Markets, Strategies, and Firms

Context

• The majority of economic transactions take place through markets. Newspaper articles focus on developments in a plethora of markets daily.

• Although the concept is familiar to most of us through mass media, markets have a myriad of flavors, each one with particular characteristics.
  • What is a market from an economic perspective?
  • Why are economists and politicians so interested in how markets are organized?
  • How do markets contribute to the organization of production?

Course Structure Overview

Lecture Structure and Learning Objectives

Structure

• Jonathan Lebed (Case Study)
• Markets, Strategies, and Firms from an Economic Perspective.
• Current Field Developments.

Learning Objectives

• Explain what a market is from an economic perspective.
• Describe with examples the main typology of markets.
• Illustrate the organizational differences within and across firms.
• Give an overview of the fundamental market structures and competition strategies.

Jonathan Lebed

• Lebed is a former stock market trader.

• He was raised in New Jersey, US.
• He was prosecuted by the US Securities and Exchange Commission (SEC) for stock manipulation.
• Lebed reached an out-of-court settlement with SEC in 2000; He was 15 years old.

The SEC Prosecution

• Lebed is the first minor ever prosecuted for stock-market fraud.

• Lebed tools were
  • an America Online (AOL) internet connection,
  • an E*trade account, and
  • four email accounts in Yahoo Finance Message Boards.
• The SEC accused him of making his money through a pump and dump strategy.

Timeline

The Settlement

• Lebed forfeited \($285000\) in profit and interest he had made on \(11\) trades.

• He has never admitted any wrongdoing.
• He kept close to \($500000\) in profit.

Everybody is Manipulating the Market

People who trade stocks, trade based on what they feel will move and they can trade for profit. Nobody makes investment decisions based on reading financial filings. Whether a company is making millions or losing millions, it has no impact on the price of the stock. Whether it is analysts, brokers, advisors, Internet traders, or the companies, everybody is manipulating the market. If it wasn’t for everybody manipulating the market, there wouldn’t be a stock market at all…

Jonathan Lebed, statement to his lawyer, (Lewis 2001)

Markets

• The first markets were locations where people gathered to purchase and sell commodities.

• Today, thinking in such terms is way too restrictive to describe markets accurately.
• In financial markets, contracts are traded instead of commodities.
• In labor markets, services are traded.
• Internet markets do not have physical manifestations.

Markets in Economics

• Economics studies the interactions of economic entities; namely firms, households, governments, and other organizations.

• How do these agents interact?
• A market is a coordination mechanism conveying information via prices among economic entities to organize production and allocate output.

Types of Markets

• Physical markets are markets that manifest in specific geographical locations. Non physical markets are markets that are not physical. (e.g., a supermarket vs. a labor market.)
• Retail markets are final goods and services markets sold for consumption. Business markets are final or intermediate goods and services markets sold from one firm to another. (e.g., a fish market vs. a tractor market.)
• Financial markets are markets in which financial instruments and contracts are traded. Non financial markets are markets in which commodities and services are traded. (e.g., a stock exchange vs. a grocery store.)
• Authorized markets are markets where the trade of commodities occurs via channels authorized by the manufacturers. Unauthorized markets (or gray markets) are markets with channels that the manufacturer does not recognize. (e.g., US version video games market in the US vs. Japanese version video games in the US)
• Legal markets are markets in which commodities and services are traded according to the governing set of rules. Illegal markets (or black markets) are markets in which transactions have some aspect of non compliance with the governing rules. (e.g., car market vs. illegal drug market)

Limits of Markets

• How inclusively a market is defined entails a level of arbitrariness.
• An electric automobile sold in Frankfurt belongs in
  • Frankfurt’s automobile market
  • Hessen’s automobile market
  • Germany’s automobile market
  • Germany’s electric automobile market
  • European automobile market
• The definition of what a market includes is crucial in legal cases concerning competition law.

Market Forces

Market Failures

• Coordination mechanisms based on prices do not always exist.
• Some commodities and services have special characteristics that
  • either prevent efficient coordination based on prices,
  • or even lead to a complete production shutdown!

• A market failure is a situation in which the price-based coordination of economic agents is impossible or inefficient.

Firms

• A firm is a legal entity that signs contracts with its suppliers, distributors, employees, and often customers (Chandler 1992).

Firms in Economics and Business

• Looking within the firm (Economics of the Firm):
  • A firm is treated as an administrative entity in which a team of managers is needed to coordinate and monitor its activities and the division of labor.
  • How do managers and workers interact?
• Looking across firms (This course):
  • A firm becomes a pool of know-how, physical, and financial capital.
  • It uses its resources to produce output.
  • For-profit firms are the primary instruments in capitalist economies for producing and distributing commodities and services.

