Woefully Imperfect Market Puzzle Asif Shakur , Shekar Shetty , Arvi Arunachalam Salisbury University, MD

1. Woefully Imperfect Market PuzzleAsifShakur,ShekarShetty, ArviArunachalamSalisbury University, MD

2. Motivation and Objectives • Interesting evidence of woefully imperfect markets • Semiconductor Integrated Circuit (IC) market is one example • Used Textbook Market is another example • Conventional economic models were found inadequate in these markets • Our objectives are to bridge the gap between conventional models and our model

3. A Familiar Conventional Model • Hotelling’s Model is one of the earliest known models • It can be invoked to explain away trivial instances of market imperfection • Price of a soda can is known to be exorbitant at airports compared to supermarkets • Customers are willing to pay for convenience and a cold can of soda!

4. Empirical Data Semiconductor Market Operational Amplifier (741) Price /100 chips Vendor A Vendor B Vendor C Vendor D $18 $22 $49 $95  Semiconductor Market Transistor (TIP 31C) Price /100 Vendor A Vendor B Vendor C Vendor D $29.30 $159 $69 $30

5. Empirical Data … continued! • Semiconductor Market Memory (2114 RAM) • Price / chip • Vendor A Vendor B Vendor C Vendor D • $13.75 $1.69 $1.29 $2.58 • Textbook Market (used) Electric Circuit Theory (Johnson) •  Price /single copy • Vendor A Vendor B Vendor C Vendor D • $10 $30 $55 $100 • These are undifferentiatedproducts • Same transportation costs

6. Synopsis of Market Models • Monopoly Oligopoly Monopolistic Competition Competition • Maximize Profit MR = MC MR = MC MR = MC p = MR = MC • Price price setter price setter price setter price taker • Market Power p > MC p > MC p > MC p = MC • Entry No Entry Limited Entry Free Entry Free Entry

7. Conventional Model Characteristics • A monopoly does not care what the rival firm does … there are NO RIVALS! • A competitive firm does not care what the rivals do because it does not matter! • An oligopolistic firm seriously considers how its actions affect its rivals and how the actions of its rivals will affect it. • A monopolistically competitive firm seriously considers how its actions affect its rivals and how the actions of its rivals will affect it. • These strategies (GAMES) lead to NASH EQUILIBRIA

8. Paradoxes of Imperfectly Competitive Markets • Entry of a new firm in the market may • actually decrease the total output and increase the equilibrium price • increase the profit of the incumbent firm • A merger of two or more firms can decrease the profits of all merged firms • The entry of a new firm in the market might decrease social welfare • Even if the entry of a firm would raise social welfare, this entry might not be profitable

9. Justification for a New Model • Hotelling’s model is not viable because there is no product differentiation in our semiconductor and textbook markets • Similarly, Chamberlin/Robinson monopolistic competition is not viable because there is no product differentiation in our semiconductor and textbook markets • Is Cournot’s model a viable candidate?

10. Cournot Model • In the Cournot Model of non-cooperative oligopoly, the firms choose their output levels without colluding (no cartels!) but they make conjectures about the reactions of their rivals in response to their actions • To set the stage for Cournot’s oligopoly, let us review the structure of a monopoly • We posit a linear inverse demand function • p(q) = a – bq • The revenue is • R = pq • R = aq – bq2

11. Monopoly … continued! • The marginal revenue can be obtained as a partial derivative of R with respect to the output q. • MR = R/q • MR = a – 2bq • In terms of elasticity ɛ • MR = p (1-1/ɛ)

12. Monopoly … pricing! The cost curve C(q) = kq where k is a constant The marginal cost MC = C/q = k A monopoly sells where p = MC = MR so we have k = a – 2bq Hence the output and price for a monopoly are qm = (a-k)/2b pm = (a+k)/2

13. Cournot Oligopoly … pricing! Without loss of generality, we posit a tractable linear demand curve q = a- p Total demand = q1 + q2 for two firms In the Cournot model, each firm conjectures that the other firm will act in a way to keep the quantity that it sells fixed. We will calculate the reaction function of each firm to the quantity supplied by the other.

14. Cournot Equilibrium A Cournot Equilibrium (C.E.), as in a Nash game (e.g. prisoner’s dilemma) occurs when neither firm wants to change and is content with its output and profit. Imposing this criterion on q1* and q2* yields C.E. = (a – k) / 3

15. COURNOT REACTION FUNCTION q2 Isoprofit curves q1 Straight line is REACTION FUNCTION for firm 1 reacting to firm 2

16. COURNOT EQUILIBRIUM q2 R12 C.E. R21 q1 R12 Reaction function of firm 1 reacting to firm 2 R21 Reaction function of firm 2 reacting to firm 1

17. Cournot Equilibrium … conclusion At the Cournot equilibrium we have the following price / output equations: q1 = q2 = (a – k) / 3 Q = 2 (a – k) / 3 p = (a + 2k) / 3 Conclusion: Cournot equilibrium price is only marginally higher than the perfectly competitive price and only marginally lower than the monopoly price In general, for n firms in a Cournot oligopoly qn = (a – k) / (n + 1)

18. Woefully Imperfect! • The plethora of market models cannot explain the existence of glaring and woefully widespread price differences that we have found in the semiconductor and other markets. • Clearly challenges the notions of efficient markets and rational and informed buyers and sellers populating these markets. • Resolution of our woefully imperfect market puzzle lies in the domain of behavioral science and habit persistence

19. Is Behavioral the answer? • Attempt to explain this puzzle by invoking behavioral and habit persistence hypotheses that appear to override the efficient markets and the rational and informed participant hypotheses • The equity premium puzzle, Mehra and Prescott (1985) • Ravn (2006) explores the concept of “Deep Habits” which are the offshoots of Behavioral Science • Habit persistence is a preference specification that yields a utility function that depends on the quasi-difference of consumption

20. Survey study • At the heart of the rational and efficient market hypothesis is a fallacious assumption that market participants will seek out the lowest price • Survey will study the purchasing decisions of different types of customers (students, administrators, faculty) • Distinguishing the decisions by moral hazard conditions • Willingness to pay with and without constraints