MANAGERIAL MANAGERIAL ECONOMICS 11ECONOMICS 11thth Edition Edition

ByByMark HirscheyMark Hirschey

Performance and Strategy Performance and Strategy in Competitive Marketsin Competitive Markets

Chapter 11Chapter 11

Chapter 11Chapter 11OVERVIEWOVERVIEW

Competitive Market Efficiency Market Failure Role for Government Subsidy and Tax Policy Tax Incidence and Burden Price Controls Business Profit Rates Market Structure and Profit Rates Competitive Market Strategy

Chapter 11Chapter 11KEY CONCEPTSKEY CONCEPTS

welfare economics social welfare producer surplus deadweight loss problem welfare loss triangle market power market failure failure by market structure externalities failure by incentive economic efficiency economic regulation social equity consumer sovereignty limit concentration subsidy policy

tradable emission permits deadweight loss of taxation

tax incidence tax burden price floor price ceiling return on stockholders’ equity

(ROE) profit margin total asset turnover leverage reversion to the mean disequilibrium profits disequilibrium losses economic luck competitive strategy economic rents

Competitive Market Efficiency Why is it called Perfect Competition? Competitive markets balance supply

and demand. Competitive markets maximize social

welfare

Deadweight Loss Problem Any cost suffered by consumers or

producers that is not transferred, but simply lost.

Deadweight Loss Illustration

Market Failure Structural Problems

Above-normal profits are unwarranted if they reflect the raw exercise of market power.

Failure occurs when competitive markets do not sustain socially desirable activity.

Failure can occur in markets with few participants.

Incentive Problems Externalities are differences between private and

social costs or benefits. A negative externality is an unpaid cost. A positive externality is an unrewarded benefit.

Role for Government How Government Influences Competitive

Markets Tax policy or regulation is efficient if expected

benefits exceed expected costs. Fairness must be carefully weighed when social

considerations bear heavily. Broad Social Considerations

Consumer sovereignty is an important benefit of competitive markets.

Public policy can control unfairly gained market power.

Tax and regulatory policy limit concentration of economic and political power.

Subsidy and Tax Policy Subsidy Policy

Subsidy policy can be indirect, like government construction and highway maintenance grants that benefit the trucking industry.

Subsidy policy can be direct, like agricultural payment-in-kind (PIK) programs.

Tradable emission permits are pollution licenses. Deadweight Loss From Taxes

Taxes reduce economic activity and cause deadweight losses.

Pollution taxes explicitly recognizes the public's right to a clean environment.

Tax Incidence and Burden Role of Elasticity

Who pays the economic burden of a tax or operating control regulation depends on the elasticity of supply and demand.

Elasticity affects the amount of social welfare lost due to the deadweight loss of taxation.

All else equal, the deadweight loss of a tax is small when supply (or demand) is relatively inelastic.

All else equal, the deadweight loss of a tax is large when supply (or demand) is relatively elastic.

Tax Cost Sharing Example Local authorities find it difficult to tax or regulate

firms that operate in highly competitive markets.

Price Controls Price Floors Price floors cause surplus production. Costly government-set price floors

persist because of powerful special interest groups

Price Ceilings Price ceilings cause shortages. Price ceilings are a popular, but

ineffective, means for restraining excess demand.

Cities use price ceilings in an effort to make housing more affordable.

Business Profit Rates Return on Stockholders’ Equity

ROE is net income divided by the book value of stockholders’ equity.

ROE = Net Income/Sales × Sales/Total Assets × Total Assets/Stk. Equity

High margins, turnover or leverage boost ROE. Typical Profit Rates

ROE averages 10% to 15% per year for successful companies.

Sustained ROE ≥ 20% per year is rare.

Market Structure and Profit Rates Profit Rates in Competitive Markets

Competitive markets have low profit margins. In strong economic environments, competitive firms

can earn disequilibrium profits. In weak economic environments, competitive firms

can suffer disequilibrium losses. Mean Reversion in Profit Rates

Expansion from entry and firm growth cause above-normal profits to regress toward the mean.

Contraction from bankruptcy and exit allow below-normal profits to rise toward the mean.

In long-run equilibrium, profit rates for typical firms reflect only a risk-adjusted normal rate of return.

Competitive Market Strategy Short-run Firm Performance

Profits reflect transitory influences. Disequilibrium profits and losses reflect adjustment

costs. Long-run Firm Performance

Typical firms in competitive markets have the potential for a normal rate of return on investment.

Abnormal profits or losses often reflect transitory disequilibrium conditions.

If above-normal returns persist for extended periods, elements of uniqueness are at work.

The search for an economic advantage is called competitive strategy.

Uniquely productive firms earn above-normal profits.