MIKEroeconomics

Thursday 19 January 2012

Comparing Market Structures

	Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of Firms	very many	many	few	just one
Freedom of Entry	easy	easy	difficult (restricted)	nearly impossible
Nature of Product	indifferentiated	differentiated	differentiated and indifferentiated	ubiquitous, such as water, electricity, etc
Implications for Demand Curve	perfectly elastic	elastic	elastic and inelastic	mostly inelastic
Average Size of Firms	very small	small - medium	large	huge
Possible Consumer Demand	elastic	elastic	elastic or inelastic	elastic or inelastic
Profit Making Possibility	short run - economic profits if price is higher than average costs	short run - economic profit temporary until other firms enter industry due to easy entry.	short run - economic profits temporary until other firms enter industry, despite entry barriers.	short and long run - potentially indefinite economic profits if unregulated
Government Intervention	none	none	some - government licences to restrict entry, royalties to gov't in certain industries (oil and gas), collusion is illegal in most countries	yes - taxes, nationalization, price setting
Advertising Presence	none	low- medium	high	very minimal
Control over Price	none (price takers)	minimal	some	complete control (price maker)

Wednesday 11 January 2012

Defining Oligopoly and Game Theory

The East and West sides of a city are serviced by 2 rival drug gangs. Due to a City Hall budget issue, there is a sudden drop in police presence in the Central core of the city. This has created a lucrative new territory to sell drugs in, so both drug gangs see an opportunity to expand their territory. Both know that expanding into this territory is going to be tough, since both gangs have equal amounts of firepower and foot soldiers. A violent drug war would be unwise, and cause more harm than good (the definition of ‘good’ being a grey area when it comes to drug dealing), due to the mutually assured destruction of both gangs in the long run. The only way for this turf to be utilized by both gangs is to forgo their competition/feud, call a ceasefire, and cooperate by forming a cartel. Both sides know that jointly they can both achieve a profit of $100K each per month if they can agree to stick to a fixed quota decided on by the leaders of the gangs. This collusion between the 2 gangs is by far the best option, as both gangs achieve a modest profit, and they don’t need to worry about a bloody and wasteful turf war. However, there is no honor amongst thieves, and the goal of each gang is to maximize profits, not to cooperate with their competition. The leader of the West gang knows that the ceasefire would be a golden opportunity to get the jump on the East gang by supplying more than the agreed upon quota. This would give the West a profit of $150K per month, leaving East with a paltry $50K. East knows this is what West is thinking of doing, because East was thinking the exact same thing. The drug war is an eventuality, because it’s worth the chance of achieving that higher profit than your rival. Cheating must take place, because if you do not, then your rival will. The results for both gangs if they cheat is $75K per month, AND they both sides are now involved in a drug war.

On a game theory matrix, this example would look like this.

		East
		Don't Cheat	Cheat
West	Don't Cheat	100 / 100	50 / 150
West	Cheat	150 / 50	75 / 75

Although legitimate (non-criminal) businesses don’t like to be compared to drug cartels, they share a commonality in that achieving maximum total profits is their main motivation. This example illustrates the mutual interdependence of the few rival firms in an Oligopolistic market. To cooperate or to compete? How does a firm decide? Game theory is a way of statistically analyzing the possible outcomes/payoffs of all possible decisions. An oligopoly firm must think about the reactions of their rivals every time they want to make a decision. Colluding with your rivals rarely works because the temptation to cheat is too strong as it results in much higher profits and also leave your rival in a position of weakness.

Oligopolies and Monopolistic competition share the common goal of wanting to maximize profit. They both also have control over the prices they charge. They are also similar in that neither is able to achieve allocative or productive efficiency, and operate at excess capacity.

Monopolistic competition between many firms can sustain itself for so long time before the most successful firms get so large and achieve such scale that the industry gets highly concentrated. At this point, the remaining few and large oligopolistic firms now have much more control over price, and are now forced to practice much more non-price competition (advertising, etc). Their large size inhibits competition by making entry of new firms seem very difficult. This concentrated industry with few players creates an environment that fosters mutual interdependence between firms. All firms want to maximize profits, and all firms are rivals competing for customers.

