The most liked areas of Micro Economics in my Post graduate studies-Market Structure-Tha Panagora Blog

 

e201: Principles of Microeconomics

Lecture 10 - Market Structure

Justin R. Cress

University of Kentucky

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

What does market structure mean?

After studying the optimizaiton process of firms and consumers, we understand the underpinnings of the market system

The diversity of firms and consumers (in the form if differing technologies, preferences, et cetera) implies a variety of different interactions between consumers and firms

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

What does market structure mean?

After studying the optimizaiton process of firms and consumers, we understand the underpinnings of the market system

The diversity of firms and consumers (in the form if differing technologies, preferences, et cetera) implies a variety of different interactions between consumers and firms

Then, we can imagine a number of market structures displaying different emergent characteristics

By this, we mean different sorts of firms and consumers may interact in different ways

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The Competitive Environment

Firms do not operate in a vacuum, they are influenced by the competitive environment in which they operate, meaning the conditions the firm is exposed to in the markets for their factors of production and final goods. This competitive environment will determine

Productive decisions, via the cost of productive resources Marketing and price strategies, determined by the market for final goods

Understanding how firms actually act requires understanding the competitive environment in which they operate

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Perfect Competition: Defined

Perfect competition exists in an industry where

Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Established firms have no advantages over new ones. Sellers and buyers are well informed about prices.

Although few markets in the real world meet all of these requirements, understanding perfect competition informs our understanding of market dynamics

Also, we’ll be able to understand divergences from perfect competition via contrast

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Perfect Competition: Conditions

Many firms sell identical products to many buyers.

Numerous buyers and sellers create price competition, more sellers enter the market to underbid and new buyers outbid buyers allowing market mechanisms (shortages and surpluses) to function

Goods must be homogenous, simply, the same, in order for a market to be competitive. Homogenous goods include many commodities, wheat, gold, et cetera

There are no restrictions to entry into the industry.

Government imposes no restrictions on producers which hinder market entry (including licensing requirements, regulatory compliance costs )

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Perfect Competition: Conditions

Established firms have no advantages over new ones.

Firms are unable to constrain competition via brand loyalty

Factors of production are easily accessible by new comers

The minimum efficient scale is small enough to allow room for competitors

Sellers and buyers are well informed about prices.

Perfect competition requires informed bids from buyers and sellers, without which markets are distorted in one direction

This condition applies to present prices and future prices, accurate prices require symmetrical predictions.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Profit & Revenue

Given perfect competition, firms are price takers, firms cannot influence the price of a good or service.

Demand for each firm’s output is perfectly elastic. Thus, if one firm increases its price, buyers shift away At lower prices, firms are foregoing profit

Total revenue = P × Q, price times quantity sold

So, as quantity sold increases, total revenue increases.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Profit & Revenue

And, because the firm is a price taker, goods are homogenous, thus the demand for any one firms good is perfectly elastic

In perfect competition, marginal revenue is constant.

Notice, market demand is not perfectly elastic, and may even be inelastic, depending upon the good

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The Objective

A perfectly competitive firm faces two constraints

A market constraint summarized by the market price and the firm’s revenue curves.

A technology constraint summarized by firm’s product curves and cost curves.

The goal of the firm is to make maximum economic profit, given the constraints it faces.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Choice

Short Run Decision Making

Whether to produce or to shut down temporarily.

If the decision is to produce, what quantity to produce.

Remember, we’re assuming the firm can increase production by increasing labor

Long Run Decision Making

Whether to increase or decrease its plant size.

Whether to stay in the industry or leave it.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The Criteria

Maximizing Economic Profit

Recall, economic profit is total revenue (TR) - total cost (TC)

Many firms use lots of information to estimate the TR and TC curves,

However, smaller firms find obtaining information difficult and costly

Do firms maximize economic profit, even if they don’t know precisely how to do it?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Profit Maximization

At low output levels, firms incur economic loss, unable to cover fixed costs

Above that level, the firm makes economic profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Profit Maximization

At high output levels, the firm again incurs an economic loss

now the firm faces steeply rising costs because of diminishing returns.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Marginal Analysis

If M R > M C, economic profit increases if output increases.

If M R < M C, economic profit decreases if output increases.

