ECON 330 Lecture 7 Tuesday, October 9

HWKs HWK #1 THANK YOU Everyone has received full points on the HWK Please write your own individual answers. The grade on the HWK (ranging from 0 to 3) is what your answer would receive in the exam on this question.

Last lecture: the competitive model and the stylized facts about competitive markets Persistence of profits in the long run Entry and exit take place simultaneously Size of entrants and exiters smaller than industry average size The firm size distribution is similar across many different industries: there are a few large firms and many small firms.

And Now … for Something Completely Different

Gibrat’s Law The French economist Robert Gibrat, in his book Inégalités Économiques (1931), proposed a basic model of firm growth and industry structure. His model is very simple. There is no profit maximization attempts to form cartels firm specific advantage

All is based on chance elements : During each period (month, quarter, year), the growth rate of each firm is completely random The growth rate is independent across firms, and independent across time periods. The growth rate of each firm is an identically distributed random variable.

Gibrat, continued Suppose there are 10 firms in an industry each with 10 % market share. During each period, each firm experiences a random growth rate of between −20% and +30% (with a uniform distribution). For any given firm, the growth rate in any period is independent from the growth rate of the preceding period, it is also independent of the size of the firm.

What happens to market structure, as measured by the Herfindahl-Hirschman index as time goes by? For this we go to website http://www.unclaw.com/chin/teaching/antitrust/gibrat.htm

Recap: Gibrat’s Law How do firms acquire and maintain market power? GIBRAT’s answer: Simply by the consequence of historic accident. Gibrat proposes a simple model of firm growth and industry structure that continues to receive scholarly attention even today in the IO literature. The model is based on the assumption that during each period, the growth rate for each firm in a market is an independent, identically distributed random variable. (Is this assumption realistic? See John Sutton, Gibrat's Legacy, 35 J. ECON. LIT. 40 (1997).)

Now, The MONOPOLY market structure Pricing with market power

MONOPOLY Equlibrium. Inefficiency of market power The dominant firm model Estimating the inefficieny of market power

Reynolds International Pen Corporation In 1945 Milton Reynolds acquired a patent on a revolutionary new type of pen that used a ball bearing in place of a conventional point, he formed the Reynolds International Pen company, capitalised at $26,000 and began production on 6th, October 1945

The pen was introduced with a good deal of fanfare by the New York department Store, Gimbels who guaranteed that the pen would write for two years without refilling. The price was set at $12.50. Gimbels sold 10,000 pens on 29th October 1945, the first day they were on sale, In the early stages of production the cost of production was estimated to be around 80¢ per pen.

In the spring of 1946 the firm was producing 30,000 pens daily and had a profit of 1.5 million dollars. By December 1946 100 new firms had entered the market and prices had dropped to 3 dollars. By the end of the 40’s each pen was sold at 0.39 cents!

Now a few formal definitions… A firm is a monopoly if it is the only supplier of a product for which there is no close substitute. A monopoly faces a downward sloping demand curve. To sell a larger quantity the monopoly must have a lower price.

NOW … A small in class experiment: Finding the profit maximizing price…

The MONOPOLY Experiment Each student is a monopoly firm. Some firms are in Market A, some in Market B, and some in Market C. Each firm will make a decision on price. YOUR GOAL is PROFIT MAXIMIZATION. The quantity each firm can sell at the price it quoted is determined by the demand. All firms have MC = AC = 2. You are encouraged to form groups of 4 people. I will record your pricing decisions on a spreadsheet and show it on the screen.

Results of the monopoly experiment

Interpreting the results Monopoly firms with lower price elasticity (Market A) set a higher price. Monopoly firms with lower price elasticity (Market C) set a lower price.