Category Archives: Market Structures

Mozambique’s monopsony market goes nuts

The primary sector is seen as integral to assisting developing countries grow and raise their standard of living. For the Mozambican economy the cashew industry is an example of this – more than 40% of Mozambican farmers grow and sell cashew, and the processing sector provides formal employment to more than 8,000 individuals. Mozambique is currently the second largest producer in East and Southern Africa and has links with premium export markets, including the United States and Europe.

In the 1960’s the cashew nut industry in Mozambique was in good shape supplying over 50% of global supply and processed most of these domestically and thereby adding employment. However, with a civil war and the instruction from the World Bank in the 1990’s to remove controls and cut taxes on the exports of raw nuts, trading firms shipped out cashews and processed them overseas with significant job losses. But an about turn by the government in 2001 has seen:

  • an export tax of 18-22% for raw nuts
  • a 0% tax for processed kernels.
  • a ban on exports during the first few months of the harvest

16 factories employing 17,000 people, which process about half the cashews sold.

However by having less competition amongst processors – a little like a monopsony market – farmers selling raw cashew nuts are finding that the price of their crop is being reduced by the smaller number of processors. Most cashew nut farmers are smallholders and the government seems to be oblivious to the 1.3m families for the sake of protecting processing jobs.

Monopsony – one buyer many sellers – other examples include:
– large supermarkets, who can dictate terms to smaller suppliers.
– buyers of labour in the labour market.

There is a dilemma for developing countries as when a primary industry starts to expand into the secondary stage of processing, government protection can hurt nut-growers. Just like the coffee industry farmers are at the mercy of a small number of middlemen in this case the processors monopsony power.

Source: Mozambique’s nut factories have made a cracking comeback –
The Economist 12th September 2019

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper tomorrow I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

A2 Economics – Contestable Markets

I covered this topic today at the Cambridge A2 Economics revision course. The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms. Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

Entry limit pricing

The fear on the part of existing firms of rendering the market contestable (stimulating new entry) by making high levels of profit is likely to lead to the adoption of entry limit pricing, a concept introduced in the previous unit. This is essentially a defensive strategy, with existing firms setting prices as high as possible but not so high as to enable new corners to enter the industry. If the existing firms set price at P2 and output at Q2 (see diagram below), it would be possible for a new firm to enter the industry and supply Q1. Total market supply would then be Q3 (Q1 + Q2), the price would be P3 and the new firm would be covering its costs. If, instead, the existing firms chose to produce at Q3 (with price level P3), the new firm producing Q1 (total market supply would now be Q4 at price P4) would not be covering its costs and would have to exit the industry in the long run.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Source:

Anforme – A2 Level Economics Revision Booklet.

Using M&M’s to teach MC=MR

Today I held the annual M&M’s competition with my A2 class. I use them to teach MC=MR also Minimum (loss) and Maximum (profit).

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest – see graph above. Using marginal analysis, the perfectly competitive firm will produce at a rate of output where marginal revenue equals marginal cost. Marginal revenue, however, is equal to price. Therefore, the perfectly competitive firm produces at an output rate where marginal cost equals the price of output. Remember that the firm will make profits as long as the extra revenue brought in from selling the last unit of output(MR) is greater than the extra cost which is incurred in producing it (MC). Below are some Perfect Competition and Monopolistic Competition graphs created by my A2 class using M&M’s

Market structures and Netflix

Covering this topic with my A2 class and fortuitously came across a very relevant blog post from Michael Cameron’s blog Sex Drugs and Economics. He talks about Netflix increasing its subscription price by 19% (now $21.99) for the premium plan and how Kiwi subscribers are going to social media to announce their departure from the streaming service.

However although people are voting with their feet it is highly likely that Netflix are not too perturbed by this. With the law of demand a higher price will reduce the demand for the service – simple Law of Demand.

The diagram below from the Cameron Blog shows a horizontal MC=AC curve which means that the cost of producing one more unit of output is the same. Some would suggest that it could be close to zero as the additional cost of providing one more subscriber with the service doesn’t involve significant costs.

Let’s assume that Netflix originally charged a price of P0 and sold a quantity of Q0 before the increase. Note here that they still make a supernormal profit rectangle – P0 C H F.

