Who's been 'buying up' New Zealand?

There's a huge interest in foreign investment in New Zealand - it's front page news when Chinese investors aren't allowed to buy farms, or Asian investors are supposedly snapping up Auckland houses, and the piece I wrote about Statistics NZ's data on foreign direct investment has had by far the biggest number of pageviews of anything I've written recently. Yeah, yeah, yeah, I know, they're not Krugmanesque numbers, but still.

Yesterday Stats released an update to the numbers, showing the situation at the end of March '15 (the spreadsheet with the numbers is here). First, here's the total stock of foreign direct investment in New Zealand, which includes the likes of those farms.

One country overshadows everybody else. Australia has more invested here ($51.4 billion) than the rest of the world put together ($48.2 billion). There are bite-sized chunks from the US, Hong Kong, the UK and a range of other Asian and European countries, but the story starts and ends with Australia. Most of Australia's interest is the banks: I don't have a complete industry-by-country breakdown, but given that there's $32.1 billion of overseas investment in our 'financial and insurance services' sector, and that by far the bulk of that will be the Aussie-owned banks, you can say that about 60% of all Australian investment is in the finance industry.

And what about all those farms being sold out from under the feet of our own farmers? Nah. Total FDI in 'agriculture, forestry and fishing' is $5.9 billion, a small proportion (5.9%) of the total investment, and roughly on a par with foreign investment in the retail trade ($5.7 billion). 

It's also a very small proportion of the total value of farms and forests, which at a heroic guess (as I'm no expert on the data in this neck of the woods) I put at around $340 billion. That's 14.4 million hectares (2012 Agricultural Census, here) times an average price these days of some US$15,000 a hectare (which I got from this article), or NZ$23,500 or so at today's exchange rate. So roughly only 1.7% of agriculture is owned overseas, and of that I'd guess a fair slab is foreign institutional fund ownership of forests. The proportion of the archetypal family-run sheep and beef or dairy farms owned by overseas interests must be very small indeed.

For those who might be agitated that we're all in hock to the People's Bank of China, that doesn't show up, either. Here's the picture of total foreign portfolio investment - everything from government stock to listed shares to unlisted equity to money lent to New Zealand entities. Essentially it's the UK, the US and Australia, with roughly equal amounts, and there's a modest bit from Japan. Everything else is relatively insignificant.

The Price Elasticity of Supply

According to the law of supply and demand the quantity supplied of a good or service will generally decrease as its price falls. To see how strong this effect actually is, we can once again draw on the concept of elasticity. In particular, we use the price elasticity of supply.

The most relevant supply side elasticity is the price elasticity of supply. It describes to what extent the quantity supplied of a good is affected by a change in its price. Not surprisingly, there are various factors that influence the elasticity so it seems reasonable to look at the most relevant determinants first.

Determinants

The price elasticity of supply is determined by several factors that influence the production flexibility of a good or service. Being familiar with those determinants will be crucial for analyzing and comparing elasticities of various products.

• availability of raw materials: If the availability of raw material is limited, supply will be rather inelastic. In this case it is more difficult for producers to react to changes in price. Especially if the price decreases the availability of raw materials may limit the production of additional units which results in a more inelastic supply.
• complexity of product: The more complex the production of a good or service is, the more inelastic its supply will be. A more complex production process requires more specialized equipment. This makes it more difficult for producers to react quickly to price changes because the equipment cannot simply be used to produce different products. In addition to that, complex products usually take longer to produce which also contributes to more inelastic supply.
• inventories: If it is easy to keep inventories of a product, supply will be rather elastic. Keeping stocks allows producers to increase supply by selling part of the inventories even if production cannot be increased immediately. On the other hand it also reduces the financial risks of excess production, since at least part of the stock can still be sold at a later time.
• factor mobility: The more mobile the factors of production within an economy are, the more elastic supply will be. Producers can react more quickly to changes in price of a good or service if they can easily reallocate their factors of production (i.e. labor, capital, etc.) according to current demand.
• excess capacity: If suppliers have excess capacity, supply will be more elastic. As long as production is not working to capacity, it is easier to react to price changes because outputs can be changed more easily
• relevant time horizon: Generally speaking supply is more elastic in the long run as compared to the short run. Firms often cannot easily change the capacity of their production facilities in the short run (because of binding contracts, opportunity costs, etc.). Those costs are usually lower in the long run because contracts can be allowed to expire and new factories can be built or old ones can be shut down.

Now, please note that there may be additional determinants that are not mentioned here but are applicable in certain situations. This is not supposed to be a complete list. Basically every aspect that affects production flexibility in any way will have an effect on the elasticity of a good or service and can thus be considered a determinant of elasticity.

Types of Elasticity

There are different types of elasticity. Similar to the demand side, a supply curve can be elastic, unit elastic or inelastic. Please note that since elasticity is always measured at a certain point a single supply curve can have segments of all three types simultaneously. To see how this is possible, we will have to crunch the numbers and look at how elasticity is computed. The price elasticity of supply is defined as the percentage change in quantity supplied divided by the percentage change in the price of a good. This can be illustrated using the formula below.

