Nature Of Economics

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INTRODUCTION: NATURE OF ECONOMICS An economy begins with the desires of the people in the society for material goods and services. Like in the movie, the two main characters put on to their Bucket List's exotic backdrops — the Great Pyramids, the Taj Mahal, an African safari —to see and to visit. This are all material desires. Notice that we use the word "desires" or "wants", rather than "needs". We will not concern ourselves with the question of what it is that people truly need. Also notice that the focus is on material goods and services. We will be concerned with food, shelter, clothing, health care, recreation, entertainment, and so forth; we shall not be concerned with psychological desires such as love, power, or respect. (Any product that satisfies people's desires is called a "good" or a "service". The act of obtaining these material goods and services is called “consumption”.)

Modern Economics makes two assumptions about people's desires for material goods and services. •

First, they are insatiable. No matter how many goods and services people have, they still want more. Today, even the poorest Filipinos have more goods and services than could have possibly been imagined by people living 200 years ago. Yet, we still desire more and more. Morgan Freeman himself says he has movies he still wants to make. Ellen DeGeneres wants to learn Spanish; Beyoncé, a lifelong dancer, crossed ballet off her list (too hard) but added learning Arabic.

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Second, they are rational. People's desires are not to be questioned. I desire the things I desire for my own reasons. You desire the things you desire for your own reasons. I know what is best for me and you know what is best for you.

In order to satisfy their desires for consumer goods, the people in the society must engage in production. FACTORS OF PRODUCTION •

To produce, people begin with natural resources. Nature provides land, minerals, trees, water, fish, animals, and so forth. Usually the people must do something to these natural resources to satisfy their desires --- harvest the fruits and vegetables, dig the minerals, cut the trees, catch the fish, and so forth.

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The productive contribution made by the people is called labor. However, with natural resources and labor alone, the society will not be able to satisfy the desires of the people very well. From earliest times, people have learned that they could satisfy their desires better by taking some of the natural resources and converting them into a form that will not meet desires today but which will allow greater production in the future.

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Thus, wood and iron are used to make a hammer. The hammer is not desired by anyone for its own sake, but it allows people to build more of those things they do desire. We call this indirect use of natural resources “capital goods”. Do not confuse this meaning of the word "capital" with other meanings. In business use, for example, capital sometimes refers to the money invested by the owner of a business. Capital here refers to goods made by people for the purpose of increasing production. Examples are machines, tools, equipment, and factory buildings.

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Finally, there is a need for someone to recognize the desires that people have and then bring together the appropriate natural resources, labor, and capital goods to meet these desires. There is risk involved; if one does not recognize the desires correctly or if one organizes the production inefficiently, considerable loss could result. So, for example, Steve Wozniak and Steven Jobs recognized a desire of some people in the society --- a desire for a computer that could be operated at home. They didn't just develop such a computer. They started a company --- Apple. With others, they obtained the natural resources, hired and trained the workers, bought the necessary machinery, and organized the production process. The success of the Apple II allowed both of them to have wealth valued in the billions of dollars. A person who undertakes this activity is called an entrepreneur. Successful entrepreneurs become famous. So Ray Kroc (MacDonalds), Bill Gates (Microsoft), Sam Walton (Wal-Mart), Henry Sy (SM) and many others are very well known. Unfortunately, most entrepreneurs are not so successful. Natural resources, labor, capital, and entrepreneurship are called the factors of production.

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The factors of production determine the maximum amounts of the various goods and services that can be produced at the present time. But people's desires for these goods and services are insatiable. As a result, the desires always exceed the ability to meet them, a phenomenon known as scarcity.

Defining our Real Basic NEEDS vs WANTS 1. Food. All we need is nutritious food cooked at home. Food becomes want when we decided to eat regularly at fancy restaurants and food chains. 2. Clothing. We need clean, neat and suited for our daily activity. We do not need expensive and designer’s clothes. 3. Housing and Utilities. A room or a house big enough for the family, a simple basic furniture such as stove, TV set and telephone or cp. A big house, expensive furniture, a home entertainment system and sophisticated cp are wants. 4. Transportation. Enough money to go to work and return home is what we need. Owning bicycle, motorcycle or car are mostly wants. 5. Education. Quality education need not necessary to be expensive. Going to prestigious school is mostly wants. 6. Leisure. When the activity is for free or almost for free it is a need, like watching free concerts, borrowing books, going to work, etc. While those expensive and luxurious trip, vacation and having big parties are usually wants. Living our life without our basic needs makes life more difficult and not worth living. Look around you and you will see that a lot of people are living without these basic needs. This is one of the reasons why we study economics: To make sure that you will be able to afford these needs throughout your life.

Economic Terms

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 Economics: It is the study of proper allocation of scarce resources to satisfy unending human wants and needs.  Needs: are man’s basic requirements to be able to live  Wants: something desired, not essential  Scarcity: when there are not enough resources available to meet the needs and wants of everyone. Unlimited Needs & Wants + Limited Resources = SCARCITY

The fact of scarcity forces every society to have to answer three basic questions. As we learned in the previous chapter, the factors of production determine the maximum amounts of the various goods and services that can be produced. But people's desires for these goods and services are insatiable. As a result, the desires always exceed the ability to meet them, a phenomenon known as scarcity. Scarcity generates the fundamental problem faced by all societies. Because of scarcity, every society must answer three major questions:

1. The Three Questions Every Society Must Answer (1) What to Produce? In a world of scarcity, any choice to produce something is also a choice not to produce something else. Production of all of the goods and services that are desired is simply not possible. The value of whatever is sacrificed when a decision is made is called "opportunity cost". Sometimes, opportunity cost can be easily measured in money. If you choose to spend P15 on a CD, you are sacrificing P15 worth of other goods or services that you could have bought. In other situations, opportunity cost may be harder to measure. Your decision to take Economics this term has an opportunity cost. The most important opportunity cost is the value of the time you will sacrifice. If you would have worked during this time, your sacrifice can be measured easily; you sacrificed the wages you would have earned. But if you would have watched television, slept, or spent time with your children or friends, it is harder to put a dollar value on your sacrifice. But that does not change the fact that you have sacrificed time to take Economics.

