Week #1 Discussion Problem Tip Pooling At a restaurant near where the professor for this course lives, tipping servers is common (generally between 15 and 20 percent of the total bill). The restaurant has two distinct areas, the bar (or lounge) area where alcoholic drinks dominate people’s orders and the “casual dining” area where whole meals. Two bartenders serve all customers in the bar. That is, they each do not have assigned tables and bar stools. A dozen or more servers attend to the tables in the casual dining area. Each server in this area has assigned tables. The restaurant’s management has an interesting policy regarding tips. The two bartenders on duty “pool” their tips and divide the total at the end of their shifts. The servers in the rest of the restaurant keep the tips that they receive from their assigned table. In other words, there is no tip pooling in the casual dining area. 1. First and only step in the discussion a. Why does the restaurant management have tip pooling in the bar and not the rest of the restaurant? The problem of tip pooling has many of the incentive problems evident in “communal property” or “common-access resources,” which can become real problems when each person’s contribution to the total is inconsequential and monitoring of all others’ contributions is costly. (Pollution can occur for this reason.) But with only two bartenders in the bar, each bartender can reason his/her efforts can materially affect the total tips collected. Each can also watch the other for shirking (or not working hard to gain tips), and each can retaliate with shirking. In the casual dining area of the restaurant, there are a number of servers who will share in the total tips when tip pooling is the policy. Each has an impaired incentive to work hard to contribute to the total tips. Each only receives a minor share of the total tips, and will only get a portion of any increase in tips due to his/her diligence. Hence, bartenders will likely agree to tip pooling when there are two (or few) bartenders. When there are a “large” number of severs, tip pooling can be a problem for management – and servers. b. Why doesn’t management have all bartenders and servers pool their tips and divide the total? If all bartenders and servers pooled their tips, the prospects of shirking will increase. Some staff members may naturally be inclined to work at a
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Professor McKenzie Discussion Problems and Answers
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Week #1 Discussion Problem
Tip Pooling At a restaurant near where the professor for this course lives, tipping servers is common
(generally between 15 and 20 percent of the total bill). The restaurant has two distinct
areas, the bar (or lounge) area where alcoholic drinks dominate people’s orders and the
“casual dining” area where whole meals. Two bartenders serve all customers in the bar.
That is, they each do not have assigned tables and bar stools. A dozen or more servers
attend to the tables in the casual dining area. Each server in this area has assigned tables.
The restaurant’s management has an interesting policy regarding tips. The two
bartenders on duty “pool” their tips and divide the total at the end of their shifts. The
servers in the rest of the restaurant keep the tips that they receive from their assigned
table. In other words, there is no tip pooling in the casual dining area.
1. First and only step in the discussion
a. Why does the restaurant management have tip pooling in the bar and not
the rest of the restaurant?
The problem of tip pooling has many of the incentive problems evident in
“communal property” or “common-access resources,” which can become
real problems when each person’s contribution to the total is
inconsequential and monitoring of all others’ contributions is costly.
(Pollution can occur for this reason.) But with only two bartenders in the
bar, each bartender can reason his/her efforts can materially affect the total
tips collected. Each can also watch the other for shirking (or not working
hard to gain tips), and each can retaliate with shirking.
In the casual dining area of the restaurant, there are a number of servers
who will share in the total tips when tip pooling is the policy. Each has an
impaired incentive to work hard to contribute to the total tips. Each only
receives a minor share of the total tips, and will only get a portion of any
increase in tips due to his/her diligence.
Hence, bartenders will likely agree to tip pooling when there are two (or
few) bartenders. When there are a “large” number of severs, tip pooling
can be a problem for management – and servers.
b. Why doesn’t management have all bartenders and servers pool their tips
and divide the total?
If all bartenders and servers pooled their tips, the prospects of shirking
will increase. Some staff members may naturally be inclined to work at a
slow pace. Others may work at a slow pace because others are doing so,
and each person can reason that the loss of total tips will be shared by all.
c. Management has instituted the tip-pooling/no-tip-pooling policy in the
different areas of the restaurant. Is management’s policy one that the
bartenders and servers would choose if they were in control of restaurant
policy on tips?
Yes, management has likely instituted a policy that is a win-win for
management and bartenders/servers. The bartenders/servers would likely
choose the same policy that management has, because of the win-win.
d. If the restaurant were to expand to where the count of bartenders required
to cover all patrons in the bar increased to, say, a dozen or two dozen
bartenders, how would management’s policy on tip pooling in the bar area
likely change? Would the bartenders likely agree to the policy change?
With a substantial increase in number of bartenders, the problem of
shirking would likely rise. The bartenders would likely press management
for each bartenders being assigned tables and stools and to abandon tip
pooling (at least beyond some expansion of the bar).
e. If management required tip pooling across all bartenders and servers in the
restaurant, what would likely happen to the required monetary earnings of
bartenders and servers both in the short run (during which people cannot
shift jobs) and the long run (during which they can seek?
Initially, the tip earnings of all bartenders and servers would likely fall as
shirking rose, due to the increase in the number of people pooling tips (and
their falling impact on total tips). However, in the long run, such broad-
based tip pooling could cause bartenders and servers to seek employment
elsewhere. If management wants to retain employees with broad tip
pooling (and the resulting increase in shirking), then management would
have to raise workers’ compensation in some form just to keep them under
the rising risk of shirking by all. This required increase in compensation
would likely pressure management to reduce the scope of tip pooling.
Week #2 Discussion Problem
Student Choices Consider a hundred students who have been asked to choose one of these two options:
Option A. Students choosing this option will receive a certain payoff of $800.
Option B: Students choosing this option have one opportunity to pull one “ticket” from
a barrel of tickets (which they cannot see). In the barrel 85 percent of the tickets are
worth $1,000; 15 percent are worth $0.
1. First step in the discussion: Which option would you take? (Which option did
other members of your group pick, if you have a group? What is the percentage
distribution of the group in the choices taken?)
To be determined by students and their groups. There is no right or wrong
answer.
2. Second step in the discussion: Suppose that 80 percent of the hundred students
choose Option A and 20 percent choose Option B.
