osewalrus (osewalrus) wrote,

Answers to my econ quiz

If anyone cares, the answers behind the cut. Did you know your econ?

1) Switching cost.

A "swicthing cost" is the cost of switching from one product or system to another. Critically, it includes more than just the difference in money. For example, if DSL is cheaper than cable modems, why don't people switch. (While DSL has experienced a growth in market share, this comes primarily from new customers not churn). The answer in part is that the perceived total cost to the consumer exceeds the perceived savings. In other words, the ability to save potentially $20/month does not make up for the fact that I will need to switch email address, learn a new system, experience down time, wait for installers, etc.
(Other factors, such as availability and substitutability will also be factors, of course)

2) Schumpeterian monopoly.

Named for the German Economist Joseph Schumpeter, a Schumpeterian monopoly is incapable of exploiting traditional monopoly power because the pace of technological change threaten to render the monopoly obsolete. The monopolist is therefore forced to innovate and price in the same manner as a frm subject to competition, since a potentially destructive competitor may emerge at any time. This argument has enjoyed popularity during the tech era.

3) Duopoly. (Extra credit: distinguish between a true duopoly and a Steckelbergian Duopoly)

Most people seem to think that anything other than a classic monopoly represents a competitive market. In point of fact, conventional economics does not find a competitive market until you hit four equal sized firms, with the ideal for competition being ten or more equal sized firms.

A duopoly, as the name implies, is two firms. A classic duopoly consists of two like sized firms. Duopolies do not exhibit the characteristics of competitive markets, although they mitigate against monopoly abuse. Typically, duopolies engage in what is known as "conscious parallelism." Each understands the market and strives to come as close as possible to the maximazation of profit as a monopolist while competing with each other for market share. Significantly, the two firms will act jointly to exclude any additional competitors if possible.

A Steckelbergian Duopoly occurs in a field where there are more than two competitors, but two are so dominant that they can ignore the marginal players (who will follow the lead of the leaders). In a classic Steckelbergian Duopoly, one firm will be the true dominant price leader while the second firm is sufficiently large to remain a factor in the calculations of the leader but not so large as to be able to challenge the leader for dominance.

4) Network effect (as distinguished from economies of scale).

A "network effect" is observed when a good or service becomes more valuable when used by more people (as a corrolary, the cost of exclusion from the network grows at an inverse rate). Classic examples include the phone network or fax machines. A phone network that connects to only one person is not very valuable, whereas a phone network that connects to everyone in the country is extremely valuable. Similarly, a fax machine is only useful if other people have fax machines.

Economies of scale occur where goods have relatively high fixed cost and low marginal costs. A "fixed cost" is an unalterable cost, whereas the marginal cost is the cost to produce the next unit. The more units you make, the more you can spread your fixed cost over the total number of units, dropping the cost of production per unit.
Typically, as networks are adopted, the items necessary to connect to the network are manufactured in greater quantity, lowering price. This often leads to the mistaken belief that network effects lower prices. But such drop in prices will only occur where there are economies of scale.

5) Explain the difference between market share, market power, and monopsony power. For extra credit, explain how a monopsonist determines efficient price point as opposed to a monopolist.

Market share is what percentage of the market for a good or service you possess. Market power is the ability to dictate a market outcome. A typical example of market power is the ability to raise price above the price attainable in a competitive market without suffering a decrease in sales. Needless to say, this is often difficult to prove by direct evidence.
While market share may indicate market power, this is not always the case. During the dial up period, AOL enjoyed significant market share of the dial up market. Nevertheless, it did not enjoy market power because of the ability and willingness of subscribers to switch providers.

Monopsony power is the power of an entity with market power over a market, even if the entity is not a monopoly. For example, cable operators face potential competition from DBS operators. But because cable operators control more customers, and customers are unlikely to switch systems because of the presence or absence of a programming network (beyond broadcast programming networks and certain "marquee programming) cable operators can dictate terms to programmers in ways satellite providers cannot.

6) What do the Hirschal-Herfeandahl Index (HHI), Lerner Index, and Tobin Q measure? How do they differ? Bonus point- which is used by the Department of Justice Anti-Trust Division?

HHI, Lerner Index, and Tobin Q all measure the competitive nature of a market. The HHI takes all competing firms in the market and producers a number based on the number of firms and their respective size. The higher the number, the more concentrated the market. The Lerner Index is a measure of profitability for a firm. If a firm is enormously profitable, but no rival businesses seek to compete in the field, that is an indictaor that the dominant firm may be using market power to exclude competitors. Tobin's q is a measure of what it would cost to replace a firm. If the cost or replicating a firm is less than the expected profit, but no one does so, this is another indication that the incumbent is blocking market entry.

The DoJ and the FTC use HHI.

7) Substitutability. (Bonus, what does "Closely substitutable" as opposed to "non-closely substitutable" mean?)

As the name implies, this is the ability to substitue one item for another. Things are "close substitutes" if they are considered equivalent. They are merely substitutes (or worse, non-closely substitutable) if I can use one for the other but prefer (or strongly prefer) the other.
For example, are the linux operating system, windows operating system, and Apple operating system substitutable? Are they closely substitutable? This answer will vary from user to user, but answers can be averaged to determine whether a product genuinely competes with another product.

8) Price sensitivity.

If demand for a good changes in response to changes in price, then the demand is "price sensative." While all goods are, to some degree, "price sensitive," some goods are clearly more price sensitive than others. For some goods, even a slight difference in price can have significant effect on demand.

9) Transaction costs.

Transaction costs are those costs associated with the mechanics of a transaction. For example, if you buy a house, you will agree to a price for the house. You will also face numerous transaction costs associated with the sale- lawyer's fees, registry of deeds, etc. etc.

10) Rent seeking behavior.

When an actor makes a decision not because the actor concludes that it will achieve a market efficiency, but because it can capture profit (typically referred to as "rents") in some other way. For example, a decision to maintain the scarcity of a good can be characterized as sekking monopoly rents.

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