MANAGERIAL ECONOMICS 12 th Edition By Mark Hirschey

Performance and Strategy in Competitive Markets Chapter 11

Chapter 11 OVERVIEW   Competitive Market Efficiency   Market Failure   Role for Government   Subsidy and Tax Policy   Tax Incidence and Burden   Price Controls   Business Profit Rates   Market Structure and Profit Rates   Competitive Market Strategy

Chapter 11 KEY CONCEPTS   welfare economics   social welfare   producer surplus   consumer surplus   deadweight loss problem   welfare loss triangle   market power   market failure   failure by market structure   externalities   failure by incentive   economic efficiency   economic regulation   social equity   consumer sovereignty   limit concentration   subsidy policy   tradable emission permits deadweight loss of taxation   tax incidence   tax burden   price floor   price ceiling   return on stockholders’ equity (ROE)   profit margin   total asset turnover   leverage   reversion to the mean   disequilibrium profits   disequilibrium losses   economic luck   competitive strategy   economic rents

Competitive Market Efficiency   Why is it Called Perfect Competition? Competitive markets balance supply and demand. Competitive markets maximize social welfare   Deadweight Loss Problem Deadweight losses occur when market imperfections reduce transaction volume. Any benefit enjoyed by consumers or producers that is not transferred but lost due to market imperfections is a deadweight loss.

Market Failure   Structural Problems Failure can occur in markets with few participants. If above-normal profits reflect the raw exercise of market power they can be unwarranted.   Incentive Problems Externalities create incentive problems due to differences between private and social costs or benefits. A negative externality is an unpaid cost. A positive externality is an unrewarded benefit.

Role for Government   How Government Influences Competitive Markets Tax policy or regulation is efficient if expected benefits exceed expected costs. Fairness must be carefully weighed.   Broad Social Considerations Consumer sovereignty is an important benefit of competitive markets. Public policy can control unfairly gained market power. Tax and regulatory policy limit concentration of economic and political power.

Subsidy and Tax Policy   Subsidy Policy Subsidies can be indirect, like government highway spending that benefits the trucking industry. Subsidies can be direct, as in agricultural programs.   Deadweight Loss From Taxes Taxes reduce economic activity and cause deadweight losses. Pollution taxes explicitly recognize the public's right to a clean environment.

Tax Incidence and Burden   Tax Incidence and Burden Tax incidence is the point of tax collection. Tax burden is borne by party who ultimately pays the tax.   Role of Elasticity Who pays the economic burden of a tax or operating control depends on the elasticities of supply and demand. Customers pay tax when demand is inelastic (supply constant). Producers pay tax when demand is elastic (supply constant).   Elasticity affects the deadweight loss of taxation. Deadweight loss is small when supply (or demand) is inelastic. Deadweight loss is large when supply (or demand) is elastic.

Price Controls   Price Floors Price floors cause surplus production. Price floors persist because of special interests.   Price Ceilings Price ceilings cause shortages. Price ceilings are an ineffective means for restraining excess demand in some housing rental markets, e.g., New York City.

Business Profit Rates   Return on Stockholders’ Equity ROE is net income divided by stockholders’ equity. ROE = Net Income/Sales × Sales/Total Assets × Total Assets/Stk. Equity High margins, rapid turnover or leverage boost ROE.   Typical Profit Rates ROE averages 10% to 15% per year for successful companies. Sustained ROE ≥ 20% per year is very rare.

Market Structure and Profit Rates   Profit Rates in Competitive Markets Competitive markets have low profit margins. During economic booms, competitive firms can earn disequilibrium profits. During economic recessions, competitive firms can suffer disequilibrium losses.   Mean Reversion in Profit Rates Expansion from entry and firm growth cause above- normal profits to regress toward the mean. Contraction from bankruptcy and exit allow below- normal profits to rise toward the mean. In long-run equilibrium, profit rates for typical firms reflect only a risk-adjusted normal rate of return.

Competitive Market Strategy   Short-run Firm Performance Profits reflect transitory influences. Disequilibrium profits and losses reflect adjustment costs.   Long-run Firm Performance If above-normal returns persist for extended periods, elements of uniqueness are at work. The search for economic advantage is called competitive strategy. Uniquely productive firms earn above-normal profits.