Why I am Paying More Price Theory and Market Structures Made Simpl e Dear Reader, Satish Deodhar’s second book in the IIMA Business Books series, published in collaboration with Random House, is informative and stimulating The book begins with a clear discussion of basic microeconomic concepts, such as utility, cost, supply and demand curve, price determination, producer and customer surplus, and dead weight loss Satish next moves to a crisp exposition of various forms of market competition—perfect competition, monopoly, monopolistic competition, and oligopoly He highlights various mechanisms that producers might use to extract consumer surplus and provides a lucid exposition of game theory, made all the clearer with examples such as ‘Phoolan Devi and Veerappan facing prisoners’ dilemma’ The book proceeds to a description of various forms of market failure and the role of regulation in addressing them The last chapter provides retrospection through the topics covered and ends with an intriguing crossword At the end of each chapter, references afford interested readers the opportunity to explore topics in further depth, and ready reckoners provide descriptions of key terms In a deceptively simple manner, the book offers practitioners a thorough and in-depth perspective on a broad swathe of microeconomics topics Throughout, Satish explains these concepts in a straightforward manner, clarified with the help of simple and intuitive charts and peppered with rich instances from business and daily life Why I am Paying More is one of a series of books authored by IIMA professors who are not only academically proficient but also have rich experience in consulting and teaching executives These books are intended to disseminate knowledge in relevant topics in management to practicing executives Written in conversational style with illustrations from the world of practice, the books are eminently readable and applicable in daily life I am confident you will enjoy Why I am Paying More, as you will other books in the series Please let us know if there are particular topics that you would like covered in the books published in this series Ashish Nanda Director IIM Ahmedabad 11M AHMEDABAD " , ~- @ I{5J BUSIl\ESS BOOKS Why I am Payi ng More Price Theory and Market Structures Made Simple Also by Satish Y Deodhar Day to Day Economics SATISH Y DEODHAR Published by Random House India in 2013 Copyright © Satish Y Deodhar 2013 Random House Publishers India Private Limited Windsor IT Park, 7th Floor, Tower-B A-1, Sector-125, Noida-201301, UP Random House Group Limited 20 Vauxhall Bridge Road London SW1V 2SA United Kingdom This eBook is copyright material and must not be copied, reproduced, transferred, distributed, leased, licensed or publicly performed or used in any way except as specifically permitted in writing by the publishers, as allowed under the terms and conditions under which it was purchased or as strictly permitted by applicable copyright law.Any unauthorised distribution or use of this text may be a direct infringement of the author’s and publisher’s rights and those responsible may be liable in law accordingly EPUB ISBN 9788184005110 To Deepali, partner-in-life I met a score years ago and to Sylee (17) and Yash (13), the most formidable domestic teen cartel! CONTENTS Preface Acknowledgements Introduction Utility and Market Demand Cost Concepts and Market Supply Societal Welfare, Free Enterprise, and Market Price Price Ceiling, Price Floor, and the New Support Paradigm Perfect Competition Monopoly Pricing to Extract Consumers’ Surplus Monopolistic Competition Oligopoly 10 Market Failure and the Government 11 Retrospection A Note on the Author A Note on the IIMA Business Books PREFACE This book may be considered as a sequel to my first book, Day to Day Economics When Day to Day Economics was published, I was quite apprehensive about the acceptance of the book by readers However, there was a pleasant surprise in (book) store! Readers were very kind to me and they turned out to be quite an extrovert lot They would send sporadic emails or post reviews on blogs and online bookstores expressing their liking for the book Students and participants from various management programmes at IIMA also complimented me for making economics accessible and relevant While this was a humbling experience for me, readers discerningly pointed out that the book had focussed mostly on macroeconomic issues It was suggested that I should also write a similar book on microeconomic issues—issues which would describe why in most cases economists vouch for free enterprise system, how prices are set in different market structures, and what are the circumstances that justify government’s role in free enterprise system These suggestions sounded almost like the Sanskrit aphorism, Atha to Brahma Jidnyasa—an inquisitiveness to know the ultimate reality! Writing a textbook on microeconomics would not have served the purpose, for the market for textbooks has already become overcrowded The challenging task was to write a book that will appeal to the intuition of noneconomists and non-academicians Hence this modest effort—a sequel to Day to Day Economics perfectly competitive outcome, collusive or monopoly conduct leads to higher prices, lower output, and creates dead weight losses (DWL) for the society This outcome, therefore, is a form of market failure and government has to intervene Pronouncement of alleged collusion by cement companies and the severe penalty imposed by the Competition