Transcript Session 9 Imperfect Competition

Session 9 Monopoly, Competition, Oligopoly
Chapter 10 and 11 in the text
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Monopolistic Competition Example
Many similar
products, with
little price
difference.
Advertising seeks
to create a niche
image for each,
with the goal of
persuading the
customer to buy
their item.
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Which one do you select? Is it because
of price, quality, image, subliminal
impulse, or some combination?
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Example of Domestic Cartels
The price fixing among sellers is generally illegal in the US. In
price fixing agreements firms collude to maximize profits. Price
fixing is an excellent illustration of the cartel model we will learn
about in this session. Collusion allows small firms, which would
other wise be similar to perfectly competitive firms, to enlarge
profits by acting a monopolist.
SEPTEMBER 23, 2008
Federal Prosecutors
Probe Food-Price
Collusion
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Example of Price Wars
The price war behavior -- where Vanguard is following the price
cuts of Fidelity, is an excellent illustration of the Kinked Demand
Curve model that we will learn about in this session. The price
cut war is represented by the lower inelastic portion of the
kinked demand curve. It is inelastic because initially the first
firm to drop price gets a few customers, but the other firms
quickly follow thus reducing the advantage of price cut.
Vanguard Ups Ante In
Fee Wars; Move Gives
Thousands of Fund
Investors Access To
Lowest-Cost Shares;
Follows Fidelity's Cuts
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Lecture Outline
1.0
2.0
3.0
4.0
5.0
6.0
7.0
First Slide
Monopolistic Competition Market Structure
Profit Maximization
Oligopoly Market Structure
Models of Oligopoly
Comparison with Perfect Competition
Last Slide
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2.0 Market Structure
2.1 Monopolistic Competition Market Structure
2.2 Key Characteristics:
Product Differentiation
Low Barriers to Entry
2.3 Comparison to other structures
Mon Comp
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2.1 Market Structures: Mon. Comp.
Key Characteristics Describing Market Structure
Number of suppliers
• Many or few: MC--Many
Product’s degree of uniformity
• Do firms in the market supply identical products or are
there differences across firms? MC—slight differences,
thussome control over price
The ease of entry into the market
• Can new firms enter easily or are they blocked by
natural or artificial barriers?: MC—Easy (low barriers),
thus zero profits in the long run
Control over Price
• Do firms have control over price?: MC—Some but with
in narrow limits
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2.2 Product Differentiation
Sellers differentiate their products in four
basic ways
Physical differences and qualities: For example: The
choices in laptops: weight, screen size, hard drive,
video card, chip, RAM
Location: restaurants: For example: similar Italian
menu but some nearer home, or located in a trendy
area v off a highway.
Accompanying service: For example: extended
warranties or zero percent financing, or a rebate.
Product image: For example: A basket ball with
Larry Bird’s signature v Kobe Bryant—same ball
different image
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2.3 Market Structure Matrix
# of
suppliers
Product
Entry/Exit
Standardized
Control over
Price
Perfect
Competition
Many
Yes
Very easy
None
Monopoly
One
Unique, no
close
substitutes
Blocked
Considerable
Monopsony
One buyer
Monopolistic
Competition
Many
Not much as
Relatively
much differences easy
as they want you
to think
Some, but within
narrow limits
Oligopoly
Few
Not much
Limited by
interdependence,
but considerable
with collusion
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Significant
obstacles
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3.0 Profit Maximization
3.1
3.2
3.3
3.4
3.5
Substitutes & Price Elasticity
Short Run: MC=MR
Shut Down Point: Min Pt. of AVC
Long Run: Zero Economic Profit
Comparison with Perfect Competition
Excess Capacity,
Price>MC,
Higher price,
Lowerl output
Example
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3.1 Price Elasticity of Demand
The price elasticity of
the monopolistic
competitor’s demand
depends on
(a) Demand and Marginal Revenue
The number of rival
firms that produce
similar products
The firm’s ability to
differentiate its
product from those of
its rivals
Unit elastic
$3,750
o r
r i
o
Elastic
Inelastic
0
D = Average revenue
Marginal revenue
1-carat diamonds per day
A firm’s demand curve
will be more elastic the
greater the number of
competing firms and
the less differentiated
its product
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3.2 Profit Maximization MC=MR
In the short run, a firm that can at least
cover its variable cost will increase output
as long as marginal revenue exceeds
marginal cost  profits are maximized
where marginal revenue equals marginal
cost. This occurs at point e.