If M R = M C, economic profit decreases if output changes in either direction, so economic profit is maximized.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Short Run Outcomes

Break Even

In the short run, firms may break even, incurring neither economic profit nor economic loss

This occurs when ATC = MC = MR

At this level, the firm is still profitable because it is still making its normal profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Short Run Outcomes

If ATC is lower than Marginal Revenue and Marginal Cost, the firm experiences an economic profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Profit maximization

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Short Run Outcomes

If ATC exceeds MR and MC, the firm experiences an economic loss

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-run Supply Curve

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Short-run Supply Curve

A perfectly competitive firm’s short run supply curve shows how the firm’s profit-maximizing output varies as the market price varies.

Firms produce output where MR = MC,

Since MR = Price, the firm’s supply curve is determined by its marginal cost curve

However, there is a price below which a firm will produce nothing

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-run Supply Curve

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Temporary Shutdown

If price is lower than the lowest average variable cost, the firm would lose money on each unit of output

the firm shuts down temporarily to confine losses only to fixed costs

The firm must incur fixed costs either way, but by shutting down temporarily, the firm can avoid paying variable costs

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-run Supply Curve

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Temporary Shutdown

At the point T, the firm is indifferent between operating and shutting down

At T, MR = 17 and MC = 17

Any price below 17, the firm must shut down temporarily

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-run Supply Curve

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Firm Supply Curve

Comparing changing marginal revenue curves (different prices) allow us to back out the firm supply curve

At all points where MR = MC we can determine how much a firm is willing to produce, and how much supply the firm brings to market

If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC

If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-Run Equilibrium

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Industry Supply

The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

Imagine any number of firms which face similar marginal cost curves, the industry supply curve is the summation of all of the quantities supplied by these firms at a given price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-Run Equilibrium

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Market Equilibrium

Short-run industry supply and industry demand determine the market price and output.

Each firm takes the market price as a given, and produces the amount where MR = MC

Justin R. Cress

e201: Principles of Microeconomics

Overview

Short-Run Equilibrium

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Market Equilibrium

Increasing market price, changes in demand influence the marginal revenue faced by firms

Changing the point at which MR = MC (the intersection of supply and demand)

So, the amount of demand influences market supply via the price mechanism

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Short run outcomes, long run incentives

In the short run, firms may garner economic profit or loss, or could break even

Each of these outcomes in the short run influences long run decision making for firms in any given industry If firms in an industry are experiencing an economic profit, MR exceeds MC, thus, the industry will increase supply

New firms will enter the market, existing firms will expand output

On the contrary, if firms in the industry are experiencing an economic loss, MR is lower MC, the industry will decrease supply

Firms will leave the market, firms which stay may decrease output

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Industry Entry

Attracted by the allure of big bucks, economic profit encourages firms to enter an industry

If capital can garner economic profit in an industry, that is profit above and beyond its next best alternative

New firms entering the market cause the supply curve to shift right, decreasing prices and increasing quantity

Because price is decreasing, the MR of existing firms falls, decreasing their economic profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Industry Exit

If firms in an industry experience an economic loss, capital can be more efficiently used in other industries

Thus, firms exit the industry, shifting the supply curve left

because price in creases, the MR of remaining firms increases, decreasing their economic losses

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Plant Size

Recall, one of the ways firms mimize costs is by optimizing their productive capacity

If current productive capacity exceeds the minimum of the long run average cost curve, the firm can increase its profit by increasing productive capacity

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Plant Size

However, if each firm faces the same competitive environment, they will all increase their productive capacity.

In the long run, this increase in supply industry wide will decrease price

Decreasing marginal revenue, and evaporating economic profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Adjustment

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Long Run Industry Equilibrium

In the long run then,

Economic profit is zero, preventing entry and exit Long run average cost is at its minimum, making the cost-minimzing plant size static

Thus, economic profit is fleeting and temporary in a competitive environment

In most industries a stable long run equilibrium is rare,

Technological advances often cause cost decreases

Changing tastes and preferences shift demand for certain products

industries are constantly adjusting to changing long run forecasts

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Permanent shifts in demand

So, imagine a permanent change in preferences which decreases demand for a good       People recognize cigarettes       aren’t super cool, and       probably cause heart       problems       Tape players lose their luster       compared to CDs

This decrease in demand leads to a decrease in price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Permanent shifts in demand

Now consider the impact this decrease in demand has on firms in that industry,

The decrease in marginal revenue erodes profit, causing an economic loss

Firms are forced to scale back (downsize) their production

some firms exit the market all together

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Permanent shifts in demand

This response from firms results in a decrease in industry supply

Notice, in the long run, the price rises again to the original equilibrium, but at a lower quantity

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Permanent shifts in demand

Each remaining firm is then able to increase its production back to the maximizing rule MR = MC

Thus, for remaining firms, quantity produced does not change in the long run

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Industrial Economies of Scale

Thus, changes in demand only result in a change in the number of firms in an industry

the long run equilibrium price of any given industry is static, relative to demand

However, there are factors which influence the long run price of a good via changing the long run supply of a good in any given market

External economies are factors beyond the control of an individual firm that lower the firms costs as the industry output increases.

