a labor market in which there is only one firm hiring labor is called a monopsony. A monopsonist is the single buyer of a factor. Perhaps you’ve A monopsonist is a single buyer in a factor market. A market in which there is a monopsonist is a monopsony. f i g u r e 71.4 Firm Labor Supply in a Perfectly Competitive Labor Market In a perfectly competitive labor market, the labor supply curve faced by an individual firm is horizontal at the market equilibrium wage because the firm
is so small relative to the market that it can hire all the labor that it wants at the market wage. For this reason, the labor supply curve for a firm in a perfectly competitive labor market is equivalent to the marginal factor cost of labor curve. Wage rate, MFCL Equilibrium market wage W* Firm labor supply curve, Marginal factor cost of labor Quantity of labor (workers 701 seen a small town where one firm, such as a meatpacking company or a lumber mill, hires most of the labor—that’s an example of a monopsony. Since the firm already hires most of the available labor in the town, if it wants to hire more workers it has to offer higher wages to attract them. The higher wages go to all workers, not just the workers hired last. Therefore, the additional cost of hiring an additional worker (MFCL) is higher than the wage: it is the wage plus the raises paid to all workers. The calculation of MFCL is shown in Table 71.2. t a b l e 71.2 Marginal Factor Cost of Labor with Imperfect Competition in the Labor Market Quantity of Labor (L) 0 1 2 3 4 5 Wage (W ) $0 6 7 8 9 10 Total Labor Cost ( L W ) Marginal Factor Cost of Labor (MFCL) $0 6 14 24 36 50 $6 8 10 12 14 The fact that a firm in an imperfectly competitive labor market must raise the wage to hire more workers means that the MFCL curve is above the labor supply curve, as shown in Figure 71.5. The explanation for this is similar to the explanation for why the monopolist’s marginal revenue curve is below the demand curve. To sell one more, the monopolist has to lower the price, so the additional revenue is the price minus the losses on the units that would otherwise sell at the higher price. f i g u r e 71.5 Supply of Labor and Marginal Factor Cost in an Imperfectly Competitive Market The marginal factor cost of labor curve is above the market labor supply curve because, to hire more workers in an imperfectly competitive labor market (such as a monopsony), the firm must raise the wage and pay everyone more. This makes the additional cost of hiring another worker higher than the wage rate. Wage rate, MFCL Marginal factor cost of labor Market labor supply curve 702 Quantity of labor (workers Here, to hire an additional worker, the monopolist has to raise the
wage, so the marginal factor cost is the wage plus the wage increase for those workers who could otherwise be hired at the lower wage. Equilibrium in the Imperfectly Competitive Labor Market In a perfectly competitive labor market, firms hire labor until the value of the marginal product of labor equals the market wage. With imperfect competition in a factor market, a firm will hire additional workers until the marginal revenue product of labor equals the marginal factor cost of labor. Note that the marginal revenue product of labor for a perfectly competitive firm is the same as the value of the marginal product of labor and that the marginal factor cost of labor for a perfectly competitive firm is the market wage. The terms marginal revenue product and marginal factor cost are generally applicable to the analysis of any market structure. The terms we used previously, value of the marginal product and wage, refer to the specific cases of perfect competition in the product market and labor market respectively. Thus, we can generalize and say that every firm hires workers up to the point at which the marginal revenue product of labor equals the marginal factor cost of labor: (71-2) Hire workers until MRPL = MFCL Equilibrium in the labor market with imperfect competition is shown in Figure 71.6. Once an imperfectly competitive firm has determined the optimal number of workers to hire, L, it finds the wage necessary to hire that number of workers by starting at the point on the labor supply curve above the optimal number of workers, and looking straight to the left to see the wage level at that point, W. Let’s put the information we just learned together, again referring to Figure 71.6: The labor demand curve is the marginal revenue product curve. In an imperfectly competitive labor market, the firm must offer a higher wage to hire more workers, so f i g u r e 71.6 Equilibrium in the Labor Market with Imperfect Competition The equilibrium quantity of labor is found where the marginal revenue product of labor equals the marginal factor cost, at L. The equilibrium wage, W , is found on the vertical axis at the height of the market supply curve directly above L. Wage rate, MFCL, MRPL W Marginal factor cost of labor Market labor supply curve Market labor demand curve, MRPL Quantity of labor (workers) L* Equilibrium employment 703 the marginal factor cost curve is above the labor supply curve. The equilibrium quantity of labor is found where the marginal revenue product equals the marginal factor cost, as represented by L* on the graph
