CH-16-19 Competing for Monopoly: The Economics of Network Goods – Modern Principles: Microeconomics : Chapter Notes

This Document Contains Chapters 16 to 19 Chapter 16 Competing for Monopoly: The Economics of Network Goods Learning Objectives After completing this chapter, students should: > know that a network good is one whose value to the consumer increases as more other consumers use the good. > understand that competition with network goods focuses on competition for the market rather than competition within the market, and as a result, network goods are often sold by monopolies. > understand that the monopolies that sell network goods change over time as new firms innovate and surpass prior market leaders. > understand the conditions under which markets are likely to be contestable and how switching costs can reduce contestability. > explain why the application of antitrust laws to network goods is more complicated than for other goods. Chapter Outline Network Good Are Usually Sold by Monopolies or Oligopolies The “Best” Product May Not Always Win Competition Is “For the Market” Instead of “In the Market” Limiting Contestability with Switching Costs Antitrust and Network Goods Music Is a Network Good Takeaway Chapter Narrative A network good’s value to one consumer increases as more other consumers use the good. The textbook uses the example of Facebook. With more than two billion active users, it’s easier to connect with your friends on that network than a smaller one. Similarly, many online dating networks enjoy critical mass. If you’re looking for a date, it’s easier to find one among Match.com’s 20 million users than it is on a smaller network. Microsoft Word is valuable to consumers because it is easy to share and swap files with the many other users of Microsoft Word. Microsoft Word continues to command high prices even though similar word processors, such as OpenOffice, are available for free. Network goods tend to have three features: Network goods are usually sold by monopolies or oligopolies. When networks are important, the “best” product may not always win. Competition in the market for network goods is “for the market” instead of “in the market.” As pointed out in the text, there is appears to be a conflict between features 1 and 3, and it is this conflict that makes network goods appear as monopoly goods that do not always behave like monopoly goods. Network Goods Are Usually Sold by Monopolies or Oligopolies Network goods tend to be sold by oligopolies or monopolies because people want to use the same product as most other people. Microsoft is able to price Word hundreds of dollars above cost even though OpenOffice, Google Docs, and other word processors of similar quality to Word give their software away, because of people’s desire to be compatible with other Microsoft Office users. Not all network goods are sold by monopolies. An oligopoly is a market dominated by a small number of firms, and many network industries are oligopolies. eBay is the largest online auction firm, but other competitors, like Craigslist, compete in the same market by offering slightly different services. Craigslist, for example, caters to local markets. Online dating is also an oligopoly because most people want to join networks where there are already the most other people. While Match.com is the market leader, OKCupid and eHarmony compete by using different algorithms. JDate.com caters to those looking for Jewish partners. Within this niche, however, notice that the network effect helps JDate.com outcompete the overall market leader, Match.com. The “Best” Product May Not Always Win Many people fear that markets for network goods can lock in the “wrong” product or network because the value to subsequent users depends heavily on what prior users have already bought. In Figure 16.1, the textbook illustrates a coordination game for buyers of computer software. Figure 16.1 The Coordination Game Whichever product the first player chooses, the second player is better off if he chooses the same product. If a game has only two players, they can likely discuss their choice and decide to pick the product with the higher total payoff. If there are lots of people involved, however, some may initially pick the box on the lower right, and everyone else will have an incentive to do the same. Once the product is picked, no one has an incentive to change the selection unilaterally, because each user values having the same product as everyone else. In the case of Figure 16.1, both the upper left and lower right boxes are Nash equilibria at which no player has an incentive to change strategy unilaterally. A common reason one of the two equilibria is picked over the other is an accident of history. Some people believed that the dominance of the QWERTY keyboard was an accident of history, because although it was thought to be inferior to the Dvorak design, people didn’t switch simply because they were used to the QWERTY layout. However, studies have failed to show a big advantage of either keyboard over the other, and though keyboards are now easy to reprogram, few people bother to learn Dvorak. Teaching Tip: Other examples you can use are the cases of Betamax versus VHS or HD DVD versus Blu-ray DVD. In the former case, Betamax provided superior quality of the video whereas VHS allowed for longer videos on the cassette. Several people speculate that it was the eventual adoption of the VHS format by the adult movie industry that lead to the widespread adoption of VHS. Likewise, in the HD DVD versus BluRay war, HD DVD was a much more flexible format; however, many speculate that it was the fact that Sony, the creator of Blu-ray, included Blu-ray playability as part of its PlayStation 3 game console (compared to the XBOX 360 add-on HD DVD drive) that lead to the eventual win for the Blu-ray format. Some of Microsoft’s competitors have sometimes had superior stand-alone products. But when networks are important, stand-alone features must often be sacrificed for making sure the product fits into the rest of the industry and making its use as easy for consumers as possible. This often means taking shortcuts to achieve network compatibility for most users. It’s often the “expert” users who are the most unhappy and vocal. But what they complain about is usually the result of the fact that most computer users aren’t experts and they want ease of compatibility. Competition Is “For the Market” Instead of “In the Market” It is important to emphasize to students that there is competition for monopolistic and oligopolistic network industries. Firms compete to establish the industry standard, but even once there is a single winner, their market dominance is often overthrown. In 2003, Friendster was a social networking site with 20 million users. Today, Facebook dominates that market, and while Facebook is still growing, Google+ is a potential threat. Rather than a single stable monopoly, network industries tend to have a serial monopoly: new firms replace the old monopolies. Competition for the market dethrones old monopolies and better serves consumers. The important thing is that competition for the market is not impeded, so that new, more efficient monopolies can overthrow the old. A market in which a competitor could possibly enter and take business away from the incumbent firm is called a contestable market. This potential competition occurs often enough to discipline a dominant monopoly or oligopoly firm, just as actual competition disciplines firms in competitive industries. This, in part, explains why Facebook is still free although it is clearly the market leader in social networking and might appear not to have many serious competitors. The potential for competition inspires Facebook to try to keep its customers happy. Limiting Contestability with Switching Costs One of the ways that firms can try to limit the contestability in a market is by raising the switching costs. Facebook’s generous allotment of server space for user-uploaded photos is a good example of this. By allowing users to upload as many photos as they like, Facebook increases the switching costs; even if a slightly better social networking site were to come