External diseconomies are factors beyond the control of a firm that raise the firms costs as industry output increases.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Constant cost

If the cost structure of an industry is unaffected by scale, chagnes in quantity do not change price

Changes in demand influence firm exit & entry which change the number of firms, but not the equilibrium price

LS is horozontal

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Increasing cost

Some industries face increasing costs as output increases

Industries which rely on finite resources which do not have close substitutes

Airlines, real estate, et cetera

in these cases, increases in demand lead to increases in price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Long Run Dynamics

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Decreasing cost

Other industries benefit from economies of scale which decrease average costs as prices increase

Supply lines for raw materials become entrenched

The labor force is tailored to increase specializaiton

in these cases, expanding industry output decreases prices

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopoly

Market Power

Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. Perfectly competitive firms have no market power, attempts to influence price are undercut by

a large number of competitors offering perfectly substitutable goods low barriers to entry attracting new capital, eroding any economic profit

Market power provides firms the ability to increase the price by restricting supply, such that M R > M C

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopoly

Def: Monopoly

A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms. Characteristics:

A single firm dominates the supply of a good The good can not easily be substituted away from The firm is protected from competition by steep barriers to entry

The monopolist is the consolodation of all market power into a single firm

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Lack of Close Substitutes

Necessities

Some goods lack substitutes because they are necessary goods

e.g. utilities

Innovation

Some goods lack substitues because they haven’t been developed, innovative goods meet a very specific need

Hence, many firms closely guard trade secrets, such as the code behind Microsoft’s Windows

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Barriers to Entry

Legal

Legal barriers to entry create legal monopolies (when the government sees fit to grant them...)

Public charters / franchises grant de-jure monopolies for the supply of a good (the postal service) Licensing requirements restrict entry into the production of a good. Think doctors, lawyers, liquor sales Patenting provides a legal monopoly on the production of a given technology Intellectual property rights are intended to provide economic profit, in order to incentivize innovation

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Natural Monopolies

Legal

Natural Monopolies exist when one firm supplies the entire market at a lower cost than two and/or many firms could Due to economies of scale

Infrastructure intensive industries, multiple electricity providers in a sinlge market would require twice or thrice as many electrical lines Excludability, if one firm can capture the means of supply, providing competing products is higher cost consider roads, if there’s one cheap path from city a to city b, the first firm to build a road would have a natural monopoly

Does the USPS have a natural monopoly?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Natural Monopolies

The long run average cost curve is always trending downward

as Q increases, costs continue to fall

If a firm produces 4 million KWh, costs are 5 cents per

Divide that amongst two firms (equally) and each firm is producing 2 million, at a cost of 10 cents

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Single-price monopoly

A Single-price monoply is a firm that must sell its product at the same price to all customers

Since the firm controls price by controling supply, as the firm attempts to sell more of its product the price in the market falls

But, it falls for all customers, so selling an extra unit of output decreases the revenue gained from all units

Thus, if price decreases marginal revenue falls faster

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Marginal Revenue

Consider

A firm selling 2 units at price 16

Attempts to sell a third unit, but must reduce the price to 14

The sale of this unit increases revenue by 14 (price) but,

we must adjust the total revenue by the $ 4 lost on the other two units

14 - 4 = 10 MR

Thus, at all prices, M R < P

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Single-price monopoly

Recall our definition of elasticity, basically, some measure of responsivness to price

For a monopolist, elasticity matters – decreases in price will only be profitable if the increase in quantity sold at the new price outweighs the decrease in marginal revenue

So, decreaes in price have to increase quantity demanded, which only occurs in the elastic portion of the demand curve

A single-price monopoly never produces an output at which demand is inelastic.

