LECTURE 5 MARKET STRUCTURE

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Weeks 7 & 8 Competition, market structures and business decisions

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What is the market Structure Competition, market structures and business decisions How does competition affect business decisions in different market structures? Perfect competition; monopoly; oligopoly; monopolistic competition Competitive strategies. Measurement of market structures Market strategies in different market structures. Non-price competition. Multinational companies. Vertical and horizontal coordination. Learning objectives

What is the market structure? : 

Competition, market structures and business decisions Market structures What is the market structure? The competitive environment in the market for any product is the market structure faced by the firm Is measured in terms of the number of the actual buyers and sellers plus potential entrants Barriers to entry and exit Capital requirements Price vs Non-price competition Etc Potential entrants pose a sufficiently credible threat of entry to affect price/output decisions of incumbents

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Competition, market structures and business decisions Market structures What is the market structure? Perfect competition Oligopoly The firm in competitive markets Monopoly Non-perfect competition Monopolistic competition

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Competition, market structures and business decisions Market structures Perfect competition Profit maximiser Identical product Very small share of the market Price-taker Produces a homogeneous product Perfect information No barriers to entry (legal, technological, or resource) No technical progress No investment lag - Immediate implementation of production decisions) Homogeneous goals of the owners and managerial staff

The Firm Supply Curve : 

LRAC Cost and revenue per unit ($) LRMC Competition, market structures and business decisions Market structures Perfect competition The Firm Supply Curve The short-run supply curve corresponds with the portion of the marginal cost curve that lies above the average cost curve. In a perfectly competitive market, Where P<AC losses can be reduced by expanding production so long as added revenues exceed added costs

The Industry Supply Curve : 

Competition, market structures and business decisions Market structures Perfect competition The Industry Supply Curve The sum of quantities that individual firms supply at each price The sum of marginal cost curves of individual firms above their average variable cost curves

Market price determination : 

Quantity per time period (millions) Competition, market structures and business decisions Market structures Perfect competition Market price determination Negatively sloped demand curve Positively sloped supply curve

Demand Curve for a single firm : 

10 8 6 4 2 0 Price per unit ($) 50 100 150 Demand Quantity per time period (000) Competition, market structures and business decisions Market structures Perfect competition Demand Curve for a single firm Horizontal Competitive firm – price taker

Optimal price/output decision in the short run : 

Competition, market structures and business decisions Market structures Perfect competition Optimal price/output decision in the short run

Optimal price/output decision in the long run : 

Competition, market structures and business decisions Market structures Perfect competition Optimal price/output decision in the long run LRAC Cost and revenue per unit ($) Output per time period Q * LRMC P = AR = MR P

Breakeven point : 

Price, cost Output per time period MC ATC AVC 100 0 1.00 1.25 1.40 2.00 D B A Competition, market structures and business decisions Market structures Perfect competition Breakeven point per unit ($)

Basic Assumptions : 

Competition, market structures and business decisions Market structures Monopoly Basic Assumptions One firm in industry Profit-maximiser Faces market supply curve One product No close substitutes Price-maker No restrictions on resources

Price-maker’s demand curve : 

Price-maker’s demand curve Demand Quantity per time period 200 150 100 50 0 2 4 8 10 12 Price per unit ($) 6 Competition, market structures and business decisions Market structures Monopoly

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Competition, market structures and business decisions Market structures Monopoly D MR AC MC Q P, Cost Produces the quantity maximising profit (P>AC) Operates at a price above marginal revenue Makes economic profit Restricts information Imposes barriers to entry (controlling markets, inputs and/or lobbing the government)

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Competition, market structures and business decisions Solutions Problem. Perfectly competitive firm supply

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Competition, market structures and business decisions Solutions Problem. 1. Perfectly competitive firm supply A. Construct the table showing the firm’s marginal cost of production

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Competition, market structures and business decisions Solutions Problem 2. Perfectly competitive firm supply B. What is the minimum price for the firm to supply one ton of newsprint? The minimum marginal cost of newsprint is $50. So this also represents the minimum price necessary to justify supplying a single unit of output.

