Woefully Imperfect Market Puzzle Asif Shakur and Shekar Shetty Salisbury University Salisbury, Maryland, USA

1. Woefully Imperfect Market PuzzleAsifShakur and ShekarShettySalisbury UniversitySalisbury, Maryland, USA

2. Motivation and Objectives • We have uncovered abundant 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

6. Empirical Data … characteristics • These are undifferentiatedproducts • Same transportation costs

7. 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

8. 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

9. Paradoxes of Imperfectly Competitive Markets • Under smooth dynamics, outputs may follow chaotic trajectories • Entry of a new firm in the market may actually decrease the total output and increase the equilibrium price • Entry of a new firm in the market may actually increase the equilibrium price • Entry of a new firm in the market may actually 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

10. 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?

11. 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

12. Monopoly, Duopoly, and Oligopoly! In order 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

13. 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)

14. 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

15. 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.

16. Cournot Oligopoly … profit maximization! /q1 [(a - q1 - q2 )( q1 ) - k q1] = 0 a - 2q1 - q2 - k = 0 So firm 1’s reaction function will be given as q1* = (a - q2 - k) / 2 Following a symmetric procedure, firm 2’s reaction function will be given as q2* = (a – q1 - k) / 2

17. 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

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

19. q2 COURNOT EQUILIBRIUM 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

20. 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)

21. 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. • This puzzling observation clearly challenges the notions of efficient markets and rational and informed buyers and sellers populating these markets.

22. Habit Persistence • We will 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, a term coined by Mehra and Prescott (1985) is an analogous puzzle, and has been reported previously for the stock market

23. Deep Habits • 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

24. Utility Function for Habit Persistence • Ravn(2006) explores the concept of “Deep Habits” which are the offshoots of Behavioral Science • Let us specify the utility function without habit persistence as ∫[t]U(c[t]) where  is the subjective discount factor, c is the consumption in a very small time period t, U is the utility function and the integration is performed from 0 to . Then the utility function with habit persistence is hypothesized to be ∫[t]U(c[t] -  c[t-1]) where the parameter  denotes the intensity of habit persistence.

25. “Bounded Rationality” & Habit Persistence • It seems to us that that the resolution of our woefully imperfect market puzzle lies in the domain of behavioral science and habit persistence • At the heart of the rational and efficient market hypothesis is a fallacious assumption that market participants will seek out the lowest price

26. Four Ways to Spend Money! • Milton Friedman made an astute observation about the four ways people spend money • 1. You can spend your own money on yourself • 2. You can spend your own money on somebody else. Then you are more concerned about the cost and less concerned about the content of the Birthday present! • 3. You can spend somebody else’s money on yourself (Government = 10%) • 4. You can spend somebody else’s money on somebody else(Government … not concerned about how much it is and what I get = 40% of national income!!!)

27. Woefully Irresponsible Spending Habits • The popularly held Weltanschauung that markets are generally efficient and populated by rational individuals making informed choices was found to be woefully inadequate • Individuals employed by state and federal institutions do not exhibit a proclivity for seeking out the most competitive bids even under the unlikely assumption of the non-existence of venal and other ulterior motives • The size of this market is approximately 50% of the national income!!!