How economists think. · Ownership of scarce resource (diamond mine) Violence to prevent competitors (drug cartels) Economic Forces in American History 11 Monopolists earn profit

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Economic Forces in American History

Entrepreneurship & Business


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Entrepreneurship & Business: Outline

Micro principles

Profit maximization & ethics

Trusts & Mergers

Advertising

Martha Olney (U.C. Berkeley)

[email protected]


How economists think. . .

. . . about firms & profit maximization

Perfectly competitive firms

Lots of sellers

No seller has a large share of total market

Homogeneous product

No barriers to entry or exit

In the long run (what’s that?), all firms will earn zero economic profit (what’s that?)

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Long-run vs short-run

Long-run

A period of time long enough so that anyone who wants to enter or exit an industry has enough time to do so

Short-run

A period of time shorter than the long-run

Not enough time to enter or exit industry

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Economic Profit

Accounting Profit

What is reported to the accountants (and the IRS)

Revenue minus costs

Economic Profit

What impacts decisions

Revenue minus costs

Costs include all opportunity costs

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Opportunity costs?

Implicit costs of running a business

Cost of time: what could I earn if instead of running my business, I worked for someone else?

Cost of (financial) capital: what could I earn on my wealth if it wasn’t tied up in my machinery & buildings?

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3


Zero economic profit

Zero is the best you can expect to do!

Zero economic profit means you are earning as much from your business as you would be earning from your labor and your (financial) capital if you were doing something else

Called “normal” profit

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Do you start off earning 0?

Not if you’re early and if demand is high

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New business Hmm, I

can do that too!

Lots of

profit!

Prices fall

Uh-oh. Less profit.

Start

something

newer


How avoid erosion of profit?

Barriers to entry!!

Monopoly

One firm

Unique product

Barriers to entry

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Barriers?

Government franchises (cable company)

Invention or production process (protected by patents)

High fixed costs (“natural” monopoly)

Ownership of scarce resource (diamond mine)

Violence to prevent competitors (drug cartels)

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Monopolists earn profit

Barriers to entry, so competition doesn’t erode firm’s profit

Can earn economic profit > 0 even in the long run

Called “abnormal” profit

Firms like this!!! (Consumers, not so much. Potential competitors, not so much either)

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Monopolistic Competition

In between the two extremes

Characterizes many small businesses

Lots of firms

No barriers to entry or exit

Selling a heterogenous product (close but not perfect substitutes)

In the long-run, economic profit = 0

Because no barriers to entry

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5


If product isn’t truly unique

Others will still compete away profit

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New business Hmm, I

can do that too!

Lots of

profit!

Prices fall

Uh-oh. Less profit.

Start

something

newer


Oligopoly

Most big businesses in the U.S.

Maybe lots, maybe a few firms

A few firms (3 or 4) sell 80-90 percent of total market

Product may be homogeneous or heterogeneous

May or may not be barriers to entry

Often wind up with abnormal profit

No one “model” to explain

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Profit Maximization

Math-y approach to show

All firms perfectly competitive

All firms maximizing profit

All information shared equally (no asymmetric information)

All consumers maximizing utility

All costs and benefits internalized

Then “Pareto optimal” allocation of resources

And enhances economic growth

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But but but

Profit maximization and ethical behavior are not one and the same

Slavery

What are the goals we as a society want to achieve?

Not on a standardized test

But probably an important conversation to have with the students!

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Businesses dislike competition

Competition erodes profit. Boo hiss.

Competition leads to lots of market failure

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Businesses prefer market power!!

Horizontal Merger

Consolidation of competing firms

Vertical Merger

Buying suppliers (backward) or distributors (forward)

Merger Waves

1879-1893 (horizontal)

1898-1904 (vertical)

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1890 Sherman Anti-Trust Act

Prohibits "formation of trusts" or other "conspiracy in restraint of trade or commerce"

Vague!

Doesn't apply to manufacturing

Doesn't prevent monopolies

Doesn’t prevent holding companies

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Lots of Mergers

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Stopping Monopolization

1914 Clayton Anti-Trust Act

price discrimination reducing competition banned

interlocking directorates banned

mergers reducing competition banned

labor & agriculture exempted

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Horizontal mergers, 1879-1893

Why merge horizontally?

decrease price competition

decrease business failures

reaction to price deflation of 1890s & high fixed costs following industrialization

Created firms such as National Biscuit (NaBisCo), Quaker Oats, U.S. Steel, U.S. Playing Card, DuPont, Otis Elevator

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Vertical mergers, 1898-1904

Reasons for vertical mergers

decrease price competition

guarantee access to supplies

stock market frenzy

difficulties financing small firms

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Creating a “heterogeneous” product

Marketing!

Advertising moves away from “reason-why” advertisements

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Advertising

Brand Names

Not just flour, but Gold Medal flour

Marketing

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Psychology & advertising

ambition

pleasure

bodily comfort

possession

approval by others

appetite

love of offspring

health

sex attraction

parental affection

Marketing

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Documents

How economists think. · Ownership of scarce resource (diamond mine) Violence to prevent competitors (drug cartels) Economic Forces in American History 11 Monopolists earn profit