To give an example, let's assume that an increase of 2% in the price of ice cream causes sellers to produce 4% more of it. According to our formula the elasticity in this case can be computed as 4% / 2% = 2. So the elasticity of supply equals 2. However right now this number does not really say much so we still need some sort of classification to actually work with it. With the help of the different types of elasticity mentioned above we can classify the supply curve and thus interpret the result.

• If the elasticity is greater than one, a supply curve is said to be elastic.  In this case suppliers respond strongly to price changes. As a result the quantity demanded changes proportionally more than the price.
• If the elasticity is equal to one, a supply curve is said to be unit elastic. In that case suppliers respond proportionally to price changes which means the quantity supplied will also change in the same proportion as the price.
• If the elasticity is less than one, a supply curve is said to be inelastic. In this case suppliers do not respond strongly to price changes. Therefore the quantity supplied changes proportionally less than the price.

Since elasticity in our example is equal to 2 we can conclude that supply of ice cream is elastic at this point. Once again please note that this elasticity may change as we move along the supply curve, so there may be other examples where the ice cream has different elasticities on the same curve. This is due to the fact that we use relative proportions to calculate elasticities.

In a Nutshell

The price elasticity of supply measures how the quantity supplied of a good or service changes as its price changes. It is determined by a number of factors, including the availability of raw materials, the complexity of the product, the possibility to hold inventories, the factor mobility within the economy, the amount of excess capacity, and the relevant time horizon. The supply curve of a good or service can be elastic (i.e. greater than 1), unit elastic (i.e. equal to 1), or inelastic (i.e. less than 1). It is possible to have different types of elasticities along the same curve.

The Price Elasticity of Demand

According to the law of supply and demand the quantity demanded of a good or service will generally increase if its price falls. To see how strong this effect actually is we use the concept of elasticity. More specifically, the price elasticity of demand.

Depending on what we are analyzing there are different demand elasticities that can be considered (e.g. price elasticity, cross-prize elasticity, income elasticity). The most relevant of them is the price elasticity of demand which describes to what extent the quantity demanded of a good is affected by a change in its price. There are many factors that influence the elasticity so we will start off by looking at its most relevant determinants.

Determinants

The price elasticity of demand is determined by a multitude of economic, social, and psychological factors that each influence consumer preferences and choice in a unique way. Being familiar with the most relevant of those determinants will be crucial for analyzing and comparing elasticities of various products.

• necessity of the product: If a good is considered a necessity (e.g. water, bread, toilet paper, etc.), a change in the price of the good will not significantly affect its demand. Since people always have to satisfy their basic needs they do not respond much to price changes for basic goods. If a product is considered a luxury good however, demand will be much more elastic, simply because people do not actually need those products to survive.
• availability of close substitutes: Close substitutes allow consumers to switch between different goods that satisfy the same (or similar) needs, thus if a good has one or more close substitutes, demand will be rather elastic. In that case people can just buy the substitute to satisfy the same needs if the price of the original product increases. On the other hand if there are no close substitutes available, consumers cannot just switch between equivalent products so they will not respond as strongly to a price change.
• proportion of income devoted to product: Products that are expensive (i.e. take up a high proportion of the available income) tend to have more elastic demand. Absolutely speaking, a 1% increase in the price of an expensive good is more significant than a 1% price change of a cheap good. As a result, consumers generally respond more strongly to price changes if they have to devote a larger proportion of their income to a certain product.
• relevant time horizon: In most cases demand is more elastic in the long run as compared to the short run. There are many occasions where consumers face significant switching costs in the short run (because of binding contracts, opportunity costs, etc.). Those costs are usually lower in the long run because contracts can be allowed to expire and there is more time to prepare and to evaluate all available options.

Now, please note that there may be additional determinants that are not mentioned here but are applicable in certain situations. This is not supposed to be a complete list. Basically every aspect that affects consumer preferences in any way will have an effect on the elasticity of a good or service and can thus be considered a determinant of elasticity.

Types of Elasticity

There are different types of elasticity. In particular, a demand curve can be elastic, unit elastic or inelastic. In fact, since elasticity is always measured at a certain point a single demand curve can have segments of all three types simultaneously. To see how this is possible, we will have to crunch the numbers and look at how elasticity is computed. The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in the price of a good. This can be illustrated using the following formula.

To give an example, let's assume that an increase of 2% in the price of ice cream causes consumers to buy 6% less of it. According to our formula the elasticity in this case can be computed as 6% / 2% = 3. So the elasticity of demand equals 3. 
However we still need some kind of classification to actually work with that number, right now it does not really say much. This is where the different types of elasticity mentioned above come into play. With their help we can classify the demand curve and thus interpret the result.

