The Failings of Price Mechanism

The free market is defined by the allocation of resources based upon the functioning of the price mechanism. This takes into account the equilibrium between demand and supply schedules. In this essay I will argue that while the price mechanism may be efficient, there are cases where it fails. Specifically focusing on the case of monopolies and then market failure whereby there are externalities.

The price mechanism does provide efficiency, through the price signaling created by demand and supply schedules. This brings us to a point of equilibrium that is Pareto optimal as neither consumer or producer can be better off without the other being worse off. Furthermore, at this equilibrium we also achieve allocative efficiency, suggesting that there is the best allocation of resources possible. This is shown through the diagram below, at the equilibrium of Qe – Pe.

We may note that there is producer and consumer surplus, this defines our parameters of Pareto efficiency, any move from the market clearing equilibrium either the producer or consumer may be worse-off. This is limited by not considering the type of market structure that is present.

The monopoly market structure provides evidence for the possible inefficiency that may be incurred through the price mechanism system. This is a consequence of monopolies being able to set their prices, and looking to profit maximise at the point where MC=MR as seen below:

The scenario above takes the market away from away from allocative efficiency, and incurs a deadweight loss. This is a result of there being social welfare, which is not taken by the consumer or producer (shown below).

This prices out a range of consumers, so the deadweight loss represents transactions that could have occurred and would have been socially beneficial, but have not occurred. This point is not Pareto optimal as the consumer is worse-off, nor is it allocatively efficient. Allocative efficiency and Pareto optimality could be achieved if the monopoly were to go to the equilibrium of Qe-Pe, this would mean the firm prices at the point where MC=AR, returning to market clearing.

It is important to note that a monopoly may achieve dynamic efficiency, which is unlikely for a perfectly competitive firm as a consequence of having normal profit. The monopoly gains abnormal profit (as shown by the profit margin in graph 2) that can be used for research and development. Taking the example of pharmaceutical companies, it can be noted that this abnormal profit is required for new drugs to be developed, otherwise at the cost of innovation perfectly competitive firms would not be able to supply new or better drugs which may benefit society.

We must also consider inefficiency incurred through firms pursuing aggressive tactics such as using the abnormal profit to set up legal barriers, attempt to takeover smaller firms, and abuse the economics of scale to lower the price in order to stop firms entering the market. This generates greater inefficiency in terms of reducing consumer’s welfare while also ensuring future inefficiency as barriers to entry. An example of this behaviour was shown by the De Beers diamond cartel in the 1980s, where it had a market share of up to 90% (Zimnisky, Paul). This was achieved through persuading independent mines to join the cartel; if they chose not to they would flood the market with diamonds reducing their price thereby pricing them out. They also dictated price through stockpiling in order to limit supply (Zimnisky, Paul). Exemplifying firm behaviour through the price mechanism that yields inefficiency in terms of societies welfare.

The price mechanism may also fail to provide efficiency as a consequence of externalities, which are an effect on a third-party that was not involved in the original transaction that is not accounted for in the price. The degree of inefficiency tends to correlate with the typology of the good in question. The manner in which the market forces operate suggests that the price mechanism is still operating efficiently due to the market clearing, as the externality is not directly shown. We must also consider that there can also be a deadweight loss in this scenario. The externality as an inefficiency may be shown through considering marginal private cost and marginal social cost, in that the market equilibrium is at the price and quantity that corresponds with marginal private cost, not accounting for the social cost:

However, this can be countered by the efficiency stated through the Coase theorem. Suggesting that if bargaining in regards to an externality can occur, then an efficient outcome will be reached, providing there are negligible transaction costs. This scenario is shown below:

In this the net social gain is a result of bargaining in regards to the externality between the two parties, which results in net social gain. This is due to the loss of profit, take for the conventional example used of wind turbines and noise. The turbine company is willing to compensate people suffering from the noise due to the greater gain of using the wind turbines. There is also the opportunity to be Pareto optimal at Q1. However, this theory is limited by assuming the negligible transaction costs, which in reality tends to not be the case.

Consequently, we may examine methods of dealing with externalities, such as taxation and compensation. The case of tax effectively raises the cost of the good or service in order to account for the cost of the externality. Depending on the elasticity of demand we may note a change in the quantity consumed, regardless of that the price is “corrected”. Shown below:

Here the red highlighted area represents the active externality. With the size of the tax shown through the shifting upwards of price. Now at Q1 we operate at a Pareto optimal point, while the cost is at C2, when originally at the cost of C2 there would have been Q2 consumed. When we consider compensation, the total compensation paid is up to the point where cost first meets marginal social cost. With the Pareto optimal quantity at Q1, this makes up for the cost that is unaccounted for in the original transaction, as shown below:

Even though these are theoretically capable of dealing with an externality in order to yield an efficient outcome, we must consider that the government carries them out. Therefore, there is government inefficiency that may be carried through the initial inefficiency of the price mechanism, this is due to the inability to determine the degree of compensation or tax that is required to bring price to the point of market clearing.

