Motivation and Objectives Interesting evidence of woefully imperfect markets Semiconductor Integrated Circuit (IC) market is one example Used Textbook Market is another example Conventional economic models were found inadequate in these markets Our objectives are to bridge the gap between conventional models and our model
A Familiar Conventional Model Hotellings Model is one of the earliest known models It can be invoked to explain away trivial instances of market imperfection Price of a soda can is known to be exorbitant at airports compared to supermarkets Customers are willing to pay for convenience and a cold can of soda!
Empirical Data Semiconductor Market Operational Amplifier ( 741 ) Price /100 chips Vendor A Vendor B Vendor C Vendor D $18 $22 $49 $95 Semiconductor Market Transistor (TIP 31C) Price /100 Vendor A Vendor B Vendor C Vendor D $29.30 $159 $69 $30
Empirical Data … continued! Semiconductor Market Memory ( 2114 RAM ) Price / chip Vendor A Vendor B Vendor C Vendor D $13.75 $1.69 $1.29 $2.58 Textbook Market (used) Electric Circuit Theory (Johnson) Price /single copy Vendor A Vendor B Vendor C Vendor D $10 $30 $55 $100 These are undifferentiated products Same transportation costs
Synopsis of Market Models Monopoly Oligopoly Monopolistic Competition Competition Maximize Profit MR = MC MR = MC MR = MC p = MR = MC Price price setter price setter price setter price taker Market Power p > MC p > MC p > MC p = MC Entry No Entry Limited Entry Free Entry Free Entry
Conventional Model Characteristics A monopoly does not care what the rival firm does … there are NO RIVALS! A competitive firm does not care what the rivals do because it does not matter! An oligopolistic firm seriously considers how its actions affect its rivals and how the actions of its rivals will affect it. A monopolistically competitive firm seriously considers how its actions affect its rivals and how the actions of its rivals will affect it. These strategies (GAMES) lead to NASH EQUILIBRIA
Paradoxes of Imperfectly Competitive Markets Entry of a new firm in the market may actually decrease the total output and increase the equilibrium price increase the profit of the incumbent firm A merger of two or more firms can decrease the profits of all merged firms The entry of a new firm in the market might decrease social welfare Even if the entry of a firm would raise social welfare, this entry might not be profitable
Justification for a New Model Hotellings model is not viable because there is no product differentiation in our semiconductor and textbook markets Similarly, Chamberlin/Robinson monopolistic competition is not viable because there is no product differentiation in our semiconductor and textbook markets Is Cournots model a viable candidate?
Cournot Model In the Cournot Model of non-cooperative oligopoly, the firms choose their output levels without colluding (no cartels!) but they make conjectures about the reactions of their rivals in response to their actions To set the stage for Cournots oligopoly, let us review the structure of a monopoly We posit a linear inverse demand function p(q) = a – bq The revenue is R = pq R = aq – bq 2
Monopoly … continued! The marginal revenue can be obtained as a partial derivative of R with respect to the output q. MR = R/ q MR = a – 2bq In terms of elasticity ɛ MR = p (1-1/ɛ)
Monopoly … pricing! The cost curve C(q) = kq where k is a constant The marginal cost MC = C/ q = k A monopoly sells where p = MC = MR so we have k = a – 2bq Hence the output and price for a monopoly are q m = (a-k)/2b p m = (a+k)/2
Cournot Oligopoly … pricing! Without loss of generality, we posit a tractable linear demand curve q = a- p Total demand = q 1 + q 2 for two firms In the Cournot model, each firm conjectures that the other firm will act in a way to keep the quantity that it sells fixed. We will calculate the reaction function of each firm to the quantity supplied by the other.
Cournot Equilibrium A Cournot Equilibrium (C.E.), as in a Nash game (e.g. prisoners dilemma) occurs when neither firm wants to change and is content with its output and profit. Imposing this criterion on q1* and q2* yields C.E. = (a – k) / 3
q1q1 q2q2 Isoprofit curves COURNOT REACTION FUNCTION Straight line is REACTION FUNCTION for firm 1 reacting to firm 2
q1q1 q2q2 C.E. R 12 R 21 R 12 Reaction function of firm 1 reacting to firm 2 R 21 Reaction function of firm 2 reacting to firm 1 COURNOT EQUILIBRIUM
Cournot Equilibrium … conclusion At the Cournot equilibrium we have the following price / output equations: q 1 = q 2 = (a – k) / 3 Q = 2 (a – k) / 3 p = (a + 2k) / 3 Conclusion: Cournot equilibrium price is only marginally higher than the perfectly competitive price and only marginally lower than the monopoly price In general, for n firms in a Cournot oligopoly q n = (a – k) / (n + 1)
Woefully Imperfect! The plethora of market models cannot explain the existence of glaring and woefully widespread price differences that we have found in the semiconductor and other markets. Clearly challenges the notions of efficient markets and rational and informed buyers and sellers populating these markets. Resolution of our woefully imperfect market puzzle lies in the domain of behavioral science and habit persistence
Is Behavioral the answer? Attempt to explain this puzzle by invoking behavioral and habit persistence hypotheses that appear to override the efficient markets and the rational and informed participant hypotheses The equity premium puzzle, Mehra and Prescott (1985) Ravn (2006) explores the concept of Deep Habits which are the offshoots of Behavioral Science Habit persistence is a preference specification that yields a utility function that depends on the quasi-difference of consumption
Survey study At the heart of the rational and efficient market hypothesis is a fallacious assumption that market participants will seek out the lowest price Survey will study the purchasing decisions of different types of customers (students, administrators, faculty) Distinguishing the decisions by moral hazard conditions Willingness to pay with and without constraints