(2) How to Produce?

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Having decided what to produce, we must now determine how to produce it. This means that we must decide on the combinations of the factors of production that we will use. Goods produced mainly by labor are called labor-intensive. Goods produced largely by machinery and equipment are called capital-intensive. Some goods may be natural resource intensive, technology-intensive, energyintensive, skill-intensive, and so forth. There are usually many different ways to produce a given product. Rice grown in China is both labor-intensive and water-intensive. But rice grown in California is capital-intensive as well as water-intensive. Similarly, cotton grown in the American South was labor-intensive while cotton grown in California is capital-intensive. Recently, California's main growth industries have been technology-intensive and skill-intensive rather than capital-intensive.

(3) For Whom to Produce? Once it has been decided which goods and services are to be produced, it must be decided who will have these goods and services. Remember that goods and services are scarce; not every desire can be satisfied. Production of goods or services that will meet my desires may mean less of the goods or services that would meet your desires and vice versa. We are in conflict. Somehow, we must resolve this conflict in a manner that allows us to exist as part of the same society. In an economy such as that of the Philippines, our incomes determine which of our desires can be satisfied. In a later chapter, we shall discuss the factors that determine why some people have much higher incomes than others have. 2. Economic Systems Every society must answer these three questions: what to produce, how to produce, and for whom to produce. Usually people organize in some way to find the answers. Such an organization of people is called an economy. And, of course, the study of an economy is called Economics. There are two extreme types of economies: command economies and market economies. Most existing economies are some combination of the two types.

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A command economy, or hierarchy, describes itself. A commander, usually the government, decides what will be produced, how it will be produced, and who will get the goods and services that are produced. The former Soviet Union was a good example of a command economy. The government decided which goods or services would be produced (for the most

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important products). This came as an annual plan. The plan would be very detailed. So, for example, if you managed a shoe company, the plan might specify how many size 6 shoes that were black you must produce, how many size 8 shoes that were green you must produce, and so forth. The plan was more than a goal; there were significant penalties to the company management for failing to meet the plan quotas and significant rewards for succeeding. The plan also specified how goods and services were to be produced. Again, if you were the manager of a shoe company, you might be told how much leather you could have and where you must get it, how many workers you may have, how much machinery you may have, and so forth. One feature of the former Soviet economy was that the "what" and the "how" often did not reconcile. For example, it might not have been possible to produce the number of size 6 shoes that you were required to produce with the amount of leather you were allowed to have. This led to behaviors that were not intended by the government. For example, the manager would have shoes produced that were actually size 3 but have size 6 labels put on them. Or the manager would record leather as "lost in shipment" and then hoard it for use at a later time when there would not be enough. Even in the former Soviet Union, the government did not decide the "for whom" question. Generally, people would stand in line for the goods and services; those in the line first would have their desires met first. However, there was one exception: if you were a member of the communist party, you came first. In the United States, a good example of such a command economy is the military: the commanders give the orders on most matters and others are merely expected to follow. Many large companies in the United States and in Europe copied this military command principle. Another example of a command economy involves the control over land in the United States. In the eleven western states, more than 40% of all land is under the control of the United States government (most commonly the Forest Service or the Bureau of Land Management). These agencies determine who is allowed to graze animals on the land, how much grazing can be done, and what price is to be paid for grazing rights. The Forest Service also determines how many trees can be cut, who can cut them, and the price to be paid to cut them. Hunting, fishing, access to national parks, and so forth are also controlled mainly by this command economy principle. •

The other extreme type of economy is the market economy. Markets are merely places where buyers come to buy and sellers come to sell. The market may be a physical place, such as the Philippine Stock Exchange. Or it may not be a physical place; for example, foreign exchange market transactions take place through communications via telephone and computers between banks and other dealers around the world. In a market economy, it is through the

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interaction of the buyers and the sellers that the questions of "what to produce", "how to produce", and "for whom to produce" are answered. How markets do this is a main topic of this course. There has been a major change in the world since the late 1970s: market economies are replacing command economies. The former communist countries, including all of Eastern Europe as well as China, are substituting markets for command. Countries such as Mexico, the countries of South and Central America, and the countries of Asia are also increasing their use of markets. And, in the United States, large, hierarchical corporations are losing ground to smaller, more entrepreneurial companies. •

Do not confuse the terms market economy and command economy with the terms “capitalism” and “socialism”. Literally, these latter terms refer to ownership of capital goods. As we saw in the previous chapter, in capitalism, capital goods are owned by private individuals, called capitalists. In socialism, capital goods are owned by the government. In both types of systems, private individuals own consumer goods, such as clothes and televisions. Most economies are mixtures of market and command and also are mixtures of capitalism and socialism. But Philippines is basically a market economy that is capitalist. The former Soviet Union was basically a command economy that was socialist. China today is becoming more and more of a market economy but is still basically socialist. Nazi Germany was basically a command, capitalist economy. So there are many possible combinations.

3. Rational Decision Making

Economic thinking makes a specific assumption about the nature of people: people are rational, self-interested, maximizers. Such a being is often called homo economicus (economic man). As noted in the last chapter, "rational" means that each person knows what is best for himself or herself. "Self-interested" does not mean that people only act for themselves and never care about others.

But it does mean that people do act in their self-interest as they perceive it. A "maximizer" acts to get the most possible. We assume that consumers act to maximize the satisfaction they receive from the goods and services they buy. We assume that businesses attempt to maximize the profits they earn and that workers attempt to maximize the wages (or other benefits) they earn.

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THE LAW OF DEMAND

In this chapter, we shall focus on the quantity of a given product that buyers wish to buy --- called the demand. What factors explain the quantity demanded of a given product by buyers?