Take for example the externality present with industrial fishing. While fishing occurs we may assume that the amount of fishing occurring is so that there is supply to meet demand in order for the market to clear at equilibrium. However, this does not account for the negative effect on fish stocks. Due to the demand for fish exceeding the reproductive rate of fish there is a strain on fish stock. Furthermore, the methods by which fishing occurs such as trawling may adversely affect other sea life. Quotas can prove inefficient in dealing with this problem due to the lack of infrastructure related to dealing with each fishing boat and the policing required. Moreover, this can lead to fisherman using the same methods then stock dumping which also carries negative effects towards the health of sea life. We would not consider tax, as it is not in the government’s interest to raise the cost of living for the population, this leaves compensation. This may be towards subsidising fish farms, reducing the burden on natural fish stocks. Additionally, it could go towards subsiding the fisherman to the decrease in revenue if they were to fish by less efficient but more environmentally friendly means.

In conclusion, we may note that the price mechanism can at times be relied upon for providing efficiency. However, it may fail when we consider market structures such as monopolies, or the case of externalities where there are inefficiencies that are unaccounted for in the market equilibrium. To refine this analysis of price mechanism efficiency we would consider the typology of the goods in services in question such as merit and normal goods, or common access resources.

Almog Adir

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Bibliography

Zimnisky, Paul. “A Diamond Market No Longer Controlled By De Beers.” Kitco Commentary. 06 June 2013. Web. 02 Nov. 2014.

Copyright Almog Adir © 2014 · All Rights Reserved · My Website

Greggs Bakery Sink or Swim?

Greggs reported that sales for the first quarter of the year and up until this point that sale have dropped 4.4%. They are blaming “bad weather, and under pressure consumers” as the cause for the fall in sales.

The bakery is a major feature of high streets in the United Kingdom with an estimated 1,700 stores, and still creating new outlets in order to increase sales. There are two factors which may point that Greggs is only heading down. Firstly, it may be that pasties have become increasingly less popular in a society that is concerned with body image and health. Secondly, the high rent costs of high street property which may no longer balance out with profits made from sales.

The high street has already been struggling this year, but this may the first occasion that a business of this nature may fail to survive. HMV, Jessops, Blockbuster, and Comet to name a few were all involved in sales of a technological nature, whereas Greggs is part of the food market. It is possible that competition from high street competitors such as Subway, and McDonalds are simply taking a greater percentage of customers.

Greggs have reported that they believe the issue is part of the decreased footfall in UK high streets, alongside the issue of competitors.

It is understandable that over the past few years Greggs variable costs have increased as the result of increasing basic food commodity prices. This is forcing them to raise their costs, putting further pressure on consumers. The business has been heavily pursuing deals and promotions in order to revitalise their customer base, but this is so far only proving to be a strain on their already limited profits.

The question is whether or not Greggs will survive the high street squeeze? And what will this mean for competitors in this industry?

I get the feeling that Greggs might die out, not only as a result of the competitive nature of the market, but also as a result of demand for certain foods moving elsewhere. But we will have to wait and see.

Depressing Drugs?

It looks like a certain pharmaceutical company has been caught being rather naughty once again. GlaxoSmithKline is currently being investigated for paying other drug companies to decrease their production of substitute drugs for their profitable antidepressant. This particular drug is known as “Seroxat” and GSK has been caught before with previous “pay-for-delay” agreements.

It is clear that if these allegations are true, that this is a flawless example of monopoly abuse. GSK is the UK’s largest pharmaceutical company and is a key supplier for the National Health Service. The investigation is currently being investigated by the Office of Fair Trading.

There is the potential for this to cause a domino effect, with the Office of Fair Trading beginning to crackdown on various agreements between competitors in the pharmaceutical market. There is a stereotype that pharmaceutical companies are “evil” conglomerates that over price drugs in order to keep their profit margin, and people ill.

This poses a serious issue for the NHS and taxpayers, if this becomes common practice for large pharmaceutical companies then the taxpayers will bear the burden. I would argue that it is unfair to stifle the competitiveness of the market; however it is clear that large companies that innovate will not be rewarded if a competitor can come in and recreate their drug. This is a very well established issue in the pharmaceutical industry as the question of how competitive? has gone on for a while.