online, many people would find switching difficult, because they have so many photos uploaded to (and organized on) Facebook. Customer loyalty plans (such as those mentioned in Chapter 14) are another way to increase switching costs. By earning discount rewards (for example, through your bookstore loyalty plan), you make it less likely that you will switch bookstores because you face higher (full retail) prices at another bookstore. However, if all of the bookstores offer similar customer loyalty plans, then they can all raise their prices, because they no longer compete for customers who are all locked in to one bookstore or another. Cell phone carriers are another example of companies imposing switching costs. Carriers may lock cell phones or impose high fees to make it costly to move to another provider. At the same time, carriers compete for market share by offering signing bonuses meant to offset contract cancellation fees or apps one can use to move content from one phone to another to work around another firm’s switching costs. Customer loyalty plans (like bookstore discount plans or frequent flyer miles) may also have other motivations, such as price discrimination. In the case of frequent flyer miles, they act as a way for firms to compensate business-traveling employees without paying taxes: the employee books an expensive flight, the firm pays for the flight, and the employee keeps the miles. Antitrust and Network Goods The market for network goods is always likely to be dominated by one or a few firms. This complicates the application of antitrust law because the competition is for the market, not in the market. Customers are better off when the market is dominated by a small number of firms, so antitrust authorities shouldn’t be concerned with what appears to be a monopoly; rather, it is important that the competition for the market not be impeded. The text gives the example of the case against Microsoft regarding Internet Explorer. While it’s clear that Internet Explorer once had considerable market share, it is not clear whether that was simply the result of competition for the market playing out as it should for network goods—with one dominant firm—or whether Microsoft impeded that competition, making consumers worse off. Music Is a Network Good Not all network industries are high-tech. If you listen to popular music, you can swap songs with your friends, go to concerts together, and talk about musicians. So the value of a song to one person can depend on how many other people like the same song or group. Duncan J. Watt, a Columbia University sociologist, ran a series of experiments on the network effect of music. Participants were asked to listen to and rate bands they had not heard before, and if they liked the song, they could download it for free. Some subjects could see only the names of groups and the titles of songs, but others could also see how many times a song had been downloaded. He found that the more downloads a song had, the more other people wanted to download it. If tastes for music were independent of what others thought, the information on previous downloads should have been irrelevant. As he ran the experiment more and more times, he found different songs turned into hits in each different experiment. How often a song was downloaded depended on how many people downloaded it early in the experiment, thus influencing others to download it. Which song became a hit was largely an accident of history. You can see similar effects in the overall music market. Some bands catch a lucky break and become popular very quickly. The popularity feeds on itself and can turn a small head start into a huge market share even if it’s not the best in a strictly musical sense. Other very good bands are never discovered. Stars can also rise and fall quickly because of the network effect. At any one time, only a handful of entertainers are the most popular, but membership in that handful changes frequently. Teaching Tip: Sports teams also often have network effects. Try provoking a class discussion about it. Some individual players or teams gain nationwide popularity as everyone follows them. Team supporters tend to cluster in geographic markets. After all, how much fun is it to be a Yankees fan in Boston? Even very bad teams have a local following because of the network effect. Try asking students who their favorite team is in each major sport. Even among college students who come from various parts of the country, you’re likely to find a lot of homogeneity. Takeaway Students should know what a network good is and why such goods are usually sold by monopolies or oligopolies. It’s important for them to appreciate that although network industries are commonly monopolized, these monopolies often face serious competition for the market from new firms, and as a result, the identity of the monopoly serving a network industry changes over time. In- and Out-of-Class Activities One easy extension of the concept of network good is the development of fads. Have your students identify any products they consume that they can, if they’re honest, identify as being trendy—that is, at least some of the value they receive from it comes from the fact that other people, like their friends or even celebrities, also consume the good. Ask them to talk about contestability with respect to these types of network goods. It should be obvious that fads are highly contestable. Ask students whether any of the trendy goods they consume come with switching costs in an attempt to prolong their life as trendy goods. (Viral Internet phenomena—or memes—might provide good examples of highly contestable faddish network goods.) You might also ask your students to identify any goods whose network externality is a negative one; that is, a good you enjoy less when more people are using it. This is the snob effect. If you are using this as an in-class discussion topic, snob effect goods may come up in the conversation organically. Chapter 17 Monopolistic Competition and Advertising Learning Objectives After completing this chapter, students should understand: > that products can be differentiated along many dimensions, such as taste, style, features, or location. > the characteristics of a monopolistically competitive market. > the outcomes of monopolistic competition in terms of profit maximization, pricing, profitability, and efficiency. > different types of advertising. Chapter Outline Sources of Product Differentiation The Monopolistic Competition Model Is Monopolistic Competition Inefficient? The Economics of Advertising Informative Advertising Advertising as Signaling Advertising Changes Our Tastes Takeaway Chapter Narrative This chapter discusses monopolistically competitive markets and the role of advertising in such markets. A key distinction of this market structure is product differentiation. To set the stage, it may be useful to start with a discussion of some examples of differentiated products in class, so that students get a sense of the dimensions along which products can be differentiated, such as taste, style, location, or product features. Common examples are beverages (Coke versus Pepsi), fast food (Big Mac versus Whopper), and branded items (Levi’s versus Calvin Klein). Brand names are not the only source of product differentiation. For example, the same gallon of milk can be differentiated based on locational convenience (grocery stores versus 7-Eleven). Monopolistic Competition Monopolistic competition is a market structure with some features of both monopoly and competition. The characteristics of monopolistic competition are as follows: > It has many sellers in the market. > Firms can freely enter or exit the market in the long run in response to above-normal or below-normal profits. > The products sold by different firms are similar, but each firm’s product is somehow differentiated from the products sold by its competitors. As with monopolies, each firm in a monopolistically competitive market faces a downward-sloping demand curve and has some power to set prices. The downward-sloping demand is a result of the differentiated product sold by each firm. Like firms in a competitive market, however, firms