One of the key factors is certainly the price of the product. Think of buying rice. As the price rises for commercial rice, many consumers tend to lessen their demand for it. We can generalize it with the following statement: as the price of the product rises, the quantity demanded of that product falls, and vice versa. The statement is typically referred to as the law of demand.

NON PRICE DETERMINANTS OF DEMAND

One of the factors that affect the demand for a product is the price of that product. There are certainly other factors. In fact, there are seven (7) other factors. These are called the determinants of demand. Let us examine them one at a time.

1. Consider the demand for new homes. You want a new home and choose one you like. The price is $500,000. You don't buy. One reason is that your income is not large enough to be able to afford this amount. Therefore, income must be one of the factors that affect the demand for a given product. Normally, we expect that as one's income rises (falls), the demand for a product will rise (fall).

2. Return now to your decision to buy a new home. Assume that you are willing to pay the price and have sufficient income. What other factors might enter into your decision? One might involve the method you will use to pay for this home --- borrowing money. The price of borrowing money is called the interest rate. The interest rate is one example of the price of a complement. A complement is a different good that goes together with the one under consideration.

Homes and borrowing money tend to go together. So do bread and butter,

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coffee and sugar, gasoline and automobiles, homes and furniture, peanut butter and jelly, and many other examples. What happens to the demand for new homes if the interest rate rises? The answer, of course, is that it falls. It is also likely that the demand for butter will fall if the price of bread rises, the demand for automobiles will fall if the price of gasoline rises, and so on. Therefore, our relationship is: if the price of the complement rises (falls), the demand for the product (homes) falls (rises).

3. Complements are different goods that are related to the one we are considering. There is another kind of relationship: the products may be substitutes. goods that compete with the one under consideration.

Substitutes are different

Coca-Cola and Pepsi Cola are

substitutes, as are butter and margarine, American cars and Japanese cars, Wendy’s and Burger King, baseball and football (in the fall) and many other examples. In our example, the main substitute for homes is apartments. What happens to the demand for homes if the price of apartments falls? If apartments rented for P1500 per month, more people would want to live in apartments and fewer in homes. It is also likely that the demand for Coca Cola would rise (fall) if the price of Pepsi Cola rises (falls), the demand for American cars would rise (fall) if the price of Japanese cars rises (falls), the demand for Wendys burgers would rise (fall) if the price of Burger King burgers rises (falls), and so on. Therefore, the relationship is: as the price of the substitute (apartments) rises (falls), the demand for the product (homes) rises (falls).

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We have thus far discussed three factors affecting your decision to buy a home other than the price of the home: your income, the price of complements such as borrowing money and buying furniture, and the price of substitutes such as apartments. One obvious other factor involves the fact that you like homes! This we call tastes or preferences. It involves the fact that there are certain psychological reasons for liking or disliking a particular good.

Our

principle is: the more (less) we like a good or service, the greater (less) is our demand for it. So what do you think happened to the demand for red wine when the television show 60 Minutes did a report that drinking red wine moderately every day lowered cholesterol and therefore lowered the risk of having a heart attack?

5. In the case of homes, we have often observed people buying not just one home but five or six. This does not mean buying one in Beverly Hills, another in Aspen Colorado for skiing, and another in Hawaii for surfing. It means several homes in the same area. Why would one do this? One answer is that the buyer expects the price to rise in the near future or Future Price expectation of the consumer. Of course, the buyer does not know that the price will rise. So, there is a gamble here; the buyer expects the price to rise! These expectations affect our demand for many products. For example, people commonly buy stock or foreign

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monies because they expect the prices of the stock or of the foreign money to rise soon. (Do not confuse this with the last section where we considered how buyers respond when the price actually does change.

Here, the price has not changed; buyers simply expect that it will

change soon.) Our principle here is: if buyers expect the price to rise (fall), the demand rises (falls) today.

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There are other kinds of expectations one might have that will affect the demand for products. If one expects that the product will soon be unavailable, the demand will rise today. This was the case for gasoline in the early 1970s and again in September of 2001. Expecting that gas stations would soon be out of gasoline, buyers rushed to stock-up. Also, if one expects that one's income will fall, the demand for most products will fall. During recessions, other people are losing their jobs or otherwise having their incomes reduced. Even though this has not yet happened to you, you may be worried that it will. As a result, you reduce your buying of many products.

As we shall see later, expectations are important

because they often become self-fulfilling prophecies.

7.

The last of the factors affecting demand is the population (number of buyers). The market demand is simply the sum of the individual demands. If, at the price of P10, Bill wants to buy 10 units of the product, Jose wants to buys 20 units, and Mary wants to buy 30 units, then, of course, the market demand is 60 units. If Jordan becomes a buyer and wishes to buy 40 units, the market demand rises to 100 units. Therefore, if there are more buyers, there must be more market demand.

Let us summarize. The demand for a given product will rise if: 1. Incomes rise for a normal good or fall for an inferior good 2. The price of a complement falls 3. The price of a substitute rises 4. People like the product better 5. People expect the price to rise soon 6. People expect the product not to be available soon 7. People expect their incomes to rise in the near future 8. There are more buyers. The opposite will cause the demand for the product to fall.

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THE LAW OF SUPPLY Thus far, we have been focusing exclusively on buyers. But buyers are only half of the market. We must also consider the behaviors of sellers. Discussing sellers is somewhat easier because we can assume that sellers have only one motivation: to maximize their profits. Sellers will be motivated to do more of anything that increases profits and less of anything that decreases profits. The profits are calculated as the difference between the total revenues and the total costs. Let us begin with the total revenues, the money taken in from selling our product. If we sell 100 units at P10 each, our total revenues equal P1,000. If we sell 100 units at P20, our revenues equal P2,000. Since we gain more revenues if the price is P20 than if it is P10, we would likely want to sell more units of the product if the price is P20. So we can conclude that as the price of the product rises (falls), the quantity supplied will rise (fall). We call this statement the law of supply.

DETERMINANTS OF SUPPLY There are four of them.