• If the elasticity is greater than one, a demand curve is said to be elastic.  In this case consumers respond strongly to price changes. As a result the quantity demanded changes proportionally more than the price.
• If the elasticity is equal to one, a demand curve is said to be unit elastic. In that case consumers respond proportionally to price changes which means the quantity demanded will also change in the same proportion as the price.
• If the elasticity is less than one, a demand curve is said to be inelastic. In this case consumers do not respond strongly to price changes. Therefore the quantity demanded changes proportionally less than the price.

Hence, since elasticity in our example is equal to 3 we can conclude that demand for ice cream is elastic at this point. Once again it is important to note that this elasticity may change as we move along the demand curve, so there may be other examples where the ice cream has different elasticities on the same demand curve. This is due to the fact that we use relative proportions to calculate the elasticities.

Additional Demand Elasticities

The cross-price elasticity of demand is used to measure by how much the quantity demanded of a certain good changes as the price of a different good changes. It is defined as the percentage change in quantity demanded of a certain good 1 divided by the percentage change in price of a good 2. This results in the following formula.

If the cross-price elasticity is a negative number the two goods are said to be complements. In this case an increase in the price of good 1 reduces demand for good 2. On the other hand if the elasticity is positive, the goods are said to be substitutes, since an increase in the price of good 1 results in an increase in the quantity demanded of good 2.

The income elasticity of demand is used to measure to what extent the quantity demanded of a good changes as consumer income changes. It can be computed as the percentage change in quantity demanded divided by the percentage change in consumer income. Again, this can be illustrated using a simple formula.

If the income elasticity of a good is a positive number it is considered a normal good, because a higher income increases the quantity demanded. However there are goods that have a negative income elasticity, they are considered inferior goods. For those goods a higher income will result in a lower quantity demanded.

In a Nutshell

The price elasticity of demand measures how the quantity demanded of a good or service changes as its price changes. It is determined by a number of factors, including the necessity of the product, the availability of close substitutes, the proportion of income devoted to the product, and the relevant time horizon. The demand curve of a good or service can be elastic (i.e. greater than 1), unit elastic (i.e. equal to 1), or inelastic (i.e. less than 1). It is possible to have different types of elasticities along the same demand curve. Apart from the price elasticity of demand there are two additional demand elasticities: the cross price elasticity of demand, and the income elasticity of demand.

Comparative Advantage and Trade

We live in a globalized world where virtually all countries interact and engage in trade. Most of them have various trade connections with a multitude of different countries. As a consequence, there is a significant amount of competition. This raises the question how smaller countries with relatively weak economies can still participate and benefit from global trade.

To explain this we will look at the principle of comparative advantage, one of the most basic microeconomic concepts. Even though it is a rather simple concept, it will allow us to analyze some of the most fundamental processes behind production decisions and trade. So let's get started.

Absolute advantage

The principle of absolute advantage builds a foundation for understanding comparative advantage. It is commonly used to compare economic outputs of different countries (or individuals). By looking at the inputs required for producing a unit of output, it is possible to determine which country has the highest productivity. In other words, the country that requires the least inputs to produce one unit of output is most productive and therefore has an absolute advantage. 

To give an example, let's look at two countries (A and B) that both produce cars and bikes. The two countries use the exact same materials, only the makespans for the products are different. In country A it takes 10 hours to assemble a car and 5 hours to build a bike. In country B on the other hand it only takes 8 hours to finish a car and 2 hours to assemble a bike. Hence, country B has an absolute advantage in producing both cars and bikes (see table 1).

Table 1: Absolute advantage

As we can see, this illustration does not provide any information on how these countries can profit from trading with each other. It looks like country B has little incentive to trade, since it is more efficient at producing both cars and bikes. So to see how trade can actually benefit both of them, we shall introduce the concept of comparative advantage.

Comparative Advantage

An important aspect that is omitted if we only look at absolute advantages is the presence of opportunity costs. All countries only have a certain amount of resources available, so they always face trade-offs between the different goods. As we know, these trade-offs are measured in opportunity costs. Thus, the country that faces lower opportunity costs for producing one unit of output is said to have a comparative advantage.

For example, if country A produces a car it has to spend 10 hours that could have been used to work on the bikes. In fact, it could have instead assembled 2 bikes (since it only takes 5 hours to build a bike). Obviously the same goes for producing a bike. The time spent finishing one bike could have alternatively been used to build half a car. If we apply this to country B, we can see that the time spent producing one car could have been used to finish 4 bikes. Meanwhile one bike has an opportunity cost of 0.25 cars. Hence, country A has a comparative advantage in producing cars, while country B has a comparative advantage in producing bikes (see table 2).

Table 2: Comparative advantage

The important thing to note here is that it is impossible for a country to have a comparative advantage in all goods. Because the opportunity costs of one good are the inverse of the costs of the other products, there is always at least one good with relatively high and one with relatively low opportunity costs.

Specialization

The concept of comparative advantage suggests that as long as two countries (or individuals) have different opportunity costs for producing similar goods, they can profit from specialization and trade. If both of them focus on producing the goods with lower opportunity costs, their combined output will increase and all of them will be better off.

