I love croissants (or “gipfeli” as they are known here in Switzerland). I also love using bakeries as examples of businesses operating in competitive industries when teaching the concepts of perfect competition in my Theory of the Firm unit. So I was thrilled to see this article from the Economist this week called Croissantonomics.
The nature of competition in the market for baked goods in New York City is clearly intense, as the baker featured in the article implies.
In all, it costs Mr Rubin $2.60 to make a $3.50 croissant. If he makes 100 and sells 70, he earns $245 but his costs are $260. Since he refuses to sell leftovers—all goods are sold within a day—he loses money. “Welcome to the bakery business,” Mr Rubin says
The article outlines the secret to success in this competitive market.
First, product differentiation: “his best creations are distinctly American: pretzel croissants (surprisingly tasty), and recipes for making money.”
Second, know the determinants of demand for your product:
There are no brownies or carrot cake on Mondays or Tuesdays—people don’t buy rich desserts after decadent weekends. He watches the weather closely, as demand melts in the rain. He keeps an eye on school calendars, to bake less when children are away. He bakes more after the fasting of Yom Kippur, when demand from Jewish customers picks up.
The article provides an excellent example of how important it is for a producer of a good in a competitive market must be intimately familiar with his consumers in order to succeed. Markets are most efficient when perfect information and knowledge of the desires of consumers is communicated to producers, but in many markets there is information asymmetry, meaning that the sellers do not know what consumers truly want and are therefore unable to bring to market those goods and services that are most in demand.
Mr. Rubin’s bakery has discovered the secret to success in a competitive market: Know thine determinants of demand and make sure you only produce precisely what it is consumers want, and do so at the least possible cost in order to eliminate waste. In this way, Economic Darwinism assures the survival of the most efficient.
Such strategies have helped the City Bakery survive since 1990. It now has seven smaller shops in New York and seven outposts in Japan, with plans to open in Dubai.
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When a competitive industry acts like a monopoly, the consumers are the losers, the producers are the winners, and a market that may have been efficient is made less so. But how can this type of collusion be possible, and what happens when collusive agreements fall apart?
NPR’s Planet Money tells the story of a collusive agreement, and what happened when one producer betrayed the agreement.
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The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry. A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.
Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)
Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).
Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.
Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.
The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:
“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.
The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”
The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:
“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.
In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…
In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”
That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).
Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.
Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.
Why do governments regulate the prices in industries such as natural gas and electricity?
Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?
Facts: 65% of all the beer bought in the United States is produced by one of two companies: Anheuser Busch / InBev or Miller. 7% is produced by a company called Grupo Modelo. 72% of all the beer bought comes from these three companies. Much of the remaining market is shared by thousands of “micro-breweries” of varying sizes.
While there are literally thousands of beer makers in the US, technically speaking, the market is oligopolistic, since such a large share of the market (72%) is dominated by just three firms. To be classified as an oligopoly, a market must be dominated by a few large firm selling a differentiated (and sometimes a homogeneous) product. Firms are interdependent on one another and they tend to compete for consumers using “non-price competition”, which may include improving the quality of their product and offering customers a wider variety to choose from, and especially through advertising. A final characteristic of oligopoly is that high barriers to entry exist.
In the case of the beer market, there are minimal economies of scale, since anyone with a $200 home brewing kit can technically “enter the market”. But other barriers to entering the national market for beer are significant, which explains why the market is dominated by three huge firms. Notably, brand recognition poses a barrier to entry to the thousands of small brewers in America. The brands owned by the big three firms are well-established and liked among consumers, making it difficult for smaller brewers to gain share in the market.
In the Planet Money podcast below, we hear the story two of these “big three” beer makers. Anheuser Busch / InBev is attempting to merge with Grupo Modelo, a transaction that would reduce the “big three” to the “big two”, which would give the new single firm a truly dominant position in the market, and increase the two-firm concentration ratio from 65% to 72%. The podcast explains how competition in the market for beer benefits consumers, and how a decrease in competition will harm consumers. Below, I will provide a graphical analysis of the situation.
As the podcast explains, the competition between the big three beer producers has several benefits for consumers, not least of which is the huge variety of beers available across the three firms, each trying to capture a larger share of the market by offering consumers beers that appeal to their diverse tastes. In addition, however, the nature of competition in oligopolistic markets tends to result in stable prices over time. Here’s why:
Imagine Anheuser Busch / InBev, which wishes to raise its price from P1 to P2 in the graph below. If AB/InBev raises its prices, while Modelo and Miller keep theirs unchanged, the demand for AB/InBev’s beer is likely to be highly elastic, meaning that even a small price increase will cause the quantity demanded to fall dramatically (from Q1 to Q2). Due to the high elasticity of demand above P1, such a price hike will lead to lower revenues for AB/InBev. Conclusion? A price hike is a bad idea.
So what if AB/InBev decides to lower its prices? The graph below shows that at any price below P1, demand will most likely be highly inelastic, because a price cut will most likely be matched by Modelo and Miller, who would have to cut their prices to avoid losing a significant number of consumers to AB/InBev. If all three firms lower their prices, then each firm will see hardly any increase at all in their total sales. A price decrease by AB/InBev will set off a “price war” and the firm will see its revenues fall.
What we end up with is what is known as a “kinked” demand curve for AB/InBev’s beers.
The firm has almost no incentive to raise or lower its prices, since a change in either direction will cause revenues to decline. Therefore, beer consumers enjoy stable prices, and the firms choose to compete through product differentiation, innovation and, of course, advertising!