1. The goal of a company, once again, is to maximize profits, calculated as the difference between the total revenues and the total costs of production. So, one of the determinants of supply must be the costs of production. As costs of production rise, profits fall, and therefore the quantity supplied should fall. Conversely, as costs of production fall, the profits rise, and the quantity supplied should rise. Costs include the costs of natural resources such as wood used in building a home, the costs of labor (wages and benefits), and the costs of the capital. We will cover them in later chapters.

2. When we considered demand, one of the determinants was population (the number of buyers). The same is true for supply. One of the determinants of supply is the number of sellers of the product. When the number of sellers increases, the supply should increase. When the number of sellers falls, the supply should decrease.

3. When we considered demand, one of the determinants was the price of a substitute good. Again, the same is true for supply. In this case, the substitute is a substitute for the seller --another good also produced by the same seller. This may or may not be a substitute for the

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buyer. For example, wheat and corn can be grown on the same land; they are substitutes for the seller. So are avocados and oranges or Coca Cola and Diet Coke (because they are produced by the same company).

If the price of the other good rises, the supply of the good in

question will fall. For example, if the good in question is wheat and the price of corn rises, sellers will produce less wheat (and more corn). If the price of regular Coca Cola rises, the supplier will produce less Diet Coke (and more regular Coca Cola). On the other hand, if the price of the other good falls, the supply of this good will rise. Remember that goods are substitutes for the seller only if they are produced by the same company.

4. Finally, when we considered demand, one of the determinants was expectations. This is true for supply as sellers also have expectations that affect their behavior. If sellers expect the price to rise, they will want to sell less today. and wait for the price to rise later. Home sellers will hold their homes off the market if they believe the prices will rise soon. In 1973, oil tankers remained offshore while angry motorists waited in long lines for gasoline. The reason was that the price of gasoline was 36 cents per gallon. The government was allowing the price to rise only 2 cents per week; the oil companies estimated that it would rise to about 65 cents. So they reduced supply and waited until the price would reach the predicted 65 cents. Conversely, if sellers expect the price to fall, they want to sell more now. At the beginning of 1995, holders of Mexican pesos believed that the price would fall. They got rid of them (sold them in the foreign exchange market) as fast as they could. The same is true for holder of stocks in the fall of 1998.

EQUILIBRIUM

Now, we can take the two sides of the market, demand and supply, and put them together.

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Price of market balance: •

P - price

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Q - quantity of good

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S - supply

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D - demand

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P0 - price of market balance

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A - surplus of demand - when P
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B - surplus of supply - when P>P0

Surplus a condition that exists when supply exceeds demand because of a lack of equilibrium in a market. For example, if a price is artificially high, sellers will bring more goods to the market than buyers will be willing to buy.

Shortage a condition that exists when demand exceeds supply because of a lack of equilibrium in a market. If a price is artificially low, buyers want to buy more of a good than sellers are willing to sell. Equilibrium refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the equilibrium price or market clearing price and will tend not to change unless demand or supply change.

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THE CIRCULAR FLOW OF ECONOMY

HOW ECONOMY WORKS? Decision Makers: 1. Firms: (business sector) Produce and sell goods and services/ Hire and use factors of production

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2. Consumers: (Household sector) Buy and consume goods and service/ Own and sell factors of production Markets for Goods and Services •

Firms sell

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Households buy

Markets for Factors of Production •

Households sell

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Firms buy

The Household Sector is the owner of all of the Factors of Production w/c includes the ff: Factors of Production: 1. Labor- brain power and muscle power resources 2. Land- natural resources of all kinds 3. Capital- all equipment, building, and tools

In return for the Factors of Production the Business Sector gives the Factors of Payment to the h/s and it includes the ff: Factors of Payment: 1. Wages – salary of Income paid by the business firms to workers 2. Rent – the reward that goes to the land resources 3. Interests- the cost of borrowing or the price paid for the rental of funds 4. Profit – the rewards of management or entrepreneur who take risks.

MARKET STRUCTURES

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Remember that the goal of a company is to maximize its profits. Remember also that profits are simply the difference between the total revenues and the total costs of production. We examined the costs of production first because the principles affecting costs are the same for all companies regardless of the industry they are in.

But this is not true about the revenues.

To analyze the

differences in total revenue, we group industries into four types. They are classified according to the power a company would have to affect the price of the product. (A) Perfect Competition There are four criteria for an industry to be characterized as perfect competition. Of course, nothing is “perfect”. But, while no industry will exactly meet the four criteria of perfect competition, we can learn much from assuming that such an industry does exist. 1. There are so many sellers that no one seller can affect the price by himself or herself. Think of yourself buying gasoline. The price says $2.00 per gallon. Suppose you ask to see the manager and then make an offer: you will buy only if the price is reduced to 50 cents per gallon. What will the manager do? The answer is: laugh and ask you to leave. The manager will not take your offer because there are so many others who will pay $2.00. These others are your competitors. You don't think of them as competitors. Indeed, they may even be your friends.

You think of them, like yourself, as subject to impersonal market forces.

But

nonetheless, they are your competitors. And because they are there, you have no influence at all on the price. We say that you are a price taker. If we switch the example and make you a seller instead of a buyer, we have the main characteristic of perfect competition. If a seller charged more than $2.00 per gallon, no one would buy from him or her. The seller would never charge less than $2.00 because there is no reason to do so.

2. We assume that all buyers and all sellers have perfect information. Each knows what the price is, what others are charging, and all relevant features of the product. No one would ever pay $3.00 for a gallon of gasoline because everyone knows that there are sellers willing to charge $2.00.

3. We assume that there is easy entry into and exit from the industry. Any company wanting to leave the industry can do so easily. And the are no barriers preventing entry to any company from coming into the industry.

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4. We assume that the products of the sellers in the industry are identical. One company's product is just the same as another company's product.

Although there are no examples of perfect competition, agriculture is the closest.

We will start our

analysis of business behaviors with this market structure.