. The firm will pay the wage required to hire L* workers, which is found on the supply curve above L. The labor supply curve shows that the quantity of labor supplied is equal to L at a wage of W. The equilibrium wage in the market is thus W. Note that, unlike the wage in a perfectly competitive labor market, the wage in the imperfectly competitive labor market is less than the marginal factor cost of labor. In Modules 69–71 we have learned how firms determine the optimal amount of land, labor, or capital to hire in factor markets. But often there are different combinations of factors that a firm can use to produce the same level of output. In the next module, we look at how a firm chooses between alternative input combinations for producing a given level of output. M o d u l e 71 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Formerly, Clive was free to work as many or as few hours per week as he wanted. But a new law limits the maximum number of hours he can work per week to 35. Explain under what circumstances, if any, he is made a. worse off. b. equally well off. c. better off. Tackle the Test: Multiple-Choice Questions 1. Which of the following is necessarily true if you work more when your wage rate increases? a. The income effect is large. b. The substitution effect is small. c. The income effect dominates the substitution effect. d. The substitution effect dominates the income effect. e. The income effect equals the substitution effect. 2. Which of the following will cause you to work more as your wage rate decreases? I. the income effect II. the substitution effect III. a desire for leisure a. I only b. II only III only c. d. I and II only I, II, and III e. 3. Which of the following will shift the supply curve for labor to the right? a. a decrease in the labor force participation rate of women b. a decrease in population c. an increase in wealth 704. Explain in terms of the income and substitution effects how a fall in Clive’s wage rate can induce him to work more hours than before. d. a decrease in the opportunity cost of leisure e. an increase in labor market opportunities for women 4. An increase in the wage rate will a. shift the labor supply curve to the right. b. shift the labor supply curve to the left.
c. cause an upward movement along the labor supply curve. d. cause a downward movement along the labor supply curve. e. have no effect on the quantity of labor supplied. 5. The factor demand curve for a firm in an imperfectly competitive factor market is the same as which of the following curves? a. VMP b. MPP c. MFC d. MRP e. MP Tackle the Test: Free-Response Questions 1. Assume the demand curve for a firm’s product is as shown below and that the firm can hire as many workers as it wants for a wage of $80 per day. Firm demand Price $ Answer (8 points) 1 point: The firm hires labor in a perfectly competitive labor market. 1 point: The firm is a price-taker in the labor market. (It can hire all that it wants for $80 per day.) 1 point: The firm sells its good in a perfectly competitive product market. 1 point: The horizontal demand curve indicates that the firm is a price-taker in the product market (it can sell all the output it wants at the market price of $5). 1 point: the additional cost of hiring one more unit of a factor 1 point: $80 1 point: $100 Quantity of output 1 point: MRPL = MPL × MR, MPL = 20, MR = $5, so MRPL = 20 × $5 = $100. a. What is the market structure of the factor market in which the firm hires labor? Explain. b. What is the market structure of the product market in which the firm sells its good? Explain. c. Define marginal factor cost. What is the marginal factor cost of labor for this firm? d. If the last worker hired produces an additional 20 units of output, what is the last worker’s MRPL? Explain. 2. a. Draw a correctly labeled graph showing a perfectly competitive labor market in equilibrium. On your graph, be sure to label the labor demand curve, the labor supply curve, marginal revenue product of labor, the equilibrium wage (W), and the equilibrium quantity of labor (L). b. On your graph, illustrate how a decrease in the price of the product made by the firm would affect the equilibrium wage and quantity of labor. Label the resulting wage rate W2 and the resulting quantity of labor L2 705 What you will learn in this Module: • How firms determine the optimal input mix • The cost-minimizing rule
for hiring inputs Module 72 The Cost-Minimizing Input Combination In the past three modules we discussed the markets for factors of production—land, capital, and labor—and how firms determine the optimal quantity of each factor to hire. But firms don’t determine how much of each input to hire separately. Production requires multiple inputs, and firms must decide what combination of inputs to use to produce their output. In this module, we will look at how firms decide the optimal combination of factors for producing the desired level of output. Alternative Input Combinations In many instances a firm can choose among a number of alternative combinations of inputs that will produce a given level of output. For example, on George and Martha’s wheat farm, the decision might involve labor and capital. To produce their optimal quantity of wheat, they could choose to have a relatively capital-intensive operation by investing in several tractors and other mechanized farm equipment and hiring relatively little