in monopolistic competition compete with many other firms, and there is the potential for entry and exit in the long run. Thus, monopolistically competitive firms earn zero profit in the long run. Teaching Tip: It is helpful to emphasize the similarities and differences between monopolistic competition and the other market structures—competition, oligopoly, and monopoly—students have studied previously in the course. Monopolistic competition essentially blends the downward-sloping demand faced by monopolies with entry and exit as in competitive markets, driving profits to zero in the long run. The textbook uses a Chinese restaurant as an example of a firm in a monopolistically competitive market. The restaurant has some ability to raise its prices without losing all of its customers, since the restaurant has its own unique menu and other characteristics that customers may care about. Many people who are willing to pay $9.55 for Kung pao shrimp might also be willing to pay $10 or more, though some marginal customers might switch to a different restaurant in response to the higher price. In a competitive market, by contrast, an increase in price of only one penny would immediately drive quantity demanded to zero. Monopolistic competition is like the standard model of monopoly, but with entry of competing firms. As firms enter a monopolistically competitive market, the demand curve for each firm in the market shifts to the left until it is just tangent to the average cost curve, at which profits are zero. This is illustrated in Figure 17.1 in the text. Teaching Tip: It is important to emphasize that entry and exit in the long run shift the demand curve for a given firm to the left and right, respectively. This is because entry by new firms takes some of the firms’ customers away, thus decreasing their demand. Likewise, when firms exit, their customers go to the remaining firms in the market, thus increasing their demand. The shifting demand curve in response to entry and exit is the mechanism that guarantees zero profits in the long run in a monopolistically competitive market. Figure 17.1 Monopolistic Competition Even though firms in monopolistic competition aren’t earning above-normal profits in the long run, they still charge prices that are higher than marginal cost, which means that production under monopolistic competition is not efficient. Likewise, monopolistically competitive firms don’t operate at the minimum of average cost. Figure 17.2 in the text graphically compares the efficiency of monopolistic competition with that of a competitive market. Figure 17.2 Comparing Monopolistic Competition and Competition Teaching Tip: In an effort to help motivate the next section on advertising, you can connect monopolistic competition and pure competition (left-hand side of Figure 17.1 and right-hand side of Figure 17.2) quite simply using the idea of elasticity. When a firm starts in a new market, it can behave as a monopoly and enjoy positive economic profits in the short run (left side of Figure 17.1). This, however, attracts new firms, which shift the demand curve for the original firm’s good to the right. You can go further to show that if the market was competitive (meaning no product differentiation), then the entering firms would be producing exact substitutes for the first firm’s good, resulting in the demand curve for the original firm’s products becoming perfectly elastic (left-hand side of Figure 17.2). However, because there must be differentiation among the goods, the demand curve never becomes perfectly elastic after new entry occurs because for an increasing population the new product is not a suitable substitute for the original. This is why we still have some monopolistic elements in the right-hand side of Figure 17.2. So why might a monopolistic competitive firm advertise? Because it makes the demand curve for their product more inelastic (consumers think there are fewer substitutes), causing the mark-up for the advertising firm’s product to increase. The upside of monopolistic competition is that the many firms in the industry provide a variety of products, which allow consumers to choose products that match their preferences. There is also more dynamism in monopolistic competition because firms have an incentive to innovate. If a restaurant comes up with an exciting new menu item, its demand shifts out to the right and it enjoys (at least temporarily) above-normal profits. Advertising to increase customers’ perceptions of a firm’s product is another strategy for increasing demand and earning above-normal profits in the short run. Differentiation need not just be in terms of the look, taste, or brand of the product being sold. Location and convenience can also be ways of differentiation. Consider a 20-ounce bottle of soda. The very same soda can, many times, be found at least two different places in the very same store at two very different prices! If you are willing to go to the very back of the store you can usually purchase a six-pack of 20-ounce bottles for, on average, about $1.25 to $1.50 per bottle (or sometimes even less). That very same bottle of soda, however, can be had at the front of the store and cold for closer to $2.00. It is the very same item, but in the latter case the location and condition of the bottle (just as you walk out, not connected to five other bottles, and cold) allow sufficient differentiation for the store to increase the price by more than 30 percent! The text also highlights new innovations like Amazon’s “Buy it Now” button or the even newer Dash buttons for various products. The Economics of Advertising Competitive firms don’t have any incentive to advertise, since selling more output won’t increase profits. However, monopolistically competitive firms will attempt to use advertising to differentiate their products or influence customers’ perceptions of their product. Informative Advertising Advertising about price, quality, and availability is informative. In some states, optometrists used to be restricted from advertising on price. Comparisons between states that allow price advertising and those that do not reveals that advertising on price appears to lower prices rather than raise them to pay for the advertising, as some might have guessed. Informative advertising also promotes messages of quality, which gives suppliers an incentive to meet quality standards. Advertising as Signaling Sometimes advertising is not about providing customers with information at all, but it signals that the company expects a product to be a hit. Consumers may view a massive ad campaign as a signal of the product’s quality. The ad itself is the biggest piece of information. Advertising Changes Our Tastes Some commercials provide no information at all, only beautiful imagery, cool music, and so on. The textbook refers to Coke commercials as an example. These ads are not informative—people already know about Coke—but are rather trying to persuade people to think of Coke differently from how they think about other soft drinks. On the one hand, this advertising is, as discussed above, attempting to make the demand for Coke more inelastic, allowing Coke to charge a higher mark-up and move closer toward monopoly. On the other hand, however, persuasive (rather than informative) ads such as these can deepen our enjoyment and our memories. In one study, brain scans revealed that the brains of study participants drinking from cups labeled “Coke” showed activity in the memory regions of their brains, but researchers did not observe the same effect when participants drank Coke from unlabeled cups. Perhaps Coke’s advertisements have successfully turned Coke from simply a soft drink into something more. If this is the case, then the advertisement enhances consumer welfare. Advertising also helps some firms to provide goods (like Web searches, radio and television programming, and newspapers) for free or very low cost. Facebook, Instagram, and Twitter are all free to consumers because of advertising. Takeaway Students should understand the characteristics of a monopolistically competitive market and the outcomes of such a market in terms of profit maximization, pricing, profitability, and