(B) Pure Monopoly

Literally, "mono" means one. Therefore, a pure monopoly is an industry with only one seller. Such a company should have considerable ability to affect the price that it charges. However, for this to occur, two other characteristics are necessary. First, there must be high barriers to entry. If this were not the case, then when the monopoly set a high price and earned high economic profits, new sellers would enter to compete with it.

The increased competition would drive down prices,

eliminating the economic profits that were being earned. Second, the demand for the product needs to be relatively inelastic (that is, has few substitutes).

If this were not the case, then if the

monopolistic company raised its price, buyers would simply shift to other substitute products. This would limit its ability to raise the price considerably. We will consider pure monopoly after completing our analysis of perfect competition. Monopoly vs. CARTEL: cartel refers to a market situation in which firm agree to cooperate with one another to behave as if they were single firm and thus eliminate competitive behavior among them.Cartel agree among themselves to restrict total output to the level that maximizes their joint profit. Example: Organization of Petroleum Exporting Countries (OPEC) (C) Monopolistic Competition If there is one seller but a very elastic demand for the product, the industry is called monopolistic competition. The monopoly part results from there being one seller of the narrowly defined product. The competition comes from other products that are close substitutes. Most realworld competition takes this form. There is only one Coca-Cola but there are many close substitutes. There is only one MacDonalds but there are many close substitutes. There is only one iMac but there are many close substitutes. In each case, the company can raise its price and not lose all of its sales.

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However, an increase in price will cause it to lose a considerable portion of its sales. This limits greatly the power of the company to affect the price.

The first three characteristics of perfect

competition are similar for monopolistic competition. There are many sellers. The buyers and sellers have perfect information.

And there are no barriers to entry.

The difference is the fourth

characteristic: in perfect competition, the products are identical whereas in monopolistic competition, the products are differentiated. Because products are differentiated, monopolistic competition involves considerable use of advertising. (D) Oligopoly The final structure of an industry is called oligopoly. "Olig" means "few". In this industry, there are few sellers. How few is "few"? The answer is "few enough that each seller has an ability to affect the price". Usually most oligopolies are dominated by between two and ten companies. Automobiles, steel, tires, cigarettes, accounting firms, and breakfast cereals are among the many examples. Oligopolies are difficult to analyze because each firm, in making a decision, must consider not only the response of the buyers but also the response of the other sellers. Should Ford offer a rebate (lower price) on its cars? The answer depends not only on the way buyers will respond to the rebate but also on Ford's estimate of the response of General Motors, Chrysler, Honda, Toyota, and Nissan. It would be easier to predict the responses of competitors if the competitors met and discussed their decisions. Such a meeting of members of an oligopoly to coordinate decisions (especially over the price) is known as a cartel. Cartels are illegal in the United States; however, some have managed to exist.

Examples are the National Collegiate Athletic Association, Major League Baseball, the

National Football League, etc. On a world basis, there have been cartels in oil, diamonds, and other natural resources. If we can imagine measuring market power (the ability to affect the price of the product one sells) on a scale of zero to 100 (with 100 being the greatest amount of power), the four market structures would be arranged as follows:

Perfect Competition 0________

Monopolistic Competition

Pure Oligopoly

Cartel

Monopoly

_________________________________________________________100

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Notice that pure monopoly does not have a market power of 100 on this imaginary scale. Even if there were only one company, it cannot have total power over the price. Buyers always have the power to not buy the product.

Benefits of Competition and Monopoly

1. Benefits To Society From Perfect Competition

Let us conclude the discussion of perfect competition by summarizing the benefits to society from it. People believe that competition is good for the society as a whole. Why is this so? Let us list some of these benefits. (1) Economic Profit of Zero As we saw, in perfect competition, companies earn an economic profit of zero in the longrun. While the long-run is not specified in weeks or years, we can presume it is a relatively short period. (The long-run is the time it takes for new companies to enter the industry.) Why is this good for society? The answer is that, when companies are earning economic profits above zero, new companies enter the industry. The entry of the new companies will soon eliminate the economic profits. The only way a company can earn economic profits for a long time period is to be able to prevent other companies from producing products that consumers desire. This clearly is not good for society.

For many years, companies like

General Motors, IBM, and CBS earned economic profits that were well above zero. They were able to maintain these profits only by having barriers to entry that kept other companies from producing products that consumers definitely desired. (2) Productive Efficiency Productive efficiency involves producing at the lowest possible cost of production. In our example, the construction company chose to produce 7 homes. Each home cost an average of $182,857 (take the total cost of building 7 homes and divide by 7). We can assume that this is the lowest possible cost per home of producing 7 homes. Companies in perfect competition have a financial incentive to produce as efficiently as possible. Any inefficiencies are reflected in reduced profits for the owners of the companies. Since in the long-run, these

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profits equal zero, inefficiencies would cause economic profits to fall below zero. Companies would either have to find more efficient ways of producing or be driven out of business. (3) Improvements over Time As we have seen with so many products, companies with a large amount of competition have a strong incentive to find new ways of producing that will lower production costs. This strong incentive explains why products that were once very expensive ---computers, VCRs, televisions, contact lenses, and so forth --- are now so much cheaper. The incentive is actually twofold. On the one hand, there is the positive reward of increased economic profits in the short-run if a company can find a way of producing at a lower cost. On the other hand, there is the fear that competitors of the company will find a way of producing at a lower cost before it does. If they do so, they will be able to charge a lower price. Our company will not be able to earn satisfactory profits at this lower price. It risks being forced out of business.

Remember the definition of monopolistic competition.

This industry structure has all of the

characteristics of perfect competition except that the products are differentiated. In that case, we shall see that there are strong incentives not only to find ways to lower production costs but also to find ways to "improve" the product. The incentives are the same in both cases --- the increased economic profits in the short-run and the fear of a competitor doing so first. What exactly is an "improvement"?

