13.5 Conclusion: Lessons from the model

At the beginning of this chapter, we saw that markups have been rising in the United States. Firms can use a number of strategies, such as advertising, product differentiation, and reducing the number of competitors, to make demand less elastic.

We also saw that exchanges between buyers and firms are beneficial, but greater market power, higher prices, and lower output levels mean that consumer surplus shrinks and fewer buyers have access to the product. In the case of luxury water bottles, this might not be a concern, but it becomes a bigger concern when we think about housing. In his book Evicted: Poverty and Profit in the American City, Matthew Desmond documents the difficulty that low-income families face in securing affordable housing and provides detailed accounts of families that face eviction for non-payment of rent. As we saw above, some buyers cannot pay the price of rent and some who might be able to pay for it don’t get a house because some rental companies do not provide enough rental houses. Families that can or are willing to pay the rent charged by corporate landlords may have little money left over from their incomes to pay for food and medical expenses. Families whose income is devoted almost entirely to housing are at risk of eviction if they get behind on their rent due to a health or employment setback. What would happen if, instead of charging $2,000 a month, Step Right In charged a rent closer to its marginal costs? Who would be better off? Who would be worse off?

Skill and learning objectives

  1. reading an analytical graph
  2. understanding why some firms have more market power than others
  3. understanding how buyers respond to changes in price
  4. understanding the strategies that firms use to create less elastic demand
  5. calculating the elasticity of demand
  6. understanding the relationship between elasticity, revenue, and profits
  7. applying market power and the benefits of exchange to the rental housing market
  8. applying the individual and societal interests principle to the firm and buyer
  9. applying the interdependence and opportunity cost and trade-offs principles
  10. illustrating the benefits of exchange on a graph

Concepts to be learned

  1. trade-offs and opportunity costs
  2. price elasticity of demand
  3. market power
  4. markups
  5. producer surplus
  6. consumer surplus
  7. product differentiation
  8. bargaining power
  9. inelastic demand
  10. elastic demand

Seeing the Principles in Action

Principle Example Everyday economics
Interdependence principle Economic outcomes depend on strategic choices people make in different parts of the economy. The decisions firms make are influenced by several other players, such as buyers, workers, other producers, and the government. We saw that firms use advertising, product differentiation, and reducing the number of competitors to increase market power and reduce the price elasticity of demand. However, their success in reducing the price elasticity of demand and increasing their market power also depends on what other firms do, how buyers respond, and on any regulations that the government imposes. If you ran your own business and decided to spend more money on advertising so that buyers would see that your product is different from the other products on the market, would this guarantee that demand for your product would become less elastic or buyers would become less price-sensitive? What if all your competitors also increased the money they spend on advertising? How would this change things?
Doing the best you can principle People make choices that will result in the best outcome for them given what they anticipate others will do in response—like Step Right In doing the best it can by setting the single rent that maximizes its profit or Aqua doing the best it can to spend more on advertising to distinguish its water bottles so that buyers prefer to buy their water bottles over their competitors. Firms aren’t the only ones doing the best they can. Buyers do too. When companies advertise heavily or introduce new features to distinguish their products, how do you respond? For example, when smartphone makers flood the market with ads about camera quality, or food delivery apps raise prices or add extra service fees, or when streaming platforms each claim exclusive content, or when sportswear brands release limited-edition college merchandise, what do you do? How do you do the best you can?
Rules of the game principle The rules of the game—institutions—govern what people can and cannot do, such as how the rental housing market works. We saw that Step Right In decides how many rental houses to rent out and sets a single price. Individual renters then decide how many houses to rent based on the price. What would happen if a city found that firms such as Step Right In were charging too much for rent and decided to place a limit on how much landlords could rent their homes for? Who would benefit? Who would lose?
Trade-offs and opportunity costs principle People evaluate what they do in comparison to their outside option or next best alternative, which captures the opportunity cost of one action compared to another. For example, if a firm invests heavily in an advertising campaign to promote its brand or highlight unique product features, it may succeed in making buyers more loyal and less price-sensitive. However, the resources spent on advertising could have been used for other valuable activities, such as expanding production capacity or adopting new technology. Firms must weigh these trade-offs carefully when deciding how much to strengthen their market power. If you owned your own business and wanted to spend more on advertising, what else could you do with that money? What would you be giving up?
Principle of gains from cooperation and conflict of interest Cooperation can lead to greater benefits for everyone, but also to competition and conflict over the benefits. Cooperation can lead to buyers and sellers benefiting, but also to conflict over what prices products should be sold at. Step Right In determined the rental price for its homes by setting MR = MC, but as the price of rental homes increases, consumer surplus falls. As the market power of firms rises, what are the implications for buyers? What will happen to consumer surplus as market power increases? Is it only firms and buyers that might be in conflict over the benefits? Does the government play a role?
Principle of individual and societal interests When people do the best they can, they may make choices that do not lead to the best outcomes for everyone or for the environment. For example, we also saw that exchanges between buyers and firms are beneficial, but greater market power, higher prices, and lower output levels mean that consumer surplus shrinks and fewer buyers have access to the product. In the case of luxury water bottles, this might not be a concern, but it becomes a bigger concern when we think about housing. What are some of the challenges that low-income families face in securing affordable housing? What happens to these families if they are not able to pay the price that landlords set?

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