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Lecture Note 17

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Title: Lecture Note 17


1
Lecture Note 17
  • Eco300, the 2006 Spring
  • Dr. Chen, S.

2
3. Moral Hazard
  • Moral hazard is the problem, of which the
    incentive for an individual to take more risks
    when insured.
  • E.g. an insured drivers is more reckless than an
    uninsured one.
  • If everyone has no moral hazard problem,
    insurance rates will fall and everyone could
    benefit.

3
  • Some possible remedies to moral hazard problems
  • Only insure well-behaved customers
  • Only offer health insurance to nonsmokers.
    Require homeowners to install fire alarms (only
    effective if the company can observe its
    customers behavior)
  • Elicit low-risk behavior
  • Offer half-priced alarm systems
  • Sending free magazines about fitness and diet
  • Deductibles

4
4. Principle-Agent Problems
  • Employers usually cannot full-time monitor their
    employees work efforts.
  • Problems
  • Suppose that you hold a job in which having a
    1000 home computer would increase your
    productivity by 2000.
  • In a world of perfect monitoring, you would buy
    the computer and your wages increases by more
    than enough to compensate you.
  • In a world of no monitoring, an increase in
    productivity is not recognized by the employer.
    So you would never buy the computer.

5
  • How to improve employees performance without
    monitoring?
  • Offer them a share of the firms profits. But in
    a large company, free-rider problems would make
    this offer useless. An employee who is entitled
    only 1 of the profits must increase the output
    by 100 to reap a 1 reward. The employee
    probably wouldnt do it.
  • To make this offer work, the employer use an
    extreme profit-sharing scheme. I.e. pay each
    employee 100 of its profit. If the worker save
    the firm 100, should earn 100 himself. But its
    impossible to pay 800 the 8 employees if the
    firm has 100 profit.
  • Source of problems its hard to distinguish
    random events from productivity changes

6
  • Possible remedies
  • Punishment
  • punish severely the employees who get caught
    shirking. The ultimate punishment is layoff. But
    the workers can just move on to an identical
    company. This is no punishment at all.
  • Efficiency wage
  • the employer may offer a wage higher than the
    market equilibrium. This makes the job
    particularly desirable one that workers will be
    reluctant to risk losing.
  • While the employers offer higher wages, they
    demand less labor. Thus the efficiency wage
    create unemployment. This means that the worker
    who loses his job may not find another job.

7
  • Executive compensation
  • Shareholders v.s. corporate executives
  • A good remedy should
  • reward CEO for good performance and punish
    severely for the opposite
  • link closely between the firms profit and the
    CEOs wealth
  • Stocks allow the CEO to buy a large quantity of
    the companys stocks.
  • Stock options for instance, a stock option
    issued in the year 2001 give the CEO the right to
    buy shares of stock ten years down the line, in
    2011.
  • Manager v.s. workers
  • Efficiency wages (higher than market equilibrium,
    which employers pay to make workers want to keep
    their jobs)

8
Chapter 10Monopoly
9
Is Microsoft a monopolist?
  • Monopoly the single seller in the industry.
  • An objective definition of monopoly power (or
    market power)
  • A firm has monopoly power if it can affect market
    price through its action i.e.
  • it faces a downward-sloping demand curve for its
    product.

10
Price and output under monopoly
  • The monopolist maximizes its profit. Thus, it
    must operate at the point where
  • MRMC
  • Because the monopolist can control its price by
    changing quantity of output. Thus, the demand
    curve is no longer a flat straight line.
  • In turn, the monopolists MR is no longer equal
    to its price.

11
Monopolists MR curve
12
Monopoly versus Competition
  • Assuming that a monopoly and a competitive
    industry would have the same MC curve.
  • The competitive industry produces at QC and price
    PC.
  • Since MCgtMR at QC, the monopolist will reduce the
    quantity until QM such that MRMC.

P
MC
PM
PC
D
MR
Q
QC
QM
13
Monopoly pricing an example
  • The monopolist maximizes its profit. Thus, it
    must operate at the point where
  • MRMC
  • Suppose that the demand curve is Q 12-P.
  • Total revenue TR PQ (12-Q)Q
  • Marginal revenue MR 12-2Q
  • Suppose that marginal cost MCQ. What is the
    monopoly price and output?
  • MRMC
  • 12-2QQ
  • Q4, P8

14
Elasticity of Demand
  • The (price) elasticity of demand is the most
    important information for the monopolist.
  • We can derive the elasticity of demand at certain
    price and quantity by using the information of
    the demand curve.