efficiency. They should also understand the role of advertising in monopolistic competition. They should be familiar with the different types of advertising and what advertising provides to consumers. Chapter 18 Labor Markets Learning Objectives After completing this chapter, students should: > understand that working with more physical capital, having more human capital, and working in a more efficient setting are the fundamental reasons wages are higher in some countries than others. > know what compensating differentials are and why economic growth leads to higher levels of health and safety standards in workplaces. > understand how labor unions can raise members’ wages by restricting the supply of labor. > understand why unions are not a fundamental cause of high wages in wealthy countries. > know the difference between statistical and preference-based discrimination and how markets tend to break down discrimination over time. Chapter Outline The Demand for Labor and the Marginal Product of Labor Supply of Labor Labor Market Issues Why Do Janitors in the United States Earn More than Janitors in India Even When They Do the Same Job? Human Capital Compensating Differentials Do Unions Raise Wages? How Bad Is Labor Market Discrimination, or Can Lakisha Catch a Break? Statistical Discrimination Preference-Based Discrimination Discrimination by Employers Discrimination by Customers Discrimination by Employees Discrimination by Government Why Discrimination Isn’t Always Easy to Identify Takeaway Chapter Narrative This chapter covers three aspects of the labor market. It begins by exploring the fundamental reasons wages are higher for some workers than for others. The chapter discusses how human capital, along with access to and proximity of physical capital, determine the marginal revenue product of labor. It also explains how “bad” jobs require compensating differentials. The chapter then examines why unions can raise the wages of some workers at the expense of others but cannot raise the overall wage level for a country. Finally, the chapter examines reasons for discrimination and how markets tend to minimize some forms of discrimination. The Demand for Labor and the Marginal Product of Labor The increase in revenue generated by hiring an additional worker is the marginal product of labor (MPL). LeBron James has a very high marginal product of labor. When the Cleveland Cavaliers signed him in 2014, it transformed them from second-worst in the NBA into a World Champion team in 2016. As a result, the Celtics sold more tickets and merchandise and got more lucrative TV contracts, significantly increasing their revenues. That’s why they paid James $100 million over three years. Since the increase in cost for hiring an additional laborer for a competitive firm is simply the worker’s wage (including other compensation like health benefits, 401(k), and so on), firms will continue to hire more workers as long as each worker’s MPL exceeds his or her wage. The text illustrates how the marginal product of labor declines as McDonald’s hires more janitors. The first janitors are assigned the most important things to clean, like the kitchen and restrooms. As McDonald’s hires additional janitors, they are assigned less important tasks, and thus the marginal product of their labor is lower, even though they may be as skilled as the first janitors hired. Because the marginal product of labor declines, firms pay lower wages as they employ more workers. So just as with other goods, the demand curve for labor is downward sloping. The demand curve for labor is equal to the marginal product of labor, as seen in Figure 18.1 in the text. Figure 18.1 The Marginal Product of Labor Determines a Firm’s Demand Curve for Labor The first part of MRU video The Marginal Product of Labor (first third of the video) provides a discussion of the marginal product of labor and an illustration using Figure 18.1 in the text. Supply of Labor Higher wages often encourage people to work more. However, after a certain point some people may respond to higher wages by working less and consuming more leisure time to enjoy their earnings. Over some range an individual’s labor supply curve may be backward-bending. Figure 18.2 in the text illustrates this. Figure 18.2 The Individual and Market Supply of Labor When wages in an industry are higher, more people are attracted to working in the industry. So even though individuals might choose to work less when they earn more, the standard upward-sloping market supply curve is still normal in labor markets. The equilibrium wage rate in a market is found at the intersection of the supply and demand for labor. The marginal revenue product will always be very close to the wage because firms keep hiring workers as long as the marginal product of labor is greater than the wage. So it is helpful for students to think of wages as equal to the marginal product of labor in competitive markets. The illustration of the labor supply curves in Figure 18.2 is shown in the middle part of the MRU video The Marginal Product of Labor. Labor Market Issues Why Do Janitors in the United States Earn More than Janitors in India Even When They Do the Same Job? A janitor in the United States earns approximately $20,000 to $30,000 in a year, but a typical janitor in India earns less than $1,000 in a year for doing essentially the same job. The main reason for the difference in pay is that the U.S. janitor works in a more productive economy. There is more capital invested in the United States, which helps to make a U.S. office building more productive. A U.S. office building is typically producing a more valuable product than an Indian office building. As a result, it’s more valuable to keep a U.S. office clean, so the marginal revenue product of the office cleaners is higher in the United States than in India. The supply side of the market also plays a role in wage differentials between the United States and India. A large number of low-skilled Indians compete to be janitors, while a much greater proportion of Americans would not find office cleaning an attractive job because they have better alternative opportunities. Figure 18.4 in the text shows how higher demand and lower supply in the United States lead to higher wages for janitors. Figure 18.4 Wages for Janitors in India and the United States The discussion of janitors in India and the U.S. including Figure 18.4 appears at the end of the MRU video The Marginal Product of Labor. Human Capital Differences in human capital also explain differing wages both across and within nations. Human capital is the tools of the mind, or the stuff that’s in people’s heads that makes them productive. Getting an education is one way in which people improve their human capital; job experience is another. In general, investments in human capital have had a good return in the United States. College graduates earn almost twice as much as high school graduates, and the payoff of a college education has recently increased significantly. The return on investment in education isn’t just about human capital. A college education signals to an employer that you had the intelligence, competence, and conscientiousness to earn your degree. Some employers are willing to hire college graduates even when what they learned in college isn’t relevant for the job. The MRU video Human Capital and Signaling defines human capital and discusses education as a form of signaling. Compensating Differentials Real wages include pay as well as other job attributes, such as how enjoyable and safe a job is. The less pleasant or safe a job is, the higher the pay must be. Commercial fishing is one of the most dangerous jobs in the United States. Driving a truck is also dangerous. That’s why these jobs pay relatively high wages even though they do not require a college degree. The more dangerous or unpleasant a job is, the more the supply of labor for that job shifts to the left and up (see Figure 18.6 in the text), resulting in a higher wage rate. This is what we call a compensating differential. The MRU video The Tradeoff Between Fun and Wages provides a provides a short and simple introduction to the discussion