Price leadership Model

     This model is a very interesting one. It explains some phenomena that are happening in oligopolistic type markets. So what does it means? Price leadership is an implicit (invisible) agreement among oligopolists by which they can coordinate prices without involving in price collusion based on secret meeting or formal agreements. This kind of method requires the “dominant firm”  (largest or most efficient one) to initiate price changes, so that all other firms more or less will try to follow this leader.  In many industries cement, fertilizers, cigarettes, cars and diverse machineries industries practiced this price leadership.
Tactics
   Price leadership in industries suggests that the price leader may use some of the following tactics:

  Price changes (infrequent)
   Since the price change may create the risk that the rivals won’t follow it, price regulations should be made only infrequently. Price leader shouldn’t respond to daily small increases in costs and demand.  Price should be modified just in the case when costs and demand have changed greatly, for example the price of row materials or wages of workers increased rapidly, or government excised higher taxes.
Communications
   Price leader sometimes communicates higher costs other oligopolistic firms by means of speeches of major executives or press. By publicizing the need to raise the price, price leader seeks other rivals to inform and to agree about price modifications.

Limit Pricing
   Price leader may not always choose the price that maximizes the profits in short-run for the industry, because it wants to block the entry to this industry of new firms. If economies of scale of existing firms are the major barrier, then new firms can pass this obstacle if the existing firms, including price leader, set a high-price for the goods and services they produce. So, new small firms may survive only if the industry sets a very high price. To block the entry of new firms to this oligopolistic market system, this price leader may keep the price bellow short-run maximizing level. This strategy of blocking entry from the new firms is called limit pricing.
Price wars
   Sometime price leadership in oligopolistic market system may end up at least temporarily or may result in price wars.  Most price wars sometimes run their course. When the firms realize that low prices are reducing their revenues dramatically, they may “offer” price leadership to other industry’ leading firms. That firms starts to rise prices and other businesses are willing to follow.

Pure Monopoly

   Pure monopoly happens when one firm is the single supplier of a product for which there are not substitutes. Some of the main characteristics of pure monopoly are:

• Single Seller– A pure monopoly is an industry in which a sole producer is the single supplier of a specific good or service in this market model.
• No Close Substitutes– A pure monopoly’s product is unique and there aren’t any close substitutes for it, so that consumer has to choose to buy or not to buy the product.
• Price-maker– The pure monopolist controls the quantity supplied of good and service, so that it controls the price.  This kind of firm or industry is called price-maker, unlike pure competitors which are price-taker, because they can’t control the price, since quantity produce by them is very small relative to total quantity output. The pure monopolist confronts downward-sloping curve.  So it can change the product’s price by changing the quantity of good that it produces. The monopolist can use this advantage to maximize its profits.
• Blocked entry– A pure monopolist doesn’t have any competitors because there are some barriers that keep competitors away from entering the industry. These barriers may be technological, economical or some other types, but the fact remains that no other firms may enter in our pure monopoly market.

 There are very rare examples of pure monopoly, but there are examples of some less pure forms of it. In many countries many government-owned or government regulated public utilities (gas, water, electricity) may be monopolies. Also, some professional sport teams are thought to be monopolies, because they are suppliers of unique service in large geographic areas. Examples may serve some major football matches like between Real Madrid and Barcelona in Spain, which serve as representative of large cities in Spain.  In some small towns airline service or train-transport may be pure monopolies if they are represented only by one firm in these regions. Also, in some very small areas banks, pharmacies or theaters may be examples of pure monopolies.

Increased Global Competition

Free International trade has brought a harsh competition among producers from different countries. Imports have an important effect on different industries from any country. Also many firms from, let’s say, Japan have become very wealthy and well-known on international market like: Nintendo, Sony, Honda, Panasonic, Mitsubishi. However, there are a lot of firms that can’t compete, because their international competitors make better quality products or price of their goods are relatively lower, or even both these qualities may be present.

So is this competition among firms from the entire planet good or bad? Even if domestic producers may get hurt and a lot of people should find new jobs, foreign competition clearly benefits consumers and society in general. Imports break down monopoly of existing firms, and decrease the price of goods and services. Foreign competition forces domestic producers to improve their production quality and productive efficiency. However many domestic firms may compete successfully in the global market system.

What about Firms which aren’t able to compete? The truth is that they should go out of business. Economic losses mean that the scarce resources aren’t used efficiently. Alternative uses of them may be more profitable and improve the output of the whole country.

Government and Trade

People and whole society benefits from specialization and international exchange, but why sometimes governments try to restrict the free flow of imports and encourage exports? What types of world trade barriers exist and why are they applied?

There are four methods by which government can restrict free flow of goods among its country and other nations:

• Protective tariffs– are some taxes designated to protect domestic producers of goods and services from competition with foreign firms and producers. They cause a rise in the price of imported goods so that buyers will tend to purchase more domestic goods.
• Import quotas– are limits on the quantities or total value of an item that may be imported in a period of time. If quota if “filled” that good or resource can’t be anymore imported. Import quotas are more effective than tariffs, because with tariffs that items can continue to be imported in large countries, but with quotas all imports are prohibited once quota is filled.
• Export subsidies-represent government payments to domestic producers of some goods or resources. By offering this money, production costs are reduced, so these firms can lower prices of their products, so that they may sell more goods in world market.
• Non-tariff barriers (also non-quota barriers)-include burdensome requirements, unreasonable standards related to product’s quality. Some nations require importers of foreign goods to have some type of license and then government restrict number of licenses issued. Some countries may use these inspects to examine if goods aren’t harmful for people’s health, other use them to impede imports.