labor. Alternatively, they could have a more labor-intensive operation by hiring a lot of workers to do much of the planting and harvesting by hand. The same amount of wheat can be produced using many different combinations of capital and labor. George and Martha must determine which combination of inputs will maximize their profits. To begin our study of the optimal combination of inputs, we’ll look at the relationship between the inputs used for production. Depending on the situation, inputs can be either substitutes or complements. Substitutes and Complements in Factor Markets In Section 2 we discussed substitutes and complements in the context of the supply and demand model. Two goods are substitutes if a rise in the price of one good makes consumers more willing to buy the other good. For example, an increase in the price of oranges will cause some buyers to switch from purchasing oranges to purchasing 706 tangerines. When buyers tend to consume two goods together, the goods are known as complements. For example, cereal and milk are considered complements because many people consume them together. If the price of cereal increases, people will buy less cereal and therefore need less milk. The decision about how much of a good to buy is influenced by the prices of related goods. The concepts of substitutes and complements also apply to a firm’s purchase of inputs. And just as the price of related goods affects consumers’ purchasing decisions, the price of other inputs can affect a firm’s decision about how much of an input it will use. In some situations, capital and labor are substitutes. For example
, George and Martha can produce the same amount of wheat by substituting more tractors for fewer farm workers. Likewise, ATM machines can substitute for bank tellers. Capital and labor can also be complements when more of one increases the marginal product of the other. For example, a farm worker is more productive when George and Martha buy a tractor, and each tractor requires a worker to drive it. Office workers are more productive when they can use faster computers, and doctors are more productive with modern X-ray machines. In these cases the quantity and quality of capital available affect the marginal product of labor, and thus the demand for labor. Given the relationship between inputs, how does a firm determine which of the possible combinations to use Determining the Optimal Input Mix If several alternative input combinations can be used to produce the optimal level of output, a profit-maximizing firm will select the input combination with the lowest cost. This process is known as cost minimization. Cost Minimization How does a firm determine the combination of inputs that maximizes profits? Let’s consider this question using an example. Imagine you manage a grocery store chain and you need to decide the right combination of self-checkout stations and cashiers at a new store. Table 72.1 shows the alternative combinations of capital (self-checkout stations) and labor (cashiers) you can hire to check out customers shopping at the store. If the store puts in 20 selfcheckout stations, you will need to hire 1 cashier to monitor every 5 stations for a total of 4 cashiers. However, trained cashiers are faster than customers at scanning goods, so the store could check out the same number of customers using 10 cashiers and only 10 self-checkout stations. If you can check out the same number of customers using either of these combinations of capital and labor, how do you decide which combination of inputs to use? By finding the input combination that costs the least—the cost-minimizing input combination. t a b l e 72.1 Cashiers and Self-Checkout Stations Capital (self-checkout stations) Labor (cashiers) Rental rate = $1,000/month Wage rate = $1,600/month a. b. 20 10 4 10 707 Assume that the cost to rent, operate, and maintain a self-checkout station for a month is $1,000 and hiring a cashier costs $1,600 per month. The cost of each input
combination from Table 72.1 is shown below. a. cost of capital cost of labor TOTAL b. cost of capital cost of labor TOTAL 20 × $1,000 = $20,000 4 × $1,600 = $ 6,400 $26,400 10 × $1,000 = $10,000 10 × $1,600 = $16,000 $26,000 Clearly, your firm would choose the lower cost combination, combination b, and hire 10 cashiers and put in 10 self-checkout stations. When firms must choose between alternative combinations of inputs, they evaluate the cost of each combination and select the one that minimizes the cost of production. This can be done by calculating the total cost of each alternative combination of inputs, as shown in this example. However, because the number of possible combinations can be very large, it is more practical to use marginal analysis to find the costminimizing level of output–which brings us to the cost-minimization rule. The Cost-Minimization Rule We already know that the additional output that results from hiring an additional unit of an input is the marginal product (MP) of that input. Firms want to receive the highest possible marginal product from each dollar spent on inputs. To do this, firms adjust their hiring of inputs until the marginal product per dollar is equal for all inputs. This is the cost-minimization rule. When the inputs are labor and capital, this amounts to equating the marginal product of labor (MPL) per dollar