Production as a black-box

Strategies

• The collection of firms in a market forms market supply.
  • This collection can consist of exactly one firm (monopoly).
  • It can include a small number of firms (oligopoly).
  • It can include a very large (formally infinite) number of firms (perfect competition).

Competition

• Firms may compete by choosing prices.
• They may follow price discrimination strategies.
• They may compete by choosing quantities.
• They may differentiate their products to stand out.

Current Field Developments

• The transaction cost theory of the firm focusing on the firm’s relation to the market has started developing in the 1930s.
• Managerial and behavioral theories of the firm focusing on internal organization have started developing in the 1960s.
• Industrial organization is an economic field that builds on the theory of the firm and examines the market structure and the relationships among firms.

Concise Summary

• For economics, markets are the primary coordination mechanism of production and allocation.
• There is a rich typology of markets based on their characteristics (physicality, legality, etc.).
• When studying competition and market structure, it is convenient to abstract from organizational aspects and consider the firm as a black box.
• Based on this, various firm models can be used to analyze competition in the market (monopoly, oligopoly, perfect competition, etc.)
• Firms use various strategies based on prices and quantities to compete in a market.

Further Reading

• Varian (2010, chap. 1)
• Belleflamme and Peitz (2010, secs. 1.1-1.4, 2.1.1-2.1.4)
• Chandler (1992)

Exercises

Group A

1. Consider a market with demand \(d(p) = 100 - 4 p\) and supply \(s(p) = 40 + 2p\).

   1. Calculate the demanded and supplied quantities for \(p=2\). Does the market clear? Does it have a shortage or a surplus?
   2. Calculate the market clearing price.
   1. For \(p=2\), we have \(d(2) = 92\) and \(s(2) = 44\). The market does not clear because \(d(2)>s(2)\). It has a shortage equal to \(d(2) - s(2) = 48\)
   2. The market clearing price is obtained by setting \(d(p) = s(p)\) and solving for \(p\). This gives \(p=10\).

2. Consider a market with demand \(d(p) = 250/p\) and supply \(s(p) = 10p\).

   1. Calculate the market clearing price (assume that the price cannot be negative).
   2. Calculate the price elasticity of demand.
   3. Calculate the price elasticity of supply.
   1. By \(d(p) = s(p)\), we get \(p=5\). The assumption of the exercise excludes the negative root.
   2. The elasticity of demand is given by \[e_{d}(p) = d'(p) \frac{p}{d(p)} = -\frac{250}{p^{2}}\frac{p^{2}}{250} = -1.\] Demand elasticity is constant for all prices.
   3. The elasticity of supply is given by \[e_{s}(p) = s'(p) \frac{p}{s(p)} = 10\frac{p}{10 p} = 1.\] Supply elasticity is also constant for all prices.

3. Consider a market with demand \(d(p) = 22 - 3p\) and supply \(s(p) = 10 + p\).

   1. Calculate the market clearing price.
   2. Calculate the price elasticity of demand at the market clearing price.
   3. Calculate the price elasticity of supply at the market clearing price.
   1. We calculate \(p=3\).
   2. The elasticity of demand at \(p=3\) is \[e_{d}(3) = \left. -3 \frac{p}{22 - 3p} \right|_{p=3} = -\frac{9}{13}.\]
   3. The elasticity of supply at \(p=3\) is \[e_{s}(3) = \left. \frac{p}{10 + p} \right|_{p=3} = \frac{3}{13}.\]

Group B

1. Consider a market with demand \(d(p) = \alpha - \beta p\) and supply \(s(p) = \gamma + \delta p\), where all Greek letters are positive parameters.

   1. Calculate the market clearing price.
   2. Calculate the price elasticity of demand at the market clearing price.
   3. Calculate the price elasticity of supply at the market clearing price.
   1. The market clearing price is given by \(d(p) = s(p)\), or equivalently \[\alpha - \beta p = \gamma + \delta p.\] We can solve for prices to get \[p_{m} = \frac{\alpha - \gamma}{\delta + \beta}.\]
   2. The elasticity of demand at \(p_{m}\) is \[e_{d}(p_{m}) = -\beta \frac{1}{\frac{\alpha}{p_{m}} - \beta} = -\beta\frac{\alpha-\gamma}{\alpha\delta + \beta\gamma}.\]
   3. The elasticity of supply at \(p_{m}\) is \[e_{s}(p_{m}) = \delta \frac{1}{\frac{\gamma}{p_{m}} + \delta} = \delta\frac{\alpha-\gamma}{\alpha\delta + \beta\gamma}.\]

References

References

Topic's Concepts

• firm
• market failure
• black markets
• illegal markets
• legal markets
• gray markets
• unauthorized markets
• authorized markets
• non financial markets
• financial markets
• business markets
• retail markets
• non physical markets
• physical markets
• market