Personally I believe oligopolistic markets are the best choice. I believe their competition may be wasteful (redundant advertising), but the desire to differentiate your product creates technological changes that benefit not just the industry, but also the consumer in the form of lower prices.

‘Economists Do It With Models’ videos on game theory

http://www.youtube.com/watch?v=uAcVrcrqhn8

http://www.youtube.com/watch?v=TDtwsShOTjw&feature=relmfu

Sunday 8 January 2012

Defining Monopolistic Competition

Size	Small Company: Peter’s Drive-in	Medium Company: Crave Cupcakes	Large Company: Tim Horton’s
Features
Differentiated Products?	Y	Y	Y
Control Over Price?	Y	Y	Y, but at the corporate level, not at the franchisee’s behest
Mass Advertising?	N	N	Y
Brand Name Goods?	N, burgers are WYSIWYG	Y	Y
Franchises Available?	N	N	Y
Multiple Retail Outlets?	N, just one really good one on Transcanada highway	Y	Y, but corporate limits number of stores in geographic locations so as not to poach own customers
International Presence?	N	N	Y, including at the Dublin Zoo and a US base in Kandahar
Bulk Buying (Economies of Scale)?	Some	Some	Definitely

Definition: Monopolistic competition is a market structure where firms compete for things other than price, they compete for customers. In a monopolistically competitive market you will find many firms that acts independently of each other because each one wants a share of the total market demand in their industry. They each sell a product that is similar by definition but the goal is to persuade customers that it is different than the product offered by it’s competitors. For example, people like to eat hamburgers (imagine a fairly inelastic total market demand curve), so the firms have come up with products such as The Whopper, The Big Mac, The Baconator, and The Fatburger (each firm has a fairly elastic demand for their individual product). Technically, they’re all burgers, but each one is a differentiated product. Product Differentiation is a achieved through things like the logo, brandname, or packaging. It is also achieved by operating in a superior location and offering superior service to customers to keep them coming back. They must also occasionally improve or redevelop their product to stay competitive, and also engage in advertising to make their product’s presence known. These things will make the product seem unique to the consumer.

When a monopolistically competitive firm makes economic profits, it will attract new firms to take a slice of that pie. Monopolistically competitive firms offer ease of entry (with the exception of industries that require a government issued license such as taxi driving because licenses are limited in quantity). Firms also have some control over the prices they charge to their customers.

A monopolistically competitive firm should operate at the output where MR=MC, and use the demand curve as the point where they set their price. This will achieve maximum total profits, but unfortunately not allow the firms to achieve economic (min AC) or allocative (price = MC) levels of efficiency. Operating at excess capacity is the price of offering a unique product and competing in a monopolistically competitive market.

Thursday 29 December 2011

Competing as Starbucks

Starbucks is not often considered a fair player when it comes to how they conduct their business. However, they do take part in the perfectly competitive world market for coffee. The price of coffee beans is left up to the forces of supply and demand, so Starbucks is considered a price taker just like all of their competitors. Many people believe that Starbucks has a dominant presence in the world coffee market, but in fact their global demand for beans is only 2% (but 10% of the fair trade coffee bean market), which is hardly enough influence to control the price. Starbucks’s is merely another small buyer in a huge commodity market for an identical product, and they will purchase their beans from anyone who is selling them. They have the same information available as all other price-takers on the world market. Starbucks first store actually only sold beans, not beverages, when they first started their business.

Starbucks has been around since 1971, but anyone who was alive during the mid-nineties can recall the rapid expansion of Starbucks, which was ingeniously parodied on The Simpsons. Bart enters a mall, and passes multiple Starbucks stores, and by the time he leaves all of the stores in the mall have been converted to Starbucks stores, including the one he was just in. I grew up in Vancouver and remember a Starbucks across the street from another Starbucks.