spent on wages to the marginal product of capital (MPK) per dollar spent to rent capital: (72-1) MPL/Wage = MPK/Rental rate To understand why cost minimization occurs when the marginal product per dollar is equal for all inputs, let’s start by looking at two counterexamples. Consider a situation in which the marginal product of labor per dollar is greater than the marginal product of capital per dollar. This situation is described by Equation 72-2: (72-2) MPL/Wage > MPK/Rental rate Suppose the marginal product of labor is 20 units and the marginal product of capital is 100 units. If the wage is $10 and the rental rate for capital is $100, then the marginal product per dollar will be 20/$10 = 2 units of output per dollar for labor and 100/$100 = 1 units of output per dollar for capital. The firm is receiving 2 additional units of output
for each dollar spent on labor and only 1 additional unit of output for each dollar spent on capital. In this case, the firm gets more additional output for its money by hiring labor, so it should hire more labor and less capital. Because of diminishing returns, as the firm hires more labor, the marginal product of labor falls and as it hires less capital, the marginal product of capital rises. The firm will continue to substitute labor for capital until the falling marginal product of labor per dollar meets the rising marginal product of capital per dollar and the two are equivalent. That is, the firm will adjust its hiring of capital and labor until the marginal product per dollar spent on each input is equal, as in Equation 72-1. Next, consider a situation in which the marginal product of capital per dollar is greater than the marginal product of labor per dollar. This situation is described by Equation 72-3: (72-3) MPL/Wage < MPK/Rental rate © Self-checkout lines have reduced the need for many stores to hire extra cashiers. A firm determines the cost-minimizing combination of inputs using the cost-minimization rule: hire factors so that the marginal product per dollar spent on each factor is the same. 708 Let’s continue with the assumption that the marginal product of labor for the last unit of labor hired is 20 units and the marginal product of capital for the last unit of capital hired is 100 units. If the wage is $10 and the rental rate for capital is $25, then the marginal product per dollar will be 20/$10 = 2 units of output per dollar for labor and 100/$25 = 4 units of output per dollar for capital. The firm is receiving 4 additional units of output for each dollar spent on capital and only 2 additional units of output for each dollar spent on labor. In this case, the firm gets more additional output for its money by hiring capital, so it should hire more capital and less labor. Because of diminishing returns, as the firm hires more capital, the marginal product of capital falls, and as it hires less labor, the marginal product of labor rises. The firm will continue to hire more capital and less labor until the falling marginal product of capital per dollar meets the rising marginal product of labor per dollar to satisfy the costminimization rule. That is, the firm will adjust its hiring of capital and labor until the marginal product per dollar spent on each input is equal. The cost-minimization rule is analogous
to the optimal consumption rule (introduced in Module 51), which has consumers maximize their utility by choosing the combination of goods so that the marginal utility per dollar is equal for all goods. So far in this section we have learned how factor markets determine the equilibrium price and quantity in the markets for land, labor, and capital and how firms determine the combination of inputs they will hire. But how well do these models of factor markets explain the distribution of factor incomes in our economy? In Module 70 we considered how the marginal productivity theory of income distribution explains the factor distribution of income. In the final module in this section we look at the distribution of income in labor markets and consider to what extent the marginal productivity theory of income distribution explains wage differences. M o d u l e 72 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. A firm produces its output using only capital and labor. Labor costs $100 per worker per day and capital costs $200 per unit per day. If the marginal product of the last worker employed is 500 and the marginal product of the last unit of capital employed is 1,000, is the firm employing the cost-minimizing combination of inputs? Explain. Tackle the Test: Multiple-Choice Questions 1. An automobile factory employs either assembly line workers or robotic arms to produce automobile engines. In this case, labor and capital are considered independent. a. b. complements. c. substitutes. d. supplements. e. human capital. 3. If the marginal product of labor per dollar is greater than the marginal product of capital per dollar, which of the following is true? The firm should a. not change its employment of capital and labor. b. hire more capital. c. hire more labor. d. hire less labor. e. hire more capital and labor. 2. If an increase in the amount of capital employed by a firm leads 4. The cost-minimization rule states that costs are minimized to an increase in the marginal product of labor, labor and capital are considered independent. a. b. complements. c. substitutes. d. supplements. e. human capital. when a. MP per dollar is equal for all factors. b. (MP × P) is equal for all factors. c. each factor’s MP is the same. d. MRP is maximized. e. MFC is minimized 709 5. A firm currently produces its desired level of output. Its marginal product of labor is 400
