pcecon.com Class Notes

In the long run, price searchers may be able to avoid competition from other sellers. Features of a market, product or seller that keep other sellers from entering the market are called "barriers to entry." Barriers to entry include such things as
copyrights, patents, or trademarks
government licenses preventing competition
ownership of a resource
really large economies of scale (so great that ATC is falling for all amounts of output)

About the Barriers...

Of these barriers to entry, most societies and most economists agree that copyrights, patents and trademarks are necessary to get innovation. Thus, the gains (in terms of the efficiency created by having new kinds of products and methods of making goods) will outweigh the problems of having a price searcher.

Government licenses preventing competition and the ownership of a resource by a single producer may simply prevent competition without really providing any benefits to society. When this is so, economists generally favor prevention of such barriers by government action (or inaction, in the case of licenses).

The large economies of scale (translating into declining average total cost) will present society with a special problem, called a natural monopoly. This problem is discussed below.

In the long run, barriers to entry may result in a market with only a few sellers, also called an
oligopoly. In extreme (and rare) instances, barriers to entry may result in a market with only one seller, also called a monopoly.

Often, an oligopoly can simply result in the few firms competing with each other, resulting in a market resembling price takers (sometimes called a quasi-competitive market). In other cases, the oligopoly sellers more or less ignore one another, and operate like price searchers with the demand curves they each have. Sometimes, their interactions with each other are less predictable, resulting in a more complex situation.

One of the concerns we have about an oligopoly is that the sellers may get together and act as one big price searcher, rather than competing with each other. Such a cooperative venture between sellers is called a cartel, and the cooperation is called collusion.
Cartels are difficult to keep going. The cartel will try to establish a total level of output for which marginal revenue equals the summed marginal cost curves of the producers in the cartel. The price will be above the marginal cost for each firm:

The combined cartel output, Qcartel, is produced partly by each of the cartel members (they could evenly divide up the output, or create a more complex arrangement). Profits are then shared between the members of the cartel. However, since each producer in the cartel will have a price for its product that is above the marginal cost, each producer will have an incentive to produce more output than it is assigned to produce by the cartel. Producing more output than a cartel member is supposed to is called "cheating." If enough of the cartel members cheat, the outcome can be something close to a price taker situation:

This would be good for consumers (and society, in terms of the efficient use of resources), but bad for the cartel.
To prevent cheating, cartels need to
1. monitor output of members
2. punish cheaters
3. prevent entry by others

Preventing cheating and prohibiting other sellers from entering the market is sometimes achieved by cartels through government assistance. Government can license producers and require records on producers' output, thus assisting the cartel. The instances in which this has occurred is part of the reason why economists are generally wary of government licensing of businesses like hairstyling or taxicabs. When some safety issue is involved, economists would prefer that the government find legal alternatives to licensing, or set up licenses in a way that doesn't simply limit the number of producers, prevent entry or restrict the production of legitimate producers. Even well-intentioned licensing arrangements have created cartels in many states.

Sometimes, cooperation between sellers might look like a cartel, but may be socially desirable. Such situations occur when there are significant cost savings (such as shared facilities, resources, etc.) that outweigh the possible reductions in output from a potential cartel. The law allows for cartel-like arrangements in such cases.

Economies of Scale (or large fixed costs)
When there are significant economies of scale in the long run (or significant fixed costs in the short run), a seller may have a downward-sloping average total cost curve. A sign that this is happening is that marginal cost is less than average total cost for all levels of output. This cost situation will mean that production of a good or service by more than one seller will be inefficient, since (average) costs can be reduced simply by having one seller increase production (thus saving resources):

This situation is referred to as a "natural monopoly."
Natural monopoly results when costs decline as output increases. The outcomes that are possible with a natural monopoly include
1. the seller acts as a price searcher (MR=MC, so P>MC). This is point 1 on the diagram below, with output ending up at Q1 and price at P1. This will result in an inefficient use of resources (too little of the good or service is produced in the short run, since price is above marginal cost).

2. the seller is regulated so that its price is equal to marginal cost. This is point 2 on the diagram below, with output being Q2 and price being P2. This results in short run efficiency in the use of resources, but will not be viable in the long run, since price would be less than average total cost (resulting in negative economic profit). The firm will go out of business in the long run, since it can't pay its fixed costs.

3. the seller is regulated so that its price is equal to average total cost. This is point 3 on the diagram below, with output being Q3 and price being P3.This is not quite efficient in the short run (but is closer than the price searcher situation). It has the advantage of being sustainable in the long run, since P=ATC and there will be zero economic profit, but the firm will still be able to stay in business, since all of its costs can be covered.

This kind of regulation is most common, but has its own problems:
3a. Information about costs is hard for regulators to obtain. They are dependent on the regulated business for such information. Because of this, regulators usually just allow the seller to make a normal rate of return on capital (normal profit) based on its cost, which would imply that price is equal to average total cost. This gives the regulated business an incentive to hide profit, and still leaves a problem with discovering the difference between accounting profit and economic profit in the business.
3b. Regulated businesses have no incentive to economize, since any increase in costs can be passed on to ("shifted to") the customers.
3c. Regulators can become too close to the businesses they regulate. Regulators may come from, or later be hired by, the businesses they regulate, since people in that business are most knowledgeable about it, and regulators become quite knowledgeable about it.
3d. Regulatory agencies may be slow to adjust to changes in the industry. If costs change, rates may not be allowed to adjust quickly enough to match prices. Some stability in rates is desirable from the consumers' perspective, but may result in pricing that varies widely from costs for a while. For example, rising fuel costs may raise the cost of generating electricity, but regulatory agencies may not allow rates to rise until some time has passed, forcing the regulated business to take losses in economics terms, or even to go bankrupt (as happened to several California power companies in 2001).

4. Public (government) ownership and operation of the firm in theory can result in price close to marginal cost, if the governmental agency operating the firm is interested in efficiency. The fixed costs of operation are paid out of taxes, so pricing below ATC is not a problem. This will only work the governmental agency is interested in efficiency. If not, the same lack of incentive to restrain costs may exist as occurs with a regulated business. In theory, this could result in point 2 on the diagram below, with output being Q2 and price being P2.

5. Public ownership of fixed assets but private operation (with competitive bidding) of service. This is how cable TV is supplied in many states. The competition between prospective operators of the enterprise will force price to marginal cost in the short run. The fixed costs are financed through government taxes. In theory, this results in point 2 on the diagram, with output being Q2 and price being P2, an efficient outcome.

6. Allow different prices to be charged to different consumers (price discrimination). If the firm can charge different prices to each customer, based on the customer's willingness to pay, the firm has an incentive to sell every unit of output that is valued by a consumer more highly than the marginal cost of supplying it (fixed costs are covered by the consumers who get charged the higher prices). In theory, this results in point 2 on the diagram, with output being Q2 and price being P2, an efficient outcome.

Review of Natural Monopoly Possibilities
1. allow price searcher output
2. regulate so that price is at marginal cost
3. regulate so that price is at average total cost
4. government ownership and operation
5. government ownership with private operation
6. price discrimination by price searcher

Copyright 2006 by Ray Bromley. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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