Starbucks took great advantage of their economies of scale by doing such things as allowing customers to take used coffee grounds home to use in composting which would cut down the cost of Starbucks disposing of this byproduct. They also didn’t need to advertise, because they had saturated the market so much that it was impossible to not be aware of their presence. Litterbugs were also taking care of a lot of the advertising for them as well. Eventually they had taken full advantage of their economies of scale and were in a position where they were experiencing diseconomies of scale as their long run costs went up, likely due to bureaucratic inefficiencies. After all, it is the guys in suits that decided to keep expanding.

The unfortunate part of rapid expansion is that it is followed by rapid contraction. Starbucks was suddenly in a position where some of their stores were actually losing business to their own stores. So many outlets were running with excess capacity in the short run, rather than economic capacity where their average costs are at their minimum. They had lost sight of what worked for them in the first place, which was selling a unique coffee drinking experience, and were beginning to become a company that specialized in just rapid expansion. They were also beginning to sell a product that people were falling out of love with due to their once aroma rich stores no longer grinding the beans in-store. Consumer Reports had awarded McDonald’s with the best coffee title in 2007. This type of news was surely going to cut into Starbuck’s profits.

Downsizing is never easy, but a firm must do it in order to stay competitive. Starbucks was awarded with short term profits by innovatively expanding their business, but went too far, like Icarus flying too close to the sun. From Feb 2008 – Jan 2009 Starbucks closed 977 stores worldwide, and eliminated 18400 jobs in the US. This bold move would allow them to scale back to refocus on what actually works for them and their customers, and hopefully return to scale. They began doing such things as offering free Wi-Fi, started a loyalty program, and grinding their beans in the stores.

Personally, I brew my coffee at home or drink the free coffee at work because I feel the price of Starbucks coffee is too expensive. However, the long lines at most Starbucks will prove that the public is willing to pay the price that Starbucks charges, so they must be charging a little below the equilibrium price to create the long lineups. Perhaps the Starbucks cup is a status symbol, which would make it’s drinkers conspicuous consumers willing to pay more for what the brand symbolizes rather than the coffee itself. McDonalds does brew a comparable coffee for a lower price, but McDonald’s is….well…..it’s McDonald’s. If Starbucks lowered their prices, their product may be considered less of a status symbol and on par with the general vibe low cost outlets like McDonald’s receives. Without the high price, Starbucks would just be selling coffee.

Sources:

http://www.nytimes.com/2009/01/29/business/29sbux.html

http://askville.amazon.com/starbucks-beans/AnswerViewer.do?requestId=230804

http://www.catalogs.com/info/food/the-history-of-starbucks.html

http://www.marketingshift.com/2009/2/coffee-wars-mcdonalds-attacks-force.cfm

http://en.wikipedia.org/wiki/Starbucks

Monday 19 December 2011

Long Run Costs and Economies of Scale

I work for a large oil and gas company, and recently we held an event called the ‘Oil and Gas Board Game Day’. We have been holding this annual event for a number of years, and the event is so popular that there is always a waiting list of people who would like to take part. I think people enjoy these types of events, and companies can achieve benefits from the team building it encourages. The oil and gas board game people have built a fairly simple game that mimics the process of oil and gas exploration, drilling, and expansion. In a large company, we have such a division of labour that we really get caught up in the day to day operations of our own departments and we seldom get to interact with other departments. The board game forces members of many different departments (accounting, information systems, administration, drilling, engineering, etc) to come together and make decisions as a team. I think what attracted a lot of people to the game was the presentation. The game is played out on a massive 10’x 10’ wooden box, which is actually the game board with a paper map of Alberta on top of it. Teams must decide where they would like to run imaginary seismic surveys by using a battery powered studfinder over the paper map. The modular wooden box beneath hides the shapes of the oil and gas reservoirs and traps, and based on the surveys, teams can punch a hole in the paper with a long wooden stick to mimic drilling a well. If the stick hits wood, it’s a dry hole, but if it stands up, you have struck oil. It’s a great interactive experience, and the 3D aspect adds a really fun dimension. Basically, they took the rulebook of an old boardgame, and turned it into a 3D experience so the player feels more like they are inside the game.