, its marginal product of capital is 1,000, the wage rate is $20 and the rental rate of capital is $100. In that case, the firm should a. employ more capital and more labor. b. employ less labor and less capital. c. employ less labor and more capital. d. employ less capital and more labor. e. not change its allocation of capital and labor. Tackle the Test: Free-Response Questions 1. Answer the following questions under the assumption that firms use only two inputs and seek to maximize profit. a. Would it be wise for a firm that does not have the cost-minimizing combination of inputs to hire more of the input with the highest marginal product and less of the input with the lowest marginal product? Explain. b. What is the cost-minimization rule? c. When a firm hires more labor and less capital, what happens to the marginal product of labor per dollar and the marginal product of capital per dollar? Explain. Answer (5 points) 1 point: No 1 point: The input with the highest marginal product might be much more expensive than the input with the lowest marginal product, making the marginal product per dollar higher for the input with the lowest marginal product. When that is the case, costs would be lower if the firm hired more of the input with the lowest marginal product (but the highest marginal product per dollar) and less of the input with the highest marginal product (but the lowest marginal product per dollar.) 1 point: The cost-minimization rule says that firms should adjust their hiring of inputs to equalize the marginal product per dollar spent on each input. 1 point: The marginal product of labor per dollar decreases and the marginal product of capital per dollar increases. 1 point: Each factor has diminishing marginal returns. So when more labor is hired, the marginal product of labor (and thus the marginal product of labor per dollar) decreases. Likewise, when less capital is hired, the marginal product of capital (and thus the marginal product of capital per dollar) increases because the units of capital that are given up had a lower marginal product than those that remain. 2. Refer to the table below. Assume that the wage is $10 per day and the price of pencils is $1. Quantity of labor (workers) 0 1 2 3 4 5 6 7 Quantity of pencils produced 0 40 90 120 140 150 160 166 a. What is the MPL of the 4th worker? b. What is the MPL per
dollar of the 5th worker? c. How many workers would the firm hire if it hired every worker for whom the marginal product per dollar is greater than or equal to 1 pencil per dollar? d. If the marginal product per dollar spent on labor is 1 pencil per dollar, the marginal product of the last unit of capital hired is 100 pencils per dollar, and the rental rate is $50 per day, is the firm minimizing its cost? Explain. 710 Module 73 Theories of Income Distribution In Module 70, we introduced the factor distribution of income and explained how the marginal productivity theory of income distribution helps to explain how income is divided among factors of production in an economy. We also considered how the markets for factors of production are broken down. There are different markets for different types of factors. For example, there are different labor markets for different types of labor, such as for computer programmers, pastry chefs, and economists. In this module, we look at the marginal productivity theory of income distribution and the extent to which it explains wage disparities between workers. The Marginal Productivity Theory of Income Distribution According to the marginal productivity theory of income distribution, the division of income among the economy’s factors of production is determined by each factor’s marginal productivity at the market equilibrium. If we consider an economy-wide factor market, the price paid for all factors in the economy is equal to the increase in the value of output generated by the last unit of the factor employed in the market. But what about the distribution of income among different labor markets and workers? Does the marginal productivity theory of income distribution help to explain why some workers earn more than others? Marginal Productivity and Wage Inequality A large part of the observed inequality in wages can be explained by considerations that are consistent with the marginal productivity theory of income distribution. In particular, there are three well-understood sources of wage differences across occupations and individuals. The first is the existence of compensating differentials: across different types of jobs, wages are often higher or lower depending on how attractive or unattractive the What you will learn in this Module: • Labor market applications of the marginal productivity theory of income distribution • Sources of wage disparities and the role of discrimination Compensating differentials are wage differences across jobs that reflect the fact that some jobs are less pleasant or more dangerous than others 711 The equilibrium value of the marginal product of a factor is the additional value produced by the last unit of that factor employed in the factor market as a whole. job is. Workers