of compensating differentials by using the example of a lifeguard versus a sewer inspector. This video is useful as an opening to this section. Compensating differentials mean that similar jobs must have similar compensation packages. The text postulates that being an accountant and a musician might require the same amount of skill but that being an accountant is boring, while being a musician is fun. Try asking the students what would happen if both paid the same wages. How many of them would want to be accountants? This leads us to thinking about the fun and safety of jobs a little differently. Workers who take lower-paying but more enjoyable jobs can be thought of as buying fun. Similarly, workers who choose less risky jobs for lower pay are buying safety. Rich workers tend to buy more safety than poor workers for the same reason they tend to buy more BMWs. So it should be unsurprising that many workers who choose to become fishermen in the United States are recent immigrants who are relatively poor. This also explains why jobs in the United States are safer than similar jobs in poorer countries. Wealthier U.S. workers are willing to purchase more safety. One of the important reasons safety increases over time is that economic growth enables workers to purchase more safety. Teaching Tip: You might point out to your students that one common complaint about third-world sweatshops is that they have unsafe and unhealthy working conditions. Point out that the same was true of U.S. textile jobs in the nineteenth century. You might ask them to speculate about the role of regulation compared to that of economic growth in improving health and safety conditions and what this implies about policies toward third-world sweatshops today. Increasing wealth and the profit motive are the main drivers behind increased safety. The text considers coal mining, whose mortality rate per ton of coal is 100 times higher in China than in the United States. The typical U.S. coal miner earns $50,000 to $80,000 per year. How much higher wages would firms have to pay to attract workers in the United States if they had the mortality rate of Chinese coal mines? The saving in wages is the main motivator to U.S. firms in providing greater safety. When the students bring up the Occupational Safety and Health Administration, point out that OSHA would not exist if the body politic had no will for safety in employment. Figure 18.6 Riskier Jobs Pay More, All Else Being Equal Economists have estimated that firms pay employees as much as $245 billion per year to take on risk in the workplace. OSHA levies only about $150 million in fines annually. This implies that improving safety to save money on wages is likely to be a much greater motivator than fear of government fines. Also, since firms are required to buy workers’ compensation insurance and the insurance rates they pay are based on the company’s claims experience, they have an additional incentive to provide greater safety. The MRU video Compensating Differentials provides a detailed discussion of compensating differentials with a focus on job safety. Do Unions Raise Wages? Unions are not a fundamental reason wages are higher in some countries than others. In the United States, about 11 percent of workers are unionized. In Switzerland, about 18 percent are. Western European unionization rates run between 30 percent and 80 percent, yet wage levels in Switzerland and the United States are at least as high as in the Western European countries. Union jobs tend to pay more than nonunion jobs in the same industry. Unionized electricians in the United States, for example, earn about 10 percent to 15 percent more than nonunionized electricians. The reason that unionization doesn’t translate into higher overall wages in the economy is that unions’ primary method of raising wages is to reduce industry employment by restricting union membership to shift the labor supply curve in and threatening to strike or protest if an employer doesn’t use union labor. This is illustrated in Figure 18.8 in the text. Unions can lower wages in the overall economy. Strikes and work stoppages can slow the entire economy. Britain’s period of economic decline was associated with its high rate of unionization from 1970 to 1982. Coal miners went on strike in 1972 and again in 1974, leading to shortages of electricity, and for a short time a three-day work week was implemented in other industries to conserve power. In 1970 a dockworkers’ strike shut down almost all British ports. The British economy has grown faster since Margaret Thatcher decreased the government-supplied privileges to unions in the 1980s. Figure 18.8 By Reducing the Supply of Labor, a Union Can Increase Wages The MRU video Do Unions Raise Wages? provides a discussion of unions’ effects on wages including the illustration using Figure 18.8 in the text. How Bad Is Labor Market Discrimination, or Can Lakisha Catch a Break? Not all types of discrimination are motivated by prejudice. There are two main types of discrimination: statistical and preference-based. Statistical Discrimination Statistical discrimination uses information about group averages to make conclusions about individuals. Most people use statistical discrimination in their daily lives. To illustrate our tendency to use statistical discrimination, the text asks students to consider whether, while walking alone down an alley late at night, they would be more nervous seeing an angry young man in a leather jacket or seeing a man pushing his two-year-old daughter in a stroller. Statistical discrimination can be useful shorthand reasoning to make decisions, but it can also lead to errors because we won’t deal with some people that we could have profitably dealt with. Statistical discrimination isn’t motivated by malice, but it can have harmful long-run consequences for the disfavored group. Statistical discrimination tends to be most persistent when people have casual interactions with no repeat encounters. In labor markets, employers make greater profits by hiring and retaining the best workers, so they have a large incentive to develop fine-grained ways of judging job candidates to avoid making unsound judgments on candidates based on statistical discrimination. Teaching Tip: You can likely stimulate a class discussion on this topic by talking about the post-college job market. Try asking students what they will do to avoid statistical discrimination when they look for a job. How will they dress and wear their hair, for example? Also ask what methods employers are using to avoid some pitfalls of statistical discrimination. Researching candidates on Facebook is one recent innovation some employers are using. Preference-Based Discrimination Preference-based discrimination is based on a dislike of some group of people. There are three types of preference-based discrimination in the workplace: Discrimination by employers Discrimination by customers Discrimination by employees Discrimination by employers is the easiest type for the market to curtail. Discrimination by employees is the hardest. Teaching Tip: When students think about discrimination in hiring practices, they tend to think of it being based on employer preferences. You should emphasize to them that this is the easiest type of discrimination for the market to eliminate, so most of the discrimination they think they witness can be explained either by differences in worker productivity or by one of the more subtle forms of discrimination. Most cases of discrimination are not likely a result of employer preferences against a group. Discrimination by Employers If bigoted employers discriminated against a particular group of people, it would reduce the demand for the disfavored group’s labor and push their wages down. Fortunately, discrimination by employers based on their own preferences tends to break down because it is expensive for the employer and leaves the bigot vulnerable to being out-competed. The textbook runs through a quick numerical example to illustrate how discrimination can be costly for an employer. If a firm needing 100 employees could hire equally productive black workers for $2 less per hour than white workers