Exercise 9-2: Comparing Market Structures

This last Blog entry for my current Microeconomics class will be a review and comparison of the four different forms of markets. I have created this table for easy comparison:

The Four Forms of Markets
	Perfect Competition	Monopoly	Monopolistic Competition	Oligopoly
Number of firms	Very Many	One	Many / Several	Few
Freedom of entry	Unrestricted	Restricted or blocked	Unrestricted	Restricted
Nature of product	Homogeneous (undifferentiated)	Unique	Differentiated	Differentiated or Undifferentiated
Implications for demand curve	Horizontal – price taker	Downward sloping and very inelastic	Downward sloping and elastic	Downward slope and inelastic
Average size of firms	Small to large	Large	Small to large	Large
Possible consumer demand	Perfectly elastic	Inelastic	Elastic	Kinked (elastic above the kink and inelastic below the kink)
Profit making possibility	Normal Profit	Economic Profit	Normal Profit	Economic Profit
Government Intervention	Productive and allocative efficiency	Productive and allocative inefficiency	Productive and allocative inefficiency	Productive and allocative inefficiency
Examples	Agriculture (Farms)	Canadian Pacific Railway	Oreo cookies (brand loyalty)	Mobile phone companies
Comparison	Opposite of Monopoly	Opposite of Perfect Competition	Common form of market	Common form of market

This graph shows, that in perfect competition, total profit is the distance between Average Revenue (AR) and Average Cost (AC).

The same graph as above, but this time for a monopoly market. The two break-even points are where AC meets AR and the maximum profit is achieved where MC meets MR.

The economic profit for the monopolistic competition represented in the purple area.

In this model of an oligopoly market, demand is relatively elastic above the kink and relatively inelastic below the kink. The price and best profit point will be at the point where the kink happens.

Exercise 8-1: Defining Oligopoly and Game Theory

I will start off today's entry with an interesting picture I found on the Internet as I initially struggled with the different types of markets. I thought this might help other students as well to better understand the different types of markets:

source: http://fintowin.com/wp-content/uploads/2011/07/types_of_market_structure.jpg

Part of this exercise is to explain the differences between oligopoly, perfect competition, and monopolistic competition. While perfect competition only exists in a market where there are many different firms offering identical products (as mentioned above, for example farmers producing and selling milk), monopolistic competition has also many small firms but differentiated products. The examples really helped me make this clear. There are many authors out there writing novels and every novel is different. While there are also many farmers out there, but every cow produces the same type of milk initially. (Minor differences might exist thought).

On the other hand, oligopoly exist where there are only a few firms offering the same product. A good example would be the tobacco industry.

Personally, I would prefer the Monopolistic competition. The reason being that I do believe that if there are many different companies in one market, they have to compete harder, be more innovative and can't just charge any price, but have to be competitive and earn their business. At the same time, since the products they offer are differentiated, a consumer has the choice of different features depending on which manufacturer or service provider he or she decides to do business. Having said that, it does depend on the type of product. I would not expect to get milk from such a market.

I am a consumer that thinks twice about major, and even minor purchases. Having worked as a Buyer and still buying some product for my current employer, I have to make choices on a daily basis a consumer. Depending on the situation I put my focus on different aspects. As an example, when we have to hire a third party company do some on site work for our business, safety is number one. We would find out what the potential suppliers safety record is before we even get a quote. However, when it comes to batteries for a flashlight for example, price and availability are more the focus than the brand name for example.

As a consumer I do feel in control most of the time, with some exceptions such as finding a mobile phone provider - which I guess would be a Oligopoly, since there aren't all that many companies offering these services, especially not when one has to travel outside the city limits.

Game Theory:

The idea behind game theory is that every company acts according to its self interest. What that means is that if two competitors could work together and have a collusion in which they decide at what price and quantity to sell their products in order to make sure both get an equal amount of profit, sooner or later one of the two companies is very likely to "cheat" and try to sell more and/or at a different price in order to outperform the competitor. This eventually leads to the other party not having a choice but to also cheat. Once both sides are cheating they both make the same amount of profit, but the profit for each is lower than when they were working together.