in unpleasant or dangerous jobs receive a higher wage than workers in jobs that require the same skill, training, and effort but lack the unpleasant or dangerous qualities. For example, truckers who haul hazardous chemicals are paid more than truckers who haul bread. For any particular job, the marginal productivity theory of income distribution generally holds true. For example, hazardous-load truckers are paid a wage equal to the equilibrium value of the marginal product of the last person employed in the market for hazardous-load truckers second reason for wage inequality that is clearly consistent with marginal productivity theory is differences in talent. People differ in their abilities: a high-ability person, by producing a better product that commands a higher price compared to a lowerability person, generates a higher value of the marginal product. And these differences in the value of the marginal product translate into differences in earning potential. We all know that this is true in sports: practice is important, but 99.99% (at least) of the population just doesn’t have what it takes to control a soccer ball like Lionel Messi or hit a tennis ball like Serena Williams. The same is true, though less obvious, in other fields of endeavor. A third, very important reason for wage differences is differences in the quantity of human capital. Recall that human capital— education and training—is at least as important in the modern economy as physical capital in the form of buildings and machines. Different people “embody” quite different quantities of human capital, and a person with more human capital typically generates a higher value of the marginal product by producing more or better products. So differences in human capital account for substantial differences in wages. People with high levels of human capital, such as surgeons or engineers, generally receive high wages. The most direct way to see the effect of human capital on wages is to look at the relationship between education levels and earnings. Figure 73.1 shows earnings differentials by gender, ethnicity, and three education levels for people 25 years or older in 2009. As you can see, regardless of gender or ethnicity, higher education is associated with higher median earnings. For example, in 2009 white females with 9 to 12 years of Annual median earnings, 2009 f i g u r e 73.1 Earnings Differentials by Education, Gender, and Ethnicity, 2009 It is clear that, regardless of gender or ethnicity, education pays: those with a high school diploma earn more than those without one, and those with a college degree earn substantially more than those with only a
high school diploma. Other patterns are evident as well: for any given education level, white males earn more than every other group, and males earn more than females for any given ethnic group. Source: Bureau of Labor Statistics. 712 70,000 No HS degree HS degree College degree 60,000 50,000 40,000 30,000 20,000 10,000 0 White male White female AfricanAmerican male AfricanAmerican female Hispanic male Hispanic female Unions are organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively schooling but without a high school diploma had median earnings 30% less than those with a high school diploma and 60% less than those with a college degree—and similar patterns exist for the other five groups. Additional data show that surgeons—an occupation that requires steady hands and many years of formal training—earned an average of $219,770 in 2009. Because even now men typically have had more years of education than women and whites more years than non-whites, differences in education level are part of the explanation for earnings differences. It’s also important to realize that formal education is not the only source of human capital; on-the-job training and experience are also very important. This point was highlighted by a 2003 National Science Foundation report on earnings differences between male and female scientists and engineers. The study was motivated by concerns over the male–female earnings gap: the median salary for women in science and engineering is about 24% less than the median salary for men. The study found that women in these occupations are, on average, younger than men and have considerably less experience than their male counterparts. This difference in age and experience, according to the study, explained most of the earnings differential. Differences in job tenure and experience can partly explain one notable aspect of Figure 73.1: that, across all ethnicities, women’s median earnings are less than men’s median earnings for any given education level. But it’s also important to emphasize that earnings differences arising from differences in human capital are not necessarily “fair.” A society in which non-white children typically receive a poor education because they live in underfunded school districts, and then go on to earn low wages because they are poorly educated, may have labor markets that are well described by marginal productivity theory (and earnings consistent with the earnings differentials across ethnic groups shown in Figure 73.1). Yet many people would still consider the resulting distribution of income unfair. Still, many observers think