but chose not to because of bigotry, it costs the employer $1,600 per day (or $400,000 per year) to engage in discrimination. When the price of discrimination is high, even bigoted employers are reluctant to indulge their preferences. Even if some employers discriminate, other employers can profit by more cheaply hiring people in the disfavored group. As other profit-hungry employers compete for the underpaid, discriminated-against group, the wages of that group will rise until they are close to their MPL. The text offers some empirical evidence of these trends by pointing to a study that found firms that did actively discriminate based on race were almost twice as likely to go bankrupt than firms that did not actively discriminate. The text also discusses whether discrimination by employers is a reason women earn less money than men. Students are likely to have heard reports claiming women earn about 80 cents per dollar earned by men. However, this is a comparison of all women with all men. Women tend to have less job experience than men of the same age because women periodically leave the workforce to have children. Single women earn just about the same as single men, and married women without children earn about the same as married men without children. Men may also have specialized in more dangerous jobs that pay compensating differentials. Some women have moved toward higher-paying sectors and are having fewer children, and their wages are increasing. To the extent that discrimination remains, it’s not likely because of employer preferences. Discrimination by Customers When customers discriminate, owners are not always driven to hire the disfavored workers because it could decrease their profits. Prior to the civil rights movement, state laws that did not allow mixed-race establishments were one major reason for discrimination. But some discrimination was likely based on customer preferences. If many whites didn’t want to sit in the same section as blacks, restaurant owners would lose money by integrating their establishments. Even in this case, the market can play a role in limiting discrimination. Marketplace transactions bring different groups into regular contact with each other and help to overcome prejudice. Economic growth also generally weakens discrimination. In a small town with only two lunch counters, neither might be willing to take a chance at integration. But when the economy grows and there are more establishments, it becomes increasingly likely that someone will take a risk and integrate the business. Discrimination by Employees Some firefighters don’t want women to have equal status in the firehouse, and some men in the military don’t think women should be able to take combat jobs. When employees discriminate against their coworkers, the employers may be less likely to risk hiring someone from the disfavored group because the morale of the other workers could fall and some might leave for other jobs. Also, women, knowing that they are not wanted by other firefighters in the firehouse, may decide it’s not worth applying in the first place. So discrimination can be at work even when the employer doesn’t have the opportunity to hire a woman. If the market is large enough and there are enough productive workers in the disfavored group, a new business could open and compete against established firms by hiring from the disfavored group. However, this type of market response is more difficult than the market responses from the other two sources of workplace discrimination. Discrimination by Government Governments sometimes enforce discrimination. Prior to the civil rights movement, the U.S. government required separate hospitals for blacks and whites, as well as separate schools, cemeteries, restrooms, restaurants, hotels, and train services. Before segregation laws were passed in the South, many parts of the South were slowly moving toward more integration. The apartheid system was enforced by the South African government from 1948 until the early 1990s. Blacks had to live in special areas and could not compete with whites for many jobs. Once the laws were removed, many blacks changed jobs and earned higher wages. Why Discrimination Isn’t Always Easy to Identify Two economists sent out two identical sets of résumés but varied the names on them so that one set had traditional English names like “John Smith” and the other set had names closely associated with African Americans. The résumés with the “white” names received 50 percent more calls. However, this doesn’t necessarily translate to decreased earnings for blacks. Steve Levitt and Roland Fryer tested how much this mattered for long-run earnings and found that having a “black” name didn’t hurt a person’s chances in life once they controlled for the neighborhood they came from. It may be that so-called black names get fewer interviews but in the long run end up in jobs of equal quality, or it may be that they get fewer interviews in white communities but increased opportunities in black communities. Good-looking people earn about 5 percent more than ugly people. Tall people earn more, too. By one estimate an extra inch in height leads to a 1.8 percent increase in wages. But it’s not clear that this is because of discrimination. One study found that the height a man had in high school, rather than adult height, better predicts wages. So perhaps rather than discrimination against short people, tall people might be paid more because they are more self-confident, which is correlated with being tall in high school. The difference in wages could be because of employer discrimination, but it could also be because the employer is tricked into thinking taller people are better leaders or because other coworkers might pay the taller worker more respect. The point to emphasize to students is that it’s often difficult to tell whether discrimination is present, and, if it is present, what type it is. Takeaway Students should now be able to explain why wages vary across countries and between workers within a country. They should know that physical and human capital and a more efficient economy lead to higher wages. They should understand that compensating differentials explain why pleasant jobs pay less and more dangerous jobs pay more than other jobs. They should also know that safety tends to improve as wages rise and employees are able to buy more safety. The students should understand why unions can raise wages for their members relative to other workers in an economy but why they cannot produce economy-wide high wages. Students should know the difference between statistical and preference-based discrimination. They should understand the various sources of preference-based discrimination and how the free market tends to minimize some forms of discrimination better than others. In- and Out-of-Class Activities Here’s an exercise you can do with students to illustrate how compensating differentials influence pay. If you have a technology-equipped classroom, you can go to: http://money.howstuffworks.com/10-high-paying-dirty-job.htm This list illustrates that dirty jobs are well compensated. Each page of the story has a picture and description of the job and lists the approximate salaries the workers earn. If you would like to give an assignment to do at home, direct them to: http://money.howstuffworks.com/10-most-dangerous-jobs-in-america.htm This list provides the 10 most dangerous jobs in America. Ask the students to search the Web to find approximate salaries for these dangerous jobs. Here’s the list of the 10 most dangerous jobs: Logger Pilot Fisherman Iron/steel worker Garbage collector Farmer/rancher Roofer Electrical power installer/repairer Sales, delivery, and other truck driver Taxi driver/chauffeur For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: The Demand for Labor and the Marginal Product of Labor and Supply of Labor The Marginal Product of Labor Labor Market Issues: Human Capital Human Capital and Signaling Labor Market Issues: Compensating Differentials The Tradeoff Between Fun and Wages Labor Market Issues: Compensating Differentials Compensating Differentials Labor Market Issues: Do Unions Raise Wages? Do Unions