[remy.demarest]

Hello Professor Herbener,

I just watched your lecture on “Is competition everywhere imperfect?” and I’m confused by the last point regarding Alcoa. You’re saying that if a company earns monopoly prices off of an asset outside investors will bid up the price for the asset which would raise the cost structure. But how does that actually cut into the monopoly profits?

If a company managed to own all the mines of a certain resource, they would be able to keep their production low and their prices high, giving them high profits. This will certainly attract investors that want a piece of the profits, but the monopoly owner knows that if they sell one mine they’ll suddenly be undercut by their competition fishing for the profits. In which case, whatever value they sell their mine for they’re going to lose over time, wouldn’t they?

Thank you.

[jmherbener]

Cost refers to opportunity cost, i.e., the value of the alternative foregone when taking an action. In production, an entrepreneur uses assets he owns and buys inputs from others. Both owned assets and bought inputs impose costs on the entrepreneur. This is true for any entrepreneur, not just one who owns the entire supply of a resource. Any entrepreneur who has a rising demand for his product will have a rising cost structure for his owned assets. That is how he gains a monetary reward for superior entrepreneurship. The prices of assets he owns rises.

Any competitor who purchased a mine from Alcoa would have to pay the higher price (i.e., the price that incorporates the monopoly price of output) and therefore, would not be able to stay in business by undercutting Alcoa’s price. Because Alcoa can obtain the higher price by selling the mine, the cost of retaining ownership of the mine is also higher.

Consider another example: Government price supports for corn push up prices for corn. An investor who wants to get into farming would find that the price of corn-growing land has risen to the point at which no extra profit can be earned. The competitive bidding of outside investors to obtain higher profits generates this result. (Technically, it generates a tendency toward this result. Actually, all investment is uncertain and therefore, investors with superior foresight can buy assets before their prices fully rise and so earn extra profit.) Farmers who owned land before the price supports were raised do not earn extra profit (at least not after the adjustment of the market). Instead, they earn a capital gain in the market price of their assets.

[remy.demarest]

So the simple fact that people want the land at a high price is enough to raise the cost of merely owning the land? Is it when you tally up the potential sell price of a mine versus how much you earn from the sell of the output that you see whether you are making a profit?

[jmherbener]

Cost is always related to action. So one must first identify the action a person is taking before assessing its cost.

If the action is continuing to own land that a person already has, then the cost is the current market price because selling the land is the alternative foregone if one holds onto it.

If the action is buying land by an investor with the intention of selling it later for a monetary gain, then the cost is the market price at the time of purchase.

If the action is using land an entrepreneur owns as an asset in production, then the cost is the amortized portion of the current market price of the land. The market price he paid for the land when he acquired it in the past is not relevant for his decision to use the land in production now.

An entrepreneur running a business enterprise continues to own assets and then buys inputs and uses both assets and inputs in production. So today when an entrepreneur decides to use his owned assets and acquire inputs to produce output and sell it in the future with the intention of earning profit, the appropriate costs are the current market prices of inputs and the amortized portion of the current market prices of assets. A year later, When the entrepreneur makes the next production run, the appropriate costs are the current market prices of inputs and the amortized portion of the current market prices of assets. Last year’s market price of assets is no longer relevant for this year’s production decision.

[Author]

Posts