that actual wage differentials cannot be entirely explained by compensating differentials, differences in talent, and differences in human capital. They believe that market power, efficiency wages, and discrimination also play an important role. We will examine these forces next. Market Power The marginal productivity theory of income distribution is based on the assumption that factor markets are perfectly competitive. In such markets we can expect workers to be paid the equilibrium value of their marginal product, regardless of who they are. But how valid is this assumption? We studied markets that are not perfectly competitive in previous modules; now let’s touch briefly on the ways in which labor markets may deviate from the competitive assumption. One undoubted source of differences in wages between otherwise similar workers is unions—organizations that try to raise wages and improve working conditions for their members. Labor unions, when successful, replace one-on-one wage deals between workers and employers with “collective bargaining,” in which the employer negotiates wages with union representatives. Without question, this leads to higher wages for those workers who are represented by unions. In 2009, the median weekly earnings of union members in the United States were $908, compared with $710 for workers not represented by unions—about a 22% difference. Just as workers can sometimes organize to demand higher wages than they would otherwise receive, employers can sometimes organize to pay lower wages than would result from competition. For example, health care workers—doctors, nurses, and so on—sometimes argue that health maintenance organizations (HMOs) are engaged in a collective effort to hold down their wages Union members rally to demand higher wages 713 Collective action, either by workers or by employers, is less common in the United States than it used to be. Several decades ago, around 30% of U.S. workers were union members. Today, however, union membership in the United States is relatively limited: less than 7.2% of the employees of private businesses are represented by unions. And although there are fields like health care in which a few large firms account for a sizable share of employment in certain geographical areas, the sheer size of the U.S. labor market and the ease with which most workers can move in search of higher-paying jobs probably mean that concerted efforts to hold wages below the unrestrained market equilibrium level rarely occur and even more rarely succeed. Efficiency Wages A second source of wage inequality is the phenomenon of efficiency wages—a type of incentive scheme used by employers to motivate workers to work hard
and to reduce worker turnover. Suppose a worker performs a job that is extremely important but that the employer can observe how well the job is being performed only at infrequent intervals. This would be true, for example, for childcare providers. Then it often makes sense for the employer to pay more than the worker could earn in an alternative job—that is, more than the equilibrium wage. Why? Because earning a premium makes losing this job and having to take the alternative job quite costly for the worker. So a worker who happens to be observed performing poorly and is therefore fired is now worse off for having to accept a lower-paying job. The threat of losing a job that pays a premium motivates the worker to perform well and avoid being fired. Likewise, paying a premium also reduces worker turnover—the frequency with which an employee leaves a job voluntarily. Despite the fact that it may take no more effort and skill to be a childcare provider than to be an office worker, efficiency wages show why it often makes economic sense for a parent to pay a caregiver more than the equilibrium wage of an office worker. The efficiency-wage model explains why we may observe wages offered above their equilibrium level. Like the price floors we studied in Module 8—and, in particular, much like the minimum wage—this phenomenon leads to a surplus of labor in labor markets that are characterized by the efficiency-wage model. This surplus of labor translates into unemployment—some workers are actively searching for a highpaying efficiency-wage job but are unable to get one, and other more fortunate but no more deserving workers are able to find work. As a result, two workers with exactly the same profile—the same skills and job history—may earn different wages: the worker who is lucky enough to get an efficiency-wage job earns more than the worker who gets a standard job (or who remains unemployed while searching for a higher-paying job). Efficiency wages are a response to a type of market failure that arises from the fact that some employees don’t always perform as well as they should and are able to hide that fact. As a result, employers use above-equilibrium wages to motivate their employees, leading to an inefficient outcome. Discrimination It is an ugly fact that throughout history there has been discrimination against workers who are considered to be of the wrong race, ethnicity, gender, or other characteristics. How does this fit into our economic models? The main insight economic analysis offers is that discrimination is not a natural consequence of market competition. On the contrary, market forces