(These two choice options have been given students in experiments classroom
settings, with the percentage of students taking Option A varying between 75
and 85 percent.)
a. Are the choices of either group “irrational” (or “not rational”)? Why or
why not?
No, neither choice is “irrational.” Some students (a majority in this
case) can be “risk averse” and will prefer the sure-thing outcome
($800) to the gamble, which does have a higher expected value ($850 =
[85% x $1,000] + [15% x $0])
b. Is there “money being left on the table” by the choices either group of
students made? Which group? If so, are their choices irrational? Why or
why not?
From the answer to 2a, there is “money being left on the table,” in a
sense. The eighty students who choose Option A receive a total of
$64,000 (80 x $800). If all of these students had chosen Option B, their
total payoff would have been $68,000 (85% x 80 x $1,000)– which
means that $4,000 is, in a sense, being left on the table. However,
choosing individually, the value of the certain payoff of $800 for each
student is greater than the cost (or “disutility”) of their individually
running the risk of getting nothing.
c. If “money is being left on the table,” how might the money be picked up?
Develop at least two ways.
There are at least three possible ways “entrepreneurs” can collect the
“money being left on the table”:
The eighty students could collectively decide to choose
Option B. They can then divide expected total received
($68,000) equally , with each of the eighty students
receiving $850.
Some smart student could sell each student inclined to
choose Option A an insurance policy that provides
protection against getting nothing.
Some smart student (an “entrepreneur”) could offer the
students inclined to choose Option A a fixed payment of
more than $800 (and less than $850), say, $810 to choose
Option B and hand over the “ticket” value (whether
$1,000 or $0). If the smart student gets all (or just a
sizable percentage) of the students inclined to choose
Option A to pick Option B, then the smart student will
receive a “profit” of $40 on each student persuaded to
take the deal.
If one smart student figures out how to make money off
of students inclined to choose Option A, then other
students can be expected to try to do the same. The
competition among the student-entrepreneurs that
ensues should drive up the payments received by the
students inclined to take Option A and drive down the
profits of those student-entrepreneurs making the
buyouts.
3. Third step in the discussion:
a. Suppose that Option A were changed to $600, while Option B
remained the same?
i. How might the distribution of the choices of the hundred
students be expected to change? Why or why not?
In any large group, members (the students) can be
expected to vary in how they assess risk (or their “risk
aversion” will vary). As the Option A payoff falls from
$800 toward $600, more and more students will see the
growing difference in the value of the two options and
will be inclined to take Option B, the value of which has
remained at $850. This suggests that the percentage of
students taking Option A can be expected to fall, while
the percentage of students taking Option B can be
expected to rise.
ii. What applicable economic principle will be at work in
making your prediction of the change in the distribution of
choices?
The applicable economic principle: the “law of
demand” (or the expected inverse relationship between
price and quality, assuming all other relevant forces on
choice remaining constant). With the decline in the
value of Option A, the cost (or price) of choosing Option
B goes down, which suggests more students will choose
Option B.
b. Suppose that Option A remained the same (a sure-thing of $800), but
Option B is changed to the following conditions: Eighty-five percent
of the tickets in the barrel are worth $10 each; 15 percent of the tickets
are worth $0 each. However, students are each given a hundred draws
from the barrel.
i. How might the distribution of the choices of the students
between A and B be expected to change? Why?
Variance of outcomes is importance in choices (because
variance can affect outcomes and the utility of given
choices). The variance in the problem as initially set up is
quite high and stark. The outcome for each student can be
$1,000 or $0. In this new specification of the problem,
students have a chance of receiving either $10 or $0 on each
draw, but they each have a hundred draws. The total value
of all hundred draws can go all the way between $0 (they
draw all $0 tickets) to $1,000 (they draw all $10 tickets).
They can also be expected to draw different combinations
of $10 and $0 tickets. Their individual totals can, for
example, be $400 or $600 or $950. The expected value of
their hundred draws is $850. Since the variance is lower in
this specification of the problem, more students would be
expected to choose Option B.
ii. What applicable economic principle will be at work in making
your prediction of the change in the distribution of choices?
Again, the applicable economic principle: the “law of
demand.” With lower variance for Option B, the cost
(price) of choosing Option B falls. The “quantity” of
Option B chosen can be expected to rise.
Week # 3 Discussion Problem (Note, there are no Professor McKenzie answers for this week)
Gasoline Price Controls As reported in the New York Times on October 30, 2012, Hurricane Sandy, widely
described as a “superstorm,” made landfall on October 29 on the New Jersey coast, but
because the hurricane was a thousand miles in diameter, it wreaked havoc along the
Eastern Coast of the United States from the North Carolina’s Outer Banks up to the
coasts of the New England states.
The storm destroyed thousands of homes and businesses and shut down transportation
systems throughout the region as the storm made its way inland to Ohio and points
beyond. Roads for miles inland were flooded and buried in sand carried inland by the
storm surge. Even the New York subway was closed because of flooding, and emergency
back-up generators at hospitals, businesses, and homes failed after being submerged in
water.
Most important for this week’s discussion problem, Sandy knocked out electric power for
up to nine million residents at its peak (with electricity still not restored for tens of
thousands of residents three weeks after the storm’s landfall). Gasoline refineries and
gasoline distribution terminals along the coast had to be shut down. Available gasoline
supplies could not, for a time, be produced and delivered to gasoline stations. However,
the lack of fuel was of no consequence for many gasoline stations because they had lost
electricity for their pumps.
Reports emerged of people waiting in line for hours to fill their cars or five-gallon
containers at the gasoline stations that continued to operate. Throughout the initial weeks
following Sandy’s landfall, service stations were restricted in raising their prices by “anti-
price-gouging laws” on the books in New Jersey and New York. Governors in both states
warned service station owners that they stood ready to enforce the price laws, with
“gouging” subject to interpretations of local law enforcers (although reports surfaced of
some stations hiking prices by as much as $1 a gallon immediately following the storm’s
passage).
