REAL-WORLD COMPETITION AND TECHNOLOGY Chapter 15 REAL-WORLD COMPETITION AND TECHNOLOGY

Today’s lecture will: Discuss the monitoring problem and its implications for economics. Explain how corporate takeovers can limit X-inefficiency. Discuss why competition should be seen as a process, not a state. Explain two actions firms take to break down monopoly and three they take to protect monopoly. Discuss why oligopoly is the best market structure for technological change.

Short-Run versus Long-Run Profits Firms care about both short-run and long-run profit. They must be profit maximizers in the short run as well as the long run. Any expenditures on good will and good reputation can reduce short-run profits but increase long-run profits.

Executive Compensation Are these salaries in the best interest of the firm? Company Compensation in 2006 (in millions) Capital One Financial $249.4 Yahoo 230.6 Cendant 140.0 KB Home 135.5 Lehman Brothers Holdings 122.7 Occidental Petroleum 80.7 Oracle 75.3 Symantec 71.8 Caremark Rx 70.0 Countrywide Financial 69.0

Need for Monitoring Managers have an incentive to keep costs down, but their salaries are included in costs. This creates a monitoring problem – the need to oversee employees to ensure that their actions are in the best interest of the firm. To address this problem, firms sometimes give managers incentive-compatible contracts in which the incentives of each of the two parties to the contract are made to correspond as closely as possible.

True Cost Efficiency and the Lazy Monopoly per unit ATC (Producing inefficiently) MC PM ATC (Producing efficiently) B QM CLM A CM D MR Quantity

How Competition Limits the Lazy Monopolist New firms or international competition can push lazy monopolies to be more competitive. Corporate takeovers, or the threat of one, can improve efficiency. Corporate takeover – another firm issues a tender offer to gain control and install its own managers. Nonprofit organizations may display lazy monopolist tendencies.

Fight between Competitive and Monopolistic Forces Real-world competition is a fight between the forces of monopolization and the forces of competition. Self-interest-seeking individuals don’t like competition for themselves and may use political and social means to fight competition.

How Monopolistic Forces Affect Perfect Competition Our laws, social values, and customs do not allow perfect competition to work because our government emphasizes other social goals besides efficiency. The Robinson-Patman Act and several state laws prevent firms from charging a price that is too low. The U.S. has laws, regulations, and programs that prevent agricultural markets from working competitively.

Movement Away from Competitive Markets If producers of OL can keep producers of LM out of the market, price increases to PL and their profit increases by A. Price S PL A B The suppliers kept out of the market lose C in producer surplus and consumers lose B in consumer surplus. Deadweight loss is B+C. PM C D L M Quantity

How Competitive Forces Affect Monopoly Competitive forces work to break down monopoly by Political or economic forces Lobby to change the law protecting monopoly Develop a similar product without violating a patent Reverse engineering – buy another firm’s product, disassemble it, study it, and copy it within the limit of the law

Competition and Natural Monopolies Natural monopolies can make large profits because their average total cost decreases as output increases. To prevent abuse of their market power, many natural monopolies are regulated. New technologies can compete with and undermine natural monopolies.

Regulating Natural Monopolies Regulated natural monopolies have been given the exclusive right to operate in the industry. In return, they are allowed to charge a fair price, which includes all costs plus a normal return on capital investment. Regulation to allow regulated monopolies to earn a normal profit means they can pass all cost increases on to consumers.

Deregulating Natural Monopolies Many formerly regulated natural monopolies are being deregulated. In the 1980s and 1990s deregulation and competitive supply of parts of both electric and phone service grew. In the electricity industry, power supply has been deregulated, but because of the existence of economies of scale, the power line industry has remained a regulated monopoly. Only portions of industries which are likely to be competitive are being deregulated.

Cost-Benefit Analysis of Creating and Maintaining Monopolies Firms will buy monopoly until the marginal cost of maintaining the monopoly equals the marginal benefit. Firms protect their monopolies by: Advertising and lobbying Producing products as nearly unique as possible Charging low prices

Establishing Market Position In winner-take-all markets, the initial competition is on establishing market position. The winner who achieves a monopoly can charge significantly higher prices without facing any competition.

Technology, Efficiency, and Market Structure Technological development – the discovery of new or improved products or methods of production. Because the global market is significantly larger than a domestic one, globalization provides an incentive to develop new technology. Market structures that best promote technological change are dynamically efficient. Dynamic efficiency – the market’s ability to promote technological change.

Perfect Competition and Technology Perfectly competitive firms have no incentive to develop new technologies. They earn no profits to fund research. Even if they did innovate, competitors would gain from the new technology without having to pay for it.

Monopolistic Competition, Monopoly, and Technology Because of market power, monopolistic competition is more conducive to technological change. They lack long-run profits because of easy entry, but their ability to recoup their investment is limited. Monopoly Monopolists have profits but little incentive to innovate since they are protected by barriers to entry.

Oligopoly and Technology Oligopoly is the market structure most economists feel is most conducive to technological change. Because they receive ongoing economic profit, oligopolists have the money to carry out research and development. The belief that its competitors are innovating, forces them to do so as well.

Network Externalities, Standards, and Technological Lock-in Network externalities – greater use of a product increases the benefit of that product to everyone Standards – a firm whose standard is accepted dominates the market Technological lock-in – prior use of a technology makes the adoption of subsequent technology difficult

Summary Profit is an important goal of firms, but actual goals depend on the incentive structure of the firm. The monitoring problems arises because managers’ incentives are not always to maximize the firm’s profit. Incentive-compatible contracts help alleviate the monitoring problem.

Summary Monopolists facing no competition can become subject to X-inefficiency – operating less efficiently than is technically possible. X-inefficiency can be limited by the threat of competition or takeovers. Firms will spend money on monopolization until the marginal cost equals the marginal benefit. Firms protect their monopolies by advertising, lobbying, and producing products that are difficult to copy.

Summary Firms compete against patents that create monopolies by making slight modifications to existing patents and engaging in reverse engineering. The U.S. is deregulating the portions of natural monopolies where competition is feasible. Oligopoly is the best market structure for technological advance because oligopolists have an incentive to innovate since they can earn economic profits, which can also be used to invest in research and development.

Review Question 14-1 The electricity industry is a natural monopoly which has been completely deregulated. True or False? False. Wholesale electricity supply has been deregulated, but since there are significant economies of scale in the power line industry, that portion has remained a regulated natural monopoly. Review Question 14-2 Why is oligopoly thought to be the best market structure for technological advances? Oligopolies have an incentive to invest in new technologies because they are able to make economic profits due to the new technology in the long run. These profits can be used to fund research and development of new technologies.