Revisiting our example, assume that both countries have 2'000 labor hours available. If they both decided to allocate half of those resources to each product, country A could produce 100 cars and 200 bikes while country B could produce 125 cars and 500 bikes. This would result in an overall output of 925 total units (see table 3). 

Table 3: Outputs without specialization

Now, if country A specializes in the production of cars and country B specializes in the production of bikes (i.e. the respective goods with lower opportunity costs), their outputs will look considerably different. In that case, country A will produce 200 cars and no bikes while country B will still manufacture 25 cars and use the rest of its time to produce 900 bikes. This results in an overall output of 1125 units which equals an increase of 200 units due to specialization (see table 4).

Table 4: Outputs with specialization

Note that country B does not fully specialize in order to be able to maintain its current supply of cars, because country A cannot produce enough for both of them even by specializing. However, in most cases (i.e. if both countries can produce enough goods to maintain at least the current level of consumption) it most efficient for both countries to fully specialize in only one good.

Benefits of Trade

As we have seen in most situations the overall level of output can be increased if countries use specialized production. The additional output can then be traded in a way that benefits all parties involved. However, there is no optimal solution for such trade negotiations, thus the outcome mostly depends on the power structures between the two countries.

Furthermore it should be noted that even though both societies as a whole will be better off due to trade, this may not necessarily hold true for all individuals within the countries. For instance, if country A decided to put all its efforts into producing cars, companies and individuals who produce bikes will be left out and thus be worse off than before. 

Finally, we must be aware that countries produce a wide variety of different goods in reality and there are far more actors involved. As a result the decision making and coordination processes become much more complex. In that sense, the principle of comparative advantage is merely intended to provide a basic understanding of the underlying processes of trade.

In a nutshell

Trade is a global phenomenon that virtually all countries participate in. Even countries that have absolute advantages (i.e. more efficient production processes) in all relevant goods can still profit from trade, as long as they have different opportunity costs. In those cases there is always at least one good in which another country has a comparative advantage (i.e. lower opportunity costs). This is due to the fact that the opportunity costs of one good are the inverse of those of the alternative goods, so it is impossible to have the lowest opportunity costs for all relevant goods. By specializing in goods with lower opportunity costs the countries involved can increase the overall level of production and then split the additional output according to individually conducted trade negotiations.

Why Zero Profit Equilibria Can Subsist

In the long run equilibrium, firms in competitive markets make zero profit. This may seem odd, considering all the effort and time that has to be put into running a company. So why should these firms stay in business?

The answer to this question lies in the definition of the term profit. What most people think of when they hear profit is a number on the balance sheet of a firm. We call this the accounting profit. However, for many economic issues, considering accounting profits may not be sufficient. In those cases, we need to look at a different type of profit as well; the so-called economic profit.

Accounting profit

As mentioned above, accounting profit is the surplus we can find on a balance sheet. It can be calculated as the difference between total revenue and costs. However, the important aspect here is that accounting profit only includes explicit costs. That is, it only accounts for costs that result in an outflow of money (or an increase in dept) for the firm.

For example, think of an ice cream seller who wants to open a new business. Let's assume he faces costs of $100'000 for equipment and ingredients. At the end of the year, he has sold ice cream for a total of $150'000. Thus he makes an accounting profit of $50'000 ($150'000 - $100'000).

This approach is rather business-oriented. It includes everything that is relevant to set up a balance sheet. However, since we are looking at the issue from an economic perspective, we need to include some additional aspects. Therefore, we shall look at economic profits.

Economic profit

Economic profit is defined as total revenue minus total costs. That means in addition to the explicit costs it also includes implicit costs, such as opportunity costs. In other words, economic profit also accounts for the time, money and effort an owner puts into his company.

Regarding the zero profit condition, this suggests that in the long run equilibrium, owners need to be compensated for their opportunity costs. Hence the company must actually generate a positive accounting profit in the amount of the opportunity costs incurred. Therefore it will generate at least the amount of profit that is needed to maintain the factors of production (labor, capital, etc.). This profit is referred to as the normal profit.

To illustrate that idea, let's go back to our ice cream seller. If he had decided not to set up his business, he could have for instance deposited the $100'000 (i.e. the explicit costs) in a bank account to earn $5'000 in interest. In addition to that he could have worked for another ice cream producer to earn $45'000 a year. As a result, his opportunity costs add up to $50'000. If we include those costs in the calculation of the accounting profit above we get the economic profit for this case, which will amount to zero ($150'000 - $100'000 - $50'000).

This shows that even if economic profits are zero, producers still earn positive accounting profits. They have no reason to go out of business, because they receive compensation for their opportunity costs, so there is no alternative that would generate higher profits for them.