1. First step in the discussion: Assume a competitive market for gasoline for this
problem, and assume for now that the price of gasoline was held everywhere to its
pre-storm price. Given the descriptions of Sandy’s devastation effects outlined above
(and what else you can find on the extent of devastation online),
a. Draw a supply-and-demand graph for gasoline in the region affected by Sandy prior to
the superstorm. Label the curves S1 and D1.
b. In your graph, draw in the supply of gasoline immediately following the storm. Label
the new supply curve with S2. Why did you draw the curve where you did?
c. In your graph, draw in the demand curve after the storm. Label the new demand curve
with D2. Why did you draw the curve where you did?
d. Given the reports of long lines at service stations and the anti-price-gouging laws, what
should be the relative shifts in demand and supply in your graph in the weeks after the
storm hit.
1. Second step in the discussion: Given what you can observe in your redrawn graph,
a. What effect effects do the gasoline price controls have on the quantity of gasoline
available (relative to what it would have been if there had been no price control)?
b. What effect has the controls on gasoline prices done to the quantity of gasoline
demanded (relative to what it would have been if there had been no price control)?
c. What has been the net market effect of the price control?
1. Third step in the discussion:
a. What has the price control done to the “nominal pump price” of gasoline?
b. What has the price control done to the “full price” (pump price plus the value of the
wait time)?
c. Is the full price the same for all people seeking gasoline?
d. Is the pump price above or below the full price?
e. Has the price control made people better off or worse off?
f. Would you expect economists to generally favor anti-price-gouging laws?
1. Fourth step in the discussion:
a. As noted, reports surfaced that some service stations raised their price of a gallon of
gas by as much as $1.
i. Using your supply-and-demand graphs, what would have been the effects of such a
price increase?
ii. Was the price increase all “profit” to the stations that raised their prices? Put another
way, were there greater costs refineries and stations inside and outside the storm area had
to incur after the storm?
b. The federal government released 2.3 million gallons of gasoline from its reserves.
Referring to your supply-and-demand curves, what would you predict would be the
effects of that release of gasoline?
Week #4 Discussion Problem
Week #4 was skipped.
Week #5 Discussion Problem
U.S. restrictions on the importation of Brazilian ethanol The United States requires gasoline refineries to include ethanol in gasoline, equal to 10
percent of each gallon sold in the country. U.S. ethanol is primarily made from corn
grown in the country.
Brazil is second to the United States in terms of the total volume of ethanol produced
and, because of advanced technology used, is an exporter of ethanol, which is produced
primarily from sugarcane. Brazil also requires refineries to make ethanol to account for
between 10 and 22 percent of each gallon of gasoline sold.
The United States bars the importation of Brazilian ethanol.
All correct alternatives are indicated with an asterisk (*)
First step in the discussion:
1. What does the U.S. ethanol requirement for gasoline do to the (equilibrium)
price of corn in the domestic market?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why have you given the answer you have?
The ethanol requirement increases the domestic demand for corn, thus causing
the price to go up. In terms of a supply-and-demand graph, the demand curve
shifts up and to the right.
The process: At the initial equilibrium price, there will be a shortage (with the
quantity demanded increasing with the increase in demand, and with the
quantity supply remaining the same, at least initially). Buyers will bid up the
price, causing the quantity demanded to fall and the quantity supplied to
increase, until both quantities are the same at the new intersection
(equilibrium).
2. What does the U.S. ethanol requirement for gasoline do to the price of corn in
the world market?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
More U.S. corn will be used in ethanol production, which means the world
supply of corn can be expected to fall, causing an increase in the world price
and less corn consumed in the world.
Please work through the process by which the new equilibrium is
achieved.
3. What does the U.S. ethanol requirement for gasoline do to the price of
popcorn corn in the domestic market?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
With the increase in the price of corn used in ethanol production, the relative
profitability of growing popcorn will fall, which will cause popcorn farmers to
shift to corn used in ethanol. The supply of popcorn will fall (move up and to
the left), with the price increasing.
Please work through the process by which the new equilibrium is
achieved.
4. What does the U.S. ethanol requirement for gasoline do to the quantity of U.S.
corn exported?
a. increases
b. *decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
Because of the ethanol-induced greater profitability of growing corn for the
U.S. market, more U.S. corn will be diverted to ethanol, causing the quantity
of corn available for export to decrease.
Please work through the process by which the new equilibrium is
achieved.
5. What does the Brazilian ethanol requirement for gasoline do to the price of
sugar in the domestic market? In the world market?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
The Brazilian ethanol requirement can increase the demand for sugarcane and
divert the available supply of sugarcane to ethanol production. The supply of
sugar will decrease, which will cause the price of sugar to rise.
Please work through the process by which the new equilibrium is
achieved.
6. What does the ethanol requirement in both countries do to the price of
gasoline in both countries?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
If ethanol were less costly to produce (per unit of energy) than refined
gasoline, the ethanol requirements would not be needed. In their search for
greater profits (and higher stock prices), refineries would move to ethanol.
Hence, we can reason that ethanol must be more costly to produce than
gasoline – because of the requirements. Gasoline with ethanol must be more
costly to price than gasoline without ethanol, which means the supply of
gasoline will decrease and the price will increase.
Please work through the process by which the new equilibrium is
achieved.
Second step in the discussion:
1. What does the U.S. ethanol import restriction do to the price of gasoline in the
United States?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
The import restriction would not be needed if U.S. ethanol were less costly
than Brazilian ethanol. Hence, the import restriction increases the production
cost of a gallon of gasoline in the United States over what it would be were
refineries able to import freely Brazilian ethanol.
Please work through the process by which the new equilibrium is
achieved.
2. What does the U.S. ethanol import restriction do to the price of gasoline in
Brazil?
a. increases
b. *decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
The U.S. import restriction means that there will be a greater supply of
ethanol in the Brazilian economy than would be the case without the U.S.
import restriction. The relatively greater supply would cause the price to be
lower.
Please work through the process by which the new equilibrium is
achieved.