The inverse of the slope of the demand curve
15
  • The elasticity of demand helps us quantify the
    impact of a change in quantity on market price
  • Note under perfect competition, the demand curve
    is flat (i.e. perfectly elastic ?-? ). Thus,
    ?P0.

16
Elasticity of demand and monopolists marginal
revenue
  • Monopolists marginal revenue
  • Since the monopolist only produces when MRgt0
    (I.e. ?gt1. We call this segment of the demand
    curve as elastic).
  • In other word, a monopolist always operates at
    the elastic portion of the demand curve. (?gt1)

17
The monopolist has no supply curve
  • A monopolist is never asked such a question like
  • How much will you produce at a going market
    price?
  • There is no supply curve in the industry. Its
    the monopolist who sets the price.

18
Competitive pricing v.s. monopoly pricing
overview
  • Monopoly pricing
  • PgtMRMC
  • Competitive pricing
  • PMRMC

The margin between P and MR depends on the
elasticity of demand.
19
Efficient loss due to monopoly
P
MC
A
B
PM
D
C
E
PC
G
H
F
D
MR
Q
Qc
QM
20
Regulations
  • Possible remedies to the inefficiency caused by
    monopoly are to induce the monopolist increase
    the quantity and decrease the price.
  • Subsidy
  • Price ceiling
  • Rate-of-return regulation

21
Subsidize the monopolist
P
MC
MC
A
PM
B
S
D
C
E
PC
G
H
F
The subsidy of S per unit of output, which
lowers the MC curve to MC, is chosen to be of
just the right size so that monopolist will
produce at competitive quantity Qc.
K
J
D
I
MR
Qc
QM
22
2. Price ceiling
  • If the government can set the price ceiling at
    the competitive price Pc, then there is no dead
    weight loss.
  • But, the government may set a wrong price because
    of lacking accurate information about the market
    conditions (e.g. MC and MR).
  • As an alternative, the government often requires
    the monopolist to produce at PAC so that the
    monopolist earns zero profit.
  • But may not remove the entire dead weight loss
    caused by monopoly because AC usually does not
    equal MC.

23
3. Rate-of-Return Regulation
  • The goal of this regulation is to make
    monopolists behave like competitors, who earn
    zero profit in the long run (PzAC). As such, we
    hope to eliminate the dead weight loss and reach
    an efficiency outcome.
  • However, for some monopolists, the zero profit
    condition may not eliminate the dead weight loss.
  • Again, this is because AC may not equal MC.
  • See details at Exhibit 10.5

24
Natural Monopoly
  • Example
  • Consider a firm that produces a word processing
    program. The fixed costs of developing the
    software are very high, but the marginal cost is
    almost zero.
  • In a competitive market, the software will be
    sold at marginal cost (almost equal to zero).
    Then, all firms earn negative profits. In the
    long run, nobody is willing to enter the
    business.
  • Thus, a competitive market for word processors
    cannot survive.
  • To survive in the market, companies need to merge
    and form a monopoly-like company. Such an
    industry is called a natural monopoly.

25
The causes to natural monopoly (1)
  • The natural monopolist has huge fixed cost, small
    marginal cost. Thus,
  • It cannot survive in a competitive market
  • It must set the price high enough to cover its
    fixed cost.

26
The causes to natural monopoly (2)
P
  • Each firm in the industry has its average cost
    curve decreasing at the point where it crosses
    market demand.
  • Suppose that the government can forces the
    natural monopolist to price competitively (so
    price equals PcMC). None will remain in the
    industry because PcltAC, causing negative profit.

MC
Pz
AC
Pc
D
MR
Q
Qc
QZ
27
Note
P
  • If the firms average cost curve increases at the
    point where it crosses market demand, its
    possible for government to force the monopoly to
    price competitively without making the firm out
    of business.

MC
Pc
AC
Pz
D
MR
QZ
Q
Qc
28
Welfare economics of natural monopoly
  • No policy can effectively force natural monopoly
    industry to price competitively because of the
    nature of the market and cost structure.
  • Is there a hope for efficiency?
  • Competing for monopoly power
  • The positive profit in the industry would attract
    competitors, who have strong incentives to
    innovate and develop new product and upgrade the
    quality
  • The social value of the innovation

29
Sources of monopoly power
  • Natural monopoly
  • world processors, computer software
  • Resource monopoly
  • Electricity, water, oil
  • Patents
  • Legal barrier to entry
  • Restaurants or snack bars by interstate
    throughway.
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