From: Dan Fabulich (daniel.fabulich@yale.edu)
Date: Mon May 04 1998 - 17:38:50 MDT
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Right. One final down, three to go. In the meantime...
ChuckKuecker wrote:
>I agree that a 'sunk cost' does not add to production costs, but it sure
>DOES affect my ultimate profits!
>
>The 'sunk cost' needs to be covered BEFORE I can realize profits on my
>invention. Otherwise, there is no point in the whole process - if I can
>never recocver my R+D costs, why should I even think of creating something?
I don't understand what you mean when you say that your costs must be
recovered before you make a profit. You cover costs BY making a profit.
That's the whole point. :)
>Only if the demand magically expands to suck up all I produce. Look at what
>happened to DRAM makers recently due to huge increases in supply in a finite
>market.
Careful; in microeconomics we refer to two different entities which are
easily confused. When we refer to "demand increasing" or "total demand
increasing," we mean that the whole demand curve has shifted upwards (as
takes place when you bring a new product to market). However, the
"quantity demanded" is a different beast altogether; the quantity demanded
will increase, for example, when supply increases (ie the supply curve
shifts down).
As far as "magical" increases in demand, I don't think it's at all
unreasonable to think that you'd get increased demand if you were offering
a new product, even if others were also offering the same product,
presuming that there is a profitable market for what you're selling.
(DRAM, for example, may not be a profitable market at all.) People see a
new thing, so some people who want the new thing and couldn't buy it before
will now start doing so. What's so magical about that?
>How can all my 'knock off' competition also collect the SAME amount given a
>fixed market? If there is the possibility of selling X products, and you
>double the number of vendors, the profits available are X devided by each
>competitor's market share. Anything else is a pyrimid scheme.
The graphs that I showed you above were not the supply curve and demand
curve for the entire market, but only for your firm. If you were to add up
the demand of all the buyers buying from you and your competitors, as well
as the supply costs for you and all of your competitors, you'd get a
microeconomic supply and demand graph for the market. (They look
remarkably similar, perhaps I didn't make that clear.) In that case,
you're right, the increase in demand would have to be divided evenly among
the firms.
However, since I was showing you only YOUR supply and demand curve, that
means that your competitors would see an identical supply and demand curve
facing them; thus, when you get your trapezoid, they get theirs. The total
revenue inside the sum of your trapezoid and all of your competitors is
equal to the trapezoid you would find if you did a supply-demand analysis
of the entire market.
>That is true. As long as my profits exceed my costs, I will keep on
>producing, regardless of competition.
OK, well, as I think I just demonstrated, you DO earn a profit from
invention, even when there's competition. It's given by the area inside
the trapezoid, minus the sunk cost of invention. These profits are smaller
than the profits you get from monopolization, but they are still there.
Thus, in the end, if the revenues inside the trapezoid are greater than the
costs of invention, then you'll invent. If not, it's not worth it, so you
won't.
Now, as for the monopoly analysis...
>Why must I lower the price? Where is this rule posted? I don't see
>Volkswagen, who has a 'monopoly' on their New Beetle, lowering the price
>sequentially on each car they sell..
No, they don't lower the PRICE sequentially, but rather the extra revenue
earned on each car decreases sequentially. They choose a point on that
graph when they set ONE price and collect the area under it and above their
supply curve.
For example, suppose the demand curve is given by P = 10 - Q, where P is
price and Q is quantity. Now suppose you are a monopolist facing this
demand curve, and that you currently sell 3, because your price is 7. Now
suppose you want to increase your Q by one, to sell one more. Well, people
won't buy four at price of 7, they'll only buy 3 at that price. (Which is
just what the demand curve told us.) In order to get people to buy four,
you'll have to lower the price.
Now, this isn't saying that VW starts with their price at some
extraordinarily high value at the beginning of every year and then
decreases the price with each car sold. Obviously, if they were selling
cars where Q was the millions of cars sold and P was the price in thousands
of dollars, they will set one price ($7) and sell a certain quantity of
cars (3 millions). However, if they want to sell 4 millions, VW must lower
the price. [This is actually a bad example, because if you don't want a VW
you can always buy another car, whereas a monopolist would have cornered
the entire market for all cars.]
When there's lots of competitors, however, you can't set your price that
way. The market sets your prices in perfect competition, because if you
raise your prices at that quantity then nobody would buy from you;
meanwhile if you lower your price at that quantity you'll take a loss.
Thus, your price is the same price as the entire market, and thus your
marginal revenue is given by the simple demand curve.
>Why does a monopoly have a lower MR curve? Just because you are the only
>supplier, this does not affect the DEMAND for your product. Demand is quite
>different from sales. Many might like to purchase a product but refrain
>because the cost is too high. The demand is there, but sales lag. Once the
>artificailly high price is lowered (and this DOES NOT mean that you sell
>below cost!) the sales will increase. If you cut costs even further, sales
>will increase to the limit of the real demand. If this happens before you
>run out of margin and production capacity, you make lots of money. If you
>run out of supply before you can sell everything demanded, the demand does
>not disappear, but raising your price will surely cause more customers to
>back off and wait..
I'm already aware of this. But because a monopolist represents the entire
market, the monopolist cannot increase the quantity sold without directly
lowering its prices. Thus, the monopolists MR curve is lower than that for
a perfect competitor.