Raise Wages? Chapter 19 Public Goods and the Tragedy of the Commons Learning Objectives After completing this chapter, students should: > know that a public good is nonexcludable and nonrival. > understand some ways that markets are able to produce nonrival goods. > understand why nonexcludable but rivalrous goods are overconsumed, leading to the tragedy of the commons. > recognize that instituting new property rights can be a creative solution to some tragedies of the commons. Chapter Outline Four Types of Goods Private Goods and Public Goods Club Goods The Peculiar Case of Advertising Common Resources and the Tragedy of the Commons Happy Solutions to the Tragedy of the Commons Takeaway Appendix: The Tragedy of the Commons: How Fast? Chapter Narrative This chapter begins by discussing how an asteroid, Toutatis, 2.9 miles long by 1.5 miles wide, narrowly missed the earth in 2004. If it had hit, it could have ended civilization. The probability of being killed by an asteroid is approximately the same as being killed in a commercial airline accident. The textbook uses this story to illustrate how asteroid deflection is a public good. It is both nonrival and nonexcludable. The chapter goes on to discuss various types of public goods, some of which are produced by the market, and then examines club goods, the tragedy of the commons situation, and some creative solutions to the problem. The MRU video Public Goods and Asteroid Defense introduces public goods using the asteroid defense example discussed in the introduction to this chapter in the text. Four Types of Goods A good is nonexcludable if it is difficult to prevent people from using the good at low cost. A good is nonrival if one person’s use of the good does not reduce the ability of another person to use the same good. Four types of goods can be classified according to whether they are excludable or not and rival or not, as shown in Table 19.1 in the text. Table 19.1 Four types of goods Excludable Nonexcludable Rival Private Goods Common Resources Jeans Tuna in the ocean Hamburgers The environment Contact lenses Public roads Nonrival Club Goods Public Goods Cable TV Asteroid deflection Wi-Fi National defense Digital music Mosquito control The first half of MRU video A Deeper Look at Public Goods provides a detailed discussion of the different types of goods in Table 19.1. Private Goods and Public Goods Private goods are excludable and rival and are efficiently produced by competitive markets. Because the goods are rival, the fact that nonpayers are excluded from consuming them does not result in any inefficiency. Public goods, on the other hand, are both nonexcludable and nonrival. Because public goods are nonexcludable, it is difficult to get people to pay for them. This often gives people an incentive to be free riders who enjoy the benefit of the public good purchased by others but don’t pay any of the cost themselves. Buyers of the good cannot limit the incentive to free ride because the goods are not easily excluded. These two factors tend to result in underprovision of public goods. In the example that opened the chapter, since everyone will be saved so long as some people pay for asteroid protection, most people have an incentive to free ride, which results in little asteroid deflection research taking place. The textbook discusses mosquito control as another example of a public good. The spread of West Nile virus can be decreased by spraying to kill mosquitoes. But because mosquitoes fly from one area to another, spraying in your own yard will also benefit your neighbors. Similarly, you would benefit from their spraying. Everyone has an incentive to free ride, and even though people might value mosquito spraying, too little mosquito spraying could occur. Teaching Tip: Now would be a good time to link the topic of public goods to the discussion of externalities in Chapter 10. Public goods, whether asteroid deflection or mosquito spraying, generate large, positive externalities. Prices, therefore, don’t factor in the benefits one person’s purchase provides to others. You might want to revisit some of the examples, such as vaccinations, also discussed in Chapter 10, in your public goods discussion. Even though people don’t individually have an incentive to provide public goods, they may decide to provide them collectively. When no one individually contributes to a public good, it’s possible that all might agree to a broad-based tax to provide it. Government taxation for the provision of public goods does not guarantee that everyone will be made better off. National defense is an example frequently cited as a public good. However, while some people want more defense, others want less, and some (pacifists) want none. Taxation means some people will be forced riders who pay a share of the cost of the public good even though they don’t value the good themselves. The textbook informs students that in theory the government should provide the amount of a public good that maximizes the total social benefit of the good minus the cost. But in practice figuring this out is very difficult—some would say impossible. No one has devised a way to mimic the market’s invisible hand process to discover the optimal amount of a public good. Voting and other democratic processes are not as good at deciding on public good provision as competitive markets are at finding the optimal quantity of private goods. See Chapter 20 for more on limits of democratic procedures. In-Class Exercise: You might want to provoke a class discussion by asking students what type of a good “good government policy” is. Good policy requires informed and impartial behavior of voters, politicians, and bureaucrats. The benefits of good government policy are both nonrival and nonexcludable. Good government policy is itself a public good (you can also call this democracy). Furthermore, no individual has an incentive to provide for good government policy (to be a fully informed voter or for a politician to read every detail of every bill they vote on). You can highlight this by asking how many people voted in the last election and why. Then ask them what happens if no one votes. What does this imply about relying on government to solve public goods problems? The second half of MRU video A Deeper Look at Public Goods provides a detailed discussion of the free rider problem and the marketability of public goods. Club Goods Club goods are goods that are excludable but nonrival. Club goods are marketable public goods. Markets can provide these goods because they are able to exclude nonpayers. However, because they are nonrival, it is inefficient to exclude people from consuming them (compared to a first best world). Things like television shows, music, and computer software fall into this category. The key is that by excluding consumers from these goods (charging a nonzero price and only allowing payers to consume), the producers can cover the usually large fixed costs involved with the production of these goods. Because these goods are nonrival, however, the marginal cost of allowing one more consumer is zero. If we recall from our discussion of perfect competition, markets are only efficient if the price is equal to the marginal cost. This implies that the price should be zero and thus everyone should be able to consume the good. Because everyone is not able to consume the good (recall, it is excludable), we say the good is underprovided and the market is inefficient. The inefficiency from underprovision, however, is not significant compared to the benefits of having the goods provided in the first place. The fixed costs of production have to be covered, and because markets do it by excluding nonpayers, we get the benefits of diversity, creativity, and responsiveness of markets. Markets sometimes also find ways to provide these goods without excluding nonpayers. The Peculiar Case of Advertising Radio and television broadcasts are given away in large quantities even though they are nonrival and nonexcludable (over the air). When radios were first invented, people couldn’t figure out how to make a profit by providing programming. Markets eventually discovered that the sale of advertising could