The patent for Seroxat ended in 2004, and this led to the flooding of the market with cheaper substitutes. This obviously benefits consumers, but GSK then take a hit to their profits. It is arguable that the 10 year period of the patent was enough to settle the costs of research and development, and add to GSK’s already existing abnormal profit. However, it is clear that large pharmaceutical companies do not want to re-enter a R&D cycle every five years.

If it were to be revealed that GSK actively pursued “pay-for-delay” methods, then I believe it is only fair for them to be penalised for these actions. Furthermore, a possible alternative for the pharmaceutical industry would be to introduce a system which regulates the introduction of substitute products into the market. There remains the issue of whether to stifle the competitiveness of the firm, in order to create savings for the NHS and as a result the taxpayer; or keep the market deregulated and encourage the firms to innovate thereby advancing medicine to a higher degree.

GlaxoSmithKline released a press statement stating:

“GSK supports fair competition and we very strongly believe that we acted within the law,”

Now, I hate to point the obvious, and the allegations have not been proven. But I personally feel that GSK is not too certain at all. Two European commissions had already investigated the firm, so it is evident that there is increasing suspicion concerning the firm’s behaviour.

Competition in the pharmaceutical industry is already difficult with extremely high barriers to entry. This is as a result of the expertise required for drug innovation, and developments. There is also the required “capital” machinery for testing and production which small firms cannot attain.

It is clear that in the existing market that GSK is not a “pure monopoly” there is an abundance of other British pharmaceutical companies, but they are not competing at the same level as GSK. The main rivals of GSK are Pfizer, Novartis, and Sanofi. Due to this and several other factors I would argue that GSK is partaking in an oligopoly.

The  argument forms as there several key indicators. Primarily in the pharmaceutical industry there is an ever increasing amount of asymmetric competition, as the technology and science behind the drugs produced becomes more complex the more complicated it is for the average consumer to truly “understand” the product.

A key factor is the existence of many small firms, but there are more than two large firms which have a significant degree of market power. In this case it can be identified as GSK, Pfizer, etc. The market power of the central four firms, dictates the relationship between them and the various aspects of market behaviour.

Moreover, there is the existence of personal decision making, and the factor that the four major firms are price setters. This identifies the existence of market power, in the short term (5-10 years), whereas in the long term (10 years +) firms must create new products to gain the market power edge. However there is still the factor of inter-dependency and this is where there is the game theory aspect in the pharmaceutics market structure. The firms will not collude with each other, but will consider their actions, and possible repercussions.

Finally, there is product differentiation. For a given period of time one company may have an individual product which gives it greater market power. However, after that given period of time substitutes will emerge in the market and reduce the significance of the market power.

These three key identifiers clearly correlate with the behaviour of GlaxoSmithKline, and the other major pharmaceutical companies. Which is why it is notable the GSK is being investigated for breaching competition standards; it would be in their interest to maintain market power and to create an environment in which they are more of a monopoly.

I personally believe that competition is what drives the pharmaceutical industry; this keeps new products coming out and forcing firms into R&D cycles. It is still important to ensure that the firms can compete without the burdensome bureaucracy of regulation. This is why I believe that the current model is benefiting the consumer as much as possible, while maintaining the firm’s desire for profit.

Milton Friedman in his book “Capitalism And Freedom” considers that this form of market power is the lesser of three evils in which the other possibilities are government backed monopoly, or a private monopoly. It is clear that there are drawbacks in this market structure for consumers, but does that not apply to most?

It will be interesting to see how GSK will continue to respond to these allegations, and how market power may shift over time to the largest firm Pfizer.

Unemployment in Goa

Goa Taxi Regional Employment Case Study

Due to the halt in mining activity in the Goa-Karnataka region there has been an increase in unemployment. The government is attempting to reduce the unemployment from the mining market by introducing more tourist taxis in the region to go to the Dudhsagar Waterfalls due to its increasing popularity in India.

Analysis:

Unemployment is defined as: People who are out of work but actively seeking work at the current wage rate.

To decrease the unemployment the government has chosen to intervene by increasing the supply of labour in the taxi market to meet the demand by tourists. This will counteract the unemployment that occurred due to the halt of the mining activity in the region; the idea is that those who lost their jobs will be able to become tourist taxi drivers. Taxi driving in the region could support similar salaries to the workers, as their salaries are based upon how many customers they receive as they are paid a cut of their fee.