7. What does the ethanol requirement in both countries do to the price of
gasoline in the world market?
a. increases
b. *decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
The ethanol requirement in both country would reduce the world demand for
crude oil, the price of which can be expected to fall because of the ethanol
requirements. Also, with the United States and Brazil using less crude oil
because of the required ethanol requirement and because of the resulting
higher prices of gasoline in the two countries, there will be a greater supply of
crude oil to satisfy the energy needs of all other world buyers. The world
demand outside of the United States and Brazil falls; the available supply of
crude oil for all other countries increases. Both supply and demand forces on
the world market would push the price of crude downward, which will feed
into a lower gasoline price for all other countries.
Please work through the process by which the new equilibrium is
achieved.
3. What does the U.S. ethanol import restriction do to the emissions of
greenhouse gases in the United States?
a. increases
b. *decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
If ethanol causes the emission of lower greenhouse gases than gasoline (and
there is debate on this point because corn production is energy intense), then
the lower use of gasoline in the United States and Brazil will lower
greenhouse emissions. Also, the higher price of gasoline in the two countries,
because of the ethanol requirement, can lead to less miles traveled and, again,
to lower greenhouse gas emissions in the two countries.
However, it needs to be noted that the lower price for crude oil on the world
market, and the resulting lower price of gasoline outside the United States and
Brazil, should give rise to some offsetting increase in miles driven around the
world – and more greenhouse gases emitted in places other than in Brazil and
the United states.
Please work through the process by which the new equilibrium is
achieved.
Third step in the discussion:
1. What does the U.S. restriction on the importation of ethanol from Brazil do to
U.S. exports to Brazil?
a. increase
b. *decrease
c. remain the same
d. don’t know (not enough information to say)
Why?
The U.S. import restriction on Brazilian ethanol will mean fewer external
sales for Brazilians who will have fewer dollars to buy U.S. goods, which
means lower U.S. exports.
Please work through the process by which the new equilibrium is
achieved.
2. What does the U.S. restriction on the importation of ethanol from Brazil do to
the cost of producing energy in the United States?
a. *increases
b. decreases
c. remains the same
d. don’t know (not enough information to say)
Why?
There would be no need for an import restriction of Brazilian ethanol if it
were more expensive than U.S. ethanol. Hence, the import restriction
increases the price of gasoline in the United States over what it would be with
free importation.
Please work through the process by which the new equilibrium is
achieved.
Week #6 Discussion Problem
Elasticity of demand Suppose that a movie theater faces a downward sloping demand curve for popcorn, and it
increases the price of a container of popcorn from $1 to $1.20, which causes the count of
containers sold to fall from 100 to 90.
First step in the discussion:
1. What is the elasticity coefficient?
Elasticity of demand = - the percentage change in quantity/percentage change
in price = - 10%/20% = - .5
2. Is the demand elastic or inelastic?
Inelastic, as indicated by the elasticity coefficient that is below 1 and as
indicated by the fact that total revenues rise from $100 to $108 with the price
increase.
3. Should the theater consider raising the price of popcorn further?
Yes. A higher price could once again raise the firm’s revenues. The higher
price would also reduce sales, which would reduce costs, making for higher
profits.
Second step in the discussion:
1. When a firm faces a downward sloping demand curve, should it ever price its
product in the inelastic range of the demand curve?
No, aside for when the good is addictive or has network effects. Aside for the
exceptions, the firm should raise its price until it moves into the elastic range
of its demand curve.
2. Should the firm ever price it product where its elasticity coefficient is 1?
No, with an exception noted below. The firm may maximize its revenue at the
price where the elasticity coefficient equals 1, but that is not the same as
maximizing profits. The firm can increase its profit by raising the price to
where its demand is elastic (or has an elasticity coefficient greater than 1),
which means its total revenue will decline as it raise it price from where the
coefficient equals 1 to where it is greater than 1. However, its profits can rise
because its costs fall with reduced sales. So long as its costs fall by more than
its revenue, its profits will rise. The firm should stop raising its price when its
revenue falls by more than its costs. (As we will see in following lectures, the
applicable rule is that the firm should continue to raise its price until its
marginal cost equals its marginal revenue.)
The only condition under which a firm will price where the elasticity
coefficient is 1 is when all production costs are fixed, or do not vary with firm
output. (Can you think of a product that fits such a requirement?)
3. When a firm is a monopolist (or the only seller of a product), should it price
its product in the elastic or inelastic range of its demand curve?
The monopolist should price its product in the elastic range (for the reason
given just above).
4. If a firm faces a downward sloping demand curve that has an elasticity
coefficient of 1 throughout its entire range, what quantity should the firm
produce to fully maximize profits?
The profit-maximizing output level is 1. With the elasticity coefficient equal
to 1 at all points on the demand curve, the revenue at all points on the demand
curve, and at all prices, is the same. Why produce more than 1 unit? The firm
gets the same revenue with an output of 1 as with an output of 100, or 1,000.
At an output of 1, productions costs are minimized, which means that profit is
maximized.
5. Should a firm ever charge a price that is below (marginal) cost or that is below
zero (which means the firm pays customers to take the product)?
If the firm produces an addictive good or the sales of its good have
accompanying network effects, then pricing below costs and below zero can
make sense. In the case of addictive good, the added sales can cause
consumers to want more of the good over time, which means that below-cost
and below-zero pricing can increase future demand, with the higher future
price and sales justifying any loss on sales made initially with a below-cost
and below-zero price.
In the case of a good with network effects, greater current sales, induced by
the below-cost and below-zero price, can increase the value all consumers
place on their units bought, increasing demand. The higher demand can lead
to a higher price and higher sales and greater profits. (See video lecture 30
and chapter 6 in McKenzie’s Microeconomics for MBAs, 2nd
ed.)
Week #7 Discussion Problem
Wine pouring in bars Tipping servers in bars is common in the United States and many other places around the
world. This typically means that bar patrons leave a gratuity of 15 to 20 percent of the
total bar bill for the bartender(s) (when customers judge the service to be acceptable or
better).
In many bars bartenders are required to first pour ordered glasses of wine into carafes (or
small bottles tapered at the top) and then to pour the wine from the carafes into
customers’ glasses on reaching them at their positions at the bar or at tables surrounding
the bar.