make radio broadcasts profitable. Instead of selling the good directly, they sold a byproduct of the broadcasts—the ability to reach consumers—so entrepreneurs found a way to give the main product away for free but still make a profit. Teaching Tip: This might be a good time to point out that markets have a tendency to turn today’s inefficiency into tomorrow’s profit opportunity. When entrepreneurs solve public goods problems, they can profit. Sometimes government provision crowds this creative process out. Today Google indexes the Web and provides services like free e-mail to consumers by selling to advertisers the ability to reach its users. Wireless Internet access is provided all sorts of ways: it’s sold by private companies who exclude nonpayers, offered for free if the user watches advertising, provided for free in stores to attract customers, given away by people who don’t secure their network, and provided by some governments. The MRU video Club Goods provides a detailed discussion club goods and advertising along with some of the examples discussed in the text. Common Resources and the Tragedy of the Commons Goods that are nonexcludable but rival are common resources. The tendency of common resources to be overused and undermaintained is called the tragedy of the commons. The stocks of tuna in the ocean are a good example of the tragedy of the commons. Since 1960 the tuna catch has decreased by 75%. The increased demand for tuna, coupled with the decreased catch, has resulted in high prices (as much as $50,000 for a single choice fish at the Tokyo market), which gives fishermen a strong incentive to keep fishing. Many other fish are also being depleted because of the tragedy of the commons. A 2006 paper estimated that if current trends continue, all of the world’s major seafood stocks will collapse by 2048.The text points out that chickens are an even more popular food than fish but yet have no prospect of going extinct. It’s important to point out to the students that the key difference is that no one owns the fish. Throwing a fish back leaves one more in the water for someone else to catch. It’s unlikely a single fisherman will ever get the benefit of a fish he throws back. The late Frank Perdue, the chicken entrepreneur, owned his chickens, and by keeping them healthy and exercising restraint, by not “overfishing,” he could increase his flocks and reap the benefits. The key to the tragedy of the commons is that the resources are unowned, so no one has an incentive to maintain them. The textbook also mentions the slaughter of open-range buffalo in the nineteenth century, deforestation in the African Sahel region, and the hunting of elephants as other examples of the tragedy of the commons. The chapter appendix provides a numerical illustration of how quickly even slight overfishing can deplete a stock of fish. Happy Solutions to the Tragedy of the Commons Small groups can overcome the tragedy of the commons by enforcing social norms. Tribes and villages have avoided overfishing a lake or overgrazing a pasture by shunning those who use too much of the resource. Governments sometimes try command and control regulation to deal with tragedies of the commons. In 1968, British Columbia tried limiting the number of fishing boats in some fisheries that were being depleted. Fishermen responded by “capital stuffing” their boats with faster motors and more advanced electronics to help them find fish. The value of the fishing boats tripled in 10 years because of capital stuffing, and because of the better techniques, the salmon population continued to decline. Similar problems have occurred when governments restricted the number of days people could fish. In 1986, New Zealand tried an innovative approach. It offered individual transferable quotas (ITQs) similar to the pollution allowances discussed in Chapter 10. The government sets the total allowable catch and then issues a corresponding number of ITQs, which can be bought and sold. As a result, the fish stock increased dramatically and the fishermen can now catch more fish today than previously, when there were no restrictions. Teaching Tip: Another example closer to home is the government ownership of large tracts of land in the American West. These prime grazing lands are then “rented” to cattle ranchers. The grazing lands continue to be good grazing spots because the government can restrict (exclude) ranchers if they start overgrazing the area via higher rents or other regulations. This might be a good example given the relatively recent news reports of the Clive Bundy story centered on the failure of a rancher to pay for grazing on federal land. You can also point students to the history of the U.S. National Park Service. Another example of the use of a quota system can be seen in the television series Deadliest Catch, which follows fisherman in the Bering Sea. One reason the ITQ system worked well in New Zealand was that the relevant fish all live and spawn within 200 miles of New Zealand’s shore, so New Zealand has exclusive legal jurisdiction. The southern bluefin tuna migrates across the Pacific Ocean, so it will be more difficult to establish a similar property rights system for them. The MRU video The Tragedy of the Commons discusses common resources and the tragedy of the commons along with some solutions. Takeaway Students should now understand why nonexcludability and nonrivalry cause problems for public goods. They should know how the market supplies some goods that are excludable but nonrival. They should understand that a tragedy of the commons occurs because some goods are nonexcludable but rival. Commons problems are responsible for many of the environmental problems we face today. They should know that establishing new property rights that allow goods to become excludable can solve some tragedies of the commons. Appendix: The Tragedy of the Commons: How Fast? The appendix shows how to construct a spreadsheet to calculate how quickly a tragedy of the commons can lead to the extinction of a resource. The directions are self-explanatory. It can be used as an assignment for the students to work on at home, or you can construct the spreadsheet in class to illustrate it for them if you are teaching in a technology-equipped classroom. In- and Out-of-Class Activities Governments sometimes cause tragedy of the commons problems by limiting private property. Zimbabwe’s recent land reform transformed most of what was private commercial farmland into communal land. As a result, a massive devastation has occurred that is visible from outer space. The Center for Global Development Web site has satellite pictures from Google Earth (worth a thousand words) that illustrate the tragedy of the commons in Zimbabwe: http://www.cgdev.org/section/initiatives/_archive/zimbabwe/landreform/aboutphotos This page enlarges the pictures and allows you to transform them from before to after: http://www.cgdev.org/section/initiatives/_archive/zimbabwe/landreform Try showing the pictures to your students in class. The brown land is communal land, and the green land and blue water are mostly private commercial farmland. Point out how both regions have been depleted by the tragedy of the commons since land reform began. Background information on the photos and the land reform process that caused the tragedy of the commons, and related information, can be found on the same Web site: http://www.cgdev.org/section/initiatives/_archive/zimbabwe/landreform/costsofdestruction You might want to show the pictures to your students in one class period and ask them to research how land reform has affected Zimbabwe since 2000. Either have them turn in a short written assignment or just use their research as the basis for discussion in the next class. Most of the information you need to guide the discussion can be found on the Web site listed. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: Introduction Public Goods and Asteroid Defense Four Types of Goods and Private Goods vs. Public Goods A Deeper Look at Public Goods Club Goods Club Goods Common Resources and the Tragedy of the Commons The Tragedy of the Commons Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766