In a nutshell

In the long run equilibrium, firms in competitive markets make zero profits. This may seem odd at a first glance. However it makes sense because the statement refers to economic profit. It is important to note that unlike accounting profit (i.e. revenue minus explicit costs), economic profit (i.e. revenue minus explicit and implicit costs) includes opportunity costs. As a result according to the zero profit condition, competitive firms in the long run equilibrium are compensated for their opportunity costs. That means there is no superior alternative for them so they have no incentive to go out of business. On the contrary, they may still generate substantial accounting profits.

Perfect Competition vs. Imperfect Competition

Firm behavior in competitive markets is probably one of the most fundamental subjects in economics. That is mainly due to the fact that most markets we encounter in reality are competitive, at least to a certain degree.

Competition is characterized by a multitude of firms offering the same (or a similar) good or service or a close substitute. In general it can be said that the more similar the goods or services are, the more competitive the markets will be. However, the competitiveness of a market is still highly dependent on firm behavior. For example, companies engaging in collusive behavior may result in a significant impediment to competition. For now, we will assume that firms do not engage in such activities.

As mentioned above, competitive markets may experience different degrees of competition. To explain the principle of competitiveness, it is useful to distinguish between two different market structures: perfect competition and imperfect competition.

Perfect competition

As the name suggests, perfect competition is considered the purest form of competition. For a market to be perfectly competitive, the following criteria need to be met:

• The goods that are sold need to be homogeneous. In other words, they need to be exactly the same and can thus be substituted at no cost.
• There must be no preferences between different sellers. For the customers it should not matter from which seller they buy their products.
• No actor should have the ability to affect the market price. That means, both buyers and sellers do not have any market power and can thus be considered price takers.

Looking at these criteria, it becomes apparent, that they will hardly ever be met in reality. Even so, an example that comes fairly close to perfect competition is the market for rice. There are thousands of buyers and sellers and the products are mostly identical. But it will never be perfectly competitive, as there will always be minor differences in products, preferences between sellers and so on.

However, at this point it is important to note that the idea behind perfect competition as a theoretical construct is to help explain various market mechanisms and economic behavior. So even though we may not find perfectly competitive markets in reality, the concept is still extremely relevant.

Imperfect competition

In contrast to perfect competition, imperfect competition is a fairly common market structure in practice. It is defined by the following characteristics:

• The goods that are sold are differentiated. That means, even though they mostly satisfy the same needs, there are minor differences that allow customers to distinguish the products from one another. 
• Due to the differentiated goods, customers develop preferences for some sellers. Thus, they are willing to spend more money on goods from specific sellers.
• As a result, the sellers may exert a certain degree of market power and charge a price premium. Hence, they can directly influence the market price to a limited degree and are no longer pure price takers.

An example of imperfect competition is the market for cereals. Just think about the cereal aisle at your local supermarket, you will find dozens of different cereals (Cap'n Crunch, Lucky Charms, Froot Loops, Apple Jacks, etc.). Out of those brand you probably have a favorite, like most people. However, if you think about it, those cereals are actually not that different. Ultimately, they all serve the exact same need; providing you with a tasty breakfast.

In a nutshell

Competitive markets are characterized by a multitude of firms offering the same (or a similar) good or service or close substitutes. They can either be perfectly competitive or imperfectly competitive. In perfectly competitive markets the goods are homogeneous, consumers have no preferences, and neither buyers nor sellers can influence the market price. Imperfectly competitive markets on the other hand are distinguished by differentiated products, consumer preferences, and as a result a certain degree of market power for sellers.

Profit Maximization

In economics it is often assumed that companies try to maximize profit. That is, they try to maximize revenue while at the same time minimizing costs. In order to do that, firms need to look "at the margin". That means, they have to keep an eye on changes in revenue (i.e. marginal revenue) and changes in costs (i.e. marginal costs) for every additional unit sold.

To introduce the principle of profit maximization, it seems reasonable to focus on firms in a competitive market first. However, as we will see later on, this principle can be applied to most firms in various market situations (monopoly, oligopoly, etc.).

As mentioned above, to maximize profits, a firm needs to examine changes in revenue and costs for every additional unit sold. As long as the resulting increase in revenue is larger than the increase in costs, total profit can still be raised by producing more. This will hold true until marginal revenue (MR) equals marginal cost (MC). In other words, a profit maximizing firm will produce until MR=MC.

This can be illustrated by looking at a simple diagram that shows the relations between output and costs or revenue respectively. Though, before we can do this, we need to find out what the relevant marginal cost and marginal revenue curves look like.

Marginal Revenue

Computing marginal revenue in a competitive market is actually pretty simple. In fact, it is always equal to the price of the good or service sold.To explain this, we shall look at a characteristic of competitive firms. They are said to be price takers. That is, they do not have enough power to influence market prices (unlike for example a monopolist), since they only control a small share of the market. So no matter how much a competitive firm produces, price  will not change and revenue for each additional unit sold will be equal to the given market price. As a result, the marginal revenue curve will be a horizontal line at the level of the market price.