First step in the discussion:
1. If possible, go to a local bar (or restaurant that serves wine) that follows the
wine-pouring procedures outlined above and ask the bartenders why they just
don’t pour the wine directly into their customers’ wine glasses and take the
wine glasses to the customers?
You will likely hear (as the professor has heard) that the carafes are used (in
spite of the greater dish-washing costs) because it helps create a desired
“ambience” in the bar, which could be a partial explanation because the
resulting increase in traffic can more than cover the (very likely small) added
dishwashing costs.
Members of your group could have heard other explanations. Just evaluate
each for their economic reasonableness (or in terms of solving some
management problems and in terms of costs and benefits).
2. Develop your own explanation for the required wine pouring procedures
based on principal-agent analysis.
The owners of the bar are the principals who want to maximize their return by
employing bartenders to pour wine as cost effectively as possible. This means
they do not want bartenders to use firm resources for their own private gain
(unless the bartenders are willing to take a cut in pay). The bartenders, who
are hired agents, want to maximize their return from work by using the
resources at their command, including the bottles of wine over which they
have some control in how the wine is pour. The carafes are used to control
the bartenders’ inclination to over pour their favored customers. It’s harder to
over pour with the carafes (because of their narrow necks) than with the wine
glasses.
3. How might tipping affect wine pouring by bartenders if they poured wine
directly into wine glasses (especially large wine glasses that bars often use to
encourage drinking)?
Bartenders get to know many of their regular customers, including how much
they typically tip. Bartenders can over pour wine for their regular customers
who can be counted on to over tip (or the extent to which they are “big
tippers”). Customers can compensate the bartenders for the extra wine with
an extra tip. Thus, agents can use the principal’s resources (wine) to pad their
pockets, with the principals incurring the added cost for wine.
Because of this principal-agent problems in bars, managers often check how
much wine has been poured in total against cash register receipts. This means
that if bartenders over pour their regular big tippers, they must under pour
other customers just to make sure their over pouring is not detected, and the
under pouring can cost the bar customers and revenues.
4. How might the bartenders’ wine pouring affect tipping?
Needless to say, customers who get more wine than expected, can be expected
to reward bartenders with higher tips, which can cause the bartenders to
extend their over pouring (and round and round until the over pouring is
detectible by managers).
Second step in the discussion:
1. What’s the basic problem that the wine pouring procedures are intended to
solve?
Very simply, principal-agent problems, or the cost of the over pouring is
shifted to owners in the form of reduced profits.
2. If bartenders are not required to follow the wine pouring procedures outlined
above, how else might management seek to solve the “problem” you
identified in the previous question?
It should be interesting to learn what monitoring/control systems students find
managers use in bars they visit. One of the most common means bars use to
control over pouring is for the manager to watch what bartenders do. The
professor has seen some bars put a wine glass at the “pouring station” with a
green line around the glass that the poured wine is not to exceed (with the
added requirement that bartenders pour all drinks at the pouring station). Bars
also have cameras aimed at the pouring station to catch offending bartenders.
3. Is the “problem” you have identified a problem in all bars? In what situations
is the “problem” more likely to be found?
The problem of over pouring and over tipping does not appear to be a problem
everywhere. Managers may have few pouring controls in place when they
know they can trust their bartenders, maybe from long years of the bartenders
working at the bar (and their reputations for honest dealing in prior bar jobs).
Obviously, there is no principal-agent problem for bartenders who own their
bars. When they over pour wine for customers, bit tippers of just friends, the
excess wine comes out of their own pockets. It follows that control
procedures are likely used with greater frequency when owners/managers
can’t monitor bartenders, at least not directly and at little cost.
However, keep in mind that some bars will want to use excess pours as a form
of promotion, or to get customers coming back (or to reward frequent
customers). For this reason, the owners of some bars give their bartenders
some leeway in over pouring (and can reward bartenders for effective use of
their discretion on over pouring).
Week #8 Discussion Problem
Opportunities and Business Decisions Suppose you are in a crowded restaurant. You overhear a discussion at the next table.
From what you hear, you deduce (accurately) that one of people is the owner of a
prominent upscale nursery in Newport Beach, California where land values are higher
than most other locations in other parts of Orange County, California, and land values in
Orange County are higher than the vast majority of counties in the country (and even in a
number of other counties of Southern California).
The eight or so acres of land on which the nursery sits are especially well positioned, and
are very pricy. The piece of land is within a mile or two of the Pacific Ocean and is on
the perimeter of a major upscale shopping center that is one of the most profitable
shopping centers in the county. The nursery and shopping center are surrounded by
densely packed multimillion-dollar homes. One real estate agent estimates that if the
land were vacant today, it would sell for about $15 million.
You hear one of the people at the close-by table ask about how the nursery can continue
to operate on such a well-positioned and high-price piece of land. The owner explains,
“Well, my father bought the property way back in the 1970s when the area was far less
developed and the land was relatively cheap. If we had to buy the land today, there is no
way we could afford to buy the land and develop the nursery. The land would probably
be used for another shopping center or condo development.”
This restaurant conversation presents an interesting economic/business problem to
ponder, even though there may not be a definitive answer (because we don’t have all the
required details of the nursery’s operations, including its profitability). But then, many
business problems that must be taken up in a course in skeleton form don’t have
definitive answers (because of the limitations of available information). However, such
problems can bring to light concepts and principles and ways of thinking that can be
useful in considering an array of problems where the details may be far more complete.
.
1. First and only step in the discussion:
a. How do you react to the nursery owner’s claim that he could not buy
the land and develop the nursery today and that the land would be used
in some alternative business venture?
One way of looking at the issue is this: If the owner has truly
accurately assessed the real estate market in the vicinity of his nursery,
then he is saying that that he could not “afford” to buy the land today.
Interpreted differently, he is saying that the expected future
profitability of the nursery going forward in time is not sufficient for
him to pay the going price for the land. If the expected profitability of
the nursery going forward were more than sufficient to cover the cost
of the land and nursery facilities (and the differential between the
present value of the nursery’s future profits stream were greater than
the price of the land), then he should be willing to buy the land and
start the nursery. Otherwise, he would be leaving “money on the
table.”