Unemployment in the Mining Market:

The quantity of labour demanded has decreased due to the halt of mining activity, since there has been no effect on the quantity of workers there is the presence of a surplus. A surplus in this sense represents the existence of unemployment in the market. There is a considerable gap in the quantity of labour demanded versus the quantity of labour supplied; this gives the miner several options. The miners could offer to work at the equilibrium price even though the demand for labour has dropped thereby increasing the price. The other more likely option is to simply leave the market and seek employment elsewhere, preferably at a similar wage rate and working conditions. This alongside the governments support is what transfers the now underutilised human capital and places this in the tourist taxi market, having the following effect.

From the graph above it can be noted that there is an outward shift in the supply curve as more taxi drivers have entered the market. This has caused a fall in the price of the labour (fall in wages). This has not caused a surplus in the taxi driver market, as the government recognised that there was a shortage of taxi drivers for this tourist destination and has now been able to meet the demand. It should be noted that this increase in supply won’t be instantaneous as it will take time for those that were employed in the mining market to move to the taxi market due to licensing requirements and the expense of a taxi car.

Evaluation:

The government has successfully solved part of the unemployment issues caused by the halt of mining within the region. There are however several possible consequences to the employment boost in the taxi market. These issues can be identified as competition, environmental effect, future unemployment, and a decrease in government revenue.

Due to the increase of taxi drivers there will be greater competition to get customers, especially during off-season times. The taxi driver’s wages will be dependent on how many passengers they will get and the size of the fee. The taxi market can be identified to contain strong elements of perfect competition, as the consumers have extensive choice of supplier especially after an increase in the number of taxi drivers. The consumer also gets the lowest price possible from the drivers as they are looking for as many customers as possible, and the increase in taxi drivers means greater competition. In a sense there is also freedom to enter and exit the market, because once the taxi driver has a car and a license they can choose when to drive or not. This can be favourable at times when it is off-season and there are not as many tourists to meet the supply of taxis. The consequence of this is the possibilities of making low wages in one particular month, taxi drivers may seek out other work, drive their taxi elsewhere, or simply become underutilised and therefore not benefit economy or themselves. There are however factors that represent the monopolistic nature of the market. It is possible for certain taxi drivers to have nicer cars or offer to double up as tour guides, this may give that particular taxi driver market power in the short-run therefore an advantage.

There may be adverse effects on the environment of the local area due to the increase in the number of taxi drivers. It can be argued that the governments halt to mining activity in the region was to solve the environmental externality of mining. The possible effect of increased taxis may be small in comparison to the pollution caused by mining, however a result of more taxis means that there is a bigger flow of human traffic. The report mentions the need to ensure the continued protection of the rare Olive Ridley Turtles who lay eggs within the popular tourist region, the increased presence of people may affect their population. The report also mentions that the road used to get to the tourist destination is through the forest on a dirt road, this means that there may be increased erosion in the area. What makes the region a tourist destination is not only the waterfalls, but also the natural beauty of the surrounding areas. Therefore, increased traffic in the area may provide a boost to the tourism industry but prove to be a risk for the value of the region.

In the long term there may be more unemployment, as it is unlikely that all of those who had jobs in the mining industry will be able to enter the taxi driver industry. The government would need to find another source to create new employment opportunities. There may also be a decline in government revenue as more tourists will use the taxis rather than the train service (government owned) that runs a route from Goa to the popular tourist destination.

The government has effectively solved the unemployment problem that arose from the halt in mining in the region, but in a short-term manner. There may be consequent issues to the solution the government has opted for. This solution very much depends on how successful the region maintains itself to be a tourist destination in the future.

Oligopoly Vs. Monopolistic Competition Air Berlin Case Study

Case Study: Air Berlin

Theory of the Firm Analysis

Fixed Costs:

• Airplanes
• Labour (salaries)
• Airport Facilities

Variable Costs:

• Fuel
• Landing Fees

Define Fixed Cost: A cost that does not vary with output

Define Variable Cost: A cost that varies with output

The airplane is a fixed cost as once it is paid for the only variance in cost is through its operation. In the article it is mentioned that they look to sell 8 airplanes in the interest of reducing fixed costs as to reintroduce capital into the firm. An airplane in the majority of cases is bought outright, and this is established by the firm’s ability to sell it.

The fuel is a variable cost due to the possible change in price of fuel supplied to the airlines. The price of fuel is dependent on the microeconomic relationship of supply & demand, as the more routes an airline runs the more fuel it will need to purchase. In the article it identifies that jet fuel prices are “highly volatile” suggesting that this cost changes dependent on output.