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Competition, market structures and business decisions Solutions Problem 2. Perfectly competitive firm supply C. How much newsprint would Mankato supply at industry price of $75 and $100? In a perfectly competitive market, P=MR. Therefore, the firm will supply output so long as price at least covers the marginal cost of production. At P=$75, Q=3 units of output can be justified since P=$75>MC=75. However production of a fourth unit can’t be warranted since P=$75<MC=$80 A P=$100, Q=6 units of output can be justified since P=$100=MC

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Competition, market structures and business decisions Solutions Problem 3 Perfectly competitive industry supply TC=250000+200Q+0.02Q2 MC=200+0.04Q A. Calculate the industry price necessary for the firm to supply 5000, 10000 and 15000 of product The marginal cost curve constitute the supply curve for firms in perfectly competitive industries. Since P=MR, the price necessary to induce supply of a given amount is found by setting P=MC Here P=MC=200+0.04Q Q=5000: P=200+0.04x5000=400 Q=10000: P=200+0.04x10000=600 Q=15000: P=200+0.04x15000=800

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Competition, market structures and business decisions Solutions Problem 3. Perfectly competitive industry supply TC=250000+200Q+0.02Q2 MC=200+0.04Q B. Calculate the quantity supplied at industry prices of $200, $500, and $1000 per ton. P=MC=200+0.04Q 0.04Q=-200+P Therefore, the firms supply curve is Q=-5000+25P P=$200: Q=-5000+25x200=0 P=$500: Q=-5000+25x500=7,500 P=$1,000: Q=-5000+25x1,000=20,000

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Competition, market structures and business decisions Solutions Problem 4. Monopoly versus Perfectly competitive equilibrium TR=15Q-0.000005Q2 MR=15-0.00001Q MC=$5, All other costs are zero A. Calculate output, price and profit at the profit maximising activity level. MR=MC 15-0.00001Q=5 0.00001Q=10 Q=1,000,000 P=TR/Q=(15Q-0.000005Q2)/Q=15-0.000005Q=Q-0.000005x1,000,000=$10 =TR-TC= PxQ-MCxQ=10x1,000,000 - 5x1,000,000=5,000,000 P=MC=AC =TR-TC=0 B. Profit at perfect competition

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Competition, market structures and business decisions Market structures In the “real life” A typical firm, if it is not a small one, is not owner-managed Separation of ownership, long-term strategic and short-run current control (shareholders, board of directors, brunch managers) implies the segregation of objectives; Natural, economic and legal barriers Diversification (non-homogenous product, more than one kind of activity) Technical progress Different criteria for different time horizons (short-run operation vs long-run planning. Price-making Price/marketing strategies Imperfect information Investment lag A real competitive firm (compare to the “ideal” one):

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Competition, market structures and business decisions Market structures Оligopoly Element of the theory relevant to this subject An oligopolistic industry is composed of a few firms selling identical or similar products in the same market Each firm carefully watches decisions of competitors and often plans anti-strategies; they either ignore each other or form cartels or a price leader appears, causing monopolistic price formation Elements of non-profit maximisation appear. A sales- revenue producers more than a profit maximiser and charges a lower price.

Neoclassical view : 

Neoclassical view Competition, market structures and business decisions Market structures Мonopolistic competition The market consists of n mono-product firms; The products are viewed by the buyers as close though not perfect substitutes for one another; Therefore, each of the sellers is a monopolist of its particular product variant with a limited degree of monopoly power. Such a monopolist is enjoying a monopoly power and making economic profit during only a short period of time from the introduction of an unique product or technology until such a technology becomes available to rivals, or until a new “more innovative” product is introduced by a rival.

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Q Short-run quantity, price and economic profit Competition, market structures and business decisions Market structures Мonopolistic competition Price Costs Quantity MR Demand MC AC Qmc Pmc

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Long-run equilibrium same costs, lower demand and excess capacity – low output high price decision Competition, market structures and business decisions Market structures Мonopolistic competition Price Costs Quantity MR1 D1 MC AC MR2 D2 Entry of new firms offering product substitutes shifts the demand and MR curves)

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Long-run equilibrium– high output low price decision (corresponds to perfect Competition) Competition, market structures and business decisions Market structures Мonopolistic competition Price Costs Quantity MR1 D1 MC AC MR2 D2 Price Costs Quantity MC AC Pmc Qmc MR D Qac Pac

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Competition, market structures and business decisions Market structures Мonopolistic competition – contemporary view Cost functions are identical across firms Non-zero marginal costs Perfect availability of the technology used in the production of all product variants the firms are characterised by different cost functions Relatively low marginal costs Each portion of cutting-edge technological information does not spill over immediately

