1. PowerPoint Slides © Michael R. Ward, UTA 2014

2. Longrun Equilibrium When a pharmaceutical product’s patent expires, generic firms are usually legally permitted to enter. Are generic products very differentiated? Are there high entry barriers to generic entry? Do consumers have brand awareness of generic firms? So, do you think the generic drug industry is close to “perfectly competitive”? How do makers of generic drugs earn profits? Econ 5313

3. Perfect Competition A competitive firm is one that cannot affect price They produce a product or service with very close substitutes so they have very elastic demand They have many rivals and no cost advantage over them. The industry has no barriers to entry or exit Competitive firms: Cannot affect price; they can choose only how much to produce Choose how much to sell at the competitive price, so MR = P (sometimes called “price taking” behavior) So if P>MC, produce more and if P<MC, produce less Econ 5313

4. Perfect Competition Perfect competition is a theoretical benchmark But, some industries come close; and The benchmark is valuable to expose the forces that move prices and firm profit in the long run A competitive firm can earn positive or negative profit, but only in the short-run. In the long run: Positive profit (P>AC) leads to entry, decreasing price and profit Negative profit (P<AC) leads to exit, increasing price and profit In the long-run, competitive firms are condemned to earn only an average rate of return Proposition: In equilibrium, capital is indifferent between entering one industry or any other, because P=AC (economic profit is zero) Econ 5313

5. Competition  Asset Flows Asset flows (entry/exit) force price to average cost, i.e. economic profit will always revert back to zero We say that “profits exhibit mean reversion” Silver lining to dark cloud (low profits will increase as firms exit the industry) Typical reversion speed is 38% per year So, if profits are 20% above the mean one year, in the next year they will be only 12.4% above the mean, on average In the generic drug industry, margins with one firm ~50% but margins with eight firms ~0%. Most markets attract 18+ entrants Econ 5313

6. Mean Reversion Econ 5313

7. Fashion Industry How does the process of mean reversion of profits play out in the fashion industry? Many haute couture designers vie for the “Look” each season Few succeed wildly – make lots but then ideas get stale Many succeed modestly – continue to another season Most fail – close shop The “Look” then gets copied (“knock-offs”) First, high end boutiques Next, “off-the-rack” Finally, discounters No IP protection for fashion implies fast profit dissipation Econ 5313

8. Soybean Farming There are about 21,000 soybean farmers in the US. Beans are initially sold to large Ag companies like ADM and ConAgra and are traded on the CBOT. Are soybeans very differentiated? Are there high entry barriers to soybean farming? Do consumers have brand awareness of different soybean producers? So, do you think soybean farming is close to “perfectly competitive”? How is it that some soybean farmers are quite wealthy? Econ 5313

9. Immobile Assets The land that farmers work differs in its productivity Example Texas Blackland PrairiesTexas Blackland Prairies Can get much more produce per unit of labor but MC rising. Increase farm size if P > MC The “marginal farmer” just breaks even but the infra-marginal farmers can get rich This is because the “scarce productive asset” is not transferable So, selling on a competitive market but producing with non-transferable scarce assets can generate sustainable profits for infra-marginal firms Other examples? Human Capital Econ 5313

10. The Indifference Principle The ability of assets to move from lower-valued to higher- valued uses is the force that moves an industry toward long-run equilibrium If an asset is mobile, then in long-run equilibrium, the asset will be indifferent about where it is used; that is, it will make the same profit no matter where it goes For most, San Diego, CA is a lot more attractive than Arlington, TX What assets flow? Until what happens? Cost-of-living (mostly housing prices) is the cost of admission Econ 5313

11. at&t Stadium In 2004-2005, the Arlington citizens agreed to increase their sales taxes to help pay for the new Cowboys Stadium. What effects could this have on Arlingtonians? Amenity Effects – new restaurants, business, etc. plus ‘warm glow’ from being home of the Cowboys & hosting mega-events Direct Tax Effects – Have to pay higher sales taxes How to test if the net effect was positive or negative? Use the indifference principle! Are people moving into, or out, of Arlington? More precisely, is the cost of admission (the price of a house) falling or rising? How has the city government of Detroit been doing? Econ 5313