However they are not producing at the profit maximisation which is where MC=MR. Therefore although Netflix is increasing their price it is unlikely that they are charging a price at profit maximisation output as Netflix has too many subscribers to maximise profits. If they did produce at profit maximisation output Q1 and charge price P1 they would make profits of P1 B E F. So at a price of P1 – they gain profit of P1 B G P0 but lose the area G C H E. However the former area is bigger than the latter.

So with the market power that Netflix has it is not surprising that they are increasing their subscription price. With the video stores like Blockbuster, Video Ezy, United now struggling to survive and in some cases out of the market, they are less alternatives out there for the consumer.

Boeing v Bombardier with Airbus in-between

Below is a very good video on the aircraft market – a duopoly involving Airbus and Boeing. But there is another manufacturer which produces a smaller aircraft that neither Airbus or Boeing produce – the Canadian manufacturer Bombardier. In 2004, the maker of private jets and small regional airliner, decided it was time to make the jump into the big leagues. It was time to build an advanced carbon composite jetliner to compete against the Airbus-Boeing duopoly. More specifically, the Canadian plane, dubbed the Bombardier C Series, would compete against the smaller variants of the cash cow Airbus A320-family and Boeing 737.

In April 2017, Boeing filed a complaint with US Commerce Department and the US International Trade Commission alleging that the Delta Airlines C Series order was only made possible abnormally low prices supported by Canadian government subsidies. The US International Trade Commission agreed and in September of that year recommended a 219.63% tariff. A week later, the Commerce Department added another 79.82% tariff. In total, Bombardier and Delta faced a 299.45% tariff on any Canadian-built C Series plane exported to the US.

Less than one month after the tariff was announced,Bombardier handed 50.01% of its prized airliner program to Airbus  with zero upfront cash investment coming from the European aviation giant. As part of the deal, Airbus announced that the C Series will also be produced at its assembly plant in Mobile, Alabama. Fortunately for Bombardier, the US International Trade Commission struck the down the proposed tariff in January 2018, ending the dispute.

Source: Business Insider Australia

Capitalism with accountability

HT to my learned colleague David Parr for this piece from vox.com. Sen. Elizabeth Warren (D-MA) rolled out a big idea to challenge how we think about inequality and the fundamental structure of the economy. She has been concerned with the current structure of capitalism which since the 1980’s has really focused on the interests of shareholders and executives at the expense of employees further down a company’s ‘pecking order’. Reagan and Thatcher started the recent privatisation trend in the 1980’s and, with great success, a lot of the commanding heights of the economy were up for sale. This put any left wing political opposition in a quandary. Do they renationalise these industries and payout shareholders or just start to move their ideology further right on the continuum. The latter was the only real option with the expense of buying back the industries and also upsetting their maybe voters who had bought shares for saving purposes.

Warren with other Democrats is proposing the Accountable Capitalism Act in order to alter the balance of interests in corporate decision-making and giving voices to workers in corporate boardrooms. The legislation would:

  • reduce the huge financial incentives that entice CEOs to lush cash out of shareholders rather than reinvest in businesses
  • curb political activities – using lobbying funds
  • ensure workers and not just shareholders get a voice on big strategic decisions.
    bring about more meaningful career ladders for workers and higher pay
  • ensure that Corporations act like decent citizens who uphold their fair share of the social contract and not like sociopaths whose sole obligation is profitability — as is currently conventional in American business thinking.
  • limit corporate executives’ ability to sell shares of stock that they receive as pay — requiring that such shares be held for at least five years after they were received, and at least three years after a share buyback.

Business executives, like everyone else, want to have good reputations and be regarded as good people but, when pressed about topics of social concern, frequently fall back on the idea that their first obligation is to do what’s right for shareholders. A new charter would remove that crutch, and leave executives accountable as human beings for the rights and wrongs of their decisions.

More concretely, US corporations would be required to allow their workers to elect 40 percent of the membership of their board of directors. Since 80 percent of the value of the stock market is owned by about 10 percent of the population and half of Americans own no stock at all, this has been a huge triumph for the rich – see graph.