Of course, there is an important caveat to keep in mind: if he could
invest the funds required to buy the land (and cover the cost of the
nursery’s development) in some other business venture that yielded a
higher expected profit stream into the future, then he should not buy
the land. He should invest in the most profitable other business
venture.
b. If the owner has accurately assessed the economic situation of the
nursery, what should he do?
By saying he could not afford to buy the land today, he is saying one
or both of two things: First, the current value of the expected profit
stream of the nursery cannot cover the cost of the land (and other
facilities). Again, if the current value of the profit stream were greater
than the cost of the land (and facilities), he would buy the land today.
Second, he could be saying that the price of the land is so high that he
could sell the land and invest the funds in some other venture that
would be more profitable over time (or he can get a price for his land
that reflects the higher expected profit stream someone else could get
from the deployment of the land in some other use or business
venture).
c. If the nursery owner continues to operate his business, how might you
explain his doing so, in spite of his saying that he would not start the
nursery today because of the high price of the land on which it sits?
By continuing to hold the land and operate the nursery, there is good
reason to suspect (not know) that the owner has not revealed the true
economics of continuing to operate the nursery.
The profit stream might be higher than he let on.
The land could have a lower market value than he thinks.
He gets some non-money value (the pleasure from knowing he
has the premier nursery county that has become a tourist
attraction) from operating the nursery that more than
compensates for the lack of profitability of the nursery.
He might not know of other business ventures that will give
him a higher rate of return on the sale price of his nursery
business.
The owner’s personal (and transaction) costs of selling out and
developing a new business (or buying another existing
business) are greater than any expected gain he might receive.
The owner might also be constrained by the fact that a number
of family members (and investors) may not agree on what
should be done. The owners might not agree on selling out and
on the division of the sale price.
Now that the nursery has been developed on the land and is a
going, profitable business, the owner no longer needs to worry
about the risk of undertaking a new business. There is no
longer the “risk cost” associated with starting a new, untested
business concept. If the owner were to buy the land today at its
current high price to start a nursery today, he would face the
nontrivial risks of failure, with the risk costs elevated by the
high upfront investment in the land and in the development of
the business, which could now be greater than what the risk
costs were back in the 1970s, when competition was less
prevalent and intense.
So-called “behavioral economists” (whose theories will come
up at different points in the course) argue that people are “risk
averse,” which suggests that losses of a given amount (say,
$100) loom larger in decisions in all spheres, including
business, than an equal amount of gains ($100 of losses harbor
more disutility than $100 of gains). Risk (and loss) aversion
implies that people will require a higher sale payment for a
piece of property when they own it than they would pay out of
pocket when they do not own it. So, the owner might demand
$21 million before he would sell the land on which the nursery
sits, but, at the same time, he would not pay the going market
price of $15 million for the land if he did not own it. (Granted,
this line of argument has not been taken up in the lectures –
yet. I briefly and incompletely cover it here just in case some
students (out of the thousands taking the course) are familiar
with the basic tenets of behavioral economics, a basic position
of which is that people do not always act exactly as economists
assume rational people act.)
Week #9 Discussion Problem
Monopoly Vs. Perfect Competition Following conventional market-structure theory, perfect competition (a market structure
comprised of many firms and total fluidity in the movement of resources) maximizes
output and market efficiency but reduces economic profit to zero for all firms. Monopoly
(a market structure comprised of a single producer protected by entry barriers) reduces
output below the perfectly competitive level in order to hike its price and generate
economic profits. In the process, a monopoly causes the market to be less than fully
efficient. The monopoly reduces consumer surplus by reducing output and by extracting
monopoly profits.
First step in the discussion:
1. Do you accept the argument that “perfect competition” is all “good” and
“monopoly” (or “monopoly power”) is all “bad”? Why? Why not?
2. Would you want an economy that largely perfectly competitive or largely
monopoly, or some combination?
3. How do you assess barriers to market entry in terms of enhancing consumer
welfare?
4. Would you invest your own resources in the development of a product that
will go into a perfectly competitive market? Why? Why not?
Professors McKenzie and Dwight Lee have addressed all of these issues extensively
in a book titled In Defense of Monopoly: How Market Power Fosters Creative
Production (University of Michigan Press, 2008). Professor McKenzie has excerpter
many of the arguments for an article written for a policy magazine, a major portion
of which is provided below.
TEXTBOOK MONOPOLY
Many economists and antitrust lawyers have concluded that the problem with antitrust
enforcement largely has been a matter of wrongful application of monopoly theory. A
better diagnosis is that a deeply flawed conventional monopoly theory has misguided,
and continues to misguide, enforcement.
All budding antitrust lawyers and economists learn the conventional monopoly
theory, which is almost always depicted with a graph like Figure 1. From such a graph
and underlying theory, four theoretical conclusions, all of which paint monopoly as
nothing less than a source of “market failure,” are drawn:
First, monopolies everywhere lead to curbs on production to achieve higher-than-
competitive prices. That allows a monopoly to collect “rents” — supracompetitive profits
— and impose an “inefficiency” or “deadweight loss” on markets. In Figure 1, the
monopoly restricts production, reducing it from the competitive output level where price
equals marginal cost, to the point where marginal revenue equals marginal cost. That
enables the firm to raise its price to the monopoly price, which is above the competitive
price (and the marginal cost of production). Efficiency in the allocation of resources is
always fully maximized when price equals marginal cost, or so students are required to
repeat in rote fashion.
Second, the monopoly benefits from barriers to competitors’ entering the market and
thus gains pricing power (caused by market dominance, if not just bigness), a practice
that is (conventionally) antithetical to competition and welfare gain. The barriers enable
the monopoly to maintain its supply constraint, monopoly profits, and the deadweight
loss of consumer welfare.
Third, the monopoly achieves rents that are unearned and forcibly taken from
consumers’ “surplus value” (the whole of the area under the demand curve and above the
marginal cost curve in Figure 1).
Fourth, “perfect competition” — a market in which all resources are perfectly fluid
and in which monopoly rents are nowhere achievable — should be viewed as the goal to
which antitrust enforcement presses real-world markets. Then, consumers would get their
entire consumer surplus (including the striped rectangle and triangle in the graph), which
is to say that consumer welfare is maximized.