tend to work against discrimination. To see why, consider the incentives that would exist if social convention dictated that women be paid, say, 30% less than men with equivalent qualifications and experience. A company whose management was itself unbiased would then be able to reduce its costs by hiring women rather than men—and such companies would have an advantage over other companies that hired men despite their higher cost. The result would be to create an excess demand for female workers, which would tend to drive up their wages. According to the efficiency-wage model, some employers pay an above-equilibrium wage as an incentive for better performance and loyalty. 714 But if market competition works against discrimination, how is it that so much discrimination has taken place? The answer is twofold. First, when labor markets don’t work well, employers may have the ability to discriminate without hurting their profits. For example, market interferences (such as unions or minimum-wage laws) or market failures (such as efficiency wages) can lead to wages that are above their equilibrium levels. In these cases, there are more job applicants than there are jobs, leaving employers free to discriminate among applicants. In research published in the American Economic Review, two economists, Marianne Bertrand and Sendhil Mullainathan, documented discrimination in hiring by sending fictitious résumés to prospective employers on a random basis. Applicants with “white-sounding” names such as Emily Walsh were 50% more likely to be contacted than applicants with “African-American-sounding” names such as Lakisha Washington. Also, applicants with white-sounding names and good credentials were much more likely to be contacted than those without such credentials. By contrast, potential employers seemed to ignore the credentials of applicants with African-American-sounding names. Second, discrimination has sometimes been institutionalized in government policy. This institutionalization has made it easier to maintain discrimination against market pressure. For example, at one time in the United States, African-Americans were barred from attending “whites-only” public schools and universities in many parts of the country and forced to attend inferior schools. Although market competition tends to work against current discrimination, it is not a remedy for past discrimination, which typically has had an impact on the education and experience of its victims and thereby reduces their income. The following FYI illustrates the way in which government policy enforced discrimination in the world’s most famous racist regime, that of the former government of South Africa. Wage Disparities in Practice Wage
rates in the United States cover a very wide range. In 2009, hundreds of thousands of workers received the legal federal minimum of $7.25 per hour. At the other extreme, the chief executives of several companies were paid more than $100 million for fyi The Economics of Apartheid The Republic of South Africa is the richest nation in Africa, but it also has a harsh political history. Until the peaceful transition to majority rule in 1994, the country was controlled by its white minority, Afrikaners, the descendants of European (mainly Dutch) immigrants. This minority imposed an economic system known as apartheid, which overwhelmingly favored white interests over those of native Africans and other groups considered “non-white,” such as Asians. right to vote—and non-whites did not. And so the South African government instituted “jobreservation” laws designed to ensure that only whites got jobs that paid well. The government also set about creating jobs for whites in government-owned industries. As Allister Sparks notes in The Mind of South Africa (1990), in its efforts to provide high-paying jobs for whites, the country “eventually acquired the largest amount of nationalized industry of any country outside the Communist bloc.” The origins of apartheid go back to the early years of the twentieth century, when large numbers of white farmers began moving into South Africa’s growing cities. There they discovered, to their horror, that they did not automatically earn higher wages than other races. But they had the In other words, racial discrimination was possible because it was backed by the power of the government, which prevented markets from following their natural course. A postscript: in 1994, in one of the political miracles of modern times, the white regime ceded power and South Africa became a full-fledged democracy. Apartheid was abolished. Unfortunately, large racial differences in earnings remain. The main reason is that apartheid created huge disparities in human capital, which will persist for many years to come 715 the year, which works out to $20,000 per hour even if they worked 100-hour weeks. Leaving out these extremes, there is still a huge range of wage rates. Are people really that different in their marginal productivities? A particular source of concern is the existence of systematic wage differences across gender and ethnicity. Figure 73.2 compares annual median earnings in 2009 of workers 25 years or older classified by gender and ethnicity. As a group, white males had the highest earnings. Women (aver

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