The profit maximizing price for that
quantity is found on the demand curve 
point b.
Average total cost is measured as c which
is below the price.
MC
b
p
c
Profit
c
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D
e
Price minus average total cost is the
firm’s profit per unit, which, when
multiplied by the quantity is economic
profit, shown by the blue shaded
rectangle.
The monopolistic competitor, like the
monopolist, has no supply curve  there is no
curve that uniquely relates price and quantity
supplied.
ATC
MR
0
q
Quantity per period
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The monopolistic competitor is not assured
economic profit. Here the firm’s average
total cost curve lies entirely above the
demand curve  all quantities result in
losses  the firm must decide whether to
shut down temporarily.
The rule here is the same: as long as the
price covers average variable cost, the
firm should produce in the short run.
Alternatively, it should shut down if no
price covers average variable cost.
D ollars per unit
3.3 Shut Down Point
c
p
c
b
AVC
D
e
The loss-minimization solution is for the
firm to produce quantity q and charge the
price p. However, since per unit costs are c,
the firm incurs a loss shown by the red
shaded area.
MR
0
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MC
ATC
q
Quantity per period
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3.4a Long-run Equilibrium
In the long run, entry and exit will shift
each firm’s demand curve until
economic profit disappears  price
equals average total cost.
ATC
Dollars per unit
This long-run outcome occurs
where the marginal revenue curve
intersects the marginal cost curve
at point a  equilibrium q, and the
average total cost curve is tangent
to the demand curve at point b 
no economic profit.
In the case of short-run losses, some
firms will leave the industry  the
demand curve shifts to the right and
become less elastic until the loss
disappears and remaining firms earn
just a normal profit.
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MC
p
b
a
D
MR
0
q Quantity per period
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3.4b Long Run Equilibrium
Short Run Positive
Economic Profits
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Long Run Zero
Economic Profits
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3.5a Monopolistic Comp. V Perfect Competition:
P>MC
(a) Perfect Competition)
(b) Monopolistic Competition
ATC
p
d=
Marginal
revenue=
Average
revenue
Dollarsperunit
Dollarsper unit
MC
MC
ATC
p'
MR
0
q Quantity per period
0
q'
D=
Average
revenue
Quantity per period
Here we are assuming that the two firms have identical cost curves. In each case, the
marginal cost curve intersects the marginal revenue curve at the quantity where the
average total cost curve is tangent to the firm’s demand curve.
The point of tangency between d, MC and ATC in perfect competition implies that the firm
is producing at the lowest possible average cost in the long run.
In monopolistic competition, the price and average cost, identified as p’ in the right panel,
exceed the price and average cost under perfect competition, identified as p in the left panel.
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3.5b Example: The Cachet Single Malt Scotch
“Single malt" is malt whiskey sourced from a single distillery. Single
malts take at least 10 years to mature and are distilled using centuriesold techniques and are made from malted barley.
Blended scotches, about 95% of Scotch whisky brands -- including
leaders such as Johnnie Walker and Chivas include malts from more
than one distillery and some are a mixture of malted barley and grain .
In the past few years,. global sales pf single malt scotch grew by 37%
from 1992 to 2002, according to Impact Databank, compared with a 1%
contraction in sales of Scotch whisky as a whole.