12. Smogville versus Clean City Landsburg’s example of Smogville that allows air pollution versus Clean City that bans polluting emissions All else equal, do people prefer clean air? Is all else equal? What assets are mobile? Migration until what condition holds? Are the residents of Clean City better off because they banned pollution? Are the residents of Smogville worse off because they have to suffer pollution? Heterogeneity allows for sorting Econ 5313

13. Arbitrage Indifference Principle is limited by the mobility of the scarce asset The act of moving assets to take advantage of price differentials is called “arbitrage” Seinfeld - Bottle Deposit ArbitrageBottle Deposit Arbitrage Econ 5313

14. Wage Differentials Wages adjust to restore equilibrium Called “Compensating Wage Differential” Why do embalmers earn more than rehabilitation counselors? Why do garbage collectors earn more than nursery school teachers? Why is there “hazard pay” for firefighters and for inner- city school teachers? Why do accounting professors make 30% more than economics professors? Compensating wage differentials where you work? Econ 5313

15. Risk Premia Rates of Return adjust to riskiness of investment Called “Risk Premium” In equilibrium, differences in the rate of return reflect differences in the riskiness of the investment Expected return = (E[P t+1 ] - P t )/P t In equilibrium, differences in the rate of return reflect differences in the riskiness of an investment Risk premia are analogous to compensating wage differentials: just as workers are compensated for unpleasant work, so too are investors compensated for bearing unpleasant risks Econ 5313

16. Risk Premia in Prison Bargain over the price of a contraband item Shawshank Redemtion scene at 1:00scene Econ 5313

17. Stock Volitility VIX measures volatility. Why does higher volatility lead to lower stock prices? (HINT: investors must be compensated for bearing risk) Econ 5313

18. Measuring Risk Premia Gov’t bonds are considered risk-free, they returned 1.7% versus stocks 6.9%. The difference is a risk premium that compensates investors for holding the more risky stocks. Why were equity risk premia so small in 2002? What has happened since then? Econ 5313

19. Staying Ahead of Asset Mobility 1983 Macintosh was priced very high when it first appeared. Earned huge profits for a few years Eventually, though, Windows copied “look” of the OS, and price was forced back down and sales plummeted Strategy for Apple has been to enter at the top of a new market followed declining profits until the next innovation: iPod iTunes iPhone iPad Econ 5313

20. Monopoly A monopoly firm is one that faces a downward sloping demand curve. They produce a product or service with no close substitutes; they have no rivals; and there are barriers to entry, so no other firms can enter the industry If demand is inelastic enough P > AC and profits are earned In the very long run, even monopoly profits are driven to zero by the same competitive forces. Entry makes demand more elastic (P-MC)/P=1/|e|, which forces price back down towards MC. Asset mobility decreases cost advantages to infra-marginal firms Main difference is speed of the adjustments Econ 5313

21. Tissue Monopoly How can you earn profits from tissue paper? In 1924, Kleenex tissue was invented as a means to remove cold cream. After studying customer usage habits, however, the manufacturer (Kimberly-Clark) realized that many customers were using the product as a disposable handkerchief. The company switched its advertising focus, and sales more than doubled. Kimberly-Clark built a leadership position by creating an innovative use for a relatively common product. Econ 5313

22. Tissue Monopoly As others saw the profits, however, they moved into the tissue market The managers of Kimberly-Clark maintained profitability through a continuing stream of innovations and investment in advertising/promotion Printed tissue in the 1930’s Eyeglass tissue in the 1940’s Space-saving packaging in the 1960’s Lotion-filled tissue in the 1980’s. Without this continuing stream of innovations and brand support, the product’s profits would have been slowly eroded away by the forces of competition Econ 5313

23. From the Blog Chapter 9 Risk-on, Risk-off trading Entry into Medical Tests Gender pay gap The Internet and the music industry Econ 5313

24. Main Points A competitive firm can earn profits (or losses) in the short- run until assets flow to higher valued uses A monopoly earns profits because it is difficult for assets flow to higher valued uses In the long-run, assets do flow to profitable enterprises and even monopoly profits fall to competitive levels The Indifference Principle allows us to measure the cost of moving an asset across uses Applications of the Indifference Principle include: Wage differentials Risk Premia Valuing housing amenities Econ 5313

25. Main Points A monopoly continues to earn positive profits in the long- run by Blocking the movement of assets into its industry Continuously developing product innovations ahead of imitators Econ 5313