The answer, in a market economy, is that a product has been improved if

consumers desire it more and are more likely to buy it. Consumers decide when a given change in a product is actually an improvement. The strong incentives to "improve" products are easily seen in the

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continual improving of computer hardware and software, in the competition between the programs shown on television stations, in competition in fashion design, in competition between automobile companies, and in many other examples. To take just one example for illustration, let us consider the coffee maker. Prior to 1970, people who drank coffee drank instant coffee, had coffee brewed in a coffee percolator, or used a pyrex container.

The pyrex container was much cheaper than the

percolator. One would heat water in the container, put the coffee into a filter, put the filter into a plastic cone, and then pour the boiling water through the cone back into the container. In the early 1970s, Vince Marotta decided to develop a product that worked in the same way except that one poured cold water into a container and a heater boiled the water. The boiling water then ran through the coffee that had been placed in a plastic cone and into the pyrex container. He called this invention “Mr. Coffee”. He advertised it heavily, with Joe DiMaggio as the spokesperson. It was a huge hit and Marotta was soon making large economic profits. In a competitive industry, what should happen? Of course, others should start producing similar products. And so they did. As the supply rose, the economic profits fell. To maintain them, Marotta changed the design of the container to allow “Brew for Two”. This too was a huge hit and economic profits rose. Others, of course, soon copied. Then, Marotta combined his coffee maker with an alarm clock. Now instead of making a sound, the alarm would turn on the coffee maker. Another huge hit. Again it was soon copied. As time has gone one, we have seen space saver coffee makers, coffee for one, designer coffee makers, and so on. Some products have been very successful. Some have not. Since product improvements are easily copied by other companies, eliminating the economic profits, why bother developing the improvements at all? The answer, of course, is the economic profits in the short-run. Even if they don’t last very long, the huge profits made for awhile were enough so that Mr. Marotta need have no financial worries for the rest of his life.

In summary, in perfect competition in the long-run, companies will earn zero economic profits, will produce that quantity for which cost per unit is the lowest possible (productive efficiency), and will have strong incentives to find ways to lower costs of production and to "improve" their products. No wonder people believe that a market economy with perfect competition is so desirable. 2. Monopoly We have examined perfect competition. Now we turn to its polar opposite: pure monopoly. As noted, there are three main characteristics of pure monopoly. First, there is only one seller of the product ("mono" means "one"). Second, there are few good substitutes available for buyers. And

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third, there are high barriers to entry; if economic profits are being earned, it will be very difficult for new sellers to enter the industry. There are many reasons for the existence of high barriers to entry. For example, until a few years ago, it was illegal to compete with San Diego Gas and Electric Co. (We will examine the reasons for this later.) DeBeers has maintained its monopoly on diamond production through control over the natural resource. Virtually all of the diamond in the world has come into the control of this company, owned by the Oppenheimer family of South Africa. IBM maintained close to a literal monopoly on mainframe computers through its copyrighting of computer languages.

Xerox and Polaroid maintained near

monopolies by patenting their processes. Automobiles had high barriers to entry because of the very high costs of capital goods that were necessary. Some industries had high barriers to entry because of government regulations. For example, until the early 1980s, the Civil Aeronautics Board acted to prevent airlines from serving certain markets. And, until the mid-1970s, the Federal Communications Commission acted to prevent access to the airwaves to any new television network. In some industries, economies of scale make it very difficult for new companies to enter. Because the existing larger companies can produce at a lower cost per unit, a new company that starts with a small number of buyers would not be able to compete on the basis of cost.

We call these industries "natural

monopolies" and will discuss them in detail later. In some industries, vertical integration can provide a barrier to entry. "Vertical integration" means that the same company controls many phases of the production process. Companies that refine oil into gasoline also own the oil wells and the tankers. They control the gasoline stations through a franchise agreement. Any company trying to compete would have to find its own oil, develop its own tankers for shipping, and create its own stations to sell the gasoline. General Motors also was vertically integrated. General Motors owned the companies that made automobile bodies, batteries and sparkplugs, glass, and so forth. And Microsoft produces both computer operating systems and software programs.

Is it any wonder that the operating system

Windows was made purposely incompatible with Lotus1-2-3, the most popular spreadsheet in the world. (Microsoft produces a competing product --- Excel) Finally, continual innovation can act as a barrier to entry. Both IBM and AT&T were able to maintain near monopoly positions for many years by always being first with new ideas. Microsoft has carried on in this manner. In the early 1980s, IBM lost its barrier to entry. The hierarchical management of IBM was too slow to keep up with the need for innovation. Other companies came up with new and better products, causing IBM to lose almost half of its market share. Something similar occurred for AT&T.

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The rice crisis is now a major concern that is highlighted daily on the front pages of newspapers and on prime- time television. This paper explains the reasons behind the rapid increase in rice prices and what must be done to achieve reliable, plentiful supplies of affordable rice. CONTENTS What is happening? What are the underlying reasons for the rice crisis? How do price rises affect poor rice consumers? How do we prevent shortages and price rises? What needs to be done? What is happening? The poorest of the world’s poor are the 1.1 billion people with income of less than a dollar a day. Around 700 million—almost two-thirds—of these people live in rice-growing countries of Asia. Rice, the dominant staple in Asia, accounts for more than 40% of the calorie consumption of most Asians. Poor people spend as much as 30–40% of their income on rice alone. Ensuring sufficient supplies of rice that is affordable for the poor is thus crucial to poverty reduction. Given this, the current sharp increase in rice price is a major cause for concern. The Green Revolution in Asia, which began in the 1960s with the introduction of modern, high-yielding rice varieties, led to a rapid rise in both rice yields and overall production. This contributed to poverty reduction directly through increased income for rice farmers and indirectly through lower prices for rice, which benefited poor consumers in both rural and urban areas.