Their game is loosely based on the rules of the game ‘Oil Power’, released in 1982.

http://boardgamegeek.com/boardgame/2269/oil-power

If I was to start a business, I would like to do something similar using large scale interactive variations of different boardgames. I think that kids would enjoy coming into school and presented with a massive 20 foot tall and fully interactive inflatable vertical Snakes and Ladders board, or have their soccer field converted to a giant Monopoly board. Obviously I would have trouble securing the rights to brand name games, but there is room for similar rule-sets to many popular games. I think this idea could be used during such events as kids’ birthday parties, work functions, high school assemblies, and exhibitions such as the Calgary Stampede on the PNE. I think the output units would be measured in the number of people who attend an event and are able take part in full game session. Different games would be able to include different amounts of players, so I would need to figure out how to balance a desire to include lots of people in a session against keeping the game fun. Testing the game would make it possible to measure the marginal amount of fun each player experiences as new players are added. My fixed input would be the board game itself, and the variables would be the labor involved in running the game, as well as the players who will hopefully enjoy their time. Testing would determine the optimal amount of laborers needed.

This type of business would have to start small, until I could assess the demand for such a business, or how I’d like to expand it, or scale it back once I know my average costs. I think a business like this could handle a market the size of the city of Calgary, and possibly the outlying towns once I have a handle on the cost of fuel. This type of business would probably have trouble in a rural community because it would need a large market population to exist or else the costs may not allow me to achieve minimum economic scale. If successful, I could see it prospering into a firm with a small office, a space for testing games, and an area for storing/maintaining/manufacturing the games. I would probably employ an expert carpenter (salary) and perhaps a journeyman or two (paid an hourly wage), a graphic artist, an office manager, and a few general laborers. I’d also need some sort of master of ceremonies to be the announcer of the games. I would probably outsource such work as accounting, and marketing/advertising.

The costs would include:

Sunk Costs	Fixed Costs	Variable Costs
- Initial testing and market research - Research into legalities of game rules / IP / copyrights - Consultations with experts (graphic artists, carpenters, lawyers, etc)	- Actual large gameboards and related parts - A van or truck to transport game boards - Tools to maintain games - Salaries of crucial staff - Rent for storage facility and office space - Any costs for legalities (copyrights, etc)	- Wages of hourly employees - Maintenance of gameboards (cleaning products, paint, etc) - Custom features requested by customer (banners, custom game pieces, etc) - Fuel / transportation

There is a similar company in Australia (Yardparty) that already provides a similar service.

http://www.yardparty.com.au/

Ultimately, I would love to turn these games into large scale 3D versions of themselves:

http://boardgamegeek.com/boardgame/44163/power-grid-factory-manager

http://boardgamegeek.com/boardgame/29368/last-night-on-earth-the-zombie-game

Monday 12 December 2011

Law of Diminishing Returns

If you want to influence someone’s behavior, one of the most effective ways to do it is through incentives. Incentives are the proverbial carrot on the stick that keep people motivated and moving toward the goal. Most people are raised with incentives, however large or small. A small bargain with a young child, such as giving them a piece of candy in exchange for cleaning their room teaches them an important lesson that will motivate them for the rest of their life. Generally, incentives will work for people who want the most of life, but what about the people who don’t care much about life?

In Pierre Lemieux’s article ‘The Diminishing Returns of Tobacco Legislation’ published to his website May 19^th 2001, he makes some interesting points about the subject of the attempts that have been made by the government to persuade people to stop smoking. He touches on some of the tactics, such as the pictures of diseased lungs put on the packages, and sin taxes. The fact that the price consumers paid for cigarettes rose by 48% between 1995 – 1999, but the change in demand was only 11% shows just how inelastic the cross elasticity of demand for tobacco actually is (the coefficient of 11% / 48% = 0.23).The vast majority of the increased price are sin taxes, and when the demand for a product is inelastic, then the vast majority of these taxes are paid by the consumer. This will equate to straight up tax revenue to the government. How can smokers be so willing to continue in the face of such large disincentives? An interesting point that Mr Lemieux has uncovered is that between 1985 – 1995 there was also a rise in the price of cigarettes to the tune of 52%, with an 18% drop in quantity demanded, which resulted in a cross elasticity demand coefficient of 0.35. Clearly, as time has gone on, the effectiveness of the price increases has become victim of the law of diminishing returns. The people have spoken, and have shown that they have accepted the high prices.