Marginal Costs

Most firms face increasing marginal costs as output increases. This is a result of diminishing marginal products.To give an example, think of a car factory that is currently producing at a low capacity. There are only few workers employed and the machines are barely used. If the factory increases production, idle capacities can easily be put to use and additional workers can add a lot of value. In other words, marginal costs are low and marginal product is high. However, if the factory is already running at full capacity, increasing production will be more expensive (e.g. because machines are overused) and additional workers will not add much value (e.g. because they have to wait to use equipment). Therefore, when output increases, marginal product diminishes and marginal cost increases. As a result, the marginal cost curve will slope upwards.

Illustration

As mentioned above, we can visualize the principle of profit maximization in a simple diagram (see below). The x-axis represents output quantity (Q), while the y-axis stands for costs and revenue respectively (C and R).

Illustration 1: Profit Maximization

The Marginal revenue curve (MR) is a horizontal line at the level of the market price (p*). The marginal cost curve on the other hand (MC) is upward sloping, as described above. The intersection of the two lines (O*) is located at the profit maximizing level of output (q*) for the given price level. It becomes apparent that shifting MR will affect the output quantity, but not the price level. Thus, profit maximization for competitive firms means, finding the optimal level of output for a given price.

In a nutshell

Firms in a competitive market can maximize profits if they produce up to the point where marginal revenue equals marginal cost (MR=MC). Marginal revenue for competitive firms is constant and equal to the price of the good or service sold. Marginal costs on the other hand are usually increasing as output increases, due to the diminishing marginal product.
It is important to note that even though marginal revenue and marginal cost curves may look differently for firms in other market situations (e.g. monopoly, oligopoly, etc.), the profit maximizing level of output will still be located at the intersection of the two.

Monopoly Power

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market. It is characterized through a lack of competition. As a result the monopolist has the ability to affect market prices, which often results in an inefficient outcome for society. 

Monopolies typically emerge because entry into a particular market is restricted. Those restrictions may be effects of high entrance costs, government regulations, or other impediments. Due to the lack of competition, monopolies often cause higher prices, lower outputs and sometimes even inferior quality of the provided goods or services. Thus, to see why monopolies still persist in certain industries, we need to take a closer look.

Sources of Monopoly Power

As mentioned above, monopolies derive their market power from entry barriers to their markets. Those barriers can can be divided into four groups, according to their sources: specific resources, government regulations, natural monopolies, and deliberate actions.

Specific resources

If a company (or an individual) owns a specific and unique resource, it can already act as a monopolist. Imagine you live in a small village in the middle of the desert where there is just one well to provide water. If this well is owned by one individual, he (or she) can charge a lot of money, because there is no alternative supply and water is an absolute necessity. However, this source of monopoly power is not very relevant in practice, as resources can be traded worldwide today, which makes it easier for customers to find alternatives (even for seemingly unique products).

Government regulations

In many cases monopolies arise because of government regulations. This happens whenever the government grants a firm (or institution) the right to be the sole producer and seller of a certain good or service. Given that monopolies often cause inefficiencies, this may seem a little odd. However, government regulated monopolies are established specifically because they are viewed to be in the best public interest.

Just think of copyright and patent laws. When a pharmaceutical company creates a new drug, it can apply for a patent (i.e. the right to be the sole producer and seller of this drug for a limited time). This is attractive for companies because they can generate high profits during the patent period. Hence, the firms are given an incentive to engage in research and development of pharmaceuticals, which is beneficial for society.

Natural monopolies

Sometimes it is more efficient for one producer to supply the entire market than for two or more suppliers. Natural monopolies often occur in industries with the need for large and expensive infrastructures. In those industries we often see economies of scale for the relevant output range, which means that an increase in output reduces the average cost of production for the supplier. In other words, if there is more than one supplier, the output for each of them is lower, which results in higher average production costs (per supplier). 

An example of a natural monopoly is the railway system. To provide railway services, a company needs a large infrastructure (tracks, power lines, etc.). If there are two competitors in the market, both of them need to pay the fixed costs related to this infrastructure. Hence, it is more efficient for them to merge and thereby reduce the fixed costs.

Deliberate actions

Last but not least, some companies deliberately erect barriers to entry in their markets to prevent the entrance of new competitors. However, for this to be possible, the companies need to have a certain market power beforehand. As companies grow, they automatically become more powerful, since they control a bigger share of the market. The bigger (and more powerful) a firm becomes, the more the industry is at risk of limited competition.

Effects of Monopoly Power

Since a monopolist company is the sole supplier of its industry, it faces a downward sloping demand curve (unlike firms in a competitive market). As a result, the firm has to lower the price of its good or service to increase quantity sold. Therefore, a monopolist's marginal revenue (MR) is always less than the price (P) of its good or service. This is crucial for understanding monopolist behavior. 
To give an example, imagine you are the sole supplier of ice cream in your village. To keep things simple, assume you can sell 1 cone for a price of 1$, thus your revenue will be 1$. However, if you want to sell 2 cones, you have to reduce the price to 0.90$, which will result in a marginal revenue of 0.80$ and a total revenue of 1.80$. So, even though you can sell an additional ice cream cone, you earn 0.10$ less on each unit sold, therefore marginal revenue falls. 