However, this long-term decline ended in 2001, with the rice price taking a sustained upward turn since then. The price continued to rise throughout 2007 and has sharply increased in the first quarter of 2008. The world price of Thai rice, 5%-broken—a popular export grade—in December 2007 was $362 per ton but almost tripled to $1,000 per ton in April this year. Major exporting countries such as Vietnam and India have announced different forms of export restrictions to protect their domestic consumers. These restrictions have further contributed to the recent increase in rice price as the rice supply in the world market has dwindled. While exporters are holding on to their stock of rice, importers are rushing into the market to buy more rice to meet their consumption needs and to build their own stock. Hoarding by traders for speculative purposes has added fuel to the fire in some countries. The

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market shortages and rise in price have now reached a crisis point, with recent quotes for rice price being as high as $1,000 per ton. Food riots have occurred in several countries and soldiers are guarding food trucks to prevent looting. What are the underlying reasons for the rice crisis? •

We are consuming more than we are producing

Many factors, both long and short-term, have contributed to the rice crisis. At a fundamental level, the sustained rise in the price over the past 7–8 years indicates that we have been consuming more than we have been producing. This imbalance between demand and production has been partly masked by a reduction in rice stockpiles. In fact, rice stocks are being rapidly depleted, with current stocks at their lowest since 1988. This depletion of stock has moderated the rise in price that would have occurred otherwise. The current low stocks, however, negate the chances of such a moderating influence in the future and increase the risk of a sharp rise in price. •

Annual growth in yield is slowing

A major reason for the imbalance between the long-term demand and supply is the slowing growth in yield, which has decreased substantially over the past 10– 15 years in most countries. In South Asia, average yield growth decreased from 2.14% per year in 1970-90 to 1.40% per year in 1990-2005. In some years, this has been below 1%. Yield growth in Southeast Asia has decreased similarly. In the major ricegrowing countries of Asia, yield growth over the past 5–6 years has been slow. Globally, yields have risen by less than 1% per year in recent years.

•

Little room for expansion of rice area

Further, the possibility of increasing the rice area is almost exhausted in most Asian countries. With little expansion in area and slowing yield increases, growth in rice production has fallen below growth in demand as population has continued to increase. •

Reduced public investment in agricultural research and development

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An important factor accounting for the slowdown in yield growth is the reduced public investment in agricultural research and development (R&D). In particular, international donors have not provided sufficient support for agricultural R&D that is directly related to increasing crop productivity. Many governments have been unable to compensate for this by allocating more of their own resources. Rice prices declined steadily in the 1990s, leading many governments to believe that the supply of food was plentiful. Lower prices were taken for granted leading to complacency in agricultural research and development. Such investment has decreased in Asia in real terms over time. Public spending on agricultural research in Asia grew by an average of 3.9% per year during the 1990s, compared with 4.3% annually during the previous decade. In 2000, overall public research intensity, measured by the percentage of agricultural gross domestic product (GDP) invested in public agricultural research, remained low at 0.53 for developing countries as a whole. •

Africa

Rice has become an increasingly popular food in Africa, with imports into Africa accounting for almost one-third of the total world trade in rice. This has increased over time as growth in rice production is far slower than growth in total demand. It is expected that demand from Africa will continue to grow. •

Population increase

Population growth is outstripping production growth and this is projected to get worse. Demand for rice in Asia is expected to continue to rise as its population expands. Even after allowing for some decrease in per-capita rice consumption in Asian countries with higher income levels, it is projected that in 2015 Asia will need to produce 38 million more tons of rough (unmilled) rice than it produced in 2005. Globally, demand is increasing by around 5 million tons each year. This means that in ten years the world will need to produce 50 million tons more than it does now.

•

Economic growth

With rapid economic growth in large countries such as India and China, demand for cereals has increased substantially for both consumption and livestock production. This income-driven growth in demand has pushed up the price of cereals in general. In many areas with high population density, highly productive rice land has been lost to housing and industrial development, or to growing vegetables and other cash crops.

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Irrigation

Investments in irrigation, which peaked during the Green Revolution period in the 1970s and 1980s, have decreased substantially. Existing irrigation infrastructure has deteriorated considerably because of inadequate maintenance. •

Oil prices

The price of oil has increased rapidly during the past year. In addition to contributing to general inflationary pressure, this has pushed up freight costs for countries that import rice. The world price of fertilizers—which are essential for rice production—has increased sharply, with the price of urea almost doubling over the past four years. Rising oil prices and concerns about climate change have also spurred rapid investments—particularly in developed countries—in biofuels such as ethanol produced from maize grain or biodiesel produced from oilseeds. This has increased pressure on international trade of grains and livestock feed, as well as on agricultural land in some countries. Until now, the direct impact of biofuels on rice production and rice trade has likely been small. However, if the industry continues to grow, rice production and prices may be affected more seriously. •

Extreme weather

Natural disasters such as widespread drought in India and China in 2002, typhoons in the Philippines in 2006, and major flooding in Bangladesh in 2007 have contributed to the shortfall in production in recent years. Global temperatures, particularly night-time temperatures, have steadily risen in recent decades because of increasing greenhouse gas concentrations in the atmosphere. Some evidence suggests that rising temperatures may have already contributed to lower rice yields in recent years, but a thorough global assessment is yet to be conducted. Further, human-induced climate change is expected to increase the severity and frequency of extreme weather events. •

Reoccurring pest outbreaks

Pests such as planthoppers, and the various virus diseases transmitted by them, were major threats to rice intensification programs in the 1970s and 1980s. Now, they have returned as major threats to production, primarily due to breakdowns in crop resistance and the excessive use of broad-spectrum, long-residual insecticides that disrupt natural pest control mechanisms.

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Since 2005, planthopper outbreaks have affected several million hectares of rice land in countries such as Vietnam, China, Indonesia, Korea, and Japan, particularly in growing seasons with abnormally higher temperatures (which are becoming more likely because of climate change). In Vietnam, planthopper and virus outbreaks were a major reason behind the government’s decision to restrict rice exports.