Commission of India in 2012 is a testimony to the seriousness with which governments want to prevent monopolies Of course, there are two forms of monopoly outcomes which get tolerated Monopolies created by granting of patents last for 20 years Such patent granting is necessary to provide incentive for firms to carry out research and innovations that help society at large in the long-run Similarly, international cartels such as the Organization of the Petroleum Exporting Countries (OPEC) are formed at the inter-governmental level and there is nothing anyone can about it In Chapter 10, quite a few other cases of market failures were discussed, where government intervention is required One is the case of natural monopoly Electricity generation and distribution, telecom services, postal services, and many other services fall in this category Traditionally, such natural monopolies have been run by the government Increasingly, however, governments are realizing that it is better to let private sector run such natural monopolies and government may only regulate their pricing decisions Second, government has to regulate use of common property resources Natural resource based sectors such as fisheries, forest products, and wild life are characterized by non-excludability and rivalry-in-consumption Combination of these two features creates negative externality which potentially can lead to depletion and/or extinction of natural resources and wildlife Therefore, government intervention, in the form of complete ban on resource use, impositionof production quota, or licensing is adopted In fact, externality can also occur in private goods To control pollution government may have to impose taxes on polluting firms, and, to promote provision of merit goods such as education and health, government may have to provide subsidy Finally, of course, government must undertake activities that are characterized both by non-rivalry in consumption and non-excludability— that is, provide public goods such as national defence and basic research Informed Decision Makers To conclude, markets consist of myriad of intertwined issues in terms of their structure, conduct, and performance Pricing and societal welfare are closely connected to these issues The three important decision makers in the market are the customers, producers, and the government Given their preferences and incomes, customers would like to maximize their satisfaction However, they must realize that their decisions are affected by the market structure within which products are sold to them For example, while perfect competition may be an ideal market structure for customers, they must realize that many product markets are not perfectly competitive If firms advertise their products in monopolistically competitive or oligopoly markets, reading this book should give the customers an insider’s view of why firms advertise If the complaint of the builders’ association to the Competition Commission of India against the cement companies is any indication, it should make customers aware that they too need to remain alert to such adverse possibilities in the market Firms with market power engage in price discrimination If an airline charges different prices for the same flight if tickets are bought at different times, customers should now know why, and, what they could to turn this pricing strategy to their advantage Similarly, if you are a manager or an entrepreneur, you would have developed a better perspective on what one can and what one cannot when operating in different market structures For example, one should know that returns to advertising efforts will be very minimal in a perfectly competitive market structure If one operates in a monopolistically competitive market, one need not lose sleep over non-utilization of excess capacity, for that is a part and parcel of that market structure In fact, offering discount-sale to get rid of inventory may not be out of place in this market structure If one happens to be in a market which is oligopolistic in nature, one’s actions become dependent upon the actions of other firms One needs to conjecture the nature of other firms and hope that one is right about it While prisoners’ dilemma like situations may arise among the firms and one may not necessarily make higher profits, one may avoid any temptation to engage with other firms to make joint pricing efforts, lest competition commission gets a whiff of it Last but not the least, government is an important decision maker in the market economy The purport of the discussions in this book is that government’s role is to facilitate free enterprise system by correcting for the market failures While most of the goods and services are offered in a competitive environment, government needs to intervene in market failure cases related to monopoly, collusion, natural monopoly, externality, common property resources, and provision of public goods An attempt was made to give an almost-exhaustive list of examples in Table 10.1, which justify the role of government intervention A horoscope of sorts of the government activities was prepared to figure out what are the opportune moments for it to intervene in free enterprise system In fact, it can be viewed as an operating manual so that the proverbial rice pearl does not get stuck in the aperture— government avoids excessive watch over the private sector, and, at the same time does not let the opportune moments of intervention pass by Customers, producers, and the government are the