The conclusion is that antitrust enforcers enhance consumer welfare when they
prevent or destroy barriers to market entry and increase the number of competitors —and
thereby undermine the market power of monopolies.
(Figure 1 is at the end of the article.)
THE REAL WORLD
That’s all nice theory, but it is grossly misleading for several reasons.
From the theory on which antitrust law is founded, one has to wonder why
competitors to a dominant monopoly firm would press for antitrust complaints against a
monopolist when the monopolist acts like one — that is, when it curbs production to hike
its price. Would that not mean the monopoly would be giving its competitors a chance to
gain market share even with higher prices? Would competitors really want their market to
be made even more competitive through antitrust enforcement, as Microsoft’s
competitors indicated they wanted when they proposed the breakup of Microsoft into two
“Baby Bills”? Clearly, William Baumol and Janusz Ordover damned much antitrust
enforcement when they observed, “Paradoxically, then and only then, when the joint
venture [or other market action] is beneficial [to consumers], can those rivals be relied
upon to denounce the undertaking as ‘anticompetitive.’”
Notice also how the theoretical model rigs the debate. Both in Figure 1 and in abstract
discussions of monopoly, the monopolized product and the monopoly itself are subjected
to analysis only after the firm and product have come to dominate the market. Nothing is
said about how the monopoly arose. Could it not have arisen by besting its competition
with a superior product at a lower (or even higher) price?
IGNORING THE GOOD Setting that issue aside, in the market model portrayed in the
graph, any output level below the idealized competitive output level that the monopoly
causes is considered to be detrimental to consumers. Consumers have less to buy and
must pay an inflated price for what they are able to buy because of the monopolist’s
constricted market supply. Thus, the argument goes, consumers lose the potential welfare
gain that goes up in the smoke of the monopoly profits and in the market inefficiency.
Because the good itself and all that went into bring it to market are not considered by the
analysis, the analysis simply assumes that the monopoly has no just claim to any
consumer surplus.
However, products bought and sold in real-world markets do not appear by
assumption, or fall like manna from heaven. Monopolies do not achieve their dominance
for no good reason (unless established by government fiat). Products and their markets
have to be created and developed with significant initial investments. Once those points
are recognized, a monopoly that is alone responsible for achieving its market dominance
will not want to restrict output. On the contrary,
The monopoly expands total output along with the array of available products.
The monopolist does not charge higher prices; it lowers them.
Consumer welfare is not lowered; it is elevated (at the very least equal to the
triangular area in Figure 1 that is above the monopoly price and below the demand
curve).
The monopolist does not produce inefficiently; the identified inefficiency area in
the graph would not likely exist in many monopolized markets were it not for the
prospect of the monopoly profits.
Without the monopoly product, many products of monopoly would not exist in the
first place.
Rents are not an unjustified cash grab, they are likely the impetus for creating the
product in the first place.
When the product is created by the monopoly, the claim that the monopoly has no
just claim on the consumer surplus surely loses at least some of its force.
Of course, a monopoly would not restrict its output and elevate its price if it faced
perfectly competitive market conditions. But if a potential monopolist anticipated
anything close to perfectly competitive market conditions, it would not create the good in
the first place because there would be no incentive to do so. In a market with complete
resource fluidity, a firm would be foolish (and negligent to its stakeholders) to incur the
product and market development costs of a new product because such costs are not
recoverable in totally fluid markets. All prospects for development cost recovery would
be wiped out as numerous producers replicated the newly created product at zero
development costs, forcing price to the marginal cost of production. It follows that where
there are no barriers to entry, product and market development costs cannot be recovered
and “monopolized” products and their markets will not be developed, leaving consumers
less well off.
The idealized competitive price, which equals marginal cost, becomes all the more
absurd as a viable price when marginal cost of production approaches zero, which is the
case for many digital goods. A competitive price of zero is hardly a price that is
sustainable, given product and market development costs in addition to production costs
— unless, of course, the product is a “give-away” that enables producers to charge
monopoly prices on some other product tied to the give-away.
Indeed, in the real world where entrepreneurs create goods, the idealized competitive
price (which equals marginal cost) is hardly a better signal of what products should be
produced because it captures little (actually none in Figure 1) of the value of the product
to consumers. Instead, a monopoly price can more efficiently direct entrepreneurial
energies because such a price captures more of the value of the product than the
competitive price, a point that Paul Romer has made with force. (Remarkably,
economists typically start their classes heralding the mutual benefits from trade going to
trading partners, only to later idealize the perfectly competitive market in which
producers receive no net gain from production while consumers who had nothing to do
with the product and market development get all the gains.)
Paradoxically, the potential for market power over price through the generation of
new products can lead to greater competition in markets than when there is a complete
absence of market power, which is the case under so-called perfect competition. Perfect
competition is far less “perfect” in terms of generating consumer value over the long run
than markets with more constricted resource fluidity.
Think about it: how much entrepreneurial and entrepreneurial effort is being applied
right now to the development of products and markets where there is no chance of
making (directly or indirectly) at least enough monopoly rents to cover product and
market development costs? Indeed, the exact opposite occurs. Firms are constantly
searching for potential products that come with natural entry barriers or harbor the
prospect of being protected by artificially created and continually fortified entry barriers
with, if nothing else, ongoing product improvement. As opposed to being destructive of
consumer welfare, entry barriers in some form and at some level are essential for product
and market creation — and for the advancement of consumer welfare beyond what can be
achieved when products are given.
Antitrust enforcers decry “monopoly prices” because they cause monopoly rents. But
how many consumers and firms would want to deal with firms that make zero monopoly
profits and stand always on the brink of being supplanted by competitors at the slightest
of errant moves? Firms in such markets cannot make credible commitments to do what
they say they will do.
The standard models of monopoly and perfect competition that all antitrust enforcers
learn set aside a reality of markets: the vast majority of new products (and even new
firms) fail. Under such market conditions, the potential for monopoly prices and profits
on the relatively few successful products are absolutely essential, just so that the
development costs of all products — the successful and unsuccessful — can be covered
with some margin left over. Otherwise, firms would not systematically take on the risk
associated with the development of an array of products.