I'm not making this up... You should be able to find this in any
microeconomics textbook.
>>Where P* and Q* are the price and quantity which would be reached by a free
>>market, and P and Q are the price and quantity which a monopoly would
>>choose to maximize profits. (I recognize that it's hard to read... Try
>>drawing it on paper or something.) When we keep in mind that the
>>consumers' surplus is the area under the demand curve and above the price
>>line, whereas the monopoly's surplus is the area above the supply curve and
>>below the price line, it is clear that by setting the prices this high, the
>>firms are benefitting at the expense of the consumers. Worse, we also note
>>that because this quantity is lower than it would be under a free market
>>there is "deadweight loss" (the wealth which would have been created if the
>>market were free), represented by the area inside the triangle bounded by
>>the demand curve, the supply curve and the quantity line. The part of this
>>triangle above the price line is that surplus which would have been earned
>>by consumers; the part below this triangle is that which would have been
>>earned by firms. Firms will happily sacrifice this triangle, however, if
>>they can gain the rectangle formed by the y-axis, the monopoly price, the
>>quantity line, and the competitive price. The revenues in that rectangle
>>outweigh the revenues in the triangle.
>
>In a free market, will goods magically appear to fill all the holes?
What magic? Most of this stuff is true by definition: we defined the
demand curve to be the price at which people would buy a certain quantity,
the supply curve to be your marginal costs. I think I have shown why the
monopolist necessarily suffers from a lower marginal revenue curve, and it
is self-evident that you should only produce up until the point where the
revenue you would get for selling one more would be less than the costs you
would earn from it (ie MR-MC=marginal profit=0). Thus, people will pay the
price given by the demand curve at that quantity, etc.
>There
>are going to be second order effects - lags in development, tooling, etc.
>that will prevent the market from being fully satisfied at least in the
>beginning of sales of a new invention. Some 'profit' will always be
>unreaped. This 'loss' is an imaginary quantity, since there is no way to
>EVER recover it, unless you posit 'thought to production' technology..
What do you mean by "satisfied?" If for some reason you can't make enough
to "satisfy" demand, then you'll just sell fewer; the loss in sales is
deadweight loss for you and for your customers.
>The monopoly is only bad for consumers if it refuses to listen to the
>customer's wants and needs. If the company cares about it's customers, they
>will adjust their products to fit what the amrket wants.
Once we observe that a monopolist makes more profit producing at a lower
quantity and a higher price than at a competitive price and at lower
quantity, we are able to restate it in another way: a monopoly would have
to start taking a loss on every extra unit sold in order to reach the
competitive quantity, because in order to sell that much, the monopolist
has to lower its price to a competitive price (otherwise people won't buy
the competitive quantity!), further cutting into its profits.
To be blunt, you'd have to be MAD to produce like that. It simply makes no
sense, once you've got monopoly status, to cut into your profits that way.
>If this is the
>case, other firms will find ways to produce equivalent product that
>sidesteps the patent, and satisfy the true wants of the market.
I'm presuming that they can't do that in a cost effective way. If they
could, then there would be no point in having your patent anyway; instead
of reverse engineering your product, they'd just develop an equivalent.
>>If your product isn't worth making under a competitive price, but is only
>>worthwhile under government protection, maybe you should rethink whether
>>the product is worth making at all.
>>
>
>If the competitive price is arrived at by allowing anyone who happens along
>to steal my idea, I might as well stay out of the market.
Yes, that was what I was trying to say. If you can't keep afloat at a
competitive price, then that's the market's way of saying "we don't want it
that badly."
>>I don't understand what you're saying here. As you surely know if you've
>>read my other posts on this topic, I DO think that creaters deserve rewards
>>for inventing, I just don't think they deserve monopoly status on the idea.
>
>It's pretty hard to reap profits BEFORE you sell a product, unless there's
>some fairy godmother of a government agency that pays me for the
>development, then lets anyone who cares to make the gadget! We have enough
>handouts now!
Again, I think that inventors should sell their ideas, once, and then
conclude the transaction. Firms who try to negotiate a per-copy
arrangement will have greater marginal costs than firms who don't have this
arrangement, and thus won't be able to compete in a competitive market,
whereas a firm which pays a sunk cost can recover that cost from the
increase in demand.
>>Again, if you need the coerced profits in the rectangle in order to stay
>>afloat, then maybe you should be rethinking the value of your product in
>>general. And as I think I have shown, you DO benefit from invention, even
>>when other people are allowed to compete with you for your products.
>>
>
>Again, you are confusing a limited supply with infinity! If there is a
>demand for X products, and the knock-off guy can make them for less than I
>can, because I have 'sunk costs' to amortize, I am dead. The customers will
>naturally buy his product and pass mine by - after all, there is no
>difference if his quality matches mine! If he makes a cheap imitation, I
>still may be dead if he succeeds in selling long enough for me to starve to
>death, or if he poisons the market.
>
>I get no benefit from a given market if my costs prevent me from selling at
>a profit. Period.
You're not dead, you just make a smaller total profit than he does. He
gets to reap the whole trapezoid, you get the trapezoid minus the costs of
invention. However, (and this is my whole point,) that's still a positive
number.
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