If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Total Revenue

Consider

Notice the intersection of marginal revenue and the X axis,

At all points left of the intersection (Q < 5) demand is elastic. Decreases in price cause increases in demand large enough to offset falling marginal revenue

All points to the right (Q > 5) demand is not responsive enough to price decreases, thus, the monopolist begins to decrease total revenue by increasing production

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Total Revenue

Consider

Total revenue increases as quantity increases, until demand is unit elastic

At the point where changes in price cause proportional changes in demand, MR = 0

At this point, total revenue is maximized.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Profit Maximization

Monopolists face constraints similar to perfectly competitive firms, cost structures and functions are fundamentally the same

The monopoly selects the profit-maximizing quantity in the same manner as a competitive firm, where MR = MC.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Single-Price Monopoly Pricing

Profit Maximization

So, the monopolist uses its market power to set price at the highest level which allows it to sell the profit maximizing quantity

Unlike firms in perfectly competitive markets, then, monopolists are able to command an economic profit, made durable by barriers to entry

Justin R. Cress

e201: Principles of Microeconomics

Overview

Monopoly Vs. Competition

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Price and Quantity

Remember, for perfect competition, MR is determined by the intersection of Demand and MC

However, for the monopolist, the profit maximizing quantity is lower, at a higher price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Monopoly Vs. Competition

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Efficiency

Consider the effects of monopoly pricing on social welfare,

By restricting quantity, the monopolist creates a dead weight loss

The monopolist decreases both consumer and producer surplus

Justin R. Cress

e201: Principles of Microeconomics

Overview

Monopoly Vs. Competition

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Efficiency

The monopolist does this in order to expand its own surplus

The economic profit garnered by the monopolist reallocates (or extracts) from consumers to the monopolist

Justin R. Cress

e201: Principles of Microeconomics

Overview

Monopoly Vs. Competition

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Rent

Unfortunately for the monopolist, being on top of an industry comes with a cost, creating & maintaining monopoly is expensive

Buying a monopoly, or gaining monopoly status is expensive. Purchasing resources, rights, et cetera requires search costs, and the economic profit associated with monoply increases the cost of these things The right to run a taxi cab, or own a liquor store, et cetera Creating a monopoly, or intentionally restricting competition is also expensive. Purchasing politicians, restricting competition from abroad, et cetera require the allocation of resources

This type of behavior is called rent seeking, in that the monopolist is trying to extract economic rent

Justin R. Cress

e201: Principles of Microeconomics

Overview

Price Discrimination

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Price Discrimination

Defined:

Price discrimination is selling a good or service at a number of different prices

price discrimination occurs due to differences in willingness to pay not differences in cost, so not all price differences are price discrimination

Price discrimination occurs when

Identify differing willingness to pay among classes of consumers Business vs Casual travelers

Sell a product without a secondary market (cannot be resold)

Justin R. Cress

e201: Principles of Microeconomics

Overview

Price Discrimination

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Efficiency

The monopolist has an incentive to charge buyers the highest price each buyer is willing to pay, the goal is to extract consumer surplus

By pricing each unit at the demand curve, the monopolist no longer has lower marginal revenue as price decreases

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Defined:

What is Monopolistic Competition?

Monopolistic competition is a market with the following characteristics:

A large number of firms.

Each firm produces a differentiated product.

Firms compete on product quality, price, and marketing.

Firms are free to enter and exit the industry.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Defined:

Large Number of Firms

The presence of a large number of firms in the market implies:

Each firm has only a small market share and therefore has limited market power to influence the price of its product.

Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firms actions directly affect the actions of other firms.

Collusion, or conspiring to fix prices, is impossible.

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Defined:

Product Differentiation

Each firm makes a product that is slightly different from the products of competing firms

This differentiation is an attempt to create a psuedo-monopoly power over a segment of the market

Are Nike and Adidas perfect substiutes?

What about Old Navy and Abercrombie?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Defined:

Product Differentiation and Competition

Product differentiation enables firms to compete in three areas: quality, price, and marketing.

Loosley defined, quality can be understood to include design, reliability, and/or service

Each firm faces a downward sloping demand curve, price increases cause decreases in demand ( The magnitude of which depends upon elasticity) hence, firms must compete on price

Firms differentiate products in quality, but most importantly have to convince consumers that their product is superior

By spending on advertising, packaging et cetera, firms decrease the elasticity of their demand curve, hopefully making consumers think competing products are poor substitutes

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Defined:

Entry and Exit

There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.