BACK TO MICROSOFT
When the U.S. Justice Department took Microsoft to court in 1998, it chided Microsoft
for having developed its market dominance on the back of “network effects” and
consumer “switching costs.” Network effects mean that the value of the product to
consumers increases as more consumers adopt the product. Switching costs means that
consumers cannot easily move to an alternative product. The Justice Department never
realized that its network-effect/switching-cost arguments together mean that consumers
have a strong interest in the maintenance of the network — and of the network-good
producer, Microsoft, taking strong action to prevent the dissolution of the network
through the entry of alternative producers.
Finally, for sake of argument, let us assume that a firm — call it Microsoft, Apple, or
Google — is the worst of monopolies as conventionally conceived. It constricts output in
order to hike its price and profit to the limit, resulting in the maximum inefficiency in its
market. Is such a firm a drag on the economy, on balance and over the long term?
Conventional monopoly theory offers a resounding “yes.” But not so fast. There can be
an untold number of firms out there busting their organizational butts to create an array of
heretofore unknown products at their own expense because they want to be like the
monopoly that is making monopoly profits.
Paradoxically, monopolized markets can be more creative, competitive, and welfare
enhancing than the most perfect of perfectly competitive markets. Indeed, perfectly
competitive markets would be totally stagnant markets, if they could exist, which is
unlikely because no one would have an incentive to create and develop the products and
their markets in the first place. Moreover, antitrust enforcers who seek to impose their
version of a “competitive” market based on wrongheaded lessons learned from standard
monopoly theory very likely can impose more damage — inefficiency — on the world’s
economy than their targeted “monopolies” ever could do.
Joseph Schumpeter is renowned for coining the term “creative destruction,” a term
most people either misinterpret or do not understand. Schumpeter had in mind a subtle
point that needs to be emblazoned in the corner of the computer screens of all antitrust
enforcers everywhere:
A system — any system, economic or other — that at every given point in time
fully utilizes its possibilities to the best advantage may yet in the long run be
inferior to a system that does so at no given point in time, because the latter’s
failure to do so may be a condition for the level or speed of long-run performance.
The prospect (and the necessary reality) of monopoly power and profits at some level is a
necessary and crucial market force driving so much creativity and competitiveness and,
thus, long-term maximization of resource efficiency and consumer welfare. Particular
products might be protected by barriers to entry from replicators of the product, but new
ideas incorporated in new and improved products cannot be denied. Or as Schumpeter
observed, “The fundamental impulse that sets and keeps the capitalist engine in motion
comes from the new consumers’ goods, the new methods of production or transportation,
and the new markets, the new forms of industrial organization that capitalist enterprises
create.” It does not come from simple price competition, as so many conventional
microeconomics courses wrongly stress.
Unlike the price competition idealized in conventional monopoly discussions,
competition from new ideas incorporated into new and improved products strikes “not at
the margins of the profits and the output of the existing firms but at [the firms’]
foundations and their very lives.” Without including an analysis of this type of non-price
competition, Schumpeter argues, any discussion of markets, even though technically
correct, is as empty as a performance of “Hamlet without the Danish prince,” — a point
that Schumpeter would surely stress to modern-day antitrust enforcers on both sides of
the Atlantic.
# # #
READINGS
Capitalism, Socialism and Democracy, by Joseph A. Schumpeter. Harper, 1942.
The Antitrust Paradox: A Policy at War with Itself, by Robert H. Bork. Basic Books,
1978.
“The Origins of Endogenous Growth,” by Paul Romer. Journal of Economic
Perspectives, Winter 1994.
Trust on Trial: How the Microsoft Antitrust Case Has Changed the Rules of Competition,
by Richard B. McKenzie. Basic Books, 2001.
“Use of Antitrust to Subvert Competition,” by William J. Baumol and Janusz Ordover.
Journal of Law and Economics, Vol. 28 (May 1985).
Week #10 Discussion Problem
Pricing Strategies With supply and demand curves, we were able to demonstrate early in the course why
competitive markets have one price that is adopted by all producers. And all producers
charge the same price for all units sold. Such analysis clearly has relevance in
commodity markets (grains, for example). However, in many markets producers are
observed charging different people different prices and different prices for different units
sold to buyers. In this last group discussion problem, you are asked to provide
explanations for observed differences in prices. (You are encouraged to come up with a
list of markets in which the identified pricing strategy is used.)
Don’t assume that the following problems always have clear economic explanations.
Indeed proposed explanations may be, to one degree or another, “speculative,” which is
understandable, given that student groups need to devise explanations without knowing
many institutional details and without time-consuming empirical analyses (which can be
used to test the validity of hypotheses that can be devised from theoretical considerations
but can’t be considered within the timeframe of this course). Also, there could be
multiple explanations for the pricing strategies identified. Student groups should also
seek to think creatively (trying to come up with explanations that escape the professor).
The pricing problems are intended to press students to apply the economic reasoning
developed throughout the entire course. Students should consider all of the following
questions (briefly) but are encouraged to address on selected questions. There isn’t
enough time to address them all thoroughly. Students are encouraged to distribute the
questions within their discussion groups and to swap and evaluate responses devised
within and across student discussion forums.
1. Many movie theaters around the world charge “seniors” (moviegoers over, for
example, sixty years of age) more than they charge younger adults. Why?
Explain why seniors’ break on ticket prices is profitable to movie theaters.
This can be explained by the analysis of market segmentation. The demand
curve of seniors is more elastic than the demand curve of younger adults.
Seniors have more time on their hands to search for the best prices for
entertainment. Their demand may also be lower (which means that the
elasticity of demand at any given price is higher).
Review video lecture 42. Market Segmentation (25 minutes)
2. Movie theaters also charge different prices for different size containers of
popcorn, for example, $5 for a “small” (8 ounces), $6.50 for a “medium” (16
ounces), and $7.00 for a “large tub” (32 ounces with refills). (Similar pricing
strategies are used for sodas and packages of fries at fast food restaurants.)