Mr Lemieux seems to support a move toward gentle prohibition. In a way, this has already happened, as most businesses now do not allow smoking within 10 feet of their building. The heated indoor smoking lounges at airports have become a thing of the past. However, this may be a bad idea, as it may lead people to hide and smoke in dangerous places, such as in alleyways, where their cigarettes could start a fire if improperly extinguished. The ashtrays that used to be available in public areas have mostly been removed.

The fact remains that cigarettes are addictive, so it’s likely that as people are desensitizing to the pictures on the packs, they are buying more packs. Some people are just going to smoke, even though you have to live under a rock to not know that they are deadly at this point. Some people just have less interest in self-preservation, so a picture of a diseased lung has no effect on them. Anyone who was offended by a picture of a diseased lung gave up smoking long ago. In Quebec, entrepreneurs have even come out with ironic warnings and pleasant pictures to satirize the government’s efforts at panic warnings, so these warnings are just a joke to some. The point of diminishing returns may have kicked in the moment that these serious warnings became satirical. Although the sin taxes don’t make a huge difference, and the evidence of the diminishing returns, they do make a solid dent in demand, and if smokers are willing to pay them, then it may just be a necessary evil that can have positive effects. Perhaps some sort of tax on cigarettes that goes directly into a fund to research cancer may actually have a positive outcome in the end. Maybe smokers should be forced to swipe a card when they purchase cigarettes to track their personal consumption, and tax them individually based on their personal consumption. More smokes = more taxes.

Citations:
Pierre Lemieux ‘The Diminishing Returns of Tobacco Legislation’ published to his website May 19^th 2001
http://www.pierrelemieux.org/artdiminish.html

Sunday 4 December 2011

State of the Oil Industry in Alberta

Cars run on gas. Even staunch environmentalists must reconcile with that fact when they drive across the country to protest a proposed oil pipeline. However, the game is changing. More Albertans are ditching their gas guzzling cars in exchange for hybrids because they are cheaper on fuel. The extreme people are ditching gasoline completely and now exclusively riding bikes, and buying up complementary products such as helmets. We still need cars in Alberta, but our demand for them has become far more elastic due to the passage of time and the substitutes now available to us. The City of Calgary’s Transportation Plan outlines our future plans to reduce the amount of cars on the road. One LRT can replace numerous cars on the road per trip, and we will continue to make the entire city more accessible by bicycle. This will naturally reduce our demand for gasoline powered cars. Let’s face it – the price of gasoline is always going to go up, which is going to drive up demand for bikes. Our preferences are also changing, and it is more hip to carpool or bike to work than to admit you are the sole occupant of your Escalade on your daily commute. In the future we will actually be able to do a cross-elasticity calculation to see just how much demand for bikes was affected by the price change of gas, by dividing the percentage change in demand for bikes by the percentage price change for gasoline.

Alberta’s oil industry can only stand to gain from the province’s own demand for cars becoming more elastic in the long term, because it frees up more of the oil we produce to export. The demand for oil is much higher and more inelastic in the American and Chinese markets due to their larger populations and lifestyles. This will translate into a rise in income for Albertans, which will shift our demand for luxury items to the right. We can measure this by dividing the percent change in the quantity demanded for a luxury item by the % change in our income.

All in all, the oil and gas industry in Alberta is doing fine, and the future looks bright. Our continued policies of building cities less reliant on gasoline will lower our demand for oil, meaning we can export more. The Keystone XL Pipeline may have to cross some hurdles before it is built, but the Enbridge Gateway from Alberta to the coast of BC seems on track, and will increase exports to China and the Pacific Coast of the United States by 2017.