This phenomena can be better understood by looking at what is called a "pay-off matrix". There are 4 possibilities on how these two companies operate:


1. They cooperate and set prices so they can both get the highest return
2. One  company sticks to the agreement while the other cheats. This results in higher profit for the cheating company and lower profit for the honest one
3. Both companies do not cooperate, or cheat. This will result in lower profits than if both companies would be cooperating


The two competitors will make the most combined profit if they cooperate. If one of them cheats, it will make a higher profit until the other competitor figures it out and also breaks the agreement, at which point both companies make less profit than if they would still stick to the initial agreement.


A recent example of a company that was suspected to be part of a collusion is Apple with it's e-book store, see the news story here.

Exercise 7-1: Defining Monopolistic Competition

Size:	Small Company	Medium Company	Large Company
Features:
Differentiated products	Brewster's - With a few locations in Alberta and Saskatchewan and specialized on brewing own beer	Boston Pizza - Franchises all over Canada and some in the US, specialized in Pizza, but offering a variety of dishes.	McDonald's - Franchises all over the world and market leader when it comes to Hamburgers.
Control over price	Edelweiss store - Grocery and gifts store with imported goods from Germany	Pawn Shops - Can be various stores with the same owner and have control over the price	Rolex - High end watches
Mass advertising	Kokanee - Western Canadian Beer brand with TV and newspaper ads	President's Choice - Medium company with advertisement in newspaper, TV, flyer's	Scotiabank - every possible way of advertisement: in-store, TV, Radio, Newspaper, Internet, Billboards, Hockey arenas...
Brand name goods	No Name - Superstore house brand with little advertisement other than Superstore trucks, flyer's and in-store	Easton - Recognized hockey brand	Coca Cola - world wide leader when it comes to Pop

The main characteristics of a Monopolistic Competition are that there are many companies that are relatively small to the size of the market and therefore have small market shares. No special entry or exit requirements exist for new companies and while they all offer similar products, they try to differentiate from each other and advertise to inform the buyers on why product A is better than product B.

Exercise 6-2: Competing as Starbucks

I am not sure if we can talk about the coffee shop market to be perfectly competitive. However, the "fast-food" coffee is certainly not a public good. In Canada, there are a few companies in this business, however I would say the industry is dominated by the big two: Tim Horton's and Starbucks. On the outside looking in are McDonald's (McCafe), Second Cup, Timothy's and a few even smaller chains.

Reading through the email send by CEO Howard Schultz (see the email here) I agree with the Starbucks experience being on the declining side of things. In a matter of fact, my wife and I used to go to Starbucks and sit there and drink our coffee. We haven't done this in a while and I do agree that it used to be nice to see how our beverage get's prepared and see the barista preparing it. The new machines do block the sight and I had no idea they actually grind coffee there too. In a matter of fact, after ordering the beverage, you can't see much until you actually get it at the receiving end of the shop.

This is how Starbucks started to built it's brand and it has gone away from that in order to be faster. Starbucks should stand for it's quality and the experience though while McDonald's is less about the experience and more about fast food and the children play-ground.

I can understand the closure of some of the Starbucks stores in 2008 and 2009. Because people didn't have as much money and were worried about their job's, they would substitute the "expensive" Starbucks coffee for home made coffee. If they cared about the taste of Starbucks coffee they would most likely buy the grinded Starbucks coffee and brew it at home instead of enjoying it in store or at the drive-thru.

This would result in lower quantities of coffee produced in many stores. Some of them, as discussed in these two articles (CBC and The Seattle Times) would operate at or below the break-even price and eventually get to the shutdown price, once the price drops below the average variable cost. Below this point the store won't even cover it's variable expenses anymore and produce losses higher than the fixed costs. This is where stores have to be shutdown, at least temporally.

Personally I do think the coffee at Starbucks is too expensive. I rather go to Tim Horton's and have my coffee there or have a K-Cup machine at home and drink my "fancy" coffee this way. However, there are many fans of Starbucks that support the brand itself. Starbucks seems to almost be a "status symbol" in an office. So is Tim Horton's. I think the brand has such a strong reputation, that people are willing to pay for it.

