Lecture 7

Output and Price in Market Structures : 

1 Output and Price in Market Structures Firms output and pricing decisions depend on the current market structure in which the firm is operating i.e. “How much control over price we have.” whether the firm is competing in perfect competition, monopoly, monopolistic competition or oligopoly situation

Competition vs. Monopoly : 

2 Competition vs. Monopoly One useful way in which issues of competition and monopoly can be investigated is called the Structure, Conduct and Performance Model

Competition vs. Monopoly continued : 

3 Competition vs. Monopoly continued

Perfect Competition : 

4 Perfect Competition Firms are price takers they face a perfectly elastic demand curve market price changes only if demand or supply changes Given the market price, what is the appropriate level of production? Since market price will settle at the point where only normal profits are earned  output will settle where p = MC = AC = MR AC P* Output MC D=MR=AR q*

Industry Demand Increase and the Long-Run Industry Supply Curve : 

5 Industry Demand Increase and the Long-Run Industry Supply Curve S1 S2 D1 D2 Long-run S P Q a) Constant industry costs a b c

Industry Demand Increase and The Long-Run Industry Supply Curve continued : 

6 Industry Demand Increase and The Long-Run Industry Supply Curve continued S1 S2 D1 D2 Long-run S P Q b) Increasing industry costs: external diseconomies of scale a b c

Industry Demand Increase and The Long-Run Industry Supply Curve continued : 

7 Industry Demand Increase and The Long-Run Industry Supply Curve continued S1 S2 D1 D2 Long-run S P Q c) Decreasing industry costs: external economies of scale a b c

Why is perfect competition so rare in the real world - if it even exists at all? : 

8 Why is perfect competition so rare in the real world - if it even exists at all? One important reason for this has to do with economies of scale: Perfect competition requires there to be many firms (non having a large market share). Firms must therefore be small under perfect competition - too small for economies of scale. D LAC1 LAC2 LAC3 Output

BUT : 

9 BUT once a firm expands sufficiently to achieve economies of scale, it will usually gain market power it will be able to undercut the prices of smaller firms and so drive them out of business  perfect competition will be destroyed therefore, perfect competition could only exist in an industry, if there were no (or virtually no) economies of scale

Perfect Competition and Public Interest : 

10 Perfect Competition and Public Interest Possible pluses: the fact that p = mc leads to efficient resource allocation competition between firms will spur to efficiency will encourage the development of new technology there is no point in advertising!? in long-run equilibrium: LRAC at its minimum, so company producing at the least-cost output consumers gain from low prices quick response to changed consumer tastes

Perfect Competition and Public Interest continued : 

11 Perfect Competition and Public Interest continued Pitfalls of perfect competition: firms may be too small to afford R & D! produces only undifferentiated products how about the taste of variety?!

Monopoly : 

12 Monopoly Why do monopolies exist? Barriers to entry Control of scares resources or input for instance diamonds (De Beers) Economies of scale natural monopolies Technological superiority but not a guarantee if network externalities exist Government-created barriers Alko, patents, copyrights

Slide 13: 

13 Demand function facing a monopoly is the market demand for the product Monopoly firm’s ability to set its market price is limited by the demand curve (demand elasticity) downward sloping demand and MR-curves But supernormal profits may be earned even in the long run depends on how contestable the market is P1 Q1 MC ATC D = AR MR

Monopoly and Public Interest : 

14 Monopoly and Public Interest Disadvantages of monopoly: higher prices and lower output than under perfect competition possibility of higher cost curves due to lack of competition loss of efficiency unequal distribution of income monopoly profits

Monopoly and Public Interest continued : 

15 Monopoly and Public Interest continued Advantages of monopoly: economies of scale possibility of lower cost curves due to more research and development and more investment competition for corporate control innovation and new products

Monopolistic Competition : 

16 Monopolistic Competition Firms have some degree of market power but demand curve typically flatter than in monopoly since there is more competition Output-pricing decision is defined by MR = MC as always the absence of entry barriers means that super normal profits are competed away... firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MC Output D MR AC MC F P = AC1 Q1

Limitations of Monopolistic Competition Model : 

17 Limitations of Monopolistic Competition Model Information may be imperfect; firms will not enter an industry if they are unaware of the supernormal profits currently being made Firms are likely to be different from each other not only in the product they produce or the service they offer, but also in their size and in their cost structure. Also the entry may not be completely unrestricted The model concentrates on price-output decisions; in practice the profit-maximizing firm under monopolistic competition will also need to decide the exact variety of products to produce and how much to spend on advertising

Limitations of Monopolistic Competition Model continued : 

18 Limitations of Monopolistic Competition Model continued Compared to perfect competition: less will be sold at a higher price firms will not be producing at the least-cost point (i.e. min AC) = firms have excess capacity On the other hand it is often argued that these wastes are insignificant (since highly elastic demand curves and some scale economies gained) and perhaps well compensated to the consumer by the great variety of products to choose from

Oligopoly : 

19 Oligopoly A market dominated by a few large firms—imperfect competition How concentrated is an industry? consider the market share of four largest firms Some highly concentrated industries (in the world or in a country): mobile phones, paper industry, cigarettes, batteries, automobiles, banking, breweries, airplane industry, oil industry, etc.