How did they do it? By creating “cachet”
The scotch industry has come a long way in shaking off the
slippers-and-fireside image of your grandfather's whiskey Today
distillers pitch high-end scotch, or "single malts," as a hip drink
with origins as exclusive as a fine vintage wine. Sales of single
malts have taken off in recent years with affluent baby boomers
and increasingly sophisticated 30-somethings seeking new status
symbols.
The industry investing heavily in educating consumers about the
differences in whiskey brands from different regions. Single malts
from the island of Islay, for instance, taste smoky and briny
because a lot of peat is used in the process; distillers near the
River Spey, on the other hand, use little or no peat, producing a
scotch with a sweeter taste..
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Outline: MC
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3.5c Example: The Cachet Single Malt
Scotch
An economic analysis of the sales growth would include:
Change in tastes and preferences -- An increase in demand for single malt,
a decrease in demand for blended scotch
Slope of the Demand Curve: customers may be willing to pay a slightly
higher price for single malt than blended scotch becomes of the “cachet”
status.
Thus, the demand curve for the single malt scotch may become downward
sloping and producers will then be able to pick a price and output, whereas
the demand curve for blended scotch may remain horizontal and those
producers will have to accept the market price and only worry about
choosing the output to produce.
Adapted from: Scotch on the Rocks? 'Single Malt' DiversifiesDeborah Ball. Wall Street
Journal. (Eastern edition). New York, N.Y.: Dec 30, 2003
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4.0 Oligopoly Market Structure
4.1 Key Characteristics
4.2 Barriers to Entry
Economies of Scale
Large Minimum Plant Size
Brand Names
4.3 Matrix
Oligopoly
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4.1 Market Structures: Oligopoly
Key Characteristics Describing Market Structure
Number of suppliers
• Many or few: O—Few, thus control over price, but each
must consider the effect of its own actions on
competitors’ behavior  the firms in an oligopoly are
interdependent
Product’s degree of uniformity
• Do firms in the market supply identical products or are
there differences across firms? O--slight differences
The ease of entry into the market
• Can new firms enter easily or are they blocked by
natural or artificial barriers?: O—Difficult (high
barriers), thus positive economic profits in the long run
Buyer information
• Do buyers have full information of prices and product
attributes?: O--No
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4.2a Economies of Scale as a Barrier to Entry
Here we have a long-run
average cost curve for a
typical firm in the industry.
If autos sell for a price less
than ca, a potential entrant
can expect to lose money.
This tends to discourage
entry into the industry.
Dollars per unit
If a new entrant sells
only S cars, the average
cost per unit, ca, far
exceeds the average cost,
cb, of a manufacturer
that sells enough cars to
reach the minimum
efficiency scale, M.
a
ca
b
cb
0
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S
M
Long-run
average
cost
Autos per year
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4.2b Barriers to Entry: High Advertising Costs
Established Brand Names:
High start up cost for advertising a new
product enough to compete with
established brands may also require
enormous outlays
Oligopolists often compete with existing
rivals and try to block new entry by
offering a variety of models and
products
Firms often spend billions trying to
differentiate their products
Some of these expenditures have the
beneficial effects of providing valuable
information to consumers and offering them
a wide variety of products
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4.3 Market Structure Matrix
# of
suppliers
Product
Entry/Exit
Standardized
Control over
Price
Perfect
Competition
Many
Yes
Very easy
None
Monopoly
One
Unique, no
close
substitutes
Blocked
Considerable
Monopsony
One buyer
Monopolistic
Competition
Many
Not much as
Relatively
much differences easy
as they want you
to think
Some, but within
narrow limits
Oligopoly
Few
Not much
Limited by
interdependence,
but considerable
with collusion
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Significant
obstacles
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5.0 Models of Oligopoly
5.1 Cartels
5.2 Price Leadership
5.3 Kinked demand curve
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5.1a Cartel
Formal collusion and cartels are illegal
in the United States; other countries
are more tolerant and some even
promote cartels  OPEC
The next slide provides us with an
illustration of the impact of firms
colluding and forming a cartel
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5.1b Cartel Model
The first task of the cartel is to determine
its marginal cost of production. Since the
cartel acts as a monopoly operating many
plants, the marginal cost curve is the
horizontal sum of the marginal cost curves
of all firms in the cartel .