Exercise 5-5: Long Run Costs and Economies of Scale

This time, I will think about Long-run, Short-run costs and fixed costs for a potential business I might start together with my wife.

She enjoys taking pictures since her childhood and owns an SLR camera. She has taken some online courses, has a software to get the full potential out of every snapshot and, being a mom of a 8 month old, now she has her own model too. (No, her husband doesn't make a good model)

We are now thinking about offering affordable baby photo shoots for parents, at their home.

While there are many professional photo services in town, not too many specialize in at home baby photo shooting. Having a breast fed baby ourselves, we know how hard it is to commit to appointments at an exact time. Let alone the babies mood at the point of the appointment. And who wants a fuzzy baby on their pictures? Our service would offer parents to book a large window during a day for the photo shooting and we would be visiting the young family at their own home, where the babies feel most comfortable, have their favourite toys, aso.

Now, how come we can be competitive in this business?

By having a home-based service business, with the only machinery being the already existing SLR camera, the already existing computer and software, and the also already existing vehicle, we can keep our explicit costs very low. All we need to get started is a website and some business cards.

My wife, being a stay at home mom and able to bring our daugther to the photo shooting will only have gas as her variable cost. The website will be paid annually and is a fixed cost. Same with her "plant". She can modify, review and print pictures right at her desk in our house, which we own anyways.

Even thought it isn't our intention, a way to expand would be to train other mom's the in's and out's in photography and offer courses. If we would decide to offer this new product, in the short-run we would have to do one-on-one sessions, since we don't have a classroom to host more people. This would mean, that our Average Total Cost per unit of lesson would be high, since the quantity of lessons we can provide per day is limited.

If these lessons would become a huge success and we couldn't keep up with the demand, we would have to consider renting an office/classroom somewhere in order to teach several moms (or dad's) simultaneously how to capture their babies milestones. This would increase our fixed costs, since now we would have to pay for rent, but should lower our Long-run cost, since we can now increase the amount of student's significantly. All the time saved driving from one client to another would be saved.

Looking for a similar business, I have found Marie-Helene Bilodeau's business. Here.

She already offers SLR camera classes and her strength seems to be, that she already has a facility available to her (the North Glenmore Community Centre). The one disadvantage comparing her courses with our idea, is probably that her course is more generic, where we would specifically target young parents and keep the sessions to one single class, focusing on their kids.

Exercise 5-3: Diminishing returns to Tobacco Legislation

This week we were asked to write about an article posted by Pierre Lemieux on March 19th, 2001. His full article can be found here.

I am a non smoker myself and have been all my life. As I have seen friends and co-worker smoke in the past, I did often talk to them about their motivations behind smoking and why they wouldn't stop smoking. It was something I have found interesting, since I don't see any benefits in smoking myself, but I wanted to understand why these people would make the choices they do. The answers I have gotten range from "I plan to quit in x days, weeks, months", to "I just enjoy it too much" and "don't care about possible health effects".

Certain points Pierre Lemieux was talking about, I can absolutely agree with:

(1) "...[f]urther reductions in smoking in countries where the health consequences of smoking is widespread will be more difficult" (Prabhat Jha and Frank Chaloupka, Ed., Tobacco Control in Developing Countries, Oxford University Press, 2000)."

(2) "One reason why government intervention against smoking becomes less effective is that smokers who were the most easily persuaded have already quit. The remaining ones are those who value smoking more, and therefore require higher disincentive before they quit..."

I do think, smokers that do get scared about pictures on the cigarette boxes and do realize what they do to their bodies by continuing smoking, have quit already and don't even need to see these pictures anymore. It was a good campaign when it was initially started, but I think it has worn off by now. Also, since most smokers don't have a surgeon or nurse profession, I don't think they even know how a non-smoker lung looks like. So why should a smoker lung picture be intimidating? I certainly haven't seen my lung from the inside yet...

(3) "Too much information may also kill information. As advice, warnings, and threats from authority become more numerous and visible, they tend to be discounted or ignored."