Why government would impede free trade when it’s beneficial for a nation? Why would it increase quantity and value of exported goods and decrease value and quantity of imported ones?

There is a misunderstanding that greatest benefit from international trade is greater domestic employment in export sector. It’s commonly thought that exports are “good” because they increase employment, but imports are bad because they deprive people from their jobs. Actually the true benefit of free trade is that a nation can get a higher output of goods obtained after international specialization and exchange. A nation can fully employ its labor force and resources with or without international trade. However, international trade enables the society to use its resources in a way that increase the total output and well-being of society.

A nation doesn’t need international trade to operate on PPC. That’s why a non-trading society can have all labor force employed. But, with international trade a nation can reach a point that’s upper than PPC. The gains from trade are “extra-output” –they are production obtained with less cost than if it was produced home.

Political Consideration

While a nation whole gains from trade, it may harm some particular domestic industries or groups of people. These who benefit from import protection are few in number but with enormous authority. The overall costs of quotas and tariffs exceed the benefits. It’s known that if government spends 1 million on protecting an industry, the latter one doesn’t pay back even half of this amount. Since the costs are spread over large number of people the cost related to each demander of that good is quite small. Since public doesn’t know about this stuff it can be won by this political groups by apparent plausibility (“Decrease imports, and so prevent unemployment”) or with some patriotic slogans (“Buy only Australian”).

 Cost for the entire Nation

Tariff and quotas benefit domestic producers but they harm the domestic consumers, who shall pay higher that world prices for that goods and services. They also harm the domestic firms that use protected resources in their production of goods. With less competition from foreign countries, domestic firms may be less efficient at implementing cost-saving methods and improving the method of production.

International Linkage

There are several economic flows that link one country’s economy to other national economies and these are:

• Resource flows or Capital and labor flows– One country can establish its capital in a foreign countries. Labor force also moves from one country to another. Each year millions of people move to other countries.
• Trade flows or Goods and service flows- To improve their economic situation countries import and export goods and services.
• Financial Flows- Money is transferred between countries because of several reasons: paying for imports, paying interest on debt, providing aid for some countries.
• Informational and technology flow- Countries transmit each other information about their prices of goods and services, investment opportunities. Countries use one others technology in order to have the most efficient output.

Let’s take for example Latvian economy.

THE CIRCULAR FLOW MODEL with Government

In the following figure we have integrated government. What have changed?

Flows (5) through (8) illustrate that government make purchases in resource and product market. Flows (5) and (6) represent buying of products, but (7) and (8) represent buying of resource by government.

Government shall have money to pay its members, teachers, police, inspectors, bus drivers, doctors, fire fighters etc. Government might buy land to build a new school, expand a hospital.

Government offers public goods and services to both households and businesses, as shown by (9) and (10). Government gets paid for these goods and services by collecting taxes by flows (11) and (12).  Flow (11) represents different subsidies to airlines, doctors which are then paid back to government, because most of them are low-interest loans, taxes, or public facilities provided at prices below their real price. Flow (12) includes taxes collected by government from households and different kind of social insurance benefits offered by government. The structure of taxes and transfer payments affects income distribution. In flow (12), taxes drawn from “rich” households, combined with a system of transfer payments to low-income households, reduces income inequality.

Flows (5) through (8) imply that government takes away resources from private sector or use,  and directs them to constructing public goods. This resource reallocation is required for producing public goods and services.

“Invisible hand” in economics

“Invisible Hand” in Economics
Firms and resource suppliers want to increase their revenue and seek their own self-interest, so that they are like guided by an “invisible hand”. In this environment businesses are the least costly producers of goods and services, because this is their interest is to get higher revenues. In the same way, using few resources to produce goods is in interest of demanders.
Businesses want to make higher profits; resource suppliers want higher rewards, so both of them manipulate resources usage order to get best allocation of them for the entire society.
Competition of self-interests unintentionally furthers fulfilling of society’s needs. The “invisible hand” maximizes profits of firms and also it maximizes the output and wish-fulfillment.
Most important characteristics of market system are:

• Efficiency– Market system produce only that goods and services that are most demanded by society. It forces using the most efficient techniques of production, so that in increases the total output.
• Incentives– Market system requires hard-work and innovation. So ones who are working a lot, get better results and efficiency, so that they also get higher revenues. Implementation of new efficient production techniques also offers higher revenues.
• Freedom-Firms and industries can enter or leave the industry when they want. Entrepreneurs and labour force are free to seek their own self-interest, so that they may get better results or big losses.

Key Terms:
Invisible Hand-The ten­dency of firms and resource suppliers seeking to further their own self-interests in com­petitive markets to also promote the interests of society as a whole.