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Competition, market structures and business decisions Market structures Мonopolistic competition – contemporary view Cutting-edge technology does not spill over immediately For the time, each firm possesses some unique product-attributable elements of otherwise common technology These unique elements make the product variants different The differences are viewed by the buyers as differences in quality characteristics We assume the simplest case: all the quality characteristics of each product can be aggregated into a scalar quality characteristic Increase quality generates increase in consumer demand. Increase in quality can be achieved by a firm only through increase in the cost of the first copy Each firm is characterised by its cost elasticity of quality

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Competition, market structures and business decisions Market structures Мonopolistic competition – contemporary view Aiming at increase in profit, High Tech firm struggles for consumer demand investing in the quality of its product. Increase in quality is associated with increase in costs. The firm sets the price to cover the costs and earn profit, depending on anticipated demand Increase in quality causes increase in quantity demanded Increase in price causes decrease in quantity demanded

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Competition, market structures and business decisions Market structures Мonopolistic competition – contemporary view To ensure economic profit, relative increase in demand, associated with increase in quality per unit of relative increase in cost should not be offset by relative decrease in demand per unit of relative increase in price; and Otherwise, the firm is not competitive.

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Competition, market structures and business decisions Competitive strategies in Imperfectly competitive markets Not all industries offer the same potential for sustained profitability; Not all firms are equally capable of exploring the profit potential that is available. An effective competitive strategy in imperfectly competitive markets must be founded on the firms competitive advantage.

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Competition, market structures and business decisions Competitive strategies in Imperfectly competitive markets A competitive advantage is a unique or rare ability to create, distribute or service valued by customers. It is a business-world analogue to what economists call comparative advantage or when one nation or region of the country is better suited to the production of one product than to the production of some other product Above-normal rate of return require a competitive advantage that cannot easily be copied In production; In distribution; or In marketing

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Competition, market structures and business decisions Competitive strategies in Imperfectly competitive markets Reasons for competitive advantage: Access to a unique resource (Exclusive) Access to a mineral deposit (Exclusive) Access to a material Efficient energy source Unique climatic condition Unique technology Unique (specially qualified or very talented) labour force; or Access to a unique market A university bookshop The rice market in Japan etc

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Competition, market structures and business decisions Non-price competition. Product differentiation Product differentiation refers to the increase in time of the number of product categories suppled and the number of items in each category Historically, a step from oligopolistic to monopolistic competition

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Competition, market structures and business decisions Non-price competition. Product differentiation A simple model of the reason for product differentiation Price Quantity Q P P* Considers constant quantity as well as non-changing AC and MC corresponding to this quantity Producing a little bit different product a firm might hope to charge a higher price

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Competition, market structures and business decisions Non-price competition. Barriers to entry Price Quantity Q P P* LAC LAC* Absolute cost advantages: Ability of established firms to produce any given level of output at lower unit costs than potential entrants Q*

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Price Quantity Q* P Economies of scale: Ability of established firms * To produce any given level of output greater than a certain level Q* at lower unit costs and * To restrict potential entrants who are not able to invest in that level of production D LAC Competition, market structures and business decisions Non-price competition. Barriers to entry

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Price Quantity Q* P* Product differentiation advantages: Variety of demand curves and common LAC. Some firms have advantage of technology or specialisation and are facing demand curves to the right of the critical one. D1 LAC D2 D2 Competition, market structures and business decisions Non-price competition. Barriers to entry

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Appear as the result of Ability to affect prices and Separation of ownership and managerial control Managers’ aim at stability and increase in salaries Stability may be achieved through the increase in the scale of operations Increase in sales (not in profit) affects manager’s remuneration Banks and retailers would prefer to deal with firms increasing the volume of sales Competition, market structures and business decisions Non-profit-maximising competition.

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D MR AC MC Q P, Cost Profit maximising decision Competition, market structures and business decisions Non-profit-maximising competition.

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D MR Q P, Cost Profit maximising decision Sales maximising decision Increasing sales, the firm is moving to the right and downward the demand curve and, therefore, decreases price, The limitation is AC curve. Some profit should be earned anyway Competition, market structures and business decisions Non-profit-maximising competition.

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D MR AC MC Q P, Cost Profit maximising decision Competition, market structures and business decisions Non-profit-maximising competition.

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Old sales maximising decision is a profit maximising decision at a new level of average cost Old profit maximising decision New profit maximising decision D MR AC MC Q P, Cost Competition, market structures and business decisions Non-profit-maximising competition.