Meanwhile, CEO pay has soared as executive compensation has been redesigned to incentivize shareholder gains, and the CEOs have delivered. Gains for shareholders and greater inequality in pay has led to a generation of median compensation lagging far behind economy-wide productivity, with higher pay mostly captured by a relatively small number of people rather than being broadly shared. The graph below show the share of wealth with the top 1% owning 38% of the country’s wealth and the bottom 90% holding only 19% of wealth.

This kind of huge transfer of economic power from rich shareholders to middle- and working-class employees would provoke fierce resistance. But reform of corporate governance also has some powerful political tailwinds behind it.

I am on holiday now and out of internet range – back on the 8th January. Have a good xmas and new year.

Source: Top House Democrats join Elizabeth Warren’s push to fundamentally change American capitalism. Vox

A2 Economics – the need to move to more contestable markets.

The Economist had as its main Leader an article on the lack of competition in the global market place. Too many companies have  monopoly power and earn, what the economics textbooks call,  significant ‘abnormal profits’. In 2016 a survey found that more than half of young Americans no longer support capitalism. In the past governments have made it a more level playing field.

  • US – at the start of the 20th century they broke up monopolies in railways and the energy industry. Ronald Reagan also unleashed the power of the market
  • West Germany – created competitive markets to rebuild their post-war economy
  • Britain – Margaret Thatcher exposed state-owned inefficient domestic industries to the dynamic foreign competition. She also privatised the Commanding Heights of the economy.

There are 3 tests that The Economist use to examine the market structure:

Concentration Ratios
A lot of firms have experienced inertia and become very comfortable whilst the tech firms are building significant amounts of market power. In the US Concentration ratios between 1997 and 2012 have risen in approximately 600 census industries, with the weighted average market share of the top 4 firms growing from 26% to 32%. 10% of the US economy is made up of industries where 4 firms have more than 66% of the market share. The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio.

Abnormal Profits
In a healthy economy you would expect profits to be competed down, but the free cashflow of companies is 76% above its 50-year average, relative to GDP. In Europe the trend is similar, if less extreme. The average market share of the biggest four firms in each industry has risen by three percentage points since 2000. On both continents, dominant firms have become harder to dislodge.

Openness
Of US firms that made very high profits in 1997, 50% still did in 2017. There is a reduction in new firms and with a lowdown in globalisation industries that are less exposed to trade have become more dominant in the market place – the domestic market. The current protectionist policies of the Trump Administration don’t help to breakdown the barriers to entry and as the high stock values of profitable firms show, investors believe their advantages will continue. Powerful firms tend to stay and of the total capital spending and R&D done by America’s leading 500 companies the top 20 firms account of 38% of this spending.

The Contestable Market – A2 Economics – Theory

The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms.
Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Sources:

The Economist – The Next Capitalist Revolution – November 17th 2018

Anforme – A2 Level Economics Revision Booklet

A2 Revision: The Perfectly Competitive Firm and the Market

Supernormal, normal, and subnormal profit only identified what happens to the firm. However it is important to be aware of what is happening in the market as a whole. Take for instance a firm making supernormal profits. The price that the firm charges is determined by what is happening in the market (supply and demand). If a firm makes supernormal profits this attracts other firms into the industry to take advantage of these profits. Therefore the supply of firms in the market increases which in turn reduces the price that firms can charge and they now make normal profits and are in the long-run see fig below.

Airline price discrimination

Price discrimination involves charging different prices to different sets of consumers for the same good or service. So when you are on your next flight there are going to be different fares for the same class of seat whether it be in economy, business class or first class. What variables at work to bring about price discrimination in airline routes?

  • What day of the week you fly – Monday and Friday are usually peak times for business so you should find that fares are expensive. Also because it is usually for business purposes it is assumed that firms will be paying for the flights and therefore are prepared to pay more.
  • Times of the day – morning and evening tend to be more expensive as this is peak time.
  • How competitive the route is – if there is a lot of competition fares will be cheaper to the extent that there maybe predatory pricing. There is a good piece in the video showing the fares for flights from Montreal to St Johns Newfoundland. Once low cost carriers entered the market Air Canada dropped their price below cost.
  • Reputation of each airline – better reputation = higher fare

The video below is a very good especially the fare structure on the New York to Los Angeles route.