Oligopoly continued : 

20 Oligopoly continued The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors Oligopoly may be characterized by collusion or by non-co-operation

Collusion and Cartels : 

21 Collusion and Cartels COLLUSION an explicit or implicit agreement between existing firms to avoid or limit competition with one another CARTEL is a situation in which formal agreements between firms are legally permitted e.g. OPEC

Collusion is difficult if: : 

22 Collusion is difficult if: There are many firms in the industry The product is not standardized Demand and cost conditions are changing rapidly There are no barriers to entry Firms have surplus capacity

Tacit Collusion: Price Leadership : 

23 Tacit Collusion: Price Leadership Dominant firm price leadership Dominant firm sets the price for the industry, but lets followers sell all they want at that price. Dominant firm will provide rest of the market demand Followers, like in perfect competition, accept the price as given  their joint supply is the sum of their MC curves (like in perfect competition)

The leader’s D-curve can be seen as that portion of market demand unfilled by the other firms, i.e. the difference between the market demand at each price and supply by followers at each price : 

24 The leader’s D-curve can be seen as that portion of market demand unfilled by the other firms, i.e. the difference between the market demand at each price and supply by followers at each price Sall other firms Dmarket Dleader P1 P2 Q a b

Kinked demand for a firm under oligopoly : 

25 Kinked demand for a firm under oligopoly Q O P1 Q1 D demand in response to a price reduction is likely to be relatively inelastic The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move, so …but for a price increase rivals are less likely to react, so demand may be relatively elastic above P1 Demand curve kinked at current price: Tacit collusion outcome

Stable price under conditions of a kinked demand curve : 

26 Stable price under conditions of a kinked demand curve Q O P1 Q1 D = AR a MR When Q < Q1, the MR curve corresponds to the shallow part of the AR curve

Stable price under conditions of a kinked demand curve continued : 

27 Stable price under conditions of a kinked demand curve continued Q O P1 Q1 MR a b D = AR At Q > Q1, the MR curve will correspond to the steep part of the AR curve Note the cap between points a and b

Stable price under conditions of a kinked demand curve : 

28 Stable price under conditions of a kinked demand curve Q O P1 Q1 MR a b D = AR Price will tend to be stable, even in the face of an increase in marginal cost: if MC lies anywhere between a and b the profit-maximizing price and output will be P1 and Q1

Stable price under conditions of a kinked demand curve continued : 

29 Stable price under conditions of a kinked demand curve continued Q O P1 Q1 MC2 MC1 MR a b D = AR

Non-Collusive Oligopoly: Game Theory : 

30 Non-Collusive Oligopoly: Game Theory A method of analyzing strategic behavior behavior of a firm will depend on how it thinks its rivals will react to its policies Invented by John von Neuman (1937) and extended with Oskar Morgenstern (1944) John Nash: Nash equilibrium (1949-1950) a dominant strategy equilibrium

Prisoners’ Dilemma – an one-shot game : 

31 Prisoners’ Dilemma – an one-shot game A two-person, non-zero-sum, non-cooperative game with dominant strategy Dilemma: To confess or not to confess the crime committed If confesses, can get a shorter prison time, but will the partner in crime confess or not? Best joint outcome if both would deny If only one talks he gets a minimum sentence and the other the maximum If both confess moderate outcome for both

Prisoners’ Dilemma: Payoff Matrix : 

32 Prisoners’ Dilemma: Payoff Matrix John’s strategies Confess Deny Confess Deny Bob’s strategies 3 years 3 years 2 years 2 years 10 years 10 years 1 year 1 year

A Strategic Game Example : 

33 A Strategic Game Example Soap Wars Procter & Gamble and Unilever are engaged in a long running “soap war”, each company trying to capture a larger proportion of the detergent market P&G has just started a huge marketing campaign to launch their new Ariel tablets and trying to convince the public that their product is better than the Persil tablets introduced by Unilever a year ago

UK Detergent Market 1995-1998 : 

34 UK Detergent Market 1995-1998 Ariel Percil

Slide 35: 

35 The Two companies are constantly looking for strategies to raise market share and profits One way to do that is product development Tablets introduced Let’s consider this as a strategic game Tit-for-tat repeated game

Soap Wars: A Strategic Game : 

36 Soap Wars: A Strategic Game Unilever’s strategies No tablet Launch tablet No tablet Launch tablet Procter&Gamble’s stragegies +8% +8% +12% +12% -4% -4% +4% +4%

Slide 37: 

37 Duopoly Payoff Matrix: The equilibrium is a Nash equilibrium, both firms cheat Company A’s strategies Cheat Comply Company B’s strategies £0 Cheat Comply £0 -£1.0m -£1.0m +£4.5m +£4.5m +£2m +£2m

Oligopoly and Public Interest : 

38 Oligopoly and Public Interest If oligopolists act collusively and jointly maximize industry profits, they will in effect be acting together like a monopoly and then the disadvantages to society would be the same as under monopoly Further more, in two respects, oligopoly may be more disadvantageous than monopoly: Oligopolists are likely to engage in much more extensive advertising than a monopolist Depending on the size of individual oligopolists, there may be less scope for economies of scale to decrease the effects of market power

Advantages of oligopoly to society over other market structures: : 

39 Advantages of oligopoly to society over other market structures: Can use part of the supernormal profits for R&D (incentive to do so higher than in monopoly) Non-price competition through product differentiation may result in greater choice for the consumers

Non-Price Competition : 

40 Non-Price Competition Product Development aims to develop products which will sell well and which are different from rivals' products leads to less elastic and potentially high demand Advertising to increase demand and to make demand curve less elastic Advertising and product development not only increase a firm's demand and hence revenue, they also involve increased costs so how much to spend in order to maximize profit?

The Changing Nature of Market Structure : 

41 The Changing Nature of Market Structure the market types that actually exist in business situations are not always clear-cut or stable the type of market in which a firm competes may change over the life of the products being sold Prof. Michael Porter has introduced a useful way to incorporate the possibility of change in market structure into the analysis of business decision making the model of "five competitive forces"

The Porter Competitive Framework : 

42 The Porter Competitive Framework Intra-Market Rivalry Potential Entrants Customers Substitute Markets Suppliers Threat of new entrants Bargaining power of buyers Bargaining power of suppliers Threat of substitute products or services