So how would a merger between two of the big three beer makers change the situation in the market? What if just TWO firms controlled 72% of the market instead of three? The fear is that AB/InBev, once it owns Modelo, will be less interdependent on the actions of Miller. In other words, it will care less whether Miller ignores its price increases or matches its price decreases. Since there will be fewer substitutes for the gigantic firm’s dozens (or hundreds?!) of beer brands, demand for them overall will be more inelastic. This would give AB/InBev more price making power, and essentially make the market look more like a monopoly.
When a firm has monopoly power, as we can see, a large increase in price (from P1 to P2) leads to a relatively smaller decrease in sales (from Qt to Q2). If AB/InBev and Modelo were to merge the firm would be able to get away with raising the price of all of its beer brands, as consumers are less likely to switch to the competition, since a big chunk of the competition would be owned by the firm itself!
The amount of competition that exists in a market has major bearings on the consumers, as this podcast demonstrates and our graphs illustrate. With just three big firms making 72% of the beer in the US, it may not seem like that big a deal if two of them merge. But even the loss of one firm in a highly concentrated market like beer could lead to higher prices for dozens of the top selling beers in the country; hence the US government’s hesitance to give AB/InBev a green light in its plan to acquire Grupo Modelo!
How can a market with thousands of individual sellers be considered oligopolistic?
Why is “brand recognition” considered a barrier to entry into the beer market?
Explain why prices in oligopolistic markets tend not to increase or decrease very often.
Why is “non-price competition” so important for beer makers in the US? What are some forms of non-price competition that they practice?
What is meant by the statement that “monopoly price is higher and output is lower than what is socially optimal.” Would this apply to the beer market if the AB/InBev and Modelo merger were to proceed?
I have two interesting stories on Apple and the iPad to reflect on today.
First, ABC’s Nightline recently became the first Western journalists actually welcomed into an Apple assembly plant in China. The show recently aired a 15 minute feature on working conditions inside Apple’s Foxconn factory in Shenzhen, China last week. Watch the video and then scroll down for what may be some additional surprising news about Apple’s operations in China.
Next, the story that has gone unreported lately is a University of California study titled “Capturing Value in Global Networks: Apple’s iPad and iPhone”. The study’s most interesting finding, in my opinion, is the tiny percentage of the total value of Apple’s iPhone and iPad that actually goes to the Chinese manufacturers of the products. The charts below, from the study, show how the value is divided among the various groups involved it their production and sales:
The chart shows a geographical breakdown of the retail price of an iPad. The main rewards go to American shareholders and workers. Apple’s profit amounts to about 30% of the sales price. Product design, software development and marketing are based in America. Add in the profits and wages of American suppliers, and distribution and retail costs, and America retains about half the total value of an iPad sold there. The next biggest gainers are South Korean firms like Samsung and LG, which provide the display and memory chips, whose profits account for 7% of an iPad’s value. The main financial benefit to China is wages paid to workers for assembling the product and for manufacturing some inputs—equivalent to only 2% of the retail price.
A student today asked why Apple doesn’t produce its products in the United States, where an economic downturn has left 14 million American out of work for the last three or four years. If iPads and iPhones were just made in America, jobs could be created, households would have more income to spend on Apples products, and both the country and the economy would benefit.
The data in the UC study indicates that in fact, more than half the value of an iPad or iPhone does end up in the hands of Americans. But Apple could never achieve the low costs and high profits that it does by assembling its products in the US. After watching the Nightline video above, it should be clear that the type of production involved in Apple factories’ is very low-skilled and labor-intensive. Using American labor, with its unions, minimum wages and 40 hour work weeks, would require Apple to employ such large numbers of workers and raise the company’s variable cost to such a level that the firm’s profits would be reduced significantly and its sales would fall dramatically. Apple would lose out to foreign producers of smart phones and tablet computers, such as LG, Samsung, Sony and others, which would continue assembling their goods with Chinese labor.
Ultimately, any gain to the low-skilled American workers (presuming Apple could even find enough to do the work of the 400,000 Chinese employed in the production of Apple products in China), would be offset by a loss of profits enjoyed by the millions of Americans who hold shares in Apple Computer and the thousands of American who are employed engineering and designing its products, as the firm’s sales would slip in the face of lower-cost competitors.
So this student’s question identifies an interesting paradox: America, with its large pool of unemployed workers, will never be attractive as a place to produce labor-intensive products such as phones and tablet computers, due to the vast wage differential between the US and China. And even if one firm did decide to produce its products in America, the gains to low-skilled workers who may find minimum wage work in the new assembly plants would be off-set by losses to the firms’ shareholders and the high-skilled workers whose jobs would be lost as sales decline due to the lower prices offered by lower-cost competitors.
The lesson here is two-fold: First, Apple and other American technology companies should continue using Chinese labor to assemble their products, and second, America is better off for it: lower costs mean cheaper products and higher sales, thus greater employment in the high-skilled sectors of the US economy, and more profits and returns on the investments of shareholders in American corporations. Americans are richer and enjoy a higher standard of living thanks to the millions of Chinese working in factories assembling the goods we consume.
Keep in mind, this analysis did not even consider the effect on the Chinese economy and the millions of Chinese workers (whose lives are much harder than the typical American) should companies like Apple shut down their Chinese manufacturing plants. That’s a whole other blog post!