I do remember reading on a cigarette box lately, that smoking kills the equivalent of a small town in Canada every year. While I am sure this is true, probably a series of towns get killed in traffic accidents. Yet we still all drive to work. Someone may suggest most people die in a bed - so should we avoid going to bed? Point 3 goes kind of hand in hand with points 1 and 2. I think the smokers that start reading this information and get scared because of them - they already quit smoking.

(4) "A push towards mild forms of prohibition should not be discounted. Indeed, smoking is prohibited in more and more so-called "public places" – which are generally pieces of private property open to customers."

This is the first point where I disagree with the text. I have elected not to smoke and I think, who ever wants to smoke has to make sure he or she does not affect any non-smoker in any way. There should be designated areas for smokers (and there more often than not are these days), but the non-smokers should not have to "move" or "watch out" for smokers. Also kids should be protected from smokers and be able to go wherever they want without having to be secondary smokers.

I do think that more and more people start to take on a healthier lifestyle. This will most likely cause governments tax income to diminish. Initially this is what governments wanted, to get smoking rates down and possibly save money in health care costs. However, I do think that the extra tax income is missed also, and governments will want to make up for at least a portion of the lost revenue. Increasing the taxes on cigarettes to have the remaining smokers make up for the lost ones will not be a favourable solution in the long-term, as I could see some initial price elasticity by smokers, but eventually some won't be able to afford it anymore.

Two things could happen at that point:

1) More smokers quit and the tax revenue drops even further

2) More cigarettes get smuggled and sold illegally

When I have talked to smokers in the past, some of them were actually realizing the amount of money they light up over the course of a year. One particular person that I have known for years is saving every cent possible for retirement and investments. He still smokes away more than $3,000 a year... He knows it could be a great investment providing him with a nice retirement in 20-30 years down the road, or pay for an amazing vacation - every year. Still, he does enjoy smoking too much to quit.

I do not think that pictures and warnings on the cigarette boxes still help anyone. Smokers ignore them, tobacco companies know about the price elasticity and attitudes of their remaining customers, and the remaining smokers just don't care (anymore).

Exercise 4-3: Demand elasticity in the Oil & Gas industry in Alberta

This week's Assignment had me look into the current state of the Oil and Gas Industry inAlberta. I have an interest in this sector, as I have recently started my new Position at a Power Station with an Oil & Gas company and haven't had any exposure to this industry before. Since our Power Station is powered by natural gas, we actually profit from the current low natural gas prices.

An article from "The Alberta Oil Magazine" (find the article here) suggested that the natural gas prices will remain low for the foreseeable future, which again, is good news in my particular situation, as our input cost at the Power Station will allow for a good profit. But I guess it is safe to say, that Oil and Gas company in Alberta in general would rather see the price come back up.

If we take a look at the price of natural gas in Alberta in the last ten years, we can see how the price spiked and then dropped three times, but every

time it spiked, it actually didn't quite make it the the previous high. What I also find interesting is the fact, that the price seems to have reached a consistent level. In the previous ten years, it has never taken that long, before the prices started to raise at least a little bit:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

On the website of the National Energy Board of Canada, I have also found a forecast for the natural gas demand, which interestingly shows a fairly consistent demand, except for the Energy sector, which will increase it's demand over time. I would assume part of it could be the conversion of many coal powered Power Stations to Natural Gas Power Stations in the future, as well as the raising demand for Power itself:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

The forecast for the demand goes hand in hand with the Energy Board's forecast for the price as seen here:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

This brings me to my conclusion.

I think there is a fair amount of elasticity when it comes to natural gas. If the gas price would be exploding, there are alternatives on how we produce power as well as how we heat our homes and businesses. Even cars are still mainly powered by gas and the industry is moving towards electric cars. Hydrogen cars are another alternative and I have worked for a manufacturer of Natural gas and Hydrogen vehicle gas tanks before.

This last image clearly shows, that there is more supply than demand right now and it certainly shows, why the Alberta Oil Magazine doesn't expect the gas price to recover anytime soon.

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

But all it takes is one really cold year and demand can increase immediately. After all, switching energy sources to warm up our home's can't be done over night either - and most of us would probably rather spend the money, than freeze at home.

Sources:

Alberta Oil Magazine (http://www.albertaoilmagazine.com)

National Energy Board of Canada (www.neb.gc.ca)