three important decision makers in the marketplace As quoted at the beginning of this chapter from an ancient Indian text, Shukraniti—all are capable enough but the one that is rare is the informed decision maker Trust this book facilitates that informed decision making As we conclude, solve the crossword puzzle that follows It can be viewed as an unobtrusive self-accreditation by the reader and a litmus test for the book—to paraphrase Harry Johnson, whether or not it was able to unravel simplicity in the pricing and market structure issues and present that simplicity as common sense rather than ivory tower insensitivity Crossword Puzzle ACROSS DOWN A situation in an economic activity where there is a divergence between private cost or benefit and social cost or benefit (11) Bygones are bygones and the cost incurred in the past can neither be recovered nor considered for current business decisions (4) A formal collusion among firms (6) A dilemma where competing firms can neither communicate nor trust each other (9) 12 Cost that changes directly with the level of output (8) 14 High asset specificity of textile machinery implies this cost is zero (11) 15 Jawaharlal Nehru was enamoured with this kind of socialism (6) 16 A pricing strategy both McDonalds and Microsoft have in common (8) 18 He was the first to formally draw graphical representation of demand and supply, though he is known more for his oligopoly model (7) 19 A pricing strategy used by a monopolist or oligopolists to Utility derived or cost incurred as a result of consumption or production of an additional unit of a product (8) An index that measures the degree of market power enjoyed by a firm in terms of the wedge between price and marginal cost (6) The degree of price discrimination that can be practised in professional services (5) The maximum price a customer is willing to pay for a product (11) A trade-off borne in a monopolistically competitive market, where excess capacity is the price society pays to get this (7) 10 A market situation, similar to a satellite circling around the earth, where there is no tendency for price and quantity to change until an external factor disturbs it (11) 11 An output level that corresponds to attaining minimum average cost in the short run and/or long run (8) 13 Both cable television and electricity distribution services are monopolies, however, they have one more common feature (7) 17 An acronym for the reduction in the societal welfare, when prevent entry of small or medium sized firms (5) markets deviate from perfectly competitive outcome (3) 20 These goods are, in fact, services characterized by nonrivalry in consumption and non-excludability (6) REFERENCES: Taylor, J., (1816), Lilawati: A Treatise on Arithmetic and Geometry, translated from the original Sanskrit work by Bhaskaracharya, 12th century C.E., p 3, Mumbai: Literary Society of Bombay Oppert, G., (circa 1880), Shukraniti, an edited ancient Sanskrit text attributed to original author, Shukracharya, Volume 12, in The Sacred Books of the Hindus, Allahabad: Panini Office (Agents: Luzac and Co., London) A NOTE ON THE AUTHOR Satish Y Deodhar teaches economics at the Indian Institute of Management, Ahmedabad (IIMA) After pursuing his bachelor’s and master’s degree in economics at the Gokhale Institute of Politics and Economics, Pune and at The Ohio State University (OSU), USA, he received his PhD in agricultural economics at OSU A recipient of the Outstanding PhD Dissertation Award from the Food Distribution Research Society, USA, and the Distinguished Young Professor Award for Excellence in Research from IIMA, he has worked on imperfectly competitive market structures, agricultural trade, World Trade Organization (WTO), and food quality issues Dr Deodhar was selected as the Fellow of the Hewlett-IATRC Capacity Building Programme during 2006–08 He has conducted consulting projects for Indian Bank; Ministry of Food Processing Industry, Government of India; and the Economic Research Service of the United States Department of Agriculture Several of his research studies have been conducted for the Ministry of Agriculture, Government of India His recent book, Day to Day Economics made it to the national bestseller list in the non-fiction category in 2012 Professor Deodhar was the first Convener of the computerized Common Admission Test (CAT) of the Indian Institutes of Management At IIMA, he has served as chairperson of the PGPX programme, chairperson of PGP Admissions, and Warden Currently, he is the chairperson of the Economics Area A NOTE ON IIMA BUSINESS BOOKS The IIM Ahmedabad Business Books series brings key issues in management and business to a general audience With a wealth of information and illustrations from contemporary Indian business, these non-academic and user-friendly books from the faculty of IIM Ahmedabad are essential corporate reading www.iimabooks.com OTHER BOOKS IN THIS SERIES ... choices of utility maximizing levels of each activity must be compared implicitly in one’s mind Workings of a mind may be a black box but the mind must be making implicit calculations taking into... applicable in daily life I am confident you will enjoy Why I am Paying More, as you will other books in the series Please let us know if there are particular topics that you would like covered in... Satish Deodhar’s second book in the IIMA Business Books series, published in collaboration with Random House, is informative and stimulating The book begins with a clear discussion of basic microeconomic