Successful production, pricing and marketing strategies are emulated

new firms enter profitable markets

So, in the long run, economic profit is zero

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Short Run Decision Making

In the short run, the marginal revenue curve mirrors a monopolist, as each firm is a monopolist over its product

The profit maximizing output is still MR = MC

Price is still the intersection of supply and the demand curve

Thus, for some firms, the profit maximizing output may garner an economic profit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Short Run Decision Making

Not all firms, though, will earn an economic profit

Many firms will capture an insufficient share of the market to create a profit

In this case, ATC will be above the demand curve

At this level, the firm is losing money, profit maximization means loss minimization

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

But, in the long run ...

Economic profit attracts new firms, more capital, et cetera

As more firms enter the market, they attract market share, they take customers from existing firms

This means that each firm faces a decreasing demand curve for its own production

Firm entry will continue until price = ATC, where economic profit = 0

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Long Run

Excess Capacity

Monopolistic competition differs from perfect competition because firms will always produce below the efficient scale

Unlike perfectly competitive firms, monopolistically competitive firms have downward sloping demand curves

as price falls, marginal revenue falls faster

So, expanding to the efficient scale would decrease price, and marginal revenue

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Long Run

Because marginal revenue is lower than price, firms operate with a mark-up

Buyers will pay a higher price in the long run

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Long Run Efficiency

So, consumers pay higher prices in monopolistically competitive markets

Is this outcome efficient?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Monopolistic Competition: Pricing

Long Run Efficiency

So, consumers pay higher prices in monopolistically competitive markets

Is this outcome efficient?

It depends. Remember, firms achieve their mark-up via product differentiation

So, monopolistically competitive markets increase choice and product variety, which people value Given a choice between homogeneity at a low price and heterogeneity at a high price, which should society choose?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Market Strategy

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Creating an economic profit

Product Development

Maintaining an economic profit requires constantly improving a product

Innovation decreases substitutability, increasing a firm’s market share

Incentives for innovative products increase social benefit

Justin R. Cress

e201: Principles of Microeconomics

Overview

Market Strategy

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Creating an economic profit

Advertising

The goal for each firm is to decrease responsiveness to price, to create an inelastic demand curve for its product relative to the market demand curve

Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs.

The advertising expenditure shifts the average total cost curve upward

Justin R. Cress

e201: Principles of Microeconomics

Overview

Market Strategy

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Creating an economic profit

Advertising

If all firms advertise, equillibrium quantity increases, allowing more firms to enter the market

Also, by increasing information, if all firms are advertising, the demand curve becomes more elastic

Thus, advertising increases overall costs and decreases price, which decreases the mark-up

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Defined

Oligopoly is a market structure defined by,

Natural or legal barriers that prevent entry of new firms A small number of firms compete

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Defined

Oligopoly is a market structure defined by,

Natural or legal barriers that prevent entry of new firms A small number of firms compete

Oligopolies may be

Natural, due to natural barriers to entry -or- Legal, legal barriers to entry

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Why Should We Care?

Interdependence

The actions of each firm in the market simultaneously influences the nature of the market, and the strategy of other firms

This introduces a level of strategic interaction which makes oligopoly complex, and unique

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Why Should We Care?

Interdependence

The actions of each firm in the market simultaneously influences the nature of the market, and the strategy of other firms

This introduces a level of strategic interaction which makes oligopoly complex, and unique

Collusion

A small number of firms makes collusion possible – cooperation among firms designed to increase price

When firms cooperate to create a monopoly price they form a cartel

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Defined

Market Concentration

The defining characteristic of Oligopoly is that these markets have a small number of firms

but, what is ’small’ ?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Defined

Market Concentration

The defining characteristic of Oligopoly is that these markets have a small number of firms

but, what is ’small’ ?

Market concentration is measured via the Herfindahl-Hirschman Index (HHI) (see p. 208 in parkin)

The HHI is computed by summing the squre of market share for the top 50 firms in a market (or all firms, if fewer than 50)

So, consider a competitive market with 100 firms, each with 1% of the market share, 12 + 12 + ... 11 = 50 (pretty low)

Compute the HHI for a monopolist: 1002 = 10, 000

For a market with two firms, dividing the market equally: 502 + 502 = 5, 000

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Long Run

Market Concentration

Generally, an HHI above 1000 is considered an oligopoly

Notice, many oligopoly markets are dominated by a few firms, specifically the four largest firms (shown in red)

Justin R. Cress

e201: Principles of Microeconomics

Overview

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Oligopoly: Defined

Natural Oligopoly

A natural barrier to entry, defined by the nature of the ATC curve

In this case, the market is a natural duopoly, two firms are able to supply the entire market most efficiently

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Kinked Demand Curve

From the perspective of one firm in an oligopoly:

The firm cannot charge more than other firms, because the other firms will undercut their prices and steal market share

The firm could decrease prices, but knows they could not increase market share by doing this, because other firms will mimick their discounting

From the perspective of the manager, the demand curve is not continuous, it breaks at the current market price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Kinked Demand Curve

What it looks like:

The firm perceives a break at the current market price

A decrease in price drastically reduces marginal revenue due to lost market share

keep in mind, the demand curve displayed here is the curve the firm faces

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Kinked Demand Curve

Compare

Compare the actual marginal revenue curve to the hypothetical extension of the kinked marginal revenue curve

The break in marginal revenue results from the broken demand curve

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Kinked Demand Curve

Compare

In this (exceptional) case, an increase in marginal cost does not necessarily increase price

If the increase in marginal cost results in a marginal cost below demand, none of the firms are able to increase price

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Dominant Firm Oligopoly

The kinked demand curve model occurs when a small number of firms have similar cost structures, and thus, divide market share equally

However, this is not always the case.

Imagine, instead, that market concentration is high because it is dominated by a large firm, with many firms supplying small portions of the market Consider,

Gas stations Video rentals Wal-Mart (in many markets)

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Dominant Firm Oligopoly

The Firm

The dominant firm acts like a monopolist, and prices accordingly

If the dominant firm charges a single price (there’s no discrimination), it faces a marginal revenue curve similar to a monopolist

Justin R. Cress

e201: Principles of Microeconomics

Overview

Traditional Oligopoly Models

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Dominant Firm Oligopoly

The Market

In doing so, the dominant firm sets the market price

Other firms in the market are unable to price higher than the dominant firm

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Economic Games

The defining characteristic of oligopoly is strategic interaction

Firms must position themselves in a way that capitalizes on market conditions, which means constantly jockeying for market share

This requires adapting behavior to competitior behavior, actual and expected

This strategic interaction is an economic game, and it is studied by game theory, the study of strategic behavior, or, behavior taking into account the behavior of other actors

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Two people are suspected of a crime for which the police have limited evidence

The police know they are going to have to exact a confession from one or both of the prisoners in order to convict

The prisoners are placed in seperate rooms, and are not allowed to speak to one another

What happens?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Strategy

Strategy are the possible actions each player could take. In the case of the prisoner’s dillema each prisoner could:

Confess

Deny

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

The Payoff Matrix

Given a finite number of players and strategies, the possible payoffs, results, are known

The payoff matrix describes the results each strategy for each plaer, given the other player’s strategy

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

The Payoff Matrix

Summarizing the prisoner’s dillema payoff matrix:

if both confess, they each recieve three years

if neither confess they recieve 2 years

if one denies, and one confesses, one recieves the lightest treatment while the other gets the harsh treatment

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Equilibrium

Each player in the game choses his strategy assuming the other player will follow their dominant strategy

In the case of the prisoner’s dillema,

Art can confess or deny,

if art confesses, Bob’s best strategy is to confess, and they both get three years

if art denies, Bob’s best strategy is still to confess, to avoid the 10 year sentence

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

But this outcome is sub-optimal, if both prisoners were to deny the accustions they would both get 2 years

However, because the two prisoners are unable to collude, the equilibrium is sub-optimal

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Games in Oligopoly

Firms in oligopoly have an incentive to collude, in order to extract and divide monopoly profits Although explicit collusion is illegal, it still occurs

implicitly / informally secretly

If the two firms agree to restrict output to the single firm monoply level, price will increase and so will profit

Could such collusion be maintained?

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Games in Oligopoly

What happens if someone cheats?

If one firm abandons the agreement and increases production, quantity supplied increases

The price falls, and the cheating firm sells more output (and gains market share) at the expense of the complying firm

The complying firm, then, experiences an economic loss, because they’re producing on a non-profitable portion of the ATC curve

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

The prisoner’s dillema

Equilibrium

So, here’s the payoff matrix A complying / comply equilibrium is impossible. If one firm considers complying, they’ll recognize that the other firm will cheat

expecting the other firm to cheat makes each firm cheat

Justin R. Cress

e201: Principles of Microeconomics

Overview

Game Theory & Oligopoly

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Games in Oligopoly

Here’s the point:

In the long run, without an enforcement mechanism, cartels break down

When co-operation and overt collusion are costly or prohibited, the pursuit of self interest leaves both players worse off

In prisoner’s dillema type situations, utility maximizing behavior

often harms social welfare