How do price rises affect poor rice consumers? Domestic rice prices have not risen as much as international prices because of the weakening of the U.S. dollar and stabilization policies implemented by national governments. Nevertheless, a rise in the price of rice is equivalent to a drop in real income for poor consumers in urban areas and landless laborers in rural areas who need to buy rice. Even a small increase in price can seriously affect the household food security of such people. For example, a 25% increase in rice price translates into a 7– 10% drop in the real income of poor consumers, as rice purchases often constitute 30–40% of their total expenditures. Such a drop in income not only increases the number of poor people but also pushes people deeper into poverty and hunger. With less money available, the poor are forced to spend less on such essential needs as health care and nutritious (protein- and vitamin-rich) food—essential for good health, especially for children and pregnant women. Families may even pull children out of schools, thus threatening future generations with ongoing poverty. The rise in food prices is also affecting the poor indirectly as international relief agencies are forced to provide less food. According to the United Nations Population Fund, its program of school feeding and “food-for-work” is being severely affected as a result of the price rise. The World Food Programme recently said that its costs are increasing by millions of dollars per week.

How do we prevent shortages and price rises? The best strategy for keeping the price of rice low is to ensure that production increases faster than demand. Rice production can be increased by expanding the area planted to rice, by increasing the yield per unit area, or by a combination of the two. The opportunity for further increasing the rice area in Asia is now quite limited. The total rice area in Asia is unlikely to increase much beyond the 10 current estimate of 136 million hectares. Although some increase in cropping intensity is still possible, rice land is being lost to industrialization, urbanization, or conversion to other crops. The main source of additional production will therefore have to be yield growth. Global average rice yields must

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continue to rise at an annual rate of at least 50 kg per hectare to keep pace with the expected demand, or by 0.5 tons per hectare over the next 10 years (about 12% above current levels). Productivity growth through the development and dissemination of improved technologies is the only long-term viable solution for bringing prices down, preventing future increases in price, and ensuring that affordable rice is available to poor rice consumers. To achieve this, a second Green Revolution is needed now as much as the first Green Revolution was needed to avoid famine and mass starvation. The task is equally challenging but not insurmountable, provided a substantial boost is given to agricultural research, which continues to remain highly underinvested. Increased research investment together with policy reforms that make rice markets more efficient will help bring rice prices down to a level affordable to the poor and, ultimately, reduce poverty. What needs to be done? In the near term, urgent actions from national governments and international agencies are needed on two fronts: rapidly exploiting existing technological opportunities for increasing rice yields and policy reforms to improve poor people’s food entitlements. Rice production can be revitalized, but there are no silver bullets. The world community must invest now and for a long time to come. Some of the actions listed below deal with the immediate crisis while others provide long-term solutions to prevent future crises. IRRI is calling for the implementation of the following nine-point program of short- and long-term interventions:

1. Bring about an agronomic revolution in Asian rice production to reduce existing yield gaps Farmers have struggled to maximize the production potential of the rice varieties they are growing, so there is a gap between potential yield and actual yield. Depending on production conditions, an unexploited yield gap of 1–2 tons per hectare currently exists in most farmers’ fields in ricegrowing areas of Asia. Such yield gaps can be reduced through the use of better crop management practices, particularly in irrigated environments. This requires funding support for programs aimed at improving farmers’ skills in such practices as land preparation, water and nutrient management, and control of pests and diseases.

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2. Accelerate the delivery of new postharvest technologies to reduce losses Postharvest includes the storing, drying, and processing of rice. Most farmers in Asia suffer considerable losses in terms of both quantity and quality of rice during postharvest operations because of the use of old and inefficient practices. Active promotion of exciting new technologies that are currently available for on-farm storage and drying will reduce losses considerably. 3. Accelerate the introduction and adoption of higher yielding rice varieties New rice varieties exist that could increase production, but farmers are not using them mainly because the systems that develop and introduce new varieties are under-resourced. 4. Strengthen and upgrade the rice breeding and research pipelines Funding for the development of new rice varieties has steadily declined over the past decade or more. This must be reversed in order to develop the new rice varieties that will be required for sustained productivity growth. Opportunities exist to accelerate the development of new rice varieties with increased tolerance of abiotic stresses (such as drought, flooding, and salinity) and resistance to insects and diseases through new precision-breeding approaches. Likewise, record high fertilizer prices and new pest outbreaks demand the urgent revitalization of research on rice crop and resource management. 5. Accelerate research on the world’s thousands of rice varieties so scientists can tap the vast reservoir of untapped knowledge they contain Working with IRRI, the nations of Asia have spent decades carefully collecting the region’s thousands of rice varieties. More than 100,000 types of rice are now being carefully managed and used at IRRI and in Asian nations. However, scientists have studied in detail only about 10% of these types. It is urgent that researchers learn more about the other 90% so they can be used in the development of new varieties.

6. Develop a new generation of rice scientists and researchers for the public and private sectors Another vital concern for the Asian rice industry is the education and training of young scientists and researchers from rice-producing countries. Asia urgently needs to train a new generation of rice scientists and researchers—before the present generation retires—if the region’s rice industry is to successfully capitalize on advances in modern science. 7. Increase public investment in agricultural infrastructure

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Adequate investments in agricultural infrastructure such as roads, irrigation systems, and market systems are critically important for raising and sustaining productivity growth in rice. As with agricultural research, the underinvestment in infrastructure needs to be corrected urgently. 8. Reform policy to improve the efficiency of marketing systems for both inputs and outputs Domestic and international marketing systems need to improve so that changes in consumer prices are reflected in producer or farm-gate prices (this is known as efficient transmission of price signals). Policies should be developed and revised to remove barriers to the efficient transmission of price signals and to create conditions that allow the private sector to function smoothly. 9. Strengthen food safety nets for the poor Poor and disadvantaged people who are highly vulnerable to food shortages require strong food and social safety net programs to ensure that their needs are adequately met. Both urban and rural poor people would benefit from food or income transfers and nutrition programs focusing on early childhood. *Suggested citation IRRI (International Rice Research Institute). 2008. Background Paper: The rice crisis: What needs to be done? Los Baños (Philippines): IRRI. 12 p. www.irri.org.