The fact that marginal revenue is lower than the price of the good has several implications for the profit maximizing behavior of a monopolist. Those can be illustrated in a supply and demand diagram (see illustration 1).

Illustration 1: Profit maximization of a monopolist

As we just saw, a monopolist usually faces a downward sloping demand curve (D) and a marginal revenue curve (MR) that lies below the demand curve. In fact, whenever we face a linear demand curve (e.g. y= a*x - b), the marginal revenue curve will be twice as steep (e.g. y=a*x - 2b). Though, please note that this only applies to linear curves.
To maximize profits, the monopolist will produce up to the point where marginal revenue equals marginal cost (MR = MC). This results in an output quantity of QM, and a price of PM. In contrast, in a competitive market (where MR = D), the company would produce quantity QC, for a price of PC.

Hence, monopoly output is lower than competitive output, but prices are still higher. This results in a welfare loss for society (deadweight loss) which can be quantified as the shaded triangle DWL. The deadweight loss is the reason why monopolies are often not in the best interest for society.

Government Policy towards Monopolies

To react to the inefficiencies caused by monopolies, the government has different options to chose from. The most relevant ones are the following: competition law, price regulations, nationalization, or doing nothing.

Competition law

One way to prevent monopolies from arising is through competition law. In this case, government institutions primarily control mergers and acquisitions to make sure they will not result in an impediment to the competitiveness of an industry. In addition, the institutions enact laws to prevent collusive behavior and other activities that could restrict competition.

Price regulations

Alternatively, if a monopoly already exists, the government policy can confide itself to controlling the negative effects of monopoly power. Generally, this is done by prescribing the prices the monopolists are allowed to charge. However, it is rather difficult to set those prices appropriately, which makes it difficult to successfully implement this policy in reality. 

Nationalization

A rather invasive option is the nationalization of existing monopolies. This allows the government to directly control the firm's behavior and thus minimize its negative effects on society. However, since this kind of policy is diametrically opposed to the idea of a free enterprise economy, it has become extremely rare in practice.

Remain inactive

As we have seen above, there are certain occasions where monopolies are socially desired or even encouraged by the government (e.g. patents, copyrights). Furthermore, it is possible that the inefficiencies caused by a possible intervention would be more harmful than the effects caused by the monopoly itself. In those cases the monopoly outcome is more desirable for society and the government will remain inactive and not interfere in the market.

In a nutshell

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market. Monopolies can arise because of specific resources, government regulations, costs of production, or deliberate actions. They are characterized through a lack of competition, which results in lower production outputs and higher prices. The government can react to monopolies by enacting competition law, imposing price regulations, nationalizing the monopolies or, if the inefficiency is acceptable (or even desirable) for society, by not doing anything at all.

Positive Externalities vs. Negative Externalities

Externalities are often defined as the positive or negative consequences of economic activities on unrelated third parties. Since the causers are not directly affected by those externalities, they will not take them into account. As a result, the social cost (or benefit) of these activities is different from their individual cost (or benefit), which leads to a market failure.

There are different types of externalities. The definition above already suggests that they can be either positive or negative. Additionally, there is another (and maybe less familiar) distinction which should be made here: Both positive and negative externalities can arise on the productionor on the consumption side.

In the following paragraphs we will look at the different types of externalities in more detail.

Positive externalities

Economic activities that have positive effects on unrelated third parties are considered positive externalities. As we learned above, they may be present in the form of production or consumption externalities.

Positive production externalities are positive effects that originate during the production process of an economic actor. An example of this could be an orchard placed next to a beehive. In this situation both the farmer and the beekeeper benefit from each other, even though neither of them has considered the other one's needs in his decision-making.

Positive production externality

This can be illustrated by comparing social cost and social benefit based on a supply and demand diagram. In this case, individual demand (D) is equal to social benefit (SB) since there are no externalities on the consumption side. However social cost (SC) is lower than individual supply (S) because there is an external benefit (EB) that is not included in the individual supply curve. As a result the market equilibrium (E*) is different from the optimal market situation (O*) and there is an undersupply of both orchards and beehives.

Positive consumption externalities are positive effects on third parties that originate from the consumption of a good or service. A possible example could be your neighbor’s flower garden. She most likely cultivates the plants solely for her own pleasure, yet you can still enjoy the beauty of the flowers whenever you walk by.

Positive consumption externality

Again, this can be illustrated by comparing social cost and social benefit. In this case however, the individual demand curve (D) lies below the social benefit curve (SB) because the external benefit (the beauty of the flowers) is not included in the neighbor's demand curve. The social cost (SC) on the other hand is equal to the individual supply (S) because there are no externalities on the production side. Like in the first illustration the market equilibrium (E*) is different from the optimal market situation (O*) and as a result there is an undersupply of flowers. What is different from the previous illustration though, the optimal price (p2) in this example is higher than the equilibrium price (p1).