Profit maximization occurs where the
cartel’s marginal cost curve intersects the
market’s marginal revenue curve. This
intersection yields price p, industry output
Q, and marginal cost of production c.
MC
p
c
Dollars per unit
The market demand curve is shown as D.
The two key issues are:
•what price will maximize the cartel’s profit
•how will production be allocated among
participating firms?
0
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D
MR
Q
Quantity per period
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5.1c Cartel Model
To maximize cartel profit, output must be
allocated so that the marginal cost for the
final unit produced by each firm is identical
Assuming two firms
with identical costs,
output and profit are
determined from the
intersection of
industry MR and MC
 each firm charges
the industry Price,
and sells ½ the
industry output.
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5.1d Cheating
Perhaps the biggest
obstacle to keeping
the cartel running
smoothly is the
powerful temptation
to cheat on the
agreement
By offering a price slightly below the
established price, a firm can usually
increase its sales and economic profit
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5.1e Cheating
However, as
more cheat the
outcome
approaches
that of perfect
competition
With increases in  market price is
forced down until Price = min ATC, as in
perfect competition
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5.2 Leadership Model
An informal, or tacit, type of collusion
occurs in industries that contain price
leaders who set the price for the rest of
the industry
A dominant firm or a few firms establish
the market price, and other firms in the
industry follow that lead, thereby
avoiding price competition
Price leader also initiates price changes
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5.3a Kinked Demand Curve Model
A type of Price Leadership Model
In the kinked demand curve model, each
oligopolistic firm believes that
if it raises its price all its competitors will not follow
suit.
if it lowers its price all its competitors will follow suit.
These assumptions imply that:
the firm’s demand curve is elastic above the current
price
the firm’s demand curve is inelastic below that price.
the firm’s demand curve is kinked at the current price,
P
Prices increase only when all firms raise them at
the same time
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5.3b Kinked Demand Curve Model
the firm’s demand
curve is elastic above
the current price
the firm’s demand
curve is inelastic
below that price.
the firm’s demand
curve is kinked at the
current price, P
•The kink in the demand curve means that the MR curve is discontinuous
immediately below the kink (as indicated by the vertical dotted segment of
the MR curve).
•Kink discourages competitors from changing prices
•Thus, fluctuations in MC that remain within the discontinuous portion of the
MR curve do not cause changes in either the firm’s price or quantity produced .
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5.3c Diaper War: Example of Kinked Demand Curve
the firm’s demand
curve is elastic
above the current
price (Huggies)
the firm’s demand
curve is inelastic
below that price.
(Pampers)
•In the summer of 2003 Kimberly Clark (producer of Huggies) covertly raised the price of its
diaper 5% by reducing the number of diapers in each package and reducing the package price
by a few cents.
•Procter & Gamble (producer of Pampers) responded by keeping the number of diapers per
pack constant and reducing its package price by the same amount .
•Huggies market share fell and Pampers’ share rose
•Source: WSJ 9/5/03, In Lean Times Big Companies Make A Grab for Market Share, By Sarah
Ellison
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6.0 Comparison of Oligopoly & Perfect Competition
Higher price, lower output, positive economic
profits
Price is usually higher under oligopoly
With fewer competitors after the merger, remaining
firms would become more interdependent  they
will try to coordinate pricing policies  if they
engage in some sort of implicit or explicit collusion,
industry output would be lower and price would be
higher than under perfect competition
Higher profits under oligopoly
If there are barriers to entry into the oligopoly,
profits will be higher than under perfect competition
in the long run
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Mon Comp
Oligopoly
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