The second variable cost is the landing fees, as more airplanes fly the greater the landing fees, as more airplanes have to pay the fee. There is also the nature of the cost of landing fees which may change; this is identified in the article through competition with Lufthansa for a central hub.

Case for Oligopoly:

Main Factors:

• Interdependency
• Competition
• Etihad (market power)
• Sustained Losses
• Abnormal Profit & Reserves

Interdependency is a clear signal of oligopolistic competition, this is identified in the article as the need to develop a new airport. To continue competition both Air Berlin and Lufthansa must expand and open new routes, which is why there is the development of another central airport in Berlin. Currently, Lufthansa have an advantage as they have more docks for airplanes at “Tegel Airport”

There is clear evidence of competition with Lufthansa, as Air Berlin is stated to be the second-largest airline in Germany. This means that domestically the two big players are Lufthansa and Air Berlin, but the article goes on to mention the involvement of Etihad Airlines. The article also identifies that there is the intention of competition in the long run against alternative airlines, as Mehdorn states that “We want to strengthen our profile as an airline company… we need long-haul flights.”

The fact that the losses of the firm are being sustained provides clear evidence that Air Berlin is part of an oligopoly. Firstly, losses being sustained shows that the firm is not part of perfect competition, in perfect competition the firm will stop production the moment losses are being made as it is “easier” to stop producing rather than leave the market altogether. Secondly, the sustaining of losses means that at point in time the firm was making abnormal profit to build cash reserves, a firm that operates with abnormal profit is at a point of monopoly, but Air Berlin still has its competitors.

Due to the various competitions in the domestic sector mainly between Air Berlin and Lufthansa it can be argued that a kinked demand curve is in play in the German airline sector (as displayed below).

The above graph shows that they are not competing on price, this is clearly identified in the article as there is only the mention of reducing costs, introducing more routes, greater output (new airport), and airline unions (i.e. One-world Alliance). Lufthansa is shown to have a lower marginal cost due to economies of scale, as Lufthansa is a considerably bigger airline globally and in Germany in comparison to Air Berlin.

In the long run Air Berlin may be able to cut its costs down so that there is a return to normal profit, and with the eventual opening of BER the firm will be able to effectively expand and possibly compete at the same level as Lufthansa. However further delays in the opening of the new airport may mean that Air Berlin will continue to eat into their cash reserves, as stated by the article the costs per month are approximately €5 million will slowly degrade the €100 million in cash reserve. In the article it is stated that Air Berlin is selling airplanes to reduce their fixed costs, while this is appropriate action in the short run, in the long run it may mean that the firm will fail to fully utilise its new facilities of the new airport.

Case for Monopolistic Competition:

Define Monopolistic Competition: The existence of monopoly for a given firm at a given period of time in the short run. The firms in the long run will compete on price and other factors (e.g. branding, quality, etc.) eventually losing monopoly power over time as firms begin to differentiate less.

Main Factors:

• There are Many Airlines and Consumers, and no Firm Has Total Control Over Market Price
• Existence of Asymmetric Information
• Independent Decision Making
• Limited Barriers to Entry & Exit in Long Run

It is clear that there are many firms in the airline industry within Germany, and that there is a spread of consumers across the different airlines. It can be argued that no firm has clear control over market price based on external information, airlines often compete on price for specific dates or near certain events, and since there is the involvement of international airlines there is no single firm with complete control over market price.

There is clear evidence of independent decision making by Air Berlin. The first independent decision was to make a move to a new airport to act as a central hub so the firm can expand; Lufthansa had not taken any action in particular to cause this move, and it is likely that Air Berlin would have done this regardless of Lufthansa.

There is to a degree an ability to enter and exit freely into the market, this is identified by Air Berlins ability to sell airplanes, reduce unprofitable routes, and as a result reduce marginal cost. There are many competitors in the airline industry, Air Berlin could sell all of its airplanes, docks, and facilities to an international airline, or even sell parts to Lufthansa. There is the possibility of a clean exit, however in the airline industry there are many barriers to entry due to the cost of airplanes and facilities.

The diagram above shows the short run loss of Air Berlin, it can be noted that there is a shift in marginal revenue and therefore average revenue as the article states that Air Berlin begins to lose customers. There is also the issue of high fixed costs which drives the average cost curve above average revenue, as the cost of the new airport facilities is considerable.

However, in the long run it can be argued that Air Berlin shall return to a point of normal profit. This is because there is the intention to sell eight airplanes to reduce those high fixed costs. There is also the mention of introducing long haul flights and the reduction of unprofitable routes which is the reduction of the supply to meet demand. This is shown in the diagram below as the firm returns to a position of normal profit.