Generally speaking, for positive externalities the overall benefit to society is higher than the one that is taken into account by the actors during their decision-making process. This results in an undersupply of beneficial products (or activities) for society. In order to correct these market failures it is important to know whether the externality arises from the production or the consumption side, since this affects the desired optimal market equilibrium. 

Negative externalities

Analogous to the previous paragraphs, negative externalities are economic activities that have negative effects on unrelated third parties. They can be divided further into production and consumption externalities.

Negative production externalities are negative effects that originate during the production process of an economic actor. The most common example of this kind of externality is the pollution caused by a firm during the production of their goods. Pollution affects the entire population, however as long as companies are not held accountable for their activities, they have no incentive to reduce their economic impact (since that would be more expensive).

Negative production externality

To illustrate this, we shall compare social cost and social benefit again. Similar to the positive externality example, individual demand (D) represents social benefit (SB). The social cost curve (SC) in this case however is higher than the individual supply curve (S) because of the external cost (EC) that is not included in the firms supply decision. As a result the market equilibrium (E*) is different from the optimal market situation (O*) and there is an oversupply of harmful behavior. In this example the optimal price of the good (p2) is higher than its actual market price (p1).

Negative consumption externalities are negative effects that arise during the consumption of a good or service. To give an example, we can revisit your neighbor. If she likes to play loud music in the middle of the night, a negative externality on your part could be sleep deprivation. Once again, she may not take this into account since the consequences do not directly affect her.

Negative consumption externality

In this case, the individual demand curve (D) lies above the social benefit curve (SB) because of the external cost (your sleep deprivation) that is not included in the neighbor's demand curve. The social cost curve (SC) on the other hand is equal to the individual supply (S), because there are no externalities on the production side. Again, the market equilibrium (E*) is different from the optimal market situation (O*) and as a result there is an oversupply of loud music. In this example the optimal price of the good (p2) is lower than its actual market price (p1).

The major characteristic here is, that without any regulatory influence, neither the firm nor your neighbor will take the negative effects of their activities into account. They are not directly affected by the consequences and will thus produce more than in an efficient market (where externalities are taken into consideration). This results in an excess supply of harmful behavior.

In a nutshell

Externalities are the consequences of economic activities on unrelated third parties. They can arise on the production or on the consumption side and can be either positive or negative. In all cases however, they will result in market failures that can only be avoided by imposing some kind of regulation to internalize the externalities. 

The Law of Supply and Demand

The principle of supply and demand is one of the most important concepts in microeconomics. It helps us understand how and why transactions on markets take place and how prices are determined. To learn more about supply and demand we mainly need to look at consumers and producers.

Consumers

In this case, consumers are all the economic units that are potentially willing to buy a certain good or service. The actual demand for said good or service depends on different variables (as we will see later). For now we will focus only on the most important one, the price. For most goods and services we can say that demand will increase as the price falls and vice versa. This actually seems pretty obvious: Just think about how many people would buy a Ferrari if they were not that expensive.

Producers

Producers on the other hand are the ones that are potentially willing to produce and sell a certain good or service. The actual supply again depends on multiple variables, yet as we did before we will focus only on the price for now. For most goods and services this implies that supply will decrease as the price falls and vice versa. Again the reasoning behind this is rather simple: If you were to sell ice cream you would probably try and sell as much as you could if prices were high, because you could make a good profit. However, if prices were to fall (maybe even beyond your production cost) it would not be profitable to sell ice cream anymore and you would produce less.

Illustration

Now these relationships are a lot easier to understand if we look at a simple illustration (see below). The x-axis of this graph represents quantity (Q) and the y-axis stands for price (P). 

Illustration 1: Supply and Demand

If we look back at the behavior of the consumers, we said they were willing to buy more (i.e. a higher quantity) of a good or service if the price falls. So for every price there is a quantity demanded, which will be higher the lower the price is. Now if we plot all these quantity-price combinations we get a graph called the demand curve (D).

Now we can do the same thing for the producers. But since they are willing to produce less (i.e. a lower quantity) as the price falls, the graph we receive is somewhat similar to a mirror image of the demand curve. We call this the supply curve (S).

The point where both curves (D and S) intersect is called the market equilibrium (E*). At this point (and price) the consumers are willing to buy exactly as much of a good or service as the producers are willing to sell, and the market clears. This is the best possible situation for all actors, thus they will always tend to get to this outcome. This means the two curves will keep shifting until the equilibrium quantity and price are reached. 

In a nutshell:

Consumers are willing to buy more of a good or service as prices fall, so they are represented by a downward sloping demand curve. Producers are willing to sell less of a good or service as prices fall, so they can be represented by an upward sloping supply curve. The intersection between the two curves is called the market equilibrium. It determines both the equilibrium price (